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

Course presentation Objectives and main topics Tax law fundamentals Introduction to “Tax Planning” References: 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 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 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 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 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 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 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 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 9

Classical System of Dividend Taxation Profit: P t. P Corporate Tax: Profit after Tax: Classical System of Dividend Taxation Profit: P t. P Corporate Tax: Profit after Tax: (1 -t)P Assumption: share a is distributed Dividend: (1 -t)a. P Income tax: m(1 -t)a. P Net dividend (1 -m)(1 -t)a. P 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: t. P Profit after Full Imputation System of Dividend Taxation Profit: P Corporate Tax: t. P Profit after Tax: (1 -t)P Assumption: share a is distributed Dividend: (1 -t)a. P Income tax: ma. P Tax Credit: ta. P Net dividend (1 -m)a. P 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 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 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 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 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 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 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. 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 due 3. 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 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 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 Postponement of taxes Method 3 Let ts be the tax rate on short term gains, and t. L the tax rate on long term gains with ts>t. L 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 t. L x gain Tax saving equal to (loss=gain) (ts-t. L) 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 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 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 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 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 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 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 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 + q. D) – q. D = [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 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 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) – q 100= 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 • 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 30