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Session 4 An introduction to ? Implicit taxes ? Tax clienteles ? Tax arbitrage 15.518 Fall 2002 Session 4 Implicit Taxes In equilibrium the after-tax returns on all assets with the same risk and maturity have to be the same. For equal after-tax returns the pre-tax return on tax favored assets must be lower than that of fully taxed assets ? This reduction in pre-tax returns is referred to as an "implicit tax" ? The most common example of implicit taxes is the yield on municipal bonds, interest on which is (generally) excluded from gross income for federal tax purposes. ? The yields on municipal bonds are lower than those of fully taxable bonds with similar risk. 15.518 Fall 2002 Session 4 Taxes and Relative Prices: Implicit Taxes While our focus today will be on assets and rates of return, the implicit tax concept is more general than just the returns on financial assets. For example: ? When a compensation package has mostly heavily taxed components, workers require more total pretax compensation than when the firm uses tax-advantaged forms of compensation. ? Multinational investment provides another example. Input prices (especially land) in countries that offer multinational corpo…………
Session 20 - Tax-free acquisitions For tax purposes, a reorganization is a transaction in which one corporation acquires the stock or assets of another corporation Similar to taxable acquisitions discussed previously except that in a reorganization the consideration used by the acquiring corporation is its own stock (or the stock of its parent) Generally transactions meeting the definition of a "reorganization" are not taxable 15.518 Fall 2002 Session 20 Tax-free acquisitions Why are these allowed? ? Shareholders are not "cashing out," rather they are maintaining their same investment in the underlying assets, but in a different corporate form ? However, in many situations going through a reorganization can be the next best thing to cashing out, but without the tax cost 15.518 Fall 2002 Session 20 An example You start your own business, organize it as a corporation, operate it for several years, iit becomes quite profitable Microsoft decides that they would like to acquire your business, and make you an offer you can"t refuse Your corporation is merged into a subsidiary of Microsoft ? you turn in your old shares and receive in exchange 1,000,000 shares of Microsoft common stock Eve…………
Session 13 - Capital structure Debt v Equity ? characteristics # Priority of claim # Fixed v residual claim ? tax treatment # int deductible # dividends not, but receive special treatment if received by a corporation 15.518 Fall 2002 Session 13 What is debt? ? Debt and equity are the two extremes of a continuum ? Courts have considered a large number of factors in classifying debt and equity # Debt-to-equity ratio. No ratio is too high or too low, but as the risk of the debt increases the debt takes on characteristics of equity # Proportion held by shareholders. For example, if shareholders hold debt in proportion to their equity, shareholders receive the benefits of debt without a loss of residual claim. # Intent # Other factors ..... 15.518 Fall 2002 Session 13 Section 385 ? Enacted in 1969 in response to judicial uncertainty. ? Amended over time to address various concerns such as # inconsistent treatment by issuer and holder # hybrid securities # earnings stripping # see section 163 ? Instructs Treasury to issue regulations ? Still waiting.... 15.518 Fall 2002 Session 13 Dividends ? Distributions from corporations are taxed as dividends to the extent that the firm has "earnings…………
Objectives ?Sessions 9 and 10 Tax Planning & Executive Compensation Taxation of various forms of compensation Multilateral planning perspective (both employee and employer costs are important) Incentive stock options (ISOs) Non-qualified stock options (NQSOs) Other issues 15.518 Fall 2002 Sessions 9 and 10 What is an employee? Classification of a worker as an employee: ? Employer subject to payroll taxes (i.e., Social Security, Unemployment) ?Employee subject to regular Social Security tax rather than higher self employment tax ? Employee unreimbursed business expenses are deductible only as itemized deductions and subject to a limitation Classification of a worker as an independentcontractor: ? Employer pays no payroll taxes ? Worker subject to self employment tax ? Worker"s business expenses are always deductible IRS does not allow taxpayers to choose whether they are employees, classification is based on strict rules about the relationship between the employer and the employee (e.g., can the employer tell the employee how to do his or her job?) 15.518 Fall 2002 Sessions 9 and 10 Taxation of Various Forms of Compensation Current Salary ? Employee - taxable as currently paid ? Emp…………
