Canada: Lauria v. The Queen: The Intersection Of Valuation And Misrepresentation

The Tax Court of Canada ("TCC") recently had the opportunity to address the interaction between a dispute about valuation and the sort of misrepresentation which allows the Canada Revenue Agency ("CRA") to reassess after the normal reassessment period.

Background

Lauria v. The Queen, 2021 TCC 66 dealt with appeals by two taxpayers, Joanne Lauria, and Jeremy Freedman. Lauria and Freedman were both executives with Glukskin Sheff +Associates ("GS+A"). GS+A is a wealth management firm. Lauria and Freedman were also both shareholders. They had acquired their shares under similar share purchase agreements. Those share purchase agreements contained a formula for valuing the shares as well as restrictions on the shares. Later the founders of GS+A decided to pursue and initial public offering ("IPO"). Apparently, this came as quite a surprise.

Lauria and Freedman, as well as other executives, decided to undertake certain planning in preparation for the IPO. This involved transferring a portion of their shares to newly established family trusts. This transfer occurred after the underwriter for the IPO had been retained, and the IPO was underway but not yet completed. Lauria and Freedman reported the transfers to the respective trusts on their tax returns. In doing so, they used the share values determined in accordance with the formula from the earlier share purchase agreements ("Formula Value").

A number of years later, after the expiration of the normal reassessment period, the CRA reassessed on the basis that the value of the shares transferred to the trusts was significantly higher than the Formula Value reported. The primary argument was that by the time of the transfers to the trust there was a pending IPO, and the Formula Value did not take that into account.

There were two interconnected issues in Lauria's and Feldman's appeals of the reassessments. One was the correct valuation of the shares they transferred to the trusts. The second was whether reporting based on the Formula Value involved a misrepresentation "attributable to neglect, carelessness or wilful default" allowing the CRA to reassess beyond the normal reassessment period pursuant to subsection 152(4) of the Income Tax Act ("ITA").

The court commented on the relevant law. That included summarizing the subsection 152(4) requirements noted above, observing that it is up to the Minister to establish the misrepresentation, and noting that the time for determining a misrepresentation is the time of filing the tax return.

The court also commented on the meaning of fair market value, noting that it is not defined in the ITA. The court cited the well-known definition from Henderson Estate and Bank of New York v. Minister of National Revenue, (1973), 73 DTC 5471 (FCTD) as quoted in Nash v. Canada, 2005 FCA 386. A key portion of that definition refers to "the highest price an asset might reasonably be expected to bring if sold by the owner . in the ordinary course of business in a market. composed of willing buyers and sellers dealing at arm's length and under no compulsion to buy or sell".

The court then turned to whether there had been a misrepresentation. It considered the appropriate valuation of the shares in the context of that determination.

The portion of the reasons dealing with misrepresentation deals with the evidence of the CRA's expert witness on valuation. The expert witness reviewed a number of factors including the terms of the share purchase agreements. Those factors also included the IPO which he considered to be an "imminent liquidity event", i.e., one happening within six months. The expert indicated that when there is an imminent liquidity event, the use of minority discounts is no longer appropriate. According to his analysis, the Formula Value involved a discount of approximately 95%. However, he did also note that there were still certain risks associated with the IPO at the time of the transfer to the trusts Those risks included that the IPO may not take place as planned, that market conditions would deteriorate, or that the founders could change their minds. Due to those remaining risks, some discount was still necessary, and the expert proceeded with a discount of 40%.

The court considered the evidence of the taxpayers as well. They did not retain their own expert witness. Their position seems to have involved arguing that the formula from the earlier agreements was still appropriate. They also argued that the 40% discount for the IPO was an unreliable number. The court did not find their arguments persuasive. Ultimately, the court accepted the evidence of the CRA's expert witness.

The court accepted that the fair market value of the shares was not the Formula Value and proceeded on the basis that using the Formula Value was a misrepresentation.

The court then turned to whether the misrepresentation was attributable to neglect, carelessness, or wilful default. In that regard the court indicated that it "defie[d] credibility" that the taxpayers would not think that the proposed IPO would impact the value of their equity in the firm. The court also pointed out that the taxpayers took other action in light of the proposed IPO including establishing trusts and the transfer at issue. The previous transactions which had relied on the value all took place before the IPO was announced as well. Additionally, neither taxpayer sought independent confirmation of the value.

In this section of the decision, the court also addressed the argument that a valuation which is challenged by the CRA is not necessarily a misstatement when it is reasonably held. This argument had been considered as part of the assessment of whether there was a misrepresentation at all in earlier cases, in particular Petric v. The Queen, 2006 TCC 306. In this case, the court simply concluded that the belief was not reasonably held.

In the end, the court concluded that the taxpayers were careless and negligent.

Conclusion

The CRA was successful on both issues and the reassessments stood, apart from an adjustment to reflect the CRA's updated valuation by their expert.

This case serves as an important reminder of the importance of valuations for tax purposes. It is also a reminder of the nuances and difficulties that can arise and why professional valuations can be important and helpful. Taxpayers should carefully consider the basis for values being used in their transactions and whether a formal valuation is necessary.

Lauria and Freedman have appealed to the Federal Court of Appeal so there may yet be further developments in this case.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.