New Valuation Approach Raises Hackles
of Art Donors and Gallery Staff

By Stephen P. Sweeting

Stephen P. Sweeting is a partner with Toronto-based Appraisal Associates, a personal property valuation firm specializing in fine art, antiques, and decorative art. The author's articles and commentaries on personal property valuation issues have appeared in Canadian and American professional journals, magazines and newspapers.

The following article first appeared in its original form in "Appraisal Associates Newsline", Vol. 1, No. 6. The article has been updated and expanded for the readers of Art Business Magazine.
A new approach to the valuation of art property by the Canadian Cultural Property Export Review Board is drawing criticism from both donors and the representatives of museums and galleries. The approach -- based on a valuation methodology known as blockage discounting -- adds a new degree of uncertainty to the donation procedure. In at least one instance, a fair market value determination by the Board was significantly less than the donor's purchase price. Critics fear donors will give up on the donation program if they are penalized in this manner.

The Board's version of blockage discounting is known as the "Market Adjustment Factor (MAF). The methodology is used in situations where donation-related sales constitute the largest share of market activity. Donation package schemes and other bulk donations appear to fall into this category. The MAF -- a series of graduated percentage discounts of value -- hinges on the number of artworks by a given artist donated through the program since 1994. Artists whose work shows up repeatedly in the program suffer the most significant discounts. These can range from 20% through to 60%.

Blockage is a concept rooted in the valuation of stocks and securities for estate taxation purposes. It is defined as "...a form of depreciation resulting from a number of similar properties being offered that is too large for the normal market to absorb as of a specific date. Blockage discounts for stocks and securities are estimated through the use of present value formulae " an income approach to value used by business valuators. The methodology depends on past performance or market absorption rate, the homogeneity of the property, and the appropriateness of the discount.

American estate executors and lawyers use the principle with some frequency to reduce the amount of tax payable to the Internal Revenue Service. The technique also is used with artist's estates comprised of large numbers of unsold works. The two most notable art-related applications of the principle involved the estates of sculptor David Smith and painter Georgia O'Keeffe.

In both cases, the final court-imposed blockage discounts hinged on something less than clearly articulated valuation methodologies. The judge presiding over the Smith case fell back on a "Solomon-like pronouncement to establish the discount. For the O'Keeffe estate, the judge "split the difference between the proposed blockage discounts argued by the opposing litigants.

The concept of blockage discounting cultural properties is even less clear in Canada. In the 1980 book "Art Law", lawyers Aaron Milrad and Ella Agnew postulate that the wording of the Income Tax Act precludes blockage discounts in the determination of fair market value in estate situations. The authors maintain that the Act stipulates that each capital property is deemed to have been disposed of immediately before death. There is no reference to all properties. This reading of the Act suggests that context within a collection or bulk of properties may be irrelevant in the determination of fair market value.

The relevance of the blockage discount principle within the cultural property sphere was tested in a recent Tax Court of Canada case (Zelinski v. The Queen). In this case, the appraiser working for the Justice Department argued that a blockage discount of 50% was appropriate in a donation scenario involving a large collection of paintings by First Nations artist, Norval Morrisseau. The appraiser argued that the large size of the collection would impede its marketability and that even in a best case scenario, it would take a number of years to sell. The presiding judge rejected the appraiser's use of blockage, stating in his decision that "the hypothetical open market in which fair market value is determined contemplates purchasers and vendors acting without pressures to buy or sell. There was no evidence that the [donors] were under any pressure to dispose of the Morrisseau art."

This pivotal decision undoubtedly raises questions about the legality of the Review Board's use of the Market Adjustment Factor. Clearly, as in the Zelinski case, cultural property donors are under no compulsion to gift items to recipient institutions. Nonetheless, it is unlikely that the Board will eliminate the MAF of its own volition. Canadian donors, museums and galleries probably will have to wait for a court challenge to settle that score. Although challenging the Board in court is both expensive and time-consuming, it can produce results. Readers will remember that the Art Gallery of Ontario successfully challenged the Review Board's handling of the Sarick donation of Inuit carvings.

An interesting postscript to the current situation is that according to generally recognized principles of valuation, fair market value and a blockage discounted value can never be the same. Fair market value must be established before a supportable blockage discount can be estimated. The two values are not equivalent. This train of thought suggests that market adjusted determinations do not provide donors with a full and fair recognition of fair market value. If this is indeed the case, the Board's actions run counter to both the Income Tax Act and its own published guidelines.