3 Contents Overview Assets and liabilities Go there now iiiContentsOverviewAssets and liabilities Go there nowfrom a domestic perspectiveEntities Go there nowInternational Go there nowassets/liabilities and entities (and their owners) from a global perspective
4 The Overview runs for about 11 minutes At the end of the Overview you will be asked if you wish to exitIn ensuing sections on assets/liabilities, entities and international, issues are discussed in more detail
5 What does the Kyscope do? 2What does the Kyscope do?The Kyscope brings together:assets and liabilitiesentities that own the assets/liabilitiesand the people that own the entitiesIt measures the income of assets and liabilitiesAnd tracks that income as it flows from the assets/liabilities through the entities and out to the ownersAnd shows the tax paid at each stage depending on the tax treatment selected for the assets, entities and owners
6 What can the Kyscope be used for? 3What can the Kyscope be used for?To undertake aggregate revenue analysisestimating changing year-by-year tax receipts across a sector/economy caused by a change in tax treatmentThis is illustrated in Kyscope Example 1 – ‘Economy-wide effects of accelerated depreciation’To compare tax outcomes for an investor under:benchmark tax treatmentversusselected tax treatmentUse this comparison and associated effective tax rate calculations from the Kyscope in tax policy analysesAll the Kyscope examples except Example 1 illustrate such useThe ‘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
7 The Kyscope measures income earned in a year 4The Kyscope measures income earned in a yearAnnual receiptslessAnnual expensesplusChange in annual value of assets (and liabilities)Everyone knows that the money earned from selling apples from an orchard less annual costs of maintaining the orchard is profit or ‘income’.BENCHMARKBut if the value of the orchard goes down (up) in the year the orchard investor’s income also goes down (up).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.How, when and whether the income is taxed is a separate issueThe Kyscope measures ‘full’ annual income whether or not assets are soldChange 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.
8 The Kyscope shows effect of benchmark on investor returns 5The Kyscope shows effect of benchmark on investor returnsThe pre-tax return of a ‘marginal’ investment is 10%.A 10% pre-tax return from all of a person’s investment choices (the bank, bonds, property, manufacturing, etc) is reduced in proportion to his/her tax rate10% pre-tax returnIf the benchmark base applies to this investment…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…Annual net receiptsplusChange in value of assets/liabilitiesHis/her investment decisions would therefore not be much affected by the imposition of tax…the pre-tax return is reduced after tax in proportion to the investor’s tax rate.What is the relevance of the benchmark income tax base? Say an investor is faced with a 10% pre-tax return across a range of alternative investments - putting money in the bank, establishing a vineyard, investing in a manufacturing activity, etc. If the benchmark income tax base applied to all these marginal investments, their 10% pre-tax return would be reduced in proportion to the investor's tax rate - to 7% if the investor's tax rate was 30%, to 5.3% if the investor's tax rate was 47%, and so on. From this you should get the idea that the investor's post-tax decisions would be pretty much in line with pre-tax decisions. The tax would be 'neutral' or non-distorting.What about risk?What is a marginal investment?7% post-tax return30% tax rate5.3% post-tax return47% tax rate
9 Pre-tax Marginal Investments In contrast to risk-free bonds, a risky investment has a spread of possible outcomesAn 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 investmentThe risky investment could be viewed as ‘marginal’ as any lower expected return would make the risk-free alternative preferableThese two investments could illustrate just two of a continuum of investments that are on the entrepreneur’s investment ‘margin’ before taxBut does the risky investment stay on the entrepreneur’s investment ‘margin’ after tax?Possible above average returns from risky investmentPossible negative returns (losses) from risky investmentReturn %Risk-free return from government bondsAverage (or expected) return from risky investment
10 Post-tax Marginal Investments Go backAfter tax under the benchmark base, pre-tax returns of all possible investment outcomes are reduced in proportion to the investor’s 30% tax rate if change in asset value is determined using those pre-tax returnsThe 5% risk-free return, the expected 10% return from the risky investment and the range of possible returns around it are all reducedThe way that all the returns are ‘squeezed’ after tax, suggests the same investments as before tax, could well be on the entrepreneur’s investment margin after taxPossible profits from risky investment reduced in proportion to investor’s 30% tax rateReturn %Possible losses from risky investment reduced in proportion to investor’s 30% tax rate (if other income is available against which to write losses off immediately)There is more robust discussion of these issues in the ‘Business tax paper’ on the Kyscope website5% pre-tax return from government bonds reduced in proportion to investor’s 30% tax rate
11 Use the Kyscope to choose pre- and post-tax look of assets 6Use the Kyscope to choose pre- and post-tax look of assetsAnnual receiptslessAnnual expensesTAXABLEINCOMEIt is not surprising that income tax systems usually include annual net receipts from investments in taxable income.Income tax systems differ, however, in whether they incorporate changes in value of assets in taxable income – and, if so, when.plusChange in annual tax value of assets (and liabilities)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.Want to view a typical depreciating asset?The income tax base in practice usually only differs from the benchmark tax base to the extent that 'tax values' are substituted for actual value in determining annual change in value of assets and liabilities.Or tax value may remain unchanged at original cost prior to sale, etc.Want to view an appreciating asset?Use the Kyscope to choose pre-tax features of assets and measure the annual income from themUse the Kyscope to select tax treatment of the assets and see how tax value of the treatment differs from actual valueUse the Kyscope to see the effect of tax value differing from actual value on tax revenue, after-tax returns and effective tax ratesWant to compare pre- and post tax returns of depreciating/appreciating assets?
