Opinion ID: 2763968
Heading Depth: 3
Heading Rank: 2

Heading: Trapped-In Capital Gains Deduction

Text: 64See Hansen v. 75 Ranch Co., 957 P.2d 32 (Mont. 1998); In re 75,629 Shares of Common Stock of Trapp Family Lodge, Inc. (Trapp Family), 725 A.2d 927 (Vt. 1999); Brown v. Arp & Hammond Hardware Co., 141 P.3d 673 (Wyo. 2006). 65 957 P.2d at 43. 66 See id. (―[O]rdinarily when dissenting stock is accorded net asset value, that value is to be determined by considering the corporation as a going concern and not as if it is undergoing liquidation.‖ (internal quotation marks omitted)); Trapp Family, 725 A.2d at 934 (―Here, there was no evidence that [the company] was undergoing liquidation on the valuation date. Indeed, the evidence indicated that [the company] was a going concern.‖); Brown, 141 P.3d at 689 (―The undisputed testimony indicated that there were no current plans to sell any of [the company‘s] land, unless such action was required to pay the judgment to [the dissenters].‖). 21 URI v. MTC Opinion of the Court ¶47 After reducing the value of the St. George real estate by 5.5 percent for transaction costs, Mr. Smith further reduced the real estate‘s value to account for trapped-in capital gains taxes. This calculation required reducing the adjusted value of the real estate by 37.3 percent67 of the difference between the real estate‘s adjusted value and its book value (the difference being the net appreciation of the real estate). ¶48 The district court rejected this deduction and held that it was impermissible because the sale of the St. George real estate was not ―imminent‖ as of the valuation date. As an additional basis for rejecting the deduction, the court held that it was ―improper to deduct capital gains tax liability in determining the fair value of dissenters‘ shares where the dissenters have already or will pay capital gains taxes on the appreciation of their shares.‖ ¶49 The district court erred in rejecting this deduction because it again relied on inapplicable cases from other jurisdictions and because, as each appraiser recognized, it is a generally accepted financial technique to consider reasonably foreseeable taxes. ¶50 The court rejected the deduction for trapped-in capital gains based on the same caselaw68 it relied on in rejecting the discount for transaction costs, stating that the sale of the St. George real estate was not imminent, and thus discounts for future capital gains taxes would be too speculative. But each of those cases rejected use of a trapped-in capital gains deduction where the company had no plan to sell its assets prior to the triggering event.69 In contrast, it is 67This percentage represents URI‘s estimated combined federal and state marginal tax rate. 68 See Paskill Corp. v. Alcoma Corp., 747 A.2d 549 (Del. 2000); Hansen, 957 P.2d 32 (Mont. 1998); Trapp Family, 725 A.2d 927 (Vt. 1999); Brown, 141 P.3d 673 (Wyo. 2006). 69 Paskill, 747 A.2d at 552 (―The record reflects that a sale of its appreciated investment assets was not part of [the company‘s] operative reality on the date of the merger.‖); Hansen, 957 P.2d at 38 (noting that the company ―exchanged substantially all of the property of the Corporation other than in the ordinary course of business‖); Trapp Family, 725 A.2d at 934 (―[T]he trial court correctly determined that no tax consequences of a sale of corporate assets should be considered where no such sale is contemplated.‖); Brown, 141 P.3d at 688 (―As of [the triggering event] date, no sale of assets was contemplated.‖). 22 Cite as: 2014 UT 59 Opinion of the Court undisputed here that URI‘s business plan before the shareconsolidation transaction included selling all of its St. George real estate. ¶51 URI argues that most courts actually allow for consideration of trapped-in capital gains tax deductions where the taxes are incurred in the ordinary course of business and are unrelated to the triggering event. For instance, in Matthew G. Norton Co. v. Smyth, the Washington Court of Appeals rejected adopting a bright-line rule that would prohibit consideration of trapped-in capital gains taxes in all instances.70 Instead, the court stated that we believe . . . that while discounts for built-in capital gains are not generally appropriate in dissenters‘ rights appraisal cases where no liquidation of the corporation is contemplated, such discounts might be appropriate, at the corporate level, if the business of the company is such that appreciated property is scheduled to be sold in the foreseeable future, in the normal course of business.71 The First Circuit Court of Appeals,72 several New York appellate courts,73 and the Colorado Court of Appeals74 have applied similar reasoning. 