document de travail 2007-009 - FSA ULaval

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Jan 3, 2007 - HEC Montreal respectively. The authors are grateful to Nadi Chlala, Gary McGill, and Michel Magnan for their insightful comments on the ...
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DOCUMENT DE TRAVAIL 2007-009 THE TAX BENEFITS OF HEDGING FOR CANADIAN SMALL AND MEDIUM SIZE FIRMS

Jean-Marie GAGNON Nabil KHOURY Suzanne LANDRY

Version originale : Original manuscript: Version original:

ISBN – 2-89524-289-5

Série électronique mise à jour : On-line publication updated : Seria electrónica, puesta al dia

03-2007

THE TAX BENEFITS OF HEDGING FOR CANADIAN SMALL AND MEDIUM SIZE FIRMS

Jean-Marie Gagnon1 Nabil Khoury2 Suzanne Landry3

January 2007

_____________________ 1

Professor Emeritus, Laval University; 2Desjardins Chair in the management of derivative products, University of Quebec in Montreal; and 3Professor of Taxation, HEC Montreal respectively. The authors are grateful to Nadi Chlala, Gary McGill, and Michel Magnan for their insightful comments on the previous versions of this paper. They also thank S. El Ghoul for his able assistance. Financial support from the Chair in the management of derivative products is gratefully acknowledged.

Corresponding author: Suzanne Landry, Accounting Department, 5.359, HEC Montréal, 3000 ch. de la Côte Ste-Catherine, Montreal, Qc, Canada, H3T 2A7; (email: [email protected]).

THE TAX BENEFITS OF HEDGING FOR CANADIAN SMALL AND MEDIUM SIZE FIRMS

Abstract This paper focuses on one particular aspect of the need for hedging for Small and Medium Size Firms (SMF) in Canada, namely the tax benefits arising from the Canadian Income Tax Act (CITA). This need derives from various provisions of the CITA, more particularly from the progressivity of tax rates and from the carryover of net operating losses (NOLs). The study differs from previous work on hedging for tax purposes in that it takes into account the taxable incomes of both the SMF and its shareholder and derives the hedging decision on the basis of CITA which differs markedly from the Internal Revenue Code as regards progressive tax rates for SMFs. The study also innovates by showing that the hedging decision for tax purposes is a multivariable and a two-stage process. In the first stage, the level of the SMF’s taxable income, the level of variability of that income and the forecasted correlation between the successive annual taxable incomes together with the distribution policy adopted for its shareholder must be taken into account simultaneously and analysed over the planning horizon in order to determine the present level of the combined tax liability of the SMF and its shareholder that is pertinent for hedging purposes. In the second stage, the tax liability of the SMF and its shareholder are estimated separately in order to determine the actual profitability of a hedging policy in each case. The study also shows that the interplay of all the variables involved in the analysis increases the complexity of the decision process in such a way that a Monte Carlo simulation procedure becomes appropriate. Comparisons with US studies reveal several important differences, that are of interest as more and more US companies turn to Canada for financing and investment opportunities. Keywords: Hedging, Taxable Income, NOL, Monte Carlo Simulations, Progressivity

THE TAX BENEFITS OF HEDGING FOR CANADIAN SMALL AND MEDIUM SIZE FIRMS The high levels of volatility in many financial variables, including interest and exchange rates and in some basic commodity prices that continue to characterize world markets have fuelled new demands for hedging corporate exposure to these risks. On the other hand, the continued growth in options, futures, and related markets has supplied new instruments needed to match these demands. Yet, in spite of the fact that corporate hedging is ranked by financial executives as among their most important objectives (Rawls & Smithson (1990)), the rationale behind hedging decisions remains subject to controversy (Jalilvand (1999)). Hedging can be defined as the establishment of long and short positions in order to reduce or even eliminate the risk of adverse price fluctuations. In the extreme case of a frictionless world, hedging is irrelevant since investors can freely and costlessly unpackage and repackage various investment outcomes on their own to suit their needs (Modigliani and Miller hypothesis). Under these assumptions, cash flow variability entails no costs to the firms or to their shareholders and the need for hedging therefore disappears. In contrast, the theory of corporate risk hedging is based on real world frictional costs associated with cash flow variability (Mayers & Smith (1982)). Indeed, such variability will tend to increase taxes and the costs of financial distress as well as create conflicts of interest between shareholders and creditors. In this sense, hedging can increase the value of the firm by reducing expected taxes, expected costs of financial distress and agency costs of debt and equity (Bessembinder (1991), Froot et al. (1993), Mayers & Smith (1987)). Along these lines, Smith and Stulz (1985) for instance, show that by reducing their cash flow volatility firms can reduce the costs of financial distress, thereby enhancing their market value. All such frictional costs make it more efficient for firms to provide certain combinations of investment outcomes, than for investors to do so.

