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Influence of profit and investors' value taxation on financing decisions of Lithuanian companies Paulius Jūrelė1 Kaunas University of Technology Laisves av.55, LT-3000 Kaunas, Lithuania Abstract The first part of the paper reviews financial models and their empirical tests (such as Modigliani-Miller [1958; 1963], Miller [1977], DeAngelo and Masulis [1980], J.L.Berens and C.J.Cuny [1995], etc.), which analyse value of companies as a function of financing decisions and taxes paid by companies and their investors. Despite quite opposite conclusions of the models, it is obvious that value of the so called “debt tax shield” depends on taxation system, legal environment and operating risk. The analysis identifies an additional factor, which has not been covered by any of the reviewed authors – transfer pricing used by financial groups. The conclusion is, that in Lithuania financing decisions are inefficient and expensive mean of tax minimization due to the following reasons: 1) availability of other tax shields; 2) specifics of operations of large financial structures; 3) inefficient and illiquid capital markets; 4) uncertainty, risk, lack of information and limited planning opportunities. Introduction The definition of financing decisions, as it is used in the paper, comprises two elements: 1) The decisions determine ways how to attract recourses, which are necessary to support business operations and their growth; 2) The decisions have an influence on allocation of business value between certain groups of interests, such as state, shareholders, debtholders and employees. Financial economists still argue about influence of financing decisions on costs of capital and value of a company. Solution of the problem is the key in understanding the role of financiers in a company: are they able to create additional value by choosing appropriate financing decisions and financial instruments, but without interfering into main operations (manufacturing, trading or other activities). Researchers have specified various factors influencing financing decisions of companies, such as control, risks, management preferences, information asymmetry, growth and investments, conflicts of various interests, characteristics of shareholders and creditors, characteristics of assets and operations, etc. In this article the focus is put on the link between taxation, financing decisions and business value. As debt interest is tax-deductible cost item, it can be treated as income of capital 1 providers, which is subsidised by state. The term “profit tax shield” covers all the items, which are deductible from earnings before interest, taxes, depreciation and amortisation (EBITDA) for the purpose of tax base calculation. The profit tax shield allows to reduce the profit tax base and thus to reduce the value of business, which is allocated to the state in the form of profit tax. Profit tax shield includes such items as depreciation, interest, and other non-cash cost items. The purpose of the work is to find out, what is the impact of specific Lithuanian conditions on the tax management through financing decisions. The object of the analysis is Lithuanian conditions, such as legal and taxation system, economic situation and traditions, which determine decisions of Lithuanian companies. Methods of the research. Methods of scientific literature analysis, comparison and summarising were used in the research. On the basis of the theoretical analysis Lithuanian conditions were analysed, interpreted and summarised using logical methods. Profit taxation Theories of Mogidliani F. and Miller M. [1958 and 1963], known as MM theory, state, that market value of any company in efficient market depends only on its expected operating profit EBIT and its business risk and does not Tel. +370 7 45 17 38 E_mail address: [email protected] 1 depend on capital structure, if there s no state interference (i.e. profit taxation): Vunlev eraged Vlev eraged EBIT k0 (Equation 1) where k0 -capital costs of unleveraged company In the course of efficient market arbitrary process the prices of shares are set so, that lower costs of additional debt are offset by higher premium required by shareholders for financial risk. In efficient markets with profit taxation financing decisions do not influence value of companies, unless through profit tax savings: VLEVERED VUNLEVERED t PROFIT x D ; (Equation 2) where tPROFIT - profit tax rate, and D-market value of debt. The product tPROFIT D is called debt tax shield and indicates tax savings related with the debt. Thus optimal capital structure shall be 100% debt, because interest is tax deductible. However, even authors of the theory recognize existence of actual internal and external limitations on maximum possible leverage. Empirical researches of the debt tax shield result in quite opposite results. Mogidliani F. And Miller M. [1966] conducted a research to support their theory, which evidenced that assets make only 68,1-75,9% of companies value. Growth opportunities add additional 2,3-10% and debt tax shield - 22,6-23,7% of