Jan Široký *) tel.: ; *) Jan Široký, associate professor by VSB - Technical University Ostrava,Czech Republic,

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1 There are several factors, which influence the actual range of the corporate tax: the relation between the personal income tax and the corporate income tax Jan Široký *) Abstract: When 10 new countries entered the European Union, a discussion opened again over the issue of using corporate tax as an instrument of economic policy. One of the objectives of the European Commission in the sphere of tax cooperation is fighting the harmful competition within the direct income taxes. The question remains how to measure the actual corporate tax rates, which sometimes differ significantly from the nominal rates. In his paper, the author tries to point out factors, which need to be respected when looking for the answer to the actual rate of competition among corporate taxes within European communities, specifically to the question of interconnecting the corporate income tax and personal income tax. Abstrakt: Přistoupení 10 dalších zemí do Evropské unie znovu otevřelo diskusi nad otázkou možnosti využívat daně ze zisků korporací jako nástroje hospodářské politiky. Evropská komise jako jeden z cílů spolupráce v oblasti daní považuje boj proti škodlivé konkurenci v oblasti přímých důchodových daní. Je otázkou, jak poměřovat skutečné sazby daně ze zisků firem, které se mnohdy velmi liší od sazeb nominálních. Autor se ve svém příspěvku snaží ukázat na faktory, které je potřeba zohlednit při hledání odpovědi na skutečnou míru konkurence daní ze zisků firem v rámci Evropských společenství, konkrétně na problém propojení osobní a firemní důchodové daně. Key-words: Corporate tax, integration of corporation income tax and personal income tax, taxation policy, effective tax rate, nominal tax rate Klíčová slova: Daň ze zisků korporací, integrace firemní a osobní důchodové daně, daňová politika, efektivní sazba daně, nominální sazba daně JEL Classification: H 20, H 22 Introduction The actual (effective) range of the corporate tax rate is influenced by many factors. At first, it is necessary to specify all deducted taxes imposed on companies. On 31 st December 2005, the Slovakian Republic and Malta had the highest corporate tax rate (35%), the lowest one had the Cyprus (10%). The Slovakian Republic and Malta had the same corporate tax rate as the personal income tax rate. The existence of various methods and the period of deducting, the possibility to take the inflation into account by means of the LIFO or FIFO methods, by applying losses, and in particular by taking the various types of investment incentives as well as other privileges of companies into account, results in a significant diversion of the nominal rate from the actual (effective, real) corporate tax rate. According to the criterion of *) Jan Široký, associate professor by VSB - Technical University Ostrava,Czech Republic, tel.: ; jsiroky@mmo.cz 1

2 integrating the corporate income tax into the personal income tax, three major categories can be distinguished: the classical system, systems preventing double taxation, and systems avoiding double taxation. To enable the analysis of the tax burden, several indicators have to be figured out: capital costs, effective marginal tax rate and effective average tax rate. 1. Income tax systems: The integration of corporation income tax and personal income tax Double taxation of dividends can have distortion effects on the financial as well as investment decision making of companies Various methods of how to divide the systems of interconnecting personal and company income tax can be found in literature. For the purpose of this article, classification by Ernst a Young (2004) was adopted, in particular because it deals with the new member states of the European Union. There are various types of corporate income tax systems in European Union. Regarding the extent of integration of the corporate income tax into the personal income tax of the individual shareholder, three main categories can be distinguished: the classical system, double taxation reducing systems and double taxation avoiding systems (see Fig. 1). Figure 1: Classification of the systems of integration of corporation income tax and personal income tax Systems of Corporate Income Taxation Classical System Double Taxation Reducing Systems Double Taxation Avoiding Systems Corporate Level Shareholder Level Corporate Level Shareholder Level Dividend Deduction 100% Shareholder Relief Dividend Deduction = 100% Full Tax Imputation System Split Rate System Partial Imputation Split Corporate Tax Rate Dividend Exemption The classical system results in the double taxation of dividends by imposing both corporate and personal level. It is not in effect in any of the new member states. The double taxation avoiding systems ensure that profits are taxed only once either at the corporate level or at the shareholder level. Malta is the only new member state that applies a full imputation system. Latvia and the Slovak republic eliminate double taxation through a system of dividend exemption at the shareholder level. Profits are subject only to corporate income tax. Consequently, the corporate income tax rate determines the tax burden of both retained and distributed profits. Estonia combines elements of a split-rate system with a system of dividends exemption. 2

