Does income tax planning create value?

• Author: Hafkenscheid, Rutger

Introduction

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

where

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.

[ILLUSTRATION OMITTED]

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...