Policy Statement on Business Equity Valuations

NO.: 89-3

DATE: August 25, 1989

SUBJECT: Policy Statement on Business Equity Valuations


1. This Information Circular outlines the valuation principles, practices and policies that the Department generally considers and follows in the valuation of securities and intangible property of closely-held corporations for income tax purposes.


2. All valuations should be made in accordance with the provisions of the Canadian Income Tax Act and the Income Tax Regulations.


3. (a) Fair market value is the highest price, expressed in terms of money or money's worth, obtainable in an open and unrestricted market between knowledgeable, informed and prudent parties acting at arm's length, neither party being under any compulsion to transact.

(b) Value, as found in paragraph 7(1)(a), is generally interpreted by the Department to mean fair market value.

(c) A closely-held corporation is a corporation whose shares are owned by a relatively limited number of shareholders. There is no established market for such shares, in that they are sold infrequently.

Valuation Approaches

4. The Circular discusses, in general, the approaches applicable to closely-held or private corporations, recognizing that the facts and circumstances of each case will be determinative of fair market value. The valuator must use reasonable judgment and objectivity in the selection and analysis of the relevant facts of each valuation.


5. When dealing with the valuation of shares of closely-held corporations and of intangible assets, the effect on value of a number of fundamental factors, such as the following, should be considered and analyzed: (a) The nature of the business, and history of the business from its inception. (b) The general outlook, the specific outlook and condition of the particular industry and the company's position in the industry. (c) The balance sheet, the financial condition and the capital structure of the particular company. (d) The company's earnings record and its earnings power. (e) The dividend-paying capacity of the specific company. (f) The existence of goodwill and/or other intangible assets. (g) Sales of the company's stock. (h) The size of the specific shareholding to be valued. (i) The stock market prices of comparable stocks of reasonably similar corporations in the same line of business, where these shares are actively traded in an open, unrestricted and public market. (j) The value of the corporate assets underlying the shares.

6. There are also numerous factors and issues relevant to the valuation of specific shareholdings, apart from the fundamental factors considered in valuing the enterprise as a whole. These include the existence of (a) options, other buy-sell agreements or other contractual rights or obligations; (b) control or minority shareholder interests; (c) the rights and privileges of the various classes of shares under the company's letters patent, bylaws, or memorandum of association; and (d) corporate-owned life insurance.

Weighting of Various Factors

7. Depending on the nature of the corporation's business, certain of the relevant factors may be accorded greater weight. In some businesses, earnings may be the primary determinant of value, while in others it may be asset value. The valuator must consider a different combination of factors in each case in determining fair market value.


8. The earnings and asset value methods are the two most generally accepted bases for determining value. The earnings method is of primary concern when valuing shares of operating companies that manufacture or market products or services.

9. Asset value methods are useful where: (a) A reasonable and viable alternative to buying an existing business is to start one from scratch, such as small construction subcontractors operating on competitive bids, auto body repair shops, machine shops, some retail outlets. (b) A business sells largely on an asset basis, that is, it derives its income largely from the assets, either tangible or intangible, rather than from the personal efforts of the owners and personnel, e.g., real estate holding companies, equipment leasing or investment companies, franchise or dealership operations.


10. Generally speaking, the fair market value of a business is usually the greater of (a) its liquidation value, and (b) its going concern value.

11. The liquidation value approach is generally used where (a) the business is not a viable ongoing operation and is consequently suitable only for liquidation; (b) the business is a going concern, but its value is related to the liquidation value of the company's underlying assets; and (c) it is an aid in the determination of fair market value on a going concern basis, as in determining risk.

12. The going concern value approach is normally used where the business is a continuing enterprise with the potential for earning a reasonable return on investment. Where there is adequate potential earning power in the form of economic future profits or discretionary cash flows, the determination of going concern value depends on the amount and quality of the earnings or cash flows, and the business and financial risk that these earnings or cash flows can be achieved and sustained.

