Chapter 3: Taxes as Transaction Costs

The role of NPV in decision making

-businesses need to make decisions that generate profit and create value

taxes as a part of business transaction

taxes are a part of out business transaction because there is a cash outflow when we pay taxes

-not every transaction happens in a single time period

-look at everything from a business perspective (understand the words of a problem)

-look from a tax perspective (identify revenue and deductions and when they are allowed)

-look from a cash flow consequences perspective (cash inflows (tax savings, exp) and outflows (taxes, rev)

quantifying cash flows

-first step in evaluating a business transaction is to quantify the cash flows from the transaction

--> can be receipt of cash from firm, firm disbursing cash, or inflows and outflows that must be evaluated on the basis of net cash flow (the difference between cash received and cash disbursed)

-revenue generating transactions usually result in a positive net cash flow that increases the value of the firm. If managers must choose between alternative revenue-generating opportunities, they should choose the one with the greatest positive net cash flow

-in isolation, negative net cash flows decrease the value of the firm, but costs are essential components of an integrated business activity and contribute to short-term and long-term profitability

-if cost is unnecessary, remove it

-if cost is justified, managers should reduce negative net cash flow associated with the cost as much as possible

Time value of money

a dollar available today is worth more than a dollar available tomorrow because the current dollar can be invested to start earning interest immediately

Discount rate

the rate of interest used to calculate the pv of future cash flows

net present value (NPV)

the sum of the present values of cash inflows and outflows from the transaction

Present value

-helps us evaluate transactions and whether we should engage in a transaction

-if after we engage in a transaction we have a net cash flow, we should engage

-if after we engage in a transaction we have a negative cash flow we should not engage

annuity

a cash flow consisting of a constant dollar amount available at the end of the period for a specific number equal time periods

The issue of risk

-how risky it is to engage in a company

-the quantification of cash flows and calculation of their NPV are based on assumptions concerning future events; no matter how careful tyou are, most assumptions are incorrect

-but still some things we know will be less wrong than others which is why the decision to invest in a U.S. Treasury bill is less risky than the decision to invest in the IPO

-the PV of a highly speculative future dollar should be based on a higher discount rant than the PV of a guaranteed future dollar

-Assumptions about financial risk:

1. the discount rate in the example accurately reflects the risk of the transaction under consideration

2. The examples assume that such risk is stable over time so that the appropriate discount rate does not change from period to period

challenges a taxpayer has to be aware of

-we are not in control of how the IRS audits

-its laws could change before the end of our transaction

-tax payers marginal rate is a good one to look at when evaluating but it could change over time

Taxes and cash flows

calculations of NPV must reflect all cash flows, including any tax costs or tax savings resulting from the transaction

--> in the decision making process, cash flows before tax have no relevance

Tax costs

-if a transaction results in an increase in any tax for any period, the increase (tax cost) is a cash outflow

-a tax cost may be incremental to a nontax cost

tax savings

-if a transaction results in a decrease in any tax for any period, the decrease (tax savings) is a cash inflow

-many business expenditures can be subtracted, or deducted, in the computation of taxable income

-the deduction reduces taxable income and causes corresponding reduction in tax. so the deductible expenditure results in a tax savings

-the taxpayer must pay the tax on their current income during the current year and not when they file their tax return in the following year

-- if a taxpayer engages in a transaction with tax consequences in a particular year, the taxpayer's tax cost or savings is a cash flow in that same year

The significance of marginal tax rate

-the income tax cost or savings from a transaction is a function of the firm's marginal tax rate

-in an analysis of transactions that either increase or decrease taxable income, the marginal rate is the rate at which the increase or decrease would be taxed. If this rate is constant over the increase or decrease, the computation of the tax cost or savings from the transaction is simple but it is more complex if the marginal tax rate is not constant over the change is taxable income

The uncertainty of tax consequences

audit risk, tax law uncertainty, marginal rate uncertainty

audit risk

-oftentimes the correct application of the tax law to a proposed transaction is unclear or unresolved

--> the business manager must decide on the most probable tax consequences to incorporate into the NPV calculations

-if there are ambiguous tax issues, the IRS will challenge the tax treatment on audit which the firm can dispute in court

-managers can reduce the risk of an IRS challenge by engaging a tax professional, such as a CPA or an attorney or even ask the IRS (who replies via private letter ruling or PLR which can be expensive)

Ta law uncertianty

-possibility that tax laws may change during the time period of the NPV computation

the ta consequences of a proposed transaction to whihc a stable tax provision applies are more predictable than the consequences of a transaction subject to a provision that congress modifies every year. THe NPV of the former transaction can be calculated with greater certainty than the npv of the latter

marginal rate of uncertainty

-the estimated tax costs or savings from a transaction are a function of the firms projected marginal tax rate

-can change if govt changes the statutory rates for all taxpayers, or change in firms circumstances

structuring transactions to reduce taxes

the tax consequences of business transactions depend on the legal and financial structure of the transactions

-firms change the tax consequences by changing the structure

-business managers who decide to change the structure of a transaction to reduce tax costs must consider the effect of the change on nontax factors. If a change that saves tax dollars adversely affects other factors, the change may be a bad idea. A strategy that minimizes the tax cost of a transaction may not minimize NPV and may not be an optimal strat for the firm

Transactional markets

the extent to which managers can control the tax consequences of transactions depends on the nature of the market in which the transaction occurs

-a market is a forum for commercial interaction between two or more parties for the purpose of exchanging g/s

--> one or both parties may want to customize the terms of the exchange to obtain a certain tax result. Their ability to do so depends on the flexibility of the particular market

private market transactions

-private parties who deal directly with each other. The parties have flexibility in designing a transaction that accommodates the needs of both and the characteristics of the transaction are specified in a contract that both parties agree to

--> each party should evaluate the tax consequences not only to itself but also to the other party to work together to minimize the aggregate tax cost of the transaction and share the tax savings between them

The arm's-length presumption

-the presumption about market transactions is that the parties are negotiating at arm's lenght (each party is dealing in its own economic self-interest, trying to obtain the most advantageous team posisble from the other party

-in an arms length transaction, the parties' consideration of the mutual tax consequences is just one element of their bargaining strategy. If one party suggests a modification to the transaction that directly improves its tax outcome, the other party may not agree unless it can indirectly capture some part of the tax benefit for itself. to do so, the other party might demand more favorable terms with respect to another aspect of the transaction

public market transactions

Considered too large, too impersonal or too regulated to allow for bilateral tax planning (parties communicating privately), resulting in one-sided tax planning.

-firms entering these markets must accept the terms dictated by the market

-firms have limited flexibility in tailoring public market transactions to control the tax results

Fictitious Markets: Related Party Transactions

related party transactions lack the economic tension characteristic of transactions between unrelated parties. Related parties may have compatible obkjectives or even share a single objective and are eager to accomidate each other in negotiations

-if related aprties are not dealing at arms length, no true market exists, and any transaction between them may not reflect economic reality

--> fictitous market, related parties are unconstrained by many of the financial considerations that normally drive arms length transactions

-If the IRS says a transaction is bogu, it may disallow any favorable tax outcome claimed by related parties