Return of capital

Tax consequences

There will be tax consequences that are specific to individual countries. As examples only:

    * Governments may want to prevent the shrinking of the business base of their economy. So they may tax withdrawals of capital.

    * Governments may want to stimulate the exploration for O&G. They may allow companies to 'flow-through' the exploration expense to the shareholders so it can be redeployed.

    * REITs may also flow through the depreciation expense they do not need to shareholders. It may be decades before the property is sold and taxes payable. It is better to give the excess cash and the tax write-off to the shareholders.

    * Since the ROC shrinks the business and represents a return of the investors' own money, the ROC payment received may not be taxed as income. Instead it may reduce the cost base of the asset.

Misperceptions

It is wrong to think that the concept of ROC is only a tax issue. It is an economic measure. But the measurement of ROC resulting from accounting financial statements will be different from the tax man's ROC. While accountants try to measure the economic reality (in theory at least), governments may allow businesses to expense the cost of capital assets faster, in order to stimulate investments. This difference in the speed of expensing will result in different ROC values.

It is wrong for the investor to think of the ROC as income. Income is a measure of how much 'better off' you are now, than you were then. The ROC simply transfers assets from the business to the investor. As the investor benefits from the payment, the business shrinks, and the investor's interest in that business shrinks.

* Cash flows do not measure income. They measure only cash flows.

* Depreciation, depletion and amortization cannot be ignored as 'non-cash expenses'. They are valid allocations of a one-time cash flow over the time period that the asset helps generate revenues.

* In the process of normalizing rates of return between different investment opportunities, ROC should not be included in the consideration of 'income' or 'dividends'.

Time value of money

Some people dismiss ROC (treating it as income) with the argument that the full cash is received and reinvested (by the business or by the shareholder receiving it). It thereby generates more income and compounds. Therefore ROC is not a 'real' expense.

There are several problems with this argument

* No one is arguing that the income earned on the full cash flow reinvested is not additional real income.

* If the original asset purchase had not been made, its cash cost would have been invested and earning returns in that same way.

* If you consider that depreciation is an allocation of the original cost of the asset, then you must agree that time-value-of-money considerations make the original cost HIGHER than the sum of the subsequent ROC expenses not realized until many years in the future.

* If you consider that depreciation measures the amount of cash that must be retained in order to finance the eventual replacement asset, then you must agree that the cost of that replacement will have increased in cost in the interim by inflation. Inflation is the basis for the time-value-of-money.

Copyright 2008 - France BtoB from Wikipédia