Strategic Tax Management

ACT 123
Chapter 4
Chapter 4: FINANCING A NEW
VENTURE

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Chapter 4
Overview

 There are two basic forms of strategies for financing a business: internal financing and
external financing. Internal financing is a strategy where the company uses its retained
earnings to finance its new venture. Retained earnings are accumulated net income since the
corporation was formed that is retained after all distributions of dividends to stockholders.
Companies that purchases new property, plant, and equipment out of cash flows from
operations are using an Internal financing strategy.
 On the other hand, External financing is a strategy whereby cash comes from sources other
than the firm’s own positive cash flow. It comes in two different forms: debt or equity. Debt
financing may be in the form of short-term borrowing (e.g. purchase on account) or long-
term borrowing (e.g. bonds payable). Equity financing includes selling of business interest
to outside sources such as selling common stock to either new shareholders or existing ones
or selling partnership interest to new investors or receiving new contributions of capital from
existing partners.

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Chapter 4
COURSE MATERIAL -1:
INTERNAL FINANCING
 A company may use this strategy when it has available retained earnings to finance a
firm’s growth. However, as part of its long-run planning, an organization may plan to
transition from external to internal financing eventually.

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Chapter 4
COURSE MATERIAL -1:
STRATEGY
 Retained earnings are not generally subject to payout and control restrictions compared to
external financing. Debt financing requires periodic payment of interest. Equity financing
will dilute earnings per shares as well as control.

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Chapter 4
COURSE MATERIAL -1:
ANTICIPATION
 Anticipated tax law changes affect internal financing choice. For example, if income taxes
are expected to increase, the company must retain sufficient earnings to cover the expected
increase in income tax payments. Similarly, anticipated tax decreases will release
additional funds for internal financing.
 Using internal financing, the company can control the timing of tax benefits and
deductions in response to anticipated changes in the taxes. With the anticipated decrease in
corporate income tax from 30% to 25% until 2022, followed by a 1% reduction yearly
until 2027, the company can anticipate the loss on tax savings on planned plan expansion,
and act accordingly without lags to commit investment.

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Chapter 4
COURSE MATERIAL -1:
ANTICIPATION
 If the company is planning to acquire a property, plant, and equipment that costs P20
million with a residual value of 10% of the cost and a useful life of 10 years, the lost tax
savings would be
 Year of acquisition 2020 2022 2027
 Current Tax Rate 30% 30% 30%
 Anticipated Rates 30% 25% 20%
 Difference - 5% 10%
 Depreciation
 (P20 million x 90% /10) P1,800,000 P1,800,000 P1,800,000
 Tax Benefit - 90,000 180,000

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Chapter 4
COURSE MATERIAL -1:
ANTICIPATION
 The table shows the tax benefit that would be derived from acquiring the property. There is a tax benefit
because the depreciation from the property is tax deductible, thereby, reducing the income tax payable.
 Based on the foregoing, if the company acquires the property in 2022 where the corporate tax rate
dropped to 25%, it would lose P90,000 tax savings compared to when the property was acquired in
2020 where the tax rate is still 30%. When the property was acquired in 2027, the company would lose
P180,000.
 The decision to acquire the property would not solely depend on tax savings. The company would still
need to consider other circumstances to compute the net benefit of the acquisition.
 If the company has sufficient fund, it could readily acquire the property in 2020 without using external
financing. If internal funds are not sufficient, it can borrow from the banks or issue new equity. But it
may totally forego the tax savings and wait until internal funds are available if it thinks the costs of new
debt or new equity are higher than the tax savings. Note that there is less danger of losing such tax
benefits if the firm uses internal financing.

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Chapter 4
COURSE MATERIAL -1:
VALUE-ADDING

 The value added through internal financing is potentially higher than from external
financing. This is because neither the enhanced cash flows nor the increased value of the
firm is shared with anyone other than the original owners.

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Chapter 4
COURSE MATERIAL -1:
NEGOTIATIONS
 Negotiation of tax benefits is not really affected by the use of internal financing, but, as
also discussed later, it is an important factor in structuring debt financing.

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Chapter 4
COURSE MATERIAL -1:
TRANSFORMING
 While there are no direct transforming advantages to internal financing, there is a definite
advantage in the absence of transaction costs (as discussed in the next section). However,
increases in firm value are not usually taxed until there is an exchange transaction, such as
a sale of corporate stock. Thus, an internal financing strategy that bolsters the value of a
firm’s equity held by existing owners can be quite tax advantaged.

