Mady v. The Queen

Mady v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2017-06-14
Neutral citation
2017 TCC 112
File numbers
2015-1539(IT)G
Judges and Taxing Officers
Robert James Hogan
Subjects
Income Tax Act
Decision Content
Docket: 2015-1539(IT)G
BETWEEN:
DR. DAVID MADY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on April 3, 4, 5, 6 and 7, 2017, at Toronto, Ontario
Before: The Honourable Justice Robert J. Hogan
Appearances:
Counsel for the Appellant:
Vern Krishna, Q.C.
Alexander Yu
Osnat Nemetz (student-at-law)
Counsel for the Respondent:
Suzanie Chua
AMENDED JUDGMENT
The appeal from the reassessments made under the Income Tax Act (Canada) for the 2010, 2011, 2012 and 2013 taxation years is allowed in part only and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
The parties will have until June 24, 2017 to agree on costs, failing which they are directed to file their written submissions on costs no later than June 25, 2017. Such submissions are not to exceed 10 pages.
This Judgment is issued in substitution for the Judgment dated June 14th, 2017.
Signed at Ottawa, Canada, this 20th day of June 2017.
“Robert J. Hogan”
Hogan J.
Citation: 2017 TCC 112
Date: 20170614
Docket: 2015-1539(IT)G
BETWEEN:
DR. DAVID MADY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
AMENDED REASONS FOR JUDGMENT
Hogan J.
I. Introduction
[1] The Appellant, Dr. David Mady, has appealed reassessments made in respect of his 2010, 2011, 2012 and 2013 taxation years. This appeal concerns the tax consequences of two distinct series of transactions.
[2] The first series concerns a transfer of shares in a professional corporation from a family trust, to the Appellant’s spouse and, immediately thereafter, to the Appellant. Dividends were subsequently declared while the shares were held by the Appellant. However, those dividends were reported and taxed in the hands of the Appellant’s spouse on the basis that section 74.1 of the Income Tax Act (“ITA”) applied. [1] The Minister reassessed the Appellant, adding the dividends received by him to his income on the basis that subsection 74.5(11) applied.
[3] The second series of transactions involved an internal reorganization carried out by the Appellant immediately prior to the sale of his dental practice to an arm’s length purchaser. The Minister reassessed the Appellant, alleging that he carried out a reorganization of the share capital of the professional corporation for the purpose of having a significant portion of the capital gains realized on the arm’s length sale taxed in the hands of his spouse and two children. The Minister observed that the Appellant’s spouse and two children each acquired 85 common shares from the Appellant for $0.85. These shares were immediately thereafter sold to the arm’s length purchasers for a capital gain of $734,888. Therefore, the Minister takes the position that the purchase price on the sale of the shares to the Appellant’s spouse and children was significantly below the fair market value (“FMV”) of those shares under the market approach method of valuation.
II. Facts
A. Contextual Background
[4] Dr. Mady is a dentist. He operated two clinics, one in Windsor and one in Belle River, Ontario. His practice was conducted through Mady Dentistry Professional Corporation (“MDPC”), which was at various times also known by the names JJM Hygiene Corp. or 1352155 Ontario Inc.
(1) The first series of transactions
[5] In 1999, the Appellant’s mother settled a family trust, with the Appellant, his spouse Mrs. Judy Mady, and his children as beneficiaries. All issued and outstanding shares of MDPC, then known as JJM Hygiene Corp., were held by the trust. A change in the rules of the Royal College of Dental Surgeons of Ontario required that the Appellant own the voting shares of MDPC. Thereafter, the shares could no longer be held in the trust.
[6] The Appellant, his spouse, and two children were all capital beneficiaries of the trust. As trustee, the Appellant could have transferred the shares directly to himself. The Appellant, however, first distributed the shares to his wife, who immediately thereafter gifted the shares back to the Appellant. In doing so, Dr. Mady was acting on the advice of a partner at BDO Dunwoody LLP. Dr. Mady’s current advisor, Mr. Van Essen, was not his advisor at that time.
[7] After this first series of transactions, the Appellant declared dividends from MDPC to himself. However, the dividends were reported in his spouse’s income through the operation of the attribution rules in section 74.1. The Minister applied subsection 74.5(11) to prevent the attribution of income to the Appellant’s spouse, alleging that the purpose of the transfers was to reduce the amount of tax payable on the dividend income.
(2) The second series of transactions
[8] The second series has two parts. Part one is the internal share reorganization, commonly known as an estate freeze.
