Understanding Natural Resources Taxation: Daishowa v. The Queen 2011 FCA 267

1. Caselaw Update2nd Understanding NaturalResources Taxation Steve Suarez May 23, 2012

2. Daishowa v. The Queen 2011 FCA 267 Daishowa solicits bids for sawmills and related timber rights Tolko bid offers $180 million less TBD estimate of reforestation obligation being assumed by Tolko Daishowa negotiates sale price as $169 million, with Tolko assuming the reforestation obligation

3. Daishowa v. The Queen 2011 FCA 267 Sale agreement also provides for a post-closing payment by Daishowa to Tolko of any amount by which post-closing audited statement of current and long-term reforestation liabilities exceeds $11 million (or vice versa if less) PWC advised that structuring the sale as a net purchase price of $169 million, with a separate rep/warranty and post-closing payment if reforestation estimate differs from $11 million, will limit Daishowa’s proceeds for tax purposes to $169 million

4. Daishowa v. The Queen 2011 FCA 267 Agreement of Purchase and Sale Purchaser assumes responsibility for Assumed Obligations Vendor estimates reforestation liabilities at $11M Parties agree that vendor will have reforestation statement setting out estimated costs prepared and audited, and that purchase price will be adjusted for any variance from $11M figure

5. Daishowa v. The Queen 2011 FCA 267 Two months post-closing, PWC provides a statement estimating current and long-term reforestation liability as $11,296,225  Daishowa pays Tolko $296,225 Daishowa does not include any amount relating to reforestation costs in its sale proceeds for tax purposes CRA adds $11 million to Daishowa’s sale proceeds

6. Taxpayer Arguments No addition to sale proceeds, since FMV of liabilities not determinable at closing Alternatively, $11 million not the true value of reforestation liability (no time value of money discount) Alternatively, whatever the value was, allow an offsetting deduction for paying Tolko to assume the obligation

7. Summary of Court Decisions

8. Tax Court of Canada Daishowa admits if Tolko had not assumed reforestation liability, it would have paid more money to Daishowa Being relieved of reforestation obligations has some value, but not $11 million The $11 million figure was not the true value of this obligation, and not the number the parties agreed as consideration  Value was current portion + 20% of long-term portion No offsetting deduction: capital expenditure

9. FCA Majority Daishowa admitted that but for the obligation assumption it would have received more cash Restructuring the sale agreement as PWC proposed changed nothing The parties used the reforestation numbers as values, not estimates, and having valued reforestation at $11 million, that is the amount added to Daishowa’s sale proceeds Note precise dollar amount in PWC statement

10. FCA Majority (cont’d) Whatever value parties attribute to an assumed liability is the vendor’s addition to sale proceeds for tax purposes “true” value is irrelevant Example: The parties attributed no value to the purchaser being responsible for all future tort liability from running the mill No offsetting deduction: capital expenditure

11. FCA Minority The Province of Alberta legally required Tolko to assume the reforestation obligations, and would not otherwise consent to the transfer As such, these obligations are inextricably linked to, and depress the value of, the underlying property  no amount should be added to Daishowa’s proceeds

12. FCA Minority (cont’d) It makes no sense to have the same transaction taxed differently depending on whether the parties ascribe a value to the obligations being inherited If liabilities being assumed are severable from the underlying property, the value of those obligations is included in the vendor’s sale proceeds

13. Status of Case No automatic right to appeal to the Supreme Court of Canada SCC must grant leave to appeal Taxpayer has sought leave to appeal; leave application and Crown’s reply have been filed On April 26, SCC leave panel deciding the leave application ordered an oral hearing on the decision to grant leave, (highly unusual), which is scheduled for June 4

14. Discussion What was being sold here: a property worth $169M or a property worth $180M? in an arm’s length transaction, logically that should tell us what the proceeds of disposition should be Fundamentally, the way in which the transaction was documented and the case presented to the courts hinged on this question, which was never directly addressed

15. Discussion If the obligation is not severable from the property, how can it be said that the vendor has $180M of value to convey? This is unlike the situation of a $180M property with an $11M mortgage on it, where the vendor can choose to sell the property for $169M plus have the purchaser assume the $11M mortgage; or sell the property unencumbered for $180M, and use $11M of the proceeds to pay off the mortgage Here, the vendor only had $169M of value to convey, and that should be its proceeds

16. Discussion Note that the vendor could create a property with $180M of value, by spending the required amounts to eliminate the accrued reforestation obligations so that the property really was worth $180M then, the vendor would have cash proceeds of $180M, but would also have tax recognition for the remediation expenditures The dissent’s analogy is a compelling one: if you sell a building that requires expenditures to be made in order to bring it into compliance with disability access laws, do we increase the vendor’s sale proceeds by the estimated compliance costs? of course not: the latent obligation (which is not severable from ownership of the building) simply reduces the property’s fair market value

17. Discussion Other problems with the FCA majority’s holding: lack of symmetry between tax treatment of vendor (who gets liability added to proceeds of disposition) and purchaser (CRA denies purchaser any basis addition for contingent liabilities) Inclusion of obligation assumption in vendor’s sale proceeds without any corresponding deduction (both courts denied this as being on capital account) effectively taxes the vendor on amounts that do not represent an accretion to wealth (phantom income) What is needed is a legislative solution for dealing with contingent liabilities and obligations created as part of (but which crystallize after) the income-earning process

18. Lessons from Daishowa 1. Form and Phrasing Matters Lots of liabilities get assumed by purchasers on asset sales without any effect on the vendor’s proceeds: what went wrong here? Documentation: the parties characterized and documented the reforestation obligation as something that was a liability severable from the property and capable of being assumed independently Pleadings: in the court pleadings the taxpayer admitted that the purchaser would have paid more if it had not assumed the liability (as opposed to “the property would be worth more if there was no associated reforestation obligation”) This clearly encouraged the Tax Court and the FCA majority to treat the reforestation obligation as a distinct assumed liability, like a mortgage

