Marks v HM Inspector of Taxes [2004] UK SPC00418 (23 June 2004)

SPC004183060 2000 ROSS MARKS C P Bishopp Mrs R Dean London 10 and 11 May Carol Fraser, Solicitor, for the appellant Michael Gibbon, of counsel, for the respondent COLIN BISHOPP

	CAPITAL GAINS TAX  — valuation of shares — TCGA 1992 ss 35(2), 55(1), 272(1), (2), 273 — small unquoted company — nature of material hypothetical purchaser would take into account — approach to be adopted

THE SPECIAL COMMISSIONERS

 	
	ROSS MARKS	Appellant

	- and -

	VALERIE JANE SHERRED (HMIT)	Respondent

			Special Commissioner:	 Colin Bishopp 
						
Sitting in public in London on 10 and 11 May 2004
Carol Fraser, solicitor, for the appellant
Michael Gibbon, of counsel, for the respondent

	© CROWN COPYRIGHT 2004

DECISION
1.	I am required in this appeal to determine the market value, at 31 March 1982, of the taxpayer’s shares in Ross Marks Ltd (“RML”) which later became Ross Group plc.  That value is relevant to the taxpayer’s liability to capital gains tax for the years of assessment 1992/3 to 1995/6 on his disposals of the shares but I am not required at this stage to determine the amount of his liability, nor to decide some other matters which have arisen during the course of the appeal.  The only matter before me is the 31 March 1982 value of the shares; the taxpayer is deemed by sections 35(2) and 55(1) of the Taxation of Capital Gains Act 1992 to have sold the shares on that day and have reacquired them immediately at their market value.
2.	On that date the taxpayer, Ross Marks, owned 66% of the shares in RML.  His mother and brother owned a further 30%, and the general manager of the company, who was also a director but not a member of the taxpayer’s family, owned the remaining 4%.  I was asked to take no account of any possible premium or discount which might have arisen by reason of the taxpayer’s holding a controlling shareholding on the one hand, or his having to take into consideration the interests of minority shareholders on the other, but instead to value the entire company and to determine the value of the taxpayer’s shares at 66% of the resulting figure.
3.	What is meant by “market value” is defined by section 272(1) and (2) of the 1992 Act in these terms:
“(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.
(2) In estimating the market value of any assets no reduction shall be made in the estimate on account of the estimate being made on the assumption that the whole of the assets is to be placed on the market at one and the same time.”
The principles to be applied in the valuation of unquoted shares are prescribed by section 273 as follows:
“(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 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.”
4.	The taxpayer’s evidence was that RML was incorporated in July 1972 as a private company, and it was still a private company (and correspondingly unquoted so as to come within section 273) in March 1982.  The taxpayer was at all material times its managing director and, for all practical purposes, its controlling mind.  Its principal business was the import and sale within the United Kingdom of small electronic equipment for the domestic consumer market, and especially headphones, although in total it dealt in about 350 different products.  They were sold under the brand name “Ross”; the company had obtained some fairly limited formal trademark protection by 1982 but I accept that, even where there was no formal protection, the company had a recognised trade name and (as later events showed) it was able to procure further protection without difficulty.  I am satisfied that RML was not vulnerable to the abuse by others of its trading name.
5.	Only limited financial records for the period before 1982 survive.  Such as remain show that RML’s turnover increased quite strongly during the 1970s.  In the year to 31 March 1981, the last year for which audited accounts were available on 31 March 1982, it achieved turnover of £1,496,006.  Its gross profit in that year was £594,220, just short of 40% of turnover, and its net profit before tax, after allowing for directors’ emoluments, was £160,074, or 10.7% of turnover.  In preceding years, those percentages had been somewhat different but there had nevertheless been steady growth in net profit.  No dividends were declared in any year and the accumulated net profit was carried forward.
6.	In the year to 31 March 1982, the audited accounts show, RML’s turnover increased to £1,884,100 (an improvement of almost 26% on the preceding year) and gross profit was £621,264, or just under 33% of turnover although gross profit was depressed by an increase in stock.  Net profit after directors’ emoluments but before tax was diminished by a significant increase in overheads and, at £54,311, was a mere 2.9% of  turnover.
7.	It may be remembered that at that time, there was considerable speculation in the currency markets. During the early 1980s sterling fell quite sharply against most major currencies including in particular the US dollar.  RML’s products were almost entirely manufactured in the Far East, mainly in Hong Kong and Taiwan, and were priced (and had to be paid for) in US dollars.  The sterling cost of the goods therefore increased quite considerably.  In earlier years, the taxpayer said, RML had obtained some protection against currency movements by buying dollars forward but in 1981 its broker, obviously taking an optimistic view of sterling’s future prospects, advised the taxpayer that RML should no longer continue that practice.  The taxpayer told me he followed that advice with adverse consequences for RML’s profitability, which was reflected in the reduction in gross profit as a percentage of turnover.  I mention in passing that currency movements do not explain the substantial increases in overheads which were responsible for the significant fall in net profit.  Within these overheads, directors’ remuneration fell, but other expenditure increased, sometimes by large amounts.
