Taxes and Management Decisions
Taxes and Management Decisions MA 826
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h4A826 TJotes Taxes and Business Strategy Second Set of Notes Summer 2003 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Chapter 12 Corporate Formation Capital Structure and Liquidation 0 Unless otherwise specified we re talking about C corporations Most entities that you think of as corporations are in fact C corporations 0 One of the central tenets or at least it used to be of corporate taxation is that corporate profits should be taxed and distributions to corporate owners should also be taxed This is double taxation 0 The determination of taxable income actually starts with income for financial reporting purposes Important temporary differences in accounting methods used for tax and financial reporting purposes include the accelerated writeoff of depreciable assets use of the cash basis accounting for warranty obligations the use of actual writeoffs of AR vs estimated writeoffs Permanent differences include the recognition of foreign source income for financial reporting but not for tax purposes exemptions relating to municipal securities the writedown of goodwill for financial reporting but not tax purposes and the expensing of nonqualified stock options for tax purposes but not for book purposes 0 Corporate Formation is generally a nontaxable event Specifically investors contribute property to the corporation in return for which they get shares of stock that represent ownership claims Absent Section 351 this exchange would give rise to taxable income because dissimilar assets are being exchanged equal to the difference between the basis of the property in the hands of the investor and the fair market value of the property Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 2 0 To avoid corporate formation being treated as a taxable event three conditions that are noted below have to be met As a practical matter it s not terribly difficult to meet these conditions Perhaps the most interesting is the first There it is important to make sure that the product of service type work gets characterized as property Insuring that this happens appropriately is a job for lawyers 1 investors must contribute property not services services would be taxable immediately 2 investors must receive stock 3 investors must collectively control 80 of the firm 0 In a nontaxable corporate formation the corporation inherits the investor s basis in property socalled carryover basis That is property contributed is not stepped up to market value The same is true when an individual receives property as a gift though not when property is received as a bequest under current estate taX law 0 Investors take a basis in stock equal to their basis in contributed property socalled substituted basis 0 Basis is used for the determination of gain or loss It is also used to determine amounts of writeoffs in the case of depreciable or amortizable assets Consider the following an asset qualifying under Section 1231 is purchased for 100000 and depreciated 40000 The acquisition price is the asset s basis the basis less accumulated depreciation 60000 is referred to as adjusted basis If the asset were sold for 110000 the total gain of 50000 would be parsed into two pieces 40000 related to the recapture of depreciation would be ordinary income The remaining 10000 would be a capital gain The accounting analogue to basis and adjusted basis is cost and book value 0 If investors in a corporation receive boot think cash or some other asset anything but the stock of the newly formed corporation they have to recognize taxable income never a loss equal to the lessor of the realized gain on the transaction or the boot received The investor s basis in turn will equal the basis of contributed property Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 3 plus any realized gain you can think of this as a step up in basis paid for by recognizing the gain for taX purposes less any boot received the investor would have separate basis in the boot Example an investor contributes property with a basis of 100000 and a fair market value of 200000 and gets in return shares of common stock and 110000 in cash What s the realized gain What s the boot What will the investor report as income What will the investor s basis in the stock be What s the investor s basis in the boot received 0 If one company holds more than 50 of the equity of another company consolidated financial statements have to be prepared for financial reporting purposes If one company holds more than 80 of the equity of another company it can consolidate for taX purposes Advantages of consolidation include the opportunity to offset one controlled firm s income against another controlled firm s losses 0 Some fairly strong empirical evidence indicates that firms with high marginal taX rates are more likely to use debt than firms with low marginal taX rates Why does this make sense 0 Trustpreferred stock is reported in the mezzanine Section of the Balance Sheet between liabilities and equity Related dividends are deducted from income for both taX and financial reporting purposes and treated as ordinary income to recipients no dividend exclusion to corporate investors In essence trustpreferred stock looks an awful lot like debt What is to me somewhat remarkable is that it counts towards Tier 1 capital for banks ie banks can meet their capital requirements by issuing a security that generates taX deductible interest vs non taX deducible dividends Will trustpreferred stock be a favored form of financing for firms with high or low taX rates 0 Earnings and Profits EampP is the taX analogue to Retained Earnings 0 Corporate distributions can be treated as Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 4 p A Dividends provided there is sufficient EampP 2 Returns of capital if there is not sufficient EampP out of which to pay dividends or 3 Capital gains implies that distributions have eliminated EampP and that the shareholder s basis in the stock has been reduced to zero through returns of capital 0 Constructive dividends occur when distributions are made to shareholders without formal declaration of dividends You see this when firms try to distribute corporate profits to owners in a tax deductible manner eg excessive compensation and excessive perks This is especially likely in closely held corporations 0 Property dividends occur when property is distributed to shareholders Gains must be recognized at the corporate level on distributed property so that the corporate tax is not avoided 0 Share repurchases trigger capital gains and losses for shareholders The relative tax benefit to individuals has declined significantly as a result of the 2003 tax act which makes dividends taxable to individuals at capital gains tax rates 0 Corporate liquidation entails the sale of all of a corporation s assets payment of all liabilities and distribution of proceeds to shareholders Any gains or losses on sale of assets or settlement of liabilities would be taxable at the corporate level Shareholders would have to recognize capital gains or losses equal to the difference between the liquidating dividend and their basis in the stock 0 When a parent corporation liquidates a subsidiary it is typically structured as a nontaxable event under Section 332 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Chapter 13 Introduction to Mergers Acquisitions and Divestitures Five rationales for mergers and acquisitions ll214 gt two companies combine operations or one company acquires another 1 J U A U MampA activity results in combined entities that can generate economic performance superior to the sum of the performance possible of each as standalone entities e g economies of scale scope dumping deadwood management MampA activity results from management overreach eg excessive optimism rose colored glasses desire to empire build be a big man on campus e g Dennis Kozlowski former CEO of Tyco and soon to be a resident of a New York State penitentiary MampA activity is an attempt to undermine the interests of nonowner firm claimants eg employees creditors by increasing the relative riskiness of their claims thus reducing the value of those claims MampA activity results from the Svengali like in uence of investment bankers whose sole albeit understandable motive is to get rich off MampA related fees MampA activity can result in a stepup in basis of acquired assets ie acquired assets are steppedup for tax purposes which in turn results in larger writeoffs in future periods Note step up typically triggers income recognition for the seller The tax cost associated with this recognition will typically outweigh the tax benefits from stepup lots of folks don t get this A couple of rationales for divestitures one company effectively disassociates itself with one of its business units 1 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Focuses the management of the divested firm and the continuing firm on operating the business or remaining business This is what Thermo Electron does it is a classic forerunner of organizations that have more recently been called incubators 2 Segregating divested subsidiaries allows for a better appraisal of the value of the segregated subsidiary as well as the remaining business the ultimate tracking stock A primer on Basis Basis re ects your investment in an asset or liability Basis is used to determine whether you have to recognize a gain or loss on the sale of an asset or settlement of a liability Working through some Basis stu Company A is a C corporation that does an IPO raising total equity capital of 100 million in cash 0 The basis of the stock in the hands of shareholders is 100 million 0 The basis of the company s cash is its face value100 million Company A uses the entire 100 million in cash to purchase depreciable assets It uses these depreciable assets to generate income before taX and depreciation of 30 million it depreciates the assets 10 million and pays a taX on pretaX income equal to 6 million 0 Adjusted basis in the depreciable assets is now 90 million 1 001 0 o The basis in net assets generated from the income less taxes is 24 306 Basis increases when a firm reports income and pays taX on that income This is true for both C corporations as well as conduit entities such as S corporations partnerships and sole proprietorships When income is distributed to owners of C corporations they pay an additional taX on the distribution When income is distributed to owners of S corporations partnerships and sole proprietorships no additional taX is generally due since these owners have already paid a taX on the income Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 7 Total net asset basis is 114 million adjusted basis of depreciable assets 10010 plus pretax income pre depreciation income of 30 less tax on income of 6 Basis of stock in hands of shareholders is still 100 million Good news about the company is released and the market value of the company s stock increases from 100 million to 150 million The original shareholders sell their stock for 150 million The original shareholder s report a capital gain equal to 50 million 150 million sale price less their basis in the stock of 100 million This gain can be either shortterm or longterm depending on how long the stock has been held If the shareholder is an individual and the gain is longterm the maximum capital gains rate is 15 Tax basis of the stock in the hands of the new shareholders is 150 million Company basis in assets is still 114 million Note the shareholder s gain on the sale of stock is unaffected by and does not affect the basis of the assets of the company in which the shareholder held an interest Company A sells the depreciable assets for 200 million in cash Company A will recognize an ordinary gain on sale equal to the depreciation recapture of 10 million Assume the tax on the ordinary income is 3 Company A will recognize a capital gain on the sale equal to the excess of the purchase price over the original basis in the asset 200100 Assume the tax on the capital gain is 30 The basis of Company A s assets after the sale will the equal the 200 received from the sale of the assets less the tax due upon the sale 33 plus 24 of basis related to aftertax income exclusive of depreciation previously recognized or 191 Tax basis of the stock in the hands of the shareholders is still 150 million Assume Company A distributes all assets in a liquidating dividend to the shareholders There will be no entity level tax since the value of the assets Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy distributed is equal to their taX basis ie 191 If the fair market value of the assets distributed was greater than their book value a taxable gain would be recognized at the corporate level this is not true of losses however The shareholders will recognize a capital gain on the difference between the 1 91 and their basis of 150 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 9 Chapter 14 Taxable Acquisitions of C Corporations Taxable acquisitions are distinguished in part from non taxable acquisitions in that someone either the selling corporation the buying corporation or the selling shareholders is paying a tax when the transaction occurs The Players Target Company Target shareholders Acquiring Company Government We re going to look at three types of Taxable Acquisitions of C Corporations 1 Taxable Asset Acquisition Target does not liquidate ie Target shareholders remain shareholders after the transaction Tax paid by Target Company J Taxable Stock Acquisition followed by Section 338 Election which results in tax treatment equivalent to an asset acquisition followed by liquidation the event contemplated in 2 above Tax paid by Acquiring Company also tax paid by Target Company shareholders U Taxable Stock Acquisition NO Section 338 Election This is the most common form of taxable C corporation acquisition Tax paid by Target Company shareholders Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 10 1 Taxable AssetAcquisition Target does not liquidate ie Target shareholders remain shareholders after the transaction a Gain on sale is taxable at Target Company level ie from the Target Company s standpoint this sale is the same as the sale of any single asset or group of assets 0 Gains and losses on the sale of assets that would ordinarily give rise to ordinary income e g inventory accounts and notes receivables are taxed as ordinary income Gains losses on the sale of assets used in the business Section 1231 assets are ordinary to the extent depreciation is recaptured and capital ordinary losses to the extent that the sale value exceeds cost Gains and losses on assets that would ordinarily give rise to capital gains treatment eg stock of another company are taxed as capital gains and losses note capital losses can only offset capital gains Corporate capital losses not used can be carried back 3 years and forward 5 years use them or lose them b Gain on sale is not immediately taxable to Target shareholders they haven t sold their shares c The Acquiring Company stepsup the value of assets for tax purposes so that its basis for tax purposes is equal to the assets purchase price ie their fair market value The possibility exists that the Acquiring Company has purchased goodwill Goodwill and most other intangible assets are tax deductible under Section 197 over a 15year life How the purchase price of acquired assets gets allocated to different assets will have implications for the target and acquirer Section 1060 For the target the allocation will affect the characterization of income from the sale ie ordinary versus capital For the acquirer the allocation will Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 11 affect the characterization of future period s income as well as future period s writeoffs In general the purchase price is allocated first to liquid assets then to shortterm tangible assets eg inventory then to long lived tangible assets and specific intangible assets e g buildings patents trademarks and lastly to goodwill Most purchased intangible assets have to be amortized by the acquirer over 15 years The allocation scheme makes sense in that those assets and liabilities most objectively identifiableverifiable are valued first and those least identifiableverifiable are valued last 9 The Target Company retains its taX attributes eg net operating losses taX credit carryovers These taX attributes can be used to offset income from the sale of assets Nontax issues associated with asset acquisitions a The Acquiring Company may avoid contingent liabilities associated with the assets acquired b Contracts and title to assets may not be easily transferable eg labor contracts franchise assets licenses Aftertax return to target after an asset sale Sale price less TaX due on sale TaX due on sale is a function of the sales price the basis of the Target Company in the assets sold the availability of net operating losses to offset any resulting gain the taX rate on any remaining gain and the availability of taX credits to offset any resulting taX Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 12 Basis matters since it is used to determine taxable gain or loss How to estimate the tax basis of assets and liabilities of a target From the outside looking in what you have available are the financial statements of the Target Company In these statements assets and liabilities are stated at values that may not be the same as those used for taX purposes Deferred taX assets and liability accounts re ect differences in value of assets and liabilities for financial reporting and taX purposes The following procedure can be used to generate a first approximation of the taX basis of assets and liabilities Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 13 Less Plus Plus Less Less Equals Net Assets ALE reported for Financial Purposes Deferred Tax Assets not assets for tax purposes Deferred Tax Assets Statutory Tax rate Deferred tax assets originate whenever taxable income is recognized sooner for tax purposes than for financial reporting purposes Whenl say taxable income is recognized sooner I mean that net assets and equity on a firm s tax books are greater than net assets and equity on a firm s financial statements for reporting purposes and so we re adding back the difference here Common sources of such difference would be losses and expenses recognized sooner for financial reporting purposes than for tax eg estimated versus determined uncollectible accounts receivable estimated versus actual warranty related costs NOL carryovers Deferred Tax Liabilities not liabilities for tax purposes Deferred Tax Liabilities Statutory Tax rate Deferred tax liabilities originate whenever taxable income is recognized later for tax purposes than for financial reporting purposes Whenl say taxable income is recognized later I mean that net assets and equity on a firm s tax books are less than net assets and equity on a firm s financial statements for reporting purposes and so we re subtracting the difference here A common source of such difference would be accelerated depreciation for tax purposes versus slower depreciation for financial reporting purposes Nondeductible Goodwill being nondeductible for tax means it does not exist for tax purposes it s not recognized for tax purposes Net Assets reported for Tax Purposes Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 14 Problem Assume a potential Target Company reports the following assets top corporate taX rate 35 Accounts Receivable gross 10000 Allowance for Doubtful Accounts 2000 PPE net 20000 Deferred TaX Asset 700 Deferred TaX Liability 3000 Equity 25700 What is your estimate of the taX basis of the assets of the Target Company Speculate as to why the taX basis differs from the amount reported for financial accounting purposes Where in the financial statements could you get additional information regarding the source of differences between taX and book assets and liabilities Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 15 How to tell a company has tax deductible goodwill Goodwill is no longer systematically writtenoff for financial reporting purposes Goodwill recognized in connection with a corporate acquisition may or may not be deductible for taX purposes If a firm assumes that it will never writeoff goodwill for financial reporting purposes and goodwill is not taX deductible the accounting for goodwill will be the same for financial reporting and taX purposes Thus the accounting for goodwill will result in neither a timing or permanent difference If a firm assumes that it will never writeoff goodwill for financial reporting purposes and goodwill is taX deductible the accounting for goodwill will not be the same for financial reporting and taX purposes