Understanding the effects of tax incentives on the pricing of securities is crucial to investors, issuers and policy-makers
Last summer, while looking for a new fuel-efficient car, a young broker was surprised to discover that the car he wanted was selling for significantly more in Canada than in the US, even though the Canadian dollar was at par with the US currency. Furthermore, the car dealer was not offering any sweetener on the green cars as demand for them was great. When asked why the price was higher, the dealer replied that buyers of such vehicles were eligible for a tax rebate from the Canadian government through the ecoAuto Rebate program. Would the buyer actually benefit from this tax refund or was the government offering a subsidy in disguise to the car dealer or manufacturer?
Governments provide various forms of tax incentives in an attempt to achieve different socioeconomic goals. Examples include tax credits for R&D, accelerated depreciation on manufacturing equipment, as well as tax incentives on equity aimed at helping firms raise capital.
Tax incentives on equity primarily take the form of reductions in dividend or capital gains taxes, but can also be given in the form of tax deductions to investors. Who benefits the most from such tax incentives-the investor who claims the deduction, the firm or some other party? How do incentives affect asset prices? Understanding the extent to which favourable tax treatment affects the pricing of securities is a fundamental issue for investors, firms' financing decisions and for tax policy.
To illustrate, assume two firms need to raise capital through the issuance of shares. Further assume the firms are identical in terms of risk, size, project opportunities, etc., with one exception: Firm X can issue new shares, the cost of which is tax deductible to individual investors in the year the shares are purchased; Firm Y can only issue nondeductible shares. As the two types of securities have identical pretax cash flows and identical risk, it is expected that individual taxpayers will bid up the price of the taxfavoured security relative to that of the tax-disfavoured one such that the after-tax cost will be the same to some investors. For example, assume the price of the nondeductible share is $100. For taxpayers with a 27% marginal tax rate it should make no difference whether they pay $100 for the regular share or $136.99 for the tax-deductible share: that is, in paying $136.99 for a tax-deductible share, taxpayers reduce their tax liability by $36.99 and, thus, the net cost of the share is $100 (see table below). If prices adjust in this manner, these taxpayers are no better off investing in the tax-favoured shares. Although they can reduce their taxes paid explicitly to the government, a hidden tax (referred to as an implicit tax) is paid indirectly through a higher pretax cost for the shares relative to similar shares not eligible for the tax deduction. Who benefits from the favourable tax treatment? In this example, Firm X reaps the entire tax benefit as it obtains a higher price for the shares ($136.99 vs. $100) relative to Firm Y. But is that always the case?
In a recent study, we examined a setting similar to the one described above in which initial public offerings (IPO) of eligible Quebec companies received favourable tax treatment at the investor level.1 Under the Quebec stock savings plan (QSSP)2, Quebec individual residents who purchased newly issued shares of certain corporations were entitled to a generous tax deduction for Quebec income-tax pur- poses of up to 150% of the cost of the shares purchased during the year. Introduced in 1979, the initial ob- jectives of the QSSP were to provide tax relief to high-income taxpayers, to increase the participation of Que- bec residents in the stock market and to help Quebec-based businesses raise capital. Over the years, the program was modified and later streamlined to focus on small firms' capitalization needs. The objectives of the study were to examine how the tax benefit was shared between the issuing firm (existing shareholders) and the new shareholders and to identify factors that could affect the sharing of the tax benefit.
The case of the QSSP
For the period under study (1982 to 2002), individuals who were resident in Quebec at the end of the taxation year were entitled to deduct, in computing provincial taxable income, a stipulated percentage of the cost of qualifying shares purchased during the year with no adverse effect on the investors' adjusted cost base. The deduction rate could be 50%, 75%, 100% or 150%, depending on the class of shares issued, the size and type of the issuing corporation, as well as the time period considered. To benefit from the deduction, individuals had to meet certain holding period requirements; otherwise, they had to include the recapture of the amount previously deducted in their income.
Qualifying shares were generally comprised of newly issued common and restricted common shares of Canadian corporations whose central management was in Quebec or that had more than 50% of salaries paid to employees of an establishment in Quebec. Corporations faced restrictions with respect to their size, the number of full-time employees, the payment of dividends, and the use of funds. Thus, not all firms qualified for the program.
Given that certain Quebec individual investors had high marginal provincial tax rates (ranging from 24% to 33% between 1982 to 2002), it was expected that, all else being equal, some would be willing to pay a generous premium for QSSP shares compared with shares that were not eligible for the deduction, thereby lowering the pretax rate of return on these shares in a competitive market. If that were the case, investors would be considered to be paying a hidden tax associated with QSSP subsidized shares. Issuing firms could capture the tax benefit through an increase in issue prices and, thus, a lower cost of capital.
