Pretax and After-Tax Rates of Return: Why They Make a Difference in Distressed

Asset/Debt Cases

By Martin Hanan, CFA 1

Several types of analyses are employed to show the lack of economic substance in a
typical distressed asset/debt case. The comparison of ex-ante (“expected”) and ex-post
(“actual”) pretax and after-tax rates of return demonstrates that an investor would not
choose such an investment except for the tax benefits.

A distressed asset/debt (“DAD”) case usually involves a U.S. investor or a group of U.S. investors
buying assets that have very little potential for producing a profit. The assets may be
denominated in U.S. or in foreign currency. They may involve non-performing loans, accounts
receivables or may be similar to deep out-of-the-money options. Usually, the assets are separated
from the investor by several layers of partnerships, trusts and corporate ownership.

Irrespective of the organizational structure, the typical DAD case has two underlying
characteristics:

1. A claimed tax basis that is much higher than the initial investor contribution

2. A claimed tax loss that is much higher than the initial investor contribution

These two characteristics create a unique opportunity to employ a tailored analysis to expose the
lack of economic substance of the case. This paper briefly presents how to construct a base case
analysis and discusses its effect. Sophisticated tools such as “What If” scenario analysis and
simulation analysis are also addressed.

Presenting a concise analysis while not neglecting the particular details of the case can have a
significant effect on the progress of a trial and its outcome. Moreover, an objective and focused
approach may encourage the opposing party to settle before the trial.

1
ValueScope, Inc.
603 S. Main St., 2nd Floor
Grapevine, TX 76051
817-481-4900
www.valuescopeinc.com
Martin Hanan, CFA is nationally recognized as a leading valuation expert. He is the founder of one of the
country's premier firms, and is the President of ValueScope, Inc. Mr. Hanan’s expertise includes the
valuation of closely held business interests, financial derivatives and intellectual property, as well as
financial and tax reporting issues, including transfer pricing and economic analyses. Mr. Hanan is also
very active in merger and acquisition advisory work. Contact Mr. Hanan at 817-481-4900 or
mhanan@valuescopeinc.com.
Copyright© 2010 ValueScope, Inc.
A Tale of Two Rates of Return Figure 1. Pretax and after-tax rates of return for an ordinary
investment (example)
The tax effect on the profit or loss for an ordinary
investment asset does not change the nature of the 10.0%

after-tax profit—a profit remains a profit while a loss

remains a loss. The tax simply has the effect of lowering 5.0%

the magnitude of the pretax profit and the pretax loss.

0.0% Pretax Rate of Return
Consider, for example, an asset that had a purchase Af ter-tax Rate of Return
price of $100 and the investor was able to extract -5.0%
(through a combination of cash flow and sale price)
$110 at the end of the holding period. Assuming an
applicable tax of 35%, the pretax and after-tax rates of -10.0%
Gain of $10 Loss of $10
return are 10% and 6.5%, respectively. 2 If the investor
were able to recover only $90, the pretax and after-tax
rates of return would be negative 10% and negative The result may be violated when the investor makes an
6.5%, respectively. 3 unusual assumption about the tax basis of the asset.
For example, the investor may assume that the tax basis
In both cases, a profit remains a profit and a loss was $1000. This may be due to the investor considering
remains a loss (Figure 1). This basic result is a a tax basis based on an historical accounting basis
fundamental tenet of investment. rather than the price paid.

The investor’s calculations for tax purposes reflect the

tax basis assumption. In the case of the $110 extracted
value ($10 pretax gain), the tax benefit is $311.50,
2
The tax paid is $3.50 and the pretax and after-tax profits are which increases the after-tax rate of return from 6.5%
$10 and $6.50, respectively. The pretax and after-tax rates of to an extreme 321.5%. 4
return are, respectively:
Similarly, in the case of a pretax loss of $10, the
$110 −$100
= 10% investor’s calculations would show a tax benefit of
$100

and

($110 −$3.50)−$100
= 6.5%
$100

3 4
The pretax loss would be $10. The after tax loss is The calculations for a $10 gain and a $1000 claimed tax
calculated as: basis are:

