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Characteristics of a good tax according to Adam Smith

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- Fair (reflect person's ability to pay) - Absolute (certain not arbitrary) - Convenient (easy to pay) - Efficient (low collection costs)

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3 major principles of good tax policy

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Equity Efficiency (PAYE system) Economic effects

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2 types of taxes

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- Direct: imposed directly on the person or enterprise required to pay the tax (tax on personal income, on business profits, on disposal of chargeable assets): income tax, capital gains tax, corporation tax - Indirect: imposed on one part of the economy with the intention that the tax burden be passed on to another (sales tax, VAT)

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Tax incidence

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The distribution of the tax burden (who is paying the tax)

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2 types of incidence

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- Formal incidence: the person who has direct contact with the tax authorities - Actual incidence: the person who actually ends up bearing the cost of the tax Eg. VAT: formal incidence has the entity making the sale actual has the buyer

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Hypothecation

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Certain taxes are devoted entirely to certain types of expenditure (road tax, London congestion charge)

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Tax gap

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Gap between the tax theoretically collectable and the amount actually collected

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3 types of taxes (by rate)

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Progressive Proportional Regressive

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Source of tax rules

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Legislation produced by national governments Precedents based on previous legislation (interpretations, bulletins) Directives from the EU Agreements between different countries (double tax treaties)

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Tax bases

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Income or profits (income and corporation tax in the UK) Assets (capital gains tax) Consumption (sales tax)

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2 types of direct taxes

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Tax on trading income Capital tax

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Tax on trading income

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Taxable income = Accounting profit - income exempt from tax or taxed under other rules + disallowable expenses (entertaining customers, gift aid payments, political donations in the UK) + accounting depreciation - tax depreciation

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Accounting profit...

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the profit shown in financial statements before taxation

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Disallowable expenses...

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they are allowable under the accounting standards, but for tax purposes they can't be claimed

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Depreciation...

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is added back because it is an accounting entry that is not allowed for tax purposes because it's too subjective

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Tax depreciation...

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is calculated on the tax WDV (written down or net book value)

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A balancing allowance (BA) =

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a tax *loss* on disposal When an *asset* is sold, any accounting profit or loss must be disallowed for tax purposes and replaced with the tax equivalent known as *balancing allowance or charge*

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A balancing charge (BC) =

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a tax profit on disposal

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If the proceeds are greater than the carrying amount...

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Balancing charge

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If the proceeds are less than the carrying amount...

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Balancing allowance

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4 possible ways of relieving a loss

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(1) Carry losses forwards against future profits of the *same* trade (2) Carry losses backwards against previous periods (3) Offset losses against group company profits (4) Offset losses against capital gains in the same period

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Terminal Loss Relief (UK)

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If an enterprise ceases to trade, it can carry back the loss three years to generate a tax refund

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Capital tax gains...

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are gains made on the disposal of investments and other non-current assets. The tax base is assets.

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Allowable costs for deduction

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- original cost of purchasing the asset - costs to buy the asset eg legal fees, estate agent fees - costs to sell the assets - improvement costs - indexation allowance, if exists, that will *reduce* the gain

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Possible ways of relieving capital losses:

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- carry forwards against future capital gains - carry backs against previous capital gains - offset against trading income in the current period

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2 issues for tax purposes

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1 Group loss relief 2 Appropriations for profit

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Group loss relief

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- *Tax consolidation*: enables a tax group to be recognized, allowing trading losses to be surrendered between different entities. If two entities are part of a tax group, they can transfer losses between them to save tax for the group as a whole - *Capital losses*: cannot be surrendered between group entities

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Appropriations of profit (dividends)

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4 main systems: - Classical system - Imputation system - Partial imputation system - Split rate system

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Classical system

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Dividend is taxed twice: firstly as part of the entity's taxable earnings and secondly when received by the shareholder as part of personal income

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Imputation system

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The shareholder receives a tax credit equal to the underlying corporate income tax paid by the entity

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Partial imputation system

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A tax credit is offered to the shareholder but only for part of the underlying corporate income tax paid by the entity on its taxable earnings

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Split rate system

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This system distinguishes between: *distributed earnings* and *retained profits* A lower tax rate is applied to corporate income tax on distributed profits.

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2 indirect taxes

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*Unit taxes*: tax based on the *number* or *weight* of items ( excise duties) *Ad valorem taxes*: based on the *value* of items

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Excise duties

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Imposed to: discourage overconsumption of harmful products pay for extra costs, such as increased healthcare or road infrastructure tax luxuries (in the USA, is hung equipment, firearms and air tickets)

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Wealth taxes

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Imposed on: work of arts, pension funds, insurance policies

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2 types of consumption taxes:

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(1) Single stage taxes, applied to one level of production only, e.g. at either the manufacturing, wholesale or retail level (2) Multi-stage sales tax: *Cascade tax* and *VAT*

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Cascade tax

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It is a *business cost* because the tax is applied at each stage of production, no refunds are provided by local government

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VAT

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Used by almost all countries in the world. VAT is charged each time a component or product is sold but the government allows businesses to claim back all the tax they have paid (input tax).

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VAT payable =

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output - input tax Output tax: VAT charged on sales to customers Input tax: VAT charged on purchases

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VAT =

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(gross price / 1 + tax rate) x tax rate

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Pay-As-You-Earn (PAYE) system

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Enterprises withhold tax on employees' salaries and report earnings to the tax authorities

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Benefits of PAYE:

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- Tax is collected at source - Tax authorities receive regular payments from employers: helps to budget cash flows for the government - The tax authority only has to deal with the employer - Most of the admin costs are borne by the employer, instead of the government

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3 types of taxation relief:

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(1) Exemption (2) Tax credit: tax paid in one country may be allowed as a tax credit in another country. Relief is normally restricted to the *lower* of the foreign OR country of residence tax (both underlying and withholding) on the gross dividend (see page 39) (3) Deduction

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2 types of overseas operations:

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(1) Subsidiary: separate entity for tax purposes, loss relief not available for the group, the subsidiary cannot claim the same tax depreciation as the parent on any assets (2) Branch: the branch is treated as an extension of the UK activity, all profits will be subject to UK taxation, loss relief available for the group, assets can be transferred between the branch and holding company at no gain/no loss, the branch can claim tax depreciation on all assets

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2 types of foreign taxes:

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(1) Withholding tax: the tax that the countries deduct at source on dividends. The net income (gross payment - tax) is received by the beneficiary in the foreign country (2) Underlying tax: the amount of tax included in the dividend that has already suffered taxation (from after tax profits)

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Tax avoidance:

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Planning to arrange affairs *within the scope of law*, to minimize the tax liability, eg. by setting up a subsidiary overseas in a low tax country => negative publicity and adverse effect on the overall business

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Tax evasion:

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the *illegal* manipulation of the tax system to avoid paying tax

Indirect: imposed on goods and services

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