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Università Bocconi, A.A: 2005-2006 1Mec – Comparative public economics 1
Università Bocconi A.A. 2005-2006
Comparative public economics
Giampaolo Arachi
Università Bocconi, A.A: 2005-2006 2Mec – Comparative public economics 2
Course presentationCourse presentation
Objectives and main topicsTax law fundamentalsIntroduction to “Tax Planning”
References:
M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch.1 and 2
K. Messere, F. de Kam, C. Heady, Tax policy: theory and practice in OECD countries, OUP, 2003, ch. 2, 6, 8, 10
Università Bocconi, A.A: 2005-2006 3Mec – Comparative public economics 3
Course presentationCourse presentation
Objectives and main topics
Tax law fundamentals
Introduction to “Tax Planning”
Università Bocconi, A.A: 2005-2006 4Mec – Comparative public economics 4
Corporate income taxCorporate income tax
• Why tax corporations?
• Tax base
• The Combination of Corporate and Personal Income Taxes
Università Bocconi, A.A: 2005-2006 5Mec – Comparative public economics 5
Corporate income taxCorporate income tax
Why tax corporations?
• A corporation has the status of a legal person and, like physical persons, should therefore be liable to income tax
• The corporate tax may be seen as a payment for the legal privilege of limited liability or for cost-reducing public services to the corporate sector
• The corporation is desirable if it is a tax on pure profits or rents
Università Bocconi, A.A: 2005-2006 6Mec – Comparative public economics 6
Why tax corporations?Why tax corporations?
Backstopping the personal tax
• In the absence of taxation at the corporate level, shareholders would have strong incentives to postpone taxes by leaving retained earnings at the corporate level rather than taking them out as (taxable) dividends or managers’ compensations.
• corporate income taxes may, to some extent, be considered an appropriate offset to the lack of personal taxation on capital income received by foreigners.
Università Bocconi, A.A: 2005-2006 7Mec – Comparative public economics 7
Tax baseTax base
The starting point is usually the income statement
There are two main types of differences between tax and book income
Temporary differences: the transaction is included in both sets of books (i.e. in calculating taxable and net income) but in different time periods (timing differences)
• Permanent differences: the transaction is included in one set of books (i.e. taxable or net income) but never in the other
Università Bocconi, A.A: 2005-2006 8Mec – Comparative public economics 8
The Combination of Corporate and Personal The Combination of Corporate and Personal Income TaxesIncome Taxes
Problem: Corporate Profits are ultimately distributed to the owners of the corporation. Given that these profits have been subject to the corporate income tax, how should distributed profits be taxed at the personal (shareholder) level?
Università Bocconi, A.A: 2005-2006 9Mec – Comparative public economics 9
Systems for the taxation of profit income
unincorporated firms incorporated firms
personal income tax corporate income tax
imputation system classical system
full imputation partial imputation
Università Bocconi, A.A: 2005-2006 10Mec – Comparative public economics 10
Classical System of Dividend TaxationClassical System of Dividend Taxation
Profit: P
Corporate Tax: tP
Profit after Tax: (1-t)P
Assumption: share a is distributed
Dividend: (1-t)aP
Income tax: m(1-t)aP
Net dividend (1-m)(1-t)aP
Example: t=40%, m=40% overall tax burden: 64%
Università Bocconi, A.A: 2005-2006 11Mec – Comparative public economics 11
Full Imputation System of Dividend TaxationFull Imputation System of Dividend Taxation
Profit: P
Corporate Tax: tP
Profit after Tax: (1-t)PAssumption: share a is distributed
Dividend: (1-t)aP
Income tax: maP
Net dividend (1-m)aP
Example: t=40%, m=40% overall tax burden: 40%
Tax Credit: taP
Università Bocconi, A.A: 2005-2006 12Mec – Comparative public economics 12
Forms of Double Taxation ReliefForms of Double Taxation Relief
1. Full Imputation (Finland, Malta, Norway)
2. Partial ImputationFrance, Japan, Canada, Spain, U.K.
3. Dividend ExemptionEstonia, Greece, Latvia
4. Classical System with reduced taxation at the shareholder level(Belgium, Denmark,Germany, Italy, Lithuania, Luxemburg, Netherlands, Austria, Poland, Portugal, Sweden, Slovakia, Slovenia, Cech Republic, Hungary, USA)
Università Bocconi, A.A: 2005-2006 13Mec – Comparative public economics 13
Wealth and property taxesWealth and property taxes
• Net wealth taxes common in Continental Europe not in U.S. and U.K.
