1. 1 Update: 8 Feb 2012 ECON 635:PUBLIC FINANCE Lecture 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

2. 2 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

3. 3 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.

4. 4 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 1 1.10 2 1.21 3 1.33 Sales200220242 Purchases100110121 COGS100110121 Taxable Income100110121 Tax Liability (nominal)@50% 505560.5 Tax liability (real)45.45 PV of tax liability (@ 8% discount rate) 117.14

5. 5 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 Sales200220242 Purchases100110121 COGS110121100 Taxable Income9099142 Tax liability (nom) @ 50% 45.049.571.0 Tax liability (real)40.91 53.34 PV of tax liability (@ 8% discount rate) 115.29

6. 6 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.

7. 7 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

8. 8 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 S v = Salvage value n = life of the asset (standard tables for different machinery/equipment are usually available) D = annual depreciation Then D is expressed as, D = (C - S v ) / n Assume Value of Asset Purchased is 90 Years0123 Taxable income before depreciation allowance 100 Depreciation (straight line over 3 years) 30 Taxable income70 Tax liability @ 50%35 PV of tax liability (@ 10% discount rate) 87.05

9. 9 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. Years123 4 Taxable income before depreciation allowance100 Depreciation9000 Taxable income10100 Tax liability @ 50%550 PV of tax liability (@ 10% discount rate) 83.44

10. 10 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. Years012 3 Taxable income before depreciation allowance 100 Depreciation0090 Taxable income100 10 Tax liability @ 50%50 5 PV of tax liability (@ 10% discount rate) 90.53

11. 11 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.

12. 12 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.

13. 13 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 Years01 2 Taxable income50 Tax liability @ 50%25 PV of tax liability (@ 8% discount rate) 64.42

14. 14 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 Years01 2 Taxable income50 Interest Expense555 Taxable Income45 Tax Liability @ 50%22.5 PV of tax liability (@ 8% discount rate) 57.98

15. 15 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.

16. 16 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.

17. 17 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.

18. 18 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.

19. 19 Ex: CLASSICAL METHOD If the taxable income is $800, the corporate tax rate is 30% and the individual tax rate is 40%: As may be seen, the effective average tax rate is 30% with retained earnings and 58% with full distribution of dividends.

20. 20 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.

21. 21 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

22. 22 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.

23. 23 Note the tax on retained earnings is 30%, and on distributions 40%.

24. 24 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.

25. 25 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.

26. 26 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.

27. 27 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.

28. 28 Ex.

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30. 30

31. 31 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.

32. 32 Ex.