12 Depreciating asset Value Tax value Go back Asset acquired for $1000 Tax value declines faster than actual value in this illustration because there is accelerated depreciation
13 Appreciating asset Value Tax value Go back Tax value stays at the $1000 cost of the assetTax value
14 Comparison of depreciating and appreciating assets Go backPre-tax returnPost-tax returnBenchmark tax baseInvestor’s tax rate is 47%Accelerated depreciation 30%Gains taxed on sale of assetsDepreciating asset – 5 years15% pa decline in value10%5.3%ETR*=47%6.0%ETR*=40%Appreciating asset – 5 years10% pa increase in value5.8%ETR*=42%Bank account*ETR = Effective tax rate = (pre-tax return less post-tax return)/pre-tax return
15 Use the Kyscope to compare options against the benchmark 7Use the Kyscope to compare options against the benchmarkUse the Kyscope to get a feel for behavioural effects, price effects etc of your selected tax treatment………………effects relating not only to the treatment of assets, but also to the entities that own them and the people owning the entitiesUse the Kyscope to estimate the tax revenue cost of tax treatments relative to the benchmark (ie ‘tax expenditures’)Moreover, the income from an entity’s assets and liabilities (including changes in their actual values) ultimately flows through to the entity’s ownersTax valueValueINVESTMENT OVER TIMEComparing 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.Why?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.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 entitiesAnd the benchmark tax base (with its limited effect on investment decisions) incorporates actual asset valuesUse 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 8The Kyscope integrates the three key componentsOverview complete Want to exit now?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 benchmarkASSETS AND LIABILITIES SECTIONAssets and liabilitiesEntitiesEntity ownersUse 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 separatelyENTITIES SECTIONUse 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 ratesINTERNATIONAL SECTIONIn 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
17 Assets and liabilities 9Go backContentsAssets and liabilitiesAssets and liabilities change in value year by yearHowever, in practice, it is change in ‘tax value’ that is used to calculate annual taxable incomeThe Kyscope enables you to choose the ‘tax value’ profile of selected assets and assess the impact of those profiles
18 Use the Kyscope to assess the tax impact of tax value profiles 10Use the Kyscope to assess the tax impact of tax value profilesAnnual changes in the tax values of assets (and liabilities) in a country’s income tax base feed into taxable incomeUse the Kyscope to simulate tax treatment of depreciating and appreciating assets, financial assets/liabilities and trading stockHow does that work?The actual change in value of an asset is, however, often reflected in the owner’s taxable income over the period of ownershipSee it again?It is then the profile of tax value versus value over time that represents difference in treatment from the benchmark baseUse the Kyscope to get a feel for the impact of different tax value profiles on behaviour, prices, tax revenue, etcTraditional gaps in the coverage of business assets in income tax systems have been shrinking worldwideUse 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 Value Tax value Go to appreciating asset Go back The ‘clawing back’ is done in practice either via traditional ‘balancing adjustments on disposal’ or by equating tax value with sale valueIn the Kyscope, ‘clawing back’ always occurs with depreciating assets and financial assets/liabilities and is identified with a specific ‘balancing adjustment on disposal’Depreciating assetGo backGo to appreciating assetIn net terms, only the actual change in value of the asset is reflected in the owner’s taxable income over the 5 years of ownershipAsset acquired for $1000ValueTax valueThe extra deductions from accelerated depreciation over the period of ownership are ‘clawed back’ when the asset is soldTax value is lower than actual value each year because of accelerated depreciation
20 Appreciating asset Value Tax value 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’)Appreciating assetGo backWhen the asset is sold, some or all of the difference between value and tax value could be subject to tax………ValueTax valueTax value stays at the $1000 cost of the asset because of practical policy-making……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 owner’s taxable income
21 Set tax value profiles in the Kyscope and see effects 11Set tax value profiles in the Kyscope and see effectsIn practice, transactions to be included in the tax base are often identified individuallyIs business expenditure involved?All expenditure in the Kyscope is business relatedYesWith the Kyscope, instead of answering this question, you select the assets to be included in the analysis plus their pre-tax characteristicsDoes the expenditure create/improve an asset?NoTax value at cost until sold – eg appreciating assets, trading stockYesChange in tax value based on write-off rate – eg depreciating assetsChange in tax value computed from future net receipts- eg financial assets,leasesrightsTax value in line with market value – eg trading stock, financial assetsTax value at cost until production starts – eg forestry, miningDeduction allowed in the year expenditure is incurredIn all Kyscope examples, annual costs in ‘Net receipts’ are deducted that yearKyscopeExample 7Kyscope Examples 2 & 3Kyscope Examples 4, 5, 8 & 9KyscopeExample 6Kyscope Examples 2 & 3Details?Details?Details?Details?Details?Details?The ‘details’ illustrate how the selected treatment might arise in practiceHow is this annual change computed?
