The following key principles can be drawn from the case:
- Goodwill can exist in a regulated industry.
- There is no set legal definition of goodwill. It is a flexible concept that arises from the expectation of future earnings, returns or other benefits and must be assessed on a case-by-case basis.
- The residual value method of valuing goodwill is to be preferred. Under this approach, the more easily valued assets are first given a fair market value, and any consideration in excess of this fair market value is assigned to goodwill.
- The Minister or the court cannot substitute its judgment for what is a reasonable amount to pay for goodwill. The test is what a reasonable business person would have paid in the circumstances. Regulatory and industry practices are relevant to determining the reasonableness of a goodwill valuation for income tax purposes.
In 2002, TransAlta "sold its regulated electricity transmission business in Alberta to AltaLink, L.P. at a price negotiated as 1.31 times the net regulated book value of its tangible assets. The parties allocated the bulk of the 31% premium over net regulated book value (an amount of $190,824,476) to goodwill.
The Minister reassessed TransAlta under section 68 of the Act on the basis that this allocation was unreasonable, taking the view that no goodwill exists in a regulated industry, and therefore allocated the premium to tangible assets. This resulted in the recapture of capital cost allowance ("CCA) to TransAlta.
TransAlta’s appeal to the Tax Court of Canada "was allowed, in part. Justice Campbell Miller concluded that goodwill can exist in a regulated industry and that TransAlta did, in fact, sell goodwill. However, he considered that $50 million of the amount allocated to goodwill should be allocated instead to tangible assets. In his view, this amount represented the value of two items: the potential for leverage and a potential tax allowance benefit, both of which were attached to the tangible assets.
TransAlta appealed to the FCA and the Crown cross-appealed.
The FCA looked at whether goodwill could exist in a regulated industry, whether the allocation between TransAlta and AltaLink was unreasonable under section 68 of the Act and, if so, whether the Tax Court judge could substitute his own allocation based on his own valuation.
Concept of goodwill
FCA Justice Robert Mainville rendered the reasons for judgment. He noted that there is no clear legal definition of goodwill. Instead, he said that various characteristics of goodwill should be identified and then used to ascertain goodwill on a case-by-case basis.
He set out three characteristics that should be present for goodwill to exist:
- Goodwill must be an unidentified intangible, as opposed to a tangible, asset or an identified intangible such as a brand name, patent or franchise.
- It must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business.
- It must be inseparable from the business to which it belongs and cannot normally be sold apart from the sale of the business as a going concern. (para 54).
Justice Mainville further noted that an established reputation, customer satisfaction, a unique product or process leading to a monopolistic position, good or astute management, favourable location, manufacturing efficiency, harmonious labour relations, advertising, quality of products and financial standing have all been found to constitute goodwill.
The existence of goodwill in a regulated industry
The Crown’s expert argued that what is acquired in the purchase of a regulated business is the revenue stream generated by the tangible regulated assets of that business. Therefore, even though the purchase price in this case reflected a multiple of the net regulated book value of the assets, the entire purchase price should have been allocated to those assets.
The taxpayer’s expert argued the opposite, basically that regulatory restrictions limit the fair market value of rate-regulated assets to their net regulated value, so that any premium above that amount should be attributed to goodwill or other intangibles.
After reviewing the expert opinions, the legal framework of the regulatory system and industry practices, Justice Mainville concluded that returns on equity in excess of those approved by a regulator are possible and could result from exceptional business management, new business opportunities or other strategic factors. In this case, he specifically noted efficient management by TransAlta and the potential for new business opportunities flowing from TransAlta’s transmission business.
These factors resulted in the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business. They were inseparable from the business to which they belonged, and they could not normally be sold apart from the sale of the business as a going concern. As such, they were intangible assets that had the requisite characteristics of goodwill.
As mentioned the Tax Court judge had also found that goodwill was sold and purchased in the transaction, but had concluded that the potential for leverage and a potential tax allowance benefit were not part of the goodwill, and that their value, which he estimated to be $50 million, should be allocated to TransAlta’s tangible assets.
FCA Justice Mainville disagreed with respect to the potential for leverage, which he held was an intangible asset that had all the characteristics of goodwill.
The potential tax allowance benefit resulted from the Alberta Energy and Utilities Board’s consideration of taxes for the purposes of setting rates. The purchaser, AltaLink, could expect to receive an allowance for income taxes as part of its annual revenues permitted by the Board. The expectation was that the tax allowance permitted by the Board would exceed the income tax actually paid by at least one of AltaLink’s partners, which was a non-taxable pension fund.
With respect to this potential tax allowance benefit, Justice Mainville noted that the value of that benefit was lower than that determined by the Tax Court judge. And even if a small portion of the premium in excess of net book value could be attributed to the potential tax allowance benefit, it was not unreasonable for the parties to the transaction to allocate that portion to goodwill for the purposes of section 68 of the Act.
Most important, Justice Mainville endorsed the residual value method of valuing goodwill. . Under this approach, the more easily valued assets are first given a fair market value, and any consideration in excess of this fair market value is assigned to goodwill.
Reasonableness of the goodwill allocation under section 68 of the Act
Section 68 of the Act states the following [emphasis added]:
68. Where an amount received or receivable from a person can reasonably be regarded as being in part the consideration for the disposition of a particular property of a taxpayer or as being in part consideration for the provision of particular services by a taxpayer,
- the part of the amount that can reasonably be regarded as being the consideration for the disposition shall be deemed to be proceeds of disposition of the particular property irrespective of the form or legal effect of the contract or agreement, and the person to whom the property was disposed of shall be deemed to have acquired it for an amount equal to that part; and
- the part of the amount that can reasonably be regarded as being consideration for the provision of particular services shall be deemed to be an amount received or receivable by the taxpayer in respect of those services irrespective of the form or legal effect of the contract or agreement, and that part shall be deemed to be an amount paid or payable to the taxpayer by the person to whom the services were rendered in respect of those services.
Justice Mainville adopted the concept of reasonableness expressed in Gabco Limited v MNR, 68 DTC 5210 (Ex. Ct.) at p. 5216: "It is not a question of the Minister or his Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind."
TransAlta argued that in applying section 68, considerable weight should be given to the fact that the allocation to goodwill was negotiated by arm’s-length parties. Justice Mainville acknowledged that this was an important factor to be considered, but found that the weight to be given to it depends on the circumstances. Obviously, it should be given less weight if one of the parties is indifferent to the allocation, or if the parties’ interests are aligned.
The Tax Court judge found that AltaLink was indifferent to the allocation of the price to goodwill beyond the net regulatory book value of the assets, and substituted his own allocation for that agreed upon by the parties.
Justice Mainville found this inappropriate, based on the evidence presented as to industry and regulatory norms, and accounting and valuation theory for regulated businesses, all of which pointed in the direction of the agreed-upon allocation. Therefore the "reasonable business person" test under section 68 had been met.
In the final result, TransAlta’s appeal was allowed and the Crown’s cross-appeal dismissed — a very significant victory for the taxpayer.
The purchase or sale of a business is a complex transaction requiring significant technical and industry knowledge. Your Ernst & Young advisors have the tax planning and financing experience to help you meet your goals and objectives. Contact us today.