Chapter Four: Taxation and Corporate Decision Making

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
….
THE END

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CHAPTER FOUR

TAXATION AND CORPORATE DECISION

how much of the capital structure to support by

how much of the earnings to retain for use as

firms can finance their investments using equity

Debt – a firm can raise debt by borrowing from

Dividends are not tax- deductible;

• Empirically, the evidence is mixed:

• Some indicate that higher corporate tax rates

dividend deduction – deducting the

split rate system- under which dividends

double taxation of dividends encourages

taking on more debt, so that the firm’s

Firms make cash payments to shareholders by

repurchasing shares would result in a reduced

Low-tax jurisdictions also exist within countries;

For example, U.S. companies make extensive

As of 1999, nearly 60 percent of U.S. firms

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