AFM361 Tax Planning Supplemental notes.pdf

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Accounting & Financial Management
AFM 361
Dan Rogozynski

Ch. S-1/Concepts of Tax Planning 1 ¶1,900 CONCEPTS OF TAX PLANNING ¶1,901 Tax Planning and Tax Compliance This supplement to chapter 1 of Beam, Laiken and Barnett, Introduction to Federal Income Taxation in Canada, 1 introduces some of the fundamental concepts of tax planning. Tax planning and tax compliance both require a detailed knowledge of the tax law, but tax planning differs along many dimensions from tax compliance. For example, tax compliance often occurs after a transaction is complete, and so the structure and timing of the transaction are fixed; however, tax planning usually occurs before the transaction and so the structure and timing of the transaction can be managed to achieve the most desirable outcome. Tax planning can add considerably to value. Example Problem 1 Bob is unsophisticated in his finances. He has been working since he was 18; he is now 35. He lives a comfortable life but has limited investments or knowledge of investing. He also has no tax knowledge. In July 2010, Bob received $10,000 as a bequest. He would like to save the bequest for a future need, or more likely, for the thirty years until he expects to retire. He plans to improve his investment acumen because he hates paying others to manage his finances. Somewhat limited in his time, he can only acquire one skill: tax planning or investment strategy. Tax planning will give him a decent knowledge of individual taxation whereas investment strategy will allow him to improve his investment returns. Absent additional investment knowledge he will invest in large, Canadian companies’ common shares. Assume that Bob will invest for 30 years and the blue-chip stocks he has chosen have a combined expected annual return over that period of 12%. Assume also that his current and future marginal tax rate is 40%. — REQUIRED Making realistic assumptions, which skill should he acquire? — SOLUTION If Bob acquires even rudimentary tax knowledge, he will learn that investing in an RRSP defers taxation. He could invest $10,000 at 12% in an RRSP and receive $299,600 in 30 years after tax.(1)If he gains investment knowledge but not tax knowledge, he would (2) have to achieve an average return of 20% before tax to achieve the same after-tax savings, which is dramatically better than the market return. If he is unsuccessful in achieving this exceptional return and only achieves a 15% return, he will only have $132,677 in 30 years. Therefore, while both skills are valuable, Bob would be better to acquire at least a basic understanding of personal income taxes to maximize his after-tax wealth. —NOTES TO SOLUTION (1)An RRSP’s after-tax value in 30 years is computed as $10,000  (1+ 0.12)30  (1 – 0.40) ÷ (1 – 0.40) = $299,600. 1In this document, BLB will be used to refer to the Beam, Laiken and Barnett book. 2 Supplement to AFM 361 (2The value of such an investment is $10,000 (1+ 0.20 (1 – 0.40))30= $299,600. The goal of this document is to introduce the three main components of tax planning. The first theme describes the basic calculations needed to understand tax planning. The second is to introduce the forms of tax planning and emphasizes the need to consider the timing, character, and parties to the transaction. As part of this description, tax plans are segregated into those that involve the taxpayer alone versus those that involve several economic parties. Finally, most transactions involve additional costs, other than taxes. These additional costs need to be considered when deciding on the best action to take. ¶1,905 Review of Tax Calculation Computing the amount of tax owing to a government body can be thought of as simply the tax base times the tax rate. Tax = Tax Base  Tax Rate The tax base is the value on which the tax is levied. For example, the tax base for the income tax is taxable income, defined in the Income Tax Act (see BLB ¶1,200 – 1,220) and the tax base for the goods and services tax (GST) is taxable supplies (BLB ¶1,430). The tax rate is applied to the base. In some cases, like the GST, the same rate is applied to the entire base. In cases like the income tax, the rate will vary as the base becomes larger. For taxes where the rate changes as the base increases, the base is typically divided into segments, or brackets, and a rate is applied to each bracket. For these types of taxes, the rates typically increase as the base gets larger. This tax structure is referred to as a progressive tax. The income tax is a progressive tax because the tax rate increases as the base increases. A proportional tax is one for which the tax rate does not