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LECTURE 2

INCOME TAX

The income tax in its modern form is now over 200 years old. It originated in
Great Britain at the very end of the 18 th century and developed in the early 19th
century principally in that country, some of the German states, Sweden, and
some American states. Most of the industrialised countries adopted it only
towards the end of the 19th or early in the 20th Century. In many countries, war
finance was a reason for adoption or expansion of the tax; but only during and
after World War Two did the income tax become a “mass tax” applicable to the
bulk of the population in industrialised countries.

The income tax has become widespread. While there are a few small countries
which have no income tax, virtually all the 183 countries that are members of
the IMF have some form of income tax.

The Bahamas and Vanuatu do not have an income tax. Several countries have
an income tax of only limited application. Thus Maldives has a tax on bank
profits only. St Kitts and Nevis imposes income tax on corporations but not on
individuals. Paraguay taxes businesses only. The United Arab Emirates, Oman
and Qatar have corporate taxes, but these apply mostly to oil companies and
financial institutions.

DEFINITION OF INCOME

(a) Economic Concept of Income

Income is equal to consumption + change in net worth

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I = C + DW – Haig – Simons – accretion concept on a comprehensive income tax

base.

Personal income may be defined as the algebraic sum of (i) the market value of
rights exercised in consumption and;

(2) the change in the store of property rights between beginning and end of the
period in question.

The problem with this definition is that it cannot be measured. It is measured on

the source side of income e.g. income from employment, business, property,
capital gains and miscellaneous income.

(b)Legal Concept of Income

The legal concept of income is derived from ordinary usage, trust law, business
and financial accounting - income arises from purposeful economic activity and
occurs regularly.

Legal concept of income concentrates on source side of the household budget.

Income = Employment + Property + Business + Capital Gain + Miscellaneous

I=E+P+B+CG+Misc.

Legislatures have decided in most countries that these concepts do not make sense
as a matter of tax policy.

(See Section 17 of the Income Tax Act).

Income is not defined under the Income Tax Act CAP 323. There is Classification
of income.
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INDIVIDUAL INCOME TAX

Two theoretical models exist for the structure of the personal income tax.

(1) Scheduler; and

(2) Global.
(a) A Scheduler income tax model is one in which separate taxes are imposed
on different categories of income.

In a Scheduler system, gross and deductible expenses are determined

separately for each type of income. The rates of tax applicable to each
category of income are then applied to the taxable amount of the income.
The rates of tax may vary from category to category. Different procedures
may apply to each category of income for the reporting, assessment and
collection of tax. Some types of income may be taxable only through
withholding; others may involve the filing of returns.

(b)A Global income tax model is one in which single tax is imposed on all
income, whatever its nature.

In a Global system, there is no matching of particular types of income to the

expenses incurred to derive the income. All income and expenses are
considered together to arrive at a single net gain that is subject to tax. Thus
under a pure global system the category of income is irrelevant.

Most tax policy theoreticians consider the global income tax to be superior
to the scheduler system. It is commonly suggested that the scheduler
taxation suffers from the following disadvantages:
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1. The separation of an individual’s income into more than one tax regime may
make it difficult or impossible to impose progressive taxation and to provide
for personal tax relief.

2. The scheduler system is potentially more difficult to administer. Scarce

administrative resources may be wasted on classification issues arising at the
borders between schedules. The border between an employer-employee and
a customer-assistant relationship is difficult to draw.

3. Any differences in the final tax burdens imposed under a scheduler system
on income in different categories will be exploited by taxpayers engaging in
tax planning and restructuring to ensure that their income fits within the
most advantageous category. Tax planning activities of this sort not only
imposes economic dead-weight losses as resources are diverted into
unproductive planning activities, but also may cause serious economic
inefficiency as taxpayers opt for income earning activities that may be less
efficient, but more lightly taxed.

Though a global income tax may be preferable from a conceptual perspective, the
purest form remains a theoretical ideal only. In practice, all global income taxes
contain some scheduler elements and most existing income tax systems lie on the
spectrum between scheduler and global.

SINGLE OR SEPARATE TAX LAWS

A basic structural question for income tax law is whether to have all income taxes
in a single law or to have two separate laws, one for individuals and one for legal
persons (companies and other taxable entities).
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From a technical perspective, it is equally acceptable to use separate company and

individual income tax laws or a single law.

It seems preferable, however, to abstain from separately setting forth the rules for
individuals and companies which would lead to duplication, complexity and risk of
establishing divergent rules. More important than the form of the legislation is the
substance. It is important that the tax base and rates of the company tax and the
individual tax on business income be similar to simplify administration and
discourage taxpayers from using a possibly less efficient business form only to
secure tax savings arising from differences between the company and individual
tax systems.

