The Tax Court of Canada decision in Transalta Corporation v The Queen, 2010 TCC 375 (“Transalta”), is an important addition to the jurisprudence concerning the meaning of goodwill for tax purposes and the application of section 68 of the Income Tax Act (Canada) (the “Act”)1 to valuation and price allocation disputes with the Minister of National Revenue arising from asset sale transactions.
In this case, the taxpayer, Transalta Corporation (“Transalta”), sold its electricity transmission business, which provided almost 60% of Alberta's population with electricity, for $818 million to AltaLink, a limited partnership formed to acquire the business. AltaLink and its partners dealt at arm’s length with Transalta. In their agreements, the parties allocated approximately $190 million of the price, representing the premium above the net regulated book value and working capital of the transmission business,2 to goodwill.
The Minister reassessed Transalta allocating nothing to goodwill and the entire premium to depreciable property arguing that goodwill cannot exist in such a heavily regulated business where there is very limited ability to generate a return on invested capital above the net regulated book value of the business. The Minister likened the assets of the transmission business to an income producing property such as a rental property or bond.
Transalta claimed that there were several factors that went beyond reasons for paying more for hard assets and directly to what is goodwill. It also argued that the price allocation had been arrived at by hard bargaining between arm’s length parties and that because the Crown had failed to demonstrate a clear or patent unreasonableness, the parties' allocation must stand.
Goodwill Analysis: What is goodwill and was it sold in this case?
Justice Miller began his analysis by considering what he called the “residual” or “plug” approach used by both experts in this case. Under this approach, goodwill is simply the difference between the purchase price and the value attributed to tangible assets. Justice Miller found that this approach is more a formula than a definition. It does not identify an amount paid for goodwill as a separate asset or if it even exists. He was concerned that it can “sweep into goodwill” amounts that just represent reasons why a purchaser might pay more for tangible assets. Accordingly, he was reluctant to adopt it as an appropriate legal test for purposes of section 68, despite its acceptance in accounting and valuation circles and to a limited degree in legal circles.
Justice Miller opted instead to adopt Lord Macnaghten’s description of goodwill in the House of Lords decision in Inland Revenue Commissioners v. Muller & Co.'s Margarine,3 which reads as follows:
... What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start. The goodwill of a business must emanate from a particular centre or source. However widely extended or diffused its influence may be, goodwill is worth nothing unless it has power of attraction sufficient to bring customers home to the source from which it emanates. Goodwill is composed of a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element may preponderate here and another element there. To analyze goodwill and split it up into its component parts, to pare it down as the Commissioners desire to do until nothing is left but a dry residuum ingrained in the actual place where the business is carried on while everything else is in the air, seems to me to be as useful for practical purposes as it would be to resolve the human body into various substances of which it is said to be composed. The goodwill of a business is one whole, and in a case like this it must be dealt with as such.4
Justice Miller concluded that several components of what Transalta sold fell squarely within Lord Mcnaghten’s definition of goodwill, including the highly skilled employee base that came with the business, particularly the EPCM project team,5 and the positioning of the business to take advantage of new opportunities in the unregulated merchant transmission industry and to expand markets within the regulated transmission industry.
Section 68 Analysis: Justice Miller’s four principles
From his review of several cases concerning the application of section 68,6 Justice Miller formulated a road map to guide the Court in determining whether the amount allocated by the taxpayer as proceeds of disposition of an asset can reasonably be regarded as consideration for the asset. This road map consists of four principles:
- Where the transaction involves a sham or subterfuge
In this situation, a section 68 analysis is engaged and the Court shall determine a range of what is a reasonable allocation considering all relevant factors.
- Where the other party to the sale agreement has not agreed to the taxpayer’s allocation
In this situation, the Court shall also determine a range of what is a reasonable considering all relevant factors.