3 Most of the new member states grant only partial relief from double taxation on dividends. In Cyprus, Czech Republic, Hungary, Lithuania, Poland, and Slovenia shareholders receive (compared to other sources of personal income) preferential treatment for their dividend income. Since shareholder relief systems do not discriminate foreign dividends against domestic dividends they do not violate the fundamental freedoms of the European Community Treaty. By contrast, imputation systems result in a discrimination of foreign dividends since the tax credit is restricted to domestic dividends. Generally, double taxation of dividends can have distortion effects on the financial as well as investment decision making of companies, and there is a clash with the tax neutrality incorporated within the problems of double taxation. However, the adopted regulation (The Parent-Subsidiary Directive) is a factor, which has reduced the problem of internal taxation. It eliminates the internal double taxation between the subsidiaries of a controlling company. Nevertheless, the indicated problem appears to contribute (meanwhile) to the difference between the nominal and real (actual) corporate tax rates. 2. Directive Income tax systems: The integration of corporation income tax and personal income tax The harmonisation of direct taxes has not been implemented so consistently in the European Union as it has been with indirect taxes. There are not many pivotal regulations in the European communities in the sphere of direct taxation, and they are presented (in Fig. No.2): Directive No. 90/434/EEC ( The Merge Directive ); Directive No. 90/435/EEC ( The Parent-Subsidiary Directive); Directive No. 2003/48/EC ( The Savings Directive ); Directive No. 2003/49/EC ( The Interest and Royalties Directive). Figure 2: Basic directives in the sphere of direct taxation Direct Tax Legislation Directive No. 77/799/ECC Directive No. 90/434/EEC Convention No. 90/436/EEC Directive No. 2005/19/EC Directive No. 90/435/EEC Directive No. 2003/123/EC Directive No. 2003/48/EC Directive No. 2003/49/EC 3

4 The Parent-Subsidiary Directive aims at removing the double taxation of profit, which is paid by companies that are members of a group residing in one member state while the residence of the controlling company is in another member state. The directive makes sure that the member state of the controlling company either does not tax the profit of the subsidiary residing in another member state, or, if the profit is taxed, the controlling company is allowed to deduct the income tax paid by the subsidiary in the other member state from its tax base. In addition, the directive makes it possible not to tax, by means of a deducted tax, the divided profit of the subsidiary. The directive went through a significant updating by the directive No. 2003/123/EC. In addition to incorporating the statutes of the European society and the European cooperative society into the Parent-Subsidiary Directive, its provisions were extended to dividing profits acquired by permanent establishment, and dividing company profits to permanent establishments residing in a member state different from that of the controlling company or the subsidiary. Conclusion This issue is subject to continuous discussion and no agreement has been achieved so far whether to retain this double taxation, reduce it or remove it completely, how to tax dividends and how to interconnect the taxation of dividend yield from shares and the taxation of profit, whether to implement this interconnection on the corporate level or on the level of shareholders, and which method to use. The existence of various tax benefits and tax allowances determines the nominal tax rates significantly. New member countries of the European Union use the corporation tax as an instrument of economic policy, in particular with the aim of stimulating investment activity. Obviously, it is necessary to analyse the actual effective rates of corporate taxes and measure the methods, which determine them. Sources of information [ 1] Company Taxation in the New EU Member States. Frankfurt: Ernst & Young and ZEW, [ 2] European Tax Handbook. Amsterodam: IBFD, [ 3] KOLÁŘ, P., VÍTEK, L., PAVEL, J. a kol. Zdanění a neutralita. Praha: Eurolex Bohemia, [ 4] KUBATOVÁ, K.: Daňová teorie a politika. Praha: Eurolex Bohemia, [ 5] NERUDOVÁ, D. Harmonizace daňových systémů zemí Evropské unie. Praha: ASPI, [ 6] ŠIROKÝ, J. Daně v Evropské unii. Praha: Linde, [ 7] [ 8] [ 9] [10] Appendix: The integration of corporation income tax and personal income tax in European Union Austria The Austrian corporate income tax is based on the classical system. Corporate profits are subject to corporate income tax. Dividends paid to individual shareholders and portfolio corporate shareholders are subject to a withholding tax. For an individual shareholder, the withheld tax is final; for a portfolio corporate shareholder, it is credited against final income tax liability (on other income) or refunded on request. There is no withholding tax on 4

