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UNITED STATES TAX COURT - TRIAL

ESTATE (OF MICHAEL J. JACKSON DECEASED)

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EXECUTORS: JOHN G. BRANCA. AND JOHN MCCLAIN

COMMISSIONER OF INTERNAL REVENUE (IRS)

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February 13th 2017

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Presiding Judge Mark V. Holmes

Jacksons estate is represented by Avram Salkin, Charles Paul Rettig, Steven Richard Toscher, R
obert S. Horwitz, Edward M. Robbins Jr., Sharyn M. Fisk and Lacey E. Strachan of Hochman Sa

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lkin Rettig Toscher & Perez PC, Paul Gordon Hoffman, Jeryll S. Cohen and Loretta Siciliano of
Hoffman Sabban & Watenmaker and Howard L. Weitzman of Kinsella Weitzman Iser Kump &
Aldisert LLP. ae
The
IRS is represented by its attorneys Donna F. Herbert, Malone Camp, Sebastian Voth, Jordan Mus
en and Laura Mullin.
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--------------------------------------------
NANCY FANNON
Certified Public Accountant
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Judge Holmes: Let's see. I think the floor was yours, Mr. Toscher .... Mr. Salkin?

Mr. Salkin: I have something, Your Honor.

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Judge Holmes: Yes.

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Mr. Salkin: I'd like to move for admission into evidence Exhibit 646-P, which was the four
pages from the Consur report and 647-P, which was the calculation of the percentage difference
between 2009 and 2016.

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Judge Holmes: Okay. Those are entered as well.
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Judge Holmes: And next up.
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Ms. Strachman: Good afternoon, Your Honor.

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Judge Holmes: What's your name again, miss?

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Ms. Strachman: Lacey Strachan.

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Judge Holmes: Strachan, okay.

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Ms. Strachman: Petitioner calls Nancy Fannon.

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Court Clerk: Nancy Fannon sworn in.

A. Nancy Fannon, .

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Ms. Strachman: Your Honor, may I ask the court to mark for identification Ms. Fannon's expert

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report dated October 18 as Exhibit 648-P and her rebuttal report dated December 15 as 649-P.

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Judge Holmes: Ms. Brooke ....., can you move to this one?

Court Clerk: Thank you. Exhibit 648-P is marked for identification, and Exhibit 649-P is
marked for identification.
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Ms. Strachman: May I have the Clerk hand those to Ms. Fannon?
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Judge Holmes: Thank you.

A. Thank you.
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Judge Holmes: And go ahead, Ms. Strachan.

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DIRECT EXAMINATION
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Ms. Strachman:
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Q. Ms. Fannon, can you look at the report that has been identified as 648-P? And other than the
notice of submission that's attached to the front of it, do you recognize that report?

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A. I do.

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Q. Is that your expert report in this matter dated October 18th, 2016?

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A. Yes.

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Q. And then turning to 649-P, other than the notice of submission, is that your expert rebuttal
report in this matter dated December 15th, 2016?

A. Yes.
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Ms. Strachman: Your Honor, at this time, I'd like to move those into evidence.
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Judge Holmes: They are admitted.

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Ms. Strachman:
Q. Ms. Fannon, can you briefly just explain to us what this tax affecting issue is about.
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A. Yes. So the tax affecting issue comes up in the context when you're using an income
approach to value a pass-through entity.
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A. pass-through entity is a form of business that doesn't directly pay taxes on the business
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income stream, but rather the individual owners of that business pay taxes on that income stream.
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And the issue has arisen where the IRS has denied a deduction for taxes on the business income
stream on the premise that individual owner taxes don't affect the value of an asset. And in
contrast to this, valuation professionals have nearly uniformly taken the position that individual

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taxes do affect the value of an asset, and so you should deduct them from the income stream
when you're doing the income approach.

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Q. Now, you referred to pass-through entities. Can you elaborate more what you mean by that
and specifically .... for example, in this case, we have the right of publicity, which is an asset that
is not held in entity form but is held directly by an individual owner?

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A. Mm-hmm.

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Q. Does that include assets like that?

