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Chapter 2 Part 1 Taxation On Corporate Income When Distributed Notes

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MCL: Corporate Taxation

Chapter 2 Taxation on Corporate Income when distributed Abbreviation: Corporation: Corp With respect to: Wrt Equal to: =
Shareholder: SH

Mind Map Introduction



If a corporation is viewed as a separate entity, then dividends are clearly a payment made. Normally, corporations seek deduction treatment for payments made, and if viewed as independent of SHs, dividends are at some level an expense. But if a corporation more closely identified with its owners and controllers, dividends are a division of net profits. So, distributions not deductible when calculating accounting profits and in calculating a corp's taxable income (GR) interest expense- deductible in calculating corporate income. Two important features of nature of dividends: o NB to identify dividends - because they are singled out for special tax treatment. o Any attempt to identify dividends as a distribution of corporate income - will result in circularity.

Framework Framework

Identify shares Identify which payments (distributions) received by a person owning shares could be considered as made with respect to those shares. o Identify particular payment with shares in question such that shares can be said to be the source of the payment. o Then identify type of payment that may constitute a distribution. (To do this, must identify tax base of SH.) Then identify the tax treatment of the SH wrt the distribution.

Classifying Corporate Rights

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MCL: Corporate Taxation


Tax law and Corp law overlaps in identification of dividends. Some say corp law identification (definition) of dividends too formal for tax law purposes. Corp law also struggles to identify members and to deal with constructive dividends. These areas cause bigger problems - because dividends are highly fungible or substitutable with other types of payments made by corporation, particularly interest payments. Leads to high risk of arbitrage because they receive different tax treatment. The approach must be to focus on the nature of the rights with respect to which a particular payment is made. Two artificialities of a corporation cause double taxation (deriving income twice): o Treating the corporation as conducting the business and deriving the income from it. o Situation reversed on distribution: person deriving the income is real, but the source of the income is artificial (the membership rights wrt which the distributions are made.)

Must first identify who is a SH for tax purposes?
Identifying shares is critical in characterising dealings in corporate rights. Also relevant to e.g. deciding whether two corps are members of a group. Typically critical wherever an income tax law seeks to reinforce or erode the separate identity of a corporation.

Types of Capital Equity Capital

Equity capital = share capital and accumulated profits. Important policy issue = whether

Debt capital

= other primary form of investment. (loan/debenture) rights re debt capital - for a

Hybrids

Equity vs. debt at opposite ends of spectrum: many instruments not clearly one or the other (hybrid 2

MCL: Corporate Taxation

'shares' should be identified differently depending on tax rule in question. Option 1 - Identify shares holistically (happens when referred to as an item of property) Option 2 - Identify shares as containing individual rights, particularly these 3 rights/features: o Residual right to Co when wound up o Right to dividends o Right to vote

limited period and no subordination to other creditors (i.e.: ranks pari passu with other unsecured creditors) entitled to a fixed periodic return (interest) calculated as a rate by the effluxion of time, payable regardless of whether the corporation makes a profit no right to participate in the organs of a corporation

instruments). Some instruments may appear to be debt or equity, but then in context of overall financing of a corporation may not be so clear. E.g.: If debt-to-equity ratio is too high (lots of debt financing), in substance the rights attached to the excessive debt might behave more like equity capital than debt capital.

Corp tax systems focus on different parts of these features depending on purposes for which shares need to be identified. Rules that reinforce separate identity (such as Transfer Pricing Rules or "TPR") tend to focus on the ability to manipulate pricing in transactions with a corporation (control) regardless of form of manipulation. By contrast, rules eroding separate identity of a corporation are more likely to focus on shares holistically, but then reinforce substance by ensuring the relevant percentage is held of each of the rights attaching to shares. So in the context of group loss relief, primary test of owning share 3

MCL: Corporate Taxation

capital is backed up with a voting test to ensure both substantial ownership as well as control.

Identification of Membership Rights with Corporate Profits

In characterising a payment received as a dividend courts will look to the source of the rights with respect to which the payment is made, i.e. there will be an implicit reference to membership rights. Definition of shareholder in corporate law: o UK - "Member" is "person … whose name is entered in its register of member". o Germany - "Shareholders" are "only those who are entered as such in the share register". o US - ""Shareholders" are "the person in whose name shares are registered in the records of a corporation." Profits





SHs are entitled to corp profits How much they are entitled to depends on manner in which profits are calculated for corp law purposes. Profits for corp law will not equal profits for tax law purposes. Corp law - corp profits match the entitlement to distributions of SHs. Tax law breaks the logic between corp profits and shares. Thus, not clear on what basis a tax law should identify source of distributions of corp profits.