Rather the writeoff of goodwill for taX purposes will give rise to a permanent difference This difference would be revealed in the reconciliation of the firm s effective taX rate to its statutory taX rate This reconciliation is reported in the firm s taX footnote Note the deductibility of goodwill for taX purposes will reduce the effective taX rate relative to the statutory taX rate If a firm assumes that it will eventually writeoff goodwill for financial reporting purposes and goodwill is taX deductible it is likely that the timing of the writeoff of goodwill will not be the same for financial reporting and taX purposes Thus we will have a timing difference If goodwill is written off sooner later for taX purposes the writeoff will give rise to a deferred taX liability asset If a firm assumes that it will eventually writeoff goodwill for financial reporting purposes and goodwill is not taX deductible this will give rise to a permanent difference This difference would be revealed in the reconciliation of the firm s effective taX rate to its statutory taX rate Note the writeoff for financial reporting purposes though not for taX purposes will have the effect of increasing the effective taX rate relative to the statutory taX rate I m sure all this goodwill stuff is pretty obvious now Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 16 2 Taxable Stock Acquisition followed by a Section 338 Election which results in taX treatment equivalent to an asset acquisition followed by liquidation a Gain from sale taxable at entity level However in this case the entity that s taxed is the Target Company in its new incarnation as a subsidiary of the Acquiring Company b Gain from sale is immediately taxable to Target shareholders because they sold their shares c Acquired assets are steppedup to fair market value and taX deductible goodwill may result d The Target Company does not retain taX attributes eg net operating losses taX credit carryovers though its taX attributes can be used to offset taX on sale Acquiring Company taX attributes cannot be used to offset the income associated with this transaction reported by its new subsidiary ie the Target Company e The Acquiring Company takes basis in the stock of the acquired company equal to the consideration paid to holders of the Target Company stock Basis in Target Company assets will equal the aggregate deemed sales price ADSP defined on next page Nontax issues associated with stock acquisitions a The Acquiring Company will inherit contingent liabilities associated with the purchased company However the Acquiring Company will have the advantage of the corporate shield since the Target Company is now a subsidiary of the acquiring company b Contracts and title will transfer easily relative to asset sales A ftertax return to Target sh areholders from a stock sale followed by a Section 338 election The aftertaX return to Target shareholders is equal to the amount they receive for their shares less the taX on the sale The taX on sale will equal the sale price less the basis of the stock sold multiplied by the shareholder s taX rate Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 17 How does the Section 338 election affect the acquiring company By making a Section 338 election the Acquiring Company essentially converts the stock acquisition to an asset acquisition followed by a liquidation As such the price the Acquiring Company will be willing to pay the shareholders of the Target Company is equal to the aftertax retum the Target Company would have realized on an asset sale the aftertax return the Target Company would have realized on the sale is the amount that would be available in liquidation to Target shareholders What s the value of the assets purchased in a stock transaction followed by a Section 338 election the same as it would have been had the Acquiring Company purchased the Target Company s assets and assumed its liabilities Aggregate deemed sales price ADSP P L t ADSP Basis where P price paid for stock price paid for equity piece L liabilities assumed price paid Via the assumption of liabilities that eXisted at the time of acquisition t corporate taX rate Basis adjusted taX basis of Target Company assets prior to sale t ADSP Basis price paid Via the assumption of the taX liability created as a result of the acquisition The Target Company can use its net operating loss carryovers if any to offset the gain from the deemed sale just as it can to offset any gain from the sale of assets contemplated in case 1 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 18 3 Taxable Stock Acquisition NO Section 338 Election a Gain from sale not taxable at the target entity level Basically this is a transaction between Target shareholders and the acquiring company b Gain from sale immediately taxable to Target shareholders they sold their shares c No stepup in basis of assets this means no tax deductible goodwill The transaction does not involve the Target Company directly only the Target shareholders and the acquiring company d The Target Company tax attributes e g net operating losses tax credit carryovers survive but are limited by Section 382 see next page e The Acquiring Company takes basis in the stock of the acquired company equal to the consideration paid to holders of the Target Company stock Basis in Target Company assets will equal the basis of the Target Company in the assets before the acquisition carryover basis This basis will be used to determine future taxable income Nontax issues associated with stock acquisitions o The Acquiring Company will inherit contingent liabilities associated with the purchased company However the Acquiring Company will have the advantage of the corporate shield 0 Contracts and title will transfer easily relative to asset sales 0 Goodwill may be recorded for financial reporting purposes but since there s no step up in basis there will be no goodwill for tax purposes Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 19 Sec 382 Limitation on net operating loss carryforwards and certain builtin losses following ownership change Sec 382 also affects all non taxable acquisitions of C corporations which we ll be discussing next a General rule The amount of the taxable income of any new loss corporation for any post change year which may be offset by prechange losses shall not exceed the Section 382 limitation for such year b Section 382 limitation For purposes of this Section 1 In general except as otherwise provided in this section the Section 382 limitation for any postchange year is an amount equal to A the value of the old loss corporation s equity multiplied by B the longterm taxexempt bond rate 2 Carryforward of unused limitation If the Section 382 limitation for any postchange year exceeds the taxable income of the new loss corporation for such year which was offset by pre change losses the Section 382 limitation for the next postchange year shall be increased by the amount of such excess See next page Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 20 Note The imperative to use NOLs is like the imperative to use foreign tax credits or corporate capital loss carryforwards if you don t use them you can lose them because of time limits on the carryover amounts 20 years currently for NOLs and 5 years for foreign tax credits and capital loss carryforwards NOLs and tax credits limited under Section 382 may expire unused The imperative to use tax losses and tax credits leads to incentives to accelerate the recognition of income curiously just the opposite of one of the widely accepted basic tax planning tenets of postponing the recognition of taxable income For example consider an acquiring firm that purchases a Target Company Assume the Target Company has NOLs of 40 million that are going to expire in 5 years The purchase price of the Target Company s equity is 80 million and the federal longterm rate is 5 The annual limit on the use of NOLs is 8005 or 4 million It appears that you can only use 20 of the 40 million in NOLs and thus will only pay for the 20 million One way to get around the 382 limit is to sell target assets that had builtin gains before the target is purchased by the acquirer The target will have an incentive to help the acquirer identify such assets or the target should sell these assets on its own trigger the gain recognition and apply the NOL against the gain Aftertax return to shareholders from a stock sale NOT followed by a Section 338 election The aftertax return to Target shareholders is equal to the amount they receive for their shares less the tax on the sale The tax on sale will equal the sale price less the basis of the stock sold multiplied by the shareholder s tax rate In other words the Section 338 election does not affect the target shareholders Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 21 Cases 1 and 2 Taxable acquisitions of a freestanding C corporation s assets and acquisition of a freestanding C corporations stock followed by a 338 election results in a tax at the entity level and may result in a tax at the shareholder level Case 3 A taxable acquisition of a freestanding C corporation s stock not followed by a 338 election does not result in a tax at the entity level though it does result in a tax at the shareholder level Which is the best form of a taxable acquisition from a tax standpoint In a nutshell the issue boils down to the following Is the tax benefit of stepping up basis worth the tax cost Tax benefit from Stepup Present value of tax savings from increased basis in the Target Company s net assets Function of Tax rate of acquiring company Level and timing of tax savings Cost of Capital of acquiring company Tax cost of Stepup Present value of additional taxes that must be paid by or on behalf of the Target Company note these taxes might be reduced through the use of net operating loss carryovers and tax credits Plus The present value of the lost use of net operating losses and tax credits that are used up at the point of sale that would otherwise be available to offset future taxable income in taxable stock acquisition NOT followed by a Section 338 election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 22 The next two pages summarize the algebra that explains the returns to shareholders from acquisitions Altertax returns to Target shareholders assuming a taxable asset sale and immediate liquidation case 1 assuming that proceeds are immediately distributed Aftertax Return to shareholder gATRShareholderL ATIshareholder ATIzentity 39 tcgAT1entity 39 BaSissh where ATRen ty Aftertax return to entity distributed to shareholder tcg taX rate applied to shareholder s gain BasissI1 basis of target stock in hands of shareholder Aftertax Return on asset sale at entitv level ATRenhW ATRen ty SPa tcSPaBasisaNOLs taX credits where SPa Sale price of assets t0 TaX rate applied to corporate gain on sale less available operating losses Basisa Target asset basis NOLs NOL carryovers available to offset gain on sale taX credits TaX credits available to offset taX due on sale Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 23 Altertax return to Target shareholders assuming a taxable stock sale cases 2 and 3 ATIshareholder SPstock 39 tcgSPstock 39 BaSissh where SPstock Sale price of stock tcg taX rate applied to shareholder s gain BasissI1 basis of target stock in hands of shareholder Problem You are given the following information Sale price of assets 1000 Corporate basis in assets 400 Shareholder basis in stock 400 NOL carryovers 200 TaX credits carryovers 10 Shareholder level taX rate 20 Corporate taX rate 35 Life of Steppedup Assets 5 years Aftertax cost of capital 12 a What is the aftertax return to the shareholders of a Target Company that sells its assets to an Acquiring Company assuming that the Target Company liquidates immediately after making the sale b Given you response in part 1 at what price would the shareholders of the Target Company be willing to sell their shares outright to the acquiring company Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 24 T 0 Step up or not Step up AftertaX cost of an acquisition assuming no step up in basis no Section 3 3 8 1 Acquisition cost incremental taX benefits which equal zero in the no step up case which is equal to the price paid to acquire the stock SPsmllt AftertaX cost of an acquisition assuming step up in basis g Section 338 election or an asset acquisition considered in cases 1 and 2 2 Asset cost incremental taX benefits which equal the present value of the step up in basis less incremental cost which is equal to the present value of lost future NOL usage used up when transaction treated as an asset sale less taX due on step up of assets because assets treated as sold SPa PV of step up An acquirer is indifferent when SPstock SPa PV of step up Problem Given the information in the problem on the preceding page and assuming that the NOLs could be used to offset income earned by the acquirer over the next 4 years at a rate of 50 per year 0 Should the Acquiring Company above make a 338 election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 25 How often do you think acquiring companies make 33 8 elections Out of curiosity does a Section 338 election affect the aftertax return of Target shareholders Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 26 Chapter 16 Taxfree Acquisitions of C Corporations Typically a gain or loss is recognized upon the exchange of property that has appreciated or depreciated An exception to this general treatment relates to nonrecognition of gains and losses in the context of corporate formation Section 351 An additional exception to this general treatment relates to corporate reorganizations Section 368 Taxfree acquisition are provided for under Section 368 a 1 AB and C as well as Section 351 which governs corporate formation Important things to note 0 Taxfree acquisitions are primarily stock deals the Acquiring Company must give the Target Company shareholders stock of the acquiring company so that Target Company shareholders maintain a continuity of interest Note the requirement of continuity of interest does not mean that shareholders of the Target Company that accept stock of the Acquiring Company have to keep the stock The can sell the stock right away triggering of course a taxable gain or loss on sale 0 It is not necessary that all shareholders accept stock Some can accept just cash some cash and some stock some cash some stock some notes All nonstock consideration is referred to as boot Target shareholders must recognize gains immediately equal to the lessor of the gain on sale or boot received Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 27 Taxfree acquisitions are really just taxdeferred from the standpoint of the Target Company shareholders if and when Target shareholders sell stock received in exchange for Target Company stock they will have to recognize a gain from the sale In a taxfree acquisition the Acquiring Company does not stepup the basis of Target Company assets As such no sale of the assets is recognized by the Target Company and no resulting taX is payable The taX attributes of the Target Company eg net operating loss carryovers taX credits can be preserved but their use is restricted see earlier discussion of limitations under Section 382 in case of taxable acquisition not followed by 338 election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 28 1 Section 368a1A reorganization To qualify under as a 368 A the transaction has to be a statutog merger which required that the transaction be approved by both acquiring and target firm shareholders as stipulated under state law Broadly how a 368 A reorganization works 1 Acquiring Company transfers consideration stock and boot to Target Company in return for which it receives Target Company assets and assumes Target Company liabilities No gain or loss is recognized at the Target Company level 2 Target Company transfers all consideration to Target shareholders in a liquidating distribution After the deal Target Company shareholders are at least to some extent Acquiring Company shareholders This structure works best when some Target shareholders want cash or other property up to 50 but some are willing to accept acquiring firm stock typically at least 50 One reason Target shareholders might be inclined to accept stock is that they have a large built in capital gain that would be triggered upon sale One big problem with this structure is that the Acquiring Company has to assume all the liabilities of the Target Company There are however some ways to work around this More detail on 368 A reorganization Consideration At least 50 of acquiring firm stock Stock can be voting nonvoting preferred or common Nonstock consideration can include assets such as cash or other securities Shareholders who receive boot have to pay taX equal to the lessor of the boot received or the gain realized on the transaction Shareholders who receive acquirer stock will receive substituted basis Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 29 What is Acquired Benefits of Structure Costs of Structure in the stock of the acquirer equal to their former basis in target stock Shareholders who receive stock and cash will have a basis in acquirer stock equal to their basis in target stock plus the recognized gain on sale less the boot received Don t confuse realized gains with recognized gains Realized gains equal the difference between total consideration received and basis Recognized gains equal the lessor of boot received and realized gains The assets and liabilities of the target not the stock The basis of acquired assets and liabilities to the Acquiring Company is the same as it was for the target ie no step up Nontaxable to Target shareholders that accept and hold acquiring firm stock Flexible in terms of consideration Difficulty in transferring assets such as contracts licenses and permits The acquirer assumes is eXposed to the liabilities of the target Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 30 Triangular mergers In a triangular merger three parties are involved the acquiring company a subsidiary of the acquiring company and the Target Company three parties ergo the triangular nature of the transaction In a forward triangular merger qualifying as a reorganization under Section 368alA the Acquiring Company forms a subsidiary funding the subsidiary with acquirer stock and any other consideration the acquirer plans to transfer to the Target Company The Acquiring Company accepts subsidiary stock in return The subsidiary then transfers Acquiring Company stock and other consideration to the target and the balance of the transaction unfolds The chief advantage of the triangular merger form is that it insulates the Acquiring Company from the liabilities of the Target Company they are in the subsidiary A secondary benefit is that the approval for the merger comes from the shareholders of the acquiring firm s subsidiary ie the acquiring firm and not the shareholders of the acquiring firm A reverse triangular merger is similar to a forward triangular and a straightforward 368 A transaction After all is said and done the transaction qualifies as a statutory merger some portion of the Target shareholders accept acquiring firm stock in exchange for target stock and the basis in the target assets is unchanged What is different is that the Target Company is now a subsidiary of the Acquiring Company and the acquiring subsidiary setup to do the reverse triangular merger does not survive The chief advantage of a reverse triangular merger is that since the Target Company survives as a subsidiary of the acquiring company otherwise difficult to transfer assets do not pose a problem Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 31 2 Section 368a1B reorganization Broadly how a 368 B reorganization works Acquiring Company transfers Acquiring Company shares to Target Company shareholders getting Target Company shares in return Target Company then becomes a subsidiary of the acquiring company much as in a reverse triangular merger After the deal Target Company shareholders are Acquiring Company shareholders This structure works best when Target shareholders are willing to accept acquiring rm stock 100 of consideration One reason Target shareholders might be inclined to accept stock is that they have a large built in capital gain that would be triggered upon sale The acquiring firm may want this structure because it has little cash to offer Target shareholders Also this eliminates the need to transfer target assets and insulates the acquiring frrm against target liabilities More detail on 368 B reorganization Consideration 100 of consideration has to be voting stock either common or preferred of the acquiring frrm Any cash consideration would disqualify the transaction for 368 B with the exception