The Tax Environment

"Temporary" Tax Retief Provisionlsl. In May 2008 President Bush signed an economicstimulus bill - Economic Stimulus Act (ESA) of 2008 - into law. The Act has a number of provisions that are supposed to be only "temporary." For students of finance, one provision is especially important because it can dramatically affect a company's federal tax payments and capital budgeting decisions. The critical provision involves "bonus depreciation." Under the 2008 Act businesses are allowed to take an additional first-year depreciation deduction, commonly known as "bonus depreciation," equal to 50 percent of the original "adjusted (depreciable) basis" - usually the fully installed cost - of quaiified property. Property eligible for this treatment includes property to which MACRS depreciation applies with a recovery period of 20 years or less. Certain tlpes of water utility property, software, and leasehold improvements also qualif, for bonus depreciation. Property must generally be purchased and placed in service in 2008. The bonus depreciation is allowed for both the regular tax and the alternative minimum tax (AMT).

In addition, the business is entitled to "normal" first-year depreciation. However, the depreciable basis of the property and the regular depreciation allowances are adjusted to reflect the additional first-year depreciation deduction. And, finally, a taxpayer may elect out ofthe 50 percent bonus depreciation by asset class and be subject to "normal" tax depreciation on the original "adjusted (depreciable) basis."

In the above example, the "effective" depreciation percentage for the first year is a whopping 60 percent [($sO,OOO bonus depreciation plus $10,000 normal first-year depreciation) divided by the $100,000 original adjusted basisl. In the second year, the "effective" depreciation is 16 percent [$16,000 divided by $100,000]. And so on.

lnterest Expense versus Dividends Paid. Interest paid on outstanding corporate debt is treated as an expense and is tax deductible. However, dividends paid to preferred or common stockholders are not tax deductible. Thus, for a profitable, tax-paying company, the use of debt (e.g., bonds) in its financing mix results in a significant tax advantage relative to the use of preferred or common stock. Given a marginal tax rate of 35 percent, a firm that pays out $1 in interest lowers its tax bill by 35 cents because of its ability to deduct the $1 of interest from taxable income. The after-tax cost of $ 1 of interest for this firm is really only 65 cents - $1 x (t - tax rate). On the other hand, the after-ta-x cost of $1 of dividends paid by the firm is still $1 - there is no tax advantage here. Therefore there are tax advantages associated with using debt linancing that are simply not present with either preferred or common stock financing.

Dividend lncome. A corporation may own stock in another company. If it receives a cash dividend on this stock, normally 70 percent of the dividend is tax exempt.s The ta-x laws allow this tax break for corporations (not individuals) to help reduce the effects of multiple taxation of the same earnings. The remaining 30 percent is taxed at the corporate income tax rate. A firm that receives $10,000 in dividend income pays taxes on only $3,000 of this income. At a marginal tax rate of 35 percent, taxes would amount to $1,050, as opposed to $3,500 if the entire dividend income were treated as taxable income.

CarrybackandCarryforward. Ifacorporationsustainsanetoperatingloss,thislossmay generally be carried back 2 years and forward up to 20 years to offset taxable income in those years.u Any loss carried back must first be applied to the earliest preceding year. If a firm sustained an operating loss of 9400,000 in 2008 it would first carry this loss back to 2006. If the company had net profits of $400,000 in that year and paid taxes of $ 136,000, it would recompute its taxes for 2006 to show zero profit for tax purposes. Consequently, the company would be eligible for a tax refund of $136,000. If the 2008 operating loss was greater than operating profits in 2006, the residual would be carried back to 2007 and taxes recomputed for that year.