Design of Corporate Tax Law Systems
The required reading for this week is a general overview of taxation of income derived from business profits. Since business activities come in many different shapes and sizes, a business tax system must deal with a multitude of possible cases.
Profits of incorporate businesses are usually taxed under a separate corporate income tax. Dividends may be also taxed at an individual level, as may the profits from unincorporated businesses and self-employed people.
From what we pointed out above, it is possible to identify two challenges that a tax system must meet:
- For small businesses, the system should not introduce distortions based on the choice of one or another legal form
- For multinational corporations, it should determine how taxable profits are allocated between countries
The tension between those two (and other) goals result in an increasingly complex tax system that attempts to deal with national and international “centrifugal forces”.
Justification of Corporate Tax
Corporate taxation is not a logical consequence of either a company’s separate legal status or its limited liability. Neither are the effects of such taxes restricted to the company itself: one should always take into account the effects on the individuals associated with the company in question, such as suppliers, employees, and so on.
The higher-order effects of corporate tax play a key role on the political and policy debates on the topic, as the forms of taxation and the context where it happens determine who ultimately bears the burden of corporate tax. The behavior of stakeholders may be influenced by whether the “effective incidence” of company taxes falls more on shareholders, on workers – through reduced salaries –, or consumers – that have to deal with higher prices. Effective incidence also affects the moral and political calculations related to taxation.
Mirrlees et al. (2011) justify corporate taxation with two considerations.
Even with modern technologies, it is easier to tax profits at a corporate level than to calculate what would be the ideal share of taxable profits that should be allocated to each stakeholder. The issue is complicated when one takes into account the existence of financial intermediates, such as pension funds, that own shares of companies. How should one distribute the tax responsibility on an exclusively personal tax system? (Could one frame this as an “emerging” aspect of tax?)
Foreign ownership of national companies and local ownership of stakes in international businesses introduce further complications to a purely personal tax system. Implementation of such a model would require even greater levels of coordination and information sharing between countries, not to mention the political and computational issues involved on deciding the tax share due to each involved state. In contrast, a source-based corporate tax allow states to obtain revenue from firms operating in their domestic economies, even when those operations are controlled by foreign nationals.
Impact on personal taxation
Corporate tax is also justified as a complement of the personal taxation system. In fact, one can see corporate ownership as a form of unconsumed savings, and as a consequence, the taxation of corporate profits should be similar in form and structure of personal taxation (especially when it comes to savings). That “symmetry” aims to avoid tax deferral through retaining profits at the corporate level, but without penalizing investment on corporations as a form of savings.
For small business, there is also the issue of the blurred lines between labor income and capital income. If those incomes are taxed at too different rates, there is an opportunity for tax arbitrage.
Taxable Base & Rate
In all OECD countries (and many others), corporations are taxed on a measure of company profits after allowance for interest payments and presumed depreciation costs; few countries, such as Brazil, allow the deduction of dividends. Most countries consider worldwide net income for the tax base of companies incorporated there, but foreign companies with significant operations are usually only taxed on the income obtained from local sources.
Quoting Prof. Douma:
In most countries, losses from one of the company’s activities can reduce the taxable income from other taxable activities of that same company. Likewise, some jurisdictions allow losses of a taxable year to be offset against profits of later or earlier years. Countries allowing offsetting of losses often impose limitations on the number of years in which the losses may be utilized.
Corporate income tax systems generally provide relief for inter-company dividends. This relief, created to avoid economic double taxation (that is, the taxation of two or more different entities, often by the same country, with respect to the same income), comes in two main ways:
- Participation exemption: income is exempted from taxation at the level of the parent company.
- Imputation: the parent company receives tax credit for taxes already paid by their subsidiary.
As an example, if a parent company is established in the Netherlands, the company can benefit from an exemption of dividends and capital gains if it holds at least 5% of the nominal paid-up capital of the subsidiary and passes one of three tests.
Preferential Tax Regimes
This base scheme may be altered by preferential tax regimes, which are specific rules built into a country’s tax system to benefit some kinds of entities or activities. They can manifest themselves as a smaller tax rate and/or a smaller tax base, and some manifestation include IP boxes – which offer advantages for income from qualifying intellectual property –, interest box regimes – which benefit specific activities–, among others.
Harmful regimes are identified by OECD (1998) as sharing four traits:
- No or low effective tax rates
- Ring fencing of regimes: Partial or full isolation from domestic markets
- Lack of transparency
- Lack of effective exchange of information
Regimes that share those traits can distort the international tax system and offer unfair advantages to their beneficiaries.
A more extreme form of “unfair” tax competitition can be seen in tax havens, that is, country that levy little or no corporate income. OECD (1998) identify tax havens through two characteristics:
- Nominal or inexistent tax rates
- Lack of effective exchange of information with foreign tax authorities
- Lack of transparency in the operation of legislative, legal, or adminstrative provisions.
