General Report on ‘The Notion of Income from Capital’(preliminary version 2, June 11, 2003)

EATLP Congress, Cologne 12-14 June 2003

General reporters: Prof. Peter Essers and Prof. Arie Rijkers, Tilburg University, The Netherlands

Contributors: Prof. Joachim Lang, University of Cologne, GermanyProf. Manfred Rose, University of Heidelberg, GermanyProf. Claudio Sacchetto, University of Torino, Italy Prof. Laura Castaldi, University of Siena, ItalyProf. Henk van Arendonk, University of Rotterdam, The NetherlandsProf. Peter Kavelaars, University of Rotterdam, The NetherlandsDr. Kevin Holmes, University of Budapest, HungaryProf. Bertil Wiman, Stockholm School of Economics, SwedenProf. Judith Freedman, University of Oxford, United KingdomDr. Ian Roxan, London School of Economics, United Kingdom

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CONTENTS

PrefaceAbout the Authors

IntroductionPeter Essers and Arie Rijkers

Part I General Aspects of an Income Taxation on Income from Capital

1. The Influence of Tax Principles on the Taxation of Income from CapitalJoachim Lang2. Economic Aspects of Taxation of Income from CapitalManfred Rose3. Relationship between Personal Income Tax on Income from Capital and

Other Taxes on Income from Capital (Corporate Income Tax, Wealth Tax, Inheritance and Gift Tax and Real-Estate Tax)

Claudio Sacchetto and Laura Castaldi4. Fixed Amount Taxation with respect to Income from Capital in Personal

Income Taxation Henk van Arendonk

Part II The Notion of Income from Capital: The Taxable Base

1. Accrual versus RealizationPeter Kavelaars2. Deferral PossibilitiesKevin Holmes3. Treatment of Capital Gains and LossesJudith Freedman4. Influence of InflationIan Roxan5. Imputed IncomeIan Roxan6. Emigration and ImmigrationBertil Wiman

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Preliminary Conclusions and Points for Discussion Peter Essers and Arie Rijkers

Appendix: Questionnaires and National Reports1. Austria (Eva Burgstaller)2. Belgium (Jacques Malherbe)3. Denmark (Aage Michelsen)4. France (Cyrille David)5. Germany (Joachim Lang)6. Hungary (Daniel Déak)7. Italy (Claudio Sacchetto)8. Luxembourg (Alain Steichen)9. Netherlands (Irene Reiniers)10. Norway (Frederik Zimmer)11. Poland (Wlodzimierza Nykile, Tomasz Kardach)12. Portugal (Francisco de Sousa da Câmara)13. Spain (Carlos Palao Taboada)14. Sweden (Sture Bergström, Lars Pelin, Peter Melz)15. Switzerland (Christophe Deiss, Peter Locher)16. United Kingdom (John Tiley)

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PREFACE

At the meetings of the Academic Committee of the EATLP of 6 June 2002 in Lausanne and of 27 August 2002 in Oslo the Academic Committee opted for the subject ‘The Notion of Income from Capital’ for the 2003 EATLP Congress to be organized in Cologne.In these meetings strong support existed for the idea not to aim exclusively at a traditional empirical analysis based on national reports of the different notions of income from capital in several countries, thus stressing the state of the art. Instead, a limited number of specialized colleagues would be asked to write reports on specific issues with respect to the notion of income from capital, starting from general legal (equity, equality, certainty) and specific tax principles (ability to pay, benefit), thus stressing the ius constituendum.This approach was generally considered as the most promising, since it would offer the best chance for an interesting report, both from an academic perspective and from a practical perspective. The academic perspective is favoured because a report that presents clear opinions with respect to the ius constituendum based on general accepted legal principles may be expected to offer more opportunities for a meaningful debate between academics than a report based only on the scattered state of the art. Besides, this approach would not exclude the possibility of summarizing the state of the art in the individual contributions of the authors.But also practical reasons pleaded for this strategy. Instead of the obligation to ask many national reporters in the traditional method, in the chosen approach only a limited number of specialized tax law professors needed to be addressed to write reports on specific items. Some of these authors also prepared questionnaires in order to receive information on the various national approaches with respect to the different aspects of taxation of income from capital. Individual members of the Academic Committee of the EATLP have answered these questionnaires.This preliminary report contains the contributions of most selected authors, followed by some conclusions and points for discussion for the EATLP conference in Cologne. In the final version of this report our final conclusions and a summary of the discussions in Cologne will be added.

We end this preface with a quote from Joachim Lang’s report (Chapter 1 of Part I):

‘It is a task of the tax sciences to strengthen the certainty of tax law by finding a concept of income, which is generally accepted. The taxpayer ought to rely on the fact that there are neither loopholes nor hidden privileges for his neighbour. Politicians may determine tax rates but the definition of income as the best measure for the ability to pay taxes should not

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be a playing field for politicians. The non-political character of the income tax base gives stability to the tax law. Institutions of civil law have grown in long traditions of jurisprudence and therefore are immunized against political abuse. The legal definition of income should obtain the same immunity. This gives the taxpayer the feeling that taxation is part of a civilized society.’

We truly hope that this report and the discussions during the conference in Cologne will contribute in achieving this ‘civilized society’.

Peter Essers and Arie RijkersTilburg, 21 May, 2003

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ABOUT THE AUTHORS

Henk van Arendonk Professor of Tax Law, Erasmus University Rotterdam, The Netherlands

Laura Castaldi Professor of Tax Law, University of Siena, Italy

Peter Essers Professor of Tax Law, Tilburg University, The Netherlands

Judith Freedman Professor of Tax Law, Oxford University, United Kingdom

Kevin Holmes Principal Research Associate, International Bureau of Fiscal Documentation, Amsterdam; Visiting Professor of Law, Eötvös Loránd University, Budapest.

Peter Kavelaars: Professor on Fiscal Economy, Erasmus University Rotterdam, The Netherlands and Director of the Scientific Department of Deloitte & Touche Tax Lawyers Rotterdam, The Netherlands

Joachim Lang Professor of Tax Law, University of Cologne, Germany

Arie Rijkers Professor of Tax Law, Tilburg University, The Netherlands

Manfred Rose Professor of Business Administration, University of Heidelberg, Germany

Ian Roxan Lecturer, London School of Economics and Political Science, United Kingdom

Claudio Sacchetto Professor of Tax Law, University of Torino, Italy

Bertil Wiman Professor of Tax Law, Stockholm School of Economics, Sweden

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INTRODUCTION

Peter Essers and Arie Rijkers

One of the most difficult questions tax law faces is how to determine the tax base. Starting from the ability-to-pay principle, income is generally considered to be the best indicator to measure the ability to pay taxes. However, no consensus exists with respect to the question how income should be defined. Several theories have been developed, like the source theory, the accrual theory based on the net accretion theory and the cash flow theory leading to a consumption-type notion of income. In practice, in most countries a mixture of these theories determines the concept of taxable income. Besides, politicians have severely biased the theoretical just notion of income to achieve social-economic goals. For that reason, they introduced exemptions, reliefs but also extra tax burdens. This process of ‘instrumentalism’ of tax law has led to many conflicts with the equality principle, since - mostly - one can only achieve these social-economic goals by treating equal taxpayers differently. The desire to use taxation as a way to influence the economy has also been the basis for the recent trends in most countries towards schedular income taxes. From a tax law perspective, a global income tax seems to be superior since all kinds of income are treated equally. Nevertheless, experience shows that schedular taxes, mostly leading to a lower taxation of income from capital compared to labour-income, seem to be better suited to face the challenges of a globalizing world economy in which ‘one push on the button’, replaces capital from one point of the earth to another. For the Netherlands, this was the reason to introduce the so-called box 3 in its Personal Income Tax Code 2001, resulting in a fictitious income from capital of 4% of the average net wealth in a year, taxed at a flat rate of 30%.Finally, the notion of taxable income in most countries has proven not to be resistant against tax saving schemes and constructions. The natural reaction of most legislators to introduce specific and general anti-abuse measures has led to very complicated regulations which seem to be only accessible to taxpayers who can afford expensive tax lawyers. On the other hand, it must be said that these schemes and constructions were made possible by imperfections of the legal concept of the notion of income. These imperfections were often the result of negligence or political compromises.Because of these developments, general legal principles as equity and equality, which are crucial for a fair tax system, are constantly under fire. Tax science should take the responsibility to create an alternative for the present situation by trying to develop a generally accepted notion of income based on the general legal principles of equity, equality and certainty, and generally accepted specific tax principles as the ability-to-pay

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principle and the benefit principle. This notion of income should not be influenced by political motives, nor should it be susceptible to abuse. Besides, it should fit within generally accepted principles of international tax law and within supranational agreements like the EC Treaty and the WTO-agreements. This also means that the notion of income should make a comparison possible, leading to co-ordination and adjustments between countries. Seen from both an EC and a WTO perspective, this would mean an important step forward. The European Association of Tax Law Professors offers an excellent forum to accept this challenge. It provides European tax academics the opportunity to develop a notion of income, which is adapted to the difficulties and challenges of the 21. Century. Of course, such a wide topic cannot be discussed in detail during only one conference. For that reason, the Academic Committee of the EATLP has chosen to focus on the subject of the notion of income from capital. There are many good arguments for this choice. Most problems with respect to, e.g., the ability-to-pay principle, the relationship between personal income taxes and other taxes like the wealth tax, the inheritance tax and corporate income tax occur in the field of taxation of income from capital. Also, the differences between the various theories on the notion of income can be explained by referring to the different results with respect to the taxation of income from capital. Finally, globalization proves that the traditional way of taxing income from capital on the basis of the residence principle does not work any longer. As a reaction, this could lead to more emphasis on the taxation of the ‘sitting ducks’, meaning that ordinary workers have to pay the burden of the fact that capital owners cannot be taxed any longer. To avoid this process, a new concept with respect to taxation of income from capital has to be developed.

This report has been divided into two parts. In the first part the general aspects of income taxation on income from capital are discussed. The first question that arises in this respect is what should be the influence of general legal and specific tax principles on the taxation of income from capital. In his report Joachim Lang addresses this question. After describing the framework of tax principles in the constitutional and European law, he analyses specific tax principles to determine the income. Many theories and methods to determine the income have been derived from these principles. Lang first describes the historical debate between the net accretion theory (The S-H-S-model) and the source theory. Then, he comes to the analysis of the present debate between the accrual method and the cash flow method. In that respect he also addresses the question whether schedular or global income taxation should be adopted. Manfred Rose stresses in his report the importance and relevance of income theories like the cash flow method from an economic point of view.The problem of the relationship between personal income tax on income from capital and other taxes related to income from capital is discussed in the report of Claudio Sacchetto

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and Laura Castaldi. The first problem they face is whether the combination of a personal income tax on capital proceeds and a wealth tax causes double taxation. They also discuss the problem of economic double taxation caused by the co-existence of corporate income tax and personal income tax on dividends. Henk van Arendonk deals with the question whether the real income from capital or a fixed amount like in the Netherlands should be taxed in personal income taxation. His contribution concludes the first part of this report.

The second part of this report deals with the question how in the various notions of income from capital the taxable base should be determined. Peter Kavelaars addresses the question whether income should be determined on an accrual basis or whether the realization principle should prevail. Kevin Holmes poses the fundamental question whether deferral is allowed. He describes the conflicting objectives in this respect: investment and economic efficiency arguments versus equity, simplicity and other economic efficiency arguments. Judith Freedman explores the treatment of capital gains and losses. Some jurisdictions include capital gains and losses in their general income taxation; others regard them as a conceptually different tax base and treat them separately, in some cases under an entirely different tax code, or under the general tax code but with some different rules. She analyses the justifications both theoretical and practical for differential treatment of capital and income gains. Ian Roxan deals with the difficult problems caused by the influence of inflation on taxation. He also considers the phenomenon of imputed income.Finally, Bertil Wiman pays attention to the most recent cases of the European Court of Justice with respect to emigration and immigration of the taxpayer.

This preliminary general report is concluded by the preliminary conclusions and a summary of the points to be discussed at the conference in Cologne. In the final version of this general report a summary of the discussions in Cologne and our final conclusions will be added.

In the Appendix the questionnaires and national reports based on these questionnaires have been included.

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PART I GENERAL ASPECTS OF AN INCOME TAXATION ON INCOME FROM CAPITAL

CHAPTER 1 The Influence of Tax Principles on the Taxation of Income from Capital

Joachim Lang

I. Introduction

There may be a worldwide consensus of opinion that income is the best indicator for the ability to pay and that a global income tax with its equal treatment of all kinds of income is the fairest tax. In contrast to this there is a worldwide tendency towards schedular income taxes. This tendency has been increased by the tax competition. In a globalized world income from capital seems to be taxed lower than labour-income. The shift from the concept of global notion of income to schedular concepts like the dual income tax or Dutch boxen income tax seems evident.

Nevertheless, in the history of income taxation the concept of a global income tax has never been realized worldwide. In all countries the mix of theories and accounting methods, lobby influenced loopholes, exemptions and reliefs result in strong schedular effects of unequal tax burden. Especially the mixture of accounting methods creates a hybrid income tax: on the one hand the accrual method based on the net accretion theory and on the other hand the cash flow method as a consumption-type notion of income.

II. The Framework of Tax Principles in the Constitutional and the European Law

1. Tax Equity and Equality

First of all tax equity means equal treatment of the taxpayer. Other aspects of tax equity are based on fundamental values in the legal systems of the nations and the European Community: social equity of the welfare state, but also freedom of the property, the four freedoms of the EC Treaty and the protection of the family by the state.

The notion of income refers to the horizontal equity while the vertical equity addresses equity towards different income classes. For example it justifies progressive tax rates.

2. Certainty

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Certainty of law is very closely limited to legality, both principles of formal adherence to the rule of law. In most European countries the statutory tax law occupies a strong position. The provisions of tax law have to be enacted by the parliament. The ruling of tax courts has to be based on statutory law.

But politicians abuse the power to act the tax law. The tax legislation permanently modifies the statutory law and by doing so it produces a large uncertainty of law. Thus, the certainty of law nowadays is a very weak principle. A main reason for uncertainty is the general discontent of the taxpayer with the current tax law.

It is a task of the tax sciences to strengthen the certainty of tax law by finding a concept of income, which is generally accepted. The taxpayer ought to rely on the fact that there are neither loopholes nor hidden privileges for his neighbour. Politicians may determine tax rates but the definition of income as the best measure for the ability to pay taxes should not be a playing field for politicians. The non-political character of the income tax base gives stability to the tax law. Institutions of civil law have grown in long traditions of jurisprudence and therefore are immunized against political abuse. The legal definition of income should obtain the same immunity. This gives the taxpayer the feeling that taxation is part of a civilized society.

3. Right to Property

Taxation disturbs the right to use and enjoy one’s property. The influence of the constitutional right to property is very unclear. In most countries only a ban of confiscatory taxation is established. For example Art. 31 of the Spanish constitution forbids confiscatory taxation and the supreme courts of Switzerland (schweizerisches Bundesgericht) and Germany (Bundesverfassungsgericht) derive a ban of confiscatory taxation from the right to property.

Besides confiscatory rates the notion of income can have confiscatory effects of taxation. Especially the nominal notion of income does not consider the inflation and therefore the income tax burdens fictitious income with the effect that the substance of capital is confiscated. Moreover, all kinds of income fiction can have confiscatory effects if there is no income derived from capital. For example the Dutch boxen model fakes income derived from private property. This violates the right to property but it is not clarified whether this is unconstitutional.

4. Rights of the Family

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In most European countries the family is entitled to a particular protection by the state. On the one hand this means a ban of family discrimination and on the other hand a duty to promote the family.

First of all, tax law has to respect the ban of discrimination. In relation to the real ability to pay the family is discriminated and has to bear a higher tax burden than the single taxpayer, if the tax law doesn't consider the alimony obligations of the taxpayer and the distribution of income within the family. Tax rules of income splitting avoid the unconstitutional discrimination of the family.

5. The Four Freedoms of the EC Treaty

The four freedoms of the EC Treaty (free movement of goods, persons, services and capital) have a deep impact on the national tax law. The four freedoms provide a very strict system of non-discrimination and non-restriction rules, which also determine the notion of income.

Important examples are the application of splitting rules for non-residents decided by the ECJ in the Schumacker case (1995). In 2001, the EATLP discussed the taxation of cross-border-pensions in Lisbon. One of the main issues is the cohesion of such a tax system, which allows the deduction of contributions to life assurances, pension funds etc. under the condition that the assurance or funds payment can be taxed. This cohesion principle was ruled by the ECJ in the Bachmann case (1992) and justifies differential tax treatment. But in the Wielockx case (1995) the ECJ decided an important restriction of the justification by the fiscal cohesion principle if a double taxation treaty gives up the cohesion of contribution deduction and payment taxation.

III. Specific Tax Principles to Determine the Income

1. Ability to Pay

The ability-to-pay principle is the generally accepted legal rule to achieve equal treatment of the taxpayer. Ability to pay calls for taxpayers with equal capacity to pay the same. In the historical origin the ability-to-pay principle was connected with the progression: taxpayers with greater ability should pay more. Some European constitutions consider this historical approach, for example art. 53 of the Italian constitution.

In our opinion the ability-to-pay principle mainly serves the horizontal equity: income is the best measure for the ability to pay taxes and the notion of income basically has to

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consider the real, not the fictitious ability to pay. As a rule of equality the ability-to-pay principle justifies only a distribution of the tax burden in proportion to the income. Therefore, a proportional tax rate corresponds with the equal treatment of the taxpayer related to the amount of his income. In this function the ability-to-pay principle only justifies a proportional rate and a correct definition of income. The ability-to-pay principle does not support the fiscality of the state. It is not a principle aiming at the payment of a lot of taxes but a principle protecting the taxpayer against a tax burden, which is too high because of a wrong notion of income.

In connection with the welfare state principle the ability-to-pay principle may serve the vertical equity of a progressive tax rate in relation to the amount of income. The rate-structure cannot be determined by legal arguments. The amounts of a proportional or graduated tax rate and of the progression steps will always be a choice of social policy.

In the past and nowadays, powerful groups of economists always have been fighting against the ability-to-pay principle. They plead for the benefit principle, which demands that taxes should be levied in accordance with the benefits arising from the government services. They believe that the ability-to-pay principle disturbs the efficiency of taxation. This is a strong misunderstanding: the ability-to-pay principle as a legal rule of equal taxation and as an economically correct income definition supports the fiscal neutrality. As a legal rule the benefit principle does not work in tax law because taxes are not connected with certain benefits of the state.

2. Individual Taxation

The ability-to-pay principle as a basic rule of tax equity refers to the individual taxpayer and not to a unit of people like the family unit. Therefore, the ability-to-pay principle forms the individual taxation rule.

This rule prohibits the taxation of family units with the effect of discriminating the family because of a higher progressive tax burden. Thus, rules of income splitting are necessary in a progressive tax system. In case of a flat rate the lack of splitting rules has no discriminating effect. The splitting rules are derived from the basic rule of individual taxation. In accordance with the rights of the family (see II.4) they consider the distribution of income among spouses and other family members as provided by alimony obligations. The splitting rules are also based on the ability-to-pay principle because the obligation decreases the ability of the alimony payer and increases the ability of the payee.

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3. Real Income versus Inflationary Gains and Fictitious Income

As mentioned above, the ability-to-pay principle demands a measure of real, not fictitious income. Thus, the foundation concept of income ought to include only real economic benefits. Gains without improving the taxpayer's economic position in reality are "illusory gains" (Kevin Holmes) and unsuitable to measure the ability to pay. The taxation of "illusory gains" does not only get into conflict with the ability-to-pay principle, with tax equity and equality, but also violates the right to property (see II.3).

In a period of inflation the nominal accounting of income delivers taxpayers that have liabilities an untaxed real gain and taxpayers that are selling assets a taxed "illusory gain". The longer the assets are held in a period of inflation, the greater the inflation component of the gain is likely to be. Thus, the nominal accounting principle is working against the ability-to-pay principle.

In Germany, the Supreme Court (Bundesverfassungsgericht) interprets the nominal accounting principle as a principle supposed to protect the currency. This opinion refers to the experience especially in the countries of South America where the general use of index methods increased the inflationary situation of an economy. In Germany, index methods for accounting or for clauses to save the money value are generally not permitted. Only the central bank (Bundesbank) is authorized to allow such clauses, which disturb the value of a currency.

But index methods are not necessary to get taxation, which is neutral to inflation. It depends on the choice between accrual method and cash flow method. Only the accrual method needs index methods while the cash flow method guarantees the intertemporal neutrality of taxation including the inflation neutrality (see IV.2).

The fiction of income (for example the taxation of private property in the Netherlands) results in a tax benefit if the real amount of income is higher. In the case of a lower real income the fiction of income has a confiscatory effect, which violates the right to property (see II.3). Furthermore, the unequal treatment is evident.

4. Net Income

The income as a criterion for the ability to pay taxes consists of the positive factor of proceeds and the negative factor of costs related to the earning of the proceeds. The result

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of both factors is the net income as the right criterion for the ability to pay and therefore the net income principle (net principle) puts the ability-to-pay principle in concrete terms. The ability-to-pay principle demands the full deduction of costs and losses as well as the full consideration of the proceeds.

Furthermore, the deductible costs and losses have to be defined as costs and losses caused by an earning activity with the intention to make profit. Hobby losses as the result of a consumption activity cannot be part of the net income.

In accordance with the ability-to-pay principle the tax base of a global income tax includes all profits and losses from capital just as from labour. In contrast to this, a schedular income tax with different tax rates merely allows the summation of profits and losses on the same schedule. This is not in accordance with the ability-to-pay principle but there may be reasons to justify a separate tax regime.

The treatment of capital gains and losses especially needs to consider the inflation. Some countries tax long-term capital gains with a lower tax rate. In our opinion, a lower tax rate to compensate for inflation is too rough. But a provision, which exempts a growing part of long-term capital gains from taxation, seems too complicated. Scientists should look for better and simpler methods. The cash flow method is the simplest way to inflation neutrality but cannot be realized for all kinds of income. In most countries capital gains and losses are taxed by a special regime. This prevents the global summation of profits and losses and violates the net principle.

Besides special tax regimes simplifying rules (see II.3) infringe the net principle. The limited deduction for a certain kind of income can hardly be justified; for example the limited deduction of employee expenses in the Spanish tax law. In the Netherlands, the deduction of real employee expenses was completely abolished by the Income Tax Act 2001. This evident discrimination of the employees with regard to the deduction of business expenses cannot be justified.

5. Non-Disposal Income

The ability-to-pay principle demands not to tax the minimum subsistence. This is not a matter of a zero rate (zero-bracket amount) but a matter of tax base. In this context the part of income which is needed for the subsistence level is not at the disposal for taxation and therefore the non-disposable part of the income must stay untaxed either as an amount of regular subsistence or as deductible extraordinary expenses, for example in case of illness.

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In the German tax law the non-disposable rule gets constitutional validity as a basic rule of the ability-to-pay principle by the ruling of the Supreme Court (Bundesverfas-sungsgericht). Similar developments of jurisprudence can be observed in Austria, Spain and Italy.

In Germany, the social security system fully protects the minimum subsistence. In this regard the Bundesverfassungsgericht decided that the amount of social help has to be the measure for the tax-free amount because it is not bearable that a taxpayer who earns his minimum subsistence himself has to pay taxes while the recipient of social help gets the minimum subsistence tax-free. An important opinion in Germany demands a tax-free amount even higher than the minimum subsistence. Due to social obligations the working people need a higher minimum standard of living than lodgers of the welfare state do.

6. Efficiency of Taxation: Fiscal Neutrality and Simplicity

There are different points of view to understand efficiency: Economists use the term "efficiency" to describe the effectiveness of using resources. From that point of view taxation should not disturb economic decisions to allocate resources. It ought to be neutral to the allocation of resources (so-called fiscal neutrality). A growing group of economists plead for a consumption-type or cash-flow-income tax because the traditional net-accretion income tax distorts the intertemporal allocation of consumption decisions.

From the legal point of view efficiency is identified with simplicity, mostly in contrast to tax fairness. The legal opinions are very different. Simplifying rules often break equity principles like the ability-to-pay principle. This has to be justified.

The reason to tax deemed or fictitious income may be simplicity. The violation of the right to property (see II.3) and of the ability-to-pay principle may be justified if the efforts to account the income are unreasonable in relation to the result. But this justification does not take place in case of a general income fiction that practically concerns all private property like in the Netherlands.

7. Periodicity

The periodical notion of income violates the ability-to-pay principle if the measure of ability to pay is the lifetime income. In our opinion, the periodical accounting and taxing

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are based on technical and fiscal reasons. Practically it is not possible to account a lifetime income and it is not acceptable for the budget if the whole income tax is not paid before the death of the taxpayer. But these reasons do not speak against the concept to consider lifetime aspects in the periodical accounting of income.

The correct measure of the ability to pay taxes is the complete income of the taxpayer, which is not restricted by an arbitrary period of time like one year. Therefore, the notion of income has to consider interperiodical or intertemporal matters of income. For example the carry-over of losses (carry-back and carry-forward) is no tax benefit. The carry-over-rules are justified by the ability-to-pay principle.

IV. Theories and Methods to Determine the Income

1. The Historical Debate: Net Accretion Theory versus Source Theory

In the nineteenth century the development of income tax law was essentially influenced by two categories of income theories: firstly the source theories with their origin in the Roman law (income as fruits of capital assets) and secondly the net accretion theories which shape the traditional concept of a global income tax based on the Haig-Simon-Schanz concept of income. This global concept aims to seize "the net accretion of one's economic power between two points of time" (R. M. Haig).

In contrast to this, source theories only cover the income from the source, not the source itself, that is to exclude capital gains and losses as the result of the source sale: taxable is the income derived from selling the fruit; non taxable is the capital gain derived from selling the fruit garden.

In the current income tax law of many countries the tax base is a mixture of net accretion and source theories, in the best case completed by a separate tax regime for capital gains and losses (see II.5).

The net accretion theory includes three kinds of income:

(1) Market income: In most countries the legal concept of taxable income embraces income derived from market transactions. In this way the taxpayer makes use of his skills and earns income derived from labour or he invests capital or he combines labour and capital to achieve income. Capital gains and losses belong to market income. Windfall gains are some sort of accidental market success.

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The main legal issue is to exclude the consumption: the nucleus of the market income theory is to determine the taxpayer's action with the intention to make profit. If this intention is missing the action may be consumption. For example the losses are not deductible if the taxpayer enjoys a sailing boat but needs some receipts to finance the boat and therefore runs a part-time charter business. The whole sailing activity ought to be treated as consumption. Of course, the criteria of a profit action have to be judged as objectively as the findings of the German Tax court (Bundesfinanzhof) do. Especially the criterion of intention does not depend on the subjective opinion of the taxpayer but the objective chance to make profit.

In the German tax law game profits and losses are part of consumption because the chance to make profit is objectively too small. In most cases the total result of gambling is negative even though the gambler subjectively intends to make profit. In contrast to this the taxable speculation gains and other gains out of gambling are based on an investment with an objective commercial chance to make profit.

While the rule that losses from hobby are not deductible is practised worldwide the treatment of game losses is very different. If the taxpayer visits a gambling casino he definitely wants to make profit. In the United States casino profits are taxable and casino losses are merely deductible from casino profits. In Germany all kinds of games (lotteries, bets, wagers, and gambling casinos) are part of consumption because the chance to win is too uncertain. The net accretion theory is very unclear: are game losses part of the net accretion? If game gains have to be included in the net accretion, game losses must also be taken into account to determine the net accretion. The above-mentioned net principle (see III.5) demands this. The casino loss has to be deductible not only on the schedule of casino profits.

(2) Imputed income: In contrast to the market income the imputed income is only seldom part of a taxable income. The term "imputed income" comprises "the value of the benefits derived from non-market transactions" (Kevin Holmes, p. 521). R. M. Haig (1921) stated that income includes "the money-worth of...goods and services as are received directly without a monetary transaction..." (Kevin Holmes, p. 79). Thus, taxpayers receive the economic benefits from the use of their own assets and their self-performed services.

In the legal concepts of taxable income only the use of own real estate is taxed (for example in Switzerland), not the use and enjoyment of houseboats and other assets in the consumption sphere. And there is not a single concept, which consequently

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taxes self-performed services. The Swiss tax lawyer Peter Böckli (1978) discussed the services of a housewife (so-called "Schatteneinkommen"). What kind of services should be taxed? It seems to end in delicate issues.

In our opinion the economic concept of imputed income is legally not executable and so an equal treatment of the different kinds of imputed income is impossible in tax law. Therefore, equality demands to abolish the taxation of only a few cases of imputed income, especially the use of own real estate.

(3) Transfer income: Gifts and inheritances are income if you look at the enrichment of the recipient. But if you look at the transfer, the donor becomes poorer. In reality, the transfer of property creates no new economic power. It leads to a decrease in the ability of the donor and to an increase in the ability of the recipient.

In most countries the taxation of gifts and inheritances is excluded from the tax base of the individual income tax and subject to the gift and inheritance tax. Both taxes cause double taxation: the same economic power is taxed twice. Of course, a double taxation is not recognized if only the ability to pay of the recipient is regarded. But the economic effect is double taxation, if the same income is taxed twice in a row of two taxpayers. A similar case is the double taxation in a classical corporate income tax system.

Double taxation may violate the right to property. Whether the taxation has confiscatory effects or not depends on the tax rates and the particular time of the double taxation. In any case the double taxation discriminates the saved income and especially the income from capital. This is the reason why no other tax produces such a strong resistance as the gift and inheritance tax. Therefore, the revenue from this tax is relatively low everywhere. In the tax competition some nations like Austria try to abolish or at least minimize the gift and inheritance tax.

Alimony payments and maintenance grants are part of the net accretion. In many cases the tax law leaves this kind of transfer untaxed if the payment has already been subject to the income taxation or if a public institution gives the grant. The splitting rules mentioned above (see II.4) consider the transfer of economic power and therefore realize a fair family taxation.

After all the net accretion theory is only partially realized in the legal concepts of income. First of all, the market income is subject to the individual income tax. The taxation of

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imputed income or of transfer income may come in conflict with the constitutional framework of tax principles (equality, ban of confiscatory taxation) if other kinds of income are exceptionally taxed.

2. The Present Debate: Accrual Method versus Cash Flow Method

The present debate about income concepts is focused on the issue whether the notion of income has to be periodical or intertemporal. The traditional concept of income is based on the net accretion theory with its periodical approach of "one's economic power between two points of time" (R. M. Haig, see IV.1). For this periodical theory the accrual method is appropriate.

In contrast to this those economists who follow the optimal taxation theory plead for an intertemporally neutral concept of income, which is realized by the cash flow method. For many decades economists and American tax law professors have been discussing the issue of a consumption-type income tax versus the traditional concept of income. This dispute suffers from a deep misunderstanding because the traditional concept of income is more or less consumption based, too. The conceptual debate has to consider the following facts: - Firstly, the net accretion theory refers to all kinds of economic benefits and

therefore to the power to consume. Like all economic theories the net accretion theory as well as the cash-flow-income theories reflect the efficiency of con-sumption in a world of limited resources.

- Secondly, the traditional income tax is only partially based on the net accretion theory. It is a mixture of net accretion, accrual methods, cash flow methods (especially the taxation of employees and their pensions), and cash flow realisation but not periodical evaluation of the assets.

Worldwide current income tax systems have a hybrid character with a strong tendency to escape from the old ideas of net accretion and global income tax.

The main issue of the controversy is the accordance of the concepts with the ability-to-pay principle. If the measure of ability is decided upon as the lifetime income the arguments of intertemporal neutrality have to be respected. Theoretically, the lifetime income of taxpayers has to be compared. From this point of view the carry-over-rules are justified and the discrimination of the future consumption becomes relevant.

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There is no methodical difference if the taxpayer consumes his labour income in the same period. The difference of methods gains importance if a part of the labour income is saved. In this case the saved income from capital has to bear an increasing tax burden, well known since the statement of John Stuart Mill (1865) that interests are double taxed. Actually, Manfred Rose (Heidelberg) pointed out the increasing tax burden of the periodical and accrual method in contrast to the constant tax burden of the cash flow method (see the following chart).

From the legal point of view the economic arguments of double taxation (John Stuart Mill) and of the increasing tax burden (Manfred Rose) cannot be understood easily. The saved income creates new income-like interest. Nevertheless, the interdisciplinary discussion has to consider the different economic effects, which are shown by the following chart with a money investment of € 10,000, an interest rate of 6 percent and a proportional tax rate of 30 percent. The chart represents the following three basic cases:

- The first column represents the fortune increase in a world without taxation. The final fortune amount of € 102,857 is the measure for the final tax burden.

- The second column shows the increase of the tax burden if the money is given to a bankbook. The interest is periodically taxed (accrual method) with the effect that the final tax burden increases within 40 years to an amount of 64.72 percent, which is more than twice the tax rate (see the statement of John Stuart Mill). Progressive tax rates of 50 percent and more produce a final tax burden of 90 percent and more. That is why taxpayers risk tax fraud and invest their capital abroad.

- The last column shows the taxation of pension schemes (see V.3.1). Contributions to the fund are deductible or not taxed if the employer pays into the fund. The interest is not disposable until it is paid out as a part of the pension. Finally the pension is taxed as the total result of the investment. Here the cash flow method works. Therefore, the final tax burden exactly amounts to a tax rate of 30 percent.

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Accrual and Cash Flow Taxation of Interests

interest rate: 6 percent tax rate: 30 percent

age of taxpayer

fortune increasewithout taxation

€

accrual taxation

€

tax burdenpercent

cash flowtaxation

€

252627282930••

606162636465

10,00010,60011,23611,91012,62513,382

••

76,86181,47386,36191,54397,035102,857

7,0007,2947,6007,9208,2528,599

••

29,54430,78532,07833,42534,82936,292

30.0031.1932.3633.5134.6335.74

••

61.5662.2162.8663.4964.1164.72

10,00010,60011,23611,91012,62513,382

••

76,86181,47386,36191,54397,035102,857-30,857

consumable income € 36,292 € 72,000

final tax burden 64.72% 30 %

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V. Notion of Income towards a Cash Flow Income Tax?

1. The Phenomenon of Hybrid Income Taxation

a) Basic qualities of computation methods: The chart on page 18 shows the intertemporal constancy of the tax burden in case of the cash flow method while the accrual method causes an increase of the tax burden. The cash flow method has the following qualities of fiscal neutrality: neutrality of the tax payer's decision (saving, investment or consumption), neutrality of inflation, intertemporal neutrality of tax burden.

The main disadvantage of the cash flow method is the present lack of tax revenue because of the payment's deductibility. But in the future the tax revenue is increasing. The cash flow method ensures a better comprehension of income in the tax base than the accrual method. Taxpayers strongly oppose the accrual method. For example they risk tax fraud to avoid the accrual taxation of interests. In contrast to this, deductible contributions to pension funds stimulate the taxpayer to save his income under the control of the tax authorities, which can have the full information about the fortune increase in the fund.

The main advantage of the accrual method is the efficiency of the present tax revenue, which is attractive for politicians who want to be voted into parliament only for a relatively short period of years. Therefore, the legislator prefers net accretion theories and accrual taxation. On the other hand the taxpayer has to suffer the disadvantageous effects of accrual taxation, the taxation of inflationary gains, the increase of the tax burden, the cuts and restrictions to carry-over losses, and the uncertainty of asset valuation.

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The academic controversy focuses on the quality of tax equity: A powerful group of scholars argues that the cash flow method results in a consumption-type income tax and in a rich man's prerogative. This may be doubted. On the one hand, rich people have too many possibilities to use the tax competition and to allocate their income to the places where taxation is lowest. On the other hand, the cash flow method helps taxpayers with labour-income to get a better tax position in relation to the capital investors if the taxation of pension schemes is based on the cash flow method. Eventually, the legal approach of equity only depends on the period of time or on the lifetime. If the window is opened on the lifetime of the taxpayer, you can see all the defects of the accrual method.

b) The struggle between efficiency of tax revenue and acceptance of tax burdens results in the phenomenon of a hybrid notion of income, which is shaping up the income taxation worldwide and has the following features:

(1) The computation of entity profits generally uses the accrual method but the realization requirement and rules of book reserves refer to the cash flow method;

(2) Income from private capital and labour-income is mostly computed with the cash flow method but the chart on page 18 shows that interests are accrually taxed:

(3) Pension schemes are purely cash flow taxed: the contributions to the pension funds are deductible or untaxed if the employer pays into the fund. The paying of the fund is fully taxed. But mostly this kind of taxation is restricted to a certain amount;

(4) Capital gains on the one hand are cash flow taxed because of the realization requirement and on the other hand accrually taxed because of the taxation of inflationary gains;

(5) The increase of some capital is not taxed due to the source theory. This is neither in accordance with the accrual method nor with the cash flow method;

(6) Low corporate tax rates partially realize cash flow taxation. A pure business cash flow tax allows the full deduction of the investment and finally burdens only the distribution of dividends. That implicates a corporation tax rate of zero.

2. Schedular or Global Income Taxation?

Tax competition gives the acceptance of a tax burden more importance. Therefore, most European governments have lowered the tax burden on income from mobile capital either by decreasing the tax rates or by modifying the tax base.

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The accrual tax accounting may be moderated by cash flow rules like generous book reserves, especially risk and inflation reserves, provisions for bad debts and specific accounting rules for the shipping industry, for co-ordination centres of foreign in-vestments. In some countries like in Germany the soft character of the tax accounting is based on the connection with the commercial accounting with its caution rules. Sometimes it is difficult to decide whether an accounting rule is part of the general system or a harmful investment incentive. But anyway, low tax rates are the alternative, which is more transparent for foreigners. The tendency towards schedular income taxes shows the following characteristics:

(1) Flat rate taxation of income from capital and progressive taxation of labour-income (dual income tax) not only applied in Scandinavian countries but also in the Netherlands as essential of the boxen system;

(2) Specific accounting rules for particular sources of income, for example the low valuated fiction of income from the shipping industry or from the private property in the Dutch boxen system;

(3) Low corporate tax rates (Ireland: 12.5 percent), but return from imputation systems to the classical systems of double taxation or to systems with a small shareholder relief;

(4) Tightening of the tax accounting for the benefit of low tax rates, especially reduction of intertemporal cash flow rules (book reserves, deduction of losses).

Of course, the transition from the global income tax to schedular income taxation violates the principles of tax equity and equality. But the academic discussion of tax policy has to find solutions and justifications for a concept of income, which on the one hand considers the conditions of administrative practice and tax competition and on the other hand conserves the approach to equity and equality. Thus in Cologne, we will continue the discussion we had in Lausanne.

Schedular effects can be accepted, if so far different kinds of income concern every taxpayer. Equality means the equal treatment of the taxpayer and not the equal treatment of all kinds of income. If the taxpayer consumes his whole income in the same period, the right tax base is easy to define: the whole-consumed income ought to be included in the tax base. But if the taxpayer saves income or invests money or loses invested money, the time value of money ought to be respected and the issues of intertemporal fiscal neutrality ought to be discussed.

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The basic idea is to find a general rule to treat saved or invested income. The cash flow with its qualities of the above-mentioned qualities of intertemporal neutrality method includes such a rule. The problem of this rule is its limitation because the cash flow method lowers the present tax revenue. But in the long run the cash flow method supports the comprehension of the tax base and the lack of tax revenue is compensated.

3. Two Essentials of the Income from Capital

3.1 Taxation of Pension Schemes

The taxation of pension schemes purely follows the cash flow method [see above V.1.b(3)]. It shifts the income from the economically active period to the retirement period and therefore represents the first-best tax form to indicate a lifetime ability to pay.

Furthermore, it redresses the discrimination of labour-income in the tax competition as far as labour-income is contributed to a pension fund. In this case the labour-income is lower taxed than dividend income because the taxation of pensions is equivalent to a corporation rate of zero.

The participation in pension funds ought to be open to all taxpayers, not only to employees but also to freelancers and any kind of businessmen. In many countries the form of the cash flow taxation of pensions is increasing, for example in the UK and in the USA.

Nowadays, the rules of limitation are too complicated. The legislator presents the cash flow taxation of pensions as a tax incentive. But in fact this form of taxation is based on the ability-to-pay principle with its purpose to fairly tax the lifetime ability to pay. Only the background of a periodical understanding of the ability to pay pretends a tax incentive.

A severe problem of revenue inefficiency derives from the International and European law. If the retired taxpayer moves from a cold, rainy and cloudy northern country to a Mediterranean country, the pensions may be only taxable in the state of residence of the recipient. Therefore the deduction of contributions in the northern country will not be compensated for the taxation of the pensions. The residence rule is to apply in case of private employment (see Art. 18 OECD Model Convention). Only governmental pensions can be taxed by the paying state (see Art. 19 OECD Model Convention).

Under the EC (see above II.5) law the cohesion principle justifies the connection between the deduction of contributions and the taxation of pensions. But the Wielockx-decision

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denies this justification if the cohesion principle is given up in a double taxation treaty (see above II.5). The adaptation of the treaty law is a difficult task, which ought to be prepared by the academic discussion. The concept of adaptation has to consider that the contributions to a pension scheme do not represent income. That is why the contributions are deductible or not taxable if the employer pays into the fund. The former home states are the source countries of the pension payments and therefore they must have the right to tax the pensions.

3.2 Treatment of Capital Gains and Losses

The taxation of capital gains exceptionally suffers from the problem to tax inflationary gains. Therefore in many countries (for example in the UK) the taxation of capital gains is separated into a special schedular tax regime. This regime considers the inflation effects either with low tax rates or with taper reliefs. The latter act of reducing the tax base in relation to the length of the holding period refers to the inflation effects more exactly than low tax rates but only covers one side of the coin. The inflation also reduces the debt burden and so creates a real gain, which is not taxed. Therefore, separate tax regimes for capital gains and losses do not completely neutralize the impact of inflation on tax bases.

The first-best solution would be the cash flow taxation of capital gains and losses. But this may be too disadvantageous for the present tax revenue. Therefore, separate tax regimes may be accepted which roughly consider inflation. Of course, capital losses are only to be taken into account on the schedule of capital gains. A full deduction of the losses is only justified from the full capital gain. That raises the question whether the amount of losses ought to be reduced in relation to the holding period, too. The complexity of such a rule may justify the full loss relief as a simplification rule.

VI. Conclusions

In our academic discussion tax principles may have a deep impact on the notion of income. Nevertheless, the real tax policy often denies tax principles even of the constitutional and European law. A lot of Supreme Court and ECJ verdicts show the permanent violation of principles by the legislator. In spite of that, the discussion about principles and basic rules supports the development of a common European understanding of better tax structures. In this paper I would like to emphasize the following conclusions:

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(1) The income tax base ought to be reduced to the market income (see IV.1). Imputed income should be excluded because the equal treatment of the different kinds of imputed income is impossible;

(2) If the right measure of ability to pay is the lifetime income, the tax base should only include the realized income. The accrual method causes the uncertainty of asset valuation, the increase of the tax burden and denies inflationary effects (see V.1);

(3) Basically fictitious or deemed income should not be part of the income tax base. The taxation of fictitious income gets into conflict with the ability-to-pay principle and the right to property (see III.3). In some cases the fiction or deeming of income may be justified as a rule of practicability. A large fiction of income derived from private property cannot be justified. The income tax gets the character of a property tax.

(4) The net principle (see III.4) demands the full deduction of costs and losses. The fiction of costs may be an appropriate rule of practicability. But the full substitution of the real costs (for example: employee expenses in Spain) cannot be justified. In separate tax regimes the relief of losses can be limited to the schedule of the tax regime (see V.3.2).

(5) The concept of the lifetime ability to pay demands a cash flow notion of income. This is already largely realized by the taxation of pensions. A second step towards a cash flow income tax could be the cash flow taxation of capital gains and losses. But that first-best solution decreases the present revenue too much. Therefore, a separate tax regime, which considers inflation effects in a rough way, can be accepted.

(6) In the long run the notion of income should move towards a cash flow income tax. That will give us the best chance to keep the concept of a global income tax. The accrual taxation stimulates the resistance of the taxpayer and eventually ends in schedular income taxes. Of course, the income tax will not lose its hybrid character. But this does not disturb the equal treatment of the taxpayer if the basic rules concern the saved or invested income of each taxpayer. Pension schemes, capital gains and also dividends are income essentials of most taxpayers. Therefore, special tax regimes including the double taxation of dividend income are acceptable. Nevertheless a fictitious income schedule for real estate property violates equality as real estate is normally not part of each fortune and affects only a certain group of taxpayers.

(7) Splitting rules consider the distribution of income among spouses and other family members in accordance with the individual taxation rule (see III.2.3).

(8) Finally the non-disposal income ought to be excluded from the tax base (see III.5).

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PART I

CHAPTER 2 Economic Aspects of Taxation of Income from Capital

Manfred Rose

WORK IN PROGRESS

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PART I

CHAPTER 3 Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital (Corporate Income Tax, Wealth Tax, Inheritance and Gift Tax and Real-Estate Tax)

Claudio Sacchetto and Laura Castaldi

1.1 Does the combination of personal income tax on capital proceeds and a wealth tax cause double taxation?

The ability-to-pay principle - as a usually constitutionally sanctioned criterion of allocation of public burden among members1- tends to become positive in the single state normative, in the individuation of tax requirement represented by facts or events expressing the economic force directly, or indirectly.Under this standpoint, capital, as a mostly economical force, the principle’s capacity to express its provision for tax, may be considered under two separate views2:a. per se, and thus in its static-wealth dimension, as direct expression of levy capability (capital/wealth);b. as origin of new wealth due to its productive use, and thus in its dynamic-income dimension, with reference to the proceeds that it may produce (proceeds from use of capital/income).The role of the capital in the normative description of tax requirement is clearly different in the two views.In particular, capital can have the role of tax prerequisite with reference to wealth taxes, but becomes typical source (and normatively typified) of wealth considered as tax

1 The express reference to the concept of ability-to-pay-tax principle as guideline for the ordinary lawmaker for the allocation of public burdens among members is considered by only a few European constitutions (Italy, Spain, Germany). More generally, European Constitutions tend to solve it in the principle of equality (or to gather it from said principle): meant as a principle of rationality/reasonableness in lawmaking as for the individualization of the parameters distributing public burden as for the participation of members to public expenses. Actually the various starting points of constitutional norms are closer than we think; in particular if we consider that, especially after the introduction of the IRAP, (Regional Tax on Productive Activities), the Italian tax discipline has been trying to give a new trend to an interpretation that would valorize the peculiarity of the article 53 of the Constitution, compared to the article 3 (see FEDELE, GALLO).2 Here capital and property are similar in what they represent at the same time: a. they are ontologically suitable to be considered as indexes of provision to levy. as sizes expressing economic force;b. historically meant as intrinsically productive sources of income that may become normatively typified sources of new wealth; the latter may be subject to tax (capital gains; land income)

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prerequisite with reference to income taxes. The latter are meant to affect a conceptually distinct economic body represented by increases in the values determined in relation to a pre-existing capital due to its productive use3. The two forms of wealth, although the second one is undeniably genetically linked to the first, are conceptually autonomous and distinct.Under this point of view, as a matter of principle, it seems conceptually wrong to think about the problem of double tax relevant to a fiscal system in which wealth taxes on capital (or able to influence it) coexist with income taxes on the proceeds (or able to influence them) of the use of capital. No matter what sense we wish to give it, this is true in so far as double tax implies double subjective and/or objective withdrawal with reference to the same tax requirements:a. Same fact/event taken as tax requirements towards different subjects (double internal subject tax);b. Same fact/event taken as tax requirements from different taxes (double internal object tax);c. Same event/fact relevant to tax purposes with reference to different state disciplines (double international objective tax).4

1.2 The trend of developing fiscal systems in which income taxes and wealth taxes coexist

Having said this, we must verify whether the passage of proceeds from the use of capital in the profitability area to that of patrimoniality due to income taxes5, although not giving problems of double tax in strict sense, imposes a more careful approach to the different problem rising with the opportunity, under the legislative choices6, to subject the wealth, previously docked by taxes due to its (original) income value, to a further tax. The recognition of the norm in a historical-evolutional key makes us notice the sensitivity of some tax system to the problem. This entails an attempt to avoid, or reduce, the

3 Thus considering product-income as taxable income. As for the normative, the different tax systems notice in different measures a shift towards the tax of revenue-income. Capital incomes in broader sense (including capital gains) are particularly sensitive to this evolution: here the taxability area seems to affect also revenues that cannot be attributed to juridical action intentionally directed to acquire new wealth.4 In other terms, with the expression “double internal tax” we mean to refer to double tax levies on the same economic force on the part of different subjects (double subject tax); i.e., double tax levy on the same economical force by several taxes on the same subject (double objective tax) within the same juridical system. Usually tax systems tend to ban double tax in both meanings (see article 127 IITC on income tax, December 22, 1986, No. 917; “ the same tax shall not be applied more than once for the same prerequisite, not even on different subjects”).5 It is clear that once the tax is discounted, income acquires a wealth connotation.6 With the relevant exigency to suitably balance the completive tax on the various kinds of securitized and real-estate wealth.

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coexistence of wealth taxes and income taxes on incomes from sources of income (land incomes, capital gains)7.As for the Italian tax system, we believe it is important to mention:- the political8 more than theoretical9 resistance put up against the proposal made in the early 60s by the Committee studying the tax reform, chaired by professor Cosciani, to introduce a periodical wealth tax to couple the ordinary income tax10: when the delegated act project for tax reformation11 was approved by the cabinet on June 20, 1969, and presented to the Chamber of Deputies on July 1st, 1969, the resistance resulted in the adoption of the alternative solution given by the developing of a real ordinary tax on incomes coming from wealth sources (ILOR, Imposta Locale sui Redditi).12

- The strong consequences on the overall taxability system of land income due, in the early 90s, to the introduction of a periodic tax on real-estate wealth (ICI, Municipal Tax on Real Estate)13, despite the fact that the latter has low economical consequences, due to the limited rate varying between 4 and 7%.- That one of the political arguments14 used to justify the elimination of the inheritance tax from the Italian tax system was done defining it as a tax burdening the testator’s wealth at the transmission of the patrimony, and thus subject to add up to the

7 The European regulations point out that:a. In many countries taxation on assets is totally absent, such as in France, Belgium, Denmark, and Great Britain.b. Where it exists, taxation on assets is generally characterized as being taxes on real estate assets (Austria, Swede, Portugal), and in many cases they are local taxes (Switzerland, Portugal). Spain seems to be the exception, as there is a tax on both real estate and personal property.8 Highlighting the stronger political motivations in the dismissal of the wealth tax in COSCIANI; Struttura dei sistemi tributary e loro riforma, in Dir.prat.trib. 1979, 1, 517.9 Where an unexpected similarity in viewpoints between jurists and financial experts on the need to integrate levies on income through an ordinary wealth tax, as a means to carry out the principle of contributing capacity. (Compare MOSCHETTI, Il principio di capacità contributive, Padova, 1973, 29 and foll.; MANZONI, Il principio di capacità contributiva nell’ordinamento costituzionale italiano, Torino 1965, 134; MAFFEZZONI, Il principio di capacità contributiva nel diritto finanziario, Torino 1970, 105 and foll.; GALLO, L’autonomia tributaria degli enti locali, Bologna 1979, 107 and foll.; TRAMONTANA, Aspetti e problemi dell’imposizione ordinaria sul patrimonio, Padova, 1974, passim.10 For a detailed exposition of the reasons to prefer the introduction of a wealth tax along the about-to-be-introduced new income taxes, see Stato dei lavori della Commissione per lo studio della riforma tributaria (Documento di lavoro elaborato dal vivepresidente prof. C. Cosciali), Milan, 1964, 104 and foll.11 The bill was approved by the Cabinet on June 20, 1969, and presented to the Chamber of Deputies on July 1st, 1969 (Parliamentary Acts, Chamber 5 legislature, No. 1639).12 For a detailed study on the works of the Cosciani Committee and on the reasons that brought to the final choice to abandon the project of introducing a wealth tax, and to the choice to introduce the ILOR tax, see MICCINESI, Redditi (imposta locale sui), in Enciclopedia Diritto, Milano 1988, Vol XXXIX, 174 and foll.13 Indeed, together with the introduction of the ICI tax it was decided for the exclusion of land incomes from the ILOR tax, and in particular, of house income, rental income for building sites and agrarian lands, not to mention agrarian incomes. In particular, see PERRONE, L’imposta comunale sugli immobili: primi spunti critici, in Rivista Diritto Tributario 1994, 1, 757 and foll.14 Report of the act Chamber C6062, signed by MP Silvio Berlusconi et al, related in full in LUPI, Il tributo successorio, tra funzione astratta disfunzioni concrete e proposte di abrogazione, in L’imposta sulle successioni e donazioni tra crisi e riforme, Milan, 2001, 32, nt.7.

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income levy with reference to patrimonies formed (even partly) by previously taxed incomes15.

1.3 The degree of acceptability of a tax system developing a periodical ordinary direct tax on income/capital proceeds and other taxes on capital/wealth

From this point of view, the possible combinations of coexistence between income taxes and wealth taxes affecting respectively the proceeds from the use of capital, and on the capital itself show different degrees of feasibility/acceptability.First of all, we believe that we must put two preliminary questions:a. firstly, the obvious functional, if not conceptual, alternation between wealth taxes on the one hand, and on the other hand taxes (additional compared to ordinary income taxes) affecting incomes of wealth source16, makes us consider their coexistence in a tax system impossible.This is confirmed by the matter that marked ILOR’s effectiveness in the Italian tax system: this tax was introduced as a replacement for a wealth tax, but a wealth tax edited out land incomes from its application area, together with the introduction in the system of the tax on real-estate wealth (ICI).In other words, the Italian experience shows the intrinsic incompatibility between taxes meant to affect wealth incomes as for qualitative discrimination of the sources of income, and wealth taxes.

b. Secondly, the prohibition to have a double tax seems to avoid the compressence in a tax system made of direct periodic ordinary taxes on wealth, and indirect taxes whose taxable income have wealth overtones17 (estate tax, gift tax, inheritance tax).18

Under this point of view, consider that one of the many explanations Italian doctrine gives to support the elimination of estate taxes from the Italian tax system is its configuration as tax affecting the testator’s wealth at the moment of the hereditary transmission; the latter,

15 For a more careful position of the doctrine according to which the remark should have brought not to elimination of the probation duty, but to the decreasing its consequence with reference to patrimonies formed by incomes, considering the tax levy already carried out, see STEVANATO, Donazioni e liberalità indirette nel tributo successorio, Padova, 2000, 231.16 As the ILOR tax was in Italy, before 1997.17 Not all indirect taxes have taxable income with wealth connotations: in the category, probation and gift taxes may surely be included, besides registration fees. Conversely, the taxable base of the INVIM tax (tax on real-estate’s increase in value) has an income overtone in the revenue proceeds meaning. In fact, part of the discipline, although not very persuasively, has depicted it as replacing/alternative tax to income tax, affecting real-estate capital gains deducted from ordinary income taxes.18 See below paragraph 2.1 as for the elimination of estate taxes and INVIM tax as lightning of fiscal burden on real estate as reason for the introduction of the ICI tax.

33

due to the fact that is it meant to affect the real-estate feature of said wealth 19, proves incompatible with the introduction of the ICI as ordinary tax on real-estate wealth20.Moreover, we should consider the controversy on the introduction within the Italian tax system of the tax on companies’ net assets. Today abrogated due to the introduction of the IRAP, in as much as this tax was applied it affected also that part of net assets represented by capital, which had already paid the registry tax at the moment of its beginning.This said, and accepting the above-mentioned explanations, the best solution seems to be the one that would match a periodic income tax system with a low-rate periodic income tax. For a suitable gradation of the overall fiscal burden, the latter should consider the possible presence in the taxed wealth of already-taxed components, and possibly, the different impact of this tax levy on the very income component.21

In other words, a periodical income tax should consider not only the wealth’s composition, but, in case of wealth components of original income configuration of the possibly different amount of income tax levy supported by the wealth components. Consider, for instance, that in the Italian system, the acceptation of the coexistence of ICI (periodic tax on real-estate wealth) and an ordinary income tax affecting also land income (i.e., incomes from real-estate sources) depends on two simultaneous factors: the low ICI rate and the relatively light contribution of land incomes to the determination of the taxable accrual under the effect of their determination on the cadastral base. Under this point of view, the introduction of a wealth tax could be disputable in case the levy on capital gains should reveal quite significant, if not penalizing compared to the fiscal burden affecting other income categories, due also to particular mechanisms of taxable audits and/or tax application22.On the other hand, the option to introduce a periodical wealth tax to flank, with the right tactics, an ordinary income tax, would meet the requests coming from discipline. The latter has underlined how an even repartition of public burdens would mean considering the different relation among members, expressed not only by their high-income degree, but

19 On the pathological, yet “structural” deduction of the securitized aspect from the hereditary wealth, as for estate taxes, see among others MARONGIU, La riforma dell’imposta sulle successioni e donazxioni, in Various Authors L’imposta sulle successioni, quoted above, 9.20 MARONGIU notices the incompatibility in La riforma, quoted above, 7: “Estate taxes still have a force connected to their raison d’être. They justify the inexistence in our system of an ordinary income tax”.21 Thus, under this point of view, it would be technically preferable to choose a wealth tax system of the real type, more than personal. Obviously, a periodic wealth tax should consider not only the composition of the patrimony, but, in case of wealth components of primary income configuration, also of the possible different shape of the income tax levy supported by the patrimony. Consider, for instance, that in the Italian system, accepting the coexistence of ICI (periodic tax on real-estate wealth) and an ordinary income tax affecting also land income (i.e., incomes from real-estate sources) depends on two simultaneous factors: the low ICI rate and the relatively light contribution of land incomes to the determination of the taxable accrual under the effect of their determination on the cadastral base. Under this point of view, the subjection of capital to a wealth tax could be disputable in case the levy on capital gains should reveal quite significant.22 See below, paragraph 2.

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also by different symptoms, such as the different composition in terms of quality and quantity of wealth availability. The latter expresses a different social status and a basic social and economic condition suitable to stand up to allocation criterion in the concurrence in public expenses. Let’s consider now the famed reservations that have long been opposing the introduction of a general income tax as stock. Among these, the easy conceivability of some forms of wealth availability (such as non-registered securitized goods) compared to others (real estate), which could generate as for their application, problems of tax effectiveness and equalization, not to mention the dreaded negative reflexes that such a tax could generate on the economical initiative, due to its broadly “para-dispossessing” features.23

Within a given tax system, let’s admit that the coexistence of capital/wealth taxes and taxes on the proceeds coming from the use of capital/income is abstractly compatible, if not constitutionally desirable. The consideration should shift inside the two distinct tax areas to verify possible problems that the tax of capital and capital proceeds could pose, in the light of systematic coherence and effectiveness, not to mention the case of double objective and/or subjective tax.

2. Income taxes. Taxing the proceeds of the use of capital in the light of income tax: the principles

To date, despite the growing perplexity expressed by discipline on the effectiveness of the pattern of even and rational public burden distribution among members24, we notice a strong trend of current tax system to structure income taxes, at least in principle, basing them on one or more personal taxes: usually on progressive rate, as for what concerns individuals.In such a context, the capital gains tax discipline shows some peculiarities hardly harmonizing with the system and its founding principles.If we simply consider as reference the Italian normative, we can notice at least two breaches in the discipline of capital gains taxes in reference to the general principles on income tax:

23 For the sake of completeness, we should mention that an authoritative, yet isolated part of the Italian discipline has noticed a constitutional limitation to the introduction of wealth taxes that may affect productive sources of income, in the article 42 of the Constitution, for the safeguarding that the article gives to economical initiative (see GAFFURI, L’attitudine alla contribuzione, Milan 1969, 160 and foll.). For a careful examination of this thesis in the light of the discipline of the Italian Constitutional Court, see FEDELE, Dovere tributario e garanzie dell’iniziativa economica e della proprietà nella costituzione italiana, in Rivista Diritto Tributario, 1999, I, 971 and foll.).24 For the Italian tributary discipline, see TREMONI – VITALETTI, La fiera delle tasse, Bologna 1991, 35 and foll.; FEDELE, Imposte reali e imposte personali nel sistema tributario italiano, in Rivista diritto finanziario 2002, 450 and foll. (in particular 472 and foll.)

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a. The record of the gross taxable base, thus with no acknowledgement of the analytical or flat relevance of the costs relevant to the production of the income itself25.b. The systematic recourse to (proper and improper) withholding tax regimes26, with subsequent deduction of capital gains from the taxable accrual, subject to the personal/progressive tax27.If we start examining this latter profile, the choice of legislative policy in mirroring past options and normative forms, has always found strong justifications. These relied upon the need for simplicity in application and/or safety and promptness in tax levy,28and on the need to set broadly simplifying tax systems. This with the double target of suitably orienting financial fluxes between venture capitals and borrowed capitals in the frame of the economic and financial policy’s targets, and at the same time of safeguarding and enhancing public savings in compliance with what the article 47 of the Constitution sets.We cannot omit the negative influx that the expansion of withholding taxes exert on the overall coherence of the system, which we can see under two different profiles:- Ab externo, respectively in the comparison between capital gains and other kinds of incomes29, and between incomes from capitals subject to deduction at source as tax (or

25 See the article 42 IITC on income tax. “Capital gains are made up by the amount of the interests, revenues, or other proceeds collected in the tax period without deduction”.26 With this terminology we indicate respectively, and theoretically the following hypothesis: a. those in which the legislator decides on the elimination, or non re-inclusion ab origine of an income-relevant matter in question, from ordinary tax, to move it on to an alternative, or surrogating tax system; b. those in which, it being understood the substantial re-inclusion of the income-relevant matter in question within the categories examined in the IITC on income tax 917/1986 for the determination of the taxable base IRPEF-IRPEG, as for the application, the case in question does not contribute to the formation of the taxable accrual. Thus, it does not correspond to the determination of the marginal rate of the taxpayer, and is conversely subject to an autonomous and exhaustive tax levy. The latter can be traditionally the deduction at source as tax (in which case the payment of the tax occurs through the tax substitute), or a real substitutive tax.27 Indeed, the more and more qualitative and quantitative weight of the income phenomena affected by the withholdingtax process end up in strong distortions in systems –such as the Italian one- which are considered marked by a progression and personalization of the tax, at least in principle. Thus creating what, in reference to capital gains, was authoritatively defined as one of the most conspicuous and discussed forms of erosion of the IRPEF tax, and of legal income subtraction from the progressiveness of tax (COSCIANI, Su di alcune deformazioni della progressività dell’imposta sul reddito delle persone fisiche, in Rivista diritto finanziario, 1975, I, 5 and foll.).28 See Report of the Committee Finances and Treasure of the Chamber on the delegated act project to the Government for the tax reform, in RINALDI, Contributo allo studio dei redditi di capitale, Milan 1988, 103, nt 284.).29 For instance, in Italy capital gains subject to withdrawing tax undergo a levy oscillating from 12.5% (as interests from certificates of public debit) and 27% (as interests from deposits or current accounts): the income categories not subject to taxation (such as land income, income from subordinate or independent work, company assets), adding up to the IRPEF accumulation, can suffer tax levies with marginal aliquot equal to up to 44.5% (maximum aliquot for the year 2002) and 45% (maximum aliquot for the year 2003).

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as withholding tax), and capital gains included in ordinary tax30. This difference affects not only the objective profile, but, very absurdly31, the subjective profile of income allocation.- Ab externo, in subjecting the various kinds of capital gains to withholding tax levies of unfairly diversified amounts32.The article 42 of the IITC approves the peculiar criterion of quantification of the gross taxable income, in the Italian discipline. The provision has ancient roots, as we can find a similar one in the article 13 of the statute No. 14.7.1864, creating the tax on Securitized Wealth (later merging in the article 21 of the Unique Txt 24.8.1877, No. 4021). Originally conceived in reference to a tax system with dividend taxes with the aim to carry out qualitative discrimination of incomes33, the provision in hand ends up having abolishing overtones when assessed in reference to the current tax system. In the latter, not only the qualitative discrimination, at length realized through an additional autonomous tax (ILOR), was later abandoned as it was considered hardly tenable from a strictly theoretical point of view34. But also, the compliance with the constitutional discipline, and thus of the principle of ability- to-pay-tax, imposes that the actual economical force of the subject is the object of the levy. In other words, the increased wealth net of the costs supported for its production. The technical and regulative modalities can be different when it comes to the clearing of costs35.Thus, to justify the persistence in the system of said discipline, many an explanation has been brought, all of them rather unsatisfactory.

30 For instance, I Italy the interests for loans/mortgages are not subject to withdrawal taxes as levy but to a 12.5% withdrawal tax. Thus, the natural person financing a company through subscription of bonds is subject to a tax levy on the interests equal to 12.5-27%, according to the expiry of the share (above or under 18 months). Conversely, in case of interest-bearing loan, interests undergo just the 12.5% withdrawal taxation, thus undergoing a levy according to the marginal aliquots of the financer that can go from 44.5 to 45%.31 We wish to explain our statement: there have been cases in which the subjective differentiation of the kind of tax (duty or deposit) applicable to the same income matter in point, responded to precise theoretical and/or practical instances. This is evident also in reference to the hypothesis of deduction at source as tax, for non-residents (here the option finds its base in the obvious need for the state to be sure to levy, and for the easy application for taxpayers); and to the general adoption of the deduction at source as deposit for objectively capital gains, but collected in the context of a company (where the choice responds to the need to a uniform and overall record of the managing and income result of the company). 32 In Italy, an evident effort to uniform withholding rates was made with the reform of the capital gains tax and of the other financial proceeds, realized with the government decree 461/1997.33 We speak of quality discrimination every time that, amounts being equal, incomes are subject to different taxes as they are thought to evince different degrees of attitude to levy, due to their respective source. 34 In point of fact, the qualitative discrimination between wealth incomes and working incomes, or mixed ones, but with strongly working composition, was very much dampened in Italy by the abrogation of the ILOR tax, together with the introduction of the IRAP which, not being an income tax, has not role in this perspective. 35 Conversely, as per the article 42 of the IITC, a non entrepreneurial subject contracting an onerous mortgage (5% rate) to get the capital needed to implement in turn the interest-bearing loan (7.5% rate) will not fiscally deduct from the amount of interests achieved (7.5%) the passive interests paid out (5%) the passive interests equal to 5%, and will thus be taxed on 7.5 instead of on 2.5, which is the actual obtained income.

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On the one hand, the rigid mentality of the fiscal legislator tied him to an anachronistic vision of the capital as source intrinsically productive of income proved his incapability to conform to the much more complex operating systems on the financial market today36. On the other hand, the need for a simpler application and fiscal carefulness have issued from the manifest difficulty in verifying the inaction of the costs in uncountable recording systems of the taxable income. Actually, the peculiarities of capital gains discipline seem to explain themselves –but not only- as alternative instruments compared to wealth tax, to parameter taxation levy on capital gains so as to better appreciate its attitude to contribution, also as for the source of income, i.e., capital per se37.In other words, again, the common roots of this peculiar setting seems to be the need to fix the overall tax burden on capital gains so as to make it comprehensive/replacement compared to an income tax, and thus, to an autonomous taxation on capital.From this viewpoint, the existence within a given tax system of wealth taxes subject to hit capital too, autonomously, can strongly reduce the justification to keep these regimes determining taxable income and/or taxes. As for the principles of rationality and coherence of the overall system, these regimes end up finding procedural justification when it comes to needs for light, simple, and safe taxation, both for the taxpayer and for the financial administration38.

3.1 The income tax on the proceeds coming from capital gains and the examples of possible double objective tax

The analysis of possible cases of double objective tax with reference to capital gains, considering the opportunity/need, in a given income tax system, to include in the concept of taxable income39 negotiation capital gains or closing of juridical relations on the use of

36 LUPI, Gli interessi nell’imposizione diretta, in Diritto pratico tributario 1990, I, 52137 As for the need shown by the discipline to discriminate wealth income tax compared to working source incomes, for what only the former would show as levy capacity, also with reference to the source, see MOSCHETTI, Il principio di capacità contributive, Padua 1972, quoted above.38 From this viewpoint, such regimes could show better resistance compared to the tax systems that consider general wealth taxes, which are legitimate and illegitimate replacement tax systems: since these need the intervention of a third party than the owners of the tax obligation (the so-called tax replacement), are strongly trying to meet needs of easy application for the tax payer, safety and quick levy for the financial administration, only indirectly acting as replacing levy organ compared to an autonomous wealth tax.39 This specification implies that the income connotation of a given situation is the prerequisite for its being subject to income tax. In fact in any tax system the taxable area can be smaller than that of income, and thus there are, or may be relevant income cases not subject to tax. The subject moves on different terms depending on the legislative option for an open or closed tax system. We have a closed tax system every time the tax presupposition is described so as to become nominative and tax determined cases.In the open system the tax presupposition is described referring to a genus-concept whose possible norm specification is non exhaustive.

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capital, carried out outside a business context: the so-called financial surplus values, or capital gains. The problem is framed in the larger problem of the an and the taxable quomodo of wealth surplus values on good not relating to the business. For a long period, there has been much reluctance of the tax system in introducing generalized tax mechanisms40. The choice was explained focusing from time to time, on exceptionality, tendential non-reproducibility, long-term training, or uncertainness and non-intentionality to attain such proceeds41.Under the theoretical viewpoint, at the basis of the choices made for the various systems, there has been a tendency to accept a concept of taxable income of the income-product kind, and not of the income-revenue one. Indeed just the latter, admitting the idea of generalized idea of investment wealth-increase income per se (despite the reason of their attainment42. The other choice tends to exclude the attraction to taxation of wealth increases made outside business, unless attained through operations with clear speculative reasons.Having this theoretical difference in mind helps understand the evolution occurred within tax systems as for the tax of the so-called financial capital gains.The progressive change in the approach to the problem by the Italian lawmaker is important. We are aware of the fact that, for a long time it has been impossible to tax capital gains because they were considered for their uncertainness and the non-intentionality of their attainability. Only in 1997 did capital gains attain outside business were under general tax although through replacing tax systems which were decreasing the fiscal drain relevant to the ordinary systems43. All this after the long evolution that saw the Italian system

40 In many European systems, the taxation of capital gains non coming from enterprises seems to be framed to the hypothesis of their obtainance through speculating operations (Austria, Belgium, Switzerland); in countries where taxation seems to be generalized (Portugal, Spain, France, Sweden, Great Britain) it appears to be mitigated by subjecting income to proportional aliquots lower than average progressive aliquot to which income would be subject if it contributed to the taxable accumulation of the progressive personal tax. In any case, there is a special care dedicated to long-term formation capital gains taxation. In other words, to goods that have no speculative objective (house, inherited property) where there is a deeper extraordinary character, and no clear intention to attain receipts, not to mention the weight of inflation on the real substantiality of enrichment.41 Let’s add the technical difficulty, also and in particular for financial capital gains, to create a tax system that could give fiscal relevance to possible wealth capital losses, not the mentions the simply notional components of capital gains depending on inflation. Please see FALSITTA, Lezioni sulla riforma tributaria, Padua 1972.42 All those wealth increases not due to the subject’s capital lie outside, as not due to the subject’s capital: they depend on phenomena where we see a simple shifting of precedent wealth’s subjective legal ownership, as it happens for gifts or estates. Such phenomena remain income-irrelevant, no matter what their income acceptation is.43 We shall briefly describe the passages that underlined the evolution of the discipline as for the tax of capital gains attained by non-entrepreneurs in the Italian fiscal system.

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gradually shifting from a principle basically oriented to the income-product concept to the concept strongly based upon the idea of income-revenues44.On the other hand, we must remember that the expected generalized tax of financial capital gains can be justified in the light of inside systematic coherence, but it also meets the need to close the system and thus to eliminate phenomena that could entail skipping of taxes. The non-taxability of financial capital gains could play a fundamental role in the building of strongly evasive operations45.

3.2 Should capital gains be considered as capital income (i.e. revenues from the use of capital)?

If in a given tax system similar systematic, anti-evasive needs work for the generalized provision of the taxability of the so-called financial capital gains, we should verify their theoretical refutability among capital incomes.

After the tax reform, the decrees that engendered the IRPEF, IRPEG, and ILOR taxes – in particular the article 76 of the President’s Decree 597/1973- provided for wealth capital gain to be subject to tax compared to subject with no ownership of enterprise income when this was reached through speculations, in other words, meant only for to reach them (FALSITTA, Lezioni sulla riforma tributaria,Padua 1972).Since the financial Administration was in charge of the evidence of the speculative character of the operation, when the tax payer was notified the non tax of the relevant capital gains, the difficult application that was engendered in reference to these provisions carried to the provision –within the above-mentioned article 76- for a series of cases in which speculation was expected ex lege, with consequent automatic taxability of the relevant capital gains. With the advent of the Unique Text of income tax (President’s Decree 917/1986), there was a radical change of the norms. Having eliminated the general taxability provision for isolated speculative capital gains, the tax law-maker, along the line of the shifting to a closed tax system, chose to individuate taxability of taxable wealth capital gains for non-entrepreneurs, describing moreover the cases generating taxable materials in terms that were highlighting their speculative character. Just consider the condition to which the original article 81 letter c of the Unique Text on Income Taxes was subjecting the tax of financial capital gains to non-entrepreneurs. These conditions expected that transferred participations represented a qualified percentage of the share capital; that they had not been acquired through estate or gift; and that between their acquisition and the subsequent transfer for a money consideration, a period not over 5 years had lapsed. Only in the early 90’s did the Italian tax system start moving towards a generalized tax of non-entrepreneurial wealth capital gains, aside from the speculative character of the relevant operation, and thus of the intentionality of their attainment. At first providing for the taxability of capitals gains realized though transfer for a money consideration, or dispossession for public use of building sites. Later on, through the generalized attraction of the taxable areas of the so-called capital gains (article 81 letter c – quinque of the Unique Text).44 On the gradual adjustment of the Italian tax system to a tax regime of income increases according to their objective referability to capital investments, and not because of the speculation of the operation, thus of the intention to attain them, see MICCINESI, Le plusvalenze d’impresa, Milan 1993, chapters 2, 3, and 4.45 Just think of the merging operation without share swap, where the re-evaluation of the goods of the annexed company, due to the use of the merging deficit, entailed a tax skip to the extent that the acquisition by the future incorporating body of the participations of the future annexed company did not involve the emersion of taxable materials for the owners of the transferred participations (see FALSITTA, Studi sulla tassazione delle plusvalenze, Milan 1991, passim; MICCINESI, Le plusvalenze d’impresa, mentioned above, chapter 8).Moreover, in the Italian tax system, the operations of cash against term have long been used evasively in so far as, formally changing the interests on the funding capital into capital gains from crossed negotiations on shares (preferably non-participatory) allowed the tax subtraction.

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Although we cannot compare directly the various tax systems, and as we have to limit our analysis to the Italian system, we can see that the normative allocation of capital gains in the category of miscellaneous incomes, and not in that of income from capital, responds to a logic coherent to the distinction of incomes into categories, according to their different source of income. Indeed, the analysis of the norms in charge of the description of the cases generating proceeds that may be qualified as income from capital, and of the general closing clause recently introduced in the article 41 of the IITC46, makes us believe that at least the Italian law maker meant to define thus the proceeds retrievable from a current or potential, juridically-qualified productive use of the capital. Such use could become, in terms of rigid alternativeness, forms of investment/contribution, i.e., financing47.This said, we believe that the extraneity sanctioned by norms of financial capital gains in reference to capital incomes, finds a justification in their different peculiar productive source. The latter is represented not by the capital used, but by the good-juridical relation (rectius the subjective juridical situation: respectively, the status of member or creditor), which was originated by the use of the capital, and thus is autonomous object of negotiation.In other words, financial capital gains are conceptually far from the area of capital gains as their source is not the capital as an investment, but their subjective juridical position, which is related to such investment, because it is negotiated. We notice then the autonomous relevance in terms of income-relevant sources, which the juridical relation acquires fiscally, when it comes to the expression of the use of capital. This especially when such relation is considered revenue, thus creating a share, a real-estate value, with its own juridical system48.

46 The article 41 letter h provides that “interests and other revenues coming from other relations having the use of capital as object” are to be considered as unearned income, “except when positive or negative differentials can be realized from an uncertain event”.47 There are relevant consequences as for the relevant tax system, coming from one or the other form of capital use. In the first case (use of capital as loan), there is an obligatory kind of juridical relation, as in the debit-credit scheme. The tertiary relation between loan giver and financed subject partly justifies for the former to pay the latter a fee for the use of capital. This fee is generally, but not always, irrelevant to the results coming from the administration of the loaned capital. And partly, it allows the financed subject to consider the cost as real, and not taking part in the deductible result of the administration of goods. In the second case, (use of capital as investment), there is no relation of tertiary/otherness. When the use of capital is done in investment, there is no giving of capital in enjoyment to others, rather, its direct use in a productive activity, also through an intermediate organization to which the lending party takes part, through second-degree goods or participative shares, turning the subject into a member. Thus, the income coming from this alternative use of capital depends in its amount from the result of the administration, but is at the same time made up by the wealth of the organising intermediate structure at the time of its creation, with all the problems that double taxation implies. 48 NUZZO, Il regime fiscale dei titoli di credito, Milan 1988, 30, 85.

