The Kyscope A kaleidoscope for assessing business income taxation options Press the slide show button in the bar below this slide, sit back and watch the.

The Kyscope

A kaleidoscope for assessing business income taxation options

Press the ‘slide show’ button in the bar below this slide, sit back and watch the show

© Copyright 2004 Wayne Mayo

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The Kyscope

A kaleidoscope for assessing business income taxation options How you can use the Kyscope

You can interrupt the show for extra information by pressing any question underlined in blue

© Copyright 2004 Wayne Mayo

To exit at any time, press ‘Esc’ key

To return to the main show at the end of extra information detours, press ‘Go back’

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The main show runs for about 28 minutes

Examples of Kyscope ‘runs’ are referred to in the show (eg Kyscope Example 1). They can be downloaded from the web site.

If you find the material progressing too slowly at any time, click your mouse on the screen

Contents Overview

Assets and liabilities Go there now

from a domestic perspective

Entities Go there now from a domestic perspective

International Go there now

assets/liabilities and entities (and their owners) from a global perspective

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Overview

The Overview runs for about 11 minutes

At the end of the Overview you will be asked if you wish to exit

In ensuing sections on assets/liabilities, entities and international, issues are discussed in more detail

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The Kyscope brings together:

• assets and liabilities

• entities that own the assets/liabilities

• and the people that own the entities

It measures the income of assets and liabilities

And tracks that income as it flows from the assets/liabilities through the entities and out to the owners

And shows the tax paid at each stage depending on the tax treatment selected for the assets, entities and owners

What does the Kyscope do?

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What can the Kyscope be used for?

To undertake aggregate revenue analysis estimating changing year-by-year tax receipts across a

sector/economy caused by a change in tax treatment

The ‘benchmark’ tax treatment is simply taxing people on the income from their assets/liabilities in the year it is earned - whether these people own the assets or liabilities directly or indirectly (via entities)

While an understanding of the benchmark base is not required to use the Kyscope, it adds to the depth of analysis possible

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To compare tax outcomes for an investor under: benchmark tax treatment

versus selected tax treatment

All the Kyscope examples

except Example 1 illustrate such

use

Use this comparison and associated effective tax

rate calculations from the Kyscope in tax policy

analyses

This is illustrated in Kyscope Example 1 – ‘Economy-wide effects of accelerated depreciation’

The Kyscope measures income earned in a year

Annual receipts less

Annual expenses

plus

Change in annual value

of assets (and liabilities)

But if the value of the orchard goes down (up) in the year the orchard investor’s income also goes down (up).

Change in value has to be added, however, even if the asset is not sold. A sound measure of income cannot change simply because the asset is retained.

The Kyscope measures ‘full’ annual income whether or not assets are sold

This is clear if the investor sells the orchard, as the cash received on sale is then less (or greater) than the investment at the start of the year.

Everyone knows that the money earned from selling apples from an orchard less annual costs of maintaining the orchard is profit or ‘income’.

How, when and whether the income is

taxed is a separate issue

BENCHMARK

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The Kyscope shows effect of benchmark on investor returns

10% pre-tax return

7% post-tax return

30% tax rate

5.3% post-tax return

47% tax rate

Annual net receipts

plus

Change in value of assets/liabilities

The pre-tax return of a ‘marginal’ investment is 10%.

If the benchmark base applies to this investment…

…the pre-tax return is reduced after tax in proportion to the investor’s tax rate.

A 10% pre-tax return from all of a person’s investment choices (the bank, bonds, property, manufacturing, etc) is reduced in proportion to his/her tax rate

What about risk?

What is a marginal investment?

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His/her investment decisions would therefore not be much affected by the imposition of tax

10% pre-tax becomes say 5.3% across the choices

…and if the investor has sufficient other income against which to write-off any annual losses in the same year…

Use the Kyscope to choose pre- and post-tax look of assets

Annual receipts less

Annual expenses

Use the Kyscope to see the effect of tax value differing

from actual value on tax revenue, after-tax returns

and effective tax rates

Want to compare pre- and post tax returns of depreciating/appreciating assets?

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plus

Change in annual tax value of assets (and liabilities)

It is not surprising that income tax systems usually include annual net receipts from investments in taxable income.

