Tax Planning and Strategy PDF

BACTEL2X Strategic Tax Management 2TAY2223 Tax Planning and Strategy Tax Planning  TAX PLANNING Reducing taxes is beneficial, but why should managers learn the basics of tax planning? It may seem obv...

BACTEL2X Strategic Tax Management 2TAY2223 Tax Planning and Strategy Tax Planning  TAX PLANNING Reducing taxes is beneficial, but why should managers learn the basics of tax planning? It may seem obvious at first glance, especially to the owner-manager or corporate entrepreneur. But this is an important question, which can be answered differently at different times, in different organizations, and for operations in different countries. Managers need to learn about taxes because optimizing a venture’s total tax burden is important to its success, and managers are the main decision makers in an organization. Knowing the fundamentals of taxation and how to apply them allows managers to make better decisions and thus be more effective in their jobs. Managers who are able to identify tax issues can also make more effective use of tax consultants, because these managers can recognize a problem when it arises and advise consultants of the tradeoffs involved. Taxes impact success because operational decisions are generally based on the risk-adjusted net present value of expected after-tax cash flows. In addition, income taxes, payroll (e.g., Social Security), business (e.g., value-added, goods and services, or gross receipts), and property taxes often add up to one of the largest expense items of an organization. Furthermore, tax payments typically have a high legal priority claim on an organization’s cash flow. That is, not only can taxes be a big expense, but they must also be paid, and paid quickly. Publicly traded companies can be especially sensitive to tax expense. This is because earnings (which usually have a major impact on stock prices) must be reported on an after-tax basis. Indeed, not only must earnings be reduced by taxes paid in the current year, but earnings must also be reduced by any expected future income taxes generated by such earnings. Because senior Tax Planning and Strategy Tax Planning page 1 BACTEL2X  managers’ compensation is often tied to earnings via stock prices (e.g., through stock options), key decision makers in multinational organizations often have a high personal stake in optimizing taxes. Tax Planning vs. Tax Management Tax planning is often misconstrued with tax management, which simply means the process of systematically dealing with taxes. Tax management connotes the effective management of finances of a taxpayer, to file the returns and pay taxes on time while complying with the provisions of the relevant Income tax law and allied rules regularly and timely, so as to avoid the imposition of interest and penalties. Tax Planning Tax Management The objective of tax planning is to reduce the tax The objective of Tax Management is to comply with the Objective liability to the minimum. provisions of tax laws. Tax planning is very wide in its coverage and includes Tax Management has a limited scope, i.e., it deals with Scope tax management. specific activities related to tax compliance. Practice Tax Planning is optional. Tax Management is essential for every taxpayer. Tax Management relates to past (i.e. assessments proceedings, rectification, revisions, appeals etc.), Approach Tax planning is futuristic in its approach. present (filing of return of income on time based on updated records) and future (corrective action). Tax Planning and Strategy Tax Planning page 2 BACTEL2X  The benefits arising from tax planning are substantial As a result of effective Tax Management, penalty, penal Benefits particularly in the long run. interest, prosecution, etc. can be avoided. Emphasis It lays emphasis on reducing tax liability. It lays emphasis on reducing taxes and penalties. Tax Escapes Escapes from taxation are the means available to the taxpayer to limit or completely avoid the impact of taxation. With Loss of Government Revenue The following are the escapes from taxation that would result to loss of government revenue. BASIS TAX AVOIDANCE TAX EVASION TAX EXEMPTION What is it? Hedging of tax Concealment of tax Not falling within scope of tax Immoral in nature, which involves Illegal and objectionable, both in Attributes bending the law without breaking Special privilege given by law script and moral. it. Taking unfair advantage of the Deliberate manipulations in Application of concept of legislative Concept shortcomings in the tax laws. accounts resulting in fraud. grace Tax Planning and Strategy Tax Planning page 3 BACTEL2X  Legal Use of such means that are Non-compliance is not subject to any Use of Justified means Implication forbidden by law legal implication Before the occurrence of tax Occurrence After tax liability arises Imposition of taxes liability Type of Act Legal Criminal Legal Consequences Deferment of