Canada: Goodwill Hunting: Identifying And Allocating Value To Goodwill On The Sale Of A Business

Last Updated: February 23 2012
Article by Stephen J. Fyfe and Stephanie Wong

Most Read Contributor in Canada, September 2016

One of the more significant issues in an asset purchase deal is the allocation of purchase price among the assets being purchased. The allocation impacts the tax liability of the vendor arising from the sale and the future tax shield of the purchaser, as well as various commodity taxes that arise under HST/GST legislation, provincial sales taxes, land transfer taxes and property taxes. Generally, the rule of thumb has been that an allocation made between parties dealing at arm's length in situations where there is evidence of hard bargaining will be respected; this allows taxpayers to plan their future affairs with some certainty. The Tax Court of Canada decision in TransAlta Corporation v. The Queen ("TransAlta") caused planners to think a little harder about that conclusion.

On January 20, 2012, the Federal Court of Appeal ("FCA") allowed the taxpayer's appeal and dismissed the Crown's cross-appeal from the Tax Court decision in TransAlta. The general issues raised in the case were whether commercial goodwill can exist in a regulated industry – in this case, the electricity transmission industry – and what factors can create goodwill in an electricity transmission business.

The FCA agreed with the Tax Court that goodwill can exist in a regulated industry. However, the FCA rejected the lower court's more narrow definition of goodwill, reversing the finding that a significant part of the purchase price allocation to goodwill was unreasonable under the test in section 68 of the Income Tax Act (Canada) (the "Act").


  • Contrary to the Minister's position, the FCA confirmed the Tax Court's conclusion that goodwill can exist in regulated industries, such as TransAlta's electricity transmission business.
  • The FCA endorsed the use of the residual value method to value goodwill for income tax purposes, and confirmed that long-standing regulatory and industry practices (in addition to accounting and valuation standards) are relevant to determining the reasonableness of that valuation for income tax purposes.
  • The Minister's ability to change the parties' agreed upon purchase price allocation pursuant to section 68 is limited to situations where the parties' allocation fails the reasonable business person test. The FCA's decision provides some assurance to taxpayers that their negotiated purchase price allocations will be respected where they deal at arm's length with the seller/buyer and have an objective basis for their allocation (e.g., established business practice or an independent formal valuation).
  • The FCA considered the case in a practical, business-oriented way, concluding that intangibles that do not necessarily constitute "goodwill" under the legal test may nevertheless be allocated to goodwill for tax and accounting purposes where it is reasonable to do so.
  • The FCA emphasized that goodwill is a flexible concept, that it can include a wide range of intangible benefits having as their common thread an expectation of future business growth, and that its composition can vary depending on the particular business sector as well as on the precise circumstances of the taxpayer's business. The FCA's commentary on, and analysis of, goodwill in this case provides a useful framework for identifying and allocating value to non-tangible assets generally in the context of M&A transactions.


In 2002, TransAlta sold the tangible assets of its regulated electricity transmission business in Alberta to an arm's length buyer, AltaLink, L.P. ("AltaLink"), for a price negotiated at a 31% premium to the net regulated book value ("NRBV") of those tangible assets.

Under a standard price allocation clause, the parties allocated the NRBV to depreciable property and land. The 31% premium over NRBV (approx. $191M) was allocated to goodwill.

The Minister of National Revenue ("Minister") reassessed TransAlta under section 68 of the Act, reallocating the entire goodwill amount to the tangible property, ignoring the allocation to goodwill. The Minister's position was that the allocation to goodwill allowed TransAlta to avoid recapture of capital cost allowance on the sale of its depreciable assets in circumstances where the purchaser of those assets was otherwise indifferent to the loss of tax shield, or other transfer taxes payable.

