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Chapter 1 Corporate Tax Planning

‘Tax’ - Tax is “a contribution exacted by the
Introduction state” – Chambers English Dictionary (New
Delhi: Allide Publishers Ltd., 1992). “The
term taxes is confined to compulsory,
unrequited payments to general
government” – Organization for Economic
Cooperation and Development (OECD)
(1988).

Key Words / Outline

Corporate Tax Planning Corporate Tax Planning

The term ‘corporate tax planning’ consists ‘Planning’ –
of three words: Planning is “the process of determining in
Corporate advance the factors necessary to achieve a
Tax set of goals; designing an effective means
Planning of achieving some future goals (ends)” –
Kohler’s Dictionary for Accountants (1984).

Corporate Tax Planning Corporate Tax Planning

‘Corporate’ - Corporate means “of a Thus, ‘corporate tax planning’ means dealing with the
tax matters of a corporation or company with a view
corporation”, where a corporation (or to maximizing the after-tax rate of return on
company) is a legal entity formed under the investments after ensuring voluntary tax compliance.
For this purpose, each corporate entity has to –
Companies Act having a continued
1. ensure that it keeps proper records;
existence, paid-in capital represented by 2. deduct tax at source where it is necessary;
transferable shares, limited liability for the 3. pay advance tax in time, if applicable;
shareholders and a separation between 4. file returns in time;
5. comply with notices received from the tax
management and ownership. authorities; and
6. be aware of legal remedies where it does not
have its rights under the law recognized.

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Corporate Tax Functions Tax Evasion, Avoidance & Planning

Tax function activities are those activities Tax Evasion:
which are concerned with fiscal issues.
“Evasion is illegal. It can involve acts of
commission or omission” (Webley et al. 1991).
These functions are of two types: “Noncompliance is a more neutral term than
evasion since it does not assume that an
1. Tax compliance activities inaccurate tax return is necessarily the result of
2. Tax planning activities an intention to defraud the authorities and it
recognizes that inaccuracy may actually result
in overpayment of taxes” (Webley et al. 1991).

Corporate Tax Functions Tax Evasion, Avoidance & Planning

Tax Compliance Activities: Tax Evasion: …… cont’d
Tax compliance activities are those activities which “‘Tax cheating’ describes deliberate acts of
include the functions or obligations according to the
provisions of various fiscal statutes. noncompliance and does not entail the
difficulty of legal proof of tax evasion” (Webley
et al. 1991).
Tax Planning Activities:
“In evading tax one is knowingly breaking the
Tax planning means dealing with the tax matters of
a taxpayer with a view to maximizing the after-tax law. This has social and psychological
rate of return on investments after ensuring consequences such as stigma and guilt and
voluntary tax compliance. involves confronting different costs since there
is a risk of being caught and fined or sent to
prison” (Webley et al. 1991).

Corporate Tax Planning has legal Sanction

Tax Evasion, Avoidance & Planning
Benjamin Franklin is credited with the classic statement- “Two
certainties in the world- death and taxes.”
Tax Evasion: …… cont’d
“The expression ‘Tax evasion’ means illegally
It is the general tendency of the assessee to minimize his tax
liability/payment. As such three methods are developed in most hiding income or concealing the particulars of
countries for minimizing tax: - income or concealing the particular source or
Tax evasion -Tax avoidance and Tax planning
sources of income or in manipulating the
Tax evasion is the general term for efforts to not pay tax by illegal accounts so as to inflate the expenditure and
means.
Tax avoidance is the legal utilization of the tax laws to one’s own other outgoings with a view to illegally reduce
advantage, in order to reduce the amount of tax that is payable by the burden of taxation. Hence, tax evasion is
means that are with in the law.
illegal and unethical” (Lakhotia and Lakhotia
Tax planning is a strategy to minimize tax liability for an individual 1998).
or company by analyzing the tax implication of various options
through out a tax year.
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Tax Evasion, Avoidance & Planning Tax Evasion, Avoidance & Planning

Tax Avoidance: Tax Avoidance: …… cont’d

Perhaps the most celebrated statement made in defense of tax
According to Justice Jagadisan J., “Avoidance avoidance came from the pen of Judge Learned Hand. In a
of tax is not tax evasion and it carries no dissenting opinion, in Commissioner v. Newman (1947), he
ignominy with it, for, it is sound law and, once said:
certainly, not bad morality, for anybody to so
arrange his affairs as to reduce the brunt of “Over and over again courts have said that there is nothing
sinister in so arranging one’s affairs as to keep taxes as low
taxation to a minimum” – mentioned in the
as possible. Everybody does so, rich or poor, and all do right,
verdict of Aruna Group of Estate v. State of for nobody owes any public duty to pay more than the law
Madras (1965) case (Palkhivala and Palkhivala demands: taxes are enforced exactions, not voluntary
1976). contributions. To demand more in the name of morals is mere
cant.”

Tax Evasion, Avoidance & Planning Tax Evasion, Avoidance & Planning

Tax Avoidance: …… cont’d Tax Planning:

Avoidance involves ‘every attempt by legal “‘Tax planning’ takes maximum advantage of
means to prevent or reduce tax liability which the exemptions, deductions, rebates, reliefs
would otherwise be incurred, by taking and other tax concessions allowed by
advantage of some provision or lack of taxation statutes, leading to the reduction of
provision in the law … it presupposes the the tax liability of the tax payer” (Lakhotia and
existence of alternatives, one of which would Lakhotia 1998).
result in less tax than the other’ (Report of the
Royal Commission of Taxation 1966, 538; vide
Webley et al. 1991).