CHARGING PROVISIONS AND BASIC TERMINOLOGY

The personal income tax is, as its name implies, a tax on persons, not on
transactions or things. The charging provision in the income tax law should
therefore impose the tax on persons. The tax is not imposed on all persons; rather,
it is imposed only on those persons who have taxable income for the relevant tax
period.

Some countries impose the income tax on the taxable income of persons, rather
than on persons having taxable income. A charging provision of this type needs to
be supported by a provision that imposes a liability to pay the tax on the person
having the taxable income. The administrative provisions of the legislation will
specify the due date for payment of the tax and include mechanisms for the
collection or recovery of the tax due.

The charging provision sets out four central concepts underpinning the income tax.
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(1) It identifies the person liable to tax, namely any person who has taxable
income for the tax period.

(2) The charging provision imposes the income tax by reference to the tax
period. This means that the taxable income of any person must be calculated
separately for each tax period. Generally, the tax period for the income tax is
a specific period of 12 months, commonly the Calendar year or financial
year of the relevant country.

ITA defines - assessable income

Cap 2 - charge year, financial year.

The periodic nature of the income tax means that it is necessary to provide
accounting rules for allocating income and expenses to particular tax periods
for the purpose of calculating a person’s taxable income for the period.

(3) The concept of taxable income defines the tax base. Taxable income is a net
concept determined by reference to the tax period. All income tax systems
whether global or scheduler, generally seek to impose taxation on a net
amount because this amount properly reflects a person’s increase in
economic capacity for the tax period. The taxable income of a person for a
tax period is therefore commonly defined as the gross income of a person for
the period less the total deductions allowed to the person for the period.

(4) The charging provision should provide for the calculation of the amount of
tax payable. In the ordinary case, this involves applying the relevant tax
rates to the taxable income of the taxpayer and then subtracting any tax
offsets that may be available to the taxpayer. Tax offsets are reductions in
the amount of tax otherwise payable. They are allowed primarily to reflect
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tax already paid through a special collection regime or as a concession to

achieve social economic objectives.

By clearly specifying the central concepts, the charging provision will ensure that
there is consistency in the use of terminology, thereby providing a coherent
structure for the substantive provisions of the legislation. It is preferable that the
charging provision be included at the commencement of the legislation so that the
substantive provisions can then be developed as an elaboration of the central
concepts specified in the provision. The importance of consistency cannot be
emphasised too strongly. At best, failure to provide a coherent structure will lead to
a confused application of the tax law; at worst it will make the law unworkable e.g.
it must be clear that the charging provisions apply to taxable income and not to
gross income.

There are three key elements in the definition of the tax base:

(a) the inclusion of amounts in gross income;

(b) the identification of amounts that are exempt income; and

(c) the allowance of amounts as deductions.

OBJECTIVE OF INCOME TAX

The tax system cannot be designed without knowing the income distribution.
Income tax can be used to change income distribution. There is a general belief
that income tax is the fairest way of transferring resources from individuals to
government. This is the only tax which individuals pay according to their ability.
Ability to pay brings about the 2 notions of horizontal and vertical equity.
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Although people are at the same level, their ability to pay may be different e.g. A
and B get the same salary. A is married with 6 children and 2 dependents (late
sister’s children), his mother is still alive, he is also handicapped.

B on the other hand is single, no dependents and he lives alone. These two people
are on the same horizontal plain. However, in Zambia the circumstances of these
two people will not be taken into consideration and as such their disposable income
will not be the same.

Most income tax systems all over the world do take circumstances into
consideration. This is an advantage of the income tax. Income tax is able to take
into account the different circumstances of the taxpayer. The consumption tax
does not take these circumstances into account. Consumption tax does not
discriminate.

The horizontal and vertical principles are very vital in every society because
people want to see the fairness in tax. Tax is a very emotional issue so the thread
of fairness and reasonableness should be seen in the tax law.

Income tax is also considered to be fair because it is progressive. This means that
tax increases as income rises.

Progressivity – increase in tax as income rises. Once income tax is seen to be fair,
people will comply.

Income Tax is also proportional.

Proportional tax means that the ratio of tax over income remains constant.

