Maxims of Income Tax Planning

Chapter 4
Maxims of Income
Tax Planning
4-2
Objectives
1. Differentiate between tax avoidance and tax evasion

2. List the four variables that determine the tax
consequences of a transaction
3. Explain why an income shift or a deduction shift can
improve NPV
4. Explain how the assignment of income doctrine constrains
income-shifting strategies
5. Contrast the tax character of ordinary income and capital
gain
6. Distinguish between an explicit and implicit tax
7. Summarize the four tax planning maxims
4-3
Tax Avoidance not Evasion
• Tax avoidance consists of legitimate means of

reducing taxes
• Tax evasion consists of illegal means of reducing

taxes and is a felony offense punishable by severe
monetary fines and imprisonment
4-4
Tax Planning Variables
• Tax consequences of a transaction depend on the

interaction of four variables
1. The entity variable: Which entity undertakes the
transaction? (sole traders, partnership, corporate, etc.)
2. The time period variable: In which tax year does the
transaction occur? (the tax period, tax base)
3. The jurisdiction variable: In which taxing jurisdiction
does the transaction occur? (what type of tax, income
tax, VAT, or CGI tax)
4. The character variable: What is the tax character of
the income from the transaction?
4-5
Income Tax Planning - Entity
• Generally, taxable income is computed under the

same rules across business entities
• However, the tax on business income depends on
the difference in tax rates across entities
• The two taxpaying business entities are individuals
and corporations
4-6
Income Tax Planning - Entity
• Individual taxpayers
• Have a progressive tax rate structure
ranging from 10% to 35%
• Corporate taxpayers
• Have a progressive tax rate structure
ranging from 15% to 39%
4-7
Income Tax Planning – Entity Variable
• Tax costs decrease (and cash flows increase) when

income is generated by an entity subject to a low
tax rate
• When establishing a new business, consider the tax

rates paid by the type of business entity
4-8
• Income shifting
• Arranging transactions to transfer income from a high
tax rate entity to a low tax rate entity
• Deduction shifting
• Arranging transactions to transfer deductions from a
low tax rate entity to a high tax rate entity
4-9
• After an income or deduction shift, the parties in

the aggregate are financially better off by the tax
savings from the transaction
4-10
Assignment of income doctrine constrains on income

shifting
• Income shifting transactions usually occur between related
parties
• Income must be taxed to the entity that earns it by
the sale of goods or performance of services
• Income generated by capital must be taxed to the
entity that owns the capital
4-11
Income Tax Planning – Time Period Variable
• Tax costs or savings from a transaction depend on

the year in which the transaction occurs
• In present value terms, tax costs decrease (and

cash flows increase) when a tax cost is deferred
until a later taxable year
• Constrained by:
• Opportunity costs
• Tax rate increase
4-12
• Opportunity costs
• Shifting tax costs to a later period may involve
postponing a cash inflow to a later period. Thus, the
opportunity cost of postponing the cash inflow may
exceed the savings from the tax deferral
• The opportunity cost is the loss of the immediate

use of the cash (nếu dùng hết đống đó thì period sau
không có đủ CF để trả thuế)
4-13
• Tax rate increase
• If taxpayers defer the recognition of taxable income to a

future year and future tax rates increase, the cost of the
rate increase offsets the benefit of the deferral
• The risk that deferred income will be taxed at a higher

rate increases with the length of the deferral period
4-14
Income Tax Planning - Opportunity Costs
• Assume that a taxpayer has a 30% tax rate and uses a

10% discount rate. Compute NPV of the following:
• Taxpayer receives $100 cash/income and pays tax now
• NPV = $70
• Taxpayer defers the receipt of cash/income by one year
• NPV = $64 ($70 × 0.909)
• Taxpayer receives $100 cash but defers recognizing
income by one year
• NPV = $73 ($100 – $27[$30 × 0.909])
4-15
Income Tax Planning - Tax Rate Increase
• Taxpayer receives $100 cash but defers

recognizing income by one year. However, the tax
rate increases from 30% to 40% next year
• NPV = $64 ($100 – $36[$40 × 0.909])
4-16
Income Tax Planning – Jurisdiction Variable
• The jurisdiction variable is important because local,

