Part IV Taxation and corporate
decision making
taxes have important impacts on
investment and economic activities;
For example, the use of tax policy to
attract companies highlights 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;
interest paid by a corporation to its
lenders is tax-deductible, generating a tax
shield;
Dividends are not tax- deductible;
there is an incentive for firms to use debt
instead of equity;
likely to lead to excessive debt financing;
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 of 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;
Double taxation - likely to cause economic
distortions:
double taxation of dividends encourages
corporations to favor debt financing;
taking on more debt, so that the firm’s cash
payments to its investors take the form of
interest payments;
double taxation of dividends discourages
businesses from holding corporation status;
Encourages retaining earning;
Systems to dividends taxation;
classical,
imputation and exemption
split rate and dividend deduction .
Classical system:
no relief is given for double taxation;
Imputation (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;
example on dividend imputation system.pd
f
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;
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;
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;
• Part V Tax avoidance and evasion
• Tax avoidance - an attempt to reduce tax
liability by legal means, for example, by
exploiting loopholes;
• legal exploitation of the tax regime to
one’s own advantage;
Tax evasion - attempting to reduce tax
liability illegally (by breaking laws);
Tax evasion - intentional
misrepresentation or hiding of the true
state of taxpayers’ affairs;
Tax evasion may be through suppression of
income or exaggeration of expenditures;
Includes taxpayers that deliberately
understate their income; over claim
deductions, credits; fail to lodge returns and
pay; or do not keep the required records etc
(McKerchar 2002, p. 27)
• Theoretically, there are a number of factors
causing tax evasion:
• Complex tax structure;
• high tax rates;
• low probability of audit;
• low penalty rate;
• level of education;
• peers’ evasion decision etc
Tax planning
Systematic analysis of differing tax options aimed
at the minimization of tax liability in current and
future tax periods;
Features of tax planning :
tax planning is legal;
consider tax effects before transactions are
finalized;
pay close attention to the structural and
transactional categories established by the
government;
mitigate tax liability by:
avoid statutory income, obtaining
deductions;
use exclusions
postpone income recognition;
accelerate losses and deductions;
change tax jurisdictions – to those that
have preferential treatment;
Spreading/shifting income among
related taxpayers
• Basics of tax planning
• deduct, defer and divide
