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Chapter 2 Part 2 Taxation On Corporate Income When Distributed Notes

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MCL: Corporate Taxation

Chapter 2 - Part 2 Taxation on Corporate Income when distributed Dual Nature of Corporation Income

Corporate income peculiar in that treated as income twice; once when derived and once when distributed. Most countries tax both these events and so the result is economic double taxation unless specific relief is provided.

Economic Double Taxation: The Classical System

Corporate tax systems treat dividends as income of the SH. May seem intuitive, but at a deeper level is disturbing. Income tax seeks to tax creations of wealth accruing to a person when and if transformed by a payment received from another person, i.e. when realized. But where is the creation of wealth when corporation distributes a dividend?
o Presuming dividends not deductible, dividend does not cause an erosion of another person's income such as a payment of interest, wages or other disbursements. o So, the funds that represent the dividend have typically already been taxed as a creation of wealth as income of the corporation. o Dividend = 'divided' - why should division in profits result in income separate from the earning of those profits? Most countries' income tax laws do not consider the division of partnership profits as income separate from the earning of those profits.

Rationale for this charge to tax seems to be the separate identity of the corporation. The focus here seems to be on legal form rather than economic substance and is particularly problematic where non-corporate entities are identified as subjects of the corporate tax system.

Regardless, not useful to dwell on issue of whether it should constitute income. Nevertheless, this uneasy nature of dividends as income helps to explain why full consequences of this income nature are often not followed through in the tax system. A corporate tax system that subjects income to double taxation in this manner without relief for one tax against the other is most commonly referred to as a 'classical system'.

Will now focus on 2 features of dividends as tax: o (1) Charge to Tax o (2) Whether charge is on gross/net amount of dividend.

The Charge 1

MCL: Corporate Taxation

The dual nature of corporate income provides two potential taxing events: The taxation of corporate income when derived is typically taxed in the hands of the corporation, i.e. corporation tax, corporate distributions are typically taxed at SH level, SH tax. However, there are examples of corporations being taxed with respect to their own distributions and examples of both corporations and SHs being taxed with respect to distributions.

SH Taxation

Where dividends are included in income, the income is the income of the SH so it is clear that what is envisaged is a SH tax. An example is the US - Section 61(a) of IRC identifies 'gross income' in terms of 'all income from whatever source derived.' This includes dividends, but provision goes on to list some examples and specifically includes dividends. German income tax law also lists types of income subject to the charge, but requires further investigation to identify dividends as one of those types. One of the heads is 'income from capital assets', which is defined in a separate provision and specifically includes 'profit shares (dividends)'. Again dividends are income of recipient so German law envisages a SH tax.

In both US and Germany, dividends are included in income of the recipient irrespective of whether dividends are from a resident or nonresident corporation.


Global system - Dividends aggregated with other income. Schedular system - may be different rules of calculation, or different tax treatment for dividends.

Corporate distributions tax

Were effectively struck down in EU by Court of Justice. Some countries (Argentina, Mexico) still use corporate equalisation tax on profits distributed out of untaxed funds. Some countries also levy general corporate distributions tax on dividends distributed by a corporation. A corporation may also be charged with responsibility of withholding tax from dividends it distributes.

Withholding and Dual Taxation

When a corp is req to withhold tax from its dividends, it must calculate the tax and pay it to the tax administration. In substance, this is a form of indirect tax, intended for the SH but collected from the corp. In addition, the SH may be taxed wrt the dividend, but receive a 2

MCL: Corporate Taxation credit for the tax paid at corp level.

Withholding tax = common, and usually referred to as a system of "deduction at source". Most all countries operate a withholding tax system for wage income.

Germany

country that operates a general withholding tax system for dividends paid by resident corporations. o General Rule - German corporations are required to withhold tax at the rate of 25% from dividend distributions. o The tax is withheld even in situations in which the SH is exempt or partially exempt, though it may be reduced in certain circumstances, e.g. tax treaty. o General withholding taxes becoming more common in EU due to increase in number of countries applying a final dividend withholding tax to dividend income.