Objectives ?Sessions 9 and 10 Tax Planning & Executive Compensation Taxation of various forms of compensation Multilateral planning perspective (both employee and employer costs are important) Incentive stock options (ISOs) Non-qualified stock options (NQSOs) Other issues 15.518 Fall 2002 Sessions 9 and 10 What is an employee? Classification of a worker as an employee: ? Employer subject to payroll taxes (i.e., Social Security, Unemployment) ?Employee subject to regular Social Security tax rather than higher self employment tax ? Employee unreimbursed business expenses are deductible only as itemized deductions and subject to a limitation Classification of a worker as an independentcontractor: ? Employer pays no payroll taxes ? Worker subject to self employment tax ? Worker"s business expenses are always deductible IRS does not allow taxpayers to choose whether they are employees, classification is based on strict rules about the relationship between the employer and the employee (e.g., can the employer tell the employee how to do his or her job?) 15.518 Fall 2002 Sessions 9 and 10 Taxation of Various Forms of Compensation Current Salary ? Employee - taxable as currently paid ? Emp…………
Objectives and Game Plan Provide an overview of the class Provide some background on tax policy and the economics of taxation Outline the key points of "Scholes-Wolfson?framework 15.518 Fall 2002 Session 1 What is 518? MBA-Style Tax Strategy Course Blend of tax law, corporate finance, and microeconomics Birth-to-death approach with a focus on some high value- added applications (e.g., international, M&A) We will, however, also address some high-level issues to understand the economics of taxation and the underlying principles of the U.S. tax system We will address the taxation of individuals only to the extent they intersect with corporate topics or are useful to illustrate certain topics 15.518 Fall 2002 Session 1 What is 518? What we will cover ? Corporate formation ? Compensation ? Investments and operations ? Restructuring ? Multijurisdictional tax planning 15.518 Fall 2002 Session 1 Some big picture questions Who levies taxes? Why do we tax? What do we tax? How do we tax? What are the effects of taxes? Who pays taxes? 15.518 Fall 2002 Session 1 Tax avoidance vs. tax evasion Tax Evasion ? The reduction of a person"s tax liability through an activity that is either illegal, frau…………
Session 7 - Nontax costs One important non-tax cost we have already seen is the implicit tax on tax-favored assets We now focus on other types of non-tax costs: ? Organizational form costs ? Risk ? Administrative costs ? Agency (incentive) costs ? Financial reporting costs ? Transaction costs 15.518 Fall 2002 Session 5 Organizational form costs Suppose you want to use a partnership to reduce tax costs. What types of non-tax costs will you face? ? The Boston Celtics Limited Partnership (BCLP) faced this decision in 1997 when Congress changed tax law in 1987 to tax "publicly traded partnerships" as corporations. The provision was "grandfathered" so that it did not apply to existing publicly traded partnerships for 10 years ? BCLP was operated as a publicly traded limited partnership 15.518 Fall 2002 Session 5 Alternatives considered by BCLP Maintain BCLP"s tax status as a partnership by paying the "toll tax" imposed under the tax law. The tax would be a federal tax at a rate of 3.5% of gross income from the active conduct of trades or businesses in taxable years beginning after December 31, 1997. ? Benefit梥till have partnership tax treatment ? Cost梩he toll tax Allow BCLP to be taxed…………