Impact of the QSSP on shares prices
To conduct our study, we collected data on 246 IPOs of Quebecbased corporations from 1982 to 2002. As in our car buyer's case, we wanted to know who was benefiting from the program. Our analysis revealed that investors paid more for IPO shares that were eligible for the QSSP deduction than they would have if the deduction was not available; that is, underpricing for QSSP shares was less severe than for non-QSSP shares. Underpricing is the difference between the offering price of the new stock and the first-day trading price of the stock following the IPO3. The first-day trading price should not be affected by the tax subsidy since only newly issued stock was eligible for the deduction.
Next, we wanted to examine the magnitude of the premium paid by investors relative to the expected premium that should be paid if, as for Firm X, the entire benefit was passed on to the issuing corporation. The figure below illustrates how the benefit was shared for corporations that issued shares eligible at the 100% deduction rate (more than 50% of corporations issued shares at this rate). We estimated that corporations captured, on average, approximately 63% of the tax subsidy, while high tax-rate Quebec individual investors retained 37%. Thus, Quebec individual investors retained a significant benefit from the program.4
The tax subsidy calculated for Firm X in the table on page 39 assumes that investors were eligible for the QSSP deduction and that offer prices were adjusted such that Quebec taxpayers in the 27% tax bracket saw no difference between purchasing nonqualifying shares and QSSP shares. However, not all investors, such as non-Quebec residents, were eligible for the tax deduction. As such, these investors should not have been willing to pay a premium for these shares. Corporations that sell a large proportion of their IPO QSSP shares to ineligible investors should have lowered their offering price in order to attract these investors. As predicted, we find that the underpricing was higher in this case and that as a consequence, the sharing of the tax benefit between the eligible investors and the corporation varied with the proportion of ineligible investors. The figure above illustrates how the benefit was shared when the proportion of the issue sold to ineligible investors was low (less than 30%) and high (more than 30%). When the proportion was low, the portion of the tax benefit retained by the corporation increased from 63% to approximately 72% whereas when it was high, this percentage was reduced to only 22%. Thus, corporations retained a greater share of the tax subsidy when the issue was sold primarily in the province of Quebec than when a large proportion of the shares was sold to ineligible investors.
Implications for investors, issuers and tax policy-makers
Understanding the effects of tax incentives on the pricing of securities is crucial to investors, issuers and tax policy-makers.
Although investors reduce their explicit taxes paid to the government when investing in assets with favourable tax treatment, they may be paying hidden taxes such that the pretax returns from these investments are lower than that on nontaxfavoured investments. In comparing returns on an after-tax basis, certain taxpayers may find it optimal to invest in nontaxfavoured assets.
Firms that issue tax-favoured securities must evaluate how the tax subsidy will affect their cost of raising capital. In our setting, firms that made their QSSP shares available to ineligible investors reaped a much lower share of the tax benefit than those who sold their shares primarily in Quebec.
Policy-makers should also take into account how their tax incentive will be shared between the parties and the factors that may affect that sharing in the design and evaluation of their programs. Our results may be of particular interest to policymakers in Quebec who replaced the QSSP program with a similar program, the SMB Growth Stock Plan. Introduced in 2005, this program has a single rate of 100%, is targeted to smaller corporations and is set to expire December 2009. Although we cannot provide conclusive evidence on the effectiveness of the QSSP program based on our study, our results suggest that removing the QSSP deduction would increase the cost of raising capital for some corporations.
[Sidebar]
The initial objectives of the QSSP were to give tax relief to taxpayers, to increase Quebecers1 participation in the market and to help Quebec businesses raise capital
[Reference]
References
1. Jean B�dard, Daniel Coulombe, Suzanne M. Paquette, "Tax Incentives on Equity and Firms' Cost of Capital: Evidence from the Quebec Stock Savings Plan." Contemporary Accounting Research 24 (3): 795-824.
2. For a technical description of the rules, see Title VI.I of the Taxation Act (Quebec).
3. Although several theories have been proposed to explain the underpricing phenomenon, most prior theory and evidence suggest that underpricing stems from information asymmetry between the entrepreneur and investors, including the level of ex ante uncertainty that uninformed investors have about the true value of an IPO firm's shares.
4. These reported numbers are based on estimated coefficients from a regression model and are estimated with error.
[Author Affiliation]
Jean B�dard, PhD, CA, is full professor in the School of Accounting at Laval University. Daniel Coulombe, PhD, CA, is full professor in the School of Accounting at Laval University. Suzanne Paquette, PhD, CA, is full professor in the School of Accounting at Laval University.
Technical editor: Christine Wiedman, PhD, FCA, School of Accounting and Finance, University of Waterloo
