A547_Lecture+Slides_Chapter+5_SV

Class Session #4 Implicit Taxes
A547/B732: Strategic Tax Planning
Dave Greene and Ajay Mehrotra
Noves for Class #4
LO # Restated
Tax-exempt
5% 3% (8% – 5%) None 3% 37.5% (3%/8%)
Explicit tax rate Total tax rate
37.5% (3%/8%) 37.5%
0% (None/8%) 37.5%
1% / 8% = 12.5% 37.5%
Risk Premia complicates matters
9 Congress gives out tax bennies, but the market sets the price (the rate of implicit tax that is paid through lower pretax returns). The implicit tax rate is the same for everyone, regardless of their marginal explicit tax rate. Congress giveth, but they can taketh away, too…a tax disadvantaged asset is worth less (and will have to pay a higher yield = NEGATIVE implicit taxes) PPE: implicit taxes may not be observable, b/c we don’t have a BENCHMARK Implicit taxes are not paid to IRS, but to a TRANSFER AGENT Yields differ because of taxes, but also because of RISK. You can’t calculate the implicit taxes until you strip out the risk premium. High tax bracket TPs should pay implicit taxes; low bracket TPs should not. Taking implicit taxes into consideration increases PROGRESSIVITY It may be possible to exploit differential tax treatment to create a sure profit. This is what we call TAX ARBITRAGE.
Let’s have an auction. Here are the facts.
• • • • 1 year time horizon Only 2 investments exist: Bond A and Bond B Both bonds have a $1,000 face and will pay $100 in interest at the EOY Mommy always liked you better Congress likes Bond A better than Bond B, and has 5 alternative ways of conveying their feelings – Interest on A is exempt from tax, OR – ½ of interest on A is exempt from tax, OR – Purchasers of Bond A get a 10% tax credit (based on the face amount of the bond) against their income tax in the year of purchase, OR – Purchasers of Bond A get to deduct the cost of the bond against their TI in the year of purchase (but this doesn’t reduce their AB in the bond), OR – Purchasers are taxed on 1/3 of income in year of receipt (+ 1/3 in Yrs #2 + #3) Bond B sells for $1,000…what would you pay for Bond A in each alternative Oops…Teams 1-5 have a 10% tax rate, Teams 6-10 = 25%
• Already talked about double/triple tax (DRD discussion in Class 3) • Partnerships (and S Corps) are flow-through entities…no entity level tax is paid • The choice of entity depends on – Comparison of tax rates on “owners” (Tp) vs. corporations (Tc) – Duration (n) that funds will stay in the “business” (P/S or corporation) – Tax that will be paid on extraction of funds from corporation (Ts) – Non-tax factors – Note: PT ROR (R) is also a factor in the calculations, but presumably is the same for both investments
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Principles of Te and Ti (ignoring risk premia)
• • • For a fully taxable asset, there are no implicit taxes (Ti = 0) For a fully tax-exempt asset, there are no explicit taxes (Te = 0) Implicit taxes = extent to which the pretax return on an asset is less than the pretax return on the benchmark, i.e. a fully taxable asset (Ti = Rb – R). – Ti always has to be derived or inferred. Explicit taxes = extent to which the pretax return on an asset is greater than that on a tax-exempt asset. (Te = R – Re). – Note, this would rarely (if ever) be the same as the statutory rate. One would expect it to be < the statutory rate because the “marginal investor” is not subject to the highest tax rate. SW calculates the Ti rate with respect to Rb. This is necessary to satisfy the condition that SW has set that Ti + Te should be the same for all assets (assuming perfectly competitive markets)
10 11 12 13 14 16 17
SW says there are 5 flavors of tax favoritism for investment assets
• And those would be…? – Full tax exemption muni bonds – Partial tax exemption (or a lower tax rate) capital gains – Tax credit Investment tax credit, targeted jobs credit, R&E credit, low income housing credit – Tax deductions faster than rate of decline in economic value MACRS depreciation – Income taxed at a later time than when it becomes “economic income” Unrealized income
• In the real world, there are two reasons why the R ≠ r – Taxes – Risk How does risk affect the price of an asset and why?
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On Monday: Organizational form and tax planning…Chapter 4
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Apply the rules of the road to a scenario (Table 5.1 format, slightly reordered, new facts)
Fully taxable Pretax return Implicit tax Explicit tax Total tax Implicit tax rate Explicit tax rate Total tax rate 8% Tax-exempt 5% Partially Tax Exempt 6%