Università Bocconi A.A. 2005-2006
Comparative public economics
Giampaolo Arachi
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
1
Course presentation
Objectives and main topics
Tax law fundamentals
Introduction 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
Mec – Comparative public economics
2
Course presentation
Objectives and main topics
Tax law fundamentals
Introduction to “Tax Planning”
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
3
Corporate income tax
• Why tax corporations?
• Tax base
• The Combination of Corporate and
Personal Income Taxes
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
4
Corporate 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
Mec – Comparative public economics
5
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
Mec – Comparative public economics
6
Tax 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
Mec – Comparative public economics
7
The Combination of Corporate and Personal
Income 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
Mec – Comparative public economics
8
Systems for the taxation of profit income
unincorporated firms
personal income tax
imputation system
full imputation
Università Bocconi, A.A: 2005-2006
incorporated firms
corporate income tax
classical system
partial imputation
Mec – Comparative public economics
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Classical 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
Mec – Comparative public economics
10
Full Imputation 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:
maP
Tax Credit:
taP
Net dividend
(1-m)aP
Example: t=40%, m=40% overall tax burden: 40%
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
11
Forms of Double Taxation Relief
1. Full Imputation
(Finland, Malta, Norway)
2. Partial Imputation
France, Japan, Canada, Spain, U.K.
3. Dividend Exemption
Estonia, 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
Mec – Comparative public economics
12
Wealth 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
Mec – Comparative public economics
13
Course presentation
Objectives and main topics
Tax law fundamentals
Introduction to “Tax Planning”
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
14
Strategies 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
Mec – Comparative public economics
15
Postponement 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 1
Invest in a pension plan
Method 2
An 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
Mec – Comparative public economics
16
Postponement 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.
2.
3.
The taxpayer borrows shares of stock equal to the number already owned
The taxpayer sells the borrowed shares, thus realizing cash but no taxes
are due
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
Mec – Comparative public economics
17
Postponement 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
Mec – Comparative public economics
18
Postponement of taxes
If capital gains are regarded as income
lower rates are justified on long-term gains to avoid problems
related to
inflation
progressive 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
Mec – Comparative public economics
19
Postponement of taxes
Method 3
Let ts be the tax rate on short term gains, and tL the tax rate on long term
gains with ts>tL
1.
2.
3.
build a straddle: at any date buy a security and sell a perfectly
correlated (set of) security (securities) short
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 loss
soon after the security becomes eligible for long term treatment realize
the capital gain and pay tax
tL x gain
Tax saving equal to (loss=gain)
(ts-tL) x gain
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
20
Postponement 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
Mec – Comparative public economics
21
Converting 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
Mec – Comparative public economics
22
Converting income from one type to another
Method 1
Payoffs
Result of coin flip
Security
Heads
Tails
Heads
€ 110
0
Tails
0
€ 110
Short Heads
-€ 110
0
Short Tails
0
-€ 110
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
23
Converting income from one type to another
Method 1
No taxes
The 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=0
Cash 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
Mec – Comparative public economics
24
Converting income from one type to another
Method 2
Assume 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
Strategy
Time t
buy gold at price P
Borrow P using gold as collateral
Time t+1
Sell gold at price P(1+r)
Reimburse debt and pay interest P(1+r)
Pay capital gains tax tg r P
Save tax through interest deduction tp r P
Net gain (tp-tg) r P
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
25
Converting 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
Mec – Comparative public economics
26
Shifting income from one pocket to another
Method 1: dividend washing
In many countries dividends are taxed under the PIT
but the shareholder receive a credit for the CIT paid by
the distributing company
tp (D + qD) – qD = [tp (1+ q) –q ] D
where q = ts/1-ts
Usually non-residents and tax-exempt entities are not
entitled to the credit
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
27
Shifting income from one pocket to another
Method 1: dividend washing
Time 1
A foreigner sells stocks of a domestic company to another Italian
company at a cum dividend price 1000
Time 2
The Italian company receives dividend equal to 100
Time 3
The domestic company sells back to the foreigner at ex dividend
price 900
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
28
Shifting income from one pocket to another
Method 1: dividend washing
Changes in pre tax income
Foreigner = -100 (lost dividends) + 100 capital gain
Domestic company = 100 (dividends) – 100 capital loss
Changes in taxes
Foreigner if dividend taxed as capital gain = 0
Domestic company
ts (D – capital loss + q D) – q D = ts (100 – 100 + q 100) – q100=
ts q 100 – q 100 = - (1-ts ) q 100
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
29
Limits 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
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
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