Corporation Income Tax Structure in Developing Countries

Corporation Income Tax Structure in Developing Countries GEORGE E. LENT * rpHE BASIC APPROACHES to the taxation of corporate profits by devel- JL oping countries are modeled on those of developed countries, and are subject to evaluation on similar grounds. As is true of industrial countries, the issues involved have never been satisfactorily resolved, and shifts continue to be made from one system to another. There is, there- fore, an abundance of experience with different forms of corporation tax, even within particular countries, and a voluminous literature exists on the comparative merits and limitations of each.1 Differences in the economic environment and in the relationships between shareholders and corporations in different stages of economic development, however, call for a re-examination of the tax treatment of corporations that is most appropriate for developing countries. This paper appraises the variety of approaches to the taxation of corporations in developing countries from the standpoints of their effects on resource allocation, equity, and administration. It considers not only the modalities of the corporation tax and the treatment of dividend income but also the tax rate structure, the discrimination between different forms of business organization, and the discrimination between foreign and domestic shareholders.2 * Mr. Lent recently retired from the Fund as Senior Advisor in the Fiscal Affairs Department. He has been on the faculties of the University of North Carolina and Dartmouth College. He has served as an assistant director of the tax analysis staff, U. S. Treasury Department, and as Consultant to the Organiza- tion of American States. 1 See, for example, Richard Goode, The Corporation Income Tax (New York, 1951); Charles E. McLure, Jr., "Integration of the Personal and Corporate Income Taxes," Harvard Law Review, Vol. 88 (January 1975), pp. 532-82; Mitsuo Sato and Richard M. Bird, "International Aspects of the Taxation of Corporations and Shareholders," Staff Papers, Vol. 22 (July 1975), pp. 384-455; William J. Byrne and Mitsuo Sato, "The Domestic Consequences of Alternative Systems of Corporate Taxation,5' Public Finance Quarterly, Vol. 4 (July 1976), pp. 259-84. 2 The various forms of tax relief to promote investment are discussed else- where. See George E. Lent, "Tax Incentives for Investment in Developing Coun- tries," Staff Papers, Vol. 14 (July 1967), pp. 249-323. 722 ©International Monetary Fund. Not for Redistribution CORPORATION INCOME TAX STRUCTURE IN DEVELOPING COUNTRIES 723 I. Factors Influencing Corporation Tax Policy The formulation of corporation tax policy for developing countries must take into account their essential differences from industrial countries in economic, legal, and social structures. Among developing countries, there are wide differences that reflect their relative stages of economic and social development. From the standpoint of corporation tax policy, perhaps the most striking distinctions are the relative scarcity of capital that characterizes most developing countries and the critical role played by the corporation in mobilizing capital for investment. As a result, most of these countries depend on the attraction of capital from abroad. As capital importing countries, their corporation tax policy is greatly influenced by the tax treatment of earnings by the creditor countries to which they are remitted. The internal capital markets of developing countries are either non- existent or relatively unorganized, so that the mobility of capital is lim- ited.3 The corporations themselves are a major source of capital for new investment, and cash flow attributable to depreciation allowances and earnings provides substantial funds for new development. These factors also influence the form of the corporation tax, as well as that of special provisions to promote domestic savings and wider public ownership of corporations. Although the corporate sectors of developing countries are often characterized by foreign ownership and control, resident companies generally are small-scale enterprises controlled by local family inter- ests. The tax treatment of locally-owned resident companies may be shaped by considerations that do not apply to foreign-owned or publicly-owned corporations; this sometimes leads to various forms of discrimination based on size and ownership. The taxation of corporate income cannot be considered apart from the entire income tax complex of a country—taxation of shareholders at home and abroad; taxation of proprietorships and partnerships; tax treatment of capital gains and other forms of income (such as interest); and, indeed, taxation of capital (especially net wealth). In a neutral tax system, income from all these sources would be treated equally. Such an idealized system, however, has never been instituted.4 Recogni- 3 See U Tun Wai and Hugh T. Patrick, "Stock and Bond Issues and Capital Markets in Less Developed Countries," Staff Papers, Vol. 20 (July 1973), pp. 253-302. 