MILLER`S MODEL ON PERSONAL TAXES AND THEBRAZILIAN TRIBUTARY STRUCTURE

FUNDAÇÃO GETÚLIO VARGAS

ESCOLA BRASILEIRA DE ADMINISTRAÇÃO

PÚBLICA E DE EMPRESAS

CÉSAR SILVA GOMES

MILLER’S MODEL ON PERSONAL TAXES AND THE

BRAZILIAN TRIBUTARY STRUCTURE

Rio de Janeiro

2010

César Silva Gomes

Miller’s Model on Personal Taxes And The Brazilian

Tributary Structure

Monografia apresentada ao curso de Administração da Escola Brasileira de Administração Pública e de Empresas da Fundação Getúlio Vargas do Rio de Janeiro como requisito à obtenção do título de Bacharel em Administração. Orientado pelo Prof. Rogério Sobreira.

Rio de Janeiro2010

César Silva Gomes

Miller’s Model on Personal Taxes And The Brazilian

Tributary Structure

_________________________________________

Rogério Sobreira

_________________________________________

Membro 2

_________________________________________

Membro 3

ABSTRACT

This study shows how the Miller’s Model on Personal Taxes may work in the

Brazilian tributary legislation. Through this work we see the basics of capital structure

theories and how Merton Miller developed his theories to the personal taxes model.

In order to help assess Miller’s model to Brazil this work studies the Brazilian

legislation mainly regarding the income taxes. Following Miller’s model there is an

emphasis on corporate income tax, personal tax on bonds and personal income tax

on stocks. Also it is shown how companies in Brazil may benefit from the interest

over equity, a form of paying dividends to a certain limit (the TJLP) that can be

deducted from the corporate income tax.

In this work there is shown the income tax rates to form Miller’s Model on

Personal Taxes in Brazil. According to the Brazilian legislation these rates are 34%

for corporate income taxes, 15% for personal income tax on stockss and it may vary

between 15% and 22.5% for personal income tax on bonds, depending on the

duration of the bond.

The conclusion of this paper is that according to Miller’s model and the

Brazilian legislation, companies in Brazil have an incentive to issue debt indefinitely,

as this would increase its value.

Key words: Capital Structure; Modigliani & Miller; Miller’s Model; Personal

Taxes; Brazilian Taxes; Brazil; Interest on Equity; Dividends; Income Taxes.

JEL Classification: G32

LIST OF FIGURES

Figure 1 - Value of the leveraged firm as a function of bonds issued........................12

Figure 2 - Cost of as a function of bonds issued........................................................13

Figure 3 - Value of the leveraged firm as a function of the Corporate Income Tax

Rate...........................................................................................................................15

Figure 4 - Value of the leveraged firm as a function of the Personal Income Tax on

Stocks........................................................................................................................16

Figure 5 - Value of the leveraged firm as a function of the Personal Income Tax on

Bonds.........................................................................................................................17

Figure 6 - Gain of leverage as a function of the amount of Bonds issued (each line

represents a different tax bracket on the Personal Income Tax on Bonds)...............25

LIST OF FIGURES

Table 1 - Benefits for the use of Interest on Equity....................................................22

Table 2 - Personal Income Tax Rate on Bonds.........................................................23

LIST OF ABREVIATIONS

B - Value of the firm’s bonds

Bl - Value of the leveraged firm’s bonds

r0 - Return of the firm

rb - The interest rate of the firm’s bonds

rs - The expected return on shares

S - Value of the firm’s shares

Tb - Personal income tax rate on bonds

Tc - Corporate income tax rate

Ts - Personal income tax rate on shares

Vl - Total value of the leveraged firm

Vu - Total value of the unleveraged firm

SUMMARY

1 - INTRODUCTION..........................................................................................3

2 - METHODOLOGY.........................................................................................3

3 - CAPITAL STRUCTURE REVISITED...........................................................3

3.1 - MODIGLIANI & MILLER........................................................................3

3.1.1 - CORPORATE TAXES ON MODIGLIANI & MILLER.......................3

3.1.2 - MILLER’S MODEL ON PERSONAL TAXES..................................3

4 - BRAZILIAN TRIBUTES................................................................................3

4.1 – CORPORATE INCOME TAX................................................................3

4.2 - PERSONAL INCOME TAX ON EQUITY...............................................3

4.3 - PERSONAL INCOME TAX ON DEBT...................................................3

5 - MILLER'S MODEL AND BRAZILIAN TAX STRUCTURE............................3

6 - FINAL CONCLUSIONS................................................................................3

REFERENCES..................................................................................................3

8

1 - INTRODUCTION

One of the important questions that the finance theories have been trying to

answer through the years is which is the best capital structure for each company.