tax liability Penalty or imprisonment Non-payment of tax To reduce tax liability by applying To reduce tax liability by exercising Objective To provide legislative grace the script of law unfair means Without Loss of Government Revenue Escaping from taxation, however, may not result into loss of government revenue. Common examples of which are as follows. Shifting This is the process of transferring the tax burden to other taxpayers. Capitalization This pertains to the adjustment of the value of an asset caused by changes in tax rates. This pertains to the elimination of wastes and losses by the taxpayer to form savings to compensate Transformation for the tax imposition or increase in taxes. Tax Planning and Strategy Tax Planning page 4 BACTEL2X  Tax Amnesty vs. Tax Condonation Tax amnesty is a general pardon given by the government to erring taxpayers. It generally operates Tax Amnesty retrospectively by forgiving past violations. It is conditional upon the taxpayer paying a portion of the tax. Tax condonation or tax remission prospectively applies to forgiving any unpaid balance of tax. The Tax Condonation portion already paid is not refunded and no further payment is necessary. GOALS OF TAX PLANNING Most people think that minimizing taxes should be the goal of tax planning. This is shortsighted, because taxes are only one factor, albeit a major one, in the mix of costs and other factors that generate the amounts most often taxed: profits and wealth. Put simply, one can avoid many taxes by neither earning a living nor owning property, but most people do not aspire to a life of poverty, however tax free it is. Furthermore, strategies that reduce taxes are rarely cost free. If nothing else, when focusing on saving taxes, managers are not focusing on increasing sales, improving product quality, or producing goods and services more efficiently. The SAVANT framework recognizes this by striving toward optimizing taxes rather than minimizing them. The goal is to balance the benefits against the risks and costs. Tax strategies are also risky: Changing operations to save taxes (e.g., by operating through multiple corporations) often results in an increase in long-term administrative costs and generates uncertain returns because tax laws can change (and, as the Tax Planning and Strategy Tax Planning page 5 BACTEL2X  Comprehensive Tax Reform Program of the government have demonstrated in the Philippines, change can occur dramatically, rapidly, and unpredictably), and tax rules themselves are all too often obscure at best. In cross-border transactions, the interactions of multiple taxes imposed by different jurisdictions also must be appreciated. Also, tax-savings strategies can be intrusive. Why is it, for example, that profitable businesses in the National Capital Region do not all move to identified less developed areas (LDAs) should they want to avail incentives under preferential taxes? One reason is that it is costly to move. Another is that nontax factors dominate the decision: Many business owners may simply want to live in a specific area. Yet another reason is that skilled labor, qualified subcontractors, and competitive suppliers may be plentiful in a particular area. COST-BENEFIT CONSIDERATION All in all, there are many factors that combine to motivate managers of organizations to seek to reduce taxes, provided the cost of doing so is not too high. This is because tax planning requires making changes, and doing so is not cost free, nor are the rewards certain. First, the details of taxation are hideously complex. Second, the cost of complying with tax rules (e.g., preparing tax returns and providing details requested by tax auditors) can be significant. Not only can it be costly to figure out how much to pay but also who to pay and when to pay. Tax Planning and Strategy Tax Planning page 6 BACTEL2X  Such costs can be particularly high for cross-border activities, which can involve a multitude of different tax jurisdictions imposing different taxes. In addition, similar taxes are often imposed by different jurisdictions using similar but different basic definitions. This raises the specter of multiple taxation (e.g., the same income effectively being taxed at rates exceeding 100%), although governments typically try to avoid this situation through tax treaties and special adjustments, such as the foreign tax credit. Cost of Withholding Taxes Looking at the nature of expanded withholding taxes, the income is immediately taxed, thus the amount received is already net of the tax withholding. The amount deducted, however, can be claimed as tax credits against the income tax due. In this scenario, should the withholding did not happen, the taxpayer should have additional funds that can be used for short-term income generation or working capital. The creditable tax withholdings on expenses paid, on the other hand, provides for the same. Depending on the EWT rates and tax