The taxation of business income and shareholder income in the objective business valuation is complex. Taxes at company and shareholder level must always be taken into account.
The taxation of business income and shareholder income in the objective business valuation is complex. Taxes at company and shareholder level must always be taken into account. The decisive factor is the exact amount and type of taxation, which this article explains.
The subject of the following discussion is the determination of an objectified enterprise value. The objectified enterprise value represents an intersubjectively verifiable future success value from the shareholders' perspective. The value of a company is determined by the amount of cash inflows to the shareholder. These net cash inflows are to be determined taking into account the company's income taxes and the personal income taxes of the company owners.
In the theory and practice of business valuation as well as in case law, the need to take personal income taxes into account is undisputed. Due to the relevance of personal income taxes to the value, the tax situation of the shareholders must be standardized on a case-by-case basis in order to determine the objectified business value. In an objectified business valuation, a standardized tax rate is used, although the actual tax situation of the shareholders may be known.
Typification can be carried out directly by explicitly specifying the taxation effect when determining the cash surplus and in the capitalization interest rate. Indirect standardization is applied if the effect of taxation on the cash surplus and the capitalization interest rate is the same and therefore negligible.
The reason for a business valuation can be diverse, including the substantiation of entrepreneurial initiatives, the determination of value based on legal regulations or the valuation based on contractual agreements. The appraiser often acts as a neutral appraiser to determine an objectified business value as part of entrepreneurial initiatives. In such cases, an indirect standardization of the tax circumstances of the shareholders is appropriate.
For corporate and contractual valuation purposes, the objectified business value is determined in accordance with long-standing valuation practice and German case law from the perspective of a domestic natural person with unlimited tax liability as a shareholder. Appropriate assumptions regarding personal income taxes must be made both for the financial surpluses and the capitalization interest rate.
The legal form of the valuation object has a direct impact on which taxes are incurred and where they are incurred:
It is 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 resulting from an investment in a company or from an entrepreneurial activity.
Indirect typification dispenses with the explicit calculation of taxes at shareholder level and bases the valuation directly on the distributable cash flow or income. This requires that the opportunity costs of the alternative investment, i.e. the discount rate, are also determined before personal taxes. If the effect of personal taxes is identical for the alternative investment and the valuation object, it can be dispensed with, as both valuation methods (apart from small mathematical differences) lead to the same result.
In order to be able to assess the match, it is important to understand that the alternative investment is usually a portfolio of shares traded on the stock exchange. Their distributions and capital gains are subject to withholding tax. When valuing a corporation, it can often be assumed that the distributions are subject to withholding tax. This is therefore the case.
Valuation before personal taxes is frequently used in the Anglo-Saxon world in particular. In the capital market environment and for valuations within large corporations, where the shareholder is rarely a natural person, this form of valuation is dominant.
However, it is also clear that this correspondence between the taxation of the alternative investment and the valuation object does not apply to partnerships and sole proprietorships. Applying the flat-rate withholding tax to income from partnerships is generally not appropriate. Even if indirect standardization would be justifiable in this case, indirect standardization is ruled out due to a lack of comparability.
In the aforementioned cases and in the case of corporate and contractual valuation reasons, direct standardization is required. The cash flow or income relevant to the valuation must be determined after deduction of corporate taxes and additionally after deduction of personal taxes. In order to establish equivalence with the discount rate, this must also be determined after personal taxes.
The theoretical basis for this is the tax CAPM. In contrast to the standard version of the CAPM, the risk-free interest rate and equity risk premium must be calculated after personal taxes. Since an investment in listed shares is assumed to be an alternative investment within the meaning of the CAPM, it makes sense to apply the flat-rate withholding tax when calculating the personal taxes of the alternative investment. This applies to both the risk-free investment and the risky equity investment.
The IDW has long advocated the inclusion of personal income taxes in business valuation and has thus followed the prevailing opinion in the theory and practice of business valuation.
In its practical notes, the IDW points out that a standardized personal tax rate of 35% may be appropriate. It should be noted that this rate originated in the 1990s, i.e. before the introduction of the solidarity surcharge, and was calculated as an average tax rate. There are also indications in the WP Handbook and among renowned authors that a standardized personal tax rate of 35% will continue to be used.
Finally, it should be explicitly pointed out that the legal form is decisive as to whether this tax rate makes sense. In the case of valuations of corporations, the flat tax rate plus solidarity surcharge should be used when applying direct standardization. For partnerships, it makes sense to apply the standardized tax rate of 35%. Together with the trade tax incurred by the company, this can correspond to a marginal tax burden even for higher incomes. If, on the other hand, trade tax is offset, a tax rate of 35% would be comparatively low, especially if the income from the partnership is in the range of the top tax rate. This also applies to sole proprietorships.
The purpose of the valuation and the reason for the valuation are decisive in determining which type of tax standardization is appropriate. In addition, the legal form of the company means that indirect standardization cannot always be implemented appropriately. The valuer must deal intensively with the issue of taxation, as there is no one-size-fits-all approach to business valuation. smartZebra's expertise and tools can help navigate these complexities and ensure accurate and reliable business valuations.
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