Tax Evasion, Avoidance & Planning

Tax Avoidance: …… cont’d Tax Planning: …… cont’d

Tax avoidance “is the art of dodging taxes According to Shuklendra and Gurha (1992),
without breaking the law. ……tax avoidance the prime objectives of tax planning are to
means of traveling within the framework of the achieve the following results:
law or acting as per the language of the law (i) Reduction of tax liability,
only in form, but murdering the very spirit of the
law and thus acting against the intention of the (ii) Minimization of litigation,
law and defeating the purpose of the particular (iii) Productive investment,
legal enactment” (Lakhotia and Lakhotia 1998). (iv) Healthy growth of economy, and
(v) Economic stability.

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Objectives of Tax Planning

Tax Planning: …… cont’d According to Lakhotia and Lakhotia (1998), the various
 According to Scholes and Wolfson (1992), objectives of corporate tax planning can be grouped under
“Traditional approaches to tax planning fail to different heads:
recognize that effective tax planning and tax
minimization are very different things. The reason (a) Maximum taxpayer units;
is that in a world of costly contracting, (b) Taking maximum advantage of the exemptions,
implementation of tax-minimizing strategies may deductions, rebates, reliefs, and other tax
introduce significant costs along nontax concessions;
dimensions. Therefore, the tax-minimization
strategy may be undesirable. After all, a particular (c) Legally avoiding unwarranted additions to the
easy way to avoid paying taxes is to avoid income; and
investing in profitable ventures.” Thus, effective (d) Avoidance of tax worries and tensions through
tax planning means not to minimize tax, but to voluntary tax compliance and tax management.
maximize after-tax rates of return on assets.
(e) Corporate tax management and other obligations
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Corporate Tax Planning has legal Sanction General Principles of Tax Planning

Eventually, Supreme Court’s Judge made a clear

distinction between tax avoidance and tax 1. Tax planning strategy should be taken on the basis of
planning. existing provisions of the tax laws to achieve short
“ Tax planning may be legitimate term and long term benefits
2. Tax planning strategy should not exceed the legal
provided it is within the framework of boundary i.e it may be used as a tool of avoiding tax,
law. Colorable devices can not be part not to evade since evasion is illegal
of tax planning and its is wrong to 3. Alternative investment opportunities should be
encourage or entertain the belief that it critically analyzed to ensure maximum benefits in
terms of investment, savings, growth and tax
is honorable to avoid the payment to tax advantages
by resorting to dubious methods. It is 4. Time value of money should be given proper
the obligation of every citizen to pay the importance while establishing the tax panning
taxes honestly without resorting to strategy.
subterfuge” 20 23

Tax Evasion, Avoidance & Planning General Principles of Tax Planning

Legal Ethical Desirable Other types of area of planning includes-

Tax Evasion
× × × 1. Choice of inventory valuation in accounting points of view
Tax
Avoidance
 May or May
not be1
May or May
not be2 2. The timing of equipment purchases
Tax
Planning
   3. Spreading of income among the family members

1When used as an art of dodging taxes without breaking the law or acting
as per the language of the law only in form, but murdering the very spirit
4. Selection of tax avoidance plan from investment
of the law and thus unethical from the viewpoint of policymakers alternatives etc.
2 When acting against the intention of the law & every attempt by legal means
to prevent or reduce tax liability and thus avoiding profitable venture also.
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Slide 1-28

Merits and Demerits of Tax Planning Tax Formula & Traditional Tax Planning

Merits: Tax Planning Formula Tax Planning Action

1. Effective tax planning reduces the tendency to Aggregate Income

tax evasion
– Exclusions Maximize
2. It helps the assessee to minimize the tax
liabilities = Gross Income
3. It helps to enhance savings which in tern also – Allowable Deductions Maximize
acts as a mechanism of domestic resources
mobilization = Taxable Income
4. It helps to build up an effective and efficient × Tax Rate Minimize
relationship between the tax payers and tax
authorities = Gross Tax
5. Effective tax planning improves the tax – Tax Credit & Tax Rebate Maximize
compliance behavior of an assessee = Tax Payable
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Merits and Demerits of Tax Planning TRADITIONAL TAX PLANNING TECHNIQUES

Traditional Tax Planning Techniques based on Tax Formula

Demerits:
Traditional tax planning is based on maximizing the tax-favored
1. It has a negative impact in fulfilling he status and minimizing the tax-disfavored status.
revenue target of the tax authority Since the ultimate objective of traditional tax planning is the
2. Inflation may hamper the tax planning minimization of the bottom line (i.e., the minimization of the
net tax payable), the rules of simple arithmetic suggest that tax
benefits planning must necessarily involve:
3. Long term benefits may not be effective due • Maximization of tax credits/rebates/reliefs,
to various changes in tax laws • Minimization of the applicable tax rate(s), and
• Maximization of deductions and/or exclusions.