(−$10) × (1 − 35%) = −$6.50 Final value $110.00

Tax basis $1000.00
The difference of $3.50 represents a tax benefit to the Pretax gain (loss) - $890.00
investor. The pretax rate of return is given by: Tax paid (benefit) - $311.50 = 35% x (-$890)
After-tax gain (loss) - $578.50
$90−$100 −$10
= = −10%
$100 $100
The after-tax rate of return increases from positive 6.5% to
and the after-tax rate of return is still negative and equal to: the extreme:

($90+$3.50)−$100 −$6.50 ($110 +$311 .50)−$100 $321 .50

= = −6.5% = = +321.5%
$100 $100 $100 $100

Copyright© 2010 ValueScope, Inc. 2

$318.50 and the after-tax rate of return of negative
6.5% would become positive 308.5%. 5
Figure 2 shows the significant contrast. This result
violates basic investment theory and is the key to
identifying and exposing the motivations of the
investor.
Figure 2. Pretax and after-tax rates of return for a typical DAD
investment (example)
seen as a positive cash flow for the investor because the
loss can be used to offset gains from other investments.
When the investor assumes a tax basis that greatly
exceeds the price paid, the positive cash flow brought
by the tax benefit would outweigh the cash flow from
the actual investment.
Figure 3 presents the cash flow contributions from
business activity and from the U.S. Treasury, assuming a
tax basis of $1000 and a final investment value of $90.

400.0% Figure 3. Cash flow contributions from business activities and the
U.S. Treasury
300.0%

200.0%
Pretax Rate of Return
100.0% Af ter-tax Rate of Return 22%
Business
0.0% Contribution
U.S. Treasury
-100.0%
Contribution
Gain of $10 Loss of $10
78%

The Investment Economics versus the Tax Shelter

Benefit

The value of a business or an investment proposition is Such business plans have no economic reality and
determined by its ability to generate cash flow. One clearly indicate the investor’s intentions. There is no
source of cash flow is given by the business operations capital market for these investment results. The only
or the actual investment. Taxation introduces another “market makers” for these investment types are tax
cash flow, which can be negative (i.e., the tax paid) or professionals.
positive (i.e., the tax benefit). The tax benefit can be
In certain cases, it may be possible that the investor had
5
an expectation of economic profits but the DAD
The calculations for $10 loss and $1000 claimed tax basis investment was structured to take advantage of any
are: built-in losses. Furthermore, the investor would
Final value $90.00
increase the outside basis (usually at the end of the
Tax basis $1000.00
Pretax gain (loss) - $910.00
year) by contributing other assets. This last minute
Tax paid (benefit) - $318.50 = 35% x (-$910) contribution, made mainly for tax purposes, results in
After-tax gain (loss) - $591.50 huge tax benefits to the investor. Moreover, the newly
contributed assets might not be at risk because they
In this case, the after-tax rate of return of negative 6.5% might not be used to acquire more distressed assets.
would become: The above factors may be used to show the lack of
economic substance of the increase in the outside basis
($90+318 .50)−$100 $308 .50
$100
=
$100
= +308.5% contribution.