TAXABLE

INCOME

Use the Kyscope to choose pre-tax

features of assets and measure the annual income from them

Use the Kyscope to select tax treatment of the assets and see how tax value of the treatment differs from

actual value

Income tax systems differ, however, in whether they incorporate changes in value of assets in taxable income – and, if so, when.

If included, change in ‘tax value’, rather than change in value, is used in calculating annual taxable income.

Change in tax value may seek to estimate change in annual value.

Or tax value may remain unchanged at original cost prior to sale, etc.

Want to view a typical depreciating asset?

Want to view an appreciating asset?

Use the Kyscope to compare options against the benchmark

Because, without tax, actual values drive investment decisions. The share investor is interested in share value not just dividends. The property investor is interested in increases in value not just rents, etc.

Moreover, the income from an entity’s assets and liabilities (including changes in their actual values) ultimately flows through to the entity’s owners

Therefore, comparisons against the benchmark base can help you get a feel for the effects of selected tax treatment of entities, as well as of the people owning the entities

And the benchmark tax base (with its limited effect on investment decisions) incorporates actual asset values

Comparing rates of return of your selected tax treatment against those of the benchmark base should help you get a feel for behavioural effects, price effects, etc.

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Use the Kyscope to get a feel for

behavioural effects, price effects etc of your selected tax treatment………

Use the Kyscope to estimate the tax

revenue cost of tax treatments relative to the benchmark (ie ‘tax

expenditures’)

………effects relating not only to the treatment of assets, but also to the entities that own them and the people owning

the entities

Why?0

500

1000

1500

2000

2500

3000

0 1 2 3 4 5 6 7 8 9 10Year

Value

Tax value

Value

INVESTMENT OVER TIME

Use the Kyscope to identify ‘tax breaks’ and to estimate the aggregate cost of them year by year as required by many governments (in tax expenditure reports)

The Kyscope integrates the three key components

Assets and liabilities

Entities

Entity owners

Use the Kyscope to assess how your selected tax treatment applies to the source of all income: ie assets and liabilities. With each asset/liability, the Kyscope compares the selected treatment against the benchmark

ASSETS AND LIABILITIES SECTION

Use the Kyscope to judge the impact of selected tax treatment of the domestic interface between entities and their owners. See whether a single (or double) layer of tax applies. Run a benchmark comparison separately

ENTITIES SECTION

Use the Kyscope to move to the global scene and assess the impact of credits for foreign taxes (or lack of them) and the impact of exchange rates

INTERNATIONAL SECTION

In the Kyscope examples, the tax rate of the people investing is usually 47% and the pre-tax return is 10%. Thus, the benchmark after-tax return is 5.3% from directly owned assets and for people selling their entity ownership

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Overview complete Want to exit now?

Assets and liabilities

Assets and liabilities change in value year by year

However, in practice, it is change in ‘tax value’ that is used to calculate annual taxable income

Go back

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The Kyscope enables you to choose the ‘tax value’ profile of selected assets and assess the impact of those profiles

Contents

Use the Kyscope to assess the tax impact of tax value profiles

Annual changes in the tax values of assets (and liabilities) in a country’s income tax base feed into taxable income

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Traditional gaps in the coverage of business assets in income tax systems have been shrinking worldwide

Use the Kyscope to simulate tax treatment of depreciating and appreciating assets, financial assets/liabilities and trading stock

The actual change in value of an asset is, however, often reflected in the owner’s taxable income over the period of ownership

How does that work?

It is then the profile of tax value versus value over time that represents difference in treatment from the benchmark base

See it again?

Use the Kyscope to get a feel for the impact of different tax value profiles on behaviour, prices, tax revenue, etc

Use the Kyscope to simulate a range of responses to two practical questions on the treatment of assets and liabilities:1. how is change in value to be estimated (to give change in tax value)?2. what practical policy constraints cut across such estimations?

Set tax value profiles in the Kyscope and see effects

Is business expenditure involved?

Yes

How is this annual change computed?

Does the expenditure create/improve an asset?With the Kyscope, instead of answering this question, you select the assets to be included in the analysis plus their pre-tax characteristics

Deduction allowed in the year expenditure is incurred

No

In all Kyscope examples, annual costs in ‘Net receipts’ are deducted that year

Details?