• Capital transfer taxes– The main policy option is whether the amount of the tax on
the bequest should be determined by the amount left by the deceased (donor-based or estate tax) or buy the amount inherited by the beneficiary (donee-based or inheritance tax)
• Taxes on buildings and land
Università Bocconi, A.A: 2005-2006 14Mec – Comparative public economics 14
Course presentationCourse presentation
Objectives and main topics
Tax law fundamentals
Introduction to “Tax Planning”
Università Bocconi, A.A: 2005-2006 15Mec – Comparative public economics 15
Strategies of tax avoidanceStrategies of tax avoidance
Shifting income from one time Period to Another
Postponement of taxes
Converting income from one type to another
Tax arbitrage across income streams facing different tax treatment
Shifting income from one pocket to another
Tax arbitrage across individuals facing different tax brackets
Università Bocconi, A.A: 2005-2006 16Mec – Comparative public economics 16
Postponement of taxesPostponement of taxes
It is desirable to defer paying taxes as long as interest is not being charged on the tax liability, unless tax rates are increasing over time
Method 1Invest in a pension plan
Method 2An appreciated asset is held until death. When the individual dies, his heirs close out his positions; with the step up in basis, no tax liabilities, become due.
Based on two features of tax systems:Capital gains are taxed only upon realization Step up in basis at death
Università Bocconi, A.A: 2005-2006 17Mec – Comparative public economics 17
Postponement of taxesPostponement of taxes
Method 3: shorting against the box
Aim: defer taxation on appreciated stock while at the same time obtaining cash and locking in the gain
Strategy: 1. The taxpayer borrows shares of stock equal to the number already owned 2. The taxpayer sells the borrowed shares, thus realizing cash but no taxes
are due3. The loan is repaid at a later date by delivering the original appreciated
stock
It is possible to lock in the gain and defer taxation by selling short the same share or buying a put option
Università Bocconi, A.A: 2005-2006 18Mec – Comparative public economics 18
Postponement of taxesPostponement of taxes
Method 4
Arbitraging between short-term and long-term capital gains rates
Background
Usually long-term gains are subject to reduced tax rates.
Two different approaches to capital gains taxation
First: capital gains are regarded as income
Second: capital gains are not considered to be income
Università Bocconi, A.A: 2005-2006 19Mec – Comparative public economics 19
Postponement of taxesPostponement of taxesIf capital gains are regarded as income
lower rates are justified on long-term gains to avoid problems related to
inflationprogressive tax schedule
If capital gains are not considered income
taxation of short term gains is justified as a means to tax ‘speculative gains’
(examples: Germany, Italy, UK)
Università Bocconi, A.A: 2005-2006 20Mec – Comparative public economics 20
Postponement of taxesPostponement of taxes
Method 3Let ts be the tax rate on short term gains, and tL the tax rate on long term
gains with ts>tL
1. build a straddle: at any date buy a security and sell a perfectly correlated (set of) security (securities) short
2. just before the end of the minimum holding period required for eligibility for long term treatment realize the loss and obtain tax reduction
ts x loss3. soon after the security becomes eligible for long term treatment realize
the capital gain and pay tax
tL x gainTax saving equal to (loss=gain)
(ts-tL) x gain
Università Bocconi, A.A: 2005-2006 21Mec – Comparative public economics 21
Postponement of taxesPostponement of taxes
Method 4
Rollovers: this method takes advantage of the arbitrariness of the unit of time over which taxes are levied.
