Canada's Fall Economic Update and Its Impact on Valuations

A couple of days ago, the federal government of Canada came out with its Fall Economic Update. One aspect of the update that impacts businesses (and business valuations) is the changes to the Capital Cost Allowance (“CCA”) system by which businesses get to write-off their capital assets for tax purposes. This brief article discusses some aspects of this change.

CCA and the Half-Year Rule

For non-manufacturing equipment, we used to have the “half-year rule”, whereby a purchaser of a new asset only got to apply half of the normal CCA rate in the first year; for example, if you bought an asset for $100,000 and the normal CCA rate is 20%, you’d only get to write off 10% (or $10,000) in the first year for tax purposes.

The half-year rule has now been replaced with a new first year rule which allows purchasers to apply 1.5 times the normal CCA rate in the first year; to continue the example from the previous paragraph, the CCA in year 1 would now by $30,000.

For valuators, this means that the tax shield formula on new capital expenditures will change from:

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1- (Discount Rate / (2 x (1 + Discount Rate))))

to

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1+ (Discount Rate / (2 x (1 + Discount Rate))))

Does this matter?

So, will this change impact a) actual capital expenditures and b) valuations in Canada going forward? The short answer is: in many cases, "not really".

The amount of CCA that businesses can take over the life of the asset in question does not change based on the new rules; all that is affected is the timing of CCA. By accelerating the CCA in the first year of the asset’s life, businesses will get to reduce their taxes in the first year, but their taxes will be slightly higher in subsequent years. The value of this timing difference depends on the discount rate one uses.

A common practice in valuations is to use a firm’s pre-tax cost of debt as the discount rate to calculate the present value of CCA. The reason for this is that the odds that a firm will have at least some taxable income against which to apply the CCA are fairly good, certainly less risky than the overall returns to equity holder as a whole.

Using a discount rate of 8%, I calculate that the impact of the new tax changes to the cost of asset purchases will be less than 1%, regardless of the CCA asset class. 

This is not to say that these changes will not spur a sudden rash of equipment purchases – they may have some psychological effect. But the actual savings, at least in most cases I can envision, are pretty marginal.