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Maxims of Income Tax Planning

This document discusses key concepts for income tax planning including: 1) Differentiating between tax avoidance and tax evasion. Tax avoidance uses legitimate means to reduce taxes while evasion is illegal. 2) Four variables that determine tax consequences: the entity, time period, jurisdiction, and character of income. Shifting income between high and low tax entities or deferring income can improve after-tax returns. 3) Capital gains are taxed at preferential rates compared to ordinary income, so taxpayers try to convert ordinary income to capital gains when possible.

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300 views

Maxims of Income Tax Planning

This document discusses key concepts for income tax planning including: 1) Differentiating between tax avoidance and tax evasion. Tax avoidance uses legitimate means to reduce taxes while evasion is illegal. 2) Four variables that determine tax consequences: the entity, time period, jurisdiction, and character of income. Shifting income between high and low tax entities or deferring income can improve after-tax returns. 3) Capital gains are taxed at preferential rates compared to ordinary income, so taxpayers try to convert ordinary income to capital gains when possible.

Uploaded by

heobenicer
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 22

Chapter 4

Maxims of Income
Tax Planning
4-2

Objectives

1. Differentiate between tax avoidance and tax evasion


2. List the four variables that determine the tax
consequences of a transaction
3. Explain why an income shift or a deduction shift can
improve NPV
4. Explain how the assignment of income doctrine constrains
income-shifting strategies
5. Contrast the tax character of ordinary income and capital
gain
6. Distinguish between an explicit and implicit tax
7. Summarize the four tax planning maxims
4-3

Tax Avoidance not Evasion

• Tax avoidance consists of legitimate means of


reducing taxes

• Tax evasion consists of illegal means of reducing


taxes and is a felony offense punishable by severe
monetary fines and imprisonment
4-4

Tax Planning Variables

• Tax consequences of a transaction depend on the


interaction of four variables
1. The entity variable: Which entity undertakes the
transaction? (sole traders, partnership, corporate, etc.)
2. The time period variable: In which tax year does the
transaction occur? (the tax period, tax base)
3. The jurisdiction variable: In which taxing jurisdiction
does the transaction occur? (what type of tax, income
tax, VAT, or CGI tax)
4. The character variable: What is the tax character of
the income from the transaction?
4-5

Income Tax Planning - Entity

• Generally, taxable income is computed under the


same rules across business entities
• However, the tax on business income depends on
the difference in tax rates across entities
• The two taxpaying business entities are individuals
and corporations
4-6

Income Tax Planning - Entity

• Individual taxpayers
• Have a progressive tax rate structure
ranging from 10% to 35%

• Corporate taxpayers
• Have a progressive tax rate structure
ranging from 15% to 39%
4-7

Income Tax Planning – Entity Variable

• Tax costs decrease (and cash flows increase) when


income is generated by an entity subject to a low
tax rate

• When establishing a new business, consider the tax


rates paid by the type of business entity
4-8

Income Tax Planning – Entity Variable

• Income shifting
• Arranging transactions to transfer income from a high
tax rate entity to a low tax rate entity

• Deduction shifting
• Arranging transactions to transfer deductions from a
low tax rate entity to a high tax rate entity
4-9

Income Tax Planning – Entity Variable

• After an income or deduction shift, the parties in


the aggregate are financially better off by the tax
savings from the transaction
4-10

Income Tax Planning – Entity Variable

Assignment of income doctrine constrains on income


shifting
• Income shifting transactions usually occur between related
parties
• 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
4-11

Income Tax Planning – Time Period Variable

• Tax costs or savings from a transaction depend on


the year in which the transaction occurs

• In present value terms, tax costs decrease (and


cash flows increase) when a tax cost is deferred
until a later taxable year

• Constrained by:
• Opportunity costs
• Tax rate increase
4-12

Income 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 (nếu dùng hết đống đó thì period sau
không có đủ CF để trả thuế)
4-13

Income Tax Planning – Time Period Variable

• Tax rate increase

• If taxpayers defer the recognition of taxable income to a


future year and future tax rates increase, the cost of the
rate increase offsets the benefit of the deferral

• The risk that deferred income will be taxed at a higher


rate increases with the length of the deferral period
4-14

Income Tax Planning - Opportunity Costs

• Assume that a taxpayer has a 30% tax rate and uses a


10% discount rate. Compute NPV of the following:
• Taxpayer receives $100 cash/income and pays tax now
• NPV = $70
• Taxpayer defers the receipt of cash/income by one year
• NPV = $64 ($70 × 0.909)
• Taxpayer receives $100 cash but defers recognizing
income by one year
• NPV = $73 ($100 – $27[$30 × 0.909])
4-15

Income Tax Planning - Tax Rate Increase

• Taxpayer receives $100 cash but defers


recognizing income by one year. However, the tax
rate increases from 30% to 40% next year
• NPV = $64 ($100 – $36[$40 × 0.909])
4-16

Income 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
4-17

Income 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
4-18

Income Tax Planning – Character Variable

• Most types of ordinary income are taxed at regular


rates
• Exceptions to this rule include interest on state and
local bonds (tax-exempt for both corporations and
individuals) and qualified dividends (taxed at
preferential rates for individuals)

• Capital gains
• Taxed at preferential rates for individuals
• Taxed at regular rates for corporations
4-19

Income Tax Planning – Character Variable

• Tax costs decrease (and cash flows increase) when


income is taxed at a preferential rate because of its
character.
• Because capital gains are taxed at preferential
rates, individuals try to arrange transactions to
convert ordinary income to capital gain

 Provisions prevent the conversion of ordinary


income to capital income
4-20

Conflicting 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 per se but NPV maximization
4-21

Implicit vs. Explicit Taxes

• Explicit taxes – taxes are paid directly to the government


• Implicit taxes – taxes are paid through higher prices or lower
returns on tax-favored investment
• Example: Investor A with a 15% marginal tax rate intends to
invest in a corporate bond pays 9% and a municipal bond
pays 6.3%
• The municipal bond incurs a 30% implicit tax (2.7% reduced rate/9%)
• Investor A with marginal rates less than 30% maximize his after-tax
rate of return by purchasing the corporate bond
4-22

Homework

2,7,8,11,12,18 p 86-89

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