General Principles of Taxation

Definitions:
 TAX: Compulsory monetary contribution to the state's revenue, assessed and imposed by a government on the
activities, enjoyment, expenditure, income, occupation, privilege, property, etc., of individuals and organizations.

Characteristics of Taxation:
The economist, Adam Smith, in his book 'Wealth of Nations', proposed that a 'good tax' should have the following
characteristics:
a) Equity: the tax burden should be fairly distributed, e.g. a higher rate tax for wealthier individuals.
b) Certainty: an individual should be able to determine the tax implication of their actions.
c) Convenience: tax should be easy to pay.
d) Efficiency: tax should be easy and cheap to collect.
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Characteristics of Taxation:
According to the American Institute of Certified Public Accountants’ ‘Guiding Principles of Good Tax Policy’:
• Equity and fairness • Neutrality

• Certainty • Economic growth and efficiency

• Convenience of payment • Transparency and visibility
• Economy of collection • Minimum tax gap
• Simplicity • Appropriate government revenues
The three major principles recognized today are:
a) Equity: the tax burden should be fairly distributed, e.g. a higher rate tax for wealthier individuals.
b) Efficiency: tax should be easy and cheap to collect. This is best achieved by the use of ‘unpaid tax collectors’, such
as employers who have to collect and account for payroll taxes, e.g. PAYE (pay-as-you-earn) in the UK.
c) Economic effects: the government must consider the effect of taxation policy on various sectors of the economy.
For example, tax allowances on capital expenditure may stimulate growth in the manufacturing sector.
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Sources of Tax Rules :
Sources of tax rules include the following:
a) Domestic legislation and court rulings
b) Domestic tax authority practice and guidance statements.
c) Supranational bodies, such as the European Union (EU).
d) International tax treaties.
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The Tax Base:
Taxes can be classified according to their tax base (what is being taxed). They can be based on any or all of the following
items.
 Income or profits (personal income tax and company income tax)
 Assets (tax on capital gains, wealth and inheritance taxes)
 Consumption (or expenditure, e.g. taxes on alcohol, cigarettes or fuel and sales taxes)

Schedular Systems of Tax:

