Chapter 4: Taxation
and corporate
decision making
Taxes have important impacts on investment and
other economic activities;
For example, the use of tax policy to attract
companies through low tax rates highlight the
role of taxation in investment, which in turn
contributes to economic growth.
Governments often consider the use of tax
incentives;
Theoretically, these incentive schemes are
believed to have effect on corporate decision
making;
Taxation affects the financial policy of firms;
How much of the capital structure to support by
debt, rather than equity; and
How much of the earnings to retain for use as
internal equity finance, rather than distributing
dividends and raising new equity in the market.
Taxation and choice of finance
Firms can finance their investments using equity
or debt.
Equity internally available to the firm or funds
raised by issuing stock
Debt a firm can raise debt by borrowing from its
shareholders, from financial institutions, or from the
public;
All interest paid by a corporation to its lenders is tax-
deductible, generating a tax shield;
Subject to limit in Ethiopia
Interest paid to shareholders on loans and advances shall
not be deductible to the extent that the loan or advances
in respect of which the interest paid exceeds on average
during the tax period four times the amount of the share
c:apital.
Dividends are not tax- deductible;
Distribution of after tax net income
There is an incentive for firms to use debt
instead of equity;
Likely to lead to excessive corporate leverage;
Higher level of risk
Empirically, the evidence is mixed:
Some indicate that higher corporate tax rates are
associated with increased use of debt.
Others show that corporations use significant
amount of equity capital;
There can be significant nontax costs involved
with debt financing.
standard costs of borrowing and risks of
financial distress that liabilities imply.
Firms fall into financial distress when they have
difficulty making their debt payments.
Extended periods of financial distress can lead to
bankruptcy.
Taxation and dividend policy
Double taxation is criticized for it leads to high
overall tax rates on corporate income;
Systems to dividends taxation;
Classical,
Imputation and exemption (shareholders level),
Split rate and dividend deduction (corporation level)
Classical system:
No relief is given for double taxation;
Imputation or dividend credit (Australia, New
Zealand);
tries to tax corporate income dividend- at
personal income tax rates;
Personal income is "grossed up" by the amount
of corporation tax paid and credit is allowed for
corporation tax from gross personal tax due;
Assume that CTR=0.3, DI=700, PITR=0.35
PI=700/(1-0.3)=1000
Tax liability=(1000*0.35)-300=50
Exemption exempting dividend income from
the personal income tax;
Dividend deduction deducting the dividend
from corporate taxable income;
Split rate system- under which dividends are
taxed at a lower rate;
Double taxation - likely to cause economic
distortions:
Double taxation of dividends encourages
corporations to favour debt financing;
Taking on more debt, so that the firms cash
payments to its investors take the form of interest
payments;
Impact on Form of
Organization
Double taxation of dividends discourages
businesses from holding corporation status;
DTR=10% in Ethiopia
Hence, organization as sole trader, partnership or
limited liability companies
In Ethiopia, all are subject to business IT
Is it double taxation?
Decisions to retain earnings or distribute
dividends;
Double taxation encourages corporations to
repurchase shares rather than pay out dividends;
Tg=30% & Td=10% in Ethiopia
Repurchasing shares would result in a reduced
capital gains tax rate;
So, as an investor, sale your shares if you need
the money
Firms make cash payments to shareholders by
repurchasing their own shares;
Taxation and choice of company location
Low-tax jurisdictions also exist within
countries;
Examples include:
special economic zones in China,
low-tax states and enterprise zones in the
United States;
Subsidies of land and other facilities in
Ethiopia
Companies try to use tax havens in their choice
of investment location;
For example, U.S. companies make extensive
use of foreign tax havens in their decision of
where to locate their investment;
As of 1999, nearly 60 percent of U.S. firms with
significant foreign operations had an affiliate
presence in tax-haven countries;
Involvement in Charities
Taxation influences firms involvement in
charities
Tax deductible donation policies
In Ethiopia, no more than 10% of taxable
income, including:
Donations in response to state of emergency
declared by government
Employee Benefit
Decisions
Limiting tax free and other benefits:
Transportation allowances
Pension contributions
Representation allowances
Interest for loans from owners
End of Chapter
4
