Purchase price allocations and the cost approach: Why no tax adjustment is needed

For valuation professionals and Chief Financial Officers (CFOs) dealing with purchase price allocations (PPA) under IFRS 3/AASB 3, a common question arises: Should we apply tax-related adjustments when valuing intangible assets using the cost approach? The short answer is no.

In this article our experts discuss why no additional tax adjustment is required for the cost approach in intangible asset valuation, and dispels a few persistent misconceptions. Our aim is to help practitioners and clients understand the rationale, backed by practical examples and theoretical guidance.

What problem when using the cost approach are we solving?

In PPAs for business combinations (IFRS 3/AASB 3), valuers often use the cost approach to determine the fair value of acquired intangible assets. This approach is commonly used to fair value certain intangible assets that are readily replicated or replaced, such as routine software and assembled workforce.

The cost approach is one of the three primary valuation approaches (alongside the income and market approaches). It estimates an asset’s fair value by calculating the cost to replace or reproduce the asset at current prices, then adjusting for depreciation or obsolescence. It rests on the economic principle of substitution - a rational buyer wouldn’t pay more for an asset than what it would cost to build or acquire an equivalent one. No matter the valuation approach, the aim is to determine fair value - defined by IFRS 13/AASB 13 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” In other words, fair value is an exit price in a hypothetical sale, reflecting market participants’ views.

However, confusion arises when using the cost approach around tax effects, including:

• Should a tax amortisation benefit (TAB) be added to the cost-based value, to reflect tax savings from amortising the asset’s value?
• Should we reduce the replacement cost by the tax rate, assuming it represents tax savings when expenses are deducted?
• Should we tax-effect the value of an asset valued with the cost approach when used as a contributory asset in an excess earnings method to align with post-tax cash flows?

We clarify these points for valuation practitioners and their clients, so you can confidently answer the questions, “Why not tax adjust the costs in cost approach valuations?” or “Why not add a tax amortisation benefit?”

Below, we dive deeper into these three common misconceptions and support these conclusions with practical examples.

Common misconceptions and detailed explanations

Misconception one: “We should add a TAB to the cost approach value.”

Reality: No, you should not. A TAB (the present value of tax savings from amortisation of the value of the asset over its useful life) is applied to assets valued via the income approach where local legislation permits amortisation of the asset as a tax-deductible expense. However, a TAB is not applied to assets valued using the market approach or cost approach as the benefit is typically already reflected in the market data used for the valuation. The market approach typically does not require an adjustment for incremental tax benefits from a ‘stepped-up’ or new tax basis. The market-based data from which the asset’s value is derived is assumed to implicitly incorporate any potential tax benefits associated with obtaining a new tax basis. Just as in the market approach, you would not adjust observed market prices (replacement costs) for a TAB (because the transaction prices presumably already embody any tax benefits to the buyer).

If you took a replacement cost and then added a TAB on top, you would effectively be counting tax benefits twice. Leading valuation standards (e.g. guidance from The Appraisal Foundation’s Best Practices for Valuations in Financial Reporting: Intangible Assets working group) explicitly advise against adding a TAB in cost or market approach valuations. They confirm that the cost approach’s output should already be a market participant, tax-consistent fair value.

In practice, some valuers mistakenly first reduce costs by a tax factor and then add a TAB. This approach tends to nearly cancel out (a tax deduction lowers value, TAB increases it), resulting in a number not far from the original gross cost. It is an unnecessary loop that imports income approach logic into a cost approach. It complicates the analysis without improving accuracy, because a properly applied cost approach would have started and ended at the gross cost-based value which inherently included those considerations.

Illustrative example

Suppose an internally developed software has a replacement cost of $10 million. If the cost meets the recognition criteria for intangible assets, the company can capitalise the cost (and then amortise the asset over a certain period), otherwise the cost will be expensed directly. Either way, the cost will represent a tax deductible expense. Hence, the $10 million already represents what a market participant would pay for that software knowing they could expense or amortise those costs. Adding, for example, a 30 per cent TAB (≈$3 million) on top would inflate the value to $13 million, which is incorrect - no buyer would pay $13 million to avoid spending $10 million on building the software. The correct fair value remains $10 million, and indeed if recorded at $13 million, the acquirer would have overpaid on paper.

Misconception two: “When using the cost approach, we should reduce the costs by the tax rate (since expenses are tax-deductible).”

Reality: No, costs should typically not be ‘tax-effected’ (i.e. not reduced by a tax rate) when valuing a single asset’s fair value under the cost approach. The idea behind tax-effecting costs is the assumption that, because a company gets a tax deduction for expenses, the ‘true’ economic cost is lower by the tax savings. While that reasoning might apply in a project appraisal, it does not apply to fair value measurement of an asset for financial reporting.