Countries often separate different types of income into different categories and then have separate rules to determine
how that income is taxed. This is known as a schedular system.
For example, in the UK, the tax system includes the following schedules for company income tax:
a) Schedule DI – Trading income
b) Schedule DIII – Interest income
c) Schedule DV – Income (i.e. dividends) from overseas subsidiaries
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Tax Terminology:
 Direct Tax: These are imposed directly on the person or enterprise required to pay the tax. The person or
enterprise must pay the tax due directly to the tax authorities. Examples include personal income taxes, company
income tax, tax on capital gains.
 Indirect Tax: This is imposed on one part of the economy with the intention that the tax burden is passed on to
another. The tax is imposed on the final consumer of the goods or services. The more a person spends, the more
tax is paid. An example is sales tax, for example VAT in the UK and TVA in France.
 Taxable person: The person liable to pay tax is called a taxable person. The taxable person can be an individual or
a company.
 Competent jurisdiction: Jurisdiction relates to the power of a tax authority to charge and collect tax. Competent
jurisdiction is the authority whose tax laws apply to an individual or a company.
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Tax Terminology:
 Tax rate structure: A government will structure its tax rates according to where it wishes the burden of taxation to
fall. There is a general agreement that people on higher incomes should pay more tax. There are three possible tax
rate structures.
• A proportional tax rate structure taxes all income at the same rate, so the same proportion of all income is
taken in tax.
• A progressive tax rate structure takes a higher proportion in tax as income rises.
• A regressive structure would take a decreasing proportion as income rises.
 Tax gap: This is the gap between the tax theoretically collectable and the amount actually collected. The tax
authorities work unceasingly to minimize this gap.
 Hypothecation: The government can choose to ring-fence (i.e. restrict the use of) certain types of tax revenue for
the purposes of certain types of expenditure. This prevents the money being spent on anything else and is known
as hypothecation.
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Tax Terminology:
 Incidence/effective incidence: The incidence of a tax is on the person or organization that pays it. It is important
to distinguish between formal and effective incidence.
 The formal incidence of a tax is on the person or organization who has direct contact with the tax authorities,
i.e. who is legally obliged to pay the tax.
 The effective/actual incidence of a tax is on the person or organization who actually bears the end cost of the
tax.
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Administration of Tax:
 Record keeping: Tax authorities require businesses to keep records of the tax they pay. It makes no difference if
the tax is a cost to the business (e.g. tax on business profits or gains) or whether the business acts merely as a tax
collector (e.g. employee tax and social security contributions). Tax records usually need to be kept in more detail
than is strictly necessary than for financial reporting purposes. This is so that the business can satisfy the tax
authority that is has complied with the law.
 Retention of Records: Most tax authorities have the power to inspect business records to ensure compliance. If
mistakes are made, the tax authority may be able to re-assess earlier years and collect back taxes owed. Therefore
there is usually a minimum period for which tax records must be kept. In the UK this is six years for certain types of
tax.
 Deadlines: There are deadlines for reporting and paying outstanding tax to the tax authorities. There may be
different deadlines for the different types of tax.
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Tax Enforcement:
Tax authorities have the power to enforce compliance with the tax rules. These powers generally include the following:
a) Power to review and query filed returns. Tax legislation will usually specify a deadline for the tax authorities to
open an enquiry into a filed tax return.
b) Power to request special reports or returns. A special report or return is usually requested when the tax
authorities believe that an entity may not be providing full information.
c) Power to examine records (generally extending back some years). This is generally carried out by appointment
with the company.
d) Powers of entry and search. When the tax authority believes that fraud has occurred, it can obtain a search
warrant to enter a business's premises and seize the records.
e) Exchange of information with tax authorities in other jurisdictions. This has become very important as a counter-
terrorism measure in recent years. One tax authority may become aware of funds being moved to another
country in suspicious circumstances. It will then warn the tax authority in that other jurisdiction.
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Tax Avoidance and Tax Evasion:
 TAX AVOIDANCE is a way of arranging your affairs to take advantage of the tax rules to pay as little tax as possible.
It is legal and is often referred to as tax planning.
 TAX EVASION is a way of paying less tax by illegal methods, for example by not declaring income or claiming
fictitious expenses.
Tax avoidance and evasion tend to be most common where the following situations apply:
 High tax rates, making it more worthwhile to avoid tax and to spend money on tax advice
 Imprecise wording of the tax laws, leaving loopholes to be exploited
 Insufficient penalties for tax evasion
 Perceived inequity in the tax laws, which makes evasion/avoidance seem more justified
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Minimizing Tax Avoidance and Tax Evasion:
A tax authority has to concentrate on the following if it wishes to minimize avoidance and evasion:
a) reducing opportunity by deducting tax at source whenever possible
b) keeping the tax system as simple as possible
c) increasing the risk of detection by having an efficient system of checking tax returns
d) developing good communications between tax authorities and enterprises
e) maximizing penalties for evasion and making sure that this is well publicized
f) making sure that the tax system is perceived as equitable and that the tax administration deals fairly and
courteously with taxpayers
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Direct Taxes:
Company Income Tax on Profits:
A company pays company income tax on the taxable profits it generates. Company income tax is charged on the trading
income of the company.
TAXABLE PROFIT is the accounting profit adjusted according to the tax rules and is the amount on which tax is actually
paid.
The financial statements provide the starting point for calculating taxable profits, however some items included in the
accounting profit may not be allowed for tax purposes. The following items are often specifically disallowed:
• Entertaining
• Depreciation
• Formation and acquisition costs
• Donations to political parties
The company income tax charge is calculated as taxable profit × tax rate.
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Proforma to Calculate Taxable Profit:
$
Accounting Profit X
Less: income exempt from tax or taxed under other rules (X)
Add: disallowable expenses X
Add: Depreciation X
Less: tax depreciation (X)
Taxable Profit X
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Tax Depreciation:
Accounting depreciation is not an allowable expense for tax purposes. Instead, tax depreciation is given to compensate
entities for the fall in value of their assets. Tax depreciation is calculated in a similar way to accounting depreciation, but
following the specific tax rules. Tax depreciation can be used by the government to encourage businesses to invest in
particular assets or to generally boost the economy. This is done by giving accelerated tax depreciation, for example a
100% first year allowance, on these assets in the year they are purchased.
In most of the countries, similar assets are grouped together and put into a ‘pool’ of expenditure. A tax depreciation
allowance (called the ‘writing down allowance’) is given on the tax written down value (i.e. cost less previous allowances)
of the pool. The writing down allowance is usually given as a percentage of the written down value.
Over the life of an asset, the tax depreciation should equal the purchase price of the asset less any amount realized on
disposal. Therefore, when disposal takes place, there is often a ‘balancing charge’ or ‘balancing allowance’ to account for
any difference.
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Treatment of Trading Losses:
When a company makes a loss instead of a taxable profit, no tax will be payable for that year, instead tax relief will be
given according to the rules of the tax regime.
Possible ways of getting tax relief for a trading loss are:
 Carry the loss forward against future trading profits of the same trade
 Offset the loss against other income or capital gains of the same period
 Carry the loss back against profits of previous periods
 Offset the loss against the profits of another group company (‘group loss relief’)
Some countries do not allow capital gains/losses to be offset against trading gains/losses and vice versa. Some countries
do not allow losses to be carried back and some restrict the number of years for which they can be carried forward.
General Principles of Taxation
Cessation of Trading:
When a business ceases trading, there may be provision for carrying back any losses generated in the last year of trading
(sometimes known as terminal losses) against previous years’ taxable profits. In the UK, a business calculates the losses
for the last twelve months ending on the day trade ceases. These terminal losses can then be carried back and offset
against the final year of assessment and the three previous tax years.
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Capital Gains Tax:
A company pays capital gains tax on capital gains it makes. When an asset is disposed of for more than its original cost, a
‘capital gain’ arises. A distinction is made between ‘trading income’ that arises from the trade of the business and which is
subject to company income tax, and ‘capital gains’ which result when an asset is disposed of for more than its cost which
are subject to capital gains tax. Most tax regimes have separate rules covering the taxation of capital gains.
Standard proforma to calculate capital gain is as follows:
$
Proceeds X
Less: costs to sell (X)
Net Proceeds X
Less: cost of original asset (X)
Less: costs to buy (X)
Less: enhancement costs (X)
Less: indexation allowance (X)
Chargeable gain X
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Indexation Allowance:
The relief for inflation is known as the indexation allowance. Companies are entitled to indexation allowance from the
date of acquisition until the date of disposal of an asset. It is based on the movement in the Retail Price Index (RPI)
between those two dates and is calculated as follows.