[9] Mr. Van Essen had been advising Dr. Mady to implement an estate freeze for a number of years. The purpose of the freeze was to allow Dr. Mady to income split by declaring dividends to his daughters and to purify MDPC so that gains realized on the sale of its shares would qualify for the capital gains exemption.
[10] Under the plan devised by Mr. Van Essen, the 100 Class A common shares in MDPC (the “old shares”) held by Dr. Mady were exchanged for a mix of fixed-value preferred shares and common shares (the “new shares”). The plan called for issuing fixed-value preferred shares equal in value to the FMV of MDPC. This necessitated a valuation, which was performed by a valuator at BDO. The freeze resulted in the following new shares being issued, allegedly on a tax-free basis pursuant to section 86:
No. Class FMV
2,071,497 Class A Preferred Shares $2,071,497
100 Class B Common Shares $1
100 Class C Common Shares $1
100 Class D Common Shares $1
$2,071,500
[11] In the final step of the freeze, Dr. Mady sold 85 of the Class B, C, and D common shares to each of his spouse and his two children in trust for an amount equal to their paid-up capital (“PUC”) and adjusted cost base (“ACB”), being one cent per share.
[12] The freeze was not carried out until January 13, 2012, the same day that all of the issued and outstanding shares of the corporation were sold to an arm’s length purchaser for $4.5 million in the circumstances described below. Despite this delay, the freeze reorganization was executed using the FMV as at July 1, 2011.
[13] Part two of the second series is the sale of the shares to the arm’s length purchasers.
[14] At the beginning of October 2011, Dr. Mady was approached at a hockey game by Mr. Marco Dolfi. At that time, Mr. Dolfi was acting for Dental Corporation of Canada Inc. and Dental Corporation of Canada Holdings Inc. (jointly referred to as “DCC”).
[15] DCC was new to Canada. Its business model, derived from the Australian dental service provider, Dental Corporation, called for acquiring a large number of dental practices and spreading costs over those practices for the purpose of realizing higher earnings.
[16] Mr. Dolfi introduced Dr. Mady to Dr. Andrew Meikle and Graham Rosenberg, co-CEOs of DCC. Negotiations began and, on October 14, 2011, the Heads of Agreement were signed, the purchase price being $4.5 million. On December 15, 2011, the Share Purchase Agreement (“SPA”) was executed.
[17] The transaction with DCC included a SPA for the purchase of the outstanding shares in MDPC from Dr. Mady, his spouse, and his two children in trust. The transaction price of $4.5 million was paid with $3.6 million in cash and 900,000 shares in DCC on a tax-free basis pursuant to section 85. The reported FMV of the 900,000 shares in DCC was $900,000.
[18] Dr. Mady and DCC also executed a Professional Services Agreement in conjunction with the SPA. The Professional Services Agreement required Dr. Mady to continue to provide services for 5 years or to arrange for someone else to provide such services. He would be paid a set remuneration. He was required to guarantee a minimum profit level in the form of earnings before interest, tax, depreciation and amortization (“EBITDA”). If the minimum EBITDA was not met, Dr. Mady would face a clawback from his salary. If he exceeded the EBITDA target, he would receive a bonus.
B. Partial Statement of Agreed Facts [2]
[19] The parties filed a partial statement of agreed facts stating the following:
[20] The Appellant was married to Judith Jamail-Mady and they had two daughters, Alexis and Madison, who were minor children at the relevant time.
[21] The Appellant was a dentist practicing in Ontario.
[22] JJM Hygiene Corp. was incorporated on June 21, 1999.
[23] JJM Hygiene Corp. or Mady Dentistry Professional Corporation (“MDPC”) was the Appellant’s professional corporation for his dentistry practice.
[24] The paid up capital and adjusted cost base of 100 Class A common shares in JJM Hygiene Corp. were each $100.
[25] Prior to October 18, 2002, the sole shareholder of JJM Hygiene Corp. that owned 100 Class A common shares was The David Charles Mady, Jr. Family Trust. [3]
[26] The Appellant was the sole trustee of The David Charles Mady, Jr. Family Trust.
[27] On October 18, 2002, the Appellant, acting as the sole trustee of The David Charles Mady, Jr. Family Trust, transferred 100 Class A common shares to Mrs. Mady. [4]
[28] On October 18, 2002, Mrs. Mady gifted the same 100 Class A common shares of JJM Hygiene Corp. to the Appellant. [5]
[29] After the aforesaid transfers, the Appellant became the sole shareholder of MDPC. [6]
[30] The Appellant did not report dividends declared by MDPC in 2010 and 2011 to him.