A. Yeah, it does. Basically, the distinguishing thing for this so-called pass-through entity
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treatment is that the taxes on the business income are borne at the individual level. So it includes
S-corps, LLCs, partnerships, sole proprietorships, and it also includes the assets that are the
subject of this matter.
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Q. Can you briefly explain for us the background as it relates to your work in this tax affecting
area?
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A. Mm-hmm, I can. So I've been working on this issue for about ....I guess it would be about 19
years. I started working .... there was a group of us nationally who got together and started
realizing we needed to do something about how we value pass- through entities because we
recognized that there was a difference in taxation compared to C-corporations. Before we had a
chance to really get to any form of resolution or recommendation, the Gross case came out,
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which was the first case that the tax court ruled in this area and really pushed things along in our
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discussions. I think because I had been involved in it since even before that, I started getting
asked to moderate lots of panels, give presentations and so forth over the next .... well, I'm still
doing it. So I've probably given 60 or 70 presentations to accounting groups, expert groups,
lawyers, judicial panels, business owners, all kinds of groups who would have an interest in this
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issue. Midway through that process, in 2008, I wrote a book on this topic because it had gotten to
be such a debate in the valuation community. So I wrote my first book on this topic. And it was
in the course of writing that book that I realized, although we had all kinds of models ....
theoretical models for how to deal with this, no one had really addressed the seminal question
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yet, and that was the question of do individual level taxes affect the value of an asset. And so I
set out to find the research to see what .... if there was any research on that question, and if there
was, what it said. And I was somewhat surprised to find a very rich and robust body of research

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that directly answered that question of whether or not taxes affect value, and in fact, it says
unequivocally that taxes borne at the shareholder level to affect value. So I spent the next
literally several years reading 70 studies anyway that has been done by academics addressing this
particular issue to understand it and formulate it in a way that was coherent for the valuation

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profession, and then I published my book in 2015 on the findings of that research.

Q. Can you give us some examples on the empirical evidence that you've found relating to the

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issues that you were researching and trying to find answers on?

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A. Mm-hmm. So one of the ways the .... many of the researchers studied this issue is they
looked at what happened when there were changes in tax rates on individual investors. So for
example, the 2013 Tax Act was a great example because it really reduced the tax rates on
dividend and capital gains. So what they .... what these studies do .... and that wasn't the only tax
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act .... they've done it since the 60's .... they examined the changes in stock prices in the public
market place in reaction to the differences in taxes. And what they found was that when taxes on
individuals for dividend and capital gains go down, stock prices go up. And then the converse is
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also true as well. I think one of the easiest places that most people are familiar with where this
concept is most readily understood by people is tax exempt versus tax .... taxable bonds. Those
are investments that only bear .... the taxable bonds .... only bear taxes at the individual level.
And there is clearly a difference in the pricing of taxable versus tax exempt bonds. And one of
the key reasons for that is tax .... the avoidance of taxes on the tax exempt bonds. And in fact, the
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models that were prominent in the business valuation profession for many years, those models
were predicated on tax exempt versus tax exempt .... taxable bond model.

Q. From the empirical evidence you found, the research you did, were you able to reach a
conclusion and, if so, what were you conclusions?
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A. I was. So I found that because the research shows undeniably that individual level taxes
affect value, there are two implications for that when you're valuing a pass-through entity. The
first is that because the taxes that the owner in the pass- through entity is going to have to pay ....
the owner of that asset will have to pay affect value, the taxes they will have to pay should be
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deducted from the income stream. But remember, there's two elements to an income approach.
One is the income stream, and the other one is the cost of capital. We deduct the taxes that will
be paid from the income stream because those taxes will affect the value as the research shows.
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But the other element of the income approach, the cost of capital, we also need to make an
adjustment there. And the reason we need to adjust the cost of capital is because the cost of
capital has embedded in it taxes that pass-through entity owners don't pay. So the cost of capital

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is developed largely by dividend and capital gain returns, which is derived from the price of
stocks .... changes of prices of stocks in the marketplace. Those prices of stocks are lower than
they would otherwise be because investors in the public market have to pay dividend and capital
gains taxes. So if you are going to use that cost of capital that includes that embedded negative

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tax effect to value an interest where they won't be paying that second level of tax, that means you
have to remove that from the cost of capital, and that's a positive adjustment to the valuation.

