Tax Motivated Payout Financing

Abstract

Many firms, even those that are cash rich, routinely engage in costly borrowing and, more rarely, equity issuance in order to finance their payouts. A reported motive for this payout-financing behavior is the sheltering of corporate income tax. We present a model of a firm that maximizes its after-tax cash flow through jointly selecting the amount of its profits to recognize in a foreign tax haven and the amount of new capital it raises. The firm is subject to fixed payouts as well as a constraint on raising new capital. Consistent with U.S. tax law, the firm cannot use foreign-recognized earnings to finance payouts without triggering domestic taxation. The model shows that under certain benign conditions it may be optimal to raise external capital to meet payouts rather than using internally-generated cash flow. Consistent with this shelter-finance-payout strategy, we find that sticky-dividend firms that have more foreign earnings subject to repatriation taxes use more debt to finance their ordinary dividends. In addition, sticky-dividend firms that are tax aggressive use more debt to finance their ordinary dividends. Finally, sticky-dividend firms that are tax aggressive use more debt to finance their ordinary dividends if their domestic tax rate (cost of borrowing) is high (low).

Keywords: Tax aggression, repatriation tax, payout policy, dividend policy, share repurchase

JEL Classification: G32, K34