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.
  

Franchise Rescission under the Wishart Act - Treatment of HST

I have been involved in quantifying financial remedies in roughly 50 franchise rescission cases under the Arthur Wishart Act and other franchise disclosure acts. One of the most common errors I have seen in calculations prepared by franchisee counsel relates to the treatment of GST/HST. This article discusses how these taxes should be treated in such cases.

(Throughout the article, for the sake of brevity I will refer to HST only, using the 13% rate in effect in Ontario; the principles set out here will apply equally to provinces that have GST).

 An Example

 Consider a simple example in which an Ontario franchised business paid a $50,000 franchise fee, purchased $200,000 in equipment and leaseholds from third parties, did $100,000 in sales, and had expenses of $200,000. Here is how the rescission remedy would be presented, on both a pre- and post-HST basis:

Which is the correct figure for the rescission remedy? Is it the $350,000 or the $389,000? To answer this question, it is necessary to understand how the HST system works.

Businesses that are registered to collect HST are required to remit the net HST they collect. If the HST they paid to other vendors exceeds the amount of HST they collected, then they are entitled to a refund for the difference.

Returning to our example, if the franchised business is registered to recover its net HST paid, then the $39,000 in net HST paid gets refunded back to the business when it files its HST return, and the true losses are only $350,000, not $389,000.

It is for this reason that I typically calculate rescission damages on a pre-HST basis.

Some Other Arguments

Is this issue black-and-white? Or are there some cases in which it might be appropriate to include the HST paid?

If the franchised business is HST-exempt, then it cannot recover the HST it has paid on its expenditures. Examples of HST-exempt businesses that are sometimes franchised would include child care services, medical services, and (in some cases) educational services. In those cases, it would certainly be appropriate to include the HST paid as part of the rescission remedy.

There may also be semantic arguments to be made. Here is the actual text of subsections 6(6)(a) to (c) of the AWA:

(a) refund to the franchisee any money received from or on behalf of the franchisee, other than money for inventory, supplies or equipment;


(b) purchase from the franchisee any inventory that the franchisee had purchased pursuant to the franchise agreement and remaining at the effective date of rescission, at a price equal to the purchase price paid by the franchisee;


(c) purchase from the franchisee any supplies and equipment that the franchisee had purchased pursuant to the franchise agreement, at a price equal to the purchase price paid by the franchisee;


Subsection (a) speaks of the “money received” by the franchisor. When the franchisor is paid a franchise fee or royalty, the amount includes HST. A literal reading of subsection (a) would seem to argue in favour of including the HST paid.

Similarly, one might argue that the “purchase price paid” for inventory, supplies and equipment referred to in subsections (b) and (c) might also include HST.

Will this literal approach result in a windfall to the franchisee? In most cases, the answer should be “no”. Where a claim is also being made under subsection (d), then to the extent that the HST paid by the franchisee is being considered under subsections (a) to (c), it would be appropriate to consider the tax credit received by the franchisee under the calculation of operating losses.

Thus, using our example from above, if one includes the $6,500 in HST paid on the franchise fee as part of the calculation under subsection (a), one would need to deduct the very same $6,500 from the calculation of operating losses. Effectively, the final amount calculated would still be a pre- HST amount.

But what if no claim is being advanced under (d), for whatever reason?[1] In those cases, a strict reading of the language of the AWA might indeed result in a windfall to the franchisee if they are granted the post- HST amount under subsections (a) through (c).

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[1] Such cases are possible; see 2189205 Ontario Inc v Springdale Pizza Depot Ltd, 2013 ONSC 1232

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.

Personal Injury Damages and Taxation

A couple of weeks back I posted on the issue of damages and taxation. The discussion was focused on awards in respect of lost profits. Someone asked me whether the same concepts apply to personal injury damages? The short answer is no. For a longer answer, please keep reading.

Personal injury damages occupy a unique position within the spectrum of financial loss calculations. The goal in quantifying financial losses is generally considered to be to return the plaintiff to the financial situation he or she would have been in if not for the wrongdoing.  Arguably, that is not what happens in many personal injury cases, and the reason has to do with income taxes.

