Does income tax planning create value?
Many studies suggest that the financial directors of most quoted firms consider the reduction of their firm's effective tax rate (ETR) (1) as the main objective of their tax department. (2) Apparently, these firms believe that reducing ETR creates value for their shareholders. Recent interviews with investors and financial analysts, however, suggest they pay little attention to after tax earnings when valuing a firm. These investors and analysts do not believe that a company can sustainably outperform the firm's statutory tax rate. They also think that tax information in the public accounts is so unclear that it is unusable for their valuations. This article argues that in theory tax planning potentially creates value for a company, but argues that this should be calculated differently from the value creation from operational activities, suggesting some value creation formulas for different types of income tax planning.
Tax as a Value Driver--Some Theory
The most commonly used formula for calculating the value of a business is, (3) as follows:
Value = NOPLAT - Net Investments/WACC - g
NOPLAT = New Operating Profits Less Adjusted Taxes
WACC = weighted average cost of capital
g = rate at which the company's cash flow grows every year
The NOPLAT is the free cash flow generated by the core operations of the business less the income taxes related to the core activities. The drivers of company value are displayed in Exhibit 1.
A simple example shows how tax reduction according to the theory increases business value. Suppose a firm has a Net Operating Profit of 100 [euro], a tax rate of 30 percent, a growth rate of 5 percent, and a WACC of 12 percent. According to the formula, the value of that business would be
100 [euro] - 30% x 100 [euro]/12%-5% = 70 [euro]/7% = 1,000 [euro]
Now suppose that the firm introduced a tax strategy through which it would reduce the operating tax with 1 percentage point. The value of the business would then be:
100 [euro] - 29% x 100 [euro]/12%-5% = 71 [euro]/7% = 1,014 [euro]
Why Investors and Financial Analysts Do Not Value Tax In interviews with investors and analysts, they confirmed that reduction of income tax should theoretically drive value, but none of the interviewees acknowledged paying much attention to income tax when analysing a firm's value, because:
* they believe that the value creation potential of tax planning is less than the potential of improving core operations;
* they do not believe a firm can sustainably outperform its statutory tax rates; and
* there is little useful information about taxation of the firms analyzed. (4)
Lack of value creation potential. Most analysts believe that core operations drive the value of a business harder than tax reductions. Through investing in market position, competitive advantages, developing new products and services, etc., a firm can create much more value, they believe, than through investing in tax reduction.
Lack of sustainability. Analysts do not believe that a firm can sustainably outperform the statutory tax rate (STR), i.e., the tax rate that a firm should be expected to pay based on the statutory rates in the jurisdictions where it is active. They rather believe that a firm's long-term average effective tax rate will regress to the firm's statutory tax rate.
Lack of transparent information. In their investment decisions, financial analysts and investors use both cash flow based valuation models (DCF model) and earnings based models. They prefer the first over the latter because the earnings are the result of many valuations by the firm that the analysts tend to doubt. In interviews, investors and financial analysts said that they find the information that is available on the tax position is limited, very often ambiguous, and therefore difficult to understand, let alone effectively use in a DCF model.
These responses suggest the need to examine the theoretical value creation potential of tax planning and how to calculate the value created.
Types of Tax Planning
Before analyzing the value creation potential of tax planning, consider first which types of tax planning strategies tax departments have available to reduce their firm's tax expense. Tax planning strategies can be divided in three types:
Type 1--efficiency enhancement strategies
Type 2--strategies through restructuring a firm's business model or organization
Type 3--strategies through restructuring a firm's legal and capital structure
Type 1 strategies try to save taxes through the optimal use of all relevant tax deductions and facilities. These strategies do not require a firm to adapt its business or legal organization, but rather to increase its administrative hygiene by making sure it does not miss the evident tax deductions and facilities. This strategy type may typically be the side effect of implementing an ERP-system. Improving administrative hygiene tends to have a one-time and marginal effect and a decreasing continuous effect, in a healthy firm, Type 1 strategies will not create value, because these firms will have their administrative hygiene in order. For this reason, Type 1 strategies will not be discussed further in this article.
