Taxation Considerations in Economic Damages Calculations

By: Jonathan S. Shefftz
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Abstract
Present value cash flow calculations for economic damages should be performed on an after-tax basis, regardless of whether the damages award will be subject to taxation. Pre-tax calculations can arrive at incorrect results, particularly where accounting income and cash flow do not match. If the damages award will be subject to taxation, then the analytically correct approach is to take the result of the after-tax damages calculation and simply "gross-up" for expected taxes, rather than perform the present value calculations on a pre-tax basis.
Jonathan S. Shefftz is a Senior Associate at Industrial Economics, Incorporated, an economic and environmental consulting firm located in Cambridge, Massachusetts.

Introduction

As the relevant literature discusses quite extensively,¹ economic damages in commercial litigation or personal injury cases are typically determined as the difference between two scenarios: a non-breach/non-injury (or hypothetical "but-for") scenario and a breach/injury (or "actual") scenario. Elements that are common to the two scenarios can be ignored -- as they simply net out in any comparison -- but the analysis must incorporate all elements that are different. Then the analysis must identify the cash flows associated with the two scenarios� various elements.

Finally, if the cash flows occur over an extended period of time, they must be adjusted for the time value of money. Future cash flows are adjusted back in time using a discount rate to produce their equivalent present value as of some common date.² Discounting thereby allows dollars from different years � which can be thought of as different "currencies" -- to be expressed in a common measure so that they can sensibly aggregated and/or compared. Properly performed, the damaged party would be indifferent between the lump sum present value as of this common date and a specified stream of payments extending into the future.

Concerning the choice of this common date (i.e., to which the cash flows will be discounted), an important complication arises, especially when a considerable lag exists between the time of the breach/injury and the time of trial/award. One approach is to first discount all cash flows back to the initial breach/injury date, then compound them forward -- often at a rate that is specified by the applicable legal statute -- to the trial/award date. Another approach is to discount all future cash flows -- with "future" defined from the perspective of the time of trial/award -- back to the trial/award and separately compound all past cash flows forward to the trial/award date. Depending on the different rates specified for discounting and compounding, and depending on the types of cash flows involved, this at first seemingly mere mechanical difference can have a drastic impact upon the results.³

Yet another distinction is that the first approach described above is often -- though not always -- conducted from an ex ante perspective (i.e., drawing on only the information that was known at the time of the breach/injury) whereas the latter approach is conducted from an ex post perspective (i.e., utilizing all available information known to the analyst). Sometimes different discount and compound rates are used for different parts of the calculation, corresponding to which cash flows are "known" and "unknown" as of certain dates.⁴

Many aspects of the summary contained in the preceding four paragraphs are expounded upon in great detail in the relevant literature. However, a surprising paucity of research focuses on the adjustment of the cash flows to an after-tax basis.⁵ This article�s goal is to demonstrate the importance of this adjustment, regardless of whether the damages award will be subject to taxation. Note that the article�s goal is not, however, to discuss case law precedent regarding taxation issues in damage awards.

Background

In a typical commercial litigation matter, but for a contract breach or injury, the plaintiff would be able to earn certain cash flows, and would incur income taxes on the accounting income associated with those cash flows. As a result of the breach or injury, it will earn some other stream of cash flows, which will also include income tax effects. If liability is found, the plaintiff will also receive an economic damage award, which similarly is subject to income taxation. This article postulates -- and a review of the previously cited relevant professional literature generally confirms -- that the damage award should be set to create an after-tax equivalence between the non-breach scenario and the sum of the damage award and the breach scenario. That is, the plaintiff should be in the same position after-taxes with its award, that it would have been in on an after-tax basis with no breach.

As a general rule, net present value calculation should be computed on an after-tax basis, using an after-tax discount rate. Brealey and Myers state:

"You should always estimate cash flows on an after-tax basis. Some firms do not deduct tax payments. They try to offset this mistake by discounting the cash flows before taxes at a rate higher than the opportunity cost of capital. Unfortunately, there is no reliable formula for making such adjustments to the discount rate."⁶

Thus, in simple algebraic terms, the equivalency postulate for economic damages is:

NPV(AT Non-Breach Cash Flows) = NPV (AT Breach Cash Flows) + (1-T)*Award

where "T" represents the tax rate applied to the damage award.

Thus, from a theoretical perspective, "making the plaintiff whole" requires "grossing-up" the difference in after-tax net present values for the tax. That is:

Award = [NPV(AT Non-Breach Cash Flows) - NPV(AT Breach Cash Flows)]/(1 - T)

Two alternative methods may be contemplated. Pre-tax cash flows could be discounted at a pre-tax discount rate; or, pre-tax cash flows might be discounted at an after-tax discount rate. Unfortunately, both of these approaches have the potential to produce inaccurate results.

The following sections demonstrate that the former approach always produces an inaccurate estimate of damages (on either a pre-tax or after-tax basis), whereas the latter approach will produce an accurate estimate of pre-tax damages only when accounting income is equal to cash flow and when tax rates are constant over time.

Evaluation of Alternative Approaches in the Commercial Damages Context
Three simple cash flow scenarios ("cases") illustrate the impacts of these less-accurate alternatives. All scenarios involve a ten-year stream of income, depreciation, capital expenditures and taxes, and rely on the same set of economic and financial parameters, i.e., inflation, tax rate, and weighted-average cost of capital ("WACC") as the basis for the discount rate. All cases assume that the only differences between income and cash flow are capital expenditures and depreciation (thereby ignoring a plethora of other factors such as working capital changes, deferred taxes, etc. that should ideally be reflected in a more detailed cash flow analysis, if feasible).

. . . Continue to article and footnotes (PDF).

Jonathan S. Shefftz, is an independent consultant specializing in the application of financial economics to litigation disputes, regulatory enforcement, and public policy decisions. He has provided expert witness testimony on numerous lawsuits filed in state court, federal district court, and federal agency administrative hearings.

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