1

Practice Valuation and Canada Revenue Agency (formerly Revenue Canada) By David Harris Introduction

When selling your practice (or shares of a corporation owning your practice), there are situations where Canada Revenue Agency (“CRA”) will review the practice value. CRA may also become involved when there is no actual sale but a value of your practice is required for some other purpose. The purpose of this article is to examine when CRA may become involved with the valuation of a practice, to outline the approach taken by CRA and to provide practical assistance in dealing with the valuation process. Arm’s Length Sale of Shares in a Corporation

This type of sale has the least potential for review. An actual purchase price paid between arm’s length parties defines market value and is not open to review. In a sale of shares, all of the practice assets are automatically transferred with no change in “book value” on the corporation’s books. This means that there is no requirement for the buyer and seller to make an allocation of the price to specific assets and no ability to manipulate the allocation to reduce taxes. Arm’s Length Sale of Unincorporated Practice

In an arm’s length asset sale, CRA may conduct a review that is limited in scope. Once again, the appropriateness of the total purchase price is not really open to question in an arm’s length sale. However, the allocation of the purchase price between goodwill, equipment, supplies, etc will normally have tax consequences and could be manipulated. For example, a dentist selling a practice having a higher market value for equipment than the depreciated or “book value” would normally have to

2

“recapture” some depreciation that was claimed previously. For example, if the market value of a practice’s equipment is $70,000 but the depreciated value is only $55,000, selling this equipment for market value will result in $15,000 being included in the selling dentist’s income as recaptured deprecation. The temptation is therefore to reallocate the purchase price so that equipment is sold for its depreciated value, and the extra value is applied to goodwill where it may result in no tax or may create “capital gain” where only 75% of the gain is taxed. CRA may review a transaction of this type to ensure that the price allocation is reasonable. If the allocation is not found to be reasonable, CRA will adjust the allocation and assess the buyer and seller based on the tax consequences of the revised allocation. The other area where value is sometimes misallocated involves a “sweetheart deal” where, for instance, a vendor of a practice is hired on a “consulting contract” for a few years with no substantive responsibilities. If CRA feels that this is really a disguised part of the price, it will make what it feels are appropriate adjustments. Non Arm’s Length Sales

When sales are made to someone with whom the seller does not deal at arm’s length, the overall purchase price is also now open to review. This may take place where a second-generation dentist purchases the parent’s practice. While there is nothing preventing this type of sale at any price that the parent and child agree to, the seller will be taxed as if he / she sold the practice for fair market value. However, the buyer’s depreciation base will reflect the actual purchase price paid. Accordingly, if a purchase price below market value is used, this provides no change in tax consequences for the seller but reduces future deprecation for the buyer. For this reason, it is often better to make this type of purchase at fair market value. If the parent wishes to assist the child, a gift of money can be made after the purchase.

3

Tax Re-organizations

Perhaps the area where CRA has been most involved in the past few years with practice valuation is in the areas of practice tax re-organizations. While these transactions may take several forms, the common element is that they require value to be assigned to the practice where there is no actual sale. Some of the transactions involved are the following:  Incorporation of a practice (requires the sale of the unincorporated practice to a corporation)  “Crystallization” -- Intramural sale of a corporation’s shares to make use of the $500,000 lifetime capital gains exemption available on the sale of shares of a small business  Valuation in the 1994 tax year required pursuant to the phasing out of the $100,000 lifetime capital gains exemption. In these situations, the value assigned to the practice may have significant tax implications. CRA is well aware of the potential for manipulation and can be expected to review this type of transaction closely.