22 Assets with known value change – financial assets, etc Go backSometimes a component of change in asset value is known or readily computed each yearchange in market value obtained readilyeg listed shares, trading stock, open futures contracts, etcTrading stock in Kyscope Example 6variable interest on a bank deposit, etc over the periodchange computed from the interest rate equating the sum of the asset’s discounted known future receipts with its up-front priceThe Kyscope allows you to specify the known component of future net receiptsThe zero coupon bond in Kyscope Example 4, capital repayment assignment in Kyscope Example 9, lease payments in Kyscope Example 8, annuities, redeemable preference shares, etcchange from applying known annual value of indices, such as CPI, commodity and share price indices or changed exchange ratesThe CPI-indexed security in Kyscope Example 5change computed from applying a specified interest rate to an assumed profile of associated benefitsThe lease over a depreciating asset in Kyscope Example 8
23 Depreciating assetsGo backDecline in value of depreciating assets is usually estimated from a specified write-off rateValue 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 impossibleSee Kyscope Examples 2 and 3Alternative straight line or declining balance write-off rates are often derived from a schedule of effective livesWhere the declining balance rate happens to match actual rate of decline in value of the asset, the benchmark base resultsRelationship between market information, effective life and write-off ratesEstimation from, say, wear and tearEstimation from market value dataDeclining balance rate of write-offStraight line rate of write-offEffective life
24 Estimation difficulties and pragmatic policy decisions Go backSometimes expenditure attracts immediate write-off even though an asset may be createdeither because value estimation is difficult and/or practical policyeg mining and petroleum exploration expenditureSometimes 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 assetbecause of pragmatic policy decisionseg annual interest payments on holiday cottagesSometimes an asset/liability’s tax value is not changed even though a known change occurs in its value during a yearbecause the change in value is unlikely to be maintainedeg exchange rate effects on foreign debtSometimes an asset’s tax value does not change from its original costeither because value estimation is difficulteg options, value increase prior to production commencingor because of pragmatic policy decisionseg listed shares, landSee Kyscope Examples 2 & 3See Kyscope Example 7
25 Change in asset value – general methodology Go back$100…..then you know the annual income (‘interest’) component of this year’s net receipts – ie value x return. This adds to (tax) value of the asset.10% returnAnd the annual return from the asset’s future end-of-year net receipts…….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$250 net receipts reduce (tax) value at year end$1000If you know the (tax) value of the asset at the start of the year…….Net change in value = annual income less net receipts= $150 lossThe Kyscope uses this forward-looking method with assets and liabilities to compute change in pre-tax value, as well as tax valueYear end value $850
26 13Go backContentsEntitiesAn ‘entity’ (eg a company) is a separate taxpayer from its ownersIncome generated by an entity’s assets may flow on to other entitiesThis slide show gives a general feel for what Kyscope offers in terms of tax revenue analysis and tax policy analysis to those in treasuries and tax offices, as well as those dealing with similar issues.And ultimately out to the people who own the entitiesThe Kyscope enables you to design entity taxation confidently because it draws together the people who own the entities and the entities themselves
27 The Kyscope draws together the taxation of people and entities 14The Kyscope draws together the taxation of people and entitiesPeople - Direct InvestorsDesign of entity taxation needs to recognise both the entity and the people who own itEntityEntity taxed each year on its annual taxable incomeCash flow only distributed when entity decides to do soCash flow received in the year it is producedAssets and liabilitiesIncomeSome 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 entitiesAnnual taxable income goes straight to individuals’ tax returns – to be taxed once ( ie it attracts a single layer of tax at each individual’s tax rate)The single layer of tax is consistent with the single layer of tax faced by the direct investor (or unincorporated business)……………Entity owners – Indirect InvestorsThey are taxed separately from the entity……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 incomeOther entity tax systems impose a double layer of tax