Factors in Capitalization Rate Selection

13. The risk, expressed in a going concern value calculation as the capitalization rate, relates to a number of factors in the business, among which may be: (a) The tangible asset backing. (b) The liquidation value. (c) The nature and history of the business operations. (d) The general economic, money and stock market conditions and outlook. (e) Specific industry and market comparisons. (f) The financial condition of the specific business being valued. (g) The quality of the business operations, including such factors as its management depth, its marketing, research and development capabilities, the composition of its labour force and product mix, and the existence of major contracts. (h) The impact of inflation and foreign exchange fluctuations. (i) The specific risk as related to the stability or irregularity of the maintainable level of earnings or cash flows of the particular business. (j) The general and specific political environment. (k) Opportunities for growth as related to the social environment of the business. (l) The existence and importance of competitors. (m) The cost or ease of entry into the particular industry being reviewed. (n) The choice of and rates of return on alternate investments.

It should be noted that the foregoing list is not exhaustive.

The valuator must exercise judgment in determining the extent to which these and other potential external and internal factors are relevant in the quantification of a capitalization rate.

14. The general approach, appropriate methods and relevant factors are applicable to the determination of fair market value of any type of business interest, incorporated or unincorporated and of intangible assets, for income tax purposes.


15. The organization of the departmental business equity valuation function is outlined in the current version of Information Circular 72-25.

16. The Regional Valuation Officer may ask for documents, statements or other information, including the following: (a) Details and the basis of values filed, for Valuation Day or any other dates. (b) A balance sheet with supporting statements, schedules and notes as at the date of valuation. (c) Copies of any appraisals of the fixed assets and/or real estate. (d) Financial statements for the five most recent fiscal periods prior to the valuation date, or since the commencement of operations, whichever represents the shorter period. (e) If the business has been operating for five years or less, the financial statements should include an opening balance sheet. (f) Copies of all option, buy-sell or other shareholder agreements or partnership agreements. (g) Complete details of all acquisitions and dispositions of the taxpayer's interest in the entity, proposed or completed. (h) Copies of any arm's length offers for substantially all of either the company's shares or its fixed assets. (i) For small closely-held companies, a list of shareholders outlining the number of shares held and any family relationships. (j) For large closely-held companies and public companies, a list of major shareholders, outlining the number of shares held and any family relationships, if applicable. (k) For partnerships, a list of the partners outlining their profit and capital-sharing ratios. (l) If the property is a bond or other obligation, details of the series, face value, interest rate and maturity date. (m) Copies of extracts from the corporate letters patent, memorandum of association, or by-laws detailing the rights and privileges attaching to all classes of shares. (n) With regard to companies, details of any recent sales of similar securities. (o) A brief history of the business operation, including the area it serves, its relation to its competitors in the same industry, and the specific outlook and condition of the particular industry. (p) Any pertinent facts or opinions concerning such issues as the dependence of the company on key personnel, suppliers or customers, the taxpayer's role in the company, the company's potential for growth, the adequacy of its facilities, and the existence of contracts or leases. (q) Details of life insurance policies owned by a corporation or partnership on the lives of its key personnel. (r) Details of and comments on the adequacy of salaries and/or other benefits paid or credited to the principal shareholders, partners or proprietor and their families.

It should be noted that the foregoing list is not exhaustive.


Options and Buy-Sell Agreements

17. Options and buy-sell agreements affect fair market value determination as required by several sections of the Income Tax Act, notably section 69 and subsection 70(5).

18. In a closely-held corporation, fair market value must be determined by referring to share rights and restrictions, whether found in the company's articles, by-laws or valid contracts between shareholders. These rights or restrictions can have an appreciatory or a depreciatory effect on the price a willing purchaser would pay for the shares in the notional market.

19. Where these rights cannot be changed without incurring the possibility of minority shareholder court or breach of contract action, where such rights limit the amount that can be realized at the date of valuation and require the shares to be disposed of for a stipulated amount, their value must be determined according to the provisions of such agreement or article. In these circumstances, other relevant factors normally considered in valuing shares may not be relevant.

20. On the other hand, where a majority shareholder holds shares subject to rights and restrictions and can modify these same rights and restrictions without incurring the possibility of adverse minority action, the value of these shares should not be restricted to the amount prescribed by the terms of the arrangement.

