Preferred Stock and Taxes

Journal of B u r i n m Finance @ Accounfing, 18(1), January 1991, 0306-686X 82.50

PREFERRED STOCK AND TAXES

IRAJ FOOLADI, PATRICIA MCGRAW AND GORDON s. ROBERTS*

INTRODUCTION

Miller’s (1977) seminal paper on ‘debt and taxes’ has spawned numerous extensions and empirical tests. However, the overwhelming majority are conducted in a US context and focus on the choice between debt and equity.’ Researchers have paid relatively little attention to the motivation for using capital structure instruments other than debt and equity or to comparative applications under various European tax regimes.

One exception is a recent paper by Fooladi and Roberts (1986) which develops a tax-motivated equilibrium for preferred shares. Modeling personal as well as corporate taxes, they follow the logic developed by Miller (1977) and extended by Fung and Theobald (1984) to analyze the existence of preferred shares as an alternative to debt under the US and Canadian tax systems as they existed prior to 1986.

In this paper we extend their model to incorporate the tax regimes of Germany, the United Kingdom, France and Denmark. Following Fooladi. and Roberts (1986), we take as given that debt has a place in corporate capital structure and show why preferred stock is not necessarily ‘a bond with a tax disadvantage’. The analysis does not address the relative merits of preferred versus common stock.

We begin our analysis by stating general conditions under which corporations are willing to supply and investors are willing to demand preferred shares. These combine to create a market equilibrium in the presence of corporate and personal taxes characterized by a positive amount of preferred shares. Based on this equilibirum, we develop empirical implications for each of the six countries.

SUPPLY AND DEMAND FOR PREFERRED STOCK

Like Fooladi and Roberts (1986), we assume complete and efficient capital markets in which the supply of securities is determined by firms as they seek

*The authors are respectively, Associate Professor in the Department of Finance; Research Associate; and Bank of Montreal Professor of Finance; all at Dalhousie University. They are grateful for linancial support from the Social Sciences and Humanities Research Council of Canada. Helpful comments were received from the anonymous referee and from Colin Dodd, Edgar Scott, Peter Secord, Lenos Trigeorgis and Y.B. Yalawar as well as from audiences at the Financial Management, North American Economic and Finance and European Finance Associations. (Paper received June 1988, revised March 1989)

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100 FOOLADI, McGRAW AND ROBERTS

to maximize their values. When demanding securities, investors base their choices on after-tax returns.

The firm's value depends on after-tax flows to all investors and on the rate at which these flows are discounted and is equal to2

where

In this equation, notation follows Fooladi and Roberts (1986) V, firm's value; NOZ, net operating income; B, P , amount of debt and preferred stock, respectively; T,, Td, Th, corporate tax on retained earning, on distributed income, and withholding tax respectively; t,, tb, t p , personal tax rates of stockholders, bondholders, and preferred shareholders, respectively; r , rb, rp, after-tax rates of return on stock, bonds, and preferreds, respectively; K,, Kb, Kp , before tax cost of stock, bonds (interest rate), and preferreds, respectively.

On the demand side, assuming preferred stock and debt have the same certainty equivalent return for non-taxpaying investors, a taxpaying investor finds preferred stocks more attractive than bonds when

The derivation in the Appendix shows that for preferred stock to be supplied by value-maximizing firms and demanded by investors, the following expression must hold for at least some sellers and buyer^.^

If dividends and interest are taxed at the same rate, ( t p 7 t b ) , equation ( 3 ) holds as an equality, provided the corporate tax rates on distributed income and withholding tax, Td and Th, are zero. Firms are able to issue preferred stock because, in this case, there is no difference between tax shelter advantages to debt and preferred stocks.

More generally, when firms do pay taxes (T, and/or Th > 0) and dividends and interest are taxed identically, the inequality fails to hold and no preferred shares will be issued in the absence of other non-monetary advantages in issuing preferred shares. On the other hand, if, for some investors, preferred dividends are more lightly taxed than interest ( tp < t b ) , then equation ( 3 ) shows that it becomes possible for some tax-paying firms to issue preferred stock which will be attractive to some taxpaying investors. So, as one possible way to explain preferred stock issues, one may look to the differential personal tax treatment of preferred dividends and interest in different tax regimes.

PREFERRED STOCK AND TAXES 101

DIFFERENTIAL TAXES IN DIFFERENT COUNTRIES

We can now use equation (3) to examine the tax climate for preferred shares in six countries. Tax laws evolve over time and in the rest of this paper we model tax regulations in place in 1986. Other things being equal, we predict that those countries for which the expression holds as a strong inequality are more likely to exhibit significant use of preferred stock as a financing source.

