Let common sense prevail

By Alison Thomas
Illustration: Mike Constable

With nonarm’s length contracts, business valuation must passa common sense test without losing sight of commercial realities

The impact of a nonarm’s length contract is fundamental to business valuations. When a business deals at nonarm’s length with another entity, generally the terms of a nonarm’s length contract should be adjusted or “normalized” to the terms that a notional arm’s length purchaser and vendor would negotiate, regardless of whether or not there is in fact a contract.

In The Valuation of Business Interests, Ian Campbell and Howard Johnson state: “Where nonarm’s length transactions are being consummated at noncommercial rates, appropriate earnings [and possibly asset] adjustments will be necessary. This is particularly crucial in situations where the business interest on only one side of the
noncommercial transaction is being valued [as opposed to the consolidated entity], or where the two business interests are at materially different risk. A skewing of the income to one or the other would result in erroneous value/price conclusions.”

A thorough analysis of the underlying facts, circumstances and commercial realities should always be undertaken before concluding how to appropriately normalize, or not, a nonarm’s length contract.

Usually expertise in the specific area at issue is required to support adjustment to a market rate, i.e., such as a real estate appraiser for market rents or a human resources specialist for fair compensation.

In many cases, the decision whether to adjust the contract or relationship to fair and open-market rates and terms isn’t complex. An example is a lease agreement with a related party renewable annually at a noneconomic rate. In this case, noneconomic terms would generally be ignored and replaced by a market rental rate and market terms in estimating the fair-market value of the firm since it’s assumed the notional parties to a sale of the business would negotiate to market terms.

Consider the more complex example of a 30-year legally binding contract between a parent and its wholly owned subsidiary at a rate nearly 90% below market. This was the situation considered in Corner Brook Pulp and Paper v. The Queen. This Tax Court case reminds us of the importance of assessing each case in light of its particular circumstances and without losing sight of the underlying commercial realities.

The central issue in this case was whether, in determining the fair-market value of all of the outstanding shares of a wholly owned subsidiary, the terms of a supply contract between the parent and subsidiary that is unfavourable to the subsidiary should be taken into account or ignored.

To briefly summarize the background facts of this case, Corner Brook Pulp and Paper Ltd. was in the business of manufacturing and selling newsprint. Corner Brook owned all Deer Lake Power Co. Ltd.’s shares. Deer Lake was in the business of hydroelectric generation. It sold all the electricity it produced to Corner Brook pursuant to a long-term supply contract entered into on June 30, 1955 for a period of 30 years and renewable for two additional 30-year terms at Corner Brook’s option. It had been extended in 1985 and could be extended again in 2015.

Pursuant to the terms of the contract, Deer Lake charged Corner Brook $2.80 a kilowatt a month, a price the parties seemed to accept was a commercial market rate in 1985. But, this was only 9% of the market rate on February 1, 1995, the valuation date.

On February 1, 1995 Deer Lake issued four million shares to Corner Brook at $5 a share as consideration for the extinguishing of a $20-million debt. Corner Brook and Deer Lake amalgamated in December 1998, following which Corner Brook fully utilized noncapital losses carried forward from the former Deer Lake in the first taxation year of the amalgamated corporation.

The Minister’s valuation of the Deer Lake shares was much lower than the taxpayer’s because the Minister’s was based on the pricing terms of the 1955 contract as opposed to the market-based pricing as at the valuation date. The Minister’s position was that Deer Lake’s noncapital losses had been reduced to nil (under section 80 of the Income Tax Act) since the fair-market value of the four million shares issued by Deer Lake was less than the amount of the $20-million debt, resulting in a forgiveness of debt.

The central valuation issue was whether or not the price charged under the 1955 contract should be taken into account in valuing the shares of Deer Lake, since it was conceded by the parties that, in the alternative, the fair-market value of the shares of Deer Lake would be far in excess of $20 million.