Nowadays there are infinite ways to structure the capital of a firm, by different equity-

to-debt ratios, or by the use of different ways to obtain capital, like preferred stocks,

convertible bonds among others (ROSS ET AL. 2002).

Since back in the late 50’s Modigliani & Miller tried to solve this matter with

their proposition I and II in their first paper (MODIGLIANI & MILLER 1958). In their

second paper, they published a correction regarding the role of tax rates and its

influence on capital structure (MODIGLIANI & MILLER 1963).

Later on, Miller published another paper with his model on personal taxes,

where he showed the effect of personal taxes on the capital structure of a firm. Miller

divided the effect of corporate income taxes, personal income taxes on shares and

personal income taxes on bonds, to evaluate how they influence in the value of a firm

when deciding to issue bonds or shares.

Although these theories are well known in finance, they were made for the

American tax reality, and are not straightly adapted to other countries with different

legislation regarding income taxes.

In Brazil, there are some differences that must be considered. Through the

research to be made on this study, these differences are to be found and used in the

proposition of an adaptation of Miller’s model to Brazil.

The main relevance of the study is to help understand the capital structure of

Brazilian firms, and also help the companies improve their value by a better

understanding on how their capital structure may or may not influence on their total

market value. Also the adaptation of such a worldwide important theory to Brazilian

9

taxes should help finance students located in Brazil to learn, evaluate and discuss

Miller’s Model.

The objective of this study is then to answer the question on how would the

Miller’s Model on Personal Taxes adapt to the current Brazilian legislation on taxes.

To answer this question first we need to pass through some other smaller problems,

which are, how the Brazilian legislation deals with the payment of dividends, which is

the corporate income tax rate, which is the personal income tax rate on shares and

on bonds. It is also important to find difference in the ways that these taxes may be

applied in Brazil, when compared to the American reality in which the original

theories were constructed.

10

2 - METHODOLOGY

To adapt the Miller Model on Personal Taxes (MILLER 1976) to the Brazilian

tributary reality there is going to be used a bibliographic research on the capital

structure papers of Modigliani & Miller (including here Miller’s paper on personal

taxes) and on the Brazilian Legislation.

On the capital structure papers of Modigliani & Miller there will be analyzed the

major points in which the tax legislations may cause a difference when trying to adapt

the capital structure theories to other countries realities, such as which taxes affect

the models to be studied here, and which differences in the legislations may change,

and how they may change, the model.

On the Brazilian legislation there will be a search for laws that impact the

tributes that may interfere with Miller’s Model on Personal Taxes, as seen in the

previous paragraph. There will be conduct a search through the Brazilian IRS to find

the laws that present relevance to the problem, such as laws on corporate income

taxes, personal income taxes on bonds, personal income taxes on shares, and other

differences to the model that may be relevant to the capital structure of the firms.

11

3 - CAPITAL STRUCTURE REVISITED

Before dealing with the analysis needed to adapt the Modigliani & Miller

theories to the Brazilian tributary reality we have to understand how these theories

deal with, the capital structure of a firm.

The capital structure of a firm is how it finances its assets. It can be done

though equity (or stocks) debt (like bonds and leases) or some hybrid securities

(ROSS ET AL. 2002). These hybrid securities are not going to be discussed here

because although they are largely used in the real market, the analyses get too

complex and don’t bring deepness into the study.

The importance of studying the capital structures of the firms is to try to

answer the question if the debt-to-equity ratio can add value to a company and its

stockholders. And if it is true, which is the best debt-to-equity ratio to maximize the

company and its stocks value.

According to Ross (2003) and to Brealey (2003) the capital structure policy

which maximizes the company value also maximizes the return of the stockholders.

This statement is important because through the theories to be studied we are only

going to find methods to show how to maximize the value of the firm, and then we

can infer that it also maximizes the wealth of the stockholders. We are not going to

see means to maximize the wealth of stockholders directly.