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Chapter 4
COURSE MATERIAL -2:
EXTERNAL FINANCING: DEBT VERSUS EQUITY

 Debt may be in the form of short-term debt or long-term debt. Short term debts are
expected to be settled within a year. It is characterized overall by higher interest rates than
long-term debt but can be interest free. Suppliers usually offer a credit term of 30 days
where buyers can purchase on account and can pay interest free for 30 days. Long-term
debt consists of bonds (secured by specific assets) and debentures (not secured by specific
assets).
 Equity financing may be in the form of contribution in cash or in property by partners in a
partnership or issuance of capital stock by a corporation. Owners of common stock most
often have voting control of the corporation, yet, they have residual interest in the assets of
the corporation. Owners of preferred stock usually have no voting rights but must be paid a
specific dividend before common stock get its shares.

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Chapter 4
COURSE MATERIAL -2:
STRATEGY

 Managers search for an optimal capital structure in the long run. The optimal capital
structure depends on the objective of the organization. A not-for-profit organization will
minimize its debt financing wile a for-profit organization will seek optimal debt-to-equity
mix to maximize shareholders’ wealth.

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 A key aspect of debt financing is leverage. Debt adds value when debt increases operating
cash flows in excess of the required periodic payments of interest and repayments of
principal. Also, firms with higher effective tax rates benefit more from debt because of the
tax shield.
 For example, ABC Company and XYZ Company have the following financial information:
ABC Company XYZ Company
Sales P100 million P100 million
Net Income 10 million 10 million
Assets 10 billion 10 billion
Debt 2 billion 7 billion
Common Stock 7 billion 2 billion
Retained Earnings 1 billion 1 billion

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 ABC Company may have a higher credit rating because of lowered debt. ABC’s appears to
have a healthier financial standing. In turn, higher credit rankings usually result in lower
costs of acquiring additional external financing. However, XYZ Company has a lower cost
of capital. If we assume that these companies operate in the Philippines and are subject to
corporate income tax rate of 30%, and the debt and equity investors demand a 10% pretax
return, the cost of capital would be:

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

ABC Company XYZ Company

Cost of Debt
Debt P2 billion P7 billion
Pre-Tax Required Return_____________ 10% 10% _
Total 200 million 700 million
Tax Savings (60 million) (210 million)
Net Cost of Debt 140 million 490 million
Cost of Equity
Common Stock P7 billion P2 billion
Pre-Tax Required Return____________ 10% 10% _
Total Cost of Debt 700 million 200 million
Total Cost of Debt and Equity 840 million 690 million

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 Under ABC’s capital structure, total annual cost of capital is P840 million. XYZ’ total
annual cost of capital is P690 million. XYZ saves P150 million compared to ABC.
Overtime, this extra cash flows, when reinvested, would give XYZ significant advantage
over ABC. This is a trade-off in the long run for having a healthier-appearing financial
structure.
 The higher the relative use of debt, the greater the risk of bankruptcy or costly debt
renegotiations. Debt financing is riskier than equity because of required periodic payments.
However, an income tax can act to mitigate some of this risk for investors, and this
lowered risk can be passed on to the firm in the form of lower interest rates. On the other
hand, dividends are not tax deductible.
 However, value-added decreases at some point because of lenders charging higher interest
rates for additional loans as the firm’s risk of default increases.

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 From the point of view of providers of fund, investing in equity is riskier than investing in debt. If the creditor
defaults on debt, the remaining balance becomes a tax-deductible loss to the lender. If the lender is in the
business of making loans, the loss is fully deductible. But if the lender is not in that business such as investment
in bonds, the loss is considered a capital loss, which is deductible only to the extent of capital gain. Moreover,
interest income from long-term investments (including bonds) issued by banks is tax-exempt. The gain from the
sale of a long-term investment (maturity of five years or more) is likewise tax exempt.
 Investing in equity is riskier, yet, there are possible tax offsets to reduce risk. Share price appreciation is not
taxable until the investments are sold. In case the stocks investments were sold directly to another investors,
any gain or loss on such a sale is considered capital gain or loss. If the sale results in a capital loss, such a loss
shall be deductible only to the extent of capital gains from the same type of transaction during the same period.
The resulting net capital gains shall be subject to 15 percent capital gains tax. Moreover, in case of liquidation,
only 50% of the capital gain is subject to basic income tax subject to holding period of more than 12 months.
But if the shares are sold through local tax exchange, a stock transaction tax of 0.6% on the gross selling price
shall be imposed, not income tax. Even if the sale results in a loss, such a loss is not deductible for tax
purposes.

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 For example, On January 1, 2021, Mr. A invested in P1 million for common stock in a
start-up company. The information on the company’s earnings and appreciation of the
investment is shown below.

End of Year Net Income of the Company Value of the Mr. A’s Investment
2021 P500,000 P1,500,000
2022 P1,000,000 P2,000,000
2023 P1,500,000 P3,500,000

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 If at the end of 2023, Mr. A sold his investment to Mr. B for P5,000,000, Mr. A will pay
P600,000 capital gains tax.