Copyright© 2010 ValueScope, Inc. 3

In other situations, the investor may use a combination
of the historical foreign exchange rate and historical
accounting in a foreign currency to increase the tax
basis, completely disregarding the actual amount paid.
Given an investment final value of less than 20% of the
price paid, the U.S. Treasury contribution would be
even larger (Figure 4).
Figure 4. Real world-based cash flow contributions from business
activities and the U.S. Treasury
4%
Business
Contribution
U.S. Treasury
Contribution
96%
The Base Case
DAD cases of the real world are more complicated than
the straightforward examples illustrated herein.
However, a base case analysis can be constructed to
present the expected business or investment
performance.
Similar assets or economic activities can be identified
for each asset, business or investment. Many countries’
central banks provide market expectations for a variety
of economic indicators, including inflation and foreign
exchange rates. Large international banks also
disseminate similar information. For derivatives-based
investments, synthetic portfolios can be constructed to
mimic the characteristics and performance of an
investor’s asset.
For a DAD-type investment, the base case would
present the inconsistencies detailed herein between the
pretax and after-tax rates of returns. Furthermore, the
base case can be compared to the actual performance.
In a typical DAD case, the investor does not care about a
Copyright© 2010 ValueScope, Inc.
profit or a loss, but only about the tax benefit. As a
result, the actual performance of a distressed asset
would be below the performance of comparable and
legitimate investments where greater care and due
diligence would be exercised.
The base case represents the first step of the tailored
analysis. It can be used to construct expected pretax
and after-tax rates of return and illustrate the lack of
economic substance of an investor’s activities.
The Profit Potential and the One-Dollar Profit
Once a DAD-type of investment is proposed, one or
several promoters typically try to attract investors. It
may also be the case that one intermediary tries to
profit by involving only one large investor. Regardless
of the transactional details, the promoters or the
intermediaries try to obtain a gain for themselves,
usually in the form of a large fee charged to the
investor(s).
Such fees reflect the nature of DAD cases and are
related to the expected tax benefit obtained by the
investor or to the claimed tax basis. Because the tax
benefit usually dwarfs any expected benefit from the
actual asset, the promoter fee may be similar in size or
even exceed the actual investment amount. Fees of this
magnitude essentially deny any potential for profit and
the investor is highly unlikely to realize or even expect
one dollar of profit.
For illustration purposes, assume that the promoter
charges a fee of 5% of the tax basis, or $50. Such a fee
should always be included in the purchase price when
computing rates of return. The pretax rates of return in
the case of a final value of $110 and $90 are negative
26.7% and negative 40%, respectively. 6
6
The pretax rate of return in the case of a final value of $110
is:
$110 −($100 +$50)
=−
$40
= −26.7%
$100 +$50 $150
The pretax rate of return in the case of a final value of $90 is:
($90 − ($100 + $50))/($100 + $50) = $60/$150 = −40.0%
4
As expected, a promoter fee that would seem
reasonable at a tax basis level eliminates any chance of
a positive pretax profit, regardless of the investment
outcome. Combining the no-profit potential with a
positive after-tax rate of return creates a very powerful,
yet straightforward, argument for the lack of economic
substance.
It is important to note that a one-dollar profit, implying
a rate of return of barely over 0%, is not considered a
reasonable rate of return. An investor always has the
option to keep his or her money in a savings account or
to buy U.S. government bonds and obtain a positive
rate of return without incurring risk. Thus, it is
necessary for the investor to expect a high rate of
return in order to be compensated for the risk
associated with investing and holding risky distressed
assets.
“What If” Scenarios
The base case shows only one number, the expected
outcome, but provides little information about other
worse or better outcomes. Therefore, in certain
situations, the base case might not be sufficient to
convincingly illustrate a no-profit potential.
Different outcomes may occur due to investor actions
or due to different economic and business conditions.
The next step of the tailored analysis is identifying and
summarizing other possible scenarios and determining
the profit potential of the investment.
Figure 5 presents an example of a scenario matrix of
expected gains for different combinations of economic
and business conditions.
Figure 5. Pretax gain (loss) under different scenarios
Expected Economic Conditions
Extremely
Pessimistic
Base
Optimistic
Pessimistic Case
Extremely
($40) ($30) ($20) ($15)
Pessimistic
Conditions
Expected
Business
Historical data available as of the investment date can
be used to identify pessimistic and optimistic scenarios
for many economic and business indicators such as GDP
growth, industry growth, market share, foreign
exchange rates, interest rates, stock and bond market
performance, and options and other derivates income.
Forecasts from multinational corporations, economic
think tanks, central banks and other institutions can be
used for the same purpose.
Due to the lack of realistic business perspectives and
investor due diligence, as well as the excessive
promoter fees, a typical DAD-type investment would
turn a dollar profit only under the combination of
extremely optimistic scenarios. Given that such
scenarios are highly unlikely when considered
individually, the combination that would result in a
positive outcome is even less likely. An investor would
not choose to invest in such an asset or a business
except for other benefits being present—in this case, a
substantial tax benefit.
The “What If” scenario analysis paints a more nuanced
picture and is able to explain different investor
expectations and the corresponding expected
outcomes. Since the above analysis is a pretax analysis,
it is also able to address the economic substance (or
rather, the lack thereof) of the investor’s enterprise.
Simulation Analysis
The “What If” scenario analysis does not quantify the
likelihood of each scenario and does not list all the
possible “in-between” scenarios. Pushing the inquiry
further is the role of the simulation analysis. The
simulation analysis requires more data and more
calculations than the scenario analysis, but it is able to
answer questions regarding the likelihood of obtaining a
one-dollar profit and/or an expected rate of return that
Extremely would reward the investor for the risk taken.
Optimistic
($10)
In a simulation analysis, each major business and

Pessimistic ($30) ($20) ($15) ($10) ($6)