Remember, fair value is the price to sell the asset in the market. A seller would not willingly knock 30 per cent off the price of their software intangible just because the buyer might get some tax deduction benefit in the future - the buyer’s tax situation is separate from the asset’s intrinsic value to the market.

Here is why tax-effecting the cost base is improper:

• Fair value is a market concept and represents a singular, definitive measure of an asset’s worth: By IFRS 13’s/AASB 13’s definition, ‘fair value is independent of the buyer’s or seller’s unique tax attributes’. In a business combination and financial reporting setting, the fair value of an individual asset should not differ due to the way in which a business combination was structured (i.e. share purchase versus asset purchase). This means that the fair value of an intangible asset must reflect the price it would achieve if sold individually in the market. There is no ‘pre-tax’ versus ‘post-tax’ fair value in the standards, there’s just fair value.
• Consistency with the valuation and financial reporting of other assets: Tax-effecting replacement cost is inconsistent with the way other assets are valued in a business combination or accounted for if purchased as part of a company’s normal business operations. Taking fixed assets as an example, an investment in machinery is not adjusted for tax (savings) before being capitalised and included in the fixed asset register. Furthermore, a fixed asset valuer revaluing a company’s fixed asset register as part of the business combination using the replacement cost approach will not tax-effect the costs when determining the fair value of the fixed assets. All assets in a PPA should be valued on a comparable basis.
• Circular reasoning problem: Tax-effecting the cost presumes the asset’s value to the buyer is lowered because the buyer saves on taxes. But the buyer’s ability to deduct the expense does not reduce what the asset is worth in the hands of any owner. Those tax savings benefit the owner, not the asset. The vendor providing the service or building the asset charges their full fee, not a net-of-tax fee. So, the replacement cost that a market participant would pay remains gross.

Practical examples

• Software development: Consider again a software development that was recently completed (just before the business combination) for a total cost of $10 million (which we assume is the development cost for any market participant developing a similar software). All costs were capitalised. As part of a purchase price allocation, the valuer then values the software to $7 million by arguing that costs should be reduced by the effective tax rate (assumed to be 30 per cent) to reflect the deductibility of expenditures. This would lead to a negative fair value adjustment of $3 million. Some may say that this is only accounting but then let us assume that the company sells the asset for the $7 million determined by the valuer the day after the business combination. The company spent $10 million on the asset, which is also its tax cost base. Hence, the sale will result in a loss of $3 million (or $2.1 million net of tax). The company will have to sell the software for $10 million to not lose money on its investment. Furthermore, a buyer of the software is arguably indifferent between paying $10 million to buy the software from the company or spending the $10 million required to develop a similar software internally.
• Assembled workforce: Imagine valuing an assembled workforce (the collective employee base of a company) via the cost approach. It might cost $10 million in recruitment, training, and lost productivity to replace the workforce. However, these costs are typically expensed as incurred (not capitalised), so the company’s tax base for the workforce asset is $0. Some might argue the fair value of the workforce is $7 million after ‘tax-effecting’ at 30 per cent. But a buyer acquiring just the workforce (hypothetically, if that were possible) would not pay only $7 million - because to rebuild that workforce would cost $10 million. If they paid $7 million, the seller effectively loses money - the seller invested $7 million net (since they expensed it, they saved $3 million tax, net outlay $7 million), and if they get $7 million in sale proceeds, the seller will end up with around $4.9 million net of tax (the workforce sale would be fully taxable as the tax book is $0). Clearly no rational seller would agree to that. Both parties know the workforce is worth $10 million in the market. So fair value must be $10 million, not $7 million.

Misconception three: “If I use a cost-based value in an income approach (like for a contributory asset charge), I need to tax-effect that value for consistency with the post-tax return.”

The multi-period excess earnings method (MPEEM), under the income approach, is another valuation method commonly used in purchase price allocations, especially when valuing customer related intangibles. The MPEEM starts with an estimate of the expected net income of a particular asset group (e.g. customers contracts and relationships). The CAC or ‘economic rents’ are then deducted from the total net after-tax cash flows projected for the asset being valued to obtain the residual or ‘excess earnings’ attributable to the intangible asset. The CAC represent the charges for the use of an asset or group of assets (e.g. working capital, fixed assets, other tangible assets, and other intangible assets) and should be calculated considering all assets, excluding goodwill, that contribute to the realisation of cash flows for a particular intangible asset.

Reality: When calculating a CAC for an asset valued via the cost approach, use the full (untaxed) value of the asset and apply a post-tax required return to it. You do not first reduce the asset’s value by tax.

