Income tax considerations are vital to conducting a proper business valuation. Step 8 to reviewing a business valuation report involves ensuring the value conclusion incorporates the relevant income tax considerations.
The value of an operating business is dependent on its ability to generate discretionary after-tax cash flows. In cases where business value is driven by the underlying asset values, such as real estate holding companies, important income tax considerations must also be taken into consideration.
Some of the relevant income tax considerations applicable in the valuation of operating companies and real estate holding companies are discussed below:
Under a cash flow based valuation approach (e.g. CCF or DCF), the following tax considerations should be addressed:
- Cash flow and cap rate consistency – after-tax discretionary cash flows should be capitalized by after-tax cap rates
- Redundant assets – should be valued net of corporate income taxes (i.e. net realizable value) and added to the value of the business operations otherwise determined
- Tangible asset backing – should reflect the value of the capital cost allowance tax shield inherent in capital asset values that would not be available to an acquirer of shares (i.e. the tax shield foregone)
- Existing tax balances – the present value of future tax savings that may arise from existing tax pools generally represents incremental value assuming the buyer is a taxable entity.  In Canada, existing tax balances can include the following:
- Undepreciated capital cost (UCC) and cumulative eligible capital (CEC) balances;
- Non or net capital tax loss carry forward (LCF) balances;
- Unused investment tax credit (ITC) balances;
- Refundable dividend taxes on hand (RDTOH) balance; and
- Capital dividend account (CDA) balance.
It is beyond the scope of this article to discuss each of these tax balances in detail. In reviewing a valuation report, however, you should review the company’s corporate income tax returns to identify whether any of the above noted tax pools existed as at the valuation date.
Real Estate Holding Companies
Real estate holding companies are typically valued using an adjusted book value approach. An important tax consideration in valuing the shares of a real estate holding company is the real estate valuation adjustment (REVA).
In a share valuation, the REVA represents the estimated discount a potential purchaser would require as compensation for the disposition costs (e.g. sales commissions, legal fees and income taxes) that would be incurred on an ultimate sale of the underlying real estate assets at fair market value. The income tax costs are sometimes referred to as built-in tax costs.
In Canada, there is no formally agreed upon position with respect to the treatment of built-in tax costs.  Options for treatment include:
- Full recognition
- No recognition
- Partial recognition
The arguments for full recognition and no recognition will not be discussed herein. With respect to partial recognition, the following options can be considered:
- Calculate the disposition costs on an assumed immediate sale of the real estate and take a discount (e.g. 50%) to reflect the uncertainty associated with the timing of a future disposition (i.e. to reflect the present value);
- Calculate the present value of the disposition costs based on an assumed holding period (e.g. 5, 10 years) that is reasonable under the circumstances and reflects the intentions of the potential purchasers; or
- Take the mid-point of the following two extremes:
- Immediate disposition: calculate the disposition costs based on an immediate sale; and
- Perpetual hold: calculate the lost tax benefit to the purchaser assuming the underlying properties will never be disposed of (i.e. foregone tax shield). In the case of a perpetual hold, the purchaser’s only disadvantage would be the tax shield foregone by virtue of acquiring the shares of the company as opposed to the assets directly and being able to bump up the cost base of the land and building to their fair market value for tax purposes. By not being able to bump up the cost base of the land and building to their fair market value for tax purposes the purchaser has lost the ability to write off depreciation for tax purposes (i.e. capital cost allowance) on the higher tax bases.
Income tax considerations are integral to preparing an accurate valuation and should be a major focus in reviewing a business valuation report. If you have any questions with respect to income taxes in conducting a business valuation, contact us at www.vspltd.ca._____________________________
1. This is not the case when valuing net assets as existing tax pools do not flow to the acquirer in an asset purchase.
2. Source: Financial Principles of Family Law, Freedman, Loomer, Alterman, White, page 22-1, 22-6.