28 The Kyscope can assist in the design of entity taxation 15The Kyscope can assist in the design of entity taxationEntity taxation systems that are designed to impose at most a single layer of income tax on domestic entity income include:full integrationfull imputationtrust treatmentClassical entity taxation is designed to impose at most two layers of tax – one in the entity and another in the hands of individual ownersThe Kyscope handles all these tax systems, and is able to accommodate plenty of options within eachUse the Kyscope to ensure robust entity taxation design under either single or double taxationThe Kyscope enables you to take into account the complexities imposed by the separation of the entity and the people owning itWhat are some of these complexities?Under an entity tax system imposing a single layer of tax, it could be expected that, in some years, the benchmark outcome would occurthat is, annual income of entity’s 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
29 Complexities relevant to entity taxation Go backThe Kyscope helps you work through the following complexities when designing entity taxationThe entity may retain income in a yearDistributions of retained income may occur either prior to or at the time of the entity’s liquidationTax 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)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 incomenevertheless, the tax can be important, for example, in the international context or to avoid pricing distortionsthe design challenge is to ensure the appropriate level of tax revenue overallThe entity may buy back its ownership interests from some owners, perhaps in the context of CGTthe buy-back may be ‘off-market’ or ‘on-market’ where the owners do not know the entity is buying their interestsIncome may flow via other entities (perhaps subject to different tax treatments) before coming out to individual owners
30 When might the benchmark outcome occur with entities? Go backEntity interests (eg shares in a company) are assetswith their values and associated cash flows linked to the income of the underlying assets owned by the entity‘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 entity’s 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 yearand trust treatment will produce it if annual taxable income equals full annual incomeFull 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 entity’s retained net assets)The benchmark outcome results each year in Kyscope Example 10 (Company with domestic assets)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 entity’s 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)
31 Full integration – designed for the benchmark outcome Go back‘Full integration’ is designed to tax people owning an entity on income from the entity’s assets in the year the income is earnedOwners are taxed on the income even if the entity does not distribute it in the year it is earnedThe Kyscope allows you to run full integration to see what would be required to operate such a system in practiceAnd to see the effects of ‘integrating’ taxable rather than actual incomeAnd, if CGT were applied to entity interests, to appreciate adjustments that would be required to the tax value of those interests from time to timeAs 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 owner’s tax ratethat is the benchmark outcome10% pre-tax in a year becomes 5.3% with 47% taxIntegration forms the conceptual basis for taxing ‘controlled foreign corporations’ in the global context
32 Full imputation - benchmark outcome sometimes Go backA full imputation system imposes one layer of tax on domestic entity incomeby giving local people owning an entity full credit for any domestic tax already paid by the entity on distributed incomeIf income is distributed to individual owners in the year it is earned, the benchmark outcome is achieved with that incomeBecause 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 distributionIf 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 retentionIn 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)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 Go backUnder trust treatment the entity itself pays no tax and its taxable income is distributed to entity owners annuallyBecause taxable income is distributed to individual owners in the year it is earned, the ‘10% to 5.3%’ benchmark outcome is achieved for that incomeAnnual income that is not taxable may be distributed tax free or retainedAn 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 soldIn Kyscope Example 11 (Fixed trust with tax preferences) accelerated depreciation results in trust income not being taxable in some yearsA 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 preferencesThe Kyscope enables you to solve such issues by clarifying the relationship between the tax treatment of the entity and its ownersUse the Kyscope to design tax law that achieves policy objectives without unintended side effects
34 Kyscope Example 10 Local Entity Owners Liquidation Dividends 16Kyscope Example 10Depreciating assetLocalEntityAppreciating assetYear 5LiquidationThe company owns two local assets and is liquidated in Year 5How does tax treatment on liquidation look under full imputation and CGT to ensure a single layer of tax only?All cash flow is distributed over the 5-year period and the owners may sell their shares in any yearHow would the tax treatment of a share buy-back look under full imputation and CGT to ensure a single layer of tax only?Full imputation and, on sale, full capital gains tax (CGT) applyDividendsReturn capitalOwnersIn addition, the annual pre-tax return of 10% from the assets is reduced by the owners’ 47% tax rate to 5.3% each yearA single layer of tax at the owners’ tax rate applies to the company’s income over the 5-year periodThis benchmark outcome occurs annually despite unexceptional tax designThe Kyscope shows the overall tax design required to achieve this single tax layer over timeWhy?
