Comparative Corporate Tax: Tax Treatment

CCT

  • Should corporate income be taxed at the point it is derived (as opposed to when it is distributed or at some other point in time)?
    • No, because corporations are inappropriate subjects of taxation, primarily because they do not bear the burden of taxes imposed on them
    • Yes:
      • Because:
        • If other forms of return on personal savings are taxed, then it will be necessary to tax the retained profits of corporations (equity and efficiency perspectives).
        • If it were otherwise, corporations would provide a simple means of deferring, potentially permanently, the taxation of personal income.
      • Two issues in taxation when corporate income is derived:
        1. who is taxable with respect to corporate income (the corporation? its members?)
        2. the rate at which retained corporate profits should be taxed
  • The first issue: who is taxable?
    • It is presumed that corporate profits should be taxed under an income tax irrespective of whether they are distributed, if for no other reason than to protect the individual income tax base from unacceptable deferral.
    • So, who should be taxed?
      1. Corporation
        • Issue: the rate at which corporations should be taxed
      2. Management (BoD)
        • secondary or residual tax subject (solvency)
      3. Shareholders, on retained profits
        • Justification:
          1. shareholders in closely held corporations have an ability to call for distributions at their will
          2. such shareholders have a personal ability to pay tax out of profits retained by the corporation
        • The rate is not an issue (can use marginal rates)
        • Issue: how the profits of a corporation should be allocated among multiple shareholders? Some ways to allocate corporate profits among shareholders:
          1. Partnership method
            • The aggregate profits (in corporate level) are allocated amongst persons according to their respective interests in the corporation (e.g. in proportion to shareholdings)
            • Limited use: only practical in the context of simply structured closely held corporations, because some issues arises with the method:
              • a corporation may have different classes of shares with different rights as to distributions
              • a shareholder cannot file a tax return until such time as the corporation has determined its profits and set an allocation (worse: layered ownerships)
              • how to allocate corporate profits, consisting of exempt income, capital gains, foreign income, etc, to shareholders? Should it follow the types of income or have a homogeneous character like dividends?
              • share transfers: should the profits allocation be based on shareholding at the end of the year or be proportionate during the year?
            • US:
              • US S-Corp
                • IRC s. 1363(a)… an S corporation shall not be subject to the taxes imposed by this chapter. (b) The taxable income of an S corporation shall be computed in the same manner as in the case of an individual… (c)(1) … any election affecting the computation of items derived from an S corporation shall be made by the corporation.
              • “Shareholders must include in their taxable income their ‘pro rata share’ of the corporation’s taxable income. If separate parts of the income might affect the tax liability of a particular shareholder, those parts are allocated separately. For example, the allocated share of a capital gain, dividend or foreign income of the corporation retains that character when allocated to the shareholder”
                • IRC s. 1366 (a)(1) In determining the tax… of a shareholder… there shall be taken into account the shareholder’s pro rata share of the corporation’s- (A) items of income… loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and (B) nonseparately computed income or loss…
                • IRC s. 1366 (b)  The character of any item included in a shareholder’s pro rata share… shall be determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.
          2. Reference to value of shares
            • Effective for widely held corporations (particularly if the shares are listed on a stock exchange)
            • Two methods:
              1. to tax shareholders on the increase in the value of their shares
              2. a schedular approach to income taxation of individuals, categorising the income of individuals according to ‘boxes’ (Netherlands)
          3. Capital gains with deferral charge
            • Problem: potentially taxing unrealised gains
              • Solution: taxing gains on the disposal of shares (dividends would also be taxable).
              • However, may give an incentive to deferral of taxation.
                • Solution: incorporating an interest charge for deferred tax on gains on the disposal of shares (US does use it with respect to passive foreign investments)
                • Illustration:
                  • A holds shares in A Co for 5 years and makes a gain of 100 on the sale of the shares
                  • This gain must be apportioned over the 5 years of ownership. Presume that the apportionment is simply 20 gain to each of the five years.
                    • 1st year: The tax would be subject to a compound interest charge for the deferral of that tax in years 2, 3, 4, and 5.
                    • 2nd year: The tax would be subject to a compound interest charge for years 3, 4, and 5.
                    • and so on
  • The second issue: at what rates?
    • Interfacing issues: (especially with respect to closely held corporations)
      • Business form
        • If the corporate tax rate is lower than the marginal tax rate faced by a sole proprietor, there is an incentive to incorporate the business.
      • Financing sources
        • Unless retained profits are taxed at the same rate as interest in the hands of the financier, there will be either an incentive or disincentive to finance with debt comparative to equity.
      • Decision on profits
