Tax Treatment of Regulated Investment Companies - Essay Example

? Tax Treatment Introduction Corporate income tax in United s is imposed at the federal level on the income of entities treated for tax purposesas corporations. Federal tax rate which is imposed on corporate taxable income differ from 15 percent to 35 percent. Corporation’s shareholders are taxed on dividends allocated by the corporation. Some corporations such as mutual funds are not taxed at the corporate level; in fact their shareholders are taxed on the corporation’s income. Domestic corporations are taxed at the state and federal level on their international income. Corporate income tax depends on the net taxable income. Where taxable income surpasses $335,000, all taxable income is subject to tax at 34 percent or 35 percent. Tax rate enforced below the federal level fluctuate from 1 percent to over 16 percent. Regulated Investment Companies (RICs) are the domestic corporations which during the taxable year are listed under the Investment Companies Act of 1940, as amended as a unit investment trust or a management company or to be treated as a business development company under such Act. This paper will focus on tax treatment of regulated investment companies and the corporate income tax and how do they differ from one another. Historical Content During the past decade, the corporate income tax has been the centre of attention of much debate and criticism in the United States (U.S.). It may be due to the low level of business investment in US and it has been also condemned as a primarily illogical and unfair tax because corporations are taxed as independent entities, in spite of the tax brackets of individual shareholders. The recent tax acts have lessened the corporate tax burden by substituting the system of several asset depreciation classes with three capital recovery classes. Business structures can be written off over fifteen years, other equipment over five years and light equipment over three years (Auerbach, 451-458). The corporate tax is the 3rd major source of federal revenue after the payroll taxes and the individual income tax. Regulated Investment Companies are listed under the Investment Companies Act of 1940. RICs escape corporate taxes due to the reason that they make profit from investments through shareholders and they do not have any real operations. Thus, they pass profits to shareholders and circumvent double taxation. They meet definite standards and therefore do not have to pay federal income taxes on interest, distribution of dividends and realized capital gains. Economic Incidence of the Policy Shareholders must be the citizens or residents of United States. The tax is imposed on the profits of the resident corporations of U.S. at graduated rates ranging from 15-35%. Corporate shareholders pay individual income tax on capital gains and on dividends from sale of their shares. The corporate tax rules which are faced by the U.S. based corporations on their profits from United States business activities, of which the foreign multinational companies are the owner, are same as that of U.S. owned companies. An increase in the corporate income tax increases the cost of capital in the corporate sectors due to the burden of tax-wedge. The return to corporate capital falls as capital flows from corporate sector to non corporate sector. For high capital intensive industries, corporate income tax increases the prices of goods and services and for low capital intensive industries, prices falls with the tax. U.S. capital bears the small incidence of the corporate income tax and labour bears more or less 100% of the incidence of the corporate income tax. The domestic corporations who bear the economic incidence and therefore opt to be taxed as a RIC are as follows: RIC must be a corporation which should be registered under the Investment Companies Act as a unit investment trust or as a management company. It may also be a common trust. Each series fund which is ascertained by a RIC will be treated as a separate corporation and they should separately meet all the qualification requirement of the RIC. A RIC may have extra class of shares but no class may get preferential dividend distributions. Economic Distortions Deadweight loss refers to the excess burden of taxation. It can be caused due to other factors also such as monopoly pricing, binding price ceilings and externalities. If the deadweight loss is caused due to taxation then it can because of the direct and indirect tax imposed by government or extortionist which results in specific transactions that would have otherwise happened to not happen. This took place if the amount of tax is more than the social surplus produced by the transaction. There are four easy steps to calculate deadweight loss and these are as follows: Firstly, relationship is estimated between the number of units of products bought by the customer as prices change and the number of units sold by the producers as prices change. Secondly, price of the product should be calculated under the tax. Thirdly, number of units should be calculated that consumers will buy now buy at the increased price. Fourthly, the change in the price of the product should be multiplied by the change in the number of unit