One of the basic difficulties with academic study generally is the tendency to compartmentalize areas of learning; the tax people look at the tax rules and the corporate governance people look at the corporate and securities rules but the effects of the intersection of the rules are often unnoticed. Recently, however, in the United States, increasing attention has been paid to the interaction of the taxation and corporate governance systems and that is what I would like to focus on here. I will consider two subjects. First, I will examine the impact which the tax rules may be seen to have on corporate capital structure and the resulting implications for corporate governance issues. Secondly, I will describe some specific tax rules in the United States which have been aimed at what could, broadly speaking, be called questions of corporate governance. I will try to make some comparative points about the corresponding issues in the Swedish system which I hope will stimulate more consideration here of the interconnection between the two fields of study.
2 Financing corporate investment
Corporate investment can be financed from three sources: new equity capital, loans, or retained earnings. In a world without taxes, the decision as to the appropriate capital structure to finance corporate investments would be made on the basis of business and commercial considerations, including transaction costs and investment policy. When taxes are introduced, however, the relative attractiveness of these financing arrangements, and the corresponding patterns of corporate governance, may change.
Taking the United States corporate tax system as an example, there are several features which have important implications for corporate governance issues. We have a so-called classical system of corporate taxation in which corporate profits are taxed first at the corporate level and then taxed again to individual shareholders when distributed. Interest payments made by corporations, however, are deductible at the corporate level and thus bear only one level of tax. In addition, capital gains realized on the sale of shares have typically been taxed at a lower, preferential rate in comparison to dividend distributions. Finally, the tax rate applied at the corporate level has traditionally been, and to some extent still is, lower than the rate ordinarily applicable to individual investors.
This pattern of taxation has some effects on corporate governance issues. In the first place, it facilitates management decisions to finance new investment through retained profits rather than by other means. Shareholders, who would incur an additional layer of tax on taxable distributions, are less likely to force management to distribute funds and more likely to acquiesce in the reinvestment of retained profits in projects which, at least in some cases, are more based on the interests of management than on the maximization of the return to shareholders.
Even more important, the existence of the preferential tax rate for capital gains provides an incentive for shareholders to ”flee not fight” if they oppose arguably ineffective management. Realizing the value of retained earnings by a sale which results in preferred tax treatment is encouraged in comparison to insisting that the profits be distributed so they can be invested elsewhere. It is also preferable to sell at low capital gains rates rather than to fight for more productive investments, the return on which might take the form of increased dividend distributions which would be subject to a higher rate of tax.
In addition, the existence of a lower corporate rate on the income stream generated by additional investment of retained earnings, when compared to a corresponding individual investment of distributed profits, also affects the shareholder decision to allow profits to be retained by management. Thus, in ways that are presumably quite unintentional, the tax rules in the United States combine to provide what can be viewed as a disincentive to effective shareholder monitoring of management activity, a point which has been increasingly noticed in the United States academic literature.
While my knowledge of the situation in Sweden is somewhat limited, it seems to me that here matters may be rather different. In the first place, since your tax reform in 1991, capital gains are no longer taxed at preferential rate; all income from capital, dividends as well as capital gains, is taxed at a flat 30 %. Thus the incentive to sell rather than fight, at least from a tax point of view, is not present in the same way as it is in the United States. Of course the existence of transaction costs, the availability of proxy mechanisms and other non-tax factors may affect the decision, but the point is that tax rules here are not impacting the decision as directly as in the United States.
In addition, since the effective corporate rate is only slightly lower than the individual rate on distributed income, there is less incentive for shareholders to acquiesce in the retention of income at the corporate level in order to keep the income stream from the potential investment subject to a lower rate of tax than a corresponding individual investment. The decision to retain profits also, of course, postpones the shareholder level tax which may or may not be an incentive for retentions, depending on the availability of corresponding non-corporate investments with similar before-tax rates of return. On the whole, however, the Swedish tax rules seem more favorable to effective corporate governance in this regard than do the United States rules.
As an aside, perhaps the most favorable tax rules, from a corporate governance point of view, were those of the short-lived previous Swedish system, in which dividend distributions were tax-free while capital gains were still subject to tax. There was a positive incentive to fight for higher tax-free dividends rather than flee in the face of a capital gains tax. Indeed, any system which eliminates the double tax on distributed corporate profits will have advantages from a corporate governance point of view, since there is no difference in tax treatment between retained profits and distributed and reinvested profits. There are, of course, other factors involved in the overall evaluation of such a system.