of small amounts for fractional shares Also the acquiring firm must achieve at least 80 control of the target What is Acquired The stock of the target The basis of acquired assets and liabilities to the Acquiring Company is the same as it was for the target ie no step up Since the Acquiring Company is buying Target Company shares rather than Target Company assets and liabilities as in an A reorganization the Acquiring Company has Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 32 Benefits of Structure Costs of Structure a basis in Target Company stock The acquiring company s basis in Target Company stock is equal to the basis of that stock in the hands of former Target shareholders This basis is not likely to be the same as carryover basis in Target Company assets and liabilities Nontaxable to Target shareholders Useful when Target Company assets are difficult to transfer The acquirer assumes is eXposed to the liabilities of the target but the eXposure is limited to investment in target since the target is a subsidiary of the acquirer Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 33 3 Section 368a1C reorganization Broadly how a 368 C reorganization works 1 Acquiring Company transfers consideration stock and boot to Target Company in return for which it receives Target Company assets and assumes Target Company liabilities No gain or loss is recognized at the Target Company level 2 Target Company transfers all consideration to Target shareholders in a liquidating distribution After the deal Target Company shareholders are at least to some extent Acquiring Company shareholders This structure is a lot like a 368 A reorganization but it does not have to qualify as a statutory merger It works when some Target shareholders want cash or property up to 20 but some are willing to accept acquiring firm stock 80 One reason Target shareholders might be inclined to accept stock is that they have a large built in capital gain that would be triggered upon sale More detail on 368 C reorganization Consideration At least 80 of acquiring firm stock Stock must be voting preferred or common Nonstock consideration can include assets such as cash or other securities Shareholders who receive boot have to pay taX equal to the lessor of the boot received or the gain realized on the transaction Shareholders who receive acquirer stock will receive substituted basis in the stock of the acquirer equal to their former basis in target stock Shareholders who receive stock and cash will have a basis in acquirer stock equal to their basis in target stock plus the recognized gain on sale less the Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 34 boot received They will also have basis in the boot What is Acquired The assets and liabilities of the target The basis of acquired assets and liabilities to the Acquiring Company is the same as it was for the target ie no step up Benefits of Structure Nontaxable to Target shareholders that accept and hold acquiring firm stock Flexible in terms of consideration Costs of Structure Difficulty in transferring assets such as contracts licenses and permits The acquirer assumes is eXposed to the liabilities of the target Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 35 4 Section 351 reorganization Preface Corporate formation is generally a nontaxable event under Section 3 5 l 351 General rule No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control as defined in section 368 c of the corporation 368c Control defined For purposes of partl other than section m part II this part and part V the term HcontrolH means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation Broadly how a 351 reorganization works 1 The shareholders of the Acquiring Company and the Target Company contribute their shares and the Acquiring Company can also contribute assets such as cash to create a new corporate entity accepting in return shares in the new entity or in the case of Target Company shareholders who want it cash or other assets This structure works best when a majority of the Target shareholders want something other than stock in the acquirer in return for their shares ie when you can t structure the deal to meet the conditions specified under 368 A B or C In particular it s worth noting that Section 351 reorganization can be tailored to meet the objectives of Target shareholders in that it allows for cash consideration as well as multiple classes or stock e g quasisecured preferred stock dividend paying preferred stock residual interest nondividend paying common stock Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 36 More Detail on a 351 reorganization Consideration Benefits of Structure Costs of Structure Stock in the new company or nonstock consideration Stock can be voting or non voting preferred or common Nonstock consideration can include assets such as cash or other securities Shareholders who receive boot have to pay taX equal to the lessor of the boot received or the gain realized on the transaction Shareholders who receive new company stock will take a substituted basis in the stock of the acquirer equal to their former basis in target stock same as with a startup Shareholders who receive stock and cash will have a basis in acquirer stock equal to their basis in target stock plus the recognized gain on sale less the boot received Nontaxable to Target shareholders that accept and hold new company stock Very exible in terms of consideration Have to set up new entity The acquirer assumes is eXposed to the liabilities of the target Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 37 Summary of advantages and disadvantages of various taxfree reorganization structures 368 A reorganizations 0 Flexible in type of stock and level 50 of stock required this exibility can be used to preserve control of acquiring shareholders 0 Must be statutory merger requiring target and acquirer shareholder consent BUT 0 Some assets may not transfer easily 368 B reorganizations 0 Target stock is acquired rather than net assets as in A C and section 351 reorganizations limiting exposure to target liabilities although this can be achieved in triangular A reorganization o No difficulties transferring assets since stock is acquired BUT 0 Consideration has to be 100 voting stock 368 C reorganizations 0 Asset acquisition like an A reorganizations creating exposure to target liabilities and difficulties in transferring assets since stock is acquired 0 Consideration has to be voting stock like B reorganizations but need only account for 80 of total consideration 351 corporate formation 0 Exposure to all liabilities of the target remains 0 Can get the deal done taxfree even if majority of Target shareholders unwilling to accept acquirer stock Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 38 So which are better Taxable or T axfree structures 0 No one structure dominates however understanding the tax implications of the proposed transaction to the Target shareholders as well as to the acquirer and thus by extension acquirer shareholders can help you identify an optimal structure 0 Taxable structures work well 1 when you don t want to issue stock to Target shareholders when Target shareholders have low tax rates if Target shareholder tax rates are zero eg pension fund taxable and taxfree structures are equivalent from the Target shareholders perspective 3 when the incremental benefits from stepping up assets future writeoffs outweighs the incremental costs immediate taxation of gain on assets plus lost future use of NOLs J o Taxfree structures work well 1 when the tax on gain from sale by Target shareholders would be large either because the gain on sale would be large or the tax rate on the gain is large 2 when you want to use pooling of interests accounting not for long So which are better Asset purchases or stock purch uses 0 You buy the stock you get the liabilities 0 You buy assets you may avoid some of the liabilities Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 39 Chapter 15 Taxable Acquisitions of S Corporations Recall from chapter 4 PassThrough Entities The income of passthrough entities aka conduits is not taxed at the entity level Rather it is passed through to the owners and they pay tax Sole Proprietorships Partnerships Scorporations Limited Liability Corporations LLCs Limited Liability Partnerships LLPs While the focus is on S corporations most of the tax issues associated with S corporations translate in a substantially similar manner for other conduit entities Key issues in acquisitions of S corporations 1 What are the tax implications from being acquired for the target S corporation shareholders 2 What are the incremental costs and benefits of stepping up the basis of acquired S corporation assets Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 40 Major types of Taxable Acquisitions of S Corporations 1 Taxable Asset Acquisition followed by Target liquidation o The tax on sale is assessed at the target level even though as in all conduit contexts the owners of the conduit pay the tax 0 The income recognized on the sale may be either ordinary or capital depending on the nature of the assets sold e g if you sell inventory the income is ordinary39 if you sell depreciable property recaptured depreciation is taxable as ordinary income and any income above original basis is capital S corporation shareholder basis is increased by the income they recognize for tax purposes relating to the sale of assets Subsequent distribution of remaining S corporation assets to shareholders does not trigger an additional tax 0 The acquirer gets a steppedup basis in the acquired assets equal to the purchase price 2 Taxable Stock Acquisition NOT followed by a Section 338h10 Election Target shareholder s pay tax at capital gains rate on difference between the purchase price and their basis in S Corporation stock Since it s a stock acquisition difficulties associated with transferring legal claim to assets are avoided The acquirer gets a carryover basis in the acquired assets ie no stepup in basis 3 Taxable Stock Acquisition followed by a Section 338h10 Election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 41 o The 338hlO election results in the transaction being treated as an asset purchase for tax purposes The 338hlO election must be made jointly by the target and the acquirer recall that the 338 election in the context of a taxable C corporation acquisition can be made unilaterally by the acquirer The requirement that the 338 hl 0 election be joint unlike the unilateral Section 338 made in the context of a C corporation acquisition makes sense since the election will have a direct effect on how S corporation shareholders will be taxed the 338 hl 0 election results in tax at ordinary and capital gains rates versus just capital gains rates in the event no election is made Since it s a stock acquisition difficulties associated with transferring legal claim to assets are avoided The tax on the sale is assessed at the target level even though the tax is paid by the owners of the conduit since a 338hlO election is made S Corp shareholders pay only the target level tax there is no additional shareholder level tax since shareholder basis is stepped up as in the asset sale Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 42 Which is the better taX deal stock acquisition with or Without a 338h10 election Basically the issue is this Does the taX benefit to the Acquiring Company from the step up in basis exceed the taX cost that must be paid by the selling S corporation shareholders If the benefit exceeds the cost the Target shareholders and the Acquiring Company have something to negotiate Looking just at returns to Target shareholders we can see that Target shareholders have to be compensated for any additional taX they have to pay as a result of the 338h10 election Aftertax return Purchase Price taX on target level to Target shareholder gain some with a 338h10 ordinary some election capital gains Aftertax return Purchase Price taX on shareholder to Target shareholder level gain all with NO 3 3 8hl 0 capital gains election How much more will the acquirer pay the seller to get the seller to make a 338h10 election Price without a 338h10 election plus the incremental taX benefits from the election these relate to step up in basis Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 43 Problem Company A wants to buy the outstanding shares of Company S an S corporation The following is a profile of the taX characteristics of Company S TaX basis of assets that generate ordinary income 2000 TaX basis of assets that generate capital gains 1000 TaX basis of stock 3000 Life of steppedup ordinary income assets 1 year Life of steppedup capital gains assets 10 years AftertaX discount rate of acquirer 10 Marginal taX rate of acquirer 35 Assume that 23 of the total value of Company S will be allocated to assets that generate ordinary income upon sale and 13 will be allocated to assets that generate capital gains Also assume that shareholders of Company S will pay taX on ordinary income at 35 and taX on capital gains at 15 Company A is willing to pay Company S shareholders 5000 for their shares without any step up in the basis of their assets 1 What is the maximum amount Company A would be willing to pay Company S shareholders if Company S shareholders consent to a 33 8h10 election J What is the minimum amount Company S shareholders would be willing to accept in return for consent to a 338h10 election U Who gets the taX benefits from a 338h10 election the buyer the seller or both Why Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 44 Chapter 17 Tax Planning for Divestitures A primer on basis with respect to subsidiaries 1 Assuming the parent and subsidiary prepare a consolidated tax return parent company basis in the stock and net assets of a subsidiary is increased each time the subsidiary generates taxable income and is decreased each time the subsidiary makes a distribution to the parent The tax position of the parent with respect to the subsidiary is analogous to that of an S corporation shareholder If the subsidiary was developed internally the parent s basis in the stock of the subsidiary is going to be the same as its basis in the net assets of the subsidiary If the subsidiary was purchased in a taxable transaction the parent s basis in the subsidiary s stock will equal the purchase price of the stock adjusted for the parent s interest in subsequent taxable income earned by the subsidiary and distributions made by the subsidiary to the parent Recall that most taxable acquisitions are structured so that the acquirer takes a carryover basis in the assets acquired Stock acquisition not followed by Section 338 election Thus the parent s basis in stock gt basis in assets If the subsidiary was purchased in a nontaxable transaction the parent s basis in the subsidiary s stock will equal the seller s basis adjusted for the parent s interest in subsequent taxable income earned by the subsidiary and distributions made by the subsidiary to the parent In this case also the parent will have taken a carryover basis in the assets acquired and thus the parent s basis in stock likely gt basis in assets Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 45 Subsidiary sales can be structured as either taxable 0r taxfree Taxfree subsidiag sales Selling subsidiary stock in exchange for stock of an Acquiring Company can structured to qualify for taxfree treatment under Section 368 A B or C or Section 351 just like C corporation taxfree transactions A The selling parent takes a substituted basis in acquirer stock equal to their prior basis in subsidiary stock Recognized gain will be equal to the lesser of the realized gain on sale or boot received B The net asset basis of the sold subsidiary carries over as does its tax attributes Section 382 limits use of tax attributes C The acquiring company s basis in the stock of the subsidiary will be the same as it was in the hands of the former parent plus any boot paid Features of taxfree structures A The selling corporation retains an exposure to the sold subsidiary s assets This is likely not a desirable situation Taxable subsidiag sales When selling a subsidiary the parent can 1 Sell the assets of the subsidiary and then dissolve the subsidiary taxfree under Section 332 2 Sell the stock of the subsidiary and then in conjunction with the acquirer make a Section 338h10 election to have the stock sale treated as an asset sale or 3 Sell the stock of the subsidiary and not make a Section 3 3 8h10 election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 46 1 Selling the Assets The selling parent recognizes a gain or loss ordinary or capital depending on the nature of the assets equal to the difference between the sale price and the basis of the net assets sold Gain from sale can be offset by taX attributes of parent or subsidiary Any remaining taX attributes of the subsidiary are passed on to the parent without limitation as to use Loss from sale can be used to offset otherwise taxable income The acquirer takes a basis in the net assets of the subsidiary equal to the purchase price 2 Sell the stock and make a Section 338h10 election you get the tax treatment of an asset sale without the nontaX costs Both buyer and seller have to agree to Section 33 8h10 election The seller has to recognize gain or loss equal to the difference between the purchase price and the basis in the net assets sold Any gain can be offset by the taX attributes of the parent or subsidiary The acquirer takes a basis in the net assets and stock equal to the purchase price 3 Sell the stock and do not make a Section 338h10 election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Selling parent recognizes a capital gain or loss equal to the difference between the purchase price and its basis in the stock of the subsidiary The Acquiring Company gets carryover basis in the net assets of the acquired subsidiary Basis in the acquired subsidiary s stock is equal to the purchase price Subsidiary taX attributes remain with the subsidiary but are limited by Section 382 47 What s the difference in return to the selling parent from electing or not electing 338h10 No 338h10 election P110338 tc P110338 S election P338 to P338 where P110338 Price assuming no 338h10 election P338 Price assuming 338h10 election S Basis in Stock A Basis in Assets t0 corporate taX rate Will the selling parent want more for agreeing to a 338h10 election Assume that the buyer and seller agree upon P110338 Would the seller want more or less than P110338 to make a 338h10 election Setting returns to selling parent equal P338 to P338 A Pno338 to 13110338 S 1H P338tc A 1H Pno338tc S P338 2 13110338 to 139t 0 S39A In a nutshell the seller will want a higher price if the seller s basis in the subsidiary s assets is less than its basis in the stock of the subsidiary This is more likely to be the case when the subsidiary was acquired versus being developed internally If the seller s basis in the stock of the subsidiary is the same as its basis in the net assets of the subsidiary which will be the case if the subsidiary is developed internally then the parent will be indifferent to making or not making a 338h10 election Will the Acquiring Company want a 338h10 election Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 48 It depends on whether P338 P110338 is less than the incremental benefit from stepping up the assets from the 338h10 election Note As the difference between the net asset basis of the subsidiary and the fair market value of the net assets grows the incremental benefit to stepup grows Other T axfree forms of divestiture Equity Carve Outs In an equity carve out the subsidiary sells shares of itself to outsiders The sale of shares generates cash and dilutes the claim of the parent on the subsidiary This sale is not taxable On the books of the subsidiary cash goes up as does stockholder s equity On the parent s consolidated financial statements the ownership interest of the outside shareholders is re ected in Minority Interest Spin Offs In a spinoff a parent issues the stock of a subsidiary to its shareholders effectively freeing the subsidiary from the parent s control 0 As a result of the transaction the parent s shareholders hold shares in two separate entities o The parent s shareholders split their stock basis between the two new firms in proportion to the two new firms fair market value 0 On the consolidated books of the parent the assets and liabilities of the subsidiary go away and retained earnings is reduced as well just like a property dividend Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 49 This transaction is taXfree provided a number of conditions are met including the following 1 Parent distributed a controlling share of stock more than 80 ownership 2 The parent or the divested