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Business Valuations

on Monday, 16 January 2017.

BUSINESS VALUATIONS: THE ART OF THE SCIENCE - PART 2

Business Valuations

We will address the following two questions we ended part 1 with: 

1. The influence of our fair rate of return/discount rate ( 15% in example ) has on the valuation, or how we determine the correct rate.

2. How long we assume the company will exist (three years in the example).

In plain language the rate of return or discount rate is the rate that a rational investor will expect to earn if he / she would invest their money in your business or in our example in Company A. Off course in many valuations there is not an actual investor wanting to invest in the business, however we still use this logic. To determine the fair rate of return we use the Capital Asset Pricing Model (CAPM) : 

E(Ri) = Rf + Beta(RPm) + RPu

where:

  • E(Ri) is required return on security i
  • Rf is the risk-free rate
  • Beta is the influence the general market risk has on the specific company
  • RPm is the general market risk premium
  • RPu is the premium due to company specific risk

This may seem complicated, but fear not, I will explain.

The risk-free rate (Rf) is the rate of return an investor can expect when investing in an investment that carries no risk (all investments actually do have risk, thus we are talking hypothetically). Usually a valuator use the 10 year government bond rate for this. Let’s say in our example the 10 year government bond rate is 8%. You can find the actual bond rates for South Africa at: https://www.resbank.co.za/Research/Rates/Pages/CurrentMarketRates.aspx

The general market risk premium is the added return for additional general risk in the market. This is where the judgement of the valuator plays a role - this can be a subjective consideration. For example if the economic forecasts (say based on political events etc.) is bleak the risk for the investor is greater. Thus the investor would expect more return to compensate for the additional risk. Let’s say we add 5% return for general market risk.

However the general market risk may not have the same influence on all industries or types of businesses. This is where the Beta variable plays a role. It may be that when economic conditions are bad it is actually good for some businesses and bad for others. For example, if the economic conditions are bad people may be under financial stress and shop more at Shoprite (low cost grocery store) and less at Woolworths (high-end grocery store). So in this case bad economic conditions my be good for Shoprite and bad for Woolworths. The Beta variable can have a value between -1 and 1. With a value of -1 it means that whatever the general market risk premium is, it is has the opposite effect on the business. If the market risk premium is 3% then it actually lowers the rate the investor will expect (E(Ri)) by 3%, since -1 x 3% = - 3%. Intuitively it means say bad economic conditions are good for the specific company (Shoprite in example above). On the other end of the scale a Beta of 1 will add the full impact of the market risk premium to the business. The Beta value can also be anything else between -1 and 1. For example 0 would mean the market risk  premium has no influence on the business. The decision on which Beta to use is again one where the valuator will use professional judgement, experience and if available comparable market data. Let’s say in our example the Beta is 0.6.

Lastly the company specific risk (RPu) is the what it says, the risk specific to this company. There may be a number of risk factors specific to a company, for example an inexperienced management team may cause the investor to take on more risk and thus expect for return. Let’s say in our case the company specific risk is 4%.

Now, to calculate our example’s required return / fair rate of return:

E(Ri) = 8% + 0.6 (5%) + 4% = 15%

If you now refer back to Part 1 of our example it will be clear that a higher rate of return will make the value of the business smaller because we discount each future profit back to present value by dividing with (1 + rate of return) to the power of the relevant number of years.

Which brings us to our second question - how long the company will exist or the window period. We can expect the business to exist a certain number of years - again this is based on professional judgement and can be a subjective decision. In many cases there is no clear reason to expect that the business will only exist a certain number of years, but it may be that you are working with a clear exit strategy of say 5 years. Normally I would select 10, 15 or 20 years as a window period. In our example we used 3 years for simplicity. 

Author: Chris Herbst

How the new Tax Compliance Status (TCS) (the replacement of Tax Clearance Certificates (TCC)) works.

on Wednesday, 22 June 2016. Posted in Tax

As from 18 April 2016 the old Tax Clearance Certificate system made way for the new Tax Compliance Status system.

