Tax Law - Diritto Tributario (Prof. Parada)

Tax law (Parada) Università degli Studi di Torino, Business and Management, 2nd Year

Lecture One: Taxes are a distortion of the market

Taxes are a compulsory levy imposed by governments on individuals and businesses in order to:

• Finance their expenditure (to provide public goods)
• Stimulate some specific sectors of the economy
• Avoid certain behaviours
• Control macroeconomic indicators

Taxes can be a levy on:

• Income/profits
• Assets
• Consumption

In many countries, a politician cannot say he wants a new tax to make something specific because they cannot ensure that they will use them for that purpose. In some countries, when a person is dying, there is a tax imposed on the total amount of assets.

There are limitations to taxation; generally, every country applies various principles:

• Rule of law (principle of legality): Taxes have to be provided by law, there must be a control, because taxes give the power of money to the government. It has to be democratic, as they are a really sensitive issue.
• Tax neutrality: Means that taxes should not affect your economic decisions, it does not matter who you are.
• Ability-to-pay: Basically, you should not have to pay more than you have; in many countries, it is represented by a constitutional article (at firm level, for example, limitations on deduction).

There are different sources of taxation:

• Domestic law
• International law (tax treaties): Its purpose is to avoid double taxation.
• EU tax law

However, countries have tax sovereignty; they can choose how to tax, what to tax, and how to do it. We have different types of taxes:

• Direct taxes (taxes on income and profits)
• Indirect taxes (taxes on goods and services)

There are several tax rates:

• Nominal tax rate (statutory): Tax rate that you see on the law.
• Effective tax rate: Tax you effectively pay, you have deductions, taxes are applied on taxable income.

At the same time, we can divide tax rates into other types:

• Progressive tax: Tax is moving according to the amount of money you’re receiving.
• Proportional tax: There is no movement on the tax rate; it is 50% for everybody (VAT).
• Regressive tax: Tax rate is decreasing according to the level of your income.

There are not so many regressive taxes, but several proportional taxes that are considered to have a regressive effect.

Case Study

Country X decides to introduce a domestic rule that limits the deduction of interest for business activities up to 30% of the total amount of interest paid either domestically or internationally by a business.

Do you think that the new domestic rule in the country might conflict with any of the principles of the taxation already studied?

➢ It conflicts with the ability-to-pay principle and tax neutrality.

Do you think that it would make a difference whether those principles are expressly recognized within domestic law, supranational law (e.g., EU law), or international law?

➢ It will make a difference because, if it is EU regulations or national, in other parts of the world it may be cheaper, while if it is international it will make no difference.

Case Study

Country X has a corporate income tax with a tax rate of 25% since 1999. In 2018, the tax administration issues a notice that provides that in the case of tax evasion, this rate will be increased up to 80% as a penalty.

Do you see any problem with this new administration notice?

➢ Yes, it is not in accordance with the rule of law principle (because it is issued by a tax administration and not through a law issued by the parliament).

What principles of taxation may be jeopardized in this case?

➢ It is not in accordance with the ability-to-pay principle, neutrality, and the rule of law principle.

Case Study

Dr. Tortellini is a re-known tax expert who affirms in his last paper that a VAT rate of 10% has indeed a regressive effect.

Do you agree with his statement?

➢ It depends, you must justify.

Why? Why not?

➢ In some cases, VAT is different in relation to the types of goods (primary or luxury). Moreover, if I am very rich, I will buy things like iPhones and Ferraris; otherwise, I will take buses.

Case Study

Dr. Tortellini is now advising Country X to implement a tax reform. He proposes to introduce a “progressive” CIT (progressive income tax rates as per the size of the firms and the income they produce).

According to Dr. Tortellini, this will increase fairer taxes because larger size firms will pay more taxes than smaller ones.

Does Dr. Tortellini’s advice make sense?

➢ No, it does not make sense to me.

Why? Why not?

➢ The tax increase in a big corporation would be paid by consumers, by workers, by investors and by all the individuals behind the legal entity. Moreover, it will bring the big company to get out of the country and move somewhere else, which would increase unemployment, etc.

Lecture Two: How can business activities be performed?

• Individuals: Self-employment income. A person who is carrying out a business by himself has an income and has to pay taxes annually by himself (both with social security and health insurance).
• Legal entities: Business profit. An employee who works for instance for Fiat has a tax (payable) that is paid by the employer (Fiat, 10%). The obligation to pay the taxes is given to the employer (he has social security and health insurance too).
• Corporate (corporation)
• Non-corporate (partnership)

During the course, we will focus on individual taxes/self-employment. However, legal entities can be divided into corporate entities (here we have limited liability) and non-corporate entities. Some kinds of businesses must be performed just by corporations, like insurance companies and banks.

In terms of taxes, a corporation is a separate legal entity that exists for all tax purposes; you pay a specific tax for that entity. If it has profit, it will pay taxes on it and then it will pay taxes on dividends. A non-corporate entity, on the other hand, does not exist for tax purposes, it is not recognized as an entity, but rather at the level of the owner. Here, the income will not be taxed at the level of the partnership, but only at the level of the company. Every profit in a partnership will not be subject to taxes but only later, at the level of the single owners.