In other words, the items on all even-numbered lines in

the above formula constitute the critical variables in tax
planning.
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Technique and Methods of Tax Planning TRADITIONAL TAX PLANNING TECHNIQUES

Tax Planning techniques used by a business: 1. Maximization of Exclusions:

A business organization can minimize its payment of • Exclusions are the incomes which are not included in the tax-base of the
tax considering the following strategies: income tax [‘total income’ as defined u/s 2(65), the scope of which is
1. Forms of business outlined u/s 17 and computed u/s 43 according to the heads of income u/s
20, but to be reported under the heads mentioned in the ‘Form of Return
2. Setting up recognized funds of Income’ (Form IT-GA for non-company assessees and Form IT-GHA
3. Availing investment opportunity having tax for companies) u/r 24].
advantages • Under section 44(1), any income or class of income or the income of any
person or class of persons specified in Part A, Sixth Schedule shall be
4. Use of debt capital exempt from the tax, and shall be excluded from the computation of total
5. Investment in Business having tax holiday scheme. income.
• Along with this list under Part A, Sixth Schedule, Government has issued a
number of S.R.O. u/s 44(4) of the ITO to extend this exclusion list.
So it can be said that an effective tax panning is possible • 6 (six) SROs issued u/s 60(1) of the Income-tax Act 1922 are still in force
if the assessee has a proper knowledge about the tax for similar exclusion purpose.
law of a company. Careful planning may provide the • The business entities which have been allowed tax holiday u/s 46A or
assessee with maximum tax advantage. under any SRO are able to exclude their income enjoying tax holiday.
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2. Maximization of Deductions:
2. Maximization of Deductions:
Except ‘Salaries’ head u/s 21, all other statutory heads of income
have provisions of deductions: • But in case of capital loss, carry-forward can be done after
• Sec. 23 for deductions from “Interest on securities”, deduction of Taka 5,000 [u/s 40(3)].
• Sec. 25 for deductions from “Income from house property”, • Loss will be calculated for carry-forward after deducting any cash
subsidy from the Government [second proviso to section 37].
• Sec. 27 for deductions from “Agricultural income”,
• Loss due to depreciation can be carried forward for unlimited
• Sec. 29 for deductions from “Income from business or
period [u/s 42].
profession” [along with section 30 for inadmissible expenses
from “Income from business or profession”], • In case of loss, how to maximize the setting-off of the loss
in the year concerned should be given special attention and
• Sec. 32(1) for deductions from “Capital gains” [along with section
in case of unset-off losses, special tax planning regarding
32(12) for restricted deductions from “Capital gains”], and
accounting method can help to set off those losses before
• Sec. 34 for deductions from “Income from other sources”. the expiry of the time limits

31 34

2. Maximization of Deductions: 3. Minimization of Tax Rate(s):

All these deductions are subject to limits, and conditions and subject • Marginal tax rate (MTR) is the relevant tax rate for any
to evidential proofs. business decision.
So a business entity must be careful about these conditions, limits • As stated by Sommerfeld et al. (1980), “the marginal tax rate
and authenticity of the transactions and thereby, disallowances is to business affairs what the law of gravity is to physics.
may be avoided and deductions can be maximized. Just as water seeks its lowest level (due to the laws of gravity),
Loss as a Deduction: so also taxable income seeks its lowest marginal tax rate.
• Under section 37, in the year of loss, losses under any head The tax planning objective is achieved, of course, when the
other than two losses – loss in speculation business and capital marginal tax rate is minimized.”
loss –can be set-off against other head(s) except against
speculation business income and capital gain. 4. Maximization of Credits/Rebates/Relief :
• But one speculation business loss can be set off against other • Final emphasis for tax planning is to be given to maximize tax
speculation business income only and one capital loss can be credits, tax rebates and tax reliefs.
set off against other capital gain only. • Again these are subject to conditions, limits and special
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applicability.

2. Maximization of Deductions: Alternative View of Tax Planning Opportunities

• From AY 2007-08, “loss from business or profession” is An alternative way of viewing tax-planning opportunities is to observe
restricted to set off against “income from house property.” that income tax is constrained by:
• Under other provisions of sections 38-42, set-off of losses can be Time, Entity, and Accounting method.
done in future six successive income years only against the • Since income tax rates “start over” with each new tax year and because
concerned head of income and applicable only for following very few taxpayers have a constant level of taxable income in each year,
incomes: there tend to be high-tax years and low-tax years.
 Speculation business income (u/s 39), • The ‘tax value’ of a deduction is directly dependent on the marginal tax
 Other business income (u/s 38), bracket of the party reporting it.
• Obviously, therefore, taxpayers tend to recognize losses and other
 Capital gains (u/s 40), and deductions in high-tax years and to defer the recognition of taxable
 Agricultural income (u/s 41) income to low-tax years.
• To the extent that a taxpayer can control tax timing, s/he should do so
only after giving full considerations to the time value of money.
• Sometimes the financial cost of deferral is greater than the tax benefit.
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Effective Tax Planning

Alternative View of Tax Planning Opportunities Effective Tax Planning vs. Tax Avoidance …cont’d
Method of Accounting in ITO:
Effective Tax Tax Avoidance
The method of accounting may be:
Planning
• ‘Mercantile system’ (or accrual basis) or
Consideration of tax Yes considered Usually not
• ‘Cash system’ (or cash basis) or
implication of all considered
• Hybrid system (i.e., mixture of these two for separate heads of income).
parties involved
However, in the income tax laws, few incomes must be
computed under a specific accounting method. For instance, Possible avoidance Not done May be done by
of investment in adopting easy way
• Dividend is taxable under cash system [u/s 19(7)], profitable ventures to avoid paying tax
• Income from house property is taxable under cash system
[S.R.O. No. 454-L/80 dt. 31.12.80], and Tax cost May be high along Minimum
• Advance salary income are taxable under cash system [u/s with higher after tax
21(1)(b)] subject to a relief u/s 172. return

