TAXATION- Concept Book

TAXATION Approved courseware for the Certified Financial Planner CM certification education programme in India\" Published by 'International College of Financial Planning Ltd.' \"Every effort has been made to avoid any errors or omission in this book. Inspite of these errors may creep in. Any mistake, error or discrepancy noted may be brought to our notice, which, shall be taken care of in the next printing. It is notified that neither the publisher nor the author or seller will be responsible for any damage or loss of action to anyone of any kind, in any manner, there from. No part of this book may be reproduced or copied in any form or by any means or reproduced on any disc, tape, perforated media or other information storage device, etc. without the written permission of the publisher. Breach of this condition is liable for legal action. All disputes are subject to Delhi jurisdiction only.\" Taxation – Global & India Published by the International College of Financial Planning Ltd. © International College of Financial Planning Limited 2002

This subject material is issued by the International College of Financial Planning Ltd. on the understanding that: 1. International College of Financial Planning Ltd., its directors, author(s), or any other persons involved in the preparation of this publication expressly disclaim all and any contractual, tortuous, or other form of liability to any person (purchaser of this publication or not) in respect of the publication and any consequences arising from its use, including any omission made, by any person in reliance upon the whole or any part of the contents of this publication. 2. The International College of Financial Planning Ltd. expressly disclaims all and any liability to any person in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this subject material. 3. No person should act on the basis of the material contained in the publication without considering and taking professional advice. 4. No correspondence will be entered into in relation to this publication by the distributors, publisher, editor(s)or author(s) or any other person on their behalf or otherwise. Author Sanjiv Bajaj CFPCM, MBA (Finance), International Certificate for Financial Advisors (CII – London) Revised By: Madhu Sinha CFPCM, CIWM Author (“Financial Planning A Ready Reckoner”. Easy strategies for all, Campus Director, International College of Financial Planning, Mumbai Former Director , FPSB India. Revised By: Dinesh Gupta CFPCM from FPSB, IRDA and AMFI Certified. Associate in Insurance from Insurance Institute of India. \"Unless otherwise stated, copyright and all intellectual property rights in all course material(s) provided, is the property of the College. Any copying, duplication of the course material either directly, and or indirectly for use other than for the purpose provided shall tantamount to infringement and shall be strongly defended and pursued, to the fullest extent permitted by law.\"

CONTENTS TAXATION – GLOBAL (1 - 56) Chapter 1: Tax – Principles, Planning & Pay Liabilities (3 - 23) Taxation: one of the clearest manifestations of the powers of a public authority 3 Income Tax 4 Types of Income Tax 6 Horizontal equity 8 The ability-to-pay principle 8 The Benefit Principle 9 Economic efficiency 9 Economic goals 10 Direct and indirect taxes 11 Tax Computation Systems 12 Property-Related Taxes 17 Capital Assets: Gains and Losses 21 Annuities 22 Chapter 2: Cross Border Taxes & Rule of Tax Sources (24 - 33) Financial Planning Principles, Process & Skills 25 Cross-Border 26 Your tax obligations 27 Source Rules 28 Interest and Dividend Income 28 Services 29 Tax Arbitrage 31 Retirement—Pension Plan Distributions 32 Chapter 3: Cross Border Taxes & Rule of Tax Sources (34 - 42) Tax Systems Overview 37 Suitability and Relevance 37 Offshore Investing 38 Income Shifting 39 Tax-Deferred Savings 40 Tax-Free Versus Taxable Yields 40

Chapter 4: Accounting Standards & Research (43 - 56) Organizational Ownership Structures 45 Glossary of Terms Related to Taxation 47 TAXATION – INDIA (57 – 561) Section–I: Features of Indian Tax system and Direct Taxes (61 – 108) 1.1. Features of Indian Tax System 61 1.1.1. Three-tier Federal Structure of Taxation - Union Government, State 61 Governments and Urban/Rural Local Bodies 61 1.1.2. Direct and Indirect Taxes 62 1.1.3. Predominance of Indirect Taxes 62 1.1.4. Tax-induced Distortions on Investment and Financing Decisions 64 1.2. Indian Direct Tax Structure 64 1.2.1. Central Board of Direct Taxes (CBDT) 65 1.2.2. Income-tax (IT) Act,1961 and Income Tax Rules (ITR),1962 67 1.2.3. Wealth Tax Act-1957 67 1.2.4. Finance Act 73 1.3. Tax Compliance Matters 73 1.3.1. Tax Returns and Procedure of Assessment 76 1.3.2. ITR Forms, Filing dates and Documentation 78 1.3.3. E-filing of Income Tax Returns 82 1.3.4. Advance Tax and Due Dates 84 1.3.5. Tax Deducted at Source (TDS) 93 1.3.6. Interest and Penalties 95 1.3.7. Fraud/Concealment Penalties 95 1.3.8. Tax Refund 97 1.4. Residency Rules 97 1.4.1. Residential Status of an Individual 99 1.4.2. Residential Status of Other Taxable Entities 99 1.4.3. Indian Income and Foreign Income 105 1.4.4. Tax Incidence for Different Taxpayers

Section–II: Personal Taxation and Business Taxation- Computation and Tax (109 - 490) 2.1. Salary Income 111 2.1.1. Gross Salary Income - Basic pay, Bonus, Allowances, Retirement Benefits and Perquisites 112 2.1.2. Treatment of Various Allowances 115 2.1.3. Perquisites - Valuation and Taxability 121 2.1.4. Treatment of Retirement Benefits and Voluntary Retirement Scheme (VRS) 131 2.1.5. Profit in Lieu of Salary 139 2.1.6. Deductions from Salary 140 2.2. Income from House Property 198 2.2.1. Basis of Charge and applicability 199 2.2.2. Self-Occupied and Let out House Property 199 2.2.3. Determination of Gross and Net Annual Value 199 2.2.4. Deductions and Special Provisions 200 2.3. Income from Business or Profession 249 2.3.1. Scope of Income and its Computation 250 2.3.2. Deductible and Inadmissible Expenses 251 2.3.3. Deemed Income and Special Provisions 278 2.3.4. Tax Shelter and Tax Holidays 298 2.4. Capital Gains in Transfer of Capital Assets 314 2.4.1. Nature of Capital Gain - Short Term or Long Term Depending on 314 Capital Asset and Holding Period 320 2.4.2. Computation of Capital Gains/Losses 352 2.4.3. Netting Rules and Carry Forward of Capital Losses 353 2.4.4. Exemptions in Capital Gains 2.5. Income from Residuary Sources and Tax Calculation Rules 385 2.5.1. Income from Other Sources - Chargeability, Exemptions and Deductions 386 2.5.2. Clubbing of Income 394 2.5.3. Deductions under Chapter VI-A 406 2.5.4. Taxable Income & Tax liability 426 2.6. Tax Characteristics of Business Forms 455 2.6.1. Sole Proprietorship 455 2.6.2. Partnership Firm 456 2.6.3. Hindu Undivided Family (HUF) 460 2.6.4. Association of Persons (AOP) 468 2.6.5. Cooperative Societies 473 2.6.6. Trusts 474

2.6.7. Companies 480 2.6.8. Others 480 Section-III: Taxation of Various Financial Products and Transactions, Tax Planning Strategies (491 - 561) 3.1. Tax Implications for Non-resident Indians (NRIs) 493 3.1.1. Exempt Income of Non-resident Indians (NRIs) 493 3.1.2. Special Provisions on Certain Transactions 494 3.1.3. Double Taxation Relief 500 3.2. Tax Planning - Various Avenues and Techniques 501 3.2.1. Need and Importance of Tax Planning 501 3.2.2. Tax Planning vs. Tax Evasion and Avoidance 503 3.2.3. Tax Planning vs. Tax Management 505 3.2.4. Deferral of Tax Liability ‘Grade 3 & 4’ 506 3.2.5. Maximizations of Exclusions and Credits ‘Grade 3’ 507 3.2.6. Managing Loss Limitations ‘Grade 3’ 508 3.2.7. Deductible Expenditures of Individuals and Business Forms ‘Grade 3 & 4’ 509 3.3. Taxability of Various Financial Products 512 3.3.1. Provident Fund and Small Savings Schemes - Contribution, Interest, 5 512 Withdrawal and Terminal Value 516 3.3.2. Equity Shares - Listed and Unlisted 520 3.3.3. Equity Transactions - Stock Market and off Market 522 3.3.4. Equity Oriented Products - Equity Schemes of Mutual Funds, ETFs, ELSS, etc. 3.3.5. Debt Products - Bonds, Debentures, Government Securities, Income Schemes 526 of Mutual Funds Including Fixed Maturity Plans (FMPs) ‘Grade 3 & 4’ 533 3.3.6. Income Distribution and Dividends on Various Investment Products 533 533 ‘Grade 3 & 4’ 3.3.7. Securities Transaction Tax (STT) and Dividend Distribution Tax (DDT) 3.3.8. Life and Health Insurance products, Unit Linked Insurance Plans (ULIPs), Unit Linked Pension Plans (ULPPs), etc. 3.4. Taxation of Various Financial Transactions 541 3.4.1. Transaction in the Nature of Gifts/Prizes/Winnings 541 3.4.2. Agricultural Income 541 3.4.3. Cash Payment Over a Specified Limit 543 3.4.4. Dividend and Bonus Stripping Provisions - Shares, MF Schemes Including 553 with Reinvestment Option