[31] Mrs. Mady reported the dividends declared by MDPC in 2010 and 2011 in amounts of $659,750 and $110,000 respectively. [7]
[32] On December 6, 2002, JJM Hygiene Corp. was renamed MDPC.
[33] MDPC’s Ontario corporation number was 1352155. [8]
[34] 2309712 Ontario Inc. was incorporated in Ontario on December 15, 2011 by the Appellant as the sole shareholder. [9]
[35] On or about January 13, 2012, the following series of transactions were undertaken by the Appellant, Mrs. Mady, the Appellant acting as trustee for Alexis and Madison, and as the sole shareholder of Alexis Dental Ltd. and 2309712 Ontario Inc. (incorporated on December 15, 2011) respectively:
Reorganization of MDPC under s. 86 of the Act
(i) Pursuant to an agreement dated December 15, 2011, Dental Corporation of Canada agreed to purchase the shares of MDPC for $4,500,000 on January 13, 2012; [10]
(ii) The Appellant exchanged 100 Class A common shares of MDPC for 2,071,497 Class A preference shares, 100 Class B common shares, 100 Class C common shares and 100 Class D common shares on a tax-free basis; [11]
(iii) The purchase price of the share exchange stated in the agreement was $2,071,500;
(iv) This share exchange agreement included a price adjustment clause; [12]
(v) The 2,071,497 Class A preference shares had:
i. Paid-up capital of $97;
ii. An adjusted cost base of $97; and
iii. A redemption value of $2,071,497; [13]
(vi) The paid-up capital and adjusted cost base of the 100 Class B common shares, 100 Class C common shares and 100 Class D common shares was $1 each; [14]
Transfer 800,000 MDPC Class A preference shares to Alexis Dental Ltd.
(vii) The Appellant was the sole shareholder of Alexis Dental Ltd; [15]
(viii) The Appellant sold 800,000 MDPC Class A preference shares to Alexis Dental Ltd. for $800,000 on a tax-deferred basis under s. 85 of the ITA; [16]
(ix) The purchase price was paid by Alexis Dental Ltd. issuing 800,000 Alexis Dental Ltd. Class A preference shares to the Appellant; [17]
(x) The parties reported the transaction under s. 85 of the ITA as follows: [18]
i. Fair market value of 800,000 MDPC Class A preference shares was $800,000;
ii. The adjusted cost base of 800,000 MDPC Class A preference shares was $37.46;
iii. The agreed amount under s. 85(1) of the ITA was $37.46;
(xi) MDPC redeemed 800,000 Class A preference shares for $800,000; [19]
(xii) Alexis Dental Ltd. reported a deemed dividend of $799,962.54 as a tax-free intercorporate dividend; [20]
Class B, Class C and Class D common shares – Mrs. Mady, Alexis and Madison
(xiii) Mrs. Mady, Madison and Alexis (the latter two through the Appellant acting as trustee) purchased 85 Class B, 85 Class C and 85 Class D common shares in MDPC respectively from the Appellant; [21]
(xiv) The purchase price stated in each of the agreements between the Appellant and Mrs. Mady, Alexis and Madison respectively, was $0.85 subject to a price adjustment clause; [22]
Goodwill
(xv) The Appellant purchased the goodwill of the dental practice from MDPC for $900,000; [23]
(xvi) The Appellant paid MDPC with a non-interest bearing promissory note for $900,000; [24]
(xvii) The Appellant sold the goodwill of the dental practice to 2309712 Ontario Inc. for $900,000 on a tax-deferred basis under s. 85 of the ITA, for 100 common shares in 2309712 Ontario Inc. The parties reported the transaction as follows: [25]
i. The fair market value of the goodwill and of the share consideration was $900,000;
ii. The redemption value of 100 common shares was $9,000 per share;
iii. The agreed amount under s. 85(1) of the ITA was $900,000.
[36] On January 13, 2012, the Appellant, Mrs. Mady, and the Appellant acting as trustee for Alexis and Madison sold to third parties shares in MDPC and 2309712 Ontario Inc. for an aggregate sum of $4,500,000 as follows: [26]
(i) Sold by the Appellant to Dr. Meikle Dentistry Professional Corporation (“PC Purchaser”), 100 common shares in 2309712 Ontario Inc. for $900,000;
(ii) Sold by the Appellant to Dental Corporation of Canada Holdings Inc. (“DCCH”), 900,000 Class A preference shares in MDPC for $900,000 on a tax-deferred basis under s. 85 of the ITA for 900,000 common shares of DCCH;
(iii) Sold by the Appellant, Mrs. Mady, and the Appellant acting as trustee for Alexis and Madison, to Dental Corporation of Canada Inc. (“TSC Purchaser”), 371,497 Class A preference shares, 100 Class B, 100 Class C and 100 Class D common shares for the aggregate price of $2,700,000.
