Statutory Fiction

Quasi-partnership company shares must be valued on a going concern basis with no discount on the value of minority holdings, say the judges. ROBIN MATHEW QC reports.

OFTEN, NOWADAYS, ACCOUNTANTS are faced with the issue of the value, on 31 March 1982, of minority shareholdings in unquoted, private trading companies. Their clients are the entrepreneurs who started a business and are about to sell or have sold their shareholdings. What is the 'base value' on that date for capital gains tax purposes? In a typical case, a few bright sparks may have got together, taking a minority shareholding each, and started a business now to be sold at a great profit. They have worked hard and co-operated as partners in developing the enterprise. Is each of their shareholdings to be valued at a discount on 31 March 1982, but taxed for the premium at which each sells to a (bona fide third party) purchaser in 2003?

The Shares Valuation Division would say that is correct. A recent case, however, shows that it is quite wrong, in my view, as I shall show. But there will always be debate on an issue such as this.

Section 35(2), Taxation of Chargeable Gains Act 1992, which applies to the disposal of an asset which was held on 31 March 1982 by the person making the disposal, states (so far as relevant):

' in computing for the purposes of this Act the gain or loss accruing on the disposal, it shall be assumed that the asset was on 31 March 1982 sold by the person making the disposal, and immediately reacquired by him, at its market value on that date.'

The criteria for valuation, pursuant to the 1992 Act, are found in sections 272 and 273. So far as pertinent, section 272 provides:

'(1) In this Act market value in relation to any assets means the price which those assets might reasonably be expected to fetch on a sale in the open market.'

Section 273 provides, so far as relevant:

'(1) The provisions of subsection (3) below shall have effect in any case where, in relation to an asset to which this section applies, there falls to be determined by virtue of section 272(1) the price which the asset might reasonably be expected to fetch on a sale on the open market.

'(2) The assets to which this section applies are shares and securities which are not quoted on a recognised stock exchange at the time as at which their market value for the purposes of tax on chargeable gains falls to be determined.

'(3) For the purposes of a determination falling within subsection (1) above, it shall be assumed that, in the open market which is postulated for the purposes of that determination, there is available to any prospective purchaser of the asset in question all of the information which a prudent prospective purchaser of the asset might reasonably require if he were proposing to purchase it from a willing vendor by private treaty and at arm's length.'

As the cases demonstrate, the task is to follow a statutory fiction, and it is not easy. It is not a question of ascertaining the actual value or the true value or the intrinsic value or the value to a particular person (as Lord Russell said in Commissioners of Inland Revenue v Crossman [1936] 15 ATC 94), but the statutory value. In undertaking such a task, Mr Justice Danckwerts said in In re Holt [1953] 32 ATC 402 that:

' I must enter into a dim world peopled by the indeterminate spirits of fictitious or unborn sales.'

Those unborn sales of minority shareholdings in quasi-partnership, companies on 31 March 1982, must be judged now 20 years later. It may seem bizarre to the shareholder on the Clapham omnibus, but it is a vital issue to many, wreathed in a mysterious argument of legal logic and accountancy hypothesis.

A radical re-assessment of the principles has been made recently by the Privy Council. The principles are startlingly clear and set out by Lord Millett (delivering the judgment of the Privy Council) in CVC/Opportunity Equity Partners Ltd and another v Demarco Almeida [2002] 2 Butterworths Company Law Cases 108 (or 2002 UKPC 16), a case from the Cayman Islands' Court of Appeal. His speech readily reconciles, in my view, with the important earlier Special Commissioners' decisions in Hawkings-Byass v Sassen [1996] (SpC 88) and Caton's Administrators v Couch [1997] STC 970.

CVC/Opportunity was not a tax case, but the principle is applicable to valuation issues in terms of capital gains tax or inheritance tax, taking into account the statutory hypothesis required. The facts were that Mr Demarco Almeida, the respondent, was one of four 'deal-makers' engaged by Opportunity on similar terms, as employees and directors. Each held one of the company's 100 issued shares. The remaining 96 shares were held by Opportunity. Opportunity was a single venture vehicle which carried on business as general manager of a venture capital limited partnership established in the Cayman Islands. The limited partners, who provided the funding, were an American bank and associated companies. The funds were invested in Brazilian enterprises and belonged to the limited partners only. Fees and commissions, for making deals and so on, were the income of Opportunity. The limited partners expelled Demarco Almeida, as they were entitled to. Opportunity wished to exercise its call option over Demarco Almeida's share. The basic question was the price they should pay, which engaged the appropriate principles of valuation in such a case. The first issue concerns the nature of the company. After referring to the often cited speech of Lord Wilberforce in Ebrahimi v Westbourne Galleries and others [1973] AC 360, Lord Millett said:

'Companies where the parties possess rights, expectations and obligations which are not submerged in the company's structure are commonly described as quasi-partnership companies. Their essential feature is that the legal, corporate and employment relationships do not tell the whole story; and that behind them there is a relationship of trust and confidence similar to that obtaining between partners which makes it unjust or inequitable for the majority to insist on its strict legal limits. The typical characteristics of such a company are that there should be: (i) a business association formed or continued on the basis of a personal relationship of mutual trust and confidence; (ii) an understanding or agreement that all or some of the shareholders should participate in the management of the business; and (iii) restrictions on the transfer of shares so that a member cannot realise his stake if he is excluded from the business. These elements are typical, but the list is not exhaustive.'