TAXATION – GLOBAL CFP Level 2 - Module 2 – Taxation - Global Page 1

CFP Level 2 - Module 2 – Taxation - Global Page 2

Chapter 1: Tax – Principles, Planning & Pay Liabilities You will learn the various aspects of taxation and how tax principles have evolved globally, the basic concepts and key terms related to taxation system Taxation: one of the clearest manifestations of the powers of a public authority. It has existed since the earliest forms of recorded government in history: from ancient Egypt, when the pharaohs levied taxes in the form of shares of agricultural production and labour; to ancient Rome where farmers were required to pay a tenth of their production (decima) to the tax administration (aerarium); and even in Medieval Europe, where a similar taxation system became one source of financing for the Church. Nowadays, governments have developed more sophisticated systems and processes for defining who is taxed, what is taxed (the ‘tax base’), how much is taxed and which personal conditions of the taxpayers should be taken into account. Tax is the compulsory financial charge levy by the government on income, commodity, services, activities or transaction. The word ‘tax’ derived from the Latin word ‘Taxo’. Taxes are the basic source of revenue for the government, which are utilized for the welfare of the people of the country through government policies, provisions and practices. In India, Income Tax was first time introduced in the year 1860 by Sir James Wilson in order to meet the loss caused on account of ‘military mutiny’ in 1857. In the year 1886, a separate Income Tax Act was passed, this act was in force for a long time, subject to the various amendments from time to time. In the year 1918, a new Income Tax Act was passed, but again, it was replaced by another new act of 1992. The Act of 1922 became very complicated due to various amendments. This act remains in force to the assessment year 1961-62. In the year 1956, the Government of India referred to the Law Commission in order to simplify the law and also to prevent the evasion of Tax. CFP Level 2 - Module 2 – Taxation - Global Page 3

The Law Commission submitted its report in September 1958 in consultation with the Ministry of Law. At present, this law is governed by the Act of 1961 which is commonly known as Income Tax Act, 1961 which came into force on and from 1st April 1962. It applies to the whole of India, including the state of Jammu & Kashmir. All levels of government— national, state / province / region, local— may levy taxes in a variety of ways and from many sources: - Income (earned and unearned) - Payroll - Uses of income (e.g., sales, VAT and use taxes) - Business earnings - Trade and imports of goods (i.e., tariffs) - Licenses, franchises, and other privileges (i.e., excise) - Ownership (e.g., real and personal property, investments, etc.) - Transfers of wealth or assets (e.g., gifts, inheritance, estate, stamp duties) INCOME TAX Different Rates in Selected Territories It should come as no surprise that income tax rates vary substantially from one territory to the next. This is the result of many factors. Benefits provided to citizens, infrastructure development, government-related expenses, and many more components go into determining a territory’s income tax structure. As an example of how rates can vary, consider the following chart for ASEAN territories (World Tax, 2017). CFP Level 2 - Module 2 – Taxation - Global Page 4

Figure 2: Personal Income Tax in Asian Notice that income tax rates range from zero (Brunei), to a top rate of around 35%. The table only includes income-related taxes and does not include additional taxes that may apply. What Is Income Tax? Income tax is a type of tax that governments impose on income generated by businesses and individuals within their jurisdiction. By law, taxpayers must file an income tax return annually to determine their tax obligations. Income taxes are a source of revenue for governments. They are used to fund public services, pay government obligations, and provide goods for citizens. • Income tax is a type of tax that governments impose on income generated by businesses and individuals within their jurisdiction. • Income tax is used to fund public services, pay government obligations, and provide goods for citizens. CFP Level 2 - Module 2 – Taxation - Global Page 5

• Personal income tax is a type of income tax that is levied on an individual's wages, salaries, and other types of income. • Business income taxes apply to corporations, partnerships, small businesses, and people who are self-employed. Certain investments, like housing authority bonds, tend to be exempt from income taxes. How Income Tax Works Most countries employ a progressive income tax system in which higher-income earners pay a higher tax rate compared to their lower-income counterparts. The U.S. imposed the nation's first income tax in 1862 to help finance the Civil War. After the war, the tax was repealed; it was reinstated during the early 20th century. In the U.S., the Internal Revenue Service (IRS) collects taxes and enforces tax law. The IRS employs a complex set of rules and regulations regarding reportable and taxable income, deductions, credits, et al. The agency collects taxes on all forms of income, such as wages, salaries, commissions, investments, and business earnings. The personal income tax the government collects can help fund government programs and services, such as Social Security, national security, schools, and roads. Types of Income Tax Individual Income Tax Individual income tax is also referred to as personal income tax. This type of income tax is levied on an individual's wages, salaries, and other types of income. This tax is usually a tax the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income. The IRS offers a series of income tax deductions and tax credits that taxpayers can make use of to reduce their taxable income. While a deduction can lower your taxable income and the tax rate that is used to calculate your tax, a tax credit reduces your income tax by giving you a larger refund of your withholding. CFP Level 2 - Module 2 – Taxation - Global Page 6

Business Income Taxes Businesses also pay income taxes on their earnings; the IRS taxes income from corporations, partnerships, self-employed contractors, and small businesses.4 Depending on the business structure, either the corporation, its owners, or shareholders report their business income and then deduct their operating and capital expenses. Generally, the difference between their business income and their operating and capital expenses is considered their taxable business income.1314 State and Local Income Tax Most U.S. states also levy personal income taxes. As of 2020, there are seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. In addition, two other states—New Hampshire and Tennessee—do not tax earned income; however, they do tax dividends and interest.15 However, Tennessee is set to eliminate those taxes on dividends and interest (an effort to repeal the tax in New Hampshire failed in 2018) and it is projected that the number of states in the U.S. with no income tax will reach eight in 2021. For taxpayers, it may not necessarily be cheaper to live in a state that does not levy income taxes. This is because states often make up the lost revenue with other taxes or reduced services. In addition, there are other factors that determine the affordability of living in a state, including healthcare, cost of living, and job But what are the principles that should underpin taxation and how do these impact on our daily lives? The 18th-century economist and philosopher Adam Smith attempted to systematize the rules that should govern a rational system of taxation. In The Wealth of Nations , he set down four general principles or canons: I. Equality or Equity: The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.… II. Certainty: The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person.… III. Convenience: Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.… CFP Level 2 - Module 2 – Taxation - Global Page 7

IV. Economy: Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state.… Although they need to be reinterpreted from time to time, these principles retain remarkable relevance. From the first can be derived some leading views about what is fair in the distribution of tax burdens among taxpayers. These are: (1) the belief that taxes should be based on the individual’s ability to pay, known as the ability-to-pay principle, and (2) the benefit principle, the idea that there should be some equivalence between what the individual pays and the benefits he subsequently receives from governmental activities. The fourth of Smith’s canons can be interpreted to underlie the emphasis many economists place on a tax system that does not interfere with market decision making, as well as the more obvious need to avoid complexity and corruption. Various principles, political pressures, and goals can direct a government’s tax policy. What follows is a discussion of some of the leading principles that can shape decisions about taxation. Horizontal equity The principle of horizontal equity assumes that persons in the same or similar positions (so far as tax purposes are concerned) will be subject to the same tax liability. In practice this equality principle is often disregarded, both intentionally and unintentionally. Intentional violations are usually motivated more by politics than by sound economic policy (e.g., the tax advantages granted to farmers, home owners, or members of the middle class in general; the exclusion of interest on government securities). Debate over tax reform has often centered on whether deviations from “equal treatment of equals” are justified. The ability-to-pay principle The ability-to-pay principle requires that the total tax burden will be distributed among individuals according to their capacity to bear it, taking into account all of the relevant personal characteristics. The most suitable taxes from this standpoint are personal levies (income, net worth, consumption, and inheritance taxes). Historically there was common agreement that income is the best indicator of ability to pay. There have, however, been important dissenters from this view, and a number of present-day tax specialists differ from it. The early dissenters believed that equity should be measured by what is spent (i.e., consumption) rather than by what is earned (i.e., income); modern advocates of consumption-based taxation emphasize the neutrality of consumption-based taxes toward saving (income taxes discriminate against saving), the simplicity of consumption-based taxes, and the superiority of consumption as a measure of an individual’s ability to pay over a lifetime. Some theorists CFP Level 2 - Module 2 – Taxation - Global Page 8