Most regulated industries allow for the recovery of a return on the net book value of a regulated business' capital investment. Under the regulatory system that applied to TransAlta's electricity transmission business at the time of the sale, the Alberta Energy and Utilities Board (the "Board") followed this approach and established a revenue requirement that would allow TransAlta to (a) recover the NRBV of its assets as they depreciated for regulatory purposes; (b) recover the estimates of the operating expenses the business planned to incur; and (c) earn a reasonable return on the equity investment portion of the NRBV of its assets that the Board deemed fair.

At the time of the sale, the Board-approved after-tax ROE was 9.75% for the previous two years, based on a deemed debt-to-equity ratio of 65/35. The actual ROE earned by TransAlta in this period of time was 11.79% in 2000 and 13.57% in 2001.

During the regulatory approval process for the sale, ratepayers raised concerns that AltaLink would try to recover the premium paid on the sale by way of rate increases. In its submission to the Board, AltaLink indicated that its customers would be protected from that possibility, as it would exclude any portion of the premium from the rate base by agreeing to adopt TransAlta's closing NRBV as its opening NRBV for rate-setting purposes. Having obtained this future rate protection, the Board approved the sale without ordering any recapture of the premium in favour of ratepayers.


1. Can Goodwill Exist in Regulated Industries?

The FCA held that goodwill can exist in regulated industries for the following reasons:

  • Goodwill, as defined under common law principles, has the following three characteristics (and if these three characteristics are present, it can reasonably be assumed that there is goodwill):
  • it must be an unidentified intangible rather than a tangible asset or an identified intangible asset such as a brand name, a patent or a franchise;
  • it must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business; and
  • 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.
  • The regulatory process applicable to TransAlta's business served as a form of proxy to a market environment, with returns to equity holders normally being determined based on a fair market value approach. As such, the fair market value of the tangible assets of the regulated business should normally reflect the NRBV of those assets. That conclusion was supported in this case by a report submitted by TransAlta's expert, KPMG, which determined that the fair market value of the tangible assets sold by TransAlta using a discounted cash-flow approach was within 2.7% of the NRBV of those assets (and well within an acceptable margin of error).
  • However, regulated businesses may sometimes achieve a ROE higher than that approved by the regulator for rate-making purposes for various reasons, e.g., exceptional managerial performance, efficient management controls of costs, new business opportunities generating additional earnings, and strategic business opportunities which enhance business value. Any increased value of the business resulting from such factors should normally be allocated to goodwill. In this case, potentially increased value resulting from efficient management by TransAlta and the potential for new business opportunities flowing from TransAlta's business were viewed as goodwill since both reflected the three characteristics of goodwill.

2. Was the Tax Court Judge Wrong in Excluding Certain Items from Goodwill?

The FCA concluded that the Tax Court judge had erred in excluding from the value of the goodwill sold by TransAlta the potential for leverage (i.e., the possibility of the AltaLink partners financing part of their equity participation through debt which would have a lower cost than the regulated ROE) and the potential tax allowance benefit (i.e., the possibility that the revenue requirement would take into account a notional tax payable on those revenues, even though 25% of the partnership profit would be allocated to a tax-exempt partner, viz. the Ontario Teachers' Pension Plan Board).1 Instead, the Tax Court judge assigned values to those two items, which he in turn allocated to TransAlta's tangible assets.

The FCA concluded that the Tax Court judge's concept of goodwill was too narrow, as he had relied on a more than century-old definition of goodwill without taking into account modern business, accounting, valuation and legal developments. Since the potential for leverage reflected the three identified characteristics of goodwill described above, and there was no good reason to conclude otherwise, the FCA found that it was part of the goodwill sold with TransAlta's transmission business.

