Finance:Tax benefits of debt
In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems around the world, and until recently under the United States tax system , firms are taxed on their profits and individuals are taxed on their personal income. For example, a firm that earns $100 in profits in the United States would have to pay around $30 in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say $20 on the $70 of dividends. The $100 of profits turned into $50 of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30. This implies for $100 of profits before taxes, investors got $70.[1][2]
This tax-related encouragement of debt financing has not gone uncriticized.[3] For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.[3]
See also
- Trade-Off Theory
- Capital structure
- Dividend tax
References
- ↑ Graham, John R. (2000). "How Big Are the Tax Benefits of Debt?" (in en). The Journal of Finance 55 (5): 1901–1941. doi:10.1111/0022-1082.00277. ISSN 1540-6261. http://faculty.fuqua.duke.edu/~jgraham/HowBigFinalJF.pdf.
- ↑ "EBITDA - Financial Glossary" (in en). http://glossary.reuters.com/index.php/EBITDA.
- ↑ 3.0 3.1 Page, Richard T. (2010). "Foolish Revenge or Shrewd Regulation? Financial-Industry Tax Law Reforms Proposed in the Wake of the Financial Crisis?". Tul. L. Rev. 85: 191. https://ssrn.com/abstract=1724530.
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