WACC: Practical Guide for Strategic Decision- Making - Part 8: Increasing Shareholder Value by Utilizing Tax Opportunities

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WACC: Practical Guide for Strategic Decision-
Making - Part 8: Increasing Shareholder Value
by Utilizing Tax Opportunities


The eighth and last article in this series on the treatment for the different capital components is
weighted average cost of capital (WACC) discusses different. In most countries, the cost of debt is tax
how to increase shareholder value by utilizing tax deductible while the cost of equity isn’t (for hybrids
opportunities. Generally, shareholder value can be this depends on each case).
created by either:
The corporate tax rate in the general WACC equation,

Increasing operational cash flows, which is similar discussed in the first article of this series (see Part 1:
to increasing the net operating profit ‘after-tax’ Is Estimating the WACC Like Interpreting a Piece of
(NOPAT); or
Art?), is applicable to debt financing. It is appropriate,

Reducing the ‘after-tax’ WACC.
however, to take into consideration the fact that
several countries apply thin capitalization rules that
This article starts by focusing on the relationship may restrict tax deductibility of interest expenses to
between the WACC and tax. Best market practice a maximum leverage.
is to reflect the actual environment in which a
company operates, therefore, the general WACC Furthermore, in some countries, expenses on hybrid
equation needs to be revised according to local capital could be tax deductible as well. In this case
tax regulations. We will also outline strategies for the corporate tax rate should also be applied to
utilizing tax opportunities that can create shareholder hybrid financing and the WACC equation should be
value. A reduction in the effective tax rate and in the changed accordingly.
cash taxes paid can be achieved through a number of
different techniques.
Finally, corporate tax regulation can also have a
positive impact on the cost of equity. For example,
Relationship Between WACC and Tax
Belgium has recently introduced a system of notional
interest deduction, providing a tax deduction for the
Within their treasury and finance activities, cost of equity (this is discussed further in the section
multinational companies could trigger a number below: Notional Interest Deduction in Belgium).
of different taxes, such as corporate income tax,
capital gains tax, value-added tax, withholding tax As a result of the factors discussed above, we
and stamp or capital duties. Whether one or more believe that the ‘after-tax’ capital components in
of these taxes will be applicable depends on country the estimation of the WACC need to be revised for
specific tax regulations. This article will mainly country specific tax regulations.
focus on corporate tax related to the WACC. The tax
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Revised WACC Formula
Notional Interest Deduction in Belgium
In other coverage of this subject, a distinction is made Recently, Belgium introduced a system of notional
between the ‘after-tax’ and ‘pre-tax’ WACC, which is interest deduction that provides a tax deduction for
illustrated by the following general formula:
the cost of equity. The ‘after-tax’ WACC formula, as
mentioned earlier, can be applied to formulate the
revised WACC equation in Belgium:

AT : Weighted average cost of capital after-tax
WACCPT : Weighted average cost of capital pre-tax
TC : Corporate income tax rate
WTA : Weighted average cost of capital without tax
advantage, formulated as follows: RD x DM / [DM+EM] + RE x EM
/ [DM+EM]
In this formula the ‘after-tax’ WACC is grossed-up
TA : Tax advantage related to interest-bearing debt and
by the corporate tax rate to generate the ‘pre-tax’
common equity, formulated as follows: TC x [RD x DM + RN x
WACC. The correct corporate tax rate for estimating
EB] / [DM+EM]
the WACC is the marginal tax rate for the future! If a
TC : Corporate tax rate in Belgium
company is profitable for a long time into the future,
RD : Cost of interest-bearing debt
then the tax rate for the company will probably be
RE : Cost of common equity
the highest marginal statutory tax rate. However, if
RN : Notional interest deduction
a company is loss making then there are no profits
DM : Market value of interest-bearing debt
against which to offset the interest. The effective tax
EM : Market value of equity
rate is therefore uncertain because of volatility in
EB : Adjusted book value of equity
operating profits and a potential loss carry back or
forward. For this reason the effective tax rate may The statutory corporate tax rate in Belgium is 33.99%.
be lower than the statutory tax rate. Consequently, The revised WACC formula contains an additional tax
it may be useful to calculate multiple historical deduction component of [RN x EB], which represents
effective tax rates for a company. The effective tax a notional interest deduction on the adjusted book
rate is calculated as the actual taxes paid divided value of equity. The notional interest deduction
by earnings before taxes. Best market practice is to can result in an effective tax rate, for example,
calculate these rates for the past five to ten years. intercompany finance activities of around 2-6%.
If the past historical effective rate is lower than the
marginal statutory tax rate, this may be a good The notional interest is calculated based on the
reason for using that lower rate in the assumptions annual average of the monthly published rates of
for estimating the WACC.
the long-term Belgian government bonds (10-year
OLO) of the previous year. This indicates that the real
This article focuses on the impact of corporate tax cost of equity, e.g. partly represented by distributed
on the WACC but in a different way than previously dividends, is not deductible but a notional risk-free
discussed before. The following formula defines component.
the ‘after-tax’ WACC as a combination of the WACC
‘without tax advantage’ and a ‘tax advantage’ The adjusted book value of equity qualifies as the
basis for the tax deduction. The appropriate value
is calculated as the total equity in the opening
balance sheet of the taxable period under Belgian
GAAP, which includes retained earnings, with some
adjustments to avoid double use and abuse. This
WACCAT : Weighted average cost of capital after-tax
indicates that the value of equity, as the basis for the
WACCWTA : Weighted average cost of capital without tax
tax deduction, is not the market value but is limited
to an adjusted book value.
TA : Tax advantage related to interest-bearing debt, common
equity and/or hybrid capital
As a result, Belgium offers a beneficial tax opportunity
that can result in an increase of shareholder value
by reducing the ‘after-tax’ WACC. Belgium is,
Please note that the ‘pre-tax’ WACC is not equal to the therefore, on the short-list for many companies
WACC ‘without tax advantage’. The main difference seeking a tax-efficient location for their treasury and
is the tax adjustment in the cost of equity component finance activities. Furthermore, the notional interest
in the pre-tax calculation. As a result, we prefer to deduction enables strategies for optimizing the
state the formula in a different way, which makes it capital structure or developing structured finance
easier to reflect not only tax advantages on interest-
bearing debt, but also potential tax advantages on
common equity or hybrid capital. The applicable tax
advantage component will be different per country,
depending on local tax regulations. An application of
this revised WACC formula will be further explained
in a case study on notional interest deduction in
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How to Utilize Tax Opportunities?
holding or finance company will act as an in-house
bank to all operating companies. The benefit of a
This article illustrates the fact that managing the finance company, in comparison to a holding, is
‘after-tax’ WACC is a combined strategy of minimizing that it is relatively easy to re-locate to a tax-efficient
the WACC ‘without tax advantages’ and, at the location. Of course, there are a number of tax issues
same time, maximizing tax advantages. A reduction that affect the choice of location. Selecting an
in the effective tax rate and in the cash taxes paid appropriate jurisdiction for the holding or finance
can be achieved through a number of different company is critical in implementing a tax-efficient
techniques. Most techniques have the objective to group financing structure.
obtain an interest deduction in one country, while
the corresponding income is taxed at a lower rate in Before deciding to select a tax-efficient location,
another country. This is illustrated by the following a number of issues must be considered. First of
two examples.
all, whether the group finance activities generate
enough profit to merit re-locating to a low-tax
The first example concerns a multinational company jurisdiction. Secondly, re-locating activities affects
that can take advantage of a tax rate arbitrage the whole organization because it is required that
obtained through funding an operating company certain activities will be carried out at the chosen
from a country with a lower tax rate than the location, which means that specific substance
country of this operating company. For this reason, requirements, e.g. minimum number of employees,
many multinational companies select a tax-efficient have to be met. Finally, major attention has to be
location for their holding or finance company and paid to compliance with legal and tax regulation and
optimize their transfer prices.
a proper analysis of tax-efficient exit strategies. It is
advisable to include all this information in a detailed
Secondly, country and/or company specific hybrid business case to support decision-making.
capital can be structured, which would be treated
differently by the country in which the borrowing When selecting an appropriate jurisdiction, several
company is located than it would be treated by the tax factors should be considered including, but not
country in which the lending company is located. limited to, the following:
The potential advantage of this strategy is that the
expense is treated as interest in the borrower’s •
The applicable taxes, the level of taxation and the
country and is therefore deductible for tax purposes.
availability of special group financing facilities
However, at the same time, the country in which
that can reduce the effective tax rate.
the lender is located would treat the corresponding •
The availability of tax rulings to obtain more
income either as a capital receipt, which is not
certainty in advance.
taxable or it can be offset by capital losses or other •
Whether the jurisdiction has an expansive tax
items; or as dividend income, which is either exempt
treaty network.
or covered by a credit for the foreign taxes paid. As a •
Whether dividends received are subject to a
result, it is beneficial to optimize the capital structure
participation exemption or similar exemption.
and develop structured finance instruments.