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3.3 Possible cases of double income tax coming from the incorporation of profits/interests in the compensations of share assignments

This said, and acknowledged the fact that capital gains and financial capital gains are two different taxable phenomena, we have to admit that the tax attraction of financial capital gains may entail dangers of double tax on capital gains due to their inclusion in the transfer compensation of the relevant shares as the capital gains were accrued but not collected.In other words, every time the receipt from the use of capital that have been accrued but not collected help determining the share negotiation compensation49, and thus change easily from capital gains to financial capital gains50, the tax of the latter can entail two different tax problems:a. on the one hand, a gap in the capital gains tax system in as much as their formal transformation into financial capital gains subjects them to a different levy51 (that of financial capital gains) than the one they would be usually submitted.b. On the other hand, the danger of double tax on said gains every time a suitable device fails to be adopted so as to avoid that the proceeds previously taxed at their collection as compensation of financial capital gains from the transferor, undergo further levy at the time of their real payment by the transferee.As for the first problem, this can be faced under two different viewpoints:a. either conforming the tax systems (especially as for amount of tax burden), respectively reserved to capital gains and to financial capital gains52

b. or, as for the procedure, introducing tax application systems allowing/obliging the setting aside, within the share negotiation compensation, of the part of the share representing the replacement of the capital gains accrues and not yet collected, and to subject it to the capital gains’ tax system53.The second viewpoint is more complex and, as far as we know, less considered. Maybe this is because a real danger of double tax can be seen only (and thus rather rarely) in 49 And more in general, help determining the juridical relation entailed by the use of the capital.50 This occurs in particular day-by-day interests accrued on debenture shares transferred before ex-dividend. Think of use of capital as financing (debenture shares) entailing for the financer a capital credit equal to 100 and 10% annual interests. After 6 months, should the debenture holder negotiate his debenture shares getting 108, the 8 gain accrued would include 5 represented by the day-by-day interest already accrued on the debenture share, and collected as part of the compensation of the negotiation of the share.51 As for the an or of the quantum, and/or the quomodo.52 This is what Italy has tried to do through the decree 461/1997 when, besides levelling the deduction rates (12.5% - 27%) for the different kinds of capital gains, introduced tax system replacing financial capital gains with similar rates (12.5% - 17%). See articles 5, 6, and 7 of the decree November 21, 1997, No.461.53 In the Italian tax system this setting aside is compulsory due to the so-called replacement principle as per the article 6 of the Unique Text: “the receipt obtained as income replacements, even due to the transfer of the relevant credits, (…) become incomes of the same category as the ones they are replacing”. When applying such principle, and as further clarification, the article 82 paragraph 6 of the Unique Text reads that “as for the determination of financial capital gains and losses, from the compensation received, or from the reimbursed amount, (…) accrued but non-collected capital gains different from the revenues, are set aside.”

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reference to shares negotiated by and among non-entrepreneurial subjects. In case of a company, the actual charging to the transferee of the sole day-by-day interest (and, more generally, of capital gains) accrued on the share after its acquisition is granted by the accounting of calculation of interest and rediscount.In principle, it should be evident that for the transferor only the proceeds accrued on the share negotiated after its acquisition are to be considered as capital gains54. Thus, the compensation of amounts representing proceeds accrued before that moment should be like a wealth case, affecting the real value of the share for the calculation of the possible relevant financial capital gains55.

4.1 The problem of the tax treatment of the proceeds causally referring to participation in associations, when the latter are already subject to income tax

Much more complex are the subject double tax problems relating to the tax treatment to be performed on income proceeds coming from the use of capital of the investment-contribution kind. Here the use of the capital starts a participating relation with an association/company structure56.The peculiar phenomenon of partial subjective overlapping between the associated structure (company/association) and its single components (members/associates) due to the tie, in theory admit the possibility of a double tax of the same wealth. First to the association and then to its single components, when these are the final recipients of said wealth57. In this regard, two different argumentations seem to permit the support of a tax discipline that considers a tax levy on two levels. Each has its own peculiar operating area, separated as for the kind of organization is has adopted, and according to the different causal connotation trimming the participating relation of the single subject to the structure itself.

4.2 The possibility that the tax treatment of the proceeds coming from (and for the effect of) participating relations must be separated according to the lucrative and non-lucrative causal of the connotation of the participation bond

54 As that is the moment from which the transferor is the owner of the primary source of the income.55 The article 82, paragraph 6 of the Unique Text seems to adjust to this principle when it says that as for the determination of financial capital gains and losses, (…) from the cost or buying value of the share the accrued, but non-collected capital incomes are set aside.56 See above, note No. 4257 It is plain to see that the idea of taxing the same wealth twice to two different subjects is not in the principles that oversee the individualization of the tax prerequisite. As this prerequisite cannot be met, for the same factual body, for two subjectively different juridical cases. But it s also clear where the theoretical base from which the theory of the double tax of the incomes coming from association comes from. This derives from the peculiar participation link existing between the structure, on the one side, and its single components on the other, so as to allow a partial subjective coincidence between the former and the latter.

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Let’s start from the idea according to which the repartition of the wealth produced as a group among the members occurs within organization structures, the participation to which is not causally justified by the pursuit of lucrative aims of the individual.In this case, the ratio of a possible income double tax seems to be rooted in the substantial connotation of the phenomenon. If the participation in the intermediate organization structure is based, under the causal viewpoint, upon the interest of the individual to operate through the shared intermediate structure for the pursuit of non-economically relevant interest, the transparency of the organizing system as for its single components may only occur in this limited section, and not in the economical one58.It is now clear which path could theoretically justify the hypothesis of double tax of wealth. Firstly, at the moment of its surfacing as intermediate organization structure. Then, for the single member if, and in as much as, it goes back to him. The said justification can be found in the non-inclusion of the income-economical results registered in the association structure, within the incidence of the principle of transparency in relation to its participants.The problem is more of deciding whether, although no economical interest can justify the participating relation started by the individual with the association, the mere existence of such a participation bond is by itself capable of justifying a configuration of wealth previously taxed as income on the organization level, again in terms of income – and not of wealth – to the single member that will be the final recipient. In this section – association bodies with participating bond with non-causally lucrative connotation – the economical lack of ontological identity characterizing the participating relation between the individual and the association, could make one think that income-relevant wealth increases surfaced in association structures, and thus subject to tax levy, can be qualified as income for the single member, just because the latter if qualified to be its final recipient59.This unless these proceeds are assessed as wealth increases attributed to the original capital injection, which saw the start of the participation-association bond, and, under the viewpoint if tax of income-revenues, as wealth financial capital gains coming from invested capital.

58 In other terms, when the cause implying the participation is not lucrative, as the single member wishes to use the organization to pursuit non-economical results and interests, we can see a peculiar connotation of intermediate organization only is, and in as much as, the statement is referring to the non-economical results pursued and obtained.59 As a consequence of the dissolution and liquidation of the association, or interruption discontinuance of the participating relation.

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Actually, as we will see comprehensively later on, the trend of some system (such, for instance, as the Italian one), to pursue this path60 apparently depends on the need to fill the lack of tax related to the absence of an ordinary wealth tax.

4.3 The possibility that the actual problem of subject double imposition of group incomes refers solely to the incomes coming from participations, in reference to associations in which the participation connotes causally for the pursuit of the single members’ lucrative aims

The same can be said when we consider the other hypothesis in which the distribution among members of the wealth, produced on a group structure level, occurs in reference to organizations, in which the participation connotes causally for the pursuit of the single members’ lucrative aims.In this case, through the participation started with the intermediate organization, the single member invests and bonds a part of his wealth to the performance of a productive activity so as to reach income results – sub species of incomes – coming from that activity61.Thus, if the association sets itself up as organization, and in their participation in it the single members carry out an activity producing results in terms of incomes or losses, a substantial transparency of the structure in reference to its participants becomes possible, also, and in particular, in reference to the economical-income results achieved by the structure62.This said, in a similar context, the perspective of a double taxation of the produced richness, fist to the company, then to the single participants, would only be serious when double taxation is meant as a means to diversify, and compound, the taxation levy relevant to company income/participation profit compared to others, amounts being equal.

4.4 Possible justifications of double income tax on company revenues

The Italian system has traveled along this path, after the tributary reform of the 1970s to explain the relation – in terms subjectively alternative, but objectively cumulative –

60 This emerges from the article 44, paragraph 3 of the Unique Text, according to which the amounts or the normal value of the good received from other members in case of discontinuance (…) or liquidation, even exam liquidation, of the companies or bodies, are to be considered as income for the part exceeding the paid price to buy or underwrite shares or cancelled dues.61 If we wish to compare the previously examined situation, we can state that the participating deal to the association takes its justification on the cause of the single member’s interest in operating through the organization, so as to reach economically relevant results.62 In other words, the wealth increases registered in associations (companies), as they are physiologically and causally destined to the single members, the latter become chargeable as possessors, although through the structure they are participating in.

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between the IRPEG and IRPEF taxes on the incomes produced in associations: the norm selection returned in the instrument area to carry out the quality discrimination of the incomes63. In particular, the Italian system was justifying the original double tax on the basis of a (stated) autonomous contribution ability of companies: the larger possibility to resort to the credit and the advantage of the limited wealth responsibility tried to show a possible privileged position for the performance of a given activity in favor of those who had decided to carry it out not as individuals, but through an organization: this was the argument they used to justify a larger tax on the income that they attained. The other theory that could justify the double tax of the incomes produced through associations should come from the substantial area, and focus on a basically different interpretation of the use of participation capital, highlighting the typical productive investment function, more than the participating one.This is likely to be the path followed by those tax systems, as in the US, Switzerland, Denmark, Sweden, and Austria, where double taxation of company profits, is not admitted for partnerships, as it is when it comes to capital companies. In other terms, the gap between the administration-managing company structure and the members found in corporations, especially when these are in the stock exchange list, it becomes seriously defensible to consider the acquisition of participating shares as a simple capital investment form, and thus, the dividends as proceeds from the use of capital per se, with no consideration of their identification with company income.Similar remarks are likely to be at the basis of the optional system that the Italian lawmaker has recently introduced for the tax of the proceeds paid to individuals as per non-qualified participations, and lying in their subjection to a deduction-at-source tax of 12.5%. The latter adds up to the IRPEG tax already paid by the company on the divided revenues.Moreover, when these justifications to double tax do not seem seriously defensible, and thus it is believed that acquiring incomes through the participation in an association/company structure is not the index to an autonomous and/or peculiar capacity to contribute shown by the single receiver, a different need arises. That of acquiring tax systems that may grant that the income produced by the association undergoes a non-discriminating levy compared to what happens to income, which –despite the associative production modalities- show the same ontological shape. This implies norms that deny from the start the perspective of association incomes subject to a tax system set out on two subject levies, one in cumulative relation to the other.

63 It was believed that the IRPEG tax was the right instrument to affect the larger contribution ability of the incomes produced by (and through) companies.

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The problem is solved in singling out the subject of the charge of tax levy, between two potential receivers of the income debit subjectivity: it must be decided whether the receiver should be the organized structure, or its single members.

4.5 Solutions to eliminate/decrease double tax on company revenues

With respect to the tax subjective criteria of tax obligation, choosing one normative or the other proves basically irrelevant.Once the subjective interrelation between associations considered as a unit, and the collectivity of its participants, is clear, it becomes natural to state the equality between the solution of performing the levy at the medial structure’s level, or per share to the single members, for a correct subjective tax.Conversely, choosing one or the other is not the same when it comes to assessing the norm in reference to the implications linked to the personal/progressive shape we want to give to the overall system.In particular, when the tax that poses the problem of taxing the income attained through an association is of the real kind, and with proportional rate, the choice of the receiver of the tax obligation does not make a difference under the subjective point of view. The choice depends on considerations that respond to needs of simple application and safeguarding of state interests as per the exact and prompt collection of the taxes64.The matter is different when the tax system is so that the wealth produced by the association flows back (or is potentially supposed to flow back) to a subjective juridical sphere subject to a tax levy of personal or progressive kind65.In such a tax system, the lawmaker may in principle wish for the proceeds (profits) coming from the use of capital of participation/association kind (contributions) to be subject to a tax mechanism that makes the incomes subject to a tax levy in respect of the institutions in charge of the levy’s personality, and in the amount resulting from the application of the progressive rates of the single member.Thus, there is a need to shift the level of the tax incidence on the single member and a consequent need to clarify the association.This result is usually achieved through two separate technical-normative mechanisms, one alternate to the other:

64 Under this viewpoint it seems preferable to opt for the assessment and the unitary income tax towards the association, with consequent exclusion of the same income from the tax, as for the single members. Stemming the tax to the medial structure instead of parcelling it out to the single members is on the one hand easier for the financial administration to ascertain and collect, and on the other hand lees complicated for the taxpayer.65 This is what happens in almost all the systems in Europe, Italy included. Here the income charged on individuals is subject to a tax (IRPEF) with clear characteristics of personality and progressiveness.

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a. skipping the company’s screen through a direct charge and income tax, obtained at the level of the association/company structure, upon the single participants and according to the degree of their participation. This solution was adopted in Italy for the tax of the incomes produced by partnerships and bodies equalized by law.b. subjecting the income to tax, first to the association and then to the members, but so as the income tax for the medial structure becomes a mere advance to the tax due by the single member. This is the so-called charge criterion, implemented in Italy66 with reference to the tax of the proceeds coming from the use of capital as participation to corporations and trading bodies, through the acknowledgement of the credit of the IRPEG tax on the single participants.Both mechanisms present obvious limitations in their application: by its nature, the first one is unsuitable to be implemented outside its natural subjective context, that of a partnership67. The second mechanism is rather complicated in its functioning and presents some structural drawbacks, the most evident of which is that of causing a physiological uncertainty of the IRPEG tax levy.Thus, a relevant number of European countries68 have biased the tax exemption system to that of the tax credit. The former is set up from a real, non personal approach to the problem of dividend tax, thus is it concocted so that the ordinary income tax to the company is coupled by an additional tax, usually a partial one, on the dividends collected by the individuals outside the company. Thus, the overall tax burden coming from the two cumulative levies becomes a substitution of the tax that the dividends would have undergone, had they been produced personally by the single receivers, without the company’s intermediation, thus deducting the different progressive rates.

66 But also in Spain and Great Britain.67 This is indirectly confirmed by the fact that the Tremonti bill for the fiscal reformation considers the possibility for corporations to choose the system of fiscal transparency typical of partnerships, but only as participants in the company, which must be a corporation with participations, not lower than 10% in the capital. In this case the principle of transparency is exploiting the famous phenomenon of fiscal impartiality of the inter-company distribution of revenues.68 Such as the Netherlands, Belgium, Luxembourg, and recently, Germany, France and Portugal.

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PART I

CHAPTER 4 Fixed Amount Taxation with respect to Income from Capital in Personal Income Taxation

Henk van Arendonk

1. Introduction

In the course of the years, personal income tax has developed into a tax to be levied on the actual income of natural persons in one calendar year. The question of what counts as income can best be approached from the point of view of net accretion theory (Haig-Simons-Schanz-concept of income). If, however, we look at the way in which personal income tax is given shape in different countries, we generally find a very pragmatic approach. It turns out that in establishing fiscal legislation, many social forces play a role in the final decision-making process. Nevertheless, it is recognised that personal income tax is a levy according to ability to pay, the criterion for which is the socially determined notion of income. It is important to realise that, although this socially determined notion of income is unlikely to correspond with the theoretically correct notion of income, it is, under the circumstances, the most practicable approach. In other words, the notion of income will always be susceptible to social change and will, in actual practice, prove to be a dynamic concept. General principles of justice, such as the principle of equality before the law, play a specific role in shaping the notion of income. The intention of the legislator should, after all, be to treat similar cases equally and to treat dissimilar cases in proportion to the degree of inequality. A levying of taxes which clearly violates this principle runs counter to the ideal of justice and runs the risk of not being accepted by society. The ideal of justice makes certain demands on a system of personal income tax, partly because a failure to do so would diminish the taxpayers’ compliance needed for a proper levying of taxes. On the other hand, we also know that taxation must be practicable; practicable for the taxpayer as well as for the tax authorities. Practicability also makes demands on the way personal income tax is given shape. The practicability aspect is also susceptible to change over time. Due to present-day modern technology, such as computerisation, digitalisation and the Internet, the way personal income taxation is implemented differs drastically from what would have been thought possible only a few decades ago. Both in the past and in the

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present there will always be a certain tension between justice and practicability in the levying of personal income tax. In this area of tension, the phenomenon of fixed amount schemes (or flat-rate schemes) plays its own role. After a description of the theoretical framework of personal income taxation, some examples will be discussed of fixed amount schemes with respect to income from capital taken from the Dutch personal income tax system. In Section 4 a characterisation will be given of the various fixed amount schemes. Subsequently, Section 5 will address the place of these schemes in the theoretical framework. The conclusion will consist of a list of relevant questions.

2. Theoretical framework

Point of departure in the levying of personal income tax is the income actually earned in one calendar year. What is at issue is economic gain, which in many countries is determined on the basis of a source theory. Only to the extent to which economic gain results from legally specified sources of income, does it count as taxable income. It is common practice to tax net income; that is to say, deducting the costs incurred in acquiring benefits from a particular source can reduce gross income. Here, too, we are dealing with costs that have actually been incurred.

By starting from the actually realised income and actually incurred costs, a realistic basis is created for determining a person’s ability to pay. In this way the equality principle is being adhered to.

Inconsistent with this starting point is the introduction of fixed amount schemes. In the case of a fixed amount scheme, fixed norms are regulated by law for similar cases, or rather for minimally differing figures. Fixed amount schemes should not be confused with legally regulated fictions. In the case of fictions, situations that would normally not come within the legal norm are nevertheless categorised as falling under that norm by legal definition. Examples are fictitious employment and fictitious inheritances in the inheritance tax.

The legislator can introduce fixed amount schemes for different reasons:a. without fixed amounts, implementation of the scheme may be too complicated for

the tax authoritiesb. simplification for the taxpayersc. to reduce taxpayers’ problems with burden of proof

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d. to diminish the burden of inspection for the tax authoritiese. for the tax authorities to gain advantage from computerisationf. to reduce the number of areas sensitive to dispute.

Fixed amount schemes are introduced to reduce the number of implementation problems encountered by the tax authorities. When a certain scheme applies to many taxpayers and if it turns out that, in actual practice, unsolvable disputes keep arising between the taxpayer and the tax authorities about parts of that scheme, a fixed amount scheme can be the answer; in particular when the scale of financial interests at stake is taken into consideration. A cost-benefit analysis can also be a reason for the tax authorities to adopt a fixed amount scheme. In addition, introduction of a fixed amount scheme is worth consideration if the costs of implementation of a scheme is a heavy burden on the taxpayer. When large numbers of taxpayers are burdened with a certain administration, such as the collecting and saving of bills, a fixed amount scheme can be used to alleviate this administrative burden for the taxpayer.

In recent years, the processes of tax levying and collecting have become been more and more computerised. As a result, schemes need to be designed in such a way as to allow for computerisation and, if possible, to reduce the cost of computerisation.

The question is, however, how far a legislator can go in the application of fixed amount schemes. Are there limits and, if so, what are these limits?In itself every fixed amount scheme forms a violation of the basic principles of income taxation; this does not, however, mean that a fixed amount scheme should always be considered unacceptable. The limit of acceptable application is formed by the equality principle as general principle of justice.In other words, taxation through fixed amount schemes becomes unacceptable when the gap between such taxation and reality becomes so big that the equality principle is violated. Normally, the equality principle is taken to mean that similar cases require equal treatment, but in particular that dissimilar cases must be treated unequally in proportion to the degree of inequality. A fixed amount scheme, however, is characterised by the fact that all non-equal cases are given equal treatment. This, too, can be considered a case of disproportionateness. When sufficient justification for such a situation seems to be lacking, a fixed amount scheme must be regarded as being in conflict with a just personal income tax system (see also Section 5). Justification of the use of a fixed amount scheme should be assessed not only in terms of the practicability of the scheme, but also in terms of whether

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the scheme allows for the realisation of the intended purpose and of whether the scheme is proportionate. In Section 5 these criteria will be applied to the tax on imputed return on investment effective from 1 January 2001. 3. The practice of fixed amount schemes

In this section I will briefly describe a number of fixed amount schemes. Guiding principle will be the situation in the Netherlands. The personal income tax legislation of other EU member states will probably include similar schemes. It is, however, also possible that such fixed amount schemes as employed in the Netherlands cannot be found in other member states or that these states use completely different fixed amount schemes.

3.1 Notional rental value for owner-occupiers

Unlike in some EU countries, in the Netherlands the proceeds of home ownership are still regarded by the legislator as an income. In this section we will not address the question of whether in a system based either on source theory or on the net accretion theory home ownership should lead to income. For a discussion of this topic the reader is referred to Chapter 1. Originally, personal income tax was imposed on the rental value of the owner-occupied dwelling, i.e. the annual rent which could have been got for the property had it been let to a third party. From this gross rental value were deducted the costs and expenditure, as in the case of the rental value of rented immovable property. In actual practice implementation of this scheme proved to be very difficult. Apart from establishing the gross rental value, the distinction between costs of maintenance and costs of improvement was hard to make. Due to implementation problems, 1971 saw the introduction in the Netherlands of a system based entirely on fixed amounts. One of the schemes introduced was the so-called netto-huurwaardeforfait (the net notional rental value), whereby fixed amounts were used both in the assessment of the rental value and in the deductible expenses. There are a number of exceptions to this general application of fixed amount schemes. The most important of these is that interest actually paid on loans used to finance the owner-occupied home is tax deductible. As from 2001 deduction of interest is possible only for loans used for the purchase of a house or for maintenance and improvement. After thirty years the interest on such loans is no longer deductible from the

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imputed net notional rental value of owner-occupied dwellings. Nor is it allowed to deduct the costs incurred in taking out such loans. Ground rents, finally, are deductible.

3.2 Bare ownership/usufruct situations

In the 1980s, it became increasingly common to make use of bare ownership/usufruct situations, for instance with regard to obligations and later also with regard to moveable and immoveable goods. The bare owner was always a natural person and a natural person/legal person, for whom the usufruct was a capital asset in an enterprise, enjoyed the usufruct. In a system of taxing only income from capital, the development from bare ownership into full ownership could not be taxed on the basis of personal income tax. The Supreme Court confirmed this in several judgements. On the other hand, the entrepreneur enjoying the usufruct could be taxed for the benefits on the basis of operating profit; at the same time, deduction was allowed for the depreciation of the right of usufruct.The legislator qualified these constructions as improper use. Consequently, amending regulations were introduced in 1990 and 1995, as a result of which the bare owner/natural person became liable for tax for the appreciation from bare ownership to full ownership. The appreciation was assessed through a system of fixed amounts. In those cases where bare ownership concerned property rights, such as obligations and shares, during the validity of the right of bare ownership, 4.8% of the economic value of the asset was annually added to the income of the bare owner, without taking into consideration the expenditure of the right of usufruct. This fixed amount taxation of return was only applied in the case of temporary right of bare ownership. Later a provision for evidence in rebuttal was added. If the taxpayer could demonstrate that the fixed amount added was considerably higher than the actual benefit, the amount added could be reduced to the actual benefit. The criterion ‘considerably higher’ (at least 30%) was considered necessary to restrict the implementation problems.In the case of bare ownership constructions involving moveable and immoveable goods, taxation of return was not based on a system of fixed amounts. The value of the right of bare ownership and the value of the full ownership was assessed at the moment the right of bare ownership was created. The difference between the two values was then imputed over the years during which the temporary right of possession was to apply. In other words, it was assumed that the benefits would be gained from day to day. For reasons of simplicity, tax was imputed on a linear basis.Both these schemes to combat improper use were abolished with the introduction in 2001 of the fixed amount tax on imputed return on investment (vermogensrendementsheffing).

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3.3. Income foreign investment companies

The Corporation Tax Act 1969 (Wet op de vennootschapsbelasting 1969) includes a special scheme for domestic investment companies. As soon as a domestic investment company meets the conditions of this scheme for investment institutions, a zero-rate applies in corporate tax. One important condition is that within eight months after the end of the calendar year the results available for dividend must have been distributed to the shareholders. With a year’s delay, therefore, the profits from investment can be taxed at the level of the shareholders.If, on the other hand, the shareholders were to invest in investment companies based abroad the scheme for fiscal investment institutions does not apply. When the foreign investment company does not pay any dividend, no tax can be levied with the shareholders/natural persons. Since under the Personal Income Tax Act 1964 (Wet IB 1964) capital gains were not taxed, shareholders in a foreign investment company could not be taxed at all for return on investment. This would mean that investment in domestic investment companies would no longer be attractive. For this reason, the Investment Tax Act 1964 provided that taxpayers investing in foreign investment companies were to add annually 4.8% or 6% (depending on the kind of investment) of the value of the shares at the beginning of the calendar year to the income from capital. When the results of the foreign investment company could be shown to be lower, a lower percentage could be applied.In the Personal Income Tax Act 2001 (Wet inkomstenbelasting 2001) taxation of income from capital has been changed into the tax on imputed return on investment (see below). Since the imputed return is now fixed at 4% of the average value of the shares, including those of foreign investment companies, a separate provision for investors in foreign investment companies is no longer needed. This, however, only holds for investors taxed in box III. Substantial shareholders are taxed in box II. They are taxed on the one hand for regular proceeds and on the other for proceeds from disposal. Regular proceeds include distribution of dividends; proceeds from disposal include capital gains from the disposal of shares by a substantial shareholder.When a substantial shareholder holds shares in a domestic investment company the unquoted investment company cannot opt for application of fiscal investment institutions. Consequently, there is an obligation to distribute dividends. Substantial shareholders who invest in a foreign investment company are, however, annually taxed for 4% of the value of the shares at the beginning of the calendar year. Subsequently, the fixed rate of profit is added to the acquisition price of the shares; if not, disposal of the shares at a later stage might lead to double taxation.

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The fixed profit scheme for foreign investment companies no longer includes a provision for evidence in rebuttal. Instead, the scheme provides that if the foreign investment company is subject to a tax according to profit or income that is reasonable by Dutch standards, addition of the fixed amount does not take place. Recently, the Supreme Court of the Netherlands judged in a legal procedure that the 10% tax levy of an Irish concern finance company should be regarded as reasonable according to Dutch standards. This means that in the case of investment in investment companies based in one of the EU member states the fixed amount scheme will hardly ever apply. 3.4. Fixed amount return for saving and investing

Under the Personal Income Tax Act 1964, income from capital was taxed according to the progressive rate, while capital gains were not taxed. In the 1990s particularly, this led to an increase in the number of investment products, which made it possible for the investor/natural person to earn tax-exempt capital gains. As a result, the need to change the system became more and more urgent. The question, however, was how to solve this problem. A number of countries have solved the problem by applying a capital gains tax. In a 1998 report by the Dutch Association for Tax Research (Vereniging voor Belastingwetenschap) a system was designed in which capital gains tax formed part of personal income tax. Politicians in the Netherlands were, however, averse to introducing a capital gains tax.The alternative proposed by the government was a fixed rate tax on imputed return on investment. Every year investors are supposed to have earned 4% of the average capital at the beginning and the end of a calendar year. Imputed return on investment is assessed on the basis of all property and debts not included in box I or box II. Instead of income from capital, it is now the capital that needs to be assessed every year. When the assessed imputed return is negative it will be set at zero. As a result, there will be no debt settlement in box III. During the parliamentary proceedings attention was paid to the possibility of evidence in rebuttal. If, in a particular year, a taxpayer were to realise a lower return on his capital, the 4% ought to be reduced. However, the government successfully defended the 4% without evidence in rebuttal by arguing that we were dealing here with a long-term average of both profits from investment and capital gains. Immediately following the introduction of this fixed rate tax, the value of investments in shares fell sharply. For many investors the years 2001 and 2002 yielded a negative return. Nevertheless, the annual basis for taxation is a fixed rate of return of 4%. This 4% fixed rate of return is taxed for 30%, resulting in a tax burden on capital of 1.2%. Even if the

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investor has realised a negative return, this tax burden of 1.2% will have to be paid, leading, on balance, to an even more negative picture.

4. Kinds of fixed amount schemes

Fixed amount schemes can take various forms. We can distinguish the following kinds of fixed amount schemes:

A. Fixed amount schemes without possibility of evidence in rebuttal

When a taxpayer meets the conditions for application of the fixed amount scheme, the scheme will have to be applied without any further consideration of personal circumstances. An example is the fixed rate tax on imputed return on investment introduced in 2001. If a taxpayer has any assets that must be classified as assets on the basis of which imputed return on is assessed, the taxpayer has to apply the fixed rate of return of 4%. The possibility of evidence in rebuttal proposed during the parliamentary proceedings was rejected by the legislator as being inconsistent with the nature of this scheme. The 4% fixed rate of return is regarded by the legislator as a return on capital to be realised in the long term. In that case, it would be inconsistent to allow, on a yearly basis, for exceptions in individual cases, should the taxpayer have realised a lower return. Conversely, realisation of a higher return should, in that case, lead to an upward adjustment. Granting the possibility of evidence in rebuttal would, therefore, undo the effect of the fixed rate scheme.

The fixed amount scheme for owner-occupiers does not allow for evidence in rebuttal either. If a house meets the legal conditions for an owner-occupied dwelling, the fixed amount is applicable. Since the introduction of the Act on the assessment of immoveable goods as part of the fixed amount scheme for home-occupiers (Wet waardering onroerende zaken in het kader van het eigenwoningforfait), it is no longer possible to discuss the value of the owner-occupied dwelling with the tax authorities. Every owner-occupier receives from the council an assessment of immoveable property. If the owner-occupier disagrees with the assessed value, he should immediately on receipt of the assessment object to or, eventually, bring an appeal against this assessment. As soon as the value assessment is made final, the assessed value also serves as the basis for the calculation of the fixed amount of imputed income from the owner-occupied dwelling in personal income tax for a period of four years.

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Likewise, evidence in rebuttal was excluded in the situation of temporary bare ownership constructions with regard to moveable and immoveable goods.

B. Fixed amount schemes allowing evidence in rebuttal

The fixed amount income from foreign investment companies applied under the Personal Income Tax Act 1964 did allow for evidence in rebuttal. On the basis of the annual accounts of the foreign investment company in question, the taxpayer had to show that the dividend paid by the foreign investment company was lower than the 4% fixed rate of return. In practice, these foreign investment companies would discuss this matter with the tax authorities, which would subsequently set out in a ruling listing the foreign investment companies for which a lower return for the income tax declaration of that year was applicable. For investors this provision was replaced in 2001 by the fixed rate of return of box III, for which there is no possibility of evidence in rebuttal. The provision as such has been maintained for substantial shareholders. The possibility of evidence in rebuttal mentioned above, however, has been removed. This is due to the structure of the provision for substantial shareholding. The annual tax on the 4% fixed rate of return is, in a sense, an advance levy on the tax imposed later in the event the shares are sold. By annually increasing the acquisition price of the shares that constitute a substantial interest with the taxable benefit, double taxation will be prevented. This means that there is no need to assess on a yearly basis exactly what the benefits to be distributed could have been.

C. Appropriateness of a fixed amount scheme

The legislator can opt for introduction of a fixed amount scheme as an alternative to other statutory regulations. No examples of this can be found within the framework of income from capital. In other areas of income tax in the Netherlands, however, such fixed amount schemes do occur, such as the deduction for a cooperating spouse in one’s enterprise (meewerkaftrek). One possibility is to opt for a realistic income for the assisting partner. There are, however, other possibilities. Thus it is possible for man and wife to enter into a partnership, in which case the assisting partner can become an entrepreneur; alternatively, married partners can choose to form a private company with limited liability, in which case the assisting partner enters into an employment contract with the company.

For the taxpayer, introduction of a fixed amount scheme can be attractive because of the simplicity of such scheme. This will particularly be the case in those situations where

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alternative schemes may lead to difficulties concerning evidence. If the parties opt for a system based on realistic income, it needs to be demonstrated that the income agreed on is commercially sound. This can easily lead to considerable disagreement with the tax authorities.

Another example is the old age reserve for entrepreneurs (oudedagsreserve). Taxpayers can opt for application of this scheme on a yearly basis. Alternatively, taxpayers can opt for annuity insurance. Under the Personal Income Tax Act 2001 it is possible for taxpayers to deduct the annuity premium from their income in box I, as part of the maximum annual tax allowance. This alternative requires the taxpayer/entrepreneur to deposit the annuity premium with an insurance company. If, on the other hand, the taxpayer opts for the old age reserve, he can continue to use the reserved amount for business purposes.

In the case of employee stock-option schemes the legislator provides a fixed amount scheme for the assessment of the expected value of the options issued. The employee can apply this scheme the moment the options have become unconditional. Originally, the scheme was set up in such a way that at that moment the employee was obliged to apply the fixed amount valuation. Some [years] ago the employee was given a choice. Nowadays he can choose to defer taxation until the moment he exercises his option, in which case the actually realised benefits are taxed as income (cash flow method). As long as application of the fixed amount scheme was the only option, taxation took place before any benefits had been realised. The tax on wages or income owed could usually be borrowed from the employer. If, however, during the period of the option, the option turned out to be worthless, the employer was left with a debt – a common situation in recent years. By offering the possibility of taxation at the moment the option is exercised, not only can taxation be assessed on the basis of the benefits realised, but also in addition the employee can pay the income tax owed out of these benefits. This approach is more in line with the principle of pay-as-you-earn underlying the system of income taxation.

D. Fixed amount scheme applicable to certain extent only

Normally, fixed amount schemes are applicable if the facts and circumstances specified by law are met. As a result, the fixed amount as a whole will be applied. It is, however, possible for a fixed amount scheme to be designed in such a way that it is possible to fall back on the real situation in case certain limits are exceeded. An example is the former deemed income from capital at a fixed rate of return in the case of temporary bare ownership constructions. When a taxpayer could demonstrate that the

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fixed rate of return of 4.8% was considerably higher than the actually realised benefits, he was allowed to add the actual return to the income. What we are dealing with, in other words, is a provision for evidence in rebuttal, but one with clear restrictions: addition of actual benefits was allowed only if the difference between the fixed and the actual return amounted to at least 30%.

5. Fixed amount schemes and the theoretical framework

Until 2001 Dutch personal income tax only provided fixed rate taxation in a number of specific areas. This changed radically with the introduction of the Personal Income Tax Act 2001. The system of taxation of actually realised income from capital combined with a wealth tax which had been applied for decades was replaced by a fixed rate tax on imputed return on investment, while at the same time wealth tax was abolished. The fixed amount scheme for owner-occupiers has, however, been maintained, and is applied in box I. Placing the owner-occupied dwelling in box III would have meant that for many taxpayers the tax benefit of the mortgage interest would have been considerably smaller. Because of the possible social unrest this would have caused, it was decided to keep the owner-occupied dwelling in box I.

Why this radical change of system?

During the 1990s it came increasingly clear that a system of tax on income of capital only, not linked to a capital gains tax, led to gross inadequacies, and in some cases to leaks in the system of taxation. More and more financial constructions were created for investors, the main purpose of which was for the investor to be able to realise tax-exempt capital gains. Taxation of income from capital increasingly became an illusion. At the same time, these constructions violated the nature of personal income tax as a system of taxation according to the ability to pay.

Personal income tax therefore needed to be adapted. The question was in which direction?

The least far-reaching solution would have been to amend taxation of income from capital in such a way as to remove the worst loopholes. However, given the experiences of the 1980s, the legislator understood quite well that each amendment would only lead to new constructions, and that such an ad-hoc policy would merely result in patchwork legislation. A more radical solution could have been the introduction of a dual system of personal income tax, as introduced in the Scandinavian countries in the early 1990s. A substantial

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element of such dual personal income tax is the levying of a capital gains tax. However, since the introduction of the Personal Income Tax Act 1964, introducing a capital gains tax has never been politically feasible in the Netherlands. The solution eventually opted for was the fixed rate tax on imputed return on investment.

The reasons for choosing this particular system were the following:

- The evasion of taxation on income from capital had to be stopped. The legislator expected to be able to achieve this by means of a tax on imputed return on investment, which would make all kinds of investment constructions aimed at capital gain pointless. For the tax authorities the question of how the investor invests his capital is no longer of interest: all that matters is that the basis for the calculation of the imputed return of capital is correct. The only way to evade taxation is to transfer capital to a tax haven with which no exchange of information takes place.

- Previously, a legal approach was taken to benefits from capital. This, however, resulted in many inadequacies in the system. A more economic approach was considered preferable. What needs to be taxed is, in fact, the earning capacity of the capital. The legislator believes that the 4% fixed rate of return comes close to this earning capacity, whereby the 4% fixed rate is to be regarded as a long-term average. In the context of pension schemes, too, the 4% rate was often used in practice as an approximation of actual return. What is interesting is that in the period between 1892 and 1914, under the Wealth Tax Act 1892 (Wet op de vermogensbelasting 1892), the Netherlands already used the 4% fixed rate of return as the basis for taxation of income from capital. The only difference was that at the time the tax rate was considerably lower than nowadays. The 4% return not only aims at taxing the fruits of the capital but also pretends to reflect the changes in value of the assets.

- In view of the period before 2001, the legislator believed a system of tax on imputed return on investment to be more consistent with the nature of personal income tax as taxation according to the ability to pay. In this system every property owner having property in box III would be taxed on a yearly basis, irrespective of any actual income from that property. This means that wealthy people do not escape this annual taxation, the result being – in the legislator’s eyes - a fairer distribution of tax according to ability to pay. To help small investors, the system

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of tax on imputed return on investment further allows a fixed part of the capital to remain exempt from taxes.

- The Dutch legislator has looked closely at the systems of taxing capital used in other countries. In the course of the years, several countries had reduced the burden of taxation. In many cases this was achieved through the introduction of analytical forms of taxation, whereby income from capital was rated (considerably) lower than earned income (including in particular operating profit and income from employment). Starting from a fixed rate of return of 4%, and taxing this return at a lower proportional rate of 30% (box I has a progressive rating structure with a top rate of 52%), a tax burden of 1.2% was created, which was also more in line with tax rates in other countries. The Dutch authorities assumed that because of the higher mobility of capital such a reduction in the tax burden was desirable in order to prevent a flight of capital to other countries. In addition, the European developments with regard to the directive on the savings interest were borne in mind. What we find there, however, is source taxation on the one hand and exchange of information on the other. In the latter case, we are dealing with information concerning the interest on savings balances, not with information concerning the capital assets themselves. Nevertheless, the Dutch legislator believes that in future the Dutch system could serve as an example for other countries and that these countries, in a few years’ time, will be willing to adopt a similar system.

- The Dutch legislator wanted to introduce a box structure, i.e. an analytical system for income tax. In such a system every box is given its own assessment basis and its own rating structure, while the different boxes are divided by strict partitions. In transferring assets from one box to the other, a fiscal balancing of accounts is always required. The purpose of this system is to prevent erosion of the assessment basis by certain constructions. Previously, taxpayers would often contract considerable loans, which were not counterbalanced by taxable benefits. The costs of interest were subsequently deducted from operating profit or income from employment. By using strict partitions between the boxes, such constructions can no longer yield the desired tax benefits.

The way tax on imputed return on investment works (‘box III’).

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As pointed out before, each year the average is taken of the capital at the beginning and the end of the year, whereby capital is the balance of assets and liabilities. When assets and liabilities have already been allocated to box I or box II, these assets and liabilities shall no longer serve as an assessment basis for imputed return on investment. Liabilities such as personal/consumptive loans can also be deducted from the assets. When in a particular year the liabilities are higher than the assets, the assessment basis for imputed return on investment is set at zero. In other words, a negative basis, which could then be deducted from the basis of either previous or subsequent years, is not allowed. The purpose of the system is to tax the earning capacity of the assets, whereby is made use of a fixed rate of return rather than of the actual returns. An annual assessment however, that does not take into account a system of settlement of losses leads to arbitrary and unfair results. This is also true for the system of a fixed rate tax on imputed return on investment.

The income from savings and investment is subsequently set at 4% of the calculated basis for imputed return on investment. By applying a proportional tax rate and by allowing a tax-free amount we end up with a Bentham rate structure. But because the tax base is a fixed rate of return of 4%, higher actual returns are not taxed. The result is a degressive effective tax rate!

The tax burden as percentage of the gross return will then be as follows:

Gross return Box III taxation Tax burden2% 1.2 60%4% 1.2 30%6% 1.2 20%8% 1.2 15%10% 1.2 12%12% 1.2 10%14% 1.2 9%16% 1.2 8%18% 1.2 7%20% 1.2 6%

The higher the return, the more eager the taxpayer will be to have the asset allocated to the assessment basis for imputed return on investment. Conversely, in the case of debts taxpayers will prefer allocation to box I, since it is there that, due to the progressive rate of

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taxation, the advantage gained will be highest. Based on the maximum tax rates, the tax savings for the different interest levels are as follows.Tax savings expressed as a percentage of the debt:

Level of interest Box I (52%) Box II (25%) Box III (30%) 2% 1.04% 0.5% 1.2%4% 2.08% 1.0% 1.2%6% 3.12% 1.5% 1.2%8% 4.16% 2.0% 1.2%10% 5.20% 2.5% 1.2%12% 6.24% 3.0% 1.2%14% 7.28% 3.5% 1.2%16% 8.32% 4.0% 1.2%18% 9.36% 4.5% 1.2%20% 10.40% 5.0% 1.2%When the savings on tax are expressed as a percentage of the interest, the result is as follows:

Level of interest Box I Box II Box III2% 52% 25% 60%4% 52% 25% 30%6% 52% 25% 20%8% 52% 25% 15%10% 52% 25% 12%12% 52% 25% 10% 14% 52% 25% 9%16% 52% 25% 8%18% 52% 25% 7%20% 52% 25% 6%

The preceding shows that placing debts in boxes I or II, respectively, rather than in box III soon leads to advantage. The tax authorities therefore have to remain attentive and make sure that in the case of debts allocation is carried out properly.

The law contains an anti-evasion measure to prevent ‘box shopping’. When around the date of reference a taxpayer transfers assets from box III to boxes I or II, and if these assets are moved back again within three months’ time, this will be regarded as an attempt at tax

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evasion. The assets in question will then still in their entirety be included in the assessment basis for imputed return on investment. When during this period these assets have yielded a profit, these profits will be taxed in either box I or box II. When the transfer of assets takes place within a period of six rather than three months, the taxpayer is given the opportunity to prove that the transfer was based on business considerations.

The system of tax on imputed return on investment can only be qualified as fixed amount taxation. There is no fiction involved. The purpose of the system is not to depart from the actual economic return, but from a fixed rate return instead. So, it is not the case that fictitious assets have been added to the assessment basis for imputed return on investment to realise a certain broadening of the basis.

Section 2, on the theoretical framework, presented a list of possible reasons for the legislator to introduce this fixed amount scheme.

a. without fixed amounts, implementation of the scheme may be too complicated for the tax authorities

In the period before 2001, it turned out that the tax authorities had big problems implementing the statutory regulations regarding income from capital. These problems became even bigger when over the years a large number tax-friendly investment constructions became available. The tax authorities had to judge whether these constructions were acceptable within the statutory regulations in force, or whether action needed to be taken against the use of these constructions, for instance on the basis of fraus legis.

b. simplification for the taxpayers

Previously, taxpayers had to calculate their income from capital every year. That was not always easy, even though, by issuing annual statements, banks provided information about income from interest and dividends. Now, every year the taxpayer has to keep the value of his assets and liabilities up to date by means of a capital administration.To a certain extent, the system does simplify matters for the taxpayer. The box structure, on the other hand, does not make things simpler. The allocation of assets to the boxes and the choices this involves, often with far-reaching consequences in the long term, cause insurmountable problems, with the risk of fiscally incorrect outcomes, for many taxpayers.

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On balance, one may therefore doubt the net advantage of the simplified system for the taxpayer.

c. to reduce taxpayers’ problems with burden of proof

As such, the fixed rate tax on imputed return on investment has not been introduced to reduce the problems taxpayers may experience in providing evidence. In fact, the problem of providing evidence has now been shifted to the assessment of the value of the assets in box III.

d. to diminish the burden of inspection for the tax authorities

Inspecting income from capital is more complicated than the inspection of assets and their values. Switching to a tax on imputed return on investment undoubtedly diminishes the burden of inspection for the tax authorities.

e. for the tax authorities to gain advantage from computerisation

In the 1990s, the tax authorities in the Netherlands have, in a short period of time, made up any arrears with regard to the computerisation of the processes of taxation and collection. Of particular interest, in this respect, were the United States and the way in which computerised systems were already used there.An optimal use of the possibilities of computerisation further requires consideration of the question of how tax legislation can be designed in such a way as to allow for a better and more extended use of computerised systems. A tax on imputed return on investment is more consistent with this approach than the previously applied system of taxation of real income from capital.

f. to reduce the number of areas sensitive to dispute

Under the old system, litigation about matters concerning income from capital was a frequent phenomenon. In the new system, it is expected that disputes will arise over the allocation of assets and liabilities to the boxes and, of course, over the question of whether the interested party is entitled to one of the many allowances granted in box III. It is also possible that a considerable number of disputes will arise over the assessment of the value of the assets. On the other hand, it may be the case that, because of the low burden of tax,

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taxpayers will not be much inclined to start expensive and time-consuming legal procedures.

The preceding shows that in the conversion to a tax on imputed return on investment efficiency has been the deciding factor. It will be clear that in this respect the advantages of the new system for the tax authorities have also played an important role.

But is this system also a fair system?In Section 2 mention was made of the equality principle. In applying this principle as a test, two situations can be distinguished:

a. comparison of box III with other categories of income in boxes I and II; b. comparison within box III to determine whether the way in which the various kinds

of investments are taxed still qualifies as proportional.

Re a.One distinguishing feature of synthetic income tax is that gross income is taxed on the basis of one and the same rating structure, regardless of whether the income has been obtained by much or little effort. What does play a role is whether a certain income has already been subject to some other levy, such as corporation tax in the case of income from dividend. This does not, however, apply to other income from capital. The argument that, because this income has already been subject to income tax or to some other tax, wealth tax should be imposed according to a reduced rate is not correct. The income saved after taxation subsequently forms capital. A system of income tax aimed at subsequently taxing income from that capital does not lead to double taxation of income. It would be different in the case of a wealth tax. However, in the Netherlands there no longer exists a legal foundation for a wealth tax, which has therefore rightly been abolished as part of the general reform of the Dutch tax system.

In an analytical income tax, benefits from capital tend to be taxed according to a lower rate than other forms of income. No justification for this is given. Normally, this form of rating is applied for pragmatic reasons, such as mobility of capital, susceptibility to fraud, etc. In opting for this form of taxation, efficiency prevails over justice.

Re b.In box III the assets and liabilities allocated to this box are balanced and a fixed rate return of 4% is imposed on the balance. In practice, however, we find that there are considerable

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differences in return between the various kinds of investment. Therefore there are substantial differences between the return on rented dwellings and that on rented offices. Because of the legislation on leasing, the return on leased land is generally no more than 2%. Similarly, in the long term, the return on obligations bears no comparison with the return on shares. Nevertheless, one and the same fixed rate return applies to all these different kinds of investment. We are not dealing with equal cases, yet they are equally treated. When one compares the net return of these investments, one may wonder whether we are still dealing with proportional taxation. In addition, however, different types of investors can be distinguished. Small investors, with modest savings, are typically risk-averse investors. Certainly after the recent drop in rates, many small investors will be cured for years to come from the fever of investing in shares. In most cases, they will realise only a small return on their investment. Moreover, since for banks and other investment advisers these small investors are not a very interesting target group, these investors often have to do without professional advice. The big investors, on the other hand, do have access to the necessary know-how and will therefore be more likely to realise a higher return on investment. Every return exceeding 4% yields, on balance, a lower tax burden on capital. In actual practice, therefore, this system will lead to a difference in tax burden between small and big investors.

6. Some important issues

The system of tax on imputed return on investment introduced in the Netherlands is unique in the world. This is why this fixed rate scheme has been discussed in considerable detail. I would like to end by formulating a number of important issues:

1. Is it acceptable to subject taxpayers to a fixed rate taxation system for an entire category of income, such as income from capital?

2. It looks as though, as far as efficiency is concerned, the system has been assessed in terms of its advantages for the tax authorities rather than for the taxpayer. Of particular importance have been the reduction of the workload for the tax authorities and a more optimal use of computerised systems. Is it justified, in designing a system for a whole category of income, to have the aspect of efficiency prevail to such an extent that this may threaten the chances of a fair system of taxation for the citizen?

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If a system of fixed rate taxation of a whole category of income is to be deemed unacceptable, under which circumstances should it be allowed to impose a fixed rate tax on a partial basis?

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PART II THE NOTION OF INCOME FROM CAPITAL: THE TAXABLE BASE

CHAPTER 1 Accrual versus Realization

Peter Kavelaars

1. Introduction

At present, there is no discussion about the receipt of capital proceeds that split off and are taxed under the current system. Specifically, there is no discussion about the moment of actual receipt, when realisation takes place, and the income is taxed. If the discussion concerns fictitious income, then a fictitious moment of receipt will also have to be determined. In these situations it does not concern realisation69. However, it does not concern taxation on an accrual basis either, since nothing actually accrues in the event of fictitious income.The issue of taxation according to the moment of realisation, or according to the moment or period of accrual, is especially important with respect to movements of capital. Both systems – taxation at the moment of realisation or at the moment of accrual – have advantages and disadvantages. Since the imposition of income tax is usually based on the actual receipt of income, the realisation principle seems to be the primary method of determination. In general, that applies to (separate) income as well as to movements in capital (increases and decreases in value). By way of background, the realisation principle basically states that under an income tax system, income should only be taxed when it is actually available for investments. That is not the case with non-realised income. Given the foregoing, one could argue that taxation according to non-realised capital growth does not fit an income tax at all.The question is, however, whether the actual availability of income for use qualifies as a necessary requirement for taxation. After all, one could argue that the beneficial ownership has increased70. In that situation, realisation is no more than a technical operation in order to actually use the benefit of the movement in capital. If one were to consider the first assumption, that the actual possibility to invest is just as important as the increase of the beneficial ownership, then one does not get to the question of whether movements in capital should be taxed according to the accrual concept or to the realisation concept. The reason is because in that situation the choice is already included in the concept of income 69 Not as a rule anyway; this is only different if the real income equals the fictitious income.70 The same applies, mutatis mutandis, to the decrease of the beneficial ownership.

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to be used. If the ‘mere’ movement of the beneficial ownership suffices for taking income into account, then the question of whether to apply the accrual concept or the realisation concept does come up for discussion. However, even here this will mostly be confined to arguments with respect to implementation and technique.

In short, in one view the issue to be discussed here is part of a theoretical interpretation of the concept of income (there is only income if the beneficial ownership has increased, and this increase is realised and readily available for investment), and in the other view it is part of the theoretical and practical elaboration of the concept of income (there is income if the beneficial ownership increases). In some ways, both approaches melt into one another. Below, the aspects playing a role in the choice between the accrual concept and the realisation concept are discussed.Before beginning, it is worth noting the following objections that, in particular, confront application of the accrual concept.First, there is the ‘problem’ that the capital and assets should be valued every year. Another issue is that a liquidity problem could arise because tax is due for income that has not actually been received. Of course, in addition to these two issues, there are also various other objections.As regards the realisation concept, the most important theoretical objection is that it leads to the ‘lock-in effect’, as a result of which the capital and assets are not always disposed of, although economically, socially or otherwise there is a reason to do so. Obviously, other aspects besides the lock-in effect also play a role in this case. The following paragraphs deal with these elements, discussing both the application of the accrual concept and the realisation concept. Section 9 contains a short, final conclusion.

2. (Annual) valuation

One of the most significant disadvantages attributed to the application of the accrual concept is the idea that the capital and assets included in the tax calculation should be valued every year. The disadvantage is essentially twofold. First, performing a valuation every year is labour-intensive. Second, there is the disadvantage that the valuation does not take place – as is the general rule regarding dispositions – on the basis of negotiations between unrelated third parties. The inclination will thus be to value the assets as low as possible and the liabilities as high as possible, which would result in the imposition of tax being postponed as long as possible. However, it is important to remember that such a low valuation does not lead to cancellation of the tax. After all, if the asset is at any time disposed of, the ‘remaining’ capital gain will still come to light, and this will be taxed. It is

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clear, however, that the advantage of a low valuation during the period of ownership is increased as the imposition of tax is delayed71 and the rate72 is higher.The real question is whether the drawbacks of the accrual concept are actually that large. In my opinion the drawbacks are not that significant. In the first place, the annual valuation of assets and liabilities is also under discussion in the financial reporting realm, and, as a general rule, it does not encounter insurmountable problems there. However, this argument is only of relatively minor value. After all, in the profit sphere the capital and assets tend to be valued at historical cost (including, where applicable, an adjustment for amortisation); such a valuation is neither labour-intensive nor complex. As a result, it is more appropriate to make a comparison with the valuation that takes place under a wealth tax, which requires an annual valuation at the economic value.Therefore, in circumstances where a wealth tax is applied in addition to a capital gains tax, a valuation does not lead to additional expenses in that sense. In the economic sense, however, the fact that a wealth tax and a capital gains tax exist side by side does lead to the double imposition of tax in that instance. In that sense, both taxes should theoretically not be grouped together; in other words, the capital and assets that fall under the wealth tax should not fall under the capital gains tax.The so-called ‘investment yield levy’ was introduced in the Netherlands in 2001, with respect to income from private savings and investments. The purpose of this tax is to tax income from capital and assets at a fixed rate, by calculating a fixed assumed yield over the average capital and assets in a year. This average is based on the economic value of capital and assets that do not form a part of business assets. Some asset components – particularly as regards movable property – are exempted from this tax.To date, experience shows that this annual valuation of capital and assets does not face insurmountable problems. Further, the fact that a relatively large number of important capital and asset valuations take place should be taken into account with that. The valuation of immovable property for the various levies usually takes place every four years in the Netherlands. By means of an annual inflation factor focussed on immovable property one can, if desired, arrive at a value closely approximating the economic value in a relatively simple way. It should be noted, however, that the actual valuations (which, again, take place every four years) of the immovable property leads to a very substantial number of fiscal proceedings with the fiscal judge.As with immovable property, life insurance policies can be valued without too many complications, and the same obviously applies for listed shares and fixed-interest financial values. In short, what remains are generally the non-fixed-interest investments and movable property. Usually, private persons own relatively little in respect of the first 71 That is to say, the actual disposition is delayed for a longer period.72 To put it more precisely: the effective tax rate is higher.

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category and the second category will usually not, or only to a limited extent, be involved in a capital gains tax.The above argument is not intended to trivialize the annual valuation issue, but I do argue that the potential problems related to an annual valuation are not a strong enough reason to reject a tax on the basis of the accrual concept. When the realisation concept is applied the valuation issue has no role to play, in any case not annually, but also, as a rule, not at the moment of disposition, since the purchasing party and the selling party are independent third parties. Only when neither of the parties is independent should one beware of a price quotation that is not at arm’s length. In that situation valuation does come into play. However, this usually concerns only a relatively limited number of transactions, mainly occurring among families or as intercompany transactions.

3. Liquidity: how to pay tax?

If one assumes that income for fiscal purposes should be associated with beneficial ownership, then it should not be important whether the income is available in the form of liquidities, or even if it can become available soon. In principle, there is no reason to judge the extent to which the capital and assets can be easily cashed. In addition, such a distinction would also lead to fairly arbitrary choices regarding the extent to which capital and assets can be realised. Finally, it is worth noting that funds can also be made available by pledging the capital asset (and thus realise the excess value) in order to obtain a loan. The theoretical objection to the above approach is clear, however, in that it could result in capital and assets having to be disposed of, under certain circumstances, in order to fulfil the fiscal claim. This objection is further strengthened since some capital and assets cannot be easily cashed73.This drawback is reinforced if disposal needs to take place at a time of unfavourable price development, although in this case the disadvantage can be limited, because a negative price development can trigger a capital loss/decline, thus lowering the fiscal pressure (possibly even to zero or negative). Another alternative – albeit also problematic74 – is to finance the tax burden with external capital, either by pledging capital and assets or through some other means. The foregoing situations tend to arise quite often with respect to taxes regarding an estate, particularly when the estate is comprised of relatively few liquid assets. In this situation the liquidity problem often tends to be solved by establishing a payment facility. This solution could also be considered with the accrual concept (see hereinafter).

73 In itself, such a disposition would not have any fiscal consequences when applying the accrual concept; although another tax might be due.74 Because it is usually costly.

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In addition to my argument that the theoretical best way to tax capital gains is the accrual basis, there is another theoretical argument. That is, the lock-in effect, which is intrinsic to the application of the realisation concept, is avoided. After all, in theory, tax upon realisation leads to disposal being postponed, since this also postpones the tax burden.

Under these circumstances I think that, in general, this lock-in effect is very small75. After all, the taxpayers have to include this lock-in effect in the value of the asset component76. Or, to put it differently, the owner of the capital and assets always uses the net result he will obtain upon disposal, and in choosing whether to dispose of the asset component or not, he will be led by either economic considerations, or by other necessary reasons. A comparison can be made with the transfer tax due in the Netherlands when an intangible asset is purchased. Specifically, the purchaser and buyer take into account the tax when they determine the price. Thus, the buyer will not be dissuaded from a purchase for that reason, but his offer will include the fact that he will have to pay transfer tax. As it relates to the lock-in effect, this is normally no different. As such, the effect is not a reason beforehand to come to application of the accrual concept.Application of the accrual concept is usually objected to with the argument that while tax needs to be paid every year under the accrual concept, realisation of the capital gains does not take place every year. After all, this means that tax becomes due that cannot be paid out of the taxable gain. In addition, it is possible that the capital gain that is thus taxed will never be realised, because afterwards a reduction in value could take place. Also, it is possible that in an earlier year a reduction in value could have taken place, with the result that the value of the balance (current value) is even below that of the original purchase value. With respect to this last point, it is important how one deals with value reductions of assets (and value increases of liabilities) under the accrual concept (this point is discussed further hereinafter).The question is whether the liquidity problem as described above is in principle problematic; secondly, it remains to be seen whether this can be met. Taxing non-realised capital gains can be compared to the tax on fictitious income. Many tax systems actually apply a fictitious income with respect to certain types of income, and this does not seem to cause any significant problems. The Dutch system, for example, taxes fictitious income related to an individual’s principal place of residence (home), a substantial business interest in an investment institution, and the investment yield tax previously mentioned.

75 In particular, the American economic literature attaches a fairly strong meaning to this,; in my opinion, incorrectly. In the countries with an investment yield tax (always based on the realisation concept), the lock-in effect is not put forward as a big problem. In fact, it is rarely even mentioned.76 Thus, in particular, the people who are owners at the moment that an investment yield tax is implemented are injured: the value of the asset component decreases at that moment by the (capitalised) value of the investment yield tax.

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With respect to the three examples immediately above, there are some essential differences between the first two categories and the last category. Specifically, the first two categories usually concern relatively minor fictitious income, while the third category is essentially related to all privately held capital and assets. As a result, that category generally reflects much higher income, and the drawbacks of the fictitious character can be more significant. However, this is countered by the fact that the tax rates in the third category are lower than those in the first and, to a lesser degree, second categories. As it relates to the first category, it is also important to note that because the actual finance costs are deducted from the fictitious income, it is, in general, not a tax but a deductible item.Finally, with respect to the investment yield tax, it is relevant that, as a rule, income is actually received with respect to the capital and assets (which of course are not taxed), out of which the tax due can be financed. The above rate issue explicitly refers to the Dutch situation and is, of course, not important internationally. It is evident that in the larger picture the rating does play an important role, however, that issue is not under discussion here.A number of aspects discussed above play a role in judging the liquidity argument as it relates to the accrual concept. The extent to which the liquidity argument limits the application of the accrual concept depends in particular on the following factors: the amount of tax due; and the extent to which the related capital and assets periodically generate net income (the

income after this periodical income itself has been taxed).Both factors can only be determined after the form of the investment yield tax has been determined. Regardless, I do not think the argument that a lack of liquidity should prevent taxation under the accrual concept is correct.The question is whether there is an alternative possibility to meet the liquidity aspect, one where the taxpayer is not forced to sell part of his capital and assets in order to pay the tax out of the proceeds. One possibility could be to implement a preservative system. Under this system the tax due is levied every year, however, an extension of payment is granted for that year, assuming that no disposition of the related capital and assets took place. Determination of the realisation should then take place for the total of assets and liabilities for which the investment yield tax is applicable.Under that scenario it could possibly be determined that part of the realised capital gain does not need to be used for the tax payment. For instance, the actual income (in the related year) realised from the capital and assets that are involved in the investment yield tax could also be taken into account. The advantage of such a system (as described above) is that, to a large extent, it meets the liquidity disadvantage of an accrual concept; the

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disadvantage is that the system will become more laborious to implement technically. In addition, a preservative system tends somewhat towards application of the realisation concept, which brings the lock-in effect into the picture again. It is worth noting that one important difference is that in the above structure it does not concern the realisation of an individual asset component, but rather that, which has been realised in total in a year.

4. Losses

Any form of investment yield tax raises the question of how to deal with losses. Attention will be paid to this issue herein, but only if the application of the accrual or the realisation concept is involved. The assumption is that losses are taken into account, one way or another. There is a certain connection, for that matter, between taking losses into account or not taking losses into account, and the application of the accrual or realisation concept. In my opinion, the assumption is that losses should be taken into account. This results in the following application of an economic concept of income: a loss is nothing more than negative income, and there is no reason not to take negative income into account when the beneficial ownership diminishes.The change in the beneficial ownership is determined per tax period, and, in principle, the capital and assets should be valued at their economic value at the start and at the end of the tax period. Such a system directly leads to losses – at any rate, value reductions – being taken into account immediately. In that sense, one can say that application of the accrual concept of income automatically leads to value reductions also being taken into account (annually). After all, with this approach the value increases are directly compensated by value reductions since the capital and assets that are involved in the tax are valued every year at their economic value. In connection with this, it is worth noting that this also occurs with the afore-mentioned investment yield tax applied in the Netherlands.Capital losses of the realisation year are also taken into account, of course, because the consideration upon disposition is taken into account with the year-end valuation. Actually, within an accrual concept one can conclude that capital losses are automatically taken into account. In fact, the possibility of leaving out capital losses or waiting to take the capital losses into account until the moment of realisation only makes the system of an investment yield tax more complex.The question remains, however, as to what should be done in a year where there is in total a capital loss. Specifically, what should be done when the capital losses exceed the capital gains, so that on balance there is a capital reduction? I do not see why such a loss should not or could not be taken into account. The question could arise, however, whether such a loss should directly lead to a tax refund, should be netted with other positive income in that

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year, or should be netted with positive capital gains from other years (carryback/carryforward).This question cannot be answered separately from the other elements of the tax, with respect to capital gains and the way in which other income is involved in the tax. If the assumption is that the character of the income does not play a role (synthetical levy), then combination with other income within the year is theoretically the correct approach; when different types of income are taxed according to a different regime (analytical system), then application of vertical relief is the correct approach.The conclusion with respect to the foregoing is that taking losses into account and applying the accrual concept form a logical system.

5. Migration

Application of the accrual concept does not lead to complications in the event of emigration. In the year of emigration the change in value will be taken into account, even up to the moment of emigration. If the asset component was already situated outside the original country of residence, or if it also emigrates, then no further discussion is necessary77. If the asset component stays behind in the former country of residence, then this will usually result in a non-resident tax liability, and there will be a tax every year after the emigration.If the realisation concept is applied then the claim will be lost, since emigration simply does not imply realisation. Specifically, the claim will be lost if the asset component is not located in the former country of residence, or if it leaves the former country of residence as a result of the emigration. In those cases a fiscal deduction moment is conceivable. If the asset component stays behind in the former country of residence and, if, as a result of this there is still a tax liability in that country, then the claim is preserved and it is settled in due course upon disposal. In this situation it is also important how the tax in the new country of residence takes place. See further discussion under ‘Treaty aspects’.Immigration or obtaining capital and assets as a foreigner in the Netherlands does not result in special circumstances in connection with the accrual concept of income. Immigration is not, after all, a reason for taxation. What is important, however, is which starting values are used in connection with the system, especially when trying to use a coherent approach. When a country applies the accrual concept a coherent approach entails that only the change in value during the time when the person has a tax liability in this country is taken into account. Upon emigration, including all capital and assets leads to a settlement over the period, up to the emigration. I do not consider this final settlement to 77 Of course, it remains important how the tax takes place in the land of immigration; namely, whether that country applies a step-up. See also hereinafter.

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be contrary to European law, since it ensues from the annual system of taxation as a result of the accrual concept. It does not concern an emigration tax.Based on this assumption, it goes without saying that the capital and assets should be valued at their economic value upon immigration78. It is clear here that the fiscal consequences also depend on the possible tax in the country from which one has emigrated, assuming that that country taxes capital gains. First, it depends on whether the tax there is assessed under the accrual concept or under the realisation concept. If the latter takes place, then it also depends on whether it concerns a tax upon emigration.Treaties have no rules for this, so if agreement is needed in this area it should be arranged separately. In my opinion, the capital gains article explicitly connects to the moment of realisation (see hereinafter, Section 6.).I also think that the accrual concept provides the most stable picture with respect to the emigration and immigration issue. To the extent an asset component stays behind in the country from which one emigrates, I do not think that a special arrangement should be concluded because the emigrant will become a non-resident taxpayer, but the application of the accrual concept can be continued. The fact that the taxable base for the taxation of resident and non-resident taxpayers will, as a rule, be different, does merit particular attention. With respect to the technical aspect of the taxation, a separation should be made in the year of emigration.Besides emigration and immigration, situations can occur in which an asset component is transferred from one country to another country, without the taxpayer himself emigrating. Insofar as it concerns the taxation in the country of residence, this transaction is not relevant since worldwide income is generally taxed in the country of residence. It could be that the asset component is transferred to a country in which one does not live, or that the asset component is transferred from another country. The accrual concept will not pose a problem in the first situation because in the last year the tax liability will cover the period from the start of that year up to the moment that the asset component is transferred to another country. As such, the result generated in that period is included in the tax.If the realisation concept were applied, then settlement would only take place if the moment of transfer were treated as the moment of realisation. If this is not the case, then the source state will lose its authority to impose tax altogether. With respect to the country to which the asset component is transferred (which is not the country of residence), a step-up will be used as a rule, since this is embedded in the system. With application of the realisation concept, it is not as obvious as that. If nothing has been determined, then the

78 For that matter, this system is at odds with article 13 of the OECD Model Treaty, since this uses tax upon realisation, regardless of the country in which the profit has accrued. In this sense article 13 of the OECD Model Treaty should be changed such that the tax is assigned in proportion of the country where the change in value originated.

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historical cost price will be assumed. Above, I indicated that the authority to impose tax should, as a rule, be limited to the value increase over the period in which the asset (or liability) is situated in the country of residence or the source state respectively. Therefore, in my view, a step-up provision is essential if the realisation concept is applied.The foregoing shows that double taxation can occur under certain international circumstances. I discuss certain aspects of that in Section 6.

6. Treaty aspects

In Section 5 we saw that double taxation can occur with respect to changes in assets in connection with the issue of the accrual and the realisation concept. The issue has the following two sides:a. the distinction between taxation in the country of residence and in the source state; andb. the distinction with the transfer of capital and assets between treaty members.Re a.:The country of residence generally uses the assumption that worldwide income is taxed, and that the source state only taxes certain sources situated in that country. Insofar as it concerns private persons, this will generally be limited to intangible assets and possibly substantial business interests in companies situated in the other state. Article 13 of the OECD Model Treaty assigns the authority to impose tax with respect to capital gains from intangible assets to the source state, and the authority to impose tax with respect to capital gains from shares to the country of residence. In any case, the provision uses realisation79.If both treaty members only tax a gain upon realisation, then there is no problem. The same is true if both countries apply the accrual concept. However, a problem does arise if one of the countries uses the accrual concept and the other country uses the realisation concept. Under this scenario the question is which treaty provision applies when the accrual concept is applied. I do not see many other possibilities than the remaining article. In that situation the following picture emerges with respect to intangible assets.If the country of residence uses the accrual concept, then it taxes the changes in capital every year. If in that situation the source state uses the realisation concept, then it will tax the realised capital gain and double taxation is thus not avoided. If the country of residence applies the realisation concept, then it is not authorised to impose tax. If the source state uses the accrual concept, then it will not be allowed to impost tax since the remaining article applies. In short, there is no tax.In general, there is no problem with respect to capital and assets that have been assigned to the country of residence with respect to the imposition of tax. What remains is the 79 ‘Alienation’ is the term used, but this is in fact realisation; in particular, also see the commentary in paragraph 6. As a rule, capital growth is not included; see paragraph 7 of the commentary.

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assignment of the tax on capital gains from substantial business interests to the source state in a number of treaties. In principle, the same applies here as has been stated previously regarding the intangible assets. The outcome and the structure are not pretty; the problem is that this is caused because the OECD Model Treaty exclusively uses the realisation concept. An adjustment of the treaty regarding this point would thus be preferable, possibly in the form of an optional system, with which treaty members can reach their own solution, depending on their national system.Re b.:If an asset component is transferred to another country, in terms of treaty law this is not a reason to assign the authority to impose tax. For that matter, transfer can only concern rights and current assets. As indicated previously, the resulting capital gains are always assigned to the country of residence. Only with respect to substantial business interests does the assignment of the tax fall to the source state. If rights or current assets are transferred from the country of residence, then the authority to impose tax stays with the country of residence.Thus, no claim will be lost. It also makes no difference if the country of residence applies the realisation concept or the accrual concept. The same applies to the source state: based on the remaining article, the source state is not allowed to impose tax if it uses the accrual concept, and under the capital gains article it is not allowed to impose tax on the realised capital gain. If a specific regulation is included as regards shares that form a substantial business interest in a company established in the member state (in respect of which the authority to impose tax is assigned to the source state), then a problem can only arise in the event that the actual management is transferred.If the actual management is situated abroad and it is transferred to the country of residence while the source state applies the accrual concept and the country of residence the realisation concept, then double taxation takes place, unless the country of residence uses a step-up. If, in this situation, the source state uses the realisation concept and the country of residence uses the accrual concept, then the tax will, as a rule, take place as from the value that applies at the moment of transfer of the actual management, unless the source state has a final settlement provision.If the actual management is transferred from the country of residence to the source state and the country of residence applies the realisation concept and the source state the accrual concept, then the tax will also only take place as from the time that the actual management has been transferred, unless the country of residence has a final settlement provision in the event of transfer of the actual management. In the reverse situation – the country of residence applies the accrual concept and the source state applies the realisation concept – the country of residence will tax the capital gains up to the moment of transfer and the

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source state will tax the profit made upon realisation. Unless the source state uses a step-up, this leads to double taxation on the accrued value up to the transfer of the actual management.

7. Inflation

With respect to the tax on capital gains, it is essential, more than with other income, that an adjustment is made in connection with price changes. This results from the circumstance that the inflation component of this income is generally a substantial part of the total value change during the year. Strictly theoretically, the correction for inflation should be focused on the individual type of asset. The drawback is that it is not always certain which inflation factor applies to a certain asset or liability. Further, most of the time such an inflation factor will not be known per individual component. Given the wish to get as close as possible to the actual inflation on the one hand, but on the other hand to want a system that works, it is preferable to have an inflation component per category of capital and assets. As a sample, these categories could be: intangible assets/homes; intangible assets/non-homes, current assets (general correction for inflation); shares and similar options; fixed-interest values; other assets and debts.If assets and liabilities are not held the entire year, then the correction for inflation should be applied on a pro rata basis.

Since application of the realisation concept or accrual concept does not lead to principal differences with respect to inflation, the issue will not be discussed any further.

8. Some special situations

Below, a number of specific situations related to the accrual and the realisation concepts are discussed.

8.1 Death

In the event of death, the heirs inherit the capital and assets. If the accrual concept is applied, the tax will not pose any problems because the recently deceased would be liable for tax on the capital growth up to the moment of his death, and the heirs would be liable for tax on the capital growth from the moment of death forward. However, if the realisation concept is applied, the question of whether the death is regarded as a realisation moment arises. As a rule, it concerns a transfer under a universal title and the issue is whether this is regarded as a disposal. This question can be answered no, given the circumstance that there is no effective realisation.

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If settlement with the recently deceased is considered anyway, regarding the death as fictitious realisation can only solve this. In that situation the acquisition by the heir should also be seen as a fictitious acquisition. If nothing is determined, then obviously the heir is not taxed, but the question is which acquisition price is to be considered with the heir. Without any further determination, it would seem to me that it is the value at the moment of death. Preferably, a provision in respect of that is included as a result of which the acquisition price of the recently deceased passes on. The above shows that application of the accrual concept in situations of death poses fewer problems than the realisation concept.

Another question is whether this concurs with the inheritance tax and, if so, whether that should be avoided. Usually such concurrence will occur, but given the background of both taxes a regulation to such effect will not be necessary unless the inheritance tax has the form of an estate tax. After all, an estate tax intends to achieve a kind of ‘final settlement’ and there is simply no reason for that under an investment yield tax. In my opinion, however, this stands apart from the question of whether the accrual or the realisation concept is applied.

8.2 Gifts

What is stated above regarding death is, in principle, the same for gifts. As a result, I will not discuss gifts further.

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8.3 Divorce

It is worth examining the accrual and realisation concepts in the context of divorce, particularly if capital is divided as a result of a divorce. To the extent every partner has his or her own capital and assets, then neither of the concepts generally gives rise to problems. However, when capital and assets are being allocated between partners, then this can be different. This applies both to the situation where the capital and assets are part of the community of property, and the situation where the capital and assets of one partner are allocated to the other partner. Disposal is a concern in both situations. The question is, however, whether this can be regarded as realisation. In principle it cannot. Under the realisation concept, a fictitious realisation and a fictitious acquisition should be considered here. Under the accrual concept a provision is not necessary since the system itself leads to a division of the authority to impose tax. Going back to the realisation concept, it should be considered whether a ‘pass-on regulation’ is desirable. Generally, this will not happen quickly since the acquiring party will not be willing to take over the fiscal claim from the other partner, unless this claim is discounted in the pricing. Because this can be achieved without too much trouble, the possibility to ‘pass-on’ is desirable when the realisation concept is applied.

8.4 Mergers and splits

With respect to private persons, mergers and splits are only applicable when they concern shareholdings. With mergers it concerns an exchange, and therefore a disposition, and thus realisation. This does not just apply to legal mergers. If the accrual concept is applied to this situation, then no problems arise with mergers. Generally, the obtained shares have the same value as the exchanged shares and at the end of the year the obtained shares are part of the capital in the same way as the shares that were disposed of. Hence, no pass-on facility is necessary. Application of the realisation concept yields a different result. As stated, the exchange qualifies as a disposition, with the resulting realisation. Generally, the fiscal claim is passed on to the obtained shares. For legal mergers, none of the methodologies need a regulation - the obtained shares take the same place of the disposed shares and there is no moment of realisation because there is no actual disposition. In my opinion, there is also no reason to create a moment of realisation in connection with possible losses.

The above, in principle, also applies to the split (off) of shares. Under the accrual concept the value of the split (off) shares is the same as before the split, so there is no tax and the shares are included in the final capital. Under the realisation concept there is (partial) realisation with a split as well as with a split off, and thus (so far) taxation will have to take

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place over the excess value. It is reasonable to provide for a pass-on facility, since in this situation the shares will remain to take the same position in the capital. If it concerns a legal split (off), then what has been previously stated concerning legal mergers applies.

With mergers, as well as with splits, the taxpayer should have the possibility of not using the pass-on facility, especially in those situations in which, at the moment of the merger or split, there is a loss. There are also other circumstances where the pass-on facility should be limited; for instance, when the merger or split shares are obtained in a foreign company. It is worth noting that there are other possible special circumstances, however, I will not comment on them herein.

9. Closing considerations

For the sake of this contribution I have discussed a number of questions in order to obtain some insight into the way in which various countries deal with the issues as I have discussed above. Further, I have discussed the fact that when changes in capital are included in the imposition of personal income tax, that all countries do so on the basis of the realisation concept. Application of the pass-on facilities varies substantially from country to country.

From a theoretical viewpoint I think that changes in capital should be taxed under the accrual concept. A decisive argument is that in any given year, anything that can be considered to be an increase of the beneficial ownership should be taxed. At the moment, everybody does certainly not share this view. For many people another necessary condition is that the capital gain can be used for commercial purposes, and for that realisation is necessary. I do not consider realisation to be a necessary condition.

From the above it can be concluded that, with respect to implementation, the accrual concept raises fewer problems than the realisation concept. The main drawbacks of the accrual concept are the annual valuation and those circumstances where the tax needs to be paid every year, even though no liquidities have become available because the asset component has not been disposed of. I have indicated that the importance of the valuation argument is limited, although which capital and assets are included in the tax are important. The more types of capital and assets that are included in the tax, the more complex the valuation is going to be. Also, I do not consider the lack of liquidity to weigh heavily, albeit this depends on the tax rate applied to the changes in capital. One solution is that the liquidity drawback could be met by postponing the tax through a preserving

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assessment up to the time at which realisation takes place, and charging interest over the period of postponement.

I defended, in my opinion, an interesting hybrid form with my inaugural lecture. Under this hybrid form an estimate of the change in capital is performed every year by taking into account a fixed yield (insofar this concerns the capital growth) and taxing it, and upon realisation of the asset component, reducing the actually realised capital gain by the fixed yield that has already been taken into account.

One can go one step further by not applying an annual valuation at all, but by applying a fixed yield every year in relation to the original economic acquisition price/value, and to then tax this. Upon disposition (and thus realisation) the actual capital gain is reduced by the fixed yields previously taken into account during the period of ownership. This variation has the advantage that (almost) no annual valuations of assets and liabilities need to take place. However, a different yield does need to be taken into account for each type of asset, based on empirical figures.

If such a yield is set at a fixed percentage for the long term, then an annual registration of the yield to be taken into account does not need to take place either. In that situation it is enough that the purchase date and acquisition price are known. This does not differ from the figures one needs under a capital gains tax in accordance with the realisation concept.

Further, it is possible that one could include the correction for inflation within the determination of the annual yield with respect to the capital growth. If the value of an asset component decreases during a year, then this will, in principle, not be taken into account, unless the yield is calculated annually based on the economic value.

