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Part 2
Research Reports 

Taxes and the Preferred Source of Corporate Finance 

Introduction 

In most countries, interest payments are deductible for corporate income tax purposes while dividend payouts are not, so there is often a presumption that debt is the tax-favoured source of finance. Such a distortion could encourage higher than optimal debt-equity ratios, potentially exposing firms to a greater risk of bankruptcy. It could also disadvantage firms that invest heavily in knowledge assets, which cannot be used as collateral for debt, and innovative firms that may need to finance expansion with risk capital.[1] To determine if debt financing is favoured by the tax system, however, both personal and corporate taxes must be considered. For example, while interest payments are deductible from corporate income tax, they may be taxable in the hands of the recipient, which would raise the cost of using debt to finance investment. Nevertheless, debt could still be tax-preferred relative to new equity issues if the sum of personal income tax on dividends and corporate income tax on profits distributed as dividends is greater than the personal income tax on interest.

Assessing the role of taxes in corporate financing decisions is complicated by the fact that there is some ambiguity about which tax rates are relevant (see box entitled “Taxes and the Cost of Finance”). Business investment in Canada is financed by domestic and foreign investors, who face different tax rates on their investment income. In principle, any one of these investor classes could be playing the decisive role in determining the cost of finance of firms. If a taxable individual residing in Canada is determining the cost of finance, then only domestic income tax parameters are relevant, but if a taxable resident of a foreign country is determining the cost of finance, the personal income taxes of that country are relevant. If a non-taxable investor is determining the cost of finance, then personal income taxes do not need to be considered and debt will always be the tax-preferred source of finance. Finally, the investor determining the cost of corporate finance may be different for large and small firms and may vary over time.

This paper provides an historical perspective on the tax-preferred form of finance in Canada and presents an international comparison for 2010. The tax burdens calculated in this paper[2] suggest that if the cost of finance for large firms in Canada is determined by a taxable Canadian resident, there was a tax bias in favour of debt financing until 2010, but substantial corporate income tax reductions, a lower effective tax rate on capital gains and changes in the tax treatment of income from shares have removed the tax preference for debt financing. In contrast, if a taxable foreign resident is determining the cost of finance for large firms, debt financing continues to be tax-favoured. For small Canadian firms, which are assumed to be financed by a taxable Canadian resident, the results suggest that debt financing has never been tax-favoured due to the lower corporate income tax rate for small business and the Lifetime Capital Gains Exemption.

Taxes and the Cost of Finance

Corporations finance investment through debt, new equity and retained earnings. The costs of these financing sources are linked by investors' efforts to obtain the same return on all financial assets, after adjustment for risk and taxes. For example, corporate bonds require a higher rate of return than their secure government counterparts, but the premium will be set at the rate thought to compensate for the greater risk so that investors will expect to receive the same after-tax rate of return on the two asset classes. The size of the risk premium on corporate bonds will be determined by the investor, or class of investor, who could be induced to hold more corporate bonds by a very small increase in their relative rate of return. Similarly, the impact of taxes on the relative rate of return on equity will be determined by the investor, or class of investor, that could be induced to hold more equity by a small reduction in the relative tax burden on equity.

More generally, there will be an investor class that determines the required rate of return on each corporate financial instrument because of its sensitivity to changes in relative rates of return, not necessarily because of its share of the market.1 If this investor class is taxable, changes in tax rates on corporate profits and investment income will cause pre-tax rates of return on financial assets to change as well.


1 Note that if no investor class is active in all asset markets, differences in risk-adjusted rates of return may emerge, but these differentials would be eliminated by the arbitrage activities of profit-seeking traders.

Canadian Firms Financed by Taxable Canadian Residents—Historical Perspective 

Large Corporations

Chart 1 depicts from 1980 to 2013 the total tax burden on debt, new equity and retained earnings supplied to large Canadian corporations by individuals residing in Canada taxed at the top marginal rate. The total tax burden takes into account both corporate and personal income tax paid at the federal and provincial or territorial levels. The total tax burden on debt is the amount of personal income tax on interest income since interest payments are deductible for corporate income tax purposes. For new equity issues, the return to the investor takes the form of dividends,[3] so the total tax burden consists of the corporate income tax on profits distributed as dividends plus the personal income tax on the dividends. Personal and corporate income taxes are integrated in Canada, meaning that the personal income tax on dividends received from Canadian corporations is reduced by a credit for the corporate income taxes that are presumed to have been paid by the corporation.[4] When a firm uses retained earnings to finance investment there is no direct payment to shareholders, but everything else being equal, the value of the firm increases, so the return to the investor takes the form of a capital gain. The total tax burden therefore consists of corporate income tax on profits plus the personal income tax on the taxable amount of the capital gain resulting from higher retained earnings. The tax burden calculations are set out in Table 1, using 2012 marginal tax rates and other tax parameters.

