This essay briefly describes the main different theoretical approaches (tax systems) designed to alleviate the double burden of corporation tax and shareholder income tax under Part 2. Parts 3- 5 explain how the problem of dividend double taxation was tried to be solved in the heterogeneous tax systems of the Germany, the UK and the US. However, the essay will not cover the different double tax avoiding treaties in force in those countries.
Inhaltsverzeichnis
1. INTRODUCTION
2. GENERAL DESCRIPTION OF DIFFERENT TAX SYSTEMS
A CLASSICAL SYSTEM
B DOUBLE TAXATION REDUCING SYSTEMS
I . D IVIDEND D EDUCTION S YSTEM
II . S PLIT R ATE S YSTEM
III . S HAREHOLDER R ELIEF S YSTEM
IV . P ARTIAL I MPUTATION S YSTEM
C DOUBLE TAXATION AVOIDING SYSTEMS
I . D IVIDEND D EDUCTION S YSTEM / S PLIT C ORPORATE T AX R ATE S YSTEM
II . F ULL T AX I MPUTATION S YSTEM
III . D IVIDEND E XEMPTION S YSTEM
3. THE GERMAN APPROACH
A THE FORMER GERMAN IMPUTATION SYSTEM
B THE NEW GERMAN SHAREHOLDER RELIEF SYSTEM
C DISTORTIONS OF THE GERMAN CORPORATE TAX SYSTEM
I . N EUTRALITY TOWARDS C ORPORATE F INANCE D ECISIONS
II . I NTERNATIONAL N EUTRALITY
III . N EUTRALITY TOWARDS L EGAL F ORM OF B USINESS
IV . O THERS
4. THE UK APPROACH
A THE FORMER UK PARTIAL IMPUTATION SYSTEM (THE ACT SYSTEM)
B CHANGES MADE TO THE ACT SYSTEM
C DISTORTIONS UNDER THE UK CORPORATE TAX SYSTEM
I . NEUTRALITY TOWARDS CORPORATE FINANCE DECISIONS
II . INTERNATIONAL NEUTRALITY
III . NEUTRALITY TOWARDS L EGAL F ORM OF B USINESS
IV . OTHERS
5. THE US APPROACH
A THE US CLASSICAL SYSTEM
I . INTEGRATION SYSTEMS UNDER THE CLASSICAL SYSTEM
B DISTORTIONS UNDER THE US CLASSICAL SYSTEM
I . NEUTRALITY TOWARDS C ORPORATE F INANCE D ECISIONS
II . INTERNATIONAL NEUTRALITY
III . NEUTRALITY TOWARDS LEGAL FORM OF BUSINESS
IV . OTHERS
6. CONCLUSION
7. REFERENCES
1. INTRODUCTION
The separate taxation of companies has become a common feature in the vast majority of tax jurisdiction. This separation between corporate profit taxation and shareholder income taxation can lead to a problem commonly referred to as “double taxation”. This problem arises out of the taxation of corporate profits (including retained and distributed profits) at the corporate tax rate and an additional taxation of the distributed profits (dividends) at the shareholders income tax rate. Double taxation is known to weaken economical efficiency as resources will not be allocated to their most productive use. Double taxation may cause the following economic distortions:1
- Favours Debt Financing: Due to high dividend taxes (and no possibility of deduction of theses expenses in contrast to interest expenses) corporations will rely more on debt financing than equity financing. Highly indebted firms are generally more vulnerable to economic downturns and more likely to suffer bankruptcies.
- Fosters Corporations to treasure cash: Earnings may be retained not to fund future growth but only as a tax shelter, which prevents shareholders from spending it in more productive investments.
- Creates international tax competition: Shareholders may be influenced in regards to where to invest their funds if different relief systems are in place in different countries.
- Favours certain legal forms of business: If certain legal forms of business are taxed favourably investors may choose those forms of business over others.
