The following article provides brief and concise information on the relationship between investments and depreciation in perpetual retirement.
Objectified valuation requires appropriate typification
The subject of the following discussion is the determination of an objectified company value. The objectified company value represents an intersubjectively verifiable future success rate from the perspective of shareholders. The value of a company is determined by the amount of cash inflows to the shareholder. These net inflows must be calculated taking into account the income taxes of the company and, in principle, the personal income taxes of the company owners arising from the ownership of the company.
In company valuation theory and practice as well as in case law, the need to take personal income taxes into account is indisputable; due to the value relevance of personal income taxes, occasional typifications of the tax circumstances of shareholders are required to determine the objectified company value. An objectified company valuation therefore also uses a typical tax rate, although the actual tax situation of the shareholders may be known.
The classification can be carried out directly, i.e. by explicitly defining the tax effect when calculating cash surpluses and in the capitalization interest rate. On the other hand, one speaks of indirect typification when an explicit consideration of personal taxes is omitted because the effect of taxation on the cash surplus and on the capitalization interest rate is equal and therefore negligible.
Relevance of the evaluation occasion for classification
The reason for a company valuation can be diverse. This includes, among other things, the foundation of entrepreneurial initiatives, valuation based on legal regulations or valuation based on contractual agreements.
The valuer often acts as a neutral appraiser to determine an objectified company value as part of entrepreneurial initiatives, in which the valuation serves as an objectified information basis for purchase price negotiations, fairness opinions, creditworthiness checks, etc. With regard to the need for information, an indirect typification of the shareholders' tax situation is appropriate in these cases.
For corporate and contractual valuation events, the objectified company value is determined in accordance with long-standing valuation practice and German case law from the perspective of a domestic natural person subject to unlimited tax liability as shareholder. In this classification, appropriate assumptions must therefore be made as to the amount of both financial surpluses and the capitalization interest rate in order to take personal income taxes directly into account.
Consideration of the legal form is important for the correct presentation of taxation
The legal form of the valuation object has a direct effect on which taxes are due and where they are incurred.
- Capital companies: At company level, there is corporation tax, including solidarity surcharge and trade tax. As far as natural persons are concerned, distributions to shareholders are generally subject to withholding tax plus solidarity surcharge and, where applicable, church tax.
- Partnership with an industrial character: At the level of commercial partnerships, there is trade tax. Corporation tax and solidarity surcharge do not apply here. Insofar as natural persons are involved, profit allocations are subject to personal income tax, including the solidarity surcharge of the respective shareholder, with (partial) offset of trade tax and, if applicable, church tax.
- Non-commercial partnership: In contrast to commercial partnerships, there is no commercial tax here.
- Sole proprietorship: As with partnerships, there is also no corporation tax for sole traders. If there is a commercial enterprise, there is a business tax obligation. The profits of the sole proprietorship are subject to personal income tax, including solidarity surcharge and, if applicable, church tax.
From the explanations presented above, it is immediately clear that both the form of the company and the overall tax situation of the shareholder have an influence on the amount of the total tax burden arising from an investment in a company or, more generally, from an entrepreneurial activity.
When does indirect typing make sense?
The indirect classification dispenses with an explicit calculation of taxes at shareholder level and bases the valuation directly on the distributable cash flow or income. This in turn requires that the opportunity costs of the alternative investment, i.e., the discount interest rate, before personal taxes must also be determined. If the effect of personal taxes is identical for alternative investment and valuation object, this can be dispensed with, as both valuation methods (apart from minor, mathematically related differences) lead to the same result.
In order to be able to assess the agreement, it is important to understand that the alternative investment is usually a portfolio of stocks traded on the stock exchange. Their distributions and share price gains are generally subject to flat rate withholding tax. If it is now necessary to value a corporation, then it can often be assumed there to that the distributions are subject to withholding tax. The abovementioned agreement is therefore there.
Valuation before personal taxes is typically used, especially in the Anglo-Saxon region. In an environment close to capital markets and in valuations within large corporations, in which the shareholder is rarely a natural person, this form of valuation is dominant.
However, it also becomes clear that this correspondence between the taxation of alternative investment and valuation property does not exist for partnerships and sole proprietorship. Applying flat rate withholding tax to income from partnerships is mostly not appropriate (unlike in the case of an asset-managing partnership). Even if indirect typing would be justifiable here on a case-by-case basis, indirect typing is ruled out due to lack of comparability.
When should direct typing be used?
In the cases mentioned above and for corporate and contractual valuation issues, direct classification is required. The valuation-relevant cash flow or income must be calculated after deduction of corporate taxes and, in addition, after deduction of personal taxes. In order to establish equivalence to the discount interest rate, this must also be calculated after personal taxes.
The tax CAPM provides the theoretical basis for this. In contrast to the standard version of the CAPM, risk-free interest rate and market risk premium after personal taxes are calculated here. Since, due to the lack of other alternatives, an investment in listed shares is always assumed as an alternative investment within the meaning of the CAPM. It is obvious to apply the withholding tax when calculating the personal taxes of the alternative investment. This applies to risk-free investments as well as to risky equity investments.
When is a typical personal income tax rate of 35% appropriate?
IDW has long been in favour of including personal income taxes in company valuation and thus followed the prevailing opinion in the theory and practice of company valuation.
The IDW points out in the practical advice that a typical personal tax rate of 35% may be appropriate. It must be pointed out that this rate originated in the 1990s, i.e., dates back to a period before the introduction of the solidarity surcharge and was also calculated as an average tax rate. In the WP handbook and also from renowned authors, there is also evidence that a typical personal tax rate of 35% will continue to be used.
Finally, it should be explicitly pointed out once again in this context that the legal form is decisive whether this tax rate makes sense. When valuations of corporations are applied, the withholding tax rate plus a solidarity surcharge should be used when applying the direct classification. In the case of partnerships, it makes sense to apply the typical tax rate of 35%; together with the business tax due in the company, this may be more like a marginal tax burden even if income is higher. If, on the other hand, the trade tax was offset, then a tax rate of 35% would be comparatively low, particularly if the income from the partnership was to be in the range of the top tax rate. This also applies to sole proprietorship.
Conclusion
The purpose of the valuation and the reason for valuation determine which type of tax classification is appropriate. In addition, the legal form of the company means that indirect typing cannot be adequately implemented in every case. In any case, the evaluator will have to deal intensively with the issue of taxation; there is no blanket procedure within the framework of company valuation.