35 Retained profits in entity prior to liquidation 1100Value increases by the 100 of retained incomeOver time, the entity retains 100 income (profits)Profits10030 tax70 post-tax profitOwner A1000Owner A contributes 1000 capitalContributed capitalEntity’s income attracts 30% tax
36 Liquidation of the entity bLiquidation of the entityOwner A10001100Owner A maintains ownership until liquidationContributed capital30 tax70 post-tax profitOn liquidation, all original capital plus retained income (after 30% entity tax) are distributed to Owner AOwner A on 47% personal tax pays an extra 17 tax above the 30 entity tax paidThus, a single layer of tax at Owner A’s 47% tax rate applies over timeThe Kyscope treatment in these circumstances
37 Liquidation of the entity involving a capital loss Go backOn liquidation, all post-tax income and capital go to Owner B1100100070 post-tax profitOwner A sells out to Owner B prior to liquidation for 1100Contributed capital30 taxless47 tax saving from 100 CGT lossOwner B on 47% pays extra 17 taxOwner A on 47% personal tax rate pays 47 capital gains tax (CGT)Tax on 100 income:EntityOwner AOwner B-47------47One layer at Owner A’stax rate over timeOver time, a single layer of tax appliesUse the Kyscope to assess tax effect of having no or partial CGTThe Kyscope treatment in these circumstances
38 Retained profits in entity prior to buy-back 1100Value increases by the 100 of retained incomeOver time, the entity retains 100 income (profits)Profits10030 tax70 post-tax profitOwner A1000Owner A contributes 1000 capitalContributed capitalEntity’s income attracts 30% tax
39 Sale prior to buy-back 1100 30 tax 70 post-tax profit 1000 Owner A sells out to Owner B prior to buy-back for 1100Contributed capital30 taxAt this stage, double tax has been paid in the 100 of entity income (30 by the entity and 47 by Owner A)Owner A on 47% personal tax rate pays 47 capital gains tax (CGT)Now see what happens when off-market or on-market buy-back takes place
40 Off-market buy-back – or ‘proportional liquidation’ Go backOr wait for the on-market buy-back11001000Owner B pays 1100 just prior to buy-back (47 CGT paid by original Owner A)Contributed capital30 tax70 post-tax profitOn buy-back, Owner B gets the 70 plus contributed capital plus 30 tax creditsless47 tax saving from 100 CGT lossOwner B on 47% pays extra 17 taxAt time of sale, 70 of after-tax income retainedCompany cancels profit, capital and creditsTax on 100 income:EntityOwner AOwner B-47------47Single layer of tax at owner A’s tax rate over timeKyscope Example 12Use the Kyscope to assess effect of no or partial CGT and different entity tax systems
41 The Kyscope treatment in these circumstances ‘On-market’ buy-backGo back11001000Owner B paid 1100 just prior to buy-back (47 CGT paid by original Owner A)Contributed capital30 tax70 post-tax profitOn buy-back, owner B sells to company for 1100, the same amount as paid prior to buy-back – no CGT appliesOwner B does not know who buyer isOn buy-back:Entity payment to B includes 30 for tax creditsEntity cancels profit and capital in its booksEventually, 30 tax credits reduce tax of owners not participating in buy-back, leaving single layer of tax at Owner A’s tax rateUse the Kyscope for detailed analysis of tax design of both off-market and on-market buy-backsThe Kyscope treatment in these circumstances
42 Why the benchmark outcome in Example 10? Go backThe 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)the company distributes all its cash flow each yearso shareholders receive (and are taxed on) all the company’s net receipts each yeareither as franked dividends (with the company’s 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 company’s assets (including losses arising from declining value)Thus, individual owners are taxed on an amount equal to the annual income of the entity’s net assets (ie annual net receipts plus the annual change in the net assets’ value)