bases, creditable withholding taxes may carry opportunity costs on foregone short-term income or cost of working capital. Illustration 8.1 COST OF WITHHOLDING TAXES Dr. Shaun Murphy is a visiting physician of MediCenter. He also operates a clinic in his residence and is VAT-registered. He receives his professional fees from the hospital on the 15th day following the month of earning while he makes the purchases of goods for use in his clinic on the 10th day of each month. Following are his receipts and purchases for the first quarter of the taxable year. Idle funds can be invested for short-term securities which yield a 6% return. Tax Planning and Strategy Tax Planning page 7 BACTEL2X  January February March Professional Fees from Hospital 600,000 700,000 500,000 Professional Fees from Clinic 130,000 90,000 80,000 Purchases for Clinic 60,000 60,000 35,700 Let us compute the tax withheld on the applicable transactions and the applicable costs and benefits. Tax Base X EWT Rate = EWT X Yield Rate X Term = Cost Fees from Hospital January 600,000 10% 60,000 6% 3/12 900 February 700,000 10% 70,000 6% 2/12 700 March 500,000 10% 50,000 6% 1/12 250 Purchases for Clinic January (60,000) 1% (600) 6% 1/12 (3) February (60,000) 1% (600) 6% 1/12 (3) March (35,700) 1% (357) 6% 51/365 (3) Net Cost of Withholding 1,841 Note that the professional fee from the clinic is normally not subject to CWT since most clients would be non-business entities. Tax Planning and Strategy Tax Planning page 8 BACTEL2X  Financial Reporting Losses as Costs There are tax strategies which would benefit the taxpayer substantial amounts of tax savings. Certain costs, however, should be considered in arriving for the net tax benefit of these strategies. Aside from the usual transaction and lobbying costs, entities may also incur loss in financial reporting arising from decrease in the value of tax assets. Illustration 8.2 FINANCIAL REPORTING LOSSES A corporate taxpayer reported the following net operating losses for the taxable years: 2019 (5,500,000) 2020 (18,500,000) It realized a net operating profit for the year 2021. Compute for the financial reporting loss arising from the enactment of the CREATE Law under each of the following scenarios: 1. The corporation’s total assets is P150,000,000, exclusive of land 2. The corporation’s total assets is P75,000,000, inclusive of land and uses the deferred taxes method 3. The corporation’s total assets is P60,000,000, inclusive of land and uses the taxes payable method Firstly, we do not need to concern ourselves with the Excess MCIT from taxable years 2019 and 2020 since these would be more likely fully creditable against the income tax due. Secondly, since Scenario 3 applies the taxes payable method, no deferred tax asset is recognized on the net operating losses. Therefore, there is nothing to adjust as a consequence of the decrease in the regular corporate income tax rate. Tax Planning and Strategy Tax Planning page 9 BACTEL2X  Thirdly, it is to be noted that the decrease in the RCIT rate is only reflected on the 2021 financial reporting since the enactment of the CREATE Law was a non-adjusting event for 2020. Let us now compute for the financial reporting loss resulting from the adjustment of the deferred tax asset recognized on the NOL incurred for 2019 and 2020. Scenario 1 Scenario 2 Total NOL Incurred 24,000,000 24,000,000 Old RCIT Rate 30% 30% Deferred Tax Asset – 12/31/2020 7,200,000 7,200,000 Adjustment (Financial Reporting Loss) (24,000,000 x (30%-25%)) (1,200,000) (24,000,000 x (30%-20%)) (2,400,000) Deferred Tax Asset – Adjusted 6,000,000 4,800,000 Also take note that regardless of the amount of NOL carried over for 2021, the whole of the deferred tax asset is adjusted in said year. TAX RATES AND STRUCTURES Taxes are computed by multiplying the tax rate by the tax base, that is, tax rate × tax base = tax. The tax base is the amount that is subject to tax. For income taxes, the tax base is taxable income, defined roughly as income less allowable expenses. For Tax Planning and Strategy Tax Planning page 10 BACTEL2X  property taxes, the tax base is some measure of the value of the property. Consumption taxes, such as VAT and percentage tax, are most often based on the sales price of the merchandise sold. For payroll taxes, a common tax base is compensation. For most taxes there are three types of tax rates: marginal, average, and effective rates. Marginal Tax Rate The marginal rate is the tax rate that will be paid on the next peso of tax base (i.e., the rate on the next peso of income for income taxes, or the rate of tax that will be saved on the next peso of deduction). This rate is useful when assessing the tax exposure of a particular transaction, especially when tax rates are progressive. Average Tax Rate The average rate is usually computed by dividing the total tax by the total tax base. This is useful when assessing the composition of the tax exposure