3.1 - MODIGLIANI & MILLER

The Modigliani & Miller theories are considered the most important one in the

field of the capital structure of firm. Although their famous Proposition I is considered

a non-realistic approach, it is considered a very good start for the studies later

conducted (ROSS ET AL. 2002) (BREALEY ET AL. 2003).

12

In their Proposition I, Modigliani & Miller use certain assumptions. First the

firms in a given “class” have equivalent return, i.e. their returns are proportional, so

they have a perfect correlation. The importance of this assumption is to make returns

of different firms, within the same class, homogeneous. The next assumption is that

the stocks of these companies are traded in a perfect market, which means, no

taxes, no trading costs and perfect information (MODIGLIANI & MILLER 1958).

Under these conditions Modigliani & Miller stated their Proposition I, which

says “the market value of any Firm is independent of its capital structure”

(MODIGLIANI & MILLER 1958). This statement may sound unrealistic, given the fact

that finance managers spend a lot of time and money in an effort to choose the best

capital structure of a firm. But it has to be recalled that the Proposition I is for a

perfect market situation.

Following the Proposition I Modigliani & Miller stated a second proposition.

From the fact that the total market value of the firm does not depend on its debt to

equity ratio, and manipulating the equation (1) (ROSS ET AL. 2002) so we can

isolate the variable rs we find equation (2). The equation (2) shows Modigliani &

Miller’s Proposition II, where the cost of equity is proportional to the leverage of the

company because the cost of equity rises with the risk brought to the company by its

leverage (MODIGLIANI & MILLER 1958).

r0=SB+S

.r s+BB+S

.r b (1)

Where:

r0: return of the firm;

S: value of the firm’s shares;

B: value of the firm’s bonds;

rs: the expected return on shares; and

13

rb: the interest rate of the firm’s bonds.

r s=r0+BS.(r0−rb) (2)

Where:



B: value of the firm’s bonds;

rs: the expected return on shares; and

rb: the interest rate of the firm’s bonds.

According to Brealey (2003) these propositions shows a conservation of value,

that is, the different ways in which the capital of a firm can be divided won’t change

its total value. This means that the only thing at stake when discussing capital

structure, within the assumptions of the propositions, is how the return of the firm is

going to be shared, and not how much of it is going to be created. So, based on

Modigliani & Miller (1958) the capital structure will not affect the firm’s total value, it

will only affect the distribution of its total value.

3.1.1 - CORPORATE TAXES ON MODIGLIANI & MILLER

Following their first paper, Modigliani & Miller (1963) made a correction on

their propositions with the use of tax shields. Tax shields are the benefit the firms can

get on issuing debt because the interest paid for this debt is tax deductible based on

the American tributary legislation.

For their Proposition I, the value of the firm no longer is independent of its

capital structure. Now the firm has an incentive to issue debt, because the interests

paid on them are tax deductible. So with the introduction of taxes the total market

14

value of the leverage firm can be expressed as the value of an all equity firm plus the

tax shield as in equation (3) (ROSS ET AL. 2002).

V l=V u+B .Tc (3)

Where:

Vl: total value of the leveraged firm;

Vu: total value of the unleveraged firm;

B: value of firm’s bonds; and

Tc: corporate income tax rate.

So with the introduction of taxes the total market value of the firm increases

with the issuing of debt. So the firms should issue as much debt as possible as

shown in the figure (1).

Figure 1 - Value of the leveraged firm as a function of bonds issued

For the Proposition II there is also a change because of the introduction of

taxes on the theory. The tax deductibility of interest rates paid on the debt issued

0

Vl

B

Vu

15

change our equation (2) on the cost of equity. With the addition of the tax deduction

on the Proposition II we have the equation (4).

r s=r0+BS. (1−T c ).(r0−r b) (4)

Where:

rs: the expected return on shares;

rb: the interest rate of the firm’s bonds;



B: value of firm’s bonds; and

Tc: corporate income tax rate.

So with the new equation we have the figure (2) below on how the cost of

equity rises with the issue of debt.

Figure 2 - Cost of equity as a function of bonds issued

The model with taxes let us see the increase in value when the company

issues bonds. When not considering taxes, the model does not show any change in

16

the value of the firm with the issue of bonds by the firm, the model is then corrected

showing the increase in value of the firm because of the tax deductibility of the

interest paid on the bonds.

3.1.2 - MILLER’S MODEL ON PERSONAL TAXES

On the previous papers, Modigliani & Miller already stated that the gains from

debt financing for the corporations may be reduced by personal income taxes on

interest (MODIGLIANI & MILLER 1963). But they never mention exactly how it is

done, and how much it can reduce the gains on leverage for the firms.

On a later paper, Miller (1976) introduces the actual impact of personal taxes

on the capital structure of a firm. In this paper he shows how the total market value of

a leveraged firm can be expressed as a function of the value of the unleveraged firm,

and the tax rates for corporations and for stock and bond holders.

In this new model the total market value of the leveraged firm is shown as the

value of the unleveraged firm plus an expression (the tax benefits in function of the

tax rates for corporation and for personal income on stocks and bonds) multiplied by

the amount of debt issued by the firm, as seen in equation (5) (MILLER 1976).

V l=V u+(1− (1−Tc ) . (1−T s )(1−T b ) ) .B l (5)

Where:



Tc: corporate income tax rate;

Ts: personal income tax rate on shares;

Tb: personal income tax rate on bonds; and

Bl: value of the leveraged firm’s bonds.

17

From equation (5) we can see that when all tax rates are equal zero then the

value of the leveraged firm is equal the unleveraged firm, just as the original

Proposition I. And also when the tax rates for personal income from stocks and from

bonds are equal, the value of the leveraged firm becomes the value of the

unleveraged firm plus the tax shield Tc.Bl, exactly like the equation (3) (MILLER

1976).

Also, in special cases where (1-Tc).(1-Ts)=(1-Tb) – like the case stated above in

which all the taxes are equal to zero – there is no advantage in acquiring debt, i.e.

the value of the leveraged firm is equal to the unleveraged. That happens because

the tax benefit from interest on corporate taxes will be exactly offset by the higher

taxes on personal income from bonds and stocks (ROSS 2003).

On the graphs below we can see how the tax rates influence on the gain from

leverage for the firms, keeping everything else constant. On figures (3) and (4) we

can see how the increase on corporate income taxes and on personal income taxes

from stocks increases the gains from leverage. It happens because with the high

taxes on income from stocks the cost of bonds becomes smaller.

18

Figure 3 - Value of the leveraged firm as a function of the Corporate Income Tax Rate

Figure 4 - Value of the leveraged firm as a function of the Personal Income Tax on Stocks

On the figure (5) we can see how the gains from leverage decrease

exponentially with the increase on the tax rate from personal income from bonds. We

0

Vl

Tc

Where (1- Tc) x (1- Ts) < (1- Tb)

Vu

0

Vl

Ts

Where (1- Tc) x (1- Ts) < (1- Tb)

Vu

19

can also see that for certain high rates, the taxes on bonds eat up all the tax benefits

from leverage, to a point that the gains from leverage actually become a lost.

Figure 5 - Value of the leveraged firm as a function of the Personal Income Tax on Bonds

20

4 - BRAZILIAN TRIBUTES

As we could see before the Modigliani & Miller theories on capital structure are

fundamentally based on the tributary legislation of their context. The problem to be

here attacked is the fact that the U.S. tributary system of the 50’s and 60’s is very

different from the tributary system we have in Brazil nowadays.

To try to solve this question we are going to see the Brazilian tributes that may

affect Miller’s theory on the capital structure subject to the Brazilian Tributary Code.

To analyze Miller’s model on personal taxes we have to discuss the three kind

of taxes used in the model, the corporate income tax, the personal income tax on

bonds, and the personal income tax on stocks. In Brazil, the taxes on corporate

income are the income tax (Imposto de Renda) on corporations, and the social

contribution over net profit (Contribuição Social Sobre Lucro Líquido), and there are

some differences to the American law on the deductibility.

On the personal taxes, we can divide in the same way as Miller (1976) in

income tax from bonds and from stocks, but there is also some differences on the

personal taxes when compared to the American law (Lei 7.689/88) (Lei nº 11.033, de

2004) (RIR/1999).

4.1 – CORPORATE INCOME TAX

On the corporate income tax, in the Brazilian regulation there are two brackets

to define the tax rate to be charged by the state in the form of income tax. The

companies are subject to a tax rate of 15%, on income lower than R$20,000.00 per

month. And are subject to a tax rate of 25% on income over the limit of R$20,000.00

per month (Lei 9.249/95).

21

There is also another tribute to be paid by the corporations over income, which

is the social contribution over net profit. This contribution is charged on a certain rate

over the net income before the income tax provision, so the income tax paid is not

deductible from the contribution. The rate of this contribution is 9% over the net profit

before the income tax (Lei nº 11.727, de 2008).

The total corporate income tax rate can be defined then as the sum of these

two tax rates. Considering the reality that listed companies all have an income higher

than R$20,000.00 the income tax rate of the companies can be considered as 25%.

And as the social contribution over net profit is 9%, the total corporate income tax

rate in Brazil is 34%.

It is also important to note that the dividends paid by the companies to its

shareholders cannot be deducted from these corporate taxes. On the other hand,

there is an instrument on the Brazilian legislation that allows the payment of profit to

the shareholders to be deducted from those taxes mentioned above.

This instrument is the interest paid on equity, which is the amount paid to the

shareholders as an interest rate over the capital invested on stocks of the company.

It is limited to the long term interest rate (TJLP1) which is the interest rate used by the

government to concede long term loans. Also, the interest rate paid on debt issued

by the company is deductible on the income tax and the social contribution over net

profit (Lei 9.249/95).

The firm has then, the option to pay its dividends all in the form of dividends

itself, or partly as interest on equity to the limit of the long term interest rate in

accordance to the Brazilian legislation (Lei 9.249/95). The choice for the firm is then

1 The TJLP is the long term interest rate instituted by MP 684/94 to regulate the tax rate used by the BNDES (National Bank for Economic and Social Development) for its activities in the economic and social development of the country, mainly directed for credit issued for entrepreneurs and for the custody of a variety of worker funds.

22

between paying all the dividend as dividend itself with a 34% tax rate (the corporate

income tax rate), or pay it partially as the interest on equity with a 15% tax rate (the

personal tax on equity, as seen in the next section). The optimum choice for the firm

is then to pay its profits to the shareholders as interest on equity to the limits

established by the law, before paying dividends.

In the table 1 below we see the benefits for the use of interest on equity. It

shows how the net profit can increase by 34% (the corporate income tax rate) of the

interest on equity paid to the shareholders when compared to a company that does

not use interest on equity, and use only dividends.

Table 1 - Benefits for the use of Interest on Equity

With Interest on EquityWithout Interest on Equity

(+)Income (P) P P P(-)Interest on Equity TJLP x Equity TJLP.S

(=)Income Before TaxIncome - Interest on Equity

P-(TJLP.S) P

(-)Income Tax (Tc) Income Before Tax x Tc [P-(TJLP.S)].34% P.34%

(-)DividendsDividends (or Dividends- Interest on Equity)

D- (TJLP.S) D

(=)Net ProfitIncome - Interest on Equity - Income Tax - Dividends

P-(TJLP.S)-{[P-(TJLP.S)].34%}-[D-(TJLP.S)] P-D-34%.(P-TJLP.S) P-D-34%.P + (34%.TJLP.S)

P-P.34%-D P-D-34%.P

4.2 - PERSONAL INCOME TAX ON EQUITY

On the personal income tax on equity, the Brazilian legislation establishes a

tax rate of 15% on the net profit from stocks, to be paid on the sale of the stock.

Another point to be considered when analyzing the personal income tax on

equity is the fact that dividends paid by the corporations are free of taxes for the

stockholders, as corporations cannot deduct it from their income taxes. On the other

hand, shareholders have to pay the 15% income tax on the interest over invested

capital when it is paid by the firms. So, when the companies can deduct a payment to

stockholders from their income taxes, the stockholders themselves have to pay

23

income tax on it, and when the companies cannot deduct it, the stockholders are tax

free on this payment (Lei nº 11.033, de 2004).

4.3 - PERSONAL INCOME TAX ON DEBT

The personal income on bonds is taxed in a different way. It has tax brackets

depending on the duration of the bond, or the duration holding the bond (Lei nº

11.033, de 2004).

The tax bracket is higher for bond hold for less than six months, which are

taxed at a rate of 22.5%. For bonds between six and twelve months the tax rate is

20%. A tax rate of 17.5% is charged over bonds lasting from twelve to twenty four

months. And for bonds of over twenty four months the tax rate is only 15% as in the

table 2 bellow (Lei nº 11.033, de 2004).