Type 2 strategies endeavour to save tax through reallocating operational taxable income to lower tax jurisdictions by reallocating risks, capital, and activities to that jurisdiction. Examples of such strategies are agency and stripped distributor structures, centralization of intellectual property, etc. Different from what analysts assume, Type 2 planning is sustainable because the reallocated activities become structural part of the business organization. Implementing these strategies, however, often requires exit taxes, often reduces operating profit through either limitation of sales growth or increase in operational expenses (e.g., relocation of staff, increased administrative and reporting expenses, etc.), and last but not least, tends to reduce a firm's flexibility with substantial strategic effect.
Type 3 strategies strive to reduce taxable income through tax-driven legal restructuring and structured finance solutions, such as creating interest deductions by re-leverage of operations, tax arbitrage in a firm's capital structure, etc. These strategies normally do not grow and tend to have a limited lifetime because they are often built on intragroup loans that must be repaid and because tax legislators overtime tend to close the loopholes in the tax legislation. Further, they have a higher risk profile because they are exposed to challenges of the tax authorities through abuse of law.
Value Creation through Type 2 Tax Planning Strategies
As the reallocated activities in Type 2 strategies become a structural part of the firm's business organization, the tax savings will normally have a continuing value and can be valued with the value creation formula. When applying the value creation formula, however, consideration should be given to whether the tax saving grows at the same rate as the NOPLAT growth before implementation of the planning strategy.
Consider the NOPLAT projections of a firm with one operating company, OpCo, that has 100 [euro] Net Operating Profit, 30-percent Statutory Tax Rate, and a growth rate of 5 percent per year. Suppose further that, in a Type 2 strategy, the firm concentrates its intellectual property in IPCo, a company in a jurisdiction where income is exempt. After the transfer, OpCo pays a royalty to IPCo for the use of the IP. Consider two situations: Situation A in which the royalty is 3.5 percent of OpCo's Net Operating Profit and grows at the same rate as OpCo's growth, and Situation B where the royalty is a fixed annual amount of 3.5 [euro]. The relative effect of the planning strategy in Situation B is declining, while the relative effect of Situation A overtime remains the same. Therefore, the NOPLAT after planning grows in Situation B less than the NOPLAT before planning, while in Situation A the NOPLAT growth after planning is the same as before. This will be reflected in the strategy's valuation which should be calculated, as follows:
Value = [NOPLAT.sub.btp] - Net Investments/WACC - [g.sub.NOPLAT] + Tax saving/WACC -[g.sub.Tax saving]
[NOPLAT.sub.btp] = Net Operating Profits Less Adjusted Taxes without the tax effect of the planning strategy
WACC = weighted average cost of capital
[g.sub.NOPLAT] = rate at which the company's NOPLAT without the effect of tax planning grows every year.
[g.sub.Tax saving] = rate at which the saving from the planning strategy grows every year.
For Situation, A the value creation formula can be applied to the planning strategy resulting in --
100 [euro] - 30% x 100 [euro]/12%-5% + (30% - 0%) x 3.5 [euro]/12%-5% = 70 [euro]/7% + 1.05 [euro]/7% = 1,015 [euro]
For Situation B, the value created is calculated, as follows:
100 [euro] - 30% x 100 [euro]/12%-5% + (30% - 0%) x 3.5 [euro]/12%-0% = 70 [euro]/7% + 1.05 [euro]/12% = 1,008.75 [euro]
To this point, this article has considered only the enhancement of annual cash flows through tax planning, but not the effect that Type 2 planning strategies on operations. Since Type 2 planning strategies change the way a business is organized, these strategies also tend to affect the firm's potential to grow operationally. Suppose that the Type 2 strategy in Situation A above reduces the firm's operational growth potential with 0.1 percent to 4.9 percent. Applying the value creation formula has the following result:
100 [euro] - 30% x 100 [euro]/12%-4.9% + (30% - 0%) x 35 [euro]/12%-4.9% = 70 [euro]/7.1% + 1.05 [euro]/7.1% = 1,000 [euro]
So if the tax planning reduced the operational growth with only 0.1 percent, it would completely wipe out the value created through tax planning. (5) The example shows that management should closely review the effect of a Type 2 tax planning strategy on operational growth and confirms why financial investors are critical to the value creation potential of tax planning.
