FEBRUARY 2012
TAX LAW BULLETIN
GOODWILL HUNTING: IDENTIFYING AND
ALLOCATING VALUE TO GOODWILL
ON THE SALE OF A BUSINESS
One of the more significant issues in an asset purchase deal is the allocation of
purchase price among the assets being purchased. The allocation impacts the tax
liability of the vendor arising from the sale and the future tax shield of the purchaser,
as well as various commodity taxes that arise under HST/GST legislation, provincial
sales taxes, land transfer taxes and property taxes. Generally, the rule of thumb has
been that an allocation made between parties dealing at arm’s length in situations
where there is evidence of hard bargaining will be respected; this allows taxpayers
to plan their future affairs with some certainty. The Tax Court of Canada decision in
TransAlta Corporation v. The Queen (“TransAlta”) caused planners to think a little
harder about that conclusion.
On January 20, 2012, the Federal Court of
The FCA agreed with the Tax Court that
Appeal (“FCA”) allowed the taxpayer’s appeal
goodwill can exist in a regulated industry.
and dismissed the Crown’s cross-appeal
However, the FCA rejected the lower
from the Tax Court decision in TransAlta.
court’s more narrow definition of goodwill,
The general issues raised in the case were
reversing the finding that a significant
whether commercial goodwill can exist in a
part of the purchase price allocation to
regulated industry – in this case, the electricity
goodwill was unreasonable under the
transmission industry – and what factors
test in section 68 of the Income Tax Act
can create goodwill in an electricity
(Canada) (the “Act”).
transmission business.
TAX LAW BULLETIN | FEBRUARY 2012
2
WHY THIS CASE MATTERS
• The FCA emphasized that goodwill is a
flexible concept, that it can include a wide
• Contrary to the Minister’s position,
the FCA confirmed the Tax Court’s
range of intangible benefits having as
their common thread an expectation of
conclusion that goodwill can exist in
future business growth, and that its
regulated industries, such as TransAlta’s
composition can vary depending on the
electricity transmission business.
particular business sector as well as on
the precise circumstances of the
• The FCA endorsed the use of the residual
taxpayer’s business. The FCA’s
value method to value goodwill for income
commentary on, and analysis of, goodwill
tax purposes, and confirmed that long-
in this case provides a useful framework
standing regulatory and industry practices
for identifying and allocating value to
(in addition to accounting and valuation
non-tangible assets generally in the
standards) are relevant to determining the
context of M&A transactions.
reasonableness of that valuation for
income tax purposes.
• The Minister’s ability to change the
BACKGROUND
In 2002, TransAlta sold the tangible assets
parties’ agreed upon purchase price
of its regulated electricity transmission
allocation pursuant to section 68 is limited
business in Alberta to an arm’s length buyer,
to situations where the parties’ allocation
AltaLink, L.P. (“AltaLink”), for a price negotiated
fails the reasonable business person test.
at a 31% premium to the net regulated book
The FCA’s decision provides some
value (“NRBV”) of those tangible assets.
assurance to taxpayers that their
Under a standard price allocation clause,
negotiated purchase price allocations will
the parties allocated the NRBV to depreciable
be respected where they deal at arm’s
property and land. The 31% premium over
length with the seller/buyer and have an
NRBV (approx. $191M) was allocated to goodwill.
objective basis for their allocation
(e.g., established business practice or an
independent formal valuation).
The Minister of National Revenue (“Minister”)
reassessed TransAlta under section 68 of the
Act, reallocating the entire goodwill amount to
• The FCA considered the case in a
the tangible property, ignoring the allocation to
practical, business-oriented way,
goodwill. The Minister’s position was that the
concluding that intangibles that do not
allocation to goodwill allowed TransAlta to avoid
necessarily constitute “goodwill” under
recapture of capital cost allowance on the sale
the legal test may nevertheless be
of its depreciable assets in circumstances
allocated to goodwill for tax and
where the purchaser of those assets was
accounting purposes where it is
otherwise indifferent to the loss of tax shield,
reasonable to do so.
or other transfer taxes payable.
3
Most regulated industries allow for the recovery
QUESTIONS ANSWERED BY THE FCA
of a return on the net book value of a regulated
business’ capital investment. Under the
1. Can Goodwill Exist in
regulatory system that applied to TransAlta’s
Regulated Industries?
electricity transmission business at the time
of the sale, the Alberta Energy and Utilities
The FCA held that goodwill can exist in
Board (the “Board”) followed this approach and
regulated industries for the following reasons:
established a revenue requirement that would
allow TransAlta to (a) recover the NRBV of its
assets as they depreciated for regulatory
law principles, has the following three
• Goodwill, as defined under common
purposes; (b) recover the estimates of the
characteristics (and if these three
operating expenses the business planned to
characteristics are present, it can
incur; and (c) earn a reasonable return on the
reasonably be assumed that there
equity investment portion of the NRBV of its
is goodwill):
assets that the Board deemed fair.
