5. Taxation of Business Entities and their members.pptx

1. Taxation of Business Entities and Their members
Q: Which business form is pleasing for tax purpose?
By: Alemu Taye (Asst. Prof.)
Debre Markos University
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2.  Business activities can be engaged either by individuals or legal
persons.
◦ Two or more natural persons pool labour and capital resource
and form business organizations.
◦ In the first place, different organizations are subject to different
tax rules.
◦ Secondly, the tax treatment of the legal person and its
constitutes have stayed to be full of intricacies.
 In Ethiopia, as a famed business organizations, Taxation of
Companies & Shareholders as well as Taxation of Partnerships &
Partners needs further investigation.
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3.  A corporation is a separate legal entity owned by shareholders who
purchase stock in the company.
 A CORPORATION/ COMPANY TAX is a direct tax imposed on the
net profits corporations or analogous legal entities (at entity level).
 Unlike the owners of partnerships, shareholders are not responsible
for paying taxes on the profits a corporation earns.
 In many systems it is designed as a central/ federal tax
 In Ethiopia, its both federal and concurrent.
 Many countries tax all types of corporate income at the same rate,
 For example, in Ethiopia a body is taxed at 30% flat/proportional
rate (art. 14(1) & 19(1) of ITP)
 Yet, some countries provide different rates of tax depending on
income levels or size of entity. For example,
 In US the rate vary/ progress from 15- 35% as per the income,
 In Canada there is different tax rate as per the size of
corporations- lower rates for small corporations
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4.  Most systems tax both domestic corporations (on worldwide income)
and foreign corporations (only on income from sources within the
jurisdiction) or residents and non- residents.
 National laws determine this status based on standards such as place of
incorporation, doing business, management, permanent establishment or
other presumptions for tax purposes.
 TAXATION OF SHAREHOLDERS is an income tax levied on
distributional earnings (dividends) (at the shareholders level). (see
schedule D, art 55 of the ITP)
 The corporation is required to withhold tax before the dividend is
distributed.
 Being a dual level of tax, the tax on distribution of earnings is imposed at
reduced rates. Eg. 10% in USA and Ethiopia.
 Company and tax laws outlaw distributions to shareholders except as
dividend or the tax due is paid.
 IN ADDITION, if a shareholder sells shares, he must pay capital gains
tax on the profit realized. (see schedule D, art 59 of the ITP)
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5. How do you see this tax?
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6.  There have been long-standing disputes regarding taxation of
corporations.
◦ JUSTIFICATIONS for why separate tax on corporations?
 They are a distinct juristic person independent from its
shareholders constituted to discharge its own legal obligations.
 Its income and financial liability are computed and assessed
separately.
 The tax is a price paid for the privilege of limited liability
and for having access to capital markets. (Benefit theory)
 Interests of equity- no justification to exempt bodies and tax
natural persons.
 Corporate taxation have regulatory goals
 Governments are anxious to raise revenues from corporations
(the real reason).
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7. ◦ THE CASES AGAINST THE TAX
 The three taxes fall more or less on the same tax base under
different schedule: corporate income tax, tax on dividends, and
capital gains (for a tax on sale of shares).
 The double tax violates both principles of horizontal and
vertical equity.
 The flat rate exacerbate this problem.
 The benefit principle is not strong to justify separate
taxation of corporations as the privilege of incorporation and
limited liability are not benefits compared to what corporations
are required to pay.
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8.  With this arguments we have different approaches with respect to
Taxation of Corporations and shareholders
◦ Classical systems: tax both corporations and shareholders. Many
countries follow this approach. E.g. US, the Netherlands, Sweden,
Ethiopia (of course countries like US employ other means of relieving
the double tax such as Alternative minimum tax)
◦ Imputation Systems: The corporate income tax is regarded as a tax
paid by shareholders and it provide tax credits to shareholders when
they pay tax on dividends. E.g. Germany, France, Australia
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9.  There are 3 other approaches that seek to eliminate double
taxation.
 The first is the Partnership Approach- which seeks to treat
corporations like partnerships, as pass-through entities/
conduits and tax only dividends.
 But;
 Administratively infeasible for it requires corporations to
keep accounts for every hundreds or thousands of
shareholders and their attributable profits.
 Dividend policies are largely beyond the control of
shareholders to meet personal tax liabilities.
 The second approach is to allow the corporation to deduct
dividends just as it is allowed to deduct interest paid on loans.
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10.  The third approach is the dividend-exclusion approach/ Dividend-
paid deduction approach, which argues individuals are not
required to include dividends as income as these are already subject
to tax at the corporate level.
 But
 This eliminates the preferential treatment of interest as a
deductible expense.
 And, the tax at the corporate level is not a tax at the individual
level.
 This may also potentially induce corporations to pay out
dividends to take advantage of the deductions.
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11. Major legal Issues in Taxation of
Corporations and Shareholders ?
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12.  In corporate Taxation, one of the important legal issue is defining
Entities subject to tax.
◦ Some countries exhaustively list in their tax laws the types of entities
that are subject to tax (US, Ethiopia in 286/2002), others simply
define what corporate organs are (Canada, Germany) and still others
no tax rules for classification or definition (Sweden, Ethiopia in
979/2016)
◦ In Ethiopia
 Article 2 (2) & (3) of ITP No. 286/2002 tried to define ‘body’ by
enumeration but it was confusing and was not in line with the
provisions of the Comm. Code. Registered partnership?
unincorporated body ? close corporation?
