Chapter 3: Taxation on Business Decisions Flashcards
Types of corporate tax systems
- Tax only level of the firm
- Classical tax system
- Classical tax system with shareholder relief
- Imputation system (full vs. partial)
- Partnership method (full integration)
- Tax only the level of the owner
Tax Systems:
“Tax only level of the firm”
*All firms are subject to uniform corporate tax, no matter of their legal form.
*Partnerships and sole proprietors are also subject to corporate tax.
*Distribution of dividends ARE NOT taxed at the level of the owner.
*very rare
Ex. Singapore
Tax Systems:
“Classical tax system”
*Taxes are levied on firm AND the owner.
*Corporation–> pays corporate tax
*Owner—> pays dividend tax (taxed as regular income)
*FULL DOUBLE TAXATION
*Dividends taxed at owner’s marginal income rate.
*very high total tax burden
Tax Systems:
“Classical tax system with shareholder relief”
*Double taxation remains
*Relief on dividend taxation, either:
1. reduced tax rate
2. taxing part of dividends at income tax rate
*most countries have this system.
*lower total tax burden than “classical tax system”.
Tax Systems:
“Imputation system”
Economically owner and firm are treated as one unit.
- Full Imputation–>
*corporate tax on firm’s profit
*dividends are fully taxable at owner’s level. Owner pays full income tax on corporate profits
*Shareholders receive a tax credit that responds to FULL amount of corporate income tax, which has been paid on the part of profits distributed as dividends.
ex. New Zealand, Malta
Essentially, corporate taxes are expected to be paid on behalf of shareholders.
In case of partial dividend payout, retained earnings are taxed at corporate tax rate.
If corporate tax < personal tax–> advantage to retain earnings for shareholders in high tax brackets.
- Partial imputation—>
*Shareholders receive a tax credit on PART of the income tax, which has been paid on the part of profits distributed as dividends.
ex. Canada
Tax Systems:
“Partnership method (full integration)”
All earnings (wether distributed or not) are attributed to the shareholders as if this was a partnership.
ex. “s” corporations in US
—>Full integration of taxation of the owner.
—>Irrelevance of the corporate income tax, paid on behalf of the shareholders.
Tax Systems:
“Level of the owner”
No corporate tax at all, only tax when pay out dividends.
Dividend income and realised capital gains are taxed as personal income.
Ex. in LV; EST only when profits are distributed—> to keep the money in the company.
Issues when using the wrong tax rate
1.Using the marginal tax rate instead of correct- average tax rate.
—>Tax rate that is too high enters NPV calculation.
—>NPV calculated is below true NPV
—>Consequence: Incorrectly rejected profitable project.
- Use the avg. tax rate, but should have used marginal tax rate.
—>tax rate that is too low enters NPV calculation
—>NPV calculated is above the true NPV
—>Consequence: you may accept negative NPV project (unprofitable)
Explain “Tax Paradox”
If tax on investment < tax on alternative
—>
NPV (after T) > NPV (before T)
(real and financial investments are affected by taxes to a different extent)
In which case is NPV for the owner higher: retained earnings or new equity? Why?
Retained earnings.
*For firms using retained earnings for investment:
–>There is NO CHANGE in required rate of return (R) if dividend tax INCREASES.
*For firms using new equity for investment:
–>There is INCREASE in required rate of return (R) if dividend tax INCREASES.
What happens if dividend tax increases for:
a.)Retained earning financing
b.) New equity financing
c.)partnerships
a.)Retained earning financing
higher dividend tax INCREASES required rate of return
—> leads to LESS investments
b.) New equity financing
There is NO CHANGE in required rate of return
—> NO CHANGE of investments.
c.) Partnerships
If taxes increase –> investments decrease
Debt Shifting
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Is loss carry-back and loss carry-forward both mandatory to apply?
Loss carry-back —> can be skipped
Loss carry-forward—> obligatory
Tradeoff for loss offset rules.
Discriminating investment / risk taking vs. encouraging continuous operations of low productivity firms.
Benefits:
*Increased risk taking and investment activity
*Supports innovation (start-ups)
Cons:
*Government provides support for loser firms (LCB) that should die out naturally.
*Increased payout to shareholders from tax refund!
*Loser firms start investing in projects that are not that profitable. Productivity and Output declines.
Impact of loss offset rules on mature companies vs. startups
Mature companies
–>loss offset rules have little impact on investment.
Why?
They have other profitable projects, retained earnings to use. Meaning that they can do “immediate full loss offset”. They are profitable.
Growing firms + start-ups:
-> loss offset rules reduce the tendency to invest
–> loss offset rules induce firms to pick projects with less volatile profits!
Need the innovation, but does not support it.
