SAVANT FRAMEWORK

Just as there is a deep structure to taxationthat is, a set of princi-ples

that fundamentally shape tax rulesthere is a deep structure to tax
planning. In other words, the multitude of seemingly disparate
techniques for reducing the tax burden generated by various transac-tions
can be classified into groups of tax strategies. This is done in the
SAVANT framework, which is explained in Chapter 2.

The idea of an analytic framework that classifies tax planning techniques

is based on the answer to a fundamental question: Why tax plan in the
first place? It may seem obvious at first glance, but this is an important
question, which is answered differently at differ-ent times, for different
organizations and in different countries. This is because tax planning
requires changing operations, and doing so is not cost free, and the
rewards are uncertain. However, optimizing a firms total tax burden can
be important to its success. Examples 1.44 to 1.52 illustrate the costbenefit trade-offs of corporate tax planning.

A software company has excess cash and is considering acquiring a firm.

Two targets appear attractive. One is a restaurant business holding
company, which has historically earned a 15% return on investment and
also has $100 million of tax benefits, which could be used by an

acquiring firm. The other is a computer software firm with equal returns,
but no tax advantages. Although the discounted

A Framework for Understanding Taxes

57

cash flows appear higher for the first target, becoming a worldwide
dominant software producer is not part of its strategic plan. Because
management has little expertise in restaurants, returns may actually
decline after the acquisition, making the software firm, despite the lack
of tax advantage, a better choice.

Marketing management of a breakfast cereal company has presented an

idea for a new product that, in their estimation, has a 50% chance of
success. If it succeeds, it will generate $10 million of after-tax prof-its
annually, increased to $15 million by a $5 million tax credit for research
and development. The investment in the new product would be $100
million, and the firms minimum rate of return is 15%. The new product
should be rejected because the adjusted (for probability) value-added is
10%: ($10 million) plus $5 million tax credit, or $10 million, divided by
the $100 million investment.

A bank holding company is considering selling off one of its unprofitable subsidiaries. By selling the subsidiary, conglomerate earnings per
share would increase from $4 to $5 per share. However, the sub-sidiary
generates annual free cash flows of $1 million (partly as a result of taxloss benefits) on a $1 million investment. The after-tax value-added is
significant, so the subsidiary should be kept.

A pharmaceutical company would like to build an assembly plant in the

Peoples Republic of China (PRC), partly because the current tax rate is
5%. However, managers of other Southeast Asian subsidiaries are
convinced that, if anything, the tax rate will increase because of political
pressures. Management should anticipate that the rate will increase and
adjust the expected rate of return accordingly.

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STRATEGIC TAX PLANNING

A small entertainment firm wants to hire a talented manager away from a

larger firm. The manager is currently being paid $10 million annually in
salary, which is $2 million more than the small firm can afford. The
small firm offers $5 million in cash and $5 million in stock options.
Because the options are tax-favored, the manager may find the options
very attractive. The small firm has used tax benefits to negotiate.

An investment bank has approached a firm about recapitalization. The

firm currently has $1 million and $2 million in class A and B common
stock, respectively, outstanding. The investment bank has advised that by
converting the class A to $1 million worth of bonds, the firm could save
$200,000 annually because interest paid on the bonds is tax deductible
but dividends paid are not deductible. Before accepting the deal,
management must determine what transaction costs are involved, for
example, how much the investment bank will charge for its services so
that it can determine whether the transac-tion will result in value-added.

Toward the end of the year, engineers from the production department of
a manufacturer would like to replace old machinery with new machinery.
Tax rates are scheduled to increase in the next year. Thus, tax deductions
for future depreciation will have more cash value. Accordingly,
management anticipates the changing tax rates and struc-tures the
transaction to acquire the machinery early in the next year.

A construction company is considering a contract to build a ware-house.

Construction would take one year and cost $1 million, with

A Framework for Understanding Taxes

59

expenses payable currently and $1.2 million to be received on completion of the project. Because of tax-accounting rules, both costs and
revenues are not recognized until the second year. Management needs to
consider, in determining the projects value-added, the time value of the
cash flows from this project, with cash flows net of taxes having more
impact in year one than in year two, and having a greater impact on
value-adding.

A management consulting firm owns a building in eventual need of a

new roof. Instead of reroofing, the firm repairs a part each year. Repairs
are tax deductible, whereas a new roof must be capitalized; the firm has
transformed a nondeductible cost into a deductible one.

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STRATEGIC TAX PLANNING

to the shareholder in liquidation, the corporation must pay tax (typ-ically

at the standard 35% rate) on the sale, and the shareholder must pay tax
(typically at the standard capital gains rate of 20%) on the net proceeds
that are given by the corporation to the shareholder.