Although this hybrid form also has its drawbacks, it does have the advantages that (in theory) the end result is similar to the capital gains tax, and (in practice) that it harbours the advantages of the accrual concept and misses the disadvantages of the realisation concept.

In fact, the system can be compared with a global wage tax as an advance tax on the personal income tax. However, in this case it does not concern benefits from labour, but rather benefits from capital. In principle, that does not necessarily make a difference. And, as far as the implementation is concerned, it is simpler with a capital gain tax than with a wage tax, especially since with the wage tax many more personal circumstances need to be taken into account.

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NB: FOR AN OVERVIEW OF THE TREATMENT OF THE ISSUES DEALT WITH IN THIS CHAPTER IN SEVERAL EUROPEAN COUNTRIES, WE REFER TO THE FILE ‘KAVELAARS-OVERZICHT’ (ON THE EATLP WEBSITE).

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PART II

CHAPTER 2 Deferral Possibilities

Kevin Holmes

1. Introduction

The time value of money is a major influence on rational economic behaviour. Put simply, a rational person prefers to part with ownership of funds later rather than earlier, and to derive at least a risk-free rate of return in the interim.80 This proposition is just as applicable to the payment of taxes as it is to other economic activity. Additionally, in the context of tax payments, other factors may also play a role in postponing the payments. For example, psychological phenomenon may influence some taxpayers’ attitudes towards the timing of their tax payments (and, indeed, towards the imposition of tax generally, as well as particular modes of imposition).81

Furthermore, some taxpayers may have plentiful opportunities to defer tax payments – in part, because of the nature of the income that they derive – and sometimes permanently. It would seem, for instance, that taxpayers who derive income from capital (and, in the case of individuals, who often face high marginal tax rates) may have greater opportunities (and perhaps even desires) to defer payment of tax on their capital sourced income than (say) wage and salary earners who face lower marginal tax rates.

80 This idea of the time value of money was first expounded by Irving Fisher in 1907: see Fisher, Irving, (1907) The Rate of Interest: Its Nature, Determinants and Relation to Economic Phenomena, Macmillan, New York.81 Although it has been found that taxpayer behaviour (in particular, tax evasion) is a consequence of taxpayers’ attitudes towards such things as achievement of the objectives, and fairness, of a country’s tax system, apparently the psychological factors may not be uniform between countries. Appropriately for this conference, substantial empirical research was carried out in 1970 by a pioneer in this field, Gütner Schmölders, for the Cologne Research Institute for Economic Behaviour. From a survey of taxpayers in France, (West) Germany, Great Britain, Italy and Spain, Schmölders assessed “tax mentality”, i.e. taxpayers’ attitudes and perceptions. He observed that taxpayers’ attitudes result from, or may be dependent upon, a country’s tax system and, especially, the investigative enthusiasm of the tax authorities and the compliance costs borne by taxpayers. Thus, since these features differed in each country, taxpayer attitudes would differ from country to country (see Schmölders, G., “Survey research in public finance: a behavioural approach to fiscal policy”, (1970) 25(2) Public Finance, 300-306). For a detailed (although aging) discussion of the psychological aspects of taxpayer behaviour more generally, see Lewis, Alan, (1982) The Psychology of Taxation, Martin Robinson, Oxford. The focus of these works is on tax evasion and tax avoidance; however, there appears to be no reason to assume that the attitudinal concepts of “tax mentality” and “tax morale” are not also applicable to tax deferral.

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This chapter examines the issue of deferral of tax on income from capital. It focuses on the ways in which taxpayers in European jurisdictions can defer the payment of tax on income from capital and whether that practice might be curtailed (and, if so, how).82 The chapter first addresses the meaning of deferral. Section 3 then considers some policy issues surrounding deferral and section 4 reviews particular means of deferring tax on income from capital in a selection of (primarily) European Union jurisdictions and accession countries. Section 5 briefly refers to some anti-deferral measures and section 6 draws some conclusions and makes recommendations about the way forward.

2. Meaning of deferral

What does “tax deferral” mean? One aim of a taxpayer who acts in his or her self-interest is to delay the payment of tax for as long as possible in order to invest the funds to derive additional income in the interim. Thus, the common understanding of tax deferral is a delay in payment of a tax liability. A taxpayer can achieve this objective essentially in two ways; viz. by:

(a) deferring the recognition of gross income or revenue to a later income year; or(b) creating or advancing deductible expenditure or losses to reduce a current year

tax liability.

In each case, net taxable income for a particular year is reduced, thereby reducing the income tax liability for that year. For the purposes of this chapter, the reduction in net taxable income brought about by either means is generically referred to as deferring recognition of income.

Whether or not the unrecognised income in a particular year is eventually acknowledged and brought to tax depends on whether the deferral is permanent or temporary – and here we depart from the common understanding of tax deferral as a mere postponement of the payment of a tax liability. If the amount of deferred income is never recognised, the deferral is permanent; for example, where the shareholders of a company can capitalise revenue reserves (which, upon distribution, would have constituted taxable dividends in the shareholders’ hands) into a bonus issue of shares (or stock dividend) and the proceeds of the sale of the bonus shares are tax-free. Such conversions of what would otherwise be taxable income into non-taxable capital gains are typical examples of permanent deferrals of income recognition. A permanent deferral similarly arises when ordinary income is

82 This study is confined to a review of a selection of particular deferral possibilities and their ramifications. No attempt is made to undertake any empirical quantitative analysis of the fiscal effects of deferral on governments’ revenue collections.

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converted into a capital gain and the capital gain is taxed at a lower rate than ordinary income, to the extent of the product of the amount of the gain and the tax rate differential. Further, a step-up in the basis of assets upon inter-generational or intra-family transfers also results in a permanent deferral of income recognition.83 Inter-generational rollover relief can also defer a tax liability for an indefinite period.

Permanent deferral of income recognition can also arise by enhancing deductible expenditure in a particular income year where there is no hope of recapture of the deductions by way of assessment of the income or gain that the expenditure contributes towards producing in later years. A prime example of this form of deferral is the deductibility of interest expenditure incurred on borrowings to acquire an asset where a capital gain on the subsequent sale of the asset is not taxable (or is taxed at a concessional rate or in a concessional manner, e.g. taxation of inflation adjusted gains only). Such tax arbitrage can lead to “negative gearing”, i.e. where the costs of borrowed funds (and other holding expenses) exceed the current annual income produced by the asset. Where a country’s tax law does not require any apportionment of these expenses, the resultant annual loss from the investment in the asset can be offset against other income derived by the taxpayer, thus permanently sheltering (part of) that income from taxation.

Where income is in the end recognised, but in a later (rather than an earlier) period, the deferral is temporary. In this case, the issue is simply one of timing; in other words, the income or gain will be taxed, but not immediately. For instance, to bring within the tax net debt arrangements with relatively low periodic interest payments during the term of a loan and a relatively high redemption premium payment at the end of that term, a country may have provisions in its tax law that deem the redemption premium payment to be interest and taxable as such in the year of receipt of the payment. In such cases, recognition of true interest income (in the economic, accounting and finance senses) is deferred, but only until the year of repayment.

Conversely, a borrower might make an up-front tax-deductible payment of the present value of interest in respect of the entire period of a loan at the time at which the loan is drawn down. Consequently, the present value interest liability, which would otherwise accrue over the term of the loan, is recognised wholly in the first year of the arrangement, giving the borrower a temporary deferral of his or her tax liability for that year (to the extent of the product of the amount of the up-front interest deduction that relates to later years and the taxpayer’s marginal tax rate). Of course, the deferral here is only temporary 83 For a further discussion of this point, see under Tax Policy and Deferral and Deferral Mechanisms in Selected Jurisdictions of the New Europe below.

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because no deduction for the interest can be claimed in later years, thus increasing the tax liabilities of those years.

Temporary deferral therefore requires a taxpayer to massage (a) income from an earlier to a later tax year; or, less frequently, (b) expenditure from a later year to an earlier one.

The taxation of capital gains on a realisation basis inherently produces tax deferral, i.e. although income is, in the wealth accrual sense, derived when the unrealised value of an asset increases from the beginning to the end of each year,84 the gain in the value of the asset is not brought to account for tax purposes until the asset is realised in the form of a sale or other transfer by the owner to another party.

The importance of deferral of recognition of income for tax purposes is well established in accountancy. A cursory examination of any public company’s statement of financial position reveals either a deferred tax asset or liability.

Why is reference to accounting treatment relevant here? Accounting principles attempt to follow the economic concept of income, being an unrealised accrual in wealth between two points in time.85 Thus, accounting practice generally requires income to be recognised earlier than the typical (non-business) taxation based realisation approach. A taxpayer who is able to defer recognition of his or her income for tax purposes transfers an accrued gain to a later period. This difference means that a liability to tax arises on income taken into account now on an accrual basis for accounting purposes, but payment of the tax is deferred until that income is recognised some time later for tax purposes.

International Accounting Standard IAS 12 – Income Taxes has long required that the future tax liability that results from the delayed recognition of income for tax purposes be disclosed in the financial statements.86 The quantification of a deferred tax asset or liability takes account of permanent differences and timing (or temporary) differences. Permanent differences arise when an item of income or an expense is recognised for accounting (tax) purposes, but is never recognised for tax (accounting) purposes. The recognition of an item

84 And, equally, a loss is incurred in each year that the value of the asset declines.85 For a detailed discussion of the economic notion of income and its relationship to accounting principles and practice, see Holmes, Kevin, (2001) The Concept of Income – A multi-disciplinary analysis, IBFD Publications, Amsterdam, especially chapters 2 and 4.86 Conversely, tax benefits are also required to be taken into account; for example, where a company’s future tax liability will be reduced because of tax losses available to the company to carry forward to future years. See International Accounting Standards Committee, “International Accounting Standard IAS 12 – Income Taxes”, International Accounting Standards 1999, International Accounting Standards Committee, 1999, 249.

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of income for accounting purposes but never for tax purposes (and conversely for an expense item) is akin to permanent deferral, discussed above. Timing differences arise when an item of income (or an expense) is recognised in one period for accounting purposes and in a different period for tax purposes – akin to temporary deferral, discussed above, where the accounting recognition period of an item of income (an expense) is earlier (later) than the tax recognition period.

3. Tax Policy and Deferral

Taxation is, of course, one policy instrument available to a government to achieve its social and economic aims. Tax legislation written for these purposes may intentionally or inadvertently create opportunities for taxpayers to defer tax. Consequently, the deferral of recognition of income (whether permanent or temporary) can be conveniently regarded as falling into two broad categories:(a) Tax mitigation87 – where a country’s tax legislation deliberately holds out specific

mechanisms that permit taxpayers to defer tax, e.g. rules for spreading income over future years or rollover provisions. The purpose of these types of concessions is allegedly to facilitate taxpayer equity and economic efficiency, which are discussed below. But a government’s encouragement of tax deferral is also apparent where it offers tax incentives to induce taxpayers to undertake a particular economic activity, e.g. to invest in a certain region or type of business. The desired consequence of these sorts of measures is national wealth maximisation, which arises from increased economic activity as a result of the induced investment, and is partly achieved through an ultimate increase in government revenue. Take Estonia, a country that exempts corporate income from taxation.88 The aim of this aspect of fiscal policy is to eliminate economic double taxation in a way that encourages investment in Estonia and enhances its national wealth. In adopting this policy, the government deliberately created tax deferral opportunities by encouraging hitherto non-company entities and foreign entities that had no connection with Estonia to conduct their commercial activities through a company in Estonia.89

87 A term first coined by Lord Templeman in the United Kingdom Privy Council in Challenge Corporation Limited v. Commissioner of Inland Revenue (1988) 8 NZTC 5,219, 5,223-5,225. The distinction between tax avoidance and tax mitigation is not always clear, as the above case demonstrates.88 At least until retained earnings are distributed in cash or in kind to shareholders. Partnerships are treated as companies for tax purposes, so they also fall into this category.89 Income from capital that is derived by a company is treated as business income and therefore falls within this exemption from taxation. Indeed, for taxpayer equity reasons or because the economic objective underlying this fiscal policy is so strong (or for both reasons), this tax deferral mechanism has been extended to non-corporate entities, e.g. sole traders, who pay their business and investment income into special bank accounts and who meet certain other specified conditions, largely for the purpose of administering and policing the concession.

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(b) Tax avoidance – where a taxpayer enters into a scheme or arrangement to circumvent (totally or partly) the liability to pay tax in respect of a particular income year. This may involve an arrangement to convert ordinary income into a tax-free gain, sliding income from one year to a later year, or sheltering income in entities that fall outside the taxing jurisdiction, e.g. in offshore companies or trusts.

From a public policy perspective, one instinctively tends to regard deferral of income recognition, and therefore the deferral of tax payments, negatively – particularly when it arises from a tax avoidance arrangement. This is most probably because the ability of a minority of taxpayers to obtain an advantage in the timing of their tax obligations runs against the grain of the idea of fairness of the majority of people. Nevertheless, the merits and demerits of tax deferral must be tested against the now generally accepted tax policy objectives of equity, simplicity, certainty, convenience and economic efficiency.90

These principles of taxation are commonly examined in the policy context of whether or not a tax should be imposed at all on an item of income. However, they are equally relevant in attempting to resolve the subsidiary question of how the tax should be levied. In addressing this question, one might ask, for example, whether a proposed method of taxing interest income from debt instruments or capital gains from the sale of property, which allows taxpayers to defer the recognition of the interest or a capital gain, is desirable when tested against the fundamental tenets of taxation. Therefore, the application of these standards to tax deferral is briefly discussed in this section.91

Take the equity criterion first. To the extent that a taxpayer is able to defer recognition of income from capital, horizontal equity (i.e. the equal treatment of people with comparable abilities to pay tax) is violated. Similarly, in terms of vertical equity (i.e. different taxation of people with different capacities to pay tax), deferral of recognition of income from capital (for non-corporate taxpayers, the most of which is derived by taxpayers at the upper end of the income spectrum) breaches the notion of fairness. In the year of deferral, the relief from the tax burden can be proportionately greater for recipients of income from capital than for taxpayers in the lower income ranges who might achieve deferral of income recognition by other means. So, in the United Kingdom, for example, the deferral of recognition of a taxable gain from the sale of a capital asset renders a tax benefit at the rate of 40% of the amount of the gain to the vendor who suffers tax at the maximum 90 The first four were the canons of taxation founded by the Scottish moral philosopher and economist, Adam Smith (see Smith, Adam, (1778) 2 An Enquiry into the Nature and Causes of the Wealth of Nations, Dent, London, 1947 reprint, 307-308). Economic efficiency developed later and has, since the 1980s, become widely hailed as a particularly important tenet of taxation.91 For reasons of brevity, simplicity, certainty and convenience are discussed together below.

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personal rate, whereas an employee who is on the lowest marginal tax rate and who might be able to defer some of his or her employment income to a later income year obtains a tax benefit of only 10% of the amount of income deferred. Thus, the State gives a greater subsidy to wealthier deferrers of income than to poorer ones. Furthermore, intuitively, it would appear that high-income earners who face high marginal tax rates have greater opportunities to defer recognition of income than do lower income earners who face lower marginal tax rates. The former have easier access to (and can afford to pay for) advice about tax deferral schemes and arrangements, and derive a wider range of income types, which more readily lend themselves to deferral mechanisms.

The notion of economic efficiency is founded on the simple premise that, to achieve the most efficient allocation of resources, capital (as one factor of production) should be invested where it attains its highest pre-tax rate of return. The optimal allocation of resources is distorted if some forms of investment are taxed more favourably than others because investment is driven by post-tax, rather than pre-tax, returns. Suppose that an investor who faces a marginal tax rate of 40% can invest funds for one year in either (a) a blue-chip company debenture, which produces a fully taxable rate of return of 6%, or (b) a zero-coupon government bond, which produces a tax-free redemption premium equivalent to 5% of the principal sum invested. In a tax-neutral environment, capital is most efficiently allocated by investing in the company debenture because it produces the greater pre-tax return. However, the rational investor would invest in the government bond because it produces the greater after-tax return (5% cf. 3.6%). Given that pre-tax rates of return are the free market’s indicator of optimal resource allocation, the after-tax rate of return signals a sub-optimal efficiency outcome.

Of course, the illustration here simply compares taxable and non-taxable events. Nonetheless, the principle given by the example is easily extended to tax deferral. Even if the return on the government bond was taxable, but the tax liability could be spread evenly over the subsequent 10 years, it still produces the greater after-tax return.92

Much investment tax planning turns on the advantages offered by tax deferral, which – as we have already seen – may be permanent. Take the situation where a step-up to market value in the basis of assets in a deceased person’s estate at the time of death is allowed to his or her heirs. In the absence of an estate duty or inheritance tax that would result in the same tax impost as an income tax on the unrealised appreciation in the value of the assets during the deceased’s lifetime, the tax deferral, which arises from the step-up, becomes, in 92 Assuming that the annually declining amount of the tax benefit was invested at a compound interest rate of 5% p.a.

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effect, tax forgiveness.93 A typical investment strategy, therefore, is to retain assets for as long as possible to maximise the benefits of deferral.94

The outcome of such a strategy is one manifestation of the well-known “lock-in effect”. Opponents of taxation of capital gains most often advance the lock-in effect as an argument. In essence, the opponents claim that, where capital gains are taxed, investors will hold investments that have appreciated in value because to sell them crystallises part of the gain into a tax liability. Payment of that tax liability results in a loss of funds for reinvestment and therefore necessitates a higher return on a substitute investment to maintain the rate of return that was achieved by the former investment. Therefore, taxing capital gains gives an inventive to investors to stay “locked into” existing investments, thus impairing the mobility of capital, which optimal economic efficiency necessitates.95

Consequently, we often find in regimes that tax capital gains some form of “roll-over” relief, which is intended to militate against the inherent obstacle to economic efficiency, which arises from the taxation of the gain. In simple terms, rollover relief is designed to relieve the vendor of an asset from the obligation to pay tax on the gain on realisation if the proceeds are reinvested in a substitute asset. But relief in the form of a step-up in value, referred to above, is different from rollover relief. Rather than attempting to facilitate the transfer of assets at no immediate tax cost, the step-up is a strong disincentive to transfer assets at all. On the contrary, it is an incentive to retain assets under current ownership, thus defeating the policy objective of economic efficiency.

93 The relationship between an inheritance tax and an income tax on capital gains at the time of death is briefly discussed under Intra-family arrangements, below.94 Ironically, such an approach has been described as the “efficient” investment strategy in investment circles – an interpretation of efficiency somewhat polarized from that of public policymakers: see, for example, Fender, William E., “Benefits of Tax Deferral and Stepped-Up Basis Post-TRA 1997”, (1988) 7(2) Journal of Investing, Summer, 77. 95 For detailed discussions of the lock-in incentive effects, see Burman, Leonard E., (1999) The Labyrinth of Capital Gains Tax Policy, The Brookings Institution, Washington D.C., especially pp. 68-72; Cunningham, Noël B. and Schenk, Deborah H., “The Case for a Capital Gains Preference”, (1993) 48 Tax Law Review, 319, 344-350; Henderschott, Patric H., Toder, Eric and Won, Yunhi, “Effect of Capital Gains Taxes on Revenue and Economic Efficiency”, (1991) 44(1) National Tax Journal, March, 21; Auerbach, Alan J., “Capital Gains Taxation and Tax Reform”, (1989) 42(3) National Tax Journal, September, 391; Poterba, James M., “How Burdensome are Capital Gains Taxes?”, (1987) 33 Journal of Public Economics, July, 157; and Holt, Charles C. and Shelton, John P., “The Lock-in Effect of the Capital Gains Tax” (1962) 15(4) National Tax Journal, 337, 350-352.

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The questions of simplicity, certainty and convenience can be dealt with quickly in the context of income from capital. By nature, tax deferral introduces complexities into tax law. Tax deferral provisions are often extensions of the primary capital gains tax legislation, which provide relief for taxpayers who are otherwise caught by the substantive taxing provisions. Although there may be valid economic policy and political reasons for deferral mechanisms to be introduced into tax legislation, deferral provisions themselves inherently undermine the simplicity of the tax impost.

The greater the complexities of tax law, the greater are its uncertainties and the opportunities for tax avoidance. Although the basic truth of this axiom is undeniable, concessional deferral rules in a law that taxes income from capital are, in themselves, generally not likely to result in great uncertainty. In fact, such rules can be rather precise and quantitative (e.g. income averaging rules), which reduces the scope for differing interpretations and the accompanying uncertainty about the quantum of a tax liability for any particular year.

The notion of convenience is typically viewed in terms of financial and administrative burdens imposed on taxpayers and the tax administration as a result of the operation of a provision in the tax laws. In this sense, tax deferral results in greater administrative requirements and costs to both taxpayers and the tax administrators. While additional recordkeeping is necessary, it is unlikely to be particularly onerous for most taxpayers, especially for corporate taxpayers. However, deferral possibilities result in additional, and perhaps substantial, deadweight costs for taxpayers who must obtain financial planning advice to take advantage of a deferral. Nonetheless, for taxpayers who enter into tax deferral arrangements, the value of the benefits of deferral presumably exceeds the costs. But the converse is likely to be true for the tax administration. It will incur deadweight costs in administering tax deferral concessions to taxpayers, which, by their very nature, reduce the revenue collection for any particular year.96

There is usually a tension between the canons of taxation when applied to a particular economic activity, and this is so when addressing the question of tax deferral. Equity, simplicity and convenience might point against allowing deferral of recognition of income from capital while the need or desire for increased investment in an economy and certain

96 However, a deferral concession may be less costly to a tax administration in terms of administrative inconvenience than the costs (including the financial and other resource allocation costs of litigation) of combating tax avoidance schemes, which involve the conversion of ordinary income into capital if there were no tax at all, or tax concessionally imposed, on capital gains.

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aspects of the economic efficiency tenet offer stronger arguments in favour of it. The certainty criterion appears to be more or less neutral.

Economic policymakers and, ultimately, politicians must weigh up the conflicting objectives and, in the context of tax deferral, they must decide, in particular, whether the investment and economic efficiency arguments in favour of deferral outweigh the equity, simplicity and other economic efficiency arguments against it.

4. Deferral Mechanisms in Selected Jurisdictions of the New Europe

This section reviews some possibilities to defer tax on income in the European Union Member States and some accession countries to the European Union, as well as Norway and Switzerland. Occasionally, a comment is made concerning jurisdictions outside the New Europe.97

This review is approached in two ways. First, five different methods of deferral of recognition of income from capital are postulated and each is evaluated in terms of the tax laws of the selected countries. These are followed by brief comments on other significant deferral opportunities, which are commonly practised in certain selected countries.

The five deferral scenarios are framed as follows, in relation to dividend income from share capital, interest income from non-equity financing arrangements, rent from real property, royalties derived from a patent, and capital gains from the disposal of assets:

1. Deferral of recognition of dividend income. Corporate profits, otherwise distributable as taxable dividends, are capitalised into bonus hares issued to a shareholder, i.e. a stock dividend.

2. Deferral of recognition of interest income. An investor purchases a zero-coupon bond, which is issued with a high premium payable upon edemption.

97 The selection of countries was based on a combination of the size and importance of the country, the ease by which relevant information could be obtained and the responses to questions posed to experts in each country. Also, for specific country rules referred to in this chapter, see Kesti, J. (ed.), (2002) European Tax Handbook 2002, International Bureau of Fiscal Documentation, Amsterdam; Kesti, J (ed.), (2002) I Guides to European Taxation – The Taxation of Patent Royalties, Dividends, Interest in Europe, International Bureau of Fiscal Documentation, Amsterdam; Kesti, J., et. al. (eds.), (2003) II Guides to European Taxation – The Taxation of Companies in Europe, International Bureau of Fiscal Documentation, Amsterdam; Kesti, J. (ed.), (2002) III Guides to European Taxation – The Taxation of Private Investment Income, International Bureau of Fiscal Documentation, Amsterdam; Bouzoraa, M. A., et. al. (eds.), (2002) V Guides to European Taxation – Taxation and Investment in Central European Countries, International Bureau of Fiscal Documentation, Amsterdam; and Bobbett, Catherine S. (ed.), (2002) VI Guides to European Taxation – The Taxation of Individuals in Europe, International Bureau of Fiscal Documentation, Amsterdam.

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3. Deferral of recognition of rental income. A landlord incurs interest and other revenue expenditure, and claims depreciation deductions, in respect of a rental property that she acquired and leases to tenants. The ental income stream is “back ended”, i.e. lower rents are paid in earlier ncome years and higher rents are paid in later income years. The total eductions exceed annual rental income. A capital gain is realised when the building is sold.

4. Deferral of recognition of royalty income. The owner of a patent right transfers his ownership to an offshore trust to trap royalties derived from non-resident users of the patent.

5. Deferral of recognition of a capital gain. The vendor of an asset re-invests in a new asset to obtain rollover relief from tax on the capital gain, which results from the realisation of the asset.98

The tax consequences of these fiscal events in selected countries are examined below.

Deferral of recognition of dividend incomeThe mechanism to defer recognition of dividend income by way of issuing stock dividends is effective in many jurisdictions, including Austria,99 Belgium, Germany,100 Hungary, Italy, Luxembourg, the Netherlands,101 Norway, Portugal, Spain,102 and Sweden; and in France, Ireland and the United Kingdom (provided that the shareholder does not have a choice to receive the shares in lieu of a cash dividend).103 In the United States, the stock dividend must not increase the shareholder’s proportional interest in the company.

98 The first four scenarios could be regarded as examples of tax deferral that fall into the tax avoidance category, mentioned under Meaning of Deferral above. The fifth scenario is an example of tax mitigation.99 Unless the stock dividend is paid out of earnings or reserves and followed by a repayment of the same capital (represented by the shares so distributed) within 10 years of the stock dividend issue. In this case, the applicable rate is one half of the average tax rate applicable to the entire income. 100 However, a subsequent repayment of the newly issued capital is taxed as dividend income.101 If the stock dividends are connected with a substantial shareholding, i.e. a shareholding of 5% or more, taxation is deferred until the shares are sold. Where a substantial shareholding is inapplicable, income from share capital is based on a deemed yield.102 Where taxation of both companies and individuals is deferred until the sale of the shares.103 In that case, in France the stock dividend constitutes taxable income, which qualifies for the avoir fiscal (i.e. imputation credits). In Ireland and the United Kingdom, the shareholder is deemed to have received an “appropriate amount”, which is normally taken to mean the amount of dividend foregone. In the United Kingdom, the stock dividend must also not be preceded or followed by a repayment of capital (which is exceptional).

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However, in other jurisdictions this deferral arrangement is ineffective; for example, in Finland,104 Russia,105 and Switzerland.106

The mechanism may be effective in Denmark, where stock dividends are taxed as capital gains. In general, this treatment does not offer a timing deferral (the capital gain being taxed in the year of receipt of the stock dividend, just as a dividend would be taxed in the year of receipt); however, a permanent deferral by way of exemption is offered when the shares are quoted and are held for at least three years, and the total market value of all the taxpayer’s quoted shares does not exceed DKK 125,100 (2002).107

Deferral of recognition of interest incomeWhere the derivation of interest income from bond investments constitutes (part of) a business activity, the redemption premium is often required to be recognised on an accrual basis. However, there are greater opportunities for deferral in the case of non-business individuals. Here, the use of zero-coupon (or deep-discount) bonds is an effective method of achieving a temporary tax deferral on interest in Austria, Belgium, Finland, Germany,108

Hungary,109 Italy, Luxembourg, Portugal, Sweden, and Switzerland, because, although these countries include the redemption payment within their conceptions of taxable interest, that payment is recognised only at the expiration of the term of the loan.110

Denmark offers a permanent deferral for deep-discount (cf. zero-coupon) bonds by exempting the redemption payment from tax where the bond carries a periodic interest rate that is not less than a regulatory minimum rate at the time of issue of the bond. 111

Otherwise, the deferral is temporary only: the redemption premium is taxable in the year of payment.

104 Where stock dividends are taxed in full (and not entitled to imputation credits) if they constitute a hidden profit distribution, as postulated here.105 For individuals. Although they must include the stock dividend in taxable income, the stock dividend is not subject to withholding tax.106 Although the stock dividend must be included in taxable income, it is not subject to withholding tax.107 This threshold is doubled in the case of married persons, and the shareholdings of both spouses are taken into account.108 Provided that the bonds are held as private assets. The accrual principle applies to business assets.109 Subject to certain conditions, in the case of privately traded securities.110 At least in Austria, Belgium, Finland, Germany, Italy, Sweden, and Switzerland, if the debt is disposed of before repayment falls due, the interest attributable to the period that the debt was held by the vendor is taxable in the year of disposal. Also in Finland, if the loan principal is repaid in instalments, interest is taxable at the time of each instalment payment.111 This rate is published twice per year. For bonds issued between 10 October 2002 and 31 December 2002, the rate is 3%.

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By contrast, this method of deferral of income recognition is ineffective in other countries, e.g. Norway and the United Kingdom, including some outside of Europe, such as Australia, Canada, New Zealand, and the United States, because these countries include the amount of the redemption payment as interest that accrues over the term of the loan on a yield-to-maturity basis. Here, the notion of income for tax purposes and economic and accounting income is well aligned.

Deferral of recognition of rental incomeUnlike the accrual of a discount on a bond, it seems that (subject to the applicability of a general anti-avoidance rule) many countries accept the legal form of a back ended rental income stream, thus allowing a deferral of recognition of rental income over the term of a multi-year lease. A notable exception is the United States, which requires a restatement of the rent applicable to each year.

However, there is a considerable difference in treatment between states in relation to the deductibility of interest on borrowings to acquire investment assets, particularly in relation to individuals.

The schedular nature of some countries’ tax systems lends itself to the quarantining of losses to defeat tax deferral as a result of high gearing arrangements. At the extreme, this is most evident in the Netherlands where, regardless of the actual outcome, an individual taxpayer is deemed to derive a return of 4% of the average value of the property each year. In Slovenia, rental losses cannot be offset against profits from another source. The same applies to non-entrepreneurial individuals in Russia since, in general, the tax base is gross income.112

112 Entrepreneurs may offset losses, but they cannot carry losses forward. A legal entity may offset losses against other income and carry net losses forward for up to 10 years.

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Furthermore, this income sheltering technique is only partially effective in Belgium,113 the Czech Republic,114 Estonia,115 France,116 Germany,117 Ireland,118 Luxembourg,119

Slovakia,120 Sweden,121 the United Kingdom,122 and the United States.123

In the case of companies, the rental activity generally constitutes a business undertaking. Interest and other revenue costs, and a depreciation allowance, are normally deductible against the rental income. Where the costs exceed the rental income for any year, the excess can ordinarily be offset against other income.124

Where loss deductions are disallowed or restricted, symmetry of taxation would dictate that any gain on disposition of the property would be either not taxable or subject to limited taxation. This is the case to some extent in Sweden where, for individuals, the loss

113 For personal income tax purposes, a rental loss from properties let for business use can be offset only against income from other immoveable property, and not against other categories of income. Furthermore, the loss cannot be carried forward or back to other income years.114 Rental losses can be offset against profits in another income category, but they cannot be offset against employment income. An overall net loss (excluding employment income) may be carried forward for up to seven years.115 Only where a taxpayer elects to have his or her income from a rental property treated as business income can the rental loss can be effectively offset against other business profits. An excess business loss can be carried forward for 7 years to be offset against future business income.116 Subject to some particular qualifications, in general losses of up to EUR 10,700 arising from real property investments, other than those produced by interest deductions, may be offset against other income, provided the property is let for a period of at least three years after the year of offset. However, other losses incurred in relation to real property cannot be set off against other types of income. Net rental losses for a particular year can be carried forward and set off against income from real property derived in the subsequent five years.117 A full deduction for expenses relating to the renting out of the property is not granted if the rental payments received fall short of 50% of the average of local comparable rents. The rental loss (together with any other losses) may be offset against other income up to EUR 51,500 annually. Any remaining loss is set off against 50% of the remaining taxable income. Excess losses may be carried back to the previous year (up to a maximum of EUR 511,500) and carried forward indefinitely.118 Rental losses are generally set off against rental profits derived in the same year. Excess losses are carried forward for offset against rental income of future years. Losses that arise from capital allowances applicable to commercial property rental may be offset against other income up to EUR 31,750 p.a. 119 Losses from investment income, which include a rental loss, may be set off against only other investment income. Excess losses may be carried forward if the taxpayer elects to spread certain investment expenses over five years.120 Rental losses can be offset against other categories of income except for employment income. Any excess loss can be carried forward provided that certain restrictive conditions are met.121 Only 70% of the rental loss can be offset against an individual’s business and employment income (and real estate tax) in any one year. Any excess loss cannot be carried forward to later income years; thus, the excess is permanently lost.122 The rental loss can be offset only against a rental profit from another property. Any excess loss can be carried forward and offset against taxable rental income in a later year but only in respect of the same property. 123 Losses from passive activities (i.e. activities the operations of which the taxpayer is not involved on a regular, continuous and substantial basis) can be deducted only against income and gains from other passive activities. Any excess losses may be carried forward to future income years for offset under the same conditions. However, once an activity is terminated, the quarantined losses are free to be set off against any other income.124 Ireland and the United Kingdom being the main exceptions to this general practice.

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deductions are limited to 70% but only 2/3 of the capital gain on the disposal of immovable property is taxable.

However, symmetry of taxation is not attained where all costs related to the property are not deductible, but the revenue streams and capital gains from it are taxable. Such asymmetry is evident in the Denmark, Estonia,125 France,126 Germany,127 Ireland, Luxembourg, the United Kingdom,128 and the United States.129

Full negative gearing (i.e. allowing the rental loss to be offset against any other income derived by the investor in the year of the rental loss) is permissible in Austria, Cyprus, Greece, Portugal, Spain,130 Switzerland, and Turkey. In these circumstances, the most beneficial tax deferral opportunity arises where the capital gain on disposal of the rental property is not taxable. Here, (i) a deduction is allowed to such an extent that it reduces current year tax on income to which the deducted expense does not relate and (ii) the gain that results (at least in part) from the deduction is not subject to tax or taxed in a concessional way. This is the case, for instance, in Austria, Greece, and Turkey.131

But at least some degree of tax symmetry is achieved in the full negative gearing cases where the capital gain on disposal of the property is taxed, which is the case in Cyprus,132

Portugal,133 Spain,134 and Switzerland.135

Deferral of recognition of royalty incomeThe essence of this tax deferral structure is to ensure that a legal person who is not a resident of the European state concerned, i.e. a trustee who is resident of a nil- or low-tax jurisdiction, derives income from capital. The English based common law and law of equity recognises the trustee as the legal owner of the income derived from the property,

125 With respect to individuals. Companies are not taxed on gains on the realisation of assets: see under Tax Policy and Deferral above.126 Although, if the property is sold after two years, a specified inflation adjustment and certain exemptions are allowed.127 Provided that the disposal is within 10 years of acquisition.128 Although the gain is subject to an annual de minimis exempt amount and taper relief, which reduces the taxable amount according to the length of time that the asset has been held.129 Although capital gains from the sale of assets that have been held for more than 12 months and five years are subject to two different concessional rates of tax.130 For companies only. For individuals, deductible expenses are limited to the amount of rental income derived.131 In the case of an individual, unless the property is certain immovable property, which is sold after four years of the date of acquisition.132 Although there is a modest lifetime exemption.133 Although the gain is adjusted for inflation, which enhances the deferral benefits.134 For companies, but not for individuals, since both are taxable on the capital gains that they derive. 135 The gain is subject to either ordinary income tax or to a separate real estate tax, depending on the canton.

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but the trustee has no entitlement to the benefit of that income; instead, he or she holds or applies the income for the benefit of another person. Where the trustee is resident in jurisdictions that do not tax such foreign sourced income in these circumstances (e.g. Jersey, Guernsey, the Isle of Man and the Cayman Islands), a tax deferral is achieved at the time that the income is derived from the use of the capital. A permanent deferral is possible if a subsequent distribution by the trustee to a beneficiary is treated as a tax-free capital receipt in the country of residence of the beneficiary. Such a permanent deferral may be possible in certain circumstances in some countries, e.g. France.

Controlled foreign company (CFC) legislation is common in European jurisdictions; for example, it exists in Denmark, Estonia, Finland, France, Germany, Hungary, Italy, Norway, Portugal, Spain, Sweden, and the United Kingdom. The CFC rules in Germany,136

Hungary, and Spain extend to offshore trusts and foundations. The Norwegian Supreme Court has held that Norwegian resident beneficiaries of an offshore trust may fall within the scope of the Norwegian CFC legislation, such that a trust is treated as a transparent entity under that legislation.137

Possibilities for deferral of foreign sourced income from capital through the use of an offshore entity present themselves in countries that have no CFC legislation at all; for example, Greece, Ireland, Luxembourg, the Netherlands,138 Switzerland, Cyprus, Malta, the Czech Republic, Latvia, Russia, Slovakia, Slovenia and Turkey. It is arguable that, in some of these countries (e.g. Luxembourg), the general anti-abuse rule is applicable to defeat the diversion of income for deferral purposes through a foreign entity situated in a nil- or low-tax jurisdiction.

Deferral of recognition of capital gainMost countries that tax capital gains do so upon realisation of the gain, rather than on cash receipt basis. There are some exceptions to this basic rule; for example, Hungary,139

Spain,140 and the United Kingdom.141

136 CFC-like legislation attributes a foreign foundation’s income to its German-resident founder or beneficiaries. This rule extends to irrevocable trusts.137 See State of Norway (Central Taxation Office for Large Enterprises) v. Fred. Olsen, Anette Olsen and Marete Olsen Nergaard, HR-2001-00662. An English translation can be found in (2002) 5 International Tax Law Reports, part 1.138 However, individuals who are substantial shareholders of an investment company that is situated in a tax haven country must account for imputed income of 4% of the value of their shareholding.139 Especially in respect of gains on the disposal of securities.140 The gain can be allocated to the periods of the instalment payments where this method of payment for the asset applies.141 It is possible for individuals to defer tax if the consideration for asset disposed of is received in instalments.

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Where recognition of a capital gain depends on realisation, the most common way to defer crystallisation of the resultant tax liability is to defer the realisation event. Such deferral occurs at two levels:(a) where the owner of an asset proposes to dispose of it, but puts devices in place to

defer the recognition of the gain on disposal until a later income year (a short-term deferral); and

(b) where the owner of an asset is deterred from disposing of it at all or at least until time based tax concessions become operative (a long-term deferral).

In relation to short-term deferrals, when, in accordance with private law, the date at which realisation takes place is determined by the date of an unconditional agreement between the parties to the transaction, realisation can be deferred by imposing conditions on the transfer of the property, which are fulfilled later, e.g. subject to notification of availability of finance conditions, where the timing of the notification can be manipulated by the relevant party to the contract. Only when those conditions are met does the contract become unconditional, at which point the sale occurs and the gain is realised. This is a common device to defer the recognition of the capital gain until the year following that in which the conditional sale agreement was reached, especially when the substance of the contract is achieved towards the end of an income year.

Long-term deferral produces the undesirable policy effect of locking assets into existing ownership, which counters economic efficiency.142 In an attempt to overcome this effect, many countries offer rollover relief, which defers the liability to pay tax on the capital gain. Rollover relief typically takes the form of a requirement to re-invest the proceeds of the realisation of the asset in a replacement asset of the same type as that realised within some specified period or to transfer the gain on disposal to a special reserve to be applied for that purpose within some defined period.

Unlike the deferral scenarios already discussed (where a taxpayer must structure an income earning arrangement in a particular way to achieve the benefits of deferral), rollover relief is specifically held out by the tax legislation as a means of tax deferral. It is an example of Lord Templeman’s idea of tax mitigation: it is not a manifestation of tax deferral by tax avoidance.143

142 See under Tax Policy and Deferral above.143 Op. cit., footnote 9.

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This sort of rollover relief is available in most countries in one form or another, subject to certain conditions. Different rules often apply to companies and individuals. Where rollover relief is available, it typically applies to business assets. Depending on the country, it may also apply to other assets where stipulated requirements are met. For example, in Turkey a company can obtain rollover relief if an asset is replaced within three years; however, an individual may obtain such relief only if he or she replaces a business as a whole. Notably, the Czech Republic offers no rollover relief.

While it is common for countries that offer rollover relief to require a replacement asset to be acquired (often subject to strict conditions), or to require the gain to be transferred to a special reserve, within a certain period from the time of disposal of an existing asset (for example, Denmark,144 Germany,145 Luxembourg,146 the Netherlands,147 Poland,148

Portugal,149 Sweden,150 Switzerland,151 and the United Kingdom152), a country can also impose asset holding period thresholds before rollover relief is allowed; for example, in Austria, where the asset disposed of must have been a fixed asset of a company’s resident permanent establishment for at least seven years (or 15 years in the case of land or 144 A replacement asset must be acquired within one year before or after the date of disposal.145 Companies may apply a capital gain from the disposal of qualifying assets (including land and buildings, but excluding shares) to reduce the cost of a replacement of the same kind of asset acquired in the year preceding the year of disposal, the year of disposal, and the four subsequent years (or six subsequent years in the case of buildings the construction of which started before the end of the fourth year). For individuals, half of the capital gain on the disposal of shares is eligible for rollover relief.146 A replacement building or non-depreciable fixed asset must be acquired in place of such an asset within two years of the time of disposal.147 A company or an entrepreneur must replace the asset disposed of during the year of realisation or transfer the capital gain to a replacement reserve, which must be applied to acquire fixed assets within three years.148 An individual must acquire a replacement dwelling or building or replacement land within two years of disposal of existing assets of those types, which were sold within five years of acquisition, in which case the gain on disposal is tax-exempt.149 Fifty percent of the gain derived by companies on the disposal of tangible fixed business assets is exempt if the proceeds are reinvested in similar assets within a four-year period beginning with the year preceding the year of disposal. This relief also applies to gains on the sale of shares or other rights in a company and to Portuguese government bonds held by a resident company if (a) the total consideration received is reinvested in other shareholdings, Portuguese government bonds or intangible fixed business assets; (b) the holding disposed of represents at least either 10% of the company’s capital or an acquisition value of at least EUR 20 million and both the shareholdings or bonds disposed of and acquired are retained for at least one year; and (c) subject to certain conditions, the shareholdings do not involve related-party entities. A resident individual must reinvest in a permanent dwelling within 12 months before or two years after the sale of his or her existing permanent dwelling to benefit from the exemption from tax on the gain.150 An individual must acquire a new permanent dwelling within one year from the date of sale of his or her existing dwelling. Furthermore, the existing dwelling must have been his or her main residence during the year before the sale or for three of the five years preceding the sale. The deferral applies until the replacement dwelling is sold. However, a capital gain of less than SEK 50,000 does not qualify for the rollover relief concession.151 Where fixed business assets are replaced within Switzerland. If the replacement does not take place within the same financial year as the disposal, the amount of the gain can be transferred to a reserve for application against the cost of a replacement asset within an appropriate period.152 Reinvestment in a replacement business asset must be within one year before or three years after the date of disposal.

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buildings) prior to disposal.153 Similarly, in Belgium a company’s business assets must be held for at least five years before rollover relief can be claimed.154

Much more common, however, is the use of holding period thresholds to offer permanent deferral by way of exemption of tax on capital gains, which encourages postponing a disposal until the time that it can be carried out without tax ramifications. These holding periods create potentially substantial lock-in effects and, therefore, economic inefficiency. For example, this approach is evident in Austria,155 Belgium,156 Cyprus,157 the Czech Republic,158 Denmark,159 Estonia,160 Finland,161 France,162 Hungary,163 Italy,164 Latvia,165

153 A company must replace the asset disposed of during the year of realisation or transfer the capital gain to a replacement reserve, which must be used to acquire fixed assets within one year.154 A company must reinvest the proceeds of disposal of a business asset in depreciable assets within three years of the date of disposal.155 For individuals who own non-business property for more than one year or real estate for more than (generally) 10 years. Special rules apply to a principal residence. There is a tax exemption for capital gains of less than EUR 440.156 The realised capital gain from the sale of the building is not taxable if the building is sold more than five years after acquisition (or more than three years after donation to the vendor where the donor acquired the property less than five years before the date of sale). 157 A cumulative lifetime exemption for capital gains of up to CYP 50,000 is available to the owner of a house that he or she has occupied for at least five years.158 For individuals who own immovable property for more than five years; a dwelling or main residence for more than two years; motor vehicles, aircraft and ships for more than one year; and securities for more than six months.159 For shares held for at least three years before disposal. By way of contrast, only limited tax relief is offered in respect of gains on the sale of immovable property, which invites deadweight costs in devising structures that might transform gains on disposals of immovable property into gains on share disposals.160 For individuals who own a holiday home for more than two years.161 For individuals who own a dwelling as a permanent home for more than two years.162 For individuals who own business assets for more than five years and immovable property for more than 22 years – see further comments below.163 For individuals who own immovable property for more than 15 years – see further comments below. Capital gains from immovable property also become tax-exempt if they are applied to acquire a permanent home for the vendor or his or her relatives within one year before or five years after the time of sale of the asset. 164 For individuals who hold immovable property for more than five years.165 For individuals who own immovable property, shares and securities for more than 12 months.

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Luxembourg,166 Malta,167 Norway,168 Poland,169 Russia,170 Slovakia,171 Slovenia,172

Switzerland,173 and Turkey.174

Aside from revenue gathering, the primary reason for these rules would appear to be to ensure that speculative gains are taxed when the underlying policy intent is not to tax certain other gains, particularly when it is politically unacceptable to do so – as in the case of a taxpayer’s permanent residence – although one is left to ponder the conceptual logic, particularly taking account of the tenet of equity in taxation, of why tax exemption concessions should extend to investment-type assets, such as shares and other securities, and immovable property other than a family home. Furthermore, it is difficult to rationalise why shares should be subject to a more favourable tax treatment than the underlying corporate assets, which the value of the shares reflects.

In countries where such exemptions apply, it is, of course, easier administratively to adopt an arbitrary “bright-line” numerical time limit to determine taxability. Nonetheless, the administrative benefits of this approach must be weighed up against its equity and efficiency disadvantages brought about by the tax deferral opportunities that the benefits create.

Some countries have other provisions that encourage owners of assets to retain them in order to obtain the benefits of tax deferral. These provisions often take the form of concessional rates of tax, which apply to gains on the disposal of assets that have been held for, generally, more than a minimum period; for example, Austria,175 Finland,176 France,177

166 For individuals who own immovable property for more than six months – see further comments below.167 For individuals who own and occupy a residence for more than three years and disposal is within 12 months of vacating the residence.168 For dwelling houses owned for at least one year and used as a home for at least one of the two years immediately prior to realisation; holiday houses owned for at least five years and used as a leisure- time home for at least five of the eight years immediately before realisation; and farms and forests held for more than 10 years.169 For investment assets held for more than five years.170 For individuals who own immovable property for more than five years and movable property for more than three years.171 For individuals who own a primary home for more than two years; other immovable property for more than five years; and securities for more than three years.172 For individuals who own real estate for more than three years.173 Private capital gains derived by the vendor of immovable property are generally entitled to a special deduction commensurate with the length of ownership, for cantonal tax purposes.174 For individuals who hold certain immovable property for more than four years and shares in resident companies for more than three years.175 Individuals who sell shares in corporations are subject to income tax at reduced rates if they held a participation of more than 1% of the issued share capital at any time within the five-year period preceding the sale.176 For individuals who hold property for at least 10 years, a presumptive cost of 50% of the sales proceeds is allowed in calculating the gain; otherwise, a presumptive cost of 20% applies.

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Hungary,178 Luxembourg,179 Poland,180 Portugal,181 and the United Kingdom.182

Presumably for social policy reasons, but with obvious efficiency implications, Spain offers a novel age based incentive for permanent tax deferral: capital gains on the disposal of a primary residence are tax-exempt when the taxpayer reaches the age of 65 years.

Some jurisdictions give the opportunity to defer tax by spreading a capital gain over more than one income year, subject to specified conditions; for example, France,183 Italy,184 and Norway.185

Participation exemptionsIn many countries, permanent tax deferral (by way of a tax exemption) is available to corporate shareholders who derive a capital gain on the disposal of a substantial participation in another company. Since almost all of these concessions depend on the shareholder company meeting a threshold level of participation (and often for a specified period), it is relatively easy for a company to manipulate its shareholding to meet the

177 For individuals, business assets and securities held for more than two years can be taxed at a concessional rate of 16% (which is increased by social taxes to an effective rate of 26%). In calculating the gain on the disposal of immovable property held by an individual for more than two years, the acquisition cost is increased by 10% and adjusted for inflation over the holding period, the capital gain is reduced by 5% for each year that the asset is held beyond two years, and a deduction of at least EUR 915 (for the 2002 year) is allowed.178 For individuals, gains on the sale of immovable property are taxed at a flat rate of 20%. If the property is held for more than five years, the basis abates at the rate of 10% p.a., such that after a holding period of 15 years, the gain becomes tax-exempt.179 For individuals, immovable property held for more than two years and gains on the disposal of (substantial) participations of 10% or more held by the taxpayer and his or her family members at any time during the five years preceding disposal are taxed at half of the average rate on the taxpayer’s total income (subject to an exemption of EUR 500).180 For individuals, gains on the disposal of immovable property held for less than five years are taxed at a flat rate of 10%.181 Indexation is available to companies and individuals that own real estate for more than two years. For individual entrepreneurs, only 50% of the gains on disposal of tangible fixed business assets are taxable if the assets have been held for at least one year.182 Taper relief, which applies to individuals, reduces the taxable amount of the gain on the sale of business assets according to the length of time that the assets are held. The maximum reduction in the gain is reached after four years of ownership when only 25% of the gain is taxable. For non-business assets, 95% of the gain is taxable if the asset is owned for three years; the gain is reduced by 5% for each year of ownership thereafter, such that a minimum of 60% of the gain is taxable if the asset was owned for 10 years or more. 183 Individuals may spread gains from the sale of business assets over, generally, three years if the asset has been held for less than two years.184 Companies and individuals have the option of spreading gains on the sale of business assets equally over the year of disposal and up to four subsequent income years, provided that the asset has been held for at least three years.185 Companies that realise capital gains on the disposal of ships and other vessels, drilling rigs, aircraft, and plant and buildings have the option of spreading 20% of the gain over the year of disposal and the four subsequent income years. (The proceeds of sales of machinery and equipment, vehicles, acquired goodwill, fixtures and furniture, and tools may be deducted from the collective depreciation base, rather than being included in the calculation of taxable capital gains).

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percentage holding and holding period requirements in order to benefit from the tax concession.

As is the case for the European Union Parent-Subsidiary Directive,186 the policy intent that underlies participation exemptions is to remove tax barriers to inter-company transactions when there is some degree of economic unity between the companies involved. However, the relief provided by these exemptions inherently creates (unintended) deferral opportunities, again largely because the exemption often relies on an arbitrary bright-line percentage threshold, around which tax deferrers can plan.

Participation exemptions for capital gains based on these sorts of criteria are available in such countries as Austria,187 Belgium,188 Luxembourg,189 the Netherlands,190 Spain,191 and Switzerland.192 In France, a reduced tax rate applies to capital gains that are derived on the disposal of participation shares.193 Sweden proposes to introduce a participation exemption where the threshold participation in a Swedish or foreign company is 10%.

186 Council Directive 90/435/EEC of 23 July 1990.187 The exemption applies only to participations in foreign companies, which meet certain conditions, including a minimum shareholding of 25% held for an uninterrupted period of at least two years.188 There is no minimum participation threshold (unlike the participation exemption threshold for dividends, which is 5%). The capital gains participation exemption requires only that the dividends relating to the shares or participation qualify for the participation exemption at the time of realisation. The exemption applies only so far as the gains are higher than previously deducted capital losses on the shares or participation.189 Non-tax transparent companies that own 10% of the share capital of companies described in the EU Parent-Subsidiary Directive or non-EU companies that face an effective tax rate that is comparable to that in Luxembourg. If the 10% threshold is not met, the exemption will still apply if the cost base is at least EUR 6 million. The participation must have been held for at least 12 months prior to realisation.190 Dividends and capital gains derived from the disposal of a substantial shareholding in a Dutch or foreign company are tax-exempt. The minimum shareholding is 5% of the nominal paid-up capital of the company. Further conditions apply to foreign companies. 191 The threshold percentage is 5% and the minimum uninterrupted holding period is one year. Where gains arise from the alienation of shares in resident companies, the vendor company is entitled to a credit for tax on the gain determined by reference to the extent that the gain represents undistributed profits (which have not been reduced by loss offsets) of the company whose shares were sold, during the vendor’s holding period. Gains from the sale of shares in non-resident companies are exempt from tax under the same conditions as above, provided that the non-resident company is subject to tax that is comparable to Spanish corporate tax and the company’s income is derived from passive entrepreneurial activities carried on outside Spain. Under the special “foreign share holding company” regime, capital gains are exempt from Spanish tax if the vendor’s participation is no less than EUR 6 million. In this case, the holding company’s shareholders are granted a tax credit on dividends and gains on their shares, while a non-resident shareholder’s income is not subject to tax in Spain.192 In general, for both federal and cantonal tax purposes, the threshold percentage is 20% and the minimum holding period is one year.193 The minimum participation is 5% or a cost price of at least EUR 22.8 million with respect to shares acquired in a public takeover bid. The minimum holding period is generally two years. The effective tax rate is 19.57%. The after-tax gain must be booked to a long-term capital gains reserve, which, upon distribution, corporate tax (at the rate of 341/3%) is levied with a credit given for the tax already paid at the reduced rate.

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Some countries restrict their participation exemptions to dividends and assimilated revenues, thus excluding capital gains from the tax concession; for example, Hungary.194

Corporate reconstructions Companies also have the opportunity to defer tax by way of a merger, division, or takeover because such corporate reconstructions do not cause an immediate tax liability in most European jurisdictions. Like the European Merger Directive,195 the policy intent effectively is to give rollover relief in respect of taxation of capital gains, which arise upon a corporate merger, division, asset transfer, or exchange of shares, to both the companies involved and their shareholders. However, a company that seeks a tax deferral for an otherwise taxable gain may, in appropriate circumstances, obtain the deferral by a corporate restructuring, although to do so would be contrary to the legislative intent, i.e. the tax deferrer’s primary objective is to obtain a tax deferral by way of a corporate restructuring, rather than the primary objective being to restructure the corporation where tax deferral arises as an important, but nevertheless ancillary, consequence.

By way of illustration,196 a share-for-share exchange, which would normally constitute a realisation of an asset (i.e. the shares given up by a shareholder), will not activate an immediate tax liability in Austria, Belgium, Denmark, Finland, France, Hungary,197 Malta, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland,198 and the United Kingdom. However, the deferral opportunities might be somewhat limited in Ireland and the United Kingdom because the cost base of the shares given up can be carried over, as the basis of the new shares only if a merger is not undertaken for tax avoidance purposes.199 Similarly, in the Netherlands, the merger must not be motivated by tax avoidance.200

194 Whether the dividends are received from Hungarian or non-Hungarian sources. 195 Council Directive 90/434/EEC of 23 July 1990.196 It is not the intention here to discuss the multitude of rules and their effects in connection with corporate mergers, takeovers, divisions, etc. The point is simply to demonstrate that the tax concessions that are available upon a corporate reconstruction could be used in appropriate circumstances to achieve the benefits of tax deferral on otherwise immediately taxable capital gains.197 However, stock dividends and capital gains derived by individuals as a result of a merger are taxable, but the applicable 20% schedular tax may be deferred until disposal of the shareholder’s interests.198 Provided that the shareholder is a legal entity or an individual holding the shares as business property and that the new shares are accounted for at the same value as the shares that were given up.199 Also in the United Kingdom, rollover relief applies to capital gains that arise from intra-group transactions. The transferee company takes over the acquisition cost and date of transfer of the transferor, such that the taxable gain crystallises when the asset or transferee company leaves the group. For this purpose, a group comprises a parent company and 75% owned subsidiary companies.200 If the merger is an “enterprise merger” (i.e. where the enterprise of one company is transferred to another company in exchange for shares in the latter company), the newly acquired shares must not be disposed of within three years after the merger.

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Furthermore, Article 11(a) of the Merger Directive allows a Member State to set aside the concessions offered by the Directive if the merger, division, transfer of assets, or exchange of shares, which has cross-border implications within the European Union, has tax avoidance as its (or one of its) principal objectives. If tax avoidance is construed as entering into arrangements that are motivated to deliberately circumvent the payment of tax for a particular year,201 the deferral of recognition of income (with the consequent deferral of payment of tax) to a later year falls within the notion of tax avoidance. Nevertheless, a critical test in Article 11 of the Merger Directive is that tax avoidance (even if it encompasses tax deferral) must be a principal objective of the merger, division, transfer, or exchange.

Change of residential statusIn some countries, taxes on gains on the realisation of an asset can be deferred if, before disposing of the asset, a taxpayer ceases to be a resident of the country that imposes the tax. If exit taxes apply (as they do, for example, in Austria and France), the rational taxpayer will evaluate the cost of the exit tax against the taxation tax cost of realisation of the asset (and the tax cost – if any – upon realisation of the asset in the jurisdiction of new-found residence). If no exit taxes apply, the deferral can be permanent; as is the case, for example, in Hungary,202 Norway,203 Portugal,204 Spain,205 and Sweden. In some cases, if a taxpayer resumes residence within a prescribed period, the deferral of tax on capital gains on assets disposed of during the period of non-residence will be temporary; for example, the United Kingdom.206

Capital lossesDeductible capital losses can be used to defer tax by realising losses immediately (or in years in which an individual faces high marginal tax rates) and delaying the realisation of capital gains until later years (or until years in which the individual taxpayer faces low marginal tax rates). Thus, especially taxpayers with sufficiently large and diversified portfolios can identify assets carrying book losses and realise them whilst leaving

201 Apart from tax evasion, which is in a category of its own.202 But fiscal liability of an individual may be extended based on citizenship.203 Although business assets transferred out of the Norwegian tax jurisdiction are subject to depreciation claw-backs.204 Unless a resident emigrates to a low-tax jurisdiction, in which case he or she is still considered a resident of Portugal for the four years following emigration.205 In the case of a company or permanent establishment (PE) that transfers abroad, an unrealised gain becomes taxable (unless, in the case of a PE, the assets remain with another PE in Spain). A realisation is also triggered if the PE ceases its activity in Spain or transfers assets out of Spain.206 If an individual resumes United Kingdom residence within five years of departure. By comparison, a change of residence of a company or a trust brings about an exit charge.

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untouched assets with appreciating values. Alternatively, capital gains can be sheltered from tax by realising and offsetting losses in the same income year.

Rules on capital losses vary considerably between countries, but most countries impose some sort of limitation on the deductibility of capital losses; for example, Austria,207

Cyprus,208 France,209 Norway,210 Spain,211 and Sweden.212 In Hungary, no capital loss deductions are permitted at all for individuals.On the other hand, in the Netherlands there may be an opportunity to use capital losses for tax deferral purposes: while capital gains that are derived by companies or other businesses are not taxable until they are realised, capital losses are deductible as soon as they can reasonably be expected, provided that the losses are connected to past business activities. This rule could facilitate a temporary tax deferral by recognising losses immediately to shelter other taxable business income.213

Intra-family arrangementsIntra-family asset transfer arrangements can be used effectively in many jurisdictions to permanently or temporarily defer tax on capital gains, which might otherwise arise on the transfer of assets. For instance, inter-spousal transfers are not taxable in Ireland. Rollover relief is available in Sweden for property transferred by way of gift and inheritance, and for division of community property (with no step-up in the basis of the assets transferred), and in Switzerland in respect of federal, cantonal and municipal income taxes on business property, or in respect of cantonal and municipal taxes on property, transferred by gift and inheritance, matrimonial property transfers, and sometimes transfers between parents and children. In Italy, rollover relief is available for business assets gifted inter vivos or by succession to family members.

207 Capital losses are generally deductible only from profits of the same category.208 Companies can offset capital losses against capital gains in the same or future income years without limitation.209 An individual cannot deduct capital losses from other taxable revenue, except for capital losses from the realisation of securities, which can be offset against capital gains of the same nature realised in the same year or any of the following five years.210 Capital losses are not fully deductible against income from labour.211 Capital losses can be offset against capital gains. Net capital losses can be offset to the extent of 10% of ordinary income. Remaining losses can be carried forward and offset in the same way for the four subsequent years.212 Only 70% (or less if a lower percentage of a gain were taxable) of a capital loss is deductible, but it may be offset against all types of income from capital (i.e. capital gains, dividends, interest, royalties, etc.). If net capital income is negative, up to the lesser of (a) 30% of the deficit or (b) SEK 100,000 plus 21% of the deficit can be set off against earned income.213 However, a capital loss on the disposal of a substantial shareholding is generally not deductible, except (under certain circumstances) where a loss arises on the liquidation of a company in which the shares are held or for certain write-offs of shares in such companies, which incur losses during the first five years after the shares are acquired.

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The benefits of deferral can be permanent. For example, in Luxembourg, the sale of the main residence of one’s parents or grandparents, which was inherited, is tax-exempt.214 In Malta, gains on the disposal of inherited property are tax-exempt.In France, Hungary, Spain and the United Kingdom, there is no realisation and, therefore, a tax deferral where assets are transferred upon death. A successor’s basis in the inherited assets is their fair market value at the date of death of the deceased. This is because it is that value that is subject to property transfer duty at the time of death. Similarly, in Portugal, death does not trigger realisation of a capital gain; instead, inheritance and gift tax applies. In Norway, the heir is entitled to a step-up in the basis of the inherited assets to a value no greater than the valuation adopted for inheritance tax purposes (which in practice is often lower than the fair market value at the time of death). The same rules apply to gifts, although the gift of a single business constitutes a realisation.

In these cases, a taxpayer who rationally seeks tax deferral opportunities would evaluate the income tax saving benefits of a testamentary transfer of assets against the costs of any applicable inheritance taxes. If the inheritance tax cost is less than the income tax cost of an inter vivos transfer of the assets to the successor, there are tax deferral benefits from a testamentary transfer. Furthermore, the deferral is permanent to the extent that the saving of tax on the capital gain, which is otherwise applicable to the increase in the basis from the time that the deceased acquired the property until the date of death, exceeds the inheritance tax applicable to the value of the asset at that date.

The tax deferral benefits that arise from inter-spousal or inter-partner property transfers should not be offensive when the underlying social policy is community of property. In other words, not to allow the tax deferral is contrary to the social policy goal. However, there would seem to be no convincing reason why there should be an increase in the basis of the assets transferred under these circumstances. Leaving aside the lock-in effect and subject to the comments below concerning other intra-family asset transfers, once the asset is transferred outside the matrimonial or “domestic” partnership unit, the gain on disposal – calculated as the difference between the consideration received on disposal (or, in a non-market transfer, the asset’s market value) and the asset’s cost price to the spouse or partner who contributed the asset to the marriage or cohabitation – should be taxed (as is the case in Sweden).

214 In the case of other assets transmitted at death and lifetime donations, the beneficiaries take over the cost base and acquisition date of the testator or donor.

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Whether such tax concessions should extend to other intra-family asset transfers is a more difficult policy question, which ultimately turns on a country’s idea of the tax unit. If the tax unit is extended beyond spouses and partners to encompass inter-generational family members (i.e. by adopting a cultural based concept of the – extended – family, which is common in underdeveloped countries), the possibilities for permanent tax deferral are greatly increased.

One might question why an inheritance or gift tax is necessary at all. Conceptually, none of them is a substitute for an income tax. They are taxes on a value of wealth at a specific time. Income tax, on the other hand, is a tax on a change in wealth between two points in time and consumption during that period (to adopt the Schanz-Haig-Simons approach) or an inflow of money (to use the traditional – but less conceptually robust – judicial interpretation). Capital gains, being benefits derived over time, always fall within the former concept of income and sometimes fall within the latter. But, intrinsically, a capital gain can never be wealth at one point in time. Wealth is a result of a gain. Therefore, at least in principle, a capital gain falls within the notion of income and, logically, is potentially subject to income tax.

Furthermore, inheritance and gift taxes can be viewed as property transfer taxes – something akin to a transactions tax, albeit a “transaction” without consideration. They are not taxes on income per se, although the value of the property transferred constitutes income in the hands of the recipient in the Schanz-Haig-Simons sense.

Nevertheless, all of this is not to say that a capital gain should necessarily be subject to income tax at the time of death or gifting, nor that inheritance and gift taxes cannot co-exist with an income tax that embraces capital gains, which are recognisable upon death or gifting.

Ultimately, the presence and timing of impost of these taxes turn on broad economic (and political) policy considerations. For example, a government’s desire to encourage investment may be sufficiently strong to outweigh competing factors such that capital gains upon death or gifting are tax-exempt or the recognition of them is deferred. Similarly, income redistribution or base broadening considerations could result in the imposition of inheritance and gift taxes, quite independently of an income tax, which also captures capital gains upon death or gifting.

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Finally, the design of a tax system might incorporate inheritance and gift taxes as a practical surrogate for taxes on capital gains at the time of death or gifting. Although such an approach lacks a valid theoretical foundation (as explained above), it is a relatively simple and convenient approach. But, to achieve tax neutrality, and therefore to deny tax deferral opportunities, where gift or estate duty applies to inter vivos or testamentary asset transfers, in principle the relevant tax rate must produce an amount of duty payable that is equivalent to the income tax otherwise payable on the gain that would arise if the asset were instead realised by disposal to the transferee. In this case, to avoid double taxation, the basis of the assets transferred must be increased to their value for gift or inheritance tax purposes (as is the case in Norway). If it were difficult in practice to achieve tax neutrality in this way, one might tolerate some deferral by imposing a gift or inheritance tax, prohibiting an increase in the basis of the transferee, and, upon disposal by the transferee, allowing a credit for the gift or inheritance tax against the tax payable on the ultimately realised capital gain. Here, the gift or inheritance tax effectively becomes a withholding tax.

5. Anti-avoidance provisions

We have already seen some rather limited examples of tax avoidance provisions, which target specific tax deferral arrangements, e.g. the Netherlands’ and the United Kingdom’s denial of non-taxation of capital gains upon a share exchange as part of a corporate reconstruction if the reconstruction is undertaken for tax avoidance purposes. In addition, the imposition of asset holding period thresholds before a gain that is eligible for permanent tax deferral (by way of a tax exemption), or deeming an asset to be realised upon the owner’s change of residence, can be regarded as anti-avoidance measures in much the same way as (say) a transfer pricing or thin capitalisation code is designed to impose restrictions on taxpayers to deter them from minimising their tax liabilities for a particular year.

However, more generally most countries do not have anti-avoidance rules that specifically target tax deferral arrangements.215 Instead, they rely on the fisc’s application of the country’s general anti-avoidance or abus de droit rule to attack tax deferral arrangements, which are construed by the revenue collectors as tax avoidance schemes; for example, in Austria, Belgium, France, Hungary, and Norway.

215 Although some countries (like New Zealand) specifically include tax deferral within their statutory definition of “tax avoidance”, which is used in the general anti-avoidance provision.

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One example of a country that does have a specific anti-deferral rule is Luxembourg. There a taxpayer can transfer an asset, the gain on disposal of which would be taxable, to a company by carrying out an asset-for-shares exchange, where the company takes over the vendor’s cost base of the asset. The vendor can transfer shares tax-free within his or her family (including children 18 years and older). Provided that the resultant participation in the company does not exceed 10% (25% applied prior to 2002), a gain on the disposal of the shares after five years is not taxable. The five-year and 10% thresholds are anti-avoidance mechanisms, the latter being especially effective since Luxembourg families usually have only two or three children.

6. Conclusion

This chapter has endeavoured to examine tax deferral from both a policy and practice perspective. From the policy angle, tax deferral is one fiscal instrument that a government can use to achieve its economic objectives, as demonstrated by Estonia’s corporate tax exemption system. But deliberate government encouragement of tax deferral can produce the undesired consequence of economic inefficiency; for example, when tax deferral results in locking in asset ownership. Tax deferral can also produce inequitable tax treatments between broadly comparable taxpayers.

In practice, there is considerable inconsistency between European countries in allowing tax deferral opportunities. The differences have been illustrated in this chapter by reference to examples of methods of deferral and their tax consequences in a number of selected jurisdictions.

Where tax deferral arises from tax planning or tax avoidance arrangements, which take advantage of unintentional (or government tolerated) effects of tax legislation, the integrity of the tax system is undermined. For example, those countries that do not tax stock dividends, zero-coupon or deep-discount bonds, back ended rental streams, and income trapped in offshore trusts offer fairly easy methods for taxpayers to defer their tax liabilities, with a consequential loss of immediate revenue for the government and inequitable outcomes between taxpayers. The split between countries that tax stock dividends and those that do not illustrates that some countries are prepared to counter this type of deferral mechanism. Only to a lesser extent can the same be said for discounted bonds or the use of offshore trusts.

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Similar deferral consequences arise where full negative gearing is permitted in respect of capital investments. Although there is a wide variety of practices, particularly for individuals who incur rental losses, most countries quarantine the losses in some way or to some extent, but still tax the gains on disposal of the property. This approach produces an asymmetric result. Concessional tax rates applicable to capital gains, which arise upon the sale of the property, can be regarded as a step towards tax symmetry where the earlier rental losses have been quarantined.

The differentiation in capital gains tax treatment between different types of assets (particularly between shares and other types of assets) encourages taxpayers to arrange their asset holdings to give them the greatest tax deferral advantage. Such differentiations insert a tax wedge into capital asset transactions, thereby creating market distortions and inefficiencies. Apart from the principle of economic unity behind the participation exemption and corporate reconstruction rules, which do not recognise for tax purposes a realisation of a capital gain at the time of the actual realisation event, it is difficult to rationalise why shares should be subject to a more favourable tax treatment than the underlying corporate assets, which their value reflects.

These problems illustrate the more general inadequacy of taxation of capital gains on a realisation basis and the continuing need for tax policymakers to re-examine the practical feasibility of adopting accrual based taxation of capital gains. In specific areas of taxation of investment income and gains, some countries in small ways already avoid the difficulties presented by the realisation approach by adopting accrual income methodology; for example, Norway’s interest accrual rules applicable to discounted bonds and the requirement in the Netherlands that corporate resident shareholders that own at least 25% of the share capital of certain non-resident investment companies include the annual movement in the fair market value of their shareholdings in their taxable income.

The use of inter vivos and testamentary gifts as a means of deferring the realisation of a taxable capital gain can be deterred by restricting rollover relief to inter-spousal or inter-partner transfers (where these relationships reflect a country’s notion of an appropriate tax unit) and by prohibiting any increase in the basis of the assets transferred. Subject to over-riding economic or social policy considerations to the contrary, when assets are transferred outside of the marriage or partnership, the full amount of the gain – calculated by reference to the original basis that is applicable to the contributing spouse or partner – ideally should be taxed. If gift or inheritance tax is imposed as some sort of surrogate for a tax on the

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capital gain at the time of the making of the gift or at death, a credit for that tax could be allowed against the tax ultimately levied on the capital gain.

There is also much scope for countries to strengthen their anti-avoidance legislation to combat tax deferral. The measures could be as simple as incorporating tax deferral into a statutory definition of tax avoidance, which applies in a general anti-avoidance provision. Specific anti-avoidance rules might be introduced to combat particular tax deferral mechanisms; for example, requiring accrual accounting principles to be applied to determine annual taxable income over the term of a lease or financial arrangement.

This chapter presupposes that there is a government revenue cost of tax deferral arrangements. However, the extent to which tax deferral produces immediate tax leakage to European governments requires further research. Tax policymakers need to determine the magnitude of the perceived problem in their country in the context of their government’s broader economic policy objectives, and thereby determine the tolerability of the revenue loss. Nevertheless, the somewhat cursory survey of country practices in this chapter gives an initial impression of just how far many European tax jurisdictions still have to go to close the numerous, unwelcome opportunities for tax deferral

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PART II

CHAPTER 3 Treatment of Capital Gains and Losses

Judith Freedman

This is a preliminary report. The author would welcome comments, particularly on jurisdictions with which she is not familiar. For detailed discussion of the position in particular jurisdictions the reader is referred to the country reports contained in the papers for this conference.

I. Introduction: Concepts of capital gains and income

The term 'capital gain' has different meanings in different tax systems. Ault defines a capital gain generally as a non-recurring gain, which is not part of the normal stream of income involved in a business or investment.216 The analogy of the fruit and the tree is often referred to. Although much criticised now for its inaccuracy, and discredited by economic theory, the analogy does illustrate very graphically the broad notion that, whilst income does not encroach on its permanent source, a capital gain does do so.217 As Lord Justice Dyson has pointed out in a recent UK Court of Appeal decision, however, this does sometimes beg the question: what is tree and what is fruit?218

To a UK tax lawyer familiar with the source approach to defining the tax base, a capital gain is as conceptually distinct from income as black is from white. They are dealt with under separate tax codes. The strength of the distinction owes much to the importance of this concept in trust law. This does not mean that there is always a clear distinction in practice. The line between a capital gain and income can be difficult to draw and the conversion of income into capital and vice versa in the case of expenditure is, in the UK as elsewhere, a basic method of tax mitigation or avoidance (which of these two descriptions is more accurate depends on the perspective of the analyst). Much case law is concerned with the grey area where the capital/income distinction is far from clear and the fruit and tree analogy breaks down. The sharper the difference in treatment between capital and income, the greater are the opportunities for arbitrage. Therefore a strong reason for having a tax on capital gains, even in a system where they are not considered to fall within the definition of income, is to prevent the avoidance of income tax by conversion of profits

216 Ault (1997) p194.217 Krever and Brooks (1990) p 2.218 IRC v John Lewis Properties plc. [2003] STC 117.

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into capital gains. Those who argue, correctly, that the United Kingdom raises relatively little revenue from the capital gains tax, usually receive the response that these figures do not reveal the potential loss of revenue should capital gains tax be abolished.219

Conceptually, if not in practice, the UK approach is in sharp contrast to the Haig-Simons concept of a global income tax or net accretion theory, which includes capital gains (as discussed by Joachim Lang in Part I of this report). Proponents of this concept of income aim to tax all accretions to economic power equally and so failure to tax capital gains, which seem to give an individual increased ability to pay, would contravene the principle of horizontal equity. Those who favour this view would also support an accrual basis rather than a realisation basis for the taxation of capital gains, although they might accept that this has to be modified for practical reasons.

It is arguable, however, that not all capital gains do have the quality of income. Wallich points out that economists often use a national income concept of accounting that reflects capital gains as income only to the extent that they derive from undistributed corporate profits. 220 Other sources, such as gains reflecting a rise in the general price level, are not income in a national accounting sense and do not actually represent an improvement in the owner's economic position. Sandford also shows that capital gains may arise from different circumstances and believes it is possible to make out a sustainable case that at least some of them do not amount to income.221

Sandford's (non-exhaustive) list of circumstances is as follows: -

An increase in share values because the retention and reinvestment of profits has increased the real assets of the company

a rise in share prices reflecting the constant capitalisation of larger expected income a rise in value of land because of community development an increase in asset prices from a fall in interest rates and a rise in asset prices reflecting a rise in the general price level.

219 In 2002-3, the UK Inland Revenue annual receipt from capital gains tax levied on individuals was £1,720 million as compared with £104,264 million from income tax and £29,204 million from corporation tax. The corporation tax figure includes tax on capital gains of companies (Inland Revenue Statistics: www.inlandrevenue.gov.uk).220 Wallich (1965). Muten disputes the use of net national income as a more realistic measure of the individual's ability to pay than the Hicks definition (Muten ,1995).221 Sandford and Evans (1999) p 399.

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It can be seen that gains arising in these different circumstances do have differing qualities, judged against the benchmark of net accretion of economic power between two points of time. The most obvious example is that of inflation gains. Even this is arguable, however, as those whose assets have risen by the rate of inflation have still fared better than those whose assets have not kept pace with inflation, so relatively the former do have greater economic power. 222 Taxing a capital gain based on capitalisation of large expected income may involve double counting in the national accounting sense, since the higher income will also be taxed in due course,223 but for the individual holder of the asset there is an immediate gain, at least there is if the asset is disposed off, which may support a realisation basis. The arguments are not clear-cut.

Nevertheless, the fact that inflation gains, for example, have a different quality from others is one of the rationales behind special capital gains tax reliefs for inflation, such as indexation of the base cost, tapering relief and reduced rates for capital gains. Further, even if, and to the extent that, it is accepted that capital gains amount to income, the quality of the income in the hands of the taxpayer may actually affect the ability to pay. For this reason capital gains are frequently given different treatment from other income.

A strong argument for taxing capital gains is that of vertical equity since capital gains accrue mainly to the wealthy minority who own capital.224 Failure to tax such gains only perpetuates existing inequalities. This equity argument must be weighed in the balance against pressure for special reliefs due to the quality of capital gains, the practical difficulties involved in taxing them and the argument that restraint is needed in taxing capital gains in order to encourage entrepreneurship, saving and investment.225

The difficulties created by the capital/income divide are of course one argument for having a consumption or expenditure tax rather than an income tax. In theory the distinction between capital and income receipts would disappear completely, although in practice there could be definitional issues in deciding whether certain capital assets were being used for personal consumption. This led the Meade Committee in the UK to suggest the retention of a limited capital gains tax for some assets within its expenditure tax proposals.226 For the remainder of this paper, it will be assumed that we are working within some kind of income tax system, albeit with some expenditure tax characteristics, since this is the almost universal position across jurisdictions at present.222 Ilersic (1962)223 Wallich (1965)224 Ilersic (1962).225 Holmes (2001)382.226 Tiley (2000) 604.