subsidiary can not be acquired within two years of or two years after the spinoff If either is acquired within two years the spinoff is treated as a property dividend In the case of a property dividend the parent pays a taX on any gain on the distributed property and shareholders pay a taX on the dividend received Splitups In a splitup the parent breaks itself into two separate pieces that continue while the parent itself ceases to eXist Splitups are thus like spinoffs Splitoffs In a splitoff the parent distributes shares in a subsidiary in return for some of the parent s shares In a pro rata splitoff the net result will be the same as a spinoff Tracking Stock A tracking stock is an equity claim created by a parent and distributed to shareholders that provides its holders with a return based on the performance of one of the parent s subsidiaries Unlike a spinoff the parent retains a majority interest Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 50 Taxes and Business Strategy Notes Through MidTerm Spring 2004 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Chapters 1 and 2 The Really Big Picture A few general propositions l Governments exist to serve the interests of the governed They do this primarily by providing goods and services that are not provided in sufficient quantity by markets ie a market failure of some kind has occurred or will occur in the absence of governmental action such as inadequate Defense Social safety net Education Police and Fire protection Public Parks and recreation 0 Note the desired type and amount of government provided goods and services are primary differentiators of individuals with thoughtful allegiances to particular political views J To serve the interests of the governed governments need economic resources U To get economic resources governments tax the governed A Governments can use tax policy to promote discourage socially beneficial wastefulhurtful investments Deductible home mortgage interest Targeted jobs tax credits Research and Development Tax credits Investment Tax credits Carbon emission taxes Refundable deposits U Some common forms of taxation are property taxation the primary means through which funds are generated to provide for elementary and secondary school public education activity taxation e g licenses to drive hunt many fish spew carbon Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 2 dioxide into the air social security taxation which is a capped at tax that is annually greater than the income tax for a majority of Americans and income taxation This course focuses primarily on income taxation though the concepts developed apply broadly to other economic behavior 0 Because the government taxes income it is de facto a third party to income generating transactions taxation affects prices to buyers and profits to sellers 1 Governments typically set down some general rules and some very specific bright line rules on how incomegenerating events and transactions will be taxed and everyone has to go along with them 00 All else equal people want to control as many economic resources as possible I m talking about cash or other assets 0 Let s define economic income as revenue value received for goods and services sold plus the increase in the value of assets held and decrease in the value of liabilities owed less nontax costs less tax costs lOAll else equal when people invest economic resources as opposed to consuming economic resources or simply letting economic resources sit idle they want to maximize their economic return llThe economic return that people want to maximize is AF TER TAX economic return not BEFORE TAX economic return because you don t get to keep the before tax return unless of course there s no tax The notax case is actually a fairly common occurrence If you earn passive income in a tax haven country you may effectively pay no taxes if you do not make much in the way of income you may pay no income taxes though you will likely pay social security taxes if your assets are held in a pension fund no income taxes are paid on returns until you take assets out of the fund 12Maximizing AF TERTAX economic return is where tax planning comes into play Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 3 l3 MaXimizing AF TERTAX economic return is not the same as minimizing taX Specifically incurring costs to reduce taxes greater than the taxes saved would be economically unsound a negative NPV project l4MaXimizing the AF TERTAX economic return of one party to a transaction requires that you consider what s in the best interests of all parties to the transaction aside from the government remember they write the rules so it s assumed that the government can take care of itself l5Note TaX planning is not taX evasion TaX evasion is a crime TaX planning is common sense 16A lot of what passes as taX planning looks a lot like taX evasion in a nutshell the line between the two is not always bright Do Chapter I Assignments What does Tax Planning involve 1 Converting one type of income into another e g ordinary income into capital gains Traditionally capital gains taX rates have been below taX rates on ordinary income This is true for individuals today though not for corporations Specifically for fiscal year 2003 the top marginal ordinary taX rate for individuals will be 35 while the top capital gains taX rate will be 15 this 15 rate will also apply to dividends received by individuals What is the percentage difference between these two taX rates 35 l 5 35 57 As you can see the capital gains taX rates to individuals is 57 LOWER than ordinary taX rates Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 4 Capital gains and losses are equal to the change in value of an asset over time e g the increase in value of a security Examples of ordinary income include wages and bonuses to employees and income from normal operations of a corporation Sometimes the line between what is ordinary income and what is capital gains income is fuzzy 2 Shifting income from one pocket to another eg from a high tax pocket to a low tax pocket Obviously it is better to arrange affairs such that income if it has to be recognized for tax purposes is recognized in the low tax pocket provided of course that you ve got a low tax pocket and if you don t have one maybe you should e g you could create one via an inversion transaction ala Tyco The incentive to create lowtax pockets has been the source of significant disputes in the international trade arena as well as in state taxation of income Specifically firms try to source income in low tax jurisdictions to reduce taxes that have to be paid and source expenses and losses in high tax jurisdictions to reduce taxes that have to be paid Note shifting income from one taxpayer to another is an example of the importance of considering all taxpayers that are party to a particular transaction It is especially important to consider all parties in for example compensation planning estate planning investment transactions eg leasing financing transactions debt versus equity and corporate mergers and acquisitions cash vs stock acquisitions 3 Shifting income from one time period to another eg from the present to the future Absent a change in tax rates this is a straightforward time value of money thing All else equal it s better to pay taxes later than sooner This incentive led many oldline firms with rising inventory input prices to select LIFO inventory valuation Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 5 method despite the fact that this election oftentimes reduces reported earnings Problem General Electric values some domestic inventories using LIFO and reports a LIFO inventory reserve of 606 million as of 123102 this means in a nutshell that the GE has recognized on a pretax basis 606 million less income for taX and financial reporting purposes than it would have had it used FIFO Assume GE faces a marginal taX rate of 35 and has an aftertaX cost of capital of 10 1 What s a ballpark estimate of GE s 2003 aftertaX return from using LIFO 2 What non taX cost if any does GE incur by using LIFO Problem Assume a company faces the following taX rates 2003 35 2004 35 2005 35 2006 and thereafter 40 Also assume that the company has an aftertaX cost of capital of 10 1 If the company has the discretion to recognize 1 of income in either 2005 or 2006 which should it choose Why How much better off will the company be in present value terms as of 2005 J If the company incurs an operating loss for taX purposes in 2006 and has the discretion to carryback the loss to generate a refund equal to the taX paid on 1 of income in 2005 or carryover the loss to offset income eXpected to be earned in 2007 which should it choose Why How much better off will the company be in present value terms as of 2006 What risk if any lies in the choice Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Do Chapter 2 Assignments Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Nobel Winner Stiglitz Says Deals At LTCM Had No Economic Value39 By Kara Scannell 501 words 18 July 2003 The Wall Street Journal C14 EngHsh Copyright c 2003 Dow Jones amp Company Inc Corrections amp Amplifications JOSEPH E STIGLITZ is a former chief economist for the World Bank An article in Friday39s Money amp Investing section incorrectly said he had worked for the International Monetary Fund WSJ July 212003 NEW HAVEN Conn In the battle of the Nobel Prize winners in federal court here to determine the legality of a tax shelter Nobel laureate Joseph E Stiglitz didn39t pull any punches Mr Stiglitz who won the Nobel Memorial Prize in Economic Science in 2001 testified that the transactions LongTerm Capital Management39s partners relied on to create tax deductions on 100 million had quotno economic valuequot LTCM39s lawyers swung back to challenge Mr Stiglitz39s credibility Mr Stiglitz39s testimony comes toward the end of a monthlong trial before Judge Janet Bond Arterton For a tax shelter to be considered legal it must have economic substance or a business purpose for entering into it other than to avoid taxes and a chance for profit The trial also highlights the federal government39s continued efforts to crack down on tax shelters the executives who use them and the banks accounting firms and lawyers who recommend them LTCM sued the government in 2001 after the Internal Revenue Service disallowed 106 million in losses claimed by the hedge fund39s partners on their 1997 federal incometax returns Federal authorities alleged that the losses were based on sham transactions LTCM is seeking the portion of the taxes already paid while the government is asking for penalties and interest Mr Stiglitz a former chief economist for the International Monetary Fund who has attracted controversy for his criticism of global capitalism and stockmarket abuses testified on behalf of the government that after studying the structure parties involved incentives and guarantees of the underlying leasing transactions quotIt made no sensequot He said it was quotpeculiarquot to see a flow of money that quotshowed no useful purposequot On crossexamination LTCM39s lawyer David Curtin of the Washington DC firm McKee Nelson LLP suggested that Mr Stiglitz was biased against LTCM citing his latest book and other writings and a speech to a division of the United Nations in which Mr Stiglitz discussed quotcrony capitalismll including LTCM39s 1998 bailout Mr Stiglitz said he was discussing the public debate and wasn39t taking a position on it quotIt was part of the scene in 1998 You can39t write about the scene without commenting onquot LTCM he said Bond arbitrageur John Meriwether founded LTCM in 1993 with a cadre of Nobel Prize winners including Myron S Scholes and Robert C Merton both of whom have testified on behalf of the hedge fund in this case The fund39s nearcollapse in 1998 after massive losses sparked y t e Russian currency crisis wreaked havoc on global financial markets culminating in an unprecedented 365 billion bailout orchestrated by the Federal Reserve Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 8 Chapter 3 Alternative Savings Vehicles Overview The purpose behind reviewing the effect of alternative taxation of income ordinary income vs capital gains income vs tax exempt income annual taxation vs deferred taxation deductible investments versus nondeductible investments is threefold highlight the importance of income characterization highlight the power of compounding pretax versus aftertax returns and introduce the basic algebra for the course Jp A U As an aside Individual Rates for 2003 1 Top ordinary rates 35 Top shortterm capital gains rates 35 Top longterm capital gains rates 15 long term rate generally applies to assets held more than 12 months Corporate Rates Top ordinary rates 35 Top shortterm capital gains rates 35 Top longterm capital gains rates 35 We re going to identify and discuss six types of savings vehicles SVs on the next six pages M Don t get too worked up by the algebra you don t have to memorize anything focus on understanding the intuition imbedded in the algebra really l mean this especially for those of you who don t much like mat Note that the math fits nicely into a cheap calculator that can do present values and has a memory function As a practical matter you will want to be able to solve numerical problems with your calculator I will use a Texas Instruments BA35 Solar in class If you use this particular calculator I can help you with present value calculations if you use another calculator you re on your own Note that practice makes perfect It will Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 9 likely help a lot for you to do problems visceral learning is a real thing here Also note that I think there is absolutely no excuse for not mastering the functioning of a simple handheld calculator Savings Vehicles Taxation Examples SVl Ordinary Income Annual Taxation Wages Bonus Interest income Return to sv1 1 1 R1t where I initial investment R pretax return tax rate on ordinary income each year n compounding periods Problem An individual invests 1000 in a partnership All partnership income is taxable to partners annually partnerships are referred to as passthrough or conduit entities because of this feature Assume the partnership generates a pretax return of 10 for 3 30 years all returns are reinvested and the individual faces a 35 annual tax rate What will the partnership stake be worth in 3 30 years What is the annualized rate of return A general procedure for calculating an annualized rate of return is to use a calculator and input the present value the 1000 investment here the value available at the end of the investment period as the future value of periods covered by the investment 3 and 30 periods in this problem and solve for i the interest rate or rate of return Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 10 Savings Vehicles SV2 Ordinary Income Return to SV2 where I Problem Taxation Examples Deferred Taxation Returns from foreign subsidiaries Nondeductible IRAs Return of interest on life insurance proceeds 1 1 Rn 1t It initial investment pretax return tax rate on ordinary income after n periods compounding periods An individual invests 1000 in a nondeductible IRA All returns are exempt from taxation until withdrawn The IRA invests in fully taxable corporate bonds that yield 10 for 3 30 years Assume that the individual withdraws all of the IRA s assets at the end of 3 30 years and at that point pays tax on the returns at a 35 tax rate 0 How much would the individual have at that point 0 What is the annualized rate of return SVl vs SV2 So long as tax rates do not go up returns to SV2 will always dominate ie be higher than returns to SVl Also dominance is growing in the pretax rate of return R since the relative value of SV2 over SVl is a function of compounding the pretax return on investment sometimes referred to as the inside return vs the aftertax return on investment Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 1 l Savings Vehicles SV3 Capital Gains Return to SV3 where 1 asquot 7 8V3 vs SVl Taxation Annual Taxation 1 1Rlt1tcggtquot initial investment pretax return tax rate on capital gains compounding periods Examples Dividend income Same as SVl except tax rate is capital gains rate versus ordinary rate So long as capital gains rates are lower than ordinary rates SV3 will always dominate SVl 8V3 vs SV2 Which is better depends on the value of the deferral of ordinary taxation in SV2 which depends in part on the rate of return versus the value of lower capital gains treatment in SV3 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 12 Problem Mr BornLucky had a diversified stock portfolio comprised largely of dividend paying stocks This portfolio had been assembled by the executor of his mom s estate His mom had started a business in 1960 Upon her death on 112010 Mr BornLucky inherited all of the stock in his mom s company The executor of his mom s estate sold off the stock in his mom s company and used the proceeds to construct the diversified stock portfolio currently held by Mr BornLucky Some pertinent facts include the following o The value of his mom s stock at the time of her death was 100 million His mom s basis in the stock of her company was 0 The step up in basis of his mom s stock within her estate was 0 upon her death 0 The estate tax had been successfully repealed by congress in 2003 Prior to the repeal assume that the estate tax was exactly equal to 50 on all estate value in excess of 20 million As well the basis for determination of gains and losses of all assets remaining in the estate and transferred to beneficiaries was equal to the fair market value of the time of death of the decedent 0 Capital gains tax on the sale of mom s stock prior to the creation of the diversified stock portfolio was 15 o The annual pretax dividend yield on Mr BornLucky s stock portfolio was 5 Assume that all dividends are taxed at 15 Also assume that prior to 2003 the tax rate on dividends was 35 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 13 1 What was the value of the stock portfolio Mr Lucky inherited under the new rules What would Mr Lucky s annual income be assuming the value of the stock portfolio and the dividend rate remains 15 2 What would have been the value of the stock portfolio Mr Lucky inherited under the old rules What would Mr Lucky s annual income be assuming the value of the stock portfolio and the dividend rate was 35 3 Do you think the estate taX rules should have been changed Why Estate tax Tax Needs Reform But Repeal Would be a Giveaway to the Wealthy Spartanburg HeraldJournal July 27 2003 William G Gale Senior Fellow Economic Studies The estate tax plays an important role in our economy and society It does have flaws but it should be improved not abolished A sensible reform would bolster the strengths of the estate tax and reduce the problems The estate tax has numerous strengths It is by far the most progressive source of federal revenue Despite the perception that advocates of repeal have created the vast majority of estates are not subject to the estate tax Only 2 percent of deaths result in any estate payments at all About half of all estate taxes are paid by the wealthiest 1 out of every 1000 estates By 2009 couples with less than 7 million in wealth will pay nothing at all Repeal would be a massive giveaway to the nation39s wealthiest dynasties The estate tax helps close what otherwise would be gaping loopholes in the income tax with respect to capital gains and other items Repeal would create sheltering schemes that would drain massive amounts of income tax revenue from federal coffers The tax also helps support the nonprofit sector by providing incentives to give to charities at precisely the time when people are distributing large amounts of wealth My own research indicates that repeal would reduce charitable giving at death and during life by about 10 billion per year This represents 5 percent of all charitable giving and is equivalent to the annual grant making ofthe nation39s 100 largest foundations The estate tax helps provide equal opportunity by reducing the size of massive inheritances It is hard to see why children ofthe rich should be allowed to inherit scads of money taxfree when other forms of income are taxed Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 14 Opponents claim the tax raises very little revenue But estate taxes were slated to raise about 400 billion over the next decade before being slashed in 2001 Let39s put it another way Retaining the estate tax rather than repealing it would pay for half of the entire Social Security shortfall over the next 75 years The alleged negatives of the tax have been grossly overstated The vast majority of small businesses are too small to ever face the estate tax Half of them go out of business within four