8.	Despite the setback in the year to March 1982, the taxpayer remained very optimistic for RML’s future prospects and was, he said, already contemplating flotation on the unlisted securities market (“USM”), as it then was, within the following five years – that is, by 1987.  He had also decided to protect RML from some of the adverse currency movements which had afflicted it by embarking on the manufacture of some of the company’s products within the United Kingdom.
9.	The taxpayer’s recollection, he said, was that he had already taken advice about a possible flotation, and had also taken the first steps towards establishing a United Kingdom manufacturing base.  I take into account the fact that RML did float on the USM in 1987, and that it did begin manufacturing within the UK, though a subsidiary, at some time between 1982 and 1987 – the taxpayer was vague on this point as he was in much of his evidence, though I recognise that he was giving evidence 20 years and more after the relevant events.  I came to the conclusion, after listening to his evidence, that the taxpayer was able to recall the good points about RML rather more easily than he could recall the bad, and that he was inclined to play down the difficulties which RML underwent as a result of the depreciation of sterling and to ignore altogether the other factors which had depressed its net profits in the year to 31 March 1982.  I concluded too that although both flotation and UK manufacturing  were, by that date, very much in the taxpayer’s mind, no active steps towards achieving those objectives had been taken.  It was clear that he was of an optimistic disposition, and he was certainly optimistic about RML’s prospects in 1982, although it can be said in his favour that his optimism was largely borne out by subsequent events.
10.	In 1982 RML did not have management accounts or any equivalent, nor did it undertake budgeting or forecasting.  Properly audited annual accounts were produced, in the usual way, after the year end, but as each year proceeded, the taxpayer relied upon information provided informally to him by the company’s bookkeeper, on the company’s bank statements and on his own feel for how the business was progressing.  I do not find it surprising, nor a matter for adverse comment, that a comparatively small company, controlled on a day to day basis by its majority shareholder, was run at that time in such an informal manner.
11.	Each of the parties called an expert witness, who had already provided a report.  For the appellant, I heard from Maggie Mullen and for the respondent  from Michael Ruse.  They had each spent some time in the Inland Revenue’s shares valuation division before carrying out similar work with major firms of accountants, and had then set up their own practices.  Carol Fraser, the solicitor representing the taxpayer, suggested that Mr Ruse was partial but I am quite satisfied  not only that there is no merit in that suggestion, but also that there is nothing in his report or his evidence to support it, and that Mr Ruse, like Miss Mullen, approached his task fairly.  
12.	The experts agreed that the appropriate method of valuing the company was the capitalised earnings approach, which requires the maintainable earnings of the business to be identified and then multiplied by an appropriate factor.  The disagreement between them about the multiplier was relatively modest – Mr Ruse maintained that 10 was appropriate while Miss Mullen suggested 11 – but there was a much greater difference between them about the level of the company’s maintainable earnings.
13.	Miss Mullen began with the audited figures for the year to 31 March 1981, which she compared with the available figures for preceding years in order to establish a trend.  She recognised that the audited figures for the year to 31 March 1982 showed a marked deterioration in the company’s profit but, accepting the taxpayer’s explanation that the deterioration was due to adverse exchange rate movements, she recalculated the figures so as to assume a steady exchange rate, at the average level of the three preceding years.  By this means she determined what she described as the true maintainable earnings.  The resulting figure was comparable to that achieved in the preceding years, although showing a rather slower rate of growth than had previously been achieved.  She had also taken account of the increase in overheads revealed by the 1982 accounts,  which I have already mentioned.  She considered that by adopting this approach she was doing much as a potential purchaser would have done, if he was intending to buy the company on 31 March 1982 when, for obvious reasons, the final figures to that date could not be available.  The net profit before tax, recalculated as she thought appropriate, was £190,000 for the year.  She considered that conclusion was consistent with net, after tax, earnings of £148,190, the figure achieved in the year to 1981; in her opinion that was, therefore, a maintainable earnings level.