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II. Approaches to Capital Taxation.

a) Three modelsAult identifies three alternative basic patterns of capital gains taxation. At first sight these approaches appear to be fundamentally different, based on the conceptual differences discussed above. The theoretical differences are indeed great but, in practice, it seems that most systems encounter similar practical problems of definition, rates, and timing and theoretical distinctions can give way to pragmatism and the need to raise revenue and prevent avoidance. It can be difficult to fit the various jurisdictions into these models, as in many cases the true position is a hybrid. What follows is based on the information supplied in response to the questionnaire distributed to country representatives.227

Type 1All business income is taxed, including capital gains, but non-business capital gains are normally tax-free. In many countries adopting this approach, however, certain personal capital gains such as speculative gains have been included in the tax net so that the distinction between business and non-business assets is blurring. Examples of modified versions of Type 1 systems are found in Austria, Belgium, Germany, Italy, Norway and Switzerland. These systems are still influenced by the source theory, which limits the taxation of capital gains on private assets by recognising the conceptual difference between capital and income in these circumstances.

Type 2Capital gains are treated as conceptually different from income gains and are not within the charge to income tax, but may have a special tax regime covering them, as in the United Kingdom.

Type 3 Capital gains are treated as part of a global tax base, though even under this model they may be given preferential treatments, as in the USA, France, Denmark and Luxembourg, Sweden, Spain and Portugal.

b) Distinguishing capital gains from other income gains In practice, therefore, the systems are all hybrids: neither pure source nor pure comprehensive income tax systems and they all begin to share similar characteristics. 227 Different use of language and concept may have led to misclassification and the author welcomes comments.

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Different rates of tax are applied and there are special rules about realisation and deferral reliefs such as rollover reliefs. It follows that even where in theory capital gains are seen as part of general income, it is usually necessary to distinguish capital gains from other income because of this special treatment. This is done variously by statute and case law.228

In systems where income and capital gains are seen as conceptually quite distinct, in practice it can be very difficult to distinguish receipts at the borderline. There is problematic case law in the UK, for example. To some extent it has to be recognised that capital and income represent different places on a continuum rather than quite different types of receipt. Particular problems are caused, for example, in relation to contracts, which may or may not be fundamental to the business and assignments of income flows that may amount to capital transactions depending on the length of time in question.229 Some types of transaction may be hybrid in nature, such as the purchase by a company of its own shares, and this may require legislation. This borderline may be less difficult to manage in jurisdictions where there is no expectation of a conceptual difference than it is where there is a belief in a theoretical difference, which cannot then be effectively delineated in every case. In part of course the difficulties around the borderline also depend on the degree to which receipts falling on different sides of this line are treated differently.

c) Special treatment of capital gains.Once capital gains have been identified then they may receive special treatment as follows: taxed at a different rate from other income (perhaps a flat rather than a progressive

rate) or only a proportion of the gain is taxed taxed only, or differently, if they are business assets taxed only on realisation or on certain events when realisation is deemed to have

occurred taxed only if the assets have not been held for a certain length of time, or taxed at

different rates depending on how long they have been held (holding period requirements; tapering relief)

tax is rolled over if proceeds are reinvested or on retirement or transfer of a business

228 Surprisingly few problems were reported in making this distinction in the country reports- see, for example, response to questionnaire on Norway by Frederick Zimmer, although other countries reported some complexity; for example France appears to have a case law distinction although in the case of business assets more weight is placed on accounting rules than in the case of household assets: response of Cyrille David on France.229 So, in the UK for example, there is special legislation to recharacterise premiums (capital) for short leases as rent (income): Income and Corporation Taxes Act 1988 ss 34-39. This has recently had to be amended to cover new types of rent factoring schemes as found in IRC v John Lewis Properties plc. [2003] STC 117: ss 43A-43G Income and Corporation Taxes Act 1988.

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indexation relief (adjustment of the base cost to reflect inflation) is given to recognise the effects of inflation.

III. Rationale for special treatment of capital gains.

a) Qualitative differencesIf we accept the premise that capital gains are merely a species of income under the Haig-Simons definition, then there is no reason in principle to provide any special tax treatment for such receipts. As we have seen above, however, there are sustainable arguments that at least some types and some part of capital gains are not true accretions to economic power. Under these arguments, variations between the tax treatment of income from capital and of capital gains are not purely matters of convenience or practicality but result from real differences between these types of receipt.

In addition, there are psychological reasons for treating capital gains differently. The response of individuals to capital gain is to perceive it as wealth. They will not spend the capital gain but will spend a higher proportion of their current income than would an individual with equal income but no assets. In other words they treat their capital gains as capital and not assets.230 There is a strong popular sense that the conversion of a person's capital from one investment to another, even if that capital has increased in value, should not give rise to taxation but that the person's permanent capital should be preserved. For this reason

'business persons, homeowners and farmers, for example, all appear to have a deeply-felt, visceral reaction to the taxation of the gain on the sale of their assets. Whatever the source of this reaction, they simply do not regard such a gain as income or at least not as income that should be taxed… because some forms of capital gains are not regarded as the same as other forms of income in the public's perception, for whatever reason, taxing them equitably has always been difficult'.231

This strong sense that capital gains should not be taxed accounts, for example, for the widespread exemption of the family home from the tax net, despite the fact that this creates economic distortions by preferring one type of asset so greatly over others. Owner occupied homes are completely exempt from tax, for example, in the UK, Denmark, France, Germany and Luxembourg. In Portugal, the taxpayer is required to reinvest in another residence to obtain this exemption and in Sweden two thirds of the gain is taxable. 230 Wallich (1965).231 Krever and Brooks (1990) 6-7.

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There is an argument that total, uncapped exemption goes too far but there are strong political factors at play here as well as strong perceptions of equity.

The existence and importance of these intuitions is supported by recent scholarship using behavioural economics.232 Chorvat shows that individuals perceive unrealised gains as less valuable than realised gains. The uncertainty relating to the valuation and lasting nature of unrealised gains reduces their value. People segregate different kinds of wealth into separate 'mental accounts' that are framed quite differently. This leads Chorvat to suggest the use of different rules for taxing the capital gains of corporations and of individuals, requiring more sophisticated investors to mark to market whilst taxing individuals on a pure realisation basis.

b) Ability to pay and equityThese psychological notions about capital gains need to be balanced against the fact that capital gains accrue mostly to the benefit of higher income individuals and to corporations. There is a strong 'ability to pay' argument for taxing capital gains but paradoxically it is the ability to pay principle which also results in a number of the reliefs common in relation to the taxation of capital gains. The principle provides both a theoretical and practical rationale for such reliefs and particularly for the adoption of a realisation rather than an accrual basis of taxation.

i) Realisation v accrualCapital gains are not usually regular or periodic but are one off gains. If they are taxed on an accrual rather than a realisations basis, tax may be levied at a time when there is no liquidity. Although economists will argue that the increase in value does represent increased ability to pay against which borrowings may be made if necessary in order to pay tax, this argument depends on a perfectly functioning capital market, ignores transaction costs and would add considerable risks to company cash flows.233 The impact of an accrual based capital gains tax would be to provide an incentive to sell assets showing a gain whereas it might be more commercially efficient to retain them.

There is also the problem that gains might be followed by losses in a volatile market. These unrealised losses would also have to be taken into account and revenue authorities would need to be prepared to pay credits for unrealised losses to achieve true equity. This scheme then begins to look rather less attractive to revenue authorities and could have

232 Chorvat (2003)233 IFS (2002).

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severe consequences for the fisc in an economic downturn. If credits were not paid when there was an overall loss, there would need to be generous carry back provisions for losses.

Holmes argues for an accrual basis, and that unrealised gains or losses in respect of capital should be incorporated into periodic income measurements, but notes that no country has yet attempted to implement fully such a tax policy.234 And, as Muten puts it,

‘…the fathers of the comprehensive income concept actually liked the idea of including unrealised gains and losses, yet were realistic enough not to make this an intrinsic element of their definition.’235

The practical problems with taxing unrealised gains include not only the ability to pay issues discussed above but also the expense and administrative difficulties of valuation. Where an accrual basis is used it is often in relation to marketable securities with a readily ascertainable valuation and likely to be held by those most able to deal with the costs and administrative burden of valuation, such as corporate holders. Corporate holders with large numbers of capital assets are also more likely to be able to set losses against gains, thus reducing the need for payments of tax and credits in normal conditions.

ii) Moving away from realisationIn the UK, recent changes to the taxation of transactions in intangible assets, corporate debt, derivatives and foreign exchange have had the effect of taking some gains and losses out of the capital gains regime into an income regime for corporate taxpayers. This is achieved by following generally accepted accounting treatment. In a consultation document published in August 2002 the UK government suggested that there was an economic case for treating all gains and losses on capital gains assets in the same way as income profits. This would be achieved by following the commercial accounts in recognition of profits and losses. Due to the earlier reforms, this would only affect the limited range of assets owned by companies and still covered by the capital gains rules: that is, land and buildings, financial assets not already covered by the derivative contracts or loan relationships regimes and tangible moveable property (mainly plant and machinery). Where amounts were recognised in the company’s accounts on a mark-to market basis then profits and losses would be taxed on this basis. Where accounting standards did not require the gain on revaluation of an asset to be taken into the profit and

234 Holmes (2001) 379.235 Muten (1995) 37.

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loss account, the taxation of a revaluation gain would be deferred until the asset was disposed of.236 Indexation relief would not be available.

Although not a full-scale move to an accrual basis, this proposed regime has been seen by business consultees as increasing the burden on business by bringing forward the payment of tax and by increasing the complexity of the system. This reaction is built in part on the way in which earlier moves to bring assets into the income tax system have been implemented, in a highly detailed and prescriptive fashion. The Institute of Chartered Accountants noted, for example,

‘Whilst in theory the proposal to tax all gains as income has some logic, we are concerned that legislation could result in a more complicated system. … The complexity of the legislation which was found to be necessary to bring intangibles into the income regime illustrates the scale of the problem.’237

The complexity of this legislation reflects the fact that there are important differences in the objectives and operation of accounting standards and of a tax system, not least the cash-flow implications. Tax systems need to prevent opportunities for avoidance and manipulation by keeping matters of discretion to a minimum and also need to take into account issues of horizontal equity. The factors driving the accounting standards, therefore, may not be the same as those that should drive the tax rules.238

The legislation is also made more complex because of the qualitative differences between certain types of capital gain and revenue gains, which re-emerge despite these regimes that start off by following commercial accounts. The intangibles legislation, for example, provides for extensive deferral of taxation on reinvestment which is closely based on capital gains tax roll-over relief. 239 In effect the legislation continues to distinguish between intangibles that are basically of a revenue nature and are thus dealt with by following the accounts on an accrual basis and those which are really capital by nature for which realisation remains significant and rollover relief is available. 240

It is to be noted that the UK government's recent reforms in this area and proposed reforms apply to corporations only. As discussed above, the rationale for this is that only larger firms could deal with the calculations and cash flow implications of taxing gains on an 236 HM Treasury and Inland Revenue (2002)237 ICAEW (2002)238 IFS (2002) para 2.4.239 Finance Act 2002 Schedule 29.240 Simon's Tiley & Collison (2003) 985.

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accrual basis. This would introduce further distortions as between incorporated and unincorporated businesses, however, so running counter to the principle of neutrality between treatment of different legal forms. There is a case for extending it to all businesses if it is to be introduced.

Some other jurisdictions use accounting revaluations as a basis for taxation for business assets, particularly financial instruments. These include Denmark (financial instruments), Luxembourg (opening and closing balance sheets compared for corporations which are then taxed on their increase of net wealth) and Switzerland (book revaluations of business assets subject to taxation). For the most part, however, the realisation basis remains the dominant trigger for taxing capital gains for the time being.

iii) Bunching and inflation If capital gains are taxed on a realisation basis, as is normally the case, bunching occurs which is particularly disadvantageous to the taxpayer, and inequitable, in a progressive system of income taxation. This may be dealt with by averaging (as in Australia),241 or giving an annual exempt amount (as in the UK). Taper relief as found in the UK for individuals, and in the USA, also partially meets this objection. In some jurisdictions, capital gains are simply taxed at a different rate from other income, perhaps a flat rate as in Norway and Sweden or a reduced proportional rate, as in France. In Spain progressive rates are applied for short-term gains (assets held under one year) but a flat rate for assets held for a longer period than this. In other jurisdictions there is a progressive tax on certain capital gains and a reduced rate on others, as in the Netherlands.

Similar concerns give rise to reliefs to take into account inflation,242 since assets may have been held over a long period so that inflation may account for a large proportion of the gain, unlike stock or other similar assets held normally for only a short time. Taper relief and indexation as found in the UK, France and Portugal, for example, may also be seen as a means of counteracting the argument that gains arising from inflation should not be taxable as income gains or at all since they do not represent a real increase of economic power. These problems are less acute in an accrual system under which the deduction of costs and expenses is also not deferred so that these deductions are not devalued by inflation. A number of jurisdictions make no indexation provisions but consider that the problem of inflation is taken into account by having reduced rates of tax on capital gains.

241 Evans and Sandford (1999) 394.242 Discussed in more detail by Roxan in this report.

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To the extent that these problems arise as a result of using a realisation basis, they obviously present a strong counter-balance to the arguments for this basis.

d) Incentives and reliefsConcern that the realisation basis leads to lock in effects itself suggests that there should be deferral relief,243 whilst concerns about short-term speculation result in differential rates of tax, reducing for assets held for a certain periods (for example Portugal exempts individuals from tax on gains from shares and securities held longer than 12 months: in Denmark the equivalent period is three years). In the UK, for individuals holding business assets, once an asset has been held for two years only 25% of the gain is chargeable. For non-business assets the taper is slower and reduces in tranches of 5% of the gain chargeable to a minimum of 60% of the gain being chargeable after ten years.

Many reliefs relate to the desire of governments to promote saving, entrepreneurship and risk taking, which further undermines the global nature of the tax, by relieving certain types of capital gain. It is argued that the prospect of capital gains tax deters entrepreneurs from establishing businesses and building them up and also from passing them on to the next generation.244 Thus in most jurisdictions there are reliefs for reinvestment in business assets, gifts of business assets, change of legal form, company reconstructions and, sometimes, on death, where this would otherwise amount to a deemed realisation and thus a trigger for taxation. In the UK, as we have seen, taper relief is considerably more generous for business assets than for other types of asset, whilst of course in some jurisdictions there is no tax on non-business assets at all so that the reliefs are all designed for business assets. In the UK the introduction of capital gains tax had the effect of reducing the importance of the capital/income distinction, though it remains significant in some circumstances. The reliefs, however, and in particular taper relief, have created a new borderline of importance between business and other assets and so increase opportunities for avoidance and complexity. Arguably they go further than is necessary to encourage business investment by in effect giving partial permanent exemption rather than deferral.A major relief for corporations is that for the disposal of substantial shareholdings. The UK introduced such a relief in 2002 as a response to similar reliefs (known as participation exemptions) in other jurisdictions such as the Netherlands, Germany and the USA.245 The rationale is said to be to prevent companies from holding on to their investments for too 243 This is discussed in more detail by Holmes in this report.244 Some, now very dated, evidence is given by A. Beecroft in Bracewell-Milnes (1992) 17.245 See the report on deferral by Holmes who states that Austria, Belgium, Luxembourg, Spain and Switzerland also have participation exemptions and France has a reduced rate of tax applying. Sweden proposes to introduce such a relief. He criticizes the opportunities for avoidance this relief might give.

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long and to encourage the best deployment of resources: in other words, to prevent lock-in. It was also stated by the UK government that since roll-over relief was available for the sale of business assets there was a commercial distortion as companies re being encouraged to sell as asset tier rather than share tier. This would have been a justification for a deferral, as was originally proposed, rather than an exemption, the main rationale for which was competitiveness as far as the UK government was concerned. Strangely, this relief pulls in a different direction from taper relief which seems to encourage longer term holdings and thus lock in, but which applies only to individuals.

Certain assets are considered inappropriate subject matter for capital gains tax even in systems that do tax non-business gains. Most notably, as we have seen above, the main residence is wholly or partially exempt from tax in many jurisdictions, even those that would normally tax personal capital gains. This may be seen in terms of providing an incentive for home-ownership and, quite reasonably, allowing individuals to preserve the ability to maintain a home even where they have to move house. To the extent that this is something more than a roll-over relief, however, it is likely to distort decision making on investments and, ultimately, to increase house prices. Like other tax incentives, therefore, it becomes capitalised and creates distortions in the market. Once given, however, it is very hard to remove such a relief. In addition the main residence relief favours the wealthier taxpayer for the simple reason that such taxpayers have more valuable homes and so will make greater capital gains. Clearly such a relief is regressive, especially if not capped in any way. On the other hand, caps will discriminate against those living in more expensive parts of the jurisdiction in question and so the level is difficult to set.

Reliefs given on death are also open to criticism as sometimes extending too far. A rollover relief on death seems reasonable and may preserve a family business or similar by avoiding crystallisation of a liability at what may be a difficult time for the business in any event. A complete uplift of the base cost on death resulting in exemption, as is given in the UK, is unnecessary, however, and may result in no tax being collected if there is also an exemption from inheritance tax as may be the case with business property.

Special treatments often reduce equity and increase complexity. Once built into the system they may be difficult to remove and they may involve a considerable deadweight cost. They therefore require careful consideration before being introduced.

IV. Losses

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Losses on the disposal of capital assets present a particular problem. Under a true accrual basis, as we have seen, if property and stock markets slumped this would have a major impact on the revenue collected.246 In a pure accrual system this would lead to losses arising and reducing the tax payable to the revenue authorities considerably. Given the likely cost of this, in practice there would be likely to be restrictions on losses allowed which would undermine the symmetry and therefore the equity of an accrual basis. Professor Muten comments that it would be over- generous to allow the taxpayer a reduction of his taxable income for a temporary price dip amounting to a capital loss he will never suffer but of course, under an accrual basis the taxpayer could be taxed on a temporary gain which will never benefit him. He might recoup this tax by way of a tax loss subsequently but he might find his use of such losses restricted, not to mention the question of cash flow problems. 247

Clearly under a realisation system there will be a tendency for the taxpayer to retain assets showing a profit so as to defer taxation but to dispose of those showing a loss, so as to realise that loss and make it available for set-off. This creates an advantage in terms of timing for the taxpayer over the revenue authorities and so the revenue authorities counter this by limiting the losses permitted.248 Even under a realisation basis within a global system which treats capital gains as income, set off of losses is often restricted to capital gains profits rather than being allowed freely against all types of income, although full capital loss deduction is permitted against all kinds of income in some jurisdictions, for example Norway. In the Netherlands, although the realisation requirement applies to gains, business capital losses may be deducted as soon s they can reasonably be expected, under the rules of sound business practice: an unusually generous regime.249 Sometimes capital losses are limited by allowing only a percentage of the loss, as in Sweden. Sometimes the loss may only be set off certain types of gains, sometimes carry back and forward is limited and sometimes there is a combination of these devices, as in France. Losses on certain types of assets, particularly those that always lose value such as ordinary motor vehicles, are also frequently restricted.

In the UK, there has been criticism of the fact that indexation (still available to companies but not individuals) may reduce a gain but not increase a loss; another asymmetrical treatment.250

246 Muten (1995) 40 247 ibid.248 Anti-avoidance measures to prevent such manipulation are also common (Muten (1995) 41).249 European Tax Handbook (2002) 431.250 Simon’s Tiley and Collison (2002) 674.

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Arguably, the restrictions on losses violate the principles not only of horizontal equity but also of vertical equity. This is because a wealthy taxpayer is likely to have a portfolio of capital assets and so be able to set capital losses against capital gains, whereas a less wealthy taxpayer may only have a small range of capital assets. If the latter makes capital losses he may have no capital gains against which to set them and so prohibition on use of other types of gain for this purposes will have a greater impact on him than on the wealthier taxpayer.251

Restricting the use of capital losses may also act as a disincentive to risky investments. On the other hand, permitting the use of losses may encourage unduly risky ventures by forcing the state to participate as a stakeholder in a risky and possibly economically inefficient venture.

Clearly it is valid to limit the use of capital losses to the same extent as capital gains are given preferential treatment- that is the taxpayer cannot expect to claim tax losses where his gains would be exempt and reduced tax rates must also be reflected when it comes to corresponding losses. Beyond that, the only really strong rationale for limitation is to prevent manipulation by cherry picking- taking losses and not gains.252 This may be an argument for some limitation of certain types of loss to be set off only against gains of the same class but it does not seem to be a good reason for limiting carry forward by imposing a time limit since when the taxpayer does realise a gain he will become liable to tax and should be able to claim relief for any losses, although not before this point. If and to the extent that an accrual basis is used, there is no justification for any lack of symmetry nor for any restriction by class if all gains are being taxed at the same rate as other income.

Conclusion

The dominant view amongst tax theorists is now that capital gains should be taxed in the same way as income. Under this view, we should try to achieve the most realistic definition of income possible and all accretions to economic power should be taxed equally. Proponents of this view accept that there are practical difficulties in taxing on an accrual basis but consider that wherever possible the ideal would be to tax the entire capital gains as it accrues.

251 Krever and Brooks (1990) 118.252 Ibid. 120.

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The alternative argument is that capital gains are of a different nature from income gains and should be treated accordingly. There are credible economic arguments that not all capital gains are accretions to economic power. In addition, as we have seen, economists have different measures of income for different purposes and so it is misleading to talk about one definition of income being more 'correct' than others. In any event, what is appropriate for economists and accountants may not be an appropriate measure for tax purposes. It is only a question of how appropriate the definition is for its purpose. On this view, the difficulties faced in relation to taxing capital gains, especially in taxing them on an accrual basis, such as valuation, liquidity and the problem of inflation, are not just practical problems getting in the way of an ideal method of taxation. Rather they are manifestations of the qualitative differences between capital gains and income.

The perceptions of taxpayers about the distinction between capital gains and income are also relevant to the way in which the tax system should be designed. These are not misunderstandings but, once again, manifestations of real qualitative differences. The 'mental accounting' sense that capital needs to be preserved so that any capital gain needs to be reinvested and not reduced by taxation is relevant. It affects taxpayer behaviour and represents a common view of equity that needs to be taken into account in producing an acceptable and therefore workable tax system. There seem to be good practical, psychological and economic reasons for treating individuals differently from more sophisticated taxpayers which can better manage fluctuations and valuation problems and have a different mind set in relation to capital gains.On the other hand, it is the case that capital gains do accrue to the wealthiest group of taxpayers. There are strong vertical equity arguments for taxing them in some way. There are also good efficiency arguments for taxing such gains on realisation when it is most convenient for the taxpayer to pay the tax.253 The arguments used to obtain reliefs from taxation on realised gains need to be weighed in this light. Whilst deferrals and reinvestment reliefs may seems reasonable, given the need for owners to maintain their investments at a certain level, total exemptions may not be so justifiable. A homeowner wishing to sell his house and move to another will need to reinvest and a tax on his capital gain at this stage may prevent him from acquiring an equivalent home, but there may be a need to differentiate between an average family home and a mansion. Pressure for such reliefs does need to be weighed up against the vertical equity arguments.

Business reliefs also require careful consideration. Special reliefs can be justified for reinvestment and to prevent the break up of businesses. There may also be arguments that 253 Adam Smith, The Nature & Causes of the Wealth of Nations, Book V, Chap. 11, Part II.

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lock in effects need to be counteracted, although it seems unlikely that a business disposal would be deferred purely for tax reasons if it was otherwise commercially desirable. There is a danger, however, that competitive pressures between jurisdictions could lead to such a reduction of taxation of capital gains on business assets that there will be a major incentive to convert income gains to capital. Tax incentives to entrepreneurship are hard to target and there may be a dead-weight cost in respect of transactions that would have occurred in any event. Claims that high rates of tax deter entrepreneurship can be merely special pleading from a wealthy and influential group of taxpayers, since entrepreneurs are often highly motivated in any event and the impact of taxation on their activity is uncertain. The case for favouring long term holdings can look particularly thin, since the real entrepreneur should be encouraged to divest his successful investment and move on to new opportunities, not to retain his holding to achieve a lower tax rate. 254 Each special relief needs careful examination and justification and jurisdictions need to take care to avoid a race to the bottom and the creation of distortions and inequities.

Bibliography

H. J. Ault, Comparative Income Taxation (Kluwer Law International 1997)

B. Bracewell-Milnes, A Discredited Tax (Institute of Economic Affairs, 1992)

T. Chorvat, Perception and Income: The Behavioural Economics of the Realization

Doctrine, (George Mason University School of Law, Law and Economics Working Paper

Series, 2003 htp://ssrn.com.abstract_id=407460).

C. Evans and C. Sandford, 'Capital Gains Tax- The Unprincipled Tax?' [1999] BTR 387

IBFD, European Tax Handbook (2002)

HM. Treasury and Inland Revenue (UK) Reform of Corporation Tax: A consultation

document (August 2002).

K. Holmes, The Concept of Income (IBFD 2001).

ICAEW, Reform of Corporation Tax, TAXREP 29/02 (2002)

A. R.Ilersic, The Taxation of Capital Gains (Staples Press 1962.)

A. Klemm and J. McCrae, Reform of Corporation Tax (Institute for Fiscal Studies Briefing

Note No. 30, 2002).

R. Krever and N. Brooks A Capital Gains Tax for New Zealand (Institute of Policy

Studies, Victoria 1990).

254 Edward Troup, Financial Times Jan 22, 2002.

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L. Muten, ‘Capital Gains Tax- Gaining Ground?’ in C. Sandford (ed) More Key Issues in

Tax Reform (Fiscal Publications, 1995).

Simon's Tiley & Collison: UK Tax Guide 2002-3 (Tolley, 2002).

J. Tiley, Revenue Law (4th ed., Hart Publishing, 2000).

H. Wallich, 'Taxation of Capital Gains in the Light of Recent Economic Developments',

National Tax Journal, June 1965.

In addition valuable information has been supplied by EATLP country representatives in

response to the author's questionnaire, contained in the report.

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PART II

CHAPTER 4 Influence of Inflation

Ian Roxan

1. Introduction

Inflation occurs when there is an increase in the general level of prices in the economy. This reduces the purchasing power – the value – of money. In principle, whenever monetary amounts are used at different times by the tax system, the amounts have different meanings, and inflation may be relevant. In particular there are three ways in which inflation can affect the tax system.255 First, inflation changes the effective amount of tax due on comparable incomes taxed at different times at fixed rates of tax. A related but opposite effect is that inflation will reduce the value of tax collections to the government if there is a substantial delay between the time for which income is determined and the time at which the government receives the tax. Finally, in the case of income from capital a portion of the income itself will represent compensation for the effects of inflation, and thus not add to the true well-being of the taxpayer. This category is the most important for this report, but the others are also relevant.

Whether the tax system should adjust for the effect of inflation on the amount of income from capital depends on a number of factors. It may be considered appropriate for reasons of equity, or to preserve the neutrality of the tax system. Many tax systems only adjust for the effects of inflation on certain types of income from capital, such as capital gains. Such partial adjustments for inflation may introduce serious distortions in the taxation of different types of income from capital. Factors such as simplicity, distributional effects of inflation adjustment, and the accuracy of inflation indexes, particularly for affected taxpayers, also need to be considered.

In light of these considerations, to what extent is it possible and practical to adjust for the effects of inflation on income from capital? This question will be affected by the extent to which an adjustment mechanism introduces new distortions. Does the answer depend on whether inflation is high or low?

2. Effects of inflation on tax revenues

255 I consider only direct taxes. References such as ‘tax system’ should be read accordingly.

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2.1 Fiscal drag

Inflation will change the proportion of tax collected from the real amount (the amount ignoring inflation) of a person’s income whenever the tax is imposed at anything other than a single flat rate applicable to the full amount of income. Of course, most individual income tax systems use a structure of progressive rates. In addition they usually exempt a portion of income from tax, typically reflecting family or other personal circumstances. Both of these features mean that, as the nominal amount (the amount including the effects of inflation) of income rises, more of it will be taxed in higher rate brackets. This effect is often referred to as ‘fiscal drag’ or ‘bracket creep’.

A number of authors, such as Ursprung and Wettstein (1992), have noted that fiscal drag can also occur as a result of real growth in the economy. If growth increases incomes, then taxpayers will tend to find that more of their incomes fall into higher tax brackets. This can be referred to as ‘real’ fiscal drag, as opposed to the ‘nominal’ fiscal drag that results from inflation. In so far as real fiscal drag reflects rising real incomes, it is not necessarily a problem, though it may undermine the intended redistributive effects of a progressive tax rate structure.

In contrast nominal fiscal drag results in individuals paying a higher level of taxes without earning incomes that make them any better off. The result is that taxpayers are actually worse off, but government revenues have increased without the government taking any action.256 The effects of nominal drag always apply to an individual’s total income. Depending on the particular rate structure, they may also affect a part of total income, such as a particular item of income from capital. Thus nominal fiscal drag can mean that the amount of tax effectively borne by income from capital will depend on when it is taxed. This is an issue in relation to such questions as whether to tax capital gains only on realisation or as they accrue, and on the treatment of special savings regimes, such as pension plans.

256 Taxpayers may acquiesce in this because their nominal incomes may still have risen. Suppose that a taxpayer earning 10,000 experiences inflation of 10%. Her income rises to 11,000. Fiscal drag means that her average tax rate rises from 40% to 42%. Her tax bill, instead of rising from 4,000 to 4,400 (at 40%) rises to 4,620. Since the increase in her income merely covered her for inflation, she is clearly worse off as a result of the change in her tax rate, but her after-tax income has gone from 6,000 to 6,380. The failure of taxpayers to recognise that they are worse off in such a situation is termed ‘money illusion’, but in a situation such as this it may be entirely understandable. After all, it can be difficult to assess the level of inflation one is experiencing especially as it is happening. Inflation statistics only report past inflation, not current inflation, and with a measure of inaccuracy. They are also based on a standard ‘basket’ of purchases which is unlikely to reflect the purchases of a particular family. A ‘rational’ consumer may therefore find it difficult to determine how much of a discrepancy there is between changes in her nominal and real incomes.

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Nominal fiscal drag can be countered by periodically increasing tax rate brackets and exempt amounts to reflect inflation. This can be done through express indexation, or through ad hoc adjustments. The effect of ad hoc adjustments will, of course, be the same whether or not it is announced that they are intended to correct for inflation.

2.2 Collection effect

Even where all income is taxed at a flat rate with no exempt amount, inflation can have an effect, but this time in the taxpayer’s favour. If there is a substantial delay between the time for which income is determined and the time at which a tax is payable, by the time the government receives the tax, its purchasing power will have been reduced by inflation. At very high levels of inflation (hyperinflation) this collection effect can create serious problems for a government. Even at moderate levels of inflation, however, the effect can be noticeable for certain taxes. It can be a particular problem with corporate income taxes. Heinemann (2001) observed this in seven out of twenty OECD countries studied, including Austria, Finland, Ireland and the United Kingdom. It can be dealt with by requiring advance (instalment) payments of tax, through the use of withholding taxes, by shortening collection periods, or even by indexing amounts due.

3. Effects of inflation on the tax base

A separate problem arises where income is calculated by reference to a taxpayer’s assets or liabilities, that is to say income from capital. Inflation reduces the value of assets. Looking at the assets by themselves, if their value remains unchanged the taxpayer will be worse off at the end of the year, because the value of the asset will purchase less than it would have at the beginning of the year.257 In fact, if nothing else happens one would expect the value of the asset to rise, in effect compensating for inflation. The nominal value of the asset will have risen, but the taxpayer will not be any better off. This may suggest that inflation only creates problems for the tax system when it taxes capital gains, but in fact the compensation for inflation can take any form. It is widely recognised that interest rates include a portion that represents compensation for inflation. Indeed we would expect that returns on capital in any form would include an element that would compensate for the effects of inflation, whether the asset in question is a bank account, shares in a private company, or land. Whatever form it takes, this compensation for inflation is really just

257 This description of the problem recalls the Haig-Simons-Schanz definition of the comprehensive income base for taxation: the change in the taxpayer’s net wealth over the year plus the value of consumption (purchase of goods and services) during the year. The change in the taxpayer’s net wealth before consumption represents the total resources available to the taxpayer for consumption. Inflation reduces the amount of consumption that a given wealth will purchase. See Thuronyi (1996) at 439.

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putting the taxpayer back in the position she was in at the beginning of the year, so arguably it should not be taxed.

It is important to recognise, however, that the effect of taxes and inflation on asset values does not merely create a problem of equity. Income from capital represents a return that arises over time. People save (add to their capital) in response to the rate of return available. Part of the rate of return on an investment simply provides compensation for the time value of money, part provides compensation for various risks associated with the investment, and part provides compensation for inflation. Suppose that inflation is 10% and the nominal interest rate is 15%. This implies that the real interest, after inflation, is about 5%.258 If this return of 15% is subject to tax at 40%, the taxpayer will receive a nominal after tax return of only 9%, which will not be enough to compensate for inflation. If all returns to capital are taxed without any allowance for inflation, there will be equally equitable taxation for all recipients of income from capital, but the incentive to save will be seriously distorted. It is therefore necessary to consider both aspects of the effect of inflation on the tax base of income from capital.

4. Inflation adjustment mechanisms in use

4.1 Partial adjustment

4.1.1 Capital gainsEven though inflation affects all types of returns to capital, tax systems tend to have different rules for different types of returns. Adjustment mechanisms are most likely to be found in respect of capital gains. The most common is one that indexes of the cost of assets for inflation. An example of this is found in the United Kingdom corporation tax. Since it includes a number of features also found in other tax systems, I shall discuss it in some detail by way of illustration.

4.1.1.1 An illustration: the United KingdomIn UK corporation tax the adjustment is made separately from the calculation of the gain. An indexation allowance is calculated by multiplying the cost of capital assets for tax purposes by the proportionate increase in the retail price index between the month in which the cost was incurred and the month in which the disposal of the asset occurred.259

This allowance is then subtracted from the unadjusted capital gain to determine the gain 258 Strictly speaking the real interest rate will be closer to 4.545%, but the figures used in the text represent a reasonable simplification.259 Section 54, Taxation of Chargeable Gains Act, 1992 (hereinafter “TCGA”). The UK system of taxing capital gains treats separately each item of expenditure on an asset that is taken into account for capital gains purposes (an ‘allowable expenditure’, e.g. the original cost or costs of improvements: s. 38, TCGA). Strictly speaking an indexation allowance is calculated for each allowable expenditure.

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subject to tax.260 There is an important restriction on the indexation allowance: for disposals made since 1993 it may only be used to decrease or eliminate a gain. It may not be used to create or increase a capital loss.261

Indexation creates a number of complications for the UK system of taxing capital gains. As is the case with most systems that tax capital gains, the UK system taxes capital gains only on realisation, not as they accrue from year to year, but there are occasions when the system either deems a realisation event (a ‘disposal’) to have occurred, or provides for a deferral of the taxation of a gain when a realisation has occurred.262 A deferral may be achieved by providing that the original taxpayer will be taxed on the deferred gain when a replacement asset is disposed of, or by transferring the gain to the new owner of the original asset. The UK legislation does not provide for a unified concept of the base cost of an asset, but instead treats the original cost and any other deductible items as separate ‘allowable expenditures’. As a result, in order to defer realisation by transferring the gain, the legislation cannot simply deem the disposal to have been made at cost; it must be deemed to have been made ‘for a consideration of such amount as would secure that neither a gain nor a loss would accrue to’263 the person disposing of the asset. This cumbersome phrasing is all the more necessary given the separate calculation of the indexation allowance. The result is that a disposal with deferral is deemed to be made at the indexed cost of the asset.264

Other problems arise with regard to fungible assets, that is assets, like shares in a company, where it does not matter which individual asset of the same type (such as a share identified by a numbered share certificate) is disposed of. The UK legislation generally treats such assets held by one person (e.g. a number of shares of the same class of one company) as a single pooled asset.265 This pool may well include shares acquired at different times, and therefore giving rise to different indexation allowances on disposal. In order to keep track of this while retaining the benefits of pooling, a shareholder also has to keep track of an ‘indexed pool of expenditure’. In simplified terms, whenever shares of the same class are acquired of disposed of the indexation factor (since the last such event) is applied to bring the indexed value of the pool up to date. The actual cost of the new acquisition is then added to the indexed pool, or the indexed cost of the shares disposed of 260 Sec. 53, TCGA.261 Sec. 53, TCGA, as amended by s. 93(1), Finance Act 1994.262 For instance on a transfer within a group of companies: s. 171, TCGA.263 See e.g. s. 171(1), TCGA.264 This is made explicit by s. 56(2), TCGA.265 Sec. 104(1), TCGA. For the purposes of corporation tax pooling applies most importantly to shares. It also applies to other assets that ‘are of a nature to be dealt in without identifying the particular assets disposed of or acquired’ (s. 104(3)), but not generally to debt instruments. The discussion that follows will therefore refer only to shares.

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is deducted from the pool. On a disposal the indexation allowance is calculated as the difference between the amount deducted from the indexed pool and the amount of the actual cost attributed to the shares disposed of.266

Indexation was introduced in 1982 at a time of relatively high inflation. By 1992 it was concluded that the largest part of any gains and that had accrued before 1982 by thenrepresented inflationary gains. As a result, subject to a few qualifications, in 1992 the costs of all assets owned on 31 March 1982 were re-based to their market value on that date.267

There are several important exceptions to the application of indexation. First, the scope of the capital gains regime under corporation tax has been reduced in recent years. Since 1996 gains on debt instruments are generally treated as income, not capital gains, for corporation tax.268 This has also been true for gains and losses on foreign exchange269 and on foreign currency and interest rate futures and options270 since 1995, for futures and options based on debt instruments since 1996,271 272 and for intangible fixed assets, including goodwill from April 2002.273 As a result, indexation for inflation cannot apply to these assets.

Individuals are subject to capital gains tax on their capital gains. Indexation also applied to capital gains tax until 1998. No indexation is made for periods after April 1998.274 Instead taper relief is available. Taper relief reduces the proportion of a capital gain that is taxed, depending on how long the asset has been held.275 Only one-quarter of the gain on business assets that have been held for two years or more is taxed. This effectively reduces the maximum marginal rate on such gains to 10%. For non-business assets with the maximum relief is taxation of 60% of the gain on assets held for at least ten years. While this would reduce the impact of inflation, the reduction effected by taper relief is not related to the level of inflation. The change to taper relief was intended to ‘lead to simplification of the

266 Sec. 110, TCGA. 267 Sec. 35, TCGA. The taxation of capital gains was introduced in the UK in 1965.268 Under the ‘loan relationships’ rules: Ch II, Pt IV, Finance Act 1996.269 Ch II, Pt II, Finance Act 1993 (repealed by s. 79(1), Finance Act 2002: see now Sch. 23, Finance Act 2002).270 Ch II, Pt IV, Finance Act 1994 (repealed by s. 83(2), Finance Act 2002: see now Sch. 26, Finance Act 2002).271 Sec. 150A, Finance Act 1994, added by s. 101(3), Finance Act 1996, repealed by s. 83(2), Finance Act 2002.272 These regimes were substantially revised with effect from October 2002: ss 69-83, Finance Act 2002. Note that profits on dealings in certain financial and commodity futures had long been taxed as income, but gains on financial futures traded on an exchange had been treated as capital gains since 1985. Inland Revenue, Corporate Finance Manual, para. CFM 1400. In addition, many capital gains on debts had previously been exempt from corporation tax.273 Schedule 29, Finance Act, 2002.274 Sec. 53(1A), TCGA.275 Sec. 2A, TCGA.

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CGT system by progressively removing indexation, a major complicating feature.’276

Unfortunately, the immediate effect was that assets already held in March 1998 were subject to both the indexation regime, for part of the holding period, and to the taper relief regime for the remainder of the holding period.

Individuals also benefit from an annual exempt amount for capital gains. The exemption is currently £7,700 (about €5,400) and is indexed for inflation annually.

4.1.1.2 Other approaches in EuropeWhile most European countries tax some or all capital gains, indexation for inflation is much less common. Nevertheless, of the ten countries surveyed,277 four, including the UK, apply indexation to some capital gains, but none index all taxed capital gains. Norway also applied some indexation until 1991. Most of the countries surveyed tax capital gains on the assets of a business as business income. As a consequence, none of the ten, other than the UK, provides for indexation of the assets for purposes of corporate income tax, the exact opposite of the UK approach. Of the other three indexers, only Luxembourg provides for indexation of gains of assets of individuals. Even here there is no indexation for business assets, except on the liquidation of business. The remaining countries, France and Spain, provide indexation only for gains on immovable property. Norway’s indexation was also only for immovable property. Sweden, Germany, Italy, the Netherlands, and Hungary provide no indexation for capital gains.

The low use of indexation may, as in the case of the UK, principally be a function of the relatively low current levels of inflation. It is interesting to ask whether it can alternatively be explained by the use of other devices to reduce the level of taxation of capital gains. This is arguably the explanation for the reduced use of indexation in the UK. It was seen as being too complex for individuals, given the benefits in a low-inflation environment, and in light of the introduction of taper relief. Taper relief provides a proportionate reduction in the tax on gains, rather than an adjustment to the cost of assets, so the amount of relief is not comparable to indexation. However, taper relief is higher for assets held for longer periods. Since the effects of inflation are likely to be more noticeable after a longer holding period, taper relief may provide some alleviation of the effects of inflation.

A similar pattern can be seen in most of the six countries that do not provide indexation. The exception is Germany, but here the explanation is that Germany generally only taxes

276 Inland Revenue, ‘Capital Gains Tax Reform’, Press Release Inland Revenue 16, 17 March 1998.277 The details described here are taken from the country reports received, except as noted.

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short-term gains on non-business assets, other than ‘substantial’ investments in shares of a company (Mittermaier, 2001: 110), so there is little scope for indexation.

In the cases of Norway and Sweden the use of the dual income tax system means that capital gains are not taxed at especially high rates (28% in the case of Norway). This is indeed why Norway dropped its indexation of immovable property in 1991.

Italy is another country that only taxes a limited range of non-business assets. Gains on securities are taxed at a flat rate: either 27% or 12.5%. Special rates also apply to gains on the disposal of a business, while only short-term gains on immovable property are taxed, except in the case of property zoned for construction.278 Similarly, Hungary applies a flat rate of 20% to capital gains (ETH, Hungary, Ind. sec. 1.6). A form of taper relief is also available for immovable property held for more than five years.

The Netherlands is, of course, a special case. The new regime only taxes (at a flat rate) a presumptive return on investments, which takes the place of the taxation of actual income or capital gains. Presumably the presumptive return of 4% is intended to represent a normal real return, thus excluding inflation. The old regime did not provide indexation. Interestingly, this was seen as one of the problems with the old regime. The complexity of indexation was one of the arguments that led to support for the new regime (Cnossen and Bovenberg, 2000: 10). In addition, the taxation of presumptive returns only applies to investments. Gains on business assets are taxed as business income, gains on substantial shareholdings are taxed at a flat rate of 25%, while owner-occupied housing is taxed (at progressive rates) on a presumptive return of 0.8% of the (low) official value, less mortgage interest (Cnossen and Bovenberg, 2000: 3; ETH, Netherlands, Ind. sec. 1.2.1).

Unfortunately, the picture is not this simple: the countries that offer indexation also provide other devices to reduce the burden of taxation on indexed capital gains. Perhaps the most striking is France, which offers a full range of reliefs in respect of gains on immovable property. In addition to indexation a taxpayer has an allowance for expenses of 10% of the cost (or the actual expenses if greater), taper relief, which eliminates all of the gain for property held for twenty-two years or longer, and relief from the effects of the progressive tax rates.279 (ETH, France, Ind. sec. 1.6.2.) France also applies a flat tax rate with an annual exemption to capital gains on securities, and does not tax other non-business capital gains (ETH, France, Ind. sec. 1.6). Spain merely provides flat rate taxation for capital gains (except short-term gains), but at a rate of 15%. Luxembourg permits a

278 ‘Italy: Individual Tax Summary’, sec. 1.6, in International Bureau for Fiscal Documentation (2002) (Hereinafter references to the work are abbreviated in the form ‘ETH, Italy, Ind. sec. __’.)279 The tax on the gain is five times the (marginal) tax on one-fifth of the gain.

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widespread extended deferral of taxation for capital gains: taxation is deferred where the proceeds are reinvested, even in the case of non-business assets. Many capital gains are also taxed at half the taxpayer’s average rate.

4.1.2 InterestIn contrast to the treatment of capital gains, none of the countries surveyed provide indexation for the inflationary element of interest and dividends. Some countries provide other forms of relief for interest and dividends that may be seen as providing relief from inflation. Spain provides an exemption for individuals for 40% of dividends and of interest on debts with a maturity of more than two years or where the interest is ‘notoriously irregular’. This is intended to relieve from the effects of progressive tax rates, but it can equally be seen as providing relief In Sweden and Norway, the relatively low tax rate applicable to interest and dividends under the ‘dual rate’ system can be seen as reducing the effects of inflation, as it does in the case of capital gains. Luxembourg provides for an annual exemption of €1,500 of interest and dividends for an individual (€3,000 for a married couple). This is seen as providing some compensation for the effects of inflation. The new regime in the Netherlands that taxes only presumptive returns excludes inflationary returns on all forms of investment income, not just capital gains.

4.1.3 Business profitsThe least amount of relief is found in the case of business profits. Again there is no express indexation for business profits whether earned by an individual or a company. The question is whether business profits in fact include inflationary gains. Inflation will affect business profits where the profits are derived from assets that are held over a period of time.280 Even assets held for one year can introduce an inflationary element, even at low rates of inflation. Consider a business with a real rate of return of 10%, which is subject to inflation at 3% and tax at 30%. The interaction of tax and inflation will reduce the after-tax real rate of return by 12.5%. With an inflation rate of 10% the after-tax real rate of return is reduced by almost 40%, a significant distortion by any measure.281 The two important categories of assets used in a business are trading stock (or inventory) and fixed assets.282

280 Where profits are not dependent on assets, such as profits derived solely from labour or professional services, the costs are typically deductible when they are incurred, so both receipts and expenses are included at their current values. While such profits may rise from year to year with inflation, the profits for one year taken alone will not include an inflationary element. The rise from year to year is relevant to the issue of fiscal drag, discussed above.281 In the absence of inflation the after-tax rate of return is 7% in this example. With an inflation rate of 3% it is reduced by 12.5% to 6.13%. With an inflation rate of 10% it is reduced by 38.9% to 4.27%.282 The other assets held over time will basically be financial assets, i.e. investments. It is notable that these are all assets that an individual might hold as an investment. It is arguable that in principle inflation raises the same issues for these assets whether they are held as investments or as business assets.

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There are methods of valuing stock for accounting purposes, such as LIFO (last-in first-out) or HIFO (highest-in first-out) that adjust automatically for inflation to a greater or lesser degree. Among the countries surveyed Spain permits the use of LIFO for tax purposes if it is appropriate for accounting purposes, as does Germany (Dowe, 2002: 607), Italy (ETH, Italy, Corporate Tax Summary sec. 1.3.4) and the Netherlands (ETH, Netherlands, Corp. sec. 1.3.4). Luxembourg does so as well, but the average cost method is required unless the appropriateness of another method can be established. Average cost provides some compensation for inflation, at least in comparison with the original standard accounting approach, FIFO (first-in first-out) the form of stock valuation that may be seen as being closest to pure historical cost. France normally requires the use of FIFO (ETH, France, Corp. sec. 1.3.4), but average cost can also be accepted. Hungary, Norway, Sweden and the United Kingdom283 do not permit the use of LIFO or other methods giving compensation for inflation. Interestingly, between 1974 and 1984 the UK provided stock relief in a number of forms to compensate for the effects of inflation. Initially the measure gave relief for both inflationary increases in the value of stocks and for increases in the volume of stocks. In 1981 a revised system was introduced that indexed opening stock values to an inflation index. (Kay and King, 1990: 165, Tiley, 1981: 268-70.)

None of the countries surveyed provide any compensation for inflation in respect of fixed assets. These assets are (with the exception of land and sometimes intangibles) depreciable. The tax system will either fix the permitted depreciation methods and rates, or permit the use of accounting depreciation. The simplest method eliminating the effects of inflation on such assets is through 100% depreciation allowances in the year of acquisition (Kay and King, 1990: 172). Between 1970 and 1984 the UK granted 100% depreciation allowances on machinery and plant (Kay and King, 1990: 171, Tiley, 1981: 283), though it does not appear that this was intended as compensation for inflation. A number of countries now provide 100% allowances for specific types of assets, such as computer equipment, to encourage investment and modernisation.

4.2 Global adjustment

An alternative approach to partial inflation adjustments discussed above is global adjustment. (Thuronyi, 1996: 446-53.) This is an approach that has been used in particular in a number of Latin American countries facing very high levels of inflation. Interestingly, given the European experience, it is best suited to the adjustment of business income, since 283 Patrick v. Broadstone Mills (1953), 35 TC 44 (CA); Anaconda American Brass v. MNR, [1956] AC 85 (PC Can.). It appears that the Inland Revenue takes the position that this has not been changed by the statutory requirement introduced in 1998 that profits for tax purposes should be determined by generally accepted accounting principles ‘subject to any adjustment required … by law’ (s. 42, Finance Act 1998). See Inland Revenue, Inspectors Manual, para. IM 557c.

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it is based on adjustment of the balance sheet. The following is a brief outline of how the global adjustment is applied.

First the closing balance sheet must be stated in terms of end-of-year prices. For inventory this can be achieved using a valuation method such as LIFO. The values of assets held at the start of the year have to be adjusted for inflation during the year,284 preferably by applying an index.285 Assets acquired during the year are adjusted using the change in the index since the month of acquisition. In addition, the balance sheet has to be adjusted to include (exclude) assets and liabilities that do (do not) contribute to income for tax purposes have to be excluded. These calculations yield the closing tax net worth.

To determine the income for the year subtract from this figure the inflation-adjusted opening tax net worth.286 The opening tax net worth is taken from the adjusted opening balance sheet, which is, of course simply the closing balance sheet for the previous year, calculated on the adjusted basis described above. The opening tax net worth has to be indexed for inflation occurring during the year.

Although this method sounds relatively complicated, it achieves a full adjustment for all the effects of inflation while limiting most of the adjustments to figures on the balance sheet, avoiding the need to adjust the value of every transaction (Thuronyi, 1996: 447). In a high-inflation economy the benefits from this approach can be substantial. The other benefit of this approach is that it treats all assets equally. With partial adjustment mechanisms, there is a significant danger of distortions (non-neutralities) arising because different assets receive very different treatments. Indeed, an important reason for the UK reforms of 1984, which dropped the stock relief and the 100% depreciation allowances, was to reduce) the widely varying tax treatment of different assets and different methods of finance. Before the reforms machinery and plant were subject to a marginal effective corporation tax rate of –35.6%, while the rate on stock was +41.7%. By 1988 these rates were both positive at 25.5% and 53.8% respectively. (Kay and King, 1990: 170-71.)

It must also be borne in mind that most accounting standards now make provision for some form of inflation-adjusted reporting. The United States has had such standards since 1979. They are now embodied in a set of guidelines, SFAS No. 89. The UK’s standards, SSAP No. 16 ceased to be obligatory in 1988, but are still recommended for use. The

284 They will have been valued at the price level at the end of the preceding year in the opening balance sheet.285 Market value may be more convenient to use than indexation in some cases, but it generally also takes account of real increases in value as well as inflationary ones.286 Adjustments also have to be made to include distributions or withdrawals by proprietors during the year, and to subject contributions of capital during the year. The amounts added back in should also be adjusted for inflation.

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International Accounting Standard Committee (IASC) also has standards for inflation adjustments. Once again, they now only have the status of recommendations due to the decline in inflation rates. See Choi, Frost and Meek (2002: 261-68). This confirms that, even at the rates of inflation in developed countries in the 1980s some form of global adjustment was feasible in terms of its purely commercial costs and benefits, and should be at least as feasible for tax purposes.287

The other method of eliminating the effects of inflation on business profits for tax purposes is to calculate the tax on a basis that does not depend on the values of assets at different times. An example is the cash-flow tax, that some have proposed. This would give an immediate 100% deduction for the cost of all business assets, including both fixed assets and stock, but it would deny a deduction for interest expense, as well as for dividends (Cnossen, 1996: 85).288 Such a tax provides a uniform exclusion of the effects of inflation, as global adjustment does. The difficulty is that the base of this tax is closer to a measure of consumption than of income.289 Whether that is a genuine problem, given the hybrid nature of most existing tax systems, is beyond the scope of this report. Of course, cash-flow taxes have been proposed for their general neutrality between types of assets used by business and sources of finance for business. The compensation for inflation is a secondary benefit.

4.3 Adjustment of tax rate and allowance thresholds

The other way in which a tax system can adjust for inflation is through the adjustment of the thresholds for marginal tax rates and allowances applicable to individuals to counter nominal fiscal drag. Of seven countries surveyed directly, only two, Luxembourg and the UK, operate a system of automatically adjusting tax thresholds for inflation. In addition the automatic adjustments in Luxembourg only operate when inflation reaches a rate on 3.5% in the preceding year. This is, however, a poor measure of the extent of inflation

287 The only qualification is that for accounting purposes it appears that a current cost basis is preferred to an inflation-adjusted historical cost basis. Current cost would seem less suitable for use in calculating profits for tax purposes. Current costs adjust not only for changes in the general price level, but also for changes in specific prices faced by a business. Current cost measures the income that can be withdrawn without reducing the business’s productive capacity, rather than the income that can be withdrawn without reducing the business’s capital. Choi, Frost and Meek (2002). For tax purposes the latter appears to be a better measure of income, since it is focussed on the position of the owners, rather than only on the position of the business.288 Receipts of interest and dividends would also be excluded. An alternative version of this tax would leave the treatment of interest unchanged, but would treat borrowing as a taxable receipt and lending (and repayments of borrowing) as deductible. This would make it possible to extend the tax to financial institutions. See Kay and King (1990) at 176.289 Combined with a tax on wages (or a denial of deduction for wage costs), the cash-flow tax would correspond to a subtractive direct form of value added tax, in contrast to the subtractive indirect form of VAT currently in use in the EU.

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adjustments. Automatic mechanisms can be overridden by the legislature and adjustments of thresholds in annual budgets can take account of inflation. Thus in Luxembourg there was an adjustment in only two of the last five years. In the UK the pattern is more complicated. A number of thresholds are indexed, including the key ones for income tax. Indexation has been suspended for 2003-04. It is also disrupted when there are changes to the rate structure. Some other thresholds, such as the annual exemption for capital gains are regularly adjusted for inflation in the Budget. In recent years it has been common for the adjustment to be greater than that required by inflation. Conversely, Norway has no automatic indexation system, but adjustments are regularly made that take account of inflation. Hungary also practised de facto indexation, though the adjustments there not always systematic. Germany is also said to practice de facto indexation (Heinemann, 2001: 529). Spain and Sweden do not apply even de facto indexation.

A more systematic approach to identifying the use of de facto indexation can be found in Heinemann’s (2001) study of data for the period 1972-96. He found that nominal fiscal drag was eliminated in eight European countries (Austria, Denmark, Germany, Greece, the Netherlands, Norway, Portugal and the UK), but not in another seven (Belgium, Finland, France, Ireland, Italy, Spain and Sweden). This is consistent with the information reported above. Interestingly, there does not appear to be any correlation between the adjustment of tax thresholds for inflation and the inflation adjustment of income sources.

5. Desirability of adjusting income from capital for inflation

All of the ten countries in the principal survey for this report provide some tax measures that provide compensation for inflation. Only Sweden has no measures that provide direct compensation for inflation. Only Luxembourg makes use of all three direct categories: indexation of capital gains, inflation-adjusting stocks valuation and inflation adjustment of rate and allowance thresholds. Norway, Italy and Hungary each employ one of the three, while Spain, France, Netherlands, Germany and the UK each employ two.

5.1 Equity considerations

Inflation adjustment is important both for reasons of equity and of efficiency. Adjusting income from capital for inflation preserves horizontal equity with taxpayers whose incomes are not affected by inflation, such as those earning labour income or income from services.

It also prevents a tax on nominal income from becoming confiscatory. This occurs where the after-tax rate of return is less than the rate of inflation, so that the taxpayer is not left

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with enough to preserve the real value of her capital, even if she withdraws no income for consumption.290 Arguably the problem in this case is one of transparency rather than equity. The effect is similar to that of an annual wealth tax, which is used in many tax systems. The problem is that when it results from inflation, the effective wealth taxation does not result from legislation introducing a wealth tax.291

Even when taxing nominal income is confiscatory, it involves the taxation of income that does not make the taxpayer better off. This argument also applies to the effects of nominal fiscal drag. Unadjusted tax thresholds results in taxpayers paying more tax on incomes that have not increased in real value. Even if income from capital is adjusted for inflation, there is still a need to adjust thresholds. The usual indexation methods for capital gains and stock adjust the cost of the asset, so although the inflationary element is excluded, the gain is stated in terms of current prices, not historical prices. With unadjusted thresholds this will still result in nominal fiscal drag.

5.2 Efficiency considerations

In terms of efficiency the principal concern is with the effect of taxation on the rate of return. When nominal returns are taxed the effect of taxation on after-tax real returns is magnified.292 This lack of neutrality distorts saving and investment decisions. However, much of the discussion in recent years of the reform of the taxation of investment, and of corporate taxation in particular, has focussed on the need in the interests of efficiency to ensure that returns on different types of asset and different forms of investment return are taxed at similar effective rates. See e.g. Chennells and Griffith (1997). As a result, adjusting only some types of return (e.g. capital gains) or only some type of asset (e.g. trading stock) for the effects of inflation may in fact increase the overall distortionary effects of the system of taxing income from capital.

5.3 Administration costs

Another important factor is that of the administrative and compliance burdens imposed by the tax system. The UK invoked concerns for simplification in ending the indexation of the capital gains of individuals, as did the Netherlands in deciding against introducing a system including the indexation of capital gains. Even the regular adjustment of tax thresholds, whether automatically or in the budget, adds something to the burdens imposed 290 See the example using a nominal interest rate of 15%, inflation of 10% and a marginal tax rate of 40% in section above. 291 Indeed, France and other countries impose a limit on the total amount, as a proportion of income, that may be taken in income tax and wealth tax taken together. The apparent intent of such a limit can be completely undermined by inflation.292 See the example in section boven above.

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by the tax system. Indexation systems will be relatively more costly in times of low inflation. Heinemann (2001) also suggests that taxpayers become more aware of the effects of inflation when it continues at relatively high levels for a number of years. He examined changes in the level of observed nominal fiscal drag over time, which appear to confirm this.

6. Desirability of particular inflation adjustment methods

6.1 Indexation

The question is whether these factors can explain or justify the use of partial adjustment techniques, particularly the indexation of gains on immovable property. The reason why we do not observe the indexation of interest must be simply that it is complicated. To tax real interest it is necessary to compare the nominal interest rate to the rate of inflation. This requires that taxpayers (or their banks) report not only the amount of interest received, but also the rate of interest. Whenever the rate changed, a separate calculation would have to be made. In addition, there are times when inflation gets ahead of nominal interest rates, resulting in negative real interest rates. In principle this should mean that the recipient of interest would be entitled to a tax deduction for the negative real interest. See the Meade Committee (1978, 136) for an example of these complexities.

In addition, even though nominal and real interest rates are regularly discussed in news coverage of the economy, they are not a concept that has obvious application the interest that a person actually earns. In contrast, the connection between inflation and prices is clear, so the idea that there is an inflationary element of capital gains is much more self-evident. The concern with inflation and capital gains would also appear to be a product of the realisation method of taxing capital gains. When gains are only taxed on realisation, the amount subject to tax as a result of one disposal can be very large, resulting in a large tax bill for that year. Of course, this effect can be magnified by the operation of progressive rates.

6.2 Indexation for specific assets

Indexation may have been focussed on immovable property in a number of countries because immovable properties tend to have large values and to be held for long periods, so that these concerns would be particularly relevant. For a tax system, such as that of France, that provides indexation for immovable property only when it is a non-business asset, it may also seem that immovable property is an isolated asset that can be taxed on a separate basis without greatly disturbing the neutrality of the tax system. This assumes that

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investors in immovable are quite distinct from investors in both businesses and other assets, and in particular that they do not depend on the same sources of finance (i.e. that investors in immovables do not generally borrow to finance their investments and only invest in immovables). It does not seem likely that this assumption is sufficiently valid to ensure that there will be no significant effect on the neutrality of the tax system.

It is more difficult to discern a rationale for the fact that gains on business assets are indexed in so few countries. Presumably the reason for is linked to the fact that many countries treat such gains as ordinary business income. They would then only benefit from any indexation system available for business income. This is not, however, a very convincing argument. Perhaps more to the point is that the obvious starting point for calculating business income is from the calculation of commercial profits, a process that leaves less room for the introduction of indexation. In addition, many non-financial fixed assets of a business are depreciable. Gains are less likely to arise on the sale of such assets, which would make the lack of indexation less of a concern.

6.3 Indexation and the realisation basis

The basic argument for singling out capital gains for indexation is that the realisation basis for taxing capital gains results in large gains being taxed when there is a realisation. In fact this argument neglects the fact that the realisation basis is generous to taxpayers because it defers the time at which the gains accruing each year are taxed. This can be corrected for by increasing the taxed gain by an interest factor to reflect the deferral from year to year throughout the time the taxpayer held the asset. This would use a table of interest factors, much like the tables of inflation factors used for indexation, except that they would be used to increase the taxed gain, rather than to increase the acquisition cost of the asset.

The Meade Committee (1978, 134) points out that, if the interest indexation is done assuming that the gain occurs evenly throughout the holding period of the asset and at the average interest rate for the period,293 it is possible to use a single formula to calculate the adjustments for inflation and the deferral at the same time. The formula would be based on indexing the cost for both inflation and the interest factor. As the Committee concedes, the formula is not taxpayer friendly,294 but it shows that if the real interest rate is near to zero, the combined adjustment will leave the unindexed gain essentially unchanged. Given that the relevant real interest rates tend in any event to be relatively low, under the realisation

293 These assumptions would also be need to use a table of interest factors.294 Using S for the sale price, C for the cost, C1 for the cost indexed for inflation and C2 for the cost adjusted

for the interest factor, the formula for the adjusted gain is .

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basis the indexation of capital gains is much less important than it appears to be. Adjusting interest and business profits may be much more important to preserving neutrality.

It has been noted that a number of the tax systems surveyed provide some form of taper relief, to reduce the burden of capital gains on assets held for a longer period. Given that the realisation basis already provides a deferral benefit that increases with longer holding periods, this seems an almost perverse incentive. The explanation is that the deferral under the realisation basis brings with it the distortions of the lock-in effect, and taper relief often reflects a concern to provide incentives for longer-term entrepreneurial investments. If the absence of inflation indexation largely compensates for the benefit of deferral, that would leave a proper policy space for the operation of taper relief, whether or not it is effective in achieving the avowed policy objectives.

6.4 Business profits

Just over half of the countries surveyed permit the use of LIFO or some other method of stock valuation that reduces the impact of profits. The difficulty is that the use of these methods depends on their suitability for commercial accounting purposes. It will therefore not always be possible to justify the use of LIFO. Even where the use of LIFO is permitted, that leaves both fixed assets and monetary balances without any adjustment for inflation. This will tend to make it desirable to hold stocks at year-end, since they will be less likely to give rise to the taxation of inflationary returns. In other words, this undermines the neutrality of the tax system.

6.5 Tax bases that exclude inflationary returns

This report has considered two alternative tax bases that exclude inflationary returns by the nature of the tax base adopted, the Dutch approach of taxing presumptive investment returns and the cash-flow tax.

The Dutch approach is, of course, equivalent to a wealth tax at 1.2%. This can, however, be just as well put the other way: any wealth tax is equivalent to an income tax on a presumptive return from the assets held. What is the nature of the presumptive return?

The return on capital assets can be broken down into various parts. The core return, or pure real interest element, provides compensation for the time that the investment is made (during which time the value is not available for consumption by the investor). The example of this type of return usually given is the return on a government bond, so this is a risk-free return. Beyond this, part of the return compensates for inflation, and part compensates for the various risks associated with the particular investment. Some of the

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risks will be common to other investments as well; some will reflect the features of this investment. These elements of the total return are all ones that will normally be determined by market forces. In addition, some investments offer a return that cannot be obtained elsewhere, such as the value of the one mine from which a particular mineral can be obtained, the return from a monopoly business, a return that only the investor can anticipate because of special knowledge, or a return that cannot be anticipated. Such a return is termed ‘economic rent’. Because its amount is not determined by market forces, taxing away a (large) part of it will not distort the market return available from the asset. Thus in general economic rents can be taxed without disturbing economic efficiency.

The presumptive return taxed under the Dutch model is essentially an estimate of the expected (ex ante) risk-free real return.295 In other words the new regime not only does not tax inflation, it also does not tax either risk or economic rents. Of course, it is logical that it should not tax the return to risk. Part of the reason for taxing a presumptive return is to avoid distorting risk-taking. Investors who are willing to invest in risky assets are permitted to keep the full amount of any extra return they realise, but also bear the full cost of any loss.

In contrast, the cash-flow tax exempts the normal ex ante return. It only taxes marginal returns, in particular economic rents.296 The government also shares in the investor’s risk. Provided that tax on losses can be fully reclaimed, the government in effect becomes a partner with the investor. Once again risk-taking is not discouraged. A practical problem with the cash-flow tax is that it postpones the receipt of government revenues, but it is as effective as the tax on presumptive return in not taxing inflation, and has the advantage of taxing economic rents.297

This shows that the tax on presumptive returns is far from being the only way of designing a tax base that does not include any inflationary element, but it does have quite strong features in terms of the selection of the elements of returns to capital that it does and does

295 Cnossen and Bovenberg (2000: 7) report that Bovenberg and Ter Rele used a 4% real rate of interest as the world market interest rate in analysing the effects of the new regime, indicating that they saw 4% as a reasonable estimate.296 The cash-flow tax gives a full up-front deduction for the cost of all assets, but taxes the full amount of the eventual receipts. In a sense the government lends the investor that tax on the amount invested. When the investment produces receipts, the tax on the amount originally invested plus the tax on normal expected nominal returns repays this loan and provides the government with the return it requires to make the loan, but the government also receives tax on any additional return. It is only this last part that represents new revenues for the government, so the inflationary element is effectively not taxed.297 Interestingly, one argument is that the preferable system would one that replaced the income with a progressive consumption tax (including a cash-flow tax on companies and other businesses) supplemented by a wealth tax. The role of the wealth tax would be to capture the perceived benefits of holding substantial amounts of wealth, beyond the obvious possibility of consumption out of the wealth. In this role that latter tax is better regarded as a wealth tax than as a tax on presumptive returns.

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not tax. This in turn suggests that its treatment of inflationary returns should not be treated as the predominant factor in evaluating this tax.

The most serious concern raised by the treatment of inflation in the new Dutch regime is that it is still very much a regime of partial adjustment, since the taxation of presumptive returns does not apply to business income or to income from substantial shareholdings. This means that effective tax rates will still vary between assets, and that after-tax rates of return will be distorted by inflation for some asset but not others. This element of incompleteness in this regime could have significant efficiency implications.

7. Conclusions

Inflation has a significant influence on the taxation of income from capital in terms of both equity and efficiency; however, the methods of correcting for inflation within a true income tax298 tend to be administratively costly. They are therefore much easier to justify using in times of high inflation. This itself creates a problem for the tax system in that it implies that the rules should be changed from time to time depending on current economic conditions. Moreover the costs of implementation would imply that the measures should only be introduced when inflation is not merely high but persistently high. There is a risk that the introduction of the measures then becomes an admission that inflation is not expected to decline in the near future.

These considerations go some way to explain why in the countries surveyed we find only limited adjustments for inflation being used. Of the ten countries four provide indexation for capital gains realised on at least some assets, five permit the use of LIFO in valuing stocks and six adjust the thresholds for tax rates and allowance for inflation at least in practice, but only Sweden uses none of these methods and only Luxembourg uses all of them. In addition, five of the countries provide some relief for interest income that can be seen as a form of rough compensation for the effects of inflation. Eight of the countries also provide a range of mechanisms that can similarly be seen as providing rough relief for the effects of inflation on capital gains, but these include both countries that provide indexation and those that do not.

The concern that this raises is that these isolated partial adjustment methods create significant discrepancies in the way in which different assets or forms of return to capital are treated. Since there is no reason to think that particular forms of return are affected by inflation in different ways, or that the purchasing power shown by the value of some assets

298 An income tax either on a traditional measure of income, or on the comprehensive Haig-Simons-Schanz definition.

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is any different from that of others, this limited use of inflation adjustment undermines both the neutrality and the equity of the tax system. Indeed, it may well be the case that, as the UK considered in 1984, the distortions created by the discrepancies may outweigh the benefits of indexation. Of course, as the theory of the second best tells us, trying to assess the precise effects of individual distortions in the tax system is notoriously difficult. Curiously, the indexation of capital gains may be one of the least beneficial adjustments for inflation. With a low risk-free real interest rate, the net adjustment to capital gains for both inflation and for the (interest-like) benefit of deferral under the realisation basis is small. Not correcting for either effect may be a preferable approach, particularly given how much complexity indexation adds to the calculation of capital gains.

The remaining alternatives are global adjustment or the use of a tax base that does not tax inflation. Global adjustment is well suited to the taxation of business income because businesses (other than small businesses) generally have accounting systems with sufficient information to make such adjustments feasible. The use of adjustment methods for commercial accounting shows that they can be feasible and even cost-effective with even moderate inflation. They are still, however, costly, and are not a solution that is suitable for use in every economic environment. One approach that could prove appropriate for the tax system would be to permit businesses to use commercial accounting methods that adjust for inflation at times when they can be justified by accounting principles. It may still be necessary for the tax system to specify which adjustments would be acceptable for tax purposes, but it would leave it to businesses to balance the cost of implementing the adjustments against the benefit for tax purposes. To ensure equity for all businesses it might be necessary to provide some simplified approximate adjustments that small businesses could adopt for tax purposes in times of moderate inflation.

The difficulty with global adjustment is that it is not suitable for private, non-business assets. If global adjustment for inflation is available for business income, including the income of companies, the inflationary element of returns on shares Indexation can be used for private capital gains, subject to the concerns expressed above, but the treatment of indexation of interest for individuals does not seem to be practical. One can argue that many individuals still manage in effect to solve the problem ‘privately’ by earning interest offshore, but that is of little comfort to the many with small bank accounts or bond holdings.

Here the Netherlands’ regime of taxing presumptive returns on private investment looks like an attractive complement to global inflation adjustment for business income, provided that the other implications of that system are acceptable. While the taxation of presumptive

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returns does not distort risk taking, it also exempts economic rents from tax. The weakness of the Dutch regime in this regard is that it does not exclude the inflationary element of business income from taxation. An optional accounting-based global adjustment approach to business income would be an interesting way of eliminating this lack of neutrality.

The other alternative of a cash-flow tax can, combined with its complement for private individuals, a progressive consumption tax, provide a system that does not tax any inflationary returns, while still taxing economic rents. Once again, the characteristics of that tax base are more important than the fact that it does not tax inflationary returns, and the debate on the relative merits of taxing income or consumption has yet to be settled. In addition, a consumption tax postpones the receipt of government revenues and raises some significant international issues.

A final alternative would be to exempt income from capital from tax. This would clearly also exempt inflationary returns. A global adjustment mechanism could be applied to any taxation of business income. It should be recalled that an exemption for income from capital could be considered to be comparable to a consumption tax, although with a different timing of receipts that results in its exempting economic rents as well. It could also be considered to be equivalent to a tax on presumptive income with a zero presumptive rate of return.

Inflation can affect the taxation of income from capital either through the distortions created by the taxation of inflationary returns or through nominal fiscal drag working through the structure of progressive tax rates and allowances. The latter is quite easy to correct for, and most European countries do so, quite often as part of annual budget changes without any formal automatic mechanism. Adjusting for inflationary returns is less often done and only for certain types of returns to capital. The adjustment mechanisms tend to be complex and thus costly to administer and to comply with. Moreover, adjusting only certain returns for inflation introduces new distortions into the tax system. It appears that the most well known adjustment, the indexation of capital gains for inflation is less necessary given the nature of the deferral benefit given by the realisation basis of capital gains taxation.

A better approach would be a global one, either through an accounting-based global adjustment of business profits, or through the adoption of a different tax base, such as the taxation of presumptive returns (wealth), or a cash-flow/consumption base. The adoption of a different tax base raises other important considerations. While the benefits of excluding inflationary returns from taxation should be taken into account, it is only one factor to be considered in making such a major decision.

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REFERENCES

L. Chennells and R. Griffith (1997), Taxing Profits in a Changing World (London: Institute for Fiscal Studies)

F. Choi, C.A. Frost and G. Meek (2002), International Accounting, 4th ed. (Upper Saddle River, NJ: Prentice Hall)

S. Cnossen (1996), ‘Company Taxes in the European Union: Criteria and Options for Reform’, 17:4 Fiscal Studies 67

S. Cnossen and L. Bovenberg (2000), ‘Fundamental Tax Reform in the Netherlands’, Working Paper No. 342, CESifo Working Paper Series (Munich: CESifo), available via http://www.CESifo.de

C. Dowe (2001), ‘Accounting’, in R. Amann (ed.), German Tax Guide (Neuwied: Luchterhand, and The Hague: Kluwer Law International)

F. Heinemann (2001), ‘After the Death of Inflation: Will Fiscal Drag Survive?’, 22 Fiscal Studies 527–546

Inland Revenue, Corporate Finance Manual, available at http://www.inlandrevenue.gov.uk/manuals/cfmmanual/index.htm

Inland Revenue, Inspectors Manual, available at http://www.inlandrevenue.gov.uk/manuals/immanual/index.htm

International Bureau for Fiscal Documentation (2002), European Tax Handbook 2002 (Amsterdam: IBFD Publications)

J.A. Kay and M.A. King (1990), The British Tax System, 5th ed. (Oxford: Oxford Univ. Press)

Meade Committee (1978), The Structure and Reform of Direct Taxation (London: Geo. Allen & Unwin and Institute for Fiscal Studies)

J. Mittermaier (2001), ‘Taxation of Individuals’, in R. Amann (ed.), German Tax Guide (Neuwied: Luchterhand, and The Hague: Kluwer Law International)

V. Thuronyi (1996), ‘Adjusting Taxes for Inflation’ in V. Thuronyi (ed.), Tax Law Design and Drafting, vol. 1 (Washington: International Monetary Fund)

J. Tiley (1981), Revenue Law, 3rd ed., (London: Butterworths)

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T. Ursprung and P. Wettstein (1992), ‘Die reale kalte Progression: ein totgeschwiegenes Phänomen’, Wirtschaftswissenschaftliches Zentrum der Universität Basel, Discussion Paper no. 9206

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PART IICHAPTER 5 Imputed Income

Ian Roxan

WORK IN PROGRESS

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PART II

CHAPTER 6 Emigration and Immigration

Bertil Wiman

WORK IN PROGRESS

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Preliminary Conclusions and Points for Discussion

Peter Essers and Arie Rijkers

Joachim Lang (The Influence of Tax Principles on the Taxation of Income from Capital)

In this chapter is stated that it is the task of tax science to strengthen the certainty of tax law by finding a concept of income, which is generally accepted.Thinking about a concept of income one should realize that historically income taxes are a product of the ability-to-pay principle. In other words, it is hard to imagine an existing income tax in one of the European countries that cannot be deduced from the ability-to-pay principle.This principle, in its turn, must be seen as an expression of the general legal principles. Therefore, we explicitly support Joachim Lang’s statement that the legal definition of income should obtain the same immunity as the institutions of civil law.

Therefore, if we want to determine and specify a certain element of future income taxes - which is the income from capital - it is inevitable first to answer the question whether or not the ability-to-pay principle still can and should serve as the most solid and main basis for these income taxes. This becomes more apparent if one agrees with Lang that this principle is not aiming at the payment of a lot of taxes but that it wants to protect the taxpayer against a too high tax burden.

This leads us to the main thesis concerning this chapter, to be discussed in Cologne:

1. In order to optimize equity and equality in the application of income taxes in the 21. Century the ability-to-pay principle still is the most adequate guide.299

However, in practice this principle can easily be misused to reach goals that have nothing to do with its origin. One might think of instrumental, technical or social goals. For example, in this chapter is stated that in connection with the welfare state principle the ability-to-pay principle may serve the vertical equity by a progressive tax rate.It is also possible that the ability-to-pay principle simultaneously is used as a base for several taxes, such as the income tax, the wealth tax and the inheritance tax. That leads to

299 Only theses to be discussed in Cologne are numbered.

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the question whether or not such a combination of taxes causes double taxation and should be rejected.Therefore, both tax scholars and politicians should be persuaded to use the same idea of the principle. So, we should try to define the principle in a very simple, strong and unmistakable wording. In this definition, to keep it really simple, we might skip some elements, such as the impact of alimony obligations (see par. II.4 of this chapter) and the question of the minimum subsistence (see par. III.5 of this chapter).The main features of the ability-to-pay principle should be expressed. In this chapter is stated that those main features imply:1. a lifetime notion of income (par. III.7),2. a real and realistic income, i.e. corrected for inflation and without fictitious or deemed income (par. III.3 and IV.2),3. a global income (par. IV.1),4. representing new – economic or spending – power (par. IV).

An explicit topic that will be addressed later is the question whether or not income should be defined as new economic power or simply new spending power (par. IV.1.3 transfer income). However, we hope to define the essence of the ability-to-pay principle in relation to the notion of income in choosing for spending power.Along these lines we propose the thesis:

Income is (the sum of) new real spending power measured on a lifetime basis.

