using the statutory rates of the current year (i.e, year t).

Transcription

1 7 Chapter 7 The Importance of Marginal Tax Rates and Dynamic Tax-Planning Considerations: Efficient investment decisions with long horizons may become inefficient if tax positions change over time. Shorter investment horizons offer an ability to modify investment behavior to changes in circumstances but in general incur additional costs because of fixed costs associated with each redeployment. Consider, for example, a corporation that believes funding current operations with debt is optimal currently but fears equity funding may be better in the near future. Such a firm might borrow on a short-term basis by issuing debt callable at the issuer's discretion at, for example, yearly intervals. Note, though, that callable debt generally must pay a premium interest rate. Why? If circumstances change for the worse, the holder of the debt can sell the debt. And if circumstances change for the better, the holder can continue to hold the debt. But if the debt is callable, the upside to the holder disappears. 7.1 Marginal Tax Rate: Definitional Issues: Our book defines "marginal tax rate" as the present value of all taxes that will be incurred now and in the future, explicit and implicit, if an additional dollar of income is received. The book defines "marginal explicit tax rate" as the same amount but taking into account only explicit taxes, and "marginal implicit tax rate" is defined similarly METR as a Function of Taxable Income and NOLs If taxable income is negative and there is no NOL carryforward, then current losses can be carried back for an immediate refund. The metr in this case is the statutory rate at which income was taxed in the year in which the carryback is exhausted. If the current year loss fully consumes all income in the carryback years, then see section below If taxable income is negative and there is a current carryforward, then the current loss will increase the NOL carryfoward and will produce no immediate tax benefit. The metr is the statutory rate in the future year of exhaustion discounted to present value; that is, metr = str s /(1 + r) s, where str s is the statutory rate at period s in the future when the carryforward is exhausted. Note in particular that if statutory rates are expected to decline, then the current metr will decline as well. Note also that the future years can only be estimated because future events inherently are uncertain If taxable income is positive and there is no NOL carryforward, then the metr equals the current statutory rate unless the firm anticipates losses in a year that can carry back to the current year and that exceeds the current year's income. In this (relatively unlikely) scenario, the current metr = str t str t /(1 + r) n + str s /(1 + r) s, where t is the current year, n is the number of years in the future when the losses are incurred (so n = 1 or 2 under current law), and s is the year in the future when the loss sustained in year n is fully consumed to offset future income. 4 Note in 4 The book generates a different answer in equation 7.3 that seems to me wrong because the refund is computed using the statutory rates of the current year (i.e, year t). 59

2 particular that if n = s (so that the future loss is fully exhausted by the carryback), then metr = str t If taxable income is positive and there is an NOL carryforward that is less than current income, then metr equals the current statutory rate. But if the NOL is greater than current taxable income, the current metr is determined as provided in section above Evidence of NOLs for U.S. Corporations: Because the existence of NOLs makes it much more difficult to estimate corporate metr, it is useful to know if NOLs actually appear with significant frequency. A very long-term study described on page 207 shows that NOLs play a significant role both as a percentage of corporate tax returns and in absolute dollars Estimating Corporate Marginal Tax Rates: Fascinating Additional Details on Local-Level Tax Rates and Individual-Level Marginal Tax Rates Foreign, State, and Local Corporate Taxes: Because state taxes and local taxes are deductible on a taxpayer's federal income tax return, the effect of state income taxes on overall marginal tax rate is mtr = t fed + (t state + t local )(1 t fed ). Some states fund their operations largely through an income tax while others depend on a sales tax. Note that if the sales tax is not deductible on a federal return, the sales tax is an inefficient method of funding state and local activities. In an attempt to allow states to raise revenue however they think best, Congress recently provided that individual taxpayer's may deduct state and local income taxes or sales taxes (but not both) Individual Taxpayers' Marginal Tax Rate: Individual taxpayer's conducting a trade or business (other than the trade or business of being an employee) must file a Schedule C with their tax return showing the income and deductions associated with the trade or business, and it is only Schedule C activities that (a) give rise to NOLs or (b) which can be offset by NOL carryforwards. Individuals are subject to a variety of loss limitation rules with respect to investment activities of which the most important are the passive loss rules and the limitation on capital losses. Computation of marginal tax rate for individuals is further affected by the rules that reduce non-business deductions as income rises such as home mortgage interest, medical expenses, and charitable contributions. Because of these rules, an individual's marginal tax rate may be substantially greater than the highest statutory rate Average and Effective Tax Rates Average tax rate is defined in our book as the present value of current and future taxes divided by the present value of income (grossed-up by implicit taxes). 60