Table 1
Total Tax Burden1
Large Canadian Corporations Financed by Taxable Canadian Residents2 (2012)
Tax Parameters    
Tax Rates    
  On corporate income (1) 26.1%
  On personal income (top marginal rate) (2) 45.3%
Capital Gains    
  Income inclusion rate (3) 50.0%
  Tax rate (4)=(2)*(3) 22.7%
Dividend Taxation
  Gross-up rate (5) 38.0%
  Credit rate (6) 25.1%
Tax Burden by Financing Source    
Tax Burden on Debt 45.3%
Retained Earnings    
Gross-of-tax corporate profits (7) $100.00
Corporate income tax (8)=(1)*(7) $26.10
Net-of-tax retained earnings (9)=(7)-(8) $73.90
Capital gains tax (10)=(4)*(9) $16.74
Tax Burden on Retained Earnings =[(8)+(10)]/(7) 42.8%
New Equity    
Net-of-tax profits distributed as dividends (9) $73.90
Grossed-up dividends (11)=(9)*[1+(5)] $101.98
Personal income tax on dividends (12)=(2)*(11) $46.21
Dividend Tax Credit (13)=(6)*(11) $25.60
Net personal income taxes on dividends (14)=(12)-(13) $20.61
Tax Burden on New Equity =[(14)+(8)]/(7) 46.7%
1 Combined federal and provincial personal and corporate income tax rates.
2 Individuals residing in Canada taxed at the top marginal rate. Firms are assumed to be paying taxes.

As can be seen in Chart 1, the total tax burdens on debt, retained earnings and new equity have varied substantially over time, generally declining as tax rates were brought down. Reductions in the federal top personal income tax rate in 1982 (from 43% to 34%) and 1988 (from 34% to 29%) decreased the tax burden on all sources of finance. Retained earnings became the least preferred type of finance in the 1990s when the capital gains inclusion rate was increased from 50% to 75%. Prior to 2006, dividends from small and large corporations received the same Dividend Tax Credit rate, which was less favourable for shareholders of large corporations since the credit did not fully offset the corporate income tax imposed on large corporations. Since 2006, dividends have been separated into two categories: eligible dividends (generally from large corporations) and other dividends (from small Canadian Controlled Private Corporations, or CCPCs). The treatment of dividends from small CCPCs was not changed in 2006, but the credit rate for dividends from large corporations was increased, which reduced the tax burden on new equity. Finally, actual and legislated reductions in the federal corporate income tax rate from 29.1% in 2000 to 15% by 2012[5] substantially lower the tax burden on new equity and retained earnings.

Chart 1 - Total Tax Burden

Overall, debt was the tax-preferred type of finance until 2010 and will still be slightly favoured over new equity until 2013. Retained earnings become the tax-preferred type of finance starting in 2011. However, this calculation is based on the assumption that the holding period for the shares is one year. As the holding period increases, the effective tax rate on capital gains declines, reflecting the benefit of a tax deferral. Depending on the length of the holding period, retained earnings could have been the tax-preferred type of finance beginning in 2003. Annex 2 presents a calculation of the effective tax rate on capital gains when a security is held for 5, 10 and 20 years.

Small Corporations

Chart 2 depicts the total tax burden on investments in small CCPCs in Canada from 1980 to 2013, assuming the cost of finance is determined by a taxable resident of Canada. For investments financed through debt, the tax burden is the same as for large firms, since it is determined by the top personal income tax rate on interest income. The tax burden on new equity issues has also been similar for small and large firms since 2006, when the Dividend Tax Credit was increased for large firms. However, because of the lower corporate income tax rate for small firms, the total tax burden on retained earnings is much smaller. As a result, debt has never been the tax-preferred source of finance for small business. Except during the 1990s when the capital gains inclusion rate was 75%, retained earnings have always been the tax-favoured form of finance.