[37] PC Purchaser, DCCH and TSC Purchaser were each at arm’s length vis-à-vis the Appellant, Mrs. Mady, Alexis and Madison.
[38] The working capital adjustments added to the fair market value of the shares sold by the Appellant, Mrs. Mady, Alexis and Madison to determine the proceeds of disposition were $39,783, $75,146, $75,146 and $75,146 respectively. [27]
[39] The Appellant reported the transactions above as proceeds of disposition of $1,660,597 that were the aggregate of $900,000 proceeds from the sale of 100 common shares in 2309712 [28] and $760,537 proceeds [29] from the sale of 371,497 Class A Preference shares, 15 Class B common shares, 15 Class C common shares and 15 Class D common shares in MDPC combined.
[40] The Appellant reported capital gains of $760,537 in the 2012 taxation year as follows: [30]
371,497 Class A preference shares in MDPC
$371,497
15 Class B common shares in MDPC
$116,425
15 Class C common shares in MDPC
$116,425
15 Class D common shares in MDPC
$116,425
Working capital adjustment
$39,783
100 common shares in 2309712 Ontario Inc.
Nil
$760,537
And he applied a capital gains deduction of $375,000.
[41] Mrs. Mady, Madison and Alexis each reported proceeds of disposition and capital gains of $734,888 or taxable capital gains of $367,443 on the sale of 85 Class B, 85 Class C and 85 Class D common shares respectively, and applied a capital gains deduction of $367,443, $367,443 and $356,621 respectively in the 2012 taxation year. [31]
[42] On January 13, 2012, MDPC was renamed 1352155 Ontario Inc. [32]
[43] On March 1, 2012, 1352155 Ontario Inc. was dissolved. [33]
[44] The Minister assessed the Appellant for the 2010 to 2013 taxation years by notices dated May 12, 2011, May, 17, 2012, May 16, 2013 and May 5, 2014 respectively.
[45] The Minister reassessed the Appellant on September 10, 2013 for the 2010, 2011 and 2012 taxation years.
[46] On December 5, 2014, the Minister reassessed the Appellant with respect to the 2010 to 2013 taxation years as follows:
(i) Taxable dividends of $659,750 and $110,000 in the 2010 and 2011 taxation years respectively;
(ii) Taxable capital gains of $1,214,251.50 in the 2012 taxation year;
(iii) Reduction to minimum tax carried over by $10,409.35 in the 2013 taxation year.
[47] With respect to the reassessment of taxable capital gains of $1,214,251 for the 2012 taxation year, that amount was determined on the basis that the fair market value as at January 13, 2012 of 100 Class A common shares the Appellant owned in Mady Dentistry, Professional Corporation (“MDPC”, later renamed 1352155 Ontario Inc.) that were exchanged for (i) 2,071,497 Class A preference shares with a redemption value of $1, (ii) 100 Class B common shares, (iii) 100 Class C common share and (iv) 100 Class D common shares of MDPC on a tax-free basis pursuant to section 86 of the ITA, was $4,500,000 which is based on the ultimate sale on the same day to third parties.
[48] The amount of $4,500,000 was based on the actual transaction sale price to third parties.
C. Review of Evidence
(1) Michael Van Essen
[49] Mr. Michael Van Essen is a chartered accountant with BDO Canada. He has worked full time since 2001 and has been a tax partner since 2010. He is familiar with Mr. Mady’s affairs as his advisor.
[50] The evidence shows that Mr. Van Essen had limited involvement with The David Charles Mady, Jr. Family Trust. [34] That was handled by a former partner who was the Appellant’s accountant at the time. Mr. Van Essen explained that the Family Trust was wound up in 2002 after a change in the dental hygiene rules in Ontario which mandated that no one other than a licensed dentist could practise dental hygiene unless it was in a professional corporation and that only a licensed dentist could hold shares in such a professional corporation. He further explained that the change in rules resulted in less tax-efficiency than had been the case before, in that, when the trust had been able to hold the shares of the professional corporation, dividends could be declared to any of the trust beneficiaries. Later on cross-examination, Mr. Van Essen testified that there were family law reasons for distributing the shares to Judy first, that it offered some type of protection. However, Mr. Van Essen was not the advisor at the time of the transfer, and this explanation contradicts the earlier explanation that the intent was to rely on the attribution rules in making the transfer. Furthermore, the family law explanation is not borne out by the evidence. Dr. Mady himself was a capital beneficiary of the trust and was able to directly transfer the shares to himself from the trust. The family law explanation appears to have been concocted as an after-the-fact justification for the shares being transferred in a two-step transaction to Dr. Mady.
