1 update: 8 feb 2012 econ 635:public finance lecture 10 topics to be covered: a.corporate income tax...

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Update: 8 Feb 2012

ECON 635:PUBLIC FINANCELecture 10

Topics to be covered:

a. Corporate Income Tax

b. Cost of Goods sold

c. Depreciation

d. Straight Line Depreciation

e. Immediate Expensing

f. At Realization or Loss

g. Financing Costs

h. Overheads

i. Tax Integration

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Corporate Income Tax• In business taxation or the taxation of corporate income, the

definition of income remains the same, that is, income equals consumption plus change in net worth.

Income = Consumption + Change in Net Worth

• In case of corporations, consumption is the payment of dividends to shareholders while the change in net worth is represented by retained earnings.

• The retained earnings increase the value of the shares of the corporation.

Taxable income.

• For calculation of taxable income of a corporation, the cost of earning income must be subtracted.

• Generally, taxable income is:

Taxable income = Sales - Cost of goods sold - Depreciation allowances - Financing costs - Overheads – Other Operating Costs

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Cost Of Goods Sold (COGS)• Cost of goods sold is a significant cost incurred by a

company in earning income. • In addition, as the prices may be changing with time,

the method of calculating the cost of goods sold has to be specified and well defined in the tax law.

• Price increases or changes could either be real or inflationary.

• To calculate the cost of goods sold, following two methods are generally adopted by corporations.

• First In First Out or FIFO method In FIFO, the oldest inventories are the ones that are taken as the cost of goods sold.

• Last in First Out or LIFO method In LIFO, the cost of raw materials purchased last is taken as the cost of goods sold.

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Cost Of Goods Sold (COGS)• Assume that the prices increase by 10% each year. • Also assume that no other costs except the cost of purchase of

inventory is incurred in earning income. • If the corporate tax is 50% of taxable income, the tax liability under

two methods would be as follows:EXAMPLE

FIFO Method

Year Price Index

0 1.00

11.10

21.21

31.33

Sales 200 220 242

Purchases 100 110 121

COGS 100 110 121

Taxable Income 100 110 121

Tax Liability (nominal)@50%

50 55 60.5

Tax liability (real) 45.45 45.45 45.45

PV of tax liability(@ 8% discount rate)

117.14

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Cost Of Goods Sold (COGS) (Cont’d)EXAMPLE

LIFO Method

Year

Price Index

0

1.00

1

1.10

2

1.21

3

1.31

Sales 200 220 242

Purchases 100 110 121

COGS 110 121 100


Tax liability (nom) @ 50%

45.0 49.5 71.0

Tax liability (real) 40.91 40.91 53.34

PV of tax liability(@ 8% discount rate)

115.29

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Cost Of Goods Sold (COGS)• Following conclusions emerge from this illustration.

• If the company adopts the FIFO method to calculate

COGS, it will pay more taxes in present value terms.

• In the LIFO method, the payment of tax in the initial

years is less as compared to FIFO,

• In LIFO, the company would have to pay more tax in

later years, if the company were to reduce inventories

because of bad times or poor business.

• In most countries, a corporation is allowed to choose

either FIFO or LIFO at the start of business for

calculating the cost of goods sold. Once a method is

chosen, the company cannot change it in subsequent

years.

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Depreciation (Capital Consumption Allowance)

• Depreciation is the wear and tear of capital (plant, machinery, building) during the process of production and is, therefore, a cost of doing business.

• Ideally, one should use economic depreciation, which would be the real depreciation of machinery due to its use in production of goods.

• It is, however, difficult to determine the real depreciation annually, especially if the company uses a large number of machines and equipment.

• Following three methods are used to calculate depreciation,

1) Straight line depreciation

2) Immediate expensing

3) At loss or realization

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Straight Line Depreciation• Based on the historical cost of the machine, life of the asset, and the

estimated salvage value at the end of life, a uniform rate of depreciation is calculated for all the years in the following manner.

• If C = historical cost Sv = Salvage value n = life of the asset (standard tables for different machinery/equipment are usually available) D = annual depreciationThen D is expressed as,

D = (C - Sv) / nAssume Value of Asset Purchased is 90

Years 0 1 2 3

Taxable income beforedepreciation allowance

100 100 100

Depreciation (straight line over 3 years)

30 30 30

Taxable income 70 70 70

Tax liability @ 50% 35 35 35

PV of tax liability (@ 10% discount rate)

87.05

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Immediate Expensing• In immediate expensing of the purchase cost of 90 means that in

year 1 the whole capital cost is depreciated in the first year. • This is a form of accelerated depreciation. • It functions as if the entire cost of the machine were recouped in

the very first year of operation. • Immediate expensing, combined with straight line depreciation in

certain ways, is used to encourage investment.