The court’s conclusion was that the terms of the nonarm’s length contract should be ignored in determining the fair-market value of the Deer Lake shares. The court agreed with the taxpayer’s position and was influenced by the following arguments:

• the “plain common sense” that Corner Brook would get rid of the contract since no buyer would purchase the shares of Deer Lake if the contract remained intact;
• the taxpayer’s rigorous demonstration that Corner Brook would be better off economically by cancelling the contract. This was true because the risk profile of an electricity generator is less than that of a pulp and paper company and, therefore, the additional value accruing to Deer Lake (and to Corner Brook in the form of a higher valuation of its shares in Deer Lake) would more than offset the lost revenues to Corner Brook from higher electricity costs, i.e., the same cash flows in Deer Lake would attract a higher multiple than in Corner Brook; and
• an engineering report that valued Deer Lake at $175 million to $195 million on the basis of commercial market electricity rates.

The important lessons to be learned from Corner Brook are:

• never ignore fundamental valuation theory. The Tax Court’s decision was, and future decisions are likely to be, premised on same. Integral to “fair-market value” are the concepts of “highest price” and “informed and prudent parties dealing at arm’s length and under no compulsion to act.” Clearly, both Corner Brook and a notional purchaser, acting rationally, would seek to maximize value accruing to each of their respective interests;
• never ignore common sense and commercial realities. In Corner Brook, the court framed its decision as a “common sense appreciation of the fact that the valuation of business assets is not a theoretical exercise. It takes place in the real world and in a commercial context. Conclusions that a valuator reaches must be tested against the touchstone of common sense;”
• there are no hard and fast rules in the treatment of nonarm’s length contracts; rather, each case must be assessed on its own merits. The Tax Court was clear in stating that its decision was not meant to suggest the terms of nonarm’s length contracts should always be ignored; and
• in particular, the reason or occasion of valuation will be very relevant in the determination of what is a “fair value.”

In light of the above, under what circumstances might a nonarm’s length contract not be normalized?

Consider a scenario where Corner Brook had entered into long-term supply contracts with its own customers such that it relied on the low price contracted by Deer Lake. The incremental lift in the market value of Deer Lake would have to be high enough to make Corner Brook at least neutral if not better off. This would involve complex tax, risk profile and other considerations unique to Corner Brook, and may well be somewhat independent of the marketplace for hydro rates. Or imagine that Corner Brook’s risk profile was less than Deer Lake’s such that the additional value that would accrue to Deer Lake from setting the contract aside would not have offset the reduction in value to Corner Brook from higher electricity rates. In these circumstances, one would need to carefully consider the appropriateness of normalizing the contract in the determination of the fair-market value of Deer Lake.

The context of the valuation is particularly crucial. If the purpose of the valuation was to determine a “fair value” of a minority interest, ignoring the terms of the contract may or may not be appropriate. Assume no pejorative behaviour by the parent and that the buyout is at the minority’s request. Imagine Deer Lake was only 90% owned by Corner Brook. Would the minority be entitled to the windfall that would arise in the normalization? At first blush one might say “no.” Further, this seems consistent with the Tax Court’s finding in Corner Brook that the valuation “takes place in the real world and in a commercial context. Conclusions that a valuator reaches must be tested against the touchstone of common sense.” Would it make a difference if the occasion of the buyout were due to oppression or an appraisal remedy? Should it? It is beyond the scope of this article, but the recent attempt by Sears Holdings to take Sears Canada private is another good example to consider.

The 90% scenario above is not inconsistent with Ford Motor Co. of Canada Ltd. v. OMERS, in which the Tax Court considered the impact of an unfavourable transfer pricing arrangement between the Canadian firm and its US parent on the valuation of the subsidiary’s shares in the context of an oppression action. Although the Ford decision was consistent with Corner Brook’s, the court in Corner Brook rightly stated its reluctance in relying too heavily on the Ford decision as the contexts were dissimilar. The principle is that common sense needs to prevail, regardless of the directional impact on the value of the subject company.

As US satirist Ambrose Bierce wrote, “There is nothing new under the sun, but there are lots of old things we don’t know” or forget. And so it is with valuation principles and the touchstones of commercial realities and common sense.

Alison Thomas, CA, CBV, is with Cole & Partners in Toronto

Technical editor: Stephen Cole, FCBV, FCA, partner, Cole & Partners