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The Kyscope A kaleidoscope for assessing business income taxation options Press the slide show button in the bar below this slide, sit back and watch the.

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Presentation on theme: "The Kyscope A kaleidoscope for assessing business income taxation options Press the slide show button in the bar below this slide, sit back and watch the."— Presentation transcript:

1 The Kyscope A kaleidoscope for assessing business income taxation options Press the slide show button in the bar below this slide, sit back and watch the show © Copyright 2004 Wayne Mayo i

2 The Kyscope A kaleidoscope for assessing business income taxation options How you can use the Kyscope You can interrupt the show for extra information by pressing any question underlined in blue © Copyright 2004 Wayne Mayo To exit at any time, press Esc key To return to the main show at the end of extra information detours, press Go back ii The main show runs for about 28 minutes Examples of Kyscope runs are referred to in the show (eg Kyscope Example 1). They can be downloaded from the web site. If you find the material progressing too slowly at any time, click your mouse on the screen

3 Contents Overview Assets and liabilities Go there now Go there now from a domestic perspective Entities Go there now Go there now from a domestic perspective International Go there now Go there now assets/liabilities and entities (and their owners) from a global perspective iii

4 Overview The Overview runs for about 11 minutes At the end of the Overview you will be asked if you wish to exit In ensuing sections on assets/liabilities, entities and international, issues are discussed in more detail 1

5 The Kyscope brings together: assets and liabilities entities that own the assets/liabilities and the people that own the entities It measures the income of assets and liabilities And tracks that income as it flows from the assets/liabilities through the entities and out to the owners And shows the tax paid at each stage depending on the tax treatment selected for the assets, entities and owners What does the Kyscope do? 2

6 What can the Kyscope be used for? To undertake aggregate revenue analysis estimating changing year-by-year tax receipts across a sector/economy caused by a change in tax treatment The benchmark tax treatment is simply taxing people on the income from their assets/liabilities in the year it is earned - whether these people own the assets or liabilities directly or indirectly (via entities) While an understanding of the benchmark base is not required to use the Kyscope, it adds to the depth of analysis possible 3 To compare tax outcomes for an investor under: benchmark tax treatment versus selected tax treatment All the Kyscope examples except Example 1 illustrate such use Use this comparison and associated effective tax rate calculations from the Kyscope in tax policy analyses This is illustrated in Kyscope Example 1 – Economy- wide effects of accelerated depreciation

7 The Kyscope measures income earned in a year Annual receipts less Annual expenses plus Change in annual value of assets (and liabilities) But if the value of the orchard goes down (up) in the year the orchard investors income also goes down (up). Change in value has to be added, however, even if the asset is not sold. A sound measure of income cannot change simply because the asset is retained. The Kyscope measures full annual income whether or not assets are sold This is clear if the investor sells the orchard, as the cash received on sale is then less (or greater) than the investment at the start of the year. Everyone knows that the money earned from selling apples from an orchard less annual costs of maintaining the orchard is profit or income. How, when and whether the income is taxed is a separate issue BENCHMARKBENCHMARK 4

8 The Kyscope shows effect of benchmark on investor returns 10% pre-tax return 7% post-tax return 30% tax rate 5.3% post-tax return 47% tax rate Annual net receipts plus Change in value of assets/liabilities The pre-tax return of a marginal investment is 10%. If the benchmark base applies to this investment… …the pre-tax return is reduced after tax in proportion to the investors tax rate. A 10% pre-tax return from all of a persons investment choices (the bank, bonds, property, manufacturing, etc) is reduced in proportion to his/her tax rate What about risk? What is a marginal investment? 5 His/her investment decisions would therefore not be much affected by the imposition of tax 10% pre-tax becomes say 5.3% across the choices …and if the investor has sufficient other income against which to write- off any annual losses in the same year…

9 Pre-tax Marginal Investments Possible negative returns (losses) from risky investment Risk-free return from government bonds Average (or expected) return from risky investment Possible above average returns from risky investment In contrast to risk-free bonds, a risky investment has a spread of possible outcomes An entrepreneur might view 10% expected return sufficient to offset the spread of possible returns to make the risky investment as attractive as the 5% risk-free investment The risky investment could be viewed as marginal as any lower expected return would make the risk-free alternative preferable These two investments could illustrate just two of a continuum of investments that are on the entrepreneurs investment margin before tax But does the risky investment stay on the entrepreneurs investment margin after tax? a Return %

