Texation Of Companies

Taxation on companies takes a form of tax called corporate tax which can be defined as a direct tax levied on proceeds made by companies or associations. Corporate tax rates vary from country to country based on different set of rules. In most cases corporate tax is levied before the profits have been circulated to the shareholders. This paper looks forward to discuss the impact of taxation on company i.e. corporate tax effect on policies and decision making in a corporate institution particularly on company capital structure decision. Decision making in a company capital structure is influence by many factor ranging from taxation regime which is the subject in this paper to business goals. Other includes; culture; entrepreneurial characteristics; entrepreneurs’ prior experiences in capital structure; business goals; business life-cycle issues; preferred ownership structures; views regarding control, debt–equity ratios, and short- vs. long-term debt; age and size of the firm; sources of funding for growth; attitudes toward debt financing; issues relating to independence and control; and perceived risk and attitudes toward personal risk (Romano, 2001 para 3).

The discussions in this paper shall focus on different aspect of effect for example equity policies, debt equity policies, ownership structure and organization form among others. The effect attributed by high or low tax benefit and the effect of company capital structure. This paper discusses effect of the difference in taxation of debt and equity financing on capital structures. The relevance of corporate taxes to corporate financial planning and the effect of variation in capital income tax rate to capital structure will be discussed in this paper. The paper will also discuss the relationships between non-debt tax and corporate tax rate as well as there effect on capital structure.

“Corporate income tax is based on the amount of profit distributed to the company’s owners.” (Hazak, 2007 pp 6). This means corporate tax affects to companies’ decisions involving financial as well as legal structure. According to research done by Commission of the European Communities 2004, impact of tax in the decisions touching investment as well as effect on company capital structure was evaluated. The results hinted that taxation was an important factor and influenced decisions on location of production plants, mergers and acquisitions decisions.

“…tax conditions affect companies’ decisions concerning the financial, capital and legal structure of their international operations. The main findings here are: For 87.3% of the companies taxes can influence decisions on whether foreign operations should be organized through a subsidiary, a branch or a permanent establishment, Estimates indicate that 77.2% of the companies consider tax as a factor when they decide to use new equity or debt when financing foreign operations directly or indirectly via the parent company Overall, companies with cross-border activities are significantly more sensitive to taxation when deciding the financial and legal structure of their operations than those who are active only in one country (Commission of the European communities 2004 pp 5).

Capital structure involves companies long-term financing which integrates the long term debt common stocks and preferred stock as well as retained earning. Taxation can be termed as cost which the management of any company will always consider to when making decision since taxation has direct effects on the revenue. This is because taxes reduce the profit made in a company which has a direct effect to the corporate financiers who are the shareholders. Decisions involving how much profit to be retained in the development of the company may in one way or the other be influenced by taxation. Many governments never charge taxes on the retained profit for example revenue retained for company’s expansion purpose but charge taxes on profits to be awarded as dividend to the shareholder. This may influence decisions relating to how much to retain in the reserves and how much to be distributed as dividend. The decision made on this matter influence response of the shareholder because if the decision favor retaining of revenue the company might look unattractive to the potential investors may be attracted by the value of the dividends.

            According to Sanjiva et al impact of the taxation on capital structure has two aspects. “The first concentrates on aspects of the corporate tax deductibility of debt, whilst the second looks at the way in which taxes influence the decisions of the firm’s security holders, and hence their willingness to hold the firm’s securities” (Sanjiva, 2001 pp. 24). According to Miller and Modigliani (1963) highlighted that modification to allow for corporate tax is important in case of a perfect capitals market. This is to the reason that debt offer a tax advantage as interests are deducted as expenses before declaring profits. This shows that a company can make decision on efforts to increase level of leverage through debt, an incentive in terms of tax charged which may help to save a firm faced with threat of bankruptcy.

“There is a direct negative relationship between the value of the marginal corporate tax saving and the amount of debt issued: the higher is leverage, the higher is the probability that the potential corporate tax shield from additional debt will be partially or totally lost” (Sanjiva, 2001 pp. 26). This is a factor which may influence decisions made by an organization. Modigliani and Miller (1963) on his capital market model introduced an aspect of corporate taxes and demonstrated that debts become better source of financing than equity showing decision maker have a point to not as they made decisions concerning financing. The advantage of debt financing to equity is received from the tax shield as debt decrease revenue which translate to decreased corporate tax. This implies that companies should make corporate taxes may pose influence when it comes to decisions to be taken on issues of capital structure.

            Corporate taxation shows an impact to both corporation as well as investor. Hazak, 2007 hinted that classical corporate tax where the tax was levied at company and shareholders level i.e. profits and dividend were taxed exhibited a double tax effect which affected the decisions financial decision. Classical corporate taxation influenced capital structure that would be optimal at the shareholders level as well as the impact level taxation on the financial assessment of companies.

            Taxable profit on company capital structure impacts on decision for example in case of incorporate tax depreciation and investment tax credit. “…the larger the tax-reducing adjustments to profit or non-debt ‘tax shields’, the lower the company’s motivation to use debt for tax deduction purposes. Companies with relatively high non-debt ‘tax shields’ are believed to have relatively less debt in total capital.” (Hazak 2007 pp 10). This influence the corporation decision since companies shall always make decision which will give greatest benefit. Hazak, 2007 wrote that decision made by companies facing financial constrains are not only motivated to use debt for tax deduction reasons but have enough ‘tax shield’ emanating from loss carry forward rules in according to corporate taxation.

            Decisions on company structure also depend on other interactions for example interaction between capital structures, investment, capital market information and other companies which are competing for the same resources. “Company’s capital structure is a complex issue, depending on various internal and external factors. So far no common theoretical understanding has been reached in the literature upon why certain companies at certain periods choose to utilize debt, while others use more equity” (Hazak pp 10). This has resulted to company inclinations for either equity or debt.

            Companies will make decision on investment in foreign country by evaluation factor like tax system. This decision on capital flow where a company tries to operate in integrated global markets the firm faces tax system different from where if originated. Therefore international investment and expansion decisions to the international market depend on the tax regime applied by different countries. Countries willing to attract foreign investment tries to influence issue of foreign investment they may apply tax incentive geared to lure foreign investment. This has been much influenced by increased globalization and interest in the impact of international flow of capital. When a firm target a certain country for it investment, taxation regime it expect to mean in the foreign country is a major factor of consideration and whether it will pose any effect to the company capital structure.

            The corporate borrowing decision are also influenced by tax deductibility of interest expenses and decline in response to cost imposed by capital market. Incentive

Reference:

Commission of the European communities 2004; The European Tax Survey. Retrieved on 18th July 2008 from; http://ec.europa.eu/taxation_customs/resources/documents/1128-04-sum_en.pdf

Hazak, Aaro 2007; Capital Structure and Dividend Decisions Under Distributed Profit Taxation. Retrieved on 18th July 2008 from; http://majandus.ttu.ee/public/AaroHazakPhDThesis.pdf.

Modigliani, F. and Miller, M.H (1958), Corporate Income Taxes and the Cost of Capital, American Economic Review

Sanjiva Prasad, Christopher J. Green, and Victor Murinde 2001; Company Financing, Capital Structure, and Ownership: Retrieved on 18th July 2008 from: http://www.lboro.ac.uk/departments/ec/Research/Discussion%20Papers%202001/Research%20Papers%202001/erp01-3.pdf.

Romano, Claudio A.2001. Capital structure decision making A model for family business. Retrieved on 18th July 2008 from; http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VDH-41XM8RK-4&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&view=c&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=129ba5d6d576b032bafa91315e0e4e76