12/09/2023

BỘ GIÁO DỤC VÀ ĐÀO TẠO

TRƯỜNG ĐẠI HỌC KINH TẾ - TÀI CHÍNH
THÀNH PHỐ HỒ CHÍ MINH

TAX PLANNING

Chapter 3: FUNDAMENTALS OF TAX PLANNING

TRẦN NGỌC THANH

[email protected]

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Đại học Kinh tế - Tài chính thành phố Hồ Chí Minh www.uef.edu.vn

Table of contents

The Role of Net Present

Value in Decision Making

Taxes and Cash flows

Structuring Transactions to
Reduce Taxes

Application

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1. The Role of Net Present

Value in Decision Making
Quantifying cash flows

Present value

The issue of risk

Quantifying cash flows

• The first step in evaluating a business transaction is to quantify the

cash flows from the transaction.

Net cash flow = Cash received (cash inflows) - cash disbursed

(cash outflows)

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Quantifying cash flows

• To maximize the value of the firm, managers maximize positive cash

flow or minimize negative cash flow.

Quantifying cash flows

• The various costs that firms incur can be

expressed as negative net cash flows.
• Viewed in isolation, negative net cash
flows decrease the value of the firm.
• Costs are essential components of an
integrated business activity and
contribute to short-term and long-term
profitability

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Quantifying cash flows

• If managers conclude that a

particular cost is unnecessary
because it doesn’t enhance
profitability, the cost should be
eliminated.
• After a cost is justified, managers
should reduce the negative net
cash flow associated with the cost
as much as possible.

Quantifying cash flows

Case 1: Eden Pharmaceutical Company wants to increase sales of its new medicine at
public hospitals in Ho Chi Minh City. The Company estimates the following expenses:
• Advertising spending in public hospitals.
• Training costs for pharmacists.
• Workshop and travel expenses for doctors.
• Presumptive expenses to buy gifts for doctors.
• Prescription commissions for hospitals.

Required: Which expenses should you exclude? Why?

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Present value

Would you prefer to receive $100 today OR $100 in one year?

“A dollar available today is worth more than a

dollar available tomorrow because the current
dollar can be invested to start earning interest
immediately”
Richard & Stewart, 1996

Present value
• The present value of a dollar
available in the future is based on
a discount rate.
where:
10% interest per year: i = 0.1 PV = present value
FV = Future value
i = discount rate/interest rate

=> The $110 is called the one-year future value of $100 today
=> The $100 is called the Present Value of receiving $110 in one year

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Present value

Case 2: If the discount rate is 10%, what is the present value of an

investment that pays you $1,100 next year, $1,210 the year after,
and $1,331 the year after that? Drawing the cashflow stream.

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Present value
• A cash flow consisting of a
constant dollar amount available
at the end of the period for a
specific number of equal time
where:
periods is called an annuity. PV = present value
FV = Future value
• Present Value of an Annuity is: i = discount rate/interest rate

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PV FP FP FP FP

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Present value

Case 3: You decide to purchase a new house and need a

$100,000 mortgage. You take out a loan from the bank and
promise to pay off the loan in 20 years. And the interest rate is
7%, what is your yearly payment?

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The issue of risk

• The quantification of cash flows and

calculation of their net present value are
based on assumptions concerning future
events.
• Example:
- The assumption that the U.S. government will
pay the interest on its debt obligations.
- The value of an IPO of stock will double in
value over the next 12 months.

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The issue of risk

• Business consultants must be sensitive to the resultant degree of

risk inherent in any transaction.

“A safe dollar is worth more than a risky dollar”

• The present value of a highly speculative future dollar should be

based on a higher discount rate than the present value of a
guaranteed future dollar

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The issue of risk

For example
Firm Z has the opportunity to invest in a new business venture. The
promoters of the venture provide Firm Z with a 10-year projection.
• Firm Z determines that the venture has a high degree of risk and
therefore uses a 10 percent discount rate to calculate the NPV of the
projected cash flows. With the high discount rate, the NPV is a negative
number.
• Firm Z determines that the venture has a low degree of risk and uses a 4
percent discount rate to calculate net present value. With the lower
discount rate, the net present value is a positive number.

