Fair Market Value and Built-in Capital Gains Economic Rationale Should Prevail
One of the most common assignments for a financial expert in a bankruptcy matter is to perform a solvency analysis. Generally, solvency is determined by comparing the fair market value of assets to the firm's debts. According to Internal Revenue Service (IRS)Revenue Ruling 59-60, the standard of fair market value is:
[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having a reasonable knowledge of the relevant facts.1
While most financial experts agree on the definition of fair market value, there is often a dispute over what price a willing buyer and seller would agree to. For example, in the case of a privately held company, there is often disagreement over the magnitude of a discount for lack of marketability. Similarly, when the valuation assignment requires an assessment of discount/premium for control, the magnitude of such a discount/premium is usually debated. Another area where there is much disagreement in determining fair market value arises when a company owns a closed-end fund that consists of publicly traded stocks with low cost basis relative to the securities' market values. The difference is called a built-in capital gain, or a trapped capital gain. For example, imagine that ABC Inc.'s only asset is a single share of XYZ Corp. stock, which ABC Inc. originally purchased for $20. If the current share price for XYZ Corp stock is $100, then ABC Inc. has a built-in capital gain of $80 (the current XYZ Corp share price of $100 less the $20 cost basis). The built-in capital gain is eventually realized when ABC Inc. sells the share of XYZ Corp. Assuming a 40 percent tax rate, if ABC Inc. sold the share of XYZ today, it would incur a capital gains tax liability of $32 ($80 x 40% tax rate).
[W]hy should the case of built-in capital gains differ from the above fundamental principles of finance? Independent of whether the case is bankruptcy-related or estate tax related, the answer is that it should not be treated differently.
There are two opposing points of view on the topic of discounts for built-in capital gains. One, the position long held by the IRS, is that a willing buyer would not consider the built-in capital gains into his or her valuation, and hence not require a discount. This opinion defies logic. Why would a willing buyer pay $100 for an asset with a built-in capital gain of $80 (and a potential capital gain liability of $32) when he could simply buy the asset with a cost basis of $100 and have no liability? Alternatively, several financial experts believe that a willing buyer would demand dollar-for-dollar reduction in the price of the asset. In other words, the most a willing buyer would pay would be $68 ($100 - $32). This position is also untenable for several reasons. First, if the value of XYZ Corp shares falls from $100 to $20, there would be no built-in capital gains liability. Thus, the capital gains tax is an uncertain quantity. Second, this approach ignores the time value of money as it implicitly assumes that the ABC Corp.'s underlying assets will be liquidated immediately following its purchase by the willing buyer, incurring an immediate payment of capital gains tax.
What is the correct approach? Economic rationale tells us that the truth lies somewhere in between. The fair market value of the company with the built-in capital gain should incorporate some discount, but not a dollar-for-dollar discount. The appropriate discount should be based on a time value of money approach. Consider some of the following examples in finance that are close analogies to the issue of built-in capital gains. In none of these examples does the financial expert subtract dollar for dollar the undiscounted future tax liability or add dollar for dollar the undiscounted future tax benefit.
Valuing a Company for Acquisition
Often, a profitable company will acquire a company that has tax deductions it cannot utilize because it is losing money. In this case, the merged company benefits from a synergy of the tax shields. It is widely accepted by valuation professionals and investment bankers that the value of this synergy is equal to the present value of the future tax savings. If the financial expert neglects to calculate the present value of the tax savings and instead calculates the sum of the undiscounted annual tax savings, he will overstate the economic value of the synergy.
Capital Budgeting Analysis (e.g., Buying Machinery)
When a company purchases a machine and the CFO performs a capital-budgeting analysis, the project is valued by discounting the net after-tax cash flows expected to be generated by the machine. Thus, the value of a capital project is the sum of the value generated by the machine and the present value of the depreciation tax shield. If the financial expert does not calculate the present value of the depreciation tax shield but rather simply adds the undiscounted sum of future depreciation tax shield amounts, he will overstate the value of the depreciation tax shield and as a result overstate the economic value of the capital investment's benefits.
The Decision to Lease vs. Buy
When a company is deciding whether to lease or buy a machine, it must compare the present value of the cash flow associated with each alternative scenario. The net present value of the borrow and buy options considers the following cash flows:
- interest expense on the debt;
- principal repayments of the debt;
- tax savings from the depreciation on the asset;
- other operating/maintenance expenses; and
- any salvage value remaining at the end of the asset's life.
All three of the above examples incorporate the time value of money into decision-making. Specifically, this process has three main elements: (1) the discount rate, (2) the cash flows and (3) the timing of the cash flows. However, the question remains: Why should the case of built-in capital gains differ from the above fundamental principles of finance? Independent of whether the case is bankruptcy-related or estate tax-related, the answer is that it should not be treated differently. The valuation expert needs to evaluate each case in the context of its characteristics. Some of these characteristics include:
- Likelihood and Timing of Liquidation. Similar to the three examples above, the time value of money plays a key role in determining the level of discount.
- Likely Asset Turnover of the Closed-end Fund. For example, if a fund's objective is long-term capital appreciation, typically turnover will be lower, resulting in less realization of capital gains taxes per year. In such a case, the capital gains taxes are expected to be paid over a long period, and as a result, the present value of these tax payments is relatively low.
- Quality of Underlying Assets. If the underlying assets are poor, a buyer can be rationally expected to liquidate part of the portfolio relatively soon.
Recently, we were retained to opine on the fair market value of a corporation that held a closed-end fund as its primary asset. The fund's assets were $190.8 million, which were held at a cost basis of $39 million and thus unrealized capital gains of $151.8 million. In this case, the potential capital gains tax liability was $51.6 million ($151.8 million x 34% tax rate). Also, for purposes of this discussion, assume that the corporation has no other assets or liabilities. Advocates for the "no discount for built-in capital gains" approach would argue that the fair value of the corporation was $190.8 million. On the other extreme, if one were to accept the dollar-for-dollar discount, a willing buyer would pay $139.2 million ($190.8 million - $51.6 million). An approach that relies on economic rationale would value the company using a framework that considers the time value of money. In this case, the fund's asset turnover is important. For example, if the fund sells all its securities in the next year, the built-in capital gains discount should reflect almost a dollar-for-dollar discount. We found that the funds' asset turnover was approximately 6.25 percent. Therefore, we assumed the funds would turn over all of its assets over a period of 16 years (1 divided by 6.25 percent). Next, we valued the $51.6 million built-in capital gain as an annuity with an annual payment of $3.2 million ($51.6 million divided by 16 years) for a period of 16 years, assuming a discount rate of 13.2 percent. We calculated the present value of this annuity. As a result of this analysis, we derived a discount for built-in capital gains in the amount of $21.1 million, and thus a fair value for the corporation of $169.7 million. This approach is economically justifiable and adheres to fundamental financial principles.