sold. At last, the answer should be divided by two in order to know the size of deadweight loss due to the tax. The economic distortions which are created by the corporate income tax are as follows: Saving and Investment bias: Corporate income tax reduces the inducement for individuals to save and for business to invest due to the reason that it taxes income from capital. Organization bias: Raises the incentive for business in order to systematize as non-corporate entities, which are not taxed. Therefore, the tax puts some industries at a difficulty to the level that businesses in those industries depend on the corporate form in order to raise large amounts of capital from many investors. Financing bias: Raises the inducement for business to raise capital by borrowing. A great dependence on borrowing may enhance some firm’s exposure to bankruptcy. Compliance and planning: Businesses are required to spend large amount of money on tax compliance and planning funds that could be allocated elsewhere under other circumstances (Masters 1). RICs do not allocate short term capital gains in the nature of short term capital gains. Any net short term capital gains that are realize by the funds and which are not offset by capital losses will be treated as being paid out as component of the fund’s income allocation by its shareholders. The report will show this distribution from short term capital gains but the shareholders cannot use this in order to offset other capital losses (Gastineau 88). Arguments in Favour of Policy The corporate income tax system ensures a complete income tax system. If there would be no corporate income tax, then earnings of corporate would not be taxed until they were paid out to individuals. Therefore, corporations should avoid taxes by retained earnings. Shareholders should neglect taxes as long as corporations did not pay out earnings. Moreover, shareholders would gain when the retained earnings of corporations over long time period, as delaying payouts would decrease the present value of tax burden. The argument which is in favour of RICs is: they do not have to pay federal income taxes for allocating capital gains, interest or dividends. It also eradicates double taxation i.e. paying tax at both individual and corporate levels. They do not have to pay taxes on the earnings. These companies probably have any kind of real operations. Thus, they can infringe the corporate taxes on the ground that they originate the profits out of the shareholders. So, they can carry forward the profits to the most appreciated shareholders. Arguments against the policy The current system of U.S. which imposes tax on global corporate profits puts the companies of U.S. at competitive drawback with their foreign peers that have only to pay tax on domestic profits. There are criticism regarding U.S. code, which adjourns taxation until profits are repatriated, promote these businesses to park their money overseas for an indefinite period, thereby reducing the investment of these funds at home. There are certain limitations regarding the RICs. A corporation will not be judged as RIC for any taxable year unless: it files an election with its return for the taxable year to be a regulated investment company; minimum 90% of its gross income must derive from its investment as capital gains, interest and dividends; minimum 90% of its income should be distributed to its shareholders; the company must have minimal diversification of assets; must dispense 98% of net investment income in order to circumvent paying a 4% excise tax; at the end of each quarter of the taxable year minimum 50% of the value of its total assets is characterized by government securities and securities of other RICs and by cash and cash items. If the corporation does not fulfil these criteria then they will be not considered as a RIC and will be taxed as a ordinary corporation on its whole taxable income. People who Support the Policy The corporate income tax in U.S. is supported by the Congress and the President. It is also supported by The Department of the Treasury and by the Internal Revenue Service which enforces tax laws, processes tax returns and collects taxes. Apart from federal tax authorities, state and local government agencies also supports the policy. The taxation policy of Regulated Investment Companies is supported by the Investment Companies Act as well by the individual investors and the company because it avoids double taxation. Conclusion By taking into consideration the taxation policy of the Regulated Investment Companies and the Corporate Income Tax of the United States this paper focuses on the historical content, economic incidence, economic distortions of both the policies; arguments in favour of both the policies; arguments against both the policies and by whom both policies are supported. Work Cited Auerbach, Alan. Corporate Taxation in the United States. 1983. Web. April 15, 2013. < http://www.brookings.edu/~/media/projects/bpea/1983%202/1983b_bpea_auerbach_aaron_hall.pdf> Gastineau, Gary. The Exchange- Traded Funds Manual. New Jersey: John Wiley & Sons, 2002. Print. Masters, Jonathan. U.S. Corporate Tax Reform. 2012. Web. April 15, 2013. < http://www.cfr.org/united-states/us-corporate-tax-reform/p27860> Read More