of taxable items. Effective Tax Rates The effective tax rate is useful for assessing the overall tax performance of an entity. This is because it is based on financial accounting income. There are two types of effective tax rates. The cash effective tax rate considers both the permanent and temporary differences. As such the Cash numerator is usually the Current Tax Expense. Tax Planning and Strategy Tax Planning page 11 BACTEL2X  The cash effective tax rate considers only the permanent differences. As such the numerator is usually Accounting the Current Tax Expense plus Deferred Tax Expense less Deferred Tax Benefit. Illustration 8.3 TAX RATES Assume the following financial figures of a purely self-employed as of December 30, 2021, gross of any kind of income tax. Gross Income Gross Profit from Sales Activity 4,960,000 Interest Income from Peso Deposits 25,000 Gain on Sale of Long-Term Bonds 15,000 5,000,000 Operating Expenses Deductible Expenses 2,990,000 Non-Deductible Expenses 260,000 3,250,000 Net Income before Income Taxes 1,750,000 Suppose an order was received on December 31, 2021 which would generate a gross profit of P50,000. Let us first compute the taxable income as of December 31, 2021. Gross Profit from Sales Activity 4,960,000 Deductible Expenses 2,990,000 Tax Planning and Strategy Tax Planning page 12 BACTEL2X  Taxable Income 1,970,000 In computing for the marginal rate, it is to be considered that the taxable income of P1,970,000 is taxed at 30%. The P50,000 gross profit would increase the taxable income at P2,020,000 which would now fall on the next bracket at 32%. In this case the marginal rate would be the current marginal rate of 30% on the first P30,000 and 32% for the next P20,000. Let us now assume that the order received was not fulfilled during the year, therefore, not earned. In computing for the average rate, we now need to obtain all the income subject to tax and divide it to the total of their corresponding income taxes. Total Income Taxes Regular Income Tax (basing on the tax table) 481,000 Final Tax on Peso Deposit (25,000 x 20%) 5,000 486,000 Divide by: Total Income Subject to Tax Taxable Income under Regular Tax 1,970,000 Income under Final Tax 25,000 1,995,000 Average Tax Rate 24.36% In computing for the effective rate, we use the financial accounting income in lieu of the taxable income. As such, we are now considering both permanent and temporary differences. Total Income Taxes 486,000 Divide by: Financial Accounting Income 1,750,000 Tax Planning and Strategy Tax Planning page 13 BACTEL2X  Cash Effective Tax Rate 24.67% Tax rate structures can be thought of as being proportional, progressive, or regressive. With a proportional (or flat) tax rate, the average rate remains the same as the tax base increases. Other than the income tax, most taxes are proportional. For example, local government charges a 1% real property tax on the assessed value of property owned. Whether the corporation owns P100,000 or P100 million worth of property, the rate is still 1% (i.e., it is proportional.) With a progressive tax rate structure, the average rate increases as the tax base increases. Most income tax systems are progressive. Common example is the income tax on individual taxpayers. A regressive structure is one where the average rate decreases when the base increases. Many people consider consumption taxes as regressive. This is because if the total consumption tax paid by a taxpayer is divided by income, the average rate decreases by income. Illustration 8.4 CONSUMPTION TAX AS REGRESSIVE TAX Jack and Dina are best friends who are both widowed. Their spouses left them to take care of the three children of each family. Both families consumed P10,000 worth of groceries, net of VAT, for each month. Jack earns P60,000 per month while Dina earns P48,000. Essentially, the consumers are the economic taxpayers of the value added tax. Purchases 10,000 Tax Planning and Strategy Tax Planning page 14 BACTEL2X  VAT Rate 12% Value Added Tax 1,200 Let us try to compute for the average rate for each of the families. Jack Dina Value Added Tax 1,200 1,200 Monthly Earnings 60,000 48,000 Average Rate 2% 2.5% As can be inferred, the average rate is higher for those who have less income, reflecting the characteristic of a regressive tax. GOALS OF AN IDEAL TAXING SYSTEM The basic objective of taxation is to raise revenues to finance governments. Governments also attempt to achieve other objectives in designing and implementing tax systems. These objectives are frequently complicated by the dynamics of political, economic, and social forces. Since the writings of eighteenth-century economist Adam Smith, people designing tax systems have often considered the criteria he identified: equality, certainty, convenience, and economy. Equality means that taxpayers should bear a fair level of tax relative to their economic positions (e.g., income, Equality for income