Value Creation through Type 3 Tax Planning Strategies
Type 3 strategies tend to have a limited lifetime and do normally not grow. The value creation formula, which assumes growth and continuity, is therefore not an adequate method to calculate the value created through this type of planning. The limited term in which tax savings can be achieved requires that the tax benefit from planning be valued separately from the value of the NOPLAT without tax planning. Further, Type 3 strategies contain risks different from the business risks already taken into account in the WACC because they tend to be challenged by tax authorities and tax legislators. Because these risks are not a part of the WACC, they should be valued using the expected value.
The company value with Type 3 tax planning is calculated with the following formula:
Value = [NOPLAT.sub.btp]/WACC - [g.sub.NOPLAT] + [n.summation over (t=1)] EV ([Tax saving.sub.t=n]))/WACC - [g.sub.Tax saving]
EV (Tax saving) = expected value of the tax saving from the Type 3 strategy
WACC = weighted average cost of capital6
Consider a firm with 100 [euro] NOP, 5-percent growth and an STR of 30 percent resulting in a firm's value of 1,000 [euro]. Suppose that:
* in a Type 3 planning strategy, the firm re-leverages its French operations which make up 10 percent of the firm's value.
* the re-leverage creates an intragroup loan of [10% of 1,000 [euro] = 100 [euro]] from the FrenchCo to UKCo, bearing an interest of 4 percent.
* the interest is deductible at FrenchCo, and that the interest received is only taxable for one-fifth at UKCo's level.
* in France, the tax base will be reduced with 4 percent of 100 [euro] = 4 [euro], saving 30 percent income tax, or 1.2 [euro].
* in the UK, the tax base increases with 20 percent of 4 percent of 100 [euro] = 0.8 [euro], increasing 30-percent income tax, or 0.15 [euro].
* for the loan to be qualified as a loan by the French tax office, it must be redeemed after five years.
* tax specialists estimate the likelihood that the re-leverage will succeed at 90-percent probability (7) in FY10, but that they also estimate that the French legislator may introduce anti-abuse legislation after FY10, which becomes more likely in later years.
Exhibit 3 shows how the tax planning strategy should be valued.
The value created by tax planning of either type should be calculated separately from the value created by operations. To do so, stakeholders need sufficient information. Many investors and analysts said they disregard tax as a value driver because they lack the relevant information. The importance of transparent information cannot be overstated. (8) The main source of public information about tax is a company's annual account, which contains three pieces of tax information. The first piece is the deferred tax assets and liabilities in the balance sheet. The second piece is the tax expense in the income statement, constituting the amount of income taxes payable or recoverable in respect of the taxable profit or tax loss for a period (current tax expense) and the change in net deferred tax assets and liabilities (deferred tax expense). The tax expense as a percentage of earnings is referred to as the effective tax rate (ETR). The third piece of information is the tax cash flow in the cash flow statement. In practice, all three pieces of information provide input that is difficult to use in a cash flow based valuation model.
1. In annual accounts under IFRS, deferred tax liabilities are calculated at nominal value. Annual accounts rarely state when these liabilities become payable, though this is extremely important when making a DCF valuation.
