Latent Taxes:How much to recognize?

Michael Roy, CPA, CMACICBV Annual Conference – June 2017

This presentation discusses approaches to the treatment of latent taxes in the valuation of a holding company. It is not meant to represent the CRA’s official position, or to create a policy on this issue. The individual facts of each situation will need to be considered to determine the appropriate treatment of the latent tax liability.

Disclaimer

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• Controversy exists surrounding the topic of imbedded capital gains and recapture, or latent taxes, in determining the Fair Market Value of shares of Holding companies;

• With respect to income taxes, the difference between the tax base and market value of an asset within a Holding company may trigger a capital gain and/or recapture at the corporate level;

• These latent taxes will only be recognized once the asset is sold by the Holding company and must be taken into account before any funds are available to shareholders, either via distribution or liquidation;

• Business valuators have considered latent taxes in the valuation of Holding companies, especially when investors have the option of either buying the shares of the Holding company, or acquiring the targeted asset(s) outright;

• Informed investors will consider significant latent taxes in their investment decisions when acquiring interests in Holding companies, especially if purchasing the assets is an option;

• Sellers of these interests are aware of the latent taxes as well, especially since they are more likely to want to divest themselves of the assets via a share sale.

Introduction to Latent Taxes

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• Zero discount for latent taxes;

• 100% discount for latent taxes;

• Discounts between 0% and 100%, based on a discounted or present value approach;

Issues

• Zero discount does not take into account the disadvantage of purchasing the shares of the Holding company vs. purchasing the assets outright;

• 100% discount does not take into account tax deferral mechanisms available to the purchaser of shares nor the holding period of the purchaser;

• A discount between 0% and 100% is often arbitrary and difficult to ascertain.

Range of Discounts Observed

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• Capital gains tax on disposition of capital property;

• Recapture of CCA claimed from disposition of depreciable property;

• PV of UCC Tax Shield Lost;

• Disposition costs based on a hypothetical liquidation event.

Possible Components of Latent Taxes

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• ITA paragraph 88(1)(d) “bump” is available as a tool if the purchaser of shares vs. assets is a Holding company;

• “Bump” is only available for non-depreciable assets, i.e., land and marketable securities;

• Taxes on capital gains and/or recapture may be “trapped-in” on certain depreciable assets, where FMV>ACB and UCC and ACB>UCC; these latent taxes only occur upon the actual disposition of the asset itself;

• The UCC Tax Shield Lost on depreciable assets for the purchaser of shares vs. assets is often discounted from the share purchase price;

• Discounts within the range of the UCC Tax Shield Lost and the latent taxes on the Capital Gains and Recapture can be supported, as determined on the Valuation Date, on a case by case basis;

• Usually, some form of asset sale commissions and related expenses will also be considered, depending on the circumstances.

Latent Tax Considerations

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WINDUP OF A SUBSIDIARY – SUBSECTION 88(1)

• Section 88 is used in the winding up of a subsidiary into its parent corporation.

Criteria for Subsection 88(1) to apply:

• The parent company and the subsidiary are taxable Canadian corporations;

• The parent owns at least 90% of each class of the subsidiary’s shares;

• All of the other shares, not owned by the parent are owned by persons at arms length with the parent.

Analysis of the ITA 88(1)(d) “Bump”

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What is a Windup?

• A wind up occurs when a company has decided to discontinue its operations; it pays off its creditors and distributes the remaining assets to the shareholders;

• In a Parent/Subsidiary relationship; the subsidiary will distribute the remaining assets to the parent;

• Normally, without Subsection 88(1), there would be a deemed disposition of assets at fair market value, and capital gains and recapture may result;

• Subsection 88(1) provides a tax-free rollover of assets transferred to the parent.

Transfer of Assets and Flow-Through of Balances

• The assets are all transferred at tax values just like in an amalgamation, other than the assets subject to the “bump”.

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Analysis of the ITA 88(1)(d) “Bump”

Subsection 88(1) and Bump-up Rule

• The Bump-up rule in subsection 88(1) is the same as the rule in Section 87;

• The only difference is that in Section 87, the bump-up is only available for a vertical amalgamation involving a 100% owned subsidiary;

• Subsection 88(1) Bump-up rule applies only to non-depreciable capital assets.

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Analysis of the ITA 88(1)(d) “Bump”

Bump-up Formula:

The maximum Bump-up in the ACB of non-depreciable capital properties mentioned above is the lesser of:

a) ACB of the Sub’s shares to Parent Less the tax values of the Net Assets of the Sub on the date of the wind-up Less dividends paid by the Sub to the Parent or any other corporation with which the parent was not dealing at arms length (Global Bump); and

b) FMV of the Sub’s non-depreciable capital properties Less ACB of Sub’s non-depreciable capital properties at the time the Parent acquired control of the Sub (Individual Asset Bump)

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Analysis of the ITA 88(1)(d) “Bump”

Effect on Shareholders

• The parent is generally deemed to dispose the shares of the subsidiary at ACB; therefore in most cases there will be no capital gain.