How the new Tax Compliance Status (TCS) (the replacement of Tax Clearance Certificates (TCC)) works.

This article will first explain the rational for the new system, then the difference with the previous system and finally on a practical note provide you with steps to obtain your tax compliance status on e-filing.

The new Tax Compliance Status system will be managed online via e-filing.

SARS has decided on the new Tax Compliance system for the following reasons:

Less printing: over ten million tax certificates were printed per annum. According to (see * below for source) one pine tree produces 80 500 sheets of paper. Thus SARS were printing 124 trees worth of tax certificates per year!
Less branch visits: over two million SARS branch visits were done per year for tax certificates.
More tax compliance: change from point in time to continuous compliance. I will elaborate on this point below.

Point in time compliance vs continuous compliance:

As you are probably aware in the past a taxpayer would apply for a tax certificate which will then be either granted or denied based on the taxpayer’s status at the specific time of the application. This is what is referred to as point in time compliance. The taxpayer’s tax certificate approval was fully based on the fact whether all the taxpayer’s tax affairs were in other at that given point in time.

As you are also probably aware many taxpayer’s only scrambled to get their tax affairs in order when they required a renewed tax certificate. This resulted in taxes only being put into order once a year and that is if a tax certificate was required. SARS did not like this.

Thus SARS have now introduced a continuous compliance system. Same as before if the taxpayer applies for a tax certificate, the taxpayer will only be granted one if the taxpayer’s affairs are in order at the time of application. However, the major difference now is that a pin will be issued to the taxpayer that should be provided to third parties (the parties requesting the tax certificate). The third parties can now at any time go online and check the taxpayer’s tax compliance status with the provided pin. If the third party checks the status today and all the the taxpayer’s affairs are in order it will show that the taxpayer is compliant. If the third party checks the taxpayer’s status tomorrow and the taxpayer’s affairs are not in order it will show non-compliant. Thus the pin provides a continuous status of the taxpayer’s compliance status and no longer a point in time view. A tax clearance certificate use to provide the third party with assurance for 12 months that the relevant taxpayer’s affairs were in order for that period. The pin now provides day to day continuous assurance.

If the taxpayer is compliant at a specific point in time the taxpayer can still obtain a tax certificate and print it out. This certificate informs the third party that the taxpayer was compliant at the point in time the certificate was granted, however the tax certificate states:

This certificate is valid until the expiry date reflected above, subject to the taxpayer's continued tax compliance. To verify the validity of this certificate, contact SARS through any of the following channels:

- via eFiling
- by calling the SARS Contact Centre
- at your nearest SARS branch

It is thus clear that going forward to conduct business with third parties that require the taxpayer to be tax compliant, the taxpayer will have to make sure they are compliant at all times.

Next I will provide you with the steps to obtain your tax compliance status on e-filing (see ** below for source):

Step 1: Logon to eFiling

Logon to eFiling by using your login name and password. If you are not yet an eFiler, register on www.sarsefiling.co.za.

You need to be registered for eFiling and have one tax product [such as Income Tax, Value- Added Tax (VAT) or Pay-As-You-Earn (PAYE)] already activated on your taxpayer profile in order to activate the Tax Compliance Status (TCS) service.

Step 2: Activate the Tax Compliance Status service

Tax practitioners and eFiling administrators for organisations must ensure that the correct rights are allocated to users who need access to the tax compliance status screen. For more information on allocating these rights, please refer to the “Guide to the Tax Compliance Status Functionality on eFiling” available on the SARS website www.sars.gov.za.

You only need to activate your Tax Compliance Status once and it will remain active. Once you have activated it and you have merged or declared all your registered tax reference numbers, you will be given access to your My Compliance Profile (MCP).

Step 3: View your My Compliance Profile

You can view your tax compliance profile by selecting the My Compliance Profile menu option. A colour-coded profile will appear to indicate whether you are tax compliant or not.

Red – Your tax affairs are not in order and you are not tax compliant
Green – Your tax affairs are in order and you are tax compliant.