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All expenditure in the Kyscope is business related

Kyscope

Example 7

Details?

Yes

Tax value at cost until sold – eg appreciating assets, trading stock

Kyscope Examples 2 & 3

Details?

Change in tax value based on write-off rate – eg depreciating assets

Kyscope Examples 4, 5, 8 & 9

Details?

Change in tax value computed from future net receipts- eg financial assets,leasesrights

Kyscope

Example 6

Details?

Tax value in line with market value – eg trading stock, financial assets

Kyscope Examples 2 & 3

Details?

Tax value at cost until production starts – eg forestry, mining

In practice, transactions to be included in the tax base are often identified individually

The ‘details’ illustrate how the selected treatment might arise in practice

Entities

Income generated by an entity’s assets may flow on to other entities

And ultimately out to the people who own the entities

The Kyscope enables you to design entity taxation confidently because it draws together the people who own the entities and the entities themselves

Go back

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An ‘entity’ (eg a company) is a separate taxpayer from its owners

Contents

The Kyscope draws together the taxation of people and entities

Assets and liabilities

Income

People - Direct InvestorsCash flow received in the year it is produced

Entity

Entity taxed each year on its annual taxable income

Cash flow only distributed when entity decides to do so

Entity owners – Indirect Investors

They are taxed separately from the entity

Design of entity taxation needs to recognise both the entity and the people who own it

Some entity tax systems are designed to impose a single layer of tax at owners’ tax rates on domestic income distributed to local people who own the entities

The single layer of tax is consistent with the single layer of tax faced by the direct investor (or unincorporated business)……………

……but the time profile of tax payments depends on the design of entity taxation and the particular circumstances applying, such as when the entity distributes income

Other entity tax systems impose a double layer of tax

Annual taxable income goes straight to individuals’ tax returns – to be taxed once ( ie it attracts a single layer of tax at each individual’s tax rate)

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The Kyscope can assist in the design of entity taxation

Entity taxation systems that are designed to impose at most a single layer of income tax on domestic entity income include:

full integration full imputation trust treatment

Classical entity taxation is designed to impose at most two layers of tax – one in the entity and another in the hands of individual owners

Under an entity tax system imposing a single layer of tax, it could be expected that, in some years, the benchmark outcome would occur

that is, annual income of entity’s assets sheeted home to individuals owning the entity to be taxed at their rates (giving the ‘10% pre-tax to 5.3%’ outcome)

What circumstances would give rise to this?

In Kyscope Example 10, the benchmark outcome occurs each year

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Use the Kyscope to ensure robust entity taxation design under either single or double taxationThe Kyscope enables you to take into account the complexities imposed by the separation of the entity and the people owning it

The Kyscope handles all these tax systems, and is able to accommodate plenty of options within each

What are some of these complexities?

Kyscope Example 10

Full imputation and, on sale, full capital gains tax (CGT) apply In addition, the annual

pre-tax return of 10% from the assets is reduced by the owners’ 47% tax rate to 5.3% each year

How does tax treatment on liquidation look under full imputation and CGT to ensure a single layer of tax only?

How would the tax treatment of a share buy-back look under full imputation and CGT to ensure a single layer of tax only?

A single layer of tax at the owners’ tax rate applies to the company’s income over the 5-year period

This benchmark outcome occurs annually despite unexceptional tax design

Dividends

Return capital

Owners

Depreciating asset

Local

Entity

Appreciating asset

Year 5

Liquidation

The company owns two local assets and is liquidated in Year 5

Why?

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All cash flow is distributed over the 5-year period and the owners may sell their shares in any year

The Kyscope shows the overall tax design required to achieve this single tax layer over time

How the Kyscope assists with entity taxation

These uses of the Kyscope are equally applicable when income flows are subject to foreign taxes in their travels back to the ultimate owners

Conceptually, handling international taxation is simple – just accommodate the fact that foreign taxes have previously been taken out of the income

But the practicalities of foreign tax credit arrangements involve many complications

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The Kyscope allows analysis of alternative approaches to taxing entities and the people who own them

The Kyscope calculates

investment returns to owners each

time they sell out to others

Comparing investment returns with the relevant benchmark rate (pre-tax return of entity’s assets reduced by owner’s tax rate) gives a feel for potential price pressures and behavioural effects

