THE TAXATION OF FINANCIAL Corporate-shareholder income tax issues and principles as they relate to financial taxation

1. THE TAXATION OF FINANCIAL Corporate-shareholder income tax issues and principles as they relate to financial taxation Julian S. Alworth Said Business School, Oxford and Universita Luigi Bocconi, Milan

2. TAXING CORPORATE ENTITIES • All countries have some form of separate tax on corporate entities – a Corporate Income Tax (CIT) • Some countries have a business income tax that applies to corporate and non-corporate business income

3. Integration or Autonomy: • Ways of viewing the taxation of the firm’s profit under a corporate income tax (CIT) (1) Integration model • CIT a withholding device for taxing capital income at source (prepayment of tax) • Corporation as a “tax shelter” (corporation tax is meant offset this benefit • “pass-through” “ transparency” “partnership approach - Carter Commission” (2) Firm as autonomous entity: • CIT is a tax on economic rents (“invention”?) earned by the firm, distinctly separate from its partners or shareholders.

4. Integration and Financing arrangements encompasses many issues • Split between corporate and personal level taxation • Revenue sharing at the international level • Financing arrangements • Definition of debt vs. equity • Neutrality in entity (organisational) choice • Corporate form vs. non-corporate • Group taxation (domestic and international) • Outward investment • Losses • Corporate formation and reorganisation • (Taxation of labour and capital – SME)

5. Objectives of neutrality • Tax system should attempt to leave private decisions unaffected • Neutrality should simplify the tax system • Fewer regulations • Less need for special anti-avoidance measures (thin-cap) • Alternative routes to achieve neutrality • Involves different types of alignment of tax rates

6. Achieving Neutrality does involve trade-offs • Difficult to achieve neutrality with progressive rate structures • Often entails high compliance costs • May result in revenue losses for one jurisdiction in favor of another • In practice the inability of satisfying conflicting system conflicting goals gives rise to problems • Arbitrage possibilities • International revenue division • Integration with other country tax systems

7. Neutrality under separate entity tax: “classical system” • Exempt dividends and capital gains (allow interest deductibility) and tax interest at the same rate as company profits • Incentive to transform labor into capital income? • How do you deal with tax exempt institutions? What are foreign investors’ tax status? Suppose financing comes from a zero-rate jurisdiction? • Group dividends: Exempt? Foreign source dividends also exempt? • Tax on profits lower than tax on interest plus (positive) tax on dividends and capital gains • Tricky alignment of rates to ensure progressivity • Capital gains are taxed on realisation? • Stronger incentives to shift into corporate form if personal tax rate is higher than business tax rate?

8. Neutrality under imputation system • Allows for a wider rate structure variety because corporate tax is a prepayment of personal tax: progressivity for dividends and interest • Who gets the tax credit? • Domestic tax exempt institutions? • Difficulty in extending imputation to non-residents • Potential for cross-border tax arbitrage to recover the credit • Foreign source income: complicated stacking rules?

9. Where do we stand? • Clear preference for debt in virtually all countries has eroded corporate tax base • Compensated in part by other measures to widen the base (depreciation allowances, LIFO) • Financial innovation (hybrid financial instruments) • International dimension of capital markets (Opening of the “capital account”) • “global” investors are tax exempt (Sovereign funds, pension funds, high net worth individuals) • Derivatives • MNCs increasing ability to transform equity into debt and vice versa through triangulations

10. Example of triangulation Exempt investor Borrowing Interest HQ Dividend Equity “Haven” Borrowing Interest Operating Company

11. Where do we stand? • Race to the bottom • Widening of the tax base by restricting interest deductibility • Interest allocation rules • Thin capitalisation

12. Approaches to “Thin Capitalization” • Deduction of interest limited to a percentage—say 50 percent—of net taxable income; • Passive interest deductible only on the excess over and above active interest; • Pool of capital income and expenditure—possibly also capital gains and losses--taxed separately from ordinary income, sometimes denied carry forwarding; • Arms’-length principle (firm has to show that loan observes market conditon)—France, Netherlands • Limit to debt for the purposes of income tax: debt/equity ratios in OECD countries—Canada 2, Japan 3; • Interest limited to reference rate-e.g. in Portugal, 12-month Euribor plus 1.5%;

13. Allowance for Corporate Equity (ACE) • Notional rate of return on invested equity is deductible under the CIT (Croatia 1994-2001). • Imputed equity return taxed at a reduced rate (Austria, Italy until 2001, Belgium). • Distributed imputed interest on equity deductible and liable to a the 15 percent withholding tax on interest (Brazil since 1996).

14. Allowance for Corporate Equity • Revenue • ACE has a narrower tax base (“extra-normal profit”)=> rates should be higher for equal revenue • No evidence of decline in corporate tax revenue (Croatia) • Move away from book-tax conformity • How is to be applied to self-employed or unincorporated business? • How are different types of equity valued? Can intellectual capital be capitalised? Goodwill?