years so claims that the estate tax is a major cause of the breakup of family businesses simply are wrong Likewise two major farm organizations were unable to point to a single family farm that had to be broken up due to the estate tax Even if the tax were a serious problem for small businesses and farmers those assets constitute less than 15 percent of all wealth subject to the estate tax Special provisions already allow family owned businesses and farms to shelter two to three times as much as others can and could be expanded You don39t need to repeal the estate tax to save the family business or farm The impact ofthe tax on wealth accumulation is unproven But the impact of large inheritances on the behavior of recipients is quite clear lnheriting a large estate causes people to work less and spend more Those effects clearly reduce economic growth The hysteria in labeling it the quotdeath taxquot also is misplaced About 98 percent of people who die receive a quotdeath subsidyquot their taxes on accumulated capital gains are forgiven but they don39t pay estate taxes Furthermore the estate tax need not actually be paid at the time of death It can be prepaid with prudent estate planning devices such as life insurance and for small businesses and farms the payments can be stretched out over many years The easiest way to see that all the braying over the unfairness of taxing at the time of death is a red herring is to note that no one who objects to taxes at the time of death ever proposes equally progressive taxes imposed during life All taxes impose burdens and the estate tax is no exception The bigger question is whetherthe burden per dollar raised from a tax on someone who inherits millions of dollars is more or less than the burden of what will result if the estate tax is eliminated higher taxes on working families less generous Medicare payments or some other unspecified alternative All budgetary decisions reflect priorities and eliminating the estate tax should be a lower priority than these and other claims on the national pocketbook For all of these reasons abolishing the tax is a bad idea After all a tax that is progressive closes loopholes provides equality of opportunity and encourages charitable giving can39t be all bad It should be saved and enhanced reformed to emphasize its virtues and minimize its costs This could be done by closing loopholes reducing rates modestly indexing the tax for inflation and letting the exemption rise as scheduled This would focus the tax on the truly wealthy and at the same time make it simpler and fairer Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 15 Savings Vehicles SV4 Capital Gains Return to SV4 where 1 SV4 vs SV2 SV4 vs 8V3 Taxation Examples Deferred Taxation NondiVidend paying Stock you make your money through capital appreciation and pay tax at capital gains rate upon sale of stock 1 1 Rn ltcg 1tcg Same as SV2 except tax rate initial investment pretax return tax rate on capital gains compounding periods The returns on SV4 are the same as SV2 if the capital gains rates are the same as ordinary income rates 8891 SV4 always dominates SV3 unless the capital gains rate equals 0 or there s only one compounding period Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 16 Savings Vehicles Taxation Examples SV5 Exempt Never taxable returns to 529 plans where proceeds are used to pay qualified education expenses life insurance proceeds some municipal securities Payouts from Roth IRAs Return to SV5 1 1 R n Same as SVlSV4 when tax equals zero where 1 initial investment R pretax return n compounding periods Problem A grandparent wants to put aside 50000 in a 529 plan on 1104 to fund the college education of a grandchild The grandparent anticipates that the grandchild will be starting college on 9111 and attend for 4 years Assuming that all withdrawals from the 529 plan will be for qualified expenses they will not be taxable Assume the grandchild is going to withdraw 4 equal amounts from the 529 plan starting 9111 Assume that the grandparent s tax rate is 35 1 If the 529 plan earns a pretax rate of return of 10 how much will be available for withdrawal each year on 9 1201 12014 N Had the grandparent simply invested the 50000 in a passbook saving account that yielded a pretax rate of return of 10 how much would have been available for withdrawal each year on 9120112014 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 17 Savings Vehicles SV6 Ordinary Contribution deductible Return to SV6 Taxation Examples Deferred Taxation company sponsored pension plans 401 k plans Deductible IRAs 1 1to 1 R n 1tf Note 1 1to is equal to the pretax investment where 1 R to tr Note 1 Note 2 initial investment pretax return tax rate of contributor at time of contribution tax rate on ordinary income of the recipient when funds withdrawn Note income related to funds withdrawn from a retirement plan does not retain its character e g tax exempt ordinary capital gains it s all ordinary income when it comes out compounding periods if 1t0 and 1tf cancel out in the return to SV6 you re left with 1 1 R n the same return to tax exempt investment SVS the equivalence of SVS and SV6 breaks down if the tax rate in effect at the time the contribution is made to new differs from the tax rate pensioners pay tf future when they receive pension payouts 1f t0gt tf then pension returns will be greater than returns to tax exempt savings The intuition is that the higher the current tax rate the higher the government contribution in the form of a tax deduction to the pension plan if tax rates were 100 contributing to a pension plan would be the same as paying your taxes ie pension contributions would generate tax credits Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 18 Problem An individual invests 1000 in a nontaxable zerocoupon 30 year municipal bond yielding 10 annual rate of return At the same time the individual contributes in the form of foregone compensation pretax compensation of 1000 l35 to a company sponsored pension plan The individual s current tax rate is 35 A zerocoupon bond does not make cash payments at set intervals like ordinary straight bonds Rather a zerocoupon bond increases in value over time Thus for a taxexempt zero coupon bond there are two cash ows the initial investment and the ultimate repayment With respect to taxable zero coupon bonds the investor has to pay tax on the scheduled annual accretion in value even though the investor does not receive cash 1 How much will the municipal bond be worth at the end of 30 years 2 How much can the individual withdraw from the pension plan at the end of 30 years assuming that all income is taxable on withdrawal at a tax rate of 25 3 How much can the individual withdraw from the pension plan at the end of 30 years assuming that all income is taxable on withdrawal at a tax rate of 35 4 How much can the individual withdraw from the pension plan at the end of 30 years assuming that all income is taxable on withdrawal at a tax rate of 45 It is very important to note that investors will compete for the favorable tax treatment accorded investments in SV2SV6 This competition will drive down the pretax rates of return to these different investment vehicles potentially leaving the aftertax returns available across the different vehicles ie the aftertax returns available on municipal securities fully taxable bonds returns to nondividend paying stock and returns to foreign subsidiaries might all be pretty close In fact if aftertax returns are not equal across alternative vehicles arbitrage opportunities may exist Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 19 Say you have 100000 of taxable income all of which is subject to a tax rate of 35 You can borrow money at a pretax rate of 10 and deduct interest expense from taxable income You can purchase tax exempt municipal securities that yield 75 Note there are limits on the extent to which you can borrow cash deduct interest associated with the borrowing and invest in taxexempt securities Problem How much money do you want to borrow What will you do with the money you borrow How much better off will you be on a percentage basis a b c D0 Chapter 3 Assignments for next class Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 20 Chapters 8 and 9 Compensation Flaming Forms of compensation Taxed to employees Taxed to Employers Nontaxable fringe bene ts no immediate deduction Nontaxable fringe benefits include employer paid life and health insurance really good coffee free soda employer sponsored parties really good office location space furniture health and dental coverage groupterm life insurance etc A critical issue for employers is do employees get a big enough bang out of these benefits to forgo salary For a given dollar of expenditure the employee gets to keep the entire 1 worth if it s nontaxable and only 1 1tp if it s taxable Obviously as employee tax rates increase fringe benefits look better and better It appears that really sophisticated human resource departments are beginning to provide employees with a suite of compensation choices that involves trading off nontaxable fringe benefits with taxable compensation Pensions deferred ordinary income when received immediate deduction Recall pensions are identified as savings vehicles 6 The employer gets to take a deduction when contributing to a qualified pension plan and the employee is not taxed until he or she withdraws the money perhaps well into the future Pensions get better if current employer tax rates are higher than anticipated future rates a measure of the government s subsidy and if current employee tax rates are higher than anticipated future rates better to pay taxes when the rates are low Incentive stock options ISO deferred capital gains when stock sold no deduction ISOs grant employees the right to purchase shares at a specified strike price Important conditions for ISO treatment include 1 Mandatory one year holding period after exercise 2 Mandatory holding period of 2 years after date of grant 3 Limit of 100000 in stock value peremployee peryear Since firms don t get a tax deduction ISOs are going to look better to firms with low tax rates eg startups and they re going to look better the longer the anticipated holding period eg if you hold until death you get to avoid all income taxation And if there s no estate tax the income may never be taxed It is important to note that most firms that grant ISOs never report compensation expense associated with them for financial reporting purposes Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 21 Deferred compensation deferred ordinary income when received deferred deduction Basically the employer and employee enter into a plan prior to service that specifies that a portion of compensation will be deferred Unlike pensions deferred compensation gets better if current employer tax rates are lower than anticipated future rates As with pensions deferred compensation is more attractive if anticipated future employee tax rates are less than current employee tax rates Nonquali ed Stock Options deferred ordinary income deferred deduction when options exercised capital gains on subsequent appreciation These are the big boys and girls of stock options Basically the same kind of deal as lSOs without the ISO limits ie they grant employees the right to purchase shares at a specified strike price The big difference is in how the taxes play out Firms with high tax rates can take advantage of a deduction equal to the difference between the strike price and the market price at exercise Note exercising employees have to declare ordinary income at the point of exercise t0 avoid paying tax they ve got to give away the shares It is important to note that most firms that grant NQOs never report compensation expense associated with them for financial reporting purposes Similar to returns associated with lSO s the increase in value of stock acquired via NQOs is not taxed unless sold If not sold prior to death no income tax is paid on the appreciation If there were no estate tax the appreciation in value may never be taxed Stock Appreciation Rights deferred ordinary when exercised deferred deduction Stock appreciation rights SARs are like stock options in that they enable the employee to receive the increase in stock value from some specified level When the compensation is paid to employees it is tax deductible to the employer and taxable to the employee With SARs however the employee does not buy the underlying stock Rather the employee is given the cash equivalent It is important to note that firms that grant SARs have to record compensation expense each period equal to the increase or decrease in the value of the claim of the SARs holders for financial reporting purposes It is generally suspected that having to report compensation expense on the income statement makes SARs far less desirable than ISOs and NQOs It is my personal and frankly fervent hope that the accounting for NQOs goes the way of SARs it basically makes the Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 22 value transfers associated with stock options from existing shareholders to option the holders transparent Cash salary and bonus immediately ordinary income immediate deduction The beauty of a cash salary is that it gives you cash and you need cash to buy stuff Also if you have cash you don t need to borrow cash Compensation in excess of 1 000000 that is not tied to a structured performance plan is subject to disallowance as a deduction at the corporate level Section l62m Any company that allows such a disallowance is probably led by a group of dolts Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 23 Which form of compensation is best In general it depends on what the employee values wants needs For example an employee may value nontaxable fringe benefits highly Problem Say an employee really wants a great ergonomically sophisticated though not medically required and thus not a deductible medical expense to the employee chair that costs 2000 Assume that the employee pays tax on all income earned at a rate of 35 Also assume that the employee s employer pays tax at a rate of 35 and can deduct immediately all money spent to purchase chairs for employees 1 How much money pretax does the employee need to make to get the money needed to purchase the chair 2 What is the employer s aftertax cost of paying the employee the amount identified in 1 3 What is the employer s aftertax cost of buying the chair for the employee 4 What should the employer and employee do As an aside if you re selfemployed and you re outfitting your office you might be able to get the same chair for as little as 20001t or 1300 for a taxpayer with a marginal rate of 35 I m assuming you can invoke Section 179 which allows for the immediate writeoff of up to 100000 of otherwise depreciable assets in 2003 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 24 Speci c Comparisons of Alternative forms of Compensation Salary vs Deferred Compensation Current Compensation Cost of 1 current salary to an employer is 1 1 tco where tco is equal to the current corporate taX rate Deferred Compensation Assume that the employer can invest money not paid out as aftertax current compensation 11tco and earn an aftertax rate rm for n periods The amount available to pay the employee at the end of n periods will equal 1 1tco 1 rmn Now let s say m is the actual amount of pretax deferred compensation the employer has to pay the employee at the end of n periods to make the employee indi erent to a 1 of current compensation and DC The aftertax cost of DC to the employer is DC1tcn where tan is the employer s taX rate in period n Decision rule If DC1tcn lt 11tco 1 rmn What you ve got to pay lt What you ll have then deferred compensation preferred Question What s the intuition of the decision rule Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 25 How do we nd DC the amount that has to be paid to employees after n periods to make employees indi erent between current and deferred compensation Note the following Aftertax bene t of 1 of current salary to employee lltpo Aftertax accumulation at the end of period 11 lltpo 1 rpnn where tpO employee s taX rate when compensation is deferred tpn employee s taX rate when deferred compensation is paid rpn aftertax rate of return the employee can earn investing compensation n number of periods compensation is deferred Decision rule Recall from the previous page DC1tcn lt 11tco 1 rmn Setting equal and dividing both sides by 1 tcn you get pretax deferred compensation that can be paid to the employee DC 1 ronn 39tco 39tcn If DC 1411 104130 1rn a ertax FC to employee a ertax return to employee from investing current salary then employee will be indifferent If DC1t n gt 104130 1r n a ertax FC to employee a ertax return to employee from investing current salary then deferred compensation preferred Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 26 A few observations Deferred compensation looks better when Corporate after taX rates of return get higher during the deferral period Corporate taX rates go up from the start of the deferral period to the end of the deferral period when actual payment is made Individual aftertaX rates of return go down during the deferral period Individual taX rates go down from the start of the deferral period to the end of the deferral period when actual payment is made Problem What is the profile of an employee who wants current compensation What is the profile of an employee who wants deferred compensation Problem A corporation is indifferent between paying an employee 100000 on 123103 when its taX rate is 263 or 113385 on 123105 when it anticipates a taX rate of 35 What is the corporation s annualized aftertaX rate of return Problem An employee is indifferent between accepting 100000 on 123103 and 150000 on 123106 The employee has a taX rate of 35 on 123103 and anticipates a taX rate of 25 on 123106 What is the employee s eXpected annualized after taX rate of return Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 27 Salary vs De ned Contribution Pension Compensation eg 401 c First recognize that since contributions to a qualified pension fund are taX deductible to the employer the employer is indifferent to paying employees currently or making pension contributions From an employee s standpoint all money invested in pension plans on his or her behalf accumulates returns taX free until withdrawn At that point the employee has to pay taX at ordinary rates without regard to the character of the income earned within the pension fund Thus the future value of 1 contributed to a pension plan is 1 1 Rpenn 1 tpn where RPen pretax return on assets held in the pension fund n number of periods funds are held in pension fund tpn employee s taX rate when funds are withdrawn from the fund The future value of 1 of current compensation 1 1 tp0 1 rpnn where tp0 employee s current taX rate on ordinary income rpn annualized aftertax rate of return available to the employee n number of periods funds are held in pension fund When is pension compensation preferred Whenever 1 1 Rpenn 1 tpn gt 1 1 tp0 1 rpnn Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 28 Problem Who prefers pension compensation Why Who prefers to be paid currently in cash Why Problem Assume Joe can choose to receive 10000 in cash or a 10000 contribution to a qualified pension plan In either case Joe can invest the compensation in assets that generate an annual pre taX return of 15 for 30 years At the end of 30 years Joe will take all the monies accumulated pay all necessary taxes if any and purchase a first class ticket on a cruise around the world 1 If Joe has a taX rate of 0 currently and anticipates a taX rate of 0 in 30 years should Joe take the cash and invest or invest via the pension plan J If Joe has a taX rate of 35 currently and anticipates a taX rate of 35 in 30 years should Joe take the cash and invest or invest via the pension plan U If Joe has a taX rate of 35 currently and anticipates a taX rate of 15 in 30 years should Joe take the cash and invest or invest via the pension plan A If Joe has a taX rate of 35 currently and anticipates a taX rate of 50 in 30 years should Joe take the cash and invest or invest via the pension plan Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 29 PostRetirement Compensation There are two primary forms of postretirement compensation l Pension Plan compensation 2 Health and Life Insurance coverage Contributions to qualified pension plan trust funds are taXdeductible while contributions to trusts set up to service retiree s postemployment insurance coverage are generally not taX deductible Assuming that a firm wants to compensate its employees in part by promising to cover post retirement medical coverage how should the firm accomplish this objective