Indexation allowance = acquisition cost × indexation factor

Capital Losses:
Capital losses can be relieved in the following ways:
a) Carried back against previous capital gains
b) Carried forward against future capital gains
c) Offset against current or future trading profits
However, many countries do not allow capital gains to be carried back against previous capital gains or to be offset against
trading profits.
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Rollover Relief:
An entity may sell an asset and realize a capital gain. However, it may then need to replace the asset. If the entity pays tax
on the capital gain, this will reduce the proceeds available for reinvestment. Therefore, some countries allow the tax
charge on the disposal of a business asset to be deferred until the replacement asset is disposed of. If this is a type of
asset that will have to be continuously replaced (such as manufacturing machinery), then this deferral could go on
indefinitely. In some tax jurisdictions, this is known as rollover relief.

Group Loss Relief:

If a group of enterprises are recognized as a tax group, it is possible for them to gain relief for trading losses by offsetting
the losses of one group member against the profits of another group member this is known as tax consolidation. The
rules for group relief will vary from country to country, as will the rules for recognition of a tax group (which may differ
from the rules under which groups are recognized for financial reporting purposes).
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Interaction of Corporate Tax and Personal Income Tax :
When a company pays a dividend to its shareholders, it is paid out of the company’s taxed profits and therefore has
already been subject to tax. If the dividend income received by the individual is then taxed again under personal income
tax, the dividend will effectively have been taxed twice. The system of tax which is in operation in a country determines
whether this will happen as it specifies the interaction between corporate and personal tax. There are four main systems
of tax to deal with double taxation.
1. Classical System: Under the classical system of taxation, company income tax is charged on all of the profits of the
entity, whether distributed or not. Dividends are paid out of taxed profits and are then chargeable to personal income
tax in the hands of the shareholder. This system is simple to administer but gives rise to double taxation of dividends.
This system could result in entities being less likely to distribute dividends as it leads to double taxation.
2. Imputation System: Under the imputation system, the underlying company income tax that has already been paid is
imputed to the shareholder as a tax credit. He pays income tax on the dividend but deducts the tax credit. This avoids
the problem of double taxation.
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Interaction of Corporate Tax and Personal Income Tax :
3. Partial Imputation System: It is also possible to have a system of partial imputation, where the taxpayer receives a tax
credit of only part of the underlying company income tax.
4. Split Rate System: Some tax jurisdictions operate a split rate system in which distributed profits are taxable at a lower
rate than retained profits. This avoids double taxation of dividends. This can function under the classical, imputation or
partial imputation system.

