Chapter 4 S 2 -FORMS OF BUSINESS vs. TAX PAYING ENTITY A business entity may usually be of 3 types: Sole-proprietorship Partnership firm Company. “Sole-proprietorship” has not been defined by the Income Tax Ordinance 1984 (ITO). “Firm” has the same meaning as assigned to it in the Partnership Act, 1932 [u/s 2(32) of the ITO]. S 3 - FORMS OF BUSINESS vs. TAX PAYING ENTITY “Company” [u/s 2(20) of the ITO] means a company as defined in the Companies Act, 1913 or 1994 and includes – a body corporate established or constituted by or under any law for the time being in force; any nationalised banking or other financial institution, insurance body and industrial or business enterprise; an association or combination of persons, called by whatever name, if any of such persons is a
Transcript
Chapter 4
S 2 -FORMS OF BUSINESS vs. TAX PAYING ENTITY
A business entity may usually be of 3 types:
Sole-proprietorship
Partnership firm
Company.
“Sole-proprietorship” has not been defined by the Income Tax Ordinance 1984 (ITO).
“Firm” has the same meaning as assigned to it in the Partnership Act, 1932 [u/s 2(32) of the ITO].
S 3 - FORMS OF BUSINESS vs. TAX PAYING ENTITY
“Company” [u/s 2(20) of the ITO] means a company as defined in the Companies Act, 1913 or 1994 and includes –
a body corporate established or constituted by or under any law for the time being in force;
any nationalised banking or other financial institution, insurance body and industrial or business enterprise;
an association or combination of persons, called by whatever name, if any of such persons is a company as defined in the Companies Act, 1913 or 1994;
any association or body incorporated by or under the laws of a country outside Bangladesh; and
any foreign association or body, not incorporated by or under any law, which the NBR may, by general or special order, declare to be a company for the purposes of the ITO.
For preferential tax purpose, companies are classified into following groups:
(1) Company being bank, insurance or financial institution;
(2) Mobile Phone Operator Company (Listed or Non-listed)
(3) Other companies:
(a) Company not publicly traded; and
(b) Publicly traded company, enlisted with the Stock Exchange
S 4 - FORMS OF BUSINESS vs. TAX PAYING ENTITY: tax payers status Bangladesh
Business entity Personal status Residential status : resident u/s (2/55)
Sole propietership No separate tax paying identity, “Individual” status of the owner and not of the business entity
“Individual” owner of the sole-proprietorship is to be a resident if his period of stay in Bangladesh is at least 182 days in the concerned income year, or at least 90 days in the concerned income year, and at least 365 days in the preceding 4 income years.
Firm “Firm” as a separate If the control and
tax paying identity management of the firm’s affairs situated wholly or partly in Bangladesh in the concerned income year.
company “Company” as a separate tax paying identity
If control and management of the company’s affairs situated wholly in Bangladesh in the concerned income year.
Resident assessee has to pay income tax on total global income including foreign income, but non-resident taxpayer has to pay income tax only on his total domestic income u/s 17. When an assessee is not a resident, the assessee will be a non-resident [u/s 2(42)].
S 5 - FORMS OF BUSINESS vs. TAX PAYING ENTITY: levels of taxation
• Pass-Through Entity: This entity is not taxable itself. The income of the entity will pass through the owners and is taxable after its accumulation with the owner’s other income. Sole-proprietorship is a pass-through entity. The owner of the entity is taxable for the entire income of the business entity (whether withdrawn or not) along with his/her other income. Pass-through entities are conduits through which income flows to their owners.
• Non-Pass-Through Entities: This entity is taxable itself. The income of the entity may be distributed to the owners and is usually again taxable in the hands of owners after its accumulation with his/her other income. Companies are non-pass-through entities.
• Status of Partnership Firms: In the USA, partnership firms are pass-through entities. But In Bangladesh, they are non-pass-through entities.
S 6 - FORMS OF BUSINESS vs. TAX PAYING ENTITY: levels of taxation firms – Bangladesh
• A partnership firm is taxable for its income in first instance as a non-pass-through entity.
• Payment by way of interest, salary, commission or remuneration made by a firm is not deductible [u/s 30(b)].
• The partners of the firm shall include the share of total income of the firm in the income year [to be computed u/s 43(3)]. Share of income of a partner out of the capital gains on which tax has been paid by the firm is exempted [para 18, Part-B, 6th Sch.].
