predicting Marginal Tax 16 __—C TCO Chapter objectives: Concepts of marginal Probability Present value Estimating marginal tax rate Deferred tax Increase and decrease in marginal tax | tax, implicit tax and explicit tax Marginal tax deals with future tax while statutory tax deals with historical tax, Marginal tax is the present value of current plus deferred income taxes (both explicit and implicit) to be paid per dollar of additional (or marginal) taxable income (where taxable income is grossed up to include implicit taxes paid (Scholes et. Al (2002: 157), Explicit tax is the statutory tax. This marginal tax, implicit and explicit is important because a new investment project to start commercial production usually takes around two to three years. So, current statutory tax rate is not relevant for this potential investment project. Statutory tax rate considers the explicit tax only whereas marginal tax considers both implicit and explicit tax. Marginal tax approach Predicts the future tax rate that will be relevant for future business operations. There are many reasons for which current statutory tax rate Will change, for example, discount factor, probability, and changes in statutory Tate, allowable deductions, setoff and carry forward of losses, and investing and financing decisions, ci a be taken as an opportunity cost and is added to explicit In . cos ; 0 between the rate, ‘otal marginal tax. Implicit cost is the difference ‘te of retum of a tax disfavored investment and the retu™Predicting Marginal Tax oo ofa tax favored investment. For example, investment in a fully taxable investment returns 12% whereas investment in tax favored government savings certificates returns 11%, then implicit cost or implicit tax is 1% or (12%-11%). Example 1 Statutory corporate tax rate in 2017 is 25%. From 2019 the tax rate is 70% probable to be 23% and another 30% probable of being 22%. Discount rate is 10%. What will be the marginal tax rate in 2019? Marginal tax in 2019 = (statutory rate in 2019 x probability)/(1+1)” (0.23x0.7+0.22x0.3)/(1+0.1)* 0.227 x +24 = 0.2746-0r 27-46% 83 /- “B26 Example 2 ‘Assume an extra income of TK1.00 looses an exemption of TK0.10 permanently and another loss of exemption of TK0.40 for 5 years. Statutory current tax rate is 30% and will be 32% in next 5 years. Discount rate is 10% and will prevail. Calculate his marginal tax rate in year (a) 4 and (b) 5. Solution Extra income TK1.00 Lost exemption permanently 01 Lost temporary exemption 0.4 Total extra income 15 Extra tax = TK1.5 x 30% = TK0.45. (a)The present value of lost exemption of TK0.4 in year 4 = (0.4 x 0.32)(I/1.1)* = 0.128 x 46= OASF 1087 The overall increment to tax on the extra taxable income = 0.45 — 0.187 = 0:263-= 26.3% 363%NY 4 att Advanced Issues in Taxatig, (b) The present value of lost exemption of TK0.4 in year 5 = (0.4 x 0.32)(1/1.1) = 0.128 x 16} = 0-206-0F 206% 7049 BUS ogy Ta ENS Example 3 Suppose the statutory tax rate is 35%. You invested in two Projects, one fully taxable giving a return of 12%, another partly taxable o: tar favored with a retum of 11%, and the other totally tax free wit retum of 10%. Consider discount rate of 9%. Calculate the mars, tax rate in year 3. Solution Here explicit tax rate is = 35%. Implicit rate for the tax favored asset compared to the fully taxable asset which is a benchmark asset = 12%- 11% =1% Implicit tax for the nontaxable asset compared to the benchmark asset = 12% -10%=2% Total marginal tax in year 3 = present value of implicit tax + present value of explicit tax (0.01/1.09° + 0.02/1.09? + 0.35/1.09° = (0.007 + 0.015) + 0.270 = 0.292 = 29.2% Deferred tax To determine marginal tax companies must include implicit taxes like the present value of deferred taxes. The deferred tax liability Tepresents a future tax payment a company is expected to make to appropriate tax authorities in the future, and it is calculated as the company's anticipated tax Tate times the difference between its taxable income and accounting eamings before taxes, Deferred tax asset is an accounting term that refers to a situation where a business has Overpaid taxes or taxes Paid in advance on its balance sheet. These {axes are eventually returned to the business in the tron of tnx rele and the over-payment is, therefore, an asset for the company.Predicting Marginal Tax OG Deferred tax = (difference between the value assets as per book and as per NBR) x statutory tax rate Deferred tax = (difference between liabilities as per book and as per NBR) x statutory tax rate If the book value of assets is greater there is deferred tax asset because lesser expenses were charged than allowed by NBR. If book value of assets is lower then there is deferred tax liability because more expenses were charged than allowed. The opposite happens in case of liabilities. If the book value of liabilities is greater then there is deferred tax liability because more expenses were charged than allowed. If the book value of liabilities is lower then there is deferred tax asset because lesser éxpenses were charged than allowed. Example 4 Suppose next year every one taka increase in depreciation results an accounting depreciation of TK0.02 and tax purpose depreciation of TKO.01, and an increase of perquisites results an accounting perquisites of TK0.004 and tax purpose perquisites of TK0.003. Calculate marginal tax rate in year