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Other researchers have focussed on the problems of transaction costs and asymmetric information that firms have to face when they need external financing. These factors affect the cost and availability of external funds and may make it cheaper and more expedient to use internal financing. In this context, Froot & al. (1993) show that by hedging cash flows, it is possible to generate sufficient financing internally, thus reducing the need for external financing. Mayers & Smith (1987) and Smith & Stulz (1985) have shown that by reducing their income volatility through hedging, firms can reduce their expected tax liability, provided that their effective tax function is convex. Graham & Smith (hereafter, GS (1999)) on the other hand report that corporations are more likely to face a convex tax-rate situation when, among other things, their incomes are volatile. Thus, it follows that by stabilizing taxable income, hedging can lead to lower taxes. In sum, three main reasons can motivate firms to stabilize their income through hedging. First, by reducing income volatility firms can create wealth for their shareholders, even though this may impact the wealth of their managers who hold unexpired stock options. Second, by reducing income volatility firms also increase their borrowing capacity which in turn conveys to them a tax benefit. Third, income stabilization enables firms to take advantage of the convexity of the tax function they face by reducing their tax liability. It is interesting to note in this regard that most empirical studies (Graham and Rogers, 2002; Dionne and Garand, 2003) have attempted to disentangle the last two tax effects (borrowing capacity / interest deductions and tax convexity / lower tax liability) by relying on proxies. However the robustness of these proxies and the validity of the results derived from them critically depend on the strength of their correlation with the underlying variable as well as on the lack of their correlation with the other independent variables. Graham and Rogers (2002) for example, use such proxies in their study based on US data and conclude that « the tax incentives to hedge in response to tax function convexity is one-fourth the incentive to increase debt capacity ». Dionne and Garand (2003) on the other hand, address the same problem of proxy robustness directly and find that the tax convexity proxy loses its statistical significance when one large firm is

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removed from the sample. In light of these studies, it seems then that the empirical results derived from such proxies are rather inconclusive. It could also be argued that the tax authority’s choice of a 12 months period for reporting already incorporates a measure of protection against currency fluctuations or commodity price or even interest rate fluctuations within the year. This argument does not, however, obviate the need to simulate the yearly taxable incomes, since these income figures already incorporate the impact of averaging method of the tax law and, moreover, they may also fluctuate from one year to the next under the impact of financial risk. In this study, we focus on the normative aspects of the tax incentives to hedge income fluctuations for non public small and medium size firms (SMF) as they are the ones most likely to face a convex tax function on account of their size and the limited number of their shareholders (Smith & Stulz, 1985). The analysis relies on Monte Carlo simulation techniques in order to assess the economic significance of hedging income volatility in the context of tax function convexity after controlling for the autocorrelation of annual SMF taxable incomes as well as for their payout ratios. More specifically, the study focuses on one particular factor that affects the need for hedging for SMFs in Canada, namely the tax reduction benefits arising from the Canadian Income Tax Act (CITA). These benefits are associated with the convexity that follows from various aspects of CITA, more particularly from the progressive tax rates and from the carryover of net operating (non capital) losses (NOLs). In essence, the convexity of the function that relates the income tax liability to taxable income derives from the fact that marginal tax rates are generally higher for top-levels of corporate and individual incomes. Hence, it is easy to see that a lower volatility can reduce the number of instances where taxable income is high and increase those where it is low, thus resulting in tax benefits. The objective of hedging is to generate revenue that will offset taxable income fluctuations. This issue has attracted even more attention recently on account of the growing popularity of derivatives as hedging instruments. For instance, a SMF can use derivatives to hedge market risk such as commodity price and foreign exchange risks or to protect against financial risk such as interest rate and credit risks. In view of their effectiveness in

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reducing volatility, they can be made part of an effective tax strategy. Yet, their potential role in tax planning is often misunderstood. The motivation of this paper is to shed light on the possible use of derivatives in this regard given that some basic hedging strategies can be implemented at minimal transactions costs. An example of such strategies is presented later in the paper. All told, the objective of this paper is threefold. First it investigates whether or not empirical results generated in the USA can be generalized to Canada. Secondly, it presents an analytical framework that includes relevant information, such as personal tax rates, distribution policy and autocorrelation of taxable income, which are either unavailable or at least not easily available to empirical researchers, but which introduce important non linearities in the analysis. Thirdly, it seeks to demonstrate that simulation techniques such as the one that underlines this study are an essential tool for the tax adviser of a SMF. The remainder of the paper is structured as follows. Part I presents an overview of the various characteristics of the CITA that can render the combined tax liability of the SMF and its owners a convex function of their taxable income. Part II explains the Monte Carlo simulation methodology used to study the tax benefits that could be obtained from that convex tax function, by hedging cash flows. Part III analyses and discusses the simulation results. Part IV concludes the study. Although we resort to simulation techniques similar to those used by GS (1999), our work differs from theirs in important respects. First, we take into account both individual and corporate tax rates as effective tax planning requires considering tax implications for all parties to the transaction (Scholes & al. p.2). Cloyd, Pratt and Stock (1996) report that private firms are less constrained and more inclined than public companies to make decisions that increase tax-related cash flows suggesting that SMFs are more likely to enter into transactions (e.g. hedging) if they can minimize both individual and corporate taxes. Ronen and Aharoni (1989) and Klassen (1997) provide a similar argument for

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corporations with concentrated ownership.1,2 In addition, with the tax attractiveness of flow-through forms of organization such as limited partnership, individual taxes become the main, and sometimes the only, relevant tax rates to consider in tax planning under CITA. Second, GS (1999) have used Compustat data in order to assess the value of hedging taxable income in general. In our study, the focus is on the higher values of the coefficient of variation of taxable income since our analysis concentrates on relatively small and vulnerable firms. Third, the Monte Carlo simulations take into account the tax effect of the NOLs carryover - the horizon of which is different from that in the USA which can still result in important tax savings, and therefore impact the need for hedging. Fourth, our study is based on CITA which differs markedly from the Internal Revenue Code as regards progressive tax rates for SMFs. Although some of the conclusions suggested by our controlled experiment are consistent with those of GS (1999), others differ markedly.