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NPV sample
Case 4: Suppose a consulting firm must decide between two
engagements.
• Engagement 1 will generate $40,000 revenue in the current year and
$185,000 revenue in the next year. The firm estimates that this
engagement will require $15,000 of expenses in the current year and
$10,000 of expenses in the next year.
• Engagement 2 will generate $200,000 revenue in the current year and
$85,000 revenue in the next year. The firm estimates that Engagement 2
will require $45,000 of annual expenses.
Required: Assuming that the discount rate is 5%. Which engagements
should be accepted?

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NPV sample

Case 4:

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2. Taxes and cash flows

Tax costs and tax savings

Marginal tax rate

The uncertainty of tax consequences

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Tax costs & Tax savings

Is tax always a business costs?

Does tax always result in a cash outflow for
a business?

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Tax costs
If a transaction results in an increase in any tax
for any period, the increase is a tax cost and a
cash outflow.
Ex: Firm F sells a unit of inventory for $50 cash. If the
unit cost was $40, the sales transaction generates $10
taxable income.
• If the corporate income tax is 30%, the tax cost of the
transaction is $3.
• The sales transaction generates both $50 cash inflow
and $3 cash outflow.

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Tax savings

If a transaction results in a
decrease in any tax for any period,
the decrease is a tax saving and
a cash inflow.

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Tax savings
Ex: Firm F leases office space for $1,000 monthly rent. Each $1,000 expenditure is
deductible in computing the firm’s taxable income; in other words, the expenditure
shields $1,000 income from tax.

Corporate income tax = Taxbale income x 30%

Taxable income = Revenue – costs – Deductions
• If the expenditure is deductible:
CIT = (Revenue – costs - 1000$) x 30%
= (Revenue – costs) x 30% - 1000$ x 30%
= a – $300

• If the corporate income tax is 30%, the deduction causes a $300 tax savings.
• The transaction involves both a $1,000 cash outflow and a $300 cash inflow.

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Marginal Tax Rate

• A marginal tax rate is the rate at

which the increase or decrease
in the taxable income would be
taxed.
• It may result in tax savings and
tax cost, leading to different net
cash flows.

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Marginal Tax Rate

Case 6: A garment business is subject to a progressive income tax

consisting of two rates: 15 percent on the first $50,000 taxable income and
30 percent on taxable income in excess of $50,000.
• Firm A’s taxable income to date is $100,000. And today, firm A engages in
a transaction that generates $10,000 additional income.
• Firm B’s taxable income to date is $44,000. And today, firm B engages in
a transaction that generates $10,000 additional income.

Required: Calculating marginal taxes in two firms?

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Marginal tax rate

Case 4.1: Similar Tax Treatments across Transactions:
Suppose a consulting firm must decide between two engagements.
• Engagement 1 will generate $40,000 revenue in the current year and
$185,000 revenue in the next year. The firm estimates that this engagement will
require $15,000 of expenses in the current year and $10,000 of expenses in
the next year.
• Engagement 2 will generate $200,000 revenue in the current year and
$85,000 revenue in the next year. The firm estimates that Engagement 2 will
require $45,000 of annual expenses.
• The marginal income tax rate is 40% and all of the expenses are deductible.
Required: Assuming that the discount rate is 5%. Which engagements should be
accepted?

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Marginal tax rate

Case 4.1: Similar Tax Treatments across Transactions

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Marginal tax rate

Case 4.2: Different Tax Treatments across Transactions
Suppose a consulting firm must decide between two engagements.
• Engagement 1 will generate $40,000 revenue in the current year and $185,000
revenue in the next year. The firm estimates that this engagement will require
$15,000 of expenses in the current year and $10,000 of expenses in the next year.
• Engagement 2 will generate $200,000 revenue in the current year and $85,000
revenue in the next year. The firm estimates that Engagement 2 will require
$45,000 of annual expenses.
• The marginal income tax rate is 40%. The law allows the firm to deduct 100% of the
expenses of Engagement 1 but only 75 % of the expenses of Engagement 2.
Required: Assuming that the discount rate is 5%. Which engagements should be
accepted?