This would result in $636,000 of after-tax cash flow to the share-holder:

Sales price of assets

$1,000,000 (1)
Less basis of assets

<200,000>
Gain to corporation

800,000

Corporate tax at 35%

280,000
(2)
Cash given to shareholder: (1) (2) =
720,000

Less shareholder tax on liquidation:

0.2($720,000 300,000) =

<84,000>
Net cash flow to shareholder

$ 636,000

If instead the shareholder sells the stock, the net cash flow is:

Sales price of stock

$1,000,000
Less tax on gain:

0.2(1,000,000 300,000) =
<140,000>
Net cash flow to shareholder
$ 860,000

Selling the stock transforms ordinary income into capital gain. By doing
so, the shareholder increases his cash flow by $860,000 $636,000 =
$224,000.

An example of converting a nondeductible loss to a deductible one is

profit-taking sales of securities at the end of a year in which previously
there were significant sales at a loss. A corporation can offset capital
losses only with capital gains. Although net capital losses can be carried
back three years and carried forward five years, incurring a capital loss
allows a corporation to generate nontaxed revenues immediately by
recognizing matching capital gains.

Similarly, a classic example of converting a nondeductible expense to a

deductible one can be found in identifying and properly docu-menting

the business purpose for what appear to be non-deductible personal

expenses, such as meals, travel, and entertainment. Taking a

Using the SAVANT Framework to Guide Tax Planning

87

friend to lunch is not deductible; having a substantial business discussion with a potential client (who also is a friend) can be.
Converting a capital loss into an ordinary loss is not easy, but there are
opportunities to do so. One can be found in structuring investments in
risky businesses through the use of Section 1244 stock. As discussed in
Chapter 4, purchases of capital stock directly from a corporation with no
more than $1,000,000 in paid-in capital can result up to $50,000 a year of
losses on the sale of that stock being treated as ordinary rather than
capital.

Another significant conversion method relates to depreciable plant and

equipment. During their use, the firm can take a deprecia-tion expense
that is deductible essentially without limit. As discussed in the section
entitled Value-Adding, Cash Flows, and Time Value, the gain on a
subsequent sale can be postponed with a Section 1031 like-kind
exchange.

PUTTING IT ALL TOGETHER: SAVANT CONCEPTS

ILLUSTRATED

As CFO of a computer manufacturing company, it has come to your attention

that a computer chip manufacturer is for sale for $10 million. It is privately held
by the five engineers who started the company. The value of the net underlying

assets is $9 million, with $1 million of value attributable to its highly successful

R&D department. The reason the company came to your attention is because
each year it throws off about $1 million in tax benefits through rapid tax
depreciation of equipment and tax credits for its R&D. The tax benefits are very
attractive, but you ask these ques-tions to determine whether the acquisition
makes sense from a strategic tax-management perspective.

Does the acquisition fit with the firms strategic plan? On further inquiry,
you determine that the companys chips could be used in the manufacture
of your companys computers. Moreover, some man-agement personnel
in your company have had experience working for chip manufacturers.
Most important, the vertical integration fits with your firms mission to
be a dominant (in terms of quality) com-puter manufacturer. The
acquisition could assure quality by having

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STRATEGIC TAX PLANNING

control over chip manufacture. In that sense, it would give you a strategic
advantage over your competitor.
What is the anticipated effect of the sale? Your major competitor has a
net tax loss, so it may not make a play for the chip manufac-turer, or it
may make a lower bid. You anticipate that the tax bene-fits will continue,
with R&D tax credits actually increasing due to a more liberal tax policy
that will go into effect next year. Because of the anticipated change in
R&D rules and an expected increase in the tax rate, the timing should be
early next year.

Will there be an increase in value-added? The acquisition would be

financed with 8% debt; after tax-deductible interest expense, the cost of
this capital is 8% (1 34%) $10 million, or $528,000. After-tax
operating profit for the acquisition is $800,000 per year. Thus, valueadded is $800,000 $528,000 = $272,000; this is also the net increase in
financial-accounting earnings and the annual cash flow.

What transaction costs would be involved? You ascertain that $400,000

of legal, accounting, and loan fee costs would be incurred. Half of them
are tax deductible, so the after-tax cost is $400,000 (.34 1/2
$400,000) = $332,000. You note that this is $60,000 in excess of the
first-year value-added. However, assuming you hold the company for 10
years, there is still a positive net present value of

$60,000 (year 1) + $4,625,360 (sum of years 2 through 10), or

$4,565,360. The latter figure uses an 8% cost of capital, for 10 years of
annuity, with a resulting factor of 6.7101 less .9259 (year 1 fac-tor), or
5.7842 $800,000 per year. Should there be an adjustment for risk? You
assign a necessary 10% risk premium, because chip manufacturing is

subject to intense competition. There is no risk that tax authorities will

challenge any of the tax benefit.