•it must be an unidentified intangible
At the time of the sale, the Board-approved
rather than a tangible asset or an
after-tax ROE was 9.75% for the previous two
identified intangible asset such as a
years, based on a deemed debt-to-equity ratio
brand name, a patent or a franchise;
of 65/35. The actual ROE earned by TransAlta
in this period of time was 11.79% in 2000 and
•it must arise from the expectation
13.57% in 2001.
of future earnings, returns or other
benefits in excess of what would
During the regulatory approval process for the
be expected in a comparable
sale, ratepayers raised concerns that AltaLink
business; and
would try to recover the premium paid on the
sale by way of rate increases. In its submission
•it must be inseparable from the
to the Board, AltaLink indicated that its
business to which it belongs and
customers would be protected from that
cannot normally be sold apart from
possibility, as it would exclude any portion
the sale of the business as a
of the premium from the rate base by agreeing
going concern.
to adopt TransAlta’s closing NRBV as its opening
NRBV for rate-setting purposes. Having obtained
• The regulatory process applicable to
this future rate protection, the Board approved
TransAlta’s business served as a form of
the sale without ordering any recapture of the
proxy to a market environment, with
premium in favour of ratepayers.
returns to equity holders normally being
TAX LAW BULLETIN | FEBRUARY 2012
4
determined based on a fair market value TransAlta and the potential for new
business opportunities flowing from
approach. As such, the fair market value
of the tangible assets of the regulated
business should normally reflect the
NRBV of those assets. That conclusion
TransAlta’s business were viewed as
goodwill since both reflected the three
characteristics of goodwill.
was supported in this case by a report
submitted by TransAlta’s expert, KPMG,
which determined that the fair market
2. Was the Tax Court Judge Wrong in
Excluding Certain Items from Goodwill?
value of the tangible assets sold by
TransAlta using a discounted cash-flow
The FCA concluded that the Tax Court judge
approach was within 2.7% of the NRBV
had erred in excluding from the value of the
of those assets (and well within an
goodwill sold by TransAlta the potential for
acceptable margin of error).
leverage (i.e., the possibility of the AltaLink
partners financing part of their equity
• However, regulated businesses may
sometimes achieve a ROE higher than
participation through debt which would
have a lower cost than the regulated ROE)
that approved by the regulator for
and the potential tax allowance benefit
rate-making purposes for various
(i.e., the possibility that the revenue
reasons, e.g., exceptional managerial
requirement would take into account a
performance, efficient management
notional tax payable on those revenues,
controls of costs, new business
even though 25% of the partnership profit
opportunities generating additional
would be allocated to a tax-exempt partner,
earnings, and strategic business
viz. the Ontario Teachers’ Pension Plan Board).1
opportunities which enhance business
Instead, the Tax Court judge assigned values
value. Any increased value of the
to those two items, which he in turn allocated
business resulting from such factors
to TransAlta’s tangible assets.
should normally be allocated to goodwill.
1
In this case, potentially increased value
The FCA concluded that the Tax Court judge’s
resulting from efficient management by
concept of goodwill was too narrow, as he had
Regarding the potential tax allowance benefit, the issue was whether and how the “stand alone” principle should be applied
in AltaLink’s case. In the rate-setting process, regulatory authorities generally follow the stand alone principle: the regulated
business is treated as a separate entity and only those costs and risks borne by the business which pertain to its provision
of services to ratepayers are reflected in the revenue requirement. The question was whether AltaLink was entitled to a tax
allowance even though its partners (and not it, since it was a partnership) would be liable for tax on the income earned by the
partnership. The Board concluded that AltaLink was entitled to a tax allowance as three of its four partners were taxable entities
in Canada, but it disallowed part of the estimated allowance which related to the tax-exempt Ontario Teachers Pension Plan’s
participation in the partnership. In another case where the application of the stand-alone principle was at issue, the Ontario
Energy Board concluded that a partnership, whose partners were taxable Canadian corporations, was entitled to a tax allowance
even though it had sufficient losses available to fully offset its taxable income. The Board in that case concluded that the
partnership still incurred a tax liability, which was a real cost eligible for recovery.