Question Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Alternative Stock Based Compensation Plans SOs vs NQOs Incentive Stock Options lSOs o no tax deduction for the employer 0 taxable to employees when sold at capital gains tax rate Non Qualified Stock Options NQO 0 tax deduction to employer equal to market price less exercise price at point of exercise 0 taxable to employee at ordinary rates when exercised Taxable income equal to market price less exercise price at point of exercise additional tax to employee at capital gains rates when sold Employee basis in stock equal to the market price at acquisition Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 31 To make an employee indifferent between ISOs and NQOs the employer will have to compensate the employee for the present value of the additional tax the employee is going to have to pay on NQOs ISO taxation NQO taxation PaPong PSPats PaPop PSPang where Pg Strike price Pe Market Price on day of exercise PS Price at which employee sells stock tcg capital gains tax rate tp tax rate on ordinary income The additional tax the employee will have to pay if he receives NQOs rather than lSOs is equal to Additional Tax PSPg tp tcg What it boils down to is this With both ISOs and NQOs the employee is going to have to pay tax at capital gains tax rates on the appreciation between the date of exercise and the ultimate sale of the stock With NQOs the employee is going to pay tax at ordinary tax rates on the appreciation between the date of grant and the date of exercise With lSOs the employee is going to pay tax at capital gains rates on that same appreciation and moreover will get to defer that tax payment for n periods where n equals the number of periods between exercise and ultimate sale Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 32 What this means is that the relevant tag is tcg discounted to present value ie tag1r where n equals the number of periods between exercise of the option and sale of the stock and r is a discount rate To make the employee whole the employer has to give the employee the additional tax that will be due because the option is a NQO versus an ISO Since any additional compensation will be taxable the employer has to gross up the additional payment by taxes that will be due Note this amount too is tax deductible to the employer Pe39Pg tp 39 tcg 139 tp So when will employers prefer NQOs to ISOs Tax benefit to corporation at exercise PaPgtc 1 Less aftertax additional payment to employee PSPg tp toga l tp l tc 2 If equation 1 less equation 2 is greater than zero employers will prefer NQOs to lSOs Simplifying the equation 1 2 gt 0 you get to gt tr 39 tcg 139 tcg NQOs better than lSOs What s it all mean 1 The higher the corporate tax rate tc the more attractive NQOs Recall that firms with NOLs oftentimes startups have relatively low tax rates and thus are more likely to prefer to issue lSOs rather than NQOs The higher the incremental tax to the employee tp tag the less attractive NQOs will be If ordinary income tax rates and capital gains tax rates are the same and the employee ips the stock as soon as the options are exercised there will be no incremental tax As capital gains rates decline relative to ordinary rates and as the J Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 33 expected holding period for the stock n used to calculate tag increases lSOs begin to look better and better When should an employee exercise a NQO most have a termination date Factors to consider 1 Need cash to live large 2 Expectations regarding future of value of stock future ordinary tax rates and future capital gains tax rates Basic choice 1 Exercise now and pay tax currently at ordinary tax rates and later at capital gains tax rates OR 2 Exercise later and pay tax at ordinary tax rates Tax implications of choice 1 Tax implications of choice 2 Pe39Pgtp Ps39Petcg Ps39PgtP which is equal to Pe39Pgtp Ps39Petcg Pe39Pgtp Ps39Petp Note indicates the present value of tax rate ie tag and t1 are tcg and tp discounted for the n periods between the exercise of the stock option and the ultimate sale of the optioned security ie tcglr Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 34 So when is choice 1 going to be preferred When you expect significant price appreciation in the future You exercise the option quickly take the ordinary tax rate hit but start the clock started on lower capital gains tax rates 15 versus 35 If you re not confident in the stock you don t want to do this Specifically if you exercise pay tax at ordinary rates and the stock price falls you ve got a capital loss on your hands that you can t use to offset ordinary income above a 3000 annual limit While the capital loss is available to offset capital gains these are taxed at preferred rates so the benefit is limited Important note if you re not confident in the stock but your options are in the money and there are no holding restrictions on selling stock or on short selling exercise and dump the stock sell it or short it Either way you can lock in your gain How do NQOs get accounted for on company nancial statements When an employee exercises a nonqualified option the employee pays the company the exercise price and the company gives the employee the stock At that point the employee has ordinary income equal to the difference between the market price of the stock and the option price multiplied by the number of options The issuing company in turn has a tax deduction think compensation expense of the same amount So from the company s standpoint two things happen when NQOs are exercised the following facts are used 1000 options exercised 10 exercise price 55 market price corporate tax rate of 35 1 Cash is received and stock is issued On the Balance Sheet the following occurs Assets Liabilities Equity Cash 10000 Paid in Capital 10000 On the Statement of Cash Flows the following would be reported Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 35 Cash from Financing Cash received from option exercises 10000 2 A tax benefit is realized On the Balance Sheet the following occurs Assets Liabilities Equity Taxes Payable 15750 Paid in Capital 15750 On the Statement of Cash Flows the following would be reported Cash from Operations Tax Benefit from option exercises 15750 U Items affecting Paid in Capital would also be disclosed on the Statement of Stockholders Equity the little discussed fourth major financial statement As a practical matter when you want to see the economic effect of option actiVity you re often better off going to the Statement of Stockholders Equity than to the Balance Sheet or the Statement of Cash Flows Problem Approximately how much cash did INTEL collect in 2000 2002 relating to the exercise of stock options What was the tax benefit from the exercise of these options D0 Chapter 8 and 9 assignments for next class Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 36 Chapter 4 Optimal Organizational Form Alternative Organizational Forms PassThrough Entities C Corporations The income of these organizations is not taxed at the entity level Rather it is passed through to the owners and they pay tax or enjoy the tax benefits So income of passthrough entities taxes only once Sole Proprietorships Partnerships Scorporations Limited Liability Corporations LLCs Limited Liability Partnerships LLPs Nontax considerations i ownership may not be readily marketable i case law not really well developed in some instances e g LLPs iii somebody has to be personally liability C corporations pay an entity level tax Shareholders of C corporations pay second tax on dividends at capital gains tax rates in 2003 and beyond for now Shareholders also pay a tax on any appreciation in value capital gains Taxation at the entity level and then again at the shareholder level is referred to as double taxation Nontax considerations i ownership readily marketable ii well established case law iii corporate liability shield Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 37 A nonsequitor Double taxation of income occurs a lot eg an income tax is assessed to earned income the same previously taxed income is assessed a social security tax below a threshold when taken to a store the same previously taxed income will be used to pay sales tax if an automobile is purchased the same previously taxed income will be used to pay an annual excise tax if a house is purchased the same previously taxed income will be used to pay an annual property tax We can all take comfort however in that some instances of double taxation are being addressed For example the effort to repeal the estate tax that brutalizes the beneficiaries of estates of deceased that have values in excess of several millions of dollars appears to have significant support among a majority of people This is somewhat surprising since less than 2 of the population is affected by the estate tax My guess is that a great many people are simply motivated by a sense of fair play and a desire to keep wealth concentrated in the hands of those few who apparently can handle the responsibility of wealth Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 38 Comparing returns to passthough entities to those of nonpassthrough entities Partner return equals 1 1R ltpn l where 1 initial investment R pretax return tp partner s taX rate n compounding periods gThis is just like SVl 1 Corporate return assuming no dividends equals 1 1R ltcn Less the taX on shareholders tog 1 1R ltcn tcg 1 which simplifies to 1 1R ltc ltcg 1th 2 where 1 initial investment R pretax return t0 corporation s taX rate tcg shareholder s capital gains taX rate n compounding periods gThis is just like SV2 1 When should you invest in a partnership 1 1R 1n gt 1 1R139tcn139tcg Itcg 3 When should you invest in a corporation 1 1Rlt1tpgt lt 1 1Rlt1tcgt lt1tcggt 1th 4 In a nutshell optimal organizational form from a taX standpoint depends on the personal taX rate tp the corporate taX rate to the capital gains taX rate tag the rate of return earned on investments R and the number of compounding periods n Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 39 Consider the following 1 If m 6 U97 9 U the personal taX rate equals the corporate rate which it does for individuals and corporations at top of the rate structure and there is no capital gains taX THEN returns to partnerships and corporations will be equal An aside by reducing top marginal taX rates of individuals while not changing the top marginal taX rate of corporations the 2003 taX act made partnerships a more attractive organizational form from a taX standpoint the personal taX rate equals the corporate rate as it does today and there is a positive capital gains taX THEN returns to partnerships exceed those to corporations Some nontaX benefits associated with corporations must eXist for corporations to be preferred to partnerships Such advantages might include more ready access to equity and debt markets liability protection and ease of contracting the personal taX rate is greater than corporate rate which used to be the case and there is no capital gains taX THEN returns to corporations will exceed those to partnerships Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 40 More on Partnerships versus C corporations It may be preferable to organize startups as passthrough entities e g partnerships S corporations so that early losses can be used to offset otherwise taxable income These passthroughs can then be converted to C corporations to take advantage of C corporation advantages provided there are some Do Chapter 4 assignments for next class Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 41 Chapter 5 Implicit Taxes Okay this may get a little weird for some of you Please read slowly An implicit tax is equal to the reduction in an asset s pretax return relative to a benchmark asset s return e g fully taxable corporate bonds Think of implicit taxes as the reduction in pretax returns an investor is willing to accept to get preferential tax treatment Taxpayers with relatively low tax rates e g people with low levels of income firms with net operating loss carryovers pension funds form natural clienteles for assets with high explicit taxes aka taxdisfavored assets see chart below Alternatively taxpayers with relatively high tax rates e g highly compensated graduate business students corporations that pay tax at the top corporate rate form natural clienteles for assets with high implicit tax rates aka taxfavored assets again see chart below Taxfavored Taxdisfavored Municipal bonds Junk Bonds Interest not taxable All interest taxable but junk status indicates that some of the interest is actually a return of principal so you really get taxed on both interest and return of capital in a sense Depreciable assets Shortlived Goodwill Accelerated depreciation Goodwill is generally nontax faster than the decline in deductible in no event is economic value provides goodwill written off quicker a tax subsidy for investment than 15 years even if economic value declines faster Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 42 Research and development costs RampD and Advertising costs are written off immediately without regard to economic value created Dividends paid to individuals Dividends are now taxed at capital Gains tax rates versus ordinary tax rates as they were in the past Investments in human capital HR development costs are written off immediately without regard to economic value created Investments that allow deferral of tax on increases in value nondividend paying stock earnings generated in lowtax foreign countries Gains in value of nondividend Special tax assessments windfall profits for natural resource firms Sometimes profit from particular forms of economic activity get taxed at a higher rate than regular activity e g excess profits taxes that applied to petroleum related companies Other Postemployment Benefits Other postemployement benefits give rise to current expenses for book purposes but are not tax deductible until actually paid paying stocks are not taxable until sale and then taxable at capital gains rates rather than ordinary rates Income earned by foreign corporate subsidiaries not taxable until repatriated and may be offset by foreign tax credits generated in other countries Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 43 When analyzing investments you want to focus on after tax return on the investment relative to aftertax investment Consider the following ratio After tax return on investment divided by After tax investment 11 1Rn g 1t1n future 1 1tnow Example A firm invests 1000 today The investment is immediately deductible for tax purposes at a current tax rate of 35 If that s the case the firm really invests ie invests after consideration of taxes 650 The 1 000 investment earns a pretax rate of return of 10 on the 1000 pretax investment for 5 years At the end of the 5th year the total return is taxable at a rate of 35 What is the after tax rate of return After tax return on investment 1 1 Rn 1 tin future 1000115 135 104683 After tax investment 1 1 tnow 1000135 650 So Aftertax return 104683 161051 After Tax investment 650 PV Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 44 The 161051 can be viewed as follows The 1 is the return on principal the present value in the equation PVFV1in The 61051 is the return on the principal Thus the 161051 is the future value in the equation PVFV1in Given a 5 period investment the annual aftertax return on investment is 10 which is equal to the annual pretax return on investment What can we learn from this example If the cost of an investment can be deducted against taxable income in the year of investment a measure of the government subsidy and the tax rates on investment returns are the same as those prevailing when the investment is made returns are effectively tax exempt ie you earn the pretax rate R same as SV6 What can we expect to see in the economy Companies that have high tax rates are more likely to own assets that are taxfavored ie generate tax deductions Companies with low tax rates are more likely to contract with high tax rate companies when they want to acquire taxfavored assets A very common example of such contracting is leasing Companies that have high tax rates are more likely to borrow money take short positions in taxdisfavored assets e g taxable bonds because negative holdings of such assets generates tax deductions Alternatively companies that have low tax rates are more likely to get money by issuing equity such as preferred stock which is very debt like yet is treated as equity for tax purposes and equity is tax favored relative to debt Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 45 Tax arbitrageia quick summary Arbitrage involves simultaneously taking a short position in one asset and a long position in another asset to create a sure profit Organizational form based arbitrage An example borrowing against your house to generate tax deductible interest short position that generates current deductions while at the same time investing in a tax deferred educational savings plan eg a 529 plan that allows pretax compounding of investment returns and which when withdrawn to pay for qualified educational expenses are entirely taxfree Clientele based arbitrage A high tax rate firm simultaneously purchases an asset that generates significant tax benefits in the form of accelerated tax deductions long position in tax favored asset and finances the acquisition by borrowing money tax disfavored short position Total taxes include both taxes explicitly paid to taxing authorities and implicit taxes paid via the reduction in pretax returns The implicit tax rate can be calculated as follows Rb l tia Ra Rearranging tia Rb Ra Rb Where Rb risk adjusted pretax return on the benchmark asset tia implicit tax rate Ra risk adjusted preexplicit tax return on an alternative investment Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 46 The explicit tax rate can be calculated as follows Ra r Rb Where r aftertax rate risk adjusted return on the benchmark asset Problem Assume the riskadjusted rate of return on a fully taxable bond is 10 and the riskadjusted rate of return on depreciable equipment is 9 and the risk adjusted rate of return on a tax exempt bond is 7 1 What is the explicit tax rate on the returns to the fully taxable bond The implicit tax rate 2 What is the explicit tax rate on the returns to the depreciable asset The implicit tax rate What is the explicit tax rate on the returns to the tax exempt bond The implicit tax rate U Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 47 Tax Clienteles Marginal taxpayers are those who are indifferent between holding assets with different tax characteristics ie taxfavored tax disfavored lnframarginal taxpayers are those who have a preference for either tax favored or tax disfavored assets If an inframarginal taxpayer s marginal tax rate is greater than that of the marginal taxpayer the inframarginal taxpayer will prefer tax favored assets that bear relatively low explicit taxes and relatively high implicit taxes If an inframarginal taxpayer s marginal tax rate is less than that of the marginal taxpayer the inframarginal taxpayer will prefer tax disfavored assets that bear relatively high explicit taxes and relatively low implicit taxes Example Assume that a fully taxable bond pays interest at 10 and a taxexempt municipal bond pays interest at 7 If you pay taxes at a rate of 25 which investment do you prefer If you pay taxes at a rate of 35 which investment do you prefer D0 chapter 5 assignments for next class Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 48 Reading Financial Statement Footnotes There are two accounting systems that Virtually all large organizations maintain One provides the inputs necessary for financial reporting The other provides the inputs necessary for income tax reporting The former system is the base for the latter Side note there are BIG differences between financial reporting and tax reporting Probably the biggest source of difference for multinationals relates to nonconsolidation of foreign subsidiaries for tax purposes while they are consolidated for book purposes Differences between the financial reporting system and the tax system may be permanent or temporary Permanent differences do not give rise to deferred tax assets or liabilities To the extent that firms engage in activities that give rise to permanent differences their reported tax expenses and liabilities will always differ from what we would expect given statutory rates eg if a company only purchased taxexempt municipal securities it would report positive income on its financial statements we would all else equal expect the firm to pay taxes yet since all the income the firm generates in tax exempt it would record tax expense of zero When reading the annual report of a company