the value. Masulis [1980] found decline of shares prices after conversion of debt into equity. Equity-into-debt-conversion increases share prices. However, it is doubtful if the results of the research can be explained only by the influence of financial leverage. Changes of financial leverage transfer to the market signals about expected profitability. The theory of Myers-Majluf [1984] states, that top-managers will issue the securities, which are undervalued at the time of issue. In such a case the information effect overcomes the leverage effect. The above doubts about the value of debt tax shield are confirmed by other researches. Eckbo [1986] (quoted by Fama & French [1997] analyzed the companies, which debt increased and equity remained at similar level. Price increase was insignificant and much smaller than we could expect according to the MM theory. Fama and Frech [1997] tried to solve the above problem by including into their regressions proxies for both profitability and financial leverage. However the regressions indicated negative relationship between financial leverage and Tobin Q2 ratio. The authors concluded that their regressions failed to separate net effect of debt tax shield and signalling effects of leverage decisions overcame it. Many researchers of financial leverage face similar problem, because financing decisions linked not only to taxation, but also to conflicts of interests, risk and related thereto agency costs, etc. Actually, up to the date the author of the article is not aware of any empirical research, which managed to solve the problem without deficiencies. Investors' taxation In 1977 Merton Miller modified the MM model by introducing taxation of investors. Tax rates on shareholders’ income (tEQUITY) are lower than rates on creditors’ income (tINTEREST), due to capital gains taxation specifics. Therefore value of debt tax shield is much lower and is calculated according to the following formula: (1 t P )(1 t EQUITY ) PVDEBT TAX SHIELD 1 D 1 t INTEREST Equation 3 Value of debt tax shield could disappear at all, if the following equity is valid: 1 t INTEREST (1 t P )(1 t EQUITY ) 2 Tobin Q is calculated by dividing total market value of debt and shares by the total value of assets. 2 Equation 4 Main reason of difference in taxation of shareholders and debt holders is lower tax rate on capital gains and deferred tax on capital gains until the securities are sold. According to the theory, due to taxation dividends should be less attractive to investors. The hypothesis is confirmed by the research of Elton & Grubber [1970]. The research proved, that after announcement of dividends the prices of shares fall down by the amount, which is insignificantly lower than the amount of dividends. On the other hand, research made by Eades, Hess and Kim proves, that the effect cannot be explained only by taxes. They showed similar decrease of shares after announcement of shares dividend, despite the fact that share dividends have no tax consequences. Miller and Scholes [1978, 1982] proved, that taxation of dividends has no consequences on value, because USA laws provide certain opportunities to avoid the dividends taxation. Anyway, the original theory of Merton Miller [1977] proposed to segment investors according to their marginal rate of borrowing, which depends on taxation of specific investors. Therefore, certain authors even mention “marketing” of securities, when securities are oriented towards needs of certain segments. Other tax shields and actual profit tax rates De Angelo and Masulis [1980] proposed a theory, which takes into account other profit tax shields, such as investments and depreciation. Their conclusion is that the higher debt amount, the higher possibility that a part of debt tax shield is unused due to other available tax shields. Furthermore, they proposed to segment market according to different marginal borrowing costs, which depend on level of other tax shields and taxation specifics. The theory of De Angelo and Masulis [1980] is confirmed by analysis of USA treasury data (Cordes and Sheffrin [1983], quoted by Koutsoyiannis A [1992]). It indicated differences in actual profit tax rates in various industries. The highest actual profit tax rate is in the tobacco industry (45%), and the lowest one – in agricultural and transport companies (16%). Empirical studies of M.Mason [1990] and Graham [1996] (quoted by Fama and French [1997]) proved that companies with high marginal profit tax rates prefer debt financing. * J.L.Berens and C.J.Cuny [1995] proposed a theoretical model with carry-forward and carry-backward of tax losses, which is unlimited in time. The authors conclude, that company cannot totally cover its current taxable profit due to uncertainty and growth. However, average tax rate with carry-forwards and carry-backwards of tax losses is (1+g)/g times smaller than normally. Forecasting the future: growth, risks and uncertainty Consideration of dynamics modifies theories of capital structure in the following aspects: 1. The real level of financial leverage is characterised only by ratios, which are based on cash flows or profit (loss) statements data. Debt/total value ratios distort the picture, because value of shares include value of growth, while value of debt takes into account only non-growing stream of interest. Optimal capital structure is reached, when tax shields cover the whole operating profit. A company can reach optimal coverage of operating profit by choosing different financial instruments, i.e. various debt/total value ratios can be qualified as optimal. 