Module 09 - Tax Planning PDF

BACTEL 2X Strategic Tax M a na g em ent 2TAY222 Tax Planning and Strategy Tax Planning 3  TAX PLANNING Reducing taxes is beneficial, but why should managers learn the basics of tax planning? It may seem obv...

BACTEL 2X Strategic Tax M a na g em ent 2TAY222 Tax Planning and Strategy Tax Planning 3  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 Tax Planning and traded companies can be especially Tax Planning sensitive to tax expense. This is because page 1 earnings (which BACTEL Strategy usually have a major impact on stock prices) must be reported on an after-tax basis. Indeed, not2X only  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 The objective of Tax Management is to comply Objective reduce the tax with the liability to the minimum. provisions of tax laws. Tax planning is very wide in its coverage and Tax Management has a limited scope, i.e., it Scope includes deals with 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 Approach Tax planning is futuristic in its approach. proceedings, rectification, revisions, appeals etc.), present (filing of return of Tax Planning and Tax Planning page 2 BACTEL Strategy income on time based on updated records) 2X and future (corrective action).  The benefits arising from tax planning are As a result of effective Tax Management, Benefits substantial penalty, penal 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, Attributes Special privilege given by law both in script and moral. bending the law without breaking it. Taking unfair advantage of Deliberate manipulations Application of concept of Concept the in legislative shortcomings in the tax laws. accounts resulting in fraud. grace Tax Planning and Tax Planning page 3 BACTEL Strategy 2X  Legal Use of such means that Non-compliance is not subject Use of Justified means are to any Implicatio n forbidden by law legal implication Before the occurrence of Occurrence tax After tax liability arises Imposition of taxes liability Type of Act Legal Criminal Legal Consequence Deferment of tax liability Penalty or imprisonment Non-payment of tax s To reduce tax liability by To reduce tax liability by Objective applying exercising To provide legislative grace Without Loss of the Government script ofRevenue law unfair means 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 Transformation to compensate for the tax imposition or increase in taxes. Tax Planning and Tax Planning page 4 BACTEL Strategy 2X  Tax Amnesty vs. Tax Condonation Tax amnesty is a general pardon given by the government to erring taxpayers. It Tax Amnesty generally operates 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 Tax Condonation balance of tax. The 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 S AVANT 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 Tax Planning and because tax laws can change Tax (and, Planningas the page 5 BACTEL Strategy 2X  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 Tax Planning page 6 BACTEL Strategy 2X  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 Illustration 8.1 and COSTtaxOFbases, creditable TAXES WITHHOLDING withholding taxes may carry opportunity costs on foregone short- term income or cost of working capital. 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 Tax Planning and which yield a 6% return. Tax Planning page 7 BACTEL Strategy 2X  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 Tax Planning and Tax Planning page 8 BACTEL be non-business entities. Strategy 2X  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 2019 reported the following net operating losses for the taxable years: (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 Tax Planning page 9 BACTEL Strategy 2X  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 N O L incurred for 2019 and 2020. Scenario 1 Scenario 2 Total N O L 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 N O L 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 Tax Planning page 10 BACTEL Strategy 2X  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 Theis cash usefuleffective for assessing the considers tax rate overall taxboth performance of an entity. the permanent This is because it and temporary is basedCash on financialdifferences. accounting income. As suchThere the are two types of effective tax rates. numerator is usually the Current Tax Expense. Tax Planning and Tax Planning page 11 BACTEL Strategy 2X  The cash effective tax rate considers only the permanent differences. As such the Accounting numerator is usually 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 Tax Planning and Net Income before Income Tax Taxes Planning page 12 BACTEL Strategy 2X 1,750,000  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 Regular rate, we Income now Tax need on (basing to the obtain tax all the income subject 481,000 table) to tax and divide it to the total of their corresponding Final Tax income on Pesotaxes. Deposit (25,000 x 20%) 5,000 486,000 Total DivideIncome Taxes 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 1,750,0 Income 00 Tax Planning and Tax Planning page 13 BACTEL Strategy 2X  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 Illustrationis8.4 divided by income, TAX CONSUMPTION the average rate decreases AS REGRESSIVE TAX by income. 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 Tax Planning 10,000 Tax Planning and page 14 BACTEL Strategy 2X  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, Equalitycertainty, convenience, means that taxpayersand economy. should bear a fair level of tax relative to their economic Equality positions (e.g., income, for income taxes). Equality can be defined in terms of horizontal and vertical equity. Tax Planning and Tax Planning page 15 BACTEL Strategy 2X  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 Certainty employers every payroll period. For those self-employed taxpayers, it may be generalized that only those which are operating for 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 Convenience Tax Planning and convenient for the taxpayer Tax Planning page 16 BACTEL Strategy to make the payment. This generally occurs as they receive income because this is when2X they are most likely to have the ability to pay. Another aspect of convenience is method of  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 Economy a minimum of time and effort for the taxpayer to calculate and pay the tax. Administrative costs are expenses 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 Constitution of which the powers of the sovereignty are habitually exercised. A constitutional provision Philippines regarding taxation is primarily 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 Statutes the government. Tax Planning and Tax Planning The present tax statutes of the Philippines are embodied in the Republic page 17 Act No. 8424, BACTEL Strategy which is now the 2X  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 Decisions judicial authority of competent jurisdiction. These courts may be the Supreme Court and the Court of 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 Executive Orders authority under his 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 IMPORTANT Conventions PRINCIPLES AND CONCEPTS IN TAX LAW tax enforcement and exemptions. They have the force and effect of 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 Tax Planning page 18 BACTEL Strategy 2X  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 Tax Planning and test must be met if an itemTaxisPlanning to be considered as income): page 19 BACTEL Strategy 2X   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 Realization entity. Therefore, 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, Test no income will be recognized. Under recovery of capital, a taxpayer does not usually recognize income on the sale of Recovery of an asset until the 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 Legislative Grace Constructive use, even if the Receipt Closely related to the income concepts already described is the concept of legislative grace. Here income taxpayer does not collect the 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 Tax Planning page 20 BACTEL Strategy 2X  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 Tax Planning and (and received a tax benefit), Tax the refund becomes taxable income in the year page Planning of receipt. 21 BACTEL Strategy 2X  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 Tax Planning page 22 BACTEL Strategy 2X