Università Bocconi A.A. 2005-2006

Università Bocconi, A.A: 2005-2006 1Mec – Comparative public economics 1

Università Bocconi A.A. 2005-2006

Comparative public economics

Giampaolo Arachi


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



Objectives and main topics

Tax law fundamentals

Introduction to “Tax Planning”


Corporate income taxCorporate income tax

• Why tax corporations?

• Tax base

• The Combination of Corporate and Personal Income Taxes


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


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.


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


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?


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


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%


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


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)


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



Objectives and main topics

Tax law fundamentals

Introduction to “Tax Planning”


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


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



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



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


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)



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



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


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



Payoffs

Result of coin flip

Security Heads Tails

Heads € 110 0

Tails 0 € 110

Short Heads -€ 110 0

Short Tails 0 -€ 110

Method 1



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)



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



Method 3

Borrow to invest in IRA accounts with tax exempt interest

Method 4

Borrow to invest in tax exempt treasury bonds


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



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



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


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

Università Bocconi A.A. 2005-2006

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