5 dividends paid to substantial corporate shareholders. Dividends are exempt from corporate income tax in the hands of a corporate shareholder, regardless of the size of the holding. Belgium The Belgian corporate tax system is a classical double taxation system, modified by an exemption for dividends from qualifying participations held by corporate shareholders and a reduced rate for dividends from participations held by individual shareholders. Cyprus The system of taxation of corporate profits is a classical one. Profits of a company are first subject to corporation tax at the company level, and then, upon distribution, are taxed by way of a 15% withholding tax (defence contribution) at the level of a resident individual shareholder. The withholding tax is final (dividends are exempt from income tax), and is also levied on deemed distributions. No taxes are levied on a distribution from a resident company to a corporate shareholder or to non-residents. Czech Republic The Czech Republic applies a modified classical system of taxation of corporate profits. In principle, corporate profits are taxed both at the company level and at the shareholder level. At the shareholder level, dividends are not subject to corporate or individual income tax but only a lower final withholding tax. An exemption from the withholding tax is available with respect to certain qualifying distributions to corporate shareholders. Denmark Denmark has had a classical system of taxation for corporate profits. This tax system is coupled with a participation exemption for corporate shareholders and reduced tax rates for individual shareholders on dividends. Estonia Corporate taxpayers are not subject to corporate income tax. Instead, they are subject to a distribution tax on distributed profits, including transactions that are considered as hidden profit distributions (e.g. fringe benefits, gifts and donations, non-business expenses). No tax is levied on any retained earnings. Only dividends paid to non-resident corporate shareholders are subject to an additional withholding tax. Finland (change as of 1/01/2005) The imputation system is replaced by a classical double taxation system, under which corporate income is first taxed in the hands of the company and dividends are subsequently taxed in the hands of the shareholders at the appropriate rates. However, the classical system is strongly modified in that dividends received by a resident company from another resident company are normally fully exempt in the hands of the recipient (participation exemption). France (change as of 1/01/2005) Dividends derived by corporate shareholders and assessed to tax from 1 January 2005 are taxed under a classical system. For dividends paid to parent companies or after 1 January 2005, the 5% non-exempt amount is no longer grossed up with the imputation credit. For dividend distributions made by parent companies on or after 1 January 2005, the imputation credit is no longer offset against the equalization tax. Parent companies, which benefited from the participation exemption regime, are allowed to set off the imputation credit attached to the dividends received during the past 5 years against the one-off substitute tax due on account of distributions made in Any excess credit is lost. For dividends distributed to individual 5

6 shareholders from 1 January 2005, the classical system is modified in that only 50% of the dividends received are subject to tax. Germany (change as of 1/01/2002) The former split-rate system, with a full imputation credit granted to resident shareholders. A transitional regime provides for a partial refund of corporate income tax to companies distributing profits that they had derived under the former system and that had borne a corporate income tax burden of more than 30%. Under the new classical corporate tax system, corporate profits are taxed at the level of the company at a reduced corporate income tax rate and dividends are taxed in the hands of individual shareholders without imputation credits being available for the corporate income tax paid. Economic double taxation, however, is mitigated for individual shareholders by the "half-income system," under which only one half of the dividends received is included in the individual's taxable income. Intercorporate dividends derived from both resident and non-resident companies are exempt. Companies must generally withhold dividend withholding tax from distributed profits. The tax withheld is fully creditable for resident shareholders against their corporate or individual income tax liability. Greece Greece has a dividend exemption system under which dividends paid by companies are distributed from after-tax profits and are not subject to further taxation in the hands of the recipient. Hungary Hungary has a partial integration system for the taxation of corporate profits. Corporate profits are subject to corporate income tax. Dividends paid to resident corporate shareholders are exempt from any further taxation. Only dividends paid to individual shareholders and nonresident corporate shareholders are subject to withholding tax. Ireland Ireland has an imputation system for the assessment of corporate income. Dividends paid were not subject to withholding, but the company paying the dividend was liable to pay advance corporation tax, which was creditable against its corporation tax liability (net of double tax relief credit). Part of the corporation tax was imputed to the shareholder as a tax credit. Individual shareholder was able to set this credit off against his income tax liability on the dividend plus the credit. Dividends received by a resident company from another resident company, known as franked investment income, were exempt from corporation tax. Italy (change as of 1/01/2004) Italy applies a classical system of taxation of corporate profits. The former imputation system is abolished and replaced by a 95% participation exemption for corporate shareholders and a 60% exemption for individual shareholders who hold the participation in a business capacity. Individual shareholders not holding the participation in a business capacity are also entitled to the 60% exemption if they own more than 2% of the voting power or 5% of the capital in listed companies, or more than 20% of the voting power or 25% of the capital in other companies. Otherwise, dividends derived by individuals are subject to a final withholding tax. Latvia The taxable income of a company is subject to corporate income tax and no other tax on income. Corporate income tax also applies to large individual enterprises. Dividends distributed to resident shareholders are subject neither to withholding tax nor to income tax in 6