        • If the corporate tax on retained profits is higher, there is an incentive to distribute; If the corporate tax on retained profits is lower, then retaining profits is the favoured reinvestment strategy
    • Philosophical issues:
      • Same rate as individuals
        • Problem: If corporations are taxed with progressive rate (like individuals), then individuals can split their income to avoid the threshold of higher rates.
      • Temporary surrogate for the personal income tax
        • Issue: what would be the best rate to act as a surrogate?
          • Illustration:
            • A Co, with four shareholders (each ¼ shares): Mr. A (marginal tax rate 40%), Mr. B (20%), Mr. C (exempt), and B Co (30%). At what rate should the subject A Co be taxed so that the taxation acts as an appropriate surrogate for the taxation of these shareholders?
            • Option 1: A Co should be taxed at the same rate as B Co
              • Argument: it would be an appropriate surrogate for the taxation of B Co
              • Counter-arguments:
                • many people might suggest this tax rate not because it is the best rate to act as a surrogate, but because of a belief that two corporations should be taxed at the same rate.
                • 30% is not an appropriate surrogate for any of the other shareholders, at least not individually.
            • Option 2: A Co should be taxed at 40%, being the highest rate applicable to any of its shareholders. (some countries apply it)
              • Argument: if any rate less than 40% is used, A Co may be used as a corporate tax shelter for the 40% shareholder
              • Counter-argument:
                • this approach focuses on one shareholder, and at some level it is not consistent with the collective nature of the corporation.
            • Option 3: A Co should be taxed at average weighed tax rate of the corporation’s shareholders as a group
              • Argument: The shareholders have invested on equal terms and will be expecting equal treatment, at least until such time as profits are distributed. They would expect the profits to be taxed on a homogeneous basis that reflects the reality of those profits as an undivided pool. Using average weighed shareholder tax rates as a corporate tax rate creates a particular form of neutrality in the interface between retention and distribution. Directors tend to consider shareholders as a group.
              • Counter-argument:
                • The average shareholder tax rate for one corporation may not be the same as for another, as well as for the same corporation at another point in time.
                • Persons on the higher rates will seek to shelter their income behind the corporate form.
                • Persons on the lower rates will be discouraged from adopting the corporate.
                  • They are likely to seek transparent forms of taxation by using a transparent form of business or seeking a return from the corporation in a deductible form (wages, royalties or interest)
                  • Seek distributions instead of retentions if these are taxed overall more lightly
    • Comparison
      1. Australia: 27.5% or 30%
        • Income Tax Rates Act 1986 s. 23(2) The rate of tax in respect of the taxable income of a company is: (a) if the company is a base rate entity for a year of income – 27.5%; or (b) otherwise – 30%…
      2. UK: 19%
        • CTA 2009 s. 2(1) Corporation tax is charged on profits of companies for any financial year for which an Act so provides.
        • FA 2017 s. 5 Corporation tax is charged for the financial year 2018.
        • F(No 2)A 2015 s. 7(1)For the financial years 2017, 2018 and 2019 the main rate of corporation tax is 19%
      3. US: taxable income 21%; accumulated earnings 20%; undistributed personal company income 20%
        • IRC s. 11(a) A tax is hereby imposed for each taxable year on the taxable income of every corporation. (b)(1) The amount of the tax imposed by subsection (a) shall be 21 percent of taxable income.
        • IRC s. 531  [T]here is hereby imposed… on… each corporation described in section 532, an accumulated earnings tax equal to 20 percent of the accumulated taxable income.
          • IRC s. 532(a)  The accumulated earnings tax… shall apply to every corporation… formed or availed of for the purpose of avoiding the income tax with respect to its shareholders… by permitting earnings and profits to accumulate instead of being divided or distributed.
          • IRC s. 533(a)… the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation… shall prove to the contrary.
          • (b)  The fact that any corporation is a mere holding or investment company shall be prima facie evidence of the purpose to avoid…
          • IRC s. 535(a)… the term “accumulated taxable income” means the taxable income, adjusted in the manner provided in subsection (b), minus the sum of the dividends paid deduction (as defined in section 561) and the accumulated earnings credit [see next slide] (as defined in subsection (c)).
          • IRC s. 535(c)(1)… the accumulated earnings credit is… an amount equal to such part of the earnings and profits for the taxable year as are retained for the reasonable needs of the business… [T]he amount of the earnings and profits for the taxable year which are retained is the amount by which earnings and profits for the taxable year exceed the dividends paid deduction…
        • IRC s. 541… there is hereby imposed… on the undistributed personal holding company [personal holding company: small company controlled by five people] income… of every personal holding company… a personal holding company tax equal to 20 percent of the undistributed personal holding company income.
      4. Germany: 15%
        • KStG s. 23(1) Corporation tax is 15% of taxable income.

 

1. Foto_AGUS DWI PUTRA

Hi, this article is summarised from Peter Haris’ “Corporate Tax Law: Structure, Policy and Practice (Cambridge Tax Law Series)”. If you wish to read the book, please click FREE PREVIEW from Amazon.

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