Financial Matters: Considering the time value of money

The fundamental purpose of tax law is to collect revenue for government expenditures. The timing of tax payments, however, is just as important as the amount.

Time has value in all property transactions. Thus, people should always take time value considerations into account in structuring payments as the government wrote the rules to penalize tardy taxpayers.

Time has two dimensions: future and present. Given a sum of money, we can determine its value at some future date if we know the interest rate at which we will invest the money. Conversely, if we know that we are to receive a sum of money in the future, we can determine its value today if we know the rate at which it is, or can be, invested.

To determine the value of money, we need the relevant interest rate. We express the value of all assets, tangible and intangible, in terms of their future or present value if we can determine the rate at which the asset is invested or discounted. That usually involves the prevailing market-determined interest rate.

In economic terms, interest is the rental cost of borrowing money. As with all rentals, the cost of renting money may be fixed in advance, determinable at a future time or variable according to specified conditions. Thus, interest and time are inextricably related. Interest is relevant if, and only if, it’s specified in relation to time.

Litigation lawyers and judges account for time value in computing damages. For example, suppose that a plaintiff’s lawyer is offered a choice between a cash settlement of $500,000 and six successive payments of $100,000 payable at the end of each year.

Should the lawyer accept the lump-sum settlement or pursue the extended payment plan? Ignoring issues of risk and insolvency, the answer depends upon the prevailing interest rate and income tax considerations associated with the two alternatives.

At an interest rate of 10 per cent, the six payments of $100,000 have a present value of only $435,300. Hence, the plaintiff would be better off with the lump-sum settlement. If the interest rate was four per cent, however, the six payments would have a net present value of $524,000.

Similarly, the defendant in a lawsuit involving future lost profits of a business enterprise may ask the court to reduce the size of any lump-sum award to the plaintiff to take into account the accelerated value of receiving the money today rather than over an extended period of time.

For example, if one can establish that the defendant’s actions will cause the plaintiff a loss of $100,000 in business profits annually for a period of five years, should the defendant be required to pay the nominal amount of the damages up front or some lesser, discounted amount?

At an interest rate of 12 per cent, the annual loss of $100,000 spread over five years is worth only $360,000 today if the payments are receivable at the end of each year. Thus, ignoring the time value of money would penalize the defendant and provide the plaintiff with a windfall gain.

Although most lawyers are familiar with the calculation of simple and compound interest, we are less intuitive about the concept of the discounted value of future sums of money. This is because we are taught to think of investing for the future but not of the present value of future sums.

Yet mathematically speaking, future value and present value are mirror images of each other. The primary purpose of determining future and present values is to measure money in comparable terms across time periods by translating future dollars into equivalent current dollars and vice versa.

As one might expect, the Canada Revenue Agency lives by its own rules. It compounds interest on a daily basis on outstanding amounts of taxes payable. The interest isn’t deductible for tax purposes. For example, if an individual owes $10,000 in taxes, daily compounding of the amount at an equivalent of eight per cent per year would increase the tax payable at the end of two years to $11,735.

Hence, as the compounding rate is set at about three per cent above market rates, it’s almost always better to pay a tax assessment and then challenge it at a later date. It’s virtually impossible for a taxpayer to obtain an investment that will yield an equivalent amount of interest for the same risk.

Since tax disputes can quite easily continue for eight to 10 years, daily compound interest has an enormous impact on the ultimate amount payable if the taxpayer ultimately loses the fight with the CRA. At six per cent, money doubles every 12 years.

Thus, tardiness in paying taxes is another lucrative source of government revenues. That shouldn’t be surprising. The government writes the rules.

Vern Krishna is tax counsel at Borden Ladner Gervais LLP and executive director of the CGA Tax Research Centre at the University of Ottawa. He can be reached at [email protected].

Free newsletter

Our newsletter is FREE and keeps you up to date on all the developments in the Ontario legal community. Please enter your email address below to subscribe.

Recent articles & video

Ontario court refuses to appoint disbarred lawyer as estate trustee

Doctors are expected to ensure patient understands what examination entails: review board

Convocation adds CPD requirement to certified specialist program, will expand program to paralegals

Man loses almost entire inheritance in costs for 'reprehensible,' 'scorched earth' litigation

Ontario Court of Appeal allows Trial Lawyers Association to intervene in medical malpractice case

Ontario Court of Appeal denies extension to perfect appeal in a motor vehicle collision case

Most Read Articles

Convocation adds CPD requirement to certified specialist program, will expand program to paralegals

Ontario court refuses to appoint disbarred lawyer as estate trustee

Doctors are expected to ensure patient understands what examination entails: review board