10 Post-tax Marginal Investments Possible losses from risky investment reduced in proportion to investors 30% tax rate (if other income is available against which to write losses off immediately) Possible profits from risky investment reduced in proportion to investors 30% tax rate 5% pre-tax return from government bonds reduced in proportion to investors 30% tax rate After tax under the benchmark base, pre-tax returns of all possible investment outcomes are reduced in proportion to the investors 30% tax rate if change in asset value is determined using those pre-tax returns The way that all the returns are squeezed after tax, suggests the same investments as before tax, could well be on the entrepreneurs investment margin after tax There is more robust discussion of these issues in the Business tax paper on the Kyscope website Go back Return % The 5% risk-free return, the expected 10% return from the risky investment and the range of possible returns around it are all reduced

11 Use the Kyscope to choose pre- and post-tax look of assets Annual receipts less Annual expenses Use the Kyscope to see the effect of tax value differing from actual value on tax revenue, after-tax returns and effective tax rates Want to compare pre- and post tax returns of depreciating/appreciating assets? 6 plus Change in annual tax value of assets (and liabilities) It is not surprising that income tax systems usually include annual net receipts from investments in taxable income. TAXABLEINCOMETAXABLEINCOME Use the Kyscope to choose pre-tax features of assets and measure the annual income from them Use the Kyscope to select tax treatment of the assets and see how tax value of the treatment differs from actual value Income tax systems differ, however, in whether they incorporate changes in value of assets in taxable income – and, if so, when. If included, change in tax value, rather than change in value, is used in calculating annual taxable income. Change in tax value may seek to estimate change in annual value. Or tax value may remain unchanged at original cost prior to sale, etc. Want to view a typical depreciating asset? Want to view an appreciating asset?

12 Depreciating asset Tax value Value Asset acquired for $1000 Go back Tax value declines faster than actual value in this illustration because there is accelerated depreciation

13 Appreciating asset Tax value Value Tax value stays at the $1000 cost of the asset Go back

14 Comparison of depreciating and appreciating assets Pre-tax returnPost-tax return Benchmark tax base Investors tax rate is 47% Post-tax return Accelerated depreciation 30% Gains taxed on sale of assets Depreciating asset – 5 years 15% pa decline in value 10% 5.3% ETR*=47% 6.0% ETR*=40% Appreciating asset – 5 years 10% pa increase in value 10% 5.3% ETR*=47% 5.8% ETR*=42% Bank account 10%5.3% ETR*=47% 5.3% ETR*=47% Go back *ETR = Effective tax rate = (pre-tax return less post-tax return)/pre-tax return

15 Use the Kyscope to compare options against the benchmark Because, without tax, actual values drive investment decisions. The share investor is interested in share value not just dividends. The property investor is interested in increases in value not just rents, etc. Moreover, the income from an entitys assets and liabilities (including changes in their actual values) ultimately flows through to the entitys owners Therefore, comparisons against the benchmark base can help you get a feel for the effects of selected tax treatment of entities, as well as of the people owning the entities And the benchmark tax base (with its limited effect on investment decisions) incorporates actual asset values Comparing rates of return of your selected tax treatment against those of the benchmark base should help you get a feel for behavioural effects, price effects, etc. 7 Use the Kyscope to get a feel for behavioural effects, price effects etc of your selected tax treatment……… Use the Kyscope to estimate the tax revenue cost of tax treatments relative to the benchmark (ie tax expenditures) ………effects relating not only to the treatment of assets, but also to the entities that own them and the people owning the entities Why? Tax value Value INVESTMENT OVER TIME Use the Kyscope to identify tax breaks and to estimate the aggregate cost of them year by year as required by many governments (in tax expenditure reports)

16 The Kyscope integrates the three key components Assets and liabilities Entities Entity owners Use the Kyscope to assess how your selected tax treatment applies to the source of all income: ie assets and liabilities. With each asset/liability, the Kyscope compares the selected treatment against the benchmark ASSETS AND LIABILITIES SECTION Use the Kyscope to judge the impact of selected tax treatment of the domestic interface between entities and their owners. See whether a single (or double) layer of tax applies. Run a benchmark comparison separately ENTITIES SECTION Use the Kyscope to move to the global scene and assess the impact of credits for foreign taxes (or lack of them) and the impact of exchange rates INTERNATIONAL SECTION In the Kyscope examples, the tax rate of the people investing is usually 47% and the pre-tax return is 10%. Thus, the benchmark after-tax return is 5.3% from directly owned assets and for people selling their entity ownership 8 Overview complete Want to exit now? Want to exit now?

