Re Hong Kong & Shanghai Bank Hong Kong (Trustee) Ltd
Read the full judgment text of HCED 2/1974 on BabelCite. This HCED judgment.
1. This is an appeal from a decision of the Commissioner of Estate Duty given on the 24th of April 1974 wherein for purposes of estate duty he assessed the value of the shares of the above-named deceased in Morlite Steel Window, Ltd. at $15,804.40 per share as at the date of the death of the deceased i.e. the 27th February 1972.
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HCED000002/1974 IN THE SUPREME COURT OF HONG KONG (APPELLATE JURISDICTION) ESTATE DUTY APPEAL No. 2 of 1974 -----------------
----------------- Coram: Leonard J. in Court Date of Judgment: 4th January, 1975. ----------------- JUDGMENT ----------------- 1. This is an appeal from a decision of the Commissioner of Estate Duty given on the 24th of April 1974 wherein for purposes of estate duty he assessed the value of the shares of the above-named deceased in Morlite Steel Window, Ltd. at $15,804.40 per share as at the date of the death of the deceased i.e. the 27th February 1972. 2. The grounds of the appeal were that the value put on the shares was excessive and further and/or alternatively that in valuing the shares at $15,804.40 each the Commissioner failed to give due consideration to all the relevant circumstances prevailing at the date of death and in particular the fact that the shares constituted only a minority interest and that as such they ought not to have been valued on an assets basis. 3. The essential question for my decision was therefore whether or not the shares were properly valued at this figure. 4. Morlite Steal Windows, Ltd. ("the company") is a private company with limited liability. It was incorporated on the 24th March 1947 under the provisions of the Companies Ordinance Cap. 3R. On the 27th of February 1972 the date of death of the deceased the company had an authorised capital of $100,000.00 divided into 200 shares of Hong Kong $500 each, of which shares the deceased was entitled to 20. The whole of the authorised capital of the company was issued and fully paid up. 5. The first of the objects of the company as expressed in its Memorandum of Association was "to carry on the business of manufacturers of metal windows, metal doors and ventilators; metal hinges, stays, hooks, bolts, gear operators and locks and metal ornamental fittings; metal office and house furniture and fixtures." The company started its business of manufacturing fixtures and fittings in a factory in Canton Road, Kowloon. The land on which that factory stood was resumed in 1953 under the Crown Lands Resumption Ordinance and the company moved to N.K.I.L. No. 3872 a promises with an area of approximately 6,000 square feet. On this land the company built a factory of one and a half storeys in height. In 1963 the company purchased another piece of land Kwun Tong Inland Lot No. 272 for $351,537.40 and started to erect a nine-storey factory building on it at a cost of $1,785,756. ...(illegible). This building was, because of the economic conditions then prevailing not finished until July 1971 when the company occupied the ground and first floors of the building and let out the remaining floors at commercial rentals. The company let the remaining floors although it had originally contemplated using them itself because it had developed the land to its maximum potential, the building had been financed by a mortgage and the company wished to provide a fund to liquidate the mortgage and further to provide it with a regular income as its trading suffered from a severe cash flow shortage. 6. In the years ending the 31st March 1968 and the 31st March 1969 the trading side of the company suffered losses as was to be expected having regard to conditions in the building trade during those years. The building trade commenced to pick up in 1969 and for the year ending the 31st March 1970 the company made a profit on its trading side of $99,661. From the time of its incorporation to the date of the death of the deceased, the company continuously carried on trading as I have indicated. 7. At the date of his death the deceased held 20 fully paid up shares in the company. There were 16 other shareholders of whom 3 may be described as "independent" or "individual" share-holders. The largest shareholder was one of these and held 45 shares while 18 shares were held by two other "individual" shareholders. There was evidence which I accepted, that, apart from the three individual shareholders, the other shares were held by members of four families. Thus the deceased and his widow held in all 25 shares of which 20 were the subject of the appeal. The members of another family group was entitled to 30 shares; of a third, to 51 shares and of a fourth to 31 shares. The capital of the company then was closely held but there was no majority shareholder with a controlling interest; the deceased's holding was the second largest. The right of members to transfer their shares was restricted by Article 15 of the Company's Articles which provided that no share should be transferred except with the previous written consent of the directors who might in their absolute and uncontrolled discretion refuse to register any proposed transfer of shares and should not be required to give any reason for such refusal. Otherwise Articles 17 to 22 of Table A applied. 