Effective tax management is no different from any other aspect of management insofar as any transaction should at some point be expected to add value. Ultimately, most measures of value-adding are derived from the firm’s financial statements. Related to accounting earnings are the firm’s cash flows. If the net present value of cash flows from a transaction is positive, then, over time, this will translate into positive financial earnings. Both typically enhance shareholder value and increase management compensation (e.g., where bonuses are based on accounting earnings or stock options are being granted). Through this post I discuss value adding tax management in detail. Enjoy!
Using Cash Flows to Measure Value-Adding
Cash-flow analysis yields the same measure of value-adding as does financial accounting income: a $926,250 increase, for instance. The only difference between the cash flows and reported earnings is when they are reported. Shareholder value increases by a $0.90 per share earnings per share (EPS); management wealth increases by $75,000 (before they pay their own taxes). Note that cash flows will rarely exactly equal the sum of financial earnings changes over time. However, they will approximate it. The key thing to remember is that if managers maximize after-tax cash flows on each transaction, this will also maximize shareholder value, as measured by financial income. Therefore, discounted cash flow (DCF) analysis is critical in measuring whether a tax management method will increase firm value.
The present value formulas for discounting can be found in other post of my blog. This also can be found by Web search. They often can be found on academic Web sites, such as those for finance or accounting classes. These change too often to cite here. Instead, to find them, it is best simply to run a search on the key phrase “present value”.
Value-Adding, Cash Flows, and Time Value
A tenet of business is that a dollar of income now is worth more than a dollar later. Holding tax rates and bases constant, tax management implies deferring income and accelerating deductions. More formally, it is the net present value (NPV) of expected taxes which managers should work to minimize. This implies that not only cash flows, but also discounted cash flows, should be used in determining whether a transaction increases after-tax firm value.
A firm can make one of two investments. Both have three-year horizons, and both have identical pretax cash flows of $100 per year. The taxes for the first investment are $60 in total, that is, $20 in each of the three years. The taxes for the second investment are also $60, but the tax is all due in the third year. If the firm has a 10% cost of capital, then the present value of taxes under the first investment is: $20(.9091) + $20(.8264) + $20(.7513) = $49.74. (The present value factor for year one is 1/(1 + r)n = 1/(1.10)1 = .9091. That for year two is 1/(1.10)2 = .8264. For the second investment, the tax is $60(.7513) = $45.08 Thus, simply through the time value of deferring the tax, the second investment has a higher value-adding to the company.
Two common gain-deferral techniques used when planning for U.S. income taxes are worth mentioning now:
. The “Likekind Exchange” Method
It is governed by IRC Section 1031, it also is called a 1031 exchange. If a company sells assets (e.g., plant, equipment, or land) for a profit, it must pay taxes on the gain, even if it uses the proceeds from the sale to buy new assets to replace those sold. However, if the requirements of Section 1031 are met, a company that trades in the old for the new is allowed to postpone the tax on the old asset until the new asset is sold. The basic requirement for this favorable tax treatment is that like-kind property must be exchanged: realty for realty, or personalty for personalty. If the firm receives anything other than like-kind property in the exchange (called “boot,” from the practice of throwing in other property “to boot” to equalize value in a trade), it is taxed immediately if there is an overall gain on the transaction.
Suppose a firm has a piece of land worth $5 million, which originally cost $2 million. It wishes to sell the land to generate cash to buy a new plant for $5 million. However, it will have not had enough aftertax cash to do this: $5 million sales price, less taxes on the gain of .34($5 – 2 million), or $1.02 million, equals $3.98 million after-tax proceeds from a sale. However, if the firm exchanges the land for the plant, there is no tax on the land gain until the plant is sold. If the firm plans to sell the plant in 10 years, assuming an 8% discount rate, the present value of the tax on the gain is .4632($3 million) × .34% = .$56 million. By using a 1031 exchange, the manager has saved the firm over $500,000. Of course, the seller of the plant must be willing to take the land in exchange, instead of just receiving cash. The manager should be willing to give the other party up to $500,000 in addition to the land to get the deal (i.e., negotiate the tax benefits). However, the manager could find a third firm who might be a willing party to make the exchange, that is, acquire the plant for cash and trade it for the land.
Such multiple-party exchanges are not uncommon, and there are well-organized markets for doing so.
