Deferred taxes in business valuation

The topic of "deferred taxes" is rarely one of the typical finance professional's favorite topics in day-to-day accounting practice. It is therefore not surprising that the issue is ignored by valuers in the course of business valuations. When it is nevertheless worth taking a look at the topic.

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No cash flow, i.e. no consideration of deferred taxes?

Deferred taxes are hidden tax liabilities or tax benefits that arise due to differences in the recognition or measurement of assets or liabilities between the tax balance sheet and the commercial or IFRS balance sheet and that will be offset in future financial years.

Income and expenses from the formation and reversal of deferred taxes are therefore of an accounting nature, which are formed relative to the tax balance sheet by the external accounting system used. At least in all cash flow-based methods, it would appear that the valuer can therefore disregard these entries. The following article shows that this is by no means the case and that it is definitely worth looking into the subject.

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Causes of deferred taxes: loss carryforwards vs. "temporary differences"

The classic case of "temporary differences" results from different recognition and measurement rules in the tax and commercial balance sheets for a limited period of time, e.g. through the use of options. Even in the case of temporary differences, a distinction can be made between two scenarios.

1. The company generates temporary differences irregularly and unsystematically: The term is intended here to describe a case in which latencies arise from time to time in the company concerned, but on both the assets and liabilities side and the company can control their occurrence, nor that there is a relationship to the type of     business model.
2. The company systematically recognizes temporary differences on one side of the balance sheet: deferred tax assets due to tax loss carryforwards are of a different nature. This becomes clear in the simple case of a company that prepares the same balance sheet for tax and commercial law purposes and makes losses. The deferred tax asset arises here - insofar as it may be recognized - from the expected tax savings, which do not arise from accounting options, but from a return     to profitability.
3. The company has generated losses in the past: and there are prospects of (partially) offsetting future profits against accumulated losses carried forward.

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All three of these cases will be explained below, but first a distinction will be made between them and original tax receivables and liabilities.

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Differentiation from original tax receivables and liabilities

Not to be confused with deferred taxes are the original receivables from and liabilities to the tax authorities. In the annual financial statements, these arise, for example, due to differences between corporation tax prepayments and the actual, expected tax burden from corporation tax.

This type of tax receivable and liability is not deferred in the above sense. From a valuation perspective, these receivables and liabilities have the character of working capital in relation to the original (non-deferred) tax burden. This topic will not be discussed further here, but will be addressed in a separate blog.

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Taxes using the example of the DCF method for a corporation

The standard DCF method generally provides for the following procedure with regard to the treatment of taxation:

• Shareholders' personal taxes: generally not taken into account with reference to indirect standardization; this is not appropriate in all valuation cases, but should be assumed here for the sake of simplicity.
• Corporate taxes: Application of the statutory tax rates, i.e. corporation tax plus solidarity surcharge and trade tax.
• Tax shield: taken into account in the discount rate.
• Loss carryforwards: Separate valuation taking into account the limited ability to carry forward losses.
• Original tax receivables and liabilities: often neglected, but may be included in working capital.
• Deferred tax assets and liabilities ex loss carryforwards: often neglected, but possibly taken into account via the effective tax burden.

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There is no one-size-fits-all solution to the problem of "deferred taxes in business valuation". Both the way in which they are taken into account and the value contribution depend heavily on the causes behind existing deferred taxes.

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Wrapping It Up

The consideration of deferred taxes in business valuation is crucial, although often overlooked. Different types of deferred taxes - temporary differences and loss carryforwards - can have a significant impact on the valuation. It is important to consider the specific circumstances of each valuation case and correctly capture the relevant tax aspects. A sound understanding of deferred taxes and their effects can lead to more accurate and realistic business valuations.

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