17 Assets and liabilities Assets and liabilities change in value year by year However, in practice, it is change in tax value that is used to calculate annual taxable income Go back 9 The Kyscope enables you to choose the tax value profile of selected assets and assess the impact of those profiles Contents

18 Use the Kyscope to assess the tax impact of tax value profiles Annual changes in the tax values of assets (and liabilities) in a countrys income tax base feed into taxable income 10 Traditional gaps in the coverage of business assets in income tax systems have been shrinking worldwide Use the Kyscope to simulate tax treatment of depreciating and appreciating assets, financial assets/liabilities and trading stock The actual change in value of an asset is, however, often reflected in the owners taxable income over the period of ownership How does that work? It is then the profile of tax value versus value over time that represents difference in treatment from the benchmark base See it again? Use the Kyscope to get a feel for the impact of different tax value profiles on behaviour, prices, tax revenue, etc Use the Kyscope to simulate a range of responses to two practical questions on the treatment of assets and liabilities: 1. how is change in value to be estimated (to give change in tax value)? 2. what practical policy constraints cut across such estimations?

19 Depreciating asset Tax value Value Asset acquired for $1000 Tax value is lower than actual value each year because of accelerated depreciation The clawing back is done in practice either via traditional balancing adjustments on disposal or by equating tax value with sale value In the Kyscope, clawing back always occurs with depreciating assets and financial assets/liabilities and is identified with a specific balancing adjustment on disposal In net terms, only the actual change in value of the asset is reflected in the owners taxable income over the 5 years of ownership The extra deductions from accelerated depreciation over the period of ownership are clawed back when the asset is sold Go back Go to appreciating asset

20 Appreciating asset Tax value Value Tax value stays at the $1000 cost of the asset because of practical policy-making When the asset is sold, some or all of the difference between value and tax value could be subject to tax……… Go back With appreciating assets, the Kyscope allows you to choose how much of the difference between sale value and tax value is subject to tax (via balancing adjustment on disposal) ……if all the difference is subject to tax, the actual change in value of the asset over the period of ownership is reflected in the owners taxable income

21 Set tax value profiles in the Kyscope and see effects Is business expenditure involved? Yes How is this annual change computed? Does the expenditure create/improve an asset? With the Kyscope, instead of answering this question, you select the assets to be included in the analysis plus their pre- tax characteristics Deduction allowed in the year expenditure is incurred No In all Kyscope examples, annual costs in Net receipts are deducted that year Details? 11 All expenditure in the Kyscope is business related Kyscope Example 7 Details? Yes Tax value at cost until sold – eg appreciating assets, trading stock Kyscope Examples 2 & 3 Details? Change in tax value based on write-off rate – eg depreciating assets Kyscope Examples 4, 5, 8 & 9 Details? Change in tax value computed from future net receipts- eg financial assets,leases rights Kyscope Example 6 Details? Tax value in line with market value – eg trading stock, financial assets Kyscope Examples 2 & 3 Details? Tax value at cost until production starts – eg forestry, mining In practice, transactions to be included in the tax base are often identified individually The details illustrate how the selected treatment might arise in practice

22 Assets with known value change – financial assets, etc Sometimes a component of change in asset value is known or readily computed each year change in market value obtained readily eg listed shares, trading stock, open futures contracts, etc Go back The zero coupon bond in Kyscope Example 4, capital repayment assignment in Kyscope Example 9, lease payments in Kyscope Example 8, annuities, redeemable preference shares, etc The CPI-indexed security in Kyscope Example 5 The lease over a depreciating asset in Kyscope Example 8 change from applying known annual value of indices, such as CPI, commodity and share price indices or changed exchange rates change computed from applying a specified interest rate to an assumed profile of associated benefitscomputed The Kyscope allows you to specify the known component of future net receipts variable interest on a bank deposit, etc over the period change computed from the interest rate equating the sum of the assets discounted known future receipts with its up-front pricecomputed Trading stock in Kyscope Example 6