believe that wealth provides a good measure of ability to pay because assets imply some degree of satisfaction (power) and tax capacity, even if (as in the case of an art collection) they generate no tangible income. The ability-to-pay principle also is commonly interpreted as requiring that direct personal taxes have a progressive rate structure, although there is no way of demonstrating that any particular degree of progressivity is the right one. Because a considerable part of the population does not pay certain direct taxes—such as income or inheritance taxes—some tax theorists believe that a satisfactory redistribution can only be achieved when such taxes are supplemented by direct income transfers or negative income taxes (or refundable credits). Others argue that income transfers and negative income tax create negative incentives; instead, they favour public expenditures (for example, on health or education) targeted toward low-income families as a better means of reaching distributional objectives. Indirect taxes such as VAT, excise, sales, or turnover taxes can be adapted to the ability-to-pay criterion, but only to a limited extent—for example, by exempting necessities such as food or by differentiating tax rates according to “urgency of need.” Such policies are generally not very effective; moreover, they distort consumer purchasing patterns, and their complexity often makes them difficult to institute. The Benefit Principle Under the benefit principle, taxes are seen as serving a function similar to that of prices in private transactions; that is, they help determine what activities the government will undertake and who will pay for them. If this principle could be implemented, the allocation of resources through the public sector would respond directly to consumer wishes. In fact, it is difficult to implement the benefit principle for most public services because citizens generally have no inclination to pay for a publicly provided service—such as a police department— unless they can be excluded from the benefits of the service. The benefit principle is utilized most successfully in the financing of roads and highways through levies on motor fuels and road-user fees (tolls). Payroll taxes used to finance social security may also reflect a link between benefits and “contributions,” but this link is commonly weak, because contributions do not go into accounts held for individual contributors. Economic efficiency The requirement that a tax system be efficient arises from the nature of a market economy. Although there are many examples to the contrary, economists generally believe that markets do a fairly good CFP Level 2 - Module 2 – Taxation - Global Page 9

job in making economic decisions about such choices as consumption, production, and financing. Thus, they feel that tax policy should generally refrain from interfering with the market’s allocation of economic resources. That is, taxation should entail a minimum of interference with individual decisions. It should not discriminate in favour of, or against, particular consumption expenditures, particular means of production, particular forms of organization, or particular industries. This does not mean, of course, that major social and economic goals may not take precedence over these considerations. It may be desirable, for example, to impose taxes on pollution as a means of protecting the environment. Economists have developed techniques to measure the “excess burden” that results when taxes distort economic decision making. Economic goals The primary goal of a national tax system is to generate revenues to pay for the expenditures of government at all levels. Because public expenditures tend to grow at least as fast as the national product, taxes, as the main vehicle of government finance, should produce revenues that grow correspondingly. Income, sales, and value-added taxes generally meet this criterion; property taxes and taxes on nonessential articles of mass consumption such as tobacco products and alcoholic beverages do not. In addition to producing revenue, tax policy may be used to promote economic stability. Changes in tax liabilities not matched by changes in expenditures cushion cyclical fluctuations in prices, employment, and production. Built-in flexibility occurs because liabilities for some taxes, most notably income taxes, respond strongly to changes in economic conditions. A more-active approach calls for changes in the tax rates or other provisions to increase the anticyclical effects of tax receipts. Some economists propose tax policies to promote economic growth. This approach may imply a qualitative restructuring of the tax system (for example, the substitution of taxes on consumption for taxes on income) or special tax advantages to stimulate saving, labour mobility, research and development, and so on. There is, however, a limit to what tax incentives can accomplish, especially in promoting economic development of specific industries or regions. An emphasis on economic growth implies the need to avoid high marginal tax rates and the tax-induced diversion of resources into relatively unproductive activities. CFP Level 2 - Module 2 – Taxation - Global Page 10

Taxation From the Client’s View It’s unlikely that financial planning clients would request a financial planner to help him or her pay more taxes. Everyone will like to earn more, save more, invest more but no one will like to pay more taxes. Few, if any, people want to give more of their money to the government than necessary. Very rarely some people consider paying taxes to be a privilege, but most want to limit that privilege as much as legally possible. This is no less true whether focusing on taxes while living or as part of a person’s estate transfer. As a financial planner, you will need to know the tax laws and implications well only then you would be able to optimize tax plans for your clients. Classes Of Taxes Direct and indirect taxes In the literature of public finance, taxes have been classified in various ways according to who pays for them, who bears the ultimate burden of them, the extent to which the burden can be shifted, and various other criteria. Taxes are most commonly classified as either direct or indirect, an example of the former type being the income tax and of the latter the sales tax. There is much disagreement among economists as to the criteria for distinguishing between direct and indirect taxes, and it is unclear into which category certain taxes, such as corporate income tax or property tax, should fall. It is usually said that a direct tax is one that cannot be shifted by the taxpayer to someone else, whereas an indirect tax can be. Be it an individual or any business/organization, all have to pay the respective taxes in various forms. These taxes are further subcategorized into direct and indirect taxes depending on the manner in which they are paid to the taxation authorities. Let us delve deeper into both types of tax in detail: Direct Tax  The definition of direct tax is hidden in its name which implies that this tax is paid directly to the government by the taxpayer  The general examples of this type of tax in India are Income Tax and Wealth Tax.  From the government’s perspective, estimating tax earnings from direct taxes is relatively easy as it bears a direct correlation to the income or wealth of the registered taxpayers. CFP Level 2 - Module 2 – Taxation - Global Page 11

Indirect Tax  Indirect taxes are slightly different from direct taxes and the collection method is also a bit different. These taxes are consumption-based that are applied to goods or services when they are bought and sold.  The indirect tax payment is received by the government from the seller of goods/services.  The seller, in turn, passes the tax on to the end-user i.e. buyer of the good/service.  Thus the name indirect tax as the end-user of the good/service does not pay the tax directly to the government.  Some general examples of indirect tax include sales tax, Goods and Services Tax (GST), Value Added Tax (VAT), etc.  TAX COMPUTATION SYSTEMS Proportional, Progressive, and Regressive Taxes Taxes can be distinguished by the effect they have on the distribution of income and wealth. A proportional tax is one that imposes the same relative burden on all taxpayers—i.e., where tax liability CFP Level 2 - Module 2 – Taxation - Global Page 12

and income grow in equal proportion. A progressive tax is characterized by a more than proportional rise in the tax liability relative to the increase in income, and a regressive tax is characterized by a less than proportional rise in the relative burden. Thus, progressive taxes are seen as reducing inequalities in income distribution, whereas regressive taxes can have the effect of increasing these inequalities. The taxes that are generally considered progressive include individual income taxes and estate taxes. Income taxes that are nominally progressive, however, may become less so in the upper-income categories—especially if a taxpayer is allowed to reduce his tax base by declaring deductions or by excluding certain income components from his taxable income. Proportional tax rates that are applied to lower-income categories will also be more progressive if personal exemptions are declared. Income measured over the course of a given year does not necessarily provide the best measure of taxpaying ability. For example, transitory increases in income may be saved, and during temporary declines in income a taxpayer may choose to finance consumption by reducing savings. Thus, if taxation is compared with “permanent income,” it will be less regressive (or more progressive) than if it is compared with annual income. Sales taxes and excises (except those on luxuries) tend to be regressive, because the share of personal income consumed or spent on a specific good declines as the level of personal income rises. Poll taxes (also known as head taxes), levied as a fixed amount per capita, obviously are regressive. It is difficult to classify corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of uncertainty about the ability of businesses to shift their tax expenses . This difficulty of determining who bears the tax burden depends crucially on whether a national or a subnational (that is, provincial or state) tax is being considered. In considering the economic effects of taxation, it is important to distinguish between several concepts of tax rates. The statutory rates are those specified in the law; commonly these are marginal rates, but sometimes they are average rates. Marginal income tax rates indicate the fraction of incremental income that is taken by taxation when income rises by one dollar. Thus, if tax liability rises by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax statutes commonly contain graduated marginal rates—i.e., rates that rise as income rises. Careful analysis of marginal tax rates must consider provisions other than the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) falls by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points higher than indicated by the statutory rates. Since marginal rates indicate how after-tax income changes in response to changes in before-tax income, they are the relevant ones for appraising incentive effects of taxation. It is even more difficult to know the marginal effective tax rate applied to income from business and capital, since it may depend on such considerations as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation CFP Level 2 - Module 2 – Taxation - Global Page 13