Chart 2 also shows the tax burden on retained earnings when capital gains are eligible for the Lifetime Capital Gains Exemption (LCGE) up to $750,000. Implemented in 1985, the LCGE provides a $500,000 lifetime tax exemption on capital gains from the disposition of small business shares. With this exemption, the effective tax rate on capital gains is zero for some firms, which would make retained earnings by far the tax-preferred type of finance provided that capital gains on the investment are below the threshold. There is also a deferral of realized capital gains on the disposal of small business shares if the proceeds are reinvested in small business shares. As discussed above, a deferral lowers the effective tax rate on capital gains, but the impact is particularly difficult to quantify in this case.

Chart 2 - Total Tax Burden

International Comparison 

Chart 3 compares the total tax burden on the three corporate financing sources for large firms in 31 members of the Organisation for Economic Co-operation and Development (OECD), plus Brazil, Russia, India, China, Hong Kong Special Autonomous Region and Singapore in 2010. The chart highlights the degree of neutrality achieved across financing sources by showing the tax burden on retained earnings (squares) and new equity (diamonds) relative to debt. Points on the horizontal line indicate that the financing source has the same tax burden as debt, while points above the line indicate a less favourable tax treatment than debt and points below the line indicate a more favourable tax treatment than debt. The lowest point (line, square or diamond) for a given country indicates the tax-preferred type of finance in that country. These calculations are country-specific, indicating the relative tax burdens applicable to local taxable residents financing investment by a local corporation. The countries are ranked by ascending order of the spread between tax burdens on the three financing sources.

Chart 3 - Deviation from the total tax burden on dept

The international comparison reveals that in 2010 only five countries (Australia, Canada, Denmark, Mexico and Singapore) have a neutral tax treatment of corporate financing decisions in the sense that the total tax burden is approximately equal for debt, retained earnings and new equity.[6] Despite reductions in corporate income tax rates in many countries over the last 20 years, debt is still the tax-preferred type of finance in 22 of the 32 non-neutral countries. Retained earnings are preferred in 8 countries while debt and new equity are equally preferred in 2 countries. On average, the tax burden on debt is 9.4 percentage points lower than on retained earnings and 12.7 percentage points lower than on new equity.

Tax Burden on Investment in Canada by Group of Seven (G-7) Residents 

So far, the analysis has been limited to corporations financed by taxable individuals resident in the same country as the corporation. A substantial amount of investment in Canada is financed on global markets, so it is of interest to examine the tax burden by source of finance when the investor is a resident of a foreign country. Table 2 illustrates the total tax burden on investments in a large Canadian firm when the cost of finance is determined by an individual residing in one of the G-7 countries paying taxes at the top marginal rate. In this case, the firm pays corporate income tax in Canada, but the personal income tax burden is determined in the investor's country of residence, except when Canadian withholding taxes on dividends are higher than the personal income tax payable in the country of residence.[7] The table shows the tax burden on financing through retained earnings and new equity issues relative to debt. A positive entry in the table indicates a higher tax burden than on debt.

The comparison shows that when a large Canadian corporation is financed by taxable residents of other G-7 countries, the total tax burden on debt is almost always lower than on dividends or capital gains, making debt the tax-preferred source of finance. The exception is the United Kingdom, which recently increased the top personal income tax rate applicable to interest income and the top rate on capital gains, the net effect of which was to shift the tax advantage from debt financing to financing with retained earnings.[8] A lower effective tax rate on capital gains resulting from a longer assumed holding period of five years does not change the tax bias in favour of debt financing in the other G-7 countries (last column of the table). Furthermore, if the investor is non-taxable (a Canadian resident or not) then debt will always be preferred since its total tax burden will be nil while corporate income tax will be embedded in dividends and capital gains received by the tax-exempt investor.