- No requirement of substantial activities
Other countries may adopt specific policies against tax evasion through tax havens. Brazil, for example, adopts different withholding tax rates and measures such as transfer pricing rules. Brazilian transfer pricing rules differ from OECD’s approach in points such as eschewing the arm’s length principle, instead using fixed margins for price calculation.
Interest Deductions and other financial payments
The adjusted net profit-based corporate base means that, at zero inflation and realistic depreciation schedules, corporate tax does not raise the cost of capital for investments financed by borrowing, but increases the cost of equity-financed investment, since the opportunity costs of profit retention or share emission are not deductible from the tax base. As a consequence, it becomes more interesting for firms to finance their investments through debt than through equity. Since companies still use equity finance, the capital cost increase for this categories results in an overall reduction of investment levels.
The tax rules also tend to favor corporate investment in certain kinds of assets, as firms try to invest as much as possible in categories that have more favorable depreciation schemes. Rules that incentive some asset categories and disincentive others, distorting investment decisions as a consequence of policy preferences.
Inflation and Taxation
Corporate tax bases are usually unindexed, considering assets at their historic costs instead of their inflation-adjusted values. As a result, tax deductions for depreciation lose some of their real value even under modest inflation, (let alone what is seen in countries with double-digit or bigger rates) and debt-based investment becomes even more advantageous, as nominal interest payments on outstanding debt can be deducted against taxable profits. Other possible impacts of inflation on corporate tax include the increase of inventory costs, which, as pointed by Dhaliwal et al. (2015) may increase the actual tax burden for inventory-intensive firms.
Inflation indexing is pointed out by Mirrlees et al. (2011) as a possible remedy to prevent corporate taxes from generating too big of a distortion on an inflation scenario. However, no OECD country has yet fully indexed corporate tax bases, as such an approach results in a significant increase of tax system complexity.
Alternative Corporate Tax Bases
Mirrlees et al. (2011) examine three proposals for addressing the issues on the current profit-based corporate tax model. The choice between those approaches and the standard corporate income tax should reflect the desirability of uniformity between personal and corporation taxation models.
The Meade Report, published on 1978, defended that corporate taxes should be based on a measure of net cash flow. One such proposal, the R-base, would replace interest and depreciation deductions with a time-of-incurrence deduction for investment, extinguishing the different treatment given to investment vis-à-vis other current expenses. This would eliminate the bias towards debt-based investing that exists in a profit-based taxation model as discussed above, treating debt and equity financing as equivalent financial cash flows. The R-base, however, would not not tax profit from interest spreads, as the interest-free inflows and outflows would be equal. Eliminating the distinction between debt and equity finance would also present issues on an international sphere, as companies operate in countries that adopt both systems for corporate base.
The R+F-base, proposed as a solution to R-base issues, treat repayments of interest and principal as deductible outflows, while keeping new borrowing as a taxable inflow. It once again treats debt and equity financing differently, but now allows taxation of new borrowing.
Allowance for Corporate Equity (ACE)
The ACE, initially proposed in 1991 by the IFS Capital Taxes Group, aims to eliminate the distinction between debt and equity financing by introducing deferred tax allowances for equity-based investment, reducing the opportunity costs of equity finance to the same levels seen on debt finance. If the equity base is measured taking into account the depreciation schedule used for tax purposes, it is possible to solve the issues of tax depreciation and inflation.
Broadly speaking, the stock of shareholders’ funds used to compute the ACE allowance evolves according to:
Closing stock = Opening stock + Equity issued – Equity (re-)purchased + Retained profits as computed for tax purposes.
The ACE allowance for the current period is then obtained as an imputed return on the closing stock of shareholders’ funds at the end of the previous period (i.e. multiplying this stock by a specified rate of interest).
Indexing is not necessary if the allowance is calculated by applying a nominal interest rate to the unindexed equity base.
The treatment of equity- and debt- financing are equal both in present value and the timing of tax payments, as is the taxation of profits from interest spread. An ACE scheme would preserve most of the existing corporate tax structure, with the additional demand of defining how the equity base evolves over time and what would be the interest rate used for calculating the allowance. For the latter issue, Mirrlees et al. (2011) propose the interest rate on medium-term government bonds.
Comprehensive Business Income Tax
The CBIT approach, as put forward in 1992 by the US Department of the Treasury, includes the normal return on debt-financed investments in the corporate tax base, leading to the abolition of interest deduction.
If a taxation model along those lines is accompanied by a symmetric tax relief for interest payments, interest spreads once again get beyond the scope of taxation. If, however, there is no deduction for interest payments, banks and other intermediaries would have to pay significantly more tax.
No major country has abolished interest deductibility, but countries now tend to restrict it in cross-border investments as a form to combat tax avoidance.
Taxation of Corporate Groups
From the course:
In many countries, specific rules and regimes apply with respect to the taxation of companies that are part of a group, recognizing that these entities, from a group perspective, function as a single economic unit.