adjustment. A basic economic theorem holds that the marginal effective tax rate in income from capital is zero under a consumption-based tax. Average income tax rates indicate the fraction of total income that is paid in taxation. The pattern of average rates is the one that is relevant for appraising the distributional equity of taxation. Under a progressive income tax the average income tax rate rises with income. Average income tax rates commonly rise with income, both because personal allowances are provided for the taxpayer and dependents and because marginal tax rates are graduated; on the other hand, preferential treatment of income received predominantly by high-income households may swamp these effects, producing progressivity, as indicated by average tax rates that fall as income rises. Types of Taxes to Which Individuals Are Subject  Employment-related (i.e., income) taxes: These are government (national, regional, and local) taxes on earned income.  Value-added taxes (VAT): These are a type of consumption tax placed on each step of the production process and also collected when the product is sold. Tax rates vary by product or service, and by territory, ranging from less than 10% to 20% or slightly more. Most developed territories levy a VAT in some form.  Sales taxes: These taxes are imposed by a government (national, regional, local, or other) at the point of sale. Retail goods and services may be taxed. Sales taxes are not the same as VAT, the biggest difference being that sales taxes are collected from consumers at the time of sale, while VAT are collected throughout the supply chain along each step of the production process.  Property taxes: These are assessed on real property. The amount of tax usually depends on the assessed value of the property.  Excise taxes: These are normally assessed by the government on particular products. Excise taxes may be ad valorem—a fixed percentage charged on a specific good, or specific—a fixed amount based on the quantity purchased.  Estate transfer/wealth distribution taxes: These are taxes imposed by governments on the distribution of estate assets. Income Taxes The fewer income taxes paid by an individual, the more income he or she gets to keep and use. This principle infuses all tax-related strategies. The desire to earn more income presents an interesting dilemma. CFP Level 2 - Module 2 – Taxation - Global Page 14

Normally, especially in a progressive tax scheme, higher income means the individual must pay a greater percentage of taxes, as income increases beyond certain levels or bands. For example, a person may have to pay 20% on all earned income up to X level. Let’s say that the progressive nature of the tax rates proceed through levels X, Y, and Z. All income between X and Y will be assessed at 25%. All income between Y and Z will be assessed at (for example) 30%. Any income above level Z may be assessed at an even higher rate, let’s say 35%. You see the dilemma. The more the person earns, the higher tax rates he or she will pay against those earnings. However, especially in progressive tax schemes, there are times when earning X + 1 (rather than X) can cause an actual decrease in net income because of the higher tax rate or elimination of tax deductions as the earner passes certain income thresholds. One strategy is to evaluate whether a person would be better off financially reducing, deferring, or shifting income to either preserve valuable tax deductions or stay within a particular tax rate band. Social security/benefit payments can be included in the income tax category. Some territories levy a large percentage social insurance tax on employees, while others do not. The degree of taxation is not necessarily directly caused by the amount of benefits likely to be received by the employee at some point in the future, but there is, of course, a relationship. Territories with higher levels of social security benefits generally levy higher percentages of taxation, while territories at the opposite end of the spectrum generally levy fewer taxes. Tax filing status is another area to consider. A few territories assess a flat tax regardless of filing status. This means that it doesn’t matter whether the individual is single or married, divorced or separated, with or without children, a widow (er), high or low income, or has some other status. In other territories, however, filing status can make a big difference in tax rates. For example, income or maintenance payments to a former spouse may be deductible to the payor depending on the territory and whether the individuals are legally divorced or simply separated and living apart. Similarly, a single person with children at home may have a different filing status than one without dependent children. CFP Level 2 - Module 2 – Taxation - Global Page 15

Where applicable, financial planners would do well to investigate whether clients filing a tax return with a different legal status (e.g., married, single, etc.) would make a difference in the amount of tax he or she owes. Tax Terms Total income: Sometimes called gross income. This is income, unless otherwise excluded, from any and all sources. Note that total income may not actually refer to all income. Instead, it refers to all income that is counted or not excluded for tax purposes. Income that is excluded does not increase a person’s potential tax liability. Adjustments to income: These are any items that increase or decrease income. Penalties and interest on taxes owed, but not paid, are examples of adjustments that increase income. Adjustments that decrease income include all exemptions and deductions that one could apply. The specific elements will vary by territory, but may include items such as education expenses, contributions to retirement plans, expenses related to children, etc.  An exemption eliminates income from inclusion in the tax computation.  A deduction provides a credit against qualified expenses, such as those for childcare or education.  Adjusted total or gross income: The amount of reportable income after making applicable adjustments to income.  Filing status: Whether a person is married or single, with or without dependent children, etc.  Marginal tax bracket: In a progressive or banded tax scheme, the rate of tax the individual pays on the highest amount of taxable income (e.g., X + 1).  Phase outs: Some deductions or exemptions may only be available below certain income thresholds. When income increases above the threshold, the deduction may be phased out, based on exactly how much income the individual earns. There will likely come a point where the deduction is fully eliminated, because income is too high to qualify.  Source: Generally, the place income is determined to have been earned or received. This may be either a domestic or foreign territory. The source of income is important for taxation purposes, and may be mitigated by tax treaties between territories.  Tax deferral: Delaying payment of taxes. This is not the same as tax avoidance, where taxes are never paid on a certain amount of income. Deferral simply delays payment to a later date. For example, some territories allow tax deferral on earnings within certain investment vehicles used for retirement. CFP Level 2 - Module 2 – Taxation - Global Page 16

 Tax evasion: Illegally avoiding income reporting and/or tax payments. No financial planning professional should participate in any scheme to evade taxes.  Tax return: The official document(s) used to report income and related taxes.  Tax treaty: An agreement between territories regarding how taxes will be assessed on income earned in one or the other territory, especially when a company or citizen domiciled in one territory earns income in another territory.  There are many additional tax terms, some of which we will discuss when we look at property- related, and in another course, estate-related taxes.  A financial planner who is helping a client with his or her tax liability will be well-served to have a more complete knowledge of relevant tax terminology and tax experts they can collaborate with. Property-Related Taxes Income taxation can be clear-cut, with fairly simple strategic planning opportunities. However, as a client moves higher on the income and/or asset scale, he or she may have greater strategic opportunities, such as shifting or deferring income. Individuals with greater assets and/or higher income often have more options to address potential tax liabilities. This also may be true when considering property-related taxes. Sometimes a person with greater assets is able to shelter income or otherwise defer or avoid paying taxes on asset-based earnings. We will focus on the circumstances of the “average” person. Average, of course, will vary greatly by territory and situation. A person considered to have a modest level of income or assets in one territory may be considered wealthy (or poor) in another. Throughout this course, we will attempt to strike a balance that will be applicable in most areas. In some territories, a lack of, or a low, income tax may be offset by higher use taxes or taxes on property. Property refers to anything a person owns. This may be a piece of jewelry, furniture in a home, an investment portfolio, a parcel of land or a house, a business—anything that a person or other entity owns. Property may be tangible (i.e., something with a physical existence, that may be touched) or intangible (i.e., something that has no specific physical existence, such as a promissory note or a patent). Even though there may be a piece of paper involved, such as a stock certificate, don’t be fooled into thinking it’s a tangible item. It still fits into the intangible category, because the piece of paper merely represents the intangible item. The paper has no tangible value by itself. Proper categorization can make a difference in how to treat the item for tax purposes. We can highlight three distinct categories of property: 1. Personal 2. Real 3. Investments or securities CFP Level 2 - Module 2 – Taxation - Global Page 17