Proceeds P5,000,000
Cost of Investment (1,000,000)
Capital Gain 4,000,000
Capital Gain Tax Rate 15%
Capital Gain Tax P600,000.

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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 In case the company was liquidated at the end of 2023 and Mr. A received P5,000,000, the
tax implication would be

Proceeds P5,000,000
Cost of Investment 1,000,000
Capital Gain 5,000,000
Capital Gain Tax Rate 50%
Net Capital Gain Subject to Income Tax P2,500,000.

The net capital gain will form part of Mr. A’s gross income. If this is the only income of Mr. A,
the income tax payable using the graduated tax rates would be
First P2,000,000 490,000
Next P500,000 x 32% 160,000
Income Tax 650,000
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Chapter 4
COURSE MATERIAL -2:
VALUE-ADDING

 Moreover, if the shares of stock of the company is traded in a local stock exchange, the
gain on sale is not subject to income tax. But the sale transaction shall be subject to stock
transaction tax of 0.6% on the gross selling price. Hence, Mr. A would pay stock
transaction tax of P30,000 (P5,000,000 x 0.06%) if he sold the stocks through a stock
exchange.
 In sum, a company may secure more debts to get the advantage of a leveraged company
while only facings it disadvantages of having a higher financial risk. Moreover, the equity
investors may also find several alternatives of infusing capital to the company while
minimizing risks and maximizing shareholders’ wealth.

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Chapter 4 COURSE MATERIAL -2:
NEGOTIATING

 Tax benefits from losses suffered by start-up companies are good negotiating tool.
Businesses that suffer operating losses can get immediate tax benefits by carrying those
losses back to offset profits. Net Operating Loss (or the excess of allowable deduction over
gross income) may be carried over as deductions from gross income for the next three
consecutive years immediately following the year of such loss. If these tax deductions can
be transferred to investors, they will effectively reap a higher return on capital.
 For example, if a start-up company suffered P1,200,000 loss, the value of the write-off to
the new investor group is P360,000 (P1,200,000 x 30% Corporate Income Tax Rate). This
is akin to return on capital without receiving any cash flows from operation. Therefore, this
should be an acceptable investment, at least for year 1. From the firm’s perspective, debt at
the early stage has no tax benefit, so it should be willing to use debt only if the pretax cost
is lower than the after-tax cost of equity financing.

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Chapter 4 COURSE MATERIAL -2:
ANTICIPATION

 The company should anticipate macroeconomic changes that will affect interest rates or
tax- law changes affecting interest deductions or tax rates on investors. For example, the
TRAIN Law increases capital gains tax on direct sale of shares from previous 5% to 10%
to a flat rate of 15%. This means it would have been better off selling shares of stocks to
another investors before January 1, 2018, the effectivity of the TRAIN Law when the rate
is relatively lower. Moreover, under the TRAIN Law transfer of property pursuant to
Section 40(C)(2) of the NIRC is already exempt from VAT, hence, a sole proprietorship or
a partnership may defer the incorporation of its business until January 1, 2018 to avail the
tax-free exchange of property to a corporation by a person in exchange for stock or unit of
participation in such a corporation of which as a result of such exchange said person, alone
or together with others, not exceeding four (4) persons, gains control of said corporation. If
the company expects that interest rate will go up, the company is better off issuing debt
now.

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Chapter 4 COURSE MATERIAL -2:
ANTICIPATION

 With respect to timing issues, a key factor is how the firm’s (and potential investors’) tax
status is expected to change in the near future. If the company expects a decrease in
corporate income tax, then tax deductions for interest payments are of little use, and the
after-tax cost of equity capital may be cheaper than that for debt. If the capital gains tax
decreases, the investor will also favor a common stock investment.
 However, suppose the capital gains tax decreases but the company remains in a high tax
bracket, there would be a conflict of interests between the investors and the company. The
investors would favor common stock while the company favors debt. The firm and
potential investors thus must negotiate tax benefits in the form of adjusting pretax cash
flows.