Whether interest payments are restricted by a
thin capitalization rule.
There is a range of different strategies that may be •
Whether a certain controlled foreign company
used to achieve tax advantages, depending upon
(CFC) rule will absorb the potential benefit of the
the particular profile of a multinational company.
chosen jurisdiction.
Choosing the strategy that will be most effective
depends on a number of factors, such as the operating Other important factors include the financial
structure, the tax profile and the repatriation policy infrastructure, the availability of skilled labor,
of a company. Whatever strategy is chosen, a living conditions for expatriates, logistics and
number of commercial aspects will be paramount. communication, and the level of operating costs.
The company will need to align its tax planning Based on the aforementioned criteria, a selection
strategies with its business drivers and needs.
of attractive countries for locating group finance
activities is listed below:
The following section highlights four practical
strategies that illustrate how potential tax advantages Belgium: In 2006, Belgium introduced a notional
and, as a consequence, an increase in shareholder interest deduction as an alternative for the ‘Belgian
value can be achieved by:
Co-ordination Centres’. This regime allows tax-
efficient equity funding of Belgian resident

Selecting a tax-efficient location.
companies and Belgian branches of non-resident

Optimizing the capital structure.
companies. As a result, the effective tax rate may be

Developing structured finance instruments.
around 2-6%.

Optimizing transfer prices.
Ireland: Ireland has introduced an attractive
Selecting a tax-efficient location
alternative to the previous ‘IFSC regime’ by lowering
the corporate income tax rate for active trading profits
Many companies have centralized their treasury to 12.5%. Several treasury and finance activities can
and finance activities in a holding or separate be structured easily to generate active trading profit
finance company. Best market practice is that the taxed at this low tax rate.
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Switzerland: Using a Swiss finance branch structure
strengthening of the credit rating.
can reduce the effective tax rate here. These
structures are used by companies in Luxembourg.
Tax sparing investment products: To encourage
The benefits of this structure include low taxation at
investments in their countries, some countries
federal and cantonal level based on a favorable tax
forgive all or part of the withholding taxes that
ruling - a so called tax holiday - which may reduce
would normally be paid by a company. This practice
the effective tax rate to even less than 2%.
is known as tax sparing. Certain tax treaties consider
spared taxes as having been paid for purposes of
The Netherlands: Recently, the Netherlands proposed
calculating foreign tax deductions and credits. This
an optional tax regulation, the group interest box,
is, for example, the case in the tax treaty between
which is a special regime for the net balance of
The Netherlands with Brazil, which enables the
intercompany interest within a group, taxed at a rate
structuring of tax-efficient investment products.
of 5%. This regulation should serve as a substitute
for the previous ‘Dutch Finance Company’.
Double-dip lease constructions: A double-dip lease
construction is a cross-border lease in which the
Optimizing the capital structure
different rules of the lessor’s and lessee’s countries
let both parties be treated as the owner of the leased
One way to achieve tax advantages is by optimizing
equipment for tax purposes. As a result of this, a
not only the capital structure of the holding or finance
double interest deduction is achieved, also called
company but that of the operating companies as
double dipping.
well. Best market practice is to take into account the
following tax elements:
Optimizing transfer prices
Thin capitalization: When a group relationship
Transfer pricing is generally recognized as one of
enables a company to take on higher levels of debt
the key tax issues facing multinational companies
than a third party would lend, this is called thin
today. Transfer pricing rules are applicable on
capitalization. A group may decide to introduce
intercompany financing activities and the provision
excess debt for a number of reasons. For example,
of other treasury and finance services, e.g. the
a holding or finance company may wish to extract
operation of cash pooling arrangements or providing
profits tax-efficiently, or may look to increase the
hedging advice. Currently, in many countries, tax
interest costs of an operating company to shelter
authorities require that intercompany loans have
taxable profits. To restrict these situations, several
terms and conditions on an arm’s length basis and
countries have introduced thin capitalization rules.
are properly documented. However, in a number of
These rules can have a substantial impact on the
countries, it is still possible to agree on an advance
deductibility of interest on intercompany loans.
tax ruling for intercompany finance conditions.
Withholding tax: Interest and dividend payments
Several companies apply interest rates on