43 How the Kyscope assists with entity taxation 17How the Kyscope assists with entity taxationThe Kyscope allows analysis of alternative approaches to taxing entities and the people who own themComparing investment returns with the relevant benchmark rate (pre-tax return of entity’s assets reduced by owner’s tax rate) gives a feel for potential price pressures and behavioural effectsThe Kyscope calculates investment returns to owners each time they sell out to othersIt will rarely be necessary to compare investment returns from selected entity treatment against returns from a full integration system under the same circumstancesMost 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 effectsThese uses of the Kyscope are equally applicable when income flows are subject to foreign taxes in their travels back to the ultimate ownersConceptually, handling international taxation is simple – just accommodate the fact that foreign taxes have previously been taken out of the incomeBut the practicalities of foreign tax credit arrangements involve many complications
44 18Go backContentsInternationalThe same tax principles apply to international investment flows as domestic flowsBut there are many extra practical issues involvedThe Kyscope offers much help with these practical issues
45 The Kyscope shows effects of benchmark internationally 19The Kyscope shows effects of benchmark internationallyForeign pre-tax return is reduced by the tax rate in the home country10% pre-tax return 20% foreign tax rateIncome returning to home countryInvestment from home country30% domestic tax Full foreign tax credit 7% post-tax returnInvestment from home country attracts 20% foreign income taxIf 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
46 Use the Kyscope to analyse practical international tax issues 20Use the Kyscope to analyse practical international tax issuesNo new theoretical concepts are added just because foreign taxes applyIf the home country provides a full credit for foreign taxes against home country tax, investment decisions turn on the home country’s tax baseBut in practice many issues arise, for example, the:extent to which credits for foreign taxes are providedtreatment of capital gains or losses when, for example, a local company sells a previously acquired foreign companydesign of arrangements to tax income of foreign entities even when the income is not distributed (full integration is the conceptual model)Use the Kyscope to analyse these and other practical issuesIn Kyscope Example 15, the home country provides full credit for foreign taxesThis Kyscope example enables you to see how administration and compliance requirements change with different foreign tax crediting arrangements
47 Use the Kyscope with foreign tax credit issues 21Use the Kyscope with foreign tax credit issuesUse the Kyscope to address such issues in a comprehensive and integrated wayThe offshore income flows through the home country to offshore owners – ‘conduit’ incomeEntityForeign tax is paid offshore on income flowing back to the home countryDoes the local entity get a credit against domestic tax for the foreign tax already paid on the offshore income?Is the conduit income subject to additional home country tax?EntityPeople owning itIf 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?People owning itDo 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?
48 Kyscope Example 15 Owners Home Company Offshore Company Owners Year 5 Home company buys offshore companyYear 5Year 2Capital gain on saleCapital loss on saleHome company sells offshore companyIn 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 company’s imputation credit account. Many ledgers (represented by lines on the entity’s Kyscope spreadsheet) are not required.Under alternative policy options, additional ledgers are required, reflecting increased administration and compliance costs.22Year 5LiquidationHome 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 directlyIt gets a full credit for all the foreign taxes paid on its offshore incomeAppreciating assetDepreciating assetOwnersDividendsReturn capitalHome CompanyOffshore and tax paid thereAppreciating assetDepreciating assetOffshore CompanyOffshore company pays tax offshore on the income from two assets it owns thereIt distributes all cash flow to the home company in each year that the home company owns itDividends flowing to the home company attract the offshore country’s dividend withholding taxOwnersDividends/return capitalLocal owners have the full foreign tax credit passed through to themUse the Kyscope to analyse the link between policy design and administration/compliance costs