Comparative public economics

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Università Bocconi A.A. 2005-2006
Comparative public economics Giampaolo Arachi
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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

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Course presentation

• Objectives and main topics
• Tax law fundamentals
• Introduction to Tax Planning

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Corporate income tax

• Why tax corporations?
• Tax base
• The Combination of Corporate and Personal Income
  Taxes

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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

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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.

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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

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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?
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Systems for the taxation of profit income
unincorporated firms
incorporated firms 
personal income tax
corporate income tax 
imputation system
classical system
partial imputation
full imputation
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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 t40, m40 overall tax burden 64
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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 t40, m40 overall tax burden 40
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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)
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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

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Course presentation

• Objectives and main topics
• Tax law fundamentals
• Introduction to Tax Planning

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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

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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

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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
• 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

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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

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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)

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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 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

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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

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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

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Converting income from one type to another

• Method 1

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
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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 0 100-1000
• 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)

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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 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

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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

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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

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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

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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

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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