TAX PLANNING under the TAX PLANNING under the

SCHOLES-WOLFSON PARADIGM SCHOLES-WOLFSON PARADIGM
Scholes-Wolfson have adopted a contractual perspective for
Scholes-Wolfson Paradigm jointly developed in 1992 by: their paradigm & suggested 3 key aspects of tax planning globally:
• Myron S. Scholes, the 1997 Nobel Winner in Economics 1. Multilateral Approach: All contracting parties must be taken
as the co-originator of the Black-Scholes option pricing model into account in tax planning, which allows a global or
and a partner of Oak Hill Capital Management and multilateral, rather than a unilateral, approach.
• Mark A. Wolfson, a managing partner of Oak Hill Capital 2. Importance of Hidden Taxes: All taxes (both implicit tax and
Management, explicit tax) must be taken into account considering the global
measures of taxes. Implicit tax is the decrease in return due to
through their book titled Taxes and Business Strategy: A availing tax favored investment and explicit tax is the tax
Planning Approach. deposited in the treasury.
3. Importance of Nontax Costs: All costs of business must be
The focus of Scholes-Wolfson Paradigm is: considered, not just taxes.
Thus, the paradigm is based on consideration of
Effective Tax Planning. ALL PARTIES, ALL TAXES, ALL COSTS.
These are also prerequisites of Effective Tax Planning.

TAX PLANNING under the

Effective Tax Planning SCHOLES-WOLFSON PARADIGM
So Effective tax planning means considering the tax
Effective Tax Planning vs. Tax Avoidance
implications of a proposed transactions to all parties of the
Effective Tax Tax Avoidance contract, explicit taxes, implicit taxes, and tax clienteles; and
the costs of implementing various tax planning strategies.
Planning
Objective Maximizing after tax Legal tax avoidance to So, Effective tax planning requires the planner-
return minimize tax  to consider the tax implications of a proposed transaction to
the all parties to the transaction;
Desir- Always desirable May be undesirable in
 to consider not only explicit taxes but also implicit taxes;
ability some cases  to recognize that taxes represent only one among many
Non-tax Considered Not considered and hence business costs, and all costs must be considered in the
cost those costs may be planning process.
introduced significantly They told that tax minimization strategy may be
undesirable.

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Why Study Corporate Tax Planning? TRADITIONAL TAX PLANNING TECHNIQUES

Factors Affecting Tax Planning:

Taxpayer’s or Tax Professional’s Perspective:
 Preparing to be a Tax Professional • Choice of Entity: Which entity undertakes the transaction?
Different entities have different tax rates. Pass-through entities
 Developing the tax assessment and tax (sole-proprietorship) allow shifting income to owner and one level
auditing skill of tax. Non-pass-through entities (companies) are subject to
 Understanding the tax notices issued by the double taxation, once at corporate level and then again at the
tax authority and preparing the responses to shareholder level.
tax queries
 Selecting a new Tax Professional or changing • Period of Transaction: Over what period does transaction take
the existing Tax Professional place? Tax deferred is tax saved based upon time value of
money. Common techniques are to accelerate deductions (e.g.,
 Selecting the services to be sought from a Tax following accelerated depreciation) and to defer income (e.g.,
Professional – tax compliance or tax planning through installment sale). A taxpayer has to consider when taxes
services are actually paid (e.g., quarterly estimates versus end of year
computation).

Why Study Corporate Tax Planning? TRADITIONAL TAX PLANNING TECHNIQUES

Factors Affecting Tax Planning:

Tax Authority’s Perspective:
• Tax Jurisdictions: In which jurisdiction does the transaction
 Preparing to be a Tax Executive take place? Tax liability depends whether the income will be
 Developing the tax assessment and tax accrued in foreign country (subject to exemption or tax relief) or
auditing skill Bangladesh or whether the income will be earned by establishing
the entity in a low tax zone or a high tax zone.
 Preparing the tax notices to be issued and
understanding the responses to tax queries • Character of Income: What is the character of the income?
 Selecting a Tax Professional in case of a Depending on the income character, certain types of income are
decision of outsourcing exempted fully or partially. Certain types of income are taxed at
preferential rates (e.g., capital gain on transfer of stocks and
 Selecting the services to be sought from a Tax shares of non-listed private limited company taxed @ 15%,
Professional – tax compliance or tax planning dividend income from shares taxed to companies @ 15%).
services