• But to avoid double taxation, the share of income will be treated as tax-free income subject to tax rebate at ATR if the firm has already paid tax on its income [para 16, Part-B, 6th Sch.].
• But where any tax payable by any partner of a firm in respect of his share of income cannot be recovered from him, then DCT shall collect it from the firm [sec. 98].
• In case of discontinued business of a firm or if the firm is dissolved, the partners are jointly and severally liable to pay due tax, if any [sec. 99].
S 7 - FORMS OF BUSINESS vs. TAX PAYING ENTITY: levels of taxation company – Bangladesh
• A company is taxable for its total income always as a non-pass-through entity.
• The shareholders of the company are taxable for the income of the entity, only if distributed to them as dividend, which is subject to a source-tax u/s 54 [@ 20% for companies; 10% for resident/non-resident Bangladeshi non-corporate shareholders; 25% for non-resident non-Bangladeshi non-corporate shareholders].
• At the time of sale/transfer of shares, the shareholder may require to pay tax on capital gain arising from the sale or transfer.
• Thus, shareholder-level of tax (ts) usually includes tax on dividend distributed and tax on capital gain on sale/transfer of shares.
• However, capital gain on transfer of shares of a company may be exempted or subject to a reduced rate.
S 8 - FORMS OF BUSINESS vs. TAX PAYING ENTITY : levels of taxation company – Bangladesh
• Up to AY 2009-10: Capital gain on transfer of stocks and shares of public companies listed with a stock exchange in Bangladesh is fully exempted [sec. 32(7)], if no investment tax credit taken earlier [sec. 32(12)].
• From AY 2010-11: Capital gain on securities** of listed companies are taxable at:
S 9 - FORMS OF BUSINESS vs. TAX PAYING ENTITY : levels of taxation - multiple level taxation non pass through entities – Bangladesh
- a partnership firm defined u/s 2(32) [SRO No. 269-Ain/Aykar/2010, dated 1.7.2010]
10%
- a company [SRO No. 269] 10%
- a sponsor shareholder or director or placement-holder of a listed company [source tax u/s 53M and settled tax u/s 82C]
5%
- a sponsor shareholder or director of bank, financial institution, merchant bank, insurance company, leasing company, portfolio management company and stock dealer company [SRO No. 269]
5%
- other shareholder or director of a listed company having more than 10% of share capital of a company at any time in income year [SRO No. 269]
5%
** “Securities” means stocks, shares, mutual fund unit, bond, debenture or other securities, except government securities listed with the stock exchange [SRO No. 269] .
Capital gain on transfer of stocks and shares of private limited company is taxable at 10% [S.R.O. No. 220-Ain/Aykar/2004 dated 13.07.2004]
• In case of a non-pass-through entity, there is at least double-level taxation.
• First, a tax is paid by the entity and then a second tax is paid by the owners of the entity (partners of a firm or shareholders of company).
• In case of firm which has duly paid its tax, double taxation is avoided by considering the share of firm’s income as tax-free and allowing a tax rebate thereon to the partners.
• But in case of a company, it has to pay tax on its income at prescribed rate (27.5%, 35%, 37.5%, 42.5% or 45%, with a minimum of Tk. 5,000) and then the individual shareholders have to pay source-tax at 10% (Bangladeshis) or 25% (foreigners), which will be treated as AIT and then considering the marginal tax rate of the concerned Bangladeshi shareholders, tax rate on dividend may be up to 25% for high-income resident non-corporate Bangladeshi taxpayers.
• 42.5% (Bank, insurance or financial institutions),
• 35% (mobile phone operator companies listed with at least 10% shares),
• 45% (other mobile phone operator companies),
• 27.5% (listed industrial companies with at least 10% dividend declaration and payment of declared dividend within SEC stipulated time i.e., 60 days as per SEC’s SRO No. 385-Ain/91, dated 15.12.1991; 30 days from 9.2.2010 as per SEC Notification on same date),
• 37.5% (other industrial companies)
S 10 - FORMS OF BUSINESS vs. TAX PAYING ENTITY: levels of taxation - multiple level taxation non pass through entities – Bangladesh
• In case of a company investing in shares of another company, there will be triple taxation.
• The company of which shares have been purchased has to pay first-level tax on its income at 27.5%, 35%, 37.5%, 42.5% or 45% rate with a minimum of Taka 5,000 irrespective of profit or loss.
• Then the investing company has to pay second-level tax on distributed dividend at 20%.
• When it will distribute its income as dividend, its shareholders have to pay third-level tax (source-tax & possible extra tax for resident non-corporate shareholders).
S 11 - Double Taxation for Corporate Income: When?
• Only corporate income attributable to stockholders, the residual claimants, is subject to double taxation.
• Income distributed to:
1. Creditors,2. Employees, and3. Suppliers,
• in the form of interest, compensation, and other costs to produce and sell goods and services,is not taxed at the corporate level, because these items are deductible in computing corporate taxable income: Instead, this income is taxed exclusively to its recipients, just like pass-through entity’s income.
S 12 - FORMS OF BUSINESS vs. TAX PAYING ENTITY : USA
• Two or more levels of taxation: Corporate form of organization
• One level of taxation: Sole-proprietorship and Partnership forms of organization.
• Factors influencing the Choice between Corporate form of organization (2 or more levels of taxation) and Partnership form (1 level of taxation):
1. Length of the investment horizon2. Three tax parameters:
i) The investor’s personal tax rates on ordinary incomeii) Corporate-level tax rates, andiii) The shareholder-level tax rates on the returns to investing in
corporate shares.
Assumptions:
• No transaction or information costs (frictions).
• No expectation to observe both partnerships and corporations producing the same goods and services.
S 13 – 4.1 Organizational Forms for Producing Goods and Services – USA
• Sole Proprietorship: Income statement is filed along with owner’s personal tax return. The profits of the business are taxed only once at the owner’s personal level. In this regard, the sole proprietorship serves as a conduit through which the income of the business is passed through to the tax return of its owner.
• Partnership: It is another legal organizational form that serves as a tax conduit between the business and its partners. The partnership files its own information tax return, including an income statement, a balance sheet, and a schedule of specific allocations to each partner. These allocations are broken down by type of income and expenses; partners report their designated share of income and expense on their
own tax returns. The partnership entity does not pay any income tax. Partnerships may have two classes of partners: general partners (liability limited only by their personal resources and the bankruptcy laws) and limited partners (more limited liability and typically do not participate actively in the operations of business).
S 14 - 4.1 Organizational Forms for Producing Goods and Services : USA
Corporations:
• US corporations are taxed directly on their taxable income.
• In addition to corporate-level taxes, stockholders are taxed on dividend income and realized capital gains at their own personal tax rates.
• Realized capital gains and losses are granted special treatment. It is taxed only when realized under the tax laws, which ordinarily occurs on a sale.
• Capital gains (losses) on the sale of stock are computed as the difference between the sale price and the basis of the asset (usually the purchase price).
S 15 - Reasons for which the common reference to the corporations as a “double tax” system can be misleading:
1. Shareholders are taxed only on the after-tax profits earned by the corporations. The taxes paid by the corporation are effectively deducted in determining the income taxed at the shareholder level.
2. The after-tax income earned at the corporate level is not taxed instantly to shareholders unless the corporation immediately pays out all of its after-tax earnings as a dividend or shareholders sell their shares each period.
3. Other sources of reduction in the two0level tax include the following:
a) An ability to distribute corporate profits in a tax-deductible way via interest, rent, royalty, compensation, and other payments, rather than by way of non-deductible dividends to stockholders.
b) Reduced tax rates at the shareholder level
c) Reduced corporate level tax rates for certain entities
d) Deferral of corporate income taxes (e.g., deferred repatriation of foreign subsidiary’s income)
S 16 - After-Tax Returns to Pass-Through and Non-Pass Forms of Organization
Assumptions:
1. Pre-tax rate of return (R) on a project is constant per year whether the project is undertaken in corporate or partnership form.
2. The project lasts for n years, at which point the organization is assumed to liquidate.
3. All after-tax income generated in the interim that is not distributed is reinvested in the business at rate R per period before tax.
Returns to Partnership Firms:
If the project is undertaken in partnership form, partners pay tax at their marginal tax rates, tp, each year, as income is earned. Distributions at rate tpR are made each period from the partnership to enable partners to pay their personal tax. A partner’s after-tax accumulation for an initial $1 investment is:
$1[1 + R(1 – tp)]n ……………………….(4.1)
Similar to Savings Vehicle I (Chapter 3)
If R = 20%, tp = 40% and n = 5 years, then
$1[1 + .20(1 – .40)]5 = $1.76
S 17 - After-Tax Returns to Pass-Through and Non-Pass Forms of Organization
Returns to Corporate Entities:
If the project is undertaken in corporate form, initially we assume the corporation pays no interim dividend. In this case, shareholders pay tax at their capital gains rate, tcg, when the firm liquidates or when shareholders sell their shares. In addition to the shareholder-level tax, the corporation must pay taxes each year at rate tc on the before-tax return, R. Combining the annual corporate-level tax and the shareholder-level tax, the after-tax accumulation for an initial $1 investment is:
S 20 - CHANGING PREFERENCES FOR ORGANIZATIONAL FORMS INDUCED BY TAX-RULE CHANGES
The Required Before-Tax Rates of Return on Corporate and Partnership Activities
• The corporate sector of the economy has dominated (in terms of capital under control) and continues to dominate the partnership form as the vehicle through which goods and services are produced.
• For this dominance to persist, the cost of converting from corporate form to partnership form or the nontax advantages of corporate form must be considerable.
• In this section, it is determined how large the before-tax return of corporations (Rc) must be (because of the nontax advantages) to preserve indifferences between the partnership and the fully taxable corporation.
S 21 - CHANGING PREFERENCES FOR ORGANIZATIONAL FORMS INDUCED BY TAX-RULE CHANGES
The Required Before-Tax Rates of Return on Corporate and Partnership Activities
After corporate taxes, but before shareholder-level taxes, the corporation realizes a return of rc, where rc = Rc – tcRc = Rc(1 – tc).
S 22 - CHANGING PREFERENCES FOR ORGANIZATIONAL FORMS INDUCED BY TAX-RULE CHANGES
The Required Before-Tax Rates of Return on Corporate and Partnership Activities
TABLE 4.1: Various Required Annualized Corporate After-Tax –
but Before Shareholder-Level Tax – Return on Shares r*c
Shareholder Tax Rates
Rp r*c (in %) [After corporate tax but
before shareholder-level tax] After-tax Return (rp)
tp tcg n =1 5 10 20 50
50% 20% 10% 6.25 6.11 5.97 5.76 5.43 5.00
40% 16% 10% 7.14 7.00 6.86 6.65 6.35 6.00
30% 12% 10% 7.95 7.82 7.70 7.52 7.27 7.00
S 25 - CHANGING PREFERENCES FOR ORGANIZATIONAL FORMS INDUCED BY TAX-RULE CHANGES
The Effective Annualized Tax Rate on Shares [ ts ]
This captures the hypothetical annual tax rate shareholders could pay each year on their pretax stock returns that would be equivalent to paying the share-holder-level tax they actually pay when they sell their shares. The ts is found from:
r*c (1 – ts) = rp ……………………….(4.8)
Thus,
ts = 1 – rp / r*c ……………………….(4.9)
If Rp =10%, tp= 50%, rp = 10%(1 – .50)=5%, r*c=5.97% at n = 10 (from Table
4.1),
ts = 1 – .05/.0597 = .162 = 16.2%.
If investors paid tax at a rate of 16.2% on accrued gains each year, it would be equivalent to paying tax at a 20% capital gains rate (tcg) on selling their shares in 10 years.