Distribution of Profits

UK - Has a comprehensive definition of "distribution" of a company - includes "any dividend paid by the company". UK doctrine of source suggests that there must be at least an implicit right wrt which a dividend is paid, otherwise the payment would be a simple gift. UK reference to dividends presumes a calculation of profits and that payment is made as a division of those profits. Narrow, but broad enough that person may be in receipt of a dividend, despite not having membership interest. Germany - refers to 'shares of profits (dividends), income and other benefits from shares' and other specified corporate rights. The rights referred to largely follow interests in the entities that are subject to corp tax and so commercial law classification is followed. o Like other approaches, it is a right to share in 'profits' that is primary determinative factor. 4

MCL: Corporate Taxation

US - refers to investor in the corporation rather than the investment that is the source of dividends. 'Dividend' is defined to mean any distribution of property made by a corporation to its SHs … out of its earnings and profits..." SH is undefined. If it were to take a technical meaning, would be unduly restrictive (would be limited to entities (corp) that issues shares), so case law takes a substance approach to what is a SH and what are shares. See below.

Hybrid Instruments (Classification as Debt or Equity)

Fixation on right to division of corporate profits is not a substantive test of who is a SH, and results in circularity. If tax law accepted, could choose whether to receive interest or dividends by structuring the form of instruments they hold in a corporation - so long as substantial differences b/w tax on return of debt and equity, potential for unacceptable arbitrage. Clearly, simultaneous exist of subordination, rights to profits and surplus and a participation in organs of a corp = in substance a share. What about where only some of those features present?
o Suggested that capital risk associated with investment = most important factor, but there is a spectrum in rates of return and risk: there may be substantially more risk in some straight debt than other shares. o As a matter of practicality, income tax laws must accept as a starting point the commercial law characterisation of assets and transactions. Most tax laws then proceed to re-characterize debt and shares in isolated cases by reference to substance of investment in question.

Debt instruments

May be debt in form yet incorporate substantial features of equity, Examples = profit sharing debentures (return dep. on performance, but may rank equal with other debt,

Preference Shares

Pref Shares = Shares in form, but incorporate substantial features of debt (higher rank than ordinary shares, dividends may be fixed, cumulative (if not paid in this year, it will be added and paid next year), may not have 5

MCL: Corporate Taxation

no right to share in surplus on winding up or participate in organs) and convertible notes (debentures) (may behave like debt, but underlying value of investment determined by reference to shares to which they can be converted). Germany: Approach is formal and restricted. Profit shares and dividends are identified, and shares and certain other corp rights are classified under commercial law. However, in addition to formal equity instruments dividends may be identified with 'profit participation rights'. Only where the rights grant both a 'right to profits and liquidation proceeds.' Accordingly, profit sharing debentures with a right to surplus on liquidation will be treated as equity, but those without a liquidation right will be treated in accordance with their form 9 (i.e. as debt and return thereon as interest). Typically, treatment of convertible notes will also follow their form. In extreme cases, concept of 'hidden profit distribution' may have some application to hybrids, but most commonly used wrt constructive dividends to SHs. US: IRC contains no definition of SH for purposes of s.

316. However, courts apply substance approach to classification of an investment as debt or equity. Take into account various characteristics of investment to determine whether on balance is debt or equity. Some of the main factors that courts consider are set out in s. 385(b) of IRC: o (1) is there a written unconditional promise to pay on demand or a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and

voting rights, and may be redeemable after a fixed term. Therefore may be functionally equivalent to subordinated debt. Nevertheless, tax laws less likely to re-characterize shares as debt than they are to treat debt as equity. Germany: Preference shares = shares for tax purposes. May be because German corp law regulates issue of pref shares to a greater extent than in common law jurisdictions (e.g. if dividend not paid, corp law activates certain inalienable rights incl. voting rights). US: Preference shares = debt for tax purposes (most likely). Depends on weighing characteristics of investment referred to above. At one extreme preference shares that participate in profits are likely to give 'an invulnerable equity status". As more debt-like features are introduced, greater risk of instrument being classified as debt.

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MCL: Corporate Taxation

to pay a fixed rate of interest; o (2) whether there is subordination to or preference over any indebtedness of the corporation; o (3) ratio of debt to equity in the corporation; o (4) whether there is convertibility into stock of the corporation; and o (5) relationship between holdings of stock in the corporation and holdings of the interest in question. John Kelley Co v. Commissioner: o USSC said 'no one characteristic, not even exclusion from management, which can be said to be decisive in determination of whether obligations are risk investments in the corporations or debts' Section 385 o Authorises Secretary of Treasury to make regulations to determine whether an interest in a corp must be treated as stock or debt (or both). o Regulations were published but were then later revoked again. o Issuer's characterisation of an instrument is binding on issuer and holders of the instrument, but not the tax administration or holders who have notified the tax admin. Features of Instrument o Example - Profit sharing debentures and convertible notes o Classification as debt or equity will depend on particular features of the instrument in question:
 Long maturity date?
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