The United States

In the US the tax codes favor corporate investors. By applying for an exemption, firms can avoid any withholding tax on dividends (Th = 0) and there is no difference between corporate taxes on retained earnings and distributed income (T, = Td). Interest income is fully taxable in the hands of individuals as well as corporations holding debt issued by other corporations. Corporations may exclude from taxable income 85 percent of dividends received from taxable domestic corporations. The effective tax rate on dividends received from another corporation, tp, is only 6.9 percent: 46 percent times (1 -0.85).

Substituting into equation (3) produces the result that as long as a corporation is paying tax at less than 42 percent (T, < 42%), it can issue preferred stock for an after-tax cost below the after-tax cost of debt and these will carry an after-tax yield attractive to corporate investors.

Canada

As in the US, there is no withholding tax on dividends, no difference between tax rates on distributed and non-distributed profits, and interest income received by a corporation is fully taxable. Dividends received by one Canadian corporation from another are fully exempt from corporate income tax. As a result, all it takes for a transaction in preferred shares between two Canadian corporations to take place (based on equation (3)) is for the issuing firm to be in a lower effective tax bracket than the purchaser.

Taking individual investors into consideration, the only tax relief available for interest is an exemption on the first $1,000 received. Otherwise, interest is fully taxed. Dividend income is also eligible for this exemption and, in addition, dividends received from Canadian corporations by individuals give rise to a dividend tax redi it.^ The tax rate on interest income is

where t is the investor’s federal tax rate and Pt is the provincial tax rate added as a flat percentage of federal tax with the percentage varying across provinces.

Canadian tax law provides for a dividend tax credit under which dividends received are multiplied by a factor of 1.5 (grossed up by 50 percent) and shareholders are entitled to a federal tax credit of 22;percent of the new total


(34 percent of the dividends). This makes the effective tax rate on dividends

tp = (1.5t-0.34)(1 + P l ) . ( 5 )

The maximum federal tax bracket ( t ) in Canada is 34 percent, and it follows that tp < t b for all Canadian individuals. Substituting from equations ( 4 ) and ( 5 ) and considering that for Canada T, = Td and Th = 0, equation ( 3 ) may be rewritten as

( l - T c ) Z ( l - t ( l +Pf ) ) / (1 - (1 .5 t -0 .34 ) (1 + P f ) ) . ( 6 )

Solving the right-hand side of inequality (6 ) repeatedly for different individuals with different federal tax rates for 1986 and for each province produces a range from 0.63 to 0.69. It follows that firms paying combined federal-provincial income tax at rates under 37 percent are able to supply preferreds at rates attractive to some individuals.

West Gemzany

In West Germany the tax system introduces a dual tax rate on corporations. While the normal tax rate for corporations, T,, is 56 percent, the tax rate on distributed profits, Td, is only 36 p e r ~ e n t . ~ (The tax rate for corporations subject to limited tax liability is 50 percent.) In addition, a 25 percent withholding tax is deducted at source from the dividends paid to shareholders. Stockholders are deemed to receive the dividends gross of both corporate and withholding taxes. However, both these taxes may be claimed by shareholders as a credit against their tax bills.

Incorporating this information into our model shows that the effective tax rate on dividends received by investors is

Therefore, for West Germany, inequality (3 ) reduces to

( l - T d ) ( l - T h ) ( l - T d ) ( l - T h ) (8)

which means, in this country, the condition for a market for preferred stock is only marginally satisfied. Investors in West Germany face a higher tax rate on equity income at the corporate level, but this higher tax rate is exactly offset by a lower tax rate at the personal level.

United Kingdom

In the United Kingdom, the tax rate for corporations is 40 percent regardless of whether income is retained or distributed (i.e., T, = T d ) . 6 Dividends paid by a UK company are subject to no withholding tax, but an advance corporation tax (ACT) must be paid at a rate of 3/7th (42.9%), or 30 percent of the grossed


up dividend. This ACT may then be offset against the corporate tax due on the company’s taxable income. Individual investors are deemed to receive the net dividend and the ACT, but can obtain a tax credit against their personal liability equivalent to the ACT. Dividends received by a U K company from other UK companies are tax free but are eligible for the same tax credit.

Incorporating the unique feature of the UK tax system (T, = Td Th = 0 , and an advance tax rate of TA) into the model presented above reveals that, for an individual investor who earns a dividend of D but is deemed to receive Dl(1- TA) and is entitled to a credit of DTAl(1- TA), the effective tax rate on preferred is tp = ( t b - TA)/(l- TA). Substituting for tp, Td and Th in (3) produces T, 5 TA as a condition for sale of new preferred shares to individuals in the UK. That is, other things being equal, any firm whose effective corporate tax rate, at the time of issue, is less than the basic ACT, is able to issue preferred stocks that are attractive to individuals, regardless of their tax brackets.