Session 19 -Taxable acquisitions Acquire stock or assets? Assume that Buyer Corporation wants to acquire the business of Target Corporation Target"s assets have appreciated and are worth more than their tax basis Assume the acquisition will be a taxable purchase ? purchase price will be cash or notes rather than the buyer"s stock 15.518 Fall 2002 Session 19 Why use a taxable purchase? seller wants cash buyer wants seller out of the continuing entity buyer wants "step-up" in tax basis of acquired assets seller has losses that can be used to offset taxable gain 15.518 Fall 2002 Session 19 Transaction structure The transaction can be structured in one of three ways ? methods 1, 2, and 3 on page 324 all referred to as "taxable" methods because Target"s shareholders will have a taxable gain from the transaction 15.518 Fall 2002 Session 19 Transaction structures 1. Buyer purchases all of the assets from Target ! Target liquidates and pays cash out to its shareholders 2. Buyer purchases all of the Target stock from Target shareholders ! Target is liquidated ! Buyer ends up with all of Target"s assets 3. Buyer purchases all of the Target stock from Target shareholders ! Target is maintaine…………
Session 8 - Marginal tax rates Provide an overview of the structure of the corporate income tax Define the marginal tax rate Understand the importance of the dynamics of the tax code 15.518 Fall 2002 Session 8 Basic Structure of the Corporate Income Tax RECEIPTS -DEDUCTIONS: TAXES Business receipts Compensation Income tax Less cost of sales Repairs Other taxes Interest Bad debts Personal holding co. Rents Rent paid Recapture taxes Royalties Taxes paid Alternative minimum tax Net capital gains Interest paid = Total income tax before credits Net gain, noncapital assets Contributions or gifts - Credits Dividends received Amortization Foreign tax credit Other receipts Depreciation U.S. possessions tax credit Depletion Qualified electric vehicle credit Advertising Nonconventional source fuel credit Pension, profit-sharing etc General business credit Employee benefits Prior year minimum tax credit Net loss, noncapital assets Other deductions = Total income tax after credits = Taxable Income before NOLD and special deductions - NOLD and special deductions = Taxable income (non-negative) 15.518 Fall 2002 Session 8 The Alternative Minimum Tax (AMT) Expanded in 1986 to address perceived disp…………
Session 12 - Structuring a Start-up Transaction All common stock deals Alernatives to all common stock deals Restricted stock Structuring a start-up as a flow-through entity (S corp, partnership) when venture capital money is used. 15.518 Fall 2002 Session 12 Structuring a Start-up Transaction Basic Setup: ? Your team (TEAM) has just won the 50K Competition ? A local venture fund principal impressed by your product抯 potential, approaches you with an offer to invest $10 million in your concept. ? You make an appointment for the following week to go over your proposed structure for the new company. 15.518 Fall 2002 Session 12 Structuring a Start-up Transaction TEAM VC Ideas/Expertise $$$$$ Start-up 15.518 Fall 2002 Session 12 Structuring a Start-up Transaction TEAM Proposal: All Common Stock VC TEAM Amount invested $10 million Ideas & Expertise Stock received 49,000 shares 51,000 shares Does the VC fund accept your proposal? If they do, should you be pleased with your negotiated proposal? 15.518 Fall 2002 Session 12 Structuring a Start-up Transaction VC funds generally reject 100% common-stock structures for a new start-up. What happens if STARTUP fails? ? Example: After $5 million i…………
Objectives and Game Plan More on the effects of deferral, deductibility & rate differences on after-tax returns. Some policy issues. 15.518 Fall 2002 Session 3 Tax Planning versus Investment Expertise Investors traditionally paid little attention to the effect of taxes on mutual fund returns. This began to change in the early 1990s when Charles Schwab & Co. introduced a series of "tax-efficient" funds and began publicizing a study quantifying the effect that taxes have on mutual fund returns. Since then, more investors have begun paying attention to a fund‘s taxable distributions. Assume the following: Pretax return - Index Fund (R):20% Tax rate (t):40% Inclusion rate (g):70% Annual turnover of fund: 100% (active) 0% (index) (1) What pretax return does an active fund manager have to earn to match the performance of the index fund? Compute results for 1, 5, 10, and 30-year horizons. (2) If the inclusion rate drops to 50% (i.e., tcg = 20%) does that make the fund manager‘s job more or less difficult? Compute results for 1, 5, 10, and 30-year horizons. (3) How can an investor minimize the active fund penalty computed above? 15.518 Fall 2002 Session 3 Tax Planning versus Investment Exp…………