- Where arm's length parties to the sale agreement with relatively equal bargaining positions have agreed on the allocation submitted by the taxpayer and the evidence shows real bargaining with respect to the allocation between such parties
In this situation, there is prima facie proof of the reasonableness of the allocation, and the Minister can only challenge the allocation under section 68 by proving a fundamental mistake in the foundation of the parties' agreement. A difference of opinion on value would not be sufficient.
- Where there is an agreed upon allocation between arm's length parties to the sale agreement but the taxpayer has failed to meet the requirements of the third principle
In this situation, the Court shall determine a range of what is a reasonable, again considering all relevant factors, and the amount within the range closest to the parties' agreed upon allocation shall be the reallocated amount for purposes of section 68.
Justice Miller also listed various factors the Court should consider in determining a reasonable range in applying each principle.
Which of these principles applied in this case?
In Transalta, Justice Miller had to decide whether to apply the third principle or the fourth. The first and second principles did not come into play because there was no suggestion of any sham or subterfuge and the purchase price allocation had been agreed upon with the purchaser.
He found that while the parties dealt with each at arm’s length and were of equal bargaining strength in relation to the purchase price, there was minimal bargaining on the allocation of the premium and Transalta had a stronger hand in its allocation. It was to its advantage to allocate as much as possible of the purchase price to goodwill. He also found, despite the absence of any direct evidence from the purchaser and the differing views of the experts on this point, that the purchaser was indifferent on the allocation of the premium as between goodwill and depreciable property. Based on these findings, he concluded that the requirements of the third principle had not been met and, therefore, a prima facie case of reasonableness had not been established. Applying the fourth principle, the next task for the Court was to determine a range of a reasonable allocation to make to goodwill.
Final Step: Determining a reasonable allocation to make to goodwill
Justice Miller was very much persuaded by Transalta’s expert that there was considerable value attributable to goodwill, so much so that he decided to take a slightly different approach to determining the issue. Instead of first establishing a range of reasonable amounts for goodwill, he chose to start with the amount allocated to goodwill by the parties to the transaction and then determine what amounts, if any, should be deducted from it to get to the upper end of the range. He decided that in this case there was no need to determine the bottom end of the range. This approach implicitly reflected another principle derived from the case law on section 68, namely, that considerable weight is to be attached to an agreement reached by arm’s length parties on purchase price allocation.
He found that two items advanced by Transalta as constituting part of goodwill did not relate to any goodwill that Transalta had created or developed or was selling, but rather represented reasons why the purchaser paid more for the income-producing or tangible assets of the business. These were: (1) the leverage AltaLink’s partners could achieve by financing their investment beyond debt levels allowed by the regulator for ratemaking purposes; and (2) the anticipated difference between the income tax allowance AltaLink would receive for ratemaking purposes and the tax that would be payable by its partners (one of which was tax exempt) on the income generated from their investment.
Justice Miller determined that a reasonable value to attribute to these two items was between $50 and $75 million and, therefore the upper end of the range of what could reasonably be regarded as consideration for goodwill was the $190 million amount agreed upon by the parties to the transaction less $50 million. He allowed the appeal and referred the matter back to the Minister for reassessment on that basis.
The Tax Court's decision is important for its review of the meaning of goodwill for tax purposes and approach for determining when and how section 68 can apply to reallocate a taxpayer’s proceeds of disposition in asset sale transactions. It gives the Court a set of principles to follow in future cases in determining if a section 68 analysis is engaged. It also lists various factors that the Court should take into account in determining a reasonable purchase price allocation in those cases where a section 68 analysis is engaged. The decision leaves no doubt that while an agreement on purchase price allocation between arm’s length parties is certainly most helpful and is to be given significant weight, it is not enough to establish a prima facie case of reasonableness. Real bargaining on the allocation of the amount(s) in issue between parties of relatively equal bargaining strength is also necessary. If any of these items are not present, the door will remain open for the Minister to challenge the reasonableness of the allocation under section 68.
The Federal Court of Appeal will have the opportunity to consider the Tax Court's approach to these issues. Transalta filed an appeal on September 29, 2010. Stay tuned.