14.	In order to determine a fair multiplier, she examined six quoted companies which also traded in the consumer electronics markets.  Of these, only two were sufficiently similar to RML to be useful for comparison purposes.  One, Amstrad plc (much larger than the appellant) had a market valuation which supported a multiplier (its price-earnings ratio) at 31 March 1982 of 11.4.  (I observe that Mr Ruse had the figure at 11.6).  The other comparator, Electrocomponents plc, traded in the same market as the appellant, which was in fact one of its suppliers, but that fact of itself made it necessary to treat this company with some caution when using it for comparison purposes.  Its capitalisation supported a multiplier of 19.4 at 31 March 1982.  The average of the electricals sector of the FT Actuaries Share Index at that time was 17.4 (which Mr Ruse put at 17.63).
15.	Miss Mullen recognised that RML was not a public company, that it was comparatively small and that it had to be considered in a different light from the comparators.  Taking Amstrad, Electrocomponents and the average together, she arrived at a starting point for the multiplier of 15, which she then adjusted to take account of factors which appeared to her likely to have some effect on that figure: that what was being sold was a majority shareholding and that RML had a strong brand name on the one hand, but that it lacked liquidity, was in competition with larger companies and had a less strong growth pattern than some of them on the other.  She arrived – although, as she accepted, with no precision – at a range of 10 to 12 and her selected figure was in the middle of that range, that is 11.  Consequently her value of the company at 31 March 1982 was 11 multiplied by £148,190 or £1.63 million; the taxpayer’s shares therefore had a value, rounded down slightly, of £1,050,000 at that date.
16.	Mr Ruse, while adopting a broadly similar approach to Miss Mullen, was of the view that a purchaser would be influenced much more by the company’s recent trading history than Miss Mullen had conceded.  He accepted that the accounts for the years up to that ending on 31 March 1981 showed reasonably strong growth but he took the view that no purchaser would be satisfied with that; he would want details of RML’s trading results for the current year (and if it had not been analysed, he would look at the available raw data and analyse it himself).  The hypothetical purchaser would also be aware that a company such as this made the bulk of its purchases in US dollars and was exposed to currency fluctuations.  He considered that it was unrealistic to do as Miss Mullen had done, that is rework the company’s figures as if the adverse currency movements had simply not occurred; and her calculation took no account of the actual sterling – dollar exchange rate at 31 March 1982.  He was sure that it would not have been a difficult task to make a reasonably accurate calculation of RML’s results for the first 11 months of the trading year, particularly since the bulk of its trade occurred in the period leading up to Christmas, from which it would be apparent that the results for the whole year would be much less good than those for the year to 1981.  
17.	On the other hand he had identified some costs which had reduced the company’s profitability and which a purchaser would not need to suffer.  These were the high level of directors’ emoluments and the high cost of entertaining.  Adjusting those figures downwards to what he considered more reasonable levels enabled Mr Ruse to increase the pre-tax net profit available to an intending purchaser from the £54,311 shown in the 1982 accounts to as much as £82,000.  He accepted too that a purchaser would not take one poor year in isolation but would recognise that the company had been adversely affected by factors which would not necessarily continue.  The hypothetical purchaser would, he said,  take into account that in previous years, when it had not been badly affected by adverse currency movements, RML had achieved better results.  Those results too should be adjusted to take account of the excessive expenditure which he had identified.  He proposed, therefore, that the sustainable profit should be determined at £100,000 per year, by adding a “hope” factor of £18,000 to the £82,000 adjusted profit for 1982.  It is worth mentioning that this figure, despite the adjustments, gives much greater weight to the results actually achieved in the year to 1982 than to the results in the preceding two years.  Mr Ruse’s estimate of the after tax profit was £85,000 per year.  That was, he conceded, imprecise but it is (as I accept) impossible from the available accounts to determine RML’s effective corporation tax rate.  Miss Mullen’s estimation of the tax liability is no more precise.  
18.	Mr Ruse’s approach to determining the multiplier was very similar to that of Miss Mullen and he too took Amstrad as a comparable company, although he described a number of limitations on its use as a comparator. (He rejected Electrocomponents as only a small part of its turnover was generated by goods similar to those dealt in by RML.)  Amstrad had a much higher corporation tax rate (less susceptible to change than was RML’s).  Its capitalisation was based upon sales of comparatively small parcels of shares while what was at issue here was the disposal of the majority shareholding.  As it was a listed company, Amstrad’s shares were more marketable than those in RML.  There  was no realistic prospect of a flotation of RML in the near future;  Mr Ruse did not regard the taxpayer’s prediction of flotation within 5 years from 1982 as “the near future”.  Amstrad’s price-earnings multiple of 11.6 was, as he accepted, low for the industry sector but it had to be regarded as significant to RML’s valuation because of the comparability of the two companies and must be given substantial weight in determining the multiplier to be used in this case.