70 51 P.3d 159, 169 (Wash. Ct. App. 2002). 71 Id. at 168. The Dissenters‘ interpret the court‘s use of the word ―scheduled‖ to mean that an appreciated asset must be subject to a contract to sell before any built-in capital gain tax can be deducted in determining fair value. But this interpretation conflicts with the court‘s focus on whether an asset is merely ―contemplated‖ to be sold in ―the foreseeable future, in the normal course of business.‖ Id. Moreover, later in the opinion, the court clarifies by stating, ―we believe that facts that were known or could be ascertained as of the date of the merger that relate to disposition of a particular appreciated asset—such as contemplation of sale of the asset in accord with pre-existing planning in the normal course of business—are properly considered in determining net asset value.‖ Id. at 169 (emphasis added). 72 Bogosian v. Woloohojian, 158 F.3d 1, 7 (1st Cir. 1998) (―The valuation of [the company] must include the expected tax liability that will be incurred on the three specifically planned sales and transfers and [the dissenting shareholder] will effectively shoulder (continued) 23 URI v. MTC Opinion of the Court ¶52 And although we have never expressly addressed whether deducting capital gains taxes is permissible, our caselaw supports doing so in certain contexts. As we explained in Oakridge Energy, Inc., ―dissenting shareholders are entitled to receive the value of their holdings unaffected by the corporate action.‖75 That basic principle suggests that it would be appropriate to deduct trapped-in capital gains taxes in this case because URI‘s plan to sell its St. George real estate was implemented long before the triggering transaction. In fact, calculating fair value without considering the trapped-in capital gains taxes would give the Dissenters a windfall because had the triggering transaction never occurred, URI still would have sold its St. George real estate and paid the accompanying capital gains tax, one-third of the reduction. Any other decision would falsely inflate the value of [the company].‖). The Dissenters attempt to distinguish this case on the basis that it was a dissolution case and is therefore inapposite. But the fact that the case was originated by a petition for dissolution is immaterial because the corporation later decided to purchase the minority shareholder‘s shares, which triggered a fair value appraisal. Id. at 3. 73 Murphy v. U.S. Dredging Corp., 903 N.Y.S.2d 434, 437 (App. Div. 2010); Wechsler v. Wechsler, 866 N.Y.S.2d 120, 122–29 (App. Div. 2008). Here again, the Dissenters attempt to distinguish Murphy by noting that it was a dissolution case. But in that case, as in Bogosian, the corporation elected to buy out the minority shareholders, which triggered a fair value appraisal. See Murphy, 903 N.Y.S.2d at 436. 74 Walter S. Cheesman Realty Co. v. Moore, 770 P.2d 1308, 1312 (Colo. App. 1988). The Dissenters contend that this case is inapplicable here because in Walter S. Cheesman Realty Co. the capital gains taxes were ―already owed as of the valuation date.‖ Although true, this fact made no difference in the court‘s reasoning. The court noted that ―the tax liability in question arose from the corporation‘s sale of its securities at a time unconnected with the corporate dissolution.‖ Id. In other words, the assets were sold in the ordinary course of business. The court‘s opinion does not focus on whether the capital gains tax was incurred before or after the triggering event, but instead on whether the tax was ―unconnected‖ to the triggering event. Id. This reasoning is equally applicable here given that the sale of URI‘s real estate was contemplated long before the shareconsolidation transaction. 75 937 P.2d at 134. 24 Cite as: 2014 UT 59 Opinion of the Court which would have necessarily affected the value of the Dissenters‘ shares. ¶53 Moreover, it is a generally accepted, proper financial technique to consider trapped-in capital gains taxes in appraising the value of an asset that is to be sold. All three expert appraisers deducted the taxes in their assessments. Mr. Smith, the courtappointed appraiser, removed the deduction only after the district court sustained an objection by the Dissenters. The fact that three different financial appraisers all used the deduction in valuing URI suggests that it is a generally accepted, proper financial technique. ¶54 Finally, we note that the district court erred in requiring that an asset sale must be ―imminent‖ before the tax consequences of the sale can be an appropriate consideration in determining fair value. The district court applied an imminence standard based on its reading of Brown v. Arp & Hammond Hardware Co., a Wyoming Supreme Court case. But Brown itself does not require that an asset sale be imminent in order for a court to appropriately consider trapped-in capital gains. Rather, as noted above, Brown merely disallowed use of a trapped-in capital gains deduction where the discount ―was premised upon action contemplated by the corporation subsequent to (or because of) the reverse stock split.