Step 4: Request your Tax Compliance Status via eFiling

Select the Tax Compliance Status Request option and the type of TCS for which you would like to apply. You will have the following options:

- Good standing

- Tender 

- FIA (individuals only) Emigration (individuals only)

Complete the Tax Compliance Status Request and submit it to SARS.

Once your request is approved by SARS, you will be issued with an overall tax compliance status and a PIN. The PIN provides you with a way to authorise any third party to view your tax compliance status online via eFiling. You can request that the PIN be sent to you via SMS and you can view it on your “Tax Compliance Status Request” dashboard on your eFiling profile.

IMPORTANT: A unique PIN will be issued for each request that you make.

In addition to the PIN, you will also be able to print a Tax Clearance Certificate (TCC), in the existing format, via your own computer by selecting “Print TCC”. The “Print TCC” function will only be available if your overall tax compliance status reflects as compliant.
Once you have provided the PIN to a third party, the PIN will enable the relevant organisation or government department to view your current tax compliance status online. It will present them with your overall compliance status as at the date and time they check it and not your status as it was at the date that the PIN was issued to you. To protect the confidentiality of taxpayer information, no other information will be accessible.

Author: Chris Herbst

Contact us: https://www.chconsulting.co.za/contact

Tax deductions for Pension, Retirement and Provident funds simplified

on Wednesday, 13 April 2016.

As of 01 March 2016 amendments were made to the tax act regarding the above mentioned tax deductions.

Tax deductions for Pension, Retirement and Provident funds simplified

All contributions to pension, retirement annuity and provident funds can be deducted from the individual's taxable income. The deduction is capped at a rate of 27.5% of the greater of remuneration and taxable income. In other words, if say your total pension fund contributions for the year was R100 000, your taxable income was R200 000, and your remuneration was R300 000, then your deductions would have been limited to 27.5% of R300 000 (since R300 000 is greater than R200 000). Thus your deductions would have been limited to R82 500.

From our example above you would notice that R17 500 (R100 000 - R82 500) were not allowed for a deduction in the relevant tax year. However, the deductions that were not allowed is carried over to the following tax year and deemed as contributions for that tax year. In other words say for the next tax year your pension contributions were R100 000, your taxable income R300 000 and your remuneration R400 000. Thus your allowed deduction would be R400 000 x 27.5% = R110 000. You only contributed R100 000, but now you can also deduct R10 000 of the R17 500 from the previous year, thus a total deduction of R110 000. The remaining R7 500 is now carried over to the following tax year.

 

Some technical points:

  • Both contributions made by an employer and the employee are deemed as contributions made by the employee and thus part of the deductions. The employer contribution is now included in the taxable income of the employee by way of a fringe benefit.
  • In the example, the taxable income and remuneration exclude retirement lump sum and severance benefits

Update: Completing your income tax return:

Our institute (SAIT) has alerted us on the following matter:

If you see the following error when saving or submitting your return:

The 'Total contributions for this year of assessment' must be equal to the sum of 'Contributions made this policy.'

To correct this, please ensure that you have completed the Retirement Annuity section correctly. The new Retirement Annuity section allows you to complete the details of multiple policies held – look out for the additional containers labelled “Details of Policy(ies)” below the field that houses source code 4006. 

At each container, you are required to complete the contribution for that particular fund (e.g., for Policy 1 you have contributed R5 000, for Policy 2 you have contributed R2 000). The sum of all contributions made to all policies should be completed next to the source code 4006, which is the first container located under the Retirement Annuity section. Example: (Policy 1) R5 000 + (Policy 2) R2 000 = R7 000; therefore R7 000 is the amount that should reflect at source code 4006. 

Important! Even if you make contributions to only one policy, the details of that policy and the amount contributed still need to be completed in the details section. 