2. Optimal capital structure depends on specific moment of time, because in the presence of the real growth and inflation, amount of the coverable profit will vary from period to period. J.L.Berens and C.J.Cuny proposed the formula, which takes into account influence of growth: PVDEBT TAX SHIELD = t P D r r -g 3 Equation 5 Where r is nominal risk free rate of return, g growth of operating profit, D – market value of debt, tp profit tax rate. The higher the growth, the higher value of debt tax shield. Firms, which grow faster, can reach full and optimal profit coverage under lower debt/value ratio. 3. Growth consists of the growth due to inflation and the real growth. Inflation reduces value of shareholders and value of debt tax shield due to the following reasons: Taxes of capital gains are charged on nominal increase of value, although the real increase is much lower. Thus a part of the growth accrues to government. Depreciation is calculated on historical value of assets, which is not usually indexed to adjust for inflation. Thus the real value of depreciation tax shield is lower. While investment depends on current replacement value of assets, a lag between investment and depreciation appears. 4. More stable companies can keep higher financial leverage. Possibility Possibilities of financial distress Stable company Risky company CEXPECTED C Figure 1. Statistical distribution of operating profit before depreciation and financial risk Certain periods are possible, when operating profit before depreciation falls bellow the sum of depreciation and interest payable. Most authors, such as Modigliani and Miller, J.L.Berens and C.J.Cuny, etc., assumed, that bankruptcy never occurs. If during any period company is not able to cover all its obligations under debt contracts, creditors agree to postpone some payments, because they believe that downturn is only temporary and that later the company will earn its average expected earnings. Target optimal level of interest is reached, when operating profit before depreciation is not greater than the sum of depreciation and interest. J.L.Berens and C.J.Cuny concluded, that level of financial leverage is determined by the three factors: personal and corporate tax rates; level of tax shields other than debt; probability distribution function of company’s operating profit. Analysis of Lithuanian conditions The review of theories leads to the conclusion that application opportunities of the models reviewed depend on certain exogenous variables that describe general economic conditions, tax system and legal regulation. 1. Profit taxation. Generally, profit taxation is described by two variables: profit tax base (TE – taxable earnings) and profit tax rate t. The research of profit taxation of Lithuanian non-financial companies listed on Current and Official lists of Lithuanian Stock Exchange has lead to the following results (Table 1 and Fig. 2): a. Financial earnings before taxation EBT (as shown in profit and loss statements) are summarised by industries in the Table 1. Total EBT diminished every year since 1997 and in 1999 it made only half of the 1997 level. EBT diminished in all industries, except slight increase in light industry and similar level of port related and other industries. The fact might have two implications: (i) either operational effectiveness suffered during the period; or (ii) companies are using more tax shield to reduce their tax base. 4 Table 1. Earnings before profit taxes EBT of companies listed in the official and current lists of Lithuanian national stock exchange*, mio Litas Earnings before taxes EBT, mio Litas Change Change between 1999 between 1999 Industry 1995 1996 1997 1998 1999 and 1995 and 1996 Beer and alcohol 118,7 99,7 91,4 64,4 34,1 -71% -66% Chemistry -24,7 3,6 65,2 -33,8 -177,6 620% -5037% Electronics -13,1 52,5 20,5 13,5 10,7 -181% -80% Energy -40,2 313,4 -6,6 133,9 109,7 -373% -65% Other (trade, telecom, etc.) -9,3 92,8 146,5 214,8 192,7 -2177% 108% Light industry 2,6 16,2 11,2 18,3 20,7 688% 28% Wood products 6,7 1,5 3,1 3,8 -3,7 -155% -347% Milk processing 35,1 38,0 48,6 56,0 20,0 -43% -47% Construction 0,3 5,2 2,7 5,7 3,4 969% -35% Port related industry 156,7 117,3 200,8 66,1 108,9 -31% -7% Grand total 232,8 740,2 583,3 542,6 318,9 37% -57% Change of grand total per year 218% -21% -7% -41% *Excluding financial companies, AB “Sanitas” and AB “Alytaus tekstilė” b. Material change in tax base calculation c. Official nominal profit tax rate made 29% until requirements occurred in July 1998, when: (i) 1st January 2000, later it was reduced to 24%. investment tax credit ("zero tax rate" and Furthermore it is unclear, what profit taxation "depreciation in advance") was introduced; and will remain in future and if it will remain at all. (ii) 5-year carry forward of tax losses was Actual profit tax rate diminished during all the allowed. The Grand Total line of Figure 1 period. The steepest reduction (total average explicitly indicates the related reduction of actual tax rate diminished to 4-5%) accrued in actual profit tax rate. 1998 after the above-mentioned legal changes. 