Taxation & Long-term finance Flashcards
Personal taxation is imposed on the financial resources of an individual, such as
income, profits, inherited wealth, investment gains, and the value of assets held.
________tax is the main source of tax revenue for most governments, and both employed and self-employed individuals pay _______tax
Income tax
Governments may also introduce taxes on
capital gains, wealth taxes, and inheritance taxes.
Capital gains tax is a tax on
the gain made from selling an asset for more than it was originally purchased for.
Wealth tax is a tax on the
amount of wealth owned, such as property
________ tax is a tax on the amount transferred on death.
Inheritance
Taxing cash flows is a common practice in many countries, where taxation is limited to
cash flows that are indicative of cash being available to finance the tax payable.
Governments seek to ensure that revenue flows are taxed only once in the hands of the recipients. However, if taxes are also levied on wealth or the value of specific assets, the revenue may be taxed _____________-
twice.
Set out how taxable income is determined
Taxable income is determined as follows:
income earned
plus income in kind
plus gross investment income
less tax-free income
less tax-free expenditure
less allowance.
Assume that the personal allowance is £10,000, and that the marginal tax rates are 20% for the
first £30,000, and 40% for taxable income above this. Calculate how much tax a single person
earning £50,000 will pay assuming there are no adjustments to total income. State the
proportion of total income that is paid in tax.
Solution
There is a personal allowance of £10,000, so the person is only taxed on £40,000 of income.
Tax rates Tax bands Tax due
Taxed @ 20% £30,000 £6,000
Taxed @ 40% £10,000 £4,000
Total £10,000
Total tax paid is 20% of total income. This is known as the average rate of tax
The marginal tax rate is the percentage of
an additional unit of income that is taken in tax.
Individuals are typically subject to capital gains tax on
chargeable gains
Chargeable gains normally fall into the tax year of assessment during which
the gain is
realised that, again, the funds to pay the tax should be available
Basic definition
A chargeable gain is typically defined as:
sale price purchase cost
The sale price can be reduced to reflect any costs associated with the sale. The purchase
cost can be increased by any costs associated with the purchase, and any expenditure
made to enhance the value of the asset during the period the asset was held. In normal
circumstances, the purchase cost would be the original cost of the asset.
Companies are liable to corporate income tax on their taxable.______
profits
Taxable profits include both _________(less allowable expenses) and _______________.
Taxable profits include both income (less allowable expenses) and capital gains.
The starting point for a company’s tax assessment is ‘profit on ordinary activities before taxation’, which is calculated as
sales revenue less expenses plus non-trading income and interest.
Corporation tax rates around the world vary considerably, and some countries give relief to shareholders to ensure that dividends are not
subject to both personal and corporate income tax.
Governments may incentivize companies to retain and reinvest earnings to encourage economic growth by
levying higher taxes on dividends than on retained profits, or by allowing tax relief for new investment.
The tax system can also be used to incentivize long-term investments such as
pension provision by granting tax relief on investment income and gains and imposing taxes on pension funds only when benefits are paid out to beneficiaries.
What is Stamp Duty:
It is a tax imposed on contract documents.
It is paid by individuals based on the value of the property they buy.
For example, when an individual buys a house, he/she may pay stamp duty tax.
Other categories of taxes levied on companies and individuals.
Inheritance Taxes and Property Taxes:
It is a tax levied on expenditure, either in respect of general expenditure or specific types of expenditure.
Tax on Expenditure:
A sales tax, such as VAT in the UK, is an example of a tax on
general expenditure.
Sales taxes are collected only at the point of
final sale to the consumer,
while VAT is collected at
each stage of the production process according to the value added at each stage.
explain Customs Duties and Excise Taxes:
Customs duties are taxes on imported goods, while excise taxes are duties levied on goods produced and sold within the country.
These taxes may be designed to encourage certain patterns of consumer expenditure or to raise revenues for particular categories of government expenditure.
Different countries may tax imported goods in different ways, and special taxes may be imposed for certain industries based on emissions or physical size.
explain how you can use Loan capital (Debt) to raise funds long term
A company issues loan capital to raise money from investors. In return, the company will
pay the investor a stream of interest payments plus an eventual return of capital. The
amounts of interest and capital payments to be made will be specified at outset.
This contrasts with shares, where dividends are paid at the discretion of
the company’s directors.
Long-term loan capital instruments are often referred to as
‘bonds’ or ‘corporate bonds’, and
short-term instruments as ‘bills’.
Issues of loan capital may be listed on a
stock exchange
Holders of loan capital are ______of the company and, unlike shareholders, they do not
have_________.
Holders of loan capital are creditors of the company and, unlike shareholders, they do not
have voting rights
Holders of loan capital receive specified ‘interest’ payments which are a _______to the company, not a distribution of
_______. On a winding-up they would rank equally with, or in some cases above, other ________.
They receive specified ‘interest’ payments which are a cost to the company, not a distribution of
profits. On a winding-up they would rank equally with, or in some cases above, other creditors.
explain the Features of loan capital
It is conventional to refer to loan capital in units of £100 nominal.
The nominal amount of a loan is often referred to as its ‘par value’.
It is usual to express the interest payments as a proportion of the par value.
For example, a holder of £100 nominal of a 10% debenture will receive £10 interest per
annum. The loan coupon payments are normally made every six months so this
debenture would pay £5 every six months per £100 nominal held.
It is normal to issue loan capital at a price close to, or just below, par.
Unlike shares, there is no legal restriction on the issue price relative to par. So, £98, £99,
£100, £101 etc are all possible issue prices per £100 nominal.