you can identify the permanent differences between income reported for financial reporting purposes and for tax purposes by examining the reconciliation of effective tax rate component of the tax footnote If permanent differences increase the effective tax rate defined as income tax expense divided by pretax income the adjustments that you observe in the reconciliation will increase the effective tax rate ie be positive Conversely if permanent differences decrease the effective tax rate the adjustments that you observe in the reconciliation will decrease the effective tax rate ie be negative Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 49 We are now going to focus on the disclosures in lNTEL s 2002 tax footnote Reading Financial Statement F ootnotesiTemporary dif erences Taking it from the top First the footnote distinguishes US from nonUS pretax income Question 1 What was lNTEL s US pretax income for 2002 Question 2 What was lNTEL s nonUS pretax income for 2002 Second the footnote attributes income taxes to geographic area Question 3 What was lNTEL s US provision for income tax for 2002 Question 4 What was lNTEL s non U S provision for income tax for 2002 Third the total Provision for taxes reported on the Income Statement should equal the sum of US and nonUS tax provisions Question 5 Does it see directly above The current tax provision is an estimate of the current taxes payable It does not take into account the amount by which the tax liability is being reduced by any tax benefit from nonqualified stock options This reduction can be signi cant and if so can generally be identified in the Statement of Shareholder s Equity The deferred tax provision re ects a timing difference between the recognition of income for tax purposes versus recognition of income for financial reporting purposes Specifically either income got recognized sooner or later for financial reporting purposes than for tax purposes Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 50 How can this happen One way The value of an asset or a liability for tax purposes is not the same as it is for financial reporting purposes As a result pretax income for tax purposes is not the same as it is financial reporting purposes Stay with me here The reported Provision for Income Tax what you might think of more prosaically as Income tax Expense is based on pretax income for financial reporting Differences between pretax income for financial reporting and pretax taxable income give rise to deferred tax assets and liabilities Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 51 Example Equipment Investment Company invests 1000 in equipment For nancial reporting purposes it records depreciation expense of 200 each year for 5 years For tax purpose it records depreciation expense of 500 each year for 2 years In each of the 5 years the Equipment Investment Company has pretax predepreciation expense income of 600 In all years the Equipment Investment Company has and anticipates a corporate income tax rate of 35 Consider how the facts just discussed are described below year1 year2 year3 year4 year5 2 Inc Bef Depr and Tax 1 600 600 600 600 600 3000 2 Book Depr Exp 200 200 200 200 200 1000 3 Inc Bef Tax 400 400 400 400 400 2000 4 Prov For Tax 140 140 140 140 140 700 5 NI 260 260 260 260 260 1300 Inc Bef Depr and 6 Tax 600 600 600 600 600 3000 7 Tax Depr Exp 500 500 0 0 0 1000 8 Inc for Tax 100 100 600 600 600 2000 9 Prov ForTax 35 35 210 210 210 700 10 NI 65 65 390 390 390 1300 11 Diff in Depr Exp 300 300 200 200 200 0 12 Diff in Asset Value 300 600 400 200 0 13 Def Tax Liability 105 210 140 70 0 A couple of things important to note from the table 1 The sum of depreciation expense items 2 and 7 is the same for both book in tax over the ve yearsithus the nature of the differences between book and tax are timing and not permanent 2 The sum of income before tax for book is the same as it is for tax items 3 and 8 3 The sum of the provision for tax for book is the same as it is for tax items 4 and 9 4 The provision for tax for tax purposes represents the TAX BILL item 9 More dif cult now U The difference between the provision for tax for book purposes item 4 and the taxes actually paid item 9 is equal to the CHANGE in deferred tax liability item 13 The deferred tax liability at any point in time item 13 is equal to the expected future tax rate multiplied by the sum of the difference in depreciation expense taken for book and tax purposes which is equal to the difference in asset value at any point in time item 12 9 Key Takeaway deferred tax assets and liabilities are a function of differences in asset and liability values for book and tax purposes Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 52 Questions regarding INTEL s deferred taxes Looking just at the information provided in the tax footnote with respect to Deferred tax assets and Deferred tax liabilities l 2 U l 00 0 What is your best estimate of income taxes currently payable by INTEL in 2002 Taking into account the information revealed in the Statement of Stockholder s Equity how much cash do you think INTEL paid governments for income taxes related to 2002 It appears that Deferred Income resulted in an aggregate deferred tax asset as of the end of 2002 Why would deferred income result in a deferred tax asset What is your best estimate of deferred income on the financial statements for financial reporting purposes of INTEL The deferred tax asset related to Deferred Income changed in 2002 By how much Why would this happen By how much would financial income exceed or be less than taxable income in 2002 as a result of the Deferred Income item Do you think the income considered as deferred income is tax favored or taxdisfavored It appears that Depreciation resulted in an aggregate deferred tax liability as of the end of 2002 Why would depreciation result in a deferred tax liability 10Was the depreciation higher for financial reporting or for tax purposes llWhat is your best estimate of the difference in aggregate depreciation expense recorded for financial reporting versus tax l2It appears that the deferred tax liability related to Depreciation changed in 2002 Why would this happen 13 By how much would financial income exceed or be less than taxable income in 2002 as a result of the Depreciation item l4Do you think depreciation is taxfavored or taxdisfavored Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 53 Reading Financial Statement F ootnotesiPermanent dif erences In the preceding pages we discussed how taxfavored or taxdisfavored assets and liabilities give rise to temporary differences in how they re accounted for financial reporting and tax purposes and how those temporary differences in asset and liability value gives rise to deferred tax assets and liabilities It is also the case that taxfavored or taxdisfavored assets and liabilities can give rise to permanent differences in how they re accounted for financial reporting and tax purposes A permanent difference occurs when an asset or liability is recognized either for financial reporting or tax purposes but not for the other Specific examples of permanent differences that are relatively frequently observed include 1 Foreign corporate income re ected in the consolidated financial statements for financial reporting but not tax purposes and presumed unlikely to be repatriated to the US thus permanently avoiding US taxation We will discuss this more when we consider taxation of multinationals 2 Writedowns of assets recognized for financial reporting purposes but not recognized for tax purposes The most commonly occurring case has been the writedown of non tax deductible goodwill 3 Nontaxable income earned on municipal securities When a company has income items that give rise to permanent differences those items are not re ected in its Provision for Taxes They can be identified and their magnitude estimated using what is commonly referred to as the Reconciliation of the Statutory Tax Rate a required part of the tax footnote Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 54 Example Assume a company has two sources of income 200 of interest income from fully taxable corporate bonds and 100 of interest from fully non taxable municipal securities The company is subject to a at 35 tax rate on all taxable income It will report pretax income of 300 a provision for tax of 70 and net income of 230 The company s effective tax rate is 70300 or 233 The reconciliation of statutory tax rate that the company would prepare would look something like this Based on Based on Percentages Dollars Statutory tax rate 350 105 Effect of tax exempt Income 117 3 5 Provision for taxes 233 70 What to note from reconciliation The reconciliation can be prepared showing either the percentage effect of the permanent difference on the Provision for Income Taxes or the dollar effect In the percentage case the tax effect of the permanent difference here 10035 is divided by pretax income 300 yielding a percentage effect of 117 In the dollar case the tax effect of the permanent difference here 10035 is shown Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 55 Questions regarding lNTEL s reconciliation of statutory taX rate Looking just at the information provided in lNTEL s reconciliation of statutory taX rate 1 By how much did state taxes increase or decrease lNTEL s statutory taX rate of 35 2 NonUS income appears to be taxed at rates different than the US statutory rate Does this indicate that the taX rates INTEL faces overseas are higher or lower than those faced in the U S U Assuming that INTEL has to earn a lower pretaX rate of return on nonUS income does this indicate prices for its products will be higher or lower inside the US versus outside the US This answer to this goes to the question who bears the taX burden and its related thought what should the taX burden be what should government do Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 56 Chapter 7 Marginal Tax Rates For our purposes we re going to define marginal tax rates as the present value of the tax due on the next dollar of income earned Also define effective tax rate as the total income tax paid divided by total taxable income Tax Rate Schedules for Single Taxpayers 2002 Taxable income Tax Over But not over Tax On amount over S 0 s 6 000 s 000 10 s 0 6000 27950 60000 15 6000 27950 67700 389250 27 27950 67700 141250 1462500 30 67700 141250 307050 3669000 35 141250 307050 9472000 386 307050 Q1 What s the marginal tax rate of an individual with taxable income of 39000 What is the effective tax rate of the same individual Q2 What s the marginal tax rate of an individual with taxable income of 139000 What is the effective tax rate of the same individual Corporate Income Tax Rates2002 2001 2000 1999 amp 1998 Taxable income over Not over Tax rate 0 50000 15 50000 75000 25 75000 100000 34 100000 335000 39 335000 10000000 34 10000000 15000000 35 15000000 18333333 38 18333333 35 Q What s the marginal tax rate of a corporation with taxable income of 17000000 20000000 What is the effective tax rate of the same corporation for income at 17 and 20 million Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 57 What about State and Local taxes Problem Say the federal tax rate is 35 the state tax rate is 5 and the local tax rate is 3 Recognizing that state and local taxes are deductible for federal purposes what is the firm s marginal tax rate What is taxable income for a given period of time It s not necessarily current period taxable revenues less current period tax deductible expenses though it might be A relatively important feature of the tax system is that losses generated in one year can be carried back to offset taxable income in the two preceding years and in so doing generate refunds of previously paid taxes andor carried over to offset taxable income in the subsequent 20 years Note carryback and carryovers are not mutually exclusive Problem Grace has a consulting business In 2002 she generates taxable revenues of 500000 and incurs taxdeductible expenses of 800000 In 2000 she had taxable income of 35000 In 2001 she had taxable income of 140000 She anticipates generating income of 500000 in 2003 Assume Grace s aftertax cost of capital is 10 and that she paid and expects to pay taxes as a single person based on the tax rate table on the preceding page note the rates shown in the table have changed over the past few years and are scheduled to continue to change but just ignore that fact for now What is the present value of the aftertax benefit from the net operating losses incurred in 2002 assuming 1 Grace carries back losses to generate a refund of taxes paid in 2000 and 2001 and carries forward the remaining losses to offset projected income in 200339 and 2 Grace does not carry back losses to generate a refund of taxes paid in 2000 and 2001 but rather carries forward the entire 2002 loss to offset projected income in 2003 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 58 The availability of net operating loss carryforwards aka carryovers affects that calculation of marginal tax rate If a company can offset taxable income using NOLs in a given year it effectively defers payment of tax until the future Until when in the future It depends on how long it s going to be able to defer payment How long will it be able to defer payment For as long as it has NOLs available to offset taxable income The critical issue in calculating marginal tax rates in the presence of NOLs or other tax credit carryovers is identifying expected future taxable income and when that expected future taxable income will exhaust available NOLs or other tax credit carryovers Problem Assume a company has 100000000 in NOLs and expects to generate 25000000 per year in taxable income without regard to the NOL The firm faces a marginal statutory tax rate on every dollar of income of 35 The firm s aftertax cost of capital is 10 What is the firm s marginal tax rate Remember that PVFV1i Problem What kinds of investments and financing are you going to prefer if you re a corporation with a low tax rate What happens to your investment and financing preferences if your tax rate changes Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 59 A few other things 0 Don t confuse marginal tax rates with effective tax rates Effective tax rates are typically defined as the sum of taxes paid or payable divided by pretax income The effective tax rate doesn t tell you what the marginal tax rate is on the next dollar of income Rather they get at the tax burden borne by a particular taxpayer It s not only NOLs that might reduce a firms marginal tax rate 1 Obviously level of income will do so since tax rates are progressive 2 The presence of tax credit carryovers most especially alternative minimum tax credit carryovers reduce marginal tax rates To give you a quick sense of the relative importance of taking NOLs into account in the calculation of marginal tax rates in the U S somewhere between 25 and 40 of public corporations at any point in time have net operating losses and these aren t just the obvious losers Included among the firms with NOLs are companies with significant reported accounting earnings but no taxable income For many of these firms the NOL is the product of generous nonqualified stock option compensation Do chapter 7 assignments for next class Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 60 State Tax Planning Many companies operate in various states in the United States In a survey by PricewaterhouseCoopers corporate tax managers indicated that they spent 44 of their tax planning time on state and local tax issues Tax issues at the state and local level include income taxation on which we ll focus as well as property and other taxes At present fortyfour states impose income taxes on corporations The rules for the determination of taxable income for state tax purposes essentially follow those used for determining federal taxable income One notable exception is that interest earned on US government securities is tax exempt at the state level There is a basic three factor apportionment formula that most states use to assign income The apportionment formula is as follows Total Taxable Income 2Salestotal sales State Payroll Total Payroll State Property Total Property 1A State Taxable Income A few special things 1 States cannot tax the income of corporations that do not have a physical presence e g employees inventory within the state this is known as the nexus requirement 2 Delaware is sometimes viewed as an in country tax haven a great place to store intellectual property 3 Under current law states are prohibited from assessing sales or use tax on purely Internet sales Problem If a customer is willing to spend 60 on a sweater plus a sales tax of 8 for how much could this sweater be sold for via the Internet if shipping costs are a at 5 of sales price Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 61 Chapters 10 and l l Multinational Tax Planning In an economic environment where major companies operate businesses around the world and where many U S multinationals draw significant amounts of their income it helps to have a grip on multinational tax planning How is income earned across national borders taxed in a home country There are two basic approaches to taxing income earned outside a home country 1 Territorial Taxation tax exemption 2 Worldwide Taxation tax credit Countries that operate territorial tax systems do not tax foreign source income e g Canada France and Australia Countries that operate worldwide tax systems tax all income without regard to where it is earned eg US Japan UK Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 62 Tax Exemption versus Tax Credit Systems for Foreign Dividends Comparison and International Trends from the International Chamber of Commerce Prepared by the Task Force on Tax Exemption versus Tax CI39E ClIT Systems Introduction A discussion on the merits of an exemption or credit system is typically a discussion dealing with the essence of international taxation ie the methodologies used for the recognition of foreign income and taxes on such income The economies of developed countries of the world are in the process of becoming truly global Multinational enterprises MNEs must be able to compete in today39s global marketplace and a system of international tax rules should not disadvantage them in that competition Therefore it can be said that if a country allows its international tax rules to act as an impediment to successful competition the cost will be measured in lost opportunities and lostjobs The following discussion on tax credit and tax exemption systems focuses on a worldwide versus a territorial tax system applied to foreign dividends Within the OECD roughly one half of the countries use a worldwide system and the other half use a territorial system Countries like US UK and Japan have a worldwide tax system whereas Canada Germany France and the Netherlands generally use a territorial system Countries with a territorial system often tax passive income on a worldwide basis and use a credit system to avoid double taxation eg under bilateral tax treaties A debate on the merits of a credit versus an exemption system can contain emotional elements Forthe purpose of this policy paper a An exemption system is described as exempting dividends received by a corporate shareholder in a multinational enterprise from a foreign subsidiary b A credit system prescribes that a corporate shareholder for any dividends received from a foreign subsidiary adds to its taxable income the business profits from foreign operations and deducts from tax due thereon any corporate income tax and source tax on dividends paid abroad Global environment Recent years have seen an increased attention being paid to competitive angles of tax systems Globalization is the new economic environment within which tax systems operate In 1998 the OECD published its report on Harmful Tax Competition An Emerging Global Issue and has since followed it up with publications in 2000 Towards Global Cooperation and in 2001 Progress report The European Union started in 1997 with its Code of Conduct group aimed at the elimination of harmful taxation within the EU The Monterrey Consensus of March 2002 ofthe International Conference on Financing for Development calls attention to the tax position of developing countries and countries with economies in transition Within the framework of Sustainable Development a level playing field is viewed as necessary to allow an effective encouragement of export and trade by the businesses in developing countries As a result of these developments more attention is being paid to the various systems in use by countries to not only develop their own existing businesses but also to attract foreign investment An integral part thereof is the methodology