The FCA also disagreed with the Tax Court's conclusion that the potential tax allowance benefit was not goodwill. While the potential tax allowance could not be viewed as an asset of TransAlta, it also could not be allocated to the assets sold by TransAlta, as it was an advantage that belonged to the purchaser (or to the Ontario Teachers' Pension Plan) in the context of this deal. Nevertheless, in the FCA's view, this conclusion did not justify deducting between $25-50M from the agreed upon goodwill allocation for three reasons:

  • The potential tax allowance benefit was much lower than assessed by the Tax Court judge and, in light of its contingent and uncertain nature, a prudent investor would likely have largely discounted its value.
  • Even if a small part of the purchase price premium could be attributed to the potential tax allowance, it was not unreasonable for the parties to allocate that portion to goodwill for the purposes of section 68 of the Act since it could not be allocated to the tangible assets sold and would receive the same treatment as if it were goodwill. In the FCA's view, " amount which is not 'goodwill' in the legal sense of the concept may still be allocated to 'goodwill' for accounting and taxation purposes if such an allocation can be regarded as reasonable".
  • Since goodwill is inherently difficult to value and different aspects of goodwill will be given different values depending on the circumstances, the preferred method of valuing goodwill is the residual approach whereby the fair market value is determined for the more easily valued assets (e.g., tangible assets) and then any purchase price paid in excess of that value is attributed to goodwill.

3. What Is the Test for Reasonableness Under Section 68?

Reviewing relevant case law, the FCA framed the reasonableness test as follows (at para. 75):

"..for the purpose of section 68 of the Act, I conclude that an amount can reasonably be regarded as being the consideration for the disposition of a particular property if a reasonable business person, with business considerations in mind, would have allocated that amount to that particular property".

Applying the reasonable business person test, the FCA concluded that long-standing regulatory and industry practices, as well as auditing and valuation standards and practices, were relevant to determining whether the goodwill allocation was reasonable in this case. In other words, if long-standing accounting and industry practice approached the allocation in a particular way, there is no reason why a reasonable business person would have sought a different path.

While the FCA agreed with TransAlta that the allocation negotiated between arm's length parties is also an important factor to consider, it emphasized that it does not trump the reasonableness test under section 68. The FCA also cautioned that the weight given to an arm's length negotiated agreement will vary depending on the circumstances: considerable weight will be given to an agreement where the parties have strong divergent interests concerning the allocation, while less weight will be given to an agreement where one of the parties is indifferent or both parties' interests are aligned. In this case, the Tax Court judge had concluded that AltaLink was indifferent to any allocation of the purchase price to the tangible assets above NRBV, due to the fact that its rate-setting base would be limited to the NRBV of those assets, as well as to the fact that the effective depreciation rate for goodwill would be similar to the depreciation rates for the classes of tangible assets purchased. The parties' agreed upon allocation of purchase price in the purchase and sale agreement indicated that a little more than 50% of the tangible assets were class 1 (4%), while the remaining assets were class 2 (6%).


In the FCA's view, the Tax Court judge did not apply the reasonable business person test, instead using a test with no guiding principles that allowed him to substitute his own subjective allocation for the goodwill allocation agreed upon by the parties. The FCA concluded that the agreed upon allocation was reasonable because it complied with industry and regulatory standards and was consistent with standard valuation theory for regulated businesses and standard accounting principles applied in such industries.

Based on its answers to these four questions, the FCA allowed TransAlta's appeal and dismissed the Crown's cross-appeal.


1 Regarding the potential tax allowance benefit, the issue was whether and how the "stand alone" principle should be applied in AltaLink's case. In the rate-setting process, regulatory authorities generally follow the stand alone principle: the regulated business is treated as a separate entity and only those costs and risks borne by the business which pertain to its provision of services to ratepayers are reflected in the revenue requirement. The question was whether AltaLink was entitled to a tax allowance even though its partners (and not it, since it was a partnership) would be liable for tax on the income earned by the partnership. The Board concluded that AltaLink was entitled to a tax allowance as three of its four partners were taxable entities in Canada, but it disallowed part of the estimated allowance which related to the tax-exempt Ontario Teachers Pension Plan's participation in the partnership. In another case where the application of the stand-alone principle was at issue, the Ontario Energy Board concluded that a partnership, whose partners were taxable Canadian corporations, was entitled to a tax allowance even though it had sufficient losses available to fully offset its taxable income. The Board in that case concluded that the partnership still incurred a tax liability, which was a real cost eligible for recovery.

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