[51] Mr. Van Essen did prepare the Appellant’s tax returns for 2010 and 2011. In those years, the dividend income from MDPC was attributed Mrs. Mady. [35] Mr. Van Essen testified that Mrs. Mady has not been reassessed to remove the dividend income that the CRA has attributed to the Appellant pursuant to section 74.5(11).
[52] Mr. Van Essen relied on Joanne King, a chartered business valuator in his office, to value the shares of MDPC as at July 1, 2011 which was the date immediately following the par-end of the fiscal year for which its latest financial statements were available. Mr. Van Essen used this valuation in carrying out the freeze. Significantly, Mr. Van Essen did not tell Ms. King about the DCC offer to purchase Dr. Mady’s practice. Mrs. King was also unaware of the fact that the freeze was to be carried out on the same day that MDPC was to be sold to an arm’s length purchaser.
[53] Step one was the section 86 share-for-share exchange. The 100 Class A common shares held by Mr. Mady in MDPC were exchanged for 2,071,497 preferred shares and 100 each of Class B, C, and D common shares. The preferred shares were assigned a value of $1 per share, and each class of common shares was assigned a value of one cent.
[54] The section 86 share-for-share exchange was done in conjunction with articles of amendment. The articles provide that the preference shares are to be redeemed at fair market value. [36] The share exchange agreement regarding the section 86 share-for-share exchange contained a price adjustment clause (“PAC”). [37] The purchase price was stated to be $2,071,500, “being the parties’ best estimate of the fair market value.” [38]
[55] The second step was to purify MDPC, since it had made loans to Dr. Mady’s holding corporation Alexis Dental Ltd., as well as to another corporation called Aesthetica. This was done using a section 85 rollover to transfer 800,000 of the Class A preference shares in MDPC from Dr. Mady to Alexis Dental Ltd. In exchange, Dr. Mady took back 800,000 Class A preference shares in Alexis Dental Ltd. Step three was for Alexis Dental Ltd. to redeem the MDPC shares it held for $800,000, resulting in a deemed dividend, to offset the $798,690 debt that Alexis Dental Ltd. and Aesthetica owed to MDPC. After the purification, the value of MDPC was reduced by $800,000, with 1,271,497 Class A preferred shares in MDPC remaining in Dr. Mady’s hands.
[56] Mr. Van Essen also instructed the lawyer to draft the agreement for the transfer of shares under section 85 to purify MDPC. [39] This agreement also has a PAC. [40]
[57] In step four, Dr. Mady sold the Class B, C, and D common shares to his spouse and two children. Mr. Van Essen considered these shares to be worth nothing, so they were sold for a value equal to their paid-up capital (being one cent per share). At this point, Dr. Mady is left with the 1,271,497 Class A preferred shares and 15 each of the Class B, C, and D common shares.
[58] Separate SPA to sell 85 each of the Class B, C, and D common shares to his spouse and two children were drawn up. [41] Each of these has a price adjustment clause. [42] Mr. Van Essen was also involved in providing instructions on these agreements.
[59] Mr. Van Essen testified that Dr. Mady relied on him and BDO in the course of these transactions. Dr. Mady did not provide input on the transactions. Mr. Van Essen thought it was in Dr. Mady’s best interests to obtain as high a capital gain as possible in exchange for less salary.
[60] In exchange for the purchase price of $4.5 million, Dr. Mady received $900,000 in DCC shares and $3.6 million in cash, allocated among himself, his spouse, and their two children.
[61] Dr. Mady was required to execute a Professional Services Agreement. Under this agreement, Dr. Mady had to guarantee a minimum EBITDA (the “EBITDA Target”) or else face a clawback of his own salary. The clawback was to be effected automatically and according to a formula. There was no opting out. The only way the clawback would not operate was if Dr. Mady died or became disabled.
[62] The earnings projections that were used to set the EBITDA Target were reviewed by Deloitte in performing the due diligence on behalf of the purchaser.
[63] While the projected 2012 EBITDA Target was higher than prior year results, Mr. Van Essen described the target as “realistic” in an email to DCC because it was in line with Dr. Mady’s average revenue growth of 15% per year for the previous four years. [43] The acquisition budget called for total revenue of $2.550 million, [44] which was also the figure used in the Heads of Agreement. [45] Higher EBITDA would also be achieved through savings in overhead costs, which DCC would be able to achieve after the acquisition. [46] Mr. Van Essen admitted on cross-examination that he would not have advised Dr. Mady to accept the figure if it were not within the realm of possibility.