taxes). Equality can be defined in terms of horizontal and vertical equity. Tax Planning and Strategy Tax Planning page 15 BACTEL2X  Horizontal equity means that two similarly situated taxpayers are taxed the same. Vertical equity means that when taxpayers are in different economic positions, the taxpayer with the greatest ability to pay incurs the most taxes. Most income taxes are progressive. That is, higher tax rates apply when there are higher levels of the amount being taxed. For income taxes, this amount—called the tax base—is taxable income. However, consumption- related taxes (such as VAT) are rarely progressive (and are often considered regressive) because there is typically only one tax rate. Because poor people spend much more of their incomes on consumption than do rich people, they pay proportionately more of their incomes on sales and use taxes. Certainty means that a taxpayer knows when, how, and how much tax is paid. In the Philippines, it is most likely that those who are employed generally know that their income taxes are withheld by their employers every payroll period. For those self-employed taxpayers, it may be generalized that only those which are operating for Certainty a period of time may be knowledgeable on taxes. Others may not even give distinguishment on income tax and business tax. More so for the taxes on one-time transactions (ONETT), generally, taxpayers end up incurring large amounts of penalties due to delay in filing and payment. Convenience means that the taxes should be levied at the time it is most likely to be convenient for the taxpayer Convenience to make the payment. This generally occurs as they receive income because this is when they are most likely to have the ability to pay. Another aspect of convenience is method of collection. Income taxes in the Philippines Tax Planning and Strategy Tax Planning page 16 BACTEL2X  are privately determined by individuals and businesses and are self-assessed. In contrast, import, property, and other taxes are calculated and assessed either by governments or (for sales, use, and value-adding taxes) by vendors. Economy means that a tax should have minimum compliance and administrative costs. That is, it should require a minimum of time and effort for the taxpayer to calculate and pay the tax. Administrative costs are expenses Economy incurred by the government to collect the tax. Compliance and administrative costs are highest for income taxes, because of their complexity. SOURCES OF TAX LAWS With the exercise of the power of taxation, tax laws provide guidance on its scope. The following are the common sources of tax statutes. The term Constitution refers to that body of rules and maxims in accordance with which the powers of Constitution of the sovereignty are habitually exercised. A constitutional provision regarding taxation is primarily Philippines intended to limit and regulate the exercise of taxation power. The State can exercise the power to tax even if the Constitution is completely silent about taxation. Statutes are laws enacted and established by the will of the legislative department of the government. Statutes The present tax statutes of the Philippines are embodied in the Republic Act No. 8424, which is now the Tax Planning and Strategy Tax Planning page 17 BACTEL2X  prevailing NIRC effective January 1, 1998, which was amended by various republic acts and revenue regulations. These refer to the decisions for application made concerning tax issues by the proper courts exercising judicial authority of competent jurisdiction. These courts may be the Supreme Court and the Court of Judicial Decisions Tax Appeals. Their decisions on tax laws comprise the greater portion of tax jurisprudence. They form part of the legal system of the Philippines. Executive orders are regulations issued by the President or some administrative authority under his Executive Orders direction for the purpose of interpreting, implementing, or giving administrative effect to a provision of the Constitution or of some law or treaty. Tax Treaties and These refer to the treaties or international agreements with foreign countries regarding tax enforcement Conventions and exemptions. They have the force and effect of law. IMPORTANT PRINCIPLES AND CONCEPTS IN TAX LAW This multifaceted system of tax rules may seem bewildering at first. However, most tax systems have developed around fundamental concepts that do not change much and thus provide a deep structure to tax rules. For example, a number of principles and concepts guide how tax laws are structured in the Philippines. While they cannot be used to provide guidance on all tax rules, they generally explain why many tax laws are structured the way they are throughout the world. Tax Planning and Strategy Tax Planning page 18 BACTEL2X  Ability-to-Pay Principle Under the ability-to-pay principle, the tax is based on what a taxpayer can afford to pay. One concept that