I - The convexity of the tax function In Canada, the convexity of the function relating taxable income to the tax liability is, for a SMF, mainly due to two provisions of the CITA namely, the progressive tax rates and the NOL carryover. Progressive tax rates3: A progressive tax rates structure is one where the tax rate increases with the taxpayer’s taxable income. The Canadian tax system has a progressive tax rate structure for individuals as well as for corporations. For instance, in 2005, the federal tax rate for individuals is 16% for taxable incomes up to $35,595, it increases to 22% for taxable incomes ranging from $35,596 to $71,190, then to 26% for incomes between $71,191 to 1

Public firms incur higher non-tax costs indicating that the objective of tax planning is rather to optimize (as opposed to minimize) taxes. 2 The Monte Carlo simulations take into account the combined tax rates i.e. federal and provincial. The related provincial tax law is similar to the CITA. Therefore we do not discuss the provincial tax rules separately unless it is necessary. 3 On June 29, 2006, the federal government has released draft legislative measures aimed to reduce individual taxes on ‘eligible dividends’ paid after 2005. The provincial government has also announced some tax changes. We do not expect these changes to impact our results.

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$115,739, and, finally to 29% for taxable incomes higher than $115,739.4 The Canadian tax system for Canadian Controlled Private Corporations (CCPC) is also progressive but to a lesser degree than it used to be. Indeed, since January 1, 2005 there are only two effective tax rates for a CCPC, namely: 13.12% if it qualifies for the small business deductions (SBD) and 22.12% otherwise. The SBD is a deduction of 16% on the first $300,000 (small business limit) of taxable income that qualifies as active business income.5 Before 2005, the tax rate structure had basically three rates namely: 13.12%, 22.12% and 29.12%. The Quebec tax system, which operates independently from the federal system, is also progressive for individuals.6 In 2005, the tax rate starts at 16% on the first $27,635 of taxable income; it increases to 20% for taxable incomes ranging from $27,636 to $55,280 and reaches 24% for taxable incomes higher than $55,280.7 It should be noted that these rates do not reflect the refundable Quebec abatement of 16.5%. On the other hand, the corporate tax rate is more like a flat tax as there is a unique rate of 8.90% effective for all corporations.8 In 2005, for an individual living in Quebec, the combined federal and provincial tax rate structure displays a stair-step pattern as follows:

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In 2006, these rates have not significantly changed. They are of 16% for taxable income up to $36,378, 22% between $36,379 and $72,756, 26% between $72,757 and $118,285 and 29% above $118285. 5 The small business limit will increase to $400 000 on January 1, 2007. The small business limit can be less than $300,000 if a CPCC has total taxable capital above 10 millions dollars. 6 The province of Quebec is the only one to have an independent tax system. In the other provinces, the provincial taxes represent usually a fraction of the federal taxes. 7 In 2006, these rates have not significantly changed. 8 In 2006 and 2007, this rate will increase to 9.90% for taxable income above $400,000. For small businesses i.e. a corporation whose assets for its preceding taxation year are less than $25 million, the tax rate is 8.5% in 2006 and 2007.

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Individual’s Taxable Income

Combined Marginal Tax Rate Net of Refundable Quebec Abatement

Combined Marginal Tax Rate Net of Refundable Quebec Abatement and Dividend Tax Credit

RI > $115,739

48.22 %

32.81%

$115,740 > RI > $71,190 $71,191 > RI > $55,280 $55,281 > RI > $35,595 $35,596 > RI > $27,635 RI < $27,636

45.71 % 42.37 % 38.37 % 33.36 % 29.36 %

29.68% 25.51% 20.51% 14.25% 9,25%

In 2005, a corporation doing business in Quebec is subject to the following combined tax rate structure:

Taxable Income

Qualified for Small Business Tax Deduction

Not Qualified for Small Business Tax Deduction

RI < = $300,000

22.02%

31.02%

RI > $300,000

31.02%

31.02%

Assuming that taxable income (TI) of a SMF in a given fiscal year can be either TI(1), with probability P(1), subject to a tax rate t(1) or T1(2), with probability P(2), subject to a tax rate t(2)>t(1), the expected value of its Tax Liability, given its level of Taxable Income, E [TL|TI], will be : E[TL|TI] =P(1)*t(1)*TI(1) +P(2)*t(2)*TI(2)

(1)

If by hedging its cash flows, the firm can stabilise TI at the level of its expected value, the corresponding expected tax liability will be equal to: E[TL|E[TI]]= t(m){P(1)*TI(1) + P(2)*TI(2)} where : t(m) = w*t(1) + (1-w)*t(2)

(0 ≤ w ≤ 1)

therefore,

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(2)

E[TL|E[TI]] = [w*t(1) + (1-w)*t(2)][P(1)*TI(1) + P(2)*TI(2)]

(3)

From (1) and (3), according to Jensen’s inequality, it follows that: E[TL|E[TI]] ≤ E[TL|TI] This result is illustrated in Figure 1.

Figure 1 approximately here

NOLs carryover In Canada, if a taxpayer incurs a NOL during a fiscal year, he may choose to use it to reduce his taxable income for the three immediately preceding and the ten subsequent taxation years.9 The taxpayer may decide at his discretion to claim all or part of the NOL for a given year. The only restriction is that they must be claimed in the order they were incurred. If a NOL is carried back to reduce the taxable income of a previous year, it generates a refund of taxes paid that year. If the NOL is carried forward, it reduces the taxable income of that subsequent year and the related tax liability. In sum, NOLs can be carried back three years and forward ten years to reduce the taxpayer’s tax liability. Therefore a fourteen-year horizon is relevant. Table 1 illustrates this situation.