S 26 CHANGING PREFERENCES FOR ORGANIZATIONAL FORMS INDUCED BY TAX-RULE CHANGES
Required Before-Tax Rate of Return: Corporations vs. Partnerships
R*c(1 – tc) = r*
c ……………………….(4.10)
Equation (4.8) r*c (1 – ts) = rp can be written as:
R*c (1 – tc)(1 – ts) = Rp(1 – tp)
Or, R*c / Rp = (1-tp) / ( 1-tc) (1-ts)
If tp =28%, tc= 35%, ts = 7%,
R*c / Rp = (1-0.28) / (1-0.35) ( 1-0.07) = 1.191
S 27 - CHANGING PREFERENCES FOR ORGANIZATIONAL FORMS INDUCED BY TAX-RULE CHANGES
Other Issues:
• Cross-Sectional Variation in Corporate, Personal, and Shareholder-Level Tax Rate
- tax rates vary over time
- tax rates vary among investor
• Net Operating Losses (NOL) and the Corporate Tax Rate
- NOL carry-backward and carry-forward
• Further Complications in Determining the Shareholder-Level Tax Rate, ts
- investment horizons and personal tax rates differ
- complications in analyzing ts arises if the returns on stocks are
held in different organizational forms, which are taxed differently
• Progressive Personal Income Tax rates, tp and tcg
S 28 - OTHER ORGANIZATIONAL FORMS FOR ORGANIZING PRODUCTION ACTIVITIES
1. S-Corporations. The profits of S-Corporations are, for the most part, taxed only at the shareholder level, as with partnership income. Shareholders of S-Corporations enjoy limited liability, but the corporation must have 70 or fewer shareholders, only one class of stock, and no foreign or corporate shareholders.
2. Limited Liability Companies (LLCs). These are hybrid entities that under state law are neither partnerships nor corporations. Under state law, they offer shareholders limited liability while under current federal tax law, these entities can elect to be taxed as a partnership.
3. Small Business Corporations (Section 1244). Small (up to $1,000,000 in equity) business corporations face most of the usual corporate tax rules. However, original shareholders in these U.S. corporations can deduct up to $50,000 of capital losses in a given year instead of only $3,000 in regular corporations. To qualify, the corporation must be an operating company, rather than a passive investment company.
4. Foreign Subsidiaries. Foreign subsidiaries of U.S. corporations are taxed by host governments at the foreign tax rate and are also taxed by the U.S. at U.S. rates when the foreign profits are repatriated. The U.S. government also credits the corporation for the foreign taxes already paid (up to the U.S. tax rate).
5. Closely-Held Corporations. Closely-held corporations are typically owner-managed. Owner-managers may pay themselves generous salaries or bonuses (subject to IRS claims of unreasonable compensation) to avoid the corporation-level tax.
6. Not-for-Profit Corporations. Tax-exempt, not-for-profit entities may produce goods and services that are consistent with their tax-exempt purpose without paying corporate income tax. The “unrelated business taxable income” of such entities, however, are subject to income taxes at the maximum corporate statutory rate.
7. Tax-Imputation Corporations. Here, part of the corporate-level tax is converted into a partnership level tax.
8. Corporations Subject to a Progressive Tax Rate.
S 30 - OTHER ORGANIZATIONAL FORMS FOR ORGANIZING PRODUCTION ACTIVITIES
B. NONCORPORATE ORGANIZATIONAL FORMS
1. Master Limited Partnerships (MLPs). MLPs are basically partnerships with two types of partner: general partners (who actively participate in business operations and liability limited by their personal resources) and limited partners (who typically do not participate in operations and liability limited by investment).
2. Publicly Traded Partnerships (PTPs). Partnerships which have listed their partnership interests on organized stock exchanges.
3. Limited Liability Partnerships (LLPs). The LLP is a modified general partnership designated specifically for professional service organizations, such as the Big 4 accounting firms, to operate as a partnership with some personal liability protection.
4. Real Estate Investment Trusts (REITs). If a REIT distributes all of its earnings to its shareholders each year and satisfies some other ownership restrictions, it avoids an entity-level tax and earnings are taxed only at the shareholder level.
5. Real Estate Mortgage Investment Conduits (REMICs). REMICs are another pass-through entity. Substantially all of the REMIC assets must consist of qualified motgages and mortgage-related assets.
S 31 - NONTAX ADVANTAGES OF OPERATING IN CORPORATE FORM
1. Transaction costs of operating as a large partnership: Reorganization costs, underdeveloped case law, uncertain property rights in various circumstances, lack of limited liability, and greater operating costs increase the costs to operating as a partnership.
2. Access to capital markets: Large corporations traded on organized exchanges typically have easier access to markets for both debt and equity capital. Likewise, shareholders value their right to acquire or sell their assets in liquid markets, a right that is typically absent in the market for partnership interests.
3. Control of management: It is more difficult for limited partners to control the actions of managers (the general partners) than it is for stockholders to control managers of corporations.
4. Less onerous tax burden: The double taxation of corporate profits cannot be too onerous. Otherwise, costly changes in organizational form will occur or hybrid forms such as the LLC will emerge.
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