for the recognition of foreign taxation relating to Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 63 dividends A global level tax playing field is developing International tax competition with clearly defined rules is considered as beneficial to all Global trends The globalisation drive has led to an increased knowledge and understanding ofthe various taxation systems in countries around the world Such knowledge points to a blurring of differences between exemption and credit systems on account of increasingly sophisticated antiabuse legislation Parameters to measure the purported harmfulness of tax systems are being developed by both the EU and OECD The implementation of the exemption and credit systems is an important factor especially the details thereof Another recent feature in the discussion on global tax trends is the attention paid to the cost of complying with tax rules MNEs have to comply with a variety of tax systems and practices and hence begin to ask for a minimum of standardization in particular regarding transfer pricing documentation Some commentators mention that because of such costs consideration may be given to quotalternative tax bases other than incomequot Tentative conclusions on the cost of compliance indicate that a level of some 2 of tax revenue is paid to cover the costs of compliance by businesses It is likely that costs related to crossborder business activities are higher than those for purely domestic operations In discussions on transfer pricing the tax framework of countries starts to play a role This includes the methodologies to recognise foreign taxation paid such as exemption and credit systems Characteristics of the tax exemption system Exemption systems typically do not tax dividends from foreign business operations Dividends transferred from abroad to the shareholder are typically taxed with a withholding tax in addition to the corporate income tax on the original profits An exemption system allows resident companies to venture outside their domestic environment and compete on a level playing field with their foreign competitors Hence the frequently used term of capital import neutrality CIN An exemption system may lead to tax planning structures that could be viewed as abuses of this method Exemption countries therefore use various approaches to combat such structures including general antiabuse rules Such rules appear to work efficiently and effectively Exemption systems have the advantage of being fairly simple Compliance costs are relatively low Such systems do not require elaborate calculations allocations detailed characterisations of foreign activities and foreign tax frameworks Government tax audits can also be fairly short An exemption system encourages businesses in developing countries to venture outside to export and trade abroad The system is simple and a level competition playing field is maintained in the foreign country Likewise it encourages investments into developing countries Tax incentives granted by such countries go to the investor and not as in a credit country to the revenue of the investor39s country In general it can be said that a tax exemption system encourages businesses to trade outside their home country thus accelerating the trends towards globalisation and increase of global welfare Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 64 Characteristics of a tax credit system The philosophy behind a tax credit system for foreign dividends is to allow international businesses to operate under the same conditions as domestic enterprises If a business ventures abroad it must pay tax on foreign and domestic business income domestically at the same tax rate and tax basis Foreign tax paid dividend withholding tax and corporate income tax on the original profits can be deducted against domestic tax due but usually without refund in the event that foreign tax exceeds domestic tax This system is also called a capital export neutral system CEN A credit system does not create a level playing field abroad when a domestic business expands its horizon The company venturing abroad must pay attention to the tax consequences domestically lts competitive position in the foreign market can be considerably affected The effects of a foreign tax incentive regime for a capital investment abroad are negated an incentive simply lowers the amount of foreign tax credit the country of the investor has to recognize The cost of compliance with a tax credit system is relatively high due not only to the calculations that are required to comply with the domestic tax rules but also due to the information gathering process required to obtain the necessary data from abroad Abuses of the system for avoidance of double tax appear to be easier to monitor in tax credit systems because much information related to foreign activities must be included in domestic tax returns One of the advantages of the credit system frequently cited is indeed the ability to combat abuse through abundance of information The fact that much attention is paid in major credit countries like the US and UK to combating tax abuses does not however indicate a strong support for such an assumption In general it can be said that credit systems do not encourage businesses to trade outside their home country and are often seen by enterprises as a disadvantage in competition on the global marketplace Conclusions The current environment and future trends appear to indicate that countries should look seriously at developing a consistent approach to the recognition of foreign taxation for the avoidance of double taxation on international dividend flows The tax exemption method is simple and does not require significant numbers of expert revenue officials and auditors which is troublesome for any country but especially for developing countries A tax exemption system is less costly to comply with which is a major advantage for enterprises engaged in international business A tax exemption system encourages businesses to trade outside their home country thus accelerating the trends toward globalisation and increase of global welfare A tax exemption system makes tax competition rewarding both for the business community and for the countries Such a winwin situation is an attractive proposition for everyone The tax credit system is well established in a number of countries and enterprises resident in those countries are familiar with its operation and have organised their affairs on this basis For such countries moving from a credit to an exemption system would incur significant costs Recommendation The international business community believes that both the exemption system and the tax credit Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 65 system are useful approaches to avoiding double taxation on cross border dividend flows On balance however the ICC favours an exemption system on foreign dividends primarily because the exemption system supports the trend towards a truly global business environment encouraging businesses to export and trade abroad it preserves the impact of domestic tax policy particularly in developing countries and the costs of compliance for foreign dividends are considerably reduced as compared to a tax credit system 3 October 2003 Document 180501rev5Final Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 66 Amnesty proposed for overseas profits US TECH COMPANIES BACK SENATE BILL FOR SIXMONTH TAX HOLIDAY By Edmund L Andrews New York Times WASHINGTON US corporations that have deferred taxes for years on the profits they made overseas could be in line for a huge windfall from Congress Hoping to bring more investment to the United States the Senate Finance Committee approved a bill Wednesday that would give a one time tax holiday to companies that have accumulated as much as 400 billion in foreign profits on which they have yet to pay American taxes US companies can usually defer paying taxes on foreign profits as long as they keep the money outside the United States Much of that money is reinvested in foreign operations and some is parked in passive investments The Senate bill which is part of a much broader bill to overhaul laws on international corporate taxation would let companies bring those profits back and pay a tax rate of only 525 percent Supporters say the six month tax holiday could lure as much as 300 billion back into the United States which in turn would increase investment and create jobs To press their case companies such as Hewlett Packard have formed a broad coalition that includes the likes of Eli Lilly Merck Intel Sun Microsystems and Dell Computer One of the coalition39s main lobbyists is Bill Archer the former chairman of the House Ways and Means Committee and his former chief of staff Donald Carlson The question is do we want this money invested in equipment and plants in Egypt or do we want it invested in the United Statesquot Carlson said To get this much bang for the buck is a rarityquot But many tax experts including top tax officials in the Bush administration say the move would be a mistake because it would validate the strategies of companies that spent years sheltering their overseas profits The company that left Louisiana is going to pay a 5 percent tax on the widgets they make overseas and the company that stayed in Louisiana is going to pay a 35 percent taxquot said Sen John B Breaux D La If that isn39t an incentive to leave I don39t know what isquot Critics also warn that there is no guarantee the companies will invest their repatriated profits in new factories or larger workforces Indeed Republican lawmakers defeated an amendment offered by Breaux on Wednesday that would have required companies to reinvest their foreign profits in things such as new equipment A good deal39 The biggest beneficiaries of the legislation would be technology companies such as HP and Intel as well as pharmaceutical giants such as Merck and Eli Lilly Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 67 Intel spokesman Chuck Mulloy said Wednesday that the amnesty could spark a large infusion of capital into the US economy and stimulate domestic spending by US companies Intel says it has deferred taxes on 63 billion of foreign income This bill is a good dealquot Mulloy said We support it from a larger domestic economic stimulus point of viewquot If the bill passes both houses Intel would have to evaluate how much cash to return to domestic accounts he said HP which has been one of the bill39s most visible supporters says it has accumulated 145 billion in foreign earnings and kept them outside the country in part to avoid paying the US corporate tax rate of 35 percent Eli Lilly whose products include the anti depressant Prozac says it has 8 billion in untaxed overseas profits Lawmakers say the measure has a strong chance of becoming law The Senate bill has support from most Republicans as well as some Democrats In the House the Republican chairman of the House Ways and Means Committee Bill Thomas of California has proposed a similar plan Despite their unhappiness about the bill administration officials made it clear Wednesday that they would not try to veto the measure because they are more concerned about passing the broader legislative package The main purpose of the bill is to replace a tax break for US exporters that has been declared an illegal subsidy by the World Trade Organization If the United States does not repeal the tax break which allows American manufacturers to avoid taxes on exports by establishing off shore sales corporations the European Union has threatened to retaliate with 4 billion in tariffs on products from the United States 10 percent break The bill approved by the Senate Finance Committee would reduce the corporate tax rate on US manufacturers by as much as 10 percent and offer some modest new permanent tax breaks for American companies operating overseas By far the most controversial of those measures is the proposed tax holiday on foreign profits which supporters call the Homeland Reinvestment Actquot The idea has tremendous allure to lawmakers because it offers the possibility of bringing at least a brief flood of money into the United States The Joint Committee on Taxation the non partisan congressional agency that calculates the effect of tax proposals on revenue estimates that a six month tax amnesty for overseas profits could bring back 135 billion Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 68 Several things to note at the outset p A Income from foreignbased subsidiaries is not taxable until it is repatriated as a dividend or deemed dividend eg if a foreign subsidiary lends a domestic parent money the amount of the loan might be characterized as a dividend for tax purposes J The second level of tax that is paid upon repatriation is similar to the double tax takes place when a corporation earns income pays a tax and then after a period of time equal to n distributes a dividend based on that income to a shareholder and the shareholder pays tax The return to the shareholder is equal lRl tcn ltp where R is the pretax rate of return to is the corporate tax rate and tp is the shareholder tax rate In the multinational setting tc is the rate of tax imposed by the foreign country and tp is the tax upon repatriation Note the second level of tax to which the income of a firm based in a worldwide taxation country is subject may put that firm at a competitive disadvantage relative to a firm operating out of a territorial tax country This is something that many U S based multinationals claim and it is often put forward as a reason for tax inversions basically leaving the U S and reincorporating in a foreign tax haven like Bermuda U When foreign subsidiaries repatriate dividends a credit against U S taxes is allowed for foreign taxed paid on the dividend This is called the Foreign Tax Credit A Foreign branches of US companies cannot defer US taxation However they can readily make use of operating losses to offset US taxable income This is something that foreign subsidiaries can t do U US based firms can create Foreign Sales Corporations FSCs through which to funnel foreign sales 15 of income earned by FSCs is tax exempt in the US Groups like the WTO view FSCs as abusive tax subsidies and have actively moved to make the US repeal them 0 It is likely that significant implicit taxes exist that drive down the pretax rates of return that can be earned on investments in Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 69 countries that offer significant tax concessions to attract business e g Ireland Singapore 1 Some foreign income Subpart F income is taxable in the US when earned Subpart F income is generated from passive investments in things like bonds and stocks Subpart F income earned by a Controlled Foreign Corporation CFC a corporation that s more than 50 owned by US taxpayers where a US taxpayer is a shareholder that owns more than a 10 interest A CFC s Subpart F income is deemed distributed as dividends as earned unless some de minimus rules are met Note that unlike pretax returns to active income from conducting a business that are likely significantly in uenced by implicit taxes the pretax rates you can earn overseas on Subpart F income even in a tax haven country approximate those you can earn in the US Put another way the implicit tax on Subpart F income is not too big 00 Word of caution pun coming there s a world of complexity in the taxation of multinational operations Every country has its own set of rules for determining taxable income and for taxing distributions outside its borders Differences in the definition of taxable income can make it possible for a single expense to be deductible in two jurisdictions doubledipping Tax treaties play a large role and can affect the route dividends follow since they affect the amount of tax withheld eg firms actively attempt to move money across countries to minimize withholding taxes this type of activity is called treaty shopping Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 70 Calculation ofthe Foreign Tax Credit Limit FTC note that the FTC limit is computed for 8 separate income baskets The maximum allowable foreign tax credit is defined as FTC Pretax foreign source income US Tax on Worldwide Inc Pretax worldwide income The FTC that can be used in any given year is equal to the lesser of the FTC as calculated above or the actual amount of foreign taxes paid or deemed paid Any FTC not used in one year can be carried back 2 years and forward 5 years Generally foreign source income is equal to the sum of Subpart F income foreign income earned by branches of US companies 25 of FSC income and income earned and repatriated by foreign subsidiaries Foreign source income associated with a repatriation from a foreign subsidiary is equal to the following Df ltf MW where Df the foreign dividend tf the foreign income tax rate tW the withholding tax collected by the foreign country when dividends are paid to overseas shareholders With respect to the calculation of FTC note that the higher foreign source income the higher the allowable credit The level of foreign source income is affected by the allocation of revenues and costs within a controlled group of corporations this is done using transfer prices and by specific income sourcing rules With respect to transfer prices the guiding principle is that they should be set to approximate an arms length transaction Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 71 Problem A US based multinational company operates two foreign subsidiaries Relevant information follows AftertaX Foreign Earnings Dividend Withhold Income and Profits Paid TaX Rate TaX Rate Sub 1 100 20 10 20 Sub 2 200 40 15 30 US income taX rate equals 35 1 2 Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy Assume the company only operates Sub 1 How much taX will be due upon repatriation Assume the company only operates Sub 2 How much taX will be due upon repatriation Assume the company operates both Sub 1 and Sub 2 How much taX will be due upon repatriation Assume the company operates both Sub 1 and Sub 2 What is this company s foreign taX credit position specifically does the firm have excess foreign taX credits or will it have to pay US taxes upon repatriation assume that all foreign source income and taxes can be pooled in generating the FTC Does this company have an incentive to generate additional income in a high or low taX rate country relative to the U S How might that income be generated 72 When should a company repatriate earnings At first blush it may appear that since repatriation can trigger an additional taX say for US firms operating in countries that have taX rates lower than 35 postponing repatriation for as long as possible makes sense But it doesn t necessarily Consider the following A US based multinational company operates one foreign subsidiary The subsidiary has accumulated aftertax earnings and profits of 100 The subsidiary faces a taX rate of 20 on all income earned By treaty there are no withholding taxes on dividends to the U S parent The parent can earn 150 pretaX in the US and 1125 pretaX in the foreign country Assume the US taX rate is 40 1 Is the parent better off by postponing repatriation of accumulated earnings and profits for 5 years Assume all monies can be reinvested at rates indicated above and are taxed at rates indicated above J Would the parent be better off postponing repatriation of accumulated earnings and profits for 1 year if the foreign pretaX rate were greater than 1125 less that 1125 U Assume that the parent could invest the foreign subsidiary s accumulated earnings and profits in investments that generate Subpart F income e g stocks and bonds and that these investments return 15 per year exactly what the firm would earn on similar investments in the US Should the firm make these investments overseas or at home For the sake of concreteness calculate the difference between repatriating immediately and investing at home to earn 15 pretaX each year for 5 years and investing abroad generating Subpart F income and repatriating at the end of 5 years Do chapter 10 and I I assignments for next class Boston College Professor Gil Manzon Spring 2004 Taxes and Business Strategy 73 The Observer 2 Enqhsh cav mqht 2am The Observer nu ghts reserved when ahenmnq m af ne even exxsted 12 seems Vaur researah rs wranq she saw wme e w r New researeh hv the Assnnater Hf Accauntancv and Busmess Affavs revea s that KPMG anerates m mare h awhsted tax havens than any anhe an Faur pram25 n has af ne m 15 tax havens th 15 Ernst w seven uncaaveratwe swans qrauvs whne m h ackhsted havens harmed ham Duhhc tantracts nmanh enn aw ern we pH the Ma dwes Panama 2 Luma s mneenc and the Turks and Camus Boston College Professor on anzon 5ng 20w Tam and Emma Shufth 74
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