[64] As for the 900,000 DCC preference shares that Dr. Mady received, Mr. Van Essen thought that they might not be worth anything. There are allegations of restrictions on the sale of those shares, although no share restrictions were shown to the Court. As a result, Mr. Van Essen considered them not to be sellable. However, on cross-examination, it was shown through an email that was copied to Mr. Van Essen that Dr. Mady was clearly concerned about the price of those shares going up by the time the purchase was completed. [47] He was clearly worried that the purchaser would require that the shares be issued at a higher price. If this happened he would receive a lesser number of common shares. This indicates that Dr. Mady was satisfied that the shares were worth at least $900,000. The shares issued to Dr. Mady were reported as having an FMV of $900,000 on the section 85 rollover form. [48]
[65] While Mr. Van Essen acknowledged that the freeze was effected on January 13, 2012, he testified that the estate freeze was intended to be completed sooner than that. He blamed the lawyer for not having prepared the documents earlier. Specifically, Mr. Van Essen claimed that the reorganization was meant to have been carried out on October 31, 2011. But in an email dated October 21, 2011, Mr. Van Essen advised DCC that a reorganization was currently underway, that he would advise them of the final structure and that he would work with DCC so that the final structure would also meet their criteria. [49] The details of the reorganization remained to be worked out. Therefore, Mr. Van Essen’s attempt to blame the lawyer for the delay in implementing the freeze appears unjustified.
[66] The emails between DCC, Dr. Mady, and Mr. Van Essen suggest a first meeting with DCC took place as early as October 5, 2011, when Dr. Meikle for DCC asked Dr. Mady to sign a non-disclosure agreement, and as late as October 12 when it appears the parties were scheduled to meet. [50] On October 14, 2011, Mr. Van Essen emailed Dr. Mady and the DCC representatives, suggesting a purchase price of $4.5 million. [51]
[67] Mr. Van Essen had sent DCC a normalized profit and loss statement showing rent being normalized with a reduction of about 75%. [52] Mr. Van Essen asserted that there had been no overcharging for rent but rather they had decided to reduce the rent to increase the EBITDA and obtain a higher purchase price.
[68] The Heads of Agreement document for the DCC sale was signed on October 14, 2011. [53] The agreement states the proposed purchase price to be $4.5 million, based on an EBITDA of $913,512 and subject to due diligence and the agreement being executed. The final SPA was signed on December 15, 2011 with the same purchase price and EBITDA. [54]
(2) Dr. David Mady
[69] The Appellant, Dr. David Mady, testified that he has relied on BDO to provide tax advice to him since the 1990s. He has worked with Mr. Van Essen and had worked with another partner before him. While Mr. Van Essen spoke to Dr. Mady about the transactions, Dr. Mady testified that he did not understand the transactions and relied on Mr. Van Essen’s advice.
[70] As for the transfer of the MDPC shares from the trust to his spouse and then to himself, Dr. Mady testified that he did not remember anything about these transfers.
(3) Joanne King
[71] Ms. Joanne King was presented as an expert witness by the Appellant. She has been an associate with BDO since 2009. She is a chartered business valuator. The Crown objected to her qualification as an expert on the basis of prejudice and a lack of independence. After a voir dire, Ms. King was qualified as an expert witness.
[72] Ms. King used the income approach to value the shares of MDPC. She described such a valuation, which is done on a notional basis, as an art, not a science. It is performed in the absence of a market price. She compared the value so determined with the “rule of thumb” value, which is an industry-specific number used as a reference guide. In this case, Dr. Mady’s practice was valued at a figure much higher than the rule of thumb figure, which Ms. King considered reasonable in her report since Dr. Mady had two locations and significantly higher profit margins.
[73] Ms. King determined the value of Dr. Mady’s practice by looking at the income of the business. She admitted to making one error in her report by using after-tax income in her cash-flow calculation instead of before-tax income. She corrected this error in her Limited Critique Report. [55] She then normalized expenses that are atypical of a dental practice, which had the effect of increasing the net income used to determine the value. She took the income for the previous three years into account (from 2009 to 2011) and used a weighted average to give more weight to the most recent year. She then multiplied the figure by a capitalization rate which represents the risk of the business. Because the capitalization rate is a judgment call and there is no set number to use, she applied a high and low capitalization rate to come up with a reasonable range. In this case, the value range as at July 1, 2011 was determined to be between $1.939 million and $2.204 million, with a midpoint of $2,071,500. The midpoint number of $2,071,500 was ultimately used as the value. The corrected value in the Limited Critique Report, to account for the above noted error, is $2,442,000 as at July 1, 2011. [56]
[74] Ms. King also considered the value of the redundant assets after calculating the value on the income approach. Redundant assets are those which are not required for use in the business. This includes things such as excess cash. Typically, they can be and are easily extracted prior to a sale. Ms. King determined that there were no redundant assets at the time of this valuation. The amounts due from related parties she did not consider to be a redundant asset because of the relationship between those parties. Ms. King also valued the goodwill of the practice by taking her valuation and subtracting the value of the tangible assets. She determined the goodwill to have a value of $1,746,500.
