Taxes and Business Strategy
Notes Through Mid-Term
Spring 2004
Chapters 1 and 2: The Really Big Picture
A few general propositions:
1. Governments exist to serve the interests of the governed. They do this, primarily, by providing goods and services that are not provided in sufficient quantity by markets (i.e., a “market failure” of some kind has occurred or will occur in the absence of governmental action) such as inadequate:
Defense
Social safety net
Education
Police and Fire protection
Public Parks and recreation
· Note: the desired type and amount of government provided goods and services are primary differentiators of individuals with thoughtful allegiances to particular political views.
2. To serve the interests of the governed, governments need economic resources.
3. To get economic resources, governments tax the governed.
4. Governments can use tax policy to promote (discourage) socially beneficial (wasteful/hurtful) investments:
Deductible home mortgage interest
Targeted jobs tax credits
Research and Development Tax credits
Investment Tax credits
Carbon emission taxes
Refundable deposits
5. Some common forms of taxation are property taxation (the primary means through which funds are generated to provide for elementary and secondary school public education), activity taxation (e.g., licenses to drive, hunt, marry, fish, spew carbon dioxide into the air), social security taxation (which is a capped flat tax that is annually greater than the income tax for a majority of Americans) and income taxation. This course focuses primarily on income taxation, though the concepts developed apply broadly to other economic behavior.
6. Because the government taxes income it is, de facto, a third party to income generating transactions—taxation affects prices to buyers and profits to sellers.
7. Governments typically set down some general rules (and some very specific “bright line” rules) on how income-generating events and transactions will be taxed—and everyone has to go along with them.
8. All else equal, people want to control as many economic resources as possible (I’m talking about cash or other assets).
9. Let’s define economic income as revenue (value received for goods and services sold plus the increase in the value of assets held and decrease in the value of liabilities owed) less non-tax costs less tax costs.
10. All else equal, when people invest economic resources (as opposed to consuming economic resources or simply letting economic resources sit idle) they want to maximize their economic return.
11. The economic return that people want to maximize is AFTER-TAX economic return not BEFORE TAX economic return—because you don’t get to keep the before tax return—unless, of course, there’s no tax. The “no-tax” case is actually a fairly common occurrence. If you earn “passive” income in a “tax-haven” country you may effectively pay no taxes, if you do not make much in the way of “income” you may pay no income taxes (though you will likely pay social security taxes), if your assets are held in a pension fund, no income taxes are paid on returns until you take assets out of the fund…
12. Maximizing AFTER-TAX economic return is where tax planning comes into play.
13. Maximizing AFTER-TAX economic return is not the same as minimizing tax. Specifically, incurring costs to reduce taxes greater than the taxes saved would be economically unsound—a negative NPV project.
14. Maximizing the AFTER-TAX economic return of one party to a transaction requires that you consider what’s in the best interests of all parties to the transaction (aside from the government—remember, they write the rules so it’s assumed that the government can take care of itself).
15. Note: Tax planning is not tax evasion. Tax evasion is a crime. Tax planning is common sense.
16. A lot of what passes as tax planning looks a lot like tax evasion; in a nutshell, the line between the two is not always bright.
Do Chapter 1 Assignments
What does Tax Planning involve?
1. Converting one type of income into another
e.g., ordinary income into capital gains
Traditionally, capital gains tax rates have been below tax rates on ordinary income. This is true for individuals today, though not for corporations. Specifically, for fiscal year 2003 the top marginal ordinary tax rate for individuals will be 35% while the top capital gains tax rate will be 15% (this 15% rate will also apply to dividends received by individuals). What is the percentage difference between these two tax rates? (.35-.15) / .35 = 57%. As you can see, the capital gains tax rates to individuals is 57% LOWER than ordinary tax rates.
Capital gains (and losses) are equal to the change in value of an asset over time (e.g., the increase in value of a security). Examples of ordinary income include wages and bonuses to employees and income from normal operations of a corporation. Sometimes, the line between what is ordinary income and what is capital gains income is fuzzy.