Table I approximately here

As the table shows, tax savings resulting from NOLs carryovers could either be 22.02% or 31.02%. For example, the NOLs incurred in t, t+1 and t+2 completely eliminate the firm’s taxable income in t-1 and t-2, thus resulting in tax savings of 22.02% in terms of

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For NOLs incurred after March, 22, 2004. For losses incurred before March 23, 2004, the carryforward period was seven years. In its 2006 budget, the federal government proposed to extend the carry forward period to 20 years.

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the firm’s effective annual tax rate. The NOL incurred in t+3 is carried forward to t+4, t+5 and t+6, which results in tax savings estimated at a tax rate of 22.02% in t+4 and t+5, and of 31.02% in t+6. Indeed, in t+6, the amount of NOL which stands at $72,229 reduces the firm’s taxable income from $412,496 to $340,267 which generates a tax saving of $22,405. Recall that in 2005, all taxable income that exceeds the small business limit of $300,000 is taxed at 31.02%. Consequently, for a firm that qualifies for the SBD, any strategy consisting in reducing taxable income to the level of $300,000 generates tax savings calculated at 31.02%. In all the above estimates, the tax benefits derived from the NOLs carryforwards, not being available immediately, are discounted at a hypothetical cost of capital of 10% in order to reflect the present value of these tax savings. The previous discussion clearly shows that, in the final analysis, NOLs deductions reduce the taxpayer’s marginal tax rate. This in turn, mitigates the inequity created by the progressive tax rate structure particularly when business income fluctuates from year to year. The Monte Carlo simulations presented in part III of this paper build on this observation by generating income streams over 14 years, as in Table 1, in order to take into account the impact of NOLs carryover time period.

II - Method We now turn to an analysis of the impact of hedging the volatility of taxable incomes and the related tax liabilities for a SMF and its shareholder. This analysis brings into focus not only the impact of revenue volatility but also that of the first order autocorrelation between these successive annual taxable incomes (hereafter autocorrelation of taxable income), as well as the impact of the NOLs carryover and the distribution policies (dividends and bonuses to shareholders) on future taxable incomes. To take into account all these variables and their interactions simultaneously, the Monte Carlo simulation technique appears particularly suitable, since it generates a great number of streams of possible future taxable incomes, assuming different numerical values for the parameters and random variables, thereby allowing us to generalize our results to Canadian taxpayers in all provinces. It is important to note that the Monte Carlo simulations allow corporate

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taxable incomes to be positive, negative or zero. Also, when applicable, the NOLs are carried over according to the CITA provisions as discussed in the previous section. Starting from year t-3, the Monte Carlo simulation procedure generates streams of taxable incomes (or NOLs) for 14 years. In this framework, taxable income is assumed to follow the following process: TIt+1 = TIt + ΔTIt

t = t-3, t-2, …, t+10.

where : TIt = taxable income of year t ΔTIt = annual increase of TI, in dollars, a random variable normally

distributed, with

constant mean and standard deviation increasing from [0 to 20]*[the mean]. It follows that taxable income for any year t (TIt) is assumed to be made up of a fixed component and a random component equal to ΔTIt. As already discussed, efficient tax planning for a SMF must take into account the tax impact of all parties to the transaction, which requires the implementation of a payout policy for the shareholders. The nature of the payout should reflect an optimal tax planning strategy for a SMF. In the Canadian context, to achieve that objective, we follow this well-accepted rule of thumb: if the firm’s taxable income is $300,000 or less, the payout should take the form of a dividend.10 If the firm’s taxable income is greater than $300,000, an optimal payout policy implies that a bonus should be paid first to reduce the firm’s taxable income to the level of $300,000 and then a dividend be paid to achieve the distribution policy. For the shareholder, the combined maximum marginal tax

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This rule of thumb accounts for the fact that bonuses qualify as business expenses whereas dividends do not. It also reflects the peculiarities of the Canadian tax system such as the integration mechanism. For over 20 years, the CRA has allowed a CCPC to pay bonuses to its shareholders in order to lower its taxable income to the small business deduction limit. The CRA does not challenge the reasonableness of such bonuses as long as the shareholders are Canadian residents and involved in the day-to-day business operations (Income Tax – Technical News # 22, January11, 2002). Loans to shareholders must be repaid before the end of the subsequent taxation year in order not to be taxed. As a result, loans to shareholders are not usually used in this context.

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rate applicable to bonuses is 48.22% and 32.8% for dividends.11 In our Monte Carlo simulations, we assume that the SMF is owned by a sole shareholder and that the distribution policy follows the rule of thumb stated above. We also suppose that the SMF has adopted a constant payout ratio equal to 35% of its taxable income in a given year.12 Hence, following our rule of thumb, if the SMF’s annual taxable income is below $300,000; the shareholder receives a dividend. If the SMF’s taxable income is between $300,000 and $461,538, the payout has two components, namely a bonus equal to the difference between the taxable income and $300,000 plus a dividend up to the maximum of 35% of taxable income.13 For taxable incomes above $461,538, all the 35% payout will take the form of a bonus payment. Distributions cannot be negative; hence, if a CPCC incurs a non-capital loss during a year; the shareholder receives no distributions for that year14. The tax rates are the ones presented earlier, and the combined (federal and provincial) tax rates for individuals and corporations are used to compute the tax liability. Tax rates for 2005 are assumed to remain constant over the simulation period15. Furthermore, successive amounts of taxable income are assumed to be either negatively or positively autocorrelated or uncorrelated as follows: Г (ΔTIt+1, ΔTIt) = - 0.5 if annual taxable incomes are negatively correlated; Г (ΔTIt+1, ΔTIt) = + 0.5 if annual taxable incomes are positively correlated; Г (ΔTIt+1, ΔTIt) = 0, if annual taxable incomes are uncorrelated. The correlation coefficient identifies and measures the relationship between two successive annual taxable incomes. When they tend to move in the same direction, such 11

