Corporate income tax

Question 1

who carries a burden of CIT?

Answer 1

short-term: capital (since it is completely inelastic=rigid, the ratio of profitability falls when the tax is introduced) (long-term, the ratio stays the same, but the amount of capital lowers)
long-term: workers and consumers (bc the capital lowers, there are less jobs and lower wages for workers, as well as fewer choices and higher prices for consumers)

Question 2

what is the tax base of CIT?

Answer 2

= revenues

• exempt revenues (received dividends)
• deductible expenses (=if the expense is necessary to earn revenue)
• tax allowances

Question 3

explain two ways how CIT can be lowered. are they legal? state the limitations as well.

Answer 3

yes, both.

1. loss carryforward (moving a tax loss from the past to current year to offset the profit)
   - — mostly limited to a period of 9 years
   - — max 50% of loss-year tax base can be moved
2. loss carry back (moving a tax loss into the past to get a tax refund)

Question 4

how can PIT and CIT be integrated? explain 3 ways.

Answer 4

1. classical system: dividends = PIT base
2. imputation system
   - —full: PIT base = received dividends + 100% amount of CIT (=grossing up); amount of grossing up = tax credit against PIT
   - —partial: PIT base = received dividends + X% amount of CIT; amount of grossing up = tax credit against PIT
3. schedular system
   - —explicit: withholding tax, shareholders get net dividends
   - —implicit: PIT base = received dividends - Y% of received dividends

Question 5

state the Modigliani-Miller theorem.

Answer 5

in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.
(also called the capital structure irrelevance principle)

Question 6

state the Modigliani-Miller second theorem and why is it important.

Answer 6

when we add taxes to M&M theorem, D/E ratio becomes very important.
cash flow = earnings before interest and tax - (EBIT - Rf * D)t = EBIT - (EBIT - Rf * D)t
cf = EBIT - EBITt + RfDt = EBIT (1-t) + RfD*t
if we want to increase cash flow, we need to increase debt. that way, we will also have less taxes (since interest on debt is deducted from tax base)

Question 7

what is the problem of M&M second theorem?

Answer 7

if we constantly increase debt, there is a higher risk of bankrupcy (since in reality, debt is not risk-free). the firm also has to rely solely on banks and lenders for financing, since investors do not want to be involved (due to risk).

Question 8

what is the prevention system against M&M second theorem? (so it is not used too much?

Answer 8

thin capitalisation rules. (thin capitalisation = high D/E ratio)
example: shareholder owns 25% equity in a company. if they lend more to the company than (value of equity * 4), the interest on that debt is not a deductible expense

Question 9

what kind of tax is CIT?

Answer 9

proportional (flat rate)

Question 10

what does transfer pricing deal with? why is it important?

Answer 10

it deals with business between related parties (= when one company holds at least 20% stake of another company).
the rules are important because without them, the related parties could easily shift their tax bases and thus avoid paying taxes (too much).

Question 11

define the two rules of transfer pricing

Answer 11

rule of transfer pricing is also called arm’s length principle and it states that the price charged in a transaction between unrelated parties should be the one used for tax purposes between related parties as well.
the no more / no less than principle states that for:
- revenues we will consider the true prices (the ones between related parties), but no less than transfer prices (those between unrelated). so, compare the two and take the higher.
- expenses we will consider the true prices (related parties), but no more than transfer prices (unrelated). so, compare the two and take the lower.

Question 12

how is transfer pricing used with interest rates?

Answer 12

the related party that gives out the loan wants to have revenues (interest) as low as possible, to not increase their tax base too much. however, the tax authority would like them to increase it, so:
- revenue side: compare true interest rate (between the related parties) and the given gov rate, choose the higher one
- expense side: compare the true interest rate and the given gov rate, choose the lower
if the true is higher than gov rate, the difference on the expense side would be recognised as a non-deductible expense