Consider a simple example of Joe, a construction worker. Joe typically earns $70,000 per year and pays taxes at an average rate of roughly 30%; his typical after-tax income is normally $49,000 ($70,000 x (1-30%)). Assume Joes slips and falls on an icy sidewalk one winter, and his doctor says he will be unable to work for the next three years. The municipality, recognizing its wrongdoing, agrees immediately to compensate Joe for his loss of income. The question is, should the municipality pay Joe $70,000 per year (i.e. his lost pre-tax income), or $49,000 (his lost after-tax income)?

The Supreme Court, in R. v. Jennings et al., [1966] SCR 532, 1966,  discussed precisely this issue of whether income taxes ought to be deducted in calculating Joe’s loss of income. It argued that no deduction should be made (unless, of course, there is a specific statute – such as many of the various provincial Insurance Acts – to the contrary). Here is what the Supreme Court wrote:

It has been said that if the incidence of taxation on future earnings is ignored, the plaintiff is being over-compensated. With this I do not agree. A lump sum award under this head is at best no more than rough-and-ready compensation. There must be very few plaintiffs who are compelled to take a lump sum who would not be better off with their earning capacity unimpaired or a periodic reassessment of the effect of its impairment. There is, as things are at present, no possibility of such a reassessment. But mathematical precision is impossible in assessing the lump sum, and where large amounts and serious permanent disability are involved, I think that the award is usually a guess to the detriment of the plaintiff.

To assess another uncertainty—the incidence of income tax over the balance of the working life of a plaintiff—and then deduct the figure reached from an award is, in my opinion, an undue preference for the case of the defendant or his insurance company. The plaintiff has been deprived of his capacity to earn income. It is the value of that capital asset which has to be assessed. In making that determination it is proper and necessary to estimate the future income earning capacity of the plaintiff, that is, his ability to produce dollar income, if he had not been injured. This estimate must be made in relation to his net income, account being taken of expenditures necessary to earn the income. But income tax is not an element of cost in earning income. It is a disposition of a portion of the earned income required by law. Consequently, the fact that the plaintiff would have been subject to tax on future income, had he been able to earn it, and that he is not required to pay tax upon the award of damages for his loss of capacity to earn income does not mean that he is over-compensated if the award is not reduced by an amount equivalent to the tax. It merely reflects the fact that the state has not elected to demand payment of tax upon that kind of a receipt of money. It is not open to the defendant to complain about this consequence of tax policy and the courts should not transfer this benefit to the defendant or his insurance company.

In case you are like I am and cannot resist glossing over lengthy block quotations, what the Supreme Court alludes to – and what is in fact standard practice in personal injury damages – is that Joe will be entitled to compensation of $70,000 per year. There should be no deduction for income taxes in calculating Joe’s lost income; but Joe will not need to pay taxes on award either. In effect, Joe will be left with significantly more money, on an after-tax basis, than if he had not slipped on the icy sidewalk ($70,000 per year as opposed to $49,000).

There are a number of very interesting ideas – four of them to be precise - packed into the two paragraphs I quoted above, and it is worthwhile unpacking them. They are as follows:

      i.      Imprecision of any calculation: The SCC begins by arguing that the calculation of loss of income will never be very precise anyway, as there are many variables that are difficult to define with all but the broadest brush strokes. Tweaking our model to reflect income taxes would not add precision to what will always be at best a “rough and ready” estimate.

     ii.      Policy reasons: Calculations for loss of future income are one-time awards based on the best evidence available to the court at the time. The physical and emotional capacity of the plaintiff may take a turn for the worse; interest rates may be lower than expected. The court argued that it was better to err on the side of overcompensating the individual plaintiff, even at the expense of the defendant or his or her insurer.

    iii.       Capital asset: The plaintiff’s loss is that of a capital asset. The value of such an asset is equal to the value of its future net income on a pre-tax basis.

    iv.       Lack of legislation: The Canada Revenue Agency’s position is that awards (or settlements) in respect of losses due to personal injury are not taxable – see here (http://www.cra-arc.gc.ca/E/pub/tp/it365r2/it365r2-e.html). If the relevant legislatures are unhappy with awarding damages based on pre-tax income, they can easily remedy this. Alternatively, the Income Tax Act could be revised to make personal injury damages taxable.