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Q. So just to clarify going back to your first conclusion .... the first step about having to deduct
the taxes that the owner will pay from the income stream and the discounted cash flow analysis,
that applies regardless of whether who the owner is. If it's a C-corporation, you take into

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consideration C- corporation's taxes, and if it's an individual, you're deducting that individual's
taxes. Is that correct?
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A. That's right. Neither entity form avoids the effects of taxes. On the one hand, the corporate
level taxes that we initially think of, in the academic research, those corporate level taxes are
referred to as what's called an explicit tax. And what that means is you can look at the public
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company's financial statement, or a C-corp's financial statement, and you can see those taxes
being deducted and reducing income. So that has an effect on value. The other level of tax, the
taxes paid by the shareholders or the owners on dividends and capital gains, you can't see those
taxes being deducted in the company's results, but they, nevertheless, have a direct effect on asset
pricing. So that's what's referred as an implicit tax. And I think the whole notion of implicit tax is
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the thing that's really been missing from this whole discussion and debate and the effect that they
have value, too.

Q. And this cost of capital adjustment that you refer to, does that essentially reflect or take into
account the benefit that an individual or basically a non-C corp buyer ....
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Ms. Herbert: Objection, leading.

Judge Holmes: Sustained.

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Ms. Strachman:
Q. Can you elaborate on the purpose of the cost of capital adjustment when you're dealing with
the individual or non-C corporation buyer?

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A. Yeah. So the purpose of that adjustment is to reflect the tax savings that the pass-through
entity is going to benefit from. Clearly, the pass- through entity expects to save taxes in some

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magnitude, and those taxes should be recognized. But they don't expect to avoid them altogether,
which is the position that the IRS is taking is that they avoid them altogether. So after first
deducting the taxes on the income stream, then you add back a benefit to the value of the

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company for the effect of them not having to pay the second level of tax.

Q. Can this tax affecting issue be avoided by just doing a discounted cash flow analysis on a

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pre- tax basis?

A. I .... you know, I think it's quite difficult to do that because in order to do that, you would
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have to have a pre-tax cost of capital. And the cost of capital that we get from the public market
when we use Duff & Phelps, for example, that cost of capital is after the effects of shareholder
taxes and it also embeds the negative effects of dividend and capital gains taxes. So both of those
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taxes are baked into the cost of capital. So you can't take a pre-tax income stream and divide it
by a post-tax cost of capital and say you have a pre-tax value. You'd have to actually gross up the
cost of capital to do that. And if you did that, a pre-tax income stream divided by a pre-tax cost
of capital gets you the same result as a post-tax income stream divided by a post-tax cost of
capital.
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Q. When you were reviewing Mr. Anson's expert report, were you able to determine whether he
used a pre-tax cost of capital or an after-tax cost of capital?
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A. He used an after-tax cost of capital.

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Q. And how did you determine that?

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A. I determined that because he indicated in his report that he used the so-called ....

Ms. Herbert: Objection, Your Honor. This is rebuttal testimony again.

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Judge Holmes: I'll still let it in. Go ahead.

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A. He said in his report that the way he derived his cost of capital was to use the Duff & Phelps
so-called conditional return. The Duff & Phelps return is derived from Compustat data, which is
basically based on S&P 500 data over a long-time horizon. But it's based on dividend and capital

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gain returns from the public market place. And whenever you're using a return cost of capital
that's .... and I will use return and cost of capital discount rate interchangeably .... whenever
you're using a return that's developed from public markets, it has those embedded taxes built into

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it.

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Ms. Strachman:
Q. Mr. Anson also opined that the (inaudible) buyer, the buyer and co-buyer, to .... does not
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separate the two layers of tax evasion, basically, was not a C-corporation .... would pay the
highest price and therefore, drive the ultimate transaction price. Do you agree with that opinion?
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A. I don't, not necessarily. While it is true that a pass-through entity, because it expects to save
the dividend and capital gains tax, the second level of tax .... not all taxes, but the second level of
tax .... a buyer may pay .... or a value may be calculated that is somewhat higher than a C-
corporation, but that still doesn't mean, at all, that that pass-through entity may be .... will be the
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marginal investor or the price-setting investor for the stock because other forms of entities, most
notably C-corporations, have other reasons why they would pay a greater price for the stock,
notably access to generally more and cheaper debt financing. And in Mr. Anson's reports, he
really took the best of both of these things into consideration in his calculations in that he both
ignored taxes and he used a cost of capital that was entirely derived from public market stock
metrics, including debt.
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Q. And if we were to assume that Mr. Anson's conclusion that the marginal buyer, the one who
sets the price for transaction, were a pass-through buyer, individual or similar, do you agree with
his conclusion that taxes can then be ignored in doing a discounted cash flow analysis?
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A. Not at all. It .... that position is completely disproven by the research that shows that taxes
borne by individual owners of an asset absolutely affect and directly affect the value of that asset.
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Q. And is your conclusion the same with respect to each of the three reports that Mr. Anson
prepared valuing the right of publicity, MIJAC and Sony/ATV?