results from this is that taxpayers are generally taxed on their net incomes. Entity Principle Under the entity principle, an entity (such as a corporation) and its owners (for a corporation, its shareholders) are separate legal entities. As such, the operations, record keeping, and taxable incomes of the entity and its owners (or affiliates) are separate. Pay-as-You-Go Concept Related to the ability-to-pay concept is the pay-as-you-go concept. Taxpayers must pay part of their estimated annual tax liability throughout the year, or else they will be assessed penalties and interest. For individuals, the most common example is income tax withholding. In the Philippines, for example, employers withhold minimum amount of income taxes from each employee’s paycheck and then remit the withholding to the government. Another example would be the quarterly returns for income tax on businesses and the monthly remittance of the value-added tax. All-Inclusive Income Principle This principle basically means that if some simple tests are met, then receipt of some economic benefit will be taxed as recognized income, unless there is a tax law specifically exempting it from taxation. The tests are (each test must be met if an item is to be considered as income): Tax Planning and Strategy Tax Planning page 19 BACTEL2X  Does it seem like income? Is there a transaction with another entity? Is there an increase in wealth? Related to this principle would be the following. For income to be recognized, there must be a measurable transaction with another entity. Therefore, Realization Principle accretion in wealth cannot generate income. Increase-in-Wealth The increase-in-wealth test means that unless there is a change in net wealth, no income will be Test recognized. Under recovery of capital, a taxpayer does not usually recognize income on the sale of an asset until the Recovery of Capital taxpayer’s capital is first recovered. Claim of Right Under claim of right, income is recognized once the taxpayer has a legal right to the income. Under constructive receipt, income is recognized when it is available for the taxpayer’s use, even if the Constructive Receipt taxpayer does not collect the income. Legislative Grace Closely related to the income concepts already described is the concept of legislative grace. Here income that would normally be taxed under the preceding rules is either exempt from tax or subject to a lower tax rate due to special rules. Some examples Tax Planning and Strategy Tax Planning page 20 BACTEL2X  would be the holding period rule for capital gains of individual taxpayers, exemption of inter-company dividends from final tax, and exemption of some fringe benefits of employees. The legislative grace concept applies to deductions as well (deductions are expenses that can be used to reduce taxable income). Usually, no deduction is allowed under our tax laws unless it is specifically authorized by the law. For businesses and sole proprietors, the usual types of expenses are generally allowed for tax purposes. However, other deductions for individuals exist purely by legislative grace. For example, as already noted, there is a fixed standard deduction. Business Purpose Concept Business purpose is closely related to legislative grace as it relates to deductions. Here business expenses are deductible only if they have a business purpose, that is, the expenditure is made for some business or economic purpose, and not for tax-avoidance purposes. The test is applied to a bona fide trade or business, or to expenses for the production of income. Accounting Methods As noted, some general rules apply when a taxpaying entity wants to choose among cash, accrual, or hybrid (part cash, part accrual) methods of accounting. Tax-Benefit Rule Under the tax-benefit rule, if a taxpayer receives a refund of an item for which it previously took a tax deduction (and received a tax benefit), the refund becomes taxable income in the year of receipt. Tax Planning and Strategy Tax Planning page 21 BACTEL2X  Substance over Form Under the doctrine of substance over form, even when the form of a transaction complies with a favorable tax treatment, if the substance of the transaction is the intent to avoid taxes, the form will be ignored, and the transaction recast to reflect its real intent. References: Karayan, J.E. & Swenson, C. (2007). Strategic Business Tax Planning. New Jersey: John Wiley & Sons, Inc. References: Karayan, J.E. & Swenson, C. (2007). Strategic Business Tax Planning. New Jersey: John Wiley & Sons, Inc. Tax Planning and Strategy Tax Planning page 22 BACTEL2X  Self-Check! Basing on your readings, answer the following questions. 1. What is tax planning and what are its goals? 2. How do the four types of tax planning strategies differ from one another? 3. What are the goals of an ideal taxing system? 4. What are the tax rates and structures used for tax planning? 