Corporate income tax is the tax paid by business corporations on their corporate profit or income. It is an important consideration in making business decisions such as investing and financing. Differential corporate tax rates among countries are an important factor for multinational companies in choosing their investment locations. Although the significance of corporate income tax as a source of government revenue has gradually declined over time, it is a highly political issue in many countries. Unlike sole tradership and partnership businesses, corporations are recognized as artificial legal entities. Because of their separate legal status apart from the owners of the business, corporations are also required by law to pay income tax.
The history of corporate income tax is quite long and complex in many countries. For example, in the United States, corporate income tax predates personal income tax, although its importance has gradually declined over time. Further, the corporate income tax has implications for personal income tax. In the United States, while corporate income is taxed twice, first at the corporate level and then at the individual level when individuals report dividends as part of income in their tax returns, in Australia shareholders are protected from this “double-dipping” through the imputation tax system, where each dollar of dividend paid out of after-tax profit carries an imputation tax credit.
Low corporate income tax rates and exemption from corporate income tax for several years (also known as a tax holiday) are among the tax incentives used by various countries to attract foreign direct investment (FDI). Corporate income tax plays an important role in corporate financing decisions as well. Because interest paid on borrowed capital is tax deductible, this tax deductibility makes borrowing an attractive option to magnify shareholders’ returns. For example, if the interest expense for a corporation is $10 million and the corporate income tax rate is 30 percent, then effectively the corporation pays an interest expense of $7 million. Similarly, in computing cash inflows and outflows in relation to an investment decision, corporations need to measure after-tax cash inflows and outflows to arrive at a correct decision.
Effective corporate income tax rates vary from country to country. For example, in 2007, the corporate income tax rates in some selected countries were as follows:
In many common law countries that also predominantly use outsider systems of finance, income measured for financial reporting purpose (i.e., for reporting to shareholders of the company) can be quite different from tax rules used for determining corporate income tax liability. It is quite legitimate in these countries, for example, to use the straight line depreciation method for financial reporting purposes while using some form of accelerated depreciation method for tax reporting purposes. To the contrary, in many Roman law countries, which predominantly use insider systems of finance, the rules used for financial reporting purposes closely follow the rules used for tax reporting purposes.
When corporate income measured under tax laws differs from corporate income measured using financial reporting standards, the resultant tax difference turns into some kind of asset or liability. Suppose in a common law country like Australia, a corporation reports a profit of $200 million to shareholders. But when the tax laws are applied to this company, the profit turns out to be $170 million. If the corporate income tax rate is 30 percent, the company’s tax liability in relation to current year’s income will be $170 million x 30% = $51 million. But the income tax expense based on the income statement reported to the shareholders would be $200 million x 30% = $60 million. The difference of $9 million is a deferred tax liability for the company to be reported in its balance sheet. Had the difference been in the opposite direction, that is, tax liability > income tax expense by $9 million, the company would have reported the difference as a deferred tax asset. It would be treated as an asset because it is a tax payment that the company is making now with the expectation of saving an income tax of $9 million in the future. To what extent these tax savings materialize depends on the extent to which the tax rules and the tax rate remain the same. If the tax rate changes in the future before the deferred tax asset or liability is realized, the amount of this deferred tax liability or asset will be required to be restated, reflecting the new tax rate.
When the application of tax rules to a company’s revenues and expenses produces a loss for the company, the loss is called a “tax loss.” Tax laws in some countries allow tax losses to be adjusted against future tax liabilities or past tax payments.
- James and C. Nobes, The Economics of Taxation: Principles, Policies and Practice (Financial Times–Prentice Hall, 2000);
- Jankowski, Profits, Taxes, and the State (Praeger, 1998); KPMG, Corporate Tax Rate Survey (KPMG, 2007);
- La Porta, F. Lopez-de-Silanes, A. Shleifer, and R. W. Vishny, “Legal Determinants of External Finance,” Journal of Finance (1997);
- A. Plesko, “The Corporate Income Tax: Impact and Incidence,” in Handbook on Taxation, J. A. Richardson, ed. (Marcel Dekker, 1999);
- B. Hildreth and J. A. Richardson, eds., Handbook on Taxation (CRC Press, 1999);
- PricewaterhouseCoopers, 2007 Worldwide Tax Summaries (PricewaterhouseCoopers, 2007).
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