3 Intermediated investments
The capital markets in the United States and Sweden are both characterized by the greatly increased role of mutual funds and other vehicles for the intermediation of investments from individuals. In the United States, mutual funds, to qualify for tax exemption, must distribute all their dividend income and realized capital gains, which are taxed directly to the individual investors. This pattern of taxation has important implications for the willingness of mutual funds as shareholders to ”fight rather than flee” in the face of inefficient management. If the mutual fund sells the under performing investment to seek a more productive investment elsewhere, the resulting tax on the capital gain will reduce the return to the fund investor in comparison with another fund which is trying to improve management through better monitoring. As long as the net of the costs of the monitoring and the improved performance of the stock exceed the cost of the capital gains tax, the net return of the fund would be increased by virtue of its monitoring activities in comparison to a sale and reinvestment. Since the fund’s net return is the index by which it is being judged in the market, the tax rules would seem to reinforce the incentive for responsible shareholder action by institutional investors by passing through taxable capital gains.
Here, if I understand the Swedish system, the situation is by reversed. Like the United States, dividend income is passed through to the shareholders but capital gains realized by the fund are not taxable, either to it or to the individual investors. Instead, a notional tax is applied to the value of the fund each year whether or not it realizes gains on its underlying investments. Thus a Swedish fund would appear to have an incentive to sell and seek a more profitable investment rather than to incur the costs of fighting since the sale will not result in any tax cost while the monitoring would incur costs with no assurance that the value of the stock would improve. To this extent, the Swedish pattern of taxation could be said to encourage ”flight not fight” behavior.
The above analysis is, of course, stylized, oversimplified and ignores a number of factors which can affect the decisions of both individual and mutual fund investors. The basic point, however, is that the tax rules cannot be ignored in the overall analysis of corporate governance questions.
4 Interest deduction
Another example of the potential effect of tax rules on what could broadly be called issues of corporate governance is the treatment of interest payments on loans taken out to fund corporate investment. Interest payments, unlike dividend distributions, are deducted by the corporate payor and thus subject to tax only in the hands of the investor. On the other hand, the interest payment, unlike a profit distribution, must be paid in any event regardless of the profitability of the underlying investment. Thus the tax rules encourage loan financing with the corresponding deduction of interest expense while the commercial nature of the obligation to pay interest tends to favor investment in less risky, more reliable investments to generate income to support the interest deduction. In particular, this results in a preference for investments in tangible rather than intangible assets and in established rather than innovative and high risk investments. In terms of corporate governance, this could be said to result from the monitoring activities of banks and other institutional lenders who are concerned only that the investments be profitable enough to cover the interest costs and retire the debt.
Both the Swedish and United States systems in their present form contain this tax bias in favor of debt as opposed to equity financing. In both systems, interest payments are generally deductible while dividend distributions face a double level of tax.
One response to this problem would be to disallow the deduction at the corporate level for interest payments, thus providing the same tax treatment for loans and equity investments. This approach, however, would in fact put debt on a less advantageous footing than equity from a tax point of view since interest must be paid currently and is currently subject to tax while dividends can be postponed until some level of profitability has been reached. Alternatively, some form of the integration of corporate and shareholder level tax, either in the form of a shareholder level credit or exclusion or a corporate level deduction for dividend payments would help equalize the treatment from a tax point of view of equity versus debt investments. But the point for these purposes is that the general tax rules, by favoring one kind of financing over another, indirectly influence who is in fact taking the primary role in corporate governance decisions and the resulting structure of corporate investment.
5 Tax rules aimed directly at corporate governance
The above discussion deals with the impact of generally applicable tax rules on corporate governance. In the United States, there are several tax rules which are aimed directly at what could be considered corporate governance issues. The rules are intended to help insure that management is discouraged from favoring its own interests over the interests of shareholders. In effect, the tax rules provide a kind of Government-sponsored corporate governance. To my knowledge, there are no equivalent Swedish rules and I am not suggesting the American rules as a model. It is interesting to see, however, how the tax system can be used explicitly to affect management behavior.
5.1 Golden parachute payments
In response to the increasing number of hostile takeover attempts by acquiring companies whose avowed purposes was to oust inefficient management and restructure corporate operations, potential target companies in the late 1970’s and early 1980’s increasingly adopted so-called ”golden parachute” provisions. These arrangements typically provided that officers and other highly compensated executives would receive substantial payments in the event of the change of control of the corporation. The purpose of these provisions was to in part to discourage hostile takeovers, thus allowing existing management to stay in office. In addition, the provisions insured substantial compensation and a ”smooth ride down” if officers were removed after a successful takeover. Since the potential parachute payments were one factor that the acquiring corporation would have to take into account in valuing the target, the existence of such provisions reduced the amount which would be realized by a shareholder on a sale of the company if the takeover was successful.