build a straddle
on December 31, realize the capital loss
on January 1 buy back the security sold the day before and re-build the straddle
Università Bocconi, A.A: 2005-2006 22Mec – Comparative public economics 22
Converting income from one type to anotherConverting income from one type to another
Tax arbitrage across income streams facing different tax treatment
From an economic point of view interest, dividends and capital gains are alternative forms of return on capital. But they are subject to different tax rates
Income earned domestically and income earned abroad are subject to different taxes
Università Bocconi, A.A: 2005-2006 23Mec – Comparative public economics 23
Converting income from one type to anotherConverting income from one type to another
Payoffs
Result of coin flip
Security Heads Tails
Heads € 110 0
Tails 0 € 110
Short Heads -€ 110 0
Short Tails 0 -€ 110
Method 1
Università Bocconi, A.A: 2005-2006 24Mec – Comparative public economics 24
Converting income from one type to anotherConverting income from one type to another
Method 1
No taxesThe taxpayer borrows € 100 and purchase one unit of Heads and
one unit of Tails. If the risk-free interest rate is 10% Heads and Tails will cost € 50 each.
Cash flow in year 0 = 100-100=0Cash flow in year 1 = receive payoffs - repay debt = 110-110 = 0
With taxes
Cash flow in year 1 = receive payoffs – taxes on capital gains - repay debt +tax saving on interest= 10 (1 - tg) – 10 (1 - tp) = 10 (tp –tg)
Università Bocconi, A.A: 2005-2006 25Mec – Comparative public economics 25
Converting income from one type to anotherConverting income from one type to another
Method 2Assume that there were no uncertainty about changes in the price of gold
An exhaustible natural resource like gold should have its price rise at the rate of interest
StrategyTime t buy gold at price PBorrow P using gold as collateralTime t+1Sell gold at price P(1+r)Reimburse debt and pay interest P(1+r)Pay capital gains tax tg r PSave tax through interest deduction tp r PNet gain (tp-tg) r P
Università Bocconi, A.A: 2005-2006 26Mec – Comparative public economics 26
Converting income from one type to anotherConverting income from one type to another
Method 3
Borrow to invest in IRA accounts with tax exempt interest
Method 4
Borrow to invest in tax exempt treasury bonds
Università Bocconi, A.A: 2005-2006 27Mec – Comparative public economics 27
Shifting income from one pocket to anotherShifting income from one pocket to another
Method 1: dividend washingIn many countries dividends are taxed under the PIT but the shareholder receive a credit for the CIT paid by the distributing company
tp (D + D) – D = [tp (1+ ) – ] Dwhere = ts/1-ts
Usually non-residents and tax-exempt entities are not entitled to the credit
Università Bocconi, A.A: 2005-2006 28Mec – Comparative public economics 28
Shifting income from one pocket to anotherShifting income from one pocket to another
Method 1: dividend washing
Time 1A foreigner sells stocks of a domestic company to another Italian company at a cum dividend price 1000
Time 2The Italian company receives dividend equal to 100
Time 3The domestic company sells back to the foreigner at ex dividend price 900
Università Bocconi, A.A: 2005-2006 29Mec – Comparative public economics 29
Shifting income from one pocket to anotherShifting income from one pocket to another
Method 1: dividend washing
Changes in pre tax incomeForeigner = -100 (lost dividends) + 100 capital gainDomestic company = 100 (dividends) – 100 capital loss
Changes in taxesForeigner if dividend taxed as capital gain = 0Domestic companyts (D – capital loss + D) – D = ts (100 – 100 + 100) – 100=ts 100 – 100 = - (1-ts ) 100
Università Bocconi, A.A: 2005-2006 30Mec – Comparative public economics 30
Limits to tax minimization and arbitrageLimits to tax minimization and arbitrage
• Transaction costs
• Non tax costs
• Restrictions on taxpayer behaviour
Substance-over-form and Business-Purpose Doctrines– US: “Gregory vs. Helvering”
– UK: “W.T. Ramsay & Co. Ltd.” v IRC (http://en.wikipedia.org/wiki/IRC_v._Ramsay)
– UK: “Furniss vs. Dawson”
Assignment of income doctrine