When the business case involves a non-profit organization or a government entity that does not pay taxes, the question "What is the role of taxes in the business case?" has a short answer: none. For these entities, taxes play no role in the business case.
The same question may have a different answer when the business case represents tax paying businesses and individuals. For tax-paying entities, government taxes sometimes do have an important impact on business case results—insofar as case results include financial consequences of proposed investments or proposed actions. Results of before-tax and after-tax case analyses can differ greatly, depending on the scope and purpose of the business case.
Who is Responsible for Understanding Tax Impacts?
For any specific business case building project, the responsibility for identifying important tax impacts rests primarily on the individual case builder—the individual leading business case design and directing case analysis. Case builders who do not understand where to look for potential tax impacts, or how to build them into the analysis, risk putting everyone else involved with the case at risk of receiving inaccurate or misleading business case results.
Accordingly, sections below focus firstly on the kinds of tax effects that can impact business case results, and secondly, criteria for deciding when tax impacts belong in business case results.
The financial business case for decision support or planning purposes has at its heart a financial model whose purpose is to project (or estimate) cash inflows and cash outflows for a number of cost and benefit items, in one or more scenarios.
- Each scenario represents one decision option or one proposed action.
- In order to evaluate and compare financial results under scenarios, the projected cash inflows and outflows for each scenario are summarized in scenario-specific cash flow statements. All expenses expected under each scenario—including tax liabilities—contribute to scenario cash outflows.
- As part of initial case design, the case builder creates a comprehensive cost model that identifies cost categories potentially involved with the action or investment under analysis.
- It is the case builder's responsibility at this point to question whether or not the action will have tax consequences. If so, the Cost model should include "Taxes" as a cost category.
- When the cash flow summaries for each scenario are complete, the analyst will further analyze and measure financial results with financial metrics such as net cash flow, discounted cash flow (net present value, or NPV), internal rate of return (IRR), payback period, return on investment (ROI), and others.
- Casebuilders may also use scenario cash flow statements to project profits (gross profits, operating profit, and net profit). For operating and net profit, the case builder must estimate and apply appropriate tax liabilities. In this way, projected profits under each scenario incorporate tax effects.
- Based on a comparison of financial results and financial metrics from each scenario, the business case analyst may recommend one action or one decision over another.
Tax consequences impact projected cash flow results in the scenario summaries in several ways:
Taxes Lower Overall Gains
Where the business case shows gains or net cash inflows, taxes operate to lower overall gains because operating income and capital gains are normally taxed. If the total income tax rate is, say 30%, a $100 operating gain becomes a $70 net gain after taxes.
Taxes Reduce Overall Cost and Expense Impacts
Where the business case shows losses or net cash outflows, tax effects operate to reduce the overall loss. For a company that pays 30% taxes on income, a $100 operating loss (or net cost) also reduces the company's tax liability by $30. The net effect of the $100 loss on overall cash flow is thUS$ 70.
Tax Savings From Depreciation Improve the Bottom Line
When the business case includes the acquisition of capital assets, tax savings from depreciation can operate to increase overall cash flow.
- Depreciation Expenses themselves do not contribute to cash flow: they are an accounting convention that impacts reported income, but not a real cash outflow.
- However, because depreciation expenses lower reported income, they also lower the tax liability, which does impact real cash flow.
If a company claims $100 depreciation expense on an asset during the year, and if the company ordinarily pays a 30% tax rate on operating income, then the depreciation expense lowers taxes by $30 (that is, net cash flow for the year is increased by $30).
Should you build an "after tax" or a "before tax" version of the financial business case? Sometimes one version is more appropriate than the other; in other cases, both versions are called for.
To choose an approach for your own business case, address first the following questions:
- Do different proposed actions have different and important tax consequences?
Sometimes, in fact, different actions are proposed and compared because they have different tax consequences. In a "Lease vs. Buy" business case comparison, for instance, one reason for choosing one option (either "Lease" or "Buy") over the other may by that these choices have different tax consequences. Or, the business case evaluating proposed entry into different geographic markets will probably find different tax consequences of doing business in different countries or regions.
- How are other, competing proposals presented?
In situations where proposals from different sources compete for funding (as in a capital review process), clearly all proposals should be compared on the same basis with respect to tax consequences. As mentioned above, tax impacts lower expected gains and can also lower expected losses (by contributing a tax savings). If these tax impacts are present in one competitor and absent in another, the comparison is not fair.
- Will the subject of the business case likely impact company performance in a way that matters to decision-makers and planners?
If the case results are to be used by those responsible for profits/profitability or overall company performance, and if the tax consequences are different under different case scenarios, then an after-tax version of the case should certainly be presented.
On the other hand, where conformance to budget or budgetary planning are important considerations, a before tax version of the business case should be included. Managers at some levels of the organization may have much more interest on actual spending levels or sales revenues, and less direct interest in after tax profit levels.