The Dividend Double Count

In this post, I touch on a common error I encounter in dealing with a financial analysis of multiple companies owned by the same group or individual. I call this error the “dividend double count”, for reasons that will become apparent momentarily. The error arises in various areas of my practice, but most commonly in the areas of family law and personal injury.

The Issue

The error is as follows. Consider the following simple ownership structure:

Now, suppose that during the most recent calendar year, the following results were reported:

 

 

The question that arises in a family law context is: what was the pre-tax income available to Mr. Shareholder? An intuitive response might be to simply look at the “income before taxes” line on the income statements of Opco and Holdco, and take the sum of $120,000 (i.e. $80,000 + $40,000). Some may also be tempted to pick up the $15,000 in dividends paid to Mr. Shareholder.

But this would be wrong.

Opco shows dividends paid of $45,000. Holdco is the sole shareholder of Opco, so those dividends – which have not been deducted in calculating Opco’s income before taxes – are appearing as part of Holdco’s revenue (along with some miscellaneous revenue).

Had Opco paid out a $45,000 management fee to Holdco, the analysis would be much simpler; the management fee would show as an expense to Opco and as revenue to Holdco; the impact on the combined net income of the two companies would be neutral. The problem really arises because dividends are not deducted in calculating income. In order to calculate the overall pre-tax income, it is necessary to deduct the $45,000 in intercompany dividends. The actual pre-tax income of the two corporations is $120,000 - $45,000 =  $75,000.

(The same commentary would apply to the $15,000 reported by Mr. Shareholder on his personal tax return; these have been paid out of Holdco’s pre-tax income, and should not be included again at the personal level in analyzing Mr. Shareholder’s income).

Other Contexts

This issue also arises in other situations. A number of years ago I analyzed the income of a group of real estate development companies in the context of a claim for personal injury damages. The plaintiff’s expert had presented a claim based on a decline in net income between the pre-accident and post-accident periods, but had neglected to consider the distortions created by the issuance of large intercompany dividends.

Conclusion

Dividends issued from one company to another are included in the income of the recipient, but are not deducted from the income of the issuer.[1] In analysing the revenue or profitability of a group of companies, it is important to gain an understanding of how the revenue of each company is generated in order to gain a proper picture and to avoid double counting.

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[1] The Income Tax Act recognizes this; intercompany dividends amongst related companies are not subject to tax in the hands of the recipient company.

Inflation and Family Law

I was looking through my oldest daughter’s baby book last night and found that we had noted the price of gas at $0.70 per litre; I had noted at the time that this was “really high”! This got me thinking about inflation.

My daughter is 10 years old now, and gasoline has been hovering at between $1.00 and $1.10 in recent weeks here in Toronto. Some of the increase is due to volatile commodity prices, but a large portion of it is due to inflation.

We tend not to think about inflation these days; it is an unspoken part of our everyday lives. A friend of mine recently commented to me that inflation is a modern phenomenon and that in pre-modern societies people simply didn’t have to put up with it. I pointed out to him that a) he’s wrong, there have been four Great Waves since the 13^th century, (to borrow from the title of David Hackett Fischer’s excellent book on the topic), and that b) in modern times there have been periods of significant deflation (most recently during the Great Depression). Here is a graph showing the annual rate of change in the Consumer Price Index in Canada since 1919:

Anyway, as I said, we tend not to think much about inflation. Often, this is a good thing; many people feel good when they receive a 2% raise, and do not like to be reminded that they are just treading water. Deflation, meanwhile, can be crippling for debtors; over 100 years ago, the Democratic presidential candidate, William Jennings Bryan*, famously said that American farmers were being crucified on a “cross of gold” due to a refusal of the government to depreciate its currency.

*It still blows my mind that the Democrats gave Bryan three consecutive kicks at the can as their presidential candidate. Not until Mike Milbury took over the New York Islanders would an organization show such patience with an unsuccessful leader.