This is the combined marginal tax rate for residents of Quebec in 2005. Note that this payout policy is arbitrary although it seems to reflect real life. Indeed the payout increases as taxable income increases providing enough money to the shareholder for a comfortable lifestyle and ensuring the future growth of the corporation. 13 For instance, if the taxable income is $461,538, the shareholder receives a bonus of $161,538 and no dividend. 14 In Canada, an optimal tax planning strategy will require firms that have non-capital losses to question the need to claim capital cost allowance or tax depreciation (as they are permissive deductions). 15 In general, individual tax rates are indexed to inflation at both federal and provincial levels. Corporate tax rates are not indexed. 12

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that when the first assumes a relatively high value, the other also tends to be relatively high, the two values are said to be positively correlated. Conversely, when they tend to move in opposite directions, they are said to be negatively correlated. In both cases the correlation coefficient indicates the degree of such a relationship. It follows of course that when two successive annual incomes are independent, the corresponding correlation coefficient is zero. The numerical values are suggested by empirical observations: Foster16 reports estimates of autocorrelations for first-differenced net incomes have a .1 decile value of -.418, a median of -.023, a mean of -.011 and a .9 decile of .406. With these assumptions, two Monte Carlo simulations have been conducted. In the first case, the SMF is assumed to generate a taxable income equal to $440,000 at t-3, increasing by a random amount ΔTI equal to $20,000 (approximately 4%) per year, with a coefficient of variation ranging from 0 to 20. The coefficient of variation measures the ratio of the taxable income’s standard deviation to the average taxable income. The wide range of coefficients of variation chosen for the simulations is meant to clearly illustrate the loss carryover mechanism. In this regard, empirical evidence shows that Compustat17 firms have a cross-sectional mean coefficient of variation equal to approximately 2.2 and that these coefficients are widely dispersed as the observed standard deviation is about 9 times larger than the mean taxable income. Putting these two observations together, a logical conclusion is that the coefficients of variation should be larger for smaller firms, since they are less diversified. In light of this, the range of 1 to 20 chosen for the coefficients of variation of SMF in this study appears quite realistic. When the coefficient is 0, taxable income is equal to $500,000 at year t (hereafter the $500,000 model). The corporate tax liability is computed as of year t, discounting possible tax carryforwards at 10%. With the simulation parameters thus defined, 10,000 estimates of the tax liability for the SMF and it shareholder are generated. Averages of these estimates are reported in table II.

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G. Foster (1986, p.239). Estimated from Table 2 in Barth et al (1999, p. 397). See also Frecka and Hopwood (1983): the quotient of the high to the low standard deviation of the ratio of net income to total assets is about 9.

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In the second set of Monte Carlo simulations, it is assumed that the SMF generates a corporate taxable income level of $264,000 (hereafter the $300,000 model), at t-3, increasing randomly by $12,000 a year, so that an expected income level of $300,000 is reached at period t, when the standard deviation is zero. At this level, corporate taxable income will start hovering between the higher and the lower tax rates i.e. 31.02% or 22.02%. Apart from that, all the other assumptions underlying the first simulation apply mutadis mutandis to this one. Averages of these estimates are reported in table III. The technique of Monte Carlo simulations allows a better control of the conditions of the experiment which should lead to more convincing results. Indeed, these simulations take into account the impact of the NOLs carryovers on past and future taxable incomes. Contrary to the situation prevailing in the USA, tax savings resulting from the NOLs carryover can only be claimed in Canada by the corporation that has incurred the loss, since consolidation is not allowed for tax purposes. Hence, the firm that incurs losses cannot count on other related corporations to stabilize its income18.

III - Results Panel A of Table II sets out the results of the $500,000 model. Panel B displays a summary of these results and provides an example of the calculations. Overall, the tables show that the NOL carryover, combined with a zero (case 1) or negative (case 3) autocorrelation coefficient of taxable incomes is a relatively powerful tool for minimizing income taxes. This result does not hold to the same extent when the correlation is positive (case 2).

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Investment tax credits (ITCs), just like NOLs, can be used to hedge fluctuations in taxable income, as they can be carried over in the same way. Tax depreciation can also be used for that purpose, although it is less efficient, as it has to be spread over successive fiscal years. We assume those possibilities to have been resorted to before computing taxable income. In addition, Canada does not have an AMT based on income for corporations. Instead, large corporations pay a tax on capital that is calculated on the adjusted net assets on the balance sheet. Hence, contrary to GS (1999), we do not consider AMTs and ITCs in our simulations.

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Table II approximately here Specifically, the combined individual and corporate tax liability increases, as expected, with the coefficient of variation in all three assumptions about autocorrelation. However, when the autocorrelation coefficient is negative (case 3), the corporate and shareholder’s total tax liability increases only by 3% at year t, over the whole range of the coefficients of variation19. On the other hand, when there is no autocorrelation (case 1), the NOLs’ carryovers become somewhat less effective than before (case 3) and the combined tax liability increases by 6.5%. With a positive coefficient (case 2), the combined tax burden of the SMF and its shareholder increases by about 12% of taxable income suggesting that the NOLs’ carryover is not effective in achieving tax minimization. In other words, this tax increase represents the opportunity cost of not hedging since it is an estimate of the potential tax savings that could result from an income stabilisation policy or a less volatile taxable income. A closer examination of the table reveals that the tax liability for the SMF increases over the whole range of coefficients of variation by 2.9%, 2.1% and 5.4% of the $500,000 of year t taxable income with correlation coefficients of 0, -0.5 and +0.5 respectively. The tax liability function for the shareholder does not display the same pattern. The tax liability decreases first and then increases over the whole range of coefficients of variation and correlation coefficients: it is not a monotonic function over the interval 0 – 20 of the coefficient of variation as shown in Figure 2.