TRADITIONAL TAX PLANNING TECHNIQUES TRADITIONAL TAX PLANNING TECHNIQUES

Traditional tax planning is equivalent to tax avoidance with the main

Tax is a Function of 3 Variables:
purpose of legal reduction of tax liability. A final tax liability is a function of three (3) variables:
Tax Planning Principles: • the law,
• the facts, and
• Taxes decrease if income earned by entity is subject to a low rate. • the administrative (and sometimes judicial) process.
• Taxes decrease if payment can be deferred to a later year, because
 If any taxpayer is not satisfied with either the law or the administrative
tax deferred is tax reduced.
• Taxes decrease if income is generated in a low rate jurisdiction. and judicial processes, there is relatively little that s/he can do (unless,
• Taxes decrease if income is taxed at a preferential rate. of course, s/he has enough money and clout to get a tax law change).
 The facts, however, are generally amenable to modification.
Relevant Tax Rate:  If a taxpayer is wise enough to understand when and how to modify
For planning purposes only relevant rate is rate at which the transaction them, s/he may very well reduce her/his tax liability significantly.
will be taxed, i.e., marginal tax rate (MTR) – rate at which next Taka of  The most highly qualified professional tax experts earn most of their
income will be taxed. The MTR may change as follows: lucrative fees by giving advice on alternative ways of arranging facts.
(a) higher bracket due to more income, or  In other words, most professional tax planning is little more than the
(b) law may be changed and a new rate is prescribed. prearrangement of facts in the most tax-favored way.

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Why Tax Planning Arises? Types of Tax Planning

 Contractual terms that taxing authority  All changes in tax regimes involve turning two
imposes on its joint venture --- types of dials:
* Levels of tax rates
Tax Rules
* Relative tax rates varying --
 Tax Rules result from a variety of -- Across different tax paying units
socioeconomic forces:-
-- Across different tax periods for the
* Finance Public Projects same taxpayer
* Redistribute Wealth -- Across different economic activities for
* Encourage Economic Activities the same taxpayer and same time period

Why Tax Planning Arises? Types of Tax Planning

 Government ensures objectives of Tax Thus, types of income tax planning activities are:
Rules by – Attempts to have income converted from one
Designing to discriminate among different type to another (ordinary income vs. capital gain,
economic activities regular income vs. windfall income, domestic income
vs. foreign income, set-off of loss under any head);
This has been done through two things:-
Attempts to have income shifted from one pocket
 Progressive Taxation (for redistributing wealth)
to another (taxable vs. tax-exempt sources); and
 Subsidy (for encouraging economic activities) Attempts to have income shifted from one time
period to another (delaying recognition of income, if
Tax Rules provides also to arrange taxpayer’s tax rates are constant or declining over time, instant
affairs to keep the tax bite as painless as salary vs. deferred compensation)
possible

Why Tax Planning Arises? Types of Tax Planning

Progressive Taxation, Subsidy and Provision to In short, the types of income tax planning
arrange taxpayer’s affairs to minimize tax-bite activities are:
 Shifting income from one pocket to
Gives rise to marginal tax rate (MTR) that widely varies another
 Shifting income from one time period
to another
From one
contracting
For a given
contracting
For a given
contracting party over
 Converting income from one type to
party to the
next
party over different economic another
time activities

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Tax vs. Financial Management Decisions Tax vs. Financial Management Decisions

Financial Management Decisions Why do Tax Rules influence Investment

Investment Decisions – decision regarding Decisions? ………….. cont’d
The before-tax rates of return differ because: .. cont’d
acquisition of fixed assets
the returns to similar assets located in the same tax
Financing Decisions – capital structure jurisdiction and held through same legal organizational
decision form are taxed differently depending upon such factors
as:
Dividend Decisions – decision regarding the operating history of the organization,
distribution and/or retention of earnings the returns to other assets held by the organization,
and
the particular characteristics of the individual owners
of the organization.

Tax vs. Financial Management Decisions Tax vs. Financial Management Decisions

Why do Tax Rules influence Investment Why do Tax Rules influence Financing Decisions?
Decisions? Tax rules influence the financing decisions of firms
through their effect on the cost of financing the firm’s
Tax rules affect the before-tax rates of return activities.
on assets. Some firms select investments with
The cost of issuing a capital structure instrument
high before-tax rates of return while others depends on the tax treatment it is accorded (i.e.,
select assets with low before-tax rates of return whether the cost is tax deductible or not), which, in turn,
even when both types of investments are depends on whether the instrument –
available to all firms. is debt, equity, or a hybrid,
 is issued to an employee, a customer, a related party, a bank,
Before-tax rate of return means the rate of or any one of a number of other special classes of suppliers of
return earned from investing in an asset before capital, and
any taxes are paid to domestic and foreign, is issued by a corporation, a partnership, or some other legal
organizational form.
central and local taxing authorities.

Tax vs. Financial Management Decisions Tax vs. Financial Management Decisions

Why do Tax Rules influence Investment Why do Tax Rules influence Dividend
Decisions? ………….. cont’d Decisions?
The before-tax rates of return differ because: If investment by individual investor is deemed
to be tax-advantageous relative to corporations,
the returns to different types of assets are taxed
it is important to determine whether existing
differently,
corporations should liquidate (so individual
the returns to similar assets are taxed differently if investors can reinvest the funds in ways that
they are located in different tax jurisdictions,
result in single-level taxation) or whether
the returns to similar assets located in the same tax retained earnings should be reinvested at the
jurisdiction are taxed differently if they are held corporate level, if there exist projects that
through different legal organizational forms (such as generate returns above the competitive rate.
a corporation versus a sole proprietorship), and

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Tax vs. Financial Management Decisions Tax Planning as a Tax-Favored Activity