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A. It is. Ms. Srachman. No further questions on direct, Your Honor.

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Judge Holmes: Okay. Cross.

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CROSS-EXAMINATION

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Ms. Herbert:

Q. Good afternoon .... ae

A. Hello.
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Q. .... Ms. Dannon. Regarding your October 18th, report, your original report, how would you
characterize that report? Is it an academic research report?
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A. It's a report setting forth the research and analysis of that research regarding how taxes affect
value, and then the methodology for taking that into account.

Q. But it's not a valuation report, per se.

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A. It's a not a valuation report, right.

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Ms. Herbert: Your Honor, I would like to take the bold step of moving to exclude her report on
the basis that it is not a valuation report.
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Judge Holmes: That will be denied, but your objection is noted.

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Ms. Herbert: Okay. Thank you.

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Judge Holmes: And I'll consider it a standing one for the rest of this ......

Ms. Herbert: Okay.

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Ms. Herbert:
Q. Now, the economic interests of the hypothetical seller are an essential part of the fair market

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value analysis. Do you agree?

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A. Absolutely.

Q. An economically-motivated seller would seek the highest possible price for his or her assets.
Is that correct?
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A. Yes.
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Q. Now, if I were a buyer, would you, as an economically-motivated seller, be concerned about

my individual tax situation as a potential asset buyer?
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A. I'm going to say it doesn't matter if I'm concerned about your tax situation. I'm concerned
about what the highest price you would pay, however you might get there, and different buyers
get here different ways.
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Q. Okay. Thank you. Now, if I were a seller and you were in the market for assets, would you
expect me as a seller to give you a discount based on your individual tax rate?
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A. First of all, I'm going to disagree with you that it's a discount you're giving me. By not
deducting taxes, you are overinflating the value of the business. So deducting them doesn't lead
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to a discount. It leads to just an incorrect value conclusion.

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Q. Okay. Thank you. If I tell you my tax rate, can you tell me what I would pay for a given
asset?

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A. You as an individual investor?

Q. Yes.

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A. I still can't tell you because I don't know what other motivating factors you might have.

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Q. So there would be a number of considerations involved.

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A. Absolutely.
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Q. If I as a buyer feel that I can offer $1000 for an asset in order to meet my rate of return
requirements for ownership, does that make the fair market value of the asset $1000?
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A. If you as an individual? One single individual? No.

Q. Now, if there were, let's say, three buyers for an asset, one can offer $1000, one can offer
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$,000, and one can offer $3000, based on their individual rate of return requirements, would you
as the seller choose the $1000 bidder?

A. No.
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Q. Okay. Now, would you agree that different kinds of investments attract different types of
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investment clienteles?

A. Yes.
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Q. And different investment clienteles are characterized by different attributes and investment
interests. Is that fair to say?
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A. Yes.

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Q. Would a pass-through entity attract a specific type of investment clientele based on the pass-
through entity's specific characteristics?

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A. I'm not even sure I understand the question. What kind of characteristics are you talking
about?

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Q. We'll skip that question. All right. Let's .... I'm going to ask you it this way. Does the
investment clientele for a specific type of investment, such as a pass-through entity, perfectly

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match the investment clientele typical of a large public market, such as the New York Stock
Exchange or NASDAQ?
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A. The investors in it? I mean, it all depends on the company. I mean, there's lots of small
private companies or medium-sized private companies that are bought by public companies.
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Q. Okay. Thank you.

A. I've been involved in many of those transactions.

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Q. Do private markets, such as those for pass- through entity interests, directly mimic the trends
of large public markets such that pricing inferences can be made with certainty?

A. Well, I guess the way that I'd answer that is most of the data that we get to value private
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companies we obtain from the public stock markets. And the reason that is is because the public
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stock markets can be studied, examined, dissected in ways that the private markets can't be
simply because the data's available ....

Q. So is that then a yes or a no? Do they directly mimic?

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A. They .... we use to mimic with adjustments to the data that we think are appropriate for the
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company that we're valuing.

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Q. Okay. Thank you. Is valuation of an asset a forward-looking concept?

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A. Yes.

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Q. Would it be fair to say that historical data on large public markets really does not provide
any definitive information pertinent to current prices in small private markets? Is that true?