This thesis involves the question whether or not income from capital might be taxed at a different tax rate in comparison with income from business and labour.In par. V.2 Lang states that equality means the equal treatment of the taxpayer and not the equal treatment of all kinds of income. He writes: ‘Schedular effects can be accepted, if so far different kinds of income concern every taxpayer. Equality means the equal treatment of the taxpayer and not the equal treatment of all kinds of income.’

However, income from capital is not evenly accessible for all taxpayers. So, although the height of tax rates is a political matter, the difference of tax rates, given the same amount of spending power, is a matter of equity and equality. A remarkable example is the actual situation in the Netherlands. The schedular system produces three different types of rates:1. a progressive rate (32-52%) on income from business and labour,2. a proportional rate (25%) on substantial shareholdings and

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3. a degressive rate on income from capital.300

We will discuss this matter in relation to the chapter written by Henk van Arendonk.

Joachim Lang addresses many other topics, such as the cash flow method, inflation, pension schemes and the treatment of costs and losses. Many of these specific topics will be explicitly discussed in the coming chapters and paragraphs.

300 The rate seems to be proportional at 30%. However, income is fictitiously set at 4% of the property. Therefore, in relation to the real proceeds, the rate is degressive.

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Claudio Sacchetto and Laura Castaldi (Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital)

In their report Claudio Sacchetto and Laura Castaldi investigate the relationship between a personal income tax on income from capital and other taxes related to income from capital such as the wealth tax, the inheritance and gift tax, the transfer tax on real estate and the corporate income tax. The first problem they face is whether the combination of a personal income tax on capital proceeds and a wealth tax causes double taxation. In their opinion, starting from the ability-to-pay principle, capital/wealth has two different qualities: 1. a static wealth dimension as direct expression to pay taxes, and 2. a dynamic income dimension as origin of new wealth, resulting of the proceeds that it may produce. Considering this difference, their thesis in paragraph 1.1 is that ‘as a matter of principle, it seems conceptually wrong to think about the problem of double tax relevant to a fiscal system in which wealth taxes on capital (---) coexist with income taxes on the proceeds (--) of the use of capital.’

In our opinion, the existence of a wealth tax can only be justified to a certain extent if an imperfect notion of income from capital is applied in the personal income tax. In the Dutch tax system before the reform of the personal income tax in 2001, income from capital was taxed on the basis of the source theory. Capital gains and losses were excluded from the taxable income because they were considered as results reflecting the source itself. Only income resulting from a defined source like rents and dividends were taxed. In such a system the existence of a wealth tax might be justified to compensate the non-taxability of capital gains and losses. However, one should take in mind that in such a concept the existence of a wealth tax will also lead to a yearly taxation of unrealised capital gains. This is a problem in a system based on the realisation principle. Besides, capital gains accrued in one year and also consumed in that year, will not be taxed at all. So this reasoning, starting from an income tax based on the source theory, will never justify fully the existence of a wealth tax.301

If one would develop a comprehensible notion of income from capital based on, e.g., the S-H-S model, wealth is the result of income that has been taxed already. Seen from that perspective, the combination of a personal income tax and a wealth tax leads to juridical and economic double taxation. This conclusion also results from a more economic approach of the problem. From an economic perspective capital/wealth equals the present value of future income. Since this income will be taxable in the personal income tax, this

301 P. Kavelaars, Vermogenswinstheffing: verlies of (aan-)winst?, Kluwer-Deventer, 1997, page 14.

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perspective also leads to the conclusion that the combination of a wealth tax and a personal income tax on capital results in double taxation. In our opinion, these arguments leading to the conclusion of juridical and economic double taxation, overrule the sometimes-heard justification for taxing a tax payer’s wealth because wealth offers a kind of lifesaving for the future.

A more suitable justification for a wealth tax could be the absence of gift and inheritance taxes in a country, but then the question arises whether a yearly levy of wealth tax would be a proportionate alternative for the absence of an inheritance or gift tax on an incidental gain.302

This leads us to the following main thesis to be discussed in Cologne:

2. A wealth tax cannot be justified if the personal income tax has been based on a comprehensive notion of income from capital.

The second problem that is dealt with by Claudio Sacchetto and Laura Castaldi concerns the relationship between ‘direct taxes’ on capital like a wealth tax and ‘indirect taxes’ on capital like gift and inheritance taxes.Because the relationship with the wealth tax has been addressed before, we will focus at this point on the relationship between a capital gains tax and gift and inheritance taxes. With respect to the latter taxes, a distinction must be made between recipient levies, which are levied from the recipient, and donation levies, which are levied from the donator. Since both a capital gains tax and a donation levy aim at the same taxpayer, in the year of death the donation levy should be credited with the capital gains tax levied from the deceased. Such a credit would, however, not be appropriate in case the capital gains tax provides in a deferral provision in case of death and this deferral would be applied. In countries where the gift and inheritance taxes are recipient levies, these levies aim at other taxpayers than the capital gains tax. In these situations, in our opinion, there is no need to credit gift and inheritance taxes against the capital gains tax. Only the tax debt as a result of the capital gains taxation at the level of the deceased or donor should reduce the taxable amount that is to be taken into account in the gift and inheritance tax. In case a rollover relief would apply, the latent tax debt should be taken into account.303 Some authors argue that a deferral of the capital gains tax can only be justified in case an inheritance or gift tax is levied at the level of the recipient. For principle reasons we would

302 Compare: P. Kavelaars, Vermogenswinstheffing: verlies of (aan-)winst?, Kluwer-Deventer, 1997, pages 13 and 14.303 P. Kavelaars, Vermogenswinstheffing: verlies of (aan-)winst?, Kluwer-Deventer, 1997, pages 64 and 65.

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object to this reasoning since the position of the deceased and the heirs is not the same. However, considering practical and budgetary reasons, we understand its ratio. A combination of a deferral for the capital gains tax and the absence of a gift and inheritance tax would inevitably lead practically all taxpayers to a choice in favour of applying the rollover relief. However, this could also happen in case a gift and inheritance tax does exist.

All this, leads us to the following thesis:

Gift and inheritance taxes should only be credited against a capital gains tax in case the former taxes are levied from the donator/deceased.

Another problem addressed by Claudio Sacchetto and Laura Castaldi, concerns the relationship between personal income tax on dividends and capital gains on shares and the corporate income tax on profits of the company in which the shares are held. Since dividends are paid out of profits that have already been taxed with corporate income tax, it is obvious that economic double taxation is at stake if the levying of personal income tax takes place completely independently of the levying of corporate income tax. To avoid this economic double taxation several solutions exist. First, the double taxation can be mitigated or avoided at the level of the shareholder. Allowing shareholders a credit for the corporate income tax can realize this. One could also tax the dividends and capital gains at a moderate rate, like is done in the Netherlands for substantial shareholders, or take only part of the dividends and capital gains into account in determining the taxable income, like is done in Germany, also for substantial shareholders. It is also possible to mitigate or take away the double taxation at the level of the corporation. This could lead to a system in which a primary dividend or rent is deductible in calculating the taxable profit of the corporation.

In their report Sacchetto and Castaldi make a distinction between ‘big’ corporations, mostly listed on the stock exchange and more or less closed corporations with substantial shareholders. For the former corporations they seem to defend a classical system. In our opinion, also in case of corporations with many shareholders, the problem of economic double taxation of profits exists. This double taxation should be abolished either at the part of the shareholder or at the part of the corporation. We do agree however, that an owner of shares listed on the stock exchange has more resemblance with an ordinary investor. Mostly, he will only be interested in the net result of his investment, which means that he will shift the additional burden caused by the double taxation on to the corporation. This

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pleads for a mitigation of this double taxation at the level of the corporation, e.g., by allowing a deduction of a primary dividend or rent. A substantial shareholder resembles more a personal entrepreneur. He directly bears the burden of the corporate and personal income tax. This pleads for a mitigation of this burden at the level of the substantial shareholder, e.g., by taxing dividends and capital gains at a moderate tax rate. However, if a system would apply in which no distinction is made anymore between investors and entrepreneurs, we don’t see a need for this different treatment. In that case all shareholders should receive a compensation for the corporate income tax, either by giving them a credit for the corporate income tax, or by taking into account only part of the dividends and capital gains or by levying dividends and capital gains at a moderate rate.

Therefore, we would like to add the following thesis, to be discussed in Cologne:

3. A personal income tax based on a notion of income from capital that does not make any difference between entrepreneurs and investors, should give all shareholders a relief for the corporate income tax in order to avoid economic double taxation on the profits of the corporation.

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Henk van Arendonk (Fixed Amount Taxation with respect to Income from Capital in Personal Income Taxation)

As has been stated in Chapter 1 of Part I by Joachim Lang, there is a tendency in Europe towards schedular income taxes (Sweden, the Netherlands). This tendency may cause the problem of different tax rates as mentioned before. But, this tendency also appears to evoke fictitious income, as is the case in the Netherlands. This brings us to the question to what extent fictions are in accordance with the notion of income, particularly with the notion of income from capital.In Chapter 4 of Part I Van Arendonk suggests that taxation through fixed amount schemes becomes unacceptable if the gap between taxation and reality violates the equality principle.He summarises various arguments for simplifications and fictions in tax law. The majority of these arguments - avoiding complications, diminishing inspections and disputes - focus on the feasibility of taxation. This kind of simplification is generally accepted and will, if well applied, lower the tax burden in general.However, governments can abuse the general acceptance of this technology. First, a fiction can be used to masquerade a privilege. Second, a fiction can be used to avoid tracking down fraud. Both might be the case in the Netherlands in the case of taxation of income from private property. In that respect, Van Arendonk mentions that an annual assessment that does not take into account the settlement of losses will lead to arbitrary and unfair results. The same goes in his eyes for the fixed tax rate on the fixed rate of return.

It is worth mentioning the difference in approach of Sweden and the Netherlands. In Sweden the introduction of the dual income tax was highly related to the abolition of the joint family taxation. This abolition solved the problem of defining the tax unit. On the other side, it created the possibility for family transactions, which, in combination with the progressive tax rate, gave rise to many constructions to avoid taxation.304 The Dual Income Tax System, introducing a flat rate for income from capital, got rid of these constructions.In the Netherlands the path towards the schedular approach of income from capital was different. Due to a notion of income based on the source theory the administration had to cope with numerous constructions transforming taxable yields into tax-free capital gains. This process had been going on for decades, causing ‘gross inadequacies’ as Van Arendonk calls them. The alternation of constructions and anti-avoidance rules became a never-ending story. This story ended with the introduction in 2001 of a deemed yield of

304 See Lindencrona, The Abolition of Joint Taxation – the Swedisch Experience, Intertax, volume 30, Issue 11, page 474.

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capital income of 4% on the average private property. The 4% comprises normal proceeds, such as interest and dividends, and capital gains and losses.

Now, the question is whether or not this was a happy ending. While all other forms of income encounter a capital gains tax regime in the Netherlands, a capital gains tax for private property would have been an obvious solution. However, this solution could not be reached. Van Arendonk: ‘Politicians in the Netherlands were (…) averse to introducing a capital gains tax.’ So, there is a big difference between the Swedish Dual Tax-system and the Dutch system. The first comprises real income from capital in the tax base, the latter only fictitious income.

In Chapter 4 of Part I is shown also that the relatively decreasing tax burden on increasing gross returns from private property calls for new constructions and new anti-avoidance measures.

All this leaves us with the question to what dimension the fiscal notion of income from capital might diverge from reality before it oversteps the marks of equity and equality. Van Arendonk states that in the Netherlands efficiency prevailed over justice.

Of course, the borders of equity and equality are relative. Tax revenues have to be taken into account. Feasibility plays an important role. Nevertheless, many scholars in the Netherlands are of the opinion that the Dutch system cannot be justified and lacks legitimacy.There seems to be an important difference between simplification and simplism. A rational simplification does not surpass the basics and principles of the tax system. In that case the simplification brings the system to perfection. Simplism however accepts any measure apart from the question whether or not it fits in the tax system’s building.Van Arendonk asks whether it is acceptable to apply a fixed rate taxation on the entire category of income from capital and whether efficiency is reason enough to do so.

Therefore we put to the test the next thesis, to be discussed in Cologne:

4. Given a tax base comprising real income from labour and enterprise, the implemen-tation for all private property of fictitious income at a different tax rate is in conflict with the ability-to-pay principle.

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It should be mentioned that this thesis is based on the assumption that income from capital, as a rule, is taxable in the country of the taxpayer’s residence. However, if income from capital, as a rule would have to be taxable in the source country, the same question would have to be answered in relation to the income tax system of that source country.

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Peter Kavelaars (Acrrual versus Realization)

In his exposé concerning the choice between an accrual versus a realization type of income tax, Peter Kavelaars firstly addresses the question whether or not the realization principle is an inherent part of the notion of income from capital.This question is linked with the dispute on the notion of income on a cash flow basis (Chapter I.V). In Chapter I is stated that the lifetime ability to pay demands a cash flow notion of income. If that is the mainstream doctrine, the way towards the accrual method is seriously blocked.On the other hand, one could argue that the cash flow method should be reserved for assets that cannot be transformed in cash at all, such as non-redeemable pension schemes. If and when the criterion is new spending power, this power does not have to exist in a liquid form. It could be argued that only in cases where the accrual of capital cannot be released for consumption at all, the moment of realization is decisive. In this approach, the accrual method and the cash flow method are not inherent to the notion of income. Then, both methods could be applied to refine the basic notion of income. Therefore, we argue that the method to attribute income from capital to a certain period goes along with the peculiarities of the specific capital asset.

However, Kavelaars doesn’t consider realization as an essential of the notion of income from capital (par. 9). He concentrates on the increase or decrease of the value of private property as such. The relevance of realization of these changes in value indeed seems to be determined by reasons of feasibility and deliberations of social or instrumental nature (i.e. pension schemes).

In Kavelaars’ chapter it is remarkable that he points out many advantages of the accrual method in comparison with the realization concept. Being accustomed to the realization concept, one tends to forget the large number of disadvantages of this method: the need of fictitious realizations on the one hand, the need of rollover facilities on the other hand, the tension in relation to inheritance tax, the possible need for special rates when realized capital gains might be not in proportion to the averaged yearly income, and so on!So, we think that the accrual concept deserves serious attention. And, while addressing the drawbacks of this concept it might be useful to make a clear distinction between portfolio investments on one side and intangible property on the other. In our view, the annual valuation and the liquidity argument practically do not play a role where it concerns portfolio investments.

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Furthermore, we do agree with Kavelaars that the experiences with the wealth tax in the past and the box III- valuation for the income tax in the Netherlands do not face insurmountable problems, even though there are many legal proceedings concerning the valuation of intangible properties. The question remains whether or not these proceedings really are caused by the valuation as such. The tax rate, the taxes concerned and the consequences of the valuation in time must also be taken in consideration.

As Kavelaars clearly points out, the most stated disadvantage of the accrual method is the possibility of lacking resources to pay the income tax due. As mentioned before, the weight of this disadvantage depends to a high degree of the property concerned. In our opinion it is a non-problem for portfolio investments. They can easily be considered as cash. And, insofar it concerns substantial shareholdings, we think that they resort under the taxation of enterprises and could be set aside while discussing the concept of income from capital.Thus, the problem of lacking liquidity in everyday life regards intangible property. Here the changes in value over the years might be substantial.Kavelaars suggests some measures to counter serious liquidity problems, such as a preserving assessment and suspension of payment. The system of preserving assessments however, equals the realization concept and is therefore less adequate. A suspension of payments on the other hand can be tuned to the specific liquidity problems of the taxpayer concerned. Then, the yearly yield of all capital assets can also be taken into account, as Kavelaars mentions (par. 3). In short, we do think that the liquidity problem cannot be denied, but, that it is solvable, and that it is insufficient as an argument against the accrual method. Contrary to the liquidity problem, Kavelaars points out that the accrual method implies immediate balancing of (unrealized) losses. To what extent these losses affect taxable income in a certain year indeed depends of the global or schedular system applied. Anyway, the fact that unrealized losses are take into account should clearly be seen as an advantage for the taxpayer. We summarise the other advantages of the accrual method pointed out by Kavelaars:- The method solves the possible lock in effect.- In case of migration exit taxes are less needed and problems in connection with the EC-treaty might be avoided.- The impact of the levy upon death, divorce, mergers, splits, and so on, is mitigated.

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Special attention has to be paid to the international dimension. The collision of the realization method and the accrual method in different countries, as clearly analysed by Peter Kavelaars, could cause double taxation or double non-taxation. However, these problems seem not to be caused by the accrual method as such, but rather by the one-sided orientation of article 13 OECD Model Convention on the realization method. Therefore, it must be argued that article 13 of the OECD Model Convention needs to be amended in such a way that both methods are covered by this article. In the slipstream of this there is the need for uniformity in step up and step down rules. In other words, article 13 of the OECD Model Convention needs to be amended in such a way that the receiving country applies its capital gains tax or its taxation on an accrual basis starting from the true economic value of assets upon immigration or upon movement of the asset. 305

It is noteworthy that Kavelaars stresses that inflation plays a more serious role if it concerns capital gains, because the inflation component of this income is generally a substantial part of the total value change during the year. This matter will be addressed in a separate chapter of this report.

In his closing considerations Kavelaars comes up with some measures to be taken by implementing the accrual method in order to make this method more feasible in practice. He suggests two methods. The first one comprises a yearly fixed yield on the basis of the fair market value of the private property finalized upon realisation. In the other method the fixed yield is based on the cost price of that property.The question to be answered is whether or not the advantages of the accrual method and the realization method are thus combined, or whether the disadvantages of both systems are multiplied.

But, before addressing these kind of specific questions, we first have to deal with the question whether or not the accrual method can be embraced as the better method to assess income from private capital. Accustomed as we are with the realization method, we propose the next thesis to be discussed in Cologne:

5. The accrual method is, for the taxpayer as well as for the tax authorities, the most benevolent method to determine income from capital.

305 See IFA report 2002, The tax treatment of transfer of residence by individuals”, par. 4.3.

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Kevin Holmes (Deferral Possibilities)

Kevin Holmes describes tax deferral possibilities, defined as delays in payment of a tax liability. These delays can be achieved in two ways:

a. by deferring the recognition of gross income or revenue to a later income year; or b. by creating or advancing deductible expenditure or losses to reduce a current year

tax liability.A deferral can be temporary but, as Kevin Holmes illustrates, also permanent, or practically permanent. Possibilities to defer the recognition of gross income arise if capital gains are taxed on a realisation basis. The yearly-accrued increases in value of assets are not taxed as long as the owner has not realized them in the form of a sale or other transfer to another party. In our opinion it depends on the chosen starting-point whether you consider this situation as a deferral. Those who consider the accrual of the value of the asset as income, will speak of ‘deferral’; those who favour the realisation principle will state that before the moment of realisation there was no income, so it is wrong to speak about deferral. They will only regard a specific rollover relief as a deferral since it prevents taxation even after the hidden reserve in the asset has been realized. In both approaches deferral is often connected to tax mitigation. In situations in which a permanent or practically permanent deferral is established, the deferral is seen as tax avoidance. We agree with Kevin Holmes that the latter should be regarded negatively ‘because the ability of a minority of taxpayers to obtain an advantage in the timing of their tax obligations runs against the grain of the idea of fairness of the majority of people.’ These avoidance schemes should be tackled e.g., by specific or general anti-abuse measures.

We would like to state that in situations that are not abusive, a deferral does not necessarily lead to tax mitigation. The ‘price’ you have to pay for a rollover relief leading to a transfer of an asset to another taxpayer is mostly that this other taxpayer is obliged to take over the book value of his predecessor. The buyer will try to take into account the higher tax burden he will have to face because of the application of the rollover relief by decreasing the price he wants to pay for the assets. In case, e.g., exemptions would apply or lower tax rates if the predecessor and the successor/ buyer would have opted for the payment of tax at the moment of realization and assets are involved with a rather short term depreciation period, the overall tax burden of opting for the rollover relief could be higher than in case tax would have been paid at the moment of realization. This means that a rollover relief is not necessarily in conflict with the ability-to-pay principle. If parties deal at arms’ length the

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ability-to-pay of the predecessor is affected because the buyer will reduce the price he wants to pay with the latent tax burden. As Kevin Holmes describes, a rollover relief, which is applied by a taxpayer in case he sells assets and re-invests in substitute assets, also mitigates the so-called ‘lock-in effect’. This effect is often seen as a disadvantage of a capital gains tax (see below).

A tax policy question Kevin Holmes raises is when tax deferral should be introduced. In his opinion ‘the merits and demerits of tax deferral must be tested against the now generally accepted tax policy objectives of equity, simplicity, certainty, convenience and economic efficiency.’ His statement is that deferral violates both horizontal and vertical equity. He also states that deferral is contrary to the notion of economic efficiency. However, in our opinion the answer to the question whether deferral is in contrast to the notion of economic efficiency depends on the notion of income you depart from. If that notion is based on the accrual method, a deferral offends the notion of economic efficiency. On the other hand, if you depart from the realization principle deferral is often not at stake, nor a violence of the notion of economic efficiency. Referring to our arguments as described above, we would like to lay down the following thesis, to be discussed in Cologne:

6. Deferral is not necessarily in conflict with horizontal and vertical equity or with the notion of economic efficiency.

Kevin Holmes also describes the ‘lock-in effect’, meaning that ‘taxing capital gains gives an incentive to investors to stay “locked into” existing investments, thus impairing the mobility of capital, which optimal economic efficiency necessitates.’ Peter Kavelaars, in his report, also pays attention to this effect. He is of the opinion that the ‘lock-in effect’ should not be overestimated. In that respect he refers to the experiences in other countries that apply the realisation principle. In his opinion, in the long run a capital gains tax will not have a substantial influence on the decision to alienate an asset. The capital gains tax will be considered as part of the costs related to the alienation. As such, this tax is taken into account in the value of the asset. The decision to alienate will be influenced by many economic and other considerations and not primarily by the existence of the capital gains tax. The taxpayer will try to shift this tax on to the buyer of the asset. One could also refer to the taxation of capital gains made by entrepreneurs and substantial shareholders. These capital gains taxes neither lead to ‘lock-in effects’. So a thesis might be:

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The influence of ‘lock-in effects’ of deferral should not be overestimated.

Kevin Holmes correctly points out that ‘by nature’, tax deferral introduces complexities into tax law. These complexities could cause uncertainties and opportunities for tax avoidance. However, in his opinion, ‘concessional deferral rules in a law that taxes income from capital are, in themselves, generally not likely to result in great uncertainty’. And although deferral possibilities result in extra costs for taxpayers, he states (paragraph 3) that, ‘for taxpayers who enter into tax deferral arrangements, the value of the benefits of deferral presumably exceeds the costs.’ According to Kevin Holmes, the converse is likely to be true for the tax administration. The legal comparison he has made shows ‘considerable inconsistency between European countries in allowing tax deferral opportunities.’ He has also found examples where tax deferral arises from tax avoidance arrangements. In his opinion these problems illustrate ‘the more general inadequacy of taxation of capital gains on a realisation basis’. According to Kevin Holmes, these problems may be overcome by adopting ‘accrual income methodology’. Here, we refer to the discussion whether the notion of income should be based on the accrual method or on the realization principle.

Finally, Kevin Holmes pleads for the incorporation of tax deferral into a statutory definition of tax avoidance. Referring to Art. 11 of the Merger Directive, this leads us to the following thesis:

Structures leading to an (almost) permanent tax deferral may be considered as tax avoidance in the meaning of Art. 11 of the Merger Directive.

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Judith Freedman (Treatment of Capital Gains and Losses)

Judith Freedman raises the question whether capital gains and losses should be seen as ‘normal’ income and, as a consequence, should be included in the general income taxation scheme, like in the USA, or whether they should be considered as a conceptually different tax base and, as a consequence, should be treated separately. A different treatment could result in an entirely different tax code, like in the UK, or in different rules within the general tax code, e.g., by using special tax rates, special realization rules or roll over reliefs or by differentiating between business and personal gains. In both approaches it is sometimes very difficult to distinguish receipts at the borderline, e.g., in case of liquidation payments or receipts from a company which purchases its own shares.

Whatever concept is applied, there seems to be consensus that, starting from the ability-to-pay principle, the full exclusion of capital gains and losses from the taxation of income is not acceptable. Besides, the experience in e.g., the Netherlands before the introduction of box 3 in its personal income tax, proves that such a system leads to the conversion of taxable income into tax free capital gains. The discussion then concentrates on the extent to which taxation of capital gains may differ from the taxation of other income. The answer to this question depends inter alia on the concept of income that is applied: an accrual, or realization approach. Only in case of a consumption or expenditure tax, in theory the distinction between capital and income receipts would disappear. Judith Freedman finds it ‘arguable, that not all capital gains do have the quality of income’, e.g., inflation gains or an increase in asset prices caused by a fall in interest rates. She also points out that psychological reasons plead for a different treatment of capital gains: individuals often perceive a capital gain as wealth and would spend a higher proportion of their current income rather than would an individual with equal income but no assets. A difficult problem is the treatment of capital losses. Joachim Lang (Part I, Chapter 1, paragraph V, 3.2) states in his report that capital losses should only be taken onto account on the schedule of capital gains In his opinion, a full deduction of the losses is only justified from the full capital gain. In this respect he raises the question whether the amount of losses ought to be reduced in relation to the holding period, as is often done with respect to capital gains. For practical reasons he rejects this idea. Peter Kavelaars (Part II, Chapter 1, paragraph 4), starting from the accrual concept, connects the question of compensation of capital losses to the way in which other income is involved in the levy: ‘If the assumption is that the background of the income does not play a role (synthetical levy), compensation with other income within the year is theoretically the correct

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approach; when different types of income are taxed according to a different regime (analytical system) application of vertical relief is the correct approach.’ Thus, in contrast to Joachim Lang, Peter Kavelaars does not make a difference between the treatment of capital losses and other losses. Judith Freedman, starting from the realization concept, considers capital losses as a particular problem, since ‘under a realisation system there will be a tendency for the taxpayer to retain assets showing a profit so as to defer taxation but to dispose of those showing a loss, so as to realise that loss and make it available for set-off.’ In a Dutch report on capital gains taxation306 the compensation of capital losses with other income components than income from capital (including capital gains) is only permitted for a limited fixed amount or percentage, combined with an indefinite carry forward period and a five year carry back period. Ultimately at the time of death of a taxpayer capital losses which have not been compensated yet can be compensated with the taxpayer’s full income. Another possibility would be a limitation by a percenmtage of the loss.

In Cologne we would like to put to the test the following thesis:

7. Capital gains should be included in the general income taxation scheme. Special (business) reliefs can be justified for reinvestment and to prevent the break up of businesses. However, if we apply a notion of income based on the realization concept, as a main rule, capital losses should only be compensated with capital income, including capital gains.

306 Inkomstenbelasting over vermogensmutaties, Geschriften van de Vereniging voor Belastingwetenschap, 1998, page 66.

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Ian Roxan (Influence of Inflation)

In the case of income from capital a portion of the income itself will represent compensation for the effects of inflation. This compensation does not add to the true well being of the taxpayer. This is one of the introduction statements of Ian Roxan. Therefore an income tax system should ideally not tax these compensations.The main problem to achieve this seems to be the administrative complications. For, as dr. Roxan shows, the easier inflation neutrality can be reached the more countries are willing to apply some kind of method to erase the influence of inflation. An example is the correction for nominal fiscal drag by periodically increasing tax rate brackets and exempts amounts. However, when it comes to capital gains, interests and dividends themselves countries come up with a wide variety of methods. The most simple – indexation of the cost price of capital assets – and rough methods – such as taper relief or presumptive investments returns – seem to be popular. Additionally, very often tax systems only adjust for the effects of inflation on certain types of income from capital. Some countries offer a relief for business income but not for private investments. Other countries do it the other way around. We agree with Roxan that such partial adjustments may introduce serious distortions in the taxation of different types of income from capital. Therefore, any method to compensate for the inflationary elements should go for all types of income.Nevertheless, Roxan reports that none of the countries surveyed provide indexation for the inflationary element of interest and dividends. Instead, tax free amounts; relatively low tax rates and presumptive investments returns are implied. Those methods however do not seriously correct for inflation. More interesting is the global adjustment that has been used in a number of Latin American countries. Roxan suggests that this method is best suited to the adjustment of business income, since it is based on adjustment of the balance sheet. However, we think that this method might also be appropriate for private investments. Hereafter we will produce an example that could be discussed.

Of course there are systems to determine taxable income that automatically erase inflationary elements such as a cash flow tax and a consumption tax. However, we propose to focus on the traditional concept of income when debating on inflation neutrality. For, as Roxan states, the debate on these other systems has yet to be settled.

Roxan produces strong arguments to adjust income from capital for inflation. It preserves horizontal equity with taxpayers. It prevents a tax becoming confiscator. It prevents distortions in saving and investment decisions. However, the administration costs seem to be a major obstacle for inflation neutrality in tax systems. It is questionable whether or not

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the administrative complications produce a valid argument not to adjust for inflation. In the first place rather simple but effective methods seem to be possible. In the second place it might be left to the taxpayer to opt for the application of such a method.In this respect it is worth mentioning that in the past the Netherlands had a relatively simple system for inflation neutrality for business income that came close to a theoretically appropriate correction. It implied a deduction of a certain percentage of the enterprises’ equity at the beginning of the year (‘vermogensaftrek’, ‘equity deduction’). In 1998 a commission of the Dutch Society for Tax Science developed on that basis an equity deduction for private investments.307 The characteristics of that deduction are as follows. The taxpayer is allowed to deduct yearly an inflation related percentage of the cost price of the assets and liabilities.308 The deduction can only be applied on received interests, dividends and capital gains (schedular approach). Insofar as there is no yield, the deduction is transported to the future and indexed. This is suggested to prevent deductions - affecting the revenue - while capital gains, in a realisation system, will only be taxable in the future. Nevertheless, to meet the demands of the ability-to-pay principle, the deduction pool can be used completely upon death and emigration.The report produces the following example in figures.A possesses per 1-1 of year 110 immovables; cost price per piece 500.000 5,000,0005% bonds; cost price 5,000,000 Total 10,000,000

No debts309

Inflation rate 2%Market interest rate 5%In year 2 one immovable is sold for 600.000In year 3 one immovable is sold for 400.000To simplify the example the rent on the immovables is neglected.

Deduction pool 1-1 Addition pool Subtraction pool Deduction pool 31-12 Year 1Interest 250,000 0 200,000Deduction 307 Geschriften van de Vereniging voor Belastingwetenschap, nr. 208, ‘Inkomstenbelasting over vermogensmutaties’, ISBN 90 200 2113 3.308 This way inflationary gains on liabilities are also taken into account.309 In case of debts the deductible amount would be calculated on the cost price of the assets minus these debts.

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2/5*250,000 100,000 -/- 100,000Taxed 150,000 100,000

Year 2Indexation 2,000Addition 200,000310

Interest 250,000Gain immovable 100,000Deduction interest 100,000 -/- 100,000Deduction gain 100,000 -/- 100,000Taxed 150,000 102,000

Year 3Indexation 2,040Addition 202,000311

Interest 250,000Loss immovable 100,000 -/-Deduction interest 100,000 -/- 100,000Taxed 50,000 206,040

Year 4 206,040Etc.

This example might be discussed in Cologne as a possible, and not too complicated, global method to neutralise inflation in connection with income from capital.However, we think that on the basis of Roxans’ report we first will have to discuss about the principles of the tax system in relation to inflation. The thesis we propose involves more aspects. In the first place it concerns the fundamental idea. Next it follows Roxans’ suggestion that partial adjustments are not welcome. In the third place there seems to be a task for scientists to produce a reasonable easy system that is attractive for both governments and taxpayers. Finally, with respect to the administrative costs, it might be necessary that the legal adjustment method is optional for taxpayers.

310 I.e. 2% of 10,000,000.311 I.e. 2% of 10,100,000.

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For these reasons, we propose the following thesis:

8. In a civilized income tax regime inflation neutrality is indispensable. The method of compensation for inflation should be structural and equal for all types of income. Scientists should produce a method that is theoretically acceptable and feasible at the same time. This method could be optional for taxpayers.

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Bertil Wiman (Emigration and Immigration)

WORK IN PROGRESS

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APPENDIX

QUESTIONNAIRES

1. Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital (Part I, Chapter 3)

1) Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

2) Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

3) Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

4) Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

5) Which are the indirect taxes on capital?6) Describe the system of taxation of immovable property (i.e. real estates) in your

country.7) Describe the system of taxation of movable property (in particular bonds and similar

instruments) in your country.

2. Peter Kavelaars, Accrual versus Realization (Part II, Chapter 1)

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?(if not, the next questions have not to be answered)

2. Are capital gains taxed on accrual or on realization base?3. Related to question 2, are there differences between types of assets? If so, will you give

a short overview?4. Can you give a short overview of the fiscal treatment to the capital gains in the

following situations/cases:- death- emigration

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- immigration- mergers/splitting- divorce

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

6. Are there special regulations related to a tax treaty?7. Are there plans to change the system on taxation of capital gains? If so, give a short

description of these possible changes.

Kevin Holmes, Deferral possibilities (Part II, Chapter 2)

1. Are capital gains taxed in your country when the gains are realised by:a. An individual; orb. Non-individual entities?

2. Are capital gains taxed in your country on an accrual basis when derived by:a. An individual; orb. Non-individual entities?

3. Does the type of asset (e.g. a personal or business asset), which produces the gain, affect the answers to questions (1) and (2)?

4. If the answers to any parts of questions (1), (2) or (3) were affirmative, please briefly describe the common techniques employed by taxpayers to defer the tax liability.

5. Are there mechanisms used in your country to:a. Defer the taxation of income from capital on an accruals basis (e.g. gains

arising from the annual change in value of debt instruments) by structuring an arrangement so that the gain is taxed upon (later) realisation (e.g. gains on the realisation of equity securities)?

b. Convert capital gains otherwise taxable upon realisation into a non-taxable form?

6. Are domestic or offshore trusts, foundations or other entities utilised to own assets with the objective of deferring (temporarily or permanently) tax on capital gains otherwise leviable in your country?

7. Are accrued capital gains treated as realised upon the marriage or death of the owner, or the gifting, of an asset? If so,

a. Who is liable to pay the tax?b. Are the gains on all assets subject to tax?

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If not, and the gain is realised upon disposal of the asset, who is liable to pay the tax?

8. Does your country’s domestic law contain participation or other exemptions, which relieve corporate entities from taxes on gains that they derive from the realisation of shares or other assets? If so, briefly state the conditions that must be met to qualify for the exemption(s).

9. Does your country have provisions in its legislation designed to defeat arrangements to defer the taxation of capital gains? If so, please give a short description.

Judith Freedman, Treatment of Capital Gains and Losses (Part II, Chapter 3)

1. Does your system tax capital gains and losses through the general income taxation system?

2. If not, are such gains and losses covered by a separate code?3. Do you have a statutory distinction between capital gains and other income gains?

If not, briefly, how are these different types of gain distinguished from other income gains, if at all?4. If capital gains are included in the general income tax, do special rates and reliefs

apply?5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a

realisation? If not, what other basis is used?6. Are there rules to deal with inflation?7. Is there a deferral or exemption from tax on capital gains on death?8. Are there other deferrals and reliefs on capital gains- - for individuals on certain

types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

Ian Roxan, Influence of Inflation (Part II, Chapter 4)

Capital Gains1. Are capital gains indexed for inflation? If so, how (e.g. by adjusting the amount of

the cost for inflation or by allowing the deduction of an inflation adjustment)?

2. Have there been any major changes to the indexation system recently?

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3. Are there any restrictions on when indexation is available, e.g. by taxpayer, by type of asset, by length of ownership? Is indexation available when there is a capital loss?

4. Is there any other relief given for capital gains on assets held over a longer period? Please describe the relief briefly.

Specific Sources of Income from Capital5. Is interest income indexed for inflation? If so, how?

6. Is there any other relief for interest that is seen as providing some compensation for the effect of inflation on interest? Please describe the relief briefly.

7. Is any other type of income from capital indexed for inflation (e.g. dividends, royalties)? If yes, please describe the indexation method briefly.

8. Are businesses permitted to calculate the value of trading stock (inventory) using methods that make an allowance for inflation (e.g. ‘last-in-first-out’ (LIFO)), or given any other relief on stock that compensates for inflation?

Tax Rates9. Are the thresholds (‘brackets’) for each tax rate indexed for inflation? Are the personal (individual) deductions from total income (personal allowances / personal credit / zero tax rate limit) indexed for inflation?

10. Is indexation applied automatically every year, or is new legislation required each year? If it is automatic, is there an explicit mechanism permitting indexation not to be applied in a year?

11. Is indexation normally applied? For instance, in how many of the last five years has full indexation been applied?

General12. Are there any other thresholds (e.g. minimum amounts of particular type of income

to be taxable) that are automatically indexed for inflation?

13. Are there any noteworthy provisions where there is an adjustment for inflation that works against the taxpayer?

Ian Roxan, Imputed Income (Part II, Chapter 5)

1. Is owner-occupied housing subject to income tax? As ordinary income, or subject to special rates of tax?

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2. If so, how is the amount of income calculated (based on capital value or rental value; based on statutory amount (e.g. cadastral value), or estimate of market value)?

3. How often is the base value revalued? When was the last general revaluation?

4. Are any expenses (e.g. mortgage interest, repairs) deductible in calculating the amount subject to tax?

5. Is any other imputed income from consumption goods or services subject to tax?

6. Apart from the treatment of unrealised capital gains and shares in companies, are there any other types of income not realised by the taxpayer that are subject to tax, (e.g. certain trust income, or foreign assets)? (Brief description only)

Deemed Income7. For what transacations is market value substituted for actual transaction values? Is

this automatic or at the discretion of the Revenue?

8. Are any non-arm’s length transactions (including gifts and transfers on death) valued at a value other than market value (or actual value, if any)? Please describe briefly.

9. Are there other transactions (giving rise to income from capital or capital gains) where an amount other than the actual amount realized is included in income? Is this automatic, or at the election of the taxpayer or of the Revenue?

10. Please describe briefly any significant cases where the amount of deductible expenses in respect of income from capital or capital gains is denied or restricted, or where a standard amount is deductible (either required or as an alternative to the actual amount).

11. Are there circumstances where a taxpayer’s total income (or income tax) is limited (maximum or minimum) by reference to a general calculation of income (e.g. alternative minimum tax, maximum level of total direct taxation (income and wealth)?

Does this relate to the level of reliefs or disallowed deductions given in respect of income from capital or capital gains?

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NATIONAL REPORTS

1. AUSTRIA (Eva Burgstaller)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

Individuals are subject to income tax, corporate profits are subject to corporate income tax. Resident individuals and corporations are taxable on their worldwide income. Non-residents are subject to income tax and corporate income tax with respect to income from certain enumerated sources or income in Austria and property located there.

The Individual Income Tax Law contains a list of 7 categories of taxable income; income not falling under any of these categories is not taxable. These categories are:1. agriculture and forestry2. professional and other independent services3. trade and business

4. employment income5. investment income

6. rents, lease payments and royalties7. other specified income (including certain annuities and capital gains on private property)

Taxable income is the aggregate net result of all categories of income minus losses, special expenses, exceptional expenditure and certain other allowances and gains. The tax rate is progressive.The categories are subsidiary to each other which means that for instance rents fall only in category 6 if not in category 3. Therefore investment income is all income that is not attributable to one of the first four income categories. Expenses incurred are deductible, unless they are connected with income that is subject to a final withholding tax. Dividends received from a resident company and interests are taxable as business income or as income from capital. A final withholding at a rate of 25 % applies in both cases. Royalties and income from immovable property are

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taxable as business income or income from rents, lease payments and royalties at the normal income tax rates.

Capital gains and investment income arising from nonbusiness activities are not taxed, subject to the following two exceptions:1. Short-term capital gains – Profits on the sale of both Austrian and non-Austrian assets are considered “speculative” transactions and are subject to income tax at normal rates where the period between purchase and sale is not more than one year (real estate – 10 years, in some cases 15 years; specific rules apply for sale of principal residence). Such profits totaling less than EUR 440,-, are nor taxable (tax exemption limit).2. Sale of participations – Profits on the sale of holdings on corporations are subject to income tax at reduced rates where the vendor has held more than 1 % of issued share capital at any time within a period of 5 years preceding the date of sale.

The net wealth tax has been abolished with effect from 1 January 1994.

2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

Dividends and other profit distributions to resident individuals are subject to a final withholding tax (“Kapitalertragsteuer”) at a rate of 25 %. This also applies if the income is derived in the course of trade or business. If, however, the final 25 % tax is less favorable than one half of the effective rate on the taxpayer’s income, the latter will apply if requested by the taxpayer within 5 years.

The following types of interest received by resident individuals are subject to a final withholding tax at a rate of 25 %:- interest on deposits and other debt-claims with certain banks;- interest on certain securities, including convertible and profit-sharing bonds;- income from participations in investment funds and similar participations; and- interest on securities issued by international institutions after 30 September

1992.

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

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Corporate taxpayers are subject to national corporate income tax. There are no other taxes on the income of companies. Legal entities subject to corporate income tax include:- stock companies (“Aktiengesellschaft”, “AG”);- limited liability companies (“Gesellschaft mit beschränkter Haftung”,

“GmbH”);- private foundations;- commercial enterprises operated by public entities;- associations, institutions, foundations without independent legal existence and accumulations of property for specific purpose.Both limited and general partnerships are treated as transparent entities for tax purposes.The private foundation is not allowed to pursue trade or commercial activities itself but it may operate as a holding company. Special treatment is provided for certain items of passive income and capital gains derived by the foundation.Resident companies are taxable on their worldwide income. Income and capital gains are pooled and taxed at the same rate of 34 %. The computation of the income follows the rules of the Individual Income Tax Law, unless the Corporate Income Tax Law provides otherwise.

Resident parent companies and their resident subsidiaries may elect for consolidated income taxation (“Organschaft”) if the parent company exercises financial, economic and operational control to such extent that the subsidiary is in fact directed by the parent. Consolidated income taxation means that a subsidiary although a separate legal entity according to company law, is treated as a branch of its parent company for tax purposes. This ensures that losses of one group company are immediately set off against profits of the other companies.

Special rules apply to dividend distributions, including hidden distributions, received by resident companies from other resident companies. Such distributions are exempt from corporate income tax in the hands of the recipient company, regardless the size of the holding. The participation exemption does not extend to capital gains and liquidation proceeds.

Dividends and other profit distribution to resident companies are subject to withholding tax (“Kapitalertragsteuer”) at a rate of 25 %. No withholding tax is due

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if the dividends are paid to a company that holds at least 25 % of the shares in the distributing company. If tax is withheld, it is credited against the final income tax liability of the company, or refunded on request. A withholding tax of 25 % applies to most types of interest that are paid out in Austria, except interest on loans between two companies. Tax withheld constitutes only a prepayment of the corporate income tax liability. There is no withholding tax on royalties paid to resident companies.

The corporate income tax of 34 % on corporations’ profits plus the withholding tax of 25 % on dividends lead - in cases where the profit is entirely distributed to the shareholders - to an equal tax burden of individuals/partnerships and corporations if the marginal tax rate of 50 % is assumed for indivudals/partnerships.

Foreign source dividends that do not qualify for the participation exemption discussed below are included in taxable income. For Austrian law implementing the provisions of the EC Parent-Subsidiary Directive provides for an exemption with respect to profit distributions from subsidiaries located in another EU Member State to the resident parent company. Dividends qualify for this purpose if:- the parent company is legally required to keep books and records under the commercial code;- the subsidiary company has a form listed in the Directive and is subject to a corporate income tax listed in the Directive with no possibility of opting for taxation or being exempt;- the parent company holds directly at least 25 % of the share capital of the subsidiary; and- the parent’s minimum 25 % shareholding is held for an uninterrupted period of at least 2 years. If otherwise qualifying dividends are distributed within the 2-year holding period, they are provisionally subject to tax. After the expiration of the 2-year holding period, the tax authorities will decide in accordance with the guidelines on combating tax avoidance whether or not the taxation is final.

Dividends received from subsidiaries not resident in an EU Member State are exempt under the same conditions as EU subsidiaries. In this case, the subsidiary must be comparable to a resident company.

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

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As far as the Austrian corporate taxation system is concerned the different treatment of dividends and capital gains is not systematic. Dividends received by a corporation are tax-exempt, capital gains are not. Therefore the same hidden reserves are could be distributed tax free to shareholders or become subject to tax when realized through capital gains.

5. Which are the indirect taxes on capital?

Real estate sales tax (“Grunderwerbsteuer”)The real estate sales tax is a transaction tax which taxes the acquisition of domestic real estate:- contract of sales- acquisition of property- contracts of assignment- acquisition of realization authority - alternation of shareholders in a company that owns real estat

(“Anteilsvereinigung”)

The tax rates 3,5% of the value of the consideration (sales price) or, if such a value cannot be determined, the value. The value is either the triple assessed value or the (less) fair market value.The rate is reduced to 2% for transfers between spouses and from parents to children, grandchildren or stepchildren. The same rate applies if in the cases of divorce, when the marital property is divided

Capital transfer tax, on contributions to capital of companies (“Gesellschaftsteuer”)A tax of 1% is levied on contributions of capital to Austrian corporations if the corporation issues stock in consideration of the contribution, or if the contribution is likely to increase the value of the contributor’s interest in the corporation.The capital transfer tax is a transaction tax which taxes the supply of equity capital to domestic corporations, especially:- first-time-acquisition of corporate rights- payments of the shareholder due to company law obligations- voluntary payments of the shareholder if the remuneration is granting more

corporate rights

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- voluntary payments of the shareholder, if the payments result in a higher corporate rights value:

- allowances- abdication of debts- abandonment of objects without adequate payments- purchase of objects for payments which exceed the object’s value

The tax rate is 1 %, the tax base is the value of the consideration.

Legal act duties (“Rechtsgeschäftgebühren”)Duties are levied on many types of commercial and legal documents. It is not the legal transaction itself, which is subject to tax but the written instrument executed to document the transactions. The most common legal transactions giving rise to taxation upon execution of a document are the transfer of receivables, lease agreements, guarantee agreements, easements (certain rights over land), mortgages, private settlements and bills of exchange. Especially important are the dues levied on credit and loan contracts. Loan contracts are taxed with 0,8 %, credit contracts – due to the credit period – between 0,8 % and 1,5 %.

6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

The real estate sales tax taxes the acquisition of domestic real estate (see question 5)Immovable property situated in Austria is subject to real estate tax (“Grundsteuer”). The tax is levied on the assessed value (“Einheitswert”) of immovable property whether developed or not. In general, the assessed value is substantially lower than the market value. The tax is independent of income related to the real estate or personal circumstances of the owner, it is a tax on the object. The real estate tax is levied at a basic federal rat (“Steuermesszahl”), multiplied by a municipal coefficient (“Hebesatz”). The basic federal rate is usually 0,2 % and the municipal coefficients range up to 500 %. The tax is payable in four quarterly installments by 15 February, 15 May, 15 August and 15 November.

For unimproved plots that come in consideration for buildings an additional real estate tax is levied (“Bodenwertabgabe”). Tax base is the assessed value, the tax rate is 1%. The exempt amount is EUR 14.000,-.

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7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

Tax on securities (“Wertpapiersteuer”) has been abolished with effect from 1 January 1995.Stock exchange turnover tax (“Börsenumsatzsteuer”) has been abolished with effect from 1 October 2000.

Insurance tax (“Versicherungssteuer”)Subject to tax are insurance rates based on an insurance relationship. The tax base is the insurance rate, the tax base depends on the insured object. The engine-based insurance tax (“motorbezogene Versicherungssteuer”) is levied on all kinds of passenger cars and motorbikes. Tax base is the cylinder capacity for motorbikes and the motor capacity for passenger cars.

Motor vehicle tax (“Kraftfahrzeugsteuer”)Subject to tax are all motor not covered by the engine-based insurance tax (“motorbezogene Versicherungssteuer”) and used inland. This means trucks, omnibuses and all motorcars admitted abroad when used inland. The tax is based on cylinder capacity, motor capacity and the overall admissible weigh.

Peter Kavelaars, Accrual versus Realization

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation? (if not, the next questions have not to be answered)

Capital gains and investment income arising from nonbusiness activities are not taxed, subject to the following two exceptions:a. Short-term capital gains – Profits on the sale of both Austrian and non-Austrian assets are considered “speculative” transactions and are subject to income tax at normal rates where the period between purchase and sale is not more than one year (real estate – 10 years, in some cases 15 years; specific rules apply for sale of principal residence). Such profits totaling less than EUR 440,-, are nor taxable (tax exemption limit).b. Sale of participations – Profits on the sale of holdings on corporations are subject to income tax at reduced rates where the vendor has held more than 1 % of issued share capital at any time within a period of 5 years preceding the date of sale.

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If the shares were acquired by the seller without consideration, it is sufficient that the former owner held at least 1 % of the company’s share capital at any time the preceding 5 years.c. Exit tax – Taking measures resulting in Austria losing taxing powers are feigned to be an alienation of a participation. The participation must meet also the above characterized requirements.

2. Are capital gains taxed on accrual or on realization base?

Generally speaking, capital gains are taxed on a realization base. The exemption is the exit tax levied on hidden reserves as the alienation of the participation is only feigned. See question 1 c.

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

No.

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- deathWorldwide assets are subject to inheritance taxes, unless they are specifically exempt. If non of the parties involved is an Austrian resident or national, only the transfer of domestic property my be subject to tax. Domestic property includes:

- domestic assets of an agricultural or forestry enterprise;- property used by a non-resident enterprise having a permanent representative in

Austria;- immovable property located in Austria;- patents and trade marks registered or exploited in Austria;- assets leased to an Austrian business or to a permanent establishment of a non-

resident enterprise;- debts secured by mortages on immovable property situated in Austria; and- participation of a silent partner in an Austrian enterprise.In general, valuation is based on a fair market value. Immovable property located in Austria is valued at its assessed value, which is significantly lower than the fair market value. Debts and funeral and administration expenses are deductible. Property giving

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rise to interest income subject to the final withholding tax is exempt from inheritance tax. Inheritance tax is levied at progressive rates. The progression depends on 2 factors: the relationship between the deceased and the heir and the value of the property received. The rate ranges between 2 % and 60 %.

- emigrationsee question 1 c), exit tax- immigrationThe Minister of Finance has the possibility to grant immigration benefits to certain individuals (scientists, artists). In practice, such benefits are also granted to athletes.Concerning participations, a step-up of the tax base for participations of at least 1 % in a resident or non-resident joint stock company is provided. When these shares are sold after immigration (or upon later emigration), the cost basis is not the historic acquisition cost but the market value of the shares upon immigration. As a result, only those hidden reserves are taxed that have accrued during the time of residence in Austria.

- mergers/splittingThe Austrian Reorganization Tax Law, which was passed by the Austrian Parliament in December 1991, provides special rules for the tax treatment of mergers and splitting in order to grant a system where the restructuring of companies is not accompanied with the risk of hidden reserves taxation.The Austrian Reorganization Tax Law is applicable to the following types of restructuring:- mergers (“Verschmelzung”);- transformations under the Transformation Act (“Umwandlung”);- partial mergers (“Einbringung”; tranfer of assets);- the establishment of partnerships (“Zusammenschluss”);- the division of partnerships (“Realteilung”);- division of corporations (“Spaltung”).All transactions are in general book value transactions without any capital gain taxation. In general an option to increase book value is not granted. However, a transaction will be regarded as a taxable event in exceptional cases if a book value transaction has a negative impact for the taxpayer in a cross-border transaction or if Austria would lose its right to tax.

- divorce

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The Austrian Marriage Law follows the separation of property system. In the case of divorce the marital property is divided without any tax consequence with one exemption. If immovable property is divided, real estate sales tax has to be paid. The tax rates 2 %. The taxable base is the value of the real estate. The value is either the triple assessed value or the (less) fair market value. The assessed value is normally significantly lower than the fair market value.

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

At a company level, deferral of taxation of capital gains is possible when capital gains can be transferred to a replacement reserve: Capital gains realized from the disposal of fixed assets may be rolled over to fixed assets acquired or produced in the tax year of realization. Alternatively, a tax-free reserve (“Übertragungsrücklage”) may be set up in the amount of the capital gains in the year of realization which were not rolled over in the same tax year. This reserve may be used for acquiring fixed assets in one year. Reserves or parts thereof which were not used within 1 year must be released and thus increase the profits. The roll-over and the reserve are allowed only if:

- the asset sold has been a fixed asset of the company for at least 7 years (15 years for land or buildings); and

- the asset for which the roll-over/reserve is claimed is used in a resident permanent establishment.

- 6. Are there special regulations related to a tax treaty?

No.

7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

No.

Kevin Holmes, Deferral Possibilities

1. Please briefly describe the common techniques in your country employed by taxpayers to defer the tax liability given a capital gains tax.

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Capital gains and investment income arising from non-business activities are not taxed, subject to the following two exceptions:1. Short-term capital gains – Profits on the sale of both Austrian and non-Austrian assets are considered “speculative” transactions and are subject to income tax at normal rates where the period between purchase and sale is not more than one year (real estate – 10 years, in some cases 15 years; specific rules apply for sale of principal residence). Such profits totaling less than EUR 440,-, are nor taxable (tax exemption limit).2. Sale of participations – Profits on the sale of holdings on corporations are subject to income tax at reduced rates where the vendor has held more than 1 % of issued share capital at any time within a period of 5 years preceding the date of sale. Therefore individuals try to avoid complying with these exemptions.

At a company level, deferral of taxation of capital gains is possible when capital gains can be transferred to a replacement reserve:

Capital gains realized from the disposal of fixed assets may be rolled over to fixed assets acquired or produced in the tax year of realization. Alternatively, a tax-free reserve (“Übertragungsrücklage”) may be set up in the amount of the capital gains in the year of realization which were not rolled over in the same tax year. This reserve may be used for acquiring fixed assets in one year.

As far as the Austrian corporate taxation system is concerned the different treatment of dividends and capital gains is not systematic. Dividends received by a domestic corporation are tax-exempt, capital gains are not. Therefore the same hidden reserves are could be distributed tax free to shareholders or become subject to tax when realized through capital gains.

If the conditions of the international participation exemption for dividends are met (see question 4) also capital gains derived from the alienation of the shareholding are exempt.

2. Are there mechanisms used in your country to:a. Defer the taxation of income from capital on an accruals basis (e.g. gains arising from the annual change in value of debt instruments) by structuring an arrangement so that the gain is taxed upon (later) realisation (e.g. gains on the realisation of equity securities)?

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As capital gains are generally speaking taxed on a realization base, such instruments do not exist. The taxable gain is computed, at the time of sale, as the difference between the sales price and the purchase or (only in cases of business income) manufacturing price (less depreciation).

b. Convert capital gains otherwise taxable upon realisation into a non-taxable form?

On a company level, capital gains realized from the disposal of fixed assets may be rolled over to fixed assets acquired or produced in the tax year of realization. Alternatively, a tax-free reserve (“Übertragungsrücklage”) may be set up in the amount of the capital gains in the year of realization which were not rolled over in the same tax year. This reserve may be used for acquiring fixed assets in one year. Reserves or parts thereof which were not used within 1 year must be released and thus increase the profits. The roll-over and the reserve are allowed only if:

- the asset sold has been a fixed asset of the company for at least 7 years (15 years for land or buildings); and

- the asset for which the roll-over/reserve is claimed is used in a resident permanent establishment.

3. Are domestic or offshore trusts, foundations or other entities utilised to own assets with the objective of deferring (temporarily or permanently) tax on capital gains otherwise leviable in your country?

No.

4. Does your country’s domestic law contain participation exemption or other exemptions, which relieve corporate entities from taxes on gains that they derive from the realisation of shares or other assets? If so, briefly state the conditions that must be met to qualify for the exemption(s).

If the conditions of the international participation exemption (“Internationale Schachtelbeteiligung”) for dividends are met also capital gains derived from the alienation of the shareholding are exempt:

- the parent company is legally required to keep books and records under the commercial code;

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- the subsidiary company has a form listed in the Directive and is subject to a corporate income tax listed in the Directive with no possibility of opting for taxation or being exempt;

- the parent company holds directly at least 25 % of the share capital of the subsidiary; and

- the parent’s minimum 25 % shareholding is held for an uninterrupted period of at least 2 years. If otherwise qualifying dividends are distributed within the 2-year holding period, they are provisionally subject to tax. After the expiration of the 2-year holding period, the tax authorities will decide in accordance with the guidelines on combating tax avoidance whether or not the taxation is final.The exemption applies only for participations in foreign companies. Capital gains on domestic participations are subject to tax.

5. Does your country have provisions in its legislation designed to defeat arrangements to defer the taxation of capital gains? If so, please give a short description.

Apart from the general provisions of anti-avoidance no special rules apply.

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your system tax capital gains and losses through the general income taxation system?

Yes.

2. If not, are such gains and losses covered by a separate code?3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

As regards business income, there is no distinction in Austrian income tax law between gains on sales of capital assets and on sales of non-capital assets. All gains derived by a company from the sale or other disposition of business property (this includes all assets of the company) are taxed as business income at normal rates. The law distinguishes between business property (“Betriebsvermögen”) and non-business property (“Privatvermögen”). Gains derived from the sale of business property are taxed as business income at the ordinary rates. Gains derived from the

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sale of non-business property are taxed only if sold within a specific period after acquisition (speculative gains) or if the seller held a substantial interest (at least 1%) in a company. In cases of taxation the normal rates apply.

5. If capital gains are included in the general income tax, do special rates and reliefs apply?

No.

6. Are capital gains and losses taxed on a realization basis. If so, what amounts to a realization? If not, what other basis is used?

Capital gains are realized upon the sale of assets. The taxable gain is computed, at the time of sale, as the difference between the sales price and the purchase or (only in cases of business income) manufacturing price (less depreciation).

7. Are there rules to deal with inflation?

No.

8. Is there a deferral or exemption from tax on capital gains on death?

The inheritance tax applies to transfers of property on death. The tax is levied on the value of the taxable property transferred to the recipient. Property which produces interest income subject to final withholding tax (see topic 1.2., question 2) is exempt from inheritance tax (note that shares are not exempt). Assets are not necessarily valued at fair market value. Farming or forestry land and real estate is valued at a substantially lower value than fair market value, the assessed value fixed by the tax office for a unit, e.g. land and building, an enterprise etc.

9. Are there other deferrals and reliefs on capital gains- - for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

For individuals there are no deferrals and reliefs on capital gains:CorporationsSubstantial shareholding: If the conditions of the international participation exemption for dividends are met also capital gains derived from the alienation of

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the shareholding are exempt. The required shareholding must be in any case have been held for an uninterrupted period of 2 years. The participation exemption is not applicable to the extent the capital gains result from a former depreciation of the participation.Assets: Capital gains realized from the disposal of fixed assets may be rolled over to fixed assets acquired or produced in the tax year of realization. Alternatively, a tax-free reserve (“Übertragungsrücklage”) may be set up in the amount of the capital gains in the year of realization which were not rolled over in the same tax year. This reserve may be used for acquiring fixed assets in one year. Reserves or parts thereof which were not used within 1 year must be released and thus increase the profits. The roll-over and the reserve are allowed only if:- the asset sold has been a fixed asset of the company for at least 7 years (15 years for land or buildings); and

- the asset for which the roll-over/reserve is claimed is used in a resident permanent establishment. The Austrian Reorganization Tax Law provides special rules for the tax treatemnt of company reorganization. All transactions are in general book value transactions without any capital gain taxation. Basically, an option to increase book value is not granted. However, a transaction will be regarded as a taxable event in exceptional cases if a book value transaction has a negative impact for the taxpayer in a cross-border transaction or if Austria would lose its right to tax.

10. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

Capital losses are usually treated in the same way as ordinary losses. Losses incurred in one category of income may be deducted from income from other categories of income derived in the same calendar year. However, losses from “speculative ventures” and from “dispositions of certain participations” are deductible only against profits from the same respective category.For companies subject to corporate income tax, however, losses incurred from the disposal of substantial participations in a stock company or a limited liability company) may only be set off against other income in seven equal portions starting in the end of disposition. Only in the case of taxable write-up in value or a taxable realization of hidden reserves of the participation in question or any other participation in the same tax year may the losses be set off against these taxable amounts on the taxpayer’s request. Moreover, losses incurred from the disposal of

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participations may be claimed at all only if they are not related to a distribution of dividends.

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2. BELGIUM (Prof. Jacques Malherbe)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Income from capital is taxed to individuals on a schedular basis at 25% or 15% for dividends and 15% for interest. There is no wealth tax .

2. Capital income is taxed through withholding taxes. The tax must be withheld by the payer or the intermediary, provided he is located in Belgium. Failing withholding, the income must be reported and tax paid at the same rate as withholding.

3. Income produced by profit legal entities is taxed under the corporation tax. Non-profit entities are taxed under the withholding.Economic double taxation is not avoided between companies and individuals. Between companies, there is a 95% dividend exemption and an exemption for capital gains realized on shares subject both to various conditions.

4. Some problems of overlapping can be identified, e.g. in the event of liquidation of a company.

5. Company formation is subject to a registration tax of 0.5% on capital. There is an exemption for mergers and contributions of branches of activity, according to the European directive.

6. Real Estate income is taxable under the individual income tax and also under a regional and local tax.

7. Income from bonds will be subject to 15% as seen above under a withholding or the individual income tax.

Peter Kavelaars, Accrual versus Realization

1. Capital gains on private assets are not taxed in Belgium, except for some exceptions (real property, 25% holdings in Belgian companies)

2. To business persons, capital gains are taxed on a accrual basis.3. No difference between types of assets as to the accrual basis of taxation.4. Capital gains are not taxed upon death, emigration, immigration of divorce. In the

event of mergers or splitting, capital gains are generally exempted provided legal conditions are met.

5. There is a possibility to postpone the business taxation of capital gains in the event of re-investment.

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6. Tax treaties are according to OECD pattern.7. No plans for the time being to change the taxation of capital gains.

Judith Freedman, Treatment of Capital Gains and Losses

1. Capital gains or losses are taxed through the general income taxation system.2. No separate code.3. There is a statutory distinction between capital gains and other income.4. Special rates and reliefs apply to capital gains in the business sphere.5. Capital gains or losses are taxed to businesses on a realization basis.6. There are no rules to deal with inflation except for inflation prior to 1950.7. In the event of death, only inheritance duties apply. There is no capital gains tax.8. Individuals are only taxable on certain types of capital gains. In the other event

there is de facto a relief.When there is taxation, length of time is conducive to differences in rates for real property.

9. In the business sphere, there is no limit on the setting off of losses against gains.

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3. DENMARK (Prof. Aage Michelsen)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation

Resident taxpayers are taxable on all income, whether received in money or money’s worth. In practice, all items of income are taxable, unless statutorily exempt. There is no separate capital gains taxation. Income and capital gains are pooled and taxed together. But income and capital gains of an individual taxpayer are split into four categories : 1) personal income, 2) capital income, 3) income from shares and 4) CFC income. The aggregate of personal income and capital income less general deductions is termed taxable income. The categories are relevant for the various tax rates and for the deductibility of expenses.

Personal income is deemed to include all items of income that do not fall into categories 2, 3, and 4. In practice, personal income consists of employment income, business income, pension income and gifts (unless subject to gift tax). The income taxation of personal income is progressive. The marginal tax rate is 59 %. Social security contributions (arbejdsmarkedsfondsbidrag) are payable by employees and self-employed persons. For 2002 and 2003 the rate is 8 %. The amount of the contribution is deductible in computing taxable personal income. A pension contribution (særlig pensionsopsparing) of 1 % is levied together with the general social security contributions on the same taxable base. The pension contribution is deductible for individual income tax.

Capital income comprises net interest, gains and on bonds and other debt claims and gains on immovable property. Capital income also comprises capital gains on shares that are not taxable as income from shares, most importantly capital gains on shares owned for less than 3 years and gains on shares in financial companies resident in low-tax countries. The marginal tax rate is 59 %.

Income from shares consist of dividends and taxable gains and deductible losses on the sale of shares owned for at least 3 years. The tax rates for 2003 is 28 % for

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income from shares not exceeding 41.100 DKK. The tax rate for 2003 for income from shares exceeding 41.100 DKK is 43 %.

There is no net wealth tax.

2. Is income on capital taxed through witholding taxes substititive to the ordinary income taxation ? Which ones ? Please desribe how they function.

Declared dividends are subjekt to a of 28 %. The tax is a prepayment of tax of income from shares. But if the income from shares does not exceed 41.100 DKK the withholding tax is final.The withholding tax is final for non-resident taxpayers even if the income on shares exceed 41.100 DKK.

3. Which principles regulate the taxation of income produced by non individuals (i.e. partnerships, companies, non-profit entities, ets. ? In particular : Are there any mechanisms that avoid (internal) economic double taxation on income from companies ?

A partnerships is as a transparent entity for tax purposes.

Denmark has a classical system of taxation for corporate profits since 1992. Companies are taxable of their worldwide income. Income and capital gains are pooled and taxed at the same rate. Capital gains or losses on the disposal of shares are only included in taxable income if the disposal takes place within the first 3 years of ownership. Gains and losses on debts and debt claims are in general included in taxable income. The rate of corporate income tax is 30 %. The tax system is coupled with a participation exemption for corporate shareholders and reduced tax rates for individual shareholders on dividends (28 % or 43 %), see above.

4. Are there any problems of overlapping between taxation of income from capital and the taxation of capital gains ?

No.

5. Which are the indirect taxes on capital ?

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There are no indirect taxes on capital.

6. Describe the system of taxation of immovable property (i.e. real estate) in your country.

Gains on the sale of owner-occupied dwellings are normally exempt from taxation and losses may not be deducted.

Capital gains and losses on other immovable property are subject to taxation. For individuals such gains are taxed as capital income. If an individual’s activity of buying and selling a certain type of asset constitutes a trade or business, the profits and losses of such transactions will allways be taxable or deductible, normally as business income. Individuals are liable to social security contributions at the rate of 8 %.

The part of a gain that represents depreciation taken in the past is not taxed as capital income, but as personal income. Only 90 % of such recaptured depreciation is taxable.

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

Capital gains on the disposal of goodwill, know-how, patents, copyrights, designs or models, trademarks and similar rights are taxed as personal income for individuals. The same applies to rights under usufruct contracts aned lease contracts. Losses are deductible from personal income.

Individuals are not liable to tax on bonds and other debt claims denominated in DDK, provides that the debt claim carry interest at a normal rate which, at the time they were issued, was at leats equal to a minimum interest rate fixed by the tax authorities, The minumum rate is currently 3 %. Losses on such bonds and other debt claims are not deductible.

Gains and losses on bonds and other debt claims denominated in currencies other than DDK are tacable to the extent total gains or losses of the income year exceed DKK 1.000. Alle taxable gains and deductible losses are included in capital income.

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As mentioned above companies are as a main rule liable to tax on gains and losses on debts and debt claims.

Capital gains and losses on financial instruments are as a main rule included in taxable income.

Peter Kavelaars, Accrual versus realization

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation ?

See the answers at topic 1.2.

2. Are capital gains taxed on accrual or on realization base ?

Capital gains on private assets are as a main rule taxed on a realization basis. If a taxpayer’s activity of buying and selling shares constitutes a trade or business, the taxpayer may choose that the capital gains are taxed on an accrual basis. The taxpayer may chose that capital gains on bonds are taxed on an accrual basis. Capital gains on financial instruments are taxed on an accrual basis.

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases :

a) Death. It is as a main rule possible for individual heirs to succeed in the tax position of the deceased.

b) Emigration. In 1987 Denmark introduced a limited exit tax on certain accrued but not yet realized capital gains on shares, debts, debt claims and financial instruments.

c) When an individual becomes resident in Denmark, his assets and liabilities are deemed to acquired at the fair market value at the time when he becomes resident i Denmark. From the general rule that assets are deemed to be acquired at the fair market value, an exemption is made in connection with depreciating assets. Such assets are considered acquired at the actual acquisition price and subject to a

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maximum depreciation according to Danish rules up to the immigration to Denmark.

d) Mergers/splitting. The Merger Directive was implemented in Denmark in 1992. The relief granted is the application of the succession principle. The receiving company takes over the tax position of the tranferring company in respect of the assets and liabilities transferred. The receiving company is treated as if it acquired the asstes and liablities on the same date, the same price and for the same reasons as the transferring company and as if it has taken the same depreciation and dealt with the assets and liabilities in exactly the same way as the transferring company.

e) Divorce. Capital gains in connection with a divorce are not taxable.

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim ? If so, please give a short description of the form of postponement ?

It is possible to postpone the fiscal claim on capital gains on the sale of immovableproperty if the taxpayer purchase an another immovable property.

6. Are there special special regulations regulated to a tax treaty ?

No.

7. Are there plans to change the system on taxation of capital gains ?

There are no general plans to change the system on taxation of capital gains.

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your system tax capital gains and losses through the general taxation system ?

There is no separate capital gains taxation. Income and capital gains are pooled and taxed together.

2. If capital gains are included in the general income tax, do special rates and reliefs apply ?

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Income and capital gains of an individual taxpayer are split into four categories : 1) personal income, 2) capital income, 3) income from shares and 4) CFC income. The income taxation of personal income and capital income is progressive. The marginal tax rate is 59 %. Income from shares consist of dividends and taxable gains and deductible losses on the sale of shares owned for at least 3 years. The tax rate for 2003 is 28 % for income from shares not exceeding 41.100 DKK. The tax rate for income from shares exceeding 41.100 DKK is 43 %.

3. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation ? If not, what other basis is used.

As a main rule capital gains and losses are taxed on a realisation basis, see above under 2.2.1 (2).A realisation amounts transfer of assets by sale, donation and advancement.

4. Are there rules to deal with inflation ?

No.

5. Is there a deferral or exemption from capital gains on death ?

It is as a main rule possible for individual heirs to succeed in the tax position of the deceased.

6. Are there other deferrals and reliefs on capital gains – for indviduals on certain types of personal assets ? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction ? For assets held for a certain length of time ?

Capital gains on private cars and on other private assets are not taxed. Capital gains on the sale of owner-occupied dwellings are normally exempt from taxation and losses may not be deducted.

Shares held by a company for 3 years or more are exempt from taxation.

7. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital) ?

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The deductibility of losses on the sale of shares held less than 3 years is restricted to gains on the sale of shares held less than 3 years.

The deductibility of losses on the sale of immovable property is restricted to gains on the sale of immovable property.

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4. FRANCE (Prof. Cyrille David)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

France has since 1914-1917 a general income tax = it was at the origin composed of several proportional schedular taxes and a general progressive income tax which have been united in LF (Finance Law) for 1960 Since 1933 businesses are taxed on all their capital gains but households were not taxed on these capital gains until 1963 (for property and land capital gains) , 1976 (for other capital gains) or 1978 (for capital gains on securities). For taxpayers subjected to the progressive income tax , both incomes and capital gains are subjected to the progressive tax but with many exceptions :

a. long term capital gains from businesses (assets held more than 2 years in the balance sheet before being sold) benefit since 1965 from a reduced proportional tax : 15% in 1965 now increased to 15% + 10% =25% due to numerous social taxes ; this special rate is applicable only to partnerships (and not any more to corporations ) since 1997

b. capital gains made by resident households on sale of securities benefit since 1978 from a proportional tax = 15% at the origin now increased to 15% + 10% = 25% for the same reason (social taxes)

c. tax basis of capital gains is reduced for households by several mechanisms : taking in to account the length of the holding time on the asset (so that after 22 years of holding a capital gains on any immovable property is exempted

2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

No withholding tax on income from immovable capital (except on sale by non residents) No compulsory withholding tax for interest income (fixed investments) since 1965 but possibility for resident households to opt for a liberating proportional withholding tax (2003 amount = 16% + 10% social contributions = 26%); however interest paid by a French debtor to non residents is subjected to a withholding tax

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of 16% (with no social contributions added) with many exceptions (no withholding tax on interest coming from bonds issued by French companies and subscribed by non residents.No compulsory withholding tax on dividends paid to a resident by a French company since 1965:but withholding tax of 25% on dividends paid by French companies to non residents (rate often reduced by DTC).

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

for partnerships: the basis of the taxable gain is calculated at the level of the partnership but it is divided between the partners according to their holding in the partnership and each partner is taxed on the proportion of the profit he is entitled to according to the rules applicable for him (income tax rules when the partner is a household or an individual business, corporation rules when the partner is a corporation, what creates many difficulties).

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

Normally no. But there are some cases when the appropriate qualification is uncertain .For instance household selling securities many times during the taxable year shall be deemed to have earned no capital gains but Non-commercial income (=benefice non commercial) subjected to the progressive income tax and not to the proportional tax of 26%. ; the same seems to be true when the household sells a big amount of securities on a given transaction so that it represents its main source of revenue.

5. Which are the indirect taxes on capital?

a. transfer taxes on the selling or any similar transaction of immovable property , business or partnerships interests or shares (but in this last case only when an act had been written)

b. or on the contribution by a shareholder or partner of his own assets to the company or partnership he becomes member of

c. VAT in cases fixed by Directive May 17 , 1977

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6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

a. income tax on revenues earned by a household out of properties it rents except if it rents furnished property (it becomes commercial revenue and not any more property revenue)

b. corporation tax on revenues earned by a corporation out of properties it rents

c. income tax on revenues earned by a partnership on property it owns and rents deemed to be a property revenue when the partnership does not have any professional activity (= property management partnership=société civile immobilière) but to be a professional revenue when the partnership does have a professional activity (for instance commercial partnership or barrister partnership)

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

a. bonds held by resident household ; progressive income tax except if the holder opts for the liberating proportional tax of 16% + 10% = 26/ (art 125 A I CGI)

b. bonds held by a professional ( business man or commercial partnerships ) : only progressive income tax with no possibility to opt for the proportional tax

c. bonds held by a corporation :always taxed at the full corporation tax rate since 1997

d. shares held i) by resident household = progressive income tax with deduction of a 50% tax credit on the dividends distributed ( if French shares) ; this system should be changed and probably abrogated at the end of 2003. ii) if the beneficiary is a non resident household , he is not taxable on the dividends he receives from a French company except for a 25% withholding tax (art 119bis CGI) which can be reduced by DTC (15% or 10%) e. shares held by resident corporation = taxation at the corporation tax with

only a 10% tax credit on the dividends received (from 2003 on)

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Peter Kavelaars, Accrual versus Realization

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation? (if not, the next questions have not to be answered)

Yes: general taxation on all assets in France since 1976-1978 for households and 1934 for businesses

2. Are capital gains taxed on accrual or on realization base?

Realization base (what implies a transfer of property)

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

Immovable property (land buildings owned by a household) =progressive income tax (maximum rate = 49,7% + 10% social contributions for residents only) Movable property = same Securities = proportional tax of 16% + 10% social taxes 26% (social taxes not due by non residents) = 26% who are normally not taxed in France for non residents art 244 bis CGI If the asset is sold by a business and a capital gains is made on this sale (or any equivalent transfer of property) , since 1965, there is a special reduced favourable rate for long term capital gains made on fixed assets (= held more than two years); but this favourable regime is since 1997 applied only to individual businesses or partnerships subjected to income tax , and not any more to corporations (except for controlling shares).

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- death : there is a transfer of property to the heir for the value of the transferred good at death what normally shall make a capital gain appear (specially on immovable property). But this capital gain is not immediately taxable as there is no sale and no sale price . When the heir shall sell the property or shares he has received, he shall calculate his capital gain on the price difference between this sale price and the price at which the original earner (i.e. the deceased) had acquired the

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good , but he can substitute the declared death duty value of the transferred good (what permits to reduce the amount of the taxable capital gain) - emigration : the emigrating resident is taxed on his revenues made before he emigrates and also (since 2000) on the capital gains realized by him on securities, which have not yet been taxed (art 167 bis CGI) or even on not yet realized capital gains made by him on securities he holds (= exit tax) - immigration : no tax - mergers/splitting = capital gain deriving from a shares exchange is taxable for households but they often benefit from deferred taxation (art 150 B and D CGI).

- divorce = existence of a taxable capital gains depends on whom of the spouses was owner of the good before , during and after the marriage . Normally if the spouses have been married under the reduced community regime (=communauté réduite aux acquêts) which is the normal regime in France, each of them keeps the property of the goods he was owner of before the marriage , but goods acquired during the marriage are deemed to be common (except proof to the contrary that the acquired good during the marriage has been paid exclusively by one of the spouse). A capital gain can appear when the divorce leads to the sale of the common apartment (as the former spouses separates) ; if this was their main residence , this capital gain is exempted

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

i) postponement of taxation : art 150 U and V ii) postponement of the fiscal claim = art 150 S

6. Are there special regulations related to a tax treaty?

Normally according to art 244 bis C CGI , “provisions of article 150-0 A Z are not applicable to capital gains realized from paid transfers of securities or rights in a company (droits sociaux) by persons who are not tax resident in France according to art 4 B ,or whose social seat is located outside France”. But on the contrary capital gains deriving from a sale of immovable property situated in France shall be taxable in France except if a DTC provides another solution (what raises many difficulties for capital gains on the sale of shares in a company holding property assets deemed as property in France but not necessarily in the other country not in the DTC).

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7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

Not for households , although the opposition between the normal progressive taxation and the exceptional proportional taxation on securities may be discussed Discussions only on how far should the taxation of capital gains on securities should be applied: the threshold therefore has been very much reduced in recent years (from 300 000 francs ie 45 200 euros of sales in 1990 to 7650 euros per year in 2002 ) but has been somewhat increased (15 000 euros in 2003) . Difficult to go further from a political point of view as it would appear to favour rich people.

Kevin Holmes, Deferral Possibilities

1. Please briefly describe the common techniques in your country employed by taxpayers to defer the tax liability given a capital gains tax.