7 the hands of the shareholders (individual or corporate shareholders). Thus, there is no economic double taxation of resident companies and their resident shareholders. Lithuania The Lithuanian corporate income tax is a modified classical system. For dividends distributed to individual shareholders, Lithuania applies the classical system, under which dividends are fully taxed at the level of the distributing company and again in the hands of the shareholder. For dividends distributed to corporate shareholders, double taxation is practically eliminated. Luxemburg The corporate tax system of Luxembourg is, in principle, classical. This means that the tax is levied on corporate income and that distributed profits are again taxed in the hands of the shareholders. For resident individual shareholders, a 50% exemption for dividends applies in many cases. For corporate shareholders, either a 50% exemption or a 100% participation exemption may apply. Malta There is no separate system of corporation tax, and a company is subject to income tax in much the same way as an individual. A full imputation system is used. Under this system, dividends paid by a company resident in Malta carry a tax credit equivalent to the tax paid by the company on its profits out of which the dividends are distributed. This system applies to both resident and non-resident shareholders. Shareholders are taxed on the gross dividend at the applicable tax rates, but are entitled to deduct the tax credit attaching to the dividend against their total income tax liability. Netherlands The Netherlands corporate income tax is based on the classical system, which means that corporate profits are fully taxed and distributions from the taxed profits are again fully taxed in the hands of the shareholders. However, in the case of qualifying distributions to corporate shareholders, double taxation is eliminated through the participation exemption. In the case of individual shareholders with a substantial shareholding (generally, at least 5%), economic double taxation is mitigated through a lower flat rate of income tax on dividends (25%). Dividends and other profit distributions are subject to dividend withholding tax, which is fully creditable against the shareholders' income tax liability. Poland The Polish tax system is a classical tax system, according to which corporate income is fully taxed at the company level, with the distributed profits being taxed again by way of a withholding in the hands of the shareholders. For resident corporate shareholders, the tax so withheld is credited against their corporate income tax liability, even though the dividends are not added to the total taxable income. For resident individual shareholders and all nonresident shareholders, the withholding tax is final. Portugal (change as of 1/01/2002) Portugal applies a partial exemption system. According to both systems, qualifying domestic dividends derived by resident corporate shareholders are fully exempt in their hands. Under the new system, a 50% exemption is granted in respect of such dividends where the participation exemption does not apply, as well as in respect of dividends derived by resident individual shareholders. 7

8 Slovak Republic (change as of 1/01/2004) Slovak Republic has a single taxation system, i.e. corporate profits are fully taxed at the company level and distributed profits are not taxed in the hands of the corporate or individual shareholders. Slovenia In principle, the Slovenian corporate income tax system is a classical system, which means that corporate profits are subject to tax at the level of the company and dividends are taxed in the hands of the shareholders. The resulting economic double taxation is relieved for resident corporate shareholders through the participation exemption and for individual shareholders through a 35% reduction of the taxable amount. Spain Spain applies a partial imputation system. Resident individual shareholders are granted an imputation tax credit. For resident corporate shareholders the position is different. They are not granted an imputation tax credit, but receive a tax credit equal to 50% or 100% of their own tax on gross dividends Sweden Taxation of corporate profits follows the classical system. Double taxation may be eliminated or modified, in the case of corporate shareholders, by the participation exemption, or, in the case of individual shareholders, by the relief granted for dividends paid by small companies. United Kingdom United Kingdom applies a partial imputation system, but the corresponding imputation credit attaching to a dividend remains intact, albeit at the rate of 1/9 and non-repayable. Dividends derived by resident companies from other resident companies continue to be exempt from corporation tax. Thus, there is no economic double taxation if dividends are paid among resident companies. Income in the form of dividends in the hands of resident companies is called franked investment income. *** 8