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Marginal tax rate

Case 4.2: Different Tax Treatments across Transactions

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Marginal tax rate

Case 4.3: Different Tax Rates over Time
Suppose a consulting firm must decide between two engagements.
• Engagement 1 will generate $40,000 revenue in the current year and $185,000
revenue in the next year. The firm estimates that this engagement will require $15,000
of expenses in the current year and $10,000 of expenses in the next year.
• Engagement 2 will generate $200,000 revenue in the current year and $85,000
revenue in the next year. The firm estimates that Engagement 2 will require $45,000 of
annual expenses.
• The law allows the firm to deduct 100% of the expenses of both engagements. But
Government recently enacted legislation reducing the income tax rate from 40% in the
current year to 35 % in the next year.
Required: Assuming that the discount rate is 5%.Which engagements should be
accepted?

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Marginal tax rate

Case 4.3: Different Tax Rates over Time

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The importance of Tax Consequences

• NPV calculation is incomplete if

it does not consider current and
future tax consequences of the
proposed transaction.
• However, assumptions
concerning tax consequences
have their own unique
uncertainties.

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The Uncertainty of Tax Consequences

1. Audit risk
• Whenever a firm enters into a
transaction involving ambiguous tax
issues, it runs the risk that the tax
authorities will challenge the tax
treatment on audit.
• The tax authorities may conclude
that the transaction resulted in a
greater tax cost or a smaller tax
savings than the manager originally
projected

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The Uncertainty of Tax Consequences

2. Tax law uncertainty

• Tax laws may change during the
time period of the NPV computation.
• The potential for change varies
greatly with the particular tax under
consideration.

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The Uncertainty of Tax Consequences

3. Marginal rate uncertainty

• The firm’s projected marginal tax rate is
used to estimate tax cost or savings from a
transaction.
• This marginal rate may change in future
years because the government changes the
statutory rates for all taxpayers.
• The marginal rate may also change because
of a change in the firm’s circumstances.

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3. STRUCTURING TRANSACTIONS
TO REDUCE TAXES
An important caveat

Private Market Transactions

The Arm’s-Length Presumption

Related Party Transactions

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Important Caveat in Tax planning

“A strategy that minimizes the tax cost of a

transaction may NOT maximize net present
value and may NOT be the optimal strategy
for the firm”
=> 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.

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Important Caveat in Tax planning

Case 6: Firm C needs an additional staff to perform online marketing. There are 2
options:
• Option 1: The firm will hire one marketing staff, with a $15,000 salary. As a result
of this employment transaction, the firm is liable for payroll taxes on the salary paid
to the employee, with a $1,148 payroll tax. Both the salary and the payroll tax are
deductible in computing corporate taxable income.
• Option 2: The firm will engage an independent contractor to perform the same
task, with a $17,500 monthly fee. The firm is not liable for payroll taxes on the fee
paid to the independent contractor, and the fee is deductible as well.
• The firm’s marginal income tax rate is 35%.
Which options should be accepted?

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Important Caveat in Tax planning

Case 7:
Option 1 Option 2

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Private Market Transactions

In the private market transactions, parties

deal directly with each other.
• The parties have flexibility in designing a
transaction that accommodates the
needs of both.
• They can work together to minimize the
tax cost of the transaction and share the
tax savings.

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Private Market Transactions

Case 7: Consider the new employment contract between Firm M and key employee Mr.
John. For simplicity’s sake, the case disregards payroll tax costs and focuses on the
income tax consequences of the contract.
• Salary payment is $120.000. Salary payments are deductible by Firm M and taxable to
Mr. John.
• Mr. John has a marginal income tax rate of 30%. He also spends $10,000 each year to
pay the premiums on his family’s health insurance policy. He cannot deduct this
expense in computing his taxable income.
• Firm M has a marginal income tax rate of 35%.
Required: How to change the structure of the transaction to reduce tax costs?