2. Many firms have an ETR that drastically varies between years, but there is little information to help analysts to understand the reason for it. Exhibit 4 shows the volatility in ETR's of 148 Dutch listed companies, tracked over a period of 10 years. The STR volatility in that period was 1.89 percentage points. Only 5 percent of the companies had an ETR volatility that was smaller than 2.5 percentage points from the average. The volatility of more than 35 percent of the listed firms was larger than 25 percentage points from their average ETR. If this volatility is related understandably to fundamentals, this should not be a problem, but this is not the case.
3. The relation between a year's tax expense and that year's tax cash payments is difficult to understand. Tracked over a five year period, the tax-expense-to-cash ratio of only two companies listed at the Amsterdam stock exchange, i.e., Heineken and Royal Dutch stayed within a range of 1.25. This means that researching a firm's tax expense reveals little about that firm's tax cash flows.
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Firms generally are reluctant to provide information on their tax position, often arguing that this would negatively affect their position toward the taxing authorities. This position is open to question.
Tax planning strategies do create company value. The level of value created is dependent on the type of tax planning. Type 2 planning, involving tax savings through the change of business model or organization, has higher value creation potential than Type 3 planning, which involves creating value through the change of legal or financial organisation. Type 2 planning may, however, substantially affect the growth potential of a business that should be considered when implementing this type of planning. The value created by tax planning should be calculated separately from the value created by growth of the operating profits. For those seeking to analyse the value creation of tax savings, information contained in the annual accounts is limited.
(1.) With respect to income taxes, tax cost is normally measured in terms of ETR reduction. In a recent poll by Deloitte Touche Tohmatsu at a conference for their international top clients, 70 percent of the respondents said that their main key performance indicator is ETR reduction.
(2.) In a global survey by Ernst & Young among 474 finance directors and tax directors of international companies, 68 percent of the senior financial executives said that minimization of tax costs is one of the top three things they want their firm's tax function to achieve. Ernst & Young LLP, Tax Risk: External Change, Internal Challenge, Global Tax Risk Survey (2006).
(3.) T. Koller, M. Goedhart & D. Wessels (2005), Valuation, Measuring and Managing the Value of Companies (2005).
(4.) Financial analysts said they mainly value negative tax events, e.g., the announcement by TNT, a Dutch mail and parcel group, that it had a dispute with the U.K. authorities that could dramatically affect their profit.
(5.) The effect of Type 2 planning on growth of a company's NOPLAT before tax planning should be correlated with the company's phase in the business life cycle. In a fast growing business, the effect of Type 2 planning should be relatively larger than in a slow growing business.
(6.) Because the risks involved in Type 3 strategies are different from the business risks reflected in the WACC, theoretically one would expect a discount rate based on risk free rate and a tax risk premium. For practical reasons, the example assumes the WACC for the business.
(7.) For a method to estimate the probabilities of tax uncertainties, see R. Hafkenscheid, Quantifying Subjective Risk Estimations, a Structured Approach (2007, to be published).
(8.) A good example of the value of transparency is the market reaction to the voluntary recognition of stock-based compensation expenses in 2003. The share prices of companies that voluntarily expensed the costs of their option schemes were found to have significant positive announcement returns, particularly those stating that increased transparency motivated their decision. D. Aboody, M.E. Barth & R. Kasznik, (2004), "Firm's Voluntary Recognition of Stock-Based Compensation Expense," 43 Journal of Accounting Research 123-50 (May 2004).
Rutger Hafkenscheid advises large and medium sized companies on tax strategy, tax decision-making, and tax valuation. He is also a lecturer Tax Decision Management at the Rijkuniversiteit Groningen, Faculty of Law, and is the founder of the Institute for Tax Decision Management, a foundation that promotes value-focused thinking in tax decision-making, both for companies and fiscal authorities. He may be contacted at email@example.com.
Claudia Janssen is Corporate Financial Planner at TomTom NV, the Netherlands car navigation company. Ms. Janssen is also a lecturer at Nyenrode Business Universiteit in The Netherlands, where she teaches Strategy and Decision Making, Business Modelling, and Gaming. She may be reached at firstname.lastname@example.org.