3 Effective tax rate for GAAP is the sum of currently and deferred tax obligations defined by current taxable income. Note in particular that deferred tax obligations are not discounted to present value, an error so large it defies explanation. Thus, for financial reporting, deferral of taxes yields no savings. Note also that by using taxable income as the denominator, exempt income is disregarded rather than counted Problems with Average and Effective Tax Rates: Consider the following example. Investor has $100,000 to invest, and there are two investment possibilities: (1) taxable bonds paying 10% and subject to taxation at 40% and (2) tax-exempt bonds paying 6%. If the taxpayer invested entirely in taxable bonds, the taxpayer has an effective tax rate of $4,000/$10,000, or 40%. If the taxpayer invests half in each, the taxpayer's GAAP effective tax rate equals $2,000/$5,000, or still 40%. If the denominator included all economic income rather than just taxable income, the effective tax rate would be $2,000/$8,000, or 25%, thereby showing that some of the investment yielded a tax-free return. 7.2 Tax Planning for Low Marginal-Tax-Rate Firms: A firm with continuing losses has a very low metr because the metr for such a firm equals str/(1 + r) n, and n may be relatively large (10 or 12 years). What sort of tax planning is available for such a firm? Raising Funds With Debt or Equity: Because dividends are taxed more favorably to the holders of equity than interest is taxed to the holders of debt, a corporation that raises capital through equity should be able to offer a lower return. To be sure, the corporation loses the interest deduction, but for a low metr taxpayer, the loss of the deduction should be outweighed by the lower cost of capital, all else being equal Because depreciation of plant and equipment is accelerated, selling depreciable equipment to a high metr taxpayer and then leasing the property back should yield a return in exchange for lost tax benefits. Note, though, that if the term of the lease is significantly shorter than the useful life of the property, a saleleaseback has significantly different economics than outright ownership. This may be especially true if the taxpayer will invest additional capital in an investment specific way, for in such circumstances the purchaser-lessor may be able to extract a premium for continued use of the property after termination of the lease. How might this problem be avoided? Form a partnership with a high metr investor, and allocate most of the venture's deduction to the investor in exchange for a reduced share of eventual profits Merge with a high metr taxpayer that can use the NOLs against other income. However, the viability of this technique has been substantially reduced by the loss limitation rules in I.R.C. sections 382 and Adaptability of the Tax Plan: A plan is adaptable to the extent it can be modified at low cost as future events change. Adaptability usually comes at a cost. For example, callable bonds usually pay a higher interest rate than noncallable bonds. Similarly, investing in 61

4 short-term debt instruments preserves the opportunity to reallocate capital if interest rates rise but loses the opportunity to profit from a sudden decrease in market interest rates Transaction Costs and Tax Clienteles: Repositioning capital often cannot be done without incurring significant transaction costs. If the costs are high enough, they will dominate the benefit of capital redeployment Example 1: Investor can purchase fully taxable bonds paying 10% annual interest or tax-exempt bonds paying 7% annual interest, with each investment having the same risk and three-year investment horizon. Investor estimates a 70% chance that tax rates will be 40% and a 30% chance that tax rates will be 0% (because a disputed loss in a prior year may carry forward). The investor's estimate tax rate equals 0.70(40%) (0%), or 28%. At that estimated tax rate, a risk-neutral investor would purchase the taxable bonds to obtain an estimated after-tax return of 10% times (1 0.28), or 7.2% Example 2: Assuming the investor can change her investment after the first year when the uncertainty is resolved, what is the investor's optimal investment strategy if the cost of switching investments equals 100 basis points (after taxes) per year? If the investor initially purchases the taxable bonds, she will stick with that investment no matter what happens because of the cost of switching. In this case, her three-year accumulation per dollar invested will be 0.70[1.10(1 0.40)] ( ), or If she initially purchases the exempt bonds, she will switch to increase her after-tax return from 7% to 9% if the tax rate turns out to be 0%. In this case, her three-year accumulation per dollar invested will be 0.70(1.07) [1.07(1.09) 2 ], or Thus, an initial purchase of the tax-exempt bonds is the best decision Example 3: Reconsider example 2 but assume that the cost of switching investments is free. In this case, an initial purchaser of taxable bonds will switch to exempt bonds if the tax rate turns out to be 40% while an initial purchaser of the exempt bonds will switch to taxable bonds if the tax rate turns out to be 0%. Accordingly, the after-tax three-year accumulation of an initial purchase of taxable bonds will be 0.70(1.06)(1.07) (1.10) 3, or 1.249; the after-tax three-year accumulation of an initial purchase of exempt securities will be 0.70(1.07) (1.07)(1.10) 2, or Accordingly, taxable bonds constitute the best initial purchase Adaptability in Investment and Financing Decisions: Note that in the face of uncertain tax rates and transaction costs to redeploy capital, it may be sensible to accept a lower initial after-tax return to preserve flexibility. Put another way, there can be a value to liquidity. 7.4 Reversibility of Tax Plans 62