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Private Market Transactions

Case 7: Firm M agrees to pay Mr. John a $120,000 salary
Firm M’s cash flow Mr.John’s cash flow

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Private Market Transactions

Case 7: To change the structure of the transaction to reduce tax costs, Firm M suggests:
=> Firm M could pay a $5,000 premium for comparable health insurance for Mr. Grant
under its group plan.
=> Moreover, it could deduct the premium payment.
Required: How to change the structure of the transaction to reduce tax costs?

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Private Market Transactions

Case 7: Firm M agrees to pay Mr. John a $110,000 salary and provide health insurance
coverage under its group plan ($5000)
Firm M’s cash flow after changing structure Mr.John’s cash flow after changing structure

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The Arm’s-Length Presumption

An important presumption about market

transactions is that the parties are negotiating
at arm’s length.
• Each party is dealing in its own economic
self-interest.
• If one party suggests a modification to the
transaction that directly improves its tax
outcome, the other party may not agree
unless it can capture some part of the tax
benefit for itself.
=> Arm’s-length transaction

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The Arm’s-Length Presumption

• Despite potential tax revenue loss, the

government generally accepts the tax
consequences of arm’s-length
transactions
• Because those consequences reflect
economic reality.

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Related Party Transactions

• Related parties: family members or

subsidiary corporations
• Related party transactions lack the
economic self-interest characteristic of
transactions between unrelated parties.
• If related parties are not dealing at arm’s
length, no true market exists, tax
authorities regards the tax consequences
with suspicion and may disallow any
favorable tax outcome claimed by the
related parties

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Related Party Transactions

Example:
Mr. and Mrs. Hardy are business owners with a 25% marginal tax rate. The couple has a
18-year-old son who is interested in taking over the business at some future date. Mr. and
Mrs. Bowen decide to give their son some experience by hiring him as a full-time
employee.
• If Mr. and Mrs. Hardy pay their son a $20,000 annual salary, this deductible payment
saves them …….. a year in the income tax.
• Because the son has so little taxable income, his marginal tax rate is only 10%.
Consequently, his tax cost of the salary is only $ …….
=> As a result of this related party transaction, the Bowen family saves ….. income tax

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Excise 1:
Use the present value tables belows to compute the NPV of each of the
following cash inflows:
a) $18,300 received at the end of 15 years. The discount rate is 5
percent.
b) $5,800 received at the end of 4 years and $11,600 received at the
end of 8 years. The discount rate is 7 percent.
c) $1,300 received annually at the end of each of the next 7 years. The
discount rate is 6 percent.
d) $40,000 received annually at the end of each of the next 3 years and
$65,000 received at the end of the fourth year. The discount rate is 3
percent.

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Appendix A

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Excise 2:
Firm B wants to hire Mrs. X to manage its advertising department. The firm
offered Mrs. X a three-year employment contract under which it will pay her
an $80,000 annual salary in years 0, 1, and 2. Mrs. X projects that her
salary will be taxed at a 25% in year 0 and a 40% in years 1 and 2. Firm
B’s tax rate for the three-year period is 34%.

a. Assuming an 8% discount rate for both Firm B and Mrs. X, compute the
NPV of Mrs. X’s after-tax cash flow from the employment contract and Firm
B’s after-tax cost of the employment contract.

b. To reduce her tax cost, Mrs. X requests that the salary payment for year
0 be increased to $140,000 and the salary payments for years 1 and 2 be
reduced to $50,000. How would this revision in the timing of the payments
change your NPV computation for both parties?

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c. Firm B responds to Mrs. X’s request with a

counterproposal. It will pay her $140,000 in year 0 but
only $45,000 in years 1 and 2. Compute the NPV of Firm
B’s after-tax cost under this proposal. From the firm’s
perspective, is this proposal superior to its original offer
($80,000 annually for three years)?

d. Should Mrs. X accept the original offer or the

counterproposal? Support your conclusion with a
comparison of the NPV of each offer.

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