- Encourages Poor Corporate Governance and Promotes Speculation: Shareholders may become more interested in the stock price than in a company’s earnings statement (although this is certainly connected). Furthermore, they may get more interested in volatile stocks with potential for a quick capital gain than in companies that traditionally pay out stable or growing dividends.
- Reduces Investment and Savings: Double taxation generally biases against investment and savings by shareholders.
It is not surprising that several approaches were designed to avoid undesirable repercussions caused by double taxation - but it is even less surprising that there is still not one perfect system that blenches all possible distortions. Frequent changes of the tax systems of countries all over the world show, that philosopher’s stone is not found yet.
This essay briefly describes the main different theoretical approaches (tax systems) designed to alleviate the double burden of corporation tax and shareholder income tax under Part 2. Parts 3- 5 explain how the problem of dividend double taxation was tried to be solved in the heterogeneous tax systems of the Germany, the UK and the US. However, the essay will not cover the different double tax avoiding treaties in force in those countries.
2. GENERAL DESCRIPTION OF DIFFERENT TAX SYSTEMS
For the purpose of this essay, the different corporation tax systems will be categorised relating to the degree of integration of corporate income taxation into personal income taxation. According to this categorization tax systems can be divided into three groups: tax systems with no integration (classical system), partial integration (double taxation reducing) and full integration (double taxation avoiding).2 In the following these different systems will be briefly explained and examined in regard to their strengths and weaknesses.
A CLASSICAL SYSTEM
The Classical System is based on the entity approach stressing shareholders and companies are different legal entities, which both have a taxing capacity distinct from each other.3 Therefore, under the Classical System, corporate profits (including retained and distributed profits) are taxed at the corporate tax rate (corporation tax) and after-tax distributed profits (dividends) are taxed at the shareholder’s individual income tax rate (income tax). This is a classic case of double taxation which leads to the above mentioned distortions.
On the other hand, the Classical System is rather easy to operate and (by distinguishing between corporate tax and shareholder income tax) fulfils the requirement of simplicity. This is particularly valid in the case of cross-border situations, leaving it to both the company’s and shareholder’s state of residence to take a bite of the cake.4 However, this approach is not very helpful to achieve a neutral corporation tax system.
B DOUBLE TAXATION REDUCING SYSTEMS
Double Taxation Reducing Systems partially relief the double taxation of dividends. This can be achieved either at the corporate level or at the shareholder level. At the corporate level, dividends can be partly deducted as business expenses (Dividend Deduction System) or taxed at a lower rate as retained profits (Split Rate System). The Shareholder can be partly relieved by taxing his income from dividends at a lower level than other income (Shareholder Relief System) or by granting a tax credit (Partial Imputation System).
i. DIVIDEND DEDUCTION SYSTEM
Under the Dividend Deduction System a corporation is allowed to deduct part of its distributed profits as business expenses. Thereby dividends are (at least partly) taxed at the individual shareholder’s tax rates which makes the systems more neutral than the Classical System. Furthermore, it reduces the bias towards debt financing in countries where interest is deductible as business expenses. Unfortunately, problems arise in cross-border situations: tax competition can arise when the deduction is granted in the company’s residence country but not in the shareholder’s residence country.5
ii. SPLIT RATE SYSTEM
The Split Rate System uses two different corporation tax rates for retained profits and distributed profits. It is rather similar to the Dividend Deduction System as a zero-tax rate on distributed profits would lead to a Full Dividend Deduction System.6 Advantages and disadvantages are similar to those mentioned under 2Bi.