Years 1 2 3 4

Taxable income before depreciation allowance 100 100 100

Depreciation 90 0 0



PV of tax liability (@ 10% discount rate) 83.44

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At Realization or Loss• All depreciation allowances are allowed at the time of realization or loss.

• The following table of calculations illustrates the application of these methods of depreciation.

• In this example, taxable income before depreciation is $100, the cost of the asset purchased in year 1 is $90 (historical cost) and it has three years of life.

Years 0 1 2 3

Taxable income before depreciation allowance

100 100 100

Depreciation 0 0 90



PV of tax liability (@ 10% discount rate) 90.53

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• Among these three methods of depreciation, the present value of taxes

paid is lowest in "immediate expensing" method and is highest in "at

realization or loss method".

• The straight line method is in between.

• Therefore, immediate expensing method would encourage investment.

• It is important to observe that depreciation is based on the historical cost

of capital and not on the replacement cost of the asset.

• The value of the asset is not adjusted for change in prices in subsequent

years. Hence, the greater is the rate of inflation the lower will be the real

value of the tax deductions for depreciation, except on the case of

immediate expensing of purchase price of assets.

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Financing Costs

• Financing costs are interest expenses on loans obtained

for doing business.

• Interest expense is incurred on debt only and not on

equity.

• Therefore, with a higher debt, the tax liability decreases.

• The following example illustrates this.

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Example

• Take the case of a corporation which has only an equity financing of $200. For three years of life and a corporate tax rate of 50%, the tax liability of the corporation is as follows:

100 % equity

Years 0 1 2




64.42

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Example• Alternatively, if the financing is 50% equity and 50%

loan, the tax liability is lower.

50 % equity and 50% debt at 5% interest rate

Years 0 1 2


Interest Expense 5 5 5


Tax Liability @ 50% 22.5 22.5 22.5


57.98

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• The tax liability is reduced due to the interest expense deductions from taxable income.

• The higher the debt, higher the interest expense deduction and lower the tax liability.

• Therefore, the financial structure or debt equity ratio of a corporation plays an important role in its tax liability.

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Overheads

• Overhead expenses could include the following:

1) Expenses on advertisement;

2) Expenses on public relations or business promotion

activities;

3) Miscellaneous expenses such as cost of selling goods.

• The expenses included in this category should be

analyzed carefully in order to ensure that only genuine

and allowable items are claimed as overheads by the

company.

• A deduction is, in fact, a subsidy given by the society to

the taxpayers. A great deal of care should, therefore, be

exercised in scrutinizing the deductible items.

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Tax Integration

• Most countries have recognized the need for some sort of integration between the individual and the corporate income tax. The reason is that if the corporate and individual tax systems are not integrated, this may create some undesirable incentives in the tax system. The taxation of income from capital at both the corporation and the personal levels can lead to very high total effective tax rates.

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Methods of Integration

• Classical Method:This method does not integrate the two systems. Income from the corporation and income from dividends are taxed separately. In this case, the shareholders bear a double tax burden and the tax revenue is reduced if the corporation does not distribute dividends but retains the earnings instead.

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Ex: CLASSICAL METHODIf the taxable income is $800, the corporate tax rate is 30% and the

individual tax rate is 40%:

Dividends distribution

0% 50% 100%

Corporate income tax 240 240 240

Net profit 560 560 560

Personal Income 0 280 560


Personal income tax 0 112 224

Total tax liability 240 352 464

Average tax rate 30% 44% 58%

As may be seen, the effective average tax rate is 30% with retained earnings and 58% with full distribution of dividends.

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• Split Rate System:

The part of corporate income that is distributed as dividends is taxed at a lower rate than the part that is retained, but the dividends are also taxed at the individual level.

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0% 50% 100%

Tax on retentions 240 120 0

Tax on dividends 0 80 160

Net profit 560 600 640



Personal Income Tax 0 128 256



In this case, the effective tax is 30% with retained earnings and 52% with full distribution of dividends. Compared to the classical method, there is some degree of integration.

Ex. SPLIT RATE SYSTEM

30% if retained, 20% if distributed

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• European System of Partial Integration:In this form of integration, dividends are taxed at the personal income tax rate and retentions at the corporate income tax rate. The entire corporate income is taxed, and the part attributable to dividends is credited back as a tax credit. Hence, the system is sometimes referred to as a dividend tax credit system.