US

= example of a country that does not have a general dividend withholding tax, but does impose a dividend withholding tax on distributions by resident corporations to non-residents.

Expenses in Deriving Dividends

US

Each tax law must address the issue of whether expenses incurred in deriving dividends are deductible. Deduction of expenses is only possible (or at least realistic) in context of a SH tax. Taxes imposed on corp's wrt their distributions, (formally as corp distrib tax or informally as dividend withholding tax) can only be imposed on gross amount of dividends.

Most commonly, expenses (for deriving dividends) = interest on funds used to purchase shares or fees in managing share portfolios. Where country uses a global approach to calculation of income, a general deduction provision may permit deduction of expenses incurred in deriving dividends (e.g. Australia)

have a general deduction rule for trade and business expenses, and has specific provisions for other types of expenses. In particular, has a specific rule that permits a deduction for interest expense. o This provision is extraordinarily wide, but then cut down by limitations. Particularly, interest expense incurred by individuals for investment income is quarantined, so it cannot exceed the amount of investment income. o "Investment income" = defined in terms of "gross income from property held for investment". These rules are an example of an essentially global system indirectly adopting scheduler features. 3

MCL: Corporate Taxation o

Germany

With respect to corporations holding shares, no similar restriction on interest deductibility, but there are special rules reducing dividend relief for debt financed shares (see 2.4.3.1)

Corporations: global approach to calculating Corp Tax Base means general rule on deductibility of business expenses applies to corporations, incl expenses incurred in deriving dividend income. o However, dividends are expressly exempt and there is a special rule for deduction of costs incurred in deriving such income.

Shareholders: For individuals, treatment of expenses incurred in deriving dividends depends on whether those dividends constitute income from business or income from capital assets. In either case, expenses are in principle deductible. o These general rules are however qualified in the context of dividend relief, below. The interest barrier rules on the deduction of interest, discussed above, apply to both corporations and individuals, but they are not particularly directed at interest incurred in deriving dividends.

What happens if expenses are greater than dividend income, i.e. produce a loss from holding of shares?

Most countries do not address this issue directly, but many countries have restrictions on the use of passive losses that may impact on the use of losses from the holding of shares. The treatment of passive losses is not a matter with which this book is particularly concerned. However, it is useful to make a few observations: o Argument for quarantining passive losses = intertwined with realisations basis of income tax. Investors may finance an investment in such a way to produce losses in early yrs, but in expectation of gains when investment is finally realised. o Some incompatibility in allowing for deduction of expenses immediately (reducing tax payable on other income) while gain accrues untaxed until realisation.

Germany

Directly quarantines losses from holding of shares to set off against income from other capital assets. o 'Losses from capital assets may not be offset against earnings from other sources … However, the losses reduce the earnings of the taxpayer from capital assets in the following assessment periods." o These rules do not apply where the shares are held as part of a business, and so do not apply to corporations (because all of their income is treated as business income."

US

Has rules that quarantine losses on 'passive activities'. o These rules do not apply to deriving dividends and certain other types of investment income, but this also means 4

MCL: Corporate Taxation that losses on passive activities cannot be set against investment income. Effect of these rules is to require taxpayers to categories each of their activities into: 'normal business activity, passive activity, and portfolio investments making an allocation of income and deductions to each category.. The rules in effect turn the otherwise global system of income definition into a schedular system in which each activity is potentially a separate income category.'

Should Corporate Income be Taxed Twice?

Artificiality of corporation leads to deriving of corp income twice. This leads to economic double taxation. Doesn't not mean that corp will accept double taxation.

First chapter already noted numerous examples where system might erode separate identity of corp at point where corp income derived, esp in context of closely held corporations. System even more likely to erode separate identity of corp at point corp income is distributed.

Corp tax system might accept separate identity of corp when corp income is derived and tax the corp wrt that income. However, where corp income is distributed, system might accept in whole or in part that there is only one creation of income and provide relief from EDT"dividend relief" and involves to some extent separating identity of shareholders.

Main issues raised by EDT: These are all related to substitution issues and are therefore largely economic in nature. If subject to double tax, taxpayers expected to find a substitute with similar results and no double taxation.