[75] Ms. King also produced a Limited Critique Report of the Richter Report. [57] She stated that the fundamental difference between the two reports is the date of valuation, being, in her report, July 1, 2011, the intended date of the estate freeze, and, in the Richter Report, January 13, 2012. Ms. King’s comment that the freeze was intended to be carried out on July 1, 2011 conflicts with the testimony of Mr. Van Essen that the freeze was intended to be carried out in October 2011.
[76] She agreed with the Richter Report that DCC was a special purchaser but asserts that you need to look at the whole transaction and not just the purchase price. In this case, the whole transaction would include the DCC shares that Dr. Mady received as part of his consideration, and the Professional Services Agreement, which included the clawback mechanism. As for the 900,000 DCC shares that Dr. Mady received, Ms. King asserted that, while they were assigned a value of $900,000 by the parties, this does not mean that they were worth $900,000.
[77] On cross-examination, Ms. King acknowledged that she was not aware of the proposed transaction with DCC at the time of issuing her report. In addition, her report was made on the basis of the reorganization’s being carried out on July 1, 2011, but the report was issued much later because she needed to wait for the year-end financial statements. Ms. King also admitted that the DCC purchase would have had an impact on her report, had she known about the pending transaction when she issued her report.
(4) Jim Tracey
[78] Mr. James Tracey is a chartered professional accountant and chartered business valuator. Mr. Tracey was called as an expert witness by the Appellant. He was qualified without objection. Mr. Tracey had two expert reports. The first is a review of the BDO report by Ms. King and of the CRA report. [58] The second is a Limited Critique Report on the Richter Report. [59]
[79] My. Tracey’s first report is not a traditional report. He does not opine on the value of the shares of MDPC. Rather, he provides comments on the other expert reports, produced by the Appellant and the Respondent.
[80] First, Mr. Tracey examined the proposed 2012 budget. He compared the actual expenses from the first half of the 2012 fiscal year, annualized for the entire year, with the 2012 budget. He found that the actual expenses were higher than the budgeted expenses by 27%. He also did the same calculation for the 2012 income and found that the 2012 budget income was almost double, at 93%, the income for the first half of the 2012 fiscal year, annualized. Therefore, he concluded that the 2012 budget was not justified and not supportive of the determination of a purchase price. Mr. Tracey felt that DCC in this instance was willing to use the 2012 budget because of the clawback in the Professional Services Agreement.
[81] Mr. Tracey also compared the capitalization multiplier used by both BDO and the CRA. The CRA applied the multiplier to the EBITDA, whereas BDO applied it to the earnings. He believes that, once he accounted for this difference, BDO and the CRA were using substantially the same capitalization multiplier.
[82] Mr. Tracey also compared the redundant assets. BDO included no redundant assets. Mr. Tracey’s opinion is that the redundant assets as at January 13, 2012 amounted to $281,000.
[83] Next, Mr. Tracey adjusted Ms. King’s valuation to reflect the value as at January 13, 2012 instead of July 1, 2011. He based this on actual expenses and income, on an annualized basis, and included the redundant assets. In the end, he comes up with an updated range and takes the average midpoint between the BDO and CRA valuations, concluding that the fair market value of MDPC as at January 13, 2012 was $2,630,000.
[84] Finally, Mr. Tracey compared the figures with the rule of thumb, which he described as a reasonableness test. He used a rule of thumb of 100% of revenue, which, when applied to the 2012 projected revenue, is $2,442,000. The original CRA estimate of $4.5 million is more than twice that amount. Mr. Tracey could not figure out why. On this basis, Mr. Tracey concluded that the original CRA estimate does not represent the FMV of MDPC, unlike his own figures, which are close to the rule of thumb.
[85] In Mr. Tracey’s opinion, the purchase price is greater than the FMV because DCC is a special purchaser and there is a clawback in the Professional Services Agreement. Overall, he considered Ms. King’s methods to be appropriate with the one exception of the mistake Ms. King admitted to.