Table 2 - Personal Income Tax Rate on Bonds

Duration of the bond Personal Income Tax Rate on

Bonds

b < 6 months 22.5%

6 months < b < 12 months 20%

12 months < b < 24 months 17.5%

b > 24 months 15%

It is also important to remember that the firms can deduct the interest rates

paid to bondholders from their corporate income taxes.

24

5 - MILLER'S MODEL AND BRAZILIAN TAX STRUCTURE

In the previous sections it was seen how the capital structure theories, mainly

Miller’s Model, work on the United States tax environment, helping to increase the

value of a firm. There was also seen how the Brazilian legislation works on income

taxes, both corporate and personal, either for equity or for debt. Now it will be shown

how these theories may work in the Brazilian Taxes environment.

First, the Modigliani & Miller Proposition II depends on the corporate income

tax as seen in equation (4). In the Brazilian legislation the rates for corporate income

tax is 34%

Exchanging the value of the tax rate mentioned above in the equation (4) will

give us equation (6), where we can see the effects of the Brazilian tax rates on the

equation, to show how the value of the company is affected by the issue of bonds in

Brazil.

r s=r0+BS.66% .(r0−rb) (6)

As seen previously, the personal income tax on bonds will depend on the

duration of the bond, but this will make a small difference in the capital structure of

the firm, as will be shown here. Using equation (5) and exchanging Tc and Ts for its

rates in Brazil, we will get equation (7).

V l=V u+(1− 0.561

(1−Tb ) ). Bl (7)

Where



Tb: personal income tax rate on bonds; and


25

From equation (7) we may have four different rates for Tb depending on the

duration of the bonds, and from those four different rates we get equation (8) for

22.5%. From equation (8) we can see that if the firm decides to finance itself with

bonds that have durations of less than six months it will increase the value of the

leveraged firm on 0.276 dollars per dollar issued in bonds when compared to the

unleveraged firm.

V l=V u+0.276Bl (8)

Where


Vu: total value of the unleveraged firm; and


In equation (9) we see how the Miller’s Model works for the 20% personal

income tax on bonds rate, that is when the bonds duration is between six and twelve

months. From equation (9) we can demonstrate how the firm will increase its

leveraged value in 0.299 dollars per dollar of bonds issued when compared to the

unleveraged firm, if it decides to issue bonds with duration between six and twelve

months.

V l=V u+0.299Bl (9)

Where




Equation (10) shows the Miller’s Model on Brazilian taxes with debt issued

with durations between twelve and twenty four months, with the 17.5% tax rate. The

equation (10) shows how the firm can increase its leveraged value by 0.32 dollars

26

per dollar issued in bonds with durations between twelve and twenty four months

when compared to the value of the unleveraged firm.

V l=V u+0.320Bl (10)

Where




When adapting Miller’s Model to the 15% tax rate of personal income tax on

bonds with duration of over twenty four months we get equation (11). It shows how

the value of the leveraged firm can be increased by 0.34 dollars per dollar issued on

bonds with durations of over twenty four months, when compared to the value of the

unleveraged firm.

V l=V u+0.340Bl (11)

Where




From the results above we can see how the value of the leveraged firm is

always increased by the issuing of debt. Also the issue of debt increases the value of

the firm indefinitely. There is only a difference in the amount of value added by the

firm with the issue of debt depending on its duration, where the shorter the duration

of the bond, the slower the value of the firm will be increased by the issue of debt.

Figure (6) shows how the different gains of leverage apply depending on the duration

of the bonds, and so the tax bracket in which the personal income tax rate on bonds

the bondholders will be included.

27

Figure 6 - Gain of leverage as a function of the amount of Bonds issued (each line represents

a different tax bracket on the Personal Income Tax on Bonds)

0

Vl

B

28

6 - FINAL CONCLUSIONS

This study started from the question of how the Miller’s Model on Personal

Taxes would apply to Brazilian tributes. To solve the question there was made a

bibliographic review of the papers leading to the final Miller paper defining the model.

There was also made a bibliographic review on the Brazilian legislation,

regarding the laws that could interfere in the adaptation of the model to Brazilian

companies. These laws were referring to income taxes, either corporate or personal,

either on bonds or stocks.