Lord Millett then turned to the question of the value of Demarco Almeida's share. He said:

'There are essentially three possible bases on which a minority holding of shares in an unquoted company can be valued. In descending order these are: (i) as a rateable proportion of the total value of the company as a going concern without any discount for the fact that the holding in question is a minority holding; (ii) as before but with such a discount; and (iii) as a rateable proportion of the net assets of the company at their break-up or liquidation value.'

He then said that the appropriate basis of valuation depends on all the circumstances. But the choice must be fair and it is difficult to see 'any justification for adopting the break-up or liquidation bases of valuation where the purchaser intends to continue to carry on the business of the company as a going concern'. He added:

'If the going concern value is adopted, a further question arises: whether a discount should be applied to reflect the fact that the holding is a minority one. An outsider would normally be unwilling to pay a significant price for a minority holding in a private company Small private companies commonly have articles which restrict the transfer of shares by requiring a shareholder who is desirous of disposing of his shares to offer them first to the other shareholders at a price fixed by the company's auditors. It is the common practice of auditors in such circumstances to value the shares as between a willing seller and a willing buyer and to apply a substantial discount to reflect the fact that the shares represent a minority holding.'

He continued:

'The context in which the shares fall to be valued in a case such as the present is, however, very different. Mr Demarco is not desirous of disposing of his shares; he would rather keep them and continue to participate in the management of the company. It is Opportunity's conduct in excluding him from management that has driven him, however reluctantly, to seek to realise the value of his investment. In this situation, the case law in England is that, normally, the shares should be valued without any discount: see for example in Re Precision Bellows Ltd [1986] Ch 658 (Court of Appeal).'

He then commented that:

'To require Mr Demarco to submit not only to his exclusion from the company, but to the acquisition of his shares at less than their going concern value by a purchaser which intends to carry on the business, is hardly less unfair.'

The basis of valuation, the judge added, is not on a notional sale of the outgoing partner's share to the continuing partners who, being the only possible purchasers, would offer relatively little. It is based on a notional sale of the business as a whole to an outside purchaser.

The decision of the Privy Council is then found in the following passages. The judge said:

'In the case of a company possessing the relevant characteristics [of a quasi partnership supra], the majority can exclude the minority only if they offer to pay them a fair price for their shares. In order to be free to manage the company's business without regard to the relationship of trust and confidence which formerly existed between them, they must buy the whole, part from themselves and part from the minority, thereby achieving the same freedom to manage the business as an outside purchaser would enjoy.'

The judge later added:

'The concept of a fair price assumes that the shares have an objective value by which the fairness of the offer can be assessed.'

The judge commented that fairness of the offer should be judged by reference to what will happen if it is accepted, not if it is refused. This is a point often overlooked by the Shares Valuation Division. He then said this:

'In the case of a quasi-partnership company, the corporate structure represents the legal medium by which the business is carried on as a joint venture. The petitioner's interest in the joint venture cannot be determined by a sale of his shareholding to his co-venturers unless the price reflects his share in the underlying business. The subject-matter of the notional sale which forms the basis of valuation is, therefore, not the petitioner's minority holding, but the entire capital of the company.'

In conclusion, the judge said that Opportunity would have to pay a price which reflected the value of the business as a going concern, without discount for the shareholding's minority status, if (in the context of that litigation) liquidation of the company was to be avoided. Hence a fair price meant no discount, as the price must reflect the true nature of the quasi-partnership which was the company.

As I have indicated, from a different angle, the Opportunity decision can be reconciled with Hawkings-Byass, where a minority shareholding commanded a premium rather than a discount because of the special position or relationship of the vendors vis-à-vis the purchasers. In that case, the tribunal adopted the approach of an earlier decision, Caton's Administrators to section 273(3), Taxation of Chargeable Gains Act 1992, and held that it was effective to provide that any information including unpublished confidential information, and even information which might prejudice the interests of the company, is assumed to be available in the hypothetical sale if it would be reasonably required by a prudent prospective purchaser. It referred to the hypothetical market described by Lord Justice Hoffmann in Commissioners of Inland Revenue v Gray (surviving executor of Lady Fox deceased) [1994] STC 360 which is the clearest explanation, in my view, of the basic principle that the price to be found in such a market is one:

' which the evidence shows that various people would have been likely to pay reflecting, for example, the fact that one person had a particular reason for paying a higher price than others The valuation is thus a retrospective exercise in probabilities, wholly derived from the real world '

Some might contest the last comment which is, of course, the statutory fiction.

Robin Mathew QC is a member of New Square Chambers, 12 New Square, Lincoln's Inn, London WC2A 3SW, tel: 020 7419 8000, fax: 020 7419 8000, e-mail: clerks@newsquarechambers.co.uk

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