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Journal of Business Economics

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01.11.2014 | Original Paper

Taxes, risky investments, and the simultaneous choice of organizational form and financing

verfasst von: Kay Blaufus, Britta Mantei

Erschienen in: Journal of Business Economics | Ausgabe 8/2014

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Abstract

By taking explicit account of liability limitations, we analyse the influence of taxes on the simultaneous choice of organizational form and financing. In a two-state model for a single reporting period investors striving for maximisation of expected utility choose the organizational form (with or without liability limitation) in which they implement a given risky real investment and decide how they finance it (equity or debt). We demonstrate that liability limitations result in tax-relevant differences between organizational forms. Thus, for example, the tax bases differ in relation to the chosen liability-contingent debt capital compensations as well as to tax loss offset rules. Therefore, even in the event of identical tax rates, taxes can influence the decision regarding the organizational form.

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Journal of Business Economics

From January 2013, the Zeitschrift für Betriebswirtschaft (ZfB) is published in English under the title Journal of Business Economics (JBE). The Journal of Business Economics (JBE) aims at encouraging theoretical and applied research in the field of business economics and business administration, promoting the exchange of ideas between science and practice.

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Thus, for example, a lot of work has been done on the valuation of the tax benefits of debt financing that, however, as a rule refers to corporations (see, for example, Graham 1996; Graham and Mills 2008; Massimilano 2012).

This is sufficient to represent the basic interdependencies. The effect of tax rate differences on pay-out policies contingent on the organizational form have been already investigated. In order to analyse tax base differences resulting from different liability limitations in isolation from time effects, the investigation is conducted in the context of a single period.

If the market were arbitrage free, a preference-free valuation could occur and the influence of the risk attitude on the choice of organizational form and financing would not occur.

Empirical studies show that although the majority of individuals are risk-averse, risk-neutral and risk-loving investors cannot be neglected (see, for example, Dohmen et al. 2011; Holt and Laury 2002). Moreover, we show in the following that the individual risk attitude has an influence on the choice between limited liability and unlimited liability organizational forms and thus must be taken into consideration in the present context of the model.

To limit the complexity of the model we ignore the influence of the dividend policy on the choice of the organizational form. It would be preferable to analyse this influence in a multi-period context. We will analyse solely the effects of the differences in the tax base that are triggered by the limitation of liability.

The debt ratio λ refers to the book value of the investment.

The representation of a single ‘profit situation’ and a ‘loss situation’ is sufficient to demonstrate and analyse the differences in tax base on which we are focusing. Qualitatively other results are not even to be expected in the case of continuous distribution.

If an individual investor wishes to choose, for example, x = 0.5, he can implement this wish by establishing a business partnership in which he as well as a corporation that is completely in his ownership each owns a 50 % share. If half of the external financing of the investment takes place through the investor as a natural person with unlimited liability and half through the corporation, the desired 50 % limited liability exists. A corporation whose shareholder grants the creditors a guarantee and thereby likewise bears unlimited liability could be considered equivalent to a partnership.

We likewise explicitly exclude the employment of tax arbitrage through ‘organizational form arbitrage’ (see, for example, Scholes et al. 2008).

We would like to expressly exclude agency problems. The additional interdependency through the consideration of asymmetrical information could be examined in a separate investigation.

We limit ourselves to the typical ideal difference between the organizational forms and have therefore excluded the partnerships’ risk of insolvency. The inclusion of an additional risk premium for the allocation of debt capital to partnerships would simply complicate the analytical picture without sharpening its contours.

In our model the inclusion of (constant) costs of insolvency would have indeed had an influence on the choice of organizational form and financing, since it presents a drawback for the corporation and the debt financing. The insolvency costs, however, would have had no influence on the tax effect that is of interest to us.

The objective function in the case of \( \lambda^{LL} = \lambda_{crit}^{LL} \) shows a kink point. The function is, however, constant and everywhere else differentiable. Therefore, in the following the domains are separately analysed for \( \lambda^{LL} < \lambda_{crit}^{LL} \) and \( \lambda^{LL} > \lambda_{crit}^{LL} \).

The concept of the organizational-form and financing neutrality has been critically discussed many times (see, for example, Wagner 2006; Maiterth and Sureth 2006). We do not presume in this article to make recommendations to law makers and thus do not wish to participate in the discussion as to whether the neutrality of a tax system is desirable. We use the term organizational-form and financing neutrality simply as a ‘calibration mark’ to identify conditions under which investment risks initiate tax effects that could change the choice of organizational-form and financing.

We assume that the main demand is dealt with as a matter of priority before the interest debt. Interest can, therefore, no longer be paid in a state of loss if the cash flows are inadequate to pay off a liability.

Capital gains are likewise taxed by \( \tau_{div} \) so that the investor is indifferent to a choice between a dividend payment and capital gains. On the basis of the assumption that the investors dispose of additional, exogenous sources of income, the taxable loss from the reduction in value of the participation in the sense of a liquidation loss on the level of the shareholders can be set off immediately.

In the case of \( \lambda^{LL} = 1 \) no loss accrues on the level of the corporation, so that no tax refund results either. In this case the risk premiums correspond before and after taxes independently of the limitation of loss utilisation.

Using the Eq. (7) and \( D_{d}^{LL} = CF_{d} \) it can be shown that \( \tau_{cit} \left( {1 - \tau_{div} } \right)\left( {CF_{d} - D_{d}^{LL} - I_{0} \left( {1 - \lambda } \right)} \right) = \left( {1 - \tau } \right)T_{d}^{cit} \) is valid. In the case of symmetrical taxation the final net wealth in the state of loss declines by the same amount, since although the tax refund is paid to the corporation, it flows directly to the creditors \( \left( {D_{d}^{LL} = CF_{d} - T_{d}^{cit} } \right) \).

If one employs \( {{r}}_{{f}} = 0 \) one recognises that the relationship of the tax rates \( \tau \) and \( \tau_{{i}} \) even in the case of the refusal of the loss offset in the corporations, has no effect on the expected utility (compare Eq. 11). It is solely the refusal of the loss offset that discriminates against the corporation, so long as it is not totally leveraged. Then the results thus comply with the case \( \tau = \tau_{\text{i}} \).

The use of μ-σ-investors in the examples serves exclusively to simplify the presentation in the examples of use. In order to guarantee the compatibility of the expected utility theory with the μ-σ-principle, risk-averse investors with quadratic utility functions are assumed.

As long as the assumptions made are fulfilled, the use of other values for the cash flows or the probabilities of occurrence changes nothing on the basic results.

Equally, for losses from the sale of shares in a corporation a tax rate of 25 % is assumed, since the taxation according to § 17 IV German Income Tax Act (Einkommensteuergesetz) in connection with § 3 Nr. 40 German Income Tax Act (Einkommensteuergesetz) would merely lead to an insignificant difference that need not further be considered here.

For the analysis, \( \tau_{cit} > 0 \) is always assumed, since only then does the loss offset restriction take effect. For \( \tau_{cit} = 0 \) the equations of the symmetrical taxation result.

See on this point example 4 in Section 3.3.

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Titel: Taxes, risky investments, and the simultaneous choice of organizational form and financing
verfasst von: Kay Blaufus
Britta Mantei
Publikationsdatum: 01.11.2014
Verlag: Springer Berlin Heidelberg
Erschienen in: Journal of Business Economics / Ausgabe 8/2014
Print ISSN: 0044-2372
Elektronische ISSN: 1861-8928
DOI: https://doi.org/10.1007/s11573-014-0713-9

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