Around the globe, the tax rate percentage levied on an individual’s income varies from zero to greater than 55% (KPMG, 2017). Corporations also face taxation on earnings with a similar range of tax rates (although not as high as personal rates in most situations). Systems that tax corporations can be arranged on a worldwide method or a territorial basis. Under the worldwide method, income earned abroad by foreign subsidiaries is subject to tax by the home territory, with a credit for income taxes paid to foreign governments. Under the territorial method, also referred to as a \"participation exemption\" system, active business income earned abroad by foreign subsidiaries is wholly or partially exempt from home territory tax with no credit for foreign taxes (PWC, 2013). Property-Related Taxes Income taxation can be clear-cut, with fairly simple strategic planning opportunities. However, as a client moves higher on the income and/or asset scale, he or she may have greater strategic opportunities, such as shifting or deferring income. Individuals with greater assets and/or higher income often have more options to address potential tax liabilities. We will focus on the circumstances of the “average” person. Average, of course, will vary greatly by territory and situation. A person considered to have a modest level of income or assets in one territory may be considered wealthy (or poor) in another. Throughout this course, we will attempt to strike a balance that will be applicable in most areas. Proper categorization can make a difference in how to treat the item for tax purposes. We can highlight three distinct categories of property: 1. Personal 2. Real 3. Investments or securities 4. Personal Property 5. Personal property includes such items as: household furnishings, jewelry, artwork, clothing, computers, cars, and similar. 6. One way to identify personal property is that it can be moved. 7. Personal property also often is categorized as use property. 8. Personal use property is different from investment property. 9. Investment property is purchased and held for the specific purpose of selling it to make a profit. CFP Level 2 - Module 2 – Taxation - Global Page 18

10. The determination of whether a piece of property should be categorized in the personal use or investment category can become a little cloudy. 11. For example, a painting may be considered a use asset—simply a decoration on the wall—until it is sold at a profit, at which point it may be categorized as an investment. 12. A coin collection may represent an enjoyable hobby and considered a use asset until it is part of a profitable sale. At that point it would almost certainly be reclassified as an investment. 13. Correct categorization of personal property matters, because tax codes often treat the sale of personal use assets (i.e., most personal property) differently than an investment sale. Most purchases or sales of personal use assets do not represent a taxable event. That is, no tax consequences exist either at time of purchase or sale (beyond possible sales tax or VAT). Personal Property As a financial planner, you should know that often, but not always, the taxing authority determines an asset’s status as either use or investment. Sometimes, though, the individual can make a cogent argument that the asset’s status should be one or the other, and the taxing authority accepts the argument. As a result, it’s often beneficial to at least consider making a case if the initial determination is less advantageous than anticipated. Real Property Authorities sometimes tax real property in a different manner than personal use or various types of investment property. Owners of real property often pay taxes on an annual basis, in addition to when they sell the property. We should note, however, that not all territories assess an annual property tax . Taxation is based on the current value of the property, and characteristically is assessed for the benefit of the community. For example, property taxes may be used to help maintain roads, build schools, or support the local government. Taxes usually are based on a current appraisal, so it makes sense to ensure an accurate valuation. Depending on the territory, real property used for investment purposes may be taxed differently than property at which the owner resides. Territories sometimes give tax incentives for home ownership that are not available to investment- related real property. CFP Level 2 - Module 2 – Taxation - Global Page 19

Territories often develop tax legislation to encourage or discourage various actions. For example, if a territory wants to encourage savings and investment, it may provide tax incentives to do so. Many territories wish to promote home ownership in one form or another. This is why certain tax incentives, such as a partial (or full) deduction for mortgage interest paid, may be introduced. Investment Property Investment properties, or non-real property securities, often have tax characteristics that differ from other property. This is one reason why it’s important to correctly differentiate between personal use property and that which someone holds for investment purposes. Simply put, people purchase investments to make money. Investment return primarily comprises some combination of income and capital or asset appreciation. Income usually is categorized as unearned rather than earned, which is how wages and other employment-related income are categorized. Unearned, or investment, income may or may not receive tax treatment that differs from earned income. Bonds and dividend-paying stocks often generate unearned income. Investment real estate also may produce unearned income. Royalties originate from an arrangement where an entity (e.g., individual, corporation, trust, government) pays another entity for the right to use an asset. These arrangements may be applied to any number of situations and an entity may receive royalties from allowing the use of (for example):  Mineral or petroleum resources Page 20  Patents  Trademarks  Franchises  Copyrights  Book publishing  Music  Performance  Intellectual property CFP Level 2 - Module 2 – Taxation - Global

Capital Assets: Gains and Losses  A capital asset is property used to generate a financial return, rather than property used generally for consumption or put to other personal use.  A realized capital gain or loss is a gain or loss that results when a person sells the asset.  It is realized because the owner actually receives the results of the sale—either for a gain or a loss.  Unrealized gains or losses may happen when the owner does not sell the asset. An increase/decrease in the value of a stock in a portfolio is an example of an unrealized gain/loss.  The stock has increased (or decreased) in price or value, but the investor has not sold the stock or received any money, so he or she has not realized any gain or loss. Nonetheless, unrealized gains sometimes may be taxable.  Short-term or long-term gains or losses are a little more difficult. Both refer to the length of time a person holds a capital asset.  As a general rule, shares held for one year or more often are treated as producing long-term capital gains or losses.  Shares held for less than one year often will be treated as producing short-term gains or losses.  Strategically, if the holding period makes a potential difference in tax rates, the individual might want to consider delaying a sale so as to qualify for the longer holding period treatment. Basis Although investment property may be treated differently depending on its nature (capital asset or other), holding period (short- or long-term), status (still within a portfolio or sold), or territory, one factor is consistent: The property owner must be able to identify what was paid to purchase the asset and the price he or she received when the asset is sold. People normally pay taxes on investment-related gain. The current value or sales price is easy to know. Basis is the adjusted cost of the property. Adjustments can either increase or decrease basis. For example, in territories that have a depreciation allowance, amounts claimed typically will decrease the cost basis. On the other hand, if an investor is required to pay additional funds to improve the asset (e.g., to paint or improve rental real estate or repair an investment asset), those expenses may serve to increase the cost basis. CFP Level 2 - Module 2 – Taxation - Global Page 21

An investment purchased for $100 has an initial cost basis of $100. If that asset sells for $100, with no supplementary funding added or expenses subtracted, there is no gain or loss, and (most likely) the owner won’t pay tax on the sale. However, let’s assume the investor had to improve the asset at a cost of $50. Now, the asset has a cost basis of $150. If the asset sells for $150 after the additional investment, all things being equal, there should be no taxable gain on the sale. In the same situation, if the asset sells for $200, the investor will potentially have a taxable gain of $50. An investor invested $1,000 in mutual fund shares at a price of $10 per share two years ago (100 shares), $1,000 at a price of $8 per share one year ago (125 shares), and $1,000 at a price of $5 per share six months ago (200 shares). Assume the investor wants to withdraw $1,000 today when the share price is $10 (i.e., 100 shares). What is the investor’s basis and will taxes be levied on the withdrawn shares on the basis of long-term or short-term capital gains? The answer depends on whether shares are arbitrarily withdrawn from the entire basket of shares or if the investor can identify specific shares to be withdrawn. If shares are taken from the basket, the likely tax result will be a combination of long- and short-term capital gains. Basis also will depend on which shares are withdrawn—those purchased at $10, $8, or $5 per share. If all the shares withdrawn are those purchased last (i.e., last in first out), the withdrawal will produce a taxable gain of $500 and will be taxed as a short-term capital gain. If the 100 shares are withdrawn from the original investment (i.e., first in first out), there will be no gain (or loss) and no taxable amount. You can see why being able to identify purchase information can be quite important. Annuities Annuities represent a means of saving that, in most territories, allow the funds to grow without paying current taxes. The tax-deferred earnings help the annuity investment to grow larger than if taxes are withdrawn and paid annually. Many retirement programs use annuities in one form or another to fund retiree pension benefits. CFP Level 2 - Module 2 – Taxation - Global Page 22

When the time comes to annuitize (i.e., begin receiving regular payments from the annuity) the tax situation can change, sometimes by a lot. Non pension, nonqualified annuity payments often are taxed based on some of the money being considered a nontaxable return of premium or investment, and an amount resulting from investment earnings, which is taxable. For pension annuities (i.e., qualified retirement plans) that are not contributory, the entire distribution likely will be taxed, although some territories may exempt a portion of the payments from income. Each territory addresses taxation in its own way, and this includes ways in which annuity distributions are taxed. Non periodic distributions—lump sums or occasional payments—often are fully taxable as investment earnings. Periodic distributions, where part of each payment is considered a return of investment and part resulting from investment earnings, often will include a formula to exclude the non-taxable portion. Of course, formulas can vary by territory and specific situation. As an example of an exclusion formula, consider the following: Each payment will be adjusted by the exclusion ratio, which is the ratio that the total investment in the annuity bears to the total expected return under the contract. The key points to remember are:  that government-provided pension annuity payments usually will be taxable as income (perhaps with some amount exempt from taxation).  Lump sum and non periodic payments usually will be at least partially taxable; often the entire amount will be taxed.  Periodic annuity payments from nonqualified (i.e., nongovernment pension) annuities often will be partially taxable and partially tax-exempt, based on the amount used to purchase the annuity, the payment amounts, and the payout period.  Taxation of government-backed pension (provident) funds will vary based on the territory, exemption amounts, and employee contribution amounts, and whether those amounts were ever previously taxed. CFP Level 2 - Module 2 – Taxation - Global Page 23