5
relied on a more than century-old definition
be allocated to the tangible assets sold
of goodwill without taking into account
and would receive the same treatment
modern business, accounting, valuation
and legal developments. Since the potential
“…an amount which is not ‘goodwill’
for leverage reflected the three identified
characteristics of goodwill described above,
still be allocated to ‘goodwill’ for
and there was no good reason to conclude
as if it were goodwill. In the FCA’s view,
in the legal sense of the concept may
accounting and taxation purposes if
otherwise, the FCA found that it was part
such an allocation can be regarded
of the goodwill sold with TransAlta’s
as reasonable”.
transmission business.
The FCA also disagreed with the Tax Court’s
• Since goodwill is inherently difficult to
conclusion that the potential tax allowance
value and different aspects of goodwill will
benefit was not goodwill. While the potential
be given different values depending on the
tax allowance could not be viewed as an asset
circumstances, the preferred method of
of TransAlta, it also could not be allocated to the
valuing goodwill is the residual approach
assets sold by TransAlta, as it was an advantage
whereby the fair market value is
that belonged to the purchaser (or to the Ontario
Teachers’ Pension Plan) in the context of this
assets (e.g., tangible assets) and then any
determined for the more easily valued
deal. Nevertheless, in the FCA’s view, this
purchase price paid in excess of that value
conclusion did not justify deducting between
is attributed to goodwill.
$25-50M from the agreed upon goodwill
allocation for three reasons:
3.What Is the Test for Reasonableness Under
• The potential tax allowance benefit
Tax Court judge and, in light of its
contingent and uncertain nature,
a prudent investor would likely have
largely discounted its value.
Section 68?
was much lower than assessed by the
• Even if a small part of the purchase
price premium could be attributed to
the potential tax allowance, it was not
unreasonable for the parties to allocate
that portion to goodwill for the purposes
of section 68 of the Act since it could not
Reviewing relevant case law, the FCA framed the
reasonableness test as follows (at para. 75):
“..for the purpose of section 68 of the Act,
I conclude that an amount can reasonably be
regarded as being the consideration for the
disposition of a particular property if a
reasonable business person, with business
considerations in mind, would have allocated
that amount to that particular property”.
TAX LAW BULLETIN | FEBRUARY 2012
6
Applying the reasonable business person test,
as well as to the fact that the effective
the FCA concluded that long-standing regulatory
depreciation rate for goodwill would be
and industry practices, as well as auditing and
similar to the depreciation rates for the
valuation standards and practices, were relevant
classes of tangible assets purchased.
to determining whether the goodwill allocation
The parties’ agreed upon allocation of
was reasonable in this case. In other words,
purchase price in the purchase and sale
if long-standing accounting and industry
agreement indicated that a little more
practice approached the allocation in a
than 50% of the tangible assets were
particular way, there is no reason why a
class 1 (4%), while the remaining assets
reasonable business person would have
were class 2 (6%).
sought a different path.
While the FCA agreed with TransAlta that the
allocation negotiated between arm’s length
4. WAS THE GOODWILL ALLOCATION
REASONABLE?
parties is also an important factor to consider,
it emphasized that it does not trump the
In the FCA’s view, the Tax Court judge did not
reasonableness test under section 68.
apply the reasonable business person test,
The FCA also cautioned that the weight given
instead using a test with no guiding principles
to an arm’s length negotiated agreement will
that allowed him to substitute his own subjective
vary depending on the circumstances:
allocation for the goodwill allocation agreed upon
considerable weight will be given to an
by the parties. The FCA concluded that the
agreement where the parties have strong
agreed upon allocation was reasonable because
divergent interests concerning the allocation,
it complied with industry and regulatory
while less weight will be given to an agreement
standards and was consistent with standard
where one of the parties is indifferent or both
valuation theory for regulated businesses and
parties’ interests are aligned. In this case,
standard accounting principles applied in
the Tax Court judge had concluded that
such industries.
AltaLink was indifferent to any allocation of the
purchase price to the tangible assets above
Based on its answers to these four questions,
NRBV, due to the fact that its rate-setting base
the FCA allowed TransAlta’s appeal and
would be limited to the NRBV of those assets,
dismissed the Crown’s cross-appeal.
7
AUTHORS
Stephen J. Fyfe
Stephanie Wong
Toronto
Toronto
416.367.6650
416.367.6198
sfyfe@blg.com
swong@blg.com s
sw
TAX LAW GROUP
National Leader
Stephen J. Fyfe
Toronto 416.367.6650sfyfe@blg.com
Regional Leaders
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Charles P. Marquette
Montréal
Pamela L. Cross
Ottawa 613.787.3559pcross@blg.com
Stephen J. Fyfe
Toronto 416.367.6650sfyfe@blg.com
514.954.3121
cmarquette@blg.com
Richard J. BennettVancouver604.640.4105 rbennett@blg.com
rb
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