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EXAMPLE


0% 50% 100%

Corporate Income Tax 240 240 240

Net Profit 560 560 560


+ CIT paid on dividends 0 120 240



less Taxes withheld 0 120 240

Net Tax Payment 0 40 80



Note the tax on retained earnings is 30%, and on distributions 40%.

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Methods of Integration

• Full Integration:

(US tax treatment of type S

(small business) corporations)

Tax on business profits is withheld by the full amount (like PAYE) and claimed as a credit when personal income tax is calculated. Shareholders have to declare, as personal income, their share of corporate profit, whether or not this profit was distributed.

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0% 50% 100%

withholding Tax 240 240 240

Net Profit 560 560 560




less Tax withheld 240 240 240

Net tax Payment 80 80 80

Total Tax Revenue 320 320 320

Average Tax Rate 40% 40% 40%

Ex. Full Integration

Note how the final tax on corporate profits in all the three cases is at the personal income tax rate. Taxation of the corporate income is just a withholding device. In practice, it would make sense to set the withholding rate at a level equal to the top personal income tax bracket, so that individuals would apply for a tax refund, rather than have to pay additional personal income tax at the end of the year.

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Two Potential Problems of Partial Tax Integration

• Corporations may seek exemption from income tax which will result in a delay of realization of revenue by the government, especially if distribution of dividends is deferred. This will not be good for the stability of the tax system.

• Individuals may claim a tax credit even if taxes have not been paid at the corporate level.

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• Advanced Corporate Tax (ACT):Double taxation of the income to shareholders is eliminated by applying an advanced corporate tax. In this method, the income derived from corporate capital attributable to the shareholders is subjected to taxation only once and at the corporate level. The ACT ensures the collection of this tax at the corporate level. Thus, withholding the ACT on the distribution of dividends and providing a tax credit, the corporation is responsible for collecting the tax on distributions while it gets a relief from corporate taxation to that extent. Shareholders also obtain a credit for the advances corporation taxes that are paid.

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i) If the taxable income of a corporation is $800, corporate tax rate is 30%, personal income tax rate

is 40%, and advanced corporate tax rate is 33.33%, dividends are distributed at the rate of 50%,

Taxable income at corporate level is 800

Corporate tax (at 30%) 240

Net of tax income 560

Advanced corporate tax withheld at corporate

level when $280 (50%) are paid as dividends (at 33.33%) 93.33

Corporate tax paid is (240 - 93.33) 146.67

Tax due at the individual Level on dividends of $280 112

Less advanced tax withheld at the corporate level 93.33

Individual pays an additional (112 - 93.33) 18.67

Total Tax paid :

Corporate tax 146.67

Taxes held at corporate level 93.33

Individual pays 18.67

Total tax (146.67 + 93.33 + 18.67) 258.67

Ex.

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In this system, if all the income is retained and no dividends are paid, the tax remains at 30%. ii) Dividend exemption with corporate tax. In this system, the income from the corporate capital attributable to the shareholder, is subjected to taxation only once at the corporate level. Thus, the ACT is a withholding device both for the corporation and the individual shareholders. The individual does not pay any additional tax and does not get a refund. If the corporate income is $800, corporate tax rate is 30%, the various tax liabilities are calculated as follows: Corporate income 800 Corporate tax 240 Potential dividend (800 - 240) 560 Advanced corporate tax at the rate 30/70 of potential dividend (560) is withheld and a credit is subsequently given. Advanced corporate tax is (30/70) * 560 240 Here the company pays 240 and does not pay any other tax. This 240 is taken as ACT.

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If the company pays 400 in dividends: ACT is 400 * 30/70 171.43 Corporate tax would be 240 - 171.43 68.57 Total tax paid at corporate level is 171.43 + 68.57 = 240 This system is easy to administer.

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• Singapore Method:This is another variation of integration adopted by Singapore. In this method, either the dividends are not taxed or are taxed at the individual level. In this method, the corporation never has to make an excess payment. This system gives an incentive to corporations in lower tax brackets. The taxes paid at the corporation level are prorated as the dividends are paid.

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Corporate income 800

Corporate tax 240

Potential dividend (800 - 240) 560

Dividend paid 400

Imputed taxes (240/560 = 42.86%) on 400 171.42

Total taxable income 571.42

Individual tax (40%) 228.56

Less credit given (from impute taxes) 171.42

Total tax payable at the individual level 57.14

Tax withheld at corporate level 240

Tax credit given at the individual level 171.42

Tax credit still available 68.58

In this method, the corporation never has to make an excess payment. This

system gives an incentive to corporations in lower tax brackets.

Ex.

1 update: 8 feb 2012 econ 635:public finance lecture 10 topics to be covered: a.corporate income tax...

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