4 Perhaps its best approximation is the model proposed by the Canadian Royal Commission on Taxation, which, however, has not been adopted by the Canadian Government. The proposed system is basically structured on the part- nership principle. The corporation would be taxed at the maximum rate applic- ©International Monetary Fund. Not for Redistribution 724 INTERNATIONAL MONETARY FUND STAFF PAPERS tion of the corporation as a taxable entity separate from its shareholders poses practical and political obstacles to the realization of such an objective. As a result, the problems of reconciling the corporation tax with the taxation of dividends and other sources of income that have challenged tax experts for decades remain unsettled. II. Variations in Corporation Tax Structure The basic problems of taxing the corporation stem from its recogni- tion as a juridical person, separate from its shareholders. Corporation tax structures vary basically according to their treatment of distribu- tions to shareholders—that is, according to whether, and by what method, the tax on dividends is integrated with that on corporate income. The Appendix classifies the corporation tax structure and sum- marizes the tax rates of 80 representative developing countries. SEPARATE ENTITY SYSTEMS As in the case of other taxes, the corporation tax structure originally adopted by most developing countries replicated that of the colonial power under whose influence they came. Perhaps the most commonly accepted form employed in continental Europe had its origins in the schedular system of taxing different classes of income at different pro- portional rates.5 This is the prototype of the so-called classical system of treating the corporation as a separate entity according to the business income schedule; shareholders are taxed independently on their income from "movable property," that is, from shares. This system was intro- duced early, not only in the French colonies of West Africa, Equa- torial Africa, North Africa, and Indochina but also in Belgian and Dutch colonies throughout the world (for example, the Congo—now Zaire—and Indonesia). With few exceptions, this system has been pre- served in francophone countries, notwithstanding France's income tax reforms of 1948 and 1966 that substantially modified the traditional able to individuals, say 50 per cent, and shareholders taxed both on actual dividends and retained earnings allocated to them. Both actual and deemed dividends would be grossed up by the amount of the corporation tax and a credit would be given to shareholders against their income tax liabilities, with refunds of credits in excess of their liabilities. Canada, Report of the Royal Commission on Taxa- tion, Vol. 4 (Ottawa, 1966), pp. 3-98. 5 The basic schedules (cedules) in France covered income from (1) real property, (2) dividends and interest, (3) business, (4) farming, (5) wages and salaries, and (6) noncommercial activity. Each schedule had its own rate and special rules for determining income. Harvard University Law School, Taxation in France (Chicago, 1966), p. 88. Some developing countries have elaborated the schedules; Venezuela, for example, has employed as many as nine different schedules. ©International Monetary Fund. Not for Redistribution CORPORATION INCOME TAX STRUCTURE IN DEVELOPING COUNTRIES 725 form of the corporation tax. In addition, a number of countries in South America (for example, Argentina, Brazil, Chile, Colombia, Peru, and Venezuela) apparently have followed the continental precedent. Through a succession of reforms, the United States has departed from its original concept of the corporation tax, adopted in 1913, that provided for coordination with the personal income tax. Its basically "classical" system has served as a model for several developing countries (for example, Bolivia and the Philippines). More recently, other developing countries, such as Kenya, Tanzania, Uganda, and Zambia, have converted from integrated tax systems that originally followed the British colonial model to systems that treat the corporation as a separate taxable entity.6 In the classical model, shareholders are taxed separately on dividends received, and usually no provision is made to reduce the indi- vidual income tax on earnings distributed. Many countries, however, treat the juridical person (that is, the corporation) as they do the natural person, and do not levy a separate tax on dividends. The gradu- ated tax scales of Central American and Middle Eastern countries are the best-known

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