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A. I don't agree with that. I don't agree with that. We use information that's obtained from the
stock market over varying time horizons as predictive of what will happen in the future.

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Q. However, since private markets are private, can we ever know with certainty what drives a
given asset-pricing decision in a private market?
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A. In a particular deal? Yes. I mean that would be investment value.
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Q. Now, the principles of supply and demand have a role in pass-through entity interest sales. Is
that correct?

A. Sure.
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Q. Okay. Does an investor's individual tax rate directly influence his demand for a given asset
in any measureable way?
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A. I'm not sure I understand. You mean, the investor who has to pay the tax? Does that
influence his demand?
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Q. Yes.
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A. Is that you're saying?

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Q. Yes.

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A. It might influence the price, but it wouldn't influence the price he would pay.

Q. But not necessarily the demand for the asset.

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A. Right. You're just talking about one investor, right?

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Q. Yes.

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A. So it might influence the price.

Q. Okay. Thank you.

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A. buyer that is tax indifferent, that is, has a zero percent tax rate, would be able and willing to
make the highest bid. Is that true?
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A. I don't know who that buyer would be that would pay a zero percent tax rate. If you're
talking about a pass-through entity, the relevant tax rates are the tax rates that the owners of that
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entity will pay.

Q. But they might live in a country that has a zero tax rate, perhaps.

A. They might.
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Q. Okay. Okay, moving on. Do you have any data or empirical evidence specific to the prices
paid by pass-through entities in comparison to other forms of entities?
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A. Yes.
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Q. Is that the studies you refer to in your testimony?

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A. The studies as well as my own analysis of that.

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Q. Would it be fair to say that a large number of the studies that you relied on in your reports do
not analyze the prices paid by pass-through entities?

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A. Right. They're analyzing the prices that are paid for publically traded stocks, just like most
of the data that we use in valuation is obtained from publically-traded stocks because the private
markets are difficult .... much more difficult to get data from to examine and draw inferences

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from.

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Q. Okay. So then you don't have any empirical data from the private markets.

A. No. I have that as well.

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Q. And that's in your report.
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A. Yes.

Q. If two rational investors or hypothetical buyers were identical in every respect except that
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they reside in jurisdictions with different tax rates, what would the impact be on the relative
amount that each would be willing to pay for an asset?

A. So I assume you're asking all other things equal.

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Q. That's .... yes.

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A. Yeah. So the investor who would pay the lower taxes would likely be the .... well, maybe the
marginal buyer, but there's typically .... it's usually not that simple. There's other considerations
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that come into it as well.

Q. Okay. But we had started that hypothetical with all else being equal.
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A. All else equal, but it's not equal in the real world.

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Q. Okay. Now, based on the theory that you've put forth in your reports, when valuing a C-
corporation, should two levels of taxes be deducted in a discounted cash flow analysis, that is,
corporate taxes and capital gains or dividend taxes?

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A. No, because the .... there's no mismatch there. I mean, the whole reason this issue arises is
because there's a mismatch between the cost of capital and the pass-through entity. So the public

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market from which we get our cost of capital, is subject to two levels of taxes, a tax on corporate
earnings and a tax at the individual level. When we use that same data to value a C- corporation,
a private C-corporation, there is no mismatch, so the cost of capital already matches so we don't

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have to make an adjustment for that. So we would not deduct the individual taxes because that's
what's embedded. That's the implicit taxes and the cost of capital.
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Q. Okay. Thank you. Now, in your rebuttal report .... I believe that it was Page 5.
Judge Holmes: .... 1347 ....
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Ms. Herbert:
Q. That's 649-P. Okay. If you could look at the paragraph that starts, "For example, data from
Pratt's Stats".
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A. Yes.

Q. Okay. You say public C corporations generally pay higher prices than private buyers. And
further, prices paid for C corporations exceed those paid for PTEs, or pass-through entities. Is
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that right?
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A. Yes.
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Q. Are you aware that Mr. Anson assumed that the pool of rational investors included pass-
through entities?
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A. Yes. Absolutely I'm aware of that.

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Q. Did you analyze the prices paid by pass- through entities in comparison to other forms of
entities?

A. Well, that's what this is doing.

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Q. Would it be correct to say that the amount a C corporation would pay for an asset is not

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necessarily indicative of the amount a pass-through entity would pay for that same asset?

A. Yes. That is true. I mean, part of the reason that is true is because a lot of the C corporations

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are public buyers who pay demonstrably much higher prices than private buyers.