23 Depreciating assets Decline in value of depreciating assets is usually estimated from a specified write-off rate Go back Estimation from market value data Declining balance rate of write-off Estimation from, say, wear and tear Straight line rate of write-off Effective life Alternative straight line or declining balance write-off rates are often derived from a schedule of effective lives Where the declining balance rate happens to match actual rate of decline in value of the asset, the benchmark base results See Kyscope Examples 2 and 3 Value change cannot be computed for each depreciating asset separately, as attributing net receipts to a single asset among many in a business would usually be impossiblecomputed Relationship between market information, effective life and write-off rates

24 Estimation difficulties and pragmatic policy decisions Sometimes expenditure attracts immediate write-off even though an asset may be created either because value estimation is difficult and/or practical policy eg mining and petroleum exploration expenditure Sometimes annual business expenditure that would in principle attract immediate write-off is excluded from the tax base (eg classed as private) or treated as an asset because of pragmatic policy decisions eg annual interest payments on holiday cottages Sometimes an asset/liabilitys tax value is not changed even though a known change occurs in its value during a year because the change in value is unlikely to be maintained eg exchange rate effects on foreign debt Sometimes an assets tax value does not change from its original cost either because value estimation is difficult eg options, value increase prior to production commencing or because of pragmatic policy decisions eg listed shares, land Go back See Kyscope Examples 2 & 3 See Kyscope Example 7

25 Change in asset value – general methodology $1000 If you know the (tax) value of the asset at the start of the year……. 10% return And the annual return from the assets future end-of-year net receipts……. $100 …..then you know the annual income (interest) component of this years net receipts – ie value x return. This adds to (tax) value of the asset. $250 net receipts reduce (tax) value at year end Just after the end of the year, asset (tax) value is reduced by the amount of known annual net receipts as these are then no longer available to buyers Go back The Kyscope uses this forward- looking method with assets and liabilities to compute change in pre-tax value, as well as tax value Year end value $850 Net change in value = annual income less net receipts = $150 loss

26 Entities Income generated by an entitys assets may flow on to other entities And ultimately out to the people who own the entities The Kyscope enables you to design entity taxation confidently because it draws together the people who own the entities and the entities themselves Go back 13 An entity (eg a company) is a separate taxpayer from its owners Contents

27 The Kyscope draws together the taxation of people and entities Assets and liabilities Income People - Direct Investors Cash flow received in the year it is produced Entity Entity taxed each year on its annual taxable income Cash flow only distributed when entity decides to do so Entity owners – Indirect Investors They are taxed separately from the entity Design of entity taxation needs to recognise both the entity and the people who own it Some entity tax systems are designed to impose a single layer of tax at owners tax rates on domestic income distributed to local people who own the entities The single layer of tax is consistent with the single layer of tax faced by the direct investor (or unincorporated business)…………… ……but the time profile of tax payments depends on the design of entity taxation and the particular circumstances applying, such as when the entity distributes income Other entity tax systems impose a double layer of tax Annual taxable income goes straight to individuals tax returns – to be taxed once ( ie it attracts a single layer of tax at each individuals tax rate) 14

28 The Kyscope can assist in the design of entity taxation Entity taxation systems that are designed to impose at most a single layer of income tax on domestic entity income include: full integration full imputation trust treatment Classical entity taxation is designed to impose at most two layers of tax – one in the entity and another in the hands of individual owners Under an entity tax system imposing a single layer of tax, it could be expected that, in some years, the benchmark outcome would occur t hat is, annual income of entitys assets sheeted home to individuals owning the entity to be taxed at their rates (giving the 10% pre-tax to 5.3% outcome) What circumstances would give rise to this? In Kyscope Example 10, the benchmark outcome occurs each year 15 Use the Kyscope to ensure robust entity taxation design under either single or double taxation The Kyscope enables you to take into account the complexities imposed by the separation of the entity and the people owning it The Kyscope handles all these tax systems, and is able to accommodate plenty of options within each What are some of these complexities?

