Chapter Objectives Be able to: n Differentiate between the tax implications of debt capital financing and equity capital financing for issuers and investors. n Explain the unique features of preferred share financing. n Explain the tax treatment of financing charges, including discounts and premiums on debt securities. n Explain the tax treatment of lease payments. n Explain why leasing is a viable alternative to debt capital financing.

Debt versus Equity n Debt capital is serviced by the payment of interest which is fully deductible in arriving at taxable income. Equity capital is serviced by the payment of dividends which is not deductible in arriving at taxable income. Although dividends are paid out of after-tax income, they do receive special treatment for investors. n The taxes imposed on investors will vary due to type of income (interest, dividends and capital gains) and nature of the investor (individual, corporation, pension fund, charity, and RRSPs). n Although debt financing and preferred share financing provide a similar fixed stream of return on investment, the taxation of those returns are very different since one is interest and one is dividends. Furthermore, preferred dividends paid in excess of $500,000 are subject to a special tax. n However, preferred shares remain popular due to sweeteners.

Tax Treatment of Financing Charges n In the process of developing securities and issuing them to investors, certain costs may be incurred, such as: legal & accounting fees, printing costs, registration & filing fees, and sales commissions. n Under the general rules, these capital expenditures would not be deductible expenses. However, by special exception, they can be deducted equally over a five year period as long as they are incurred in the process of issuing shares or borrowing money. n Debt and equity may be sold at a premium or a discount. The premium or discount on a equity security has no impact on the taxation of dividends. n A shallow discount on debt (>3%) is deductible in full as a business expense when the debt is repaid. However, a deep discount on debt (<3%) is only one-half deductible as an expense. n Premiums on debt are not taxed.

Leasing n A corporation can gain the right to use an asset through ownership or leasing. Leasing relieves the corporation of the financing costs related to ownership. n The two types of leases available are operating leases and financial leases. Lease payments under a financial lease are similar to amortized loan payments since they include a recovery of the underlying asset’s cost and a return on investment. Lease payments under an operating lease are simply short-term rental payments. n Lease payments under for either type of lease are immediately deductible.