Q. Now if you could take a look at Exhibit 1 on Page 5 of the rebuttal report. And that's the
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little chart that says, "Market value of invested capital to revenue multiple." Do you see that?
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A. Yes.

Q. So does the degree to which your argument holds up diminish as the size or revenue of the
entity increases, as shown in that chart?
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A. Does it diminish? I'm sorry. Can you say that again?

Q. Okay. So if you .... is it true that the larger .... the income stream, or the greater the income
stream, the less the differential between the public and the private buyers .... between C corps
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and pass-through entities?

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A. Yes. But the public buyer in either case - - whenever there's a public buyer in either case,
they have a higher price they're paying than the private buyer.
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Q. So that's a yes then, that the differential decreases the higher the revenue?
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A. Yes.

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Q. Okay. And did you take that into consideration in postulating your theory that as the income
stream is higher, the differential is lower?

A. First of all, I want to be clear about what you're saying my theory is. Are you .... can you

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expand on what you mean my theory is?

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Q. Well, the theory in your entire report about tax-effecting pass-through entities.

A. Okay. So my entire report is based on the empirical research that was done. So what I'm

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presenting in this report is what the actual data shows about whether or not taxes of .... individual
taxes affect value. So this has no bearing on that research .... on the findings of that research that,
yes, in fact, individual taxes affect value.ae
Q. And you stated earlier that the empirical data comes predominantly from stock sales and
public transactions.
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A. Sure.
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Q. Now please look at Page 6 of that report, Exhibit 2. That chart is entitled Debt to Revenue of
Public versus Private Acquisitions. Do you see that?

A. Yes.
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Q. Is it safe to say that the data presented in Exhibit 2 is somewhat sporadic in that some C
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corps, or corporations, use more debt than some pass- through entities, and vice versa, depending
on the level of revenue of the target entity, just looking at this chart?
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A. Yeah. What this is showing is that the public buyers are generally buying companies that
have a higher level of debt as a percent of revenue than the private companies that are being
acquired.
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Q. Okay. Do you agree that private buyers of pass-through entity targets with revenue of over
50 million utilize the same amount of debt as public buyers of pass-through entity targets with
the same revenue as shown in your chart in the last line of your chart?

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A. Yes.

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Q. Did you take that into consideration in your analysis?

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A. I'm not sure how I would have, so no.

Q. Now, would your model that you have described today, in part, be used for donations to

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charity?

A. I didn't .... I don't think I testified about a particular model, but the model that's in my report,
yes.
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Q. And would apply to sales to ESOP's, employee stock option plans?

A. Yes.
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Q. And also to compensatory transfers to employees?

A. I don't know anything about those. But if it's a valuation of a company, I assume so.
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Q. Okay.
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Ms. Herbert: Okay. I have nothing else right now, Your Honor.
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Judge Holmes: Redirect?

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Ms. Strachman: We have no further questions, Your Honor.

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Judge Holmes: Okay. Oh, I have some, Ms. Fannon.

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A. I thought you might.
CROSS-EXAMINATION

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Judge Holmes:
Q. You testified in other cases involving tax- effecting as .... in valuation?

ck
A. I have certainly had cases where I have tax-effected. I don't think it's ever been an issue

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that's been given any great discussion in any cases.

Judge Holmes: You know of any other expert witnesses who have reached the same conclusion
that you have in cases?
ae
A. So I'm going to answer that if I can in two parts. There's really been two parts to this
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discussion that have gone on for a very long time. The first part has to do with the method for ....
the mechanism by which you recognize the effect of individual-level taxes. The second part has
to do with the research that I'm bringing forth about shareholder taxes, which is about both the
fact that shareholder taxes affect value and about the magnitude of those taxes, how much they
mM

affect value. So as for the first part of your question, there .... as to the theoretical framework,
one of the things that I hope I make clear in my report is that all of the various models do the
same thing. They all result in the same mathematical result. They just go about it differently. So
to answer your question about if other experts have used my model, I'm going to say the model
itself is no different. And one of things I have said all along is it doesn't matter at all which
model you use. Given the same inputs, you'll get to the same results. So I know of lots of cases
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where experts have used any one of the tax-effecting models. As to the inputs to those models, I
can't tell you what cases people have been involved in. I just know I have taught it to about 5,000
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appraisers. I have it in the teaching courses for the ASA credential. So I know a lot of people are
using it in a lot of different contexts. Even .... besides .... beyond estate matters, any kind of a tax
matter like fair value matters for divorce or in a chancery court.
w.

Judge Holmes: Now we're, of course, in California where there's a very high state income tax
as well. Did you take into account in either of your reports the effects of state income taxes?
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A. I did.

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Judge Holmes: You did?

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A. Yes.

Judge Holmes: And how did you do that?

ck
A. So the way that I did that is .... I mean, the place that I did that is the context of coming up

lJa
with the tax rates that I used for the recast of Mr. Anson's report. So for the state income tax, I
based it on a broad survey of all 50 states of effective tax rates that are paid by individual
investors.
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Judge Holmes: And you used a weighted average or something like that?
ich
A. I used .... no, it was just a broad base of tax rates across all states .... the effective tax rates.

Judge Holmes: Have you ever integrated the effective state income taxes with your discussion
of tax clienteles? In other words, takeovers are likely to be done in low tax states.
mM

A. Sure, because they're going to be looking for opportunities when they .... where they can
lower the impact of taxes. The tax rate that I settled on using in my report was only 4 percent. So
it was a fairly low rate.
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Judge Holmes: Did you look at the expert witness reports prepared by Mr. Dahl and Mr.
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Wallis?

A. Yes.
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Judge Holmes: Did you see any evidence of tax-effecting there in a way that you can
approach ..... with your model .....?
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A. Well, because they both determined that the most-likely buyer pool would be C corporations,
the issues that I'm talking about don't really come up because they then, with their buyer pool,

n.c
matched the cost of capital already. So they would determine what's the right corporate income
tax rate to deduct, given the C Corp buyer pool. And then they wouldn't need to make the
subsequent adjustment to the cost of capital because it already matches.

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Judge Holmes: That's what I was going to ask you about. Why wouldn't they need to make that
adjustment?

ck
A. They don't need to make that .... so that second adjustment, if I could just explain it again, it
arises because our cost of capital, derived from the public market, is made up of predominantly

lJa
capital gain returns. And because the stock prices that give rise to the capital gain returns are
penalized by individual-level taxes that those public market investors have to pay, it means ....
for pass- through entity, it means that cost of capital is too high to apply to a company that won't
have its shareholders paying dividend and capital gains taxes. But if the C corporation investors
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are going to pay dividend and capital gains taxes, then you have a match as .... you know, so the
C Corp is matching. So there's no need to make that second adjustment.
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Judge Holmes: So it's .... help me again. So the public prices that go into the database from
which you create a tax effect, assuming that C corps are the target buyers ....
mM

A. Right.

Judge Holmes: .... is matched by what again?

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A. The .... so the issue of needing to make the adjustment to the cost of capital only arises in the
valuation of the pass-through entity. Because the pass-through entity is avoiding dividend and
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capital gains taxes, they don't have to pay them as do the public market C corporation investors
and as do the owners of private C corporations. So the private C corporation owners have to pay
dividend and capital gains taxes. So that matches the taxes that are in the cost of capital.
w.

Judge Holmes: Okay. If you could turn to your rebuttal report. That's 650.
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Judge Holmes: 650, Ms. Wood?

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Court Clerk: 649.

Judge Holmes: 649 .... oops, I'm sorry. I'm looking at the wrong one. Her initial report is
which .... is what, Ms. Wood?

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Court Clerk: The initial report is 648-P.

ck
Judge Holmes: I might have ....

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Court Clerk: And the rebuttal report is 649.

Judge Holmes: Okay. 649-P.

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A. Is .... which one did you want me to look at?
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Judge Holmes: That is the rebuttal.

mM

A. The rebuttal report.

Judge Holmes: Page 20. Tell me when you're there.

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A. I'm there.
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Judge Holmes: This is about the tax amortization benefit again.

w.

A. Yes.

Judge Holmes: Which seems to be harder to come by. Am I right about that? And also smaller?
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A. Well, smaller than what?

n.c
Judge Holmes: The effect on weighted average cost of capital ....

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A. They're ....