iii. SHAREHOLDER RELIEF SYSTEM
The Shareholder Relief System reduces taxation of dividend income at the shareholder level and thereby mitigates the effects of double taxation. This can be achieved by excluding dividends in the personal income tax base and taxing them at a different rate instead. However, in the case where the final withholding tax for dividends is higher than the individual personal income tax rate of the shareholder, double taxation would even be increased.7 This distortion can be avoided by burdening dividends with a final dividend tax rate only in cases where that rate is lower than the individual shareholder’s income tax rate or simply excluding part of the dividend income from the personal income tax rate.8 However, Shareholder Relief Systems certainly lead to inequities as shareholders are not taxed at their individual progressive tax rates and dividends are taxed at a different rate compared to other income.9 On the other hand, they are unproblematic in cross-border situations, easy to administer and reduce tax-avoidance as the corporation tax rate determines total taxation.10
iv. PARTIAL IMPUTATION SYSTEM
The Partial Imputation system grants a shareholder a tax credit, which can be used to reduce the personal income tax base. This tax credit is smaller than the corporate tax burden for dividends and double taxation is therefore only partly abolished - legal and financial decision-making remains affected by taxation considerations. Furthermore, the system is said to be relatively complicated to administer (i.e. allocating corporate tax to dividends).11
C DOUBLE TAXATION AVOIDING SYSTEMS
Double Taxation Avoiding Systems generally have the same systematic as the above described Double Taxation Reduction Systems, but avoid certain distortions instead of just reducing them. They also either relief double taxation at the corporate level (Dividend Deduction System and Split Corporate System) or at the shareholder level (Full Tax Imputation System and Dividend Exemption System).
i. DIVIDEND DEDUCTION SYSTEM / SPLIT CORPORATE TAX RATE SYSTEM
Under the Dividend Deduction System the corporation is entitled to completely deduct its distributed profits from its corporate tax base. The same result is achieved by a Split Corporate Tax Rate System with a tax rate on dividends of zero. These two systems tax dividends at the shareholder level and therefore the shareholders’ progressive individual income tax rates are applied. Unfortunately, in regard to cross-border activities the same problems arise as described under the corresponding partial relief systems.
ii. FULL TAX IMPUTATION SYSTEM
The Full Tax Imputation System grants full tax credits with the distributed dividends. Thereby it is the only system that (at least on a national level) is neutral and does not affect corporate decision-making in regards of the distribution of profits (only when corporate and personal income tax correspond), financing policy and the choice of legal form.12 Imputation systems usually deny a tax credit to foreign shareholders13, so that foreign dividends (depending on the system of the country of residence of the company) are taxed at the foreign corporate tax rate and again at the domestic personal income tax rate.
iii. DIVIDEND EXEMPTION SYSTEM
Under the Dividend Exemption System dividends are only taxed at the corporate level through corporate taxation and the shareholder has no further tax burden on dividends as they are excluded from his income tax base. Therefore, the dividends are always taxed at the corporate tax rate (which is in most cases a flat rate) and not at the shareholder’s individual income tax rate. The advantages of a Full Tax Imputation System in regards to a company’s distribution policy and financing policy are only met by the Dividend Exemption System when corporate tax rate and individual income tax rate concur.14 In case of varying corporate and individual income tax rates, distortions towards respectively against debt/equity financing still occur.
In the following the approach adopted by Germany, the UK and the US in respect to dividend relief will be discussed.
3. THE GERMAN APPROACH
As of January 1, 2001 the German Tax Reduction Act (Steuersenkungsgesetz) went into force. The main objectives of that Act were:
- “to reduce the tax burden on German business in order to enhance its competitiveness
internationally”,15
- to be in line with fundamental freedoms anchored in the EC Treaty (freedom of establishment, Art. 43ff and freedom of capital movements, Art 46ff),16
- to keep the disparity in corporate taxation between the different legal forms as low as possible,
- to keep the system simple and resistant against abuse.17
These aims should mainly be achieved by a reduction of the income and corporate tax rates and a change from the former Imputation System to a classical Shareholder Relief System. In the following the former German Imputation System will be briefly outlined and afterwards the new system and its repercussion (in comparison to the old system) will be discussed.