Get our iOS app to help you with monthly and annual payroll tax calculations (including pension, retirement and provident fund): https://itunes.apple.com/za/app/taxtree/id1263890353?mt=8

Would you like us to complete your tax return, just complete our online form: https://www.chconsulting.co.za/online-services/individual-tax-return

For help in your tax matters, please contact us, we serve clients across South Africa and internationally. https://www.chconsulting.co.za/contact

Please note that any advice given on this blog or in any comments of this blog does constitute a legal tax opinion, and the taxpayer cannot rely on it as such. The taxpayer relies on any content of this blog or the comments of this blog at their own risk. For a legal tax opinion, please engage us directly for a consultation. 

Author: Chris Herbst from CH Consulting

Medical tax deductions explained in simple language

on Wednesday, 03 June 2015. Posted in Tax

Medical tax deductions explained in simple language

Image license: https://creativecommons.org/licenses/by/2.0/

Image title: The Cyclist's Apartment

Update: Article updated for the 2018 and 2019 tax year.

The focus in the explanation below is on a person without tax knowledge that would simply like to understand what they are allowed to deduct for their tax.

All the amounts used below are for the 2018 tax year, i.e. 01/03/2017 – 28/02/2018.

The first allowable deduction is for any contributions you make to a registered medical aid. The deduction system consists of a tax credit that you receive to deduct from the amount of tax you have payable for the relevant tax year.  If, for example, you had to pay R5 000 tax for the year you will now receive a tax credit, say R1 000, which you can deduct from the R5 000. Therefore the tax payable is now only R4 000.

Not important to remember (but you will sound smart with your colleagues and friends), this deduction is called the Section 6A medical scheme fees tax credit.

 

2018 Tax year (01/03/2017 - 28/02/2018)

 

Let us examine how the Section 6A medical scheme fees tax credit for the 2018 tax year (2019 below) is determined.

Assuming the taxpayer is below the age of 65 and there is no member on the taxpayer’s medical aid with a permanent disability (in the case of the taxpayer being older than 65 and or disability involved the amounts and rates will differ):

For each month of the tax year that the taxpayer (main member) have belonged to a medical aid you get a tax credit of R303.00. If a taxpayer has any dependents on the medical aid, such as the taxpayer’s partner or children the taxpayer will receive more tax credits. For the first dependent the taxpayer will receive an extra R303.00, for any additional dependents the taxpayer receives an additional R204.00 for each dependent.

Section 6A deduction:

Let us have a look at John’s family.

Thus if it is a family of John, John’s Wife and three children where John is the main member of the medical aid, the total monthly tax credit will be:

John (main member) R303.00
John’s Wife (first dependant) R303.00
Child One (additional dependent) R204.00
Child Two (additional dependent) R204.00
Child Three (additional dependent) R204.00
Total tax credit per month R1 218.00
Total tax credit for the year R14 616.00

However, this is not the only possible tax credit.

There is also a tax credit for additional medical expenses. Now, if you want to sound smart you can tell your friends about the Section 6B additional medical expenses tax credit:

This one is a bit trickier. You will apply the following formula:

Your total contributions to a medical aid for the relevant tax year

Less:

4 x [the tax credit that you received under section 6A (the one we looked at above)]

Plus:

All the qualifying medical expenses that were not paid by the medical aid in the relevant tax year (out of pocket expenses).

Less:

7.5% of your taxable income (with some other minor technicalities which I will not mention here).

Equals:

The excess amount

Multiplied by 25%, equals:

The section 6B medical aid tax credit

Usually, a good indicator as to whether you will qualify for the additional credit is the rule of thumb to take your annual salary x 7.5% and determine whether you made additional medical expenditure above that amount.

Let us continue with the example of the family of John. We will work with the following assumptions:

  • John paid R5 000 to a medical aid on a monthly basis, R60 000 for the full tax year.
  • John paid R35 000 of medical expenses out of his pocket during the relevant tax year.
  • John earned a salary of R300 000 during the relevant tax year, which was his only taxable income.