Analyzing the Brazilian law we found that the corporate taxes were divided in

two tributes, the corporate income tax, and the social contribution on net profit that

combined become what here was called as corporate income tax. The total corporate

income tax in Brazil is then 34%. 25% of corporate income tax plus 9% on the social

contribution on net profit (Lei 9.249/95) (Lei nº 11.727, de 2008).

Also it is worth noting the existence of the interest on equity which may be

used by corporations to pay dividends, up to a limit established by law (TJLP), that

can be deducted from the corporate income tax. This is important, because the firms

should then, when willing to pay dividends, pay as much of it as possible as interest

on equity, which will suffer a 15% tax rate, and only then pay dividends at a tax rate

of 34%. There was also showed how it interferes in the value of the firm when opting

to use the maximum interest on equity as possible in conformation with the advised

(Lei 9.249/95).

On the matter of the personal income taxes, the personal income tax rate on

shares in Brazil is 15%.

The personal income tax rate on bonds on the other hand, depends on the

duration of the bond, and may vary from 15% on the longer bonds to 22.5% on the

29

shorter bonds (Lei nº 11.033, de 2004). This different tax brackets depending on the

duration of the bond makes it preferable for the firm to issues long term bonds,

because of the lower taxes for longer bonds.

With these rates we may see that with Brazilian taxes, the firms have an

increase in value by the issuing of debt. The durations of the bonds will change the

pace in which the value of the firms will be increased, but despite it, we saw that at

any duration of bonds, the firms will increase its value indefinitely when issuing

bonds. By this model then, the firm should indefinitely issue debt to increase its value

as much as possible.

Besides that, it is widely known that there are some limits to the use of debt by

the companies that are not accounted for in Miller’s Model on Personal Taxes. The

limits to the use of debt are bankruptcy costs and agency costs.

The bankruptcy costs can be divided in direct and indirect costs, basically the

direct costs are the legal and administrative costs of liquidation or reorganization of

the company, usually in these situations lawyers, administrators and accountants

may charge big fees, which make these costs very high. The indirect costs are the

difficults that arise to conduct the business during finance distress situations. It

becomes harder to negotiate with customers and suppliers, making supplier’s prices

higher and sale prices lower (ROSS ET AL. 2002).

Agency costs occur when there is a conflict of interest, in this case between

bondholders and stockholders. These agency costs arise in moments of financial

distress, when there are incentives to stockholders to take more chances, to

underinvest and to take extra dividends from the company. It may happen because

the stockholders do not have the majority of the money invested, but have the control

of the company, creating then a conflict of interest (ROSS ET AL. 2002).

30

The next step on this work should now to make a field research to analyze

how Brazilian companies choose their capital structure in the market. Searching for

listed companies and their debt to equity ratio to define if they are in accordance or

not to the results found on this study, and how much the limits on the use of debt

applies to these companies.

31

REFERENCES

Modigliani, F.; Miller, M. H. The Cost of Capital, Corporation Finance and

the Theory of Investment. The American Economic Review, v. 48, n. 3, p. 261-297,

Jun,1958.

Modigliani, F.; Miller, M. H. Corporate Income Taxes and the Cost of

Capital: A Correction. The American Economic Review, v. 53, n. 3, p. 433-443,

Jun, 1963.

Miller, M. H. Debt and Taxes. The Journal of Finance, v. 32, n. 2, p. 261-275,

mai, 1977.

Ross, S. A.; Jaffe, J. F.; Westerfield, R. W. Corporate Finance. 6ª Edição.

São Paulo: McGraw-Hill, 2002.

Brealey, R.A.; Myers, S. C. Principles of Corporate Finance. 7ª Edição. São

Paulo: McGraw-Hill, 2003.

BRAZIL. Lei nº 11.033, de 19 de janeiro de 2004

BRAZIL. Lei nº 9.249, de 26 de dezembro de 1995

BRAZIL. Lei nº 11.727, de 23 de junho de 2008

BRAZIL. Lei nº 7.689, de 15 de dezembro de 1988

BRAZIL. Decreto nº 3.000, de 26 de março de 1999 (Regulamento do Imposto

de Renda - RIR/99)

BRAZIL. Medida Provisória nº 684 de 31 de outubro de 1994

Documents

MILLER`S MODEL ON PERSONAL TAXES AND THEBRAZILIAN TRIBUTARY STRUCTURE