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Thinking about models Back  
Business transactions occur in a web of taxation. This is true of almost all asset acquisitions, disposals, and financings. It is especially true of so called “tax based” transactions. Are the present methods of evaluating such transactions adequate?
<Tax and decisions
You are about to buy a commercial building. Is it a good idea? You will have negotiated the purchase price at length, and thought hard about how it compares with other uses for your money. You have decided that it is a beneficial deal. However, is it a good deal when you factor in 9p.c. stamp duty? And if it isn’t, might it become acceptable if part of the cost is deductible for corporation tax purposes? Perhaps it might - but have you checked whether there is any irrecoverable VAT on the transaction?

The purchase of a property can be a routine transaction in many businesses, however, as can be seen from the factors outlined above, the impact of tax on the decision is almost as influential as “location”! Undoubtedly surveyors will crawl over the building physically, lawyers will sift through title deeds and bankers will consider how good their security is. But what of the tax?

Many otherwise careful business people will go no further than calling their tax adviser to see if the 9p.c. stamp duty charge can be mitigated, and seeking confirmation that the building does indeed attract capital allowances. It is fairly typical that the VAT aspects tend to be ignored by a business person. But even if advice is sought on those as well, is this enough to make an informed judgement on the purchase?

Probably not. Another factor frequently overlooked is consideration of the time value of money. The cost of the premises will have to be financed immediately. Capital allowances will mitigate tax only over a period of years. Therefore the tax saving cannot be crudely compared with the premises cost.

Neither is there any evidence above of prudent risk analysis being applied. What underlying assumptions have been made that could prove unfounded over time? The analysis based on static present view of the position could, with hindsight, look poor if for example corporation tax rates fall, or trading losses arise in future years. If trading losses arise, capital allowances may have little or no value since there is no tax to be reduced by them. The rules relating to claiming capital allowances could also change over the period.

It might also be the case that the new premises is to be partly financed by the sale of an existing premises. If this analysis was being carried out last year, would the business have focused on the fact that roll over relief from capital gains tax was a key assumption underlining their view that the proceeds of sale of the old premises would be available in its entirety to finance the purchase of the new premises? Roll over relief was phased out (quite unexpectedly) in Finance Act 2003. The sale of a premises to move to a new location may now lead to a capital gains tax charge.

This further serves to emphasise that not only is tax central to most business decisions, but that there is frequently little focus on the assumptions underlying any tax analysis of a transaction, and on the risks which arise that those assumptions may not be valid over time.

Experience shows that models developed without appropriate planning and control are likely to be prone to error, unlikely to fulfil their purpose and will lack the appropriate structure and flexibility to cope with an ever-changing environment. The majority of models used by businesses today inadequately evaluate their project and the associated risks. There is a vast array of examples where businesses have lost many millions of Euro due to simple modelling errors.

Modelling has a role to play in ensuring that business decisions are made on valid assumptions, and having proper regard to the risks that such underlying assumptions may prove invalid in the future.

What is modelling?
Some see modelling as no more than financial projections. It is more than this. Effective modelling combines accounting, financial and tax skills with the efficient use of analysis tools. Experience and ability are vital to ensuring that robust models are constructed quickly and reliably.

The key element of developing a model is identifying the information that users require and the form in which they need it so as to enable them to make decisions reliably. It involves being able to evaluate accounting and other information systems to readily identify where within a company the key information is located and how it can be extracted and analysed. It involves understanding the rules and assumptions that lie behind variables in a decision such as interest rates, cash flow impacts, and taxation. It involves being able to produce a customised reporting tool that management can feel at ease in using, that can interact with the underlying computer based records of the company, and which permit the impact of all key risks and variables to be properly assessed.

Keeping up to date
All software and models are open to the risk that they are out of date. Are you sure that the VAT rate originally set up on your system is still the current appropriate VAT rate for your full range of products and services? Are the tax rates in your payroll software the current rates? Is your model using the current rate of capital allowances, rather than those of five years ago?

Modelling can be a means of validating existing software systems and existing models. In very basic terms, a model is a flexible inexpensive way of re-computing a particular business process on a currently valid basis of facts and assumptions, and, through comparison with the output from the existing system or model, a means of ensuring that the existing system or model is still reliable.

Modelling can also be a powerful tool for an internal auditor and a more practical method of checking that the company’s systems are currently valid as opposed to a line-by-line re-examination of the software.

When spending large sums of money, or making major investment decisions, or, if you are a financial institution, lending to support such major investments, are you satisfied that the full range of risks and variables are taken into account? Have you analysed the whole range of risks and potential variables that could make this year’s good investment or lending decision next year’s crisis? Was your model developed with the appropriate skill with the current use in mind? If you are using a model, did those who constructed it understand all of the financial and taxation variables that impact on the investment decision?

Learning by experience may be good, but it can be expensive. Learning in advance by the use of a well designed model can be more economical.

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