Why do Tax Rules influence Dividend Decisions?  Tax Planning itself, a tax-favored activity – Example
 Two alternatives with marginal tax rate (MTR) of 15%:
Say, a company distributes Tk. 1 as a dividend today,  Alternative-1: Invest Tk. 10,000 in fully taxable corporate bonds for one
shareholders pay taxes at their own ‘personal tax rates’, year with a yield of 10% p.a. before taxes.
and reinvest the ‘after-tax income on their own account for  Alternative-2: Invest Tk. 10,000 in tax planning services to save Tk.
n periods at an after tax rate of return per period. If the 11,000 in taxes in one year.
company retains the Tk. 1 of after-tax corporate income,  PTROR (pre-tax rate of return) for Alternative-1:
on the other hand, and invests it on corporate account, it (Tk. 10,000x10%)/Tk. 10,000=10%
returns at corporate rate per period after tax until it finally  PTROR (pre-tax rate of return) for Alternative-2:
distributes the accumulated amount of retained earnings. (Tk. 11,000 – Tk. 10,000)/Tk. 10,000=10%
At that time, shareholders pay tax on the distribution at his  ATROR (after-tax rate of return) for Alternative-1:
personal tax rate then. So we can compare the two [(Tk. 10,000x10%)(1 – 15%)]/Tk. 10,000=8.50%
alternatives as follows:  ATROR (after-tax rate of return) for Alternative-2:
Liquidate and invest on personal account for n periods [(Tk. 11,000 – Tk. 10,000) (1 – 0%)]/[Tk. 10,000(1 – 15%)]=11.76%
Retain and invest on corporate account for n periods Thus, Alternative-2 yields higher ATROR & hence, tax-favored.
before liquidating

Tax vs. Financial Management Decisions Important Concepts for Tax Planning
 Explicit Tax – money taxes paid directly to tax authorities.
Why do Tax Rules influence Dividend  Implicit Tax – arises because the pre-tax investment
Decision? returns available on tax-favored assets are less than those
available on tax-disfavored assets. Taxpayers wishing to
The best strategy depends upon two factors: obtain the tax-favored treatment offered by the investment
bid up the price of the investment lowering the pre-tax
the investor’s marginal tax rate today, versus the return.
investor’s marginal tax rate in the future, (a  Implicit Tax Rate – the difference in pretax returns on a
decreasing tax rate, or an ability to convert dividend given asset, and the benchmark asset (usually, “fully
income into a capital gain taxed at a reduced rate, taxable bonds” taken as benchmark asset). Say, pretax
favors dividend deferral), and return on fully taxable bond = 10%, and fully tax-exempted
return on government security = 7%, then implicit tax rate
the corporate versus investor tax rate (a higher on government security = (10% – 7%)/10% = 30%. Thus,
corporate rate favors current payout) paying tax at a rate of 30% on fully taxable bond would
result in a return of 7%, the same as the pretax return on
tax-exempt government security.

Tax Planning as a Tax-Favored Activity Important Concepts for Tax Planning

Tax Planning itself is a tax-favored activity because-  Marginal Investor: Taxpayers who are
 Money spent thereon is tax deductible indifferent between purchasing two equally
 Tax savings arising from tax planning is risky assets, the returns to which are taxed
effectively tax exempt because they reduce differently, are called the marginal investors.
taxes payable & hence, more tax-favored  Tax Clientele (inframarginal investor):
than tax-exemption Taxpayers that prefer one investment over
When PTROR (pre-tax rate of return) is equal to ATROR (after-tax another are referred to as the tax clientele for
rate of return), then it is called tax exemption (a situation in which an
asset escapes explicit taxation).
the preferred investment. Unless investors
correctly identify their proper tax clientele, they
PTROR=Pre-tax Return/Pre-tax Investment will not maximize their after-tax rates of return.
ATROR=After-tax Return/After-tax Investment

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Source of the SAVANT

Important Concepts for Tax Planning
Framework
 Friction – transaction costs incurred by Book: Strategic Corporate Tax Planning
taxpayers in the marketplace that make
certain tax-planning strategies costly. Published by: John Wiley & Sons, Inc., Hoboken, New Jersey
in 2002
 Restriction – restraints imposed by the tax
authority that prevent taxpayers from using Authored by:
certain tax arbitrage techniques to reduce John E. Karayan, J.D. Ph.D., a tax attorney and former Director of
taxes in socially undesirable ways. Taxes for a New York Stock Exchange-listed high tech multinational,
Charles Swenson, Ph.D., professor of taxation and the Elaine &
Kenneth Leventhal Research Fellow at the Leventhal School of
Accounting of the University of Southern California, and
It is these frictions and tax-rule Joseph W. Neff, J.D., a partner in the Los Angeles office of
restrictions that make potential returns PricewaterhouseCoopers.
to tax planning so high.

Important Concepts for Tax Planning Approaches to Strategic Corporate

Tax Planning
 Tax Arbitrage – the purchase of one  Taxes are important to know, but hard to
asset (a “long” position) and the sale learn.
of another (a “short” position) to  The devil is in the details.
create a sure profit despite a zero  But managers and investors do not need to
know the details.
level of net investment.  They just need to be aware of the
fundamental principles of taxation and how
to apply them when making decisions.
 Even this is no simple task.