Almost all loan capital is redeemed at par.
The market price of £100 nominal of loan capital need not be £100.
Most loan capital is redeemable on a set date, often after 10 to 20 years
Question
What is the total amount of cash you would receive if you purchased £200 nominal of a 6% bond
redeeming on 31 December 20XX+10, and purchased on 1 January 20XX?
Solution
In each of the years 20XX to 20XX+10 inclusive, you would receive 6% of £200 = £12. This would
normally be paid in two semi-annual payments of £6 for 11 years. This amounts to £132. At the
maturity of the bond you would get £200 back in addition to the final coupon payment we have
included above. Total cash received = £332.
Since bonds are tradable, the price of a bond varies with supply and demand for the bonds. One
of the main influences on the price of a bond is the interest rate in the economy. There is an
inverse relationship between interest rates and the price of a bond.
Question
Suppose interest rates or returns available on long-term investments rise in the economy. Explain
what would happen to the price of a fixed coupon long-term bond that offers a fixed interest rate
of (say) 3% pa.
Solution
If the returns available on other investments rise, the 3% pa interest rate available on the fixed
coupon bond will look poor relative to other investments, and investors will sell the bond, causing
the price to fall. As the price falls, the 3% starts to look higher as a proportion of the falling bond
price. Also, investors will then be able to buy the bond at a greater discount to par, meaning that
they will receive a bigger capital gain if they hold it until maturity. Eventually the bond price
reaches a level where the combination of these two factors makes the attractiveness of the bond
equivalent to that of other investments.
The rights of bondholders
The rights of holders of loan capital will be set out in a_____________ drawn up when the
loan is issued. In most cases, a trustee is appointed to act on behalf of the loan
stockholders.
loan agreement. The trustee is normally a corporate body such as a bank or insurance
company.
The legal documentation setting out the obligations of the issuing company to
the loan stockholders is known as
the Trust Deed.
Suggest issues that the Trust Deed of a bond issued by a company might cover
Solution
Typical issues covered in a Trust Deed include:
description of any assets of the company that might be set aside to cover the particular
loan in the event that the company winds up
details of exactly how the assets should be used to repay the bondholders in the event of
a winding-up and how surplus cash should be treated
the rights of the company to issue further bonds that rank above or alongside this
particular issue
covenants that describe how much the company’s profit must remain above the amount
of the interest payments on the bond. This is a form of protection for bondholders to
ensure that their interest payments are easily met by the company in future.
arrangements for changing the trustees
a description of circumstances under which bondholders must be consulted, eg if
covenants are breached or about to be breached
Debentures are loans that are secured on
some or all of the assets of a company.
Debentures if the company fails to make payments what happens
the stockholders have actions available to them if the company fails to make payments.
- These actions include appointing a receiver to intercept income from secured assets, or taking possession of the secured asset to sell it in order to meet the debt.
There are how many types of debenture:
two; mortgage debenture (fixed charge) and floating charge debenture.
explain A mortgage debenture
has specific secured assets mentioned in the legal documentation, and the company can sell or make major alterations to the secured asset only with the permission of the mortgage debenture holders
explain A floating charge debenture
allows the company to change the secured assets in the normal course of business, but the trustee must give permission and ensure that the assets are equally satisfactory from the debenture holders’ viewpoint.
Debenture holders can apply to the courts to convert a_______ to a________ when a company fails to make payments.
Debenture holders can apply to the courts to convert a floating charge to a fixed charge when a company fails to make payments.
Debentures and loan stocks are used to raise
large amounts of funds, have a fixed redemption date and carry a fixed rate of interest.
Debentures are more secure than
ordinary or preference shares in the same company, but there is still an element of risk.
Debentures tax characteristics
Debenture interest is tax deductible and deducted from pre-tax profits.
Interest payments must be made irrespective of the company’s profitability or cashflow position, and failure to adhere to agreed terms may place the continuation of the company at risk.
Explain element of risk on debentures
Risk comes from default and from the asset over which the fixed charge has been placed being insufficient to cover the loan.
Debentures trade at yields above government securities but may not be readily marketable.
The marketability of debentures is usually ________than that of government bonds.
worse
marketability of debenture stocks
There are bigger spreads between buying and selling prices and lower volumes traded.
Marketability is highest just after a new issue.
Debenture stocks are considered more risky than government bonds because
the security ultimately depends on the company’s continuing profitability and the market value of the charged assets, which cannot be guaranteed for the full outstanding term of the debenture.
Unsecured loan stocks
Description
With unsecured loan stock there is no specific security for the loan. If the company
defaults, the loan stockholders’ only remedy is to sue the company.
Unsecured loan stocks
Description
With unsecured loan stock there is no specific security for the loan. If the company
defaults, the loan stockholders’ only remedy is to sue the company.
Question
Suggest a reason why companies don’t always issue unsecured loan stocks rather than
debentures.
Solution
Debentures are secured upon the assets of a company. This security means that the company can
offer a lower rate of coupon (ie interest) to investors. The company will therefore find it cheaper
to borrow using debentures than using unsecured loan stock.
Sometimes a company’s credit rating may be so poor that issuing a bond that does not have a
security attached may be impossible.
Rank Debenture holders; unsecured loan stockholders
Debenture holders have a prior claim to the assets of the company on which there is a charge, and unsecured loan stockholders rank after debenture holders. Other creditors rank equally with unsecured loan stockholders.
If the company is liquidated, high-ranking claimants such as debenture holders may get __________, while low-ranking claimants
all their capital returned, while low-ranking claimants like shareholders may get nothing. A proportionate payment will be made if the total money available is insufficient.
