Insolvencies are growing - here’s how you could profit

This morning we learn that another high street retailer is on the brink of insolvency Peacocks. 10,000 jobs could be on the line as RBS refuses to back the retailer's bid to reorganise its debt.

In fact, all over the country businesses are failing. You can blame tight fisted banks. You can blame the tight fisted consumers.

I think that a lot of these insolvencies are the result of a serious error in the tax regime. I'm talking about a law that actually encourages businesses into debt and jeopardises your investment in the process.

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Today I want to show you how this cracked system works. And why it means that you, as a shareholder, could be better off with debt (bonds) than equity in 2012.

How the system works

Let's assume you've got shares in a business that is making a tidy profit. And after your profits are counted, the taxman says he wants his slice... that's 26% thank you very much. But that's not the end of it. As an equity holder, you'll be expecting a dividend a return on your investment. And the taxman wants a cut of that too! Before dividends are sent out, they're generally taxed at the basic rate of income tax. And if you're a higher rate taxpayer, you need to pay some more tax at the year end.

But what if the business raises money through debt instead of equity? Now instead of paying out dividends, the business pays interest to its lenders. And here's the thing: you can offset interest payments against tax. Interest is seen as a business expense that reduces your profits, while equity dividends are a luxury to be taxed twice.

In the US, the National Economic Council has worked out that running debt is more than 40% cheaper than running equity.

It's no wonder the financial engineers have been at it over recent years. The private equity boys have been taking sound businesses and loading them up with debt for years.

But bad practice has hit many of our biggest listed companies too. You know the share buyback scheme everyone raves on about? Well in most cases it's nothing more than swapping equity for debt. Borrow a load of money in the markets and then use it to pay off those pesky equity holders. That is, buy the shares back in the market and then cancel them. Company management can improve figures like earnings per share (EPS) with a bit of financial engineering...

But at what long-term cost?

I don't know why, but the financial engineers took a shine to the retailing sector. Icelanders loaded up on debt at home to buy UK retail estate. Much of our retail sector got snapped up by the global financial engineers and they had debt on their mind. Unfortunately, many firms later returned to the stock market with mountains of debt.

Though debt's tax advantages can be extremely handy when you're making good profits, they can't help you when your business is looking at losses. Whether you're making profits, or losses, the banker (or bondholder) from whom you've borrowed will want his pound of flesh.

And that's exactly what RBS is currently extracting from retailer Peacocks.

At least with equity you can reduce, or suspend dividends. And given that most businesses face the odd lean year or two, it's a great get out of jail' card to be tucked away.

Should there be a change in the law?

There have been calls for a change in the tax regime. And the message is growing in popularity. It's not gone unnoticed that the credit crunch that started in 2007 is largely down to the monstrous debt build up in the West.

The fact is that to bring some balance back to business balance sheets, we need to tax debt in the same way we do equity. That is, don't allow businesses to count debt interest as a business expense before corporation tax. That'll bring company profits up and give the chancellor more profit to tax them on.

With the general public anger at the banker and private equity brigade, I'm sure there'd be some broad popularity for these measures. And at a time when government coffers are tight, you can see the logic especially if the economy takes a serious lurch south.

Now I don't expect this change to take place anytime soon; but you can't rule it out either especially if the government's back is up against the wall. So there's no harm in preparing for the worst...

Why bonds could be a safer bet than equities in 2012

Though a change in the tax regime could help to bring companies into line in the future, I can assure you it would make mincemeat of equities in the short-run.

Yes, businesses would make more headline profit and so pay more tax. But then they'd have to pay out debt interest from post-tax profits. That would leave considerably less cash available for equity dividends.

Debt holdings (ie, bonds) would remain relatively unscathed however. Ultimately, bond holders wouldn't care less providing the business didn't go bust - that is.

It's why bonds are a safer bet than equities. No matter what happens, equity holders always take the rap. And this is why I urge you to be careful this year. If you're buying equities then make sure they've got robust balance sheets. It's nearly always debt that brings a company down.

And if you're concerned, then why not buy bonds? All the while the tax regime remains in favour of bonds, there'll be plenty of them about.

I'm going to stay with my bond theme during 2012 and show you some interesting ways of rebalancing your portfolio into what I believe is the much saner side of the financial market. My aim is to show you how to get security as well as decent income on your savings. And there are a few great opportunities that I have my eye on more on that in a forthcoming issue of The Right Side.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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