2. Shifting income from one pocket to another
e.g., from a high tax pocket to a low tax pocket
Obviously, it is better to arrange affairs such that income, if it has to be recognized for tax purposes, is recognized in the low tax pocket (provided, of course, that you’ve got a low tax pocket—and if you don’t have one, maybe you should, e.g., you could create one via an inversion transaction, ala Tyco). The incentive to create low-tax pockets has been the source of significant disputes in the international trade arena as well as in state taxation of income. Specifically, firms try to source income in low tax jurisdictions to reduce taxes that have to be paid and source expenses and losses in high tax jurisdictions to reduce taxes that have to be paid.
Note: shifting income from one taxpayer to another is an example of the importance of considering all taxpayers that are party to a particular transaction. It is especially important to consider all parties in, for example, compensation planning, estate planning, investment transactions (e.g., leasing), financing transactions (debt versus equity), and corporate mergers and acquisitions (cash vs. stock acquisitions).
3. Shifting income from one time period to another
e.g., from the present to the future
Absent a change in tax rates, this is a straightforward time value of money thing. All else equal, it’s better to pay taxes later than sooner. This incentive led many old-line firms with rising inventory input prices to select LIFO inventory valuation method, despite the fact that this election oftentimes reduces reported earnings.
Problem: General Electric values some domestic inventories using LIFO and reports a LIFO inventory reserve of $606 million as of 12/31/02 (this means, in a nutshell, that the GE has recognized on a pretax basis $606 million less income for tax and financial reporting purposes than it would have had it used FIFO). Assume GE faces a marginal tax rate of 35% and has an after-tax cost of capital of 10%.
1. What’s a ballpark estimate of GE’s 2003 after-tax return from using LIFO?
2. What non tax cost, if any, does GE incur by using LIFO?
Problem: Assume a company faces the following tax rates
2003 35%
2004 35%
2005 35%
2006 and thereafter 40%
Also, assume that the company has an after-tax cost of capital of 10%.
1. If the company has the discretion to recognize $1 of income in either 2005 or 2006, which should it choose? Why? How much better off will the company be in present value terms as of 2005?
2. If the company incurs an operating loss for tax purposes in 2006 and has the discretion to carryback the loss to generate a refund equal to the tax paid on $1 of income in 2005 or carryover the loss to offset income expected to be earned in 2007, which should it choose? Why? How much better off will the company be in present value terms as of 2006? What risk, if any, lies in the choice?
Do Chapter 2 Assignments
Nobel Winner Stiglitz Says Deals At LTCM Had `No Economic Value'
By Kara Scannell
501 words
18 July 2003
The Wall Street Journal
C14
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)
Corrections & Amplifications
JOSEPH E. STIGLITZ is a former chief economist for the World Bank. An article in Friday's Money & Investing section incorrectly said he had worked for the International Monetary Fund.
(WSJ July 21, 2003)
NEW HAVEN, Conn. -- In the battle of the Nobel Prize winners in federal court here to determine the legality of a tax shelter, Nobel laureate Joseph E. Stiglitz didn't pull any punches.
Mr. Stiglitz, who won the Nobel Memorial Prize in Economic Science in 2001, testified that the transactions Long-Term Capital Management's partners relied on to create tax deductions on $100 million had "no economic value." LTCM's lawyers swung back to challenge Mr. Stiglitz's credibility.
Mr. Stiglitz's testimony comes toward the end of a monthlong trial before Judge Janet Bond Arterton. For a tax shelter to be considered legal, it must have economic substance, or a business purpose for entering into it other than to avoid taxes, and a chance for profit.
The trial also highlights the federal government's continued efforts to crack down on tax shelters, the executives who use them and the banks, accounting firms and lawyers who recommend them.
LTCM sued the government in 2001, after the Internal Revenue Service disallowed $106 million in losses claimed by the hedge fund's partners on their 1997 federal income-tax returns. Federal authorities alleged that the losses were based on sham transactions. LTCM is seeking the portion of the taxes already paid, while the government is asking for penalties and interest.
Mr. Stiglitz, a former chief economist for the International Monetary Fund who has attracted controversy for his criticism of global capitalism and stock-market abuses, testified on behalf of the government that after studying the structure, parties involved, incentives and guarantees of the underlying leasing transactions, "It made no sense." He said it was "peculiar" to see a flow of money that "showed no useful purpose."