Fair Market Value through the eyes of Canada Revenue Agency

It is useful to discuss how valuators at CRA determine fair market value. It should be stated at the outset that the job of a valuator at CRA entails the valuation of a diverse range of assets and businesses. This makes it difficult to develop a huge amount of expertise in any area. The relatively small number of valuators in each region makes it impossible for valuators to specialize in one industry. The inability of valuators to specialize means that the valuators are sometimes unable to apply the same type of methodologies, detailed knowledge and judgement that professional valuators of practices use, as these skills take many years to develop. Instead, CRA valuators normally revert to standardized valuation approaches used in other businesses. Reliance is placed by CRA valuators on a body of knowledge known as Generally Accepted Valuation Principles. (GAVP)

4

GAVP places a heavy reliance on the “earnings multiplier” approach to valuing businesses. This approach involves the normalization (i.e. removal of non-recurring factors) of the historical income information for the vendor usually over the past three years or so). This income is then reduced by the expected cost of hiring a replacement dentist to arrive at a “profit”. An investment amount is then calculated that will produce that annual “profit” at a selected rate of return. This becomes the hypothetical value of the practice under this approach. For example, if the “profit” from a practice was determined to be $25,000 per year, this would support a practice value of $100,000 at a return of 25%, $250,000 at a return of 10% and so on. The practice value calculated on this basis is a value for all assets of the practice. The goodwill value would be obtained by deducting the values of equipment, supplies etc from the practice value. A critical variable in this calculation is the selection of an appropriate rate of return. CRA valuators have been using rates of return of 25% to 30%. These rates of return, which are higher than most practice valuators would employ, may produce values for practices that are quite low. A common misconception of dentists and their advisors is that CRA’s valuators have access to vast amounts of information about actual practice sales in CRA’s files. In fact, this information arrives at CRA in such a fashion that it is extremely difficult for the valuators to draw meaningful conclusions from it. Normally, the core of information on practice sales information held by the valuators is that obtained by provincial dental associations and provided to CRA for this purpose. One other element of CRA’s approach when valuing practices in situations where there is no actual sale is that when relating a practice to actual sales information that they do have, neither the highest-price sale of a comparable practice nor the lowest price sale is relevant. CRA’s objective in a situation like this is to find the middle of the “notional market”.

5

Advantages of the approach used by Canada Revenue Agency

The “excess earnings” methodology used by CRA is a conceptually superior method of practice valuation. Notwithstanding its conceptual merits (advocated by a number of experts) it is seldom used by practitioners and advisors in practice valuation for actual sales. The most prevalent method of valuing practices is a “piecemeal approach” where each practice asset is valued on an individual basis with the practice value being the aggregate of the individual assets. The reasons for the prevalence of this method include tradition and conceptual simplicity Limitations of the Canada Revenue Agency approach

Perhaps the biggest limitation that the approach taken by CRA relates to the reliance of this method on historical income figures. There are a number of cases where the past performance of the practice is not completely reflective of the future potential (which is, of course, what is really being bought). In cases where, for instance, the dentist has been ill, charging less than the going rate for services, or simply unmotivated, the historical earnings of the practice will not reflect its true value. In fact the reverse may be true – would you rather purchase the practice of a dentist who chronically undertreated or the practice of a dentist treating patients at the current standard? As adjusting for this type of factor may require knowledge of dentistry beyond what can be expected of a generalist CRA valuator, the impact of these items tends to be largely ignored. The other limitation involves the normalizing of income for a practice. This requires the reinstatement of spousal salaries in excess of fair value of services, individualized expenses such as life and disability insurance, loan interest, CE courses etc. As this adjustment process may require a detailed knowledge of the workings of the practice, the dentist or advisor discussing a situation with CRA’s valuators should make these factors known. Summary

As most dentists are aware, the proper valuation of a practice is a multidimensional task requiring experience and expertise. While CRA valuators

6

attempt to gain the skills required, they can not be expected to approach practice valuation in the same fashion as practice valuators. When dealing with Canada Revenue Agency, understanding the methodology used and the limitations faced by valuators is critical. David Harris B. Comm MBA CMA FICB CD CSC is President of Harris Beattie MacLennan & Company Limited. He has over 10 years experience in practice valuations, purchases and sales of practices and taxation.