Table 2
Deviation From the Total Tax Burden1 on Debt Large Canadian Corporations
Financed by Taxable Residents of G-7 Countries2 (2010)
    Retained Earnings
Holding Period
   
  New Equity One Year Five Years
  (percentage points)
Canada 1.8 0.2 -2.0
France 2.8 2.8 0.4
Germany 21.7 21.7 19.5
Italy 27.6 25.8 24.6
Japan 20.1 16.6 15.6
United Kingdom 9.5 -0.7 -3.0
United States 4.7 4.7 2.8
G-7 average (excluding Canada) 10.8 9.2 7.5
1 Combined Canadian federal and provincial corporate income tax plus residence country personal income tax.
2 Individuals residing in each country taxed at the top marginal rate. Firms are assumed to be paying taxes.

Conclusion 

This paper has provided an historical perspective on the tax-preferred form of corporate finance in Canada for large and small corporations and has presented an international comparison for large corporations for 2010. The tax burdens calculated in this paper suggest that:

Annex 1—Tax Rates Used in the Calculation of Total Tax Burdens 

Table A1.1
Combined Federal and Provincial Tax Rates in Canada (1980 to 2013)
          Small Corporations
         
  Corporate
Income
Tax
Personal
Income
Tax on
Interest
Income
Personal
Income
Tax on
Capital
Gains
Personal
Income
Tax on
Dividends
Corporate
Income
Tax
Personal
Income
Tax on
Dividends
  (%)
1980 51.1 64.3 32.1 41.3 25.5 41.3
1981 51.2 64.7 32.4 41.5 23.0 41.5
1982 49.8 53.0 26.5 28.3 18.8 28.3
1983 48.5 53.2 26.6 28.4 18.8 28.4
1984 47.6 53.5 26.8 28.6 18.6 28.6
1985 49.4 54.9 27.5 29.3 22.2 29.3
1986 49.7 56.5 28.3 29.0 22.2 29.0
1987 48.6 54.1 27.1 37.6 22.0 37.6
1988 41.3 46.9 31.3 32.5 19.7 32.5
1989 41.3 47.5 31.7 32.8 20.2 32.8
1990 41.4 48.5 36.3 33.4 20.5 33.4
1991 41.8 49.4 37.0 34.1 20.8 34.1
1992 42.5 49.8 37.3 34.3 20.8 34.3
1993 42.5 51.4 38.6 35.5 20.8 35.5
1994 42.6 52.2 39.1 36.0 20.7 36.0
1995 42.9 52.2 39.1 36.0 21.0 36.0
1996 42.9 52.1 39.1 36.0 20.9 36.0
1997 42.9 51.5 38.7 35.6 20.9 35.6
1998 42.9 50.8 38.1 35.3 20.7 35.3
1999 42.9 49.7 37.3 34.3 20.7 34.3
2000 42.6 48.6 32.4 33.1 20.1 33.1
2001 40.6 46.0 23.0 31.3 19.6 31.3
2002 38.1 45.7 22.8 31.1 19.3 31.1
2003 36.0 45.6 22.8 31.1 19.0 31.1
2004 34.5 45.6 22.8 31.1 18.7 31.1
2005 34.4 45.6 22.8 31.1 18.6 31.1
2006 34.0 45.6 22.8 24.4 18.3 31.9
2007 34.1 45.5 22.8 24.0 18.2 32.0
2008 31.7 45.4 22.7 23.4 15.9 32.1
2009 31.3 45.4 22.7 23.0 15.9 32.4
2010 29.5 45.4 22.7 25.1 15.5 33.1
2011 27.8 45.3 22.7 26.6 15.5 33.0
2012 26.1 45.3 22.7 27.9 15.1 33.0
2013 25.7 45.3 22.7 27.9 15.1 33.0
Source: Department of Finance.

 

