(^276) Financial Management
purpose. In India, for example interest income is tax exempt upto Rs 7,000 for individuals.
After this, they are required to pay tax at a marginal rate which can be as high as 30
per cent. Dividends in the hands of shareholders are tax exempt, and capital gains are
treated more favourably for tax purposes. The tax rate on capital gains is 20 per cent.
Tax on capital gains is paid only when they are realised. Thus, an individual can defer
paying tax on capital gains for a long period if he does not realise them and thus, his
tax on equity income will be zero. Interest income, whether received or accrued, is
taxed in the hands of individuals, although it is exempted from tax at the corporate level.
Dividends are taxed at the corporate level while it is possible to avoid tax on capital
gains at the personal level and pay no tax on the current dividends. We may conclude
that, in general, interest income is taxed at a higher rate than equity income at the
personal level.
Consider an example. In our earlier illustration, let us assume that interest income is
taxed at 40 per cent and equity income is not taxed at the personal level. The after-
tax earnings of investors are shown in Table. It can be seen that corporate borrowing
is still advantageous since an interest tax shield after personal taxes of Rs 70 is
generated. Note that the interest tax shield is reduced by the personal tax on interest
income (i.e. kd DT - kdDTpb). But it is substantially less than the case where equity
income was taxed at 40 per cent.
Table: Income of Investors of Unlevered and Levered Firms: Corporate Tax at 50%
Equity Income Tax Zero and Interest Income Tax at 40$
Income Firm U Firm L
- EBIT,X 2,500 2,500
- Interest, INT = k, I) 0 700
- Profit before tax, X - kdD 2,500 1,800
- Tax,T(X-kdD) 1,250 900
- Profit after tax (
X- kdD)- T (
X- kd D) = (
X- kd D) (1 - T) 1,250 900
- Dividends to shareholders, (
X- kdD) (I - T) 1,250 900
- Personal taxes on dividends, Tp [(
X- kd D) (I - T)] 0 0
- Dividends after personal taxes, (
X- kd D) (I - T) (I - Tp) 1,250 900
- Interest to debt-holders, kd D 0 700
- Personal taxes on interest, Tp (kd D) 0 280
- Interest after personal taxes, (kd D - Tp kd D) = kd D (I - Tp) 0 420
- Total income to investors, (8 + 11) (X - kd D) (I - T)
(I - Tp) + kd D (1 - Tp) 1,250 1,320 - Interest tax shield after personal taxes, kd DT - kd DT ◊ Tp
(I = Tp) kd DT - 70
The present value of this perpetual stream of interest tax shield is: