Taxation:

Private individuals

In Australia we have a progressive tax system where the rate of taxation increases with income.

Other countries have a flat tax rate where the rate of taxation is constant across all levels of income. For instance, Russia has a flat 13% tax rate.

A poll tax is a tax which is the same for all persons regardless of their income. For example when you leave Australia to travel overseas you pay a departure tax.

Australian system:

There are 5 different groups or tax brackets depending on your taxable income. As income increases, the rate of tax payable on that income also increases. This is referred to as progressive taxation. The tax rates vary with income as shown in the table below.

If your taxable income Y is between the lower limit L and the upper limit U for a particular bracket, then you pay tax according to the formula tax payable = M+(Y-L) Ru

Taxbracket

Lowerlimit(L)

Upperlimit(U)

MarginaltaxrateR

MinimumTaxpayableforthisBracketM

1 $0.00 $18,200.00 0.00%2 $18,200.00 $37,000.00 19.00%3 $37,000.00 $80,000.00 32.50% $3,571.814 $80,000.00 $180,000.00 37.00% $17,546.495 $180,000.00 Infinity 45.00% $54,546.12

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In addition to this you have to pay the medicare levy which is 1.5% of your taxable income. If your income is below $19,404 then you dont have to pay this medicare levy.

If your income is above $22,828 then you do have to pay the medicare levy. If your income is between these limits then you pay part of the medicare levy.

The medicare levy is a special tax dedicated to financing australias public health insurance system.

Example: if your income is $60,000 then

x You are in tax bracket number 3 since your income is in the range from L = $37,000 to $80,000

x The minimum tax payable for this bracket is M = $3,571.81 x The marginal tax rate that applies to you is 32.5%. x This rate applies to the part of your income that exceeds the

lower limit of $37000, which is $60,000-$37,000 = $23,000 x Tax on this part of your income is 32.5%.32.5% = $754 x The tax payable is $3,571.81+$754.00=$11,046.81 x M+ R= +(60000-23000) 0.32 3571.81 11046.85 = 1Y L u u x Your medicare levy is $600001.5% = $900 x Your tax payable including the medicare levy is 11946.81

For each additional $1 you pay 32.5c in tax and 1.5% for the medicare levy. This is what we mean by marginal tax rate

At an income of Y = 60000 your average tax rate is 18.4114%

And if we include the medicare levy then it is 19.9114%

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Other taxpayers:

Superannuation (retirement) funds:

Pay a flat tax rate of 15% on the contributions paid into them by the employers. Employers can claim these contributions as a tax deductible expense. Contributions paid into the fund by employees are paid from the after tax income and thus dont attract tax when received by the fund.

Investment earnings / income of a superannuation fund is also taxed at a flat rate of 15%

Pension funds:

Superannuation funds pay either a lump sum or a pension type benefit to members when they retire. Some of the funds assets may be segregated into a separate account and used for the purpose of paying the pension benefits. The investment earnings of the pension fund account is tax free (0% tax rate)

Corporations:

In Australia companies pay a flat 30% tax rate on their income

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Dividends:

Dividends are payments made by a corporation to its shareholders (owners). It is the portion of after tax corporate profits paid out to stockholders. A dividend payment is a fixed amount per share. A dividend payment received by the shareholder is taxable income for the shareholder. The amount of the income depends on the number of shares they own.

The dividend payments come from the companys after corporate tax profits. Many investors buy shares for the purpose of receiving the dividend income.

Capital Gains:

If you buy shares now for price C and sell them later for price P then you would hope to be able to sell them for more than you paid for them and thus make a profit on the transaction. The difference P-C is a capital gain. Many investors buy shares and other assets hoping to sell them later at a profit. Most investors would hope to make a positive return on their investment taking account of both the dividend income and the capital gain.

In Australia, if the holding period for the transaction was less than 12 months then the profit is regarded as income and taxed as income. However if the holding period is longer than 12 months then the profit is regarded as a capital gain and is taxed more lightly. More detail on this below.

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Classical taxation of dividends:

In the past in Australia dividend income was taxable at the taxpayers marginal tax rate. The profits that generated the dividend were taxed as income for the firm (at the company tax rate), then taxed again when received by the shareholder. So the original profits that generated the dividend were taxed twice. This system was known as classical taxation of dividend income.

For example if the firm earns $100K in profit before tax and has a flat tax rate of 30% then the tax liability of the firm is $30K and its after tax profit would be $70k = $100K - $30K. If all of this is paid out to shareholders in dividends then the dividend payment would total $700K. Suppose there are 10 shareholders each owning 10000 shares. The dividend per share would be $0.70 and the two shareholders would each receive total dividend income of $3.5K.

Suppose the 1st shareholder is in tax bracket # 3 and the 2nd shareholder is in tax bracket # 5.

The tax for shareholder 1=$3500(32.5%+1.5%)=$1190.00

The tax for shareholder 2 is $3500(45%+1.5%)=$1627.50

Taxation of Dividends in Australia & dividend imputation:

For Australian shareholders, a dividend is taxed via the dividend imputation system. This Imputation System is designed to avoid double taxation for some investors. The objective is to tax corporate income distributed as dividends at an effective rate equal to the investors personal marginal tax rate.

Suppose you receive a dividend of amount D.

The amount of the cash dividend generates a tax liability of 1

0.70D Tu u where D is the cash dividend paid, and T is the investors personal tax rate.

The dividend carries with it a tax credit of 1 0.300.70

Du u which is the corporate tax already paid by the corporation on the profits that generated the dividend.

The tax payable by the shareholder on the cash dividend is

1 0.300.70

D Tu u

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Example:

you invest in XYZ corporation shares and you receive dividend income of $1400. You are in tax bracket #4 and your marginal tax rate is 38.5%. How much tax do you pay on the dividend you received?

Solution:

The dividend received was D = $1400. The company paid tax at the rate of 30% on the profit P that generated the dividend.

Your share of the profit of the firm before company tax was P where 1 0.30 1 0.3 1400 0.70 $2000P D P Du

The corporate tax paid by the company on this part of their profits was $2000 0.30 $600u . Your tax on the dividend is based on this grossed up before tax company profit before tax.

You are taxed at your marginal tax rate on this income of $2000

Your tax bill for the income is thus 2000 38.5% $770u

However the tax department considers that the company has already paid $600 of this tax on the $2000 profit so you get a tax credit for this amount. They call this an imputation tax credit.

The amount of tax payable by you on the dividend is $770-$600 = $170

The net of tax dividend payment you get is

$1400-$170 = $1230

This is the same amount you would receive after tax if youd received the $2000 profit in your own name (instead of in the name of the company) and paid tax on it at your marginal rate of 38.5%, since $2000-200038.5%=$2000-$770 = $1230

The way the dividend imputation system works means that the tax payable on the dividend you receive is equivalent to the tax you would have paid on the corporate before tax profits if the income were earned by you directly instead of via a corporation.

Taxation of capital gains:

If you buy an asset and sell it later for a price different from what you paid for it you may make a capital gain or a capital loss.

Capital gains tax

If shares were purchased before September 1999, shareholders can use one of two methods for calculating their capital gain. Otherwise they use the discount method.

Indexation method: adjusts the capital gain for inflation, such that only real capital gain is taxed. It is taxed at the taxpayers marginal rate. If you use the indexation method instead then the capital gain is computed as

'capital gain P C where 'P is the purchase price P adjusted for inflation at the CPI inflation rate over the period from when the asset was bought to when the asset was sold.

Discount method: allows individual shareholders to reduce their capital gain by 50% (33.3% for superannuation funds) if shares were held longer than 12 months, and this amount is taxed at the taxpayers marginal rate. The tax payable on the sale proceeds of P per share would be 0.50P C T u u where P is the sale price of the shares and C is the cost of the shares and T is your personal marginal tax rate.

Example:

Suppose you bought 100,000 XYZ shares 5 years ago for $10 each and sold them today for $20 each.

Your capital gain unadjusted for inflation is

$20.00100000 - $10.00100000

= $2,000,000-$1,000,000 = $1,000,000

Suppose the inflation rate had been 1.5% per quarter year every quarter over that holding period. Then the original purchase price is equivalent to an inflation adjusted price of

61000000 1.015 1000000 1.346855 $1,346,855 u u The purchase price is adjusted upwards by 34.6855% to take account of inflation over the holding period

If using the indexation method your capital gain is

' $2,000,000 $1,346,855 $653,145.00P C This is taxable at your marginal rate in full

If your marginal tax rate is 45% + 1.5% medicare levy then the tax payable on the sale proceeds would be,

using the discount method:

12

1$2 $1 0.465 232,50$2

0

taxdue P C T

m m

u u

u u

using the indexation method it would instead be:

'

$65314 0.5 303,712465 $ .4

taxdue P C T u u

Tax deductible expenses

A common feature of the tax system in many countries is that certain expenses incurred in earning income are allowed by the tax authorities as deductions from income in measurement of taxable income. This makes your taxable income lower so you pay less in tax.

Generally, income = revenue expenses

for some expenses we are allowed to compute our income for tax purposes in this way whereas for other expenses we are not allowed to

money spent on buying clothes for work may or may not be an expense recognised for tax purposes. If you have to wear a uniform at work it would be, but if you have to buy a suit for working in an office it wouldnt be

money spent on transport to and from work may or may not be deductible

interest paid on a loan used to buy an income producing asset (e.g. a rental property generating rent income) would be deductible but interest paid on a loan used to buy a house you live in wouldnt be deductible

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the rules about what is or is not an expense allowed for tax purposes are quite complex and they vary depending on whether it is for a business or for a private individual.

Depreciation

A very important tax deduction is that for depreciation. The general idea of depreciation is that fixed assets such as machines, cars, buildings etc tend to fall in value over time. This decline in value is called depreciation.

There are two main methods for computing depreciation and these can be used both for tax purposes and for financial reporting purposes These are

(i) The straight line depreciation method and (ii) The reducing balance depreciation method

The decrease in value of the asset in each year can be computed using either method. The depreciation expense is based on the historic cost of the asset. The value of the asset at the end of each year is the value of the asset at the start of that year less the depreciation expense for that year.

This asset value is called the written down book value. It is not necessarily the same as the true market value of the asset as a second hand asset. The true change in the value of the asset is not necessarily the same as the depreciation expense as computed by these methods. However these methods are well established and used for tax and financial reporting purposes.

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With straight line depreciation, the depreciation expense is of a fixed amount each period. If the useful life of the asset is N years then

x the depreciation expense each year is 1costN

u .

x the written down value of the asset at the end of year t is cost N t

N u

For instance if the useful life of the asset is n = 5 years then the depreciation expense each year is 20% of the original cost of the asset.

Reducing Balance Method

With the reducing balance depreciation the depreciation expense for a year is a constant proportion of the value of that asset at the start of that year.

This means the amount of the depreciation expense reduces over time, as does the value of the asset. If the RB depreciation rate is %x per year then

x depreciation expense in year t is

1

value of asset at start of year t

original cost 1100 100

tx xDE u u

x written down value at the end of year t is

original cost 1100

txWDV u

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Generally the depreciation rate x is higher for the RB method than it is for the SL method

In Australia, the RB depreciation rate for an asset with a useful

life of n years is 1depreciation rate =2N

u

For example if N = 5 then

x the depreciation rate for the SL method is 20% but x the depreciation rate for the RB method is 40%

important point to note re depreciation

x the depreciation expense allowed in the measurement of income for financial reporting purposes and for taxation purposes is not an actual cash expense incurred by the business / taxpayer, it is a notional amount only

x for example with a car, it may reduce in value each year but you dont need to replace the car every year

ExampleAssumeyouboughtacar5yearsagofor$100,000whenitwasnewandthatyouestimateitsusefullifetobe5yearsfortaxationpurposes.Computex the book value of the car at the start and the end of each year for 5

years, and x the depreciation expense for tax purposes in each year for the 5

years you have owned the car x the tax saved (reduction in tax payable) as a result of the tax

deductibility of this expense (Assume the tax rate is 30%.)

Dothisforboththestraightlinemethodandthereducingbalancemethod.Notethatthebookvalueofthecarattheendoftheyearisthebookvalueatthestartoftheyearlessthedepreciationexpensefortheyearandthebookvalueattime0(whenthecarwasbought)isequaltothecostofbuyingthecar.

Solution

Withausefullifeof5years:

x the straight line depreciation rate per year is 1 100% 20%5u per

year x the reducing balance depreciation rate per year is

12 100% 40%5

u u

x the book value of the car at times 0,1,2,3,4,5 years and the depreciation expense incurred is as follows:

reducingbalancemethod straightlinemethodYear book

valueatstartofyear

depexpensefortheyear

bookvalueatendofyear

bookvalueatstartofyear

depexpensefortheyear

bookvalueatendofyear

1 $100,000 $40,000 $60,000 $100,000 $20,000 $80,0002 $60,000 $24,000 $36,000 $80,000 $20,000 $60,0003 $36,000 $14,400 $21,600 $60,000 $20,000 $40,0004 $21,600 $8,640 $12,960 $40,000 $20,000 $20,0005 $12,960 $5,184 $7,776 $20,000 $20,000 $0

Write a spreadsheet program to reproduce these calculations