Tax = K
Income
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Example: income of three individual is A- K20,000.00, B- K40,000.00; and C-

80,000.00.
Tax is at 20% therefore
Tax = 4,000 for A
= 8,000 for B
= 16,000 for C
The ration of tax remains constant for all three individuals, that is, 20%

Consider calculating the percentage of tax for A:

4,000 x 100 = 20%

20,000

Proportional tax - is also progressive. The more income you command, the more
tax.
Regressive tax – all consumption taxes are regressive in nature. Those in the
lower income bracket pay the same tax as those in the high income bracket.
Example:
Income
A = 10,000 These three go to buy a bottle of Jonny Walker at 2,000
B = 20,000
C = 40,000

2000 X 100% = 20%

10000

2000 X 100% = 10%

20000
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2000 X 100% = 5%
40000

The one with the lesser income feels the impact of tax than those in the higher
income bracket.

We know that tax is used by government to raise revenue, but in the quest of
raising revenue, you need to be careful not to hurt the poorest of the poor. If the
scenario above on regressivity was under income tax, A would have been probably
exempt.
But the main objective for consumption taxes is revenue raising. So as a drafters
need to pay attention to the policies being proposed. Remember as a drafters are
also advisors.

JURISDICTION TO TAX

Where does a country get authority to tax its people?

By international custom, a country has the primary right to tax income that has its
source in that country. Despite the priority given to the source country, the concept
of source is rather poorly developed in tax literature and in domestic legislation.

Source Principle – a principle of taxation under which residents and non-residents

alike are taxed on income from economic activity within a particular country.

Residence Principle – a principle of taxation under which all income accruing to

residents of a country, regardless of its source, is subject to tax by that country.
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The income tax law must provide rules that classify individuals and legal entities
either as residents or as non-residents.

The rules for determining the residence of individuals and legal entities are
different.

Residence of Individuals
An ideal test of residence is one that individuals can apply to obtain a clear certain
and fair result. Certainty is highly desirable because the tax consequences for
residents and non-residents are very different, and individuals need to know
whether they are residents or non-residents. Despite the desirability of a simple
and certain test for residence, however, an arbitrary test for determining residence
is objectionable on fairness grounds and is likely to result in many individuals who
engage in cross-border activities ending up as residents of more than one country.
In reality the test that can be expected is a test that provides simplicity and fairness.

In many countries residence is determined under very broad facts and

circumstances test. In effect, the government seeks to determine from objective
manifestations whether an individual has established his or her allegiance to the
country by joining its economic and social life.

The most significant manifestation of allegiance is probably the maintenance in the

country of a dwelling or abode that is available for the taxpayer’s use.
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Also relevant, however, might be the place where the individual engages in income
producing activities, the location of his or her family, the social ties maintained in
the country, the individual’s visa and immigration status and the individual’s actual
physical presence in the country.

Some countries use an arbitrary test, often tied to the number of days of presence
in the country, for determining residence. A common but defective rule or
presumption is that an individual present in a country for at least 183 days of the
taxable year is a resident for the year. The 183-day test is probably enforceable in
countries that exercise tight control over their borders. It is extremely difficult for
tax authorities of a country to enforce, when many individuals are frequently
entering and leaving the country without checks. In most countries, the test
probably cannot operate effectively unless the burden of proof is put on the
individual to prove that he or she is not present for the 183-day period. Many
individuals with substantial economic ties to a country can plan around the 183-
day test. As a result, the country using the test is likely to catch unsophisticated
and unadvised individuals, some of whom may not in fact have very substantial
ties to that country.

Residence of Legal Entities

The residence of a corporation is generally determined either by reference to its
place of incorporation or its place of management. The place of incorporation
test provides simplicity and certainty to the government and the taxpayer. It also
allows a taxpayer to freely choose its initial place of residence. Countries that
market themselves as tax havens typically offer convenient and inexpensive
arrangements for incorporating under their laws.
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In general, a corporation cannot freely change its place of incorporation without

triggering a tax on the gains that may have accrued on its property; including
intangible property that may have a very high market value. Consequently, the
place of incorporation test places some limits on the ability of corporations to shift
their country of residence for tax avoidance purposes. Many countries use the
place of incorporation test.

The place of management test is less certain in its application, at least in theory.
For many corporations engaged in international operations, management activities
may be conducted in several countries during any particular taxable year. In
practice, most countries using that test employ practical tests, such as the location
of the company’s head office or the place where the board of directors meet, to
determine the place of management. The place of management test is used by the
United Kingdom and many of its former colonies. Some countries, such as
Canada, use both the place of incorporation test and the place of management test.

A place of management test is easily exploited for tax avoidance reasons because a
change in the place of management generally can be accomplished without
triggering any tax.