Exhibit 3: Value Creation Through Type 3 Planning FY10 FY11 NOP 100.00 [euro] 105.00 [euro] Tax expense without tax planning 30.00 [euro] 31.50 [euro] NOPLAT without tax planning 70.00 [euro] 73.50 [euro] Scenario 1: Re-leverage succeeds Tax shield planning FrenchCo 30% of 1.20 [euro] 1.20 [euro] Interest expense Tax expense UK Co 30% of Interest 0.15 [euro] 0.15 [euro] income Total benefit from tax planning 1.05 [euro] 1.05 [euro] Probability Scenario 1 90% 80% Expected Value 0.95 [euro] 0.84 [euro] Scenario 2: Re-leverage does not succeed Tax shield planning FrenchCo 30% of 0.00 [euro] 0.00 [euro] Interest expense Tax expense UK Co 30% of Interest 0.15 [euro] 0.15 [euro] income Total benefit from tax planning -0.15 [euro] -0.15 [euro] Probability Scenario 2 10% 20% Expected Value -0.02 [euro] -0.03 [euro] TOTAL Total expected value 0.93 [euro] 0.81 [euro] Discount factor 0.89 0.80 Discounted value tax benefit 0.83 [euro] 0.65 [euro] NOPLAT Value 1,000.00 [euro] [euro] Expected Value Type 3 planning 2.37 [euro] [euro] Total company value 1,002.37 [euro] [euro] FY12 FY13 NOP 110.25 [euro] 115.76 [euro] Tax expense without tax planning 33.08 [euro] 34.73 [euro] NOPLAT without tax planning 77.18 [euro] 81.03 [euro] Scenario 1: Re-leverage succeeds Tax shield planning FrenchCo 30% of 1.20 [euro] 1.20 [euro] Interest expense Tax expense UK Co 30% of Interest 0.15 [euro] 0.15 [euro] income Total benefit from tax planning 1.05 [euro] 1.05 [euro] Probability Scenario 1 70% 50% Expected Value 0.74 [euro] 0.53 [euro] Scenario 2: Re-leverage does not succeed Tax shield planning FrenchCo 30% of 0.00 [euro] 0.00 [euro] Interest expense Tax expense UK Co 30% of Interest 0.15 [euro] 0.15 [euro] income Total benefit from tax planning -0.15 [euro] -0.15 [euro] Probability Scenario 2 30% 50% Expected Value -0.05 [euro] -0.08 [euro] TOTAL Total expected value 0.69 [euro] 0.45 [euro] Discount factor 0.71 0.64 Discounted value tax benefit 0.49 [euro] 0.29 [euro] NOPLAT Value [euro] [euro] Expected Value Type 3 planning [euro] [euro] Total company value [euro] [euro] FY14 NOP 121.55 [euro] Tax expense without tax planning 36.47 [euro] NOPLAT without tax planning 85.09 [euro] Scenario 1: Re-leverage succeeds Tax shield planning FrenchCo 30% of 1.20 [euro] Interest expense Tax expense UK Co 30% of Interest 0.15 [euro] income Total benefit from tax planning 1.05 [euro] Probability Scenario 1 30% Expected Value 0.32 [euro] Scenario 2: Re-leverage does not succeed Tax shield planning FrenchCo 30% of 0.00 [euro] Interest expense Tax expense UK Co 30% of Interest 0.15 [euro] income Total benefit from tax planning -0.15 [euro] Probability Scenario 2 70% Expected Value -0.11 [euro] TOTAL Total expected value 0.21 [euro] Discount factor 0.57 Discounted value tax benefit 0.12 [euro] NOPLAT Value [euro] Expected Value Type 3 planning [euro] Total company value [euro]
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|Author:||Hafkenscheid, Rutger; Janssen, Claudia|
|Date:||Sep 22, 2009|
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