Base Case
Optimistic
($20)
($15)
($15)
($10)
($10)
($5)
($5)
($2)
($3)
$0
economic variable is assigned a probability distribution
Extremely
($10) ($5) ($2) $0 $2 that covers an infinite number of values. For example, a
Optimistic
bell shaped probability density function (i.e., a “normal
distribution”) would describe the likelihood of stock
market returns (Figure 6). Rates of returns closer to 5%

Copyright© 2010 ValueScope, Inc. 5

have a higher likelihood of occurrence than rates of
return of negative 20% or positive 30%. The probability
distributions are created based on historical, expected
market or comparable investments data available as of
the date of the investment.
The one in a million chance of obtaining a one-dollar
profit should dispel any doubt about the lack of
economic substance of a DAD-type investment.
Comparison with Other Investments

Figure 6. Bell shaped distribution for stock market returns As of the investment date, the investor would have
many opportunities to invest his or her money. These
other investments can be anything from an ordinary
savings account to U.S. government bonds, U.S. and
foreign stock market indices, stock of a specific
company, index and mutual funds of different
investment styles, and exchange traded funds. A more
sophisticated investor would have access to derivatives-
type contracts such as options or could decide to invest
in a hedge fund.
-40% -30% -20% -10% 0% 10% 20% 30% 40%
Rate of Return
Classic investment theory indicates that the investor
should expect a positive pretax rate of return as a
prerequisite for a positive after-tax rate of return. The
The outcome of the simulation analysis can be investor should also expect, at the time of the
summarized by a graph that shows the probability of investment, a rate of return that is proportional to the
obtaining a certain dollar profit or attaining a certain risk taken. Such an expected rate should be low (but
rate of return. For example, in Figure 7, the probability positive) for risk-free U.S. government bonds, higher for
of a rate of return of negative 30% or greater is 88%; stock market indices, and much higher for very risky
the probability of a rate of return of negative 20% or assets. By its nature, a DAD-type investment should be
greater is 21%; and the probability of a rate of return of considered very risky. The investor should not only
0% or greater (i.e., a one-dollar profit) is 0.0001% or require a one-dollar profit, but also a very high rate of
one in one million. return.

Figure 7. Probability of observing a rate of return above a given To emphasize the lack of economic substance in a DAD
threshold (example)
case, the expected pretax and after-tax rates of return
of other investments are compared with the DAD-type
1.00
investment’s expected pretax and after-tax rates of
0.80 return. A typical result would be similar to the one
illustrated in Figure 8.
Probability

0.60

0.40
Figure 8 demonstrates the illogical nature of the DAD
investment (expected negative pretax rates of return
0.20 when better alternatives were available) and its lack of
economic substance (the switch from negative pretax
0.00
-40% -30% -20% -10% 0% 10%
rates of return to positive after-tax rates of return).
Rate of Return

Copyright© 2010 ValueScope, Inc. 6

 Figure 8. Pretax and after-tax rates of return for DAD and other investments (example)

Pretax Rate of Return Tax Paid (Benefit) Aftertax Rate of Return

80%

60%

40%

20%
Rate of Return

0%

-20%

-40%

-60%

-80%

-100%
U.S. Treasury Bills Long-Term Large Company Small Company DAD Investment
Corporate Bonds Stocks Stocks

Conclusion Together, they present a unified, yet straightforward

picture: no investor would choose the DAD investment
Each analysis described herein corroborates the unless other benefits were available—in this case, tax
conclusion of the lack of economic substance in a benefits.
typical DAD case from a different point of view:
****
• The base case analysis exposes the expected
negative pretax rate of return and shows that ValueScope, Inc. is a leader in the application of financial and
the tax benefit dwarfs the benefit from the econometric analysis to value measurement and shareholder value
actual investment. growth. The firm was founded by Martin Hanan, a nationally
recognized, leading valuation expert and founder of one of the
• The “What If” scenario analysis indicates that country's premier valuation and financial advisory firms.
the DAD investment would obtain a one-dollar
profit only in the most unlikely combination of
economic and business conditions.
• The simulation analysis calculates the likelihood
of obtaining a one-dollar profit when millions of
possible scenarios are combined and analyzed.
• The comparison with other investments
pinpoints the fallacy of the investment decision-
making process when no tax benefits are
available.

Copyright© 2010 ValueScope, Inc. 7