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Chapter 2

Chapter 2. Tax Planning. Instructor: Arshad Hasan. 2- 2. Standards for a Good Tax. In theory, every tax can be evaluated on four standards. A good tax should be: Sufficient to raise necessary government revenues Convenient to administer Efficient in economic terms

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Chapter 2

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  1. Chapter 2 Tax Planning Instructor: Arshad Hasan

  2. 2-2 Standards for a Good Tax In theory, every tax can be evaluated on four standards. A good tax should be: • Sufficient to raise necessary government revenues • Convenient to administer • Efficientin economic terms • Fairto taxpayers required to pay

  3. 2-3 Standards - Sufficiency • A tax is sufficient if: • It generates enough funds to pay for the public goods and services provided by the government • It allows a government to balance its budget

  4. 2-4 Standards - Sufficiency • Consequence of an insufficient tax system? • The government must make up its revenue shortfall from some other source: • Leasing or selling of government owned assets or property rights • Borrowing money in the capital markets

  5. 2-5 Standards - Convenience A tax is convenient if: • Government’s view • The tax is easy to administer • Easy to understand • Offers few opportunities for noncompliance • Taxpayer’s view • The tax is easy to pay • Easy to compute • Requires minimal time to comply

  6. Standards - Efficiency A tax is efficient if: • Judged by the classical standard of efficiency: • It is neutral in its effect on the market so that it does not: • Distort the market • Create suboptimal allocation of goods and services • Modify taxpayer behavior • Judged by Keynesian standards: • It is an effective fiscal policy tool for regulating the economy. • Governments should use taxes to move the economy in the desired direction

  7. 2-7 Standards - Fairness A tax is fair if: • The taxpayer has the ability to pay the tax • The tax enhances horizontal equity • Persons with the same ability to pay should owe the same tax • A rational and impartial measurement of the tax base • The tax enhances vertical equity • Persons with greater ability to pay owe more tax than persons with lesser ability to pay • A fair rate structure

  8. 2-8 Tax Policy • Tax Policy can be defined as a government’s attitude, objectives and actions with respect to its tax system. • Tax Policy reflects the standards that the government deems most important.

  9. 2-9 Tax Policy Issues - Equity Regressive: rate decreases as base increases • Smith pays $2,000 tax (10%) on $20,000 income and Jones pays $3,000 tax (5%) on $60,000 income Proportionate: single rate applied to taxable income • Smith pays $2,000 tax (10%) on $20,000 income and Jones pays $6,000 tax (10%) on $60,000 income Progressive: rate increases as base increases • Smith pays $2,000 tax (10%) on $20,000 incomeand Jones pays 12,000 (20%) on $60,000 income

  10. 2-10 Tax Policy Issues - Equity • Distributive justice as a tax policy objective • The current distribution of wealth across Pakistan households is thought to be unjust • This perception has increased in recent decades • Individuals are increasingly likely to underreport their income

  11. 2-11 Business Organizations • Taxpayer = owner(s) of entities • Sole proprietorship • Partnerships • Corporations • Taxpayer = corporation • Corporation is taxed first, then shareholders may be taxed on distributions, resulting in double taxation

  12. 2-12 Taxes as Transaction Cost • The objective of business decisions is to maximize the value of the firm • The first step in evaluating a business transaction is to quantify cash flows from the transaction • Managers want to make decisions that maximize the value of the firm by maximizing positive cash flow or minimizing negative cash flow

  13. Tax Policy and Business Managers • Business managers and their tax advisors share a keen interest in tax policy • They know that many complex tax rules have an underlying policy rationale • If they understand this rationale, the rule is easier to interpret and apply • They know that today’s policy issues shape tomorrow's tax environment • By paying attention to current policy debate, they can anticipate developments that might affect their firm’s long-term strategies

  14. 2-14 Tax Avoidance • Tax avoidance consists of legitimate means of reducing taxes • Tax evasion consists of illegal means of reducing taxes and is an offense punishable by severe monetary fines and imprisonment

  15. 2-15 International Taxation • Corporate Residence • A company is resident in one country, though it may trade in many countries. • A company is Usually resident in the place of incorporation.

  16. 2-16 Double Taxation Treaties • Countries enter into double taxation treaties to establish more clearly which tax authority has jurisdiction. • Treaties seek to avoid a business having to pay tax twice on its income simply because it deals with two authorities. • Methods of giving relief: • Full deduction • Exemption • Credit

  17. 2-17 Tax Planning Variables • Tax consequences of a transaction depend on the interaction of four variables • The entity variable: Which entity undertakes the transaction? • The time period variable: In which tax year does the transaction occur? • The jurisdiction variable: In which taxing jurisdiction does the transaction occur? • The character variable: What is the tax character of the income from the transaction?

  18. 2-18 Income Tax Planning – Entity Variable • Assignment of income doctrine • Constraint on income shifting • Income must be taxed to the entity that earns it by the sale of goods or performance of services • Income generated by capital must be taxed to the entity that owns the capital

  19. 2-19 Income Tax Planning – Time Period Variable • Opportunity costs • Shifting tax costs to a later period may involve postponing a cash inflow to a later period. Thus, the opportunity cost of postponing the cash inflow may exceed the savings from the tax deferral • The opportunity cost is the loss of the immediate use of the cash

  20. 2-20 Income Tax Planning – Jurisdiction Variable • The jurisdiction variable is important because local, state, and foreign tax laws differ • Tax costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate

  21. 2-21 Income Tax Planning – Character Variable • The tax character of an income item is determined strictly by law • Every income item is characterized as either ordinary income or capital gain • Ordinary income is generated from the sale of goods or performance of services in the regular course of business • Income generated by investments (interest, dividends, royalties, and rents) is ordinary • Capital gains are generated by the sale or exchange of capital assets

  22. 2-22 Tax Planning Maxims • Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate. • Tax costs decrease when a tax is deferred to a later taxable year. • Tax costs decrease when income is generated in a jurisdiction with a low tax rate. • Tax costs decrease when income is taxed at a preferential rate because of its character.

  23. 2-23 Conflicting Tax Planning Maxims • Sometimes, the four tax planning maxims conflict! • For example, a transaction that results in tax deferral may cause income to shift to an entity with a higher tax rate • Managers should remember that their strategic goal is not tax minimization but NPV maximization

  24. 2-24 Taxable Profit • Financial statements show accounting profit for the accounting period. • Local tax rules require certain adjustments in order to arrive at the taxable profit. • Taxable profit is the accounting profit adjusted according to the tax rules and is the amount on which tax is actually paid.

  25. 2-25 Calculating Taxable Profit $’000 $’000 Accounting Profit 5,000 Add: Entertainments Disallowed 150 Book Depreciation 250 400 5,400 Less: Non taxable Income 10 Tax Depreciation 140 (150) Taxable Profit 5,250

  26. 2-26 Types of Adjustments • Absolute Adjustments • Timing Adjustments

  27. 2-27 Absolute Adjustments • The adjustments that are permanently disallowed for tax purposes • Permanent Differences • Entertaining Expenses • Formation Costs • Government Grants • Fines and Penalties

  28. 2-28 Timing Adjustments • The item of income or expense will eventually be allowed in full, but is taken into account in a different year for book purposes than for tax purposes • Temporary Differences • Depreciation and amortization • Bad debts (allowance vs. direct write-off)

  29. 2-29 Deferred Tax • Deferred Tax Asset The amount that results from an excess of Taxes Payable over Income Tax Expense • Deferred Tax Liability The amount that results from an excess of Income Tax Expense over Taxes Payable

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