Taxes, Valuation, and Organizational Structure

Abstract

This paper estimates the impact of taxes on firm value by taking advantage of a dramatic and completely unanticipated increase in taxes for a group of publicly-traded Canadian firms called income trusts. When the tax rate for income trusts unexpectedly increased from 0% to 31.5%, equity value fell by 21% and firm value fell by 18%, on average. Prospective tax shields mitigate the decline, adding 4.9% to firm value. Consistent with the presence of tax-based investor clienteles, the impact of the tax change depends on the marginal investor’s personal tax status, which influences the value of tax shields. Therefore, simple estimates using the permanent debt approach in the Modigliani and Miller (1963) model substantially overstate the value the market places on tax shields. Finally, this dramatic change in tax policy provides new evidence on the significance of taxes for organizational form choices.