Table A1.2
Tax Rates on Income From Domestic Sources1 (2010)
  Corporate
Income Tax
Personal
Income Tax
on Interest
Income
Personal
Income Tax
on Capital
Gains
Personal
Income Tax
on
Dividends
  (%)
OECD Members        
Australia 30.0 46.5 23.3 23.6
Austria 25.0 25.0 25.0 25.0
Belgium 34.0 15.0 0.0 15.0
Canada 29.5 45.4 22.7 25.1
Chile 17.0 40.0 0.0 27.7
Czech Republic 19.0 15.0 0.0 15.0
Denmark 25.0 59.0 45.0 42.0
Finland 26.0 28.0 28.0 19.6
France 34.4 30.1 30.1 30.1
Germany 30.2 26.4 26.4 26.4
Greece 24.0 10.0 10.0 10.0
Hungary 19.0 20.0 20.0 25.0
Iceland 18.0 18.0 18.0 10.0
Ireland 12.5 47.0 31.0 47.0
Italy 31.4 12.5 12.5 12.5
Japan 39.5 20.0 10.0 10.0
Korea 24.2 33.0 0.0 31.1
Luxembourg 28.6 10.0 0.0 19.5
Mexico 30.0 30.0 0.0 0.0
Netherlands 25.5 30.0 0.0 30.0
New Zealand 30.0 38.0 0.0 11.4
Norway 28.0 28.0 28.0 28.0
Poland 19.0 19.0 19.0 19.0
Portugal 26.5 20.0 20.0 20.0
Slovak Republic 19.0 19.0 19.0 0.0
Spain 30.0 21.0 21.0 18.0
Sweden 26.3 30.0 30.0 30.0
Switzerland 21.2 35.0 0.0 20.0
Turkey 20.0 10.0 0.0 17.5
United Kingdom 28.0 50.0 28.0 36.1
United States 39.1 39.5 20.8 20.8
Non-OECD        
Brazil 34.0 27.5 15.0 27.5
China 25.0 20.0 20.0 20.0
Hong Kong 16.5 0.0 0.0 0.0
India 33.2 33.2 22.1 22.1
Russia 20.0 13.0 13.0 9.0
Singapore 17.0 20.0 0.0 0.0
1 Income received from large corporations.
Sources: OECD Tax Database, International Bureau of Fiscal Documentation and PricewaterhouseCoopers' Worldwide Tax Summaries.

 

Table A1.3
Tax Rates on Income From Foreign Sources (2010)
Personal
Income
Tax on
Interest Income
Personal
Income
Tax on
Capital Gains
Personal
Income Tax
on Dividends
G-7 Countries (%)
France 47.9 30.1 30.1
Germany 26.4 26.4 26.4
Italy 12.5 12.5 12.5
Japan 20.0 10.0 10.0
United Kingdom 50.0 28.0 42.5
United States 39.5 20.8 20.8
Sources: OECD Tax Database, International Bureau of Fiscal Documentation and PricewaterhouseCoopers' Worldwide Tax Summaries.

Annex 2—Effective Tax Rate on Capital Gains 

In Canada, capital gains are taxed when they are realized rather than as they accrue. This deferral of taxation reduces the effective tax rate on capital gains and increases the after-tax return for the investor as the holding period is extended. Accrual-based taxation is less favourable to the investor because the capital base is eroded by taxation every year, while it continues to grow tax-free under the realization approach. For example, as illustrated in Table A2.1, a $1,000 investment that increases 5% in value per year generates an after-tax capital gain of $1,239.97 after 20 years when taxes are paid on disposition compared to $1,088.15 when taxes are imposed on accrued capital gains. Note that both the pre-tax capital gain and the total taxes paid are lower under accrual taxation, reflecting the erosion of the capital base by taxation.

Table A2.1
Taxation of Capital Gains on Accrual and on Realization ($1,000 Investment)1
  Tax on Accrual Tax on Realization
 

Time Elapsed (Years) Pre-Tax
Capital Gain
Tax Paid (Current
Year)
Tax Paid (Cumulative) After-Tax Capital
Gain
Pre-Tax
Capital Gain
Tax Paid
on Disposition
After-Tax Capital
Gain
($)
1 50.00 12.50 12.50 37.50 50.00 12.50 37.50
2 89.38 12.97 25.47 76.41 102.50 25.63 76.88
3 130.23 13.46 38.92 116.77 157.63 39.41 118.22
4 172.61 13.96 52.88 158.65 215.51 53.88 161.63
5 216.58 14.48 67.37 202.10 276.28 69.07 207.21
10 462.45 17.41 148.35 445.04 628.89 157.22 471.67
20 1,113.31 25.16 362.72 1,088.15 1,653.30 413.32 1,239.97
Note: Numbers may not add due to rounding.
1Assumes the investment increases in value by 5% a year, with capital gains taxed at 25%.

A more general approach to illustrate the benefits of the tax deferral is to calculate an effective tax rate on capital gains (τˆ) that, if levied every year (as under accrual taxation), would leave the investor with the same after-tax income as when capital gains are taxed on realization.

