Distributive Taxes on Redundant Assets

April 21, 2016

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When assessing a company, valuators often review the company’s balance sheet to determine the tangible asset backing (“TAB”) necessary to operate the business. In general terms, TAB is the operating assets (including equipment and other capital assets) less the liabilities required to carry on a business. Once the fair market value of the assets and liabilities included in TAB has been determined, the company’s remaining assets and liabilities are separated into another category – the net of which are commonly referred to as redundant assets.

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Given that TAB represents the net operating assets required to carry on a business, the redundant assets (remaining net assets) are deemed unnecessary to the ongoing operations of the business. Common redundant assets include excess cash in a company and marketable securities (assuming the company is not in the business of investments). An issue arises when the valuator is determining the fair market value of a company and must decide whether to account for taxes on distribution of these redundant assets.

For the sake of simplicity, we will assume a company only has excess cash as its redundant asset. In theory, a purchaser of a business would not pay 100% for this excess cash. If the purchaser was to take this cash out of the company after buying it, commonly by way of dividends, the purchaser (now owner) would have to pay taxes on this cash. The purchaser would require that the amount they pay for this excess cash is equal to the after-tax amount they would receive after extracting this cash from the company.

Distributive tax on redundant assets is a hotly debated topic amongst valuation professionals, and an issue that has not been consistently addressed in past court cases. There are some who contend to accounting for distributive taxes during a valuation, and there are some who are against it. Some valuators deduct personal taxes on notional dividends since these taxes would have to be paid in order to realize the excess funds. However, other valuators have argued that since redundant assets are corporate assets, personal taxes should not be considered. Finally, there are some valuators who take the “in-between” approach and deduct a discounted amount for distributive taxes in order to reflect the time value of money.

As you can see, there is no correct answer on whether to account for distributive taxes. Ultimately, it is up to the valuator’s professional judgment and the particular circumstances of the company in order to decide whether distributive taxes will be considered.

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