The parachute provisions were subject to substantial criticism and Congress in 1984 enacted special rules dealing with ”excess parachute payments”. Without getting into the definitional details, such payments were subject to very restrictive tax treatment. In the first place, the corporate deduction for such payments was disallowed. In addition, a special 20 % excise tax was imposed on the recipient, in addition to the normally applicable income tax. Most interesting for our purposes, in the original legislation, these rules applied whether or not the parachute arrangement had been approved by the shareholders. In other words, Congress felt that the shareholder’s interests needed to be additionally protected by restrictive tax treatment because of concerns about the lack of effectiveness of shareholder participation in corporate governance. The legislation was subsequently modified in 1986 to exempt payments approved by shareholders in corporations where the stock was not publicly traded and at least 75 % of the shareholders approved the proposal. In these circumstances, apparently, Congress thought that shareholder control was effective enough to insure that they would be acting in their own interests in approving parachute arrangements. In the publicly traded situation, however, corporate governance is still indirectly influenced by tax policy, regardless of the ostensible wishes of the shareholders.
Another response to the hostile takeover activity in the late 1970’s and early 1980’s was the use of so-called ”greenmail” payments. The term is derived from ”blackmail” but given a different color to reflect the substantial amounts of cash changing hands. In a typical greenmail situation, a potential acquiring company would buy a significant investment in the target company stock, possibly with the intention of completing a takeover, but often aimed at forcing the corporation to buy back the stock at a higher price in an attempt to forestall the hostile takeover. Prior to 1986, the tax treatment of such payments was not completely clear, though some cases had allowed a corporate deduction for the payments on the grounds that they represented an ordinary and necessary business expense in the protection of the corporation’s business. It had become widespread in practice for such payments to be deducted.
In 1986, Congress responded by explicitly providing special treatment for greenmail payments. A greenmail payment was defined as a payment made to a shareholder who had held the shares for less than 2 years and had participated in an actual or threatened public tender offer for the stock. In addition, the payment had to be restricted to a limited number of shareholders. When a greenmail payment took place, the deduction for the payment by the corporation was denied. In addition, a special tax at a 50 % rate was imposed on the payment in the hands of the recipient, in addition to the normally applicable income tax. Thus in the classical greenmail situation where, for example, 5 % of the stock of the target is acquired by a corporate raider in anticipation of a tender for more stock and then shortly thereafter redeemed by the corporation to prevent the takeover, the total tax burden on the payment in the hands of the recipient could be nearly 90 %. As in the case of golden parachute payments, the greenmail provisions use the tax system to attempt to control the behavior of corporate managers by increasing substantially the tax cost of payments which Congress, at least, felt were not being made in the interests of the shareholders.
As a comparative matter, it is my understanding that under the Swedish corporate law on stock redemptions it is not possible to have such ”targeted” redemptions of individual shareholders or shareholder groups. Thus the question of special tax rules on greenmail payments does not arise here but the illustration is at least instructive of the role tax rules can play.
5.3 Excess executive compensation
The most recent example of a tax provision which is aimed at a perceived corporate governance issue is the limitation on the deductibility of executive compensation paid by publicly traded corporations. Inspired by press reports of large amounts of compensation being voted by compliant boards of directors, Congress in 1994 enacted provisions which limit the deductibility of compensation over $1,000,000 unless certain tests are met. In the first place, the compensation must be ”performance-based”, that is, based on pre-established objective performance goals, such as stock performance, earnings per share, income levels and the like. In addition, and more interesting for our purposes, the performance-based compensation package must be established by a compensation committee of the board of directors the members of which are ”outside” directors who have no other connection with the corporation. Finally, the ”material” terms of the compensation package as established must approved by a majority of the votes in a separate shareholder vote. Only if these condition are met will compensation in excess of $1,000,000 be deductible for corporate tax purposes.
To my knowledge, there is no corresponding provision in Swedish tax law.
The conclusions from this brief comparative exercise are admittedly modest, tentative and need both more reflection and more empirical investigation. But I do think they have some important implications. For those interested in the direction of the development of rules and principles dealing with corporate governance, it is important to keep in mind the potential effect of existing and proposed tax rules and their interaction with corporate governance policies. And for those, like me, whose principal interest is in taxation, similarly our perspective should be wide enough to understand that rules which may be responsive to tax policy considerations also have a corporate governance aspect.
Hugh J. Ault
Professor Hugh J. Ault, Boston College Law School
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