Rule of Thumb Part 2: Application of Rules of Thumb in Court

(Originally Posted November 12, 2019)

The origin of the phrase, ‘rule of thumb,’ remains unknown, however, the earliest known written use of the phrase dates back to 1685. Scholars believe the phrase refers to one of the numerous ways thumbs have been used for estimates – judging distance or alignment by holding the thumb in one’s eye line, or the measurement of an inch from the joint to the tip[1]. Regardless of the origin, the phrase has continued use in our daily lives.

As discussed in part 1 in our series [Introduction to Rules of Thumb in Valuations], rules of thumb have a long history within business valuation. Despite this history, the use of rules of thumb as a primary valuation technique has been contested by the Canada Revenue Agency, the Canadian Court System, and Chartered Business Valuators (“CBV”) alike.

Rules of Thumb and the Canada Revenue Agency

Business owners attempting to restructure their business for tax purposes may require a valuation to be performed by a CBV, or another accounting professional. According to the Canada Revenue Agency, you must make a “reasonable attempt” to determine the fair market value of your business when you undertake a corporate reorganization[2]. Failure to do so may result in adverse tax consequences, such as unwanted income inclusions, penalties and interest.

The Canada Revenue Agency may not consider rules of thumb to be a proper primary valuation technique. In Elliott v. The Queen, for example, an income tax dispute arose related to the valuation of goodwill assigned to an accounting practice. Both the plaintiff and the tax authority valued the practice using rules of thumb and other more widely-accepted valuation methods. The Court had found that one expert “relied intrinsically on the rule of thumb method as being the best method available and in reality placed too high a reliance on this method”. The Court later concluded that they are “satisfied that the rule of thumb method has its place, but the other methods should have been given more weight.”

Rules of Thumb in the Canadian Courts

The general consensus in case law is that rule of thumb application should only be used to validate the reasonableness of more commonly accepted valuation techniques[3].

In R.R.A.G. v. S.N.G., a marital dispute which required the valuation of a mutual fund brokerage, one expert applied a rule of thumb as a primary valuation methodology. An income approach was considered by the expert, however minimal emphasis was applied to the findings, and the expert justified the rule of thumb approach by stating “that’s what the industry does”.

Unsurprisingly, the Court challenged the expert’s methodology, concluding that rules of thumb needed to be “supported by another substantial valuation method”, and ultimately concluded that the “rule of thumb multiplier … is not appropriate”.

Final Thoughts on Rule of Thumb Application

The Courts have a tendency to show dissatisfaction using rules of thumb as a primary valuation method when information is available to use an earnings-based approach. As a business owner, you may find yourself in situations that require a business valuation – whether for tax reorganization purposes, shareholder disputes, family law or market transactions. Regardless of the circumstance, it may be advisable to retain a CBV to guide you through this process.

If you have found yourself in a situation that requires a formal valuation report, give the experts at Davis Martindale a call – we would love to work with you!

Information sources:

[1] https://www.phrases.org.uk/meanings/rule-of-thumb.html.

[2] Canada Revenue Agency Information Circular 89-3 Policy Statement on Business Equity Valuations.

[3] Thumbs Up or Thumbs Down? Re-examining the Use of Rules of Thumb in the Valuation of Business Interests, Canadian Institute of Chartered Business Valuators, 2015