 Involuntary Conversion Method
Another important tax deferral mechanism is the IRC Section 1033 involuntary conversion, which is important if a gain results when insurance proceeds are received because a firm had a property (realty or personalty) that was destroyed, seized, or stolen. A gain can result if the proceeds exceed the firm’s remaining investment in the property. This can happen even if the firm uses the proceeds to replace the lost property. If the requirements of Section 1033 are met, however, taxes on the gain are deferred until the replacement property is disposed of.
Suppose the firm’s factory, located in a foreign country, is seized by the foreign government as part of an antiforeign change in government policy. The factory cost $10 million, and insurance covered the fair market value (mostly due to the value of the underlying land) of $15 million. If the firm uses the $15 million to buy or build a new plant, and the new plant is held 10 years, the present value of the tax is .4632 × .34 × ($15 – 10 million) = $1.48 million. If the firm uses the $15 million for some other type of investment, there is an immediate tax of .34($15 – 10 million) = $1.7 million. By using 1033, the manager saves the firm over $200,000. Managers do not plan to use Section 1033 per se: They do not burn down a plant in order to defer taxes. However, if an involuntary conversion should naturally arise, Section 1033 is a valuable deferral technique.
Other tax deferral methods [I plan to discuss in the future]:
- Foreign subsidiaries
- Installment sales
- Management stock options
- Employee stock option plans (ESOPs)
Using Other Measures of Value-Adding
The previous discussion is not meant to imply that DCF is the only method of value increase. On a year-by-year basis, investors and creditors monitor the firm’s financial performance. Because DCF information (especially on individual projects) is rarely communicated directly to outsiders, they usually must rely on measures of performance that can be constructed from publicly available financial statement data.
Managers thus need to know how transactions affect such measures. Popular annual financial statement measures are earnings per share (EPS), return on equity (ROE)—net income divided by shareholder’s equity—and economic value-added (EVA). EVA is computed as after-tax operating profit minus the firm’s weighted-average cost of capital.
Accordingly, even if a transaction minimizes taxes, it may be poor tax management if it decreases EVA. EVA can be decreased by lower after-tax operating profits, using more capital, or using more expensive capital. Suppose a firm acquires a new plant, which increases annual pretax operating profits by $1 million. Because of the tax benefits of accelerated depreciation, assume there is no tax on the increased earnings. To finance the plant, the firm issues $1 million in bonds that pay 8%. Prior to the transaction, the firm had $100 million in after-tax operating profits, and capital consisting of $200 million in common stock having a cost of 14%.
EVA before and after the acquisition is:
After-tax Operating Profit – Cost of Capital = EVA
Before the plant: $100 million – $28 million* = $72 million
After the plant: $101 million – $28.8 million** = $72.8 million
*14% × $200 million
**28 million + (1 million × 8%) = 28.8 million
Thus, from an EVA standpoint the project should be accepted, since it increases annual EVA by $800,000. However, before a definite decision on the new plant can be made, there should be an NPV analysis to consider multiperiod effects (such as tax depreciation becoming smaller in later years).
It is important to note that exclusive use of EVA (or ROE) is not recommended for evaluating long-term projects. For example: suppose the new plant from the preceding example had $1 million in losses in its first two years but $1.5 million in positive income in subsequent years. Suppose that, when added together, the new plant had a positive NPV. If managers are overly concerned with shareholder response, they might reject the project because, in the short run, EVA (as well as ROE and EPS) is negative.
Maximizing Value-Adding and Potential Conflicts
Maintaining (or improving) value-adding is implicitly a contract between the manager and the firm’s shareholders. Closely related are explicit contracts based on financial accounting information. The company may have debt covenants tied to certain financial ratios. Therefore, a transaction, while saving taxes, might be detrimental overall if it results in financial rations that violate these covenants. For example: suppose a transaction saves $100 million in taxes. However, it is financed with debt that, when added to the firm’s existing debt, causes the debt-to-equity ratio to exceed the maximum specified in debt covenants. If it costs the firm over $100 million to renegotiate the debt, the transaction should be rejected. Other contracts based on financial accounting could be with managers (e.g., bonuses), customers, or suppliers.
So how should one measure the value-added of a tax-related transaction to shareholders? Use NPV, but also consider any important financial statement measures and financial statement-linked contractual issues.