Figure 2 approximately here To explain this non-monotonic characteristic, we have examined all the moments of the distribution. The examination reveals that the kink in the function is due to the distribution policy, which precludes negative incomes for the shareholder, so that large 19

For example: [($171,220-$154,746) / $500,000 = 3%].

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NOLs for the SMF due to a high coefficient of variation have no effect on the shareholder’s taxable income and its related tax liability. This result suggests that the shareholder must take into account the combined effect of the coefficient of variation of the firm’s income and the split between dividends and bonuses of his own taxable income before determining the need for a hedging strategy independent of that of his firm. We can thus conclude that in terms of hedging for tax purposes, no single recommendation exists that satisfies the needs of both the SMF and its shareholder in all situations. GS (1999, p 2257) concluded that serial correlation reduces the tax benefits of hedging while volatility increases them. Our results are not consistent with the first segment of their findings and suggest that the second segment does not apply uniformly to all stockholders’ tax brackets. Panel A of Table III presents the results of $300,000 model. Again panel B displays a summary of the results and the related calculations. At first sight, the combined tax liability of the SMF and its shareholder seems to follow the same trend as in Table II, namely increasing with the increase of the coefficient of variation, but more so when the autocorrelation of annual taxable incomes is +0.5 (case 5, +11%) than when it is either 0 (case 4) or -0.5 (case 6) (+5.3% and +1.7% respectively).

Table III approximately here Again, the data display a point of inflexion but this time, it is observed in the estimates of the corporate tax liability. We performed a detailed analysis of the function, and our examination suggests that the kink occurs because the NOLs carryover provisions become somewhat less powerful i.e. the tax benefit of some large NOLs for the SMF due to a high coefficient of variation cannot be carried over and have to be forfeited. That effect is illustrated in Figure 3: the maximum tax liability increases at a higher rate, in absolute value, than the minimum is decreasing.

Figure 3 approximately here

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Therefore the spread between the minimum and the mean becomes smaller than between the maximum and the mean, which is bent. It is therefore up to the shareholder (case 6), in this case, to minimise his tax liability by stabilizing withdrawals or by hedging his taxable income with derivative instruments, and to compare the benefits against the costs of such measures. Here also, our findings differ from those of GS (1999) and suggest that observations drawn from US data cannot necessarily be generalised to Canada. This analysis clearly shows that the validity of an income stabilization policy for the SMF critically depends on the level and the range of fluctuations of its taxable income, the correlation coefficient of its successive annual incomes and the distribution policy favoured by its shareholder. Given a distribution policy of dividends and bonuses that minimises the tax liability of the SMF and the shareholder as defined in this study, the analysis shows that the benefit of the stabilisation policy increases as the algebraic value of the autocorrelation of taxable incomes and the coefficient of variation increase. However, when the correlation of successive annual incomes is 0 or negative, the carryover provisions of the CITA act as a buffer which makes hedging strategies much less attractive. Furthermore, not all tax liability functions are monotonic and, therefore, the level of the coefficient of variation is relevant. In the final analysis, income stabilization will only become a viable policy if the tax reductions it generates outweigh their hedging costs. To this end, a wide range of hedging strategies with different external and internal costs could be implemented. The external costs of these strategies follow from their pricing and depend, among other things, on the particular instruments involved and on the volatility of the particular risk hedged. The internal costs are the additional outlays that a SMF must incur in order to implement the strategy. To illustrate this point, assume that the main source of risk in the SMF revenues derives from the exchange rate between the Canadian and US dollars. One possible strategy to hedge this risk for a Canadian importer would be to adopt a tunnel strategy offered over the counter by purchasing a European put and writing a European call on the US dollar

17

with the same maturity but with different strike prices selected so that the cost of the put is equal to the revenue from the call. For example, as of June 5 2006, a strategy with a one year maturity would have resulted in a zero external cost tunnel with a maximum upside fluctuation of +1.49% if the exchange rate of the US dollar increases and a minimum downside fluctuation of -3.40% if it falls with respect to the Canadian currency. For a six months maturity, this tunnel would have been limited by a maximum upside fluctuation of +1.99% and a minimum downside fluctuation of -2.95%. Assuming the cost structure of the SMF is such that this no-cost strategy reduces the coefficient of variation i.e. the income volatility from 10 to 4, then the total tax liability would be reduced by $ 6 700, or 7%, approximately given a coefficient correlation of +0.5 if the taxable income is of $300 000 (table III, case 5). The tax benefit would be of $13 975, or 8% approximately if the taxable income is $500 000. These tax benefits must then be set up against the internal costs of the strategy before a final decision is reached.