Two main ways used 1. application of the general principles of tax and private law :to defer the date

at which the transfer or sale takes place by using a device such as a conditional transfer

2. or use of specific deferral possibilities existing in some cases –the most well-known ) mergers and demergers = art 210 A , 210 Band 210 C) CGI

2. Are there mechanisms used in your country to:

c. Defer the taxation of income from capital on an accruals basis (e.g. gains arising from the annual change in value of debt instruments) by structuring an arrangement so that the gain is taxed upon (later) realisation (e.g. gains on the realisation of equity securities)?Normally income from capital is not taxed for households unless it is available for them, whereas businesses are immediately taxed on accrual provided the gains is certain in its existence and amount But in some limited cases businesses shall be taxed even when the gain is not event certain: 2 examples in France Art 39-4 CGI provides for immediate taxation (at the end of each taxable year) of gains and deduction of losses deriving for a business of holding assets or debts in a foreign currency.

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Art 209 O A CGI provides since 1998 for immediate taxation (at the end of each taxable year) of capital gains made by business subject to corporation tax on shares and interests in Collective Financial Investments (or deduction of losses)

d. Convert capital gains otherwise taxable upon realisation into a non-taxable form?Difficult to achieve now unless the taxpayer (not resident or established in France) realizes the gain in a foreign country (and this excludes French tax) ; this may be achieved by creating a corporation in a foreign country to which shares are transferred before they increase in value Another way has been to dismember securities so as to benefit from an exemption or a tax credit but this possibility has been reduced by art 258 ter I CGI since 1999.

3. Are domestic or offshore trusts, foundations or other entities utilised to own assets with the objective of deferring (temporarily or permanently) tax on capital gains otherwise leviable in your country?

We do not know in France trusts , foundations or similar entities , due mainly to the opposition of the Tax Administration which has always opposed such new devices , fearing they would be too difficult to control from the tax point of view. They are little used by households or companies resident in France as too dangerous and insecure (both from a legal and tax point of view) , although they do exist.

4. Does your country’s domestic law contain participation exemption or other exemptions, which relieve corporate entities from taxes on gains that they derive from the realisation of shares or other assets? If so, briefly state the conditions that must be met to qualify for the exemption(s).

France knows participation exemption since 1965 (art. 145 CGI ) but only for dividends and assimilated revenues (and not for capital gains what is less favourable than Luxembourg)

5. Does your country have provisions in its legislation designed to defeat arrangements to defer the taxation of capital gains? If so, please give a short description.

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For businesses , few specific provisions except those already mentioned ; but the Tax Administration may always rely on general rules such as abus de droit (difficult however to use as tax avoidance had to be the only reason of the structure created –what excluded the abus de droit –CE June 22 , 1983- ; but this is probably beginning to change

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your system tax capital gains and losses through the general income taxation system?

Yes, as they appear to be one of the eight kind of revenues enumerated by art 1 CGI , although is discussed their real nature , both when they are subjected to progressive income tax (what is the general rule) and specially when they benefit from a reduced proportional rate (what is the case for capital gains on securities by households or any long term capital gains on fixed assets by businesses subjected to income tax)

2. If not, are such gains and losses covered by a separate code?

No : they are included in the general tax code (=CGI =Code Général des Impôts)

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

No statutory distinction in France Criterion of distinction used by courts for households : capital gain requires i) A transfer of property ii) of a good iii)giving rise to a profit which should normally be exceptional (otherwise it becomes a revenue as it is periodic) many applications on sale of securities ; for businesses same rules but moreover importance is given to the accounting nature of the transferred good (fixed asset or not?)

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

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a) for households , progressive income tax with no special rate , except for capital gains on securities (proportional rate of 16% + 10% social contributions = 26% , the social contributions not being paid by non residents) b) special reliefs provided for i) some goods (exemption ex.= main house= art 150 C 1 or residential house when their owner does not own his main house) many other limited exemptions (enumerated by art 150 D CGI) ii) long term capital gains (on assets held during a minimum period by the selling household at least two years for immovable property ,and one year for movables =all other goods). The taxable basis is reduced each year by a certain percentage (=5% but only for immovable property=art 150 M ) and account is taken of inflation (so as not to tax a purely monetary gain due only to inflation =art 150 K CGI) c) for businesses , a reduced proportional rate is applicable for long term capital gains on fixed assets (=16% + 10% = 26%) when these gains are made by businesses subject to income tax ; this reduced rate is not applicable since 1997 for long term capital gains made by corporations subject to corporation tax (except on the sale of controlling shares)

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation? If not, what other basis is used?

Taxed when the good is transferred (=realization)

6. Are there rules to deal with inflation?

Only for long term capital gains made by households on both immovable property or movable property) but not on securities : art 150 K CGI = “ the acquisition price and its eventual increases , with the exception of interests from loans are revised proportionately to the variation of the annual medium index of consumer prices since the acquisition or the expensenot on long term capital gains made by businesses as they benefit from a reduced proportional rate

7. Is there a deferral or exemption from tax on capital gains on death?

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Yes there is a deferral as there is no capital gain realised in consequence of the death (but there may be a capital gain deriving from the sale of some assets, in order for example to pay death duties; capital gains will then arise from this sale). When the heir has kept the good inherited by him , and sells it afterwards , the capital gain he realises on the sale is equal to the difference between the selling price and his acquisition price or the price declared to the Tax Administration for death duties

8. Are there other deferrals and reliefs on capital gains- -

i)for individuals on certain types of personal assets? Yes on special cases Art 150 D CGI (for instance no tax on capital gains derived from sale of his furniture or his car by the taxpayer or of agricultural property being bought by public authority when the price does not exceed a certain amount) ii) on the sale of substantial shareholdings by a company or as part of a corporate reconstruction? Yes on mergers and assimilated transactions Art.210 A CGI (mergers and assimilated transactions) iii) For assets held for a certain length of time? Art 150 M = capital gains on immovables realized more than two years after the acquisition of the good are reduced of 5% for each year of holding of the good after the second year of holding iv ) art 150 Q : a 915 euros allowance is made on the total of capital gains realized during a given year v) art 150 R : the total of capital gains is divided by five. The result is added to the global net revenue. The tax is obtained by multiplying the supplementary contribution so obtained (permits to reduce the progressivity of the income tax in case of an important capital gain realized during one year).

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

Art 150 Nbis CGI: capital losses suffered on goods or rights designated in articles 150 A to 150 A ter are not deductible from the taxable revenues of the taxpayer (household) : this rule is applicable to many most assets but not to securities Ex.= CE May 28 ,1976 GAJF n° 15 : when a taxpayer sells an apartment for a price inferior to the price he has paid when buying it the loss he suffers is not deductible from his taxable revenues

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Art 150-O D 11 CGI: capital losses (suffered on securities transactions) are deductible only from capital gains of the same nature realized during the same year or any of the following five years (CGI = French General Tax).

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5. GERMANY (Prof. Joachim Lang)

1. Preliminary remark

Since the election in 1998, the red-green Schröder Administration tried more or less successfully to establish fundamental changes in the German tax system. Besides the ecological tax reform in 1999 the taxation on income was one of the main subjects of the red-green tax policy. With respect to the international competition of tax systems the corporate tax rate was lowered from 40 to 25 percent of the taxable corporate income beginning in the fiscal year 2001. At the same time, the full corporate tax imputation system was substituted by a so-called ‘Halbeinkünfteverfahren’ (half income system), which relieves the shareholder by taxing only half of the dividends.

After the re-election in 2002, the Schröder Administration presented the draft of a ‘Steuervergünstigungsabbaugesetz’ (Tax Reform Act on the Limitation of Tax Benefits) with a proposal of a full capital gains taxation. In April 2003 this draft did not pass the Federal Council. At the moment, the legislative power to impose taxes is divided between the majority of the governmental parties in the Federal Parliament (Bundestag) and the majority of the conservative parties in the Federal Council (Bundesrat). This seems to prevent any federal tax reform act. In the face of the economic disease this is certainly a very serious situation. In these days the Schröder Administration intends to introduce a final interest withholding tax (Zinsabgeltungssteuer) as a first little step towards a dual income tax. The left-wing social democrats actually demand a tax on capital gains of shares but the ministry of finance confirmed that even a reduced capital gains taxation will not be part of a governmental bill because of the recent failure in the Federal Council.

2. Overview of the Taxation on Income and on Wealth312

2.1 Dualism of Individual Income Tax and Corporate Tax

Like in other countries individuals are subject to the income tax (Einkommensteuer) and corporations are subject to the corporate tax (Körperschaftsteuer). But subjects to the German corporate tax are not only corporations like stock corporations (Aktienge-sellschaften), limited liability companies (Gesellschaft mit beschränkter Haftung) and foreign corporations but also partnerships limited by shares, registered co-operatives,

312 Question 1 by C. Sacchetto/L. Castaldi: Briefly describe the national system of taxation on income and capital, as well as that on wealth taxation.

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mutual insurance companies, commercial entities of public law institutions (Betriebe gewerblicher Art von juristischen Personen des öffentlichen Rechts), incorporated and non-corporated associations (Vereine) and all other organizations if the profit is not already taxed by the individual income tax like it is the case with partnership societies.

The dualism of the individual income tax and the corporate tax serves the purpose to tax comprehensively all subjects, which can have income including the income of non-profit organizations. Nevertheless, the German Tax law has too many loopholes so that the income is not taxed at all.

2.2 Income Tax

a) The German income tax imposes tax on particular categories of income without an all-encompassing definition of income. Therefore, income is only taxed within the following seven categories313:

1. Agriculture and forestry income (Einkünfte aus Land- und Forstwirtschaft);

2. Trade and business income (Einkünfte aus Gewerbebetrieb);

3. Independent personal services income (Einkünfte aus selbständiger Arbeit);

4. Dependent personal services income (Einkünfte aus nichtselbständiger Arbeit);

5. Capital investment income (Einkünfte aus Kapitalvermögen);

6. Rental income (Einkünfte aus Vermietung und Verpachtung);

7. Other income, including five items of income:

(1) recurring items of income (wiederkehrende Bezüge);(2) alimony payments to divorced or separately living spouses, corresponding to the payer’s deduction up to _ 13 805;(3) private short term capital gains;(4) income from singular services which is not covered by other income categories;(5) income of parliament members.

b) Dualism of net accretion theory and source theory: The categories 1. Agriculture and forestry income, 2. Trade and business income, and 3. Independent personal services

313 See the fundamental provision in ' 2 para. 1 EStG (Income Tax Act) and the special provisions for agriculture and forestry income ('' 13-14a), business income ('' 15-17), independent personal services income (' 18), capital investment income (' 20), rental income (' 20) and other income ('' 22-23).

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income are characterized by the net accretion theory (Haig-Simon-Schanz concept of income). Therefore, ' 4 para. 1 EStG (Income Tax Act) generally provides the accrual method based on a comparison of business property (Betriebsvermögensvergleich) in accordance with generally accepted accounting principles. But the governance of commercial accounting principles (' 5 para. 1 EStG) is strongly reduced by special tax accounting provisions ('' 4-7k EStG).

The comparison of business property includes all kinds of capital gains. Capital gains are also fully taxed if the taxpayer uses a special accounting method for the agriculture and forestry income (' 13a EStG) or a cash basis accounting (' 4 para. 3 EStG) which is permitted to lawyers, physicians, tax consultants, architects and - in the category of business income - to small businesses.

In contrast to this the other categories are based on the source theory which originates in the Roman law (income as fruits of capital assets). The source theory excludes capital gains. Thus, the tax accounting of capital investment and rental income does not include capital gains. Only the category of other kinds of income embraces short term capital gains as a little reference to the net accretion theory; it was a political compromise after the First World War to tax the enormous profits of the war speculators.

Of course, the dualism of net accretion theory and source theory in the German Income Tax Law produces strong schedular effects. For this reason the Schröder Administration tried to extend the taxation of private capital gains on all kinds, short term and long term capital gains314.

c) The seven categories of taxed income comprise only market income: The taxpayer makes use of his skills and earns income derived from his labour or he invests capital or he combines labour and capital to achieve income. Capital gains and losses belong to market income. Therefore, loopholes in capital gains taxation violate the market income theory.

The nucleus of the market income theory is to determine the taxpayer’s action with the intention to make profit. If this intention is missing the action may be consumption. Hobby losses are not deductible: if the taxpayer enjoys a sailing boat but needs some receipts to finance the boat and therefore runs a part-time charter business, the whole sailing activity ought to be treated as consumption.

314 The treatment of capital gains and losses is discussed below pages 9-11.

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In the German tax law game profits and losses are not part of the taxable income because the chance to make profit is objectively too small. In most cases the total result of gambling is negative even though the gambler subjectively intends to make profit. The net principle demands to consider losses if the game profits are taxed. For this reason all kinds of games (lottery, bets, wagers, gambling casino) are not subject to taxable income.

Gifts and inheritances are no market income and therefore are excluded from the income tax base. The market income theory draws a sharp dividing line between the tax bases of the income tax and of the gift and inheritance tax.

d) Computation of Taxable Income: The sum of the adjusted gross income of the seven categories is modified by a limitation of loss computation (' 2 para. 3 EStG): The use of losses from one income category against profits from another category is, as a first step, limited to _ 51 500 (_ 103 000 for married taxpayers filing jointly). As a second step the loss that is above _ 51 500/_ 103 000 may only be used up to 50 percent against the total positive income in the year.

Up to _ 511 500 of the remaining losses can be carried back to the previous year but only under the conditions of the above mentioned limitation of loss computation (' 10d para. 1 EStG). After the carry back the remaining losses can be carried forward to the following years (' 10d para. 2 EStG), limited though in every following year but with the final result of full loss computation. The limitation only has the intertemporal effect to spread the losses over several years.

Losses from tax shelter investments cannot be used to offset positive income from another category and can only be carried forward to offset positive income from the same source. Tax shelters are defined as companies, structures or arrangements, where, under the relevant finance plan, the after-tax return on invested capital is more than twice the pre-tax return (' 2b EStG).

The taxable income is the sum of the adjusted gross income reduced by the sum of the following personal deductions (' 2 para. 4-5 EStG):

8. Special expenses (Sonderausgaben): alimony payments to the divorced or separately living spouse up to _ 13 805, annuity payments, insurance premiums, paid church taxes, tax consulting fees, education costs (' 10 EStG); contributions to legal pension insurances (' 10a EStG); contributions for charitable, church,

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religious, scientific purposes (' 10b EStG);

9. expenses for extraordinary hardships (außergewöhnliche Belastungen), in general (' 33 EStG) and in special cases ('' 33b-33c EStG);

10. child tax allowances (' 32 EStG).

e) Tax rates 2003 (' 32a EStG): The progression starts at 17 percent up to a zero bracket amount of _ 7 426 for the subsistence level and ends at 47 percent up to a taxable income of _ 52 293.

A marital income splitting (' 32a para. 5-6 EStG) moves the progression zone for the summarized taxable incomes of both spouses up to a double zero bracket amount for the subsistence level of two taxpayers (_ 14 852) up to the top rate of 47 percent which is up to _ 104 586. This full income splitting particularly relieves married taxpayers under the condition that only one spouse has taxable income and the other spouse runs the household.

2.3 Corporate Tax

a) Since 2001, the German corporate tax is characterized as a classical system on the levels of corporations. The corporate tax rate of 25 percent has definitely been imposed without crediting of the corporate tax. Inter-company dividends are taxed only once. ' 8b KStG (Corporate tax act) regulates tax exemptions of inter-company dividends and of capital gains from shares in corporations.

b) Besides special corporate tax rules the definition and computation of taxable income is connected with most of the income tax provisions. But the income of corporations is exclusively categorized as income from trade and business (Einkünfte aus Gewerbebetrieb). This category includes all kinds of income, not only from trade and business, but also from agriculture and forestry, from independent personal services, dividends, interest, rentals, license fees and capital gains.

c) The profit and loss account is based on the accrual method in accordance with the generally accepted accounting principles. But the income tax provisions reduce the governance of commercial accounting rules.

d) On the level of individuals the corporate tax burden is considered by the so-called ‘Halbeinkünfteverfahren’ (half income system). In this system half of the income derived

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from a corporation (' 3 No. 40 EStG: dividends, capital gains etc.) and half of the shareholder=s expenses (' 3c para. 2 EStG) are taken into account concerning the taxable income.

2.3 Additional Taxes

The income is additionally taxed by the Gewerbesteuer (trade tax), the Solidaritätszuschlag (solidarity surcharge) and the Kirchensteuer (church tax). The average tax burden of the Gewerbesteuer is 16.67 percent of the trade profit. The Gewerbesteuer is a local tax and deductible as a business expense from ones own tax base. The Solidaritätszuschlag amounts to 5.5 percent of the income or corporate tax. The church tax is paid only by members of a religious community with the constitutional right to impose taxes (e. g. the Christian churches and the Jewish community). It amounts to 8 to 9 percent of the income tax and is deductible as special expenses (see above page 5).

The tax burden (income tax/trade tax/solidarity surcharge) on the trade and business profit of an individual amounts to 50.52 percent. The tax burden (corporate tax/trade tax/solidarity surcharge) on the retained profit of a company amounts to 38.66 percent. But the total tax burden (corporate tax/income tax/trade tax/solidarity surcharge) on the distributed company profits amounts to 54.35 percent.

2.4 Wealth Taxation

In 1995, the Bundesverfassungsgericht (German supreme court ) ruled the Vermögen-steuergesetz (property tax act) as unconstitutional315. Therefore, an overall taxation of wealth by the Vermögensteuer (property tax) is not raised at the moment and until now, all demands of left-wing politicians to reintroduce the property tax have not been successfull.

At the moment, wealth is only taxed by the inheritance and gift tax (Erbschaft- und Schenkungsteuer) and the real estate tax (Grundsteuer)316. The Federal Tax Court317

presented the Inheritance and Gift Tax Act to the Bundesverfassungsgericht. The Court claimed unequal valuations, esp. underrating of real estate property (including agricultural

315 BVerfG of 1995, June 22, BVerfGE (official collection) vol. 93, p. 121.

316 The transfer of real estate is subject to the real estate transfer tax (Grunderwerb-steuer). See below 4, b (Treatment of capital gains and losses).

317 Bundesfinanzhof of 2002, May 22, Bundessteuerblatt part II (2002), p. 598.

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and forestry property) and business property in contrast to the more or less correct valuation of corporation shares and money property.

3. Relationship between personal income tax on income from capital and other taxes on income from capital

a) Withholding taxes:318 German resident individuals and corporations are subject to withholding taxes (Kapitalertragsteuern) on dividends (20 percent), interest (30 percent) and other capital yields (25 percent). These withholding taxes are full creditable and refundable. They do not substitute the general income or corporate tax. Until now, the German Kapitalertragsteuer is no final withholding tax with the effect of a dual income tax. This may change as soon as the Schröder Administration is succesfull with its bill of a final interest withholding tax (see above page 1).

The treaty law exempts non-resident taxpayers from withholding taxes on interest. Dividends paid to a non-resident EU corporation are not subject to withholding tax, if a direct participation of at least 25 percent is held during at least 12 months.b) Relationship between personal income tax and corporate tax:319 In contrast to other countries most of the German entities are not subject to corporate tax. The income tax law is applied to 86 percent of the entities including partnerships and companies.

The new corporate tax law with a tax rate of 25 percent did not reduce the dominance of the non-corporated entities because the final tax burden on dividends amounts to 54.35 percent (see above 2.3) in relation to 50.52 percent tax burden on the profit of an entity which is subject to the income tax (see above 2.3). The shareholder relief of the half income system does not consider the trade tax burden while ' 35 EStG provides a credit of the trade tax. Furthermore, the transparency principle allows to offset entity losses against income taxable profits.

Finally, the inheritance and gift taxation privileges the non-corporated entity because of the low valuation of business property in relation to an essentially higher valuation of corporation shares.

318 Question 2 by C. Sacchetto/L. Castaldi: Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

319 Question 3 by C. Sacchetto/L. Castaldi: Which principles regulate the taxation of income produced by non individuals...?

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4. Other Issues of the Questionnaires

a) Real or fictitious income? (topic 2.2.1):320 In Germany, the income and corporate tax base refers to the real income. Only some provisions provide standard amounts for certain expenses, e. g. standard amounts of _ 51 (' 9a No. 2 EStG: Werbungskostenpauschale) and of _ 1 550 (' 20 para. 4 EStG: Sparer-Freibetrag) as deductions from capital investment income. b) Treatment of capital gains and losses (topic 2.2.2):321 As discussed above (pages 3-4), the source theory prevents the taxation of capital gains. For this reason capital gains are not fully taxed. The dualism of net accretion theory and source theory (see above pages 3-4) established the full capital gains taxation in the fields of agriculture and forestry, trade and business, independent personal services (income categories 1.-3.) and a limited capital gains taxation for the rest of the income categories. Thus, the capital gains taxation is part of the general income taxation. The German tax law does not provide a special tax regime.

aa) The business asset is the basic term for the full capital gains taxation in the fields of income categories 1.-3. Capital gains and losses are fully considered, first of all by the comparison of business property (see above 2.2, b), but also in those cases, where special provisions regulate the sales of entities or partnerships and where the termination of business is concerned ('' 16; 34 EStG): ' 34 para. 1 EStG provides a tax burden if the capital gain is distributed on five years. A personal allowance of _ 51 200 (' 16 para. 4 EStG) and half of the average tax rate up to a capital gain of _ 5 000 000 (' 34 para. 3 EStG) is applied to taxpayers until the age of 55 or to those who are unable to work.

If a business is terminated, the book values have to be stepped up. A step-up also takes place if single business assets are donated for private purposes or are cross-border transferred. But if the whole entity or a partnership is subject to an inheritance or a gift, the basis can be rolled over to the receiver. Mergers, divisions and changes of form are regulated in the Umwandlungsteuergesetz (transformation act). This very special act provides a rich variety of step-up and rollover provisions.

bb) The private asset is the basic term for capital gains outside the income categories 1.-3, where only short term capital gains are taxed. The above mentioned (page 4, second line) political compromise after the First World War with the purpose to reduce the source

320 Questionnaire by I. Roxan: questions 7-11.

321 Questionnaires by J. Freedman, K. Holmes and P. Kavelaars.

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theory was achieved by ' 23 EStG. Under this provision extended by the recent tax reform acts private capital gains are only taxed if the holding period was less than ten years for real property and less than one year for other private property. Homes of the taxpayer are excluded from the capital gains taxation. Losses only can be set off in the basket of ' 23 EStG.

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Long-term capital gains from the sale of corporate stock held as private property are taxed if the shareholder owned, directly or indirectly, at least one percent of the corporation’s share capital at any time during the five years preceding the transfer (' 17 EStG). Losses from sales regulated by ' 17 EStG can be set off with profits of other income categories.

No step-up is applied in the fields of private property. But if a private asset is transferred to business property, the market value has to be entered in the books. If private assets are transferred to another private property, the basis and the legal conditions are rolled over (so-called footstep theory), e. g. the depreciation base for rental houses.

cc) The Grunderwerbsteuer (real estate transfer tax) puts an additional burden on the taxation of capital gains. The Grunderwerbsteuer comprises real estate, rights to work minerals an other trade rights, hereditary building rights and other very special dwelling rights. The tax rate amounts to 3.5 percent of the purchase price.

c) Influence of inflation (topic 2.2.3):322 The German tax law does not index for inflation. Merely some very special accounting rules are applied, e. g. the LIFO-rule (‘last-in-first-out’).

d) Imputed income (topic 2.2.4):323 The German tax law is based on the market income theory (see page 4). Therefore, no kinds of imputed income are taxed, esp. not the fictious income from an owner-occupied home. Only the private use and consumption of business assets and the fringe benefits received by an employee have to be taxed by market values. But these subjects to taxation are based on the market theory.

322 Questionnaire by I. Roxan: questions 1.-12.

323 Questionnaire by I. Roxan: questions 1.-6.

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6. HUNGARY (Prof. Daniel Déak)

Claudio Sacchetto and Laura Castaldi, Relationship between personal income tax on income from capital and other taxes on income from capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

THE PRINCIPLES OF THE INCOME TAXATION OF INDIVIDUALS

Like in many other countries, the calculation of the individuals’ income tax liability is based on a dual system of taxation in Hungary as well. The mainstream taxation is based on the accretion-of-wealth concept. This means that all income is taxable, in whatever form it is earned, by a Hungarian resident individual or by an individual within Hungarian sources. For technical purposes, taxable income is not computable as a differential between the status of wealth as measured in two points of time. Instead, all revenue is subject to tax unless the income tax law explicitly provides otherwise. Although the tax liability is developed as to the type of the revenue derived from independent or non-independent activities, the system is open. This is because all revenues that cannot be subsumed under one of the above mentioned categories are deemed to be „other income” taxable in the same way. Revenue cannot be reduced for tax purposes by expenses unless explicitly recognised by the income tax law.

In considering how the individual income tax is structured under Hungarian law, a summary of the calculation of the taxable income and the tax payable on it can be drafted in the tables below. The income that falls within the authority of mainstream taxation is subject to progressive tax rates. In addition, there are categories of income subject to schedular taxes. This is mainly capital income. Schedular tax is milder, compared to progressive tax.

Table: Structure of individuals’ income subject to progressive taxation

HUF Revenues from independent activities X Less expenses incurred (X)

Income from independent activities X Revenues from non-independent activities X

Less: approved expenses (X)

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Income earned by non-independent activities X

Other income X Consolidated tax base X

Table: Structure of individual income tax liability

Consolidated tax base („összevont adóalap”)Calculated tax („számított adó”)Less:

Credit for the tax paid abroadCredit on wages Credit for pension and private pension contributions

TAX ON THE CONSOLIDATED TAX BASE („AZ ÖSSZEVONT ADÓALAP ADÓJA”)Less:

Tax allowances (restricted to the tax payable on the consolidated tax base)MODIFIED TAX ON THE CONSOLIDATED TAX BASE („AZ ÖSSZEVONT ADÓALAP MÓDOSÍTOTT ADÓJA”)Less:

Restricted tax allowances (globally, currently restricted to 100 percent of the tax on the consolidated tax base)

Final tax liability in respect of the consolidated tax base

CONCEPT OF TAXABLE INCOME, CALCULATION OF INCOME TAX LIABILITY

Revenue subject to tax means compensation received in connection with or without activities carried on during the given fiscal year, whether in cash or in kind [§ 4 (1) of Income Tax Act].324 There is a series of items that are either not deemed to be revenues subject to tax or considered to be income exempted from tax (§ 7).

INCOME FROM INDEPENDENT AND NON-INDEPENDENT ACTIVITIES AND „OTHER INCOME” SUBJECT TO PROGRESSIVE TAX

Hungarian tax law makes distinction between independent and non-independent activities. This is important because different rules apply to each. Independent activities are defined as all activities from which an individual receives income, which are not included in the definition of non-independent activities [§ 16 (1)]. (c)]. The so-called other income includes all items to be combined, and subject to progressive taxation, for which there is no separate provision in the individual income tax law.

324 Act CXVII of 1995 on personal income tax, as amended.

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The term of taxable „other income” has been completed in recent years by the various items of income derived from tax havens or from countries with which Hungary has not concluded a double tax convention. They include: - interest received from tax havens or non-treaty jurisdictions [§ 28 (12)]; - dividends received from tax havens [§ 28 (12)]; - the capital gains derived from the disposal of shares in tax haven corporations [§ 28 (12)]; including the capital gains derived upon partial or full redemption of the capital invested in tax haven companies [§ 28 (13)]; and - the capital gains derived from the disposal of immovable property located in non-treaty jurisdictions [§ 28 (16)]. The tax on the rental income derived from the immovable property located in a non-treaty jurisdiction is calculable according to the rules applicable to the income derived from independent personal services [§ 74 (8)]. The taxpayer may not opt for 20 percent schedular tax on this income, which is otherwise possible.

The individual income tax law refers to tax havens as low-tax states [§ 3 (5) of Individual Income Tax Act]. They are jurisdictions that levy corporate tax at a 12 percent or lower nominal rate. Oddly enough, enterprises residing in a state with which Hungary has concluded a double tax convention do not deem to be tax havens. So the Hungarian white list of treaty countries includes for individual income tax purposes any businesses residing in a treaty country, without regard to whether they are excluded from treaty benefits. In this respect, concerns arise, e.g., with classical Luxembourg holding companies. Interestingly, the white list reference to businesses residing in a treaty country has been taken out of the corporate tax law definition of controlled foreign corporations (as discussed later).

Broadly speaking, in contrast to the tax treatment of the above items of income, interest derived from savings deposits and the return paid on publicly traded securities are exempt from tax in Hungary. Dividends and all types of capital gains are normally subject to 20 percent schedular tax. The expenses made for the benefit of those who reside in tax havens are not recognised for tax purposes unless the taxpayer making expenses substantiates the basis for making such expenses [§ 8 (2)].

Taxation of capital gains arising from the transfer of movable and immovable property

The gains derived from the disposal of personal assets is subject to 20 percent tax [§ 58 (6)]. Moveable property items are defined as all assets other than real estate, payment instruments, securities, and all standing crops or produce which are sold without changing the ownership

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of the land on which they stand [§ 3 (30)]. When moveable property items are sold or ownership is transferred, the income on such a transfer is calculated as follows [§ 58 (2)-(3)]:

HUF Revenue from a transfer X Less acquisition costs and other relevant expenditure (X) Less value increasing investments (X) Less expenses relating to the transfer (X) Taxable income X

The date on which the income is deemed to be obtained is the date of the relevant contract [§ 58 (1)]. In the absence of a contract, the general rules shall be applied (income taxable on the date when payment is received).

For the purposes of calculating the revenue from the disposal of an asset, the amount specified in the contract shall be taken. In contracts of exchange (barter agreements), the value of the asset specified in the contract shall be taken as revenue. Where the contract does not specify the value, the customary market value of the asset sold shall be taken as the value [§ 58 (2)].

The acquisition cost is the amount specified in the purchase contract, invoice, receipt or delivery certificate. In exchange agreements, the value indicated in the agreement is taken. Where the asset was imported, the amount used in the calculation of the import duty is used as the acquisition cost. If no import duty was imposed, the amount invoiced in foreign currency, converted into HUF using the exchange rate on the 15th day of the month preceding the day in which the asset was acquired. Where the asset was inherited, the acquisition cost of the asset is based on the value established at probate [§ 58 (4)]. If the value of the acquisition costs cannot be determined as per these rules, then the taxable income is considered to be 25 percent of the revenue [§ 58 (5)].

No tax shall be paid if the tax on the combined income from the disposal of moveable property items is less than HUF 40,000 [§ 58 (7)]. So the amount of tax-free dispositions is HUF 200 000. The tax payable shall be included in the annual tax return of the individual, and payment of the tax is due by the date when the payment of tax on other items of income, appearing in the tax return, is due [§ 58 (6)].

The income derived from the disposal of real property is also subject to 20 percent tax [§ 63 (1)]. Real property is defined as the land, and all things connected to the land, excluding non-harvested crops or produce, which are sold without a change in the ownership of the land on which they stand [§ 3 (29)]. The property rights that this section applies to are permanent

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leasehold, leasehold and other rights to use dwellings, excluding sublease and bed rental, rights to use recreational resorts [§ 3 (31)].

The method of calculation of the taxable income on the sale or transfer of real estates or related property rights is very similar to that used for moveable property items [§ 61 (1), § 62 (1)]. The differences are the rules concerning the dates of transfer and the value of the revenue and acquisition costs:

HUF Revenue from a transfer X Less acquisition costs and other relevant expenditure

(X)

Less value increasing investments (X) Less expenses relating to the transfer (X) Taxable income X

The date when the income from a transfers is assumed to occur is the date when the contract in respect of the transfer is filed with the Land Title Registry. In cases where it is not necessary to register the rights with the land registry, the contract date is used [§ 59 (1)].

In respect of sales contracts, the amount specified in contracts shall be used as revenue. In exchange agreements, the value specified in the contract shall be taken. Where no such value is shown in the contract, the value of the consideration given (the property or rights to property given in exchange for the property or property rights acquired) shall be used [§ 61 (1)].

The acquisition costs used shall be the costs specified in the contract. In respect of exchange contracts, the acquisition cost shall be the amount that was used in calculating the property transfer duty. In respect of inheritance, or gift, the amount payable shall be the amount used in calculating relevant duties [§ 62 (2)]. If acquisition costs cannot be established from the regulations mentioned above, the taxable income on a transfer shall be deemed to be 75 percent of the revenue [§ 62 (3)].

If real estates are held for more than five years, the taxable income, calculated as described by the law in terms of a kind of tapering relief may further be reduced. The tax shall be determined in the tax return of individuals and shall be paid by the same deadline for filing the tax return [§ 63 (1)]. If part of the income from the sale or transfer of real estates or property rights is used for housing purposes by the individual himself or herself, or a relative for the purpose of acquiring a home, within the period 12 months before and 60 months after

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the date of acquisition of the income, the tax on that part of the income used shall be refunded. Housing purposes is defined as purchase of the first home, or the right to use such a home, as well as rental rights of a property in Hungary [§ 63 (2)]. If the income is used to buy land, this relief only applies if the individual builds a house on the land within the prescribed time.

TAXATION OF INTEREST, DIVIDENDS AND EXCHANGE GAINS

Where interest income falls within definitions and limits provided in the Income Tax Act, the income is taxed separately at zero percent [§ 65 (4)]. The definitions and limits of interest for these purposes [§ 65 (1)] can be summarised as follows: - interest on savings deposits, savings notes and foreign exchange deposits, governed in all cases by Hungarian or non-Hungarian law (the interest payments made by Hungarian or non-Hungarian credit institutions fall within the authority of the category of interest subject to zero-rated income tax); - the yield on debt securities, publicly issued and traded in Hungary or elsewhere (the yield includes capital gains achieved from deep-discount bonds upon the admission or the disposition of securities); - the capital gains derived from equity securities, publicly traded in the Budapest stock exchange or – following the date of Hungary’s accession to the European Union – in the stock exchange operating in a Member State, as recognised by the Hungarian Capital Markets Act; - the yield on investment certificates, admitted and traded in Hungary publicly by Hungarian fund managers or by foreign fund managers operating in Hungary (the yield includes the capital gains achieved upon the admission or disposition of certificates as well; the income derived from investment certificates in all cases other than mentioned here is subject in full to normal tax: it may be levied on the fractions of interest, dividends or capital gains, as carved out from the yield on investment certificates); - interest on non-banking loans, provided that

- the interest rate as applied does not exceed by more than five percent the prime rate in effect during the period of the loan; and

- the total amount of interest paid by the borrower does not exceed HUF 10,000 per annum and per person; and - interest on privately traded securities, including the capital gain arising from deep discount bonds, provided that

- the interest rate as applied does not exceed by more than five percent the prime rate in effect;

- the total amount of all capital income paid by the debtor company to any individual does not exceed HUF 200,000 per annum; and

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- the total amount of interest paid by the borrower does not exceed HUF 10,000 per annum and per person. Where interest income does not fall within the definitions above, or exceeds the limits prescribed therein, it is treated as other income, and added in full to the consolidated tax base.

Dividends are also subject to schedular taxation. The most common type of dividends is the individual’s share of the after tax profits of a company or other business association. This includes interest on interest-bearing shares [§ 66 (1)(a)]. The detailed process of calculating tax on dividends can be summarised as follows [§ 66 (2)]: - Individual’s share of the entity’s equity is calculated (equity capital is taken into consideration as appears in the balance sheet on the last day of the financial year, minus revaluation reserves). - A notional amount of interest payable on this share of equity is calculated, by taking the prime interest rate of the National Bank on 1 January (in the year of distribution), and multiplying this by the owner’s share in the equity. This amount is then doubled. This ratio will be replaced by 30 percent of the equity as calculated above. The old rule applies to the dividends received in respect of the profits earned until 31 December 2002 at the latest, provided that the distribution was made until 31 December 2003 at the latest. - If the dividend payable is less than the amount calculated in the above manner, then tax at 20 percent is payable. If the dividend is equal to or exceeds the amount in the latter case, then the excess is taxed at 35 percent (eleven percent medical care contribution is also payable by the entity making distribution; it treats then the contribution as an expense). No eleven percent medical care contribution is payable on the dividends subject to 35 percent income tax longer, received from 2004 on.

The payer of the dividend is obliged to withhold the tax , and pay the dividend net [§ 66 (3)]. Where dividends are also subject to taxation in a foreign country, the tax payable in Hungary shall be calculated at a rate of 20 percent [§ 66 (8) in conjunction with § 66 (1)(c)]. If the payer does not deduct the tax payable on dividends, as is likely to be the case with dividends paid from abroad, the individual must declare such dividends on his tax annual return, and pay tax accordingly. The tax paid abroad may be deducted from the tax payable in Hungary, provided that the amount payable in Hungary does not fall below five percent in the absence of double tax conventions [§ 66 (9)].

Where gains on the sale of securities are not treated as qualifying interest income (exempt from income tax), the exchange gains on the sale of securities are taxed at 20 percent [§ 67 (2)]. Interests or membership rights are deemed to be securities for these purposes, provided that they are subsumed as securities under the law relative to any of them. In addition, the business quotas held in Hungarian private limited liability companies are deemed to be

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securities for income tax law purposes [§ 3 (34)]. The characterisation of exchange gains can be challenged in cases where the gains are not achieved in open market conditions or even if the right to acquire securities was not available in open market conditions [§ 67 (1)]. Where securities are sold in transactions not considered on an „arm’s length” basis, the capital gain will be calculated as the fair market value minus the original costs of the security, minus any related costs. The difference between the actual revenue and the market price will be treated as „other income” to be added to the consolidated tax base of the seller [as discussed; see § 28 (14)].

The exchange gains are calculated as the sales proceeds, minus the acquisition costs, minus related costs [§ 67 (1)]. Related costs mean costs paid to a registered securities trader operating under the Hungarian law [§ 67 (9)(d)]. The tax must be deducted by the securities trader. If the gains are received from other than a securities trader, the taxpayer is liable to report taxable gains annually and pay tax on them accordingly [§ 67 (5)]. Under the current Hungarian income tax law, the capital losses sustained by individuals cannot be taken into consideration, while calculating their taxable income [§ 67 (7)].

The provisions of § 67A on the taxation of the capital gains derived from stock exchange transactions with financial derivatives has been repealed since 2003. This is because all income derived in this respect – like qualifying interest under § 65 (1)(j) -- is subject to zero-rate tax. Apart from tax exemption, it is noteworthy that the gains derived from notional stock exchange transactions with financial derivatives (forward contracts and futures, options and swaps) are deemed to be realised at the termination of transactions. In contrast, the capital gains derived at the termination of transactions with underlying assets consisting of physically existing securities (not traded publicly) fall within the authority of the provisions provided for by § 67 on exchange gains. On this basis, these gains are not deemed to be realised earlier but at the time when underlying assets will be disposed of. The gains derived from the exchange of securities are thus not taxable. In other words, under Hungarian income (and corporate) tax law, the receipts derived do not ensue a taxable event unless realised in cash.

The income derived from the fee stipulated for securities lending is treated as a particular form of interest, subject to 20 percent tax (§ 65A). Besides, the income derived from portfolio management contracts is to be structured for tax purposes as to the particular type of income. The income derived from the compensation paid by fund managers for the difference between the yield to capital reached and that promised by contract is deemed to be „other income” subject in full to progressive tax.

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The income derived through partial or full redemption of the shares (or business quotas) invested in Hungarian or non-Hungarian companies is taxable in full. As taxable events, the termination of companies, the reduction in the subscribed capital and the termination of shareholdership are mentioned [§§ 68 (1)-(3)]. The gains derived from tax haven companies are deemed to be „other income”, subject to progressive tax, as mentioned. By and large, the rules that apply to the calculation of taxable exchange gains are also applicable to this income [§ 68 (4)]. The tax payable is 20 percent [§ 68 (6)] to be withheld, provided that there is a Hungarian paying agent [§ 68 (10)]. The tax paid abroad can be credited against the Hungarian tax. However, in a non-treaty situation, the Hungarian tax cannot be less than five percent of taxable income [§ 68 (6)].

THE FISCAL LAW FRAMEWORK FOR DEFERRED REMUNERATION PLANS IN HUNGARY

The typical deferred remuneration plans known in the Hungarian practice may be enumerated as follows: (i) deferred compensation in cash; (ii) granting treasury shares or employee shares for no or low consideration; and (iii) grant of transferable or non-transferable stock option or rights to subscribe to, or purchase, shares. Under a simple employer deferred cash compensation plan, the remuneration is stipulated in consideration of past employment. The payment may occur upon retirement. The payment may be contingent on loyalty shown by employees during a certain period or on the success of investment. In the latter case, fund managers may be instructed to follow investment plans by employees. In any case, the income derived from an employer deferred cash compensation plan is treated in Hungary as employment income.

In other plans, remuneration may be stipulated in terms of treasury shares or employee shares for no or low consideration. The fraction of the financial value of treasury shares not paid by eligible beneficiaries was subject to 44 per cent withholding tax on fringe benefits until 2003. As of 1 January 2003, the revenue received by individuals in terms of securities rather than in cash for no, or low, compensation must be characterised for tax purposes, based on the underlying relationship between the grantor and the beneficiary and on the other conditions relevant to the realisation of revenue [§ 77A (1)]. Is an employment relationship that underlies remuneration, the income received is deemed to be employment income. Is the underlying relationship not identifiable (for example, where shares can be obtained in the foreign resident parent company), the income received deemed to be „other income”, subject in full to progressive tax. The taxable income is calculated as the difference between the fair market value of the securities received, on the one hand, and the value paid as compensation,

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and the costs incurred with the enterprise providing investment services, approached upon acquisition, on the other hand.

The issue of employee shares (or employee business quotas) in Hungary is based on the Companies Act and may be financed by profit reserves or capital reserves of the corporation which is the employer running the employee stock option programme. It may occur that part of the market value of employee shares (or employee business quotas) is paid by employees themselves. The fraction of the financial value of employee shares not paid was deemed to be dividends subject to 35 per cent withholding tax until 2003. As of 1 January 2003, this value is considered as employment income subject in full to progressive tax. The tax on the income derived can, however, be deferred [§ 77A (2)(b)]. This means that this income is not taxable upon the grant of shares (or business quotas). Instead, tax is payable – based on the original acquisition value – upon disposal only [§ 77A (5)]. In that case, the taxpayer can enjoy another relief as well. Namely, he or she is allowed to increase for the purpose of calculating the tax base the acquisition value by half of the nominal value of the employee shares (or employee business quotas) received [§ 77A (6)]. Notably, the tax deferral and the relief that the tax base upon disposal may be reduced are extended to foreign companies residing in one of the EU Member States (equivalent to the Article 2 definition of the Merger Directive) – and not residing in low-tax countries -- in cases where foreign companies release employee shares equivalent to those issued by a Hungarian corporation.

Securities may be granted through the issue of options or like rights. In that case, the income derived is deemed to be employment income or „other income”, subject in full to progressive tax, depending on whether there is an employment relationship underlying the grant of revenue or not. The taxable income is calculated as the difference between the fair market value of the securities upon the first day when it is possible to dispose of the securities, on the one hand, and the value paid as compensation, and the costs incurred with the enterprise providing investment services, approached, including the compensation, if any, paid for the option granted, upon the acquisition of the right to subscribe to or purchase securities, on the other hand [§ 77B (1)]. The taxable event is the first day when options or like rights may be called [§ 77B (2)]. Furthermore, being accelerated, the development of tax liability is due on the early date of granting the option or rights in cases where the option granted is transferable (and transferred).

Under certain plans, key employees or officers of corporation are granted options to subscribe to or purchase shares in the foreign parent corporation of a Hungarian subsidiary within the option period as stipulated. Upon the exercise of an option, an optionee has to pay the subscription price. As agreed, it must not be less than the fair market value of a share on the effective date of the grant of option covering such a share. However, at the time of exercise,

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the market value of the shares in the parent comparable to the shares outstanding may be higher than the specified subscription price. This is just the event when options are exercised. The subscription price can be paid in cash or by surrendering the shares owned. Options may only be exercised after the time that a vesting period has elapsed. In the case where employees provided with options are during the option period transferred from one entity of the multinational company group to another one, the corporation arranging for the stock option plan may request reimbursement from its counterpart in terms of an amount equal to the portion of the rights granted that are attributable to the optionees’ employment with an affiliated entity, depending on the time spent therewith.

To the extent that the beneficiary who has enrolled on a beneficiary plan was granted the right to subscribe to or purchase shares at a price lower than their fair market value as fixed upon the time of grant, it was not precluded until 2003 that the income derived at the end of the vesting period was treated as capital gains, subject to 20 percent tax only. As of 1 January 2003, the income received from the grant of the exercise of the right as stipulated under a benefit plan to acquire shares cannot be treated as capital gains even if no discount has been included in the acquisition of such rights. Once such rights are not acquired under conditions available for anybody (which is essential in benefit plans), the income received cannot be treated as capital gains longer [§ 28 (7) of Income Tax Act in conjunction with § 77A (2)(a) of Income Tax Act].

Under the Hungarian fiscal law effective as of 1 January 2003, the paying agent (as defined by the tax administration law) is obliged to disclose information on those individuals who have obtained options or like rights, or of those who have exercised the rights or disposed of them, until 31 March of the year following the year in which the rights acquired were obtained, exercised or disposed of [§ 77B (5)]. Foreigners who have no fiscal nexus in Hungary – like the foreign resident parent in which shares can be obtained – can never be considered as paying agents. Upon tax deferral (e.g. upon the grant of employee shares), paying agents are obliged to disclose information of the shares issued and of their disposal until the date as mentioned. The beneficiaries are obliged to keep registration of the shares, or rights, acquired, exercised or disposed of, as specified by the income tax law in Schedule Nr. 5 [(II)(5)]. Where an individual has enrolled on a benefit plan before 2003 and will exercise his or her right no later than 31 December 2005, it is the tax rules effective before 2003 that apply to his or her taxation.

A particular type of tax relief has been introduced for 2003. No taxable income is derived during a vesting period of not less than three years through the exercise of the right to obtain registered shares in the Hungarian employer company or its foreign parent company, as stipulated under a qualifying benefit plan under § 77C, up to the fair market value – effective

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upon the establishment of rights -- of the securities acquired, not exceeding HUF 500,000 per annum and per employee. The securities to be distributed under the plan must be deposited with an investment enterprise. Such an enterprise can also reside in the country where the parent company operates in which shares can be obtained. The programme administrator must be the Hungarian employer (e.g., the Hungarian subsidiary). Participation in a qualifying programme is confined to the employees or executive officers of the programme administrator [§ 77C (19)(c)]. This means that this beneficial Hungarian regime does not apply to the benefit plans that spread over a number of jurisdictions where there are subsidiaries, including Hungary. In cases where the employment is terminated within three years or the securities will not be deposited for three years at least, the revenue derived is taxable as employment income. Following the vesting period, the income derived upon transfer is treated as capital gains, subject to 20 percent tax only.

The qualifying plan must be registered with the Finance Ministry. Securities may be distributed under the plan that are admitted as registered shares in a country listed under the Capital Markets Act. Distribution must be available at least ten percent of the employees of the programme administrator. The number of executive officers must not be more than 25 percent of the employees of the programme administrator. The executive officers are not allowed to obtain more than 50 percent of the nominal value of the shares issued under the plan.

SCOPE AND TYPES OF LOCAL TAXES

Local governments in Hungary have been established by way of democratic elections to provide the organisational structure for the exercise of self-organised local power. One of the instruments of establishing financial independence is the imposition, and collection, of local taxes. This enables local governments to exercise the sovereign right of local taxation and correspondingly to establish a local tax policy. Act C (No. 100) of 1990 on Local Rates provides a legal framework for the different types of local taxes.

The liability to pay local taxes may be extended within the area where a local government is competent to one of the following subjects: - the ownership of immovable property or the holding of rights relating to immovable property; - employment of labour force; - stay as a non-permanent dweller; and - pursuing of business activities as determined in the law on local rates. Local taxes can be categorised as to the types as follows: - property taxes;

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- communal rates; - tourism taxes; and - local business tax (local trade tax). Notably, no kind of national wealth tax has been introduced in Hungary.

CAPITAL DUTY IN HUNGARY IN BROAD TERMS

In recent years, Hungary, with its aspirations to accede to the European Union, has made serious efforts to adjust its tax system in line with European standards. As the reform of the legal and tax system -- launched more than a decade ago in the process of the transition from a centrally-planned to a modern market economy -- has been completed, recent amendments have mainly focused on fine-tuning. Interestingly, the fiscal law regulations on capital duty is an area in particular that has been unaffected by harmonisation. This gap in Hungarian harmonisation can be seen as even stranger because the harmonised Community law on capital duty, an area of significance to the flow of capital within the Community, free of administrative barriers, is an early product of harmonisation.

Capital duty does not actually emerge in the current Hungarian tax system as a duty on property transfer. Instead, it is manifested within a bureaucratic framework as a duty on the procedure before the court of Trade Register. It is thus the particular act of public authority to make an entry into the Trade Register -- rather than the transfer of property, reflecting free market considerations -- that is emphasised in Hungarian law. In respect of capital duty, the subject of taxation is the fair market conduct of contracting parties or rather the provision of capital in exchange for shares. This is certainly not the basis on which the current Hungarian legislation is established.

CAPITAL DUTY IN CURRENT HUNGARIAN LAW

Under the effective Hungarian law, capital duty is chargeable on the capital to be subscribed – on the assets as stated in the instrument of incorporation (contract of association, articles or deed of foundation) – at a two percent rate.325 The duty payable also ranges within limits of minimum and maximum fixed amounts. In respect of legal persons, the duty payable varies from HUF 60,000 to HUF 600,000. In respect of businesses without legal personality, the duty payable varies from HUF 20,000 to HUF 200,000. A firm – for example, a sole trader’s firm, not subject to registration but optionally -- that can be established without foundation capital is obliged to pay a fixed amount of HUF 10,000. The Hungarian branch of a foreign enterprise is obliged to pay HUF 200,000 as capital duty upon registration. The Hungarian operating office of trade representation of a foreign enterprise – engaged in activities of

325 Act XCIII of 1990 on duties, as amended, § 45.

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auxiliary or preparatory character while not seeking for profit -- is obliged to pay HUF 100,000 as capital duty upon registration. The entry in the Trade Register of the branches of Hungarian residing businesses is not subject to capital duty. Changes in the Trade Register may be subject to duties of HUF 3,000 or HUF 6,000. Capital duty is chargeable at a two percent rate (within fixed-amount limits) on the increase in the assets (that is, in the subscribed capital) from HUF 10,000 as a minimum up to HUF 600,000 or HUF 200,000, depending on whether the business being subjected to duty is with or without legal personality, respectively. The duty payable on the increase in capital also includes the duty payable on changes in the Trade Register, if any.

Firms are also obliged to pay duty by way of a fee for publication in the official gazette of firms. This is not a tax but a fee payable as a return for the services of publication (including the reimbursement of the costs of publication). As can be seen, the effective Hungarian rules on capital duty are not very sophisticated.. They are based simply on the formalistic approach as to whether capital is to be subscribed, and if so, how much. No particular judiciary practice to implement the law has evolved, either.

Mergers are exempt from tax, except for capital duty and corporate tax payable by the legal successor on the capital gains arising from a merger. In one particular legal case where a partnership was transformed into a private limited liability company, the legal successor was not able to avoid paying duty on the whole amount of the capital on the grounds that it is only legal to require duty for the increase in capital. It was upheld by the court that as the legal successor was provided with a new trade registration number, its capital was fully subject to duty, irrespective of the duty paid by the legal predecessor.326 This is a clear example of the formalistic approach adopted in Hungary to date. In another case, a sole trader sought to fall within the authority of the provision of the Duties Act that a sole trader, not obliged to enter the Trade Register with foundation capital, is only liable to pay a fixed amount of duty. As was stated by the court, a firm, not obliged by law to provide foundation capital, is indeed able to enter the Trade Register, and fall within the authority of the fixed-amount capital duty. If such a firm files, however, for trade registration while opting for the provision of foundation capital, that capital is subject to a two percent duty.327

DUTIES ON PROPERTY TRANSFER, DUTIES ON PROCEDURES OF PUBLIC ADMINISTRATION AND ON JUDICIARY PROCEDURES, STAMP DUTIES AND BENEFIT CHARGES

326 47 BH 1999/569 (Legf. Bír. Cgf. II. 30.366/1998. sz.). For a similar decision, see 41 BH 1993/456 (Főv. Bír. 01-09-074-187-- Legf. Bír. Cgf. II. 32 805/1991. sz.). 327 48 BH 2000/559 (Legf. Bír. Cgf. II. 31.642/1998. sz.).

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Different duties may be levied in Hungary on the procedures of public administration in connection with land title registration and mortgage registration. Property transfer duties are levied on the transfer of immovable property and motor vehicles, made for compensation, including the contribution of immovable property in exchange for shares. The publication of company particulars are subject to charges payable by way of fee or dues, that is, these charges are payable for the services of publishing company particulars in the firms’ official gazette, based on the benefit principle. There is still some elbow room for Hungarian fiscal policy, relying on the Capital Duty Directive’s authorisation, to consider introducing duties. For example, no duty is to date payable on the contribution of personal assets in exchange for shares. Remarkably, there is no duty in effect in Hungary on the transfer of securities. This is due to well-reasoned considerations, namely, that it would not be expedient to subject evolving capital markets to special transfer duties.

In addition to capital duty, Hungary is also in need of overhauling the system of property transfer duties and duties on public administration and judiciary procedures. As to their fiscal nature, all these duties can be considered as indirect taxes that do not concern property itself or income, but rather transactions. Unlike other indirect taxes, however, property transfer duties, or duties on the procedures of public authority, cannot be passed over to the extent that, as in a number of countries on continental Europe, including Hungary, it is those who acquire property, or rather those who use services, who are obliged to pay duty. The benefits acquired in return for the duties paid may well emerge in that the particular rights that have been obtained will explicitly be recognised by law before the public.

The Duties Act comprises the following: - duties on property transfer for no consideration (duties on the transactions made „inter vivos” or „mortis causa”); - duties on property transfer for compensation (first of all, duties on the acquisition of immovable property); - capital duty (regulated as duty on trade registration); and - duties on a wide range of procedures of public administration and on judiciary procedures.

Under current Hungarian law, there are no stamp duties, although stamp duties -- or rather duties payable on the issue or authentication of documents, charters or deeds -- were proliferated in the country before the Second World War. Stamp duties were levied on the particular financial benefits acquired through concluding civil law contracts or on the creation of, or changes in, the rights as stipulated by contract. Also such duties were levied on the issue of documents that could serve as documentary evidence before public authorities.

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2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

Capital income is in broad terms subject to 20 percent schedular tax. Capital gains, qualifying interest, dividends and qualifying and non-qualifying exchange gains are not part of the taxable income to be combined. Accordingly, they are not subject to progressive income tax. This tax is withheld by paying agents if any. Those who make to taxpayers with Hungarian tax liability payments without a Hungarian fiscal nexus are not paying agents. In the absence of a paying agent, the schedular tax payable is based on self-assessment.

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: are there any mechanisms that avoid (internal) economic double taxation on income from companies?

THE HUNGARIAN FISCAL SYSTEM IN BRIEF

The fiscal law environment in Hungary can be described by the following features: - there are independent tax laws and independent individual and corporate tax systems, and there is an independent accounting law (in contrast to this Hungarian practice, it frequently occurs in a French-speaking, or in a common law, country that there is a uniform fiscal code); - the corporate tax base is in Hungary established on accounting profits (this method differs from the traditional approach of fiscal liability in common law countries); and - the taxable income of individuals is determined in a negative approach (unlike the English tradition based on the concept of income schedules as originally enacted in the 1803 Addington Act), that is, any revenue, whether or not derived in cash, is subject to tax unless a revenue item is explicitly exempted from tax.

Currently, there is a single law in Hungary applicable both to corporate tax and the dividend tax payable by corporations. The corporate tax system, including the taxation of dividends derived by foreign corporations, can be characterised as follows: - the Hungarian corporate tax system is a classical one with participation exemption (this means that there is no imputation of corporate tax to the recipient’s income, but dividends received are exempt from corporate tax, except for certain cases); - there is an exhaustive list of corporate taxpayers; - partnerships are subject to corporate tax like corporations;

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- the tax base can differ significantly from accounting profits: for example, depreciation, the carry over of losses, depreciation of financial claims or the provisions as made in commercial accounting are subject to fiscal restrictions; - dividends received by domestic corporations, whether derived from Hungary or abroad, are not part of the corporate tax base (because of the application of participation exemption); - the anti-avoidance legislation is extended to transfer pricing, thin capitalisation, and controlled foreign corporations; - the corporate tax rate is extremely low: an 18 percent corporate tax was introduced in 1997 which is clearly an incentive to commercial activity in Hungary; and - dividends remitted from Hungary to foreign corporations are subject to a 20 percent withholding tax (unless reduced by treaties).

Furthermore: - it is possible in Hungary to operate until 2006 a domiciliary (offshore) company that is subject only to a three percent corporate tax rate (although the dividends remitted from Hungary are subject to the normal dividend tax unless sheltered by the provisions of a relevant treaty); - the consolidation for large companies that is obligatory under commercial accounting rules is not recognised for tax purposes (that is, no form of fiscal unity is known currently in Hungary); and - with minor exceptions, the branches of foreign enterprises are required to determine their tax base under the same rules as the domestic taxpayers.

The main characteristics of the current Hungarian system of individual income taxation (and some minor public charges) can be summarised as follows: - taxable persons are individuals, including sole traders; - taxable income is to be combined and subject to progressive tax rates; specific classes of income are, however, subject to schedular taxes; directors’ remuneration is treated as income from dependent personal services and is subject to normal tax rules; - there are no tax deductions except for business costs incurred by those who earn business income, although the scope of tax credit is extremely wide; - the highest marginal tax rate is currently 40 percent (it is not really high but the taxable income bands are very narrow), the schedular tax rates are in general 20 percent, fringe benefits are subject to a 44 percent tax; and - due to a distinction between „normal” and „excessive dividends”, dividends are subject to a 20 percent or 35 percent withholding tax, respectively.

It is noteworthy that: - normal VAT rates are as high as 25 percent;

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- inheritance and gift duties are relatively low but the acquisition of immovable property for consideration is subject to ten percent duty; - local taxes have not been extended to a wide scope; and - contributions of the compulsory social insurance scheme and like duties represent a combined fiscal burden that is quite substantial.

THE BROAD CALCULATION OF THE INCOME INVESTED IN A HUNGARIAN CORPORATION

The starting point for determining the corporate tax base in Hungary is the calculation of accounting profits. It may be adjusted for fiscal purposes by adding what is not allowed for tax purposes and deducting what is allowable. Tax adjustment may be resulted from particular tax accounting issues or the application of fiscal incentives or disincentives. Dividends received by corporations is subject to dividend tax (a 20 percent final withholding tax). Dividends received by individuals are subject to schedular income tax at different rates (a 20 or 35 percent final withholding tax), depending on whether the dividends received can be considered as normal or successive. The surplus over the invested assets upon partial or full termination, or transformation, is deemed to be taxable dividends or capital gains, received by corporations or individuals, respectively. The 18 percent corporate tax can be alleviated by allowances (in a decreasing number). Foreign tax can also be credited against the Hungarian corporate tax.

In Hungary, there is a classical system. The dividends received by Hungarian corporate taxpayers (whether from Hungarian or non-Hungarian sources, except for the dividends received from controlled foreign corporations) are, however, exempt from corporate tax. Hungarian resident corporations are exempt from the dividend tax as well (the dividends received relief will be restricted upon the EU accession). In the absence of Hungarian dividend tax, the tax paid on the dividends received abroad cannot certainly be credited against the Hungarian tax. It can, however, be treated as an expense for Hungarian corporate tax purposes.328

The integration of corporation, dividend and income tax can be depicted by the simple sample calculation as follows.

328 Two notes may be useful for better understanding the Hungarian system of dividend taxation: - no tax paid abroad on the dividends received can be credited against the Hungarian dividend tax, no matter if the beneficiary is exempt from Hungarian dividend tax; and - while the expense accounted for the foreign tax equivalent to the Hungarian corporate tax must be added to the Hungarian corporate tax base, this is not the case for the foreign tax equivalent to the Hungarian dividend tax (even if in the foreign jurisdiction no separate dividend tax is levied).

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HUF 000 Accounting profit or loss Tax adjustment - Tax accounting issues - Fiscal incentives - Fiscal restrictions - Partial or full redemption, mergers Taxable profit or loss

Corporate tax payable at 18 percent

Less: allowances - Foreign tax credit - Investment tax credit

Final corporate tax liability

After-tax profit

Profit for distribution

Dividend or income tax at 20 percent

Net dividend

1000 --

1000

180

--

180

820

820

164

656

DIVIDEND TAX

The term of dividends has been redefined since 2001 for the purpose of the dividend tax. The current list of taxable dividends [§ 27 (11) of Corporate Tax Act],329 applicable to Hungarian and non-Hungarian businesses, may be summarised in a table below.

Hungarian resident taxpayers Foreign enterprises They are (currently) exempt from the tax on dividends, derived from Hungary or abroad, including dividends derived from CFCs, provided that dividends are directly transmitted to a Hungarian bank account.

The tax is payable by foreign enterprises with or without a Hungarian permanent establishment on the items deemed to be dividends as follows: - dividends paid by Hungarian resident taxpayers or declared by Hungarian operating branches; - profits remitted by the Hungarian permanent

329 Act LXXXI of 1996 on corporation and dividend tax, as amended.

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establishments (other than branches) of foreign enterprises; - the capital gains derived from the partial or full redemption of capital or termination (including the reduction in the capital of the Hungarian branch of a foreign enterprise); - the capital gains derived from legal mergers; - the income received from the gratuitous transfers made in cash or in-kind, including forgiven debts, by Hungarian registered individual or corporate taxpayers or by all forms of the permanent establishments of foreign enterprises; and - the excessive amount of interest or royalties derived in respect of related parties. The tax on reinvested dividends is (currently) deferred.

From the date of the EU accession on, relief from the tax on the dividends, paid following this date, will be available, subject to the conditions as provided for by the Parent and Subsidiary Directive. This means that the parent company must be a company subject to tax equivalent to the Hungarian corporate tax and hold at least 25 percent shareholding in the subsidiary’s subscribed capital for at least a two-year uninterrupted period. The terms of qualifying parent and subsidiary companies are determined in the Hungarian law in the same way as provided for by the directive.

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

Both the particular types of periodic capital income and capital gains, including exchange gains, are subject to schedular taxes. They are this way excluded from the taxable income to be aggregated. Accordingly, there is no overlapping. Economic double taxation may, of course occur to the extent that investment is made by after-tax income and the fruit of the capital invested can be subject to income tax again.

5. Which are the indirect taxes on capital?

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The transfer of securities and interests in businesses is exempt from VAT. As discussed in connection with the Sacchetto and Castaldi question No. 1, the subscription of capital is subject to capital duty and the acquisition of real estates is subject to property transfer duty.

6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

The income derived from the letting of immovable property is normally subject to 20 percent schedular tax, depending on the taxpayer’s choice, as discussed in connection with the Sacchetto and Castaldi question No. 1. The income derived from the disposal of immovable property is also subject to 20 percent schedular tax as discussed in the same place. The local rates on property (net wealth taxes) and the property transfer duties are discussed in the same place.

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

The taxation of capital gains from the disposal of movable property, of the yield on bonds and the exchange gains derived from the disposal of securities are discussed in connection with the Sacchetto and Castaldi question No. 1.

Peter Kavelaars, Accrual versus realisation

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation (if not, the next questions have not to be answered)?

Yes they are, as discussed in connection with the Sacchetto and Castaldi question No. 1.

2. Are capital gains taxed on accrual or on realisation base?

They are always taxed on realisation basis. Notably, the capital gains derived from movable property (other than securities) and immovable property are taxable not only in cases where cash is realised but also in non-cash situations (assets can with gains be contributed in exchange for shares, etc.). In contrast, the gains derived from the disposal of securities are not taxed as long as a taxpayer receives cash (e.g., the exchange of two securities is not yet a taxable event). The receipt of securities for no or low consideration is immediately taxable. Stock dividends and the capital gains

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derived during a legal merger are taxable with individuals but the 20 percent schedular tax may deferred as long as the appreciated interests held in businesses are disposed of.

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

See my answer above.

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases: - death; - emigration; - immigration; - mergers/splitting; or - divorce.

THE TAXABLE EVENTS ENVISAGED IN THE ABOVE EVENTS IN BROAD TERMS

The events as envisaged in the above question are not relevant to individuals for income tax purposes except for legal mergers. Death or divorce does not entail the realisation of the (portion of) income received for income tax purposes. The appreciation of the property held upon death is exempt from tax. This is because the successor’s taxable capital gains derived upon disposal must be calculated, based on the acquisition value equal to the (high) fair market value of the property transferred upon death. This is due to the fact that the estate is subject to property transfer duty to be levied on the fair market value at the time of death. The tax on capital gains upon legal mergers may be deferred, as mentioned above. In respect of tax emigration, it is noteworthy that there is no exit tax in Hungary. The fiscal liability of an individual can be extended, based on citizenship, however. Also, there are sporadic examples for recapture rules.

THE TAX TREATMENT OF THE TRANSFER OF RESIDENCE BY INDIVIDUALS IN HUNGARY IN GENERAL

The reform of the Hungarian legal and tax system, which was launched more than a decade ago as part of the transition from a centrally-planned economy to a modern market economy, has been complete. As the core reforms have already been implemented, recent amendments have mainly focused on fine-tuning. The Hungarian tax system is still fraught with lacunae. An evidence for this is that to date tax emigration rules have been completely missing.

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Tax legislation is in a series of countries eager to protect the basis for the income tax payable by individuals on emigration. Tax emigration may trigger exit tax targeted at accrued income. As a result of it, e.g., accrued, but not realised, capital gains or the income accrued, but not realised, during stock option plans may be treated as realised, and so taxable. Such a tax does not exist in Hungary. Another solution for the problem of avoiding fiscal liability upon tax emigration is to extend fiscal liability, based , for instance, on citizenship. Relying on deemed residence rules, the Revenue may claim tax even in cases where income is not derived from domestic sources. Extended fiscal liability does exist from 2003 in Hungary to the extent that under § 3 (2) of Income Tax Act the Hungarian fiscal residence of individuals has been extended to Hungarian citizens. Finally, in many countries, taxpayers may be subject to recapture rules. According to them, for example, in a particular country, tax deduction, or tax credit, for private pension funds may be reclaimed by the treasury upon emigration. In Hungary, the taxpayer is not required to repay the credit, exploited earlier, upon tax emigration, even if the income derived by non-Hungarians in later years may fall out of Hungarian tax jurisdiction.

Hungarian recapture rules may be escaped -- e.g., in respect of insurance tax credit -- by those who become non-resident for fiscal purposes in Hungary at the time when after emigration they otherwise fail to fulfil the requirements necessary for the use of tax credit.330 It may occur that, in the absence of tax emigration rules on accrued income, the rules on extended fiscal liability or fiscal recapture rules, the Hungarian tax claim may not be enforced efficiently in tax treaty situations. In the absence of a double tax convention, these problems may be solved, based on the broad concept of Hungarian taxable income (to be listed above), deemed to be derived within Hungarian sources.

Hungary does not have double tax conventions with safeguard clauses, except for the USA – Hungary treaty.331 The capital gains Articles of Hungarian treaties usually follow the OECD model. Exceptions to this are the Hungarian double tax convention with the Netherlands and Canada.332 Based on Article 13 (5) and Article 13 (7) of these treaties, respectively, the fiscal liability is extended to former residents. Based on the non-discrimination Article of Hungarian treaties, there is no chance for immigrants to claim Hungarian fiscal protection against international double taxation, due to extended tax liability sanctions, applicable in the country of emigration. This is because the non-Hungarian tax liability may have been developed before obtaining Hungarian fiscal residence. Hungarian tax treaties do not concern 330 Insurance tax credit is, roughly speaking, equal to 20 percent of the life insurance premium paid to Hungarian resident insurance corporations, but no more than HUF 50,000 per annum (§ 42 of Income Tax Act). The tax credit used, plus 20 percent of the credit used, must be repaid, at the time when the taxpayer who exploited tax relief disposes of the insurance police held within ten years. 331 Signed at Washington, D.C., on 12 February 1979. 332 Signed at the Hague on 5 June 1986 and at Budapest on 15 April 1992, respectively.

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in their pension income Article the problem of a possible recapture mechanism. At any rate, Hungarian treaties do not allow the source country to tax pension but with certain exception. Hungarian treaties do not refer to the tax migration problem in their Article on mutual agreement procedure or the exchange of information as well.

TAX EMIGRATION RULES

As discussed earlier, under § 4 (1) of Income Tax Act revenue is taxable in the year it is received, regardless of whether it was received in respect of an earlier or later year (cash basis principle). As explained, the time when fiscal liability is developed and the date when income is deemed to have been derived for fiscal purposes are not necessarily the same (§§ 9-10). There are no particular rules that would apply to emigration. A taxpayer who is to leave the country does not have to file special tax return. He or she may, however, by showing the valid immigration visa of a foreign state, file for the extraordinary assessment of tax, based on the special imposition of tax made by the Revenue authority (§ 80 of Taxation Order Act. A foreign resident individual that has obtained income, on which no Hungarian tax was withheld, is obliged to report taxable income and pay tax on it within 30 days of the acquisition of income [Annex 5 (10) to Taxation Order Act]. On emigration in the midst of the fiscal year, a foreign resident individual is subject to report taxable income. The tax on it will then be imposed by the Revenue [§ 80 (4) of Taxation Order Act].

It may occur that an individual, an expatriate in Hungary, has enrolled on an employer benefit plan and, whereas honouring the plan, he or she has spent one or two years in Hungary by obtaining Hungarian fiscal residence. In this case, it is assumed that at the time of granting rights, or during the lock up period, no tax liability is developed on the income to be expected from the participation in the benefit plan. At a later year when rights are exercised, however, Hungarian tax liability is due. Presumably, at this time, the taxpayer, as an expatriate, is not a Hungarian resident taxpayer longer. As a foreigner, residing in a treaty country, he or she cannot avoid Hungarian fiscal liability. This is because, under Hungarian national law, the income derived from the benefit plan is deemed to be employment income, subject to progressive tax in Hungary at the higher marginal rate of 40 percent in full. The national law characterisation of taxable income governs the application of treaty law as well. Therefore, under treaty law, the above income, qualified as employment income, is taxable in the source country. The Hungarian tax liability must be pro-rated, however. Its size depends on how much time he or she spent in service in Hungary.

In the absence of a double tax convention, the income discussed above is certainly subject to tax in Hungary, even if the taxable income is derived by a foreign resident individual, although the taxable event and the development of the liability to pay tax may occur in

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different fiscal years. This is true even if the beneficiary is not employed by the company that has launched the plan longer. This is because the fiscal liability is not affected by the fact that the employment, certain professional activity or a particular relationship, in respect of which income has been derived, has ceased [§ 9 (1) of Income Tax Act]. A foreign resident individual may nevertheless only be subject to tax in Hungary on the income derived from Hungary [§ 2 (4) of Income Tax Act].333

The recapture rules mentioned above in respect of insurance tax credit may apply to expatriates who are to leave Hungary, although not on the particular date of emigration, provided that foreign resident individuals continue to be subject to Hungarian tax on income, at least derived within Hungarian sources. In a treaty situation, the Hungarian tax may be avoided, however, because the income derived by foreign individuals upon the liquidation of the investment in terms of life insurance may be considered either as „other income” or capital gains, none of which is taxable in Hungary as a source country.

TAX IMMIGRATION RULES

Hungary as a possible immigration country does not seem to be susceptible to the tax problems arising from the accumulation of the fiscal liability due in the foreign state (as an emigration country) as well as in Hungary (as an immigration country). The tax paid on capital gains abroad, subject to 20 percent tax in Hungary, cannot be credited against the Hungarian tax. Thus, an exit tax, or the tax related to extended tax liability, cannot be taken into account in Hungary at all. The income from the pension received, whether in Hungary or abroad, within the terms of compulsory social insurance, is to be taken out of the Hungarian income tax base [§ 7 (1)(a) of Income Tax Act]. It comes from this tax treatment that the foreign tax credit in respect of pension income, exempt from Hungarian tax, is precluded.

The fiscal charges arising from non-Hungarian recapture rules can hardly be treated as a tax paid abroad, available for Hungarian tax credit. The reason for this is that they are likely far from being matched to the assessment period in which income is subject to tax in Hungary. Interestingly, benefits derived from insurance payments to be made under Hungarian law by Hungarian resident insurance enterprises are exempt from income tax Hungary [Annex 1 (6)(3) to Income Tax Act]. As a consequence, no foreign tax credit opportunity is available.

The emigration country’s taxation cannot be taken into account in the unfortunate case either where the taxpayer is subject in the country of emigration to tax on accrued capital gains

333 For example, in a case where an expatriate who participates in a stock option plan in Hungary spent two years in Hungary during a four year long lock-up period as stipulated in the scheme, the Hungarian source income is to be pro-rated. Accordingly, Hungary as a source country may tax half of the income received from the scheme.

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while he or she continues to hold a stock of assets, subject to tax in Hungary on realisation, based on historic costs. The reason for this is again that the jurisdictions of tax assessment do not coincide. This is because, while in the country of emigration it is the accrued, but not realised, income that is taxed, the immigration country – in this case Hungary – taxes the income realised at another time, possibly on another basis.

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

As discussed in connection with the Kavelaars question No. 2, the income tax on the stock dividends received or on the capital gains derived during legal mergers may be deferred. Also the tax on the gains derived through the qualifying exchange of shares may be deferred.

6. Are there special regulations related to a tax treaty?

Hungarian tax treaties do not include particular provisions that would directly be addressed to tax deferral. Instead, such cases are governed by the respective national law.

7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

No reform is expected for the time being.

Kevin Holmes, Deferral Possibilities

1. Please briefly describe the common techniques in your country employed by taxpayers to defer the tax liability given a capital gains tax.

There is a wide variety of capital gains in Hungary, exempt from income or corporate tax, or subject to low tax only. Dividend stripping or similar transactions may occur. They are, however, not recommended because of the all the more efficient ant-avoidance legislation. Tax deferral is also possible in particular cases as discussed. Importantly, as mentioned, the gains derived from the disposal of securities are not taxable as long as the taxpayer realises cash. In this context, taxpayers do not think it necessary to seek for special deferral. It is not precluded that the taxable income to be aggregated and subject to progressive tax is converted into capital income.

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Unreasonable manoeuvres are, however, comprehensively attacked, based on anti-avoidance legislation.

2. Are there mechanisms used in your country to: (a) Defer the taxation of income from capital on an accruals basis (e.g. gains arising from the annual change in value of debt instruments) by structuring an arrangement so that the gain is taxed upon (later) realisation (e.g. gains on the realisation of equity securities)?

In the absence of the income taxation of accrued gains, no such mechanisms are necessary. Marking-to-market rules are only applicable to businesses, in particular to financial enterprises.

(b) Convert capital gains otherwise taxable upon realisation into a non-taxable form?

See my notes on the question No. 1.

3. Are domestic or offshore trusts, foundations or other entities utilised to own assets with the objective of deferring (temporarily or permanently) tax on capital gains otherwise leviable in your country?

It is not characteristic that foundations or similar entities are used in order to seek for tax deferral. The distinction between legal and beneficial owners is a major problem in the international tax law practice in Hungary. Labour income is, however, frequently locked in personal service companies due to the difference in taxation of employment income and capital income.

BENEFICIAL OWNERS LEGISLATION

Although Hungarian domestic corporate tax law does not provide an explicit definition of beneficial owners for purposes of implementing tax treaty provisions, taxpayers, applying for Hungarian treaty benefit, are expected to prove that they are not simply the formal, but also the beneficial owners of payments made by Hungarian debtors. In the Hungarian practice, beneficial owners -- entitled to use treaty benefits, such as the reduced-rate taxation of the various classes of capital income, taxable in Hungary as a source country, are deemed to be those who recognise income as their own, directly derived from Hungary. Clearly, an agent who does not recognise the revenues derived from Hungary as his or her own because, transferring the income received, he or she acts on behalf and for the account of his or her principal, is by no means deemed to be a beneficial owner for Hungarian tax purposes. As a

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consequence, such a person is prevented from claiming treaty benefits. This is actually in line with international practice.

In broad terms, the Hungarian beneficial owner test is still exposed to criticism because it is fraught with legal uncertainty. In the absence of the crystallised practice in implementing DTCs, any company with third-country investors that derives capital income in Hungary has to face the danger that the claim for treaty benefits will be denied. Earlier, a term on beneficial owners was introduced in the national law to provide assistance in implementing DTCs. Since this domestic law definition was too rigid, it has been repealed. Nevertheless, the beneficial owners test continues to be applicable in the Revenue’s treaty practice. Under Annex 5 to Taxation Order Act on the administration of the taxation of foreigners, foreigners who seek to benefit from DTCs in Hungary will be obliged to make declaration on that they are not prevented from benefiting the treaty in question for any reason. In particular cases, while assuming joint and several liability for Hungarian fiscal debt, the Hungarian custodian of the assets of foreigners may declare, if necessary, that foreign beneficiaries are beneficial owners for treaty purposes of the income derived in Hungary.

PERSONAL SERVICE COMPANIES

Given that the taxes on various income classes are very different from each other in Hungary, people are tempted to enter into the co-mingling of distinct income classes for fiscal purposes. Interestingly, once a fairly low threshold has been passed, personal income from labour is subject to the highest marginal rate of 40 percent without the possibility of claiming deductions, on the one hand. On the other hand, the corporate tax rate is as low as 18 percent, and there are substantial opportunities for claiming deductions. The fiscal relief available for corporations can be seen as a major financial incentive for establishing and expanding business activity in Hungary. This incentive policy can be encouraging for particular groups of people, at least in the short term. However, it can have a distorting effect on economic behaviour in the long run. It is a clear sign of tax avoidance that many Hungarians seek to convert earnings into dividends for fiscal purposes by owning and managing personal service companies (or limited partnerships).