 ITP no. 979/2016 has omitted the confusing definitional provision.
 The provisions of the Comm. Code would have direct applicability.
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13.  Another issue stems from the treatment of different tax bases and the
case Ethiopia often lacks clarity. For example,
◦ Treatment of contributions by shareholders: contribution of cash is not
subject to tax b/c it is an after-tax money but in some states (Canada, Sweden)
contributions of appreciated or depreciated property leads to recognition
of gain or loss in many tax systems.
◦ The treatment The Capital Structure: even if both equity and debt are the
means of financing company, the forthcoming treatment of dividends from
interest must be distinguished. Because, corporations and shareholders may
exploit the tax system by re-casting payments made to them as interest rather
than dividends.
 In some systems, courts have developed case law to re-cast certain
interests as dividends (USA).
 Others provide the limitation of the rate of interest, and anti-thin
capitalization rules.
 Ethiopia?
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14. ◦ The treatment of Corporate Distributions:
 Distributions may not necessarily be from ‘profits and earnings’
only and it can be a return of capital in different manner.
 In many tax systems, the commercial or tax rules control and
characterize distributions.
 In some states (US, Australia) only profits and earnings
are taken as dividends and other distributions are
represent the return of capital (which is tax-free) unless
the distribution exceeds the former investment/ realize
gain- disposition of shares.
 In others (The Netherlands, Japan) any economic benefit
received by the shareholder is taxable.
 Ethiopia?
 There are different instances when companies benefit shareholders
without formal declaration of profits or dividends.
 For example,
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15.  Constructive Dividends: excessive compensation, excessive interest for
loans from shareholders, bargain sales, rentals of corporate assets,
payments of personal expenses etc.
 Distributions of property: Suppose a company distributes cars-
appreciated or depreciated- to shareholders.
 Distributions accompanying changes in Corporate Structure:
reduction in capital; redemption of shares; capitalization of earnings and
increased capital.
 Stock dividends: If companies distribute shares/stocks in stead of cash
as is often the case, the distributions are called stock dividends.
 Redemptions: Purchases by companies of their own shares from
shareholders.
 Liquidation Distributions: in cash or in kind distributions.
 Distributions during Corporate Reorganizations: mergers,
acquisitions, divisions/splits, spin-offs, which typically involve
transfers of assets or shares.
 In many tax systems, the commercial law rules or tax rules control
in characterizing of distributions. See Art. 34-35 of the ITP.
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16.  Major problems
 Absence of clear legal provisions
 The difficulty to characterize these distributions as Capital
gains tax dividend tax
 Absence of rules of evaluation for in kind distributions
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17.  Partnership is an association of two or more persons (legal or
juridical) to carry on a business for profit.
◦ A conventional partnership, unlike a company, is not a legal
entity but in countries such as Scotland and Ethiopia,
partnerships do have a separate legal personality, but partners do
not enjoy limited liability. A contradiction!
 Accordingly, jurisdictions regulate partnerships and partners
taxation differently.
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18. ◦ In Many common law jurisdictions (UK, USA, Hong Kong),
partnerships are a flow-through entity, where the taxes are
assessed at the entity level but which are applied to the
partners of the partnership.
 Even though profit and loss is determined at the partnership
level, there is no income tax assessed against the partnership.
 The partnership is disregarded for tax purposes and treated as
being pass-through entities or conduits or transparent, where
income, deductions, credits, and other items flow to the
partners.
 Each year the partnership notices each partner to report their
income tax returns OR withhold and report to the tax authority.
 The tax rules for partnerships are broadly similar to those for
sole traders.

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19. ◦ Many civil law jurisdictions (France) directly tax the partnership
entity and it is argued that partnership taxation is the concept
of taxing a partnership business entity.
 The partnerships receive the corporate-like treatment
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20.  Ethiopia
◦ There was no clear income tax rule for long period but the current ITP
omitted the definition of body and there are no detailed rules to effect
the intention to treat them possibly as ‘pass-through’ entities.
 Hence, through interpretation partnerships were treated like
companies and be subjected to 30% flat tax rate, b/c the Commercial
Code awards them separate legal personality.
 However, the distributions of partnerships profits escaped taxation at
the partners level, because this type of profit was not fully
mentioned as one source of income and no tax rate for it.
◦ However, the current ITP has defined dividend to include distributions
of partnership and be taxed under art. 55
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21.  In many systems, (conventional) partnerships are taken as tax efficient
◦ There is only one level of tax on profit i.e. at the partner or partnership level-
Avoid double taxation
◦ Income or loss allocations or distributions must be proportional to the
ownership interest of the shareholders as set forth in the partnership
agreement.
◦ Partnerships can liquidate tax-free, whereas corporations are taxed at the
entity level when they liquidate.
◦ Certain partnerships that do not conduct a business can choose to be
completely or partially excluded from being treated as a partnership for
federal tax purposes, if all partners agree to the choice and they are able to
figure their own individual taxes without knowledge of the other participants'
income.
 However, taxation of Husband and wife partnership might be burdensome.
◦ In some countries relief mechanisms are introduced with anti-avoidance legislation e.g.. all
members of a partnership must be suitably qualified
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22.  Review the following articles
◦ 1334629- VIP.pdf
◦ 1339381- VIP.pdf
◦ 20061903- VIP.pdf
◦ 24247741- VIP.pdf
 Instructions
◦ Anonymity presentation
◦ Page limit: 2 each
◦ Due date: 20/11/2017
◦ Submission type: hardcopy delivery
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