Should Distributive Taxes be Deducted in Valuing Redundant Assets?
When it comes to determining the fair market value of a company that owns redundant assets, one important consideration is the inclusion or exclusion of the distributive taxes associated with removing those redundant assets.
Understanding Distributive Taxes
Distributive taxes represent personal income taxes imposed on a shareholder when value is extracted from a company, generally by way of dividend. The top marginal tax rate on dividends (in BC) is currently 48.89%. So, the distribution of $1.0 million dollars of redundant assets by way of dividend would leave the shareholder with only $511,100 of net proceeds after distributive taxes.
Since distributive taxes can significantly impact the net value realized by the shareholder, the question arises: should distributive taxes be deducted when determining the value of redundant assets in a corporate valuation? In this article, we will explore both sides of the argument, weigh the pros and cons and provide a reasonable recommendation.
Understanding Redundant Assets
Redundant assets refer to assets that are no longer useful or needed by a company to generate income. They might include monetary assets such as excess cash, marketable securities or receivables, or non-monetary assets such as excess inventory, unused machinery and equipment or real estate. Some companies have redundant assets, others do not. In some situations, the value of the redundant assets may be a significant component of the fair market value of the company.
Valuing redundant assets is crucial for the valuation of a corporation, as the net realizable value of these assets are added to the value of the business operations to derive a total enterprise value.
Some valuators also deduct distributive taxes from the net realizable value of redundant assets on the basis that a purchaser would likely remove them from the company post-acquisition. However, this is an often-debated issue in the valuation profession.
The Argument for Deducting Distributive Taxes
Proponents of deducting distributive taxes in valuing redundant assets argue that these taxes represent an unavoidable cost that reduces the net proceeds post-extraction. By deducting these taxes, a more accurate representation of the asset’s true value to a purchaser is obtained. This approach ensures that the tax burden is borne by the company’s seller, reflecting the economic reality of the transaction[1]. Deducting distributive taxes also aligns with the principle of fair market value, which seeks to determine the price that a willing buyer would pay, and a willing seller would accept.
Moreover, deducting distributive taxes can provide consistency in valuation across different jurisdictions. Tax rates and regulations vary from province to province, and deducting these taxes allows for a standardized approach to asset valuation. It promotes transparency and comparability, making it easier for investors, analysts, and other stakeholders to assess the value of an organization.
The Argument against Deducting Distributive Taxes
Opponents of deducting distributive taxes argue that these taxes should not be subtracted when valuing redundant assets. They contend that distributive taxes are a personal obligation imposed by the government and should not affect the intrinsic value of the asset itself. By not deducting these taxes, the valuation remains objective and independent of any personal tax considerations which are external to the company. The only exception to this would be made for valuing deemed not to be a going concern, where the Liquidation Approach is used (i.e., where the business is assumed to be wound-up, with net proceeds distributed to owners).
Deducting these taxes may also require specialized expertise to accurately calculate the amounts, and the calculations may depend on a variety of assumptions about who the likely purchaser would be, and what their dividend tax rate is. For example, if the most likely purchaser is another corporation, the applicable tax rate on intercorporate dividends could be significantly less than for an individual purchaser.
Selected Jurisprudence[2]
It should be noted that the deduction for distributive taxes is an issue that hasn’t been addressed consistently in past court cases, resulting in a lack of consensus within the valuation profession.
As Huddart, J.A., said in Halpin v. Halpin, 1996 CanLII 3370 (BC CA), [1996] B.C.J. 2178, at para. 63:
It is well settled in this province that there is no absolute rule as to whether tax consequences should or should not be taken into account in the valuation of assets or in the determination of the amount of the compensation order. As stated in Murchie v. Murchie (1984), 1984 CanLII 754 (BC CA), 53 B.C.L.R. 157 at 162 … (C.A.), “The circumstances of each case will dictate what seems to be the best course in valuation.”
In Hall v. Atto the Court allowed a deduction for the tax cost that would be borne by a prospective purchaser in removing the redundant cash from the company. In para 90, the decision notes:
There is then an issue of the tax treatment of this [redundant asset] amount. Mr. Walker took into account the taxes that would have to be paid by a notional purchaser if the excess funds were to be taken out of the company. He assumed that the purchaser would pay the vendor the amount of cash in the corporation less the taxes he would have to pay [to extract it]. This is a reasonable approach, in my view. Therefore, the $312,000 must be reduced by the tax payable at 31.34% or $97,780.00. The amount then owing to Mr. Hall is $214,220.00.
In Hartshorne v. Hartshorne, 2001 BCSC 325, each expert valuator had a different opinion as to whether a deduction should be made for distributive taxes[3]. The court chose to include distributive taxes as a deduction but discounted the amount over an estimated deferral period of 16 years[4].
Other Options
Some take a compromise approach and deduct only 50% of the distributive taxes noting that there is uncertainty over the amount and timing of their removal, if ever.
Still, others attempt to predict when the assets will be removed and deduct a discounted present value amount for distributive taxes to reflect the time value of money.
Another option is to consider the likelihood of extraction based on the type of asset in question. For example, if the redundant asset consists of a small amount of excess working capital, or land held for future use, it might be considered unlikely for a purchaser to liquidate the asset and extract the funds. On the other hand, if the redundant asset consisted of a significant balance of term deposits, a purchaser would likely liquidate the portfolio and extract the after-tax proceeds to help pay for the acquisition.
All these arguments have some validity, and the decision ultimately depends on the specific context and purpose of the valuation.
Recommendation
To assist the users of the report, it is prudent to disclose both the pre-tax and post-tax values of redundant assets in a valuation report, enabling the reader to make informed decisions based on their individual requirements and understanding of the facts[5]. If you would like to discuss how these issues relate to your specific circumstances, please contact one of our Chartered Business Valuators
[1] We should point out that, in real-world transactions, the buyer frequently does not acquire the redundant assets held in a corporation; rather, they’re usually extracted by the seller prior to closing.
[2] This is not a complete list of relevant jurisprudence, but just a few cases that were selected to demonstrate that the Court has answered this question differently in different situations.
[3] It should be noted that the distributive taxes in this case were not for redundant assets but related to the entire equity of a law practice. The case does illustrate inconsistent practices among valuators with respect to distributive taxes.
[4] One of the arguments for discounting distributive taxes is that, where the company is likely to become the shareholder’s personal pension, those redundant assets can be withdrawn over time, presumably at lower tax brackets.
[5] This appears to be the approach taken by the expert valuator in Hartshorne v. Hartshorne, 2001 BCSC 325.