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Chapter 4 COURSE MATERIAL -2:
ANTICIPATION

 In addition to timing, the time-value aspect of tax benefits is important in the capital
structure decision. For investors, timing of payments can be engineered so that payments
are made in a tax- minimizing way. Dividends can be paid when tax rates decline, or
limited dividends can be paid, so that much of the stock’s return is in the form of
appreciation. Thus, taxes are postponed and thus transformed into (lower-taxed) capital
gain income.
 For example, a company earns 10% return. If a shareholder has P1,000,000 worth of
stocks, it implies that the shareholder should receive P100,000 dividends each year. Since
the investor is subject to 10% final tax on dividends, he is better off receiving the
dividends for five years than selling the stock for P500,000 gain. If the investor has 10%
required rate of return, the after-tax present value of these alternatives is:

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Chapter 4 COURSE MATERIAL -2:
ANTICIPATION

Alternatives Cash Flows. Present Applicable After-Tax Present

Value Factor Tax Value of
Cash Flows

Yearly
Dividends 100,000 3.7908 10% 341,170.81

Sale at end
of year 5 500,000 0.6209 15% 263,891.56
Advantage of receiving yearly dividends 77,279.25
Yearly Dividends: 100,000 x 3.7908 x (1-10%)
Sale at end of year 5: 500,000 x 0.6209 x (1-15%)

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Chapter 4 COURSE MATERIAL -2:
ANTICIPATION

 Dividends are subject to 10% final tax while the net capital gain on direct sale of shares to buyer
is subject to 15% capital gains tax.
 However, if the company can plow the dividends back to boost its operation, where after 5 years,
the shares could be sold at P700,000, the after-tax present value of these alternatives is:

Alternatives Cash Flows. Present Applicable After-Tax Present Value

Factor Tax Value of Cash Flows

Yearly
Dividends 100,000 3.7908 10% 341,170.81

Sale at end
of year 5 700,000 0.6209 15% 369,277.38
Advantage of receiving yearly dividends 28,277.38

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Chapter 4 COURSE MATERIAL -2:
ANTICIPATION

 In this case, the investor is better off instead receiving no dividends for five years and then
selling the stock. Thus, if a corporation’s shareholders are willing to accept nominal
dividends in return for stock appreciation, the firm can dramatically increase the present
value of stock financing by paying out dividends only after a certain length of time.
 However, a closely held corporation must be careful not to accumulate excessive earnings
as it is subject to Improperly Accumulated Earnings Tax of 10%.
 The above situation cannot be applied in interest payments merely by paying interest at
maturity since interest income must be recognized periodically.

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Chapter 4
Effect of Clientele

 The optimal choice for capital structure is highly influenced by the tax status of investors
in a firm’s debt or equity. This is particularly the case where the investor clientele includes
those who do not pay tax at all. For example, dividends received from a domestic
corporation are tax-exempt. There are certain exempt corporations under Section 30 of the
NIRC. These are
1. Labor, agricultural or horticultural organization – non-profit
2. Mutual savings bank or cooperative bank – non-stock, non-profit, operated for mutual purposes
3. Beneficiary society, order, or association – operating for the exclusive benefits of their members;
includes fraternal organization operating under the lodge system; or mutual aid association or a
nonstock corporation organized by employees providing life, sickness, accident, or other benefits
exclusively to the members

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Chapter 4
Effect of Clientele

4. Cemetery company – owned and operated exclusively for the benefit

of its members
5. Non-stock corporation or association organized and operated
exclusively for religious, charitable, scientific, athletic, or
cultural purposes or for the rehabilitation of veterans, provided that no part of
its income or asset belong to or inure to the benefit of any individual
6. Business league, chamber of commerce, or board of trade – Non-profit;
no part of net income inures to the benefit of an individual
7. Civic league or organization – Non-profit; operating exclusively for the
promotion of social welfare

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Chapter 4
Effect of Clientele

8. Non-stock and non-profit educational institutions

9. Government educational institutions
10. Organizations of a purely local character whose income consists solely of
assessment, duties and fees collected from their members to meet expenses;
includes farmers’ or other mutual typhoon or fire insurance company, mutual ditch
or irrigation company and mutual or cooperative telephone company
11. Farmers’, fruit growers’, and like association – whose primary function is to
market the product of their members

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Chapter 4
Effect of Clientele

 In contrast to the situations just presented, tax-free investors may prefer current
distributions, such as dividends, to delayed cash flows (e.g., waiting to sell appreciated
stock to transform income into capital gains). They also may be indifferent to interest
versus dividends. If a firm knows that its clientele will be tax exempt, it can issue debt or
equity based on its own needs, disregarding investor tax status.

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Chapter 4
Transaction Cost Effects on Value-Adding

 Debt offerings typically are cheaper than equity (5% versus 10%, depending on
circumstances). Because these costs are present at each offering, it makes sense for the
firm to try to anticipate future capital needs in order to minimize the number of issuances.

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Chapter 4
Transforming

 By issuing stock or securities that are convertible to equity, firms can enable either
themselves or their investors to transform ordinary income into capital gains or taxable
income into nontaxable income.

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Chapter 4
Assessment: CHAPTER 4: FINANCING A
NEW VENTURE
 Select a publicly listed company. Provide an analysis of its capital structure. Highlight the
tax implications and the possible impact of the proposed Corporate Recovery and Tax
Incentives for Enterprises Act (CREATE Bill).

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End