Chapter 2: Cross Border Taxes & Rule of Tax Sources You will learn how taxation across different nations work when residents status changes , what are the rules governing the cross border taxes. Most territories tax based on where you are living. As an example, if you live and work in Germany, you will be taxed by Germany. However, if you are a German citizen, but not living and working there, Germany will not claim any right to tax you on earnings from the non- German territory. If tax codes worked like this around the world, there would be little need to address cross-border scenarios. However, all territories do not follow this method of taxation. At the same time, most territories have entered into a system of cross-border legislation that generally keeps individuals from being taxed twice on income earned in their non-domestic territory. Generally, but not always. When a financial planner works with someone in a cross-border situation, it always will be important to check relevant tax treaties and regulations. Doing this is the main way to ensure compliance and to not cause tax-related difficulties for clients. Cross-border income taxation is much more nuanced and involved than most financial planners are qualified to handle. This most certainly is an area where developing a referral relationship with a cross- border tax professional is a wise thing to do. it always will be important to check relevant tax treaties and regulations. CFP Level 2 - Module 2 – Taxation - Global Page 24

Financial Planning Principles, Process & Skills CFP Level 2 - Module 2 – Taxation - Global Page 25

Financial Planning Principles, Process & Skills Cross-Border Ever-improving technology and internet-based resources, along with increased information sharing among territories, make attempting to hide income or assets difficult to the point of often being impossible. Trying to evade cross-border related tax concerns or seeking to avoid notice by tax authorities is unethical and illegal. Eventually, the authorities will uncover that which has been hidden and bring to bear the full legal force available to them. It’s far better to learn the rules and play by them. One of the rules about which people may not be aware is the common requirement to obtain a certificate of compliance with the territory’s income tax laws prior to leaving the territory. This requirement does not apply to tourists or temporary visitors, and it may not apply when a resident CFP Level 2 - Module 2 – Taxation - Global Page 26

alien intends to return to the territory. However, because it may be a relevant requirement in cross- border scenarios, it is important to check for compliance. Cross-Border Example: Canadian Non-resident Residency status: Non-residents You are a non-resident for tax purposes if you:  normally, customarily, or routinely live in another country and are not considered a resident of Canada  do not have significant residential ties in Canada  you live outside Canada throughout the tax year  you stay in Canada for less than 183 days in the tax year Your tax obligations As a non-resident of Canada, you pay tax on income you receive from sources in Canada. The type of tax you pay and the requirement to file an income tax return depend on the type of income you receive. Generally, Canadian income received by a non-resident is subject to Part XIII tax or Part I tax. The most common types of Canadian income subject to Part XIII tax are:  dividends  rental and royalty payments  pension payments  old age security pension  Canada Pension Plan and Quebec Pension Plan benefits  Retiring allowances  registered retirement savings plan payments  registered retirement income fund payments  annuity payments  management fees CFP Level 2 - Module 2 – Taxation - Global Page 27

You may come across three main kinds of individuals with cross-border assets or income 1. Foreign nationals living and working in your territory (i.e., resident aliens) 2. Expatriates (i.e., citizens of one territory living abroad—e.g., in your territory) 3. Foreign nationals living outside of your territory with assets in your territory (and perhaps in other territories) Each group has potentially different tax ramifications. Those individuals who live and work in your territory may be known as foreign nationals or resident aliens. They likely were born in one territory and now live and work in your territory. While living and working in your territory, these individuals normally will be taxed in the same way as any other individual in your territory. At the same time, they may be subject to tax schemes in one or more additional territories, if they have assets or produce income in other territories. The text does not include specific guidance regarding cross-border situations. Reasons for this include the difficulty of knowing all relevant tax regulations from all territories. Further, regulations in one territory can be (and often are) quite different from regulations in other territories. Considering that some individuals may have income or assets subject to several territorial tax regimes, the implications and application of any strict set of rules becomes prohibitive. This is why we strongly recommend developing a working, professional relationship with a knowledgeable firm or individual. Doing this will allow the financial planner to provide the highest degree of service to clients with the lowest potential for making mistakes and incurring liability. Source Rules The current residency of an individual is certainly important, but the source of any income is perhaps the most important factor. For individuals, the location in which income is generated can make a big difference in how (and where) it is taxed. If 100% of a person’s income comes from employment, business, real estate, investment portfolio, or any other assets domiciled in a territory in which they have always lived and worked, that territory’s tax scheme, including filing requirements, etc., will solely apply. CFP Level 2 - Module 2 – Taxation - Global Page 28

This means, if I live and work where I have always lived and worked, and all my income and assets come from the same territory, I only have responsibility to file and pay taxes in that territory. If I live and work where I have always lived and worked, and all my income and assets come from the same territory, I only have responsibility to file and pay taxes in that territory. The same is not true when an individual has income or assets in more than one territory. When this is the case, often, regardless of where they currently reside, the source of any income must be determined, because it can have an impact on their tax liability. The first, and most obvious question to answer is whether income has been earned from the territory in which the individual currently resides or from another territory. Most developed territories usually associate the source of income with the economic activity giving rise to it. Interest and Dividend Income Generally, interest paid by an individual, partnership, or trust is sourced at the payor’s place of residence, and interest paid by a corporation is sourced at the place of incorporation. As a result, when a resident individual or partnership, along with trusts and corporations domiciled in your territory, pay interest, it will be considered as coming from your territory. Dividends usually are considered to be sourced from the territory in which the corporation paying them is incorporated. Services Income resulting from personal services usually is sourced from the place where the services were performed. Consider, however, the situation in which an individual from one territory periodically performs services in another territory. From which territory will related income be sourced? As an example of this situation, let’s explore the National Hockey League (NHL). Some teams and players play hockey games in more than one territory, but they do not live in the foreign territories in which they play. CFP Level 2 - Module 2 – Taxation - Global Page 29

While income earned by the hockey players themselves does not create a great difficulty, the income of the team (i.e., the employer) resulting from the player’s efforts can create source problems. The reason for this is that it can be difficult to accurately determine the amount of income earned as a direct result of foreign activities. 1. Financial planners should be cautious as they work with clients in this area. 2. Making a referral to an expert is often the best practice. 3. Financial planners can, however, help clients understand some of the potential difficulties resulting from cross-border income. Avoidance of double taxation is one of the primary functions of any tax treaty. If two territories (for example) consider an individual to be a resident— especially for tax purposes—without some mitigation, the individual likely will be taxed twice on the same income. Tax treaties, or double tax avoidance agreements (DTAAs) among territories alleviate the double- taxation problem (in many situations).Sometimes a treaty eliminates the requirement to pay taxes in both territories. We can summarize the most common tax treaty objectives as follows. 1. Elimination of double taxation 2. Certainty of tax treatment 3. Reduce tax rates 4. Lower compliance costs 5. Prevention of fiscal evasion 6. Prevention of tax discrimination 7. Resolution of tax disputes 8. Provide for tax sparing Tax treaties are enacted between two specific territories. This means that Territory A will not issue a global treaty (i.e., unilaterally with the rest of the world).It’s also worthwhile to note what usually happens when one territory does not levy a tax on income to which it might otherwise be entitled. When this happens, the other (normally, domestic) territory will assess an income tax. Tax treaties rarely, if ever, result in an arbitrage-type arrangement where an individual escapes paying income taxes to any territory. CFP Level 2 - Module 2 – Taxation - Global Page 30

The other typical solution for avoiding double taxation is for the domestic territory to provide a tax credit for taxes paid in the foreign territory, to be used when the individual (or corporation, etc.) files a tax return in the domestic territory .A tax credit is somewhat more unilateral and straightforward than a tax treaty. Tax credits do not require bilateral agreement between two territories. Simply put, with or without a treaty, Territory A gives residents a credit for taxes paid on income earned in Territory B. The taxes are paid in the foreign territory—perhaps at an even higher rate than would be the case domestically. The domestic territory then provides an offsetting credit to the individual, thereby effectively allowing overall income taxation to be levied only once. All the usual considerations come into play—residency, source of income, domicile and type of income (e.g., dividends, royalties, personal service, etc.). Tax Arbitrage It is outside the scope of this text to explore specific tax arbitrage-related strategies. However, financial planners can explore opportunities arising from various classifications of income (e.g., pension distributions) where one of the tax jurisdictions may assess a lower rate on the income (or asset). The same may be true of companies and how they are structured and where they are domiciled. Sometimes, taxes on earnings or profits can be reduced by effective application of tax treaties and legal classifications. With the possible exception of territories within the European Union (EU) using the euro, inter territorial and cross-border transactions will, almost always, involve more than one currency. A transaction may be initiated in (for example) dollars, rubles, francs, yuan, or pesos, and then may need to be converted or exchanged into a different currency. One of the related issues is the question of what currency will be used to pay income tax, using what exchange rate. CFP Level 2 - Module 2 – Taxation - Global Page 31

Income tax liability often is determined in the domestic territory currency. When money is earned in a foreign territory and income tax is paid in the domestic territory, how are exchange rate spreads addressed? In simple terms, income taxes are paid in the territory of taxation. For example, a taxpayer in South Africa pays taxes in the local currency—Rand (ZAR). When the taxpayer must pay taxes on income earned in another territory (e.g., India; INR), there will be an exchange rate applied of (currently) 1 ZAR = 4.53 INR. If income was earned at this same rate, there is no gain or loss. However, if income was earned when the exchange rate was 1 ZAR = 5.15 INR, the taxpayer would essentially pay fewer ZAR on the income earned in INR. The reverse would also be true. If 1 ZAR = 4.30 INR, the tax payer would effectively pay more ZAR on the income earned in INR. One additional mention deserves to be made. Suppose a non-European taxpayer borrows Euros, which the taxpayer uses to purchase Italian real property. Any gain or loss on the sale of the real property is determined separately from any gain or loss on the ultimate purchase of Euros to repay the loan. In some circumstances the taxpayer may be permitted to integrate currency gains or losses with the gain or loss on the underlying property. Retirement—Pension Plan Distributions Most territories offer one or more types of qualified retirement plan options to employees, and perhaps unemployed citizens. By “qualified,” we mean plans that are sponsored, offered, or simply authorized by the national government to provide benefits that normally are provided on a beneficial tax benefit. Some benefits are fully income-tax-free, while others may fit into the category of being tax-deferred, which means eventually, some or all benefits will be taxed. Often, benefits fit into a combination of these options. What happens when an individual wants to receive retirement benefits earned in one territory, but he or she now lives in a different territory? Some of the answer to this may be defined by various tax treaty agreements between territories. CFP Level 2 - Module 2 – Taxation - Global Page 32

Unfortunately, this is not always the case, especially when retirement assets are coming from more than two territories. Normally, these accounts remain in the original territory, but benefits may be paid in the current place of residence. It’s certainly possible for account holders to liquidate some accounts (e.g., defined contribution or other non-defined benefit pension-type plans), but the income tax bill assessed on lump sum distributions is likely to be quite large. Liquidation is not always possible, especially when working with defined benefit-type plans that only provide a retirement benefit and do not accumulate a cash fund that belongs to the employee (as in a defined contribution-type plan). Generally, employee contributions are more transportable than those provided by the government, and in some cases, employers. Plan distributions may be taxed by the current territory of residence or the initial territory (where the account originated) Taxes may be withheld from distributions in both territories. To recover withheld taxes, the recipient must file an income tax return in the territory that does not have the right to tax payments. In some situations, both territories actually may have some right to a portion of the taxes, which serves to complicate the recipient’s picture. When the individual receives a lump sum distribution, it may be taxable in either territory, and often follows different rules than periodic distribution payments. One of the key considerations that often arises is the degree to which a foreign retirement plan meets the criteria of the national (e.g., current territory of residence) plan. This is neither always readily discernible nor easily understood. This means a qualified retirement plan in one territory may not satisfy the definition of a qualified retirement plan in a second territory. The implication of this being that earnings that were tax-deferred or nontaxable in the original territory may not be given the same status in the second territory. Cross-border income taxation is much more nuanced and involved than most financial planners are qualified to handle. This most certainly is an area where developing a referral relationship with a cross- border tax professional is a wise thing to do. CFP Level 2 - Module 2 – Taxation - Global Page 33

Chapter 3: Cross Border Taxes & Rule of Tax Sources You will learn how to distinguish between taxable and tax free yields and accordingly how to optimise tax planning strategies for your clients. One of the difficulties in writing about taxation in a global financial planning text is the significant diversity among territories. To illustrate, think about tax documents.  In the UK, the SA100 is the basic Her Majesty’s Revenue and Customs (HMRC) income tax form;  In the U.S., the Internal Revenue Service (IRS) uses form1040:  South Africans may have to submit form ITR1 2 to the South African Revenue Service (SARS),while  Citizens of Saudi Arabia have no income tax, and therefore do not need to file a return. Most territories allow at least some income to remain untaxed. In India, Tax filing forms are ITR1 to ITR7 and various other relevant forms as well which are guided by the laws of Income Tax Dept, Govt. of India. Most territories allow at least some income to remain untaxed. For income that is taxed, the maximum tax rates range from 0% to more than 50% at a national level. On top of national taxes, many sub- jurisdictions (e.g., states, provinces, wards, cities, etc.) collect income taxes as well. In addition to income, taxes may be levied on goods and services, real property, investment assets, and other categories. In all, and depending on the territory, taxation can become quite high. The process of limiting payment of one’s taxes often requires filing several additional forms in addition to the main tax filing form. All financial planners should become familiar with the realm of taxation in their own territories. However, tax planning, especially when addressing income and property (i.e., personal, real, and CFP Level 2 - Module 2 – Taxation - Global Page 34

investment), is a key element in financial planning that we cannot ignore. Still, given the inherent difficulties, we will approach tax planning from a generalist’s perspective. You should research and become familiar with the tax-related situation in your own territory. For our purposes, we will explore general areas that might be applicable in a given territory. 1. COLLECTION Collect Quantitative Information I. Collect the information necessary to establish the client’s tax position II. Identify taxable nature of assets and liabilities III. Identify the tax structure of client accounts IV. Identify current, deferred and future tax liabilities V. Identify parties relevant to the client’s tax situation Collect Qualitative Information I. Determine the client’s attitudes toward taxation recommendations 2. ANALYSIS 2-1 Assess the Client Situation I. Review relevant tax documents II. Analyze existing and potential tax strategies and structures for suitability 2-2 Identify and Evaluate Strategies I. Assess financial impact of tax planning alternatives 3. RECOMMENDATION I. Develop tax planning strategies II. Evaluate advantages and disadvantages of each tax planning strategy III. Optimize strategies to make tax planning recommendations CFP Level 2 - Module 2 – Taxation - Global Page 35

IV. Prioritize action steps to assist the client in implementing tax planning recommendations Tax Principles and Optimization Planned Approaches The question for the financial planner is the degree to which the client may control the amount of tax levied and its payment. This means taking a strategic look at the client’s tax situation. Some strategies are relatively simple. Find the proper form, complete it, and submit the form to the relevant tax authority. Many value-added tax (VAT) refunds fit into this category, as do methods used to reduce or eliminate double taxation. Double taxation occurs when two tax jurisdictions attempt to levy taxes on the same amount earned or spent. This can happen between states/provinces (or similar) and the national government. It can also happen between territories. Ways to limit double taxation vary, but almost always involve legal agreements between the taxing jurisdictions. The taxpayer has the responsibility to identify the location where he or she earned income (for example), and any taxes paid (or required to be paid)on that income. The taxpayer also retains the primary responsibility to ensure he or she does not pay taxes more than once and to obtain refunds when appropriate. CFP Level 2 - Module 2 – Taxation - Global Page 36

Tax Systems Overview The idea that a citizen or incorporated business should pay taxes based on nationality has its base in the perceived benefits enjoyed by citizens of that territory. Territoriality, on the other hand, essentially focuses on the requirement that all entities earning money from a territory share in the responsibility to support that territory. Even when a person is not a resident of a territory, that territory may assert territorial jurisdiction over income derived from the territory. Here, the focus is on the source of the income (rather than nationality or territoriality of a person). This source jurisdiction may impose a tax on royalties, investment income, rent, etc., that non residents earn. The normal circumstance is for all territories to cede primary taxing authority to the place of territorial connection (i.e., where the income is earned) and the residual, or secondary, taxing authority to the territory of nationality or residence. To avoid double taxation, the territory of secondary authority usually credits any taxes paid in the primary taxing territory against any tax that might be due. Typically, a territory only tries to collect taxes on income with which it has some connection, so, for example, the Swiss government does not try to tax income earned by a South African company in South Africa (or any other non-Swiss territory). Suitability and Relevance We know that appropriate tax strategies vary territory-by-territory. Tax laws vary considerably, and financial planners have to modify their strategies to reflect relevant laws. Developing in-depth tax strategies requires specific knowledge of the territory’s tax laws and structure. Financial planners should know how to evaluate different tax-planning approaches within any territory where they have clients (and are fully authorized to practice), and understand the impact one approach may have on another. Suitability must be a consistent theme for financial planners in putting the client’s interest first. Whatever you recommend must be suitable for the client. CFP Level 2 - Module 2 – Taxation - Global Page 37

No matter how much time is invested to develop a plan, if the recommendations are not suitable for that specific client, the plan is of little or no value. This can be especially true where taxes are concerned. The first suitability principle is that the strategy must be legal. Financial planners should never agree to a strategy that is illegal. However, not all strategies are black or white, right or wrong, legal or illegal. A strategy may fit between the two poles as a shade of gray. It may not be blatantly illegal, but it might be questionable. A professional financial planner has no business suggesting or helping to implement any financial strategies—tax or otherwise—that are not absolutely legal and ethical. This is another reason to consult with an expert, and is something the financial planner should keep in mind when evaluating different tax strategies. Offshore Investing Some investors, especially wealthy ones, may want to explore investing offshore. Offshore investing offers four potential benefits: 1. Anonymity and/or privacy 2. Asset protection and limited liability 3. Lower levels of regulation 4. Tax savings What is offshore investing? Simply, investing offshore means the individual keeps money in a jurisdiction other than in his or her territory of residence. Some territories used for offshore investing are known to be tax havens, with a focus on safe and secure offshore investing. While it is outside the scope of this course to discuss offshore investing in- depth, we can say that it may be a sensible option for some individuals. However, it is not without possible problems, one of which is potential illegality. Tax avoidance is reasonable, but evasion is not. Unfortunately, some territories view some or all offshore investing as tax evasion. Further, in the shifting legislative landscape, it’s entirely possible that what once was considered legal now may be viewed as illegal. CFP Level 2 - Module 2 – Taxation - Global Page 38

When this happens, the individual has an immediate concern about being on the wrong side of the law. Moreover, he or she faces the dilemma of how best to reallocate the funds, especially if they need to be repatriated. Consider a situation where an individual has placed the majority of his or her funds offshore. If the laws change, the money can become tied up in litigation. This has the potential to leave the individual without access to required funds, especially if the litigation and/or repatriation process is lengthy. As with tax-deferred investing, this is a good reason to coordinate strategies. By thinking through potential problems, the financial planner may help the client avoid increased taxation, lack of access to funds, or extended litigation. Income Shifting Income shifting is another tax strategy that can provide tax relief, at least in some territories. In simple terms, income shifting involves transferring income from a person in a higher tax bracket to someone in a lower bracket. Most commonly, this is done by gifting money from a parent to a child. This is not always possible, based on tax law in a given jurisdiction. Where available, income shifting can accomplish two beneficial purposes. 1. The first removes taxable income from a parent (or other person) in a high tax bracket. This may even allow the individual to move into a slightly lower tax bracket. 2. The second, discussed more in the Estate Planning course, allows the individual to give substantive gifts to children or other family members. This is often beneficial in reducing the person’s taxable estate. Family Law The way in which payments to support an ex-spouse and children are treated for tax purposes varies by territory, but there are some consistencies. Normally, child support (i.e., ongoing payment for expenses related to rearing children) is not considered to be income to the custodial (receiving) parent. Such payments almost never qualify as a tax-deductible expense to the pay or either. CFP Level 2 - Module 2 – Taxation - Global Page 39

Often, the mother is awarded child custody, at least until the child reaches a certain age, and the father is responsible for making support payments. Support payments for children may or may not automatically end when the child reaches a certain age. Alimony (maintenance or support) payments to the ex-spouse may or may not qualify as income and/or a deductible expense to the pay or. Similarities exist in EU territories, but even there, specific territories may have different ways of addressing this situation. Tax-Deferred Savings Some territories allow wage earners to make deposits into tax-deferred savings vehicles. Deferring taxes by making deposits into these accounts has the potential to help the deposits increase in value faster than if they were sitting in fully taxable accounts. This can be a good planning strategy. However, a client who places all savings into tax-deferred accounts runs the risk of increased taxation upon withdrawal. In some situations, the individual also may have to make higher withdrawals than otherwise needed to support his or her lifestyle. This may contribute to increased retirement income taxation, and it may unnecessarily speed depletion of the retirement account. A potential solution would be to allocate some funds into tax- deferred accounts, some into tax-free accounts (if available), and others into taxable accounts. In this way, the individual retains income flexibility as well as some amount of taxation control. Some territories have savings and investment vehicles where earnings are either partially or fully tax- exempt. These accounts often have special tax agreements with the national government allowing their tax-free status. Usually, not many such accounts exist, but where available, may allow savings to grow more quickly than if earnings were fully taxable. We will briefly look at a taxable versus tax-free comparison next. Tax-Free Versus Taxable Yields Some retirement plans allow individuals to invest and enjoy tax-free asset growth and earnings. Tax deferral is much more typical, but sometimes tax-free is available as well. Investments with tax-free yields or income, but not asset capital or price growth, are somewhat more common. This means an CFP Level 2 - Module 2 – Taxation - Global Page 40

asset that grows in value from X to Y would be partially taxable, but any income the asset produces would not be taxable. When an investment that produces tax-free income is available, often a similar investment exists for which yields are taxable. In such circumstances, how does a financial planner decide whether the taxable or tax-free (income) investment is more suitable? CFP Level 2 - Module 2 – Taxation - Global Page 41

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Chapter 4: Accounting Standards & Research You will learn how the tax accounting standards and their application in the tax planning strategies. Taxation is a factor in almost every person’s life, especially those who have substantial earnings or have a significant amount of assets. While there is little a financial planning professional may do to assist with the tax situation of those with very low incomes, he or she may be able to help high wage- earners, and those between both poles, address their tax situations and provide guidance to potentially decrease any negative effect on their financial well-being. One of the services a financial planner can provide is helping to make the connection between a client and a skilled accounting professional. Clients, especially those whose finances cross borders, will be well- served by working with accountants who are familiar with national and international accounting standards. This chapter will explore some of those standards, along with some of the organizations supporting them. How Accounting Fits Into the Tax World Accounting and taxation always seem to fit together. One reason for this is that much of what many accountants do is directly related to complying with relevant tax laws and filing requirements. Accountants are required to conform with accepted accounting standards. Each territory may incorporate some degree of modification to the accepted standards, but in general, most territories expect full compliance with relevant regulations and standards. You may wonder why international consistency in this area is so important. That’s a reasonable consideration, and we can highlight a few points to consider. Accounting and taxation always seem to fit together. One reason for this is that much of what many accountants do is directly related to complying with relevant tax laws and filing requirements. Accountants are required to conform to accepted accounting standards. Each territory may CFP Level 2 - Module 2 – Taxation - Global Page 43

incorporate some degree of modification to the accepted standards, but in general, most territories expect full compliance with relevant regulations and standards. Accounting principles support the economy by providing relevant, reliable financial data to global markets. This makes it easier to analyze the information and make good decisions. Clear financial rules give people greater confidence about the accuracy of financial reports. Consistent standards make it easy to compare numbers from year-to- year and organization-to-organization. All of this spurs greater accountability within governments and organizations. Clients benefit from consistent standards, too. Not only do standards help clients know their financial status, they allow investors to explore opportunities and effectively compare companies. Standards also come into play in the tax arena, which is one big reason qualified accountants can be so helpful. As a financial planner it is not mandatory for you to become an accounting expert. Nor are you required to be fully conversant with all international accounting principles and standards. However, it will be helpful for you to have a foundational level of knowledge and understanding. Two main accounting standards guide just about all territories. The U.S. supports a standard known as Generally Accepted Accounting Principles (GAAP). Most of the rest of the world follows a similar standard; although we should point out that some nations do not require either a global or specific national standard. The non-GAAP accounting standard is supported by the International Financial Reporting Standards organization (IFRS). IFRS standards are designed to promote transparency, accountability, and economic efficiency, and are permitted or required by at least 125 jurisdictions (IFRS, 2017). Both the GAAP and IFRS standards have many components, and a financial planner need not be fully conversant with all standards. To help you get a sense of the breadth of standards, we provide the following listing of a few IFRS standards. CFP Level 2 - Module 2 – Taxation - Global Page 44