Understanding Corporate Taxation: Systems, Distributions, and Debt-Equity Considerations

Business Entities and Tax Implications

Taxation of Partnerships

Partnerships are not taxed at the corporate level. Instead, taxes are levied on the individual partners based on their share of the partnership's income.

Taxation of Corporate Entities

Corporations have a separate legal personality and are subject to corporate income tax. Shareholders are also taxed on the dividends they receive.

Justification for Corporate Income Tax

• Avoid tax deferral
• Neutrality
• Incentivize investment

Tax calculation: Tax = Tax Base x Tax Rate

Corporate and Shareholder Tax Systems

Classical System

Corporate profits are taxed at the corporate level, and dividends are taxed again at the shareholder level, resulting in economic double taxation.

Full Integration System

Corporations are not considered separate entities for tax purposes. Shareholders are taxed on the corporation's profits, eliminating double taxation.

Split Rate System

Corporations pay taxes, and shareholders are also taxed on dividends. However, the corporate income tax rate is lowered when dividends are distributed.

Dividend Imputation System

Based on a credit system, shareholders can partially or fully benefit from tax credits for taxes paid by the corporation on its profits.

Dividend Exemption System

Corporations pay taxes on profits, and dividends may be exempt from taxation at the shareholder level.

Dividend Deduction System

Corporations pay taxes, and dividends paid to shareholders are deducted from the corporation's taxable income.

Corporate Distributions

Payments to Shareholders

• Dividends
• Return of invested capital

Intercorporate Dividends

Dividends received from other corporations may be deductible.

Corporate Formation

Corporations are formed through contributions from shareholders, which can be in the form of cash or in-kind contributions.

• Cash contributions: No realization event for tax purposes.
• In-kind contributions:
  • Realization event: Step-up to fair market value.
  • Non-realization event: Rollover basis.
  • In-kind (Section 351): No realization event.

Transferring a business to a corporation is generally not a taxable event.

Exit Tax

When a company moves to another country, the home country may impose an exit tax on the company's accumulated profits. This tax is typically deferred and paid proportionally over time.

Goals of Exit Tax

• Avoid loss of tax revenue

Debt-Equity Distinction

Interest payments on debt are deductible by the company and taxable to the creditor. Dividends paid to shareholders are not deductible.

Debt vs. Equity

• Debt: Represents money owed by the company.
• Equity: Represents ownership in the company.

Tax Treatment

• Interest payments: Deductible
• Dividends: Not deductible

Interest Expense Restrictions

Limitations may exist on the amount of interest expense a company can deduct to prevent undercapitalization and the use of excessive debt financing.

Thin Capitalization Rule for Intragroup Debt

This rule aims to prevent companies from disguising equity as debt to benefit from interest deductions. Tax authorities may require an upward adjustment of taxable income if thin capitalization is detected.

EBITDA Rule

Net interest expense may be deductible up to 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), with any excess carried forward to following years.