state, and foreign tax laws differ
• Tax costs decrease (and cash flows increase)

when income is generated in a jurisdiction with
a low tax rate
4-17
Income Tax Planning – Character Variable
• The tax character of an income item is determined

strictly by law
• Every income item is characterized as either
ordinary income or capital gain
• Ordinary income is generated from the sale of goods or
performance of services in the regular course of business
• Income generated by investments (interest, dividends,
royalties, and rents) is ordinary
• Capital gains are generated by the sale or exchange of
capital assets
4-18
• Most types of ordinary income are taxed at regular

rates
• Exceptions to this rule include interest on state and
local bonds (tax-exempt for both corporations and
individuals) and qualified dividends (taxed at
preferential rates for individuals)
• Capital gains
• Taxed at preferential rates for individuals
• Taxed at regular rates for corporations
4-19
• Tax costs decrease (and cash flows increase) when

income is taxed at a preferential rate because of its
character.
• Because capital gains are taxed at preferential
rates, individuals try to arrange transactions to
convert ordinary income to capital gain
 Provisions prevent the conversion of ordinary

income to capital income
4-20
Conflicting Tax Planning Maxims
• Sometimes, the four tax planning maxims conflict!
• For example, a transaction that results in tax deferral may

cause income to shift to an entity with a higher tax rate
• Managers should remember that their strategic goal

is not tax minimization per se but NPV maximization
4-21
Implicit vs. Explicit Taxes
• Explicit taxes – taxes are paid directly to the government

• Implicit taxes – taxes are paid through higher prices or lower
returns on tax-favored investment
• Example: Investor A with a 15% marginal tax rate intends to
invest in a corporate bond pays 9% and a municipal bond
pays 6.3%
• The municipal bond incurs a 30% implicit tax (2.7% reduced rate/9%)
• Investor A with marginal rates less than 30% maximize his after-tax
rate of return by purchasing the corporate bond
4-22
Homework
2,7,8,11,12,18 p 86-89

Maxims of Income Tax Planning

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Maxims of Income Tax Planning

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Chapter 4

1. Differentiate between tax avoidance and tax evasion

Tax Avoidance not Evasion

• Tax avoidance consists of legitimate means of

• Tax evasion consists of illegal means of reducing

Tax Planning Variables

• Tax consequences of a transaction depend on the

Income Tax Planning - Entity

• Generally, taxable income is computed under the

Income Tax Planning - Entity

Income Tax Planning – Entity Variable

• Tax costs decrease (and cash flows increase) when

• When establishing a new business, consider the tax

Income Tax Planning – Entity Variable

Income Tax Planning – Entity Variable

• After an income or deduction shift, the parties in

Income Tax Planning – Entity Variable

Assignment of income doctrine constrains on income

Income Tax Planning – Time Period Variable

• Tax costs or savings from a transaction depend on

• In present value terms, tax costs decrease (and

Income Tax Planning – Time Period Variable

• The opportunity cost is the loss of the immediate

Income Tax Planning – Time Period Variable

• Tax rate increase

• If taxpayers defer the recognition of taxable income to a

• The risk that deferred income will be taxed at a higher

Income Tax Planning - Opportunity Costs

• Assume that a taxpayer has a 30% tax rate and uses a

Income Tax Planning - Tax Rate Increase

• Taxpayer receives $100 cash but defers

Income Tax Planning – Jurisdiction Variable

• The jurisdiction variable is important because local,

• Tax costs decrease (and cash flows increase)

Income Tax Planning – Character Variable

• The tax character of an income item is determined

Income Tax Planning – Character Variable

• Most types of ordinary income are taxed at regular

Income Tax Planning – Character Variable

• Tax costs decrease (and cash flows increase) when

 Provisions prevent the conversion of ordinary

Conflicting Tax Planning Maxims

• Sometimes, the four tax planning maxims conflict!

• For example, a transaction that results in tax deferral may

• Managers should remember that their strategic goal

Implicit vs. Explicit Taxes

• Explicit taxes – taxes are paid directly to the government

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