In the context of
corporate finance
Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analy ...
, 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
Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...
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
In economics, personal income refers to the total earnings of an individual from various sources such as wages, investment ventures, and other sources of income. It encompasses all the products and money received by an individual.
Personal inco ...
.
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
A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...
, 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.
Graham, John, "How big are the Tax Benefits of Debt" The Journal of Finance, 2000.
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This tax-related encouragement of debt financing has not gone uncriticized.[Richard T. Page]
"Foolish Revenge or Shrewd Regulation? Financial-Industry Tax Law Reforms Proposed in the Wake of the Financial Crisis?"
85 Tul. L. Rev. 191 (2010). For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code
The Internal Revenue Code of 1986 (IRC), is the domestic portion of federal statutory tax law in the United States. It is codified in statute as Title 26 of the United States Code. The IRC is organized topically into subtitles and sections, co ...
's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.
See also
* Trade-Off Theory
*Capital structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
*Dividend tax
A dividend tax is a tax imposed by a jurisdiction on dividends paid by a corporation to its shareholders (stockholders). The primary tax liability is that of the shareholder, though a tax obligation may also be imposed on the corporation in the f ...
References
{{debt
Corporate taxation
Debt