Chapter 2Chapter 2

Tax PlanningTax Planning

Instructor: Arshad HasanInstructor: Arshad Hasan

Standards for a Good TaxStandards for a Good Tax

In theory, every tax can be evaluated on four standards. A good tax should be:• Sufficient to raise necessary government revenues• Convenient to administer• Efficient in economic terms• Fair to taxpayers required to pay

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Standards - SufficiencyStandards - Sufficiency

• A tax is sufficient if:

• It generates enough funds to pay for the public goods and services provided by the government

• It allows a government to balance its budget

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Standards - SufficiencyStandards - Sufficiency

• Consequence of an insufficient tax system?• The government must make up its revenue shortfall from

some other source:• Leasing or selling of government owned assets or

property rights• Borrowing money in the capital markets

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Standards - ConvenienceStandards - Convenience

A tax is convenient if:

• Government’s view• The tax is easy to administer

• Easy to understand

• Offers few opportunities for noncompliance

• Taxpayer’s view• The tax is easy to pay

• Easy to compute

• Requires minimal time to comply

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Standards - EfficiencyStandards - Efficiency

A tax is efficient if:

• Judged by the classical standard of efficiency:• It is neutral in its effect on the market so that it does not:

• Distort the market

• Create suboptimal allocation of goods and services

• Modify taxpayer behavior

• Judged by Keynesian standards:• It is an effective fiscal policy tool for regulating the economy. • Governments should use taxes to move the economy in the desired

direction

Standards - FairnessStandards - Fairness

A tax is fair if:• The taxpayer has the ability to pay the tax• The tax enhances horizontal equity

• Persons with the same ability to pay should owe the same tax

• A rational and impartial measurement of the tax base

• The tax enhances vertical equity• Persons with greater ability to pay owe more tax than

persons with lesser ability to pay

• A fair rate structure

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Tax PolicyTax Policy

• Tax Policy can be defined as a government’s attitude, objectives and actions with respect to its tax system.

• Tax Policy reflects the standards that the government deems most important.

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Tax Policy Issues - EquityTax Policy Issues - Equity

Regressive: rate decreases as base increases• Smith pays $2,000 tax (10%) on $20,000 income and Jones

pays $3,000 tax (5%) on $60,000 income

Proportionate: single rate applied to taxable income• Smith pays $2,000 tax (10%) on $20,000 income and Jones

pays $6,000 tax (10%) on $60,000 income

Progressive: rate increases as base increases• Smith pays $2,000 tax (10%) on $20,000 income and Jones

pays 12,000 (20%) on $60,000 income

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Tax Policy Issues - EquityTax Policy Issues - Equity

• Distributive justice as a tax policy objective• The current distribution of wealth across Pakistan

households is thought to be unjust• This perception has increased in recent decades• Individuals are increasingly likely to underreport their

income

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Business OrganizationsBusiness Organizations

• Taxpayer = owner(s) of entities• Sole proprietorship• Partnerships• Corporations

• Taxpayer = corporation• Corporation is taxed first, then shareholders may be

taxed on distributions, resulting in double taxation

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Taxes as Transaction CostTaxes as Transaction Cost

• The objective of business decisions is to maximize the value of the firm

• The first step in evaluating a business transaction is to quantify cash flows from the transaction

• Managers want to make decisions that maximize the value of the firm by maximizing positive cash flow or minimizing negative cash flow

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Tax Policy and Business ManagersTax Policy and Business Managers

• Business managers and their tax advisors share a keen interest in tax policy• They know that many complex tax rules have an

underlying policy rationale• If they understand this rationale, the rule is easier to interpret

and apply

• They know that today’s policy issues shape tomorrow's tax environment• By paying attention to current policy debate, they can

anticipate developments that might affect their firm’s long-term strategies

Tax AvoidanceTax Avoidance

• Tax avoidance consists of legitimate means of reducing taxes

• Tax evasion consists of illegal means of reducing taxes and is an offense punishable by severe monetary fines and imprisonment

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International TaxationInternational Taxation

• Corporate Residence

• A company is resident in one country, though it may trade in many countries.

