Treatment of Corporation Tax
Taxation rules vary across countries and change frequently across time. The effects of a project on a company's tax liabilities may also be dependent upon the business's overall financial performance during any given year. This combination of factors makes the effects of taxation too complex to cover in detail. However some general points can be made.
Corporation tax may affect the modelling process in two ways:
- effect on the discount rate calculation and
- effect on relevant cash flows.
Effect on the discount rate calculation
Companies frequently use their weighted average cost of capital (WACC) as the starting basis for selecting discount rates. The WACC should be calculated after tax.
Effect on relevant cash flows
Costs and cash-related benefits may both affect a company's liabilities for corporation tax. Since tax payments or credits impact on cash flow, the are often relevant to the purposes of NPV modelling. The following are examples:
- project-related costs reduce in-year profit, thus reducing tax liabilities;
- assets produced by the project may affect the company's write down of assets for taxation purposes;
- project-related profits increase a company's tax liabilities;
- some types of project may attract tax credits. For example, the UK government offers tax credits on project costs that qualify as being research and development.
Projects that include the effects of tax in NPV models should take advice from the finance and accounting function within their organisation.
Taxation may not always be relevant to NPV models
Including the effects of taxation makes an NPV model larger and more complex. Since there are advantages to keeping models as simple as necessary, the case for including or excluding taxation should be considered carefully. If NPV models are used to compare project options for which taxation effects are proportional to the relevant costs and benefits, taxation may make insufficient difference to difference to the comparisons being made for it be included.