5 7.4.1 In the face of uncertainty, contacting parties may allocate risks in their agreement. For example, an investor facing uncertain tax rates may seek a provision providing for the unwinding of a transaction if tax rates change. Note that such a provision is not fundamentally different from a provision allowing a party to avoid contractual obligations upon the occurrence of changes in weather or labor conditions. However, such clauses sometimes are used by the government as evidence that the initial contract was not what it seemed to be. For example, suppose an employment agreement between a closely-held corporation and its owner provides for a generous salary that will be reduced if challenged by the government as unreasonable. In such circumstances, the government might use the willingness of the employer-owner to relinquish nominal salary as proof that the nominal salary was excessive. In addition, some provisions of the Internal Revenue Code preclude recharacterization of a transaction. E.g., section 4958(c)(1)(A) ("The term "excess benefit transaction" means any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. For purposes of the preceding sentence, an economic benefit shall not be treated as consideration for the performance of services unless such organization clearly indicated its intent to so treat such benefit.") (emphasis added) Congress is considering significant tax reform. How might parties contract around possible changes? For example, suppose an investment strategy makes sense only if tax rates do not decline substantially. How does a party account for the possibility that nominal rates decline but effective rates increase because, for example, additional loss limitations are added to the Internal Revenue Code? What if income tax rates decline but a national value added tax ("VAT") is enacted? What if corporate tax rates increase but we move from a worldwide tax system to a territorial system? Issuers of tax-preferred investments often include a representation that the anticipated tax results will be available. For example, states and local governments issuing tax-exempt securities represent and warranty that they will not do anything to cause the securities to become taxable. Consider how contracting parties might contract against the following tax risks: A partnership will be taxed as a corporation if its ownership interests become publicly traded (even if not traded on a formal exchange). How can a promoter ensure the interests will not become publicly traded? An S corporation will lose its tax status and become a taxable C corporation if any of its shares become owned by a disqualified person including, for example, a non-us citizen. How can investors ensure no 63