Recharacterizing Debt:
Generally interest payments are tax deductible whereas dividend payments are not. Therefore groups may try to reduce
their tax bill by transferring funds between group companies in the form of interest on intragroup loans instead of by the
payment of dividends.
This has an adverse effect on government tax revenue so many countries have limited the amount of interest that is tax
deductible. Any interest which is in excess of the limit is instead re-classified as dividends and therefore will not be tax
deductible. A company may be said to be thinly capitalized when it exceeds this interest limit.
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International Taxation:
Corporate residence:
Entities usually pay company income tax on their worldwide income in the country they are resident in for tax purposes.
Therefore determining an entity’s country of residence is important. There are different ways to determine the residence of
an entity, including its:
a) Place of incorporation (domicile)
b) Place of effective management and control
c) Place of permanent establishment
A permanent establishment means a fixed place of business through which the business of an entity is wholly or partly
carried on. There must be a degree of permanence, for example: (i) Place of management, (ii) Branch, (iii) Office, (iv) Factory,
(v) Workshop, (vi) Mine, oil or gas well, quarry, (vii) A building site or construction or installation project if it lasts more than
12 months
A warehouse is not a permanent establishment, it is just a storage area. A permanent establishment is somewhere where
trade is carried out or decisions are made.
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Double Tax and OECD Deemed Residence:
Each tax authority will have its own rules on how residence is determined. This can sometimes lead to entities being
resident in two countries. For example, suppose a company is incorporated in country X, where residency is determined
on the basis of incorporation only. However, the company conducts most of its activities in country Y, where its board of
directors meet. In country Y, residency is determined based on the place of management and control. In this situation, the
company will be deemed to be resident in both country X and country Y. The company is therefore theoretically subject to
tax in both of those countries and may have to pay tax twice on its income. This is known as double tax.
The OECD Model Tax Convention addresses the issue of double residence.
In the case where an entity is resident in more than one country, the OECD Model Tax Convention suggests that the entity
will be deemed to be resident only in the country of its effective management.
A place of effective management is:
 the place where key management and commercial decisions are made
 the place where the board or senior management meet
An entity can only have one place of effective management, so using the OECD Model Tax Convention rules means that
the entity would only be taxed in that country, which solves the problem of double tax.
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Payments Remitted from Overseas Subsidiaries:
A group may have overseas subsidiaries which will from time to time pay dividends to the parent company. In this
situation, two types of tax become relevant: withholding tax and underlying tax.

Withholding Tax:
If a company makes payments to an individual or another company or an individual resident in a different country, it may
first have to pay withholding tax (WHT) to the local tax authority. A withholding tax ensures that the local government
gains some income from the dividend payment so that not all of the money earned by the company in that country is
remitted overseas. The rate of withholding tax varies depending on the country. Withholding tax also applies to other
types of payment, such as interest payments, royalties, capital gains and rents.
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Payments Remitted from Overseas Subsidiaries:
Underlying Tax:
Underlying tax (ULT) is the tax which has already been suffered by the profits from which a dividend is paid. This happens
when an entity receives a dividend from a foreign entity when the dividend has been paid out of taxed profits. Under
some tax systems, the entity can obtain relief for the tax levied in the foreign country on the amount out of which their
dividend was paid.
Underlying tax is calculated as follows.