Most importantly, the Kyscope allows you to design entity taxation confidently to achieve a policy goal of a single (or

double) layer of tax without unforeseen side effects

It will rarely be necessary to compare investment returns from selected entity treatment against returns from a full integration system under the same circumstances

International

The same tax principles apply to international

investment flows as domestic flows

The Kyscope offers much help

with these practical issues

Go back

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But there are many extra practical issues involved

Contents

The Kyscope shows effects of benchmark internationally Foreign pre-tax return is reduced by the tax rate in the home country

10% pre-tax return 20% foreign tax rate

Investment from home country attracts 20% foreign income tax

30% domestic tax Full foreign tax credit 7% post-tax return

If full credit is given for the 20% foreign tax paid, only 10% extra needs to be paid in the home country to meet its 30% domestic tax rate

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Investment from home country

Income returning to home country

Use the Kyscope to analyse practical international tax issues

No new theoretical concepts are added just because foreign taxes apply

If the home country provides a full credit for foreign taxes against home country tax, investment decisions turn on the home country’s tax base

But in practice many issues arise, for example, the: extent to which credits for foreign taxes are provided treatment of capital gains or losses when, for example, a local

company sells a previously acquired foreign company design of arrangements to tax income of foreign entities even when

the income is not distributed (full integration is the conceptual model)

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This Kyscope example enables you to see how administration and compliance requirements change with different foreign tax crediting arrangements

In Kyscope Example 15, the home country provides full credit for foreign taxes

Use the Kyscope to analyse these and other practical issues

Use the Kyscope with foreign tax credit issues

Entity

Foreign tax is paid offshore on income flowing back to the home country

Does the local entity get a credit against domestic tax for the foreign tax already paid on the offshore income?People

owning it

Do people in the home country who own the local entity get a credit against their personal tax for the foreign tax on the offshore income distributed to them by the entity?

Entity

People owning it

If the foreign income flows between local entities, are the foreign taxes tracked to allow foreign tax credits to downstream entities and local people who own them?

The offshore income flows through the home country to offshore owners – ‘conduit’ income

Is the conduit income subject to additional home country tax?

Use the Kyscope to address such issues in a comprehensive and integrated way

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Kyscope Example 15

Appreciating asset

Depreciating asset

Offshore Company

Home company buys offshore company

Year 5Year 2

Capital gain on sale

Capital loss on sale

Home company sells offshore company

Offshore company pays tax offshore on the income from two assets it owns there

It distributes all cash flow to the home company in each year that the home company owns it

Dividends flowing to the home company attract the offshore country’s dividend withholding tax

Appreciating asset

Depreciating asset

Owners

Dividends

Return capital

Dividends

Return capital

Home Company Offshore and tax paid there

Year 5 Liquidation

Home company is subject to domestic tax on the dividend income from its offshore company and the non-dividend income from two offshore assets it owns directly

It gets a full credit for all the foreign taxes paid on its offshore income

In Example 15, The home country runs a full imputation system of company tax.

The home company gets a full credit for all foreign taxes paid on its income and that full credit is passed through to its local shareholders. A single layer of tax at local shareholders’ tax rates therefore applies to the income from all the foreign assets despite the foreign tax paid on it. Moreover, foreign shareholders would not be subject to additional dividend withholding tax on dividends paid to them.

In Example 15, this policy framework is able to be implemented simply by foreign taxes being added to the company’s imputation credit account. Many ledgers (represented by lines on the entity’s Kyscope spreadsheet) are not required.

Under alternative policy options, additional ledgers are required, reflecting increased administration and compliance costs.

Owners

Dividends/return capitalLocal owners have the full foreign tax credit passed through to them Use the Kyscope to analyse the

link between policy design and administration/compliance costs

Want to know more about the Kyscope?

The show has only been able to cover the tip of the Kyscope’s capabilities

For more information on these capabilities, see the download ‘Kyscope features’

To contact the Kyscope’s developer, click on ‘Contact the developer’ on the website

© Copyright 2004 Wayne Mayo (The two maps used are © Microsoft)

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Assets/liabilities Section Entities Section International SectionStart