19. Lessons from Daishowa 2. Beware of Post-Closing Adjustments The FCA majority says that the vendor’s proceeds are whatever amount the parties choose to ascribe to them (if any) Here the parties could have simply stated the purchase price as $168,703,775, but for the fact that they didn’t have the audited estimate of $11,296,225 ready at the time the sale agreement was signed, and needed to establish the $11M reference point as the basis for a post-closing adjustment  Think about stating the purchase price as simply as possible, and avoiding post-closing adjustments if possible

20. Lessons from Daishowa 3. Vendor-Purchaser Tension To the extent that liabilities are being expressly assumed by a purchaser, under the FCA majority’s judgment the sale proceeds will be whatever amount the parties choose. Logically, one would expect the parties to allocate little or no value to assumed liabilities additional proceeds generate immediate tax for vendors purchasers get little or no current benefit to extra proceeds (deferred recognition for tax purposes, and CRA has historically refused to allow purchasers any basis increase for contingent liabilities) The parties can compensate the purchaser for foregone basis recognition by adjusting the purchase price

21. Lessons from Daishowa 4. Get Tax Advice as Early as Possible The fact that the original offer was restructured to make it more tax-advantageous for the vendors showed that the parties appeared to be treating the reforestation obligation as being akin to additional sale proceeds, notwithstanding the final wording of the purchase and sale agreement While the $11M figure used as the reference point for the post-closing adjustment may itself have been enough to sink the vendor, the fact that the accountants had advised restructuring the phrasing of the sale agreement to achieve the same effect but with better tax treatment made clear what was going on.  Get tax input at the term sheet/LOI stage: once obligations get characterized as assumed liabilities, it is very hard to overcome this

22. Lessons from Daishowa 5. Solicitor-Client Privilege In determining that the parties had allocated $11M of value to the purchaser’s obligation to reforest the harvested lands, the Courts clearly were influenced by the PWC proposal to restate the purchase price in a way to minimize the vendor’s sale proceeds for tax purposes Lawyers have privilege; others (including accountants) do not

23. TransAlta Corporation v. The Queen 2012 FCA 20 In 2002, TransAlta sells its electrical transmission business to AltaLink, a consortium of SNC Lavalin, Ontario Teachers Pension Plan Board and two smaller investors. The purchase price was set at 1.31 times the vendor’s net regulated book value (NRBV) of the tangible assets of the business, allocated as follows: $591M depreciable assets $ 12M land $ 15M land rights $ 10M working capital $191M goodwill (this includes the 31% premium

24. TransAlta Corporation v. The Queen 2012 FCA 20 CRA objects to this allocation, saying that no goodwill exists in a regulated industry and the allocation to goodwill is an attempt to avoid recapture that would otherwise be realized on an allocation to depreciable property Taxpayer reassessed to allocate entire $191M goodwill amount to tangible assets CRA reassessment based on an expert report to the effect that, contrary to the economic and legal theories underlying the regulatory system, no goodwill existed; s.68 applied to allocate the entire $191M to tangible assets

25. Tax Court of Canada TCC rejects the assertion that no goodwill existed, concluding that TransAlta had created additional profits in excess of the Energy and Utilities Board-mandated return on equity of 9.75% through the creation of an efficient cost-conscious culture that was something a buyer would pay for, this being “goodwill” However the TCC reduced the “goodwill” amount by $50M for two items claimed to be included therein, on the basis that these items did not come within the legal definition of “goodwill” from a 1901 case, and that there was no evidence of hard bargaining on the purchase price allocation

26. Federal Court of Appeal FCA concludes that goodwill does indeed exist in regulated industries and did exist in this case due to cost efficiencies relative to forecasted costs used for rate- setting purposes generating additional revenue through new opportunities strategic business opportunities Any increase in the value of the business so achieved should be allocated to goodwill, and doing so is consistent with the relevant industry practice and regulatory framework

27. Federal Court of Appeal “As noted by Lord Macnaghten, goodwill is a concept which is difficult to define. It is composed of a variety of elements, and its composition varies according to different trades and different businesses in the same trade. Consequently, even after much study and numerous publications on the subject, a proper definition of goodwill has eluded both the legal and the accounting professions. Like the accounting profession, I conclude from this that any attempt to define goodwill is doomed to failure. Rather, various characteristics inherent to the notion of goodwill should be identified and then used to ascertain goodwill on a case-by-case basis.” “Three characteristics must be present in order for goodwill to be found: (a) goodwill must be an unidentified intangible as opposed to a tangible asset or an identified intangible such as a brand name, a patent or a franchise; (b) it must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business; (c) 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. If these three characteristics are present, it can be reasonably assumed that goodwill has been found.”

28. Federal Court of Appeal FCA rejects TCC deduction of $50M from goodwill allocation, concluding that “the residual approach to valuing goodwill is preferred”, whereby any consideration paid in excess of the fair market value of other assets is allocated to goodwill TCC was incorrect to try to value different elements of goodwill individually As to s.68, the test is whether a reasonable business person, with business considerations in mind, would have allocated $191M to goodwill, taking into account industry and regulatory standards and accounting and valuation theory yes: these factors are all consistent with the parties’ allocation – therefore s.68 does not apply

29. The End Thank you For more on the Canadian taxation of mining, go to www.miningtaxcanada.com Steve Suarez Borden Ladner Gervais LLP (Toronto) 416 367-6702 ssuarez@blg.com