8. Article 44 provided that the profits of the company in each year should first be applied in paying interest at the rate of 10% on the shares of the company and that such interest should be paid in priority to any other payment, out of the profits of the company. Article 45 provided that out of the balance of the profits 15% thereof should be paid to "the undermentioned persons in the proportions hereinafter mentioned: - 5% to the Founders and to be divided among them equally. 5% to the Directors in such proportion as the Directors shall decide. 2 ½% to the Managing Director. 2 ½% to the Manager and such other members of the staff and in such proportion as the Directors may determine." 9. From its inception the company paid, in each year in which it showed a profit, the sum of $10,000 to its shareholders as required by Article 44. In 1964, 1968 and 1969 no such sum was paid because the company sustained a trading loss during these years. Apart from the interest required to be paid under Article 44 and the sums required to be paid under Article 45 the company declared no dividends and made no distribution of its profits prior to the date of death. During the four years ending on the 31st March 1971 its net losses or profits were as follows :
Losses are indicated in brackets. These figures do not take into account any sums payable under Articles 44 or 45. 10. The deceased having died on 27th February 1972 the Commissioner for the purposes of his valuation estimated the probable profits for the period of 11 months from 31st March 1971 to the date of death at 333/365 of the profits for the previous financial year. In fact the profits for the year ending 31st March 1972 came to something in the region of $600,000. In the event for the purposes of assessing the value of the shares this was regarded as immaterial by the parties and for the purposes of the proceedings I accept the estimated profits of $184,159 for the 11 months period as correct. 11. In the latter part of 1971 and early 1972 Hong Kong was enjoying a building boom and land prices had soared. With them had soared the value of company's land and buildings so that the asset position of the company as at the date of death was as follows:
12. Value of each 200 shares $19,105.00 13. The general picture presented by this company is that of an owner of considerable capital assets in the form of land, and of not inconsiderable assets in the form of plant and machinery. At the relevant date the value of its land had enjoyed a recent and very considerable increase. Its buildings were fully let and its rental income was increasing and to be expected to increase still further. Meanwhile the profits on the trading side were also increasing and a prudent but willing seller of shares in it might expect them to continue to do so for as long as the building boom then in full and rapid development should continue. This was, in early 1972, a company to get into but, because of the restrictions in the articles, difficult to get into, and, once in difficult to get out of and the prospective purchaser would not, as I see it, have been deterred too greatly by the past conservatism of the board in the matter of dividends or by its past earnings. He would, however, have been given pause by the fact that what was on offer was not a majority shareholding and that there were restrictions on transfer. Although he would be acquiring part-ownership of the valuable land he could have no certainty that he would be in a position to realize his part-ownership to best advantage. 14. Section 13(5)(a) of the Estate Duty Ordinance provides that :
When unquoted shares in private companies are to be valued what is to be ascertained is what would be the price which a hypothetical willing purchaser would pay to a hypothetical willing seller for the right to stand in the shoes of the deceased, to hold the shares which the deceased held subject to the restrictions on transfer from which the deceased suffered but with all the advantages which ownership of the shares conferred on the deceased. One must then notwithstanding any restrictions in the articles first postulate a purchaser who can get himself placed on the register but who once on is subject to those restrictions in the same way as was the deceased (A.G. v. Jameson 1905 2 I.R. 218 and Salvesen's Trustees v. I.R. 1930 Scots L.T. 387) and must ask oneself what would he pay to a willing but not anxious seller for that privilege coupled with those restrictions. That hypothetical purchaser however is not to be of a peculiar kind. It would not "be right to appreciate the value of the shares because of this special demand for a special purpose from a particular buyer" I.R.C. v. Crossman & Mann(1) at 44 :
If in the course of his judgment in Holt's case Danckwerts J. appears to stray from the path trodden by Viscount Hailsham L.C. in Crossman's case(1) when he postulates "the exceptional kind of investor who had some special reason for putting his money into shares of this kind" he does so, as I see it, not intending to detract from the ratio decidendi in Crossman's case(1) but rather in order to emphasize the care and prudence his hypothetical purchaser would show, for he reiterates the necessity of assuming the existence of an open market. 15. Counsel for appellants in the course of his able and moderate submissions contended that the safest light for me to use in exploring the "dim world" was that provided by the "dividend yield method" rather than that provided by reference to the asset value of the company. He conceded that the fact that Section 44 of the Ordinance made reference to asset value mandatory in the case of "controlled" companies did not indicate an intention on the part of the Legislature to exclude it from consideration in the valuation of minority interests but contended on the authority of McConnells Trustees v. I.R.C.