21. It must be noted that an arrangement that restricts the value of the shares subject to it must be bona fide in nature. That is, there must be some primary legitimate business purpose, such as the orderly succession of management, control over the influx of outsiders and creation of an outside market for the shares.

22. In addition, for the provisions of any arrangement to be considered relevant to the valuation of shares, the contractual agreement must be validly constituted and binding (i.e., a legally enforceable arrangement), and there must be a reasonable estimate of fair market value made.

23. The following two types of restrictions will not render the agreement determinative of fair market value:

(a) Where a restriction on transfer is one only of consent by shareholders and/or directors, which does not stipulate a price at which shares can be transferred or does not specify events under which an obligation to transfer or option to purchase shares arises, it will not be determinative of fair market value. However, the restriction may be a depreciatory factor to consider in valuing the shares subject to the arrangement. (b) Where a restriction is merely a right of first refusal at a stipulated price, it will not be determinative of fair market value, although it may be another depreciatory factor to consider.

24. In the situation where shares are subject to a bona fide commercial option at a specified or formula price at the time of valuation, the option price will likely represent the lowest (or "floor") price which a prospective and willing purchaser would pay and a willing vendor would accept. To be a bona fide commercial option, it must be a legally enforceable contract with a legitimate business purpose. Such an option would have a depreciatory effect on the fair market value of the shares.

25. The facts of a case would determine what amount, if any, a purchaser would pay in excess of that "floor" price and would depend on a number of factors including, when the option is exercisable; the likelihood that the option will be exercised; whether the option price is fixed, subject to periodic increases, or based on a formula which affects an increase in price as the company succeeds; and, the size of the particular shareholding.

26. An agreement may provide for a number of inter vivos events which will give rise to either an optional or a mandatory sale at a specific price, such as retirement, resignation, or disability. Such restrictions may have a depreciatory effect on share value. Where the terms of the agreement stipulate a mandatory sale when the shareholder wants to sell his shares, the price stipulated in the agreement should accordingly limit the value pursuant to subsection 70(5), because a prospective purchaser would not be willing to pay any more for the shares than he/she would be able to receive under the provisions of the agreement.

27. If the restrictions contained in agreements are not considered determinative of fair market value, normal valuation approaches will be used to determine the fair market value of the shares in question.

28. In order for a buy-sell agreement to be considered determinative of value pursuant to subsection 70(5), it must meet all the following requirements: (a) The agreement must obligate the estate to sell the shares at death either under a mandatory sales and purchase agreement or at the option of a designated purchaser. (b) The agreement must restrict the shareholder's right to dispose of his/her shares at any price during his/her lifetime. (c) The agreement must fix a price for the shares or set out a method for determining the price on a current basis. (d) The agreement must represent a bona fide business arrangement and not a device to pass the decedent's shares to his/her heirs for less than an adequate and full consideration.

29. If a buy-sell agreement, normally determinative of value, is executed between parties not acting at arm's length, its provisions should be determinative of value, as long as it meets the following criteria: (a) It is a bona fide business arrangement. (b) The stipulated price or formula price in the agreement provides full and adequate consideration, and represents the fair market value of shares determined without reference to the agreement at the time it is executed. (c) It is a legal and binding contract.

30. In order for an agreement to be considered bona fide, there must be no donative intent in the agreement. In other words, while the parties to the agreement may be related, they must transact as they would at arm's length with strangers.

31. Each case will be dealt with on the basis of the related facts. These facts will determine whether a specific buy-sell or option agreement is legally enforceable and whether its provisions should be determinative of value or should be some of the many relevant factors to be considered in arriving at fair market value of the shares subject to the agreement, in accordance with generally accepted valuation principles.

Reference should also be made to the current version of IT-140.

Family and Group Control

32. The Department recognizes that in certain situations either a related group or an unrelated group of shareholders may control a corporation if they owned amongst themselves at least 50% + 1 of the issued and outstanding voting shares of the corporation at the same time and if they have historically acted in concert as a group. It is a rebuttable presumption that a family group has acted in concert to control a corporation.