Conclusion This paper focuses on the necessary and sufficient conditions for the viability of an income hedging policy from the perspective of reducing the tax liabilities of the SMF and its shareholders in the Canadian context. The first part of the paper deals with the necessary condition for the viability of such policy, namely a progressive tax schedule. By extending the analysis to a 14-year period in order to take full account of the impact of the NOL carryover provisions of the CITA, the study has put in sharp perspective the progressive requirement of the tax rates in the determination of a hedging strategy to minimize the tax burden of the SMF and its shareholder. Most arguments on hedging for tax purposes do not go beyond this observation. This study contributes to the literature by further investigating if this first condition, though necessary, is also sufficient for devising a profitable income stabilisation policy for tax purposes. To answer this question, we use in the second part of the study a Monte Carlo simulation technique in order to accommodate the simultaneous interplay of several variables that

18

determine the amount of taxes paid by the SMF and its shareholder. Apart from being a more robust analytical tool, this technique makes it possible to generalise the conclusions of the study. It turns out that the income distribution policy of the SMF, the autocorrelation of taxable incomes as well as their level and variability are also relevant to determine the profitability of the income stabilization policy for tax purposes in addition to the progressivity of the tax rates. Indeed, as the analysis shows, for some income levels, the interplay of all these variables with the NOLs carryover provisions of the CITA can act as an effective buffer against income variability that makes any further stabilization policy less profitable for the SMF. Tax planners should therefore take account of these variables as they impact the profitability of any income hedging policy for tax purposes. Furthermore, comparisons with GS (1999) study for US corporations show that, contrary to their findings, serial correlation of annual taxable incomes does not reduce the tax benefits of hedging while volatility does not increase them uniformly across all tax brackets in the Canadian context. In short, this study shows that the hedging decision for tax purposes is a multi-variable and a two-stage process. In the first stage, the level of the SMF’s taxable income, the level of variability of that income and the forecasted correlation between the successive yearly taxable incomes together with the distribution policy adopted for its shareholder must be taken into account simultaneously and analysed over a 14-year planning horizon in order to determine the present level of the combined taxable liability of the SMF and its shareholder that is pertinent for hedging purposes. In the second stage, the tax liability of the SMF and its shareholder are estimated separately in order to determine the actual profitability of a hedging policy in each case. The study also shows that the interplay of all the variables involved in the analysis increases the complexity of the decision process in such a way that a Monte Carlo simulation procedure rather than a mathematical formulation (or numerical examples) becomes more appropriate.

19

Figure 1- Tax Liability as a Function of Taxable Income When the Tax Rates are Progressive

20

Table I – Illustration of the NOLs Carryover Provision Fiscal year

t-3

0

Tax liability before the NOL’s carryover $ 0

t-2

198,044

43,609

0

0

198,044

0

0

43,609

22.02

22.02

t-1

152,988

33,688

0

0

152,988

0

0

33,688

22.02

22.02

(135,255)

0

n/a

0

n/a

n/a

n/a

n/a

n/a

22.02

t-2R

198,044

43,609

135,255

n/a

62,789

29,783

22.02

13,826

22.02

22.02

t+1

(121,658)

0

n/a

0

n/a

n/a

n/a

n/a

n/a

22.02

t-2R

62,789

13,826

62,789

n/a

0

13,826

22.02

0

0

22.02

t-1R

152,988

33,688

58,869

n/a

94,119

12,963

22.02

20,725

22.02

22.02

t+2

(94,119)

0

n/a

0

0

0

0

0

0

22.02

t-1R

94,119

20,725

94,119

n/a

0

20,725

22.02

0

0

22.02

t+3

(258,253)

0

0

(258,253)

0

0

0

0

0

22.02

t+4

25,229

5,555

25,229

(233,024)

0

5,555

22.02

0

0

22.02

t+5

160,795

35,407

160,795

(72,229)

0

35,407

22.02

0

0

22.02

t+6

412,496

100,956

72,229

0

340,267

22,406

31.02

78,550

19.04

31.02

t+7

452,913

113,493

0

0

452,913

0

0

113,493

25.06

31.02

t+8

600,701

159,337

0

0

600,701

0

0

159,337

26.53

31.02

t+9

807,511

223,490

0

0

807,511

0

0

223,490

27.68

31.02

t+10

1,325,043

384,028

0

0

1,325,043

0

0

384,028

28.98

31.02

t

Taxable income $

NOL’s carryover to reduce taxable income $ 0

NOL’s at year end available for carryover $ 0

Taxable income after the NOL’s carryover $ 0

Tax savings after the NOL’s carryover $ 0

Tax savings after the NOL’s carryover % 0

Tax payable after the NOL’s carryover $ 0

Effective tax rate %

0

Marginal tax rate on the next $ 100,000 of income % 0

21

Table II - Average Tax Liability in year t of a SMF and Its Shareholder, Assuming Corporate Taxable Income Equal to $500,000 at t1. Panel A Correlation = 0 (case 1) Coefficient Corporate Shareholder’s of tax tax variation liability liability

Total tax liability

Correlation = +0.5 (case 2) Corporate Shareholder’s Total tax tax tax liability liability liability

Correlation = - 0.5 (case 3) Corporate Shareholder’s Total tax tax tax liability liability liability

0

73,815

80,931

154,746

73,815

80,931

154,746

73,815

80,931

154,746

1

74,199

79,743

153,942

75,020

79,373

154,393

73,955

80,539

154,494

2

76,363

78,054

154,417

77,879

76,707

154,586

75,010

79,015

154,024

3

78,508

76,607

155,115

80,473

75,746

156,218

76,580

77,646

154,226

4

80,305

75,783

156,088

81,678

75,464

157,143

78,057

76,698

154,755

5

81,848

75,849

157,697

82,750

76,248

158,998

79,804

76,508

156,311

6

82,289

75,458

157,746

83,035

77,735

160,770

81,162

76,259

157,420

7

82,759

76,508

159,267

83,119

79,699

162,818

82,009

76,086

158,095

8

83,067

77,371

160,438

83,170

81,087

164,257

82,232

75,715

157,946

9

83,693

79,189

162,881

83,240

82,744

165,984

82,782

75,895

158,678

10

82,980

79,400

162,380

84,858

86,260

171,118

83,352

76,624

159,976

11

84,348

82,231

166,580

86,602

89,296

175,898

84,060

78,188

162,248

12

83,868

83,089

166,957

87,759

92,428

180,186

83,590

78,304

161,894

13

82,591

83,395

165,986

87,419

93,029

180,448

82,756

78,509

161,265

14

83,723

86,051

169,774

90,651

97,380

188,031

83,331

79,812

163,143

22

Correlation = 0 (case 1) Coefficient Corporate Shareholder’s of tax tax variation liability liability