29 Complexities relevant to entity taxation The entity may retain income in a year Distributions of retained income may occur either prior to or at the time of the entitys liquidation Tax may apply to changes in value of ownership interests in the entity (eg of shares in the case of companies) – either because of general capital gains taxation or the intention to make profits (both referred to as CGT here) Go back tax on ownership interests ideally should not raise extra domestic tax revenue overall as the entity tax system already imposes a single (or double) layer of tax on local income nevertheless, the tax can be important, for example, in the international context or to avoid pricing distortions the design challenge is to ensure the appropriate level of tax revenue overall The entity may buy back its ownership interests from some owners, perhaps in the context of CGT the buy-back may be off-market or on-market where the owners do not know the entity is buying their interests Income may flow via other entities (perhaps subject to different tax treatments) before coming out to individual owners The Kyscope helps you work through the following complexities when designing entity taxation

30 When might the benchmark outcome occur with entities? Single-tax-layer entity systems may therefore produce a 10% to 5.3% benchmark outcome in a year if: owners are taxed on an amount equal to the income of the entitys net assets in that year (ie their annual net receipts plus the annual change in value of the assets) Full integration is designed to achieve this outcome each year and trust treatment will produce it if annual taxable income equals full annual income Full imputation (or trust treatment), designed to achieve a single layer of tax at owners tax rates over time, can achieve the benchmark outcome in a year: if full CGT applies to the sale of ownership interests over the year (capturing any change in value of the entitys retained net assets) Go back Entity interests (eg shares in a company) are assets with their values and associated cash flows linked to the income of the underlying assets owned by the entity With imputation, the benchmark outcome can be achieved via the application of CGT even with full retention of annual income. Temporary double tax arises, however, from the entitys also paying tax on this income. This double tax is reduced to a single layer over time as income is distributed via dividends, buy-backs and liquidation (see extra information linked to later discussion of Kyscope Example 10) The benchmark outcome results each year in Kyscope Example 10 (Company with domestic assets)

31 Full integration – designed for the benchmark outcome Full integration is designed to tax people owning an entity on income from the entitys assets in the year the income is earned Owners are taxed on the income even if the entity does not distribute it in the year it is earned Go back As with direct ownership of assets, if taxable income equals actual income, the annual pre-tax return from the assets is reduced in proportion to the individual owners tax rate that is the benchmark outcome 10% pre-tax in a year becomes 5.3% with 47% tax Integration forms the conceptual basis for taxing controlled foreign corporations in the global context The Kyscope allows you to run full integration to see what would be required to operate such a system in practice And to see the effects of integrating taxable rather than actual income And, if CGT were applied to entity interests, to appreciate adjustments that would be required to the tax value of those interests from time to time

32 Full imputation - benchmark outcome sometimes If income is distributed to individual owners in the year it is earned, the benchmark outcome is achieved with that income Because individual investors (the owners) pay tax in the year the income is earned, 10% pre-tax return is reduced to 5.3% if the investors tax rate is 47% With a 30% entity tax rate, post-tax return to this 47% tax rate investor would increase the longer the income was retained before distribution If the entity retains income, entity value increases and the benchmark outcome is achieved if owners are taxed in full on the value increase in the year of retention In practice, at most, individual owners would only be taxed in full when they sold their interest in the entity (either through capital gains taxation or because they intended to profit from selling) Go back A full imputation system imposes one layer of tax on domestic entity income by giving local people owning an entity full credit for any domestic tax already paid by the entity on distributed income In Kyscope Example 10 (Company with domestic assets) the 10% pre-tax to 5.3% outcome is achieved by owners each year because all cash is distributed each year and the owners sell out each year

33 Trust treatment – benchmark outcome on taxable income Because taxable income is distributed to individual owners in the year it is earned, the 10% to 5.3% benchmark outcome is achieved for that income Annual income that is not taxable may be distributed tax free or retained An important tax design feature is whether distributions of untaxed income reduce the tax value of units in a trust – which potentially results in the income being taxed when the units are sold Go back Under trust treatment the entity itself pays no tax and its taxable income is distributed to entity owners annually A common design issue with trusts is how to maintain the effect of permanent tax preferences (eg exempt capital gains) when associated income is distributed, without turning tax preferences that provide timing benefits (eg accelerated depreciation) into permanent preferences The Kyscope enables you to solve such issues by clarifying the relationship between the tax treatment of the entity and its owners Use the Kyscope to design tax law that achieves policy objectives without unintended side effects In Kyscope Example 11 (Fixed trust with tax preferences) accelerated depreciation results in trust income not being taxable in some years

34 Kyscope Example 10 Full imputation and, on sale, full capital gains tax (CGT) apply In addition, the annual pre-tax return of 10% from the assets is reduced by the owners 47% tax rate to 5.3% each year How does tax treatment on liquidation look under full imputation and CGT to ensure a single layer of tax only? How would the tax treatment of a share buy-back look under full imputation and CGT to ensure a single layer of tax only? A single layer of tax at the owners tax rate applies to the companys income over the 5-year period This benchmark outcome occurs annually despite unexceptional tax design Dividends Return capital Owners Depreciating asset Local Entity Appreciating asset Year 5 Liquidation The company owns two local assets and is liquidated in Year 5 Why? 16 All cash flow is distributed over the 5-year period and the owners may sell their shares in any year The Kyscope shows the overall tax design required to achieve this single tax layer over time