Approaches to Strategic Corporate Tax

Planning
Strategic This has been tried to do in two steps.
 First, an innovative analytic framework called
Corporate SAVANT has been explained and illustrated.
(A savant is an exceptionally knowledgeable person.)
Tax The framework organizes tax principles and their
applications and this framework helps nontax
Planning: specialists see tax savings opportunities and also
helps managers to apply tax principles to make
better decisions.
SAVANT is an acronym for how tax planning fits into
business decisions: through Strategy, Anticipation,
The SAVANT Framework Value-Adding, Negotiating, and Transforming.
 Second, it has been shown how managers can apply this
SAVANT framework to typical business transactions.
Key Words / Outline

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Applying SAVANT to Maximize Shareholder Why Managers Need to Know the

Value Principles of Tax Planning

SAVANT is used to show nontax specialists how to critically • Taxes impact success because operational decisions are
analyze situations to generate tax-savings opportunities. generally based on the risk-adjusted net present value of
SAVANT works as follows: expected after-tax cash flows.
To add maximum value to each transaction, decision makers need • In addition, income taxes, payroll, sales (e.g., value-added,
to stay focused on the firm’s strategic plan, anticipating tax
goods and services, or gross receipts), and property taxes
impacts across time for all parties affected by the transaction.
often add up to one of the largest expense items of an
Managers add value by considering these impacts when
negotiating the most advantageous arrangement, thereby organization.
transforming the tax treatment of items to the most favorable • Furthermore, tax payments typically have a high legal
status. priority claim on an organization’s cash flow.
Expert managers (and consultants) use these concepts, derived • That is, not only can taxes be a big expense, but they also
from economic policy and tax law, to maximize shareholder value. must be paid, and paid quickly.

Why Managers Need to Know the Why Managers Need to Know the
Principles of Tax Planning Principles of Tax Planning

• Reducing taxes is beneficial, but why should managers • Furthermore, multinational businesses that are publicly
learn the basics of tax planning? traded in capital markets can be especially sensitive to tax
• It may seem obvious at first glance, especially to the expense.
owner-manager or corporate entrepreneur. • This is because earnings (which usually have a major
• But this is an important question, which can be answered impact on stock prices) must be reported on an after-tax
differently at different times, in different organizations, basis.
and for operations in different countries. • Indeed, not only must earnings be reduced by taxes paid in
• Managers need to learn about taxes because optimizing a the current year, but earnings must also be reduced by any
venture’s total tax burden is important to its success, and expected future income taxes generated by such earnings.
managers are the main decision makers in an • Because senior managers’ compensation is often tied to
organization. earnings via stock prices (e.g., through stock options), key
decision makers in multinational organizations often have a
high personal stake in optimizing taxes.

Why Managers Need to Know the SAVANT Balances the Benefits with the
Principles of Tax Planning Costs of Tax Planning

• Knowing the fundamentals of taxation and how to apply • All in all, there are many factors that combine to motivate
them allows managers to make better decisions and thus managers of organizations to seek to reduce taxes, provided
be more effective in their jobs. the cost of doing so is not too high.
• Managers who are able to identify tax issues can also • This is because tax planning requires making changes, and
make more effective use of tax consultants, because these doing so is not cost free, nor are the rewards certain.
managers can recognize a problem when it arises and • First, the details of taxation are hideously complex.
advise consultants of the trade-offs involved. • 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.

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SAVANT Balances the Benefits with the Goals of Tax Planning

Costs of Tax Planning • Tax strategies are also risky: Changing operations to save taxes (e.g.,
by operating through multiple corporations) often results in an
• Such costs can be particularly high for cross-border increase in long-term administrative costs and generates uncertain
activities, which can involve a multitude of different tax returns because tax laws can change (change can occur dramatically,
jurisdictions imposing different taxes. rapidly, and unpredictably), and tax rules themselves are all too often
• In addition, similar taxes are often imposed by different obscure at best.
jurisdictions using similar but different basic definitions. • In cross-border transactions, the interactions of multiple taxes
imposed by different jurisdictions also must be appreciated.
• This raises the specter of multiple taxation (e.g., the same
• Also, tax-savings strategies can be intrusive. Why is it, for example,
income effectively being taxed at rates exceeding 100%), that profitable businesses in the Los Angeles area, a relatively high-
although governments typically try to avoid this situation tax location, do not all move to Las Vegas, a very-low tax location?
through tax treaties and special adjustments, such as the One reason is that it is costly to move. Another is that nontax factors
foreign tax credit. dominate the decision: Many business owners simply want to live in
southern California rather than southern Nevada. Yet another reason
is that skilled labor, qualified subcontractors, and competitive
suppliers are plentiful in southern California, as are (perhaps more
importantly) customers.

SAVANT Balances the Benefits with the SAVANT: The Generic Tax Planning
Costs of Tax Planning Strategies
• Finally, although income and payroll taxes may be the • Thus, even though total elimination of taxes is not a goal, people and
province of headquarters staff, and thus savings may not organizations often invest significant amounts of time and resources
in implementing tax-reducing strategies. The ultimate goal is to
directly affect a divisional manager’s annual performance
reduce taxes while not excessively intruding on the organization’s
bonus, other taxes almost always do. overall operations. SAVANT explicitly recognizes this.
• This is because these taxes are normally charged to • SAVANT also illustrates that tax strategies are usually based on
strategic business units and thus reduce their individual taking advantage of either the time value of money (e.g., paying taxes
bottom lines. later) or differences in tax rates (i.e., tax-rate arbitrage).
• Tax arbitrage is typically behind artificial transfer pricing schemes,
• Not every idea that saves taxes is a good one. that is, using accounting entries to shift profits to jurisdictions that
• The SAVANT framework helps managers make better impose the lowest net taxes (i.e., the lowest tax costs relative to the
decisions because it balances the benefits of tax planning benefits received by operating in a particular jurisdiction—e.g., free
with the costs of doing so. medical care for all people, including a firm’s employees.)