Can the tax benefits be negotiated? Yes. They are worth $1 mil-lion to
you each year, but worth nothing to the chip manufacturer or to your
rival.
Can any income (gain) or deduction (loss) be transformed? If the
acquisition turns out to be bad, it can be sold or part of it spun off to a
separate business in a transaction qualifying for capital gain treat-ment.
Alternatively, regarding negotiation, you can give the target companys
shareholders stock in your firm in exchange for their stock, which would
qualify as a tax-deferred transaction for them. This might result in a
lower purchase price. Therefore, based on SAVANT analysis, you decide
to acquire the chip manufacturing company.

Using the SAVANT Framework to Guide Tax Planning

89

Tax Management

Effective tax management means employing the SAVANT principles to

every important transaction. It also means periodically scanning the
environment to see what has changed that would require new taxmanagement strategies. Both the transaction-oriented and the timeoriented approaches are discussed in the next section.

Involvement in Transactions

All too often, important business transactions are structured without

considering taxes. Subsequently, tax specialists are brought to see how
taxes can be saved (if at all), given the already agreed-on form of the
transaction. Instead, managers should consider taxes simulta-neously
with all other costs. The power to tax a firms income effec-tively makes
U.S., foreign, state, and local governments partners in the firm. Managers
should strive to minimize such partners shares of the firms value-added.

Scanning the Changing Tax Environment

If the world around the firm never changed, tax management of each
transaction would be enough. However, the environment does change,
and a managers due diligence is to scan the environment to see what
changes affect the firm and how the firm should react. While such nontax
environmental changes are in the purview of other business school texts,
there are two key aspects related to tax management. First, such scanning
might necessitate a transaction that requires tax management. For
example, suppose a competitor drops its price below that of the firm. The
firm might respond by lowering prices. To maintain profit margins, the
firm might try acquiring components from another firm that had
previously been manufactured internally. If the latter approach is taken,
there may be tax costs. Such a manufacturing downsizing could produce:
(1) extra income taxes, as equipment is sold; (2) possible sales or import
taxes, depending on where the new vendor is located; or (3) possible
increases in unemployment taxes due to worker layoffs. These tax

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STRATEGIC TAX PLANNING

effects raise the cost of replacing components currently made in-house

with those made by other companies, possibly making the out-sourcing
strategy result in lower profits.
A second type of scanning is for tax-law or tax-rate changes. Taxes
constantly evolve through deliberate government policy and through
administrative and judicial modifications and interpretation. With
Internet availability, important changes can be monitored con-stantly. It
is important to note that a tax change does not beg a reac-tion: The tax
tail should never wave the economic dog. As an extreme example,
suppose the government of Malaysia announces a no-tax policy on
foreign investment. If the firms strategic plan is to become a leader in
the Latin American market, it may make little business sense to move the
firms plants to Malaysia. However, an increase in Latin American
country taxes invites a review of whether plants should be repatriated to
the United States.

Here is a sampling of tax changes that have occurred in recent years:

The U.S. tax rate on capital gains was reduced to 20% (and, in certain
cases, to 10%) from 28%.
The U.K. corporate tax rates were reduced by 1%.

The U.S. Congress exempted Internet transactions from new taxes by

states such as California.

Tariffs and duties between NAFTA countries, and between EU countries,

were reduced.

U.S. check-the-box rules were passed allowing a business entity to pick

whether it will be a taxable corporation or a tax-free flow-through entity.

There are many ways for managers to stay current on tax-law changes
throughout the world. At a very general level, The Wall Street Journal
frequently publishes brief summaries of U.S. tax-law changes, as does
the Financial Times for EU changes. Some more commonly used
research tools available both in hard copy and elec-tronically include
Westlaw, LEXIS/NEXIS, CCH, and RIA. These are all proprietary
services. As discussed in Chapter 1, a low-cost alter-native to them may
be tax resources on the Web. Tax Management in Action 2.2 provides a
good sample of the latter.

Using the SAVANT Framework to Guide Tax Planning

91

TAX MANAGEMENT IN ACTION 2.2

World Wide Web Tax Information Sites

Scanning the Changing Tax Environment

IRS Related Web Sites

www.irs.ustreas.gov/

www.irs.ustreas.gov/cover.html

www.irs.ustreas.gov/prod/bus_info/index.html

www.irs.ustreas.gov/prod/ind_info/index.html

Big Four Accounting Firms Web Sites

www.pwc.com

www.deloitte.com

www.ey.com

www.kpmg.com

Other Web Sites

www.aicpa.org

www.taxsites.com