6 disqualified person becomes a shareholder? Can such protection be extended to bankruptcy proceedings? Private equity firms generally pay their managers a fixed fee of about 2% of assets under management as well as an incentive bonus of about 20% of profits. Under current law, the incentive component is taxed as long-term capital gain, but Congress recently considered changing the taxation of such "carried interests." How might the managers and investors account for such a change? Note that tax changes almost always have only prospective application in the sense that they start to apply in the next taxable year. But such "prospective" changes are retroactive in the sense that they affect investments already made and so may defeat the expectations of investors. 7.5 Ability to Insure Against Adverse Changes in Tax Status If a transaction will not be done unless certain tax consequences result, a taxpayer may seek a private letter ruling ("PLR") from the IRS. The cost of a PLR generally exceeds $28,000 plus the legal fees to prepare the ruling (usually in the $15,000 - $50,000 range). A taxpayer must attach the PLR to its tax return covering the transaction whether the PLR was positive or negative, thus ensuring an audit if the PLR was negative. Rulings can take months to be issued, and they do not constitute precedent for any taxpayer other than the taxpayer seeking the Ruling Penalties can be imposed on a taxpayer who intentionally or negligently disregards IRS rules. To avoid these penalties, a taxpayer must be able to show that it relied on substantial authority for its position. Thus, obtaining a legal opinion from a reputable tax advisor generally will protect a taxpayer from penalties (though not from taxes and interest). The Tax Court for the first time held (in Canal Corp.) that an opinion written by a tax advisor who helped structure the transaction could not be used for penalty protection. In addition, Congress just added a 20% penalty for transactions that lack economic substance or a business purpose, and reasonable cause is not a defense to this penalty. The penalty increases to 40% if the transaction was not adequately disclosed on the taxpayer's return. Consider, for example, a taxpayer who does not report interest received on a state or local government exempt bond that is subsequently reclassified as a taxable bond One contracting party may agree to indemnify another contracting party for subsequent taxes. Note, however, that amounts received on a tax indemnification generally are themselves taxable. This means that a tax indemnification will not fully compensate the beneficiary unless the amount is grossed-up for the resulting tax liability A party who will be injured by a possible tax change can try to minimize the effect of such changes by investing in other investments that will benefit from the changes; that is, the party can try to hedge against possible changes in law. 64

7 7.6 Tax Planning When a Taxpayer's Marginal Rate is Strategy Dependent 7.7 Medical Savings Plans and Dynamic Tax Planning: An employee whose employer participates in a medical savings plan can agree to set aside a fixed amount (up to $2,500 per year) to be used for medical expenses including doctor and prescription copays along with elective procedures such as Lasik. Any amount not used by the employee within the annual period (often extended until March of the following year) is forfeited. As a result, putting too little into the medical savings plan costs the employee $t for each underfunded dollar but putting too much into the medical savings plan costs the employee $(1-t) for every dollar of overfunding. Suppose E anticipates medical expenses of either $1,000 or $1,400, each with a likelihood of 50%. How much should E set aside in E's medical savings plan? If E contributes $1,000, then E risks losing $400(t) with probability of one-half. For every dollar that E adds above $1,000, E risks losing $(1 t) and possibly saves $1(t), each with equal likelihood. Since t < 1/2, E should contribute only $1, Questions (p. 196) Question Part (a): True and false. "Effective tax rate" rarely is defined and often excludes important factors such as implicit taxes, the value of deferral, and exempt income Part (b): False. Deferred taxes should be included in the computation but appropriately discounted to present value Part (c): False. In the absence of tax rule restrictions and market frictions, all investments should yield the same risk-adjusted, after-tax return. But restrictions and frictions preclude much tax arbitrage Part (d): True unless tax rates are expected to increase in the future. For a firm without an NOL carryforward, an additional dollar of income will result in an immediate tax increase of $1(t now ), where t now = the current statutory tax rate. But if the firm has an NOL carryforward that is expected to be fully consumed in n years, then an additional dollar of income today will result in an additional tax liability of (t n ), where t n is the anticipated statutory tax rate in year n. Accordingly, the metr for such a firm equals t n /(1 + r) n, where r = the firm's after-tax discount rate Question 3: A low-tax firm should invest any spare cash in highly taxed securities (such as fully-taxed corporate bonds) and issue preferred or common stock to raise funds. Since stock is a tax-favored investment to many investors, stock bears implicit taxes through lower pretax rates of return and thus the issuer obtains an implicit tax subsidy. Low-tax firms should also lease assets rather than purchase assets because of the tax-favored depreciation treatment accorded plant and equipment. Prices of these assets will reflect the value of these tax benefits to high-tax rate taxpayers. Low-tax firms cannot efficiently utilize the tax benefits and thus will be paying high purchase prices with little tax benefit. Thus they should lease and if lease markets are competitive, some of 65