On Taxes, Value-Adding, and Book-Tax Differences
Another important issue on value-adding and taxes relates to the timing and amount of tax expense on the firm’s financial statements. If a firm never expects to pay a tax on some income, then for financialreporting purposes, it will not show a tax expense. Such permanent differences are the best of all worlds: Neither the firm’s cash flow nor its financial earnings are reduced. Although a number of such examples of permanent differences under U.S. accounting rules are mentioned throughout this book, a very important one is income from an overseas subsidiary. Under U.S. tax law, the income of a foreign subsidiary generally does not generate U.S. taxes until the income is repatriated.
Under U.S. generally accepted accounting principles (GAAP), however, the subsidiary’s income is included in the parent corporation’s consolidated financial statements. This results in accounting earnings that are not reduced by a provision for U.S. income taxes. In many cases the benefit of this permanent difference is 35%—the normal U.S. corporate income tax rate—of these earnings.
More common than such permanent differences are those that are “temporary”. These occur when the only difference in actual taxes paid and the related tax expense on the financial statements is the period in which they occur. That is, there are only timing differences. These result from differences in allowable methods in financial versus tax accounting. One important example is depreciation. Under GAAP of most countries, financial reporting generally uses straight-line depreciation. Some countries, however, allow accelerated depreciation methods for tax purposes. As noted in Chapter 1, one such method—the modified accelerated cost recovery system (MACRS)—is used for U.S. income tax purposes.
Adjusting Value-Adding for Risk
Both business risks and the risks of tax law changes should be taken into account for effective tax management. A full discussion of risk management is beyond the scope of this text. However, three wellknown risk-management techniques are diversification, insurance, and receiving a risk premium. All three can be effectively obtained by using the tax law. A risk premium is the discount in purchase price that a manager would have to be offered to accept a risky project.
Suppose a manager is offered two investments, both of which cost $100. Investment A pays $110 with certainty; investment B pays $110 on average, with a 50% chance of paying either $0 or $220. If the manager is risk averse (most people are), she will select project A. Only if the purchase price of B is lowered (i.e., a risk premium is offered by the seller) will project B be selected.
The risk premium aspect is important for two reasons:
- Many tax-favored investments have a special tax status because a government is trying to encourage investment in relatively risky investments. Examples include R&D, low-income housing, and inner-city investments. Before rushing into one of these investments, a manager should adjust the expected return for a risk premium.
- The tax benefit may be the equivalent of a risk premium. For example, the U.S. government gives a 20% tax credit for incremental R&D expenses. This effectively amounts to a 20% price cut compared to an investment with an equivalent (but less risky) return (e.g., a bond).
The deductibility of losses, combined with taxation of income (gains), results in the income tax system acting as a variance-reducing mechanism for risky investments. That is, the dispersion of anticipated gains and losses is decreased for a risky investment, as shown in Exhibit 2.4. The upper curve shows the range of possible returns without income taxes. The lower curve shows the same returns after the imposition of a tax. (The arrow shows the movement from the upper to the lower curve.) Thus, assuming the manager is risk averse (managers will trade off reduced gains for reduced losses), income taxes are good for risky investments.
Another way of thinking of this is that the U.S. income tax law effectively provides insurance by allowing loss deductions. Losses on the sale of investments due to theft or casualty are tax deductible. The taxes saved result in the government reimbursing the firm for part of the loss. However, frequently such loss deductions are limited in some way. The expected return on a risky investment, therefore, may not be as high as the manager anticipates. Risk from possible tax law changes must be managed as well. This concept is directly related to anticipation of tax law change.
Suppose the manager anticipates that there is a 50% probability that tax rates will decrease by 10%. The variance of expected returns will thus be reduced by 5% (10% × 50%) for both gain and loss.
Value-Adding and Transaction Costs
Tax management requires that the tax savings exceed the related execution costs in any transaction. Transaction costs might include brokers’ fees or legal and accounting costs. Some examples of transactions costs are:
- Stock broker fees on the sale of stock
- Attorney, accountant, and investment banker charges on mergers, acquisitions, and recapitalizations
- Lobbying costs to obtain favorable tax structures prior to locating a new plant Temporary loss of funds when paying an expense in December instead of January