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

2. Università Bocconi, A.A: 2005-2006 2 Mec – Comparative public economics 2 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

3. Università Bocconi, A.A: 2005-2006 3 Mec – Comparative public economics 3 Course presentation Objectives and main topics Tax law fundamentals Introduction to “Tax Planning”

4. Università Bocconi, A.A: 2005-2006 4 Mec – Comparative public economics 4 Corporate income tax Why tax corporations? Tax base The Combination of Corporate and Personal Income Taxes

5. Università Bocconi, A.A: 2005-2006 5 Mec – Comparative public economics 5 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

6. Università Bocconi, A.A: 2005-2006 6 Mec – Comparative public economics 6 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.

7. Università Bocconi, A.A: 2005-2006 7 Mec – Comparative public economics 7 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

8. Università Bocconi, A.A: 2005-2006 8 Mec – Comparative public economics 8 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?

9. Università Bocconi, A.A: 2005-2006 9 Mec – Comparative public economics 9 Systems for the taxation of profit income unincorporated firms incorporated firms personal income taxcorporate income tax imputation system classical system full imputation partial imputation

10. Università Bocconi, A.A: 2005-2006 10 Mec – Comparative public economics 10 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: t=40%, m=40% overall tax burden: 64%

11. Università Bocconi, A.A: 2005-2006 11 Mec – Comparative public economics 11 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 Net dividend(1-m)aP Example: t=40%, m=40% overall tax burden: 40% Tax Credit:taP

12. Università Bocconi, A.A: 2005-2006 12 Mec – Comparative public economics 12 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)

13. Università Bocconi, A.A: 2005-2006 13 Mec – Comparative public economics 13 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

14. Università Bocconi, A.A: 2005-2006 14 Mec – Comparative public economics 14 Course presentation Objectives and main topics Tax law fundamentals Introduction to “Tax Planning”

15. Università Bocconi, A.A: 2005-2006 15 Mec – Comparative public economics 15 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

16. Università Bocconi, A.A: 2005-2006 16 Mec – Comparative public economics 16 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

17. Università Bocconi, A.A: 2005-2006 17 Mec – Comparative public economics 17 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

18. Università Bocconi, A.A: 2005-2006 18 Mec – Comparative public economics 18 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

19. Università Bocconi, A.A: 2005-2006 19 Mec – Comparative public economics 19 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)

20. Università Bocconi, A.A: 2005-2006 20 Mec – Comparative public economics 20 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 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 loss 3.soon after the security becomes eligible for long term treatment realize the capital gain and pay tax tL x gain Tax saving equal to (loss=gain) (ts-tL) x gain

21. Università Bocconi, A.A: 2005-2006 21 Mec – Comparative public economics 21 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

22. Università Bocconi, A.A: 2005-2006 22 Mec – Comparative public economics 22 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

23. Università Bocconi, A.A: 2005-2006 23 Mec – Comparative public economics 23 Converting income from one type to another Payoffs Result of coin flip SecurityHeadsTails Heads€ 1100 Tails0€ 110 Short Heads-€ 1100 Short Tails0-€ 110 Method 1

24. Università Bocconi, A.A: 2005-2006 24 Mec – Comparative public economics 24 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)

25. Università Bocconi, A.A: 2005-2006 25 Mec – Comparative public economics 25 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

26. Università Bocconi, A.A: 2005-2006 26 Mec – Comparative public economics 26 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

27. Università Bocconi, A.A: 2005-2006 27 Mec – Comparative public economics 27 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 +  D) –  D = [tp (1+  ) –  ] D where  = ts/1-ts Usually non-residents and tax-exempt entities are not entitled to the credit

28. Università Bocconi, A.A: 2005-2006 28 Mec – Comparative public economics 28 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

29. Università Bocconi, A.A: 2005-2006 29 Mec – Comparative public economics 29 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 +  D) –  D = ts (100 – 100 +  100) –  100= ts  100 –  100 = - (1-ts )  100

30. Università Bocconi, A.A: 2005-2006 30 Mec – Comparative public economics 30 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