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Analysis of the ITA 88(1)(d) “Bump”

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Latent Taxes: A Conceptual ExampleSUBCO XYZ

Balance Sheet

As at December 31, 2016

Assets Book Value Tax Base FMV

Cash 50 000$ 50 000$ 50 000$

Accounts Receivable 200 000$ 200 000$ 200 000$

Inventory 100 000$ 100 000$ 100 000$

Land 150 000$ 150 000$ 250 000$

Building 150 000$ 100 000$ 200 000$

Less : Acc. Depreciation = (CCA) (50 000)$ -$

Total Assets 600 000$ 600 000$ 800 000$

Liabilities

Accounts Payable and Accrued Liabilities 50 000$ 50 000$ 50 000$

Mortgage Payable 200 000$ 200 000$ 200 000$

Total Liabilities 250 000$ 250 000$ 250 000$

Net Value 350 000$ 350 000$ 550 000$

Valuation Assumptions

Valuation Date: December 31, 2016

Tax Rate: 40%

After-Tax Rate of Return: 8%

CCA Rate: 4%

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The “Bump” Rule

Section 88(1)(d) of the Income Tax Act

The Law: As it relates to: Amount

88(1)(d) "Bump" amount determined under this paragraph in respect of each property of the subsidiary ACB of Subsidiary's 550 000$

distributed to the parent on the winding-up is such portion of the amount, if any, by which the total shares to Parent

determined under subparagraph 88(1)(b)(ii) exceeds the total of

(i) the amount, if any, by which

(A) the total of all amounts each of which is an amount in respect of any property owned by the Cost amount of 600 000$

subsidiary immediately before the winding-up, equal to the cost amount to the subsidiary of the Subsidiary's assets

property immediately before the winding-up, plus the amount of any money of the subsidiary on hand

immediately before the winding-up, exceeds the total of

(B) all amounts each of which is the amount of any debt owing by the subsidiary, or of any other Subsidiary's debt 250 000$

obligation of the subsidiary to pay any amount, that was outstanding immediately before the winding-up

350 000$

Maximum "Bump" 200 000$

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The “Bump” Limit

The Law: As it relates to: Amount

as is designated by the parent in respect of that capital property in its return of income under this Part Maximum "Bump" 200 000$

for its taxation year in which the subsidiary was so wound up, except that

(ii) the amount designated in respect of any such capital property may not exceed the amount

determined by the formula, A - (B+C), where:

A is the fair market value of the property at the time the parent last acquired control of the subsidiary, FMV of Land 250 000$

B is the greater of the cost amount to the subsidiary of the property at the time the parent last acquired ACB of Land 150 000$

control of the subsidiary and the cost amount to the subsidiary of the property immediately before the

winding-up, and

C is the prescribed amount Prescribed Amount -$

Limit on Land 100 000$

(iii) in no case shall the total of amounts so designated in respect of all such capital properties exceed Maximum "Bump" 200 000$

the amount, if any, by which the total determined under subparagraph 88(1)(b)(ii) exceeds the total of

the amounts determined under subparagraphs 88(1)(d)(i) and 88(1)(d)(i.1)

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After the Windup

Holdco:

Cost amount of net assets acquired on rollover from Subco XYZ 350 000$

"Bump" in ACB of Land 100 000$

Total Cost Amount 450 000$

The ACB of the land on the books of Holdco is equal to its FMV at the time Holdco acquired control.

This amount is recoverable tax free on the disposition of the land by Holdco. Therefore,the land

no longer contains "imbedded" tax and the purchase price for Subco XYZ should not be discounted

for such tax.

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Latent Taxes Still Left

• There continues to be latent taxes in the building now owned by Holdco, since there is no “Bump” available on depreciable property;

• At the time of Holdco’s purchase of the Subco XYZ shares, there is an unrealized income as follows:Recapture of CCA ($150,000 - $100,000 = $50,000); andTaxable Capital Gain (50% of ($200,000 - $150,000) = $25,000)

• Issue: Determine the value (or discount) required by a potential purchaser of Subco XYZ shares for the latent taxes that exist in the unrealized income accrued on the building;

• In an open market context, negotiations regarding latent taxes would take place. However, in a notional market, the business valuator must make assumptions;

• While a precise number is not possible in a notional market context, a range can be determined as follows:- The maximum discount assumes an immediate disposition and full taxes- The minimum discount assumes an indefinite hold and a lost UCC tax shield

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Immediate Disposition

Recapture: $50 000 x 40% = $20 000

Taxable Capital Gain $25 000 x 40% = $10 000

Total Latent Taxes $30 000

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Indefinite Hold

• Had the purchaser concluded an asset purchase instead of a share purchase, the UCC on the building would have been equal to its FMV;

• By acquiring the shares, the purchaser can only claim CCA on the existing UCC balance in the corporation, thereby losing the benefit of claiming the additional CCA on the asset purchase:

Present value of the UCC Tax Shield Lost (ignores ½ year rule for simplicity):

$200 000 X 4,00% X 40% is equal to 26 667$

8% + 4%

$100 000 X 4,00% X 40% is equal to 13 333$

8% + 4%

Total UCC Tax Shield Lost 13 334$

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Possible Range of Discount

• The range of Discount would be between the two extreme positions:

The Total UCC Tax Shield Lost $13 334

The Total Latent Taxes $30 000

• The actual discount would depend on the facts of the specific situation.

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Range of Fair Market ValueSUBCO XYZ

Fair Market Value

As at December 31, 2016 High Low

Assets FMV FMV

Cash 50 000$ 50 000$

Accounts Receivable 200 000$ 200 000$

Inventory 100 000$ 100 000$

Land 250 000$ 250 000$

Building 200 000$ 200 000$

Less : Acc. Depreciation = (CCA)

Total Assets 800 000$ 800 000$

Liabilities

Accounts Payable and Accrued Liabilities 50 000$ 50 000$

Mortgage Payable 200 000$ 200 000$

Total Liabilities 250 000$ 250 000$

Adjusted Net Asset Value 550 000$ 550 000$

Less: Real Estate Valuation Discount 13 334$ 30 000$

Estimated Range of "en-bloc" FMV 536 666$ 520 000$

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Conclusion

• A discount is appropriate to account for latent taxes;

• Paragraph 88(1)(d) must be taken into account;

• The quantum of the discount must account for all the facts and circumstances relevant to the individual valuation scenario.