Section 6B deduction:

R60 000 (total medical aid contributions)

Less:

4 x R14 616.00 (section 6A tax credit)

= R1 536

Plus:

R35 000 (medical expenses John covered from his pocket)

= R36 536

Less:

R22 500 (R300 000 x 7.5%) (7.5% of John’s taxable income)

= R14 036 (excess amount)

Multiplied by 25%, equals:

R3 509 (section 6B medical aid tax credit)

Thus John’s total medical aid tax credit for the year will be:

R14 616 (Section 6A) + R3 509 (Section 6B)

= R18 125.00

It is important to note that you can only deduct this tax credit against tax payable. In other words, if you have no tax payable (before this deduction) you will not get the R18 125 as a refund. Also if you have R10 000 tax payable (before this deduction), you will not get R8 125.00 as a refund.

2019 Tax year (01/03/2018 - 28/02/2019)

 

Let us examine how the Section 6A medical scheme fees tax credit for the 2019 tax year (2018 above) is determined.

Assuming the taxpayer is below the age of 65 and there is no member on the taxpayer’s medical aid with a permanent disability (in the case of the taxpayer being older than 65 and or disability involved the amounts and rates will differ):

For each month of the tax year that the taxpayer (main member) have belonged to a medical aid you get a tax credit of R310.00. If a taxpayer has any dependents on the medical aid, such as the taxpayer’s partner or children the taxpayer will receive more tax credits. For the first dependent the taxpayer will receive an extra R310.00, for any additional dependents the taxpayer receives an additional R209.00 for each dependent.

Section 6A deduction:

Let us have a look at John’s family.

Thus if it is a family of John, John’s Wife and three children where John is the main member of the medical aid, the total monthly tax credit will be:

John (main member) R310.00
John’s Wife (first dependant) R310.00
Child One (additional dependent) R209.00
Child Two (additional dependent) R209.00
Child Three (additional dependent) R209.00
Total tax credit per month R1 247.00
Total tax credit for the year R14 964

However, this is not the only possible tax credit.

There is also a tax credit for additional medical expenses. Now, if you want to sound smart you can tell your friends about the Section 6B additional medical expenses tax credit:

This one is a bit trickier. You will apply the following formula:

Your total contributions to a medical aid for the relevant tax year

Less:

4 x [the tax credit that you received under section 6A (the one we looked at above)]

Plus:

All the qualifying medical expenses that were not paid by the medical aid in the relevant tax year (out of pocket expenses).

Less:

7.5% of your taxable income (with some other minor technicalities which I will not mention here).

Equals:

The excess amount

Multiplied by 25%, equals:

The section 6B medical aid tax credit

Usually, a good indicator as to whether you will qualify for the additional credit is the rule of thumb to take your annual salary x 7.5% and determine whether you made additional medical expenditure above that amount.

Let us continue with the example of the family of John. We will work with the following assumptions:

  • John paid R5 000 to a medical aid on a monthly basis, R60 000 for the full tax year.
  • John paid R35 000 of medical expenses out of his pocket during the relevant tax year.
  • John earned a salary of R300 000 during the relevant tax year, which was his only taxable income.

Section 6B deduction:

R60 000 (total medical aid contributions)

Less:

4 x R14 964.00 (section 6A tax credit)

= R144

Plus:

R35 000 (medical expenses John covered from his pocket)

= R35 144

Less:

R22 500 (R300 000 x 7.5%) (7.5% of John’s taxable income)

= R12 644 (excess amount)

Multiplied by 25%, equals:

R3 161 (section 6B medical aid tax credit)

Thus John’s total medical aid tax credit for the year will be:

R14 964 (Section 6A) + R3 161 (Section 6B)

= R18 125.00

It is important to note that you can only deduct this tax credit against tax payable. In other words, if you have no tax payable (before this deduction) you will not get the R18 125 as a refund. Also if you have R10 000 tax payable (before this deduction), you will not get R8 125.00 as a refund.

 

Lastly, you can get all the relevant medical aid contributions, the number of members, etc. on your tax certificate that your medical aid provides to you on an annual basis. You have to keep this certificate for if SARS asks you to provide it as evidence for your deduction.