Goals of Tax Planning Tax Saving Strategies

• Most people think that minimizing taxes should be the goal of Tax savings strategies usually fall into one of four types:
tax planning. (1) creation,
• This is short-sighted, because taxes are only one factor, albeit a (2) conversion,
major one, in the mix of costs and other factors that generate the (3) shifting, and
amounts most often taxed: profits and wealth. (4) splitting.
• 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 CREATION: Creation involves plans that take advantage of
poverty, however tax free it is.
tax subsidies, such as moving an operation to a
• Furthermore, strategies that reduce taxes are rarely cost free.
• If nothing else, when focusing on saving taxes, managers are not
jurisdiction that imposes lower taxes.
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.

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SAVANT Framework:
Tax Saving Strategies The Transactions Approach to Tax Management

CONVERSION: Conversion entails changing operations so that more tax- Strategy

favored categories of income or assets are produced. For example, Anticipation
advertising in order to sell inventory results in ordinary income, which is
usually taxed immediately and at the highest rates. However, equally
successful image advertising generates an increase in a firm’s goodwill,
which is not taxed until the goodwill is sold, if at all, and then would likely
Value-
be taxed at lower capital gains rates.
Adding
SHIFTING: Shifting involves techniques that move amounts being taxed (also
called the tax base) to more favorable tax-accounting periods. A good
example is accelerated depreciation, which allows more of an asset’s cost to Negotiating Transforming
be a tax-deductible expense in early years, thus deferring the payment of
taxes until later. Another example is an individual retirement account
(IRA).

SAVANT Framework:
Tax Saving Strategies The Transactions Approach to Tax Management

Strategy  The firm looks to engage in transactions

SPLITTING: Splitting techniques entail spreading the tax base that maximize end-of-period value.
among two or more taxpayers to take advantage of differing
tax rates..  It can chose from a constellation of entities or transactions,
and the choice then is put through the lens of the firm’s
strategic objectives.
 If the transaction (including tax effects) is consistent with
the firm’s strategic objectives, it may accept the transaction.
 Otherwise, even if the transaction is highly tax-advantaged,
the firm should consider rejecting the transaction.
 Similarly, the tax aspects of the transaction can be managed
in a strategic manner.

SAVANT: The Transactions Approach to SAVANT Framework:

The Transactions Approach to Tax Management
Maximize Firm Value
• To increase firm value, managers engage in transactions.  Next, the firm anticipates its future tax
• Of course, firm value can increase for other reasons. For example, Anticipation
status and chooses the timing— this year or
the value of the firm’s assets simply can appreciate due to market
factors beyond the control of managers. a future year—of the transaction.
• However, transactions must have occurred when firms acquire  Because the effects of transactions often span more than one
such assets, and it takes transactions to convert such assets into year, the firm projects tax effects into the future, using
cash flow. Managers do things like buy, sell, rent, lease, and
current and expected future tax rates and rules, and factors
recapitalize.
• If managers structure transactions such that each is value- in management’s expectations as to the future tax status of
maximizing, then by year-end the sum of such transactions will the firm.
have maximized firm value.  If there is tax advantage to adjusting the timing of a
• However, note that each transaction has an uninvited third party: transaction, the firm should do so provided that the nontax
the government. economics still make sense.
• In strategic tax management, when a firm chooses transactions, it
keeps tax management in mind.
• This transactions approach is the SAVANT framework.

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SAVANT Framework:
The Transactions Approach to Tax Management

 Taxes are also negotiated between the firm

Negotiating and the other entity.

 The firm seeks to shift more of the tax burden away from
itself (and potentially, onto the other entity) by negotiating
the terms of the transaction.

 The firm attempts to minimize tax costs by

Transforming transforming transactions being considered
into ones with more favorable tax treatment.
 For example, managers can work to restructure transactions
that might generate nondeductible costs into ones where costs
are deductible ones, or work to transform what would have
been ordinary income into capital gain income. .

SAVANT Framework:
The Transactions Approach to Tax Management
 What is left, after taxes, is value-added to the firm. Like
taxes, value-added often inures to the firm over time.
Value-  Because it is a fundamental principle that cash inflows are
Adding more valuable now than later, tax management takes into
account the time value of a transaction as well.
• The time value of a transaction, after taxes and transaction costs, is what
increases firm value in the future.
• One aspect of a transaction that affects value-added comprises transaction
costs, such as sales commissions or attorney fees. Transaction costs reduce
the net change is inconsistent with its strategy. For example, if a firm wants
to acquire another business that is unrelated to its core competency, to
obtain tax benefits [e.g., NOL (net operating loss) carryovers], it should not
do so unless it is clear that the pretax economics make sense.
• Second, a firm’s competitive strategy may be shaped, in part, by its tax
status. Put simply, if a firm is structured so that it has a more favorable tax
status than that of its competitors, this can give the firm an overall cost
advantage over its competitors. Effective tax management is an important
tool in obtaining this kind of competitive edge.

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