(2) and Smyth v. I.R.C.(3) cases - where the deceased had been the holder of a controlling interest (there being no equivalent to our Section 44) - and the court looked both to yield and to asset value; that asset value was irrelevant or at best unimportant where the prospective purchaser was neither the owner of a controlling interest nor shown to be in a position to influence the majority to a decision to realize and distribute the assets. Mr. Gordon MacWhinnie resident senior partner of Messrs. Peat, Marwick Mitchell & Co., chartered accountants filed an affidavit in support of the appellant's case in the course of which, adopting the dividend yield method of valuation and regarding the interest of 10% payable to the shareholders under article ...(illegible) as dividend and considering that a prudent investor would require a minimum 20% yield he assessed the value of the shares at $250 per share. The Crown's valuers on the other hand, adopting the asset backing, arrived at a value per share of $19,680.49. From which sum, they suggested, there should be a deduction of 20% because of the deceased's minority holding and the restrictions in the articles - giving a valuation of $15,744.40 per share. In cross-examination Mr. MacWhinnie was asked whether, assuming one had a purchaser prepared to look only to assets he would think the 20% allowance given by the Crown was adequate. He replied in words which appeared to me to put the case for the appellant considerably higher than counsel was prepared to do, saying :
It was quite clear that in his suggested valuation of $250 per share no allowance was made for the strong asset backing. If the method of valuation suggested by him was accepted as the only method open to a valuer it would have followed inescapably that a minority interest in a private company which paid no dividends would have no value. He was not, however, prepared to go so far in evidence and agreed that in addition to the right to dividends a purchaser of the shares would receive also the rights of a shareholder. He made no suggestion as to the correct method of valuing these rights and when asked to assume that there were profit but no dividends he agreed that in such circumstances one could not say that the shares were of no value "if sold on the open market". 16. It is clear from the agreed documents that the officials of the Inland Revenue Department were no less intransigent than was Mr. MacWhinnie. For on the 24th November 1972 the Deputy Commissioner of Estate Duty had written to the appellants and in the course of his letter had said:
I cannot see how the statements contained in this letter can be justified for there was uncontested evidence before me that in the year ended 31st March 1970 the company made a trading profit of $99,661.00 without assistance from rental income. In the following year its gross trading profit was up by over $3,000 and with the assistance of substantial sums by way of rental income (against which had to be offset substantially increased expenses by way of mortgage interest and building administration fees) its net profit had risen to $201,857. While the increase was largely attributable to rental income, then, it was not entirely so and it would be quite incorrect to suggest that the company would necessarily have foundered had its manufacturing interests provided its only income. One must necessarily look somewhat askance at a valuation supported by such reasoning. 17. As I see it first element of importance in an approach to the ascertainment of the price which shares in a private company would fetch lies in the fact that the right to transfer them is restricted. The prospective purchaser will have no difficulty in having a transfer to him effected. We assume the transfer (See I.R.C. v. Crossman & Mann(1)). When on the register, he will held the shares subject to the restrictions on transfer, that is, he will stand in the shoes of the deceased shareholder whose shares pass on death. The restrictions then, insofar as they may make the shares a commodity difficult for others to obtain may, even enhance their value by causing a scarcity value. As a general rule, however, the restrictions will clearly have the opposite effect because a hypothetical customer would be affected in the price he would pay, by the nature of the market in which he may eventually wish to sell. The narrower such a market is, the greater will be the difficulties facing the prospective purchaser when he comes to sell so that almost invariably restrictions on transfer must materially deminish the price. 18. The second element that one has to postulate is that of the willing purchaser and the willing seller meeting in a free agreement; the willing seller being armed with the information which any holder of the shares would be untitled to demand of his directors and the willing purchaser with that which could have been reasonably ascertained by him as at the date of death (Salvesen's Trustees v. I.R.C. 1930 S.L.T. 387). 19. It must not be a sale in which either party dictates the price and every possible purchaser must be taken into account. 