This thought leadership piece focuses on interpreting different valuation multiples and their relevance under different applications. We further highlight differences where certain multiples are used to derive enterprise value (EV) vs multiples which lead to a direct calculation of equity.

Valuation multiples are commonly quoted in the media in connection with public equity prices as well merger and acquisition activity. These valuation metrics appeal to private business owners as they are readily understood and can easily be applied to derive an estimate of value for their own businesses. However, when making these comparisons, it is important to appreciate the theory behind the use of valuation multiples, the assumptions underlying the different types, and their relevance to the particular situation. Business owners should also be aware of certain limitations when applying the multiples of publicly-traded companies to value smaller privately-held businesses.

The Theory Behind Valuation Multiples

The application of valuation multiples across like businesses (commonly referred to as guideline public companies or market comps) is based on the premise that those businesses have similar underlying economics, which are apparent in their financial or operating metrics. In reality, there is never a perfectly comparable company; some differences are always prevalent including size, product and service offering, geographical outreach, cost structure, quality of management, amongst others.  Accordingly, considerable caution needs to be exercised, and robust analysis undertaken, when adopting the multiple of another company that may seem somewhat similar.

Valuation multiples are in effect a simplified form of the discounted cash flow. Mathematically, the multiple is the reciprocal of the capitalization (or “cap”) rate, defined as (r – g) – where “r” represents the required rate of return and “g” represents the long-term growth rate. Hence, a valuation multiple is essentially a derivation of the perpetuity equation, assuming a long-life, going concern with a constant growth rate. Consequently, multiples may be of limited use in instances where the business opportunity has a short life, or where significant growth (or contraction) of a business is expected over the next number of years.

CLICK HERE to read the full article and to learn more!

When the Tax on Split Income (TOSI) rules were first announced in July 2017, some tax experts declared that it was the death of tax planning. While it’s true that the TOSI rules dramatically altered the landscape for income splitting with family members, prescribed rate loans remain a highly effective tax planning strategy.

How it Works

Prescribed rate loans involve a family member in a high-income tax bracket making a loan to a lower-income family member such as a spouse or a minor child through a family trust. The interest rate that gets charged is the prescribed rate of interest which is set by the Canada Revenue Agency (“CRA”) each quarter.

The interest rate used in prescribed rate loans is significant since it avoids a “deemed benefit” when there are non-arm’s length parties involved. In the Canadian tax system, income or gains can be attributed back to the original transferor when trying to income split with a spouse or minor child. However, there is an exception to this rule if the funds are loaned at the prescribed rate in effect at the time the loan is made and interest is paid annually no later than 30 days after the end of the calendar year.

There should be a written agreement to support the loan with the prescribed interest rate clearly stated at the time the loan is made.

After each year that the loan is outstanding, the lender will report the interest income on their personal tax return and the borrower will claim an interest deduction on their tax return.

Why Now?

Since July 1, 2020, the prescribed rate for non-arm’s length loans has been 1% which is historically low. On July 1, 2022, the prescribed rate is set to increase to 2%. Although this rate is still quite low, now is the time to seriously consider making a prescribed rate loan.

The Benefit

Each Canadian resident individual gets their own set of graduated tax rates up to $221,708 (in 2022) of taxable income each year.

If an individual has taxable income over $221,708 and other family members earn significantly less income, this presents an opportunity to realize absolute tax savings.

In order for the family unit to come out ahead, the rate of return on the funds invested from the loan must exceed the prescribed rate of interest (currently 1%) that is charged on the loan.

What if I already have a Prescribed Rate Loan?

You may already have an existing prescribed rate loan that has an interest rate higher than 1%. In order to take advantage of the current rate, you would need to refinance the loan. The family member that borrowed the funds would need to sell the investments and repay the original loan in full to the lender. At that point, the family member can enter into a completely new loan agreement using the 1% prescribed rate.

Before undertaking a refinancing strategy, you need to be aware of the income tax implications that will arise when the investments are sold.

Prescribed Rate Loan – Example 1

Spouse A currently receives $300,000 per year in salary. Spouse A is married to Spouse B who currently receives $50,000 per year in salary. Spouse A decides to loan $500,000 to Spouse B on June 1, 2022 to invest in marketable securities. Since the loan is made during the second calendar quarter of 2022, Spouse A is permitted to charge an interest rate of 1%. This interest rate can remain in effect for the entire duration of the loan, irrespective of whether the prescribed rate of interest is increased by the CRA.

Spouse B receives $35,000 of Canadian public company dividends on an annualized basis. Spouse B will pay approximately $2,800 in Federal and Provincial income taxes and have an effective tax rate of 7.96% on this investment income.

If Spouse A were to receive $35,000 of Canadian public company dividends on an annualized basis, Spouse A would pay approximately $13,800 in Federal and Provincial income taxes and have an effective tax rate of 39.34% on this investment income.

In order to avoid attribution, Spouse B would need to pay $5,000 (i.e., $500,000 x 1%) of interest on the loan from Spouse A no later than January 30, 2023. This amount would get included in the income of Spouse A for 2022 and be deducted as an investment expense for Spouse B for 2022.

On an annualized basis, Spouse B will pay approximately $1,100 in Federal and Provincial income taxes after deducting the $5,000 of investment expenses from the $35,000 of investment income received.  Spouse A will pay approximately $2,700 in Federal and Provincial income taxes on the $5,000 of interest income received. Overall, the family has saved approximately $10,000 per year in Federal and Provincial income taxes by undertaking this prescribed rate loan.

Prescribed Rate Loan – Example 2

Parent A currently receives $300,000 per year in salary. Parent A has two minor children, Child B and Child C. Neither child receives any income. Parent A decides to create a Family Trust where Child B and Child C are beneficiaries. Parent A loans $500,000 to the Family Trust on June 1, 2022 to invest in marketable securities. Since the loan is made during the second calendar quarter of 2022, Parent A is permitted to charge an interest rate of 1%. This interest rate can remain in effect for the entire duration of the loan, irrespective of whether the prescribed rate of interest is increased by the CRA.

The Family Trust receives $35,000 of interest income from marketable securities on an annualized basis. The trustees decide to allocate $15,000 to each of Child B and Child C following the $5,000 payment of interest on the loan. Child B and Child C will each pay approximately $100 in Federal and Provincial income taxes and have an effective tax rate of 0.60% on this investment income.

If Parent A were to receive $35,000 of interest income from marketable securities on an annualized basis, Parent A would pay approximately $18,700 in Federal and Provincial income taxes and have an effective tax rate of 53.53% on this investment income.

In order to avoid attribution, the Family Trust would need to pay $5,000 (i.e., $500,000 x 1%) of interest on the loan from Parent A no later than January 30, 2023. This amount would get included in the income of Parent A for 2022 and be deducted as an investment expense for the Family Trust for 2022.

On an annualized basis, Parent A will pay approximately $2,700 in Federal and Provincial income taxes on the $5,000 of interest income received. Overall, the family has saved approximately $15,800 per year in Federal and Provincial income taxes by undertaking this prescribed rate loan.

If you are interested in finding out if a prescribed rate loan makes sense for your family, please feel free to contact us.