Judge Holmes:

ck
A. They're really two completely different things. One is the application of the income approach

lJa
and what is the right tax rates and cost of capital to use in it. And then the tax amortization
benefit is a separate calculation about the asset being able to be .... asset basis being able to be
stepped up and amortized .... in this case, over 15 years.
ae
Judge Holmes: One of the odd things about a negotiation in an asset sale between buyer and
seller is that it's one of these where it's not clear to me how you allocate the benefits absent an
auction. You refer on Page 20 to a Forbes Magazine article. It says, " A little additional cash."
ich
Do you have anything else on how to figure out whether a hypothetical rational buyer of
Sony/ATV or the MIJAC catalog would be willing to share some of those tax advantages?
mM

A. I .... advantages. Yeah. Yeah. I do, and it's the study that I refer to in the paragraph above
that. It has to do with the study that was done by Erickson and Wang. And I'll tell you. In
valuation circles, this study got quite famous. But they basically measured the amount that a C
corporation would pay to an S corporation using a 338(h)10 election, which allowed them to step
up the basis of the assets and amortize them. So they looked at a whole bunch of transactions that
had occurred where that election was made to measure what the amount of the benefit was and
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then, further, to measure how much of that benefit the buyer would actually pay over to the
seller. So what they found is that the buyer would pay over .... for every dollar of tax benefit, the
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buyer would pay over somewhere between $0.36 and $0.46 cents over to the seller. I think I
reference another .... that is the only research study that I know of on that particular topic, which
is why I brought a couple of comments that investment bankers had made about how much the
buyer will pay over. And another one referenced 50 percent.
w.
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Judge Holmes: Okay. Oh, that's on the next page. So am I correct in, after I get through all of
this, that, in the end, you think there's an 11 percent premium adjustment that should be made for
the Anson valuation? This is Page 11 of 649-P.

n.c
A. What page are you on in my report?

so
Judge Holmes: Page 11.

ck
A. 11?

Judge Holmes: Yeah.

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A. No. No, no, no. ae
Judge Holmes: Oh, okay.
ich
A. No. This is ....

Judge Holmes: Instruct me.

mM

A. This is demonstrating .... I mentioned earlier the models that different valuation practitioners
had come up with to figure out how to handle the difference in taxes between what's in the cost
of capital and what a pass-through entity investor would pay. So this is demonstrating the way
those models work. And this is basically saying compared to a fully taxable public market stock,
the pass-through entity would be valued at an 11 percent premium over it after you take the
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effects of individual shareholder taxes into account and after you adjust for the benefit of
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avoiding dividend and capital gains taxes. I have later in my report the specific adjustments to
each of Mr. Anson's analyses.
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Judge Holmes: Okay.

Judge Holmes: All right. Follow-up questions, Ms. Strachan?

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Ms. Strachman: We do not have any further questions, Your Honor.

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Judge Holmes: Follow-up questions, Ms. Herbert?

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Ms. Herbert: Just a couple, Your Honor.

RECROSS-EXAMINATION

ck
Ms. Herbert:

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Q. Ms. Fannon, in general, does the weighted average cost of capital formula contain a
component to account for the tax shield associated with interest payments on debt?

A. Yes.
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Q. Did Mr. Anson remove the tax shield in his weighted average cost of capital calculation?
ich

A. Yes.
mM

Q. Okay. Thank you. Now, in the world of transactions, the real world of transactions, aren't
there many bidders from international tax jurisdictions?

A. For the assets in this case?

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Q. For assets in general.

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A. There may be, depending on the particular asset.

w.

Q. Don't these international bidders have different tax structures?

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A. They do.

n.c
Q. Would valuations on an after-tax basis therefore distort the perspective of a bidder from a
foreign tax jurisdiction?

A. Absolutely not. I think what you may be referring to is whether or not it's too hard to

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estimate what the taxes might be. I think .... everything we do in valuation is an estimation using
the best available data that we have. Just because the data can be difficult doesn't mean that a
buyer would absolutely ignore a very material cost that they were going to incur. So I don't think

ck
a buyer would ignore that.

Q. If they .... the buyer were from a country that had a 7 percent tax rate, that would be different

lJa
from a buyer in the United States, correct?

A. For that individual buyer, yeah. I'm not - - I don't think that makes up the buyer pool, though.
ae
Q. But you have used a pretty much across the board 35 percent rate?
ich

A. Yes. Thirty-five percent for the effect of the individual taxes, which I explained in my report
how I derive that rate. And then a .... what .... the amount that's built in at the dividend .... I have
dividend capital gains taxes is about 9 percent.
mM

Q. Okay. Thank you.

Ms. Herbert: I have nothing further.

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Judge Holmes: Okay. Thank you very much, Ms. Fannon. Ms. Fannom: Thank you.

Judge Holmes: Who's next, Mr. Toscher?

w.

Mr. Toscher: Your Honor, Mr. Kane and I need about five, six minutes.
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