Università Bocconi A.A. 2005-2006

1. Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi

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. Course presentation • Objectives and main topics • Tax law fundamentals • Introduction to “Tax Planning”

4. Corporate income tax • Why tax corporations? • Tax base • The Combination of Corporate and Personal Income Taxes

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. 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. 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. 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. Systems for the taxation of profit income incorporated firms  unincorporated firms personal income tax corporate income tax  imputation system classical system partial imputation full imputation

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. 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 Tax Credit: taP Net dividend (1-m)aP Example: t=40%, m=40% overall tax burden: 40%

12. Forms of Double Taxation Relief 1. Full Imputation(Finland, Malta, Norway) 2. Partial ImputationFrance, Japan, Canada, Spain, U.K. 3. Dividend ExemptionEstonia, 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. 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. Course presentation • Objectives and main topics • Tax law fundamentals • Introduction to “Tax Planning”

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. 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. 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: • The taxpayer borrows shares of stock equal to the number already owned • The taxpayer sells the borrowed shares, thus realizing cash but no taxes are due • 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. 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. 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. 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 • build a straddle: at any date buy a security and sell a perfectly correlated (set of) security (securities) short • 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 • 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. 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. 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. Converting income from one type to another • Method 1

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. 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. 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. 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 + qD) – qD = [tp (1+ q) –q ] D • where q = ts/1-ts • Usually non-residents and tax-exempt entities are not entitled to the credit

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. 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 + q D) – q D = ts (100 – 100 + q 100) – q100= • ts q 100 – q 100 = - (1-ts ) q 100

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