Tax actually paid by foreign company

Underlying tax = Gross dividend ×
Foreign company’s profit after tax
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Double Tax:
When a parent company receives a dividend payment from an overseas subsidiary, that dividend will often already have
been subject to underlying tax and withholding tax. Because that dividend now forms part of the income of the parent
company, it will also be subject to corporate income tax in the country in which the parent is resident. In effect the
dividend has been taxed twice. To relieve this burden, double tax relief is often available for the overseas tax paid.
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Double Tax Relief:
There are three main methods for giving double tax relief.
1. Exemption Method: In the Exemption method, the dividend received is exempted from tax in the receiving
company's country. So, if income is taxed in Country A, then it will not be taxed in Country B.
2. Tax Credit/Imputation Method: In the Tax Credit method, the dividend received is subject to tax in the receiving
company's country, but the foreign tax already paid is credited against the tax due in the receiving company's
country. So the tax paid in Country A is credited against (i.e., deducted) from the tax due in Country B. No refund
of tax is given if the tax already paid in Country A is higher than that due in Country B..
3. Deduction method : This is where only the income after tax in Country A is taxable in Country B.
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Double Taxation Treaties:
Often two countries will establish a double tax treaty between them to determine which country will tax income and what
method of double tax relief will be available to entities that have taxable income in both countries. The starting point for
double taxation treaties is often the OECD’s Model Tax Convention. The Model Tax Convention recommends the use of
the Tax Credit method for double tax relief.
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Example-1:
RH, a company resident in Country Y, is a 100% owned subsidiary of APH, a company resident in Country X. At the year
end, RH paid a dividend of $54,000, after deduction of a withholding tax of 10%, to APH. RH had reported a profit after tax
of $450,000 and paid a corporate income tax bill of $90,000 in Country Y.
In Country X:
• Corporate income tax is 40%
• Double tax relief is given by the Tax Credit method.
Required:
How much tax is payable by APH in Country X?
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Example-2:
RH, a company resident in Country Y, is a 100% owned subsidiary of APH, a company resident in Country X. At the year
end, RH paid a dividend of $54,000, after deduction of a withholding tax of 10%, to APH. RH had reported a profit after tax
of $450,000 and paid a corporate income tax bill of $90,000 in Country Y.
In Country X:
• Corporate income tax is 40%
• Double tax relief is given by Deduction method.
Required:
How much tax is payable by APH in Country X?
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Indirect Taxes:
Types of Indirect Taxes:
 Unit Taxes: Unit taxes are based on the number or weight of items, i.e. excise duties on cigarettes or tobacco.

 Ad Valorem Taxes: Ad valorem taxes are based on the value of the items, i.e. a sales tax or value added tax.

 Excise Duties: Excise duties are a 'unit' tax – they are levied on the amount of the commodity. Governments apply
excise duty to goods that have large sales volumes and are easy to control, i.e. there are a few large producers and
products covered by the duty are easily defined. Excise duty tends to be levied on four major commodities –
alcohol, tobacco, oil products and motor vehicles. The tax is collected earlier in the supply chain than sales taxes.
By the time the product reaches the final consumer the price will already include excise duty.
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Types of Indirect Taxes:
 Property Taxes: Taxes on immovable property exist in many countries. The tax base is usually the capital value
of the property although in some countries it is the annual rental value. The tax is usually on land and buildings,
but a few countries also tax other items of personal property such as cars, boats and livestock.

 Wealth Taxes: A number of countries levy wealth taxes, either on individuals or on entities or on both. This will
involve measurement and valuation of assets each year. The tax is usually a straight percentage, for example 2%,
of total net worth (total assets less total liabilities).

 Consumption Tax: These are taxes imposed on the consumption of goods and added to the purchase price.
General Principles of Taxation
Types of Indirect Taxes:
 Value Added Tax (VAT): VAT is not a tax on profits or gains, and is not even eventually borne by most businesses
to a material extent. Nevertheless, it is important to businesses, because its charge and collection enter into many,
even most business transactions. Ultimately, VAT falls mainly on the final consumer of goods or services. However,
all those involved in the chain of transactions between the manufacturer and the retailer are first charged VAT and
then pass it on to the next person in the chain. The standard rate of VAT varies from one country to another.