‖76 The court neither discussed nor applied an imminence standard and the only reference to it comes in a long quotation from a law review article. ¶55 An asset sale need not be imminent in order to consider the sale in calculating fair value. Instead, courts have allowed consideration of an asset sale ―if the business of the company is such that appreciated property is scheduled to be sold in the foreseeable future, in the normal course of business.‖77 Moreover, as URI points out, an imminence standard would be especially unworkable because ―nearly all business valuations rely on assumptions about sales of assets, goods, or services that might occur years in the 76 141 P.3d at 689. 77 Smyth, 51 P.3d at 168; see Perlman v. Permonite Mfg. Co., 568 F. Supp. 222, 232, 232 n.3 (N.D. Ind. 1983) (holding that consideration of built-in capital gains taxes resulting from the sale of assets was not appropriate in that case because the corporation was not planning to liquidate, but noting that consideration of such taxes would be appropriate where ―property was for sale at the time of the [triggering event] and was eventually sold‖). 25 URI v. MTC Opinion of the Court future‖ and adoption of an imminence rule ―would effectively eliminate tax considerations‖ from the fair value calculation entirely. ¶56 The district court‘s additional basis for rejecting the trappedin capital gains tax deduction is also flawed. The court reasoned that ―it is improper to deduct capital gains tax liability in determining the fair value of the dissenters‘ shares where the dissenters have already or will pay capital gains taxes on the appreciation of their shares.‖ For this proposition, the district court cited the Washington Court of Appeals‘ decision in Smyth. But Smyth is inapplicable on this point because there the company had ―converted to Subchapter S status thereby avoiding the double taxation problems of C corporations.‖78 That is not the case here. On the valuation date, URI was a subchapter C corporation and so was subject to taxation at the corporate level.79 The Dissenters would not be able to avoid double taxation in any event. ¶57 Deductions for trapped-in capital gains are appropriate where the taxes are reasonably foreseeable in the ordinary course of business. In this case, URI implemented a plan to sell appreciated real estate long before the triggering transaction took place. Accordingly, we hold that the district court erred in rejecting the tax deductions. C. The District Court Erred in Rejecting Tax Deductions on URI’s Oil and Gas Royalty Interests ¶58 The district court erred in rejecting a deduction for income taxes on URI‘s oil and gas royalty interests. The court rejected the tax deduction because the ―tax deductions applied in this case are improper as a matter of law.‖ For that proposition, the court relied on the same cases from other jurisdictions that it relied on in prohibiting the discount for transaction costs and deduction for trapped-in capital gains. As an alternative basis for rejecting the deduction, the court concluded that the deduction was ―speculative.‖ 78 51 P.3d at 169. 79 The Dissenters repeatedly suggest that URI could convert to a subchapter S corporation. But the Dissenters have not shown that this is in fact true given that federal law prohibits a corporation from electing S corporation status if the corporation has ―as a shareholder a person . . . who is not an individual.‖ 26 U.S.C. § 1361(b)(1)(B). And as of the valuation date, URI had nonindividual shareholders, including one of the Dissenters, MTC. 26 Cite as: 2014 UT 59 Opinion of the Court ¶59 In Mr. Smith‘s initial valuation, he valued URI‘s oil and gas royalty interests using an income approach. As he explained in his report, [t]he Income Approach estimates the Fair Value based on the cash generating ability of the Company. This approach quantifies the present value of the future economic benefits that Management expects to accrue to the Company. These benefits, or future cash flows, are discounted to the present at a rate of return that is commensurate with the Company‘s inherent risk and expected growth. Such