5 Figure 2. Actual tax rate of companies listed in the official and current lists of Lithuanian national stock exchange 48% 45% 43% 40% 38% 35% 33% 30% 28% 25% 23% 20% 18% 15% 13% 10% 8% 5% 3% 0% Beer and alcohol Chemistry Electronics Energy Other Light industry Wood products M ilk processing Construction Port related industry Grand total 1995 1996 1997 1998 1999 2000** *Excluding financial companies, AB “Sanitas” and AB “Alytaus tekstilė” ** data, which was available on 15th February, 2001 Actual profit tax rate varies across different industries. The highest tax rates are paid by alcohol and beer industry (average 14%) and light industry (average 11%) and wood products. Other industries paid tax rates, which are far bellowing average. Profit distribution policy, investment policy and other tax shields available can explain the differences in profit taxation. Generally, the research indicates relatively low and diminishing profit taxation importance in making corporate finance decisions. However, profit tax rates vary significantly in different companies and industries – the fact leaves enough space for financial leverage application in certain companies. 2. Personal taxes. According to Miller [1977] investors’ taxation is described by two variables – tax rate of interest and tax rate of equity holders’ income. In Lithuania interest paid by companies to natural persons is taxed at 20% rate, but interest paid and received by banks is not taxed. Dividends paid to natural and legal persons are taxed at 29% rate and are deducted and paid by the company, which pays out the dividends. Profit, which is paid out as dividends, is subject to profit tax. However, taxable income can be reduced by the amount of dividend taxes, but no more than total profit tax of the period. Capital gains received by natural persons are not taxed. Analysis or Lithuanian conditions has shown: Personal taxes do not change value of debt tax shield (consistently with MM [1963]), if the creditor is a bank. Personal taxes make the value of debt tax shield (according to MM [1963]) negligibly small, if the creditor is natural person. Dividends are taxed more than capital gains; therefore reinvestment and subsequent capital gains are more favourable to investors. Higher leverage makes shareholders to defer their dividends and thus save taxes. On the other hand, considering low liquidity of Lithuanian stock market, explicit risk of capital gain realisation exists. Influence of financial groups None of the reviewed capital structure theories takes into consideration a very important factor transfer pricing used by financial groups. Shareholders, who control companies, receive an additional value. From the point of view of cost and management accounting the additional value received by controlling shareholders have the following features: * Researchers 3 have proved, that value of a company depends on both structure and characteristics of shareholders. Thus we can suppose, for example, “active monitoring hypothesis” of Schleifer and Vishny [1986]; theories of “agency costs reduction” and “management entrenchment” of Jensen nad Meckling [1976]; theories of Fama and Jensen [1983], cited byT.J.Brailsford and others [1998] 3 6 that shareholders, whose actions, services and abilities increase company’s value, are entitled to some additional benefits. However, actually it is complicated to measure the real value of such management services. * According to economical logic, such a transfer of a part of operating profit to shareholders is nothing else, but capital costs. * From the point of view of bookkeeping, these additional capital costs are reflected as a decrease of operating profit (in a form of either increased expenses or decreased income). * The task of judgement about such additional value, which is received by controlling shareholders, only from traditional financial reports is complicated or even impossible. Even if legal requirements become stricter, creativity of financiers and lawyers will advance simultaneously. Extent of transfer pricing can be evaluated only if adequate requirements for consolidation, disclosure of information and definition of related parties are valid and applied. Existence of financial groups makes the following corrections to the theory of capital structure: 1) Separation of financing sources only to debt and equity becomes insufficient. Shareholders shall be divided according to their control power (for example, into controlling and minor shareholders). Controlling shareholders always receive additional benefit in a form of transfer pricing, which they do not share with minor shareholders. Thus value received by shareholders depends on the level of control, and shareholdings of various sizes imply different capital costs. 