Leave it to the Pros: Why You Need an Independent Business Valuation for Tax Planning
If you’re a business owner, you’re likely no stranger to tax planning strategies that aim to take advantage of tax incentives while minimizing your tax burden.
Because several of these strategies require the Fair Market Value (FMV) of your business to be determined, one of the most common questions we’re asked is: “Do I really need a formal business valuation?” The answer to this question is more nuanced than you might expect, including complex tax laws and practical business considerations. Keep reading to learn more about the benefits and implications of obtaining a formal business valuation so you can decide if a valuation is the right step for you.
Valuation considerations for tax planning
While the Canada Revenue Agency (CRA) does not explicitly state that a formal business valuation prepared by a Chartered Business Valuator (CBV) is required for tax purposes, the recommended approach, in most cases, is to engage an expert to avoid any potential penalties and interest down the line. In information circular 89-3, the CRA makes it clear that a valuation prepared for tax purposes needs to have “reasonable judgement and objectivity in the selection of the relevant facts”.
While you may think that you can apply such judgement and objectivity, the CRA will assume that a valuation prepared by the owner, or their financial advisors, has an inherent level of bias. The CRA will therefore apply a higher level of scrutiny and skepticism when reviewing a valuation that was not prepared by an independent CBV.
Price Adjustment Clause
Many practitioners and business owners will argue that they are protected by the price adjustment clause if ever their valuation is challenged by the CRA. However, and as indicated by the CRA under the Income Tax Folio S4-F3-C1, the price adjustment clause will only apply if there was a “bona fide” attempt at determining the FMV and the FMV was “determined by a fair and reasonable method”. Furthermore, the CRA states that “it is not sufficient to rely upon a generally accepted valuation method” but “also necessary that the valuation method be properly applied having regard to all circumstances”.
So, if the CRA finds that a general approach was taken without considering all relevant facts and circumstances, they may deem the attempt at determining FMV to be unfair and unreasonable. This can result in significant interest and penalties to pay on top of additional taxes.
Succession planning has been a hot topic for many years, especially since the introduction of Bill C-208 by the CRA in 2021. Prior to Bill C-208, when a business was sold or transferred to a family member, section 84.1 of the Income Tax Act treated the transfer as a dividend and did not allow for capital gains to be realized, or for the Lifetime Capital Gains Exemption (LCGE) to be claimed.
Bill C-208 radically changed the treatment of such transactions. Now, if an individual transfers their shares in a qualified small business corporation to a corporation controlled by one or more of their children or grandchildren, the transfer is taxed the same as an arm’s length sale. This means that the LCGE can be used to reduce the taxes paid on the potential capital gain upon transfer. However, the CRA explicitly states that an “individual who transfers the shares must provide the CRA with a valuation report that is an independent assessment of the fair market value of the transferred shares”. Furthermore, “for the CRA to accept a valuation as an independent assessment of the fair market value, the valuation must be completed by someone who meets these requirements:
- Is unrelated to the corporation or vendor and does not have any financial interest in the transactions; and,
- Has sufficient knowledge and experience in valuation and the industry being dealt with”.
CBV — The obvious choice
The CRA goes one step further to say that “a report that meets the Chartered Business Valuation Institute’s standards will meet the CRA’s expectations”. So, although not an explicit requirement, engaging an independent CBV to prepare a report in accordance with the Practice Standards is beneficial. Read our article on the impacts of Bill C-208 and the subsequent updates to the legislation for more information on how this change could affect any succession planning measures you take.
Although it can seem unnecessary at first to engage a CBV when tax planning, don’t underestimate the long-term value that a professional and independent business valuation can provide. Just as any investment involves spending money to make (more) money, a business valuation is often worth it’s price in what it will save you down the line. For more information on how we can support your tax planning initiatives, contact your DMCL advisor.
Article written by Chris Riccio, CPA, CBV