Tax Implications

As firms become more creative with their financing choices and structure debt that behaves more and more like equity, there is a danger that the tax authorities might decide to treat the financing as equity and prevent the firm from deducting interest payments. Since the primary benefit of borrowing is a tax benefit, it is important that firms preserve and, if possible, increase this tax benefit.

It is also conceivable that the favorable tax treatment of some financing choices may encourage firms to use them more than others, even if it means deviating from the choices that would be dictated by the asset characteristics. Thus, a firm that has assets that generate cash flows in Japanese yen may decide to issue dollar-denominated bonds to finance these assets, if it derives a larger tax benefit from issuing dollar debt than yen debt.

The danger of structuring financing with the intention of saving on taxes is that changes in the tax law can very quickly render the benefit moot and leave the firm with a financing mix, that is unsuited to its asset mix.

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