2) Transfer pricing, as a mean of profit tax minimisation, modifies the task of tax minimisation financial group can increase an operating profit in the company, which has more available tax shields (such as investment tax credits, depreciation, interest, past tax losses, etc.). Thus profit, which is exposed to taxation, firstly can be covered by other tax shields, then by transfer pricing and the rest part, if any, - by interest. 3) If we continue to keep on the statement of MM theory, that capital structure has no other influence on valuation of company, except through debt tax shield, we can distinct two strategies of corporate and investors' taxes minimisation: a) For controlling shareholders, transfer pricing, who allows optimally utilise tax shields available to several distinct companies of the same financial group, is the most appropriate form of value distribution. b) For small non-controlling shareholders, increase in value of their shares, which is taxed at lower rate than dividends, is the most appropriate form of value distribution. 4) Free and active circulation of company's shares is vital for small shareholders, because it allows to mark-up and realize their capital gains at any time. However, free circulation of company's shares above certain level is extremely inappropriate to large shareholders, because it exposes their control to risk. Two systems of companies' management are distincted (Steponkus G., 2000): market-oriented (Anglo-Saxon and partly - Latin countries), where an active stock exchange serves as a mechanism for independent shareholders to influence management of companies; network-oriented (German and several other European countries), where a group of oligarchs make management decisions through a network of stable relations. State of balance between interests of major and minor shareholders shall depend on the following factors: a) Structure and characteristics of shareholders in a certain company. In Lithuania top-managers often coincide with major shareholders as a result of privatisation process. Major part of foreign investors is from the former Soviet Union, German and other European countries, where network-oriented systems dominate. b) Legal requirements. There are no consolidation requirements for Lithuanian companies, except banks, and no special laws, regulating operations of financial structures. Our laws set very limited benchmarks for transfer pricing. We can summarise, that both Lithuanian laws and privatisation processes are more appropriate to large shareholders. However, in developed countries (including European Community) market-oriented system is treated as more efficient and legal regulation is developed to make it more appropriate for small shareholders. c) Importance of public capital markets to specific company and to total economy of the country. According to the data of the IMF4 for three quarters of 1999, capitalisation of stock exchanges in Anglo-Saxon countries made 82,1% of GDP, and in German - 41,7%. But in Lithuania the ratio was only 13,6% and it evidences low opportunities of financing in Lithuanian stock exchange, and only minor free circulation of companies' shares. d) Requirements, control and motivation of companies managers. If managers are appointed, controlled and motivated mainly by controlling shareholders, and no leveraging power exists, then 4 cited by Steponkus G. [2000] 7 the main objective of management becomes maximisation of the value, which is distributable not to all shareholders, but only to a part of them (mainly controlling shareholders). Currently processes of ownership consolidation and strengthening take place in Lithuania; therefore influence of financial groups, as discussed previously, is really significant. Maybe, the most efficient mechanism to leverage interests of small and large shareholders is free circulation of shares above certain level. However, only several such companies can be distincted in our country. Such conditions, when earnings depend on the level of control, but not on the amount of investment, frighten away many small portfolio-oriented investors. In such a case, the main function of financial structure is not to maximise value of all shareholders, but to ensure financing of a company by simultaneously maintaining maximum control. Friction in capital markets. The MM statement regarding efficient arbitrary process, which forms real prices of securities, is valid only under insignificant friction in capital markets. Limitations of Lithuanian capital markets determine low liquidity of securities, and therefore costs of transactions are significant. The fact has the following implications: i) high transaction costs decrease present value of debt tax shield significantly; ii) inefficient arbitrary process in our capital markets often puts to question the MM statement, that financing structure influences company’s value only through taxes, and other its influence is eliminated in the course of efficient market arbitration; iii) due to ineffective arbitrage, decisions regarding profit distribution and reinvestment will not reflect market prices of shares in every case. iv) Free and active circulation of company's shares is very useful for small shareholders, because it allows mark-up and realizing their capital gains at any time. However, free circulation of company's shares above certain level is extremely inappropriate to large shareholders, because it exposes their control to risk. Signalling effect In the absence of the signalling effect managers, shareholders and other participants of capital markets have equal information and homogenous expectations about future of any company. However, in Lithuania transparency of company’s is rather low, and laws, which regulate disclosure and use of information, function inefficiently, therefore shareholders, which control information, can receive higher benefit. Under such conditions, only control can ensure complete information. Small shareholders have no complete information, as they cannot control and monitor operations. Thus increased agency costs reduce present value of debt tax shield, which is valuable only to small shareholders, as discussed above. Risk and bankruptcy costs Lack of information and transparency, as mentioned above, increases uncertainty of the future. Furthermore, Lithuanian companies operate in more risky environment (Lithuanian credit rating fluctuates on the margin between speculative and investment rates.) Present value of debt tax shield decreases, if uncertainty and risk increase. Even if any company goes bankrupt due to financial leverage, main operations of the company are continued - company is simply restructured (for example its shareholders or its capital structure is changed). Thus, “costs of restructuring” is more precise term instead of “costs of bankruptcy”. Researchers have shown, that these costs in Western companies make 10-15% of total company value. Low liquidity of both fixed production and financial assets in Lithuania determine relatively high costs of restructuring, including costs of operations suspension. Such a situation influences both shareholders’ and creditors’ very conservative understanding of financial leverage increase. Conclusions Under certain assumptions, a company can save taxes and increase its value by choosing the appropriate capital structure. Effectiveness of various tax shields (including debt tax shield) depends on tax, legal system and economic traditions of specific country. Therefore, existence and application of optimal capital structure shall vary in different countries. Calculation of capital costs shall take into consideration the segmentation of shareholders according to their level of control. Level of control influences value of shares and respectively - strategy of financing. Analysis has shown, that different industries and even different companies inside the same industry pay different actual profit tax rates, ant this is determined by different tax shields available. Lithuanian companies have available other than debt tax shields, such as investment tax credits, depreciation, carry forward of losses, etc., which are relatively more efficient and lower-costing. Review of profit and its direct/indirect distribution taxation has shown that larger part of taxes is on shoulders of natural persons, but not companies. Under current taxation system small 8 shareholders can receive significant benefit from debt tax shield. For small shareholders to capture value of debt tax shield, efficient and liquid capital markets, where real prices of shares are formed, are necessary. Furthermore, in order to make precise evaluations of future earnings and their risk, small shareholders shall be quite well informed about operations of companies. As these conditions in Lithuania are weak, present value of debt tax shield reduces significantly. Debt tax shield is negligible for large financial groups, which by transfer pricing can utilize different levels of tax shields are available to different companies of the group. Due to legal regulation, traditions, weak capital markets and specifics of shareholders, in Lithuania managers of companies focus more on interests of large shareholders. In the future balance between interests of minor and major shareholders will depend on development of each of the above factors. We can summarize, that for Lithuanian companies capital structure is inefficient and seldom applied mean of tax minimization due to the following reasons: 1) availability of other low-costing and more efficient means of tax management; 2) uncertainty, lack of transparent information and limited planning; 3) specifics of transfer pricing used by financial groups. 8. Modigliani F. and Miller M.. (1963). Corporate income taxes and the cost of capital: a correction // American Economic Review, June 1963, 433-442. 9. Steponkus G. (2000) Bendrovių valdymo kultūros įtaka kapitalo rinkos plėtrai // Verslo žinios, Nr.57. References 1. Berens J.L. and Cuny Ch.J. (1995). 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