assuming explicit tax rate of 35% and discount rate of 10%. Solution Deferred tax liability Accounting depreciation 0.02 Tax office depreciation 0.01 Difference 0.01 Accounting perquisites 0.004 Tax office perquisites 0.003 Difference 0.001 Total difference and deferred tax liability 0.011 Marginal tax rate = 0.011/ 1.1 + 0.35/1.1 = 0.01 + 0.318 = 0.328 = 32.8%Advanced Issues in Typ Miry 206 ward of Losses Si d Carry Fo! . Sectran 1 be carried forward and set off again, “ SL ined, erating losses cal : aol he te ral pesid of six years according (0 our tax laws (u/s 3-4y)"4 for a total iN : prea s a using this provision of law, iness educe its marginal tax business can reduc Example 5 wo ‘A firm has incurred a loss of TK&million in 2017. The Statutory tay rate today is 25% and 22% in future. The company is expected to cam TK2 million in 2018 and TK3 million in 2019. Discount rate is gy, Determine marginal tax rate. Solution Marginal tax = 0.22/1.08? = 0.188 = 18.8% (the firm will start paying tax in year 2) Increase and decrease of marginal tax Marginal tax rates will be lower when (i) statutory tax rates decrease or remain constant, (ii) allowable deductions increase, (iii) tax credits increase, (iv) deferred tax asset arises, (vi) net operating losses can be carried forward and set off, (v) discount rate decreases. Marginal tax rates will increase when (i) statutory tax rates increase, (ii) allowable deductions postponed, (ii) tax credit postponed, (iii) deferred tax liability arises, (v) set off and carry forward of losses postponed, (v) discount rate increases, Reducing tax treatment uncertainty Companies can request advance Tuling from the tax authority on how @ Proposed transaction will be treated for t ini fax purposes, Professional legal opinion also can help,~ predicting Marginal Tax 207 Questions 1. Differentiate between statutory tax rate and marginal tax rate. 2. What factors determine marginal tax rate? 3, How do reductions in allowable expenses affect marginal tax? 4. How do increases in tax credit affect marginal tax? 5, What alternative investments can firms use to change their marginal tax rate? 6. What alternative financing instruments can a firm use to change its marginal tax rate? 7. How does deferred tax asset affect marginal tax rate? 8. How does deferred tax liability affect marginal tax rate? 9, Determining a firm’s marginal tax rate is very difficult. Do you agree? Why? 10. How shall a firm reduce tax treatment uncertainty? 11. How is the marginal tax rate affected when current tax rules reduce tax deductions by a fraction of incremental income? 12. How is the marginal tax rate affected when tax rules postpone current tax deductions or tax credit by a fraction of. incremental income? Exercises 1. A firm has incurred a loss of TKS million in 2017. The statutory tax rate today is 25% and 22% in future. The company is expected to earn TK3.5 million in 2018 and TK4 million in 2019. Discount rate is 8%. Determine marginal tax rate. 2. Suppose a firm has a loss in the current period of TK10 million which when added to prior losses give it an NOL carry forward of TK15 million, The top statutory tax rate for the foreseeable future is 35%, Assume an after-tax discount rate of 10% and future taxable income per annum of TK2 million. ‘What is the firm’s marginal explicit tax rate? [taken from Sholes 2002: 177]Advanced Issues in Taxation 208 a lly likely to earn profit TK6 million or loose is year. Statutory tax rate is 35%. Determing fax rate. 3. A firm is equa TK4 million thi 3 the firm’s expected marginal ti TK25 million and as per NBR as per balance sheet are 4. rot milion. Liabilities as per balance sheet are TK} ae and as per NBR TK8 million. Calculate deferred tax mi 1 9, asset or liability assuming corporate tax rate 45%, Suppose a firm has a tax loss of TS$5 million in the current : period, The firm’s after-tax discount rate is 10%. Over the preceding 5 years the firm has reported the following taxable income: Year 5 43 2 -1 current Taxable income (loss) in million$ 1 1 Statutory tax rate 40% 40 35 15 3 3 6) 353030 Requirements: a) If the carry back period is 3 years, what is the firm’s marginal explicit tax rate in the current period? If the carry back period is 2 years, what is the firm’s marginal explicit tax rate in the current period? Suppose the carry back period is 2 years and taxable income in period -1 was only $1 million. What is the firm’s marginal explicit tax rate in the current period [taken from Scholes et al. 2002: 177] b) ¢) 6. Statutory Corporate tax rate in 2017 is 25%, From 2019 the tax Tate is 70% probable to be 23% and another 30% probable of being 22%. Discount rate is 9% and will prevail. Assume an extra income of TKI,00 looses an exemption of TK0.10 ey and another loss of exemption of TK0.40 for 5 ae ou also invested in two Projects, one fully taxable 6 @ return of 12%, another Partly taxable or tax favoredpredicting Marginal Tax wo with a return of 11%, and the other totally tax free with a retum of 10%. Further suppose next year every one taka increase in depreciation results an accounting depreciation of TK0.02 and tax purpose depreciation of TKO.01, and an increase of perquisites results an accounting perquisites of TK0.004 and tax purpose perquisites of TK0.003. Required a) What will be the marginal tax rate in 2018? b) Calculate marginal tax rate in 2019?