CHAPTER FOUR
TAXATION AND CORPORATE DECISION
MAKING
CONT…
Taxes have important impacts on investment and
other economic activities;
For example, the use of tax policy to attract
companies 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;
CONT…
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.
CONT…
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;
CONT…
All interest paid by a corporation to its
lenders is tax-deductible, generating a tax
shield;
◦ Subject to limit in Ethiopia
Dividends are not tax- deductible;
◦ Distribution of after tax net income
CONT…
• 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.
CONT…
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.
CONT…
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;
CONT…
Imputation or dividend credit (Australia,
New Zealand);
integrates corporate and personal income
taxes;
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;
CONT…
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;
CONT…
Doubletaxation - likely to cause
economic distortions:
double taxation of dividends encourages
corporations to favour debt financing;
taking on more debt, so that the firm’s
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;
Hence, organization as sole trader,
partnership or limited liability companies
In Ethiopia, all are subject to business IT
Is it double taxation?
CONT…
Encourages retaining earning;
double taxation encourages corporations to
repurchase shares rather than pay out dividends;
Firms make cash payments to shareholders by
repurchasing their own shares;
repurchasing shares would result in a reduced
capital gains tax rate;
CONT…
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
CONT…
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
….
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