On cross-examination, LTCM's lawyer, David Curtin of the Washington, D.C., firm McKee Nelson LLP, suggested that Mr. Stiglitz was biased against LTCM, citing his latest book and other writings, and a speech to a division of the United Nations in which Mr. Stiglitz discussed "crony capitalism," including LTCM's 1998 bailout. Mr. Stiglitz said he was discussing the public debate and wasn't taking a position on it. "It was part of the scene in 1998. You can't write about the scene without commenting on" LTCM, he said.
Bond arbitrageur John Meriwether founded LTCM in 1993 with a cadre of Nobel Prize winners, including Myron S. Scholes and Robert C. Merton, both of whom have testified on behalf of the hedge fund in this case. The fund's near-collapse in 1998 after massive losses sparked by the Russian currency crisis wreaked havoc on global financial markets, culminating in an unprecedented $3.65 billion bailout orchestrated by the Federal Reserve.
Chapter 3: Alternative Savings Vehicles
Overview: The purpose behind reviewing the effect of alternative taxation of income (ordinary income vs. capital gains income vs. tax-exempt income, annual taxation vs. deferred taxation, deductible investments versus non-deductible investments) is threefold:
1. highlight the importance of income characterization,
2. highlight the power of compounding pre-tax versus after-tax returns, and
3. introduce the basic algebra for the course.
As an aside:
Individual Rates (for 2003)
Top ordinary rates = 35%
Top short-term capital gains rates = 35%
Top long-term capital gains rates = 15%
(long –term rate generally applies to
assets held more than 12 months)
Corporate Rates
Top ordinary rates = 35%
Top short-term capital gains rates = 35%
Top long-term capital gains rates = 35%
We’re going to identify and discuss six types of “savings vehicles “SVs” on the next six pages.
Note: Don’t get too worked up by the algebra—you don’t have to memorize anything: focus on understanding the intuition imbedded in the algebra (really—I mean this—especially for those of you who don’t much like “math”). Note that the math fits nicely into a cheap calculator that can do present values and has a memory function. As a practical matter, you will want to be able to solve numerical problems with your calculator. I will use a Texas Instruments BA-35 Solar in class. If you use this particular calculator, I can help you with present value calculations; if you use another calculator, you’re on your own. Note that practice makes perfect. It will likely help a lot for you to do problems—visceral learning is a real thing here. Also, note that I think there is absolutely no excuse for not mastering the functioning of a simple handheld calculator
Savings Vehicles Taxation Examples
SV1 Ordinary Income / Annual Taxation * Wages
* Bonus
* Interest income
Return to SV1 = $I [1 + R(1-t) ] n
where $I = initial investment
R = pretax return
t = tax rate on ordinary income each year
n = compounding periods
Problem: An individual invests $1,000 in a partnership. All partnership income is taxable to partners annually (partnerships are referred to as “pass-through” or “conduit” entities because of this feature). Assume the partnership generates a pretax return of 10% for 3 (30) years, all returns are reinvested, and the individual faces a 35% annual tax rate.
· What will the partnership stake be worth in 3 (30) years?
· What is the annualized rate of return? (A general procedure for calculating an “annualized rate of return” is to use a calculator and input the present value (the $1,000 investment here), the value available at the end of the investment period as the future value, # of periods covered by the investment (3 and 30 periods in this problem), and solve for i, the interest rate or rate of return.)
Savings Vehicles Taxation Examples
SV2 Ordinary Income / Deferred Taxation * Returns from foreign
subsidiaries
* Non-deductible IRAs * Return of interest on
life insurance
proceeds
Return to SV2 = $I (1 + R)n (1-t) + $It
where $I = initial investment
R = pretax return
t = tax rate on ordinary income after n periods
n = compounding periods
Problem: An individual invests $1,000 in a non-deductible IRA. All returns are exempt from taxation until withdrawn. The IRA invests in fully taxable corporate bonds that yield 10% for 3 (30) years. Assume that the individual withdraws all of the IRA’s assets at the end of 3 (30) years and, at that point, pays tax on the returns at a 35% tax rate.
· How much would the individual have at that point?