Author: Chris Herbst

Get our iOS app to help you with monthly and annual payroll tax calculations (including medical aid section 6A): https://itunes.apple.com/za/app/taxtree/id1263890353?mt=8

Would you like us to complete your tax return: https://www.chconsulting.co.za/online-services/individual-tax-return

Contact: https://www.chconsulting.co.za/contact

Business Valuations

on Wednesday, 08 April 2015. Posted in General, Consulting

Business valuations: The art of the science - Part 1

Business Valuations

Image license: https://creativecommons.org/licenses/by/2.0/

Image title: Plan and Valuation of Pews

Business valuations are a combination between well-developed financial principles (science) and professional judgement (art). From the onset there is one principle that needs highlighting:

The best form of a business or any other valuation is the price that a willing buyer will pay to a willing seller in an arm’s length transaction. Please keep this principle in the back of your mind while reading the rest of this article.

It does not really matter what a business is worth on paper if no-one is willing to pay that amount. The danger of business valuations are that one can easily inflate the value of the business with ambitious future projections. Before we explore this statement, the discussion of some of the popular business valuation approaches will lay a foundation.

The Discounted Cash flow (DCF) and Net Present Value (NPV) methods.

These two methods are discussed together as they are closely connected. The basis of the DCF method is the calculation of the present value of future income. The backbone of these two methods is to take the future profits/cash flows that the business will generate and then determine what these profits/cash flows are worth today.

To illustrate by example:

Company A will generate profit of R10 in year 1, R20 in year 2 and R30 in year three. To determine the NPV of these profits you need to discount the profits to today’s value. All that this means is that you should look at what these profits are worth in today’s money. To simplify, say investor X had two options (ignore inflation for simplicity):

  1. Invest her money in a risk free fixed deposit at Big Bank that earns 10% interest per annum
  2. Invest her money by buying 100% shares in Company A

If she were to choose option 1 and invest R100, her investment after year one would be worth R110 (R100 x 10% = R10, add the R10 to the original investment of R100). After year two her investment would be worth R121 (R110 x 10% = R11, add the R11 to the value of the investment at the end of year one). Following the same logic the investment would be worth R133.10 at the end of year three. Thus she could increase her capital by R33.10 without taking any risk (not that a risk free investment is really possible, but that that is a topic for another day). Based on this, one can safely say that she would want to earn at least 10% on the investment in Company A. However by investing in Big Bank she does not take on any risk, with Company A she could lose all her money. Thus naturally she would expect additional return for the increased risk (higher risk = higher return). To determine the additional return for the additional risk, one would look at the Beta, Systematic and Unsystematic risky premium for the investment. I will return to this at a later stage. For now assume the additional reward for the additional risk is 5%. Thus a fair rate of return for investing in Company A would be 15% per annum.

You will recall that in order to get from the initial value of the investment in Big Bank to the value after year one, the calculation was ((R100 x 10%) + R100) = R110. An easier way to write this is simply R100 x 1.1 = R110. Thus to now discount the investment from year 1 to today, one needs to do the reverse of the above. That is R110 / 1.1 = R100.00.

Now you know how to discount the future profits of Company A:

Year 1: R10 / 1.15 = R8.69

Year 2: R20 / 1.15 = R17.39, but now we have only moved from year 2 to 1. Thus we must also move from year 1 to year 0. R17.39 / 1.15 = R15.12 (you can also write this as R20 / (1.15)^2, where ^ is “to the power of”)

Year 3: R30 / (1.15)^3 = R19.72

Thus the total value of all three year’s profits discounted to today is R43.53 (R8.69 + R15.12 + R19.72).

If we assume the company will only exist for three years then we can say that the value of the company to this investor is R43.53. Thus if the investor offer R30.00 for the company there will be intrinsic (built-in) value of R13.53. If the seller is willing to accept a price below R43.53 it will be a worthwhile investment for the investor.

At this stage there should be two things bothering you:

  1. The influence of our fair rate of return/discount rate ( 15% in example )has on the valuation, or how we determine the correct rate
  2. How long we assume the company will exist (three years in the example)

These points will be address in a follow up to this blog.

Author: Chris Herbst

Contact: https://www.chconsulting.co.za/contact