• A company is Usually resident in the place of incorporation.

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Double Taxation TreatiesDouble Taxation Treaties

• Countries enter into double taxation treaties to establish more clearly which tax authority has jurisdiction.

• Treaties seek to avoid a business having to pay tax twice on its income simply because it deals with two authorities.

• Methods of giving relief:• Full deduction• Exemption• Credit

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Tax Planning VariablesTax Planning Variables

• Tax consequences of a transaction depend on the interaction of four variables

• The entity variable: Which entity undertakes the transaction?

• The time period variable: In which tax year does the transaction occur?

• The jurisdiction variable: In which taxing jurisdiction does the transaction occur?

• The character variable: What is the tax character of the income from the transaction?

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Income Tax Planning – Entity VariableIncome Tax Planning – Entity Variable

• Assignment of income doctrine• Constraint on income shifting

• Income must be taxed to the entity that earns it by the sale of goods or performance of services

• Income generated by capital must be taxed to the entity that owns the capital

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Income Tax Planning – Time Period VariableIncome Tax Planning – Time Period Variable

• Opportunity costs• Shifting tax costs to a later period may involve

postponing a cash inflow to a later period. Thus, the opportunity cost of postponing the cash inflow may exceed the savings from the tax deferral

• The opportunity cost is the loss of the immediate use of the cash

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Income Tax Planning – Jurisdiction VariableIncome Tax Planning – Jurisdiction Variable

• The jurisdiction variable is important because local, state, and foreign tax laws differ

• Tax costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate

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Income Tax Planning – Character VariableIncome Tax Planning – Character Variable

• The tax character of an income item is determined strictly by law

• Every income item is characterized as either ordinary income or capital gain• Ordinary income is generated from the sale of goods or

performance of services in the regular course of business• Income generated by investments (interest, dividends,

royalties, and rents) is ordinary• Capital gains are generated by the sale or exchange of

capital assets

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Tax Planning MaximsTax Planning Maxims

• Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate.

• Tax costs decrease when a tax is deferred to a later taxable year.

• Tax costs decrease when income is generated in a jurisdiction with a low tax rate.

• Tax costs decrease when income is taxed at a preferential rate because of its character.

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Conflicting Tax Planning MaximsConflicting Tax Planning Maxims

• Sometimes, the four tax planning maxims conflict!

• For example, a transaction that results in tax deferral may cause income to shift to an entity with a higher tax rate

• Managers should remember that their strategic goal is not tax minimization but NPV maximization

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• Financial statements show accounting profit for the accounting period.

• Local tax rules require certain adjustments in order to arrive at the taxable profit.

• Taxable profit is the accounting profit adjusted according to the tax rules and is the amount on which tax is actually paid.

Taxable ProfitTaxable Profit

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$’000 $’000

Accounting Profit 5,000

Add: Entertainments Disallowed 150

Book Depreciation 250 400

5,400

Less: Non taxable Income 10

Tax Depreciation 140 (150)

Taxable Profit 5,250

Calculating Taxable ProfitCalculating Taxable Profit

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Types of AdjustmentsTypes of Adjustments

• Absolute Adjustments

• Timing Adjustments

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Absolute AdjustmentsAbsolute Adjustments

• The adjustments that are permanently disallowed for tax purposes

• Permanent Differences

• Entertaining Expenses• Formation Costs• Government Grants• Fines and Penalties

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Timing AdjustmentsTiming Adjustments

• The item of income or expense will eventually be allowed in full, but is taken into account in a different year for book purposes than for tax purposes

• Temporary Differences

• Depreciation and amortization• Bad debts (allowance vs. direct write-off)

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Deferred TaxDeferred Tax

• Deferred Tax AssetThe amount that results from an excess of Taxes Payable over Income Tax Expense

• Deferred Tax LiabilityThe amount that results from an excess of Income Tax Expense over Taxes Payable

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