change as the base increases, like the GST. In a regressive tax, the tax rate decreases as the base increases. There are few examples of regressive taxes because this structure violates the concept of vertical equity (see BLB ¶1,040.20). As described more fully in BLB chapter 10, federal income taxes for 2010 are computed at the rates shown in Exhibit S1-1. The tax calculation is broken into two parts. The first is the total tax applicable to all previous brackets and the second is the rate as applied to the income in the bracket. Consistent with the Ontario calculation, below, federal personal credits of $2,100 will be assumed unless otherwise specified. For example, taxable income of $100,000 generates tax of $17,755 after the assumed $2,100 of personal credits. 2 EXHIBIT S1-1 2010 Federal Income Tax Brackets Taxable income Tax $40,970 or less ............................15%..... In excess of $40,970 .........................$6,146 + 22% on the next $40,971 In excess of $81,941 .........................$15,160 + 26% on the next $45,080 In excess of $127,021 .........................$26,881 + 29% on the remainder 2 Computed as follows: $17,755 = $15,160 + 26% ($100,000 – $81,941) – $2,100. Ch. S-1/Concepts of Tax Planning 3 In addition to federal income taxes, the provinces also levy income taxes on their residents. In chapter 10 of BLB, a hypothetical provincial tax structure is given. This hypothetical provincial structure is helpful to illustrate the issues of the text, but we will use the actual Ontario rates and brackets when individual provincial taxes are computed. The tax rates and structure for 2010 in Ontario are shown in Exhibit S1-2. Due to the surtaxes, which are applied after individual credits are deducted, it will be assumed that an individual has personal credits totaling $700 unless otherwise given. Thus, for example, taxable income of $100,000 generates tax of $8,970, after considering the assumed $700 provincial credit.3 EXHIBIT S1-2 2010 Ontario Income Tax Brackets Taxable income Tax $37,106 or less ............................5.05%.. In excess of $37,106 ........................$1,874 + 9.15% on the next $37,108 In excess of $74,214 .........................$5,269 + 11.16% on the remainder Surtax: add 20% on tax above $4,006, plus 36% on tax above $5,127 Tax rates, at least for the highest-income individuals, have been relatively stable over the last decade, and compare favourably in a historical perspective. Figure S1-1 provides a summary of the top statutory tax rate that applies to income in Ontario since 1985. Capital gains rates are also included. Combined Federal-Ontario Historical Top Marginal Tax Rates, 1985 – 2010 55 50 45 40e 35 30 25 20 15ginal Top 5 0 1985 1990 1995 2000 2005 2010 Ordinary income Capital gains 3This is computed as tax after credits of $7,447 = $5,269 + 11.16% ($100,000 – $74,214) – 700. This creates surtax of $1,523 = 20% ($7,447 – $4,006) + 36% ($7,447 – $5,127), for total tax of $8,970. 4 Supplement to AFM 361 ¶1,910 Measures of Tax Rates For progressive or regressive tax rate structures, the tax rate applicable to the base changes as the base increases. In these settings, there are two basic methods of measuring the tax rate applicable to a particular taxpayer or specific transaction. The marginal tax rate is the tax rate that applies to the next increment of the base. It is computed as follows: Tax Marginal Tax Rate Tax Base Example Problem 2 Molly Lee is expecting to have taxable income of $100,000 for 2010. She was recently informed that on December 23, 2010 she will receive a bonus of $1,000. —REQUIRED Determine the marginal tax rate that applies to the bonus. —SOLUTION The marginal tax rate on the bonus is 43.4%. Her tax without the bonus is $17,755 federal plus as $8,970 Ontario, computed above, for a total of $26,725. Her federal tax with the bonus is $18,015 = $15,160 + 26% ($101,000 – $81,941) – $2,100. Her Ontario tax with the bonus is $7,558 = $5,269 + 11.16% ($101,000 – $74,214) – 700, plus $1,586 = 20% ($7,558 – $4,006) + 36% ($7,558 – $5,127). Total tax becomes $27,159. Thus, her marginal tax rate on the bonus is as follows: Tax 27,15926,725 434 43.4%   Tax Base 101,000100,000 1,000 If the incremental income is small, the marginal tax rate can be determined by using the rate applicable to the bracket that the taxpayer is in. For example, at $100,000 of income, an individual taxpayer is in the 26% federal bracket, so on small amounts of additional income or deductions, the marginal tax rate will be 26%. For Ontario, it is less simple due to the surtaxes. However, at $100,000 of income, the taxpayer is well into the top bracket and it is clear that both surtaxes apply. Thus, the Ontario marginal rate