An assertion by a minority shareholder that he/she is part of a family control group must be considered in light of all relevant factors, including the rights and restrictions attributable to his/she particular shares.

In a situation where the existence of family control is recognized, the Department will employ a rateable valuation for each family group member's shares.

33. An assertion of group control by family members, such as those referred to in subsection 251(6) of the Income Tax Act, will be accepted, provided there is no contrary evidence that they did not act in concert. Groups of relatives other than those referred to in subsection 251(6), must provide proof that they were part of a controlling family group and acted in concert with that group.

34. With regard to control by a group of shareholders dealing at arm's length, the criteria necessary for acceptance of claims of group control will include (a) a written agreement under which all the shareholders in the group relinquish their rights to vote and to sell their shares independently at all times; or (b) provision in the corporate letters patent, memorandum of association or the bylaws restricting individual rights to vote and to sell their shares independently at all times; or (c) permanent release of the individual shareholder's rights by giving of an irrevocable proxy to a designated person to vote and to sell the shares as he/she sees fit on behalf of all the shareholders in the group; or (d) a pattern of conduct to demonstrate that the shareholders acted collusively in all matters relating to the control of the corporation.

35. In order to determine whether a certain pattern of conduct is indicative of collusive action in all matters relating to control, the following actions may be undertaken individually or in any combination: (a) Shareholders' and directors' minutes may be examined to determine the extent of consultation among the group. (b) A review of remuneration may be made to insure that all members of the group were treated fairly. (c) Interviews with members of the group may be held to determine the role played by each member. (d) Details of actual purchases and/or sales made by the claimants may be examined.

36. Where the Department is satisfied that the documentation provided indicates a consistent pattern of group control, it will apply a rateable valuation for each member's shares, and not apply a minority discount.

37. The Department also recognizes that effective control can exist in a public corporation where an individual or group has a large block of shares, where through unconditional proxies, a majority of votes at any shareholders' meeting controls management and where the remaining shares are widely dispersed. In these cases, satisfactory evidence of control must be provided.

Each case will be dealt with on its own merits.

Stock Option Benefits

38. The Department's policy concerning benefits received by employees under stock option plans pursuant to section 7 of the Income Tax Act revolves around a few key words contained therein.

With regard to the phrase "value of the shares" encountered in paragraph 7(1)(a), the Department generally interprets the term "value" to mean fair market value, as defined previously.

39. For purposes of determining the date upon which the corporation's shares are "acquired" pursuant to paragraph 7(1)(a), the Department considers that to be the date at which the taxpayer acquires the rights of a shareholder with regard to the purchased shares subject to the option.

The factual circumstances of each case will determine the date at which a taxpayer obtains legal ownership or the incidence of legal ownership in and to the shares subscribed, and thereby acquires the shares.

Reference should also be made to the current version of IT-113.

Corporate-Owned Life Insurance

40. According to subsection 70(5.3), in determining the subsection 70(5) value of a deceased's shares (for deaths occurring after December 1, 1982), the value of corporate owned life insurance is its cash surrender value. This applies to the deceased, but where there are two or more shareholders and corporate-owned life insurance is required to fund a stock purchase agreement, one must determine the value of the policies held by the corporation on the other shareholders.

The factors to be considered in determining the value of such policies held on the lives of shareholders other than the deceased, should include: (a) cash surrender value; (b) the policy's loan value; (c) face value; (d) the state of health of the insured and his/her life expectancy; (e) conversion privileges; (f) other policy terms, such as term riders, double indemnity provisions; and (g) replacement value.

Reference should also be made to the current version of IT-416.

41. If the death of one of the shareholders for which corporate life insurance is owned is considered "imminent" and it is proper to consider this factor in valuing a policy, the value may be greater than the policy's cash surrender value. However, one must also consider the following factors: (a) the possibility that the insured will recover and not die; (b) the effect that the loss of a key person would have on the business operations; (c) whether the share interest being valued represents a majority or minority of the outstanding shares; and (d) the importance attached to factors other than asset value in the circumstances, such as the future earnings expectations and the prospects for dividends.

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