Let us know explore each of these arguments in more detail.

The Imprecision Argument

As accountants, we are inclined to feel we can model and quantify everything with a high degree of accuracy; this is hard to accept at first. But of course, any model is only as good as its assumptions, and the real point of the court is that assumptions regarding hypothetical future events are inherently imprecise. The degree of random error in modeling the future income of any given individual will be high. To invoke a commonly invoked metaphor, damage awards are often carved with a “broad axe”, not a fine chisel.

This argument is fine as it goes, and it suggests, for example, that it might be appropriate to round all personal injury calculations to the nearest $100,000. But it is a logical stretch to say that because there will always be imprecision in our projections, we should ignore a factor that will always serve to lower the damages award. The plaintiff’s marginal tax rate may be uncertain; but, as was long ago pointed out, the existence of some degree of taxation is one of the few certainties in life. The solution to estimation difficulty is surely not to introduce systematic bias.

It is also pertinent at this point to discuss the issue of what is commonly referred to as an “income tax gross-up”. The argument in favour of applying such a “gross-up” is that since the investment income earned on the lump sum settlement will be taxable, it is necessary to compensate the plaintiff with an amount sufficient to offset these taxes. But if one of the main reasons for ignoring taxes is simply to produce a calculation that is “rough and ready”, it would seem counterproductive to then go on to introduce an oftentimes complex upwards adjustment due to the very same income tax considerations.

The Policy Reasons Argument

This brings us to the second reason for not deducting taxes. The court argued that we would prefer to err on the side of overcompensation rather than undercompensation. One way of doing so is to ignore income taxes (and, possibly, to apply a “gross-up” to the damages award).

There is certainly no denying that ignoring taxes will increase the chances that the plaintiff will receive his or her full compensation. But one might question the merits of introducing a factor that will always result in an upwards adjustment to whatever the trial judge might have thought was a fair award.

Capital Asset

This line of reasoning holds that the plaintiff is being compensated based on the impairment in the value of his or her “capital asset”. The argument contains two elements, each of which invites interesting avenues for analysis. These are as follows:

·     Payment in respect of a capital asset is not taxable, even if the asset has a low “cost base” or historical cost.

·     The value of a capital asset is measured based on its pre-tax level of earnings or profits, discounted at an appropriate rate.

Concerning the first argument, it is important to note that Jennings was decided in 1966; this was before there were any capital gains taxes in Canada. While subsequent decisions of the SCC have confirmed the “capital asset” rationale insofar as it relates to personal injury damages and taxes (D Cirella v. The Queen [1978] CTC 1 (FCTD); rev’g. [1976] CTC 2292 (TRB)), it is unclear why there should be no taxable capital gain at all on the disposition of the individual’s ability to work. By comparison, if a business asset – a factory or piece of equipment – is damaged and proceeds are received, the transaction (unless the asset is being replaced) is deemed tantamount to a sale of the asset, and the normal tax rules of recapture and capital gains apply. See this paper for a further elaboration of this argument. 

As for the second argument, it is true that in business valuation, shareholder level taxes are not normally taken into account. The main reason for this is that a large portion of institutional investors who set market prices (e.g. pension funds or sovereign wealth funds) are non-taxable; taxes paid at the corporate level thus represent the totality of all taxes payable for these entities. In order to value an asset where some bidders are not subject to taxes below the corporate level, it is necessary to ignore shareholder level taxes, as the non-taxable investors will bid up the price of these assets.

It is difficult to see the relevance of this argument to individual labour. Anyone who is an employee is selling his or her labour based on an expected after-tax value; taxes are very much part of the equation for employees choosing between base salary versus deferred compensation or other forms of tax-favoured compensation.

(It is also important to note that the discount rate used in to convert future personal injury losses to a lump sum is in fact an after-tax discount rate, again dictated by the marginal bidders for risk-free assets such as government bonds. It is clear, in other words, that the plaintiff is receiving a pre-tax award.)