5. What are the sources of tax laws in the Philippines? 6. Explain the different principles and concepts employed in tax laws. Exercise 8.1 TRUE OR FALSE Determine whether the following statements are true or false. 1. The primary purpose of most taxes is to raise revenue to finance governments. 2. Though taxes impose significant costs, it merely cannot change one’s behavior. 3. Tax planning can affect decision making in even the most commonplace of settings. 4. Income tax typically is tax based on gross income for each calendar year. 5. Taxes are one of the most important aspects in structuring a transaction. 6. Taxes may be a dominant or minor factor in every decision to be made. 7. One way to measure how well a firm is managing its taxes is to look at its nominal income tax rate. Tax Planning and Strategy Tax Planning page 23 BACTEL2X  8. Estate taxes help provide additional horizontal equity in the tax system beyond that provided by the income tax. 9. In certain instances, there may be more than one marginal rate. 10. The concept of certainty is similar to that of the fiscal adequacy principle. 11. The basis for computing the average tax rate is the financial accounting income. 12. Tax laws arise from all three branches of the government. 13. The primary goal of tax planning of minimization of taxes. 14. Managers need to learn about taxes because optimizing a venture’s total tax burden is important to its success, and managers are the main decision makers in an organization. 15. Tax planning is free, thus, always economical to be exercised. Exercise 8.2 TAX CONCEPTS AND PRINCIPLES Identify the tax concepts and principles best illustrated by the following situations. 1. An idea was brought up by a tax advisory regarding a measure where a client may save taxes but would require higher cost of compliance. 2. X and Y corporations each have sales revenues of P500,000. Expenses for the two corporations are P100,000 and P300,000, respectively. Corporation X will pay more taxes, because it has greater net income and cash flows, and thus can afford to pay more. Tax Planning and Strategy Tax Planning page 24 BACTEL2X  3. An entrepreneur forms a corporation that develops and sells the entrepreneur’s software products. During the year, the corporation has P200,000 in revenue and P50,000 in expenses. The entrepreneur also has a salary of P100,000. The corporation will file a corporate tax return showing P50,000 in taxable income, and the entrepreneur will file an individual tax return showing P100,000 of income. 4. A corporation pays its entire P250,000 in net income to the entrepreneur as a salary for being president of the corporation. Suppose that a reasonable salary for a president of a small software company is P100,000. The effect of the salary is to reduce the corporation’s taxable income to zero, so that it does not have to pay any taxes. While salaries in such closely held corporations are deductible in general, in this case the arm’s length test is not met. As a result, only P100,000 (i.e., the reasonable portion) of the salary will be deductible by the corporation. The remaining P150,000 will be considered a dividend. 5. An individual sells the shares in his company to a larger firm. He sells the company for P10 million. His tax basis in the shares—what he put into the company in return for shares—is P1 million. After subtracting his basis (pursuant to the concept of recovery of capital), his capital gain is P9 million. The capital gain will be halved for the computation of taxable income. 6. A corporation owns two assets that have gone up in value. It owns common stock in another corporation, which it originally purchased for P100,000 and is now worth P500,000. It also owns raw land worth P1 million, which it originally Tax Planning and Strategy Tax Planning page 25 BACTEL2X  purchased for P200,000. It sells the stock for its fair market value, but not the land. Income is recognized only on the stock; there has been no realization on the land. 7. A corporation pays a consulting firm P100,000 for consulting services in one year. Because this is a normal business expense, the corporation takes a tax deduction for P100,000. Early the next year, the consulting firm realizes it has made a billing mistake and refunds P20,000 of the fees. The P20,000 is taxable income to the corporation in second year because it received a tax benefit in the prior year. 8. A corporation expects to owe P200,000 in taxes at the end of the year. It is required to prepay P50,000 every three months or else be subject to penalties and interest. 9. An entrepreneur owns 100% of the stock of her corporation. She has the corporation buy an aircraft to facilitate any out- of-town business trips she might make. The entrepreneur, who also happens to enjoy flying as a hobby, rarely makes out-of-town business trips. Since the plane will not really help the business, and there is a tax-avoidance motive (the plane would generate tax-depreciation deductions), there is no business purpose to the aircraft. Accordingly, any expenses related to the aircraft, including depreciation, are nondeductible. 