20. It must be a sale that goes through not one that is rendered abortive through the anxiety or greed or either the seller or the purchaser. As soon as one arrives at a position where one says "no reasonable seller (or buyer) would agree to that price" one must revise one's valuation upward (or downward as the case may be). 21. The "dividend yield method" of valuation as its name implies involves an estimation of the annual percentage return or "yield" an investor would look for on his outlay and the application, by means of a simple formula, of that yield to the probable percentage rate of dividend on the shares i.e. one multiplies the "face" or "par" value of the share by the probable rate of dividend over (divided by) the "expected" yield. The difficulties in this method are to decide on these two unknowns - the probable rate of dividend and the "expected" yield. To some extent the former can be deduced from the history of the company concerned and announcements made at its annual meetings and the latter from the yield current at the rate of death on comparable quoted shares. This however assumes that there are "comparable" quoted shares - one can only compare like with like and make due allowance for disparity. If one cannot find companies with quoted shares sufficiently similar to those under valuation to admit of comparison one must, to apply this method, be quite arbitrary in deciding on the "expected" yield. It was not suggested at the hearing before me that there exist any public companies with quoted shares similar to those under valuation. Furthermore, having decided on the "expected" yield one must then make further adjustments for the absence of a regular market in the shares and for the restrictions on transfer which the prospective customer will inherit. 22. I cannot see how the dividend yield method can be of any practical help in cases such as the present where dividends as such have not been declared and the only distribution of profits ever made has been that by way of interest provided for in the articles. It is certainly an uncertain crutch where there are no companies in the public sector available for comparison and can have little relevance where the assets of the company are disproportionate to its dividends. Finally I doubt its usefulness in a case such as this where a company's profits, have improved quite dramatically in a relatively short time. In these days of inflation I consider that the prudent investor in the shares of a private company will tend to look as readily if not more readily to the possibility of capital appreciation as he will to income potential. Admittedly a minority holding will give no assurance that his wishes in regard to disposal of capital assets will be observed. Nevertheless where the holding is large - as it is in the present case - he can expect to exert influence. He can more readily expect to do so where the other shareholders are few and readily ascertainable and, in this case, are getting a small return on a recently improved capital. In such circumstances he will, I am convinced, when deciding on his price pay more attention to the value of the capital assets than he will to dividend or earnings yield. 23. Counsel for the respondent has been at pains to suggest that any hypothetical seller would realize that he was sitting on "a gold mine" and that any prospective purchaser would have reasonably hoped, having regard to the fact that he would be becoming the second largest shareholder, that he would be in a position to influence his fellow shareholders towards the realisation of the capital assets of the company. He suggested that the company presented all the signs of "a classical takeover situation" which would be recognised by any prospective purchaser. I pause to remark (somewhat ruefully) that I have considerable difficulty in recognising, even with hindsight, a "classic takeover situation" and that it seems to me that the investor who can take advantage of one must be both unusually shrewd and unusually intrepid. The fact that the trading side of the business was improving rapidly was, moreover, surely a factor which in the mind of the hypothetical buyer would have led any board of directors to resist a takeover. That 51 per cent of the shares of the company were acquired some 9 months after the date of death at well over twice the value placed on the shares by the respondent is history. This was unknown to the respondent at the date of valuation and cannot have affected his reasoning. Equally it should not affect mine. The company which acquired these shares may well have had special reasons for so doing inappropriate to consider when attempting to decide at what bargain the hypothetical purchaser and seller of a minority holding would have arrived on a sale at the date of death. I am convinced that I must shut my eyes tightly to this transaction. 24. Having regard to the fact that two experts were on affidavit supporting such widely divergent valuations, as $250 per share and $15,000 per share and in an endeavour to see if any common ground could be reached I raised the question of valuation by reference to earnings rather than profits, having been prompted to do so by some rough notes contained in the agreed documents. 25. Mr. MacWhinnie's calculation on this basis resulted in a price per share of $3,450 and the Crown's in a price of $10,133. 