[86] On cross-examination, Mr. Tracey was shown a number of emails between Dr. Mady, Mr. Van Essen and DCC. These emails have Mr. Van Essen stating that the 2012 growth projection was realistic given the 15% increase per year over the past four years, [60] and generally show that the figures used by DCC and Deloitte in their due diligence came from Mr. Van Essen and Dr. Mady. Mr. Tracey had not seen these emails before. Rather, he had relied on Mr. Van Essen’s statements that they had claimed a higher EBITDA for the purpose of getting a higher capital gain. Mr. Tracey was not aware of what sort of due diligence had been carried out by the purchaser.
(5) Andrew Michelin
[87] Mr. Andrew Michelin is a chartered business valuator and chartered accountant. He has been with Richter Advisory Group Inc. as a business valuator since 2001. He was called as an expert witness by the Respondent and was qualified as an expert witness with no objection. He produced a comprehensive valuation report. [61]
[88] Mr. Michelin testified that in this case, because the arm’s length purchase and sale was carried out on the same day as the freeze, the market approach should be used to value the shares. The parties, after hard bargaining, agreed that the shares sold were worth $4.5 million. Mr. Michelin also completed a notional valuation of MDPC as a back-up check of the reasonableness of the market approach that had been decided on. In his opinion, one cannot ignore the arm’s length purchase price set by the parties given that the freeze was carried out on the same day as the sale.
[89] Mr. Michelin compared the historical revenue and expenses of MDPC going back five years and calculated the adjusted EBITDA for those years. He then compared the 2011 figures and the 2012 budget. He noted that expenses were down in the 2012 budget year on account of synergies, and that revenue was expected to grow by 15%, which was in line with growth in prior years. Overall, he considered the 2012 budget reasonable. Mr. Michelin also noted that Deloitte considered it reasonable as well. However, in determining the enterprise value he did not rely solely on the 2012 budget EBITDA since it relied on the performance of Dr. Mady. To reduce the risk that this represented, he used an average of the 2011 EBITDA and the 2012 budget EBITDA.
[90] Mr. Michelin also stated that in a situation such as this, where there is an imminent transaction, the incremental value resulting from the imminent sale must be considered in the determination of the FMV. This essentially results in use of the market approach to determine the FMV.
[91] Mr. Michelin testified that the Professional Services Agreement is no different from any other business transaction. Such an agreement is the norm in his opinion. He observed that Dr. Mady was not required to work in the practice. He could hire replacements. His only obligation was to ensure that the EBITDA Target was met.
[92] Mr. Michelin also looked at the rules of thumb and found them to be not helpful in this case. This is because Dr. Mady’s practice was very profitable. In addition, with DCC’s entry into the market in September of 2011, the rules changed, and the old rule of thumb no longer applied.
[93] Mr. Michelin concluded that the FMV of the issued shares of MDPC as at January 13, 2012 was $5.288 million, representing the stand-alone enterprise value, plus redundant assets, minus interest-bearing debt, plus the incremental value of the imminent sale to DCC.
[94] Next, Mr. Michelin considered whether there should be a discount for the clawback in the Professional Services Agreement or for the DCC shares. First, Mr. Michelin noted that the claw back only affects Dr. Mady’s future remuneration, not the value of the shares. Second, he considered the risk of a clawback low. The EBITDA Target was reasonable because it accounted for the synergies obtainable by DCC.
[95] In Mr. Michelin’s critique of the Tracey report, he comments that Mr. Tracey ignored the DCC transaction. Mr. Michelin also considers Mr. Tracey to have committed two errors: in considering the 2012 budget, he made a mistake with regard to lab fees, and he failed to consider purchaser synergies. He also points out that the Tracey valuation cannot be relied upon because it failed to take into account the DCC transaction that was agreed to prior to the freeze transaction.
(6) Lucia Hutchins
[96] Ms. Lucia Hutchins was the CRA auditor for this file. She has been with the CRA for approximately 21 years.
[97] Ms. Hutchins requested a valuation by a CRA valuator because of the representations being made by Dr. Mady and Mr. Van Essen and because of the transaction price. The CRA valuator valued MDPC at or around $5.1 million. In the end, she used the transaction price as the FMV of the 100 Class A common shares in MDPC as at January 13, 2011. She considered this a fair, realistic number, adopting a conservative approach.
[98] Ms. Hutchins applied gross negligence penalties because she found Dr. Mady to be an educated, astute man who appeared to understand tax matters well enough to know that these plans were devised to achieve tax savings. For example, with regard to the first series of transactions, her impression was that Dr. Mady knew that h