is fairly easily determined as 17.4%. If the change in income is large, so the incremental income or deduction causes the taxpayer is cross into the next bracket, then the full calculation becomes necessary. Also, some income and deductions affect other tax calculations, making a fuller analysis 4Computed as 17.4% = 11.16% x (1 + 20% + 36%). Ch. S-1/Concepts of Tax Planning 5 necessary. In the discussion of tax planning below, we will usually employ the marginal tax rate because it represents the additional taxes paid or taxes saved that results from the change produced by the tax plan. Another useful calculation is the average tax rate. An average tax rate, like other average cost values, is a comprehensive measure of taxes owing. It is computed as follows: Average Tax Rate Total Tax Total Tax Base For a progressive tax rate structure, the average tax rate is always less than or equal to the marginal tax rate; for regressive tax rate structures, the average tax rate is always greater than or equal to the marginal tax rate. The average tax rate is often used to estimate the tax burden. Tax policy makers and commentators use tax burden estimates to assess how onerous tax systems are. Example Problem 3 After including the bonus to Molly Lee, she is expecting to have taxable income of $101,000 for 2010. She is interested in her average tax rate. —REQUIRED Determine the average tax rate that applies. —SOLUTION The average tax rate is 27.4%. Her tax on $101,000 of taxable income is $27,159 as computed in Example Problem 2. Thus, her average tax rate is as follows: Total Tax 27,159 27.2%  Total Tax Base 101,000 It is also important to be able to compute the pre-tax value of an after-tax amount. For example, if an employer would like to compensate an employee for the use of her car, the employer might offer a monthly allowance. The employer estimates that the employee must receive $500 per month, after tax, to pay for reasonable vehicle costs. This type of allowance is taxable to the employee. Thus, the employer must pay the employee more than $500 per month. But, how much more must be paid? It is common to simply compute the tax on the extra income. However, this does not provide the correct answer because the extra payment to cover the tax is also taxable. The following formula provides the correct answer. PreTax Amount AfterTax Amount 1 Marginal Tax Rate Example Problem 4 Roxanne’s employer, APR Ltd., would like to pay her a monthly car allowance to compensate her for $500 of car expenses, after tax. Roxanne has a marginal tax rate of 43.4%. 6 Supplement to AFM 361 —REQUIRED Determine the amount of the pre-tax car allowance. —SOLUTION The required allowance is $883.39. Using the formula, the calculation is as follows: 883.39 AfterTax Amount  500 1 Marginal Tax Rate1 43.4% To verify that this is correct, the after-tax amount can be determined directly: Allowance paid to Roxanne $883.39 Tax on allowance 43.4%  883.39 = 383.39 After tax income $500.00 ¶1,915 Forms of Tax Planning Tax planning activities can be categorized along several dimensions. For example, plans are sometimes characterized as individual versus corporate plans, or investment versus business plans, and domestic versus multinational plans. As a start, tax planning will be summarized as those in which only one party is involved, or unilateral plans, and later those plans involving a small group of parties, or multilateral plans. The decisions to pay off a mortgage or to invest in a Registered Retirement Savings Account are examples of unilateral plans. Compensation arrangements and asset sales are among the transactions that are included in the multilateral category. Unilateral tax planning, or tax planning for one economic entity, is relatively straight forward, at least conceptually. The taxpayer faces a setting in which he or she can choose among alternatives and the goal is usually to maximize after-tax “value.” In many cases, the value that is being maximized is the after-tax profit or rate of return. However, in some settings, other factors are also very important. For example, aggressive tax-motivated transactions have a higher likelihood of audit by the Canada Revenue Agency (CRA). Many taxpayers will not undertake transactions that could draw CRA’s attention. As a consequence, some more aggressive tax plans will not be chosen even when they generate higher after-tax income. To reduce the value of taxes paid, tax planning will typically take one of three forms: altering the timing of tax payments, altering the tax character of the receipt or expenditure, or shifting income from one party to another to reduce total tax payments. Each of these forms, altering the timing, character, or party, are used