35 Retained profits in entity prior to liquidation Owner A1000 Owner A contributes 1000 capital Contributed capital Value increases by the 100 of retained income Over time, the entity retains 100 income (profits) Profits tax 70 post-tax profit Entitys income attracts 30% tax a

36 Liquidation of the entity Owner A Owner A maintains ownership until liquidation Contributed capital tax 70 post-tax profit On liquidation, all original capital plus retained income (after 30% entity tax) are distributed to Owner A Owner A on 47% personal tax pays an extra 17 tax above the 30 entity tax paid Thus, a single layer of tax at Owner As 47% tax rate applies over time b The Kyscope treatment in these circumstances

37 Liquidation of the entity involving a capital loss Owner A on 47% personal tax rate pays 47 capital gains tax (CGT) post-tax profit Owner A sells out to Owner B prior to liquidation for 1100 Contributed capital tax Owner B on 47% pays extra 17 tax Over time, a single layer of tax applies Tax on 100 income: Entity 30 Owner A 47 Owner B One layer at Owner As tax rate over time Go back Use the Kyscope to assess tax effect of having no or partial CGT On liquidation, all post-tax income and capital go to Owner B less 47 tax saving from 100 CGT loss The Kyscope treatment in these circumstances

38 Retained profits in entity prior to buy-back Owner A1000 Owner A contributes 1000 capital Contributed capital Value increases by the 100 of retained income Over time, the entity retains 100 income (profits) Profits tax 70 post-tax profit Entitys income attracts 30% tax a

39 Sale prior to buy-back Owner A on 47% personal tax rate pays 47 capital gains tax (CGT) post-tax profit Owner A sells out to Owner B prior to buy-back for 1100 Contributed capital tax c At this stage, double tax has been paid in the 100 of entity income (30 by the entity and 47 by Owner A) Now see what happens when off-market or on- market buy-back takes place

40 Off-market buy-back – or proportional liquidation Kyscope Example Owner B pays 1100 just prior to buy-back (47 CGT paid by original Owner A) Contributed capital tax 70 post-tax profit Company cancels profit, capital and credits Single layer of tax at owner As tax rate over time On buy-back, Owner B gets the 70 plus contributed capital plus 30 tax credits Owner B on 47% pays extra 17 tax Use the Kyscope to assess effect of no or partial CGT and different entity tax systems a At time of sale, 70 of after-tax income retained Tax on 100 income: Entity 30 Owner A 47 Owner B less 47 tax saving from 100 CGT loss Go back Or wait for the on- market buy-back

41 On-market buy-back Go back Use the Kyscope for detailed analysis of tax design of both off-market and on- market buy-backs Owner B paid 1100 just prior to buy-back (47 CGT paid by original Owner A) Contributed capital tax 70 post-tax profit Entity payment to B includes 30 for tax credits Entity cancels profit and capital in its books On buy-back, owner B sells to company for 1100, the same amount as paid prior to buy-back – no CGT applies Owner B does not know who buyer is Eventually, 30 tax credits reduce tax of owners not participating in buy-back, leaving single layer of tax at Owner As tax rate On buy-back: The Kyscope treatment in these circumstances

42 Why the benchmark outcome in Example 10? The benchmark 10% to 5.3% outcome results annually in Example 10 because: a full imputation system applies (imposing a single layer of tax on company income at shareholders tax rates over time) Go back Thus, individual owners are taxed on an amount equal to the annual income of the entitys net assets (ie annual net receipts plus the annual change in the net assets value) the company distributes all its cash flow each year so shareholders receive (and are taxed on) all the companys net receipts each year either as franked dividends (with the companys imputation tax credits attached) or as unfranked dividends (untaxed in the company because of depreciation allowances) the shareholders sell out each year resulting in their being subject to capital gains taxation on the annual change in value of the companys assets (including losses arising from declining value)

