1. 1 Updated: 8 Feb 2012 ECON 635:PUBLIC FINANCE Lecture 12 Topics to be covered: 1.Tax Incentives 2.Types of Tax Incentives 3.Tax Credit 4.Tax Neutrality 5.International Tax Harmonization 6.Tax Treatment of Branches and Subsidiaries by the Home Country

2. 2 Tax Incentives Tax incentives are provided by governments in order to encourage additional investments which would not otherwise be coming forth. The design of incentives requires a good deal of care so that it does not affect the "neutrality" of the tax. Neutrality is achieved when an incentive does not induce new covered investments with low rates of social yield, while failing to induce covered investments with higher rates of social yield.

3. 3 Tax Incentives If, before a tax incentive, three projects are ranked according to their social yield as: Project A 15% rate of return Project B 10% rate of return Project C 8% rate of return so that project A is preferred to B and B to C. After the tax incentive, projects A, B, and C should have rates of return such that their ranking remains unaltered, that is, Project A 18% rate of return Project B 12% rate of return Project C 10% rate of return such a tax incentive is neutral.

4. 4 Tax Incentive If the ranking of the projects changes after the tax incentive, it is not neutral. For example, if rates of return of the projects A, B, and C become: Project A 15% rate of return Project B 17% rate of return Project C 8% rate of return so that project B would be preferred to project A and project A to C, the tax system is not neutral.

5. 5 Types of Tax Incentives 1.Tax Credit 2.Accelerated Depreciation

6. 6 Types of Tax Incentives Tax credit Tax credits can be given as an incentive to encourage investment in a particular sector of the economy. In order to take the benefit of a tax credit, the individual or the company must have tax liabilities somewhere else. Investments tax credit = s If the purchase price of an asset A is = K, then the investment tax credit is sK where s is a fraction equal to or less than one. The net investment then becomes K-sK=K(1-s). This would increase the rate of return on the investment I.

7. 7 Tax Incentives (Investment Tax Credit) Ex. A credit of 20% is given if investment is undertaken. Credit can be used to reduce taxes by 200

8. 8 Tax Incentives

9. 9 Tax Incentive Give a 20% tax credit or 200 when one year bond is purchased.

10. 10 Types of Tax Incentives Accelerated depreciation Accelerated depreciation will reduce the taxable income and hence the tax liability during early years and this would improve the viability and yield of the project. Consider an asset which has 5 years of life and whose purchase price is $1,000. Corporate income tax (t c ) is 40%.

11. 11 Types of Tax Incentives Ex. Straight Line Depreciation

12. 12 Types of Tax Incentives Ex. Accelerated Depreciation

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18. 18 Tax Neutrality

19. 19 Ex.1000 (10%) D I D+I 1200 100 300 Then we should consider 2200 80 280 PVD, PVY and PV(D+I) 3200 60 260 4200 40 240 5200 20 220

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28. 28 International Tax Harmonization Some companies, called multinationals, carry out business in more than one country. The place where the company has its headquarters, is called the “home country”, while other countries where it conducts business are called “host countries”. The subsidiary is incorporated in the host country and has an independent legal existence. The subsidiary is usually wholly owned by the parent company and pays dividends to its shareholders in the home country. A branch, on the other hand, is un-incorporated and is more like a field office of the parent company.

29. 29 International Tax Harmonization For the purpose of the income tax, the difference between a subsidiary and a branch is that in the case of a subsidiary, the host country can tax profits as well as the dividends distributed to the shareholder by imposing a withholding tax on dividends, while in the case of a branch, the host country can only tax the profits. In order to capture the same amount of revenue from the two alternatives, the rate of tax has to be higher for a branch than for a subsidiary. The taxable income of a subsidiary or a branch is again: sales-cost of goods sold-depreciation-interest payments-overheads.

30. 30 1.Cost of goods sold: Issue of Transfer Pricing An increase in the cost of goods sold will affect the taxable income recorded in the host country. The host country should make sure that the prices used by the company to calculate the cost of goods sold are not inflated. The subsidiary may be purchasing inputs and raw materials from the parent company at prices that do not reflect the market prices. The internal fixation of prices between the parent company and the subsidiary is termed “transfer pricing”

31. 31 2. Overheads The subsidiary may be utilizing the services of consultants from the parent company and may be paying very high fees. The subsidiary may be receiving product samples from the parent company at very high prices. It may also be paying unusually high management fees to the parent company, thereby inflating the overhead expenses and reducing the tax liability.

32. 32 3. Interest Payments The subsidiary can borrow funds from the parent company or from a company owned by the parent company at a very high interest rate and thus increase the interest deductions. This again erodes the tax base. A provision to tax the interest payments before they are repatriated to the home country would discourage this tendency.

33. 33 Alternative Tax Treatments of Branches and Subsidiaries by the Home country a.Exemption of foreign source income b.No consideration of taxes paid in the foreign country c.Foreign tax credit d.Deduction of foreign taxes paid e.Tax holiday f.Tax holiday with tax sparing

34. 34 a. Exemption of foreign source income Tax is levied by the home country on the basis of source of income. Only income that is generated in the home is taxed. If the income comes from a foreign source, it is exempted. Ex. Suppose the income of a subsidiary or a branch is $1000. The home country tax rate is 40% and the host country tax rate is 35%. The tax liability will be $350 in the host country, and $0 in the home country, leaving a total of $650 in profits.

35. 35 b. No consideration of taxes paid in the foreign country The home country does not give any consideration to taxes paid in the host country. The company has to pay taxes in both the countries. Ex. Consider the example given in part a. The tax liability would be $350 in the host country. As the taxes paid in the host country are not considered at all, the home country will impose a tax of $400, leaving a net profit of $250. (1000-350-400=250)

36. 36 c. Foreign tax credit The home country gives a tax credit to the parent company for the taxes paid in the host country. Ex.in part a. The tax liability would be $350 in the host country and $400 in the home country. With the tax credit, the company must pay only the difference (400-350=50). The total tax liability is $400, leaving a net profit of $600 to the company. Effectively, the tax liability is the same as in the home country.

37. 37 d. Deductions of foreign taxes paid Taxes paid in the foreign country are deducted from the tax base before calculations of tax liability in the home country. Ex. The tax liability in the host country would be $350. The taxable income in the home country would be ($1000-$350=$650). Thus tax liability in the home country would be $260. Total tax liability is therefore $650, leaving a net profit of $390. (1000-350-(1000-350)*0.4=390)

38. 38 e. Tax holiday under a Foreign Tax Credit System If the host country gives a tax holiday to the branch or subsidiary, the tax is levied only in the home country. The tax liability in the host country would be $0. In the home country, the tax liability would be $400, leaving a net of tax profit of $600. The company does not get any benefit from tax holiday in the host country.

39. 39 f. Tax holiday with tax sparing There is an agreement between the two countries by which the host country gives a tax holiday while the government of the home country gives a tax credit to the company as if taxes were paid in the host country. This would give an incentive to the parent company to do business in the host country because the tax liability of the company is reduced drastically. Ex. The tax liability in the host country would be $0. In the home country, tax liability would be $400. The company gets a tax credit as if it paid a tax of $350 in the host country. Its net tax liability is $50, leaving a net profit of $950 to the company.