an approach has long been accepted by courts as an acceptable valuation method.80 ¶60 Taxes were relevant to Mr. Smith‘s analysis in two respects. First, to estimate URI‘s future net cash flows, he estimated future revenues from the royalty interests and then deducted associated expenses and income taxes on those revenues.81 Had Mr. Smith not factored in expected income taxes, URI‘s future cash flows would have been significantly overstated. ¶61 The last step of the income approach required Mr. Smith to apply a discount rate to URI‘s future cash flows. This is the second instance where URI‘s marginal tax rate was relevant in his analysis. A common method for determining the applicable discount rate is to use the Capital Asset Pricing Model.82 And one component of that 80 See Steiner Corp. v. Benninghoff, 5 F. Supp. 2d 1117, 1129 (D. Nev. 1998) (describing the discounted cash flow method as ―generally accepted by courts faced with valuation cases‖); Cede & Co. v. Technicolor, Inc., Civ. A. No. 7129, 1990 WL 161084,  (Del. Ch. Oct. 19, 1990) (―In many situations, the discounted cash flow technique is in theory the single best technique to estimate the value of an economic asset.‖). 81 See Steiner Corp., 5 F. Supp. 2d at 1131 (―[T]he correct cash flow figure to discount should be calculated on an after-tax, debt-free basis.‖). 82See id. at 1132–33 (―Probably the most accepted way to calculate the discount rate, at least for discounting cash flows, is the Capital Asset Pricing Model . . . .‖); In re Radiology Assocs., Inc. Litig., 611 A.2d 485, 492 (Del. Ch. 1991) (noting that the Delaware Court of Chancery ―has affirmed the general validity of [the Capital Asset (continued) 27 URI v. MTC Opinion of the Court model requires calculation of a company‘s weighted average cost of capital (WACC). Described simply, WACC is ―the cost of equity times the percentage of equity in the capital structure plus the cost of debt times that percentage of debt.‖83 The cost-of-debt component of WACC requires an appraiser to determine the after-tax rate of return on debt capital, which necessarily requires consideration of the applicable tax rate. To correctly calculate URI‘s cost of debt, Mr. Smith had to factor in URI‘s marginal tax rate; otherwise, the calculation would have been incorrect. ¶62 In sum, not only is it appropriate to consider tax rates in conducting an income approach valuation, it is necessary. The mathematical calculations used by finance professionals cannot be properly performed without consideration of taxes. Mr. Smith recognized this fact in his testimony, as illustrated by the following colloquy on cross-examination between Mr. Smith and Mr. White, URI‘s attorney: Mr. White: Well, shouldn‘t you have used a different discount rate when you are trying to capitalize pretax income stream?... Mr. Smith: I think the way I did it, originally, was where I took out taxes and the discount rate I used was an after-tax rate, and so I think if you just adjust it for the tax, that essentially is going contradictory to the ruling, so I stuck with the same discount rate. Mr. White: Okay. I understand how you got – Mr. Smith: You get the same value – Mr. White: Well, you don‘t exactly, because in the real world are there different discount rates that are applied to pretax cash flows as opposed to post tax cash flows? Mr. Smith: In theory you should get the same answer whether you‘re using a pretax discount rate or a post tax discount rate. Pricing Model] approach for estimating the cost of capital component in the discounted cash flow model‖). 83Cede & Co. v. JRC Acquisition Corp., Civ. A. No. 18648-NC, 2004 WL 286963,  (Del. Ch. Feb. 10, 2004) (internal quotation marks omitted). 28 Cite as: 2014 UT 59 Opinion of the Court Mr. White: I thought discount rates for pretax had to be higher, simply because they were pretax. Mr. Smith: Right. Correct. Mr. White: Well, since this was a pretax revenue stream in your amended report – Mr. Smith: Uh-huh (affirmative). Mr. White: -- shouldn‘t you have figured 13 percent, a little higher? Mr. Smith: Well, I think that – again, I mean, if you‘re talking strictly valuation theory, I would agree with you. If you‘re talking about fair value standard and the Court‘s rulings, I can‘t speak to that. ¶63 In essence, in Mr. Smith‘s amended appraisal, he applied an erroneous income approach because he was obligated to follow the district court‘s instructions to not consider any taxes. As his testimony suggests, this is simply the wrong way to perform income valuation. Mr. Smith should have either applied a post-tax discount rate to the post-tax revenue stream (as he