Session 11 - Corporate formation Discuss corporate formation rules Examine the tax implications of incorporating a business Lokk at how a start-up might be structured 15.518 Fall 2002 Session 11 Overview of Corporate Formation Rules Section 351: Deferring gain or loss upon incorporation ? What rationale exists for treating a corporate formation as a nontaxable exchange? Specific requirements: ? Property must be transferred to the corporation in an "exchange? transaction ? The transferors of the property must be in control of the corporation after the transfer ? The transferors must receive stock of the transferee corporation in exchange for their property 15.518 Fall 2002 Session 11 Example 1 John and Jane form JJ Corporation. John contributes a building that he originally purchased for $50,000 for 50% of the shares. The building has a current FMV of $100,000. Jane contributes $100,000 in cash for the remaining 50%. Section 351 applies and John does not have to recognize any gain on the building. The Property Requirement Nonrecognition of gain or loss applies only to transfers of property Courts and the government have defined property to include: ? Cash ? Patents ? Installment obl…………
Objectives and Game Plan Understand how deferral, deductibility & rate differences affect after-tax returns Discuss key features of competing investment structures 15.518 Fall 2002 Session 2 Assumptions Same underlying security # Pre-tax return (R) = 7% Tax rates constant across time & individuals # Tax rate on ordinary income (t) = 30% # Tax rate on capital gains (tg) = 15% No frictions (transaction costs) Certainty $100 initial investment 15.518 Fall 2002 Session 2 Savings Vehicles Savings vehicles differ on three dimensions ? Is the investment deductible? (yes / no) ? Are earnings tax deferred? (yes / no) ? What tax rates apply? (ordinary "t?/ capital "tg?/ exempt) 15.518 Fall 2002 Session 2 Type I: Money Market (MM) Other examples (savings accounts, corporate bonds, etc.) Characteristics ? No deduction ? No deferral ? Ordinary rates Not "tax?advantaged 15.518 Fall 2002 Session 2 Type I: Money Market (MM) After-tax accumulation (ATA): ATA = [(1+R) - tR]n = [1+R(1-t)]n After-tax rate of return: r = [[1+R(1-t)]n]1/n - 1 = R (1-t) Observations: "r?does not depend on horizon 15.518 Fall 2002 Session 2 Type II: Single Premium Deferred Annuity (SPDA) Other example (non-deductible IRA)…………
Session 14 - International Taxation Provide an overview of the taxation of international tax rules Introduce the FTC Provide an overview of transfer pricing 15.518 Fall 2002 Session 14 International tax systems Territorial - no tax is generally due on income earned outside of the country in which the parent is located Worldwide - all income is subject to taxation by the country in which the parent is located # US taxes worldwide income of citizens and permanent residents # US taxes worldwide income of domestic corporations # US taxes the US source income of nonresident aliens # US taxes the US source income of foreign corporations 15.518 Fall 2002 Session 14 Withholding In addition to taxes imposed on earnings, transfers (interest payments, dividends, royalties, etc.) between a corporation and its foreign shareholders (individuals or corporations) are generally subject to withholding taxes. The general withholding rate imposed by the U.S. is 30% of the payment amount. This rate can be reduced by tax treaties between the various jurisdictions 15.518 Fall 2002 Session 14 Some definitions A domestic corporation is one incorporated in one of the 50 US states A foreign corporation is on…………
