Pre-judgment Interest, Part II – Interest and Taxes

In the previous post, I discussed the large pre-judgment interest award in Cefaclor. In that case, one of the issues raised by defendant’s counsel was that to award the plaintiff compound interest would result in overpayment; since the damages award is calculated on a pre-tax basis, and allowing this to accumulate on a pre-tax basis, it was argued, would result in overcompensation:

[119]      Apotex argues that an award of compound interest will over compensate Lilly because it permits pre-tax dollars to be compounded rather than after-tax dollars.  It says that “an award of simple interest obviates the need to take such tax considerations – which considerations may be quite complex – into account and permits a more facile calculation.” 

The trial judge did not accept this line of argument. In this post I explore one possible reason why he was right.

 

Interest and Taxes

 

Let us begin with a simple example. Assume Plaintiff Co. suffers lost profits of $1M in Year 1, and that its tax rate on its lost profits would have been 25%. The matter goes to trial, and damages are awarded precisely 10 years later. Assume that corporate tax rates have not changed and will be assessed at 25% of the damages award.

Let us for the moment accept the "Coerced Loan Theory" advanced by Michael S. Knoll and Jeffrey M. Colon, which holds that pre-judgment interest should be assessed at the borrowing cost of the defendant. Assume the defendant’s borrowing cost throughout the loss period was 5%.*

*Lots of assumptions so far; you can imagine that real life situations are much more complex, as Apotex argued in Cefaclor. Of course, given that the two expert accountants in that case charged well over $1M between them, one would think such a calculation would not be beyond their ken.

Had Plaintiff not been wronged by Defendant and earned the profit of $1M, it would have paid taxes in Year 1, invested the after-tax amount at a rate of 5% per year, on which it would have also paid taxes. At the end of Year 10, it would have been left with an after-tax amount of $1,083,783.

Instead, Plaintiff did not earn its profit, but is granted a damages award of $1M. If we apply a compound PJI rate of 5%, Plaintiff will be left with an award of $1,628,895. Even after Plaintiff pays taxes of 25% on the net amount, it will be left with a sum of $1,221,671.

The problem - and presumably what Apotex was alluding to - is that the interest rate that has been applied is a pre-tax interest rate. Suppose we deduct taxes from the PJI that accrues each year (effectively applying an interest rate of 3.75% instead of 5%); we then arrive at the same result as if Plaintiff had earned the profit back in Year 1 - our damages award puts Plaintiff in the exact position it would have been in but for the wrongdoing.

Changes in Tax Rates

The preceding example shows that the correct approach is to apply a PJI rate that replicates the after-tax rate that Plaintiff would have earned. Even though the damages award is a pre-tax figure, whereas the profit that would have been earned absent the wrongdoing would have been taxable in the year it was earned, the two approaches will yield identical results if tax rates stay the same.

 

But what if tax rates change over time?

Consider the same example as above; this time, however, we apply the actual combined tax rates in force in Ontario during the period, which have fallen steadily from Year 1 to Year 10. Here is the Plaintiff's profit had it not been wronged:

 

 

The Plaintiff pays taxes at 34.12% on its profit of $1M in Year 1, and earns a return of 5% each year, on which it pays taxes at the relevant rates. Its after-tax funds after ten years would have been $928,237.

 

On the other hand, if the damages award of $1M is "invested" retrospectively at 5%, and taxes are deducted on the interest each year, we find that even after paying taxes on the damages award in Year 10, the total after-tax value is higher, $1,035,600:

 

 

This is a result of changes in tax rates over time.

 

Now, there is no great difficulty in contriving an adjustment to the damages award that will reflect the impact of the lower tax rate in Year 10; and as I have argued previously, this is an adjustment that will need to be made regardless of pre-judgment interest considerations.

Conclusion

Income taxes provide another layer of detail to damage calculations. But the concepts are not difficult and the calculations can be easily performed.