Turning to corporations, the exclusion of dividends from taxable income in calculation of corporate taxes makes purchasing preferred shares more attractive than buying bonds to UK companies. Based on (3), the only condition for a preferred shares transaction between two companies is that, at the time of issue, the issuer faces an effective tax rate which is lower than 70 percent of the buyer’s tax rate plus 30 percent.

France

In France the corporate income tax rate is 50 percent, regardless of whether income is retained or distributed, and (except in special cases) there is no withholding tax (i.e., Td = T, and Th = 0). The philosophy behind the French system is that 50 percent of the French corporate income tax should be refunded to the shareholders. Therefore, French individuals and corporate shareholders who do not qualify as parent companies are entitled to a tax credit (‘avoir fiscal’) equal to 50 percent of the net dividend. These investors are taxed on the grossed up dividend (net plus ‘avoir fiscal’) but can deduct the credit from their taxes. Should the credit exceed the income tax liability, the excess is refunded in cash.’ As a result, the effective tax rate on preferred dividends for these investors is tp = 1.5tb-0.5. Substituting for tp, T , Td and Th in (3) results in T, 5 0.33 as a condition for trading new preferred stocks. This means that French companies must have an effective tax rate of less than 33 percent, in order to be able to issue preferred shares at a rate which is attractive to individuals and non-parent corporations.

Parent companies (‘which hold at least 10% of the distributing company and . . . ’) are not liable to pay tax on dividends received from their subsidiaries, (t,, = 0). Therefore, all it takes, based on (3), for preferred shares to be issued by the subsidiary and purchased by the parent company is that the effective corporate tax rate for the subsidiary be lower than the rate for the parent company

104 FOOLADI, McCRAW AND ROBERTS

Denmark

In Denmark, the corporate tax rate is 40 percent for distributed income and retained earning (Tc = Td). In addition to corporate income tax, there is a withholding tax rate, Th, of 30 percent which can be counted as a payment on the account of individual shareholders (but not companies) receiving dividends. When the shareholder is a Danish parent corporation, holding at least 25 percent of the capital of the subsidiary, it does not have to include the dividend in the computation of its taxable income. In this case the withholding tax is not levied either. Individuals and non-parent shareholders are entitled to a tax credit equal to 25 percent of the dividends received. This credit should be included in taxable income.

Taking these features of the Danish tax system into consideration reveals that the effective tax rates on preferred share dividends for different taxpayers are as follows:

1.25tb- Th-0.25 1 - Th Individual shareholders tp =

Non-parent corporations tp = 1.25 (effective corp. tax)-0.25

Parent companies tp = 0.

Substituting these rates in (3) and considering that T, = Td and Th = 30 percent (except for parent companies which have Th = 0), indicates that if a Danish subsidiary’s effective corporate tax is less than the parent company, preferred shares may be issued by the subsidiary and purchased by the parent. Further, if a company is effectively paying a corporate tax, T,, of less than 20 percent, it can issue preferred shares at a rate which is attractive to Danish individuals. In addition, no Danish corporation is able to issue preferred shares at a rate which is attractive to another (non-parent) Danish corporation, unless the potential seller has a corporate tax rate of negative 14 percent. This is because the withholding tax on dividends cannot be claimed by the corporate shareholders as credit against their tax bills.

IMPLICATIONS OF THE MODEL

In this study we develop a model, including both corporate and individual taxes, to determine the conditions under which preferred shares are both issued and purchased in different countries. For each of the six countries examined, it is shown that there are conditions under which corporations are able to issue preferred shares that are profitable for the issuing corporations as well as attractive to investors. The model also produces specialized implications for each country. For example, the analysis suggests that there are stronger tax incentives to create a positive preferred stock equilibrium in Canada than in


the US. This results from the existence of the dividend tax credit in Canada and from the higher dividend exclusion for corporate investors. Thus we expect that, other things being equal, Canadian corporations finance more heavily with preferred stock than do US firms.

The implication of our model for West Germany is that the ratio of new issues of preferred shares over bonds should be quite low because the condition for issuing preferred shares is only marginally satisfied. Given that for West Germany (unlike other countries), under no circumstances is (8) a strict inequality, the preceding analysis implies that German corporations must be using a lower ratio of preferred stocWbonds than corporations in other countries such as Canada.g

For the United Kingdom, where recently the corporate tax rate has been reduced (from 50 percent in 1984 to 35 percent in 1987) we expect an increase in the ratio of the new issue of preferred shares over bonds from 1984 to 1987. This is because the condition given by our model for the new issue of preferred shares is that the effective corporate tax be less than the advance corporate tax, ACT. Given ACT, reduction in T, increases the number of corporations that have an effective corporate tax of less than ACT.'"