Total tax liability

Correlation = +0.5 (case 2) Corporate Shareholder’s Total tax tax tax liability liability liability

Correlation = - 0.5 (case 3) Corporate Shareholder’s Total tax tax tax liability liability liability

15

84,831

88,461

173,292

93,229

101,181

194,409

84,259

81,405

165,664

16

85,360

90,340

175,700

93,837

103,525

197,361

83,801

82,327

166,128

17

86,747

93,398

180,145

95,095

105,205

200,300

83,555

82,824

166,378

18

85,409

93,746

179,155

98,038

109,742

207,780

84,254

84,779

169,033

19

89,873

99,113

188,986

100,018

112,623

212,641

84,434

86,091

170,525

20 87,950 98,986 186,936 100,958 115,741 216,699 84,118 87,101 171,220 Tax liability of a SMF and its shareholders, assuming corporate taxable income equal to $440 000 at t-3, a normally distributed annual increment of $20 000, autocorrelation coefficients of 0.0, 0.5 and -0.5. The coefficient of variation ranges from 0 to 20 and the distribution ratio is equal to 35%. 1

Panel B - Summary of the Result for the $500,000 Model Correlation coefficients

Combined (SMF + shareholder)

Corporate (SMF)

Shareholder

-0.5

3%1

2.1%2

Non-monotonic

0

6.5%

2.9%

Non-monotonic

+0.5

12%

5.4%

Non-monotonic

1

For example: [($171,220-$154,746) / $500,000 = 3%]

2

For example : [($84,118-$73,815) / $500,000 = 2.1%]

23

Figure 2

24

Table III – Average Tax Liability in year t of a SMF and Its Shareholder, Assuming Corporate Taxable Income Equal to $300,000 at t1. Panel A Correlation=0 (case 4) Coefficient Corporate Shareholder’s of tax tax liability variation liability

Total tax liability

Correlation=+0.5 (case 5) Corporate Shareholder’s tax tax liability liability

Total tax liability

Correlation=- 0.5 (case 6) Corporate Shareholder’s tax tax liability liability

Total tax liability

0

66,060

24,031

90,091

66,060

24,031

90,091

66,060

24,031

90,091

1

64,256

25,331

89,587

63,655

25,853

89,508

64,791

24,934

89,726

2

62,442

26,681

89,122

60,970

27,493

88,463

63,454

25,845

89,299

3

60,641

28,050

88,691

58,680

29,489

88,169

62,089

26,756

88,845

4

58,702

29,236

87,938

56,557

31,431

87,989

60,881

27,604

88,486

5

57,550

30,909

88,459

54,992

33,615

88,607

59,742

28,877

88,619

6

56,203

32,830

89,033

53,737

35,654

89,391

58,613

30,049

88,662

7

54,781

33,896

88,677

52,459

37,816

90,276

57,670

31,044

88,714

8

53,828

35,373

89,201

51,580

39,580

91,160

56,535

31,881

88,416

9

52,917

37,188

90,105

50,678

41,203

91,881

55,739

32,864

88,603

10

51,706

38,086

89,792

50,850

43,887

94,737

55,022

34,112

89,134

11

51,628

40,012

91,640

51,288

46,202

97,489

54,713

35,571

90,284

12

51,136

41,737

92,873

51,356

48,529

99,885

53,754

36,291

90,045

13

50,132

42,385

92,517

50,883

49,171

100,054

52,582

36,970

89,552

14

50,662

44,658

95,320

52,394

51,978

104,372

52,366

38,215

90,581

25

Correlation=0 (case 4) Coefficient Corporate Shareholder’s of tax tax liability variation liability

Total tax liability

Correlation=+0.5 (case 5) Corporate Shareholder’s tax tax liability liability

Total tax liability

Correlation=- 0.5 (case 6) Corporate Shareholder’s tax tax liability liability

Total tax liability

15

50,946

46,622

97,568

53,699

54,677

108,376

52,313

39,704

92,016

16

50,506

47,180

97,687

53,654

56,365

110,019

51,572

40,566

92,137

17

50,724

48,641

99,365

54,358

57,449

111,807

51,069

41,245

92,314

18

50,814

50,563

101,376

56,216

60,305

116,521

51,030

42,771

93,801

19

51,489

52,270

103,759

57,163

62,210

119,373

50,707

43,875

94,582

20 52,106 53,837 105,942 57,753 64,203 121,956 50,423 44,583 95,006 Tax liability of the SMF and its shareholders, assuming a corporate taxable income of $264 000 at t-3, a normally distributed annual increment of $12 000, and autocorrelation coefficients of 0.0, 0.5 and -0.5. The coefficient of variation ranges from 0 to 20. The distribution ratio is equal to 35%. 1

Panel B - Summary of the Result for the $300,000 Model Correlation coefficients

Combined (SMF + shareholder)

Corporate (SMF)

Shareholder

-0.5

1.7%1

Non-monotonic

8.8%2

0

5.3%

Non-monotonic

9.9%

+0.5

11%

Non-monotonic

13.4%

1

[($95,006-$90,091) / $300,000 = 1.7%]

2

[($50,423-$24,031) / $300,000 = 8.9%]

26

Figure 3

27

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