It is noteworthy that the recent efforts of the government tend to enhance benefits of an employment relationship, compares to capital income. Remarkably, the efficiency of government supervision in labour matters has been stricter. It has been all the likely that civil law contracts for personal services are disregarded for labour, and

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fiscal, law purposes. Following the shift in government after the parliamentary elections in the spring of 2002, the wages credit (a kind of income tax allowance) has been remarkably broadened. As a result, a major portion of the wages below the national average has become exempt from income tax. Notably, the wages tax relief is not available but for the income stemming from an employment law relationship.

With a view to attacking the abuse of personal service companies, there has been no doctrine of the clear reflection of income (such as in the USA), or fiscal measures similar thereto, that would have been invoked by tax authorities in Hungary. Instead, the distinction between normal and excess dividends has been introduced for fiscal purposes. Excess dividends received by individuals from the 1997 profits of Hungarian corporations have been subject to a 27 percent schedular tax and, remarkably, the higher dividend tax has been raised from 27 percent to 35 percent regarding the dividends distributed from profits earned by Hungarian corporations as of 1 January 1998.

Dividends received are not excessive for fiscal purposes unless the dividends distributed have exceeded an amount, calculated at twice the prime interest rate of the Bank of Issue334 at the time of distribution, as applicable to the investor’s due share in the equity capital, reflected in the balance sheet of the business making distribution on the last day of the year.335 The distinction between normal and excess dividends can be seen as a kind of anti-abuse legislation. It may become a powerful vehicle that can be mobilised by the government where it attempts to deal with abuses of personal service businesses (closely-held corporations or proprietary firms). However, the tax rules that had already been very complex have become even more convoluted. Probably it would have been less tortuous to strive to eliminate the primary reasons that have led to the abuse of personal service companies. Preventing individuals from the abusive management of partnerships by making partnerships fiscally transparent – that is, by removing partnerships from the list of corporate taxpayers – would be a definite step in this direction. The introduction of anti-avoidance rules in 1997 with the resulting distinction between normal and excessive dividends appears as a legislative pitfall in the sense that, instead of trying to eliminate the genuine reasons for the distorting effect on ventures arising from the different approach to various income classes, the government was eager to plug the loopholes by making the tax system even more complicated.

334 The so-called basic rate (prime rate) of the Bank of Issue is the interest rate applied by the National Bank of Hungary to long-term loans granted to credit institutions. It is widely used as a point of reference for fiscal purposes in various cases. 335 Reference to the prime rate in distinguishing between normal and excessive dividends is applicable last time to the income earned in 2003. After then, 30 percent of the taxpayer’s equity share (as defined by the income tax law) will be taken into consideration for the purpose of the above distinction.

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4. Does your country’s domestic law contain participation exemption or other exemptions, which relieve corporate entities from taxes on gains that they derive from the realisation of shares or other assets? If so, briefly state the conditions that must be met to qualify for the exemption(s).

Yes, Hungarian resident corporate taxpayers and Hungarian operating foreign enterprises enjoy participation exemption in respect of the dividends received. This regime is not extended to capital gains (like in the Netherlands or Luxembourg). For further details, see my explanation in connection with the Sacchetto and Castaldi question No. 3.

5. Does your country have provisions in its legislation designed to defeat arrangements to defer the taxation of capital gains? If so, please give a short description.

Yes, we have anti-avoidance provisions, generally applicable to tax avoidance. We do not have such provisions, specifically applicable to the deferral of the realisation of capital gains. See also my notes in connection with the Holmes question No. 1.

Judith Freedman, Treatment of capital gains and losses

1. Does your system tax capital gains and losses through the general income taxation system?

Yes, it does. We do not have separate capital gains taxes like in the UK or France. The capital gains are, however, not part of the taxable income t be aggregated and subject to progressive tax.

2. If not, are such gains and losses covered by a separate code?

No, we do not have a separate code. The tax treatment of capital gains is covered by the income tax Act.

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

Yes, it comes from the dual system of income taxation that the various types of capital income (including capital gains) are determined by the income tax law separately.

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4. If capital gains are included in the general income tax, do special rates and reliefs apply?

Yes. See my answers in detail above, in connection with the Sacchetto and Castaldi question No. 1.

5. Are capital gains and losses taxed on a realisation basis? If so, what amounts to a realisation? If not, what other basis is used?

See my answer in connection with the Kavelaars question No. 2.

6. Are there rules to deal with inflation?

No, they are not (in contrast to Israel or other jurisdictions).

7. Is there a deferral or exemption from tax on capital gains on death?

See my answer in connection with the Kavelaars question No. 4.

8. Are there other deferrals and reliefs on capital gains -- for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

See the relief available related to the financing of a first residential home from the capital gains derived from immovable property in connection with the Sacchetto and Castaldi question No. 1. See the relief related to the capital gains derived from publicly traded securities in connection with the Sacchetto and Castaldi question No. 1. In Hungary, there is no relief relating to non-speculative gains like in Germany or Austria.

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

Currently, no losses can be recognised in Hungary in the calculation of taxable gains for income tax purposes.

Ian Roxan, Influence of Inflation

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Capital Gains1. Are capital gains indexed for inflation? If so, how (e.g. by adjusting the amount of the cost for inflation or by allowing the deduction of an inflation adjustment)?

No.

2. Have there been any major changes to the indexation system recently?

3. Are there any restrictions on when indexation is available, e.g. by taxpayer, by type of asset, by length of ownership? Is indexation available when there is a capital loss?

4. Is there any other relief given for capital gains on assets held over a longer period? Please describe the relief briefly.

Yes. If real estates are held for more than five years, the taxable income, calculated as described by the law in terms of a kind of tapering relief may be reduced.

Specific Sources of Income from Capital

5. Is interest income indexed for inflation? If so, how?

No.

6. Is there any other relief for interest that is seen as providing some compensation for the effect of inflation on interest? Please describe the relief briefly.

7. Is any other type of income from capital indexed for inflation (e.g. dividends, royalties)? If yes, please describe the indexation method briefly.

8. Are businesses permitted to calculate the value of trading stock (inventory) using methods that make an allowance for inflation (e.g. ‘last-in-first-out’ (LIFO)), or given any other relief on stock that compensates for inflation?

No.

Tax Rates

9. Are the thresholds (‘brackets’) for each tax rate indexed for inflation? Are the personal (individual) deductions from total income (personal allowances / personal credit / zero tax rate limit) indexed for inflation?

No. Valorisation is made through the amendment to effective tax laws from year to year. There is no predictable mechanism for this, however.

Ian Roxan, Imputed Income

1. Is owner-occupied housing subject to income tax? As ordinary income, or subject to special rates of tax?

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No.

2. If so, how is the amount of income calculated (based on capital value or rental value; based on statutory amount (e.g. cadastral value), or estimate of market value)?

3. How often is the base value revalued? When was the last general revaluation?

4. Are any expenses (e.g. mortgage interest, repairs) deductible in calculating the amount subject to tax?

Yes. For further details, see my answer under the subheading “Taxation of capital gains arising from the transfer of movable and immovable property”, discussed in connection with the Sacchetto and Castaldi question No. 1.

5. Is any other imputed income from consumption goods or services subject to tax?

No.

6. Apart from the treatment of unrealised capital gains and shares in companies, are there any other types of income not realised by the taxpayer that are subject to tax, (e.g. certain trust income, or foreign assets)? (Brief description only)

No.

Deemed Income

7. For what transactions is market value substituted for actual transaction values? Is this automatic or at the discretion of the Revenue?

Even though sales are not treated as not being at arm’s length, it is recommendable that an independent valuation should be obtained. This is because – not to mention transfer pricing scrutiny -- taxpayers are subject to the statutory principles of the Taxation Order Act and the Corporate Tax Act as follows: - simulated contracts are disregarded [§ 1 (7) of Taxation Order Act]; - the abuse of fiscal law is prohibited [§ 1A (1) of Taxation Order Act]; and - benefits arising from the corporate tax law are not available unless the taxpayer is able to prove that his or her claim of benefits is in accordance with the objectives of the law [§ 1 (2) of Corporate Tax Act]. Furthermore, under individual income tax law, it is a statutory principle that the benefits arising from the income tax law are not available unless the taxpayer is able to prove that his or her claim of benefits is in accordance with the objectives of the law [§ 1 (4) of Income Tax Act, first paragraph]. Unreasonable deviation from arm’s length standards must be explicitly disregarded in any case [§ 1 (4) of Income Tax Act, second paragraph].

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Where securities are sold in transactions not considered on an „arm’s length” basis, the capital gain will be calculated as the fair market value minus the original costs of the security, minus any related costs. The difference between the actual revenue and the market price will be treated as „other income” to be added to the consolidated tax base of the seller [as discussed; see § 28 (14)].

The taxable income is calculated as the difference between the fair market value of the securities received, on the one hand, and the value paid as compensation, and the costs incurred with the enterprise providing investment services, approached upon acquisition, on the other hand [§ 77A (1)].

The taxable income is calculated as the difference between the fair market value of the securities upon the first day when it is possible to dispose of the securities, on the one hand, and the value paid as compensation, and the costs incurred with the enterprise providing investment services, approached, including the compensation, if any, paid for the option granted, upon the acquisition of the right to subscribe to or purchase securities, on the other hand [§ 77B (1)].

8. Are any non-arm’s length transactions (including gifts and transfers on death) valued at a value other than market value (or actual value, if any)? Please describe briefly.

No.

9. Are there other transactions (giving rise to income from capital or capital gains) where an amount other than the actual amount realized is included in income? Is this automatic, or at the election of the taxpayer or of the Revenue?

No.

10. Please describe briefly any significant cases where the amount of deductible expenses in respect of income from capital or capital gains is denied or restricted, or where a standard amount is deductible (either required or as an alternative to the actual amount).

The expenses made for the benefit of those who reside in tax havens are not recognised for tax purposes unless the taxpayer making expenses substantiates the basis for making such expenses [§ 8 (2) of Income Tax Act].

11. Are there circumstances where a taxpayer’s total income (or income tax) is limited (maximum or minimum) by reference to a general calculation of income (e.g. alternative minimum tax, maximum level of total direct taxation (income and wealth)? Does this relate to the level of reliefs or disallowed deductions given in respect of income from capital or capital gains?

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A kind of alternative minimum tax exists in the Hungarian corporate tax law only. Particular limits on individual income tax relief opportunities do not exist in Hungary any longer.

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7. ITALY (Claudio Sacchetto)

Peter Kavelaars, Accrual versus Realization

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?

Capital gains deriving from the negotiation or the closing of contracts having regards the use of capital are subject to taxation only since 1997. Capital gains deriving from the transfer or the expropriation of building sites are taxed since 1991. As regards capital gains realised on other assets the taxation is, generally, excluded where the behaviour of the taxpayer or the objective situation are not characterised as speculative (for example, capital gains from the transfer of estates are taxed only if the transfer is made within 5 years and, in any case, never when the asset is received by inheritance or has been used, within the 5 years, as primarily abode by the taxpayer or his/her parents). It is discussed if the capital gains occasionally realised by the transfer of movable assets (antiques, etc.) might be taxed according to Article 81(1)(i) of the Income tax code (which consider within the miscellaneous income income derived by business activity not exercised regularly).

2. Are capital gains taxed on accrual or on realization base?

For individuals who do not conduct any business activity capital gains are taxed on the basis of the realization principle.

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

No.

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- death

Article 7 of the Income tax code provides for that, in case of death, incomes which follows the realization principle of taxation, are taxed in the hand of the perceivers (heirs, legatees and devisees) but they (incomes) do not concur within the general taxable basis but are taxed separately.

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- emigration- immigration- mergers/splitting- divorce

Immigration/emigration weight upon the taxation discipline of capital gains only if they traduce with the loss (or gain) of the qualification of resident. Many capital income, even having objective link with the domestic territory (for example, paid by residents) are considered as not produced within the territory of the State in order to favour the investment in Italy.

The family has not fiscal relevance within the Income tax code: the married couple, therefore, are taxed autonomously for their different income.

The merger and splitting operations do not have any relevance for the taxation of capital gains.

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

Generally income declared might be corresponded to the Treasury by instalments with a modest addition of interest. If the tax return indicates a credit for the taxpayer, he/she could choose if postpone the credit to the next year or ask for the reimbursement. The Vat subjects execute an unique payment of the sums due for taxes (income and Vat) and social security contributes and other sums due to the State or Regions or other entities with the possibility of setting off debts and credits relative to the same period resulting form the tax return.

6. Are there special regulations related to tax treaty?

Article 128 of the Income tax code provides for that its rules have to be applied if more favourable for the taxpayer even if they derogate to conventional rules.

7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

The statute which delegate the Govern to reform tax system provides for: a) the homogenisation of all income capital independently from the juridical instruments used to produce it; b) convergence of the substitutive regime on the tax regime used

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for the Public debt bonds; c) taxation of savings granted to the institutional investors on the basis of the principle of realisation and setting off; d) differentiate regime for savings deriving from pension funds and ethic funds.

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your system tax capital gains and losses through the general income taxation system

Articles from 5 to 7 of the Legislative Decree n. 461/1997 provide for alternative forms of substitutive taxation (i.e. not ordinary) of capital incomes. In a general way, capital gains do not concur to the ordinary income taxation (IRPEF: tax on income produce by individuals) but are subjected to withholding taxes: in the determination of the taxable basis, capital gains and losses – according to the realisation principle – are generally summed together.

2. If not, are such gains and losses covered by a separate code?

See the previous answer.

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

Capital gains are not considered income from capital but miscellaneous income. This solution it is based on the belief that capital gains are not originated by the use of capital but by the negotiation or the closing of contracts relative to the use of capital.

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

See answer sub 1.

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation? If not, what other basis is used?

See answer sub 1.

6. Are there rules to deal with inflation?

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No.

7. Is there a deferral or exemption from tax on capital gains on death?

A part from that already said as regard the other questionnaire as regard the hypotheses in which the capital gains are realised but not yet perceived by the de cuius (in which case Article 7 of the Income Tax Code applies), in the other cases the value for the determination of the capital gains is the value of the assets at the time of the death.

8. Are there other deferrals and reliefs on capital gains- - for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

The taxation of non financial capital gains realised by individuals outside a business purpose is delimited within specific hypothesis. In some cases, it is conserved the original scope emerged from the general tax reform of the ‘70s according to which capital gains are, in principle, taxable only if speculative. Naturally this principle is applied outside a business context. See also the answer n1 1 to the other questionnaire.

9. What restrictions are there on setting off losses against gains of a different nature (ie income versus capital)?

Generally the setting off is admitted only for losses and gains deriving from the same income category. Exception to this principle might be found in the so-called managed regime of savings where the withholding tax is applied on the net annual result of the management (income from capital and miscellaneous (financial) income).

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8. LUXEMBOURG (Prof. Alain Steichen)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

Income taxation is levied on private persons and on partnerships (personal income tax hereafter “PIT”) and separately on corporations (corporation income tax hereafter CIT). PIT is levied on progressive rates topping at 38% at approximately € 35 000. CIT is taxed at a flat 22% on a basis derived from the PIT rules pertaining to businesses.

PIT uses a synthetic income definition by taxing the aggregate amount of specific income sources at a progressive rate. There are 8 income categories, one o which dealing with capital gains. The Luxembourg PIT rules pertaining to capital gains limit taxation to short term gains of whatever nature they would be, to capital gains on real estate and and to gains on important participations (“GIP”). A short-term capital gain exists if the date of acquisition and of disposal of the asset are within a 6 month period. Contrary to standard tax rules, short term capital gains are taxed at ordinary tax rates, losses only being off-settable against taxable capital gains but not against other source income. GIP are gains relating to shareholdings in companies subject to CIT provided the tax payer owns at least 10% of the share capital in the company. The capital gains on real estate comprise any capital gains on land and buildings, except for the owner-occupied house (the gain on which is never taxable). The GIP and the gains on real estate disposals are taxed at 50% of the average rate of the tax payer’s income, the cost base of the real estate being adjusted to take account of the inflation. Taxation of gains on real estate may be deferred if the taxpayer decides to reinvest the proceeds of the gain into the purchase of additional real estate.

Persons subject to PIT are the individual tax payers, even if they are married. However, in order to take account of the fact that certain people pool their resources through marriage, all spouses that are living together are filing joined tax returns indicating as taxable income the sum of the spouses’ income. The tax liability on each spouse then is arrived by allocating 50% of the total income to each spouse and by subjecting each spouse to CIT on that income by applying the ordinary tax rates (“splitting”).

CIT applies to corporations as opposed to partnerships which are subject to PIT in the name of the partners. There exist no possibility for certain businesses to opt out of the CIT for the benefit of the PIT regime or vice-versa: any business is under law either subject to PIT or to

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CIT. CIT also uses a synthetic income definition based on the increase of net wealth of the company through comparing the opening and the closing balance sheet of the company for the year. Any increase is taxed at 22% CIT to which a local business tax (any company subject to CIT is also subject to the local tax) of 7,5%. Total tax for companies thus amounts to 29,5%. The most relevant exclusion granted under the CIT rules relate to holdings of companies. Provided certain conditions are met (see separate report) the dividend income and capital gains relaised in respect to important participations held by companies are exempt from tax.

Any tax payer under PIT or CIT is further subject to an annual net worth tax (“NWT”) levied at the rate of 0,5%. The NWT is expected to be paid out of current income, hence its tax rate set at low levels. The taxable basis is obtained through deduction of the liabilities from the tax payers gross assets. The NWT is set for 3 years each time but gets adjusted if the taxable basis substantially changes during that period.

2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

Income on capital is taxed through a 20% withholding tax if constitutive of dividends. The company withholds that tax at source. Interest on capital is not subject to withholding tax unless it is derived from a profit participating bond. The Luxembourg recently has agreed to introduce an interest withholding tax starting 2004. The rate will be 15% and move over time up to 35%.In order to alleviate the economical double taxation, only 50% of the dividends paid out by the company are taxable. Since the top marginal tax rate under PIT is 38%, a withholding tax of 20% should generate a small refund for the tax payer when he files his tax return.

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

As said above, double taxation is avoided through total exemption of intra-company dividends and a 50% exemption of dividends paid to private shareholders.

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

Under the PIT rules, income from capital is reported as a specific income category which does not comprise any capital gains. The capital gains are reported under a different

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income category not comprising any income from capital. I see neither overlapping nor double missing.

5. Which are the indirect taxes on capital?

Transfer of capital is subject to transfer taxes only if consisting in the transfer of real estate located in Luxembourg, the tax rate being 7% or 10% depending upon the location of the real estate. Movable capital however, just like immovable capital, is part of the estate and is taxed at progressive rates up to 32%. Estate inherited by the children however is not subject to estate taxation.

6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

See under 5.

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

See under 1.

Peter Kavelaars, Accrual versus Realization

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?(if not, the next questions have not to be answered)

See under 1.2.1

2. Are capital gains taxed on accrual or on realization base?

Only on a realization basis. Realization takes place upon sale and exchange (for shares or otherwise).

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

Capital gains on business assets are treated differently from those on other assets. Meaning that if a tax payer contributes its business to a company for shares, taxation

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of the unrealised capital gains, unlike the general rule, may be deferred, provided the company takes over the cost base of the assets of the former privately run business. Other than that, no material differences exist between the various types of assets. See however the deferral mechanism for real estate under 1.2.1.

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- death: none since there is no realization- emigration: none for the same reasons and never mind the tax planning opportunities that may arise out of this- immigration: assets held by the tax payer upom immagration are valued mark to market to as to ensure that Luxembourg only taxes the increase in value over and above that figure, i.e. only that inome that has been generated by the tax payer whilst being a tax resident of Luxembourg.- mergers/splitting: in theory mergers/splitting do cristallise the unerealised capital gains. However in practice taxation never arises, since the CIT code allows tax free mergers/demergers provided the cost base is carried over and all of assets and liabilities are transferred.- divorce: no realisation event

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

See 1.2.1

6. Are there special regulations related to a tax treaty?

No7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

No

Judith Freedman, Treatment of capital gains and losses

1. Does your system tax capital gains and losses through the general income taxation system?

See 1.2.1

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2. If not, are such gains and losses covered by a separate code?

N/A

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

See 1.2.1. Income under synthetic assets are taxed as capital gains.

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

See 1.2.1.

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation? If not, what other basis is used?

See 2.2.1.2

6. Are there rules to deal with inflation?

See 1.2.1. Inflation is dealt with for real estate by increasing the cost base through an inflation factor (f.i. the historical cost of land purchased in 1960 is multiplied by 3). The inflation factor is based on official data.

7. Is there a deferral or exemption from tax on capital gains on death?

Death is not a realization event and hence does not trigger capital gains taxation. Estate taxation may however arise (see 1.2.5).

8. Are there other deferrals and reliefs on capital gains- - for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

Yes there are: see 1.2.1; 1.2.3; 2.2.1.3.; 2.2.1.4.

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

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See 1.2.1

Ian Roxan, Influence of Inflation

Capital Gains1. Are capital gains indexed for inflation? If so, how (e.g. by adjusting the amount of the cost for inflation or by allowing the deduction of an inflation adjustment)?

Lux tax law generally provides for different rules as regards income items that are derived from businesses (commercial, industrial, independent services, agriculture) and from activities other than businesses (salaries, pensions, interest and dividends, renting, capital gains and other ancillary income). Unless specifically exempted, capital gains are part of the taxable income of the businesses, unlike as for non-businesses where the gains are exempted unless specifically listed as taxable items. Capital gains realised in respect to assets held privately benefit from an inflation adjustment as do those gains relaised in respect to business assets, provided they occur in the course of the liqidation of such business. Hence, unlike privately held assets, where inflation adjustment also kicks in, capital gains in respect to business assets do not benefit from any inflation adjustment if the gain is relaised in the course of a “going concern”.When applicable, the inflation adjustment is achieved through an upwards adjustment of the cost base by a factor increasing with the time the asset has been held (from factor 1,03 for assets acquired in 1999 up to factor 125 for assets acquired until 1918). The inflation factor is calculated in such a manner so as to broadly correspond to the inflation rate of the respective period.

2. Have there been any major changes to the indexation system recently?

No, disregarding the adjusting of the inflation factor table.

3. Are there any restrictions on when indexation is available, e.g. by taxpayer, by type of asset, by length of ownership? Is indexation available when there is a capital loss?

Cf. 1.

4. Is there any other relief given for capital gains on assets held over a longer period? Please describe the relief briefly.

There are specific reliefs for (a) gains on real estate held as a business, (b) gains on shares held in businesses and for (c) gains on privately held assets .

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i. Gains on real estate (land, building) held as a business benefit from an optional deferral mechanism if the real estate has been held since five years at least and provided the business reinvests the proceeds of the sale in a replacement real estate (existing or new). In that case, taxation of the gain may be deferred through the deduction of the gain from the cost base of the real estate acquired in place of the real estate that has been sold.

ii. Gains on shares held as a business asset benefit from a tax deferral provision similar to the one under (a), provided the gain is based on an exchange of shares held in a fully taxable company (Luxembourg, EU, third country) against shares to be acquired in another fully taxable company.

iii. Gains on privately held assets also benefit from a tax deferral provision as under (a), provided only that the asset acquired as a reinvestment is located in Luxembourg and will not get used by the tax payer hinself (principal or secondary residence).

Specific Sources of Income from Capital5. Is interest income indexed for inflation? If so, how?

No indexation takes place.

6. Is there any other relief for interest that is seen as providing some compensation for the effect of inflation on interest? Please describe the relief briefly.

There exists a 1 500 ( 3 000 in case of married couples) exemption for interest income. It partially aims at compensating for the inflation.

7. Is any other type of income from capital indexed for inflation (e.g. dividends, royalties)? If yes, please describe the indexation method briefly.

No indexation method exists for regular income, only for capital gains.

8. Are businesses permitted to calculate the value of trading stock (inventory) using methods that make an allowance for inflation (e.g. ‘last-in-first-out’ (LIFO)), or given any other relief on stock that compensates for inflation?

LIFO, FIFO and the Average Cost methods are all known and accepted by the tax authorities, though the choice for any one method may only be based on the nature of the activities of the business. Hence, unless the nature of the activities commands the LIFO

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method (e.g.: the tomato producer wishing to get rid of its oldest tomatoes first), the Average Cost Method is mandatory.

Tax Rates

9. Are the thresholds (‘brackets’) for each tax rate indexed for inflation? Are the personal (individual) deductions from total income (personal allowances / personal credit / zero tax rate limit) indexed for inflation?

Yes, the brackets are regularly adjusted for indexation. Personal deductions also are though at irregular intervals.

10. Is indexation applied automatically every year, or is new legislation required each year? If it is automatic, is there an explicit mechanism permitting indexation not to be applied in a year?

Under an explicit indexation mechanism, the brackets are adjusted automatically provided cumulative inflation (since the last adjustment) is in excess of 3,5%.

11. Is indexation normally applied? For instance, in how many of the last five years has full indexation been applied?

Twice.

General

12. Are there any other thresholds (e.g. minimum amounts of particular type of income to be taxable) that are automatically indexed for inflation?

Other thresholds are adjusted for inflation, though at irreegular intervals only.

13. Are there any noteworthy provisions where there is an adjustment for inflation that works against the taxpayer?

There are none.

Ian Roxan, Imputed Income

1. Is owner-occupied housing subject to income tax? As ordinary income, or subject to special rates of tax?

Yes, it is taxable albeit at ordinary tax rates. However the value of the imputed income is fixed at approximately 10% only of the rental income the owner might realise. In

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fact, taxation of imputed income serves as sole goal to allow for an interest deduction on the debt taken up for acquiring the owner-occupied house.

2. If so, how is the amount of income calculated (based on capital value or rental value; based on statutory amount (e.g. cadastral value), or estimate of market value)?

Cadastral value fixed at the pruchase price of 1940.

3. How often is the base value revalued? When was the last general revaluation?

Never since 1940.

4. Are any expenses (e.g. mortgage interest, repairs) deductible in calculating the amount subject to tax?

Costs are deductible up to the amount of gross taxable income, except for the interest finance cost that are deductible for an amount of € 1 500 per person living in the house and part of the ousehold taxation (spouses, children).

5. Is any other imputed income from consumption goods or services subject to tax?

There is no other form of imputed income.

6. Apart from the treatment of unrealised capital gains and shares in companies, are there any other types of income not realised by the taxpayer that are subject to tax, (e.g. certain trust income, or foreign assets)? (Brief description only)

Income is taxable when realised unless held through an entity that is recognised for tax purposes. Trust may or may not qualify as such depending upon their actual structure.

Deemed Income

7. For what transacations is market value substituted for actual transaction values? Is this automatic or at the discretion of the Revenue?

Deemed income only is relevant for transactions occuring between related parties: intra-family transactions or transactions between the shareholder and the company. Under market value transactions in other circumstances may not become subject to a deemed income taxation.

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8. Are any non-arm’s length transactions (including gifts and transfers on death) valued at a value other than market value (or actual value, if any)? Please describe briefly.

Sales done at under market value may be scrutinised as to to whether they do eventually constitute a disguised donation for the purposes of levying the donation tax. The intent to donate and the de minimis amount of consideration have to be proven by the tax authorities. An under market value transaction is not sufficient, it has to be de minimis. Theoretically one could separate an under market value into two components: a sale at fait market value and a donation for the difference between that amount and the amount actually paid by the tax payer. In practice however, the tax authorities only consider the “all or nothing” option and hence only question the sale if made for a nominal value.

9. Are there other transactions (giving rise to income from capital or capital gains) where an amount other than the actual amount realized is included in income? Is this automatic, or at the election of the taxpayer or of the Revenue?

No such transactions exist.

10. Please describe briefly any significant cases where the amount of deductible expenses in respect of income from capital or capital gains is denied or restricted, or where a standard amount is deductible (either required or as an alternative to the actual amount).

Expenses in respect to assets are only deductible, under case law, provided there exists a reasonable prospect of a total net positive return on the investment over a longer period of time. Hence interest financer costs in respect to a purchase of capitalizing investment funds only leading to a tax free future capital gain are non deductible.Likewise, under statute provisions, expenses in connection with tax exempt income are not deductible. If exemption is partial, the deduction is partial by same percent.

11. Are there circumstances where a taxpayer’s total income (or income tax) is limited (maximum or minimum) by reference to a general calculation of income (e.g. alternative minimum tax, maximum level of total direct taxation (income and wealth)? Does this relate to the level of reliefs or disallowed deductions given in respect of income from capital or capital gains?

The concept of a maximum or minimum income tax base is unknown under Lux tax law.

9. NETHERLANDS (Irene Reiniers)

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Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

In the Netherlands, most income is taxed on the basis of the real earned income. This means that the tax system is based on the previous actual earnings. Income from capital earned by individuals not being entrepreneurs or substantial participation holders however is taxed fictitiously: capital owners are supposed to earn 4 % on their average capital. This income is taxed at a proportional rate of 30%. In short, our income tax is divided into three schedules, called boxes; the first box (box I) taxes income generated by work and dwelling (taxed at a progressive rate of 32-52%), the second box (box II) taxes substantial shareholders for their real dividends and capital gains on their shares at a rate of 25%, and the last box (box III) taxes income from capital in a fictitious way at a rate of 30%. All boxes are treated separately, and, in principle, a negative result of one box cannot be set off against a positive result of another.The net wealth tax was abolished with effect from 1 January 2001. In fact, since that time box III acts in the same way as a wealth tax.

2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

Dividends and interest from profit-sharing bonds paid by a resident company to its shareholders or creditors, respectively, are subject to dividend withholding tax at a rate of 25%; this percentage can be lower in case a tax treaty is applicable. Resident taxpayers can credit the tax against their income tax due. In case of non-resident taxpayers the dividend withholding tax is final. Other interests or royalties are not subject to withholding tax.

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

The corporate income tax taxes the income of non-individuals. The way in which the income is taxed at the individual’s level depends on the share he/she has in the

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company. A substantial shareholder (5% or more of the share capital) pays 25% tax on real income from shares (dividends and capital gains). This 25% is rather low, because the company has already paid 34,5% corporate income tax. So, in some way taxes paid by the company are taken into account and double taxation is avoided. In case of entities, the participation exemption avoids economic double taxation. Individuals who do not have a substantial participation are taxed in a fictitious way (box III) at a rate of 30%. Already paid corporate income taxes are not taken into account.

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

No. Substantial shareholders are taxed for their real income, which means that both income from capital and capital gains are taxed when earned. Therefore there is no overlapping.

5. Which are the indirect taxes on capital?

In the Netherlands, we have no indirect taxes on capital. However, the company has to pay a capital duty of 0,55% on the distribution of share capital. Also the Netherlands has gift and inheritance taxes.

6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

First, a distinction must be made the dwelling and other real estates. The dwelling is taxed in box I. The income ‘generated’ by this house (the rental value) is determined in a fictitious way. Interests paid on a mortgage loan are deductible from this income. Because of this, most taxpayers have a negative income generated by their dwelling. All other immovable property, except business real estate, is part of box III capital. The fictitious way of determining income applies for all this immovable property. Business real estate is taxed in box I, against the normal rate of 32-52%; all real gains and losses are taxed.

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

Movable property, not being business property or a substantial participation, is taxed in box III, so by means of a fiction. Substantial shareholders are taxed in box II for

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their real income at a proportional rate of 25%. Business property is taxed in box I at the progressive rate.

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your system tax capital gains and losses through the general income taxation system?

In the Dutch personal income tax, capital gains and losses are taxed in several ways:1. As business income (taxed in box I at a progressive rate of 32-52%).2. As income earned by labour (not in the capacity of an employee), e.g., income out

of real estate explored in a way that goes beyond ‘normal investment’ or income earned because of insider trading (taxed in box I at a progressive rate).

3. As income from a substantial participation (5 % or more of the share capital). Dividends and capital gains on shares from a substantial participation are taxed at a proportional rate of 25% in box II.

4. In box III on the basis of a fictitious income of 4% on the average wealth (the net wealth at the beginning and at the end of the year, divided by two), taxed at a proportional rate of 30%. This 4% not only consists of interest on loans or dividend on stocks but also of gains and losses on selling the capital. No allowance of cost deduction or loss deduction.

2. If not, are such gains and losses covered by a separate code?

No separate code on capital gains and losses

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

See the answer to question 1.

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

See the answer to question 1.

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation? If not, what other basis is used?

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In boxes I and II this is the case. In box III the basis is determined by way of a fiction; this has some characteristics of taxation on an accrual basis.

6. Are there rules to deal with inflation?

No, we use a nominal profit computation. This means that there is no correction for inflation. However, rates, fixed taxable and deductible amounts, margins and so on, are yearly adjusted to inflation.

7. Is there a deferral or exemption from tax on capital gains on death?

In box I (for entrepreneurs) and box II rollover possibilities exist. In box III no deferral or exemption. However, the inheritance tax sometimes allows a deferral or provides an exemption.

8. Are there other deferrals and reliefs on capital gains- - for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

Substantial shareholders can apply a roll-over relief in the following situations: transfer of the shares caused by succession or marriage, in case of the end of a substantial shareholding, and in case of mergers or demergers. The period for which you hold the assets has no influence on the way in which it is taxed.

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

The Dutch income tax is divided into three schedules, called boxes. Every box taxes another type of income. The first box taxes income generated by work and dwelling, the second box taxes income from shares belonging to a substantial participation (dividends and capital gains or losses). The last box taxes capital income. Losses and gains of different boxes cannot be set off against each other. Within one box however all income can be set off against each other. Capital losses relating to a substantial shareholding are deductible, in the first instance, from income in that same box. However, 25% of any excess is, under specific conditions, creditable against the tax due on the taxpayer’s income falling under box I. This tax credit may be carried forward indefinitely.

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Kevin Holmes, Deferral possibilities

1. Are capital gains taxed in your country when the gains are realised by:a. An individual; orb. Non-individual entities?

In the Dutch personal income tax, capital gains and losses of individuals are taxed in several ways:1. As business income (taxed in box I at a progressive rate): In principle profits are determined on the basis of sound business practice. According to the reality and prudence principles of sound business practice, in general there is no need to take profits into account before they have been realized, while losses can already be taken into account when a fair probability exists that they will occur, provided they can be matched against the production benefits. Only equity securities might be taxed on an accrual basis.2. As income earned by labour (not in the capacity of an employee), e.g., income out of real estate explored in a way that goes beyond ‘normal investment’ or income earned because of insider trading (taxed in box I at a progressive rate) in the same way as described under 1.3. As income from a substantial participation (5 % or more of the share capital). Dividends and capital gains on shares from a substantial participation are taxed at a proportional rate of 25% in box II. They are taxed upon realization.4. In box III on the basis of a fictitious income of 4% on the average wealth (the net wealth at the beginning and at the end of the year, divided by two), taxed at a proportional rate of 30%. This 4% not only consists of interest on loans or dividend on stocks but also of gains and losses on selling the capital. No allowance of cost deduction or loss deduction.

Profits of corporations are taxed on the basis of the corporate income tax in the same way as described under 1.

2. Are capital gains taxed in your country on an accrual basis when derived by:a. An individual; orb. Non-individual entities?

See the answer to the previous question.

3. Does the type of asset (e.g. a personal or business asset), which produces the gain, affect the answers to questions (1) and (2)?

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See the answer to question 1.

4. If the answers to any parts of questions (1), (2) or (3) were affirmative, please briefly describe the common techniques employed by taxpayers to defer the tax liability.

For individuals it is difficult to defer the tax liability. Apart from entrepreneurs and substantial shareholders, all income from capital is taxed in box III. To avoid taxation taxpayers should avoid having capital at the beginning or at the end of a year. E.g., it is better to receive a gift in the middle of a year and then spend the money during that year, instead of receiving the gift at the end of a year and spending it in the next year. The same goes for selling a dwelling or a substantial participation. Entrepreneurs use the possibilities of sound business practice to defer taxation as much as possible. The same goes for non-individual entities.

5. Are there mechanisms used in your country to:a. Defer the taxation of income from capital on an accruals basis (e.g. gains arising from the annual change in value of debt instruments) by structuring an arrangement so that the gain is taxed upon (later) realisation (e.g. gains on the realisation of equity securities)?

No general concept available.

b. Convert capital gains otherwise taxable upon realisation into a non-taxable form?

No general concept available. In case of entrepreneurs and substantial participation holders all capital gains and income are taxed against the same rate, so it is of no use to convert capital gains into (other types of) income.

6. Are domestic or offshore trusts, foundations or other entities utilised to own assets with the objective of deferring (temporarily or permanently) tax on capital gains otherwise leviable in your country?

No general concept available.

7. Are accrued capital gains treated as realised upon the marriage or death of the owner, or the gifting, of an asset? If so,

a. Who is liable to pay the tax?b. Are the gains on all assets subject to tax?If not, and the gain is realised upon disposal of the asset, who is liable to pay the tax?

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For an entrepreneur marriage is not a realization moment, since marriage as such does not affect the entrepreneurial status. For a substantial participation holder, in principle marriage is considered to be a realization moment; the substantial shareholder is liable to pay the tax. Under conditions a rollover relief is available.For an entrepreneur death is considered to be a realization moment; he will have to pay the income tax on the goodwill and hidden reserves in all assets belonging to the enterprise. Under conditions a rollover relief towards the inheritors is available. The same goes for a substantial participation holder.

The gift of an asset is also considered to be a realization moment, both for the entrepreneur and for the substantial shareholder. The donor is taxed.

8. Does your country’s domestic law contain participation or other exemptions, which relieve corporate entities from taxes on gains that they derive from the realisation of shares or other assets? If so, briefly state the conditions that must be met to qualify for the exemption(s).

Yes, our corporate income tax contains a participation exemption. This exemption relieves corporate entities from taxes on gains that they derive from the income on and realisation of shares. The conditions are: 1. participation of 5% or more in the share capital of the subsidiary; 2. shares should not be held as stock; 3. (only in case of a foreign non-EU participation) shares should not be held as portfolio investment or as a passive financing asset; 4. (only in case of a foreign participation) the foreign subsidiary should be subject to a profit tax.

9. Does your country have provisions in its legislation designed to defeat arrangements to defer the taxation of capital gains? If so, please give a short description.

The Netherlands has many rollover reliefs, e.g. in case of mergers and demergers. Also the concept of fiscal unity leads to deferral of taxation with respect to transfers of assets within the fiscal unity. These provisions contain many anti-abuse measures. E.g., art. 15ai CITA 1969, which triggers arrangements aimed at transferring assets with hidden reserves tax free from the parent company to a subsidiary within fiscal unity, followed by the sale of shares in that subsidiary, leading to the application of the participation exemption on the capital gains on the shares. For substantial shareholders there is a special provision, providing a 4%-fictitious income in case of shares in a corporation situated in a tax haven.

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10. NORWAY (Prof. Frederik Zimmer)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1.      Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

I refer to my article in Bulletin 2002 p. 352 ff (in the IFA Oslo congress issue), in particular pp 353-54, p. 356, p. 357 and p 358.

2.      Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones?  Please describe how they function.

Withholding tax is levied on dividends, not on interest or royalty. The rate is 25 pct, but usually reduced in tax treaties, normally to 15 pct. and lower in case of substantial shareholding. Without the special legal basis for the withholding tax on dividend, there would have been no legal basis for a tax on dividend paid to non-residents. Thus, it could perhaps not be called substitutive.

3.      Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

Partnerships are transparent for income tax purposes. As regards companies and dividends, a complete imputation system applies by now. (But a committee report to

be released shortly will probably propose an element of double taxation.)

4.      Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

Capital gains are included in the concept of income; therefore there is no question of overlapping. But in some instances there may be doubt as to whether a benefit shall be taxed as ordinary capital income or as a capital gain.

5.      Which are the indirect taxes on capital?

I am not certain what this question refers to. Norway has a VAT system which is

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rather similar to the EU systems.

6.      Describe the system of taxation of immovable property (i.e. real estates) in your country.

I refer to the article mentioned above for a description of net wealth tax and real estate tax in Norway.

7.      Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

Capital income (including capital gain) on private movable tangible property is tax-free. Interest on bonds is taxable as ordinary income (28 pct. tax rate) and interest paid is deductible (for 28 pct. tax purposes). Capital gains on bonds are tax-free (and losses non-deductible) if bonds are held outside business. On bonds held as business assets, gains are taxable and losses deductible. Capital gains on shares and on share options are always taxable income, and losses are deductible, again for 28 pct. tax purposes.

Peter Kavelaars, Accrual versus Realization

1.      Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?

I refer to answer to question 8 above as far as movable assets are concerned. Capital gains on immovable assets are taxable (rate 28 pct) as a point of departure. But gains on dwelling houses are tax free (and losses non-deductible) if the seller has owned it for at least one year and used it as his home for at least one of the two years preceding the realization. A similar rule, with longer time limits (five years) applies to holiday houses. Capital gains on agricultural and forest real estates are tax free if the seller has owned for at least the ten years preceding the realisation. (if not, the next questions have not to be answered.

2. Are capital gains taxed on accrual or on realization base?

On realisation basis.

3.      Related to question 2, are there differences between types of assets? If so, will you give a short overview?

No, all capital gains are taxed on a realisation basis.

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4.      Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:        - death

Death is no realisation and the heir will get a step-up basis which can not exceed to value for inheritance tax purposes (which as a main rule is the market value, but in practice often lower). Same rules applies to gifts; however, gift of single business assets is treated like a realisation.

        - emigrationThere is no general exit taxes for persons or assets. But for business assets moved out of the reach of Norwegian tax jurisdiction, the is a claw-back rule for depreciations granted in Norway.

        - immigrationNo realisation or taxable event.

        - mergers/splittingBoth mergers and company splittings can be carried out on a roll-over basis on the condition that the companies involved are Norwegian (otherwise, a consent from the ministry is required)

-       divorce No realisation, but the receiving spouse will take over the tax basis value of the assets (thus contrary to what happens at death)

5.      Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

Only in certain cases of "forced" realization, such as expropriation, fire or similar destruction etc.

6.      Are there special regulations related to a tax treaty?

Losses is not deductible if a corresponding gain cannot be taxed in Norway because of a tax treaty.

7.      Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

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Not at the moment. An important committee report will be presented next week but will probably not concern capital gains.  Judith Freedman, Treatment of Capital Gains and Losses

1.      Does your system tax capital gains and losses through the general income taxation system?

Yes, in principle since 1911.

2.      If not, are such gains and losses covered by a separate code?

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

There are certainly some special rules for capital gains  outside business income this is the case as regards conditions for taxation (reference is made to answers to earlier questions), as for business income there are special timing rules (roll over possibilities to a larger extent than for ordinary income). Drawing the borderline has not turned out to be very difficult in practice, except perhaps regarding certain financial instruments.

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

As for special timing rules, se above. Presently, there is no special tax rates for capital gains (which, of course, has to do with the fact that the general tax rate for capital income  including gains  is 28 pct. Flat). Before the tax reform of 1991 there were special tax rates for share gains and certain gains on immovable property.

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation? If not, what other basis is used?

Yes, realisation basis. Realisation includes change of ownership for a Consideration, first and foremost sales, also compulsory sales and exchange of assets (which is realisation of both assets). Gifts and death are not included, but gifts

of single business assets are treated as realisation. In addition, end of ownership through

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fire or other destruction is realisation. Reference is also made to answer to earlier question.

6.      Are there rules to deal with inflation?

No, but the low tax rate (28pct.) is partly justified by the inflation concerns.

7.       Is there a deferral or exemption from tax on capital gains on death?

Exemption, as death is not realisation (or other taxable event). See also answer to earlier question.

8.      Are there other deferrals and reliefs on capital gains- - for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

Reference is made to earlier answers as regards movable tangible property and immovable property. There are not any longer special rules for substantial shareholdings or for shares held a certain length of time, but such rules existed until the tax reform on 1991. Instead, now the so-called RISK-system for computation of share capital gains takes care of the double taxation that could otherwise arise, see Bulletin 2002 pp.364-370.

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

To the extent that losses are deductible (and they are, to the same extent as corresponding gains are taxable) they can be deducted in all kinds of income but only

for 28 pct. tax purposes. This means that it will not be fully deductible in labour income for which the income tax rate may exceed 50 pct. (including labour income part of business income, see Bulletin 2002 for an account on the "partition model" in Norway).

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11. POLAND (Wlodzimierz Nykiel and Tomasz Kardach)

CAPITAL GAINS AND PROPERTY TAXATION IN POLAND

Introduction

Before focusing on the main subject of the report it is worth mentioning the general features of tax system in Poland and the stage it represents at the moment.

In the period before 1989 the tax system in Poland differed to very large extent from the tax systems that characterize developed market economies countries.

The differences regarded among others the following elements:- basic rules connected with political and economic system- legal sources of tax law- construction and functions of the main taxes- tax procedure- role and competencies of tax administration- attitude and behaviours of taxpayers.

The most important characteristic of the tax system in the period of the so-called real socialism was the differentiation of tax situation of taxpayers taking under consideration sectors of economy in that they operated. Three groups of taxes functioning in the system could be distinguished:

- taxes imposed on entities operating in nationalized sector (state owned entities and co-operatives)

- taxes imposed on entities operating in private sector - taxes imposed on individuals.

The main source of state revenue was nationalized sector – taxes imposed on state enterprises and co-operatives. Tax revenues from the private sector were of marginal importance and the same applied to revenues from taxes imposed on individuals. The structure of tax revenues is the derivative of the general basis of political and economic system.

The completely new tax system has been built from 1989 and since than it has been in course of development. The new tax system is shaped like systems of the developed OECD countries concerning character and functions of the main taxes, tax revenue structure, development of the tax treaty network.

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The Polish tax system includes the following taxes:- corporate income tax - individual income tax- tax on goods and services (Polish VAT)- excise duty- agricultural tax- forestry tax

- inheritance and gift tax- tax on civil law acts- immovable property tax, - tax on possession of dogs, - tax on means of transport.- tax on games

Tax law is one of the youngest areas of the Polish law and apart from the fact that the tax system resembles modern tax systems of the developed OECD countries it still contains some deficiencies and errors which the following governments attempt to fix. The fixing of the mistakes so far usually takes form of an ad hoc action, which lacks a comprehensive view of the whole tax system. The system may be characterized as very dynamic.The economic effects of the current situation are negative for Poland for two major reasons (a) the foreign (and domestic) “capital” is discouraged from investing into Poland due to the unfriendly tax environment i.e. the number of investment is lower than expected and (b) due to the lack of certain domestic provisions and necessary awareness of the tax administration certain income arising in Poland escape the taxation in Poland.

The scope of tax liability of corporations and individuals

Corporate income tax

Taxpayers with their seats or management in the territory of Poland are liable to tax on the whole of their income regardless of the location of its sources i.e. world-wide taxation or the “unlimited tax liability”.

Taxpayers with no seat or management in the territory of Poland are liable to tax on income obtained (earned) only in the territory of Poland; the “limited tax liability”.

Personal income tax

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Individuals who have their place of abode in the territory of Poland or stay within the territory of Poland are subject to tax on the whole of their income regardless of the location of its sources i.e. world-wide taxation or unlimited tax liability.

Individuals who do not have their place of abode in the territory of Poland are subject to tax only on income from “work” performed in the territory of Poland on the basis of professional or a labour relationship irrespective of the place of payment of the remuneration and on other income earned in the territory of Poland (limited tax liability).

Members of foreign diplomatic missions or consulates are treated as non-residents irrespective of their domicile or length of stay in Poland.

Territory of Poland

For the purposes of both the corporate income tax and the personal income tax the territory of the Republic of Poland shall include any exclusive economic zones situated outside the territorial sea limit in which the Republic of Poland exercises, pursuant to domestic laws and international laws, rights relating to the exploration and exploitation of the sea bed and sub-soil and of the natural resources therein.

Selected issues connected with the determination of the residence status

Seat and management

As mentioned in the section above the two factors determining the residence status are the seat and the management of the company.

The term “seat” of the company has not been defined in the tax laws. The seat of the company is determined by the constitutive documents of the company. Based on separate provisions of commercial company’s code a company incorporated in the territory of Poland must have its place of seat in the territory of Poland. Accordingly, each legal entity established under the Polish commercial law by definition becomes the Polish tax resident.

The term “management” of the company has not been defined in the tax laws. It is however clear that the management of a Polish entity does not have to be exercised from the territory of Poland i.e. the management can be placed outside of Poland.

An important issue concerns the situation of non-residents having the actual place of management in the territory of Poland. The Polish law does not provide for any test to be

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passed for the purposes of determining if an entity has a place of management in the territory of Poland. The situation is less problematic if the case involves a company resident in the country, which concluded the tax treaty with Poland. The relevant provisions of the tax treaty use the term “place of effective management” which has been extensively defined in the OECD guidelines, i.e. in case of doubt the place of effective management is decisive.

Less clear is however the situation when the entity involved has been incorporated under the legislation of a country which did not conclude the tax treaty with Poland, especially if the company is based in a tax haven. The lack of proper tax residency test may result in either “too extensive” or “to narrow” interpretation of the term “management in Poland”. Since there are no clear guidelines in the domestic law the tax authorities may attempt to apply very broad interpretation of the term “management” and as a result the might try to tax “more” than they normally should. As far as the issue concerns entities based in a tax haven country one should not have generally a problem with “unfair tax competition towards a tax haven”. The problem may however equally concern entities based in non-tax haven country which has not (yet) signed a tax treaty with Poland i.e. in such case the current Polish tax legislation plus the fiscal approach of the Polish tax authorities might theoretically result in practices of unfair tax competition. It should be noted that no cases of such an approach have been observed so far.

As a result of the above factors Poland may actually be suffering from the lack of proper, more detailed definition of the term “management” in the corporate income tax law and taxpayers, which should have been treated as residents in Poland escape any (even limited) taxation in Poland.

Permanent establishment

The considerations in the section above indicate that the Polish tax law does not provide for proper rules on the taxation of permanent establishments.

The provisions of the corporate income tax and the personal income tax laws, which refer to the taxation of non-residents, provide that such taxpayers are subject to tax on income obtained in the territory of Poland. There are no provisions stating which factors should be taken into consideration to establish if a company is subject to taxation in Poland i.e. if it has a permanent establishment in Poland. In other words the domestic provisions do not provide for any rules similar to those contained in Article 5 of the OECD Model Convention.

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Similarly there are no provisions in the Polish tax law that would provide for the methods of allocation of profits between the permanent establishment and the head office like the rules contained in the Article 7 of the OECD Model Convention.

Depending on the actual approach of the tax authorities in Poland the lack of proper rules might lead to either to excessive or to narrow application of the Polish provisions of the limited tax liability. It should be noted that so far the tax authorities did not put enough attention to the taxation of permanent establishments and as a result the current situation results in rather negative fiscal effects for Poland. Although no research on this issue has been made it is probable that there is a significant number of foreign taxpayers operating in Poland through permanent establishments which have not been identified (and consequently not taxed) by the Polish tax authorities.

Tax on Civil Law Acts

Sale of shares of Polish companies (as well as the sale of other property rights executable in Poland) is subject to civil law activities tax at the rate of 1%. The amount of tax should be paid within 14 days from the date of concluding the sale agreement.Under the law on tax on civil law acts, sales of securities to brokerage houses and banks performing brokerage activities as well as sales of securities with the intermediation of brokerage houses and banks performing brokerage activities are exempt from civil law activities tax.Brokerage activity is defined under the Polish law as, among others services consisting of selling or purchasing specified securities in the broker’s own name but on the account of an ordering entity (a client). This exemption covers all transactions made on the Warsaw Stock Exchange and on over-the-counter market.

Taxation of capital gains

Subject of taxation

Taxable income is defined as the difference between revenue earned from the sale of securities and their purchase cost. Purchase costs cover expenditures incurred on the purchase of securities plus all the costs connected with the purchase (e.g. tax on civil law acts, broker’s fee).Expenditure incurred on the purchase of securities shall not immediately recognized as tax deductible at the date the cost was incurred. It may be deducted only at the moment of the subsequent disposal of these securities.

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Attention should be drawn to the existing controversies regarding the tax treatment of financial costs connected with the purchase of shares and other securities. According to the interpretation of the Ministry of Finance all the costs directly related to the purchase of securities i.e. the costs which – if not incurred – would make the effective purchase of these securities impossible, should be included in the expenses connected with a securities purchase. Therefore, if a loan was drawn for the purchase of shares or other securities, the interest being the remuneration for the loan (and not an expenditure incurred on the purchase of shares)– according to the Ministry of Finance – becomes a tax deductible cost at the moment of its actual payment or capitalisation. As far as the statement that interest on a loan drawn for the purchase of securities is not an “expenditure ” directly connected with their purchase is correct, recognition of this interest as a tax deductible cost at the moment of its payment may be questioned. It seems that in the above case, the taxpayer is still obliged to respect the principle of assigning the costs incurred to the revenues, to which they relate.Taking into account that in principle revenues earned from securities will be earned at the moment of their sale it appears that the taxpayer should be allowed to recognise interest on a loan drawn for the purchase of these securities as a tax deductible cost only then. However, interest paid on the loan after the date of securities ’sale would become a tax-deductible item at the moment of payment of this interest.

Taxation of Polish companies

Capital gains earned by companies with their seat or management board in Poland should be accumulated with their other income and taxed at the standard CIT rate (27% in 2003).

Taxation of foreign companies

Leaving aside the special waivers and exemptions referred to below mentioned companies which have neither seat nor board of management in Poland are as a rule liable to Polish CIT but only on income earned on the territory of Poland. Gains on the disposal of Polish securities are generally treated as income earned on the territory of Poland.There is no withholding tax on capital gains and no requirement for brokers to assist in tax compliance. The tax rate is the same as for Polish companies (27%in 2003).Tax treaties to that Poland is a party to contain special provisions concerning tax treatment of gains derived from alienation of property. The exception is the tax treaty with Germany in that no income of this kind has been mentioned. The large part of tax treaties concluded by Poland includes provision allowing for taxation of gains from the alienation of shares in a company whose capital consists mainly of immovable

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property in accordance to similar rules as regard alienation of immovable property i.e. in the state where the property is situated (e.g. treaties with Lithuania, Sweden, France, Australia). Treaties mentioned above provide for definition of kinds of gains to be treated in accordance to those rules. For example tax treaty with Iceland provides that gains from the alienation of:(a) shares of the capital stock of a company the property of which consists principally of

immovable property situated in a Contracting State, and(b) an interest in a partnership, trust or estate, the property of which consists principally of

immovable property situated in a Contracting State, may be taxed in that State. The term "immovable property" includes the shares of a company or an interest in a partnership, trust or estate.

Tax waivers and exemptions relevant to foreign corporate investors

Till the end of 1995 the CIT Law contained provisions exempting certain income from taxation such as income earned on the sale of shares acquired on the Warsaw Stock Exchange and on the sale of treasury bonds. This exemption expired on 31 December 1995.However starting from the moment of expiration of the above exemption till now the Ministry of Finance issued a number of regulations based on which some types of income earned by foreign investors are not subject to tax in Poland. Based on the special regulations issued by the Ministry of Finance on 18 February 2000 the assessment and collection of CIT on gains earned by non-resident companies from the sale of shares in joint stock companies acquired on the Warsaw Stock Exchange is waived for an unlimited period. The waiver is conditional upon the existence of analogous provisions for such type of gains in the case of Polish companies investing in the country where the given foreign company has its seat.By regulation of 7 March 2002 the Ministry of Finance granted waivers from assessment and collection of CIT in respect of interest and gains earned by foreign companies on the disposal of certain Treasury bonds issued on foreign markets.

Taxation of Polish individuals

In the case of individuals profits on the sale of securities are in general included in the tax base. Profit from the sale of securities may be reduced by the purchase cost, which is defined as the price of acquisition, plus all costs directly related to the purchase of securities and other fees.Exemptions relevant to individual investors

According to the provisions of the PIT Law certain kinds of income are tax exempt. The exemptions that have been prolonged several times are as follows:

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Income earned on a remunerative disposal of securities (including shares and investment certificates issued by investment funds) that are publicly traded if these securities were acquired on the Warsaw Stock Exchange in a public offer or in a regulated over-the-counter secondary public trading (this exemption expires on 31 December 2003),

Income derived on a remunerative disposal of Treasury bonds issued after 1 January 1989 if these were acquired by the taxpayer before 1 January 2003 (exemption expires on 31 December 2003),

Income earned on the sale and realisation of certain types of derivatives (this exemption expires on 31 December 2003),

Income from the participation in investment funds if such income is paid out to the taxpayer on the basis of agreements concluded or subscription made before 1 December 2001,

Income earned until 28 February 2002 from the participation in investment or trust funds including income from the redemption of trust fund participation units and the disposal of investment certificates and participation units as well as the revenue from the redemption of participation units or investment certificates in the case of a liquidation of an investment fund.

In some of the above mentioned situations additional conditions need to be met e.g. the sale of securities cannot form a part of the business activity of the individual. Taxation of income from the participation in funds operating on the basis of the Insurance Law

Income earned by individuals from the participation in capital funds operating on the basis of the Insurance Law is subject to 20% withholding tax. The tax is collected by the insurer at the moment of paying the income out. Thus purely “putting the income at the disposal ” of the taxpayer ’s does not give rise to the obligation to collect the tax. The amount of tax withheld is final. Income from participation in funds is not included in the general tax base of personal income tax.Taxation of income from the participation in investment funds

The Law on the amendments to the Personal Income Tax Law dated 21 November 2001 eliminated the general tax exemption on income earned from the participation in investment funds. As from 1 March 2002 such income is subject to 20%withholding tax. The tax is collected by the investment funds without any reduction for tax deductible costs. The amount of tax withheld is final. Income from participation in investment funds is not included in the general tax base of personal income tax.

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Taxation of foreign individuals

Generally all the rules regarding taxation of Polish individuals also apply to foreign individuals. Gains earned by foreign investors on the disposal of Treasury bonds, which were issued on foreign markets, are also waived from taxation in Poland as provided for in the decree of the Ministry of Finance of 7 March 2002.

Taxation of interest income

Taxation of corporate entities

Interest income is taxable in Poland on a “cash ” basis. Generally the tax liability arises as interest is received. Similarly interest paid is treated as a deductible cost for tax purposes when paid.According to the present wording of the CIT Law income from interest on Polish Treasury bonds and Treasury bills is taxed with CIT. In the case of foreign investors the tax rate is subject to treaty relief.Appendix 1 includes Polish withholding tax rates on interest income applicable on basis of tax treaties concluded by Poland. Treaty regulations usually set this rate between 0 and 10%.

Taxation of individuals

Until 28 February 2002 individuals (both Polish and foreign) were generally exempt from tax arising on interest from securities issued by the State Treasury, bonds issued by local governments and on bank savings unless such income was directly connected with the business activities of the individual. From the 1st of February 2002 the 20% withholding tax is generally levied on items of income of this type.The tax exemptions that apply also after 28 February 2002 relate to the following types of income:

Interest and discount earned on government securities and municipal bonds purchased by the taxpayer before 1 December 2001,

Interest and other revenues from cash funds collected on the bank account of the taxpayer ’s or in other forms of saving, accumulating or investing if these are paid out or put at the taxpayer ’s disposal on the basis of defined period agreements concluded with an authorised entity before 1 December 2001 (with the exception for funds collected in connection with the business activities of an individual).

The above exemptions are however subject to specific conditions.The tax exemptions do not apply if:

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The agreement was amended, renewed or extended after 1 December 2001, The agreement was terminated before the end of the period for that it was concluded

(the cause for the termination is irrelevant) or, The agreement provides for the possibility of withdrawing all or part of the capital,

including the amounts relating to capitalised interest and the taxpayer takes advantage of this option.

In case of the loss of the right to the tax exemption the entity authorised to maintain the account collects tax on the date of terminating the agreement or paying out all or part of the savings.

Calculation and collection of tax, reporting requirements

Financial institutions paying out interest are required as the tax remitters to calculate, collect and remit the amounts of tax withheld to the appropriate tax office by the 7th day of the month following the month of paying /putting at the taxpayer ’s disposal of the interest. The appropriate tax office is the tax office responsible for dealing with the given taxpayer. In the case of foreigners it is possible to reduce the rate of withholding tax. This arises in connection with the provisions included in tax treaties concluded by Poland. The application of the reduced tax rate is conditional upon the tax remitter produces an appropriate certificate of tax residence of the taxpayer ’s (a document issued by the relevant foreign tax authorities stating that the given individual is resident in that country for tax purposes).

Taxation of derivative instruments

Starting from 2001 the Polish CIT and PIT Laws provide for direct rules regarding taxation of derivative instruments.The provisions of the CIT and PIT Laws define derivative instruments as property rights, the price of which depends directly or indirectly either on the price of goods, foreign currencies, gold and platinum of foreign exchange standards, securities, level of interest rates or index particularly options and futures.Expenditure connected with the acquisition of derivatives should not be recognised as a tax deductible cost at the date when actually incurred. Such expenditure should be recognized for tax purposes not earlier than at the moment of realisation of the rights from these instruments, resigning from the performing of these rights or on the disposal of such instruments provided that they do not increase the initial value of underlying fixed or intangible assets. The most important problem regarding tax treatment of derivative instruments seems to be issue of qualification of derivative instruments for tax purposes.

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Procedure for payment of tax on realised capital gains

Procedure for subjects to CIT

Polish tax law does not provide for any separate procedure of payment of CIT on capital gains earned by legal entities. Corporations are obliged to present in their monthly tax returns the amount of income or loss realised on capital operations.Polish legal entities are obliged to submit monthly tax returns and pay tax advance payments up to the 20th day of the month following the month to that the tax settlement relates indicating cumulatively income (loss) earned during the tax year and the amount of the tax advance payments made.The advance payment for the last month of the tax year should be made up to the 20th day of that month at the same amount as the advance payment for the preceding month of the tax year.After the end of the tax year, companies are obliged to submit the annual tax returns to the tax office, providing the information on the amount of income (loss) earned in the given tax year and settle the amount of tax due if any at the amount of the difference between the tax due and the tax advance payments made during the year.The annual tax return should be submitted by the end of the third month following the end of the tax year. According to the new rules that entered into force on 1 January 2003 the taxpayers may chose to pay advance payments of tax at the amount of 1/12 of tax paid in the preceding tax year. If the taxpayer did not indicate a tax due in tax return produced for the preceding tax year he may pay monthly advances amounting to 1/12 of tax indicated in the tax return produced for the next preceding tax year. The taxpayer if opting for simplified payments of advances is not obliged to produce monthly tax returns regarding advance payments of corporate income tax. Polish tax regulations do not provide for separate rules regarding payment of tax on income earned by foreign legal entities on the disposal of securities.

Procedure for individuals

Individuals who receive income from a sale of shares in companies or from a sale of other securities are obliged to submit PIT returns and pay tax advances until the 20th day following the month in which income was earned. The settlement for December is made at the date of submitting the annual tax declaration without the necessity of filing a separate tax return.The above-mentioned procedure also refers to foreign individuals.

Contribution in-kind of securities in exchange for shares of corporations

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The tax consequences of a contribution in-kind of securities in exchange for shares in capital companies were a very controversial issue until end of year 2000. According to the tax law provisions expenditure incurred in connection with purchase of or subscription to securities constitutes a tax-deductible cost only at the moment of a subsequent disposal of these shares.With respect to the above regulations the controversy arose whether a contribution in-kind of shares to company in exchange for this company ’s shares should be treated as a disposal of the shares being contributed. Should this be the case the moment of making a contribution in-kind would be a taxable event for the contributor (i.e. taxable income would arise).“Disposal ” of shares comes about when a transfer of ownership of shares takes place. When a contribution in-kind is made in exchange for the shares of the company receiving the contribution undoubtedly a transfer of ownership takes place. Taking into consideration the above doubts, on 28 August 2000 the Ministry of Finance issued an official interpretation according to that in the case of obtaining or acquiring shares in companies in exchange for a contribution in-kind no taxable income arises for the entity making the contribution (this includes both legal entities and individuals) at the moment of the contribution. The moment of taxation is postponed until the moment of a subsequent disposal of the shares taken over in exchange for a contribution in-kind in the form of shares. Therefore based on the above interpretation of the Ministry of Finance at the moment of making a contribution in-kind in exchange for shares of the company receiving the contribution the entity that made the contribution, was not subject to tax. It was at the moment that a further disposal of these shares was made that a taxable event arose.

According to the tax regulations that entered into force on the 1st of January 2001 the entity making a contribution in-kind to a company is obliged to report taxable income at the moment when the contribution is made (the exception to this rule relates to contributions in-kind of an enterprise or a part thereof). The method of calculating of such taxable income is now regulated.According to art.12 sec.1 point 7 of the CIT Law taxable revenues include in particular the nominal value of shares in the company or the share in a co-operative taken up in exchange for a contribution in-kind in another form than that of an enterprise or an organised part thereof. Based on art.15 sec.1 j) of the CIT Law in case of obtaining shares in a company (or a share in a co-operative) in exchange for a contribution in-kind in the form of other shares (or a share in a co-operative) the date of obtaining the shares gives rise to tax deductible costs for the entity making the contribution.

These costs are as follows: nominal value of shares forming the contribution in-kind if these shares were taken up

in exchange for a contribution in-kind in a form other than an enterprise or a part thereof,

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total expenditure incurred on obtaining or acquiring shares forming the contribution in-kind if these shares were taken up in any other form than a contribution in-kind,

value of an enterprise or an organised part thereof as indicated in the books of the enterprise at the date of taking up shares however, the value of the enterprise or its organised part cannot exceed the nominal value of these shares at the date of their taking up –in the case where these shares were taken up in exchange for a contribution in-kind of an enterprise or an organised part thereof.

As a result at the moment of making a contribution in-kind taxable income (tax loss) arises for the entity making this contribution (individual or a legal entity) at the amount of the difference between the nominal value of the shares received and the value of tax deductible items established in accordance with the rules described above.According to art.15 sec.1k) of the CIT Law on the day of a remunerative disposal of shares in a company (or a share in a co-operative) obtained in exchange for a contribution in-kind the tax deductible costs for the seller should be established in the following values:

nominal value of obtained shares (or a share in a co-operative) at the date of their taking up if these shares were taken up in exchange for a contribution in-kind in form other than an enterprise or an organised part thereof,

value of an enterprise or an organised part thereof as indicated in the books of the enterprise at the date of taking up shares (or a share in a co-operative), however not exceeding the nominal value of these shares at the date of their taking up.

Income from dividends

Taxation of dividends received from a Polish company

Dividends received from Polish companies are subject to 15% withholding tax collected by the payer. At the recipients ’level dividends are not aggregated with other sources of income and are not subject to further taxation. The tax withheld from a dividend payment made to another Polish company may be credited against the recipient ’s CIT liability arising on other income and thus in most cases the withholding tax is not a real burden to the recipient.Individual taxpayers are not allowed to make such deductions. For them the 15%withholding tax on domestic dividends is a final tax and dividends are not aggregated with other income.An applicable tax treaty may reduce the 15% withholding tax rate if paid to non-residents. Most of the treaties set the rate of the withholding tax at the level of 5-15% (see Appendix 1).

Taxation of dividends received from a foreign company

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Income received by Polish legal entities and individuals from dividends paid out by foreign companies is subject to taxation according to the general rules. This income should be aggregated with other income earned by the Polish company or by the individual and taxed at the rate of 27% (in 2003) in case of the legal entities and according to the progressive tax rates with respect to the individuals i.e. effectively up to 40%.If the state where the company paying the dividend is tax resident has charged withholding tax on dividend payment made to Poland, Polish entity have the right to obtain tax credit against tax liability on its total income. The amount of reduction should however not exceed this part of tax calculated before the deduction which proportionally corresponds to the income earned in the foreign state.Since the 1st January 2001 CIT law grants credit for underlying tax, subject to certain requirements. If a Polish parent company has at least 75 per cent of the voting rights in the subsidiary resident in a country with that Poland concluded a tax treaty, the parent may credit not only the foreign withholding tax paid on dividends but also the amount of the underlying foreign corporate income tax paid by that subsidiary on the income out of that the dividends have been paid. The credit may not however be higher than the amount of tax calculated before the deduction that would in proportion concern income from the given source.

Advance payments towards dividends

The regulations of the Polish Commercial Companies Code that entered into force as of 1 January 2001 introduced provisions allowing for making advance payments towards the forecasted dividends. Advance payments towards dividends should not exceed half of the profit earned since the end of the last accounting year reported in the financial statements increased by undistributed profits from the preceding years and reduced by the losses shown in preceding years and by mandatory reserve capitals created under the law or the articles of association /statute.The regulations of the Polish Commercial Companies Code do not provide the rules for the final settlement of the advance. It should be settled at the moment of making the final payment – in relation to which the prior advances were made – i.e. the payment of the actual dividend itself.In practice several situations may arise depending on the final result of the company for the given year i.e.:

the company indicates profit for distribution in an amount higher than the amount of the advance for dividends and the shareholders ’meeting passed a decision whereby the dividends are established in the amount higher or equal to the amount of the advance for dividends – the company should make the final payment to the shareholder at the amount of the potential excess of dividends over their earlier advances,

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the company reports:– loss,– profit for distribution in an amount higher than the amount of the advance for

dividends but the shareholders ’meeting passed a decision about the profit distribution in such a manner that the amount of the dividends to be paid out is lower than the amount of their advances,

– profit for distribution in an amount higher than the amount of the advance for dividends but the shareholders ’meeting passed a decision about retaining the profit within the company and as the result the company does not make any payments to the shareholder.

Some commentators are of the position that in the above situation the company may not claim a refund of the advance payments for dividends previously paid out to the shareholders (in the amount of the advance ’s excess over the final dividends) unless the company ’s statute /articles of association provides otherwise or the payment of the advance for dividends was made in conflict with the law.The basic problem to be solved is whether the payment of the advance for dividend is definite or the company may in certain situations claim the refund for example the company reports a loss should it claim a refund of the advance for dividends in the part over the established final dividend amount.The tax provisions (both CIT and PIT Laws) do not contain any provisions that would – even in an indirect way – indicate the tax treatment of advance payments towards dividends. Therefore it would appear that the basis for defining the tax consequences of the above should be the provisions of the CIT and PIT Laws according to which income from participation in profits of other entities relates to income actually received. Based on the general tax rules there are arguments to apply at least two interpretations in the scope of the tax treatment of dividend advances:

advances for dividends are not subject to tax, advances for dividends are subject to taxation on the basis of the rules for the taxation

of dividends and other income from the share in a company ’s profits.The tax authorities are of the position that the advance for dividends is subject to the same tax treatment as dividends and other income from the participation in a company ’s profits.However when determining whether received advance payment towards dividends should be taxed it should be established whether on the day of paying the advance the shareholder (individual or a corporate) actually received income. It seems that the answer to this question should be negative. If we assume that the advance payment towards dividend is repayable the receipt of actual income is conditional upon the level of the company ’s profits achieved in the entire accounting year. The actual profits and income from dividends are not known at the date of making the dividend advance payments. Consequently regardless of whether the advance for dividends was returned to the company as a result of computing the final position

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for the given accounting year or whether the payment was treated as an advance for the final dividends which were actually paid out at the end of the year, there are grounds to claim that at the date of making the advance payment the tax liability did not arise.

Certificate of residence

According to the provisions of the PIT and CIT Laws Polish entities who make payments such as interest, dividend and other income connected with participation in profits of other legal entities are obliged as tax remitters to collect withholding tax on the date of making such payments in accordance with the standard withholding tax rate.To apply the tax treaty rate for withholding taxes a taxpayer is obliged to present a certificate of residence issued by the tax authorities of the relevant country. This requirement is provided for by the provisions that entered into force on the 1st of January 2001. Before that date the reduced treaty rates were applied directly.

Foreign resident from whom the Polish tax remitter withheld tax at the standard withholding tax rate – i.e. according to the tax rates provided for in Polish income tax laws – because the certificate of residence was not submitted may apply for refund of the tax constituting the difference between the standard tax calculated and the tax established on application of the tax rate provided in the relevant tax treaty concluded with the state of residence of the taxpayer.

Debt versus equity financing - thin capitalisation rules

‘Thin capitalisation’ takes place if a company in its activity uses mainly loan or credit capital restricting its equity to a necessary minimum. In other words a company is said to be “thin capitalised” when its equity capital is small in comparison to its debt capital.

From the tax law point of view the difference is significant. Interests paid by a company with regard to loans (credits) are usually treated as costs of earning revenue on the other hand a dividend paid by a company may never be a cost from the tax law point of view.

Loans and credits that come under restrictions

Article 16 item 1 point 60 covers interests from loans and credits granted to company by its shareholders and article 16 item 1 point 61 covers interests from loans and credits granted by one company to another where in the both companies the same shareholder holds no less than 25 percent capital (shares).

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The thin capitalisation rules do no apply to interest on loans granted by resident companies provided that these companies do not benefit from income tax incentives or exemptions.Assessment of allowed level of debt-to-equity ratio

Interest due on loans (credits) made to a company by a shareholder whose equity stake (shares) in the company represent no less than 25 percent of the company's capital (shares) or by those shareholders whose cumulative holdings in the company represent no less than 25 percent of the company's capital (shares), where the company's aggregate debt to the said shareholders accounting cumulatively for 25 percent or more of the capital (shares) and to those other entities which own no less than 25 percent stakes in the capital of the said shareholder should exceed an amount equal to three times the capital (share capital) of the company.

The debt-to-equity ratio is established at the level of threefold amount of the share capital of the company. In other words debt-to-equity ratio amounts to 3:1. The attention should be paid to the procedure of assessment of the said ratio. The legislator envisaged that also loans and credits granted by the indirect shareholders should be included into the amount established for the debt-to-equity ratio assessment. Debt to the following entities is considered when assessment of the ratio is made:1. direct shareholders whose holdings amount to at least 25 % of shares (voting rights)2. indirect shareholders whose holdings in companies granting loan or credit amount to at

least 25 % of shares.

While establishing the aggregate level of debt the provisions of the corporate income tax statute envisage cumulative treatment of debt to “significant” shareholders of the company, that is ones whose holding amounts at least to 25 % of voting rights as well as cumulative treatment of debt to “significant” shareholders of the direct shareholders.Assessment of the share capital of a company Not all elements of the share capital should be taken under consideration while assessing the debt-to-equity ratio. The share capital is understood in accordance with relevant provisions of the code of commercial companies but for the purposes of assessing of the ratio the corporate income tax statute envisages a few modifications. The value of the co-operative members' fund or of the company's capital (share capital) shall be determined to the exclusion of:- that proportion of the said fund or capital which has not been effectively contributed or

paid up or

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- parts of capital which has been contributed in the form of receivables held by co-operative members or company shareholders against, respectively, the co-operative or the company for reasons of loans (credits) made to the co-operative or company and interest thereon, or

- parts of capital in the form of those intangible and legal assets on which no depreciation write-offs included into costs of earning revenue may be made.

The legislator aimed at introducing provisions that would encourage companies to finance their activity by equity and restrict financing with use of debt capital.

The ratio should be established as for the day of payment of interest.

Investment funds

Regulations contained in the Investment Funds Law dated 28 August 1997 were subject to significant changes.The amended Investment Funds Law provisions that became effective on 21 March 2001 contain much more detailed regulations regarding such institutions.Investment funds fall into the following categories:

open-end investment funds, specialised open-end investment funds, closed-end investment funds, specialised closed-end investment funds, mixed investment funds.

The funds operating on basis of the Investment Funds Law are exempt from taxation according to the provision of article 6 clause 1 point 10 of the CIT Law. As the result income/ profit of the investment fund derived from renting-out immovable property, sale of immovable property, sale of securities or derivative instruments is exempt from corporate income tax. Tax liability arises on the level of subjects participating in the funds (ones who obtained participation certificates of the fund with the right to participate in profits of the fund). Participation in the profits of the investment fund may take place in two ways. First the participant may obtain payments directly from the fund or secondly may sell the certificate of participation to the fund. If the later is the case the amount surplus over the amount previously paid in by the participant of the fund should be treated as his taxable income.

Property taxation

Immovable Property Tax

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Immovable property tax is imposed on basis of Law on local taxes and charges of 12 January 1991. Revenue from this tax goes to communes.Taxpayers and Taxable Object

Taxpayers of the immovable property tax are individuals, legal entities as well as entities not possessing legal personality having right of use of the property or part of it as envisaged in the Law of 12 January 1991 (e.g. owners, dependent possessors, perpetual usufructuaries or possessors of the real estate).

The tax is levied on:- buildings and parts thereof not used in connection with agriculture,- fixed installations connected with economic activity,- land not used in connection with agriculture.

Certain types of buildings and land are exempt e.g.:- buildings and land which are historic monuments,- buildings or parts thereof used by schools, hospitals, cultural, charitable and other

public institutions and associations,- land used for railway, airport and harbour installations,- land used for public roads, pipelines and water power stations,- state and communal forests,- buildings and land owned by religious groups and their institutions.

Taxable base

The tax base for all land and buildings is the surface area. The taxable base for fixed installations is the value used for depreciation purposes.

Tax rates

The tax rates are fixed exclusively by the Council of Commune and may not exceed the amounts provided for in the Law.Main features of immovable property tax

Immovable property tax is connected with elements of property of the taxpayer by its object and taxable base. It means that liability to tax arises irrespective of whether the property is effectively used, is a source of revenue or income etc. Immovable property tax as also in the other OECD countries is source of revenue for budgets of communes. It is necessary to mention that the construction of the tax is not in line with the

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constructions of immovable property tax in the other European countries where the taxable base is usually connected with value of property established on basis of cadastral registration. The reform of immovable property taxation provides for introduction of taxation based on value of immovable property. The reform started from designing a proper official immovable property record (cadastral registration) to be kept by tax authorities.