did in his initial valuation), or applied a pre-tax discount rate to pre-tax revenue numbers. The district court required that he do neither and instead had him apply a post-tax discount rate to a pre-tax revenue stream. This is an improper financial technique under any standard. ¶64 The cases relied on by the district court are not to the contrary. As previously noted, those cases rejected consideration of trapped-in capital gains taxes where a company had no plans of selling its assets before the triggering event.84 But those cases do not support application of a blanket rule that taxes can never be considered in performing an income approach valuation. ¶65 The district court‘s alternative basis for rejecting the tax deductions is also unpersuasive. The court concluded that the deduction was speculative because ―URI never paid 37.3 percent in taxes in the five years before the valuation date.‖ This reasoning is flawed in two aspects. First, it overlooks the fact that a company may ultimately have no tax liability even if it engages in individual transactions that are subject to tax. For instance, the company may have offsetting credits that net out taxes incurred in other 84 Supra ¶ 50. 29 URI v. MTC Opinion of the Court transactions.85 Second, URI points out that its ―tax history [is] misleading because [the company] had heavy operating losses and thus low or no taxable profits.‖ In fact, the company‘s prior financial difficulties led it to adopt the business strategy of selling its real estate holdings. In valuing the company, the appraisers made the reasonable assumption that over the course of ten years the company would successfully sell its real estate. And the appraisers explained in their testimony that it is standard valuation practice to use marginal tax rates in valuing a company, not historical tax rates. ¶66 In sum, the district court erred by overriding Mr. Smith‘s use of the generally-accepted discounted cash flow model, a model which necessarily requires consideration of marginal tax rates, and by holding that consideration of taxes was improper as a matter of law. D. The District Court Erred in Rejecting Application of a MinorityInterest Discount on URI’s Interest in HHA ¶67 On the valuation date, URI owned a minority interest in a separate company, HHA. URI‘s minority stake in HHA was properly accounted for as an asset on URI‘s books. Each of the appraisers discounted its value, however, because URI, as a minority shareholder, lacked control over HHA. The district court concluded that the discount was an impermissible marketability discount and required Mr. Smith, in his amended valuation, to remove the discount. We conclude that the court erred in construing the discount as an impermissible marketability discount. ¶68 The district court determined that the discount was impermissible under our decision in Hogle. Specifically, the court cited our reasoning in Hogle where we noted that ―a majority of courts that have addressed the issue of minority discounts has held that discounts at the shareholder level are inherently unfair to the minority shareholder who did not pick the timing of the transaction and is not in the position of a willing seller.‖86 Because dissenting shareholders are unwilling sellers, we concluded that courts ―should not employ discounts in . . . valu[ing] . . . the Minority‘s shares of [the company].‖87 85This case demonstrates the point. Mr. Smith testified that URI was able to reduce its tax liability for several years by using net operating loss carryforwards. 86 2002 UT 121, ¶ 45 (internal quotation marks omitted). 87 Id. ¶ 46. 30 Cite as: 2014 UT 59 Opinion of the Court ¶69 Although, the district court correctly recognized that courts should not employ a marketability discount with respect to a dissenter‘s interest, the court erroneously extended this principle to discounts on assets held by the company generally. The impermissible marketability discounts we referred to in Hogle were those minority discounts that apply at the shareholder level, not those that apply at an asset level. As we stated in Hogle, the reason we reject minority discounts is that ―discounts at the shareholder level are inherently unfair to the minority shareholder.‖88 ¶70 That is not the situation here. None of the appraisers discounted the Dissenters‘ interest in URI based on their minority position. Rather, the appraisers discounted an asset held by URI. URI‘s lack of control over HHA affected each URI shareholder, majority and minority, on a pro rata basis. The Dissenters were not uniquely affected by the discount and so the discount was not ―inherently unfair.‖