In the context of corporate finance
, the Tax Benefits of Debt
or Tax Advantage of Debt
refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt
than with equity
. Under a majority of taxation systems
around the world, and until recently under the U.S. tax system
firms are taxed on their profits
and also individuals are taxed on their personal income
. A firm that earns $100 dollars in profits in the U.S.
for example, would have to pay around $30 dollars in taxes. If it then distributes these profits to its owners as dividends
, then the owners in turn pay taxes on this income. Say $20 on the $70 dollars of dividends. So that $100 dollars of profits turned into $50 dollars of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30 dollars. This implies for $100 dollars of profits before interest, investors got $70 dollars.