 Cascade Tax: this is where is taken each stage of production and is a business cost. No refunds are provided by tax
authorities.
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Single-stage versus Multi-stage VAT:
A VAT can be single-stage or multi-stage.
 Single-stage VAT are applied at one stage in the supply chain, either at the manufacturing, wholesale or retail
level. Most VAT tend to be applied at the retail level (such as the retail sales tax applied in the USA), so the end
user will bear the tax burden.
 Multi-stage VAT are applied at several stages in the supply chain. A multi-stage VAT is usually chargeable and
deductible at different points in the supply chain, so the business deducts the tax it pays on purchases and pays
over the balance to the government. The incidence of tax is therefore on the final consumer of the goods or
services. A multi-stage VAT can also be cumulative (known as a cascade tax) where no refund is received for tax
paid in the previous stage and so the tax is a business cost at each stage in the supply chain.
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Multi-stage VAT:
VAT is charged by a business each time a product is sold. However, the business can claim back the VAT it has paid on
purchasing products or raw materials to make the product, which is known as ‘input VAT’. So the effect in the end is that
the final consumer suffers the full VAT amount on the final purchase price, but this amount has been paid to the tax
authorities in several slices by the various businesses in the supply chain along the way. The following example shows how
VAT works.
Price net of VAT VAT @15% Total Price
$ $ $
A. Manufacturer buys raw materials 40 6 46
Manufacturer makes and sells television to wholesaler 200 30 230
Manufacturer pays VAT 24
B. Wholesaler buys television 200 30 230
Wholesaler sells television to retailer 320 48 368
Wholesaler pays VAT 18
C. Retailer buys television 320 48 368
Retailer sells television 480 72 552
Retailer pays VAT 24
D. Customer buys television 480 72 552
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VAT Business Liability:
VAT on sales is called output tax, while VAT on purchases is called input tax. A business owes the tax authority the output
tax it collects but deducts from this liability the input tax it pays.

Amount Paid to Tax Authority = Output Tax - Input Tax

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Rates of VAT:
Some activities may be exempt from VAT, i.e. banking services. Traders who carry on exempt activities cannot charge VAT
on those activities and cannot reclaim VAT on inputs relating to those activities.
Transactions which are not exempt from VAT will be taxable at one of three rates:
a) Standard rate. In the Bangladesh this is currently 15%.
b) Higher or reduced rate. For example in the Bangladesh, Turnover Tax is at 7.5%.
c) Zero rate (0%). For example, in the Bangladesh Sale of goods/services online are taxable at 0%.
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Calculation of VAT Amount:

1. VAT Exclusive Price

VAT = Exclusive Price × VAT Rate

2. VAT Inclusive Price

Inclusive Price
VAT = × VAT Rate
( 100 + VAT Rate)
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Partial Exemption:
Where a business makes both taxable and exempt supplies, partial exemption applies. A number of schemes exist under
which the input tax can be apportioned.
The simplest method is that any input tax wholly attributable to exempt outputs is not deductible, any input tax wholly
attributable to taxable supplies is deductible in full and any remaining input tax is apportioned according to the
percentage of exempt outputs.
For instance, if 30% of outputs were exempt, the trader would be able to deduct 70% (100% - 30%) of unallocated input
tax.
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Employee Taxation:
1. Taxable Income: The amount of tax paid depends on the way that earnings are measured. An employee is taxed
on all income actually received from the employment in tax year including 'non-cash' items (called benefits in
kind). Cash income includes basic and overtime pay, bonuses, commission and redundancy pay. Examples of
benefits in kind include company cars, private health insurance, free accommodation and cheap loans from the
employer.
2. Deductible Expenses: Tax regimes often allow employees to deduct expenses from their earnings before the tax
rate is applied. Types of expenses deductible will vary from country to country.
3. Employer as a Tax Collector: Many tax regimes require the employer to deduct employee tax in instalments
directly from the employee’s pay and pay it over to the tax authorities. If the employee feels that he or she has
paid too much tax, it is up to the individual to deal with the tax authority to obtain a refund. The employer merely
acts as a tax collector.
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Employee Taxation:
4. Calculating Employee Tax: Calculating how much income tax is due for an employee is very similar to calculating
how much company income tax is due for a company. However, individuals are usually given a ‘personal
allowance’ which is an amount they can earn before they have to start paying tax. A standard proforma for
calculating employee income tax is shown below. Standard proforma to calculate capital gain is as follows:
$
Salary X
Plus: Bonuses, commission, benefits in kind X
Less:
Personal allowance (X)
Professional subscriptions (X)
Pension/PF contribution (X)
Business (X)
Charitable donations (X)
Taxable income X