can be subject to withholding tax, although in many
intercompany loans, being the same rate as an
countries dividends are exempt from withholding tax.
external loan or an average rate of the borrowings
As a result, high rates of withholding tax on interest
of the holding or finance company. When we
can make traditional debt financing unattractive.
apply the basic condition of transfer pricing to an
However, tax treaties can reduce withholding tax.
intercompany loan, this would require setting the
As a consequence, many companies choose a
interest rate of this loan equal to the rate at which
jurisdiction with a broad network of tax treaties.
the borrower could raise debt from a third party.
In certain circumstances, this may be at the same
Repatriation of cash: If a company has decided to
or lower rate than the holding or finance company
centralize its group financing, then it is relevant to
could borrow but, in many cases, it will be higher.
repatriate cash that can be used for intercompany
Therefore, whether this is a potential benefit
financing. In most countries, repatriation of cash
depends on the objectives of a company. If the
can be performed through dividends, intercompany
objective is to repatriate cash, then a higher rate
loans or back-to-back loans. It depends on each
may be beneficial.
country what will be the most tax-efficient method.
Transfer pricing requires the interest rate of an
Developing structured finance instruments
intercompany loan to be backed up by third-party
evidence, however, in many situations this may be
Developing structured finance instruments can be
difficult to obtain. Therefore, best market practice is
interesting for funding or investment activities.
to develop an internal credit rating model to assess
Examples of structured finance instruments are:
the creditworthiness of operating companies. An
internal credit rating can be used to define the
Hybrid capital instruments: Hybrid capital combines
applicable intercompany credit spread that should
certain elements of debt and equity. Examples are
be properly documented in an intercompany
preferred equity, convertible bonds, subordinated
loan document. Furthermore, all other terms and
debt and index-linked bonds. For the issuers,
conditions should be included in this document
hybrid securities can combine the best features of
as well, such as, but not limited to, clauses on the
both debt and equity: tax deductibility for coupon
definition of the benchmark interest rate, currency,
payments, reduction in the overall cost of capital and
repayment, default and termination.
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Treasury and finance decisions: Activities in the
area of treasury management, risk management
This article began with a look at the relationship and corporate finance can have a major impact on
between the WACC and tax. Best market practice is operational cash flows, capital structure and the
to revise the WACC equation for local tax regulations. WACC.
In addition, this article has outlined strategies for
utilizing tax opportunities that can create shareholder Tax decisions: Utilizing tax opportunities can create
value. A reduction in the effective tax rate, and in the shareholder value. Potential tax advantages can
cash taxes paid, can be achieved through a number be, among others, achieved by selecting a tax-
of different techniques.
efficient location for treasury and finance activities,
optimizing the capital structure, developing
This eight-part series discussed the WACC from structured finance instruments and optimizing
different perspectives and how shareholder value transfer prices.
can be created by strategic decision-making in one
of the following areas:
Based on this overview we can conclude that the
WACC is one of the most critical parameters in
Business decisions: The type of business has, among strategic decision-making.
others, a major impact on the growth potential
of a company, the cyclicality of operational cash
flows and the volume and profit margins of sales.
This influences the WACC through the level of the
unlevered beta.
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Laurens Tijdhof is a manager with Zanders, Treasury & Finance Solutions. He joined Zanders in 2000 and
is responsible for the Belgium office in Brussels. Together with his team, he provides treasury and finance
advice to corporate clients, such as multinationals, mid-size companies and utility companies. He has a broad
understanding of treasury and finance issues, especially related to treasury management, risk management
and corporate finance. He studied at Tilburg University in the Netherlands and holds master degrees in
Economics and Business Administration (MA), Fiscal Economics (MSc) and Tax Law (LLM).
Zanders, Treasury & Finance Solutions is an independent firm with a track record of innovation and success
across the total spectrum of Treasury and Finance. We provide consultancy services, interim management
and project management. Zanders is an international organization with presence in the Netherlands, Belgium
and the UK. Zanders creates value for its clients based on specialist expertise and independence.
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