19.	He also thought it pertinent to take into account the level of prevailing interest rates.  On 31 March 1982 base rate was 13%.  At that time, he thought, an investor would require a return of not less than 10% and for that reason a multiplier of 10 was the maximum he thought appropriate.  He accordingly put the value of the company at 10 multiplied by £85,000, that is £850,000, of which the taxpayer’s 66% share amounted to £561,000.
20.	What I am required to determine is the price which a willing purchaser would pay to a willing vendor for the taxpayer’s shareholding in RML.  It is inherent in the valuation that the parties should have equal access to information.  The prospective purchaser can insist on seeing even confidential information: see Caton’s Administrators v Couch (Inspector of Taxes) [1995] STC (SCD) 34 (reversed on other grounds [1996] STC 201, [1997] STC 930) and I must assume that he would do so.  I must also assume that the purchaser has no special reason for buying, nor the vendor a special reason for selling.  The purchaser must buy at the determined price; he cannot simply walk away if he does not like it.  Similarly the vendor is bound to sell; he cannot refuse to do so  if he dislikes the price.  The sale is of course hypothetical and the hypothesis brings with it a number of imponderables.  As Lord Fleming put it in Salvesen’s Trustees v IRC (1930) 9 ATC 43 at 45 “The estimation of the value of shares by a highly artificial standard which is never applied in the ordinary share market must be a matter of opinion and does not consist of precise scientific or mathematical calculation.” An obvious question is whether the company would suffer because the taxpayer was no longer the controlling shareholder, or would prosper better because of his absence.  It seems to me I must leave such considerations out of account, and treat RML, neutrally, as a continuing business.  
21.	I am satisfied that the premise from which Miss Mullen proceeds is unrealistic.  I readily accept that a purchaser would look closely at the 1981 results, and would regard them and those achieved in preceding years as relevant to the determination of the price.  He would certainly give them proper weight in reaching his conclusion but I am not persuaded that he would use them as the starting point.  I agree with Mr Ruse that he would scrutinise all of the available information up to the last possible moment before the conclusion of his purchase.  A prudent prospective purchaser would be aware of the adverse currency movements at the time (he could scarcely have been unaware of them since they were extensively reported in the press) and he would know that the company was heavily exposed to purchases in dollars, and that it had failed to take any steps to hedge against the risks.  I cannot accept that a prudent purchaser would regard a recalculation of the actual results in the year to 31 March 1982 by the use of historical exchange rates as a sensible basis for the determination of a fair price.  He would, at the most, regard the recalculated figure as an indication of what might be achieved with better management but he would also be aware that, however successful RML might henceforth be in hedging against adverse currency movements, it could not protect itself against movements which had already occurred.  It would have to buy products at the prevailing exchange rate, and not at an historical rate.  On 31 March 1982 the exchange rate was $1.82 to £1, considerably lower than the rate of  $2.13 to £1 which Miss Mullen had used, and it would have to be assumed that RML’s purchases would be correspondingly expensive, at least in the short term until a UK manufacturing base had been established.  I recognise that RML’s competitors were probably also affected by currency movements, to a greater or lesser extent.
22.	For the same reason, it seems to me that Mr Ruse’s adjustments of the profits to take account of excessive expenditure are appropriate; I am satisfied that a prudent purchaser would examine costs of that kind and would be willing to take potential savings into account in his valuation.  Rather surprisingly, Mrs Fraser attacked Mr Ruse’s approach  by contending that it was arbitrary.  To some extent it is, but it struck me as fair, and approached in a reasonable and measured manner, as was his suggested “hope” factor.  I remark only that Miss Mullen did not suggest either adjustment, although her rather different approach made them less relevant.  
23.	I also reject Mrs Fraser’s repeated contention (with which Miss Mullen dissociated herself) that Mr Ruse had based his evidence upon the  audited accounts for the year to 31 March 1982.  She argued that a prospective purchaser would not have these figures – which Mr Ruse readily agreed – and that it was unreasonable to base any calculation on the outcome for the year.  Mr Ruse’s point, with which I entirely agree, was that the actual figures for 1982 were the best available guide to what the hypothetical purchaser, making proper enquiries, would have been able to discover from the available information.  I accept the validity of the argument advanced by Michael Gibbon, counsel for the respondent, that Miss Mullen’s approach of largely ignoring what actually happened during the course of the year to 31 March 1982 cannot be right.
