The first important question is -- what is the valuation approach? Is the business a going concern or is it a liquidation situation?
Going Concern Approach
If the business is viable and is a going concern, the following are some more common tax issues that come up in a business valuation:
What is the type of corporation?
Is the business a partnership, a joint venture, a Canadian Controlled Private Corporation (CCPC), private corporation, public corporation, and so on..? The type of corporation it is will impact the level of taxation.
There could be a situation where the business was incorporated as a CCPC and is entitled to the small business deduction and therefore would be taxed at a lower rate. However, it may be determined that after a purchase that it would no longer be a CCPC and not entitled to the small business deduction and therefore the tax rate would be higher. If this is known in advance then the tax rate used in the valuation should not include the small business deduction. If it is not known with a high degree of certainty then the business valuator would have to apply the most reasonable income tax rate to the valuation.
Tax implications in an income-based valuation approach
In an income approach business valuation, the future cashflows of the business are forecasted and discounted to the present value using a discount rate to account for risk and the time value of money. This is referred to as the income approach. Sometimes a cashflow at a single point in time is capitalized (with a growth rate
usually applied) and sometimes cashflows are forecasted many years into the future and then discounted to the present value. The underlying mathematical principle is the same though. The key here is that the cashflows should ideally be after tax since the shareholders are only entitled to after tax cashflows. Sometimes pre-tax earnings like EBIT or EBITDA are used as the “cashflow” proxy and the multiple would then be adjusted to account for taxes. In other words, when capitalizing EBIT or EBITDA to calculate enterprise value, taxes are not ignored, just handled differently. This is usually done to have a more apples-to-apples value comparison with other companies that might have differing tax strategies (think EBITDA multiples).
Use after tax capitalization rates
When capitalizinggg the unlevered after-tax cashflows of a business (unlevered means before the cost of debt is deducted), the company's weighted average cost of capital (WACC) and/or capitalization rate must be calculated. The WACC is the weighted average after-tax cost of debt plus the weighted average cost of equity. The weighting is based on a normalized capital structure (normal level of debt and equity for the company). Once WACC is calculated then a growth rate is deducted from it and then this becomes the capitalization rate (the inverse is called the “multiple”).
The key to the above is that the cost of debt needs to be after tax. In other words if a company's total cost of debt is 10% and the tax rate was 25% then the after tax cost of debt would be (.10 x (1-.25) = .075 or 7.5%. The reason that we use the after tax cost of debt in the WACC calculation is that interest is tax deductible and there is a tax shield benefit to the shareholders that must be reflected.
The other real important point to remember is that you must be consistent. In other words, after tax cashflows must be used with an after tax capitalization rate.
These are assets that are in the company but are not necessary for the business to operate. As an example, think of a company that owns some vacant land that has never been used and is not expected to be used. The value of a redundant asset should be added to the value of the corporation. Redundant assets are usually added to company value net of corporate taxes. Some valuators add them net of personal taxes too but this is an often debated issue in the valuation profession.
Existing tax balances should also be considered in the business valuation
- Undepreciated Capital Cost (UCC) balances,
- Cumulative Eligible Capital (CEC) balances,
- Investment Tax Credit balances,
- Capital Dividend Account balances,
- Refundable Dividend Tax on Hand (RDTOH) balances,
- the value of non-capital tax loss carryforwards.
The Tangible Asset Backing (“TAB”) refers to the value of the operating assets of the business less the operating liabilities of the company. It is basically the tangle worth of the business enterprise. It does not include redundant assets. From a risk management perspective, the TAB refers to the tangible portion of value before goodwill and other intangibles. In other words, any value over and above TAB is an intangible, such as goodwill.
The tax considerations when calculating TAB are:
- TAB is reduced by the present value of the tax shield that is NOT available to a purchaser of shares that WOULD be available to a purchaser of assets, since the purchaser of shares would not be able to 'step up' the UCC value of the depreciable assets (this is the 'foregone tax shield')
- future income taxes (liabilities are added, assets are deducted)
Holding companies are normally valued using an adjusted net book value approach (also known as the adjusted asset value approach) and not an income approach. Basically, the assets and liabilities of the holding company are adjusted to reflect market values. However, this approach can lead to some challenging issues especially if there are imbedded taxes resulting from 'trapped-in' gains.
Consider as a simple example – a holding company that owns nothing more than a vacant lot. What would the impact on value be if the vacant lot was valued at $100,000 by an appraiser but the land had a cost base of only $20,000. There would be a gain of $80,000.00 that would be realized upon the sale of the land. This leads to some interesting questions: would a buyer value the holding company at the full $100,000? Should the value of the land be reduced by the full corporate taxes that would be incurred on disposition of the land or should the full tax amount be discounted since the land may not be sold right away?
The options in this example are as follows:
- full taxes are deducted from the value amount - the value of the holding company must be reduced to account for the full impact of capital gains taxes on the land
- no taxes are decuted from value amount – it may be argued that the land value should not be discounted. Perhaps a notional buyer would not dispose of it or perhaps section 881(d) of the Income Tax Act would apply and taxes could be avoided by a bump to the cost base of the land (beyond the scope of this post).
- Partial deduction to value amount – some valuators take the midpoint of the two above positions or sometimes take the full taxes discounted by some other period of time, based on the facts at hand.
When the business is no longer a going concern or the capital invested in the business is earning a return that is less than what would be gained from a liquidation of the business, then the business should be valued on a liquidation basis. In a liquidation the assets of the business are sold for cash and then the remaining proceeds (if there are any), net of liabilities, are distributed to the shareholders. Know that there are several income tax issues that are triggered in a liquidation (corporate tax and personal tax) but this post will focus only on the going concern approach.
Please contact Steve Skrlac, MBA, CFA, CBV at 905-592-1525 or firstname.lastname@example.org to discuss business valuation issues. www.keystonebv.ca
This blog post is for informational purposes only – please seek the services of a professional. There are also many other taxation issues in a business valuation.