Tax is defined by the Oxford English Dictionary as a "contribution levied on persons, property or business for the support of government". It is a mandatory contribution of money, enforceable by law, for public purposes. Theoretically, an ideal tax system should achieve equity, neutrality, simplicity and efficiency. Practically, this may not be easy to achieve due to competing interest, tax history, its international obligations, constitutional limitations and administrative capacity. However, it is an ideal system which all countries can strive to achieve amidst the challenges.
Equity
Tax equity is achieved by ensuring that people in the same circumstances should pay the same amount of tax. Tax should be based on the person's ability to pay. According to the article from US Federal Treasury, a fair system is one that is able to allow people of the same economic circumstances to pay the same tax. And it should be progressive in nature such that people with high income should pay more tax and people with low income should pay little or no tax. The system should also be able to detect any avoidance of tax either legally or illegally so that everybody is accounted for in the payment of taxes.
Neutrality is achieved when taxation does not interfere with the investment decisions. The tax system should not direct financing and investment decisions through its invisible hand. It should allow free market to allocate economic resources and be as neutral as possible in economic decisions. This can be achieved, according to the US Federal Treasury, through a comprehensive definition of income for tax purpose.
Simplicity
Simplicity deals with the tax system in its definition, calculation, collection, documentation, implementation and enforcement. A taxpayer should be able to determine his taxes, calculate how much he is liable to pay and be able to complete his payment with ease. In James Alm's article, a tax system should provide an environment of voluntary compliance than enforced compliance. And it should not produce heavy administrative burden on the department in the collection, implementation and enforcement of tax payment.
Classical System of Corporate Taxation
The classical system of corporate taxation is a system that views the company and the shareholders as separate taxable entity. The company is distinct from its shareholders such that the tax treatment differs with regards to corporate profits and dividends. In accordance to the Hugh J Ault, the basic approach of the classical system provides for taxation at the corporate level and at shareholder level. This creates a situation of double taxation whereby taxes are collected once on corporate profit through corporate tax and second on dividends through individual tax.
This system of double taxation contradicts the principle of economic neutrality as it taxes the profit and the dividends. This system interferes with investment and financing decisions as the corporate will be bias towards retaining the profits rather than distributing dividends. If it retains this profit, it will only be taxed once. The classical system manipulates the decisions and distorts the efficient allocation of economic resources by diverting resources to avoid double taxation. It intervenes in the economic decisions by creating favorable environment for retention of profits within the company and financing through debt than through equity. And it creates unfavorable environment for the distribution of dividends. This reduces the level of investments through equity and hence the efficient allocation of resources.
Dividend Imputation System
The dividend imputation system aims at correcting the distortions by the classical system of double taxation - corporate and shareholders - by refunding corporate taxes through the provision of credits (known as flanking credits) associated with the dividend payments. (Source: Bhavish Jugurnath, Mark Stewart and Robert Brook). Under this system, shareholder receives flanking credit for the dividends that has been taxed at the corporate level. This credit is then used to reduce the income tax of the shareholders. If the shareholder's marginal tax rate is higher than the corporate tax on the dividends, the shareholder will only need to pay the difference in the tax amount. If the shareholder's marginal tax rate is lower than the corporate tax, the shareholder will be refunded on the difference which can be used to reduce the total individual tax payable. There are however many variations of this system such as dividend deduction, split rate, and imputation. The variations will subject dividend to be tax either at corporate or shareholder level and will not result in double taxation.
The imputation system, however, benefits only the domestic shareholders receiving local sourced dividends as they will be able to receive the flank credits for their dividends and offset it against their marginal tax. Foreign shareholders will not be able to receive the imputed credits from the domestic corporations and be able to use it in their country to offset against their marginal income tax overseas. The dividends paid will also be subjected to withholding tax. Similarly under this system, domestic corporations are not exempted from tax of dividends received from foreign sources even though these dividends may have paid taxes in the foreign land. (Source: Hugh J Ault) Essentially, the foreign shareholders or foreign corporations continue to be subjected to taxation twice, once in the source country and another in the resident country. This system contradicts the principle on equity as tax equity means that people in the same circumstances should pay the same amount of tax regardless of the sources of income. If foreign dividends are given differing treatment and subjected to tax, this result in an inequitable position for people who receive the same amount of dividends from foreign source as compared to local source.
At the same time, the computation of the dividend assessed for tax is complicated. The computation by the taxpayer will require him to have full access to the financial statement of the company before he is able to compute the credits available for distribution of the dividends. The payment of dividends also depends on the company to maintain it flanking account so that there are sufficient dividends available for distribution which ultimately should tie with this account. This increases the administrative efforts and the compliance burden for both the shareholder and the company. And this contradicts the principle of simplicity in calculation, documentation and payment of taxes.
Singapore Corporate Tax System
Singapore has moved from a full dividend imputation system to a one-tier corporate tax system. The new system result in tax being levied only at corporate level and full exemption of dividends paid to shareholders. In addition, the flanking accounts are removed and credits will no longer be given to shareholders. Based on the Economic Review Committee report, the removal of the imputation system is to remove the inherent drawback of the imputation system such as the maintaining of the flanking accounts for dividend payments, adaptability of the imputation system to global more sophistical business transactions and lastly the complications of implementing new corporate tax policies with the imputation system.
The new system simplifies the tax calculation by removing the flanking accounts and tax accordingly on the profits at corporate level. Dividends paid to shareholders are fully exempted from any form of taxation. The system simplifies the calculation and taxation by removing the flanking accounts and also provides the flexibility for companies to distribute their dividends more freely without maintenance of flanking accounts.
The new system continues to require tax for foreign dividends received in Singapore. However, tax exemption is available for these dividends. The foreign dividends will only need to pay tax based on the difference of the tax rate between Singapore and the foreign country. If Singapore has a higher tax rate of 20% and the foreign country has a lower tax rate of 17%, then the dividends will only be subjected to tax of 3%.
To encourage investment, Singapore has also implemented a Group Relief scheme for companies. Under the imputation system each company of the same group is treated as a separate legal entity. The losses of the company cannot be used to offset the profits of the other company in the same group. Under the new one- tier system, the group relief scheme can be effectively implemented such that companies in the same group can offset their losses against more profitable companies.
Conclusion
From the classical system to imputation dividend to one tier, the taxation systems have evolved to meet the changing needs and demands of the countries and the global business environment. The taxation systems provide the basic taxation model but will require complementary changes such as provision of reliefs, deductions and exemption to meet the needs of the country. Each country will find merits in classical, imputation or one-tier depending on their needs, policies and challenges. An ideal tax system may not be easy to achieve in terms of equity, neutrality and simplicity but the system that is able to meet the needs of the country and the complex business transactions is a sufficiently successful system.