Inflation is something that we are comfortable with, so long as it is predictable. It is over 20 years since the Bank of Canada committed itself to fighting inflation, and we tend to assume that things will simply chug along. Yet inflation can cause tremendous distortions in the economy. It can lead to large losses on seemingly safe investments, such as government bonds, as anyone who purchased such bonds in the 1970s will know (or may not know). Payments on bonds are in nominal dollars; when the anticipated real (i.e. inflation-adjusted) value of a dollar declines, bond prices drop as well. If the annual yield on the bond you buy is less than the average rate of inflation over the term of the bond, you will lose money. Here is a look at the average real rate of return for holders of long term Government of Canada Bonds:

You can see that depending on where in the inflationary wave you purchased your bond, you could either make a lot of money, or none at all. (In general, bond yields tended to price in the recent history of inflation; they were lousy at predicting inflation. So, for example, if you bought a bond in 1982 – on the heels of the “stagflation” experienced in the late 1970s – the anticipated inflation built into your bond yield allowed you to make a killing).

Inflation and the Law

So much for the brief economics lesson. How is this relevant to lawyers?

Some areas of law consider inflation. One example is the Income Tax Act. One of the reasons that only 50% of capital gains are included in taxable income (for now) is because for assets that are held over a long period of time, there will have been an inflationary increase in the nominal asset value, which does not really represent incremental income to the asset owner. Tax brackets are also changed every year for this reason. Prejudgment interest is designed to compensate plaintiffs for inflation between the time of injury and trial.

One area of law that does not take inflation into account is family law (at least in Ontario). Consider the following case:

• A couple enters a marriage in the year 2000 with no assets or liabilities, other than a piece of land owned by the wife worth $100,000 (in 2000 dollars).
• Assume that the couple accumulates no additional assets or debts during the course of their marriage – they spend everything they earn, no more and no less. The land just sits there, but it has risen in value due to inflation. Assume that this occurs in a region of the province where inflation in land prices is equal to CPI (i.e. not Toronto). In 2010, assume the land is worth $120,000 (in 2010 dollars).
• In such a case, would there be any equalization payment to reflect the gain in the wife’s net family property? Or would the law recognize that, in real terms, the wife’s property has not appreciated at all?

I presented this scenario to a leading family law practitioner and asked whether it made any sense that an equalization payment would need to be made. He replied that under Ontario’s Family Law Act, any increase in the nominal value of family property, even if due to inflation only, is considered to be an increase and to be part of "net family property". Section 4 of the Act defines "net family property as:

the value of all the property, except property described in subsection (2), that a spouse owns on the valuation date, after deducting,

(a) the spouse’s debts and other liabilities, and

(b) the value of property, other than a matrimonial home, that the spouse owned on the date of the marriage, after deducting the spouse’s debts and other liabilities, other than debts or liabilities related directly to the acquisition or significant improvement of a matrimonial home, calculated as of the date of the marriage;

This issue arises in business valuations as well. As a result of inflation, a business will increase its selling prices (hopefully), its costs will increase, the replacement costs of its assets will increase, and a business that undergoes no fundamental change can find itself worth much more in nominal terms than it was at the date of marriage.

I suppose one could suggest a reading of the Act to the effect that the calculation should be based on real (and not nominal) values; but in my experience in dealing with family law matters, this is typically not argued.

Conclusion

One might ask, is this fair? There has been no real increase in the value of the property, why should the husband get anything? This was my first instinct In thinking about the issue. But I think now that perhaps that question - "is it fair?" - is not the right one to be asking.

Life is not fair. In some marriages, both spouses contribute equally (either to the business or to home life). This is not always the case, however. Rather than trying to assign points, the Family Law Act says simply: we will split the net increase down the middle.  It may not be “fair”, but it is impossible to legislate fairness with anything more than very broad strokes.

Statutory financial remedies will never be perfect. They cannot address all possible cases. The advantage of such relatively cut-and-dried remedies is that they provide a relatively simple system of efficiently adjudicating disputes and allocating money between the parties.

Of course, it does not always work out that way J