Why? Because this ensures you have only accounted for taxes once (in the discount rate or in converting to an after-tax charge). If you also reduced the base value by tax, you would be applying an after-tax rate to an after-tax (reduced) value - effectively taking out tax twice.

It is also important to be consistent with how other assets are dealt with when included in the CAC. For example, for tangible contributory assets (like Property, Plant, and Equipment (PP&E)) we always take their appraised value (based on gross costs and with no tax adjustment) and multiply by the required post-tax return. We should treat intangible contributory assets (valued with the cost approach) the same way.

As a final remark, there is no such thing as a pre-tax or post-tax value, only fair value. The concept of consistency with pre-tax and post-tax in valuations is a thing for cash flows and discount rates but not the outcome of the valuation, the value itself.

Let us break it down with an example:

• Suppose we have a supporting asset (say technology or software) valued at $10 million via the cost approach
• Assume the required return (market-derived) for that type of asset is 10 per cent pre-tax, which might correspond to 7 per cent post-tax if the tax rate is 30 per cent.

Now, two correct ways to calculate the CAC (they should yield the same result):

1. Use pre-tax return on pre-tax value: 10 per cent of $10 million = $1.0 million per year CAC before tax. When you incorporate that into an income model, that $1.0 million CAC will need to be deducted from EBIT. After taxing EBIT with 30 per cent, the net CAC is $0.7 million.
2. Use post-tax return on post-tax cash flows: Alternatively, we directly use the 7 per cent post-tax rate on the asset’s value to compute a post-tax CAC. However, crucially, the asset’s value in fair value terms is $10 million (fair value is already a market post-tax measure). So, 7 million of $10 million = $0.7 million.

Both approaches give a $0.7 million after-tax CAC, as they should. This is what we want for consistency with the after-tax cash flows.

What if someone tax-effected the asset value first? They might say, “The $10 million is a gross value, with a 30 per cent tax, it’s $7 million net.” Then apply the 7 per cent to $7 million, getting $0.49 million. This would clearly be too low - it does not match the $0.7 million needed to fairly compensate the asset’s contribution. In effect, the analyst would have reduced the CAC by 30 per cent unnecessarily. The result would undervalue the contributory asset’s charge, and conversely could over-allocate earnings to the primary intangible being valued (like customer relationships), skewing its value upward incorrectly.

Summary of key points

Tax-related concept	Apply in cost approach?	Explanation
Tax amortisation benefit (TAB)	No.	In a cost approach, there is no new tax basis being created through a hypothetical purchase - the cost data already reflects market participants’ typical tax considerations. Adding a TAB would double count the tax shield that is inherently captured by using market-based costs.
Tax-effecting replacement costs	No.	Fair value is the market price for the asset, not the cost minus tax. Reducing costs by the tax rate undervalues the asset and conflicts with how fair value is defined. The market cost to replace an asset is a gross amount; buyers and sellers transact at that price, regardless of individual tax profiles. Tax-effecting costs when estimating the fair value of intangible assets will lead to discrepancies to accounting and how other assets (e.g. PP&E) are valued.
Tax-adjusting cost-based values for CAC (MPEEM)	No.	CAC return is post-tax through the post-tax rate of return; tax-effecting the asset’s cost-derived value would result in double counting taxes, yielding an artificially low CAC and misallocating value among assets.

Each ‘no’ above aligns with the overarching principle: The cost approach produces a fair value that already complies with market participant assumptions, including relevant tax considerations. Any further tax tweaks usually introduce inconsistencies.

Applying the cost approach with confidence

In the domain of purchase price allocations and intangible asset valuation, the cost approach is a powerful tool - when applied correctly. The key is to keep it conceptually clean:

• Work with current replacement costs (including all economic costs)
• Factor in physical depreciation or functional/economic obsolescence as appropriate - but do not factor in buyer-specific tax strategies
• Avoid importing income approach elements like TAB or arbitrary tax deductions into the cost approach.
• Ensure consistency by handling tax impacts at the appropriate place (e.g. via discount rates for income methods), not by altering the asset’s standalone value.

By following these guidelines, you will generate cost approach valuations that are theoretically sound, easier to explain to auditors and clients, and directly comparable to values derived from other approaches. It reinforces trust that the numbers reported are true fair values that any market participant would agree on.

BDO comment

We frequently encounter questions on this topic from other valuers and clients, and our advice remains consistent - keep tax adjustments out of the cost approach. By doing so, we maintain the integrity of the valuation and compliance with accounting standards.

BDO’s deal advisory team is committed to providing clear, technically rigorous valuation guidance. If you have a complex valuation scenario or further questions on applying the cost approach in practice, our specialists are ready to assist with industry-leading expertise and practical advice.