The situation in France and Denmark should be quite similar to that of Canada. Individual investors and parent companies are entitled to similar tax relief, but non-parent firms are in a less advantageous position than their Canadian counterparts. However, the maximum effective tax rates at which French and Danish companies can potentially issue preferred shares to individuals (33 % and 20 % respectively) are lower than for Canadian companies (37%). Therefore, we expect the ratio of the new issue of preferred shares to bonds in France to be close to but a bit lower than in Canada and higher than in the United States, and in Denmark to be much lower than in France.

CONCLUSIONS

This study provides a possible explanation as to why preferred stock is issued by corporations in different countries. It presents a simple model in which preferred shares are both supplied and demanded and hypothesizes that the apparent disadvantages of preferred shares on the supply side are often offset by an advantage on the demand side, and therefore, in each examined country, there are conditions under which a market for preferred shares exists. Implications of the model are hypothesized for six countries: the US, Canada, UK, West Germany, France and Denmark.

APPENDIX

To drive the equilibrium condition for preferred stock, we start from the expression for firm value given as equations (1) and (2) in the text.


If the value maximizing firm is to find either preferred stock or debt worthwhile, either equation (A.l) or (A.2) must hold:

a v / a p = 1 - (pKp(l-&))/r, 2 o (‘4.1)

(A.2) aV/aB = 1 - ( & ( I - Tc)(l -f,))/rs 2 0.

This means that firms issue senior securities when their cost is less than the cost of issuing common stock.

Assuming that equations (A. 1) and (A.2) hold, a firm finds that supplying preferred stock is superior to issuing debt when aV/aP 2 aV/aB, i.e., when

1 - ( & ( 1 - f S ) ) / r s 5 1 - (Kb( l -Tc ) ( l - f s ) ) / r , .

pKp 5 Kb(1 - Tc).

(‘4.3)

(‘4.4)

Simplifying (A.3) results in

An investor will demand preferred stocks over bonds when

Kp(1 - f p ) 2 Kb(1 - f b ) .

When equations (A.4) and (A.5) hold simultaneously, a positive amount of preferred stock exists in equilibrium. This means that for at least some buyen

( l -Tc)/p 2 ( l - f b ) / ( I - f p ) . (A.6)

NOTES

1 See Hamada (1987) for a partial literature review. 2 The above valuation implies that no dividends are paid to common stockholders. While this

simplifies the analysis, no generality is lost and adding common stock dividends does not alter the results.

3 The Fooladi and Roberts (1986) derivation is a special case of ours for which Th = 0 , and Tc = Td, making p = 1.

4 This analysis focuses on personal tax rates on interest and preferred dividends assuming that the individual investor has already exhausted the initial $1,000 exemption. Analysis of the case of the small investor receiving under $1,000 produces identical conclusions.

5 Recently, this rate has been reduced to zero but in our analysis we consider the general case of Td > 0.

6 For many years this rate was 52 percent but a reduction plan began in 1984 to reduce progressively the corporate tax rate as follows:

Year ending: March 31, 1984 50% March 31, 1985 45% March 3 1 , 1986 40% March 31, 1987 35%

7 This is in fact true only for the individual shareholders. For corporations the excess is not refundable. However, because for most corporations the ‘avoir fiscal’ is lower than the corporation tax liability, we neglect this difference.

8 Here again, different situations exist. Parent companies are entitled to an ‘avoir fiscal’ but this cannot be credited against their corporation tax liability or refundable in cash. It is only creditable against ‘precompte’ and withholding taxes (if and when they are payable by the parent companies). Therefore, for most parent companies, in fact, these tax credits do not exist and it is reasonable to ignore them (as we did in our analysis). However, for those companies which are able to take advantage of the credit, the actual tax rate on dividends fp is negative and hence there are stronger incentives for preferred shares to be issued and traded. For example, if a company is able to utilize this ‘avoir fiscal’ fully, t p - -0.5 and therefore (based on (3)) preferred shares will be issued by the subsidiary and sold to the parent company as long as the effective tax rate of the subsidiary minus 33 percent is less than two-thirds of the rate for


the parent company. This is in fact true only for the individual shareholders. For corporations the excess is not refundable. However, because for most corporations the ‘avoir fiscal’ is lower than the corporation tax liability, we neglect this difference.

9 An alternative interpretation of (8) is that, in West Germany, bonds and preferred stocks are perfect substitutes and it is always possible for corporations to issue preferred stock at a rate which is at least as attractive as bonds for investors. With this interpretation, one would expect that the ratio of new issues of preferred shares over bonds should be randomly distributed among different companies and for the whole economy over the years.

10 A word of caution should be given here. From an investor’s point of view, British Consols have basically all the attributes of preferred shares. This may lower the demand for new preferred shares and therefore the market for preferred shares may reach its equilibrium at a level lower than implied by our model.

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Preferred Stock and Taxes