8 the tax benefits should accrue to lessees through lower lease rates. It often is cheaper to change capital structure than operating and investments in real assets (as opposed to investments in financial assets which generally can be sold in liquid markets) because of problems of hidden information and other transaction costs in selling real assets. Consider a firm facing lower future tax rates that decides to close a plant to realize losses while its tax rate is high. Such a decision may be extremely costly now. In addition, it will also be costly for the firm to reverse the decision and rebuild its labor force if it wishes to do so in the future Question 4: Computing a corporation s marginal tax rate is extremely difficult because (1) numerous investment and financing alternatives exist, (2) there is uncertainty about future tax rates, future tax rules, future IRS rulings, and the distribution of future income for any given investment and financing plan, and (3) tax rates are typically dependent on future and past investment, operating, and financing decisions. 7.9 Exercises (p. 197) Exercise 1: For firm 1, the expected marginal tax rate equals 0.50(40%) (0%), or 20%. For firm 2, the expected marginal tax rate equals 0.50(40%) (0%), or 20% Exercise Part (a): The $5 million is first carried back to year -3, then to year -2, and is then fully consumed in year -1. Accordingly, an additional dollar of income in the current year will reduce the carryback to year -1, reducing the refund by $1(30%). Thus, the answer is 30% Part (b): The current loss again will be fully consumed in year -1 so that the metr is the statutory rate in that year, or 30% Part (c): The current loss will not be fully consumed as a carryback, and so the current metr = str s /(1 + r) s, where the current loss is fully consumed in year s Tax-Planning Problems (p. 198) Problem 2: The effective tax rate reported in the firm s financial statements is calculated as the sum of currently payable and deferred tax expense divided by net income before tax. Both the numerator and the denominator exclude implicit taxes. Moreover, the tax expense figure is insensitive to the timing of tax payments (that is, a dollar of taxes paid currently is treated no differently from a dollar of taxes to be paid many years into the future) Problem 4: The advantage to the firm is clear: nondeductible dividends become deductible interest payments. But the cost to the investors is equally clear: for corporate investors, dividends received are lightly taxed (because at least 70% of a dividend received is deductible, reducing the tax rate from 35% to 30% of 35%, or 10.5%. For some corporate investors, the rate will decline to 7%). For individual investors, qualified dividends are taxed at only 20%. Thus, high- 66

9 bracket investors who paid a premium to get preferentially-taxed dividends will be dismayed to discover that they are receiving harshly-taxed interest. Note that the firm's reputation presumably will be injured: few investors will be willing to make a future equity investment if the prior equity investment turned out badly. Note also that managers who received bonuses based on profitability (that is, based on taxable income) also will be disadvantaged because dividends are nondeductible expenditures (that is, they do not reduce taxable income) while interest paid is deducible by the corporation, thereby reducing the bonuses Problem Part (a): If you do not make the price cut, your profit margin is 50%; that is, of every dollar you take in, half is a recovery of your cost and half is profit. If you reduce the sales price by 10%, you do not change your costs but you reduce your profit. For example, for every $100 in sales before the cut, you will now receive only $90. Of that $90, $50 remains your recovery of cost, leaving $40 of profit. Thus, on any items sold at the sale price, your profit margin is 4/9's. Ignoring the time value of money, we get the following pre-tax results: (a) from the cannibalized sales, profit is reduced from $500,000 to $400,000, for a loss of $100,000. On the normal sales, profit is cut from $400,000 to $320,000, for a loss of $80,000. But the new sales resulting from the price reduction yield an additional profit of 4/9 times $400,000, or $177,778. Thus, the net result is a loss of $2,222. But if we take taxes into account, the numbers look better: the tax savings from the cannibalized sales is $90,000 ($500,000 taxed at 50% as compared with $400,000 taxed at 40%, or $250,000 - $160,000), the tax savings from the normal sales is $32,000 ($400,000 taxed at 40% less $320,000 taxed at 40%, or $160,000 - $128,000), and the extra profit yields an extra tax of $71,111 ($177,778 taxed at 40%). Thus, the price reduction costs you $2,222 in pre-tax profit but saves $50,889 ($90,000 + $32,000 - $71,111), for a net after-tax gain of $60,889 - $2,222, or $48, Part (b): For purchasers who do not anticipate a change in tax rates (and again ignoring the time value of money), the price reduction saves them 10% of the cost of your product, making your product more desirable. But for purchasers who anticipate an increase in tax rates from 40% to 50% (and who can wait to purchase your software next year), the after-tax cost of the software actually increases if they accelerate their purchase from 50% next year to 60% of 90% (or 54%) this year. 67