This recognition comes in two forms:
Combined Tax Reporting
Combined tax reporting, also known as tax consolidation, allows companies within the same corporate group to pool profits and losses, effectively presenting the joint result of the group instead of the individual performance of each entity.
This allows for the disregard of intra-group transactions such as asset transfers and dividend payments, and it also allows the application of group relief, as can be seen in the U. K. group relief regime.
Countries usually only allow combined tax reporting for group companies taxed on their own jurisdictions based on residence, incorporation, or business activities. As Trevisan Neto & Pinto (2015) point out, Brazilian tax law has no concept of tax consolidation.
Transfer pricing refers to the price of goods and services between companies belonging to a same group. The OECD adopts the arm’s length principle, according to which transactions between related entities should be valued according to fair market value.
This principle is not universal, however: Brazil, for example, prefers to adopt a system based on fixed margins to handle cross-border transfers between related companies.
Corporate withholding tax is levied on payments made by one company to another, usually on payments of interests, dividends, or royalties. Usually, withholding bases are computed as a fixed percentage of the gross amount of payment, and their payment is made by the paying entity, which deducts the tax amount from the payment and pays it to the authorities.
Corporate Taxes in Brazil
The corporate income tax (IRPJ) is set at 15%. There is also a 10% surtax over income in excess of BRL240,000/year and a Social Contribution Over Net Profit (CSLL) of 20% for financial institutions and 9% for all other companies.
There is a foreign tax credit to offset IRPJ and CSLL paid for foreign-source income, subject to a series of limitations.
There are three possible calculation bases for corporate taxes in Brazil:
- Actual Profit: based on actual annual or quarterly taxable income
- Deemed Profit: available under certain circumstances, it allows taxation against a fixed percentage of quarterly estimated income.
- Simples Nacional: a regime geared towards micro- and small companies, unifying the collection of several federal, state, and municipal tributes.
The current Brazilian system concentrates taxation on the legal person, since Law 9249/95 has enshrined the notion that dividends are not part of the income tax base either at the source or at the recipient. Offhand calculations by Queiroz e Silva et al. (2015) show the potential revenue loss from that decision, but the authors are quick to acknowledge that adopting dividend taxation would result in changes on how companies deal with their profit, mitigating the potential windfall.
Law 9249/95 also establishes another method for distributing a corporation’s results to its shareholders: interest on net equity (JCP, from Portuguese juros sobre capital próprio). Unlike dividends, JCP are subject to a 15% withholding tax, treated as anticipation for a juridical person taxed under the actual profit system and as definitive tax otherwise. However, the value paid as JCP is deducted from the IRPJ and CSLL tax bases, resulting in a net tribute reduction even when taking into account the stockholder-side withholding tax.
As Deloitte (2016) points out,
Interest paid to a nonresident generally is subject to a 15% withholding tax unless the rate is reduced under a tax treaty. The rate is 25% if the recipient is resident in a tax haven.
Royalties and technical service fees are subject to a 15% withholding tax, unless the rate is reduced under a tax treaty, plus a 10% Contribution for the Intervention in the Economic Domain. (CIDE) Technical services may be exempt from taxation under tax treaties, but payments that do not involve technology transfer may be subject to a 25% or 15% withholding tax.
Deloitte. (2016) Brazil Highlights 2016. International tax series.
A brief outline of corporate and personal income taxes in Brazil. (PDF link)
D. S. Dhaliwal et al. (2015) Historical Cost, Inflation, and the Corporate U. S. Burden. Journal of Accounting and Public Policy, v. 34, issue 5, pp. 467-489, 2015.
A historical study case of the interaction between U.S. tax rules and inflation, showing that tax deductions based on historical cost increase the real tax burden on corporations, since even the existence of inflation-mitigating rules are not enough to fully capture the impact of inflation on the profits of capital- and inventory-intensive firms.
J. Mirrlees et al. (2011) Taxing Corporate Income. In: ____. Tax by Design. Oxford University Press, 2011, pp. 406-428
Core text for this week’s activities (and by extension, my course notes.)
OECD. (1998) Harmful Tax Competition: An Emerging Global Issue. Paris: OECD Publishing, 1998.
OECD. (2015) Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2015 Final Report. Paris: OECD Publishing, 2015.
J. M. P. Queiroz e Silva et al. (2015) Tributação de Lucros e Dividendos do Brasil: Uma Perspectiva Comparada. Brasília: Consultoria Legislativa da Câmara dos Deputados, 2015.
A study by advisors of Brazil’s Chamber of Deputies, describing the origins and current status of the Brazilian corporate tax system. The paper presents the historical evolution and current version of the Brazilian model and then compares it with the approaches adopted by other countries.
A. Trevisan Neto & A. E. Pinto. Tax in Cross-Border Deals 2016. Latin Lawyer, 2015-10-01.
A Q&A with Brazilian tax lawyers about cross-border deals.