Title: Comparative public economics
1Università Bocconi A.A. 2005-2006
Comparative public economics Giampaolo Arachi
2Course 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
3Course presentation
- Objectives and main topics
- Tax law fundamentals
- Introduction to Tax Planning
4Corporate income tax
- Why tax corporations?
- Tax base
- The Combination of Corporate and Personal Income
Taxes
5Corporate 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
6Why 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.
7Tax 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
8 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?
9 Â Â Â
Systems for the taxation of profit income
unincorporated firms
incorporated firmsÂ
personal income tax
corporate income taxÂ
imputation system
classical system
partial imputation
full imputation
10 Â Â
Classical System of Dividend Taxation
Profit PÂ
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 t40, m40 overall tax burden 64
11 Â Â
Full Imputation System of Dividend Taxation
Profit PÂ
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 t40, m40 overall tax burden 40
12 Forms 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)
13Wealth 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
14Course presentation
- Objectives and main topics
- Tax law fundamentals
- Introduction to Tax Planning
15Strategies 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
16Postponement 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
17Postponement 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
- 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
18Postponement 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
19Postponement 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)
20Postponement of taxes
- Method 3
- Let ts be the tax rate on short term gains, and
tL the tax rate on long term gains with tsgttL - 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 (lossgain)
- (ts-tL) x gain
21Postponement 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
22Converting 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
23Converting income from one type to another
Payoffs Payoffs
Result of coin flip Result of coin flip
Security Heads Tails
Heads 110 0
Tails 0 110
Short Heads - 110 0
Short Tails 0 - 110
24Converting 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 0 100-1000
- 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)
25Converting 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 t1
- Sell gold at price P(1r)
- Reimburse debt and pay interest P(1r)
- Pay capital gains tax tg r P
- Save tax through interest deduction tp r P
- Net gain (tp-tg) r P
26Converting 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
27Shifting 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
28Shifting 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
29Shifting 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
30Limits 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