In Transalta v. The Queen, 212 FCA 20 (“Transalta”), the Federal Court of Appeal (“FCA”) confirmed that a residual approach should be applied in the valuation of goodwill in the context of an asset purchase transaction. The two-step residual approach adopted by the FCA consists of allocating in the first step a fair market value to the tangible assets and in the second step allocating any excess of the consideration over such fair market value to the goodwill.
Transalta involves the sale by Transalta Corporation of its regulated electricity transmission business to AltaLink LP (“AltaLink”) for an aggregate purchase price of approximately $818 million, approximately $190 million of which was allocated to goodwill. At issue was the Minister’s reliance on section 68 of the Act to reallocate the portion of the purchase price allocated by Transalta Corporation and AltaLink to goodwill to tangible assets, on the basis that there can be no goodwill in a regulated industry.
On appeal to the Tax Court of Canada (“Tax Court”), Justice Campbell Miller concluded that goodwill can exist in a regulated industry but that approximately $50 million of the amount allocated to goodwill, being the value of the potential for leverage and a potential tax allowance benefit, was in fact attached to the tangible assets sold and therefore should be reallocated to such assets. Refer to Current Cases: Sale of Business – Defining Goodwill and Defending the Purchase Price Allocation for a detailed commentary on the decision rendered by the Tax Court of Canada in Transalta. Transalta Corporation appealed this decision and the Crown filed a cross-appeal.
In a unanimous decision authored by Justice Mainville, the FCA agreed with the Tax Court that goodwill can exist in a regulated industry but concluded that the Tax Court erred in reducing the portion of the purchase price allocated to goodwill by Transalta Corporation and AltaLink. Accordingly, the FCA allowed Transalta’s appeal and dismissed the cross-appeal, reinstating the $190 million purchase price allocation to goodwill.
Existence of Goodwill
The FCA confirmed that goodwill can exist in regulated industries on the basis that regulated industries have the potential to achieve returns on equity which are higher than those approved by a regulator for rate making purposes. However, the FCA did not agree with the findings of the Tax Court that the potential for leverage and a potential tax allowance benefit were not part of the goodwill.
The FCA rejected any attempt to define goodwill which, in its view, would be doomed to failure due to the difficulties in defining such a concept. Rather, the FCA opted for a modern concept of goodwill focused on the identification of the various characteristics inherent to the notion of goodwill in order to ascertain the existence of goodwill on a case by case basis. The FCA identified the following three characteristics that must be present for goodwill to exist: (i) 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; (ii) goodwill must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business; and (iii) goodwill 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.
Applying these three characteristics of goodwill, the FCA was of the view that while Transalta did not leverage its investment in its electricity transmission business, this did not mean that the potential for excess returns resulting therefrom was not one of the intangible assets that Transalta held in its business. The FCA concluded that the potential for leverage was part of the goodwill sold to AltaLink.
The FCA agreed with the Tax Court that the potential tax allowance benefit in respect of one of the partners of AltaLink, a non-taxable pension fund, could not be viewed as an asset of Transalta. According to the FCA, this potential tax allowance benefit was neither part of the goodwill nor attached to Transalta’s tangible assets but rather was an intangible asset of AltaLink and the pension fund.
Allocation of Purchase Price to Goodwill
The negotiated purchase price was equal to 1.31 times the net regulated book value of Transalta’s tangible assets. The parties allocated the premium over net regulated book value to goodwill. In the FCA’s view, the net regulated book value of regulated tangible assets of a transmission business may reasonably be understood as reflecting the fair market value of those assets as this is one of the basis upon which regulatory authorities determine the regulatory rate of return. The FCA found that any premium paid above the net regulated book value of those assets represents the value of special advantages which allow it to potentially achieve returns in excess of what is determined by regulators to be a normal market return and can properly be allocated to goodwill.
The FCA noted that goodwill is inherently difficult to value and that it would be improper to break down goodwill on an asset by asset basis in order to assign a specific separate value to each of its constituent elements. Instead, the FCA opted for a more practical approach by valuing goodwill as a residual whole with the more easily valued tangible assets being given an assigned fair market value and any consideration in excess of such value being allocated to goodwill. The FCA concluded that, based on this residual approach, the tax allowance benefit should not be deducted from the goodwill allocation notwithstanding that it may not squarely fall under the legal concept of goodwill.
The FCA found the two-tier reasonableness test adopted by the Tax Court in applying section 68 in situations where there is an agreed upon allocation of the purchase price but no evidence of real bargaining to be unduly complex and devoid of any guiding principles. The FCA was also critical of the Tax Court’s willingness to substitute its own subjective allocation for the purchase price allocation agreed to by the parties. The FCA confirmed that the proper reasonableness test in applying section 68 is whether a reasonable business person, with business considerations in mind, would have made the allocation.
Transalta provides a welcome clarification of the applicable reasonableness test under section 68 and the proper approach to goodwill valuation. The FCA’s findings in Transalta could effectively limit the Minister’s reliance on section 68 to dispute goodwill allocations.