Session 5 - Types of Organizational Forms Business organizations Taxpayer is the owner(s) Taxpayer is the corporation Organization is exempt Sole props C corps Governments Partnerships Some special cases Non-profits LLCs RICS, REITS Pensions S corps PHC 15.518 Fall 2002 Session 5 Partnerships Non-tax features ? Flexible ownership ? Limited partners have limited liability ? Must have at least one general partner Tax features ? No partnership level tax, also no deferral ? Items of income retain character ? Special allocations of income and deductions ? Basis includes share of partnership liabilities (complicated) 15.518 Fall 2002 Session 5 C Corporations Non-tax features ? Limited liability ? Flexible capital structure & ownership Tax features ? Deferral of personal taxes until dividends are paid or shares are sold ? Double taxation ? Can not pass through losses ? Capital losses can only offset capital gains 15.518 Fall 2002 Session 5 S Corporations Non-tax features ? Limited Liability (No difference between C and S corporations from "legal?perspective) Tax features ? Limitations on number and type of shareholders ? Generally no entity level tax, also no deferral ? Items of income re…………
Session 21 - More tax-free reorganizations ?68(a)(1)(B) ? acquisition of stock in exchange solely for voting stock of acquiring corporation or its parent ?68(a)(1)(C) ? acquisition of substantially all of the properties of another corporation in exchange solely for voting stock of acquiring corporation or its parent 15.518 Fall 2002 Session 21 Type B: Stock-for-Stock Exchange Acquiring corporation exchanges its stock for stock of Target, Target becomes a subsidiary of the acquiring corporation ? Keeps Target intact and avoids having to transfer title to Target"s assets Disadvantage is no consideration other than stock is allowed or the transaction will not qualify as a reorganization ? In tax jargon, "no boot in a B" Easy to inadvertently include some unintended compensation (such as the acquiring corporation paying some liability of Target) that causes the deal to become taxable. 15.518 Fall 2002 Session 21 Normal "B?Reorganization Example: ? T has assets with a basis of $100 (inside basis) and FMV of $200. ? A pays T抯 shareholders with A shares. ? T抯 shareholders have a basis (outside basis) in T stock = $80. 15.518 Fall 2002 Session 21 Normal "B?Reorganization - Results T Corp ?…………
Session 23 - Divestitures Divestitures ? 338(h)(10) Elections Equity carve-outs Spin-offs Liquidations 15.518 Fall 2002 Session 23 Divestitures A sale of a group of operating assets for cash, securities or some other property (a subsidiary, a division, a business segment) Divestiture motivations: ? eliminating unwanted assets (earning lower than required rates of return) ? regulatory considerations (antitrust) ? reversals of "mistakes?(reducing scope of activities) ? cash for debt reduction (LBOs) 15.518 Fall 2002 Session 23 Tax treatment of divestitures Almost nothing new here For unincorporated divisions or business segments, treatment is identical to any other taxable asset sale For subsidiaries, treatment depends on the type of transaction chosen ? taxable asset acquisitions ? taxable stock acquisitions ? tax-free asset acquisitions ? tax-free stock acquisitions 15.518 Fall 2002 Session 23 Taxable Stock Acquisitions Section 338 (h)(10) Election If A makes a regular Section 338 election 2 levels of tax occur on the sale of T stock ? a tax on the seller"s gain on the sale of T stock and ? a corporate-level tax on T"s deemed sale of assets to New T If a Section 338 (h)(10) electio…………
Session 18 - Corporate Reorganizations Why reorganize? Do I acquire stock or assets? Is the transaction taxable or tax-deferred 15.518 Fall 2002 Session 18 Reasons for reorganizations Improve economic efficiency ? Vertical or horizontal integration ? Economies of scale and / or scope ? Exploit asymmetric information ? Enter new lines of business (diversify) ? Exit business Extend managerial power Transfer wealth 15.518 Fall 2002 Session 18 Nontax issues Financial reporting effects Transaction costs Contingent liabilities Control issues Political / regulatory costs What consideration do I have to offer? 15.518 Fall 2002 Session 18 Tax issues Seller ? Will a tax be owed by selling firm? ? Will tax be owed by selling firm抯 shareholders? Buyer ? What will the basis in the target抯 assets be? ? What will happen to the tax attributes of the target? Both ? What effect will the financing choice have? 15.518 Fall 2002 Session 18 Key IRC sections ?68 Definitions related to corporate reorganizations ? Specifically ?68(a)(1)(A) - 368(a)(1)(G) ?36 Gain or loss recognized on property distributed in complete liquidation ?38 Certain stock purchases treated as asset acquisitions ? Especially ?38(h)(

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