43 How the Kyscope assists with entity taxation These uses of the Kyscope are equally applicable when income flows are subject to foreign taxes in their travels back to the ultimate owners Conceptually, handling international taxation is simple – just accommodate the fact that foreign taxes have previously been taken out of the income But the practicalities of foreign tax credit arrangements involve many complications 17 The Kyscope allows analysis of alternative approaches to taxing entities and the people who own them The Kyscope calculates investment returns to owners each time they sell out to others Comparing investment returns with the relevant benchmark rate (pre-tax return of entitys assets reduced by owners tax rate) gives a feel for potential price pressures and behavioural effects Most importantly, the Kyscope allows you to design entity taxation confidently to achieve a policy goal of a single (or double) layer of tax without unforeseen side effects It will rarely be necessary to compare investment returns from selected entity treatment against returns from a full integration system under the same circumstances

44 International The same tax principles apply to international investment flows as domestic flows The Kyscope offers much help with these practical issues Go back 18 But there are many extra practical issues involved Contents

45 The Kyscope shows effects of benchmark internationally Foreign pre-tax return is reduced by the tax rate in the home country 10% pre-tax return 20% foreign tax rate Investment from home country attracts 20% foreign income tax 30% domestic tax Full foreign tax credit 7% post-tax return If full credit is given for the 20% foreign tax paid, only 10% extra needs to be paid in the home country to meet its 30% domestic tax rate 19 Investment from home country Income returning to home country

46 Use the Kyscope to analyse practical international tax issues No new theoretical concepts are added just because foreign taxes apply If the home country provides a full credit for foreign taxes against home country tax, investment decisions turn on the home countrys tax base But in practice many issues arise, for example, the: extent to which credits for foreign taxes are provided treatment of capital gains or losses when, for example, a local company sells a previously acquired foreign company design of arrangements to tax income of foreign entities even when the income is not distributed (full integration is the conceptual model) 20 This Kyscope example enables you to see how administration and compliance requirements change with different foreign tax crediting arrangements In Kyscope Example 15, the home country provides full credit for foreign taxes Use the Kyscope to analyse these and other practical issues

47 Use the Kyscope with foreign tax credit issues Entity Foreign tax is paid offshore on income flowing back to the home country Does the local entity get a credit against domestic tax for the foreign tax already paid on the offshore income? People owning it Do people in the home country who own the local entity get a credit against their personal tax for the foreign tax on the offshore income distributed to them by the entity? Entity People owning it If the foreign income flows between local entities, are the foreign taxes tracked to allow foreign tax credits to downstream entities and local people who own them? The offshore income flows through the home country to offshore owners – conduit income Is the conduit income subject to additional home country tax? Use the Kyscope to address such issues in a comprehensive and integrated way 21

48 22 Kyscope Example 15 Appreciating asset Depreciating asset Offshore Company Home company buys offshore company Year 5Year 2 Capital gain on sale Capital loss on sale Home company sells offshore company Offshore company pays tax offshore on the income from two assets it owns there It distributes all cash flow to the home company in each year that the home company owns it Dividends flowing to the home company attract the offshore countrys dividend withholding tax Appreciating asset Depreciating asset Owners Dividends Return capital Dividends Return capital Home Company Offshore and tax paid there Year 5Liquidation Home company is subject to domestic tax on the dividend income from its offshore company and the non-dividend income from two offshore assets it owns directly It gets a full credit for all the foreign taxes paid on its offshore income In Example 15, The home country runs a full imputation system of company tax. The home company gets a full credit for all foreign taxes paid on its income and that full credit is passed through to its local shareholders. A single layer of tax at local shareholders tax rates therefore applies to the income from all the foreign assets despite the foreign tax paid on it. Moreover, foreign shareholders would not be subject to additional dividend withholding tax on dividends paid to them. In Example 15, this policy framework is able to be implemented simply by foreign taxes being added to the companys imputation credit account. Many ledgers (represented by lines on the entitys Kyscope spreadsheet) are not required. Under alternative policy options, additional ledgers are required, reflecting increased administration and compliance costs. Owners Dividends/return capital Local owners have the full foreign tax credit passed through to them Use the Kyscope to analyse the link between policy design and administration/compliance costs

49 Want to know more about the Kyscope? The show has only been able to cover the tip of the Kyscopes capabilities For more information on these capabilities, see the download Kyscope features To contact the Kyscopes developer, click on Contact the developer on the website © Copyright 2004 Wayne Mayo (The two maps used are © Microsoft) 23 Assets/liabilities SectionEntities SectionInternational SectionStart


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