Generally, there are a lot of factors influencing the choice between setting up a partnership or a corporation, not only taxes (flexibility, ability to raise money, etc.).

We have different factors that influence which taxes we will have to pay (as an individual or corporation):

• (Gross) Income: Everything will be income unless the government will say “this is not income.”
• Salary (wages) – Revenues
• Capital gain (results of selling capital assets – stocks, properties, bonds)
• Interests from financial instruments
• Dividends (what we keep after paying the company income taxes)
• Inheritance – not for corporation
• Gifts (over a certain amount)
• Pensions – not for corporation
• Rent
• Share in the partnership
• Tips – not for corporation
• Payments from insurance
• Royalties (when you’ve some cover-right)
• Deductions: are reducing the amount of Gross income you’re declaring.
• Salaries of employees
• Depreciation
• Amortization
• Interests
• R&D
• Marketing & Advertisement costs, etc.
• Exempt Income: It is something that is income, but you do not pay taxes on them (compensation for services, etc.); however, you have to declare it.
• Taxable Income

There are many taxes that trigger taxation:

• Residence/Domicile
• Citizenship
• Place of Consumption

Individuals:

Residence: For tax purposes, a person stays for a certain period in a place (183 days in a calendar – six months). Normally, a resident in a country will be taxed on his worldwide income. Non-resident people pay only on income generated within the country.

Domicile: It is more a legal concept; it is more about having your main business/family in the country, it is a proof that your domicile is in the country. Even if you change residence, it may be possible that you’re still taxed on your worldwide income.

Citizenship: There are two countries that are taxing citizens no matter where you are, the US and Eritrea.

Corporation:

The place of incorporation – generally used to determine where it is the residence. The place of management and control – some countries say that the residence of the corporation will depend on where the corporation is managed. For instance, in Ireland until 2013, you could incorporate the company in Ireland but manage and control it somewhere else and it wouldn’t be resident in Ireland. At the same time, it is not resident in the US because they use the other criteria, this created many problems. Each country decides on its own which criteria to use to establish where the residence is.

We can have many sources of income:

• Domestic Source
• Foreign Source

Case Study

After 20 years living and working in country X, Mr. Robinson and his family decide to move to country Y. Mr. Robinson registers his children at a school there and his wife gets a job as a school teacher too. For practical reasons, Mr. Robinson keeps his bank accounts in country X and decides to lease the family house in that country. The payments of the rent are deposited directly in the bank account in country X. In country Y, Mr. Robinson works as self-employed, but the majority of his clients are located in country X.

What problems do you see with regard to Mr. Robinson’s movement to country Y?

➢ We have to establish the difference between residence and domicile. In country X, he has a house and he is renting it (so income), he has some clients there, so he moves frequently there. On the other hand, he has moved to country Y, we can suppose that he has domicile there. So, it depends on the rule of policy applied by country X; if it is not strictly linked to staying there, then he has residence. On the other hand, if X applies just the principle of residence, he is not a resident anymore; if X applies the concept of domicile, then he pays taxes also there. It is about factors like bank accounts and clients. The same stuff is linked to country Y.

In a position as a tax advisor, would you recommend him to do something different?

➢ It would be a good idea to change the bank account and move it to country Y, try to get as few connections as possible with the old country.

Case Study

Mr. Fletcher wants to invest in a touristic business resort in Mojito Country and for that purpose he needs a legal form. The State offers the possibility to set up both corporate and non-corporate entities, including also sole proprietorship entities. The statutory CIT rate in Mojito country is of 10% and a complete exemption of taxes is applied for individuals no matter where income is sourced.

Should Mr. Fletcher set up a Corporate or Non-Corporate legal entity to carry out his business? Does it make any difference?

➢ I think that it would be convenient to set up a sole-proprietorship in order to avoid the double taxation and the CIT (we have the complete exemption).

What are the advantages of both options?

➢ In the first case (non-corporate), you avoid double taxation, it is a more flexible form of business. On the other hand, for a corporation, you can easily raise money and you have limited liabilities. Moreover, if you have a big debt, you can deduct from tax, and you have a solid structure to show as a guarantee.

Would your answer vary if I would say that the effective CIT rate in Mojito country is on average 0.001%?

➢ Maybe in this case the difference is so minimal that he will consider the corporate form. However, in some countries, it acquires more importance the stuff of double taxation and simplicity, so maybe individual or partnership it is still better.

Case Study

A group of investors decides to invest in the mining sector of country X. for simplicity of its formation in comparison to a corporation. A partnership in country X is not subjected to taxation at all. Taxes are rather charged at the level of the partners (i.e., personal income taxes) but only affecting domestic sourced income received. The partnership receives income from its operational activities of 100,000 EUR. It also receives interest from investments in country Y, which amount to 50,000 EUR and pays 5,000 EUR on taxes in country Y derived from this investment income.

How much taxes must be supported in country X? Who does pay those taxes?

➢ In this case, they pay only on the income sourced in country X, they only pay income at partners' level not through the company. So, it would be 50,000 EUR each if you have two partners.

May the investors deduct the payment of foreign taxes (country Y) in country X? Why? Why not?

➢ Can I use dollars from country Y to reduce tax in country X (so to deduct them)? The answer is no because it says: taxes “only affecting domestic sourced income received.”