If an investor buys a $1 security that appreciates at rate γ and realizes a capital gain that is taxed at the end of N periods at rate τg, the investor will have the following after-tax income (I):

I = [(1 + γ )N – 1](1 – τg)

While if the tax is levied every year at rate τˆ, the investor's after-tax income at the end of N periods is determined by:

I = (1 + γ γτˆ )N – 1

The effective tax rate on capital gains that leaves the investor with the same after-tax income can be obtained by setting the two equations equal and solving for τˆ:

τˆ= {[(1 + γ )N – 1](1 – τg) + 1}1/N – γ – 1

– γ

The effective tax rate can be calculated by specifying the holding period N, the statutory tax rate on capital gains τg, and the growth rate γ in the value of the security, which is represented by the S&P/TSX Composite Index. The average annual growth between two peaks in the index (May 1987 and May 2008) was 6.8%.

Chart A2.1 depicts the total tax burden on an investment financed through retained earnings for each of the three holding period scenarios (5, 10 and 20 years). It is a reproduction of Chart 1 in which three new lines for retained earnings have been added that are lower as the holding period is extended, indicating that the effective capital gains tax rate has fallen. With a holding period of 10 or 20 years, retained earnings were by a small margin the tax-preferred type of finance in 1980 and 1981, before the 1982 decrease in the federal top personal income tax rate. Retained earnings would be the tax-preferred type of finance since 2003 under the 20-year holding period scenario, while they would be tax-favoured since 2008 under the 10-year scenario and starting in 2010 under the 5-year scenario.

Chart A2.1 - Total Tax Burden


References 

Burman, Leonard E. and Peter D. Ricoy (1997). “Capital Gains and the People Who Realize Them.” National Tax Journal, 50 (3): 427-451.

Keen, Michael, Alexander Klemm and Victoria Perry (2010). “Tax and the Crisis.” Fiscal Studies, 31 (1): 43-79.

Klemm, Alexander (2006). “Allowances for Corporate Equity in Practice.” IMF Working Paper 06/259, International Monetary Fund.

Organisation for Economic Co-Operation and Development (2008). “Tax and Economic Growth.” Economics Department Working Paper No. 620.

Protopapadakis, Aris (1983). “Some Indirect Evidence on Effective Capital Gains Tax Rates.” Journal of Business, 56 (2): 127-138.


[1] See Organisation for Economic Co-operation and Development (2008) for a detailed examination of how tax-distorted financing decisions can harm economic performance.

[2] Tax burdens are derived from statutory corporate income tax rates and statutory personal income tax rates on interest, dividends and capital gains, assuming that individuals pay tax at the top marginal rate. Key tax changes impacting on the tax burden are identified in the discussion of results. The tax rates used in this paper are those in effect as of July 2010; they are presented in Annex 1.

[3] It could be argued that the return on new equity is sometimes realized in the form of a capital gain because of share buybacks, but for simplicity it is assumed that the return is paid out in dividends.

[4] The Dividend Tax Credit mechanism calculates a proxy for pre-tax corporate profits and then provides a tax credit to individuals in recognition of corporate-level tax. Under this approach an individual is first required to include the grossed-up amount of dividends in income. Using this gross-up the tax system in effect treats the individual as having earned directly the amount that the corporation is assumed to have earned in order to pay the dividend. The Dividend Tax Credit then compensates the individual for corporate-level tax presumed to have been paid on that amount.

[5] Over the same period, the weighted average provincial-territorial corporate income tax rate is expected to decline from 13.4% to 11.1%.

[6] Recall that the tax burden on financing by retained earnings is calculated assuming shares are held for one year, which likely overstates the effective tax burden.

[7] The withholding tax rate on dividend payments to portfolio investors residing in other G-7 countries is 15%. The tax withheld is creditable against personal income tax payable in the country of residence of the recipient. Withholding tax is therefore only relevant if it exceeds domestic tax liabilities, which occurs for payments to Italian residents, who pay 12.5% tax on dividend income, and to Japanese residents, who pay 10% tax on dividend income.

[8] As of April 2010, the United Kindgom's top personal income tax rate increased from 40% to 50%; effective June 23, 2010, the 18% flat rate capital gains tax rate was increased to 28% for high income taxpayers.


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