Agricultural Tax

The agricultural tax was introduced by the Law on Agricultural Tax dated 15 November 1984. The agricultural tax applies to land used for crop growing. The income derived from specialized branches of agriculture is subject to personal income tax or to corporate income tax, depending on the taxpayer's status. The following activities shall be the special branches of agriculture: the growing of plants in glasshouses and heated plastic tunnels; the growing of mushroom and mushroom-spawn; in vitro plant growing; commercial farming of table and laying poultry; the running of poultry hatcheries; the breeding and rearing of fur-bearing animals and laboratory animals; earth-worms and silk-warms farming; the running of apiaries; and the breeding of other animals outside the farm.Agricultural co-operatives and state farms are subject only to the agricultural tax.Agricultural tax is source of revenue of communes’ budgets.

Taxpayers

Taxpayers of the agricultural tax are individuals, legal entities as well as entities not possessing legal personality having a legal right to property classified as agricultural land or buildings.The agricultural tax is levied on agricultural co-operatives, state farms, legal entities and individual farmers producing agricultural goods (income from specialized branches of agriculture is subject to personal or corporate income tax).

Taxable base

The tax base is the "conventional hectare". Conventional hectares are the actual number of hectares multiplied by a coefficient relating to the fertility of the land (there are ten different classes), the location of the farm and the type of agriculture practised or crop grown (e.g. meadow, open land, etc.).

One hectare of very good land, for example, is equal to 1.95 conventional hectares, while a hectare of meadowland is equal to 0.05 conventional hectares.

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Tax rates

For land measured in conventional hectares the rate of tax is the value of 250 kg of rye for 1 ha. and other lands the value of 500 kg of rye for 1 ha.

Forestry Tax

The forest tax was introduced by the Law on Forests of 28 September 1991 from the 1st of January 2003 the new law was introduced –Law of 30 October 2002 on Forestry tax.

Taxpayers of the forestry tax are individuals, legal entities as well as entities not possessing legal personality having a legal right to property classified as forest.

This tax applies to all owners of forests (individuals, legal entities and other entities without legal personality) and to occupiers of state- or communally owned forests.

The applicable exemptions are as follows:- forests which are at least 40 years old and- forests, which are, treated as historical monuments.

The taxable base is the hectare of forest. The rate of the tax is established as the average price of 0.220 cubic metres of the timber.

Main Features of Agricultural and Forestry Taxes

Construction of both taxes includes features of revenue-based taxation as well as property taxation. Tax liability in both taxes is connected with acquiring legal rights to land or forest and is not connected with use of it resulting in revenue or income. This feature indicates the property character of both taxes.

Inheritance and gift tax

The inheritance and gift tax is regulated by the Law on inheritance and gift tax of 28 July 1983 and by implementing decree of the Minister of Finance of 29 February 2000.

Taxable persons

Individuals who inherit property or receive gifts are subject to the tax on the portion they receive. Taxpayers are classified into three classes (by virtue of their relationship with the

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deceased or donor) and the applicability of tax exemptions and level of rates depend on this classification.

Taxable base

The tax is levied on the net value of property and money (excluding debts) acquired through inheritance or gift. Taxable property received from the same person over a 5-year period is treated as a single acquisition, and the value of all property received is aggregated.

Tax rates

The rates of tax are progressive and depend on the class of the recipient:

Class Rate (%)I. 3 - 7II. 7 - 12III. 12 - 20

The highest rates (7%, 12%, 20%, respectively) are applied to values in excess of PLN 19,320. Usucaption is taxed separately at a flat rate of 7%.

Payment of tax

The recipient of the gift or inheritance is liable for the tax. However, if a notary is involved in settling the gift or inheritance, the notary is obliged to withhold the tax due and pay it to the Tax Office.

Main features of inheritance and gift tax

The inheritance and gift tax is property tax imposed on property acquired free of charge. The most important element determining shape of the inheritance and gift tax is relation between the taxpayer and the donor or the taxpayer and the person after whom the inheritance is acquired.

Taxation of income from sale of immovable property - Personal Income Tax

Income from the sale of immovable property and property rights shall not be consolidated with income from other sources in one taxable base.

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Income tax on the income from sale of immovable property shall be assessed as a lump sum of 10% of the revenue acquired. The lump – sum concerns the amount actually received.The said tax shall be payable onto the bank account of the relevant tax office within 14 days from the date of transaction unless the taxpayer within the said period produces a statement to the effect that he or she will spend the revenue earned from the sale on a house to fulfil the taxpayer’s housing needs provided other criteria have been met.

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Appendix 1 Tax treaty chart: withholding taxes

Treaty chart: withholding taxes

The following chart contains the withholding tax rates that are applicable to payments made by Polish companies to non-residents under the ratified tax treaties. The lower of the domestic and treaty rate is given.

Country Dividends Interest(2) RoyaltiesIndividuals, Qualifyingcompanies companies(1) (%) (%) (%) (%)

____________________________________________________________________

Albania 10 5 10 5Armenia 10 10 5 10Australia 15 15 10 10Austria 10 10 0 0Bangladesh 15 10(3) 10 10Belarus 15 10(4) 0 0Belgium 10 10 10 10Bulgaria 10 10 10 5Canada 15 15 15 0/10(5)Chile 15 5(6) 15 5/15(7)China (People's Rep.) 10 10 10 7/10(7)Croatia 15 5 10 10Cyprus 10 10 10 5Czech Rep. 10 5(8) 10 5Denmark 15 5 0 10Egypt 12 12 12 12Estonia 15 5 10 10

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Country Dividends Interest(2) RoyaltiesIndividuals, Qualifyingcompanies companies(1) (%) (%) (%) (%)

____________________________________________________________________Finland 15 5 0 10France 15 5(9) 0 0/10(1)Germany 15 5 0 0Greece 15 15 10 10Hungary 10 10 10 10Iceland 15 5 0 10India 15 15 15 20Indonesia 15 10(8) 10 15Ireland 15 0 10 0/10(1)Israel 10 5(12) 5 5/10(7)Italy 10 10 10 10Japan 10 10 10 0/10(1)Jordan 10 10 10 10Kazakhstan 15 10(8) 10 10Korea (Rep.) 10 5(9) 10 10Kuwait 5 0(13) 0/5 15Latvia 15 5 10 10Lebanon 5 5 5 5Lithuania 15 5 10 10Luxembourg 15 5 10 10Macedonia 15 5 10 10Malaysia 0 0 15 15/20(14)Malta 15 5(8) 10 10Mexico 15 5 10/15(15) 10Moldova 15 5 10 10Morocco 15 7 10 10

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Country Dividends Interest(2) RoyaltiesIndividuals, Qualifyingcompanies companies(1) (%) (%) (%) (%)

____________________________________________________________________Netherlands 15 0 0 0/10(1)Norway 15 5 0 0/10(1)Pakistan 15 15(16) 20 15/20(17)Philippines 15 10 10 15Portugal 15 10(18) 10 10Romania 15 5 10 10Russia 10 10 10 10Singapore 10 10 10 10Slovak Rep. 10 5(8) 10 5Slovenia 15 5 10 10South Africa 15 5 10 10Spain 15 5 0 0/10(1)Sri Lanka 15 15 0 0/10(1)Sweden 15 5 0 10Switzerland 15 5 10 10Thailand 15(19) 15(19) 10 5/15(5)Tunisia 10 5 12 12Turkey 15 10 10 10Ukraine 15 5 10 10United Arab Emirates 5 5 5 5United Kingdom 15 5(3) 0 10United States 15 5(9) 0 10

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Country Dividends Interest(2) Royalties

Individuals, Qualifyingcompanies companies(1) (%) (%) (%) (%)

____________________________________________________________________Uruguay 15 15 15

10/15

Uzbekistan 15 5(8) 10 10Vietnam 15 10 10

10/15(20)

Yugo- slavia 15 5 10 10Zambia 15 10 10 10Zimbabwe 15 10 10 10

1. Intercompany dividends: usually a minimum holding of 25% is required.2. Most treaties provide for an exemption for certain types of interest, e.g. interest

paid to the state, local authorities, the central bank, export credit institutions or in relation to sales on credit.

3. Minimum holding of 10% of the voting power is required.4. Minimum holding of 30% is required.5. The lower rate applies to copyright royalties, excluding films.6. Minimum holding of 20% of the voting power is required.7. The lower rate applies to royalties paid for the use of, or for the right to use,

industrial, commercial or scientific equipment.8. Minimum holding of 20% is required.9. Minimum holding of 10% is required.

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10. The lower rate applies to copyright royalties, including films.11. The lower rate applies to fees for technical services.12. Minimum holding of 15% holding is required.13. Beneficial owner is the government of the other state, or a company in which at

least 25% of the capital is owned by the government.14. Domestic rate applies to film royalties.15. The lower rate applies if a beneficial owner is a bank or an insurance company, or

if the interest is derived from certain bonds or securities.16. A holding of one third of the capital is required.17. The lower rate applies to royalties for technical know-how or information

concerning industrial, commercial or scientific experience.18. Minimum holding of 25% is required for an uninterrupted period of 2 years prior

to the payment of the dividend.19. Domestic rate. The treaty rate is higher.20. The lower rate applies to royalties paid for a patent, design or model, plan, secret

formula or process or for information concerning industrial or scientific experience.

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12. PORTUGAL (Francisco de Sousa da Câmara)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

At the end of the 1980s, Portugal followed the OECD trend of moving away from schedular taxation towards global taxation. On January 1, 1989 both the individual and the corporate income tax codes [Código do Imposto sobre o Rendimento de Pessoas Singulares (“CIRS”)] e Código do Imposto sobre o Rendimento de Pessoas Colectivas (“CIRC”)] were introduced and the several schedular taxes were revoked.Although this was an enormous change, the individual income tax was still separated into several categories of income (initially 8 and now 6 categories of income), as follows: (A) employment income; (B) business income, including self-employment income; (E) investment income, ie, capital income; (F) income from immovable property; (G) capital gains; and (H) pensions.As a rule, specific deductions are granted for computing the net result of each category. The tax is levied on the aggregated base of the income categories, less personal deductions.There is no wealth tax (net worth tax) in Portugal despite the recurrent discussions about the introduction of such a tax. It is possible that a net worth tax is introduced in the near future, at least to cover immovable property. For the time being, the Portuguese system includes a recurrent tax on immovable property, known as “Contribuição Autárquica” but the latter is not a net worth tax.

2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

As a rule capital investment income obtained by individuals is subject to WHT, which is either final or creditable against the recipient’s final tax liability. This fact, connected with a final WHT tax rate for specific capital gains, led some authors to discuss the constitutionality of our individual income tax in 1989 (when the IRS Code became effective) arguing that the “schedules” have been retained.

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Some taxpayers were discriminated against or in favour of depending on the perspective. As a rule, capital income and capital gains were the two categories of income where more situations where excluded from the aggregated base.Dividends were (but they are not any more) subject to a final WHT, up till 2002. Now, only interest from deposits, shareholder loans (if the agreed interest rate does not exceed the prevailing LISBOR rate for 12-month term loans) bonds or other securities is subject to a final 20% rate. The recipient may, however, include the interest in his taxable income, in which case tax withheld is credited against his final tax liability and any excess is refunded. In several situations, a 15% tax rate is applied on capital income as an advance levy.The prizes from raffles, totoloto and lotto are also taxed with a final WHT rate of 35%.

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

As a rule, capital income received by corporate bodies is included in the general tax income and subject to the general tax rate of 30% (for companies) or 20% (for non-profit entities such as Associations). The partial imputation system was abolished at the end of 2001. From January 1, 2002 that system was replaced by a partial exemption system under which resident individuals must include 50% of the gross domestic dividends (foreign dividends are fully taxable, even if derived from EC companies) received in their taxable income for progressive income tax proposes. This contravenes EC Law. At the corporate tax level one observe the same rule, if the provisions that implemented the Parent Subsidiary Directive do not apply (i.e. the partial exemption method is not applicable to foreign participations).

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

Investment or capital income and capital gains are two different categories of income within the individual income tax code and the tax base of each of them is different. However, at the corporate/individual levels there are several examples of situations where a specific capital income (e.g. dividend/interest, etc) has

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already been taxed at the company’s level and an economic double taxation would occur at the shareholders’ level. The existence of a chain of companies may also attract these problems in case profits already taxed at the company’s level and not distributed are taken into consideration when the shareholder sells his participation and obtains a capital gain. Inheritance and gift tax (ISDA). There are also some exemptions in particular situations.

5. Which are the indirect taxes on capital?

As a rule, indirect taxes identified as VAT and other consumption taxes are not levied on income from capital. Two other taxes apply to capital although it is arguable whether they can be considered as indirect taxes or not. In fact, specific operations related with capital or types of capital income are subject to stamp duties. Interest from bonds may also be subject to the 5% substitute inheritance and gift tax. Exemptions also apply in this area.

6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

Immovable property is taxed by the following taxes:a) Local tax on real estate (“Contribuição Autárquica”)The local tax on real estate (“Contribuição Autárquica”) is a municipal tax levied on the net worth of property situated within the territory of each municipality; such property is divided into rural and urban categories.The taxable person is the owner, the usufructuary or the party having the use or the fruition of the property on the 31st December of the year to which the tax relates.In accordance with the “Contribuição Autárquica” Code (which appeared in 1989) the taxable amount of the property should be represented by its net asset value as determined under the terms of the Evaluation Code. However, the latter Code was never implemented.Therefore, the taxable amount of each property is determined by a provisional rule which stresses that the value is the one resulting from the capitalization of taxable income (updated by reference to 31st December 1988); by applying the factor 15 in respect of urban property and factor 20 in respect of rural property.

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This also means that until the Evaluation Code comes into force or the current rules are amended, real estate will continue to be evaluated in the accordance with the rules of the Property Tax Code (except as regards building land – the value of this property is determined in accordance with the Code of Municipal Transfer Tax and Gift and Inheritance Tax) which was revoked when the “Contribuição Autárquica” entered into force on January 1, 1989.The “Contribuição Autárquica” tax rate are follows:

- Rural property: 0,8%;- Urban property: 0.7% up to 1.3%. It is the incumbent upon the competent

municipality to define each year the applicable rate.b) Municipal Transfer Tax (“SISA”)“Sisa” is levied on the transfer for consideration of ownership rights or of partial ownership on real estate. The fiscal concept of “transfer” for the purposes of this tax is coincident, in principle, with that of private law, unless otherwise provided for by law, namely with the purpose of preventing tax avoidance.The taxable person is the person who acquires the property. The transfer tax is levied on the value for which the property in question is transferred. Such value shall be determined in accordance with the following rules:

(i) There shall be taken into consideration the conventional value, unless the value of the real estate as shown in the register at the date of transfer is higher;

(ii) Whenever a valuation is carried out, the value resulting thereof should be taken into account and shall prevail unless its price is higher.

The general rate is 10% on the transfer of urban property or building land and 8% in all the other cases. Urban properties with a value identical or lower then EURO 169.376 may benefit from a sliding scale of rates that determine a tax liability lower then 10%.

c) Stamp dutiesThe transfer of real estate also triggers stamp duties at the rate of 0.8%.d) Gift and inheritance tax

If one receives an immovable by gift or inheritance it will also be subject to gift and inheritance tax.

e) Individual and corporate income tax

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Net income from real estate is included in the general tax basis of each taxpayer. The “Contribuição Autárquica” tax is also deductible in order to determine the net immovable income.

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

As mentioned earlier, the individual income tax code (IRS Code) encompasses 9 categories of income, in accordance to their source, the investment or capital income being one of them.As a rule, movable property (in particular bonds and similar instruments) is not subject to a specific tax (e.g. a net wealth tax – Portugal does not have such a tax for the time being), unless such property is transferred or produces income.Income from movable property (such as bonds) obtained by an individual, for instance, may attract individual income tax (under the category of capital income or capital gains) and the substitute gift and inheritance and gift tax. In any case, currently there are some exemptions that apply to the interest derived from this type of movables such as bonds and instruments.Income derived from this property (interest, dividends, royalties) is, as a rule, subject to WHT. Currently the WHT final rate applicable to interest from bonds obtained by individuals is 20%. Provided they are not located in low tax jurisdictions, non-residents may be exempt from WHT on interest received from specific public bonds.

Peter Kavelaars, Accrual versus Realization

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?

Capital gains on private assets are taxed restrictively, namely in relation to the alienation of immovable property and rights thereon, equity (capital stock) of a company, bonds or other debt securities, intellectual property and know-how, and operations such as financial instruments and autonomous warrants.336

Some other gains are also taxed when an individual taxpayer obtained them from compensation and indemnities, from non-compete clauses, from raffles, totoloto

336 Article 10º (1) and (2) CIRS.

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and lotto, as well as draws or competitions and other unjustified income accrual.337

However, as a rule, capital gains on private/personal assets such as stamps, paintings, cars or furniture that are not related to a business activity, and can not be taxed as a business operation (a sole “act of commerce”) are not subject to taxation.

2. Are capital gains taxed on accrual or on realization base?

In Portugal capital gains are taxed on a realization base. They are deemed to be realized when an asset is disposed of.338

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

As a rule, the gain is the amount by which the proceeds from the alienation exceed the cost of acquisition. However, the acquisition cost is reduced by the depreciation or amortization amounts deducted for tax purposes and adjusted by inflation indexation coefficients. Charges and costs related with the sale can also be deducted from the alienation value.Nevertheless, if the capital gain is related to the alienation of certain types of assets such as financial instruments or derivatives, the gain is the amount of the performance of the instrument or derivative during each year.339

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- Death – The amounts received by the heir are not qualified as capital gains and are only taxed by Inheritance and Gift Tax.

- Emigration – Not applicable. There are no exit taxes in Portugal and emigrant individuals loose their tax residence, unless they emigrate to low tax jurisdictions. In the latter case this emigrant is still considered a resident during a 4 year period but this presumption is redoubtable by himself;

337 Article 9º CIRS.338 Article 10º (4) CIRS.339 Article 10º (4) c) CIRS.

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- Immigration – Not applicable. There are no “arrival taxes” in Portugal. At the end of the day it will be necessary to prove the acquisition value;

- Mergers/splitting – The shareholders of the acquired company are not taxed on capital gains if the registered accounting value of their shares in the acquiring company is equal to the registered accounting value of the shares in the acquired company. However, if the shareholders receive any amount for the merger, this payment is subject to taxation.340

- Divorce – The amounts received by a taxpayer relating to a divorce are not qualified as capital gains and thus not subject to this sort of taxation.

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement.

It is possible to postpone the payment of taxation on certain types of capital gains, namely, from the alienation of immovable property for permanent and de facto residence of the taxpayer. During the period of 24 months the realized capital gain is not taxable provided the total consideration from the sale of the previous residential property is reinvested in the acquisition of another immovable property that must also be the permanent and de facto residence of the taxpayer.341

6. Are there special regulations related to a tax treaty?

No, there are no special regulations related to a tax treaty. In fact, Portugal has not made any proviso to the O.E.C.D. Model Convention related to capital gains (article 13º of the M.C.).Nevertheless, where capital gains derive from an alienation of equity (capital stock) of companies owning immovable property as business assets or derive from the alienation of ships and aircrafts, some specific regulations exist among tax treaties signed by Portugal.

7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

The system of taxation of capital gains is one of those areas that tends to change continually. For instance, a recent law (enacted at the end of 2002) as well as the

340 Article 70º (1) and (2) CIRC.341 Article 10º (5) CIRS.

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Budget Bill for 2003 have reinstated capital gains tax exemptions or reductions and a lower tax rate of 10% on the sale of shares owned by individuals (for a period lower than 12 months) in order to promote investment. It is expected that the Government’s intention to promote investment and economic growth will be evidenced in the introduction of other measures and amendments to the system.

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your tax system tax capital gains and losses through the general income taxation system?

Yes, capital gains and losses are taxed in Portugal through the general income taxation system. Worldwide capital gains obtained by resident corporate bodies or individuals are regarded as ordinary income. Capital gains are one of the six categories of income in which the Individual Income Tax Code (“Código do Imposto sobre o Rendimento das Pessoas Singulares” – “CIRS”) separates income and the way to determine the taxable income.342 On the Corporate Income Tax Code (“Código do Imposto sobre o Rendimento das Pessoas Colectivas” – “CIRC”) capital gains are also determined in accordance with specific rules.343 As a rule, only the capital net gain is added to their taxable income.

2. If not, are such gains and losses covered by a separated code?

Not applicable.

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

Both, the Corporate Income Tax Code (CIRC) as well as the Individual Income Tax Code (CIRS) establish a statutory distinction between capital gains and other taxable income. The CIRC definition of capital gains includes : (i) voluntary capital gains, i.e. gains derived from the sale or exchange of fixed assets or the appropriation of a company’s fixed assets for any purpose unrelated to the

342 Articles 10º and 43º et seq. of CIRS343 Articles 43º et seq. of CIRC

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operation of the corporate business and (ii) involuntary capital gains, i.e. gains realized on compensation from expropriation and on indemnities for a loss of assets.344 The CIRS separates taxable income into six categories and a specified category is established for capital gains, compensations and indemnities, and for income obtained or derived from non-compete clauses and other unjustified income accrual (category G). The other five categories of income are as follows: (A) employment income; (B) business income and self-employment income; (E) investment income; (F) income from immovable property; and (H) pensions. Former categories (C) and (D) were amalgamated into category B and they do not exist anymore.

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

Yes, either at the CIRC or CIRS level.

Corporate taxpayers may benefit from a relief scheme where only 50% of capital gains from the disposal of tangible fixed assets (owned for at least 1 year) are taxed provided that the total consideration is reinvested in the acquisition of similar assets within a 4 year period beginning in the year preceding the disposal.345 Non resident corporate entities and individuals without a permanent establishment in Portugal to whom gains can be attributed are exempt from capital gains obtained with the sales of social participations (e.g. shares), unless an anti-avoidance rules applies (e.g. the non resident entity is located in a low tax jurisdiction).

Individual taxpayers are also subject to special rates, deferrals and reliefs: (i) capital gains derived from shares, bonds and other debt securities held for more than 12 months are tax exempt;346 (ii) only half of the capital gains derived from the disposal of immovable property and rights thereon, IP and know-how are added to taxable income;347 (iii) if not exempted from tax [see (i) above] a special final tax rate of 10% applies to net gains derived from the disposal of equity, derivatives and autonomous warrants, unless the taxpayer elects to have it added

344 Article 43.º of CIRC.345 Beginning in article 45º of the CIRC the year proceeding the disposal.346 Article 10.º nº 2 of the CIRS.347 Article 43.º nº 2 of the CIRS.

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to its taxable income;348 and (iv) capital gains derived from the disposal of immovable property used as the residence of the taxpayer are tax exempt if the total consideration is reinvested in the acquisition of similar assets within a 24 month period or in the repayment of a loan taker out for the acquisition of a similar asset during the previous 12 month.349

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation?

Yes, capital gains and losses are taxed on a realization basis. The CIRS and CIRC provide a statutory definition of when the capital gains and losses are realized, namely they are deemed to be realized when an asset is disposed.350

6. Are there rules to deal with inflation?

Yes, to avoid imposing tax on inflationary gains, the acquisition cost of fixed assets, immovable property, shares and comparable interests in companies (excluding other financial assets) for corporate taxpayers (article 44.º of the CIRC) and only in respect of immovable property and rights thereon for individual taxpayers (article 50.º no 1 of the CIRS) alienated after an ownership period of 2 years may be adjusted in accordance with the indexation coefficient for the year of acquisition.

7. Is there a deferral or exemption from tax on capital gains on death?

The transfers of inherited assets are autonomously taxed through the inheritance and gift tax and do not give rise to a capital gains taxation.

8. Are there other deferrals and reliefs on capital gains – for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

Please see answer no 4.

348 Article 72.º nº 4 of the CIRS.349 Article 10.º nº 5 of the CIRS.350 Article 43.º of the CIRC and article 10.º of the CIRS.

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9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

Corporate taxpayers may set off capital losses against gains of a different nature since capital gains are qualified as ordinary income and capital losses are expressly defined as deductible expenses (article 23.º no 1 item i) of the CIRC). An individual taxpayer’s capital losses cannot be deducted from income in other taxable income categories but may be carried over for up to five years and deducted from income in the same category (category G),351 although capital losses derived from the disposal of equity, derivatives and autonomous warrants may only be set off against gains of the same type and carried over for only two years, if the taxpayer elects to add these type of capital gains to its taxable income.352

351 Article 55.º nº 5 of the CIRS.352 Article 55.º nº 6 of the CIRS.

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13. SPAIN (Carlos Palao Taboada)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. In the Spanish tax system income obtained by residents is subject at the state level to the Individual Income Tax if the recipient is a natural person or to the Corporate Tax if she is an entity. Non residents’ income is subject to an specific tax.

The Income Tax adopts a comprehensive concept of income, which includes capital gains and, of course, income from both movable and immovable capital. An imputed income is attributed to owners of urban property other than the habitual dwelling. Capital gains realized by transfer of assets possessed for more than one year are taxed since January 1st 2003 at a fixed rate of 15% (previously 18%).

The Corporate Tax base is formed by the accounting profit adjusted to the fiscal rules.

Besides the state taxation, income from immovable property is subject to two local taxes: the Tax on Immovable Property and the Tax on Gains from Immovable Urban Property. They do not rely upon market values but on the (lower) “cadastral value”, which is determined collectively by a method to a great extent of indicial nature.

A Net Wealth Tax on individuals is presently in force in Spain.

2. This only happens in the Non Residents’ Income Tax, although withholding is not a substitutive tax but a system of collection of the ordinary tax: the payer of the income has to withhold and pay the tax.

3. As mentioned before (par. 1) income obtained by entities is subject to the Corporate Tax. Entities include all kinds of companies and partnerships, with the exception of civil law partnerships (sociedades civiles), to which a flow-trough

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system is applied. Entities subject to the Corporate Tax need not possess legal personality (e.g. investment or pension funds).

Internal double taxation of companies’ profits is suppressed, or in some cases only alleviated, by means of an imputation or tax credit system, the technical functioning of which varies between the Individual Income Tax and the Corporate Tax.

4. No such problem has been pointed out by commentators. A different question is the distinction between income and gains from capital, a classical problem in this matter. The legal border-line has been often redrawn during the past fifteen years. The tendency has been to transfer items from the gain to the income concept.

5. Transfer of assets may be subject to either the Tax on Value Added or the Property Transfer Tax, depending on whether the transaction was carried out in the course of entrepreneurial or professional activity or not. The Law that governs the latter tax also establishes the Spanish version of the Capital Duty (harmonized by Directive 69/335/EEC).

6. As already mentioned (supra, par. 1), income from immovable property is subject at central level to the Individual Income Tax or the Corporate Tax. In the case of the alienation of immovable property, a coefficient is applied in both taxes to the gross amount of the capital gain in order to correct the effect of inflation. At the local level immovable property is subject to the Property Tax and the Tax on Gains from Immovable Urban Property. The latter tax is deductible from the amount of the gain for Income Tax purposes. Immovable property is of course included in the tax base of the Net Wealth Tax. The basic value of immovable property is the “cadastral value”.

7. Income from all kinds of movable property, in particular financial assets, is comprised in the base of the Individual Income Tax and the Corporate Tax. The Law governing the first mentioned tax contains very detailed rules defining movable capital income, which includes dividends, interest, income from life insurance policies, intellectual and industrial property, etc., etc. Gains realized through transfer, reimbursement, exchange, etc. of bonds, previously considered in some cases capital gains, are now treated as ordinary income.

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Movable property is comprised in the taxable base of the Net Wealth Tax.

Peter Kavelaars, Accrual versus Realization

1. Capital gains are taxed either by the Individual Income Tax or by the Corporate Tax. See supra I.

2. All capital gains are taxed on a realization base. Accounting appreciation of assets is not considered income for tax purposes, unless otherwise established by the law. However, see below 4, c) and d).

3. There are no differences between different types of assets.

4 a) Death: In the present state of the legislation mortis causa transfer of property does not constitute realization of capital gains by the deceased. The contrary was true until ten years ago (the popularly called “deceased person’s gain”). Since the transferred property is valued for the purposes of the Inheritance and Gift Tax at present value, taxation of the capital gain is relinquished by the government (step-up of basis).

b) and c) Emigration and Immigration: Neither of them determines the realization of capital gains. Nevertheless, the transfer of a company’s residence abroad brings about the taxation of the latent gains (difference between the market and book value of the assets), unless such assets remain allocated to a permanent establishment in Spain. The same applies to the assets of a permanent establishment that ceases its activity or if such assets are transferred abroad.

d) Mergers/splitting: Transfer of assets by way of these transactions determines the realization of capital gains under the common rules of the Corporate Tax. Taxation of such gains is deferred if the special regime established by Directive 90/434/EEC and internal legislation that implements it applies.

e) Divorce: Liquidation of the common property required by divorce does not constitute realization of gains or losses, but the allocated assets retain their

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original value, so no step-up of basis takes place. Hence, taxation of the gains is simply postponed.

5. The Tax Administration may grant postponement of the payment of any tax debt in the case of transitory liquidity problems of the debtor, who has to furnish a guarantee. With specific reference to income taxation, the law has traditionally provided, through various methods, relief from the taxation of capital gains realized by alienation of certain assets insofar the proceeds of the sale are reinvested in assets of similar or qualified kind. The original method for business assets was straightforward exemption of the gain. This method was replaced in 1996 by a deferral system and in 2002 by a tax credit designed to equal the rate applicable to capital gains in the Individual Income Tax (15%) and the Corporate Tax rate (generally 35%). An exemption still applies in the Income Tax for the gains from the sale of the habitual dwelling, in proportion to the amount of the proceeds reinvested in a new house.

6. Not that I am aware of.

7. Tax treatment of capital gains has been subject to various changes of different importance in the recent years; last by a Law of December 2002 amending modifies the Individual Income Tax and the Corporate Tax Laws. No new reform plans have been announced.

Judith Freedman, Treatment of Capital Gains and Losses

1. Yes: there is no specific tax on capital gains.

2. Not applicable.

3. Yes. The Individual Income Tax Law defines capital gains as “variations in the value of the taxpayer’s patrimony manifested by any alteration in its composition, unless qualified by [the Income Tax Law] as ordinary income”. This definition is completed by rules determining that certain events do not constitute an “alteration in the composition of the patrimony” or that certain transactions do not give rise to a capital gain. Thus capital gain is a residual category: any realized increase in a person’s wealth is a capital gain unless it fits

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into one of the different kinds of ordinary income (employment income, income from capital or income from “economic activities” –entrepreneurial or professional).

4. Capital gains are included in the general income tax base and taxed at the progressive rates if the assets were held for no longer than one year. However, compensation of net capital losses with ordinary income is limited to 10% of the latter. Any remaining losses can be compensated in the same way in the subsequent four years. Capital gains realized in a period exceeding one year are subject to a flat rate of 15% and can only be compensated with losses of equal nature within the following four taxable years.

5. Yes. “Alteration in the composition of the patrimony” is the formula employed by the law to express the realization requirement.

6. Yes, but only concerning capital gains from the transfer of immovable property (see supra I.6).

7. See supra II.4, a).

8. See supra II.5. Gains from the sale of a shareholding of any size are taxed in the year of realization. However, if the transfer of the shareholding qualifies as an “exchange of shares” under Directive 90/434/EEC and the legislation implementing it taxation of the gain is deferred. The duration of the holding of an asset does not determine any relief (other than application of a higher inflation coefficient) under present tax law. Under previously existing law a deduction from the amount of the gain proportional to the length of the holding period applied, which could lead to complete exemption after a number of years that varied with the nature of the asset. This system was abandoned in 1996, but still lingers by effect of transitional provisions.

9. See supra 4.

Ian Roxan, Influence of Inflation

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Capital Gains

1. Only for gains from the alienation of immovable property, by adjusting the cost for inflation applying coefficients established annually in the Budget Law.

2. No.

3. As mentioned above, only regarding the nature of the asset (immovable property). Indexation is available both for natural persons (in the Income Tax) and for entities (in the Corporate Tax). Since indexation applies to the cost of the asset it affects equally gains and losses.

4. In the Individual Income Tax gains from assets held for more than one year are subject to a flat rate (now 15%).

Specific Sources of Income from Capital

5. No.

6. A reduction of (now) 40% applies for dividends and interest having a maturity of more than two years and those that qualify as “notoriously irregular” in time. The primary purpose of this reduction is to correct the incidence of progression, but in a way it can be seen as a compensation for inflation.

7. No.

8. In general terms tax law accepts the accounting rules regarding the evaluation of inventory, hence also LIFO.

Tax Rates

9. No and no.

10 As a consequence of 9 new legislation is required, but it is not approved every year.

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11. No: the brackets established by the Income Tax Law of 1998 have not been modified until the enactment of a Law of last December amending it.

General

12. no.

13. Not that I am aware of.

Ian Roxan, Imputed Income

1. Yes, except the habitual dwelling. Property assigned to business or professional activities is also excepted. Hence, mostly only second residences give rise to this kind of income. Imputed income is considered ordinary income.

2. Imputed income is evaluated generally at 2% of the cadastral value of the property.

3. Reassessment of the cadastral value does not take place simultaneously for the

whole country but for single municipalities. However, the law authorises linear increases of the cadastral value by the Budget Law (last one of 2% for 2002). In the case of (non linear) revaluations effected in 1994 and after, the percentage applied to determine the amount of the imputed income is reduced to 1,1.

4. No expenses are deductible.

5. No.

6. If I do not misinterpret the question –the reserve concerning “shares in companies” is not quite clear to me-, it points to situations in which income not perceived by the taxpayer but by an interposed entity is attributed to him even if not distributed, sometimes called “flow-through” or “transparency” regimes. In Spanish law there are several of these regimes: closely held asset holding companies, controlled foreign corporations, economic interest groupings and joint ventures.

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Deemed Income

7. There is a subtle difference in this regard between the Income Tax and the Corporate Tax. Under the Income Tax Law the amount of the gain from the alienation of property is the difference between the transfer value and the acquisition value, the transfer value being the “real amount” of the transfer, “provided it is not inferior to the market value”. The general rule for the Corporate Tax is that assets transferred by any transaction are valued for fiscal purposes at market price. The consequence in either case is that the Tax Administration can challenge the price stated by the parties to the transaction.

8. No: all non-arm’s length transactions (i.e. between related parties) are valued at market price.

9. There is one such case: immovable property let to the spouse or a close relative of the proprietor income can not be less than the amount that would be imputed if owner occupied (see supra, 1). This obviously an anti-abuse provision.

10. There are no rules limiting the amount of deductible expenses. However, only management and deposit expenses are deductible from income from financial assets. There is an exception for income from transfer of know-how or leasing of business, which is included in capital income, from which any necessary expenses are deductible.

11. There is an overall limit to the sum of the Income Tax and the Net Wealth Tax: the amount of both taxes, prior to the deduction of credits, added together cannot exceed 70% of total income. The excess reduces the Net Wealth Tax, up to a maximum of 80%.

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14. SWEDEN (Sture Bergström, Lars Pelin and Peter Melz)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

Swedish tax-system

Introduction

The Swedish income-tax-system was reformed in 1990 and thereafter we have lower taxes and broader tax-bases (that is; fewer costs became deductible and in principle all incomes became taxable).

One of the main-reform-goals was to keep the marginal income tax at 50 % on earned income. There are, in addition to taxes, social contributions; they are to a large extent to be considered as tax and not a fee.

All together the total tax burden /taxes and social contributions) is high compared to other countries; over 50 per cent of the GDP. The average total tax burden within EC: 41.7 per cent the GDP.

Example of different taxes:

Income tax (income from employment, business and capital; marginal burden 56 % (67 %) on earned income), stamp duty, national immovable property tax (1 % of the ratable value for flats and self-contained houses), value-added-tax: VAT (on turnover of goods or services and on import of goods (and in some cases services) to Sweden. VAT is paid at all stages of production and distribution. VAT-rates: 25 %, 12 % and 6 %), selective taxes, net-wealth-tax (tax-rate: 1.5 % of that part of taxable capital over 1.500.000/2.000.000 SEK), gift- and in-heritance tax, etc:

Gift- and inheritance tax:1. Spouse, children, etc.(basic deduction 280.000 SEK (spouse);

70.000 SEK (children); Tax- 300.000 + 10 %

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300.000 - 600.000 30.000 + 20 %600.000 - 90.000 + 30 %2. Other inheritors. (basic deduction: 21.000 SEK).

- 70.000 10 % 70.000 - 140.000 7.000 + 20 %

140.000 - 21.000 + 30 %3. Different authorities. (basic deduction: 21.000 SEK).

- 90.000 10 %90.000 - 170.000 9.000 + 20 %170.000 - 25.000 + 30 %

Income tax system

The extent of tax-liability; individuals/companies.

Individual taxpayers with residence in Sweden is subject to tax liability on his world-wide-income; unlimited liability.

Non residents are subject to a limited liability; the liability is restricted to a few incomes, specified in the income tax law. They all have a special attachment to Swedish sources such as income deriving from real (immovable) property and from permanent establishment situated in Sweden.

Swedish companies tax-liability is unlimited and foreign companies tax-liability is limited to a few incomes, specified in the income law. A legal entity is considered to be Swedish if it is formed an registered under Swedish law.

Generally that the taxpayer will be subject to international double taxation, which could be avoided or limited either by application of internal rules (deductible as a cost or credited against Swedish taxes) or a international double taxation convention. The text of those conventions is incorporated and has thereafter the status of Swedish internal law.

The structure of the income tax:

1. Employment income2. Capital income

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3. Business income

1. Income from employment Taxes on income from employment are those on salaries or wages, benefits and pensions of all kind, etc. Only a few benefits are tax free such as benefits of low economic value and health care service provided by the employer.

This income category also has a function as a general collection point for incomes that cannot be taxed as income from business activity or capital; such as income from hobby activities.

2. Income from capitalThis comprises current return on capital (interest, share dividends, even from foreign companies) and all types of sales profit/capital gains, received by an individual. Interest expenses attributable to the capital are deductible.

For example interest payments on real estate loans. In general the capital gain is equal to the difference between the sales price and the purchase price.

Example: (private real property/estate - owner occupied house; home for one or two families and tenant-owner flats).

Sales price 900.000 SEKSales costs 50.000 SEK *)

850.000 SEKPurchase price 400.000 SEKCost of repairs 20.000 SEK**)Costs of improvement 80.000 SEK***)

350.000 SEKTaxable (2/3) 233.333 SEK Capital tax (30 %) 69.999 SEK

*) Ex. real estate broker commission

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**) Costs arising to 5.000 SEK or more for a calendar year during the preceding five years.

***) Costs arising to 5.000 SEK or more for a calendar year and attributable to new constructions, reconstructions or extensions

The inflation is not considered in the calculation. Instead a seller of a permanent home can postpone taxation of the capital gain (under certain conditions) until the new home is sold in the future.

3. Income from business activity Income from business activity covers incomes from business operations, agricultural and other properties (industrial).

Unregistered firmSimple company Private/individual businessLimited partnership

Limited company Independent legal entities and independent tax

sub- jects.Cooperative or economic associationTrusts

Deficit in income from business:

The main rule with deficit is that a deficit in business activity may be drawn off in the same income source the next year.

Example: Year 1 Year 2 Year 3+ 100 + 200 + 300

- 500 - 200 - 200 - 400 0 + 100

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Taxation of Individuals

Private individuals can have income from employment, capital or/and business activity and the tax- year (fiscal year) is the calendar-year immediately prior to the year of assessment. Tax on earned income and incomes from capital are shown separately when tax is levied.

On taxable earned income: income of employment and private business activity/unin-corporated business; both national and municipal tax must be paid, if the income is of a certain size.

The national income tax is 20 % on income over the first breaking point (273.800 SEK) and 5 % on income over the second breaking point (414.200 SEK). The municipal tax is taken out by the local authority/governments where the individual is resident (the average is 31 %). Total marginal burden on earned income: 56 %.

Income from capital is taxed separately with a special national tax. Tax rates amount to 30 % for all different types of income from capital (proportional tax levy).

Capital losses; the taxpayer is entitled to a tax reduction or tax credit amounting 30 % of the deductible loss up to a loss of 100.000 SEK and to 21 % of the deductible loss exceeding 100.000 SEK.

Example: Deductible capital losses: 220.000 SEK: (30 % x 100.000 = 30.000) + (21 % x 120.000 = 25.200) = 55.200 SEK (tax credit).

Summary; tax computation Income of employment +Income of business activity +general deductions (ex. pension-insurance) -Earned incomes taxed (taxerad inkomst) =General allowance (8.600 SEK) -

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Taxable earned incomes =Taxes (30 % and 20/25 % over breakpoints) = x

Income from capitalInterest income +Share dividends +Sales profits/capital gains +Interest expenses -Capital income =Tax (30 %)

Capital - deficit - tax-reduction; deductible amount of capital losses:30 % x 100.000 SEK and 21 % over 100.000 SEK -_Total amount/remaining taxes =

Social costs/contributions:

In addition to income tax there are (again) social costs/contributions, namely:

1. Employers contributions: 32.82 % 2.Personal (businessman) contributions: 31.01 %) 3. Special salary tax: 24.26%.

Social security contributions and the special salary tax are deductible,

reducing the income tax base. Standard deductions for personal

contributions:

Example: Earned income (after deductions for costs) 140.000

Standard deductions 35.000 (25 %) Income 105.000 Personal contributions 30.083 (28.65 % )

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4. General personal contributions: 2.69 % of earned income not exceeding 7.5 times the base sum (c:a 275.000 SEK).

Taxation of Companies

Tax-year (fiscal year). Limited companies and economic associations often have a different financial year than the calendar year. In such cases the tax year is that year that came to an end prior to the year of assessment.

Financial years are applicable as follows:1. 1 May - 30 April2. 1 July - 30 June3. 1 Sept. - 30 August

Limited companies and economic associations (incorporated business) pays solely national income tax. The corporate tax rate is 28 %.

Economic double taxation: A limited company profit is subject to double taxation, this by first taxing the profit at the company.

When the remaining profits are dealt out (to the shareholders) then those receiving funds (dividends) are liable to taxation without the company having the right to make deductions.

For private individuals running business indirectly via a limited company the tax rate in the second stage is 30 % (income of capital).

Example:company-income 100company tax rate - 28dividends 72income of capital rate (30 %) 21.6 rest 50.4

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Calculation of income from business:

In principle the same for private business and companies. Income from business activity is calculated according to basic accounting systems. This implies that consideration is taken of incoming and outgoing stores, to ongoing work and to debts.

Income and expenditure must be divided into periods when incomes are to be calculated. This means that if income in the form of (for example) interests bears reference to two financial years then the interest must be divided between the two years. It also implies that (for example) a rental cost does not necessarily affect that year it is paid rather than that period it applies to.

Thus an advance rental for Jan. 2003 which is paid in Dec. 2003 should not affect the result for the financial year 2002. Accounting and taxation profit calculation principles differ further on certain points.

Costs: According to general principles deductions are permitted for all overhead and expenses for the acquisition and retention of receipts.

1. Deductible immediately and without restrictions; 2. Depreciation with certain percent/year.

2.1. Depreciation of machinery and other assets or movables; three methods:

1. Financial (Book) depreciation:2. Residual value**)3.If the assets are held for a duration of three years then they may be

written off at once. This also applies to assets of lesser value.

*) Financial (Book) depreciation occurs in two ways. According to the main alternative de-duction may be made on up to a maximum of 30 % on the sum of:

+ entered value of the assets at the beginning of the financial year+ the procurement value of assets acquired during the financial year and

remaining at the end of the financial year

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- reduced with the sum of those revenues in the form of payment or insurance compensation on assets procured before the onset of the financial year and which have been disposed of or lost during the

financial year.

A supplementary rule exists according to which write off are permitted at 20 % per year on procurement costs. A list of assets and liabilities can therefore be written off over a five year period.

**) Residual value. Regulations do not require that financial depreciation take place with the accounting process. Depreciation of up to 25 % are allowed for the year concerned.

2.2 Buildings. Depreciation is permitted at rates of 3.5 per cent per year for industrial buildings and 2 % for commercial property, etc.

2.3. Land improvements (roads, parking places, tennis courts, etc; not the land itself). Normally the depreciation is permitted at rates of 5 per cent per year.

Funds

Periodic Funds: Companies and private business activity receives every financial-year tax allowances up to 30 (25) % of the year income prior to the deduction for allowance; one may make deductions from business activity for the sum in question.

That part of a fund which remains for taxation after the fifth (6) financial year after that year provision is made is transferred automatically to taxation. Each year provision accrues into a special fund. It is possible to have five funds at a given time.

Example:

Year Income Allowance1 100 25 (Fund 1)2 80 20 (Fund 2)3 120 12.5 (Fund 3)5 90 22.5 (Fund 5)

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6 110 + 25 (F1) 33.7 (Fund 1)7 70 + 20 (F2) 22.5 (Fund 2)5

Expansion funds: Private business operators have the possibility to transfer sums to expansion funds.

Taxation of expansion funds implies that one may make deductions from business activity for the sum and pay instead a special expansion fund tax; 28 % on the transferred sum.

Close companies

Rules exist on taxation of sums distributed to shareholders in order to guarantee the second stage of double taxation. Special tax regulations exists for so called "close companies".

A close company is a limited company or economic association wherein one or a small number of people own so many shares that they own more than half of the votes in the company.

A "small number" is assumed to be no more than 4 people. Shares owned by related parties are considered as shares belonging to one part. Each group of owners are therefore considered in the same light as if the ownership concerned only one person. This is due to the lack of any real two-way relationship between the company and it´s owners.

A group of rules exists with an aim towards halting the transformation of earned income to less severely taxed capital gains in the form of sales profits and share dividends. a. Share dividends. The special close company rules results in normal returns onshares in a close company being treated as share dividends from a Swedish limited company in general, with attribution to income from capital at a tax rate of 30 %. Dividends exceeding normal capital returns/excess dividends) are taxed as earned income.

Normal returns from shares are calculated as the basis (main rule: the price of shares) multi-plied by the national loan interest with a surplus charge of 5 %. If dividends in one year are

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under the scope for capital gains tax, then there is an increase in that amount which in later years may be entered as a corresponding income from capital (saved dividend).

This capital income opportunity may thus be saved to be accounted for against future capital gains by the company. The saved dividend may also be added to procurement costs at calculation of next year normal returns.

b. Sales profits from shares in a close company. The taxable sales profits on shares ina close company are estimated in the same manner as for a normal sale of shares. Sales profit is the difference between the sale price and the shares procurement price, calculated according to the so called "average method".

That which differentiates taxation of sales of shares in a close company is that a certain part of the taxable sales profits can be accounted for as income of employment. 50 % of that part of the profit from a share sale which exceeds remaining saved dividends is entered as income from employment.

Peter Kavelaars, Accrual versus realization? (topic 2.2.1)

1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?(if not, the next questions have not to be answered)

I understand private assets to contain all assets outside a business.Capital gains on all types of private assets are taxed. There I an exemption for capital gains up to 50 000 SEK (appr. 5500 Euro) for sales of household property (including art, furniture, cars etc.)

2. Are capital gains taxed on accrual or on realization base?

Realization base.

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

None.

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4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- death No income taxation at death. No step up in base.- emigration As a rule no income taxation. In one case an exit tax: when a capital gain on a share exchange was not taxed when realized, the deferred income will be taxed when the individual emigrate- immigration No special rules. - mergers/splitting Normally no taxation.- divorce No taxation.

5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

In the field of business taxation there are numerous rules permitting the deferrel of taxation when a business is reorganized (incorporation, merger, splitting etc.).For private assets there a various forms of role-over-relief/deferrel when a personal dwelling is sold or shares are exchanged.

6. Are there special regulations related to a tax treaty?

Not to my knowledge.

7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

No.

Judith Freedman, Treatment of Capital Gains and Losses

1. Does your system tax capital gains and losses through the general income taxation system?

The taxation is part of the general income taxation system. However, the income taxation is separated in two parts. The earned income is taxed with municipal and national income tax and the capital income (includes capital gains) is taxed with a

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proportional national tax (30%, which is normally lower than the taxes on earned income):

2. If not, are such gains and losses covered by a separate code?

3. Do you have a statutory distinction between capital gains and other income gains? If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

The general principle distinction is that capital gains are the result of occasional non-professional sales. In the fields where a distinction has considerable practical implications there exist case law. This case law implies that when assets are hold for short periods it indicates an intention to purchase and sell in a business.

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

Tax rate for capital income 30 % as said above. For capital gains on private dwellings only 2/3 of the gain is taxable.

5. Are capital gains and losses taxed on a realisation basis. If so, what amounts to a realisation? If not, what other basis is used?

Capital gains are taxed when the asset is sold. A sales is normally considered to be constituted when the parties are mutually bound by an sales agreement.

6. Are there rules to deal with inflation?

The lower tax rate on capital income than on earned income is meant to act as an implicit relief for inflationary components in the nominal and taxable capital income.

7. Is there a deferral or exemption from tax on capital gains on death?

There is a deferral. The basis is carried over by inheritors and a capital gain will be taxed upon their sale of the asset.

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8. Are there other deferrals and reliefs on capital gains- - for individuals on certain types of personal assets? On the sale of substantial shareholdings by a company or as part of a corporate reconstruction? For assets held for a certain length of time?

In the field of business taxation there are numerous rules permitting the deferral of taxation when a business is reorganized (incorporation, merger, splitting etc.).For private assets there a various forms of role-over-relief/deferral when a personal dwelling is sold or shares are exchanged.Otherwise capital gains are taxed irrespective of holding period.

9. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

70% of a capital loss is deductible (or less if a lower percentage of the gain is taxable). This loss could be set off against all types of capital income (capital gains, dividends, interest etc.). If the calculation of capital income results in a deficit, this deficit could be used to reduce the tax on earned income. The reduction will be 30% of the capital income deficit to a maximum deficit of 100 000 SEK and 21% of the deficit above.

Ian Roxan, Influence of Inflation

Capital Gains1. Are capital gains indexed for inflation? If so, how (e.g. by adjusting the amount of the cost for inflation or by allowing the deduction of an inflation adjustment)?

No

2. Have there been any major changes to the indexation system recently?

No

3. Are there any restrictions on when indexation is available, e.g. by taxpayer, by type of asset, by length of ownership? Is indexation available when there is a capital loss?

No

4. Is there any other relief given for capital gains on assets held over a longer period? Please describe the relief briefly.

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No, see Pelins paper

Specific Sources of Income from Capital5. Is interest income indexed for inflation? If so, how?

No

6. Is there any other relief for interest that is seen as providing some compensation for the effect of inflation on interest? Please describe the relief briefly.

No

7. Is any other type of income from capital indexed for inflation (e.g. dividends, royalties)? If yes, please describe the indexation method briefly.

No

8. Are businesses permitted to calculate the value of trading stock (inventory) using methods that make an allowance for inflation (e.g. ‘last-in-first-out’ (LIFO)), or given any other relief on stock that compensates for inflation?

No

Tax Rates9. Are the thresholds (‘brackets’) for each tax rate indexed for inflation? Are the personal (individual) deductions from total income (personal allowances / personal credit / zero tax rate limit) indexed for inflation?

No

10. Is indexation applied automatically every year, or is new legislation required each year? If it is automatic, is there an explicit mechanism permitting indexation not to be applied in a year?

No

11. Is indexation normally applied? For instance, in how many of the last five years has full indexation been applied?

General12. Are there any other thresholds (e.g. minimum amounts of particular type of income to be taxable) that are automatically indexed for inflation?

No

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13. Are there any noteworthy provisions where there is an adjustment for inflation that works against the taxpayer?

No

Ian Roxan, Imputed Income: See Pelins paper

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15. Switzerland (Prof. Peter Locher and Christophe Deiss)

Claudio Sacchetto and Laura Castaldi, Relationship between Personal Income Tax on Income from Capital and Other Taxes on Income from Capital

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

Switzerland has a federal system of governement and consequently no uniform system of taxation. The Confederation as well as the 26 cantons (and even all the communities) do all have their own legislation for the raising of taxes.

The main federal taxes are the following direct taxes:- direct federal tax on the income of individuals and on the net profit and capital

of legal entities, and a source tax on the income of certain individuals- anticipatory (withholding) tax, a tax deducted at source from income on

movable assets, lottery prizes and insurance benefits.Of course there are also different indirect taxes (e.g. the value added tax) and some special-purpose taxes existing.

The main cantonal taxes are the following direct taxes:- taxes on the income and net wealth of individuals and on the profit and capital

of legal entities- taxes on immovable property and capital gains taxes on real property.

There exist some indirect taxes (e.g. immovable property transfer tax).

2. Is income on capital taxed trough withholding taxes substitutive to the ordinary income taxation? Which ones? Please describe how they function.

Switzerland knows a direct (ordinary) tax on the income from movable and from immovable property.

Federal anticipatory (withholding) tax: Anticipatory tax is levied by the Confederation on certain types of income, particularly from movable assets, but

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also from lottery prizes and insurance benefits. Although it has certain features in common with income tax, its main purpose is to ensure the payment of taxes.

- income from movable assets:Before payment the payer must deduct 35% from the amount due to the recipient and pay the deducted withholding tax to the Federal Tax Administration within 30 days of the payment falling due. The following types of income are subject to withholding tax:° Interest on bonds and other debt certificates issued by a Swiss resident at the time of payment and interest on accounts denominated in any currency with domestic banks and saving banks.° All payments by a domestic corporation to its shareholders or persons closely related to them e.g. dividends, bonuses, interest on property under construction, distributions on participation certificates and dividend right certificates, bonus shares or free increases in the nominal value of shares, then also all declared and hidden payments. Only the repayment of the paid-in-capital is exempt.° Distributions paid by Swiss investment funds or similar asset-holding organizations.

- lottery prizesWithholding tax of 35% is withheld on payment of money prizes exceeding CHF 50 in lotteries.

- insurance benefitsIn this area, withholding tax ist levied by way of deduction at source.

3. Which principles regulate the taxation of income produced by non individuals (i.e. partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

Legal entities pay taxes on their profits and on their capital. It should be borne in mind that Switzerland does not recognize corporate groups for tax purposes.

a) Direct tax on profits of corporations

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In Switzerland taxation is based on the commercial balance sheet. The basis for calculating taxable net profit is a suitably adjusted figure for commercially reported net profit for the year. The net profit is then adjusted for items that are not commercially justified, e.g. costs associated with the purchase or improvement of capital assets, open and hidden distributions of profit.Of course, commercially justified expenditure is tax-deductible.Some transactions have no impact on taxable income, e.g. shareholders’ contributions to company capital.

b) Double taxation of corporate incomeCorporate taxation follows the concept of Swiss private law, which treats a corporation as independent of its owners. This leads to the same economic elements being taxed twice, i.e. at the level of the corporation as profit and capital, and at the level of the owner’s income (dividends) and net wealth (shares). While many foreign countries have taken steps to remedy such an overlap in their tax law, Swiss tax law does not attempt to avoid this double tax burden. Swiss tax law only provides for special relief where a substantial interest is held by a corporation.

c) Taxation of companies with substantial interests, holding companies and domiciliary companies

As noted, there is no attempt in Switzerland to avoid duplication of the tax charge on businesses. This situation already gave rise many years ago to legal entities being granted relief in certain cases on profit and capital taxes. Special – but different - reliefs are given to companies with substantial interests, holding companies, management companies and domiciliary companies.

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capitals gains?

The Swiss law does not determinate the notions of income from capital and capital gains. Concerning problems of overlapping see for further informations:Andrea Pedroli: L’imposizione dei capital gains in Svizzera e in alcuni importanti stati esteri, Helbing & Lichtenhahn, Basel 2002.

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5. Which are the indirect taxes on capital?

The Confederation knows stamp duties. These are taxes on certain transfers of rights. They arise irrespective of whether legal documents are used, and do not involve stamping in the litteral sense.The federal stamp duties are:

a) stamp duty on issue of securities b) stamp duty on securities dealing c) stamp duty on insurance premiums

6. Describe the system of taxation of immovable property (i.e. real estates) in your country

Individuals

Income from immovable propertyImmovable property denotes real estate, i.e. land and buildings, permanent leasehold rights and shares in such property as co-owner.

Income from immovable property comprises inter alia:° rental income arising from a tenancy agreement or lease° the rental value of an apartment or house owned and occupied by the taxpayer° income arising from a leasehold contract° income from sand and gravel quarrying on ground owned by the tax- payer.The following in particular may be deducted from the gross income (i.e. rent or rental value) computed for immovable property:° maintenance costs° insurance premiums for third-party liability and damage cover° operating costs for rented property° property taxes° mortgage interestIt is possible to option for a lump-sum deduction instead of actual costs.

Private capital gains on immovable property (property gains tax)

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Private capital gains on immovable property are not subject to direct federal tax. In all cantons, however, they are subject to a special property gains tax. If the vendor has owned the property for a long time, he is generally entitled to a special deduction commensurate with the duration of ownership. Conversely, if the property is only owned for a short time, a speculation surcharge may be payable. If the taxpayer uses the proceeds of the sale for purchasing or building a new home (for his own use) as a remplacement for a previous one, profit from the sale will remain untaxed. The sale of shares in a real estate company may also attract property gains tax.

Capital gains on immovable business assets (Income from self-employment)At the federal level and also in the majority of cantons, capital gains on real estate are taxed together with other business earnings. A minority of cantons impose a special tax (property gains tax) on appreciation of immovable business assets. In such cases, however, only that part of the proceeds which represents previously charged depreciation is subject to income tax. Only actual expenditure is accepted as a deduction for properties form-ing part of business assets.

Direct tax on the net wealth of individuals: immovable assetsThe Confederation does not levy a wealth tax; it is only levied by the cantons and communities.All movable and immovable property as well as rights having a cash value are taken into account in calculating net wealth. Where legislation permits, a taxpayer’s debts can be deducted from his gross taxable assets. Assets are in general valued at market value.

Legal entities

Capital gains on immovable property° Taxation as ordinary income Capital gains on the sale of real estate are regarded as taxable profit and

thus subject to profit tax for direct federal tax purposes and in the majority of cantons. Legal transactions having the economic character of a sale are treated as sales.

° Property gains tax

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In some cantons, that part of the proceeds which represents previously charged depreciation is subject to profit tax (i.e. tax is imposed retroactively on depreciation previously applied) and only the residual gain in value is subject to a separate property gains tax. In such cases, however, the cantons have to exempt these property gains form profit tax or offset the property tax against profit tax due.

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country

- Income from movable propertyIn particular, this type of income includes:° interest on all types of assets° proceeds from life insurance policies purchased by lump-sum premi-ums and having a surrender value, in the event of the policy being surrendered or the insured person surviving beyond maturity (if the policy was taken out for pension purposes, proceeds are not taxed as income)° dividends and other open or hidden distributions of profit of all types, as well as liquidation proceeds other than those representing the re-payment of a company’s paid-in share capital° income from the sale or redemption of bonds on which the bulk of the interest is remitted as a one-off payment° income from units of investment funds, unless it stems from direct hol-dings of real estate° income from the granting of rights° income from the hiring-out of movable property

If such income is paid to users/beneficiaries of the movable property or to beneficiaries of a trust under Anglo-Saxon law, it must be declared as taxable income by such users/beneficiaries. No tax is levied on private capital gains from the sale of movable property.The following in particular may be deducted from such income:° costs incurred by having the assets managed by a third party° foreign withholding taxes, unless they can be recovered or credited against Swiss tax.

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- Private capital gains on movable propertyThe Confederation and all cantons do not tax private capital gains on movable property. If, however, the pursuit of capital gains is deemed to constitute a business activity, such gains will be regarded as regular income and taxed accordingly.Moreover, if a private individual realizes a capital gain on selling a sub-stantial share in a company, this gain may be regarded as taxable income. The transfer of an operating company to another company owned by the same party or a company’s repurchase of its own shares can also have income tax implications.Please note the relation between the fact of not taxing private capital gains and the taxing of the net wealth of individuals: The net wealth tax may also be described as a surcharge on income tax, being levied on all movable and immovable property.

- Capital gains on movable business assets (Income from self-employment)Capital gains on movable business assets – and particularly those on securities – are in all cases taxed together with the company’s other earnings.

- Direct tax on the net wealth of individuals: movable assetssee answer 6 d

Peter Kavelaars, Accrual versus Realization

1. One of the characteristics of the Swiss income tax system is that capital gains on private property (excluding real estate) are tax-free. Capital gains realized on the sale of private movable property are usually not taxed in the hands of the vendor. This applies to both federal and cantonal income taxes. If, however, the pursuit of capital gains is deemed to constitute a business activity, such gains will be considered as taxable regular income. Moreover, if a private individual realizes a capital gain on selling a substantial share in a company, the gain may be regarded as taxable income.

To compensate this tax-free-system, the cantons and communities levy direct taxes on the net wealth of individuals. The net wealth tax, which may also be described as a surcharge on income tax, used mainly to serve the purpose of indirectly taxing unearned income more heavily than earned income. It is also

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payable on assets which do not yield any income. All movable and immovable property as well as rights having a cash value are taken into account in calculating net wealth.

Private capital gains on immovable property are subject to a special property gains tax levied by the cantons. If the vendor has owned the property for a long time, he is generally entitled to a special deduction commensurate with the duration of ownership. Conversely, if the property is only owned for a short time, a speculation surcharge may be payable. If the taxpayer uses the proceeds of the sale for purchasing or building a new home as a replacement for a previous one, profit from the sale will remain untaxed. The sale of shares in a real estate company may also attract property gains tax.

1. -

2. –

3. Death :Inheritance taxes are only levied by the cantons (and/or the municipalities). There is no federal inheritance tax in Switzerland. Because of the lack of harmonisation rules in respect of such taxes, each canton has its own inheritance tax law. The tax is usually calculated on the net value of assets transferred. Debts are deductible. Assets are valuated at the fair market value. Real estate is taxed at its fiscal value. Each canton has individual rates. The majority of them do not tax transfers between husband and wife. Sometimes, no taxes are levied on transfers between parents and children.

Emigration: -

Immigration: -

Mergers:

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As far as the shareholders of the take over company are concerned, the fiscal treatment of capital gains for mergers depends on the type of assets. If the shares are held in private property, there are basically no incidences. Differences between nominal values of the companies’ shares are not taxable. Balancing payments are considered as a money equivalent supply and therefore as taxable income from property. For shares that are held in business property of an individual or by legal entities, there are no consequences in respect of profit or income taxes, on the condition the new shares are booked with the same values as the shares of the undergoing company. In such a case, the hidden reserves are not realised.

Generally, shareholders’ contribution to company capital is the main item classified as having no impact on taxable income. Furthermore, a corporation’s hidden reserve may remain untaxed in the event of:

change of legal structure, provided the business continues to operate as before and ownership remains substantially the same;

amalgamation (i.e. mergers, takeover, etc.) a spin-off

If undisclosed reserves are to remain untaxed, moreover, a liability to taxation must continue to exist, and the book values on which profit tax has hitherto been levied must be retained. Hidden reserves on capital items forming part of the business assets may under certain circumstances be transferred tax-free to a similar replacement item.

Divorce: -

2. In Switzerland, there are no possibilities to postpone the payment of taxation or to postpone the fiscal claim.

3. No.

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4. In 1999, the Federation of Swiss Trade Unions filed an initiative to create a tax for capital gains on private property. It demanded a tax charge of 20% for such gains. Neither the people nor the cantons approved this initiative.

Except the described initiative, there are no plans to change the system on taxation of capital gains at the moment in Switzerland.

Kevin Holmes, Deferral Possibilities

1. We don’t have any techniques to defer the tax liability given a capital gains tax.

2. The tax treatment of capital gains varies widely under Swiss tax law. In the first place it depends on whether the asset disposed of is considered a business asset or part of an individual’s personal net wealth. The Confederation and all the cantons do not tax private capital gains on movable property. Capital gains on movable business assets – and particularly those on securities – are in all cases taxed together with the company’s other earnings. Capital gains are taxed in the moment of the realisation of shares and other assets. Book profits are also a realization event. Mechanisms to defer the taxation of capital gains in principle don’t exist. Exception: If capital items forming part of the business assets are replaced by other, similar assets, the hidden reserves created may under certain circumstances be transferred tax-free to the substitute assets (deferment of tax).

3. No

If companies with substantial interests would be taxed like other companies, the distributed profit of the company in which the interest was held would be taxed three-fold, i.e. through its own profit tax, that of the investing company, and finally the income tax of the shareholder. Such consequences are alleviated by the federal government and most cantons in that the holding company can make a deduction against the profit tax paid on the income from its interests. The privileged corporation may have interests in a domestic or foreign company. The direct holding must, however, consist of shares or similar participation rights. No such privilege is granted on an interest in a partnership or on the income therefrom. The privileged interest must be of a certain economic significance.

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Relating to capital gains (profits arising on the disposal of an asset; changement of the book value), this is deemed to be the case where the interest represents at least 20% of the nominal capital of the company in which the investment was made.

Judith Freedman, Treatment of Capital Gains and Losses

1. Swiss taxation system distinguishs between capital gains on business assets and capital gains on private assets. In federal tax law, capital gains on private assets are exempt on tax. In addition to regular earnings, capital gains on company assets are also classed as taxable income. Any book revaluations will also fall in the category of capital gains. The tax treatment of capital gains on business assets varies under Swiss tax law. It depends on whether the capital gain arose from movable or immovable property. Capital gains on movable business assets are in all cases taxed together with the company’s others earnings. On the federal level, capital gains on real estate are taxed together with other business earnings. In the tax law of the states (cantons) exist two different possibilities: Some states taxe capital gains like they are taxed on the federal level, other states impose a special tax (property gains tax) on appreciation of immovable business assets. In such cases, however, only that part of the proceeds which represents previously charged depreciation is subject to income tax.

2. In the cantons, the property gains tax is imposed on appreciation of immovable private property. Only in some cantons, also capital gains on immovable company assets are subject to property gains tax. In these cantons, that part of the proceeds which represents previously charged depreciation is subject to income tax, and only the residual gain in value is subject to the property gains tax. The amount of the tax depends on the duration of ownership: If the vendor has owned the property for a long time, he is generally entitled to a special deduction commensurate with the duration of ownership. Conversely, if the property is only owned for a short time, a speculation surcharge may be payable. Howewer, if the taxpayer uses the proceeds of the sale for purchasing or building a new home as a replacement for a previous one, profit from the sale will remain untaxed.

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3. In Swiss tax law, there exists a distinction between capital gains and capital yields. Capital gains are the profits arising on the disposal of an asset, i.e. the difference between the proceeds an the cost price or the book value of the asset. The Confederation and all the cantons do not tax private capital gains on movable property. If, however, the pursuit of capital gains is deemed to constitute a business activity, such gains will be regarded as regular income and taxed accordingly. Capital yields (like dividends, liquidation proceeds and other open or hidden distributions of profit of all types, bonus shares and any increase in the nominal value of existing shares which is effected free of charge) are subject to income tax. Other income from movable property is also taxed: Interest on all types of assets, e.g. on claims against banks or against individuals; income from the sale or redemption of bonds on which the bulk of the interest is remitted as a one-off payment (e.g. bonds with global interest, zero bonds, discount bonds).

4. No, we don’t have special rates and reliefs concerning capital gains.

5. A capital gain on business property is definated as the difference between the proceeds and the book value of an asset. If an item is sold, its hidden reserves are realised and taxed. For example, the following situations amount to a realisation:

If an item is transferred from the taxpayer’s business assets to his private assets or to a place of business abroad, the difference between the book and the market value is taxable as a capital gain.

Book revaluations of items amount to a realisation.

6. No

7. No

8. a) Income tax: If the coroporate form of a partnership or one-person company is changed, or if a business is merged with another company, ist hidden reserves are exempt from tax, on condition that: the basis book values are retained; a liability to taxation continues to exist; ownership remains substantially the same and the business continues to operate as before.

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If capital items forming part of the business assets are replaced by other, similar assets, the hidden reserves created may under certain circumstances be transferred tax-free to the substitute assets.

b) Direct taxes on profits of corporations: A corporation’s hidden reserves may remain untaxed in the event of:

change of legal structure, provided the business continues to operate as before and ownership remains substantially the same;

Amalgamation (e.g. a merger ore a takeover) ; a spin-off, provided the individual parts of the business continue to operate as

before.

Companies with substantial interests are privileged. The privileged corporation may have interests in a domestic or foreign company. The direct holding must, however, consist of shares or similar participation rights. Income of interests includes disclosed as well as hidden profit distributions and also liquidations proceeds. The privileged interest must be of a certain economic significance. For direct federal tax, this is deemed to be the case where the interest represents at least 20% of the nominal capital of the company in which the investment is made or amounts to at least CHF 2’000’000 as determined for tax purposes. For direct federal tax purposes the reduction of profit taxes is determined by the ration between net income from the participating interests to total net profit. Net income refers to earnings from participating interests less administrative costs.

9. Business losses (included capital losses) can be carried forward for seven years in total for direct federal tax.

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16. UNITED KINGDOM (Prof. John Tiley)

<I have put some cross refs to the Kluwer Book ed Ault>

1. Describe briefly the national system of taxation on income and capital, as well as that on wealth taxation.

Income tax – Schedular system K p. 111Capital Gains tax – separate tax (K. p. 113) but note that in 1998 we replaced indexation by a system of taper relief. Can supply details if required

Rates of tax have changed: I have covered current rates and structiure in an annex below

Wealth tax – no wealth tax

2. Is income on capital taxed through withholding taxes substitutive to the ordinary income taxation?

Not usually substitutive – can be for nonresidents (dividends/interest)

3. Which principles regulate the taxation of income produced by non individuals (i.e., partnerships, companies, non-profit entities, etc.)? In particular: Are there any mechanisms that avoid (internal) economic double taxation on income from companies?

Partnerships – individual members taxed Companies – corporation tax on profits Non-profit entity - the definition of company includes an unincorporated association. Dividends from companies to shareholders carry a tax credit (currently 1/9 of dividend) (see ANNEX below)

4. Are there any problems of overlapping between the taxation of income from capital and the taxation of capital gains?

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When income was taxed but capital gains were not there was some incentive to convert income into capital gain.

If shares are sold there may be CGT to pay

5. Which are the indirect taxes on capital?

No VATStamp Duty may be charged on certain transactions involving shares No other duties on issue of capital

6. Describe the system of taxation of immovable property (i.e. real estates) in your country.

Rental income arising is taxed under Schedule A Capital gains are taxed under CGT but principal residence is EXEMPT No national tax on imputed income ; Local tax (Council Tax) on value of property Income from land tax under Schedule A; capita gains under CGT

7. Describe the system of taxation of movable property (in particular bonds and similar instruments) in your country.

Bonds and Instruments –Individuals Normally no CGT – bonds from companies and government are normally exempt Interest Income from bonds taxed under Schedule D Case III (UK source) Profit from certain discounted securities – gains are taxed on realisation basis but as ordinary income (DIII)

Companies – i.e subject to corporation tax. Regime known as ‘Loan relationships’ Taxed on an accruals basis – no dist between capital and income; so changes in value of securities are lumped in with interest received and relevant expenses; CT is charged at normal rate on net sum. System extends to liabilities under loan relationships. So co issuing bond gets deduction year by year as liability changes.

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ANNEXI have adapted this from the Alicante book Chapter 9 The United Kingdom has a Schedular system of income tax.353 For very good (i.e. historical) reasons the UK’s income tax year begins on 6th April.354 The system is explained in Revenue Law chapter 7 esp at 7.2 The rate structure is for the most part relatively simple but has become more complicated in recent years. The essence of the structure is that there are three rates of tax. In 2002-03 the starting rate (10%) applies to taxable income from 0 – £1,920, the basic rate (22%) to such income from £1,920 to £29,900 and the higher rate (40%) to such income above £29,900.355 The UK does not have a zero rate band a such; however every individual resident in the UK (and every Commonwealth citizen or national of an EEA country)356 is entitled to a ‘personal relief’ which is taken into account in computing taxable income – in 2002 -03 the personal relief is £4,615.357 In computing taxable income many deductions are allowed; in addition some reliefs take effect as tax credits (called reductions in tax).358 Some of these deductions and credits reflect family obligations – others do not.

There are some special rates for the taxation of interest; here individuals whose marginal rate would be the 22% basic rate pay at the 20% instead.Dividends. The history and policy of UK tax is explained in my Revenue Law Chapter 44 and the taxation of dividends is discussed in chapter 46 esp at 46.3 (pp. 802-804) The legislation is in TA 1988 s. 1B, 20 and 231 et seq.The current rules are that a dividend usually comes with a tax credit which will be 1/9 of the amount of the dividend. So a dividend of 90 comes with a credit of 10. This makes income of 100 (dividend +credit) The dividend is taxed at 10% or, if

353 See generally Tiley Revenue Law Chapter 12 (for year 2001-02) and Tiley and Collison UK Tax Guide 2002-03 chapter 6.354 TA 1988 s. 832 (1).355 The structure of the rates is to be found in TA 1988 s. 1; the figures are contained in Finance Act 2002. See generally Tiley and Collison op cit chapter 6. UK tax legislation takes the form of periodic consolidations (e.g. Income and Corporation Taxes Act 1988, which is usually reduced to TA 1988); these consolidations are then supplemented and amended by the provisions of annual Finance Acts (e.g. FA 1998). I have cited the consolidating legislation is cited in its 2002-03 form without citation of any specific amending legislation. 356 TA 1988 s. 278357 TA 1988 s. 257 (1). The reliefs have a higher value for older taxpayers- s 257 (2) and (3) but the increase is phased out once total income exceeds £17,900.358 TA 1988 s. 256 (2) and (3)

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the taxpayer’s total income exceeds £29,900, 32.5%. The credit of 1/9 can be set against his 10% liability. This means that the basic rate taxpayer and the starting rate taxpayer have all their income tax liability resolved by the credit. The higher rate taxpayer must pays tax of £32.50 but thanks to the credit only has a further £22.5 to find. Two dividend points 1) The reason why this is 10 and 32.5 rather than 20 and 40 is that before 1998 the credit was worth more – ¼ as opposed to 1/9. Doing the sums at ¼ meant that a dividend of 90 carried a credit of 22.50. Tax of 20 and 40 on 112.50 is the same as the current tax at 10 and 32.5 on 100 using a credit of 1/9 (believe me!) A taxpayer with no taxable income CANNOT reclaim the credit from the state

A point common to dividends (Schedule F) and interest (Schedule D Case III) The UK does not allow an income taxpayer to deduct anything by way of expenses from these sources – e.g. interest on a loan to buy the shares.

These rates are historically low (in terms of post 1945 history). In 1977-78 (the last year of a Labour government before 1997) the top rate of tax on earned income was 83% and investment income could attract a surcharge of 15%, a combined top rate of 98%. In 1968-69 the effective top rate of income tax was over 110%. There are no domestic constitutional restraints on such government rapacity; whether the European convention on Human Rights can be invoked succesfully is another matter.

Tax Unit – spouses

The United Kingdom income tax system reflects the values of the recent age of extreme individualism. The tax unit in the UK is the individual. This change was made in 1988 and took effect in 1990. Under the law prevailing until 1973 a wife’s income was simply treated as that of her husband.

The relevance of the family unit has crept back in a litttle through the new rules for tax credits for families

Peter Kavelaars, Accrual versus Realization

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1. Are capital gains on private assets taxed in your country or are there plans to introduce such a form of taxation?

Yes but there are many exceptions’ e.g. principal residence; chattels if sold for less that £6,000; chattels but wasting assets. Main assets charged – shares and land, works of art, furniture and jewellery.

2. Are capital gains taxed on accrual or on realization base?

Realisation – accruals basis is used for certain corporate situations involving loan relationships or financial instruments.

3. Related to question 2, are there differences between types of assets? If so, will you give a short overview?

No

4. Can you give a short overview of the fiscal treatment to the capital gains in the following situations/cases:

- death No charge – step up/down in basis - emigration – exit charge for trusts and companies but none for individuals; charge on indivudal if return within set period (five years) - immigration - charge on individual who returns w/i 5 years- mergers/splitting base cost of old shares carried over to new shares (so no charge on occasion of merger) provided merger not for tax avoidance purposes - divorce 3 rules 1)Assets transferred between H and W living together – such figure that neither gain nor loss accrues 2) H and W living apart are ‘connected persons’ and so all disposals between the take place at market value 3) Once divorced they are no longer H and W so neither 1 nor 2 can apply.

. 5. Are there possibilities to postpone the payment of taxation or to postpone the fiscal claim? If so, please give a short description of the form of postponement?

Can defer tax if consideration is being received in instalments; this is also a deferment option for certain disposals of shares

6. Are there special regulations related to a tax treaty?

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UK Tax treaties use residence basis . The UK does not tax non-residents on gains made from assets in the UK

7. Are there plans to change the system on taxation of capital gains? If so, give a short description of these possible changes.

None

Judith Freedman, Treatment of Capital Gains and Losses 1. Does your system tax capital gains and losses through the general income taxation system?

No

2. If not, are such gains and losses covered by a separate code?

Yes

3. Do you have a statutory distinction between capital gains and other income gains?

Statute does not provide answer to question what is capital and what is income If not, briefly, how are these different types of gain distinguished from other income gains, if at all?

Case law

4. If capital gains are included in the general income tax, do special rates and reliefs apply?

N/A

5. Are capital gains and losses taxed on a realisation basis.

Yes

If so, what amounts to a realisation?

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Disposal This is backed up by certain value shifting rules

If not, what other basis is used?

N/A

6. Are there rules to deal with inflation?

Companies – indexation reliefIndividuals – taper relief

7. Is there a deferral or exemption from tax on capital gains on death?

Exemption

8. What restrictions are there on setting off losses against gains of a different nature (i.e. income versus capital)?

Individuals - One type of income loss (Trading loss) can be set against capital gains Capital losses cannot be set off against income

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