10. A corporation borrows P5 million from a bank, issues P1 million in common stock, and floats a bond issue for which it receives P10 million. Although each of these transactions involves cash inflows and transactions with other entities, there is no change in net wealth. This because for each of the three cash inflows, there is an offsetting increase in liabilities (or equity) payable. Tax Planning and Strategy Tax Planning page 26 BACTEL2X  11. An entrepreneur is the sole stockholder of his corporation. The corporation never pays dividends to the entrepreneur, and, instead, each year it pays out 100% of the corporation’s net income as a salary to the entrepreneur (who also serves as company’s chief executive officer). Tax authorities may tax at least part of the salary as if it were a dividend. 12. X Corporation has net income from the sales of widgets of P15,000. Y Corporation has net income of P15,000 from the performance of services. Both pay a tax of P2,250. Problem 8.1 TAX RATES Jack E. Pagarop, a self-employed individual reported the following Income Statement for the taxable year, gross of any type of income tax. Note Net Sales Gross Sales 8,745,000 Less: Sales Discounts 85,000 Less: Sales Returns 175,000 8,485,000 Less: Cost of Sales 4,750,000 Gross Profit 3,735,000 Other Income Tax Planning and Strategy Tax Planning page 27 BACTEL2X  Gain on sale of domestic shares 35,000 Interest income on bank deposits 15,000 Gain on sale of land 450,000 Gain on redemption of share in a mutual fund 30,000 530,000 Gross Income 4,265,000 Less: Operating Expenses Depreciation Expense 480,000 Salaries and Wages 680,000 Fringe Benefit Expense 65,000 Entertainment and Amusement Expense 45,000 Interest Expense 35,000 Pension Trust Expense 110,000 Other Deductible Expenses 1,750,000 3,165,000 Net Income before Income Taxes 1,100,000 Following are the relevant notes: Note 1 - P15,000 of this amount is given as discounts to senior citizens and disabled persons. Note 2 - The shares were sold directly to the buyer at P100,000. Tax Planning and Strategy Tax Planning page 28 BACTEL2X  Note 3 - The land which was classified as a capital asset had a carrying amount of P1,400,000 and fair market value of P2,000,000. Note 4 - Included in this amount is the annual depreciation of a vehicle which had was acquired on July 1 of the current year at P2,500,000 and has a useful life of 10 years. Note 5 - Included in this amount is P25,000 salary of senior citizen employees and P15,000 salary of a disabled person employee. Note 6 - Half of this amount is the monetary value of what is subject to Fringe Benefit Tax. Note 7 - P25,000 of this amount is applicable to past service costs. Compute the following: Jack Uses Itemized Deductions Optional Standard Deduction Marginal Tax Rate should Jack have additional taxable income of P150,000 Average Tax Rate Effective Tax Rate Tax Planning and Strategy Tax Planning page 29 BACTEL2X  Problem 8.2 TAX STRUCTURES The three siblings of Amon Family have the following income and paid the following taxes. Jack Dina Pal Monthly Income 60,000 80,000 120,000 Tax A 2,625 3,500 5,250 Tax B 360 320 240 Tax C 4,000 6,500 12,500 Determine which of the following taxes is progressive, proportional and regressive. Problem 8.3 EFFECTIVE TAX RATE Two corporate taxpayers have the following financial figures for a particular year. Corp. A Corp. B Taxable Income 5,600,000 8,900,000 Permanent Difference due to being subject to 10% final tax 30,000 80,000 Permanent Difference due to Income exemption 210,000 250,000 Taxable Temporary Difference 120,000 190,000 Deductible Temporary Difference 190,000 90,000 Tax Planning and Strategy Tax Planning page 30 BACTEL2X  Which of the two corporations is better in managing its taxes for the year? Problem 8.4 COST OF WITHHOLDING TAXES Juan dela Cruz, CPA is a partner of SVG & Co. Each 15th of the month, the GPP provides a net income share to Juan amounting to P200,000. He also owns a small convenience store in which monthly purchases of P100,000 are made every 20th of each month. Idle funds can be invested for short-term securities which yield a 6% return. Estimate the net cost of withholding per quarter using 30-day months. Problem 8.5 FINANCIAL REPORTING LOSS An entity reported the following net operating profits/(losses): 2017 (500,000) 2019 900,000 2018 (1,800,000) 2020 (600,000) Compute the financial reporting loss arising from the enactment of CREATE Law assuming: 1. Its total assets, exclusive of land, amounts to P160,000,000 2. Its total assets, inclusive of land, amounts to P80,000,000 and uses the taxes payable method 3. Its total assets, inclusive of land, amounts to P60,000,000 and uses the deferred taxes method Tax Planning and Strategy Tax Planning page 31 BACTEL2X