26. Mr. MacWhinnie's calculation was based on average profits of $276,343 which he capitalized on a P.E. ratio of 5 (i.e. a 20% yield) giving a per share value of $6,900 discounted by 50% for severe cash shortage. The Crown's calculation was based on estimated future profits rather than the average of past profits. The estimated future annual profits available for distribution were assessed at $380,000 capitalized at 15% to give a price per share of approximately $10,000 after an allowance of 20% for minority shareholding and restrictions on transfer. I could not regard these attempts to value the shares on an earnings yield basis, so wildly divergent, both in their approaches and in their end results, as of assistance to me. Further neither side appeared to me to place any reliance on them as a trustworthy method of valuation. 27. Again, the considerations which led me to discard the "dividend yield" method of valuation apply to some extend to the "earnings yield" method whether it be used alone or in conjunction with the "dividend yield" method; both are based on the profitability of the company concerned; the former on its profitability as expressed in dividends the latter on its profitability in fact. Shares confer more than a right to participate in profits they confer part-ownership in the capital of the company and where the capital assets of the company are considerable in relation to earnings and the shares closely held this right may be of much greater value than the right to dividends. No thoughtful seller could have agreed on a price calculated with reference to earnings alone. 28. I do not, therefore, consider it possible to place reliance on either the basis of dividend yield or earnings yield. I am convinced that in the highly volatile atmosphere of Hong Kong the ordinary investor is attracted more readily by the possibility of capital gain than by the probability of secure annual returns. This, as much as the fact that there had been no dividends paid over the years but only the interest on shares which the board was obliged by the articles to pay, or the fact that its mounting land values was an important factor in giving its shares a high attraction, leads me to foresake the dividend yield and the earnings yield methods of valuation. I am left with the "asset backing" method and am convinced that any shrewd seller would refuse to calculate a selling price on any other basis in the peculiar circumstances of this company. 29. I am told by Mr. Ladd that it is common practice for the Estate Duty Office to value even minority interests in private companies by reference to their asset backing and in the peculiar atmosphere of Hong Kong I do not consider this inappropriate. Indeed if one is not to play with figures or to pluck figures arbitrarily out of the air it seems to me to offer the only logically justifiable approach. 30. This is particularly so in the case of this company for no willing but not anxious seller of its shares could have failed to realize the extent to which its land and buildings had appreciated in the period immediately prior to the date of death. Mr. MacWhinnie told me that at that time the price of proporties was very inflated and that the "whele picture in land prices was distorted". A purchaser and certainly the type of purchaser envisaged by Danckworts J. in Holt's case would have been aware of, and, perhaps rendered the more cautious by, this distortion, but he would nevertheless have appreciated that the most important thing about the company was the capital value of its land holdings; its rental incomes and its trading profits while they would have influenced him would have been secondary. 31. At the same time I do not consider that the ordinary investor could reasonably have hoped for an immediate distribution of assets or an immediate realization of his investment. He could have hoped to influence his fellow investors towards the sale of the assets but it is clear that he could have had no certainty of his ability to do so. His holding would be subject to restrictions on transfer which would mean he might find himself "locked in". This was the more likely in view of the conservative manner in which the company had been ran, the nature of the family holdings and the uncontroverted evidence of Mr. Eddie Lamb that the directors of the company were, as individuals, in sufficiently affluent circumstances to enable them to repay the mortgage moneys due by the company if this became necessary. Therefore although the company suffered from a serious shortage of cash this was not a problem which of itself would have led to liquidation, and the directors were in a position to reject a "takeover" bid if they so desired. 32. For all these factors I consider that a deduction of 20% - the amount proposed by the Crown is entirely inadequate. A prudent investor - even taking into account the possibility of a takeover and the fact that he was acquiring an influential holding - would have required a deduction of at least 40% in my view. Since the asset backing value of each share was $19,105 I consider the price which each share would have attracted if sold on the open market to have been $11,463 and that the deceased's holding should have been valued at $229,260. 33. I would therefore allow this appeal with costs to be taxed. In conclusion may I remark that the fact that I may have emerged from the "dim world" with continuing doubt as to the nature of its inhabitants is in no way due to any shortcomings on the part of counsel to whom I am indebted.
Representation: Mr. Denis Chang (J.S. & M.) for appellant. Mr. Somerville, c.c. for the Crown/respondent. |