24.	It will be apparent that I prefer Mr Ruse’s approach to that of Miss Mullen.  Nevertheless, I have concluded that, overall, the hypothetical purchaser  would take a rather more generous view than Mr Ruse.    I am satisfied that he  would consider whether RML had a sound business to whose true profitability the pre-1982 figures were a realistic and reliable guide, and would ask himself whether the year to 1982  (using the information to be gleaned from the company’s books) was an isolated poor year whose outcome might not be repeated.  Prudently, he would be aware that RML’s results could not be improved immediately – it would have to adjust to a more expensive dollar and it also seems to have been left with a good deal of highly-priced stock; but he would, in my opinion, take a view about the longer term.
25.	A simple average of the results for the three years to 31 March 1982, after making the adjustments suggested by Mr Ruse, is £141,000.   For the reasons I have given, I do not think a prudent purchaser would regard that as a figure on which he could realistically base his valuation; he would want to discount it to some extent.   Some protection against the low value of the pound, and further currency movements, could be obtained by beginning manufacture in the UK (though that would not be immediate and would incur some cost) and by currency hedging.  The purchaser would also be concerned, I think, by the significant (and, at least to me, largely unexplained) increase in overhead costs during the year.  Nevertheless, Mr Ruse’s suggested £100,000 seems to me to be extremely cautious, and one which attaches too much weight to one poor year, for which there is some explanation, and too little to the earlier years.  There is no suggestion in Mr Ruse’s report, or elsewhere, that the business itself was in decline; I am satisfied that this was a sound business which had suffered a setback.
26.	Achieving a fair valuation is, to a very large extent, a question of impression; although both of the experts have proceeded upon established valuation principles, ultimately their conclusions depend on informed opinion rather than precise arithmetic.  I cannot claim that my own view is based on anything more than a feel for what is right.  While I am satisfied that, overall, Mr Ruse’s approach is to be preferred, to my mind it takes too little account of the fact that the hypothetical purchaser, if he were to buy the shares at all, would do so only if he took an optimistic, even if cautiously optimistic, view of RML’s future prospects.  I am satisfied that such a purchaser would be willing to uplift the 1982 results (or, to be pedantic, what he would anticipate to be the 1982 results) by rather more than the £18,000 (after adjustment) which Mr Ruse proposes.  
27.	I have come to the conclusion that a fair figure for the net sustainable pre-tax annual profit of the business at 31 March 1982 is £115,000.  That figure takes into account the better results, and the history of growth, to March 1981, the poor results in the year to March 1982, the cost of taking protective measures, Mr Ruse’s proposed adjustments of the overheads and the comparatively high level of stock held by RML at 31 March 1982.  A calculation of the effective rate of corporation tax which the company actually suffered is no longer possible, as I have mentioned.  Mr Ruse suggested 15% but on the assumption that pretax profits were £100,000; Miss Mullen did not make any formal suggestion although her figures assume 22%.  The effective rate of tax in the three years to 31 March 1982 was 16.6%.  It seems to me that adopting a 15% rate is likely to be excessively generous to the taxpayer and I propose to adopt the average rate of 16.6%.  Net after tax earnings are therefore £95,910 per year.
28.	I prefer, too, Mr Ruse’s arguments about the appropriate multiplier.  I accept – as indeed both experts indicated – that the average rate for the electrical sector at the time was 17.6 but that sector covers a very broad range of businesses and it must, I think, be treated with great caution.  If, as both experts also agreed, the most directly comparable company was Amstrad, whose price-earnings ratio at the time was 11.6, it seems to me that an investor in this company (particularly one willing to take some chance on the future) and buying less readily marketable shares, would expect to fix his price by reference to a smaller multiplier.  I have concluded that I should determine this appeal on the basis that Mr Ruse is right at a multiplier of 10.
29.	I accordingly conclude that the value of the entire company at 31 May 1982 was £959,100 and that the value of the taxpayer’s shareholding was £633,006.
30.	I am aware that that determination does not dispose of the appeal since assessments are now to be made and, if they are not agreed, further determinations will be necessary, and that there are ancillary issues outstanding.   I accordingly give the parties permission to apply for directions for a continuation of the appeal in such manner as may be appropriate

COLIN BISHOPP
SPECIAL COMMISSIONER
SC/3060/2000 				RELEASED : 23/06/2004