by taxpayers working alone, and so are forms of unilateral planning. They are also used in multilateral planning arrange- ments. The final strategy, income shifting, is particularly suited to multilateral planning; however, one party can control multiple tax entities, thereby allowing income shifting to occur in a unilateral setting as well. Ch. S-1/Concepts of Tax Planning 7 ¶1,920 Strategies Involving Timing ¶1,920.10 Time value of money The time value of money is a fundamental concept in many financial decisions. Earning a dollar today is better than earning a dollar next year. To compute how much better, one can compute the future value of today’s dollar in some future period, n. For example, using an 8% discount rate for one period, r, the following formula can be used to compute the value of a dollar next year: Future Value = Present Value  (1 + r) n= $1  (1 + 0.08) = $1.08 Similarly, paying a dollar of tax next year rather than paying it today is preferred under most conditions. For example, using an 8% discount rate for one period, the present value of a dollar of tax payment next year has a current value of only $0.93. n 1 Present Value = Future Value  (1 + r) = $1  (1 + 0.08) = $0.93 As a consequence, arrangements that delay the taxation of income or accelerate deductions decrease the present value of tax payments. Example Problem 5 Molly is an astute tax planner and instead of receiving her bonus on December 23, 2010, she asks to receive it on January 2, 2011. Assume that taxes are not withheld on the bonus payment, Molly has a discount rate of 8%, and her marginal tax rate is 43.4%. —REQUIRED Determine the tax savings from delaying the payment these ten days. —SOLUTION Since the income will be received at a very similar date, there is little difference in the present value of the income. However, if Molly receives the bonus payment late in 2010 and there is no tax withheld on the amount, she will have to pay tax on the income when she files her 2010 return, early in 2011. If however, Molly receives the bonus in early 2011, she will not have to pay tax on the income until she files her 2011 tax return, early in 2012. Thus, the payment of tax is delayed 1 year. Her increase in after-tax income from this delay can be computed as follows. Scenario #1: receive the bonus in late 2010 Value of bonus $1,000.00 (1) Tax in early 2011 43.4%  1,000 = 434.00 After tax income $ 566.00 Scenario #2: receive the bonus in early 2011 $1,000.00alue of bonus (1) Tax in early 2012 43.4%  1,000 = 434.00 Present value of 2011 tax payment 434  (1 + 0.08) = 401.85 After tax income $ 598.15 Comparison of the two scenarios After tax income from scenario #2 $598.15 After tax income from scenario #1 566.00 8 Supplement to AFM 361 Tax savings from delay $ 32.15 —NOTES TO SOLUTION (1)We will ignore the minor timing differences involving a few days or months. ¶1,920.20 Timing strategies when tax rates are constant From this example, it is clear that a taxpayer can increase the after-tax value of a transaction if the tax payment related to income is delayed or if the tax payment related to a deduction is accelerated. However, these statements are only true if the cash flow from the income or deduction is not altered as well. For example, waiting one year to receive income, even if the tax is also delayed one year, will not increase the present value of that income. Timing strategies are commonly used. The bonus strategy described in Example Problem 4 is so common that present tax rules include at least two provisions to limit the strategy. As described in Chapter 3 of BLB, to be deductible to the employer, the bonus must be paid within 179 days of the end of the taxation year. Because the employer will receive the deduction immediately using the accrual method, delaying the payment of the bonus effectively accelerates the deduction to the employer. If not for the 179-day rule, bonus payments could be delayed for several years. Secondly, tax regulations require employers to withhold income taxes on compensation payments, so the bulk of the taxes owed on the bonus are effectively paid at the time the bonus is paid. Another example of the timing strategy is the common use of tax-deferred savings vehicles such as registered pension plans, registered retirement savings plans (RRSPs), and registered educations savings plans (RESPs). These plans delay the tax payment on investment income until the income is withdrawn from the plan. ¶1,920.30 Timing strategies when tax rates change The general guidance that delaying the reporting of income or accelerating the deduction of expenses are based on the taxpayer facing a constant tax rate. Howeve
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