A THE FORMER GERMAN IMPUTATION SYSTEM
Since January 1, 1977 Germany was using a full imputation system that granted full imputation of corporate tax to individual and corporate shareholders18, but did not grant any tax credit to non-resident shareholders.19 The system featured a split rate for distributed and retained profits with 30 per cent for distributed profits and 40 per cent for retained profits in its last year of application (Tax year 2000). Due to a system of subsequent credit and additional charges each tax paying company had to record its after-tax profits in different baskets according to the rates they had been taxed at.20 Tax paid on foreign income in the state of source was only deductible from the German tax liability if the income was derived from 10 per cent plus subsidiaries.21 Furthermore a withholding tax (25 per cent in the last year of application) was levied upon distribution. Shareholders were afterwards granted a credit for both corporation tax and withholding tax with excesses being refunded.
The German Imputation System was criticised to be very complicated in its application and a change of system was said to be necessary in that regard. Furthermore, the system was deemed to be facilitating tax avoidance especially through dividend-stripping.22 However, the main argument against the Imputation System was its lack of conformity with the fundamental freedoms anchored in the EC-Treaty, as non-resident shareholders did not receive any imputation credit on their income in the country of residence.23
B THE NEW GERMAN SHAREHOLDER RELIEF SYSTEM
The new German corporate tax system can be seen as a hybrid between a Classical system and an Integration System, as it taxes companies and their shareholders separately, whilst granting shareholder relief against domestic double taxation.24
The former split-rate for corporate taxes was substituted by a flat rate of 25 per cent, which is levied for both retained and distributed profits25. This new rate applies to German permanent establishments and other income of non-resident companies as well. Furthermore, no tax credit is granted to shareholders anymore, in fact dividends and capital gains are now exempt from tax for corporate shareholders.26 No distinction is made between foreign and domestic income of corporate shareholders in regard to tax exemption, but expenses directly connected with domestic dividend income (such as interest cost of financing the investment) are not deductible up to the amount of the tax exemption. Expenses related with foreign dividend income are defined as being 5 per cent of the dividend actually received and if actual costs exceed that amount they are deductible as well.27
[...]
1 Compare Edwards, C., Statement at the Cato Institute before the Senate Democratic Policy Committee (21.01.2003) and also Joshua Hall, “Problems with the Double Taxation of Dividends”, Buckeye Institute Web Document, 3 March 2003.
2 See Jacobs, O., “Corporation Income Tax Systems in the European Union - An Analysis of their Effects on Competition and Reform Proposals”, (1999) 27 INTERTAX 8-9 supra 7.
3 See Tontsch, A., “Corporation Tax Systems and Fiscal Neutrality: the UK and German Systems and their Recent Changes” (2002) 30 INTERTAX 5 at 173.
4 Id supra 18.
5 See above n 2 at 267.
6 See above n3 at 174 (3).
7 See above n2 at 266.
8 Compare Austria and Luxembourg.
9 See above n3 at 174 (2).
10 Id at 174.
11 Ibid.
12 See above n2 at 268.
13 See above n3 supra 30.
14 See above n2 at 266.
15 Federal Ministry of Economics and Technology, Corporate Taxes in Germany (2nd ed 2001) at 21.
16 Eickert K., “EC Tax Scene - Germany Introduces a Classical System of Corporate Taxation in Order to Meet European Requirements” (2000) 28 INTERTAX 11 at 454.
17 See above n15 at 22.
18 See above n3 supra 67.
19 Id supra 68.
20 Id supra 71.
21 KStG (Körperschaftssteuergesetz), s 26(2) repealed.
22 Buchholz, W., Vorlesungsskript: Theorie und Praxis der Besteuerung (WS 2002/2003) at 80.
23 See above n3 supra 68.
24 See above n15 at 22.
25 KStG s 23(1).
26 KStG 8b(1).
27 KStG s 8(b)(5).
- Arbeit zitieren
- Benjamin Mahr (Autor:in), 2004, Comparison of US, UK and German corporate income tax systems with respect to dividend relief, München, GRIN Verlag, https://www.grin.com/document/28077
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