EDT of distributed corporate income involves 3 fundamental elements: o (1) Corporation conducting an economic activity o (2) Funding of that activity with equity financing o (3) Distribution of results of economic activity to person from whom equity financing was received.

There are other elements, but relate in particular to location of investment and international context. These 3 elements are core of major distortions caused by EDT: o Bias against using corporate form. o Bias against equity financing. o Bias against distributing corporate profits.

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Comparison Corporate Unincorporated Sectors

vs

Often argued that EDT leads to greater use of partnerships and sole proprietorships - this distorts an efficient allocation of resources between incorporated and unincorporated sectors.

US: Perfect example of this distortion o Tax planners worked on methods to avoid second layer of tax, leading to creation of S corporation regime - (produces look-through treatment of small corporations) o Next up was MLP's and then US passed rule that certain publicly traded partnerships = treated as corps for federal tax purposes. o After that was enactment of State LLC statutes - these laws played on federal list of corp characteristics giving rise to classification as a corporation for tax purposes. o US tax administration then gave up on "business-entity classification game" and introduced check-thebox regime - permits taxpayers to elect whether or not their LLC is a corp for US tax purposes. o Each of these examples demonstrate sensitivity to corp vs unincorp divide re issue of economic double taxation.

Limits to this Sensitivity o Double taxation is the price paid for benefits of the corporate form (namely limited liability) Unconvincing on at least 2 grounds:
 Limited liability most beneficial in context of insolvent corporations which do not pay income tax.
 Limited liability is available when using certain other types of artificial entity, and increasingly so. o

More convincing argument - Corporate form involves benefit of access to financial markets to raise finance:
 Here, corp law facilitates bundling of rights that are freely transferable, and which are regulated by government. Perhaps benefit of access to market should be paid for, but unlikely there is any direct relationship between amount of benefit and double taxation.

o

Access to markets may mean conducting activity in unincorporated form is not a ready substitute for corporation, meaning no distortion in this regard.
 This argument is only relevant where the activity is likely to need access to financial markets for financing purposes. (eg - small businesses don't need access.)
 Thus, argument = Double taxation is less likely to distort large scale activities as to form of 6

MCL: Corporate Taxation


intermediary than small scale activities. Note this is what we saw in US experience above: small business led to erosion of separate identity, but for widely traded partnerships reinforced that identity. Also evident in extent of dividend relief provided by some countries, where higher levels are available for small than large corporations.

Bias regarding double tax of corp form on dividends = just one factor in selecting a particular vehicle. But, bias can be overcome by other tax benefits of corp form: o Can substantially avoid double taxation by deriving other returns from a corporation (interest, gains on sale of shares, etc.) o Use of corporation may facilitate benefit of income-splitting between related parties. o If corp tax rate sufficiently low, beneficial taxation of retained profits may offset the detriment of economic double taxation of distributed profits. See Ireland as an example.

Other forms of income that may be derived = interest, wages, consultancy fees, royalties, rents, capital gains, liquidation distributions, share buyback distributions etc. o If these only subject to 1 level of tax - dividends will be disfavoured as a particular form of return. o NB to point out that many of the other types of income are fully taxable in the hands of recipient. o In these cases, distortion occurs because other types of payment might be deductible for corp whereas dividends typically not deductible.

Major distortion = debt financing over equity financing (though is much broader). o Distortion may be ameliorated by other considerations (eg Ireland = Financing with equity may be favourable if profits are retained in a corporation subject to a low corporate tax rate (i.e. lower than if interest accrued to the investor))

In corporations (especially widely-held) = dividends are similar to interest in that both constitute the cost of capital. o That one form of cost of capital is deductible and other is not, naturally leads to tax induced distortion to excessively rely on debt capital rather than equity capital. o Often suggested that because classical system induces corps to overly rely on debt, such a system can make corporations more vulnerable to insolvency and collapse.

Distortions caused by debt / equity distinction have been particularly distressing in context of 2008 financial crisis.

Dividends vs Other Returns

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