Legislation

I have relatively little to say concerning this last argument. In many provinces, legislation exists that deducts income taxes for personal injury cases involving motor vehicle accidents; some do so for past losses only, others for future losses as well.

Conclusion

Personal injury damages are subject to unique treatment when it comes to taxes. They are calculated on a pre-tax basis, yet are not subject to tax. As we have seen, there are a variety of reasons for this treatment, some of which may be more persuasive than others. But barring any further action by the CRA (in assessing taxes on such awards) or the legislatures (in requiring the deduction of taxes in computing the awards), this unique treatment will continue to exist.

Tax Rates, Timing and Damages II: Small Businesses

As a follow-up to yesterday’s post, I wanted to add that the same phenomenon of declining tax rates be observed for businesses that are eligible for the small business deduction. The following chart shows the small business tax rate since 2000:

 

In addition, the limit up to which a corporation can claim the small business deduction has also risen over the years, from $200,000 in 2000 to $500,000 in 2014. As a result, a business receiving a damages award in 2014 as opposed to 2000 will pay less corporate tax.

I underline the word “corporate”, because in many instances of business disputes involving small companies, the shareholder(s) of the plaintiff corporation are also named as parties to the suit. While there are no doubt different legal considerations that go into the decision to name individual plaintiffs, as a general rule when a dividend is declared to the individual shareholder, the combined taxes payable at both the corporate and personal level will be very close to the taxes that would have been payable had the income been earned by an unincorporated entity. In such situations, changes in the small business rate over time will (arguably) be largely irrelevant.

Tax Rates, Timing and Damages

The deadline for most individuals in Canada to file their income taxes is today, so I thought I would post on the issue of damages and taxation.

In Canada, as a general rule, damages awards are subject to the same tax treatment as the monetary amounts they are meant to replace. For example, awards for lost profits are taxed as business income.[1] Litigation can often take a long time to resolve; some lawsuits span decades. What happens when the tax system undergoes significant changes between the year the lost profits would have been earned and the year in which the damages award is paid?

In Canada, corporate tax rates have fallen significantly in recent years. The following chart shows the combined corporate tax rate for income earned in Ontario for income not subject to the small business deduction. Rates have fallen from slightly over 50% in the 1960s to under 30%. This can have a significant impact on damages calculations:

Consider the case of Eli Lilly and Company v. Apotex Inc.,2014 FC 1254. Apotex was found to have infringed Eli Lilly’s patents for the drug cefaclor; after many years, in late 2014 the court awarded Eli Lilly approximately $31M in damages resulting from the infringement over the period 1997 to 2000.

There is no discussion of income taxes in the written decision, and it is not clear if the issue was raised at trial. I refer to this case simply to illustrate the concept, and impact, of differential tax rates.

Had Eli Lilly and its Canadian subsidiary not been deprived of their lost profits in the period 1997 to 2000, they would have paid an average income tax rate of roughly 35% for sales made in Ontario; rates were similar in most other provinces. By comparison, on receiving its damages award in 2014 or 2015, Lilly will pay taxes at a rate of around 26.5%, a differential of 8.5%.

Had Lilly earned the profits in question in the period 1997 - 2000, its after-tax profit would have been $31M x (1-35%) = $20.15M. Receiving the same profit in 2014, the after-tax value is$2.64M higher. This is a factor that should have been taken into consideration in assessing, (and reducing) Lilly's losses.

Stated otherwise, had the court wished to give Lilly an award in 2014 that would equate to $20.15M in after-tax dollars (the amount of after-tax profit it would have received in 1997-2000), the award should have been $27.4M, or $3.6M less than the actual award ($27.4M x (1-26.5%) = $20.15M).

Considering that prejudgment interest of $75M was also awarded on the damages assessed - and I will return to this spectacular prejudgment interest award in future posts - the issue of declining tax rates likely represented a $10M issue in this case.

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[1] http://www.cra-arc.gc.ca/E/pub/tp/it365r2/it365r2-e.html