Appendix: Effective Tax Rates with Tax Deferral
Klemm (2012) extends Devereux and Griffith (2003) to allow for tax holidays. It assumes, however, that tax holidays change only the corporate income tax. In the case of Cambodia, the tax holiday is a deferral of tax, which is recovered at the time of distribution. That means that profits from the tax holiday period face a different tax treatment on distributions than profits that are earned after holiday period. Below we derive the effective tax rates for this case.
Klemm (2012) assumes an infinite horizon and defines the EATR as the ratio of the present value of taxes over the present value of profits:
where R* is the present value of the economic rent earned in the absence of taxation, R is the same in the presence of taxation, p is the pre-tax net profit, r is the real interest rate, and δ is true economic depreciation.
Considering first financing by retained earnings (superscript RE, the rent is shown to be (equation (10) in Klemm (2012)):
where y = (1- md)/(1-z) is a factor measuring the difference in treatment of new equity and distributions, with md the personal tax on dividends and z the accrual-equivalent tax on capital gains, p is net real profit, τ is the corporate tax rate, π is inflation, ρ = (1- mi)/(1-z) is the investor’s discount rate, with mi the personal tax rate on interest and i the nominal interest rate, I is the investment undertaken, ø is the official depreciation allowance, and KT is the tax-written-down value of capital.
This formula needs to be adapted to changing CIT rates and dividend tax rates. Klemm (2012) (equation (14)) shows the impact of a changing CIT rate on the first sum in equation (2) above. The new aspect is that in Cambodia also the tax on distributions changes, which implies a change in γ so that there are two distinct values γ1 and γ2. The product of the first sum of (2) and γ can now be written as:
where Y is the number of years of tax holiday.
The second sum of (2) is simply 1, as by assumption there is no further investment or disinvestment in the future. The change in the rate on distributions is also irrelevant, as only the only transaction here occurs in the first period, so the produce is simply γ1.
The third sum of (2) is the present discounted value of depreciation allowances (A). This will also be affected by the tax holiday as there is no corporate tax liability, as shown in Klemm (2012). The only new aspect to note is that it should be multiplied by γ1, because it will only be relevant after the tax holiday period.
Putting all together, we obtain:
For financing by sources other than retained earnings, a financial effect (FD for debt or FNE for new equity) will need to be added to (4). For new equity, this is unchanged from Klemm (2012), except that we need to be careful to pick the correct dividend tax rate, i.e., the one that applies during the tax holiday:
For debt financing, we need to take into account that interest deducibility is worthless during the tax holiday, as well as the changing effect on dividend taxes. This yields:
The cost of capital is obtained by setting the sum of (4) and any financing effects to 0 and solving for p. Labelling the cost of capital
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The authors would like to thank Alexandros Mourmouras, Jarkko Turunen, Koshy Mathai, David Wentworth and participants at an APD seminar and a presentation at the Cambodian General Department of Taxation for useful comments and suggestions. Ross Rattanasena and Chhim Pichsovann provided excellent research assistance.
Various double taxation agreements (DTAs) are at different stages of negotiation, with two agreements (Singapore and Thailand) active as of January 1, 2018 and two more agreements (China and Brunei) awaiting ratification. These DTAs reduce the withholding rate on dividends to 10 percent.
All QIPs are exempt from duties on production equipment and construction materials. Additional exemptions vary by the precise type of QIP, e.g., projects with an export share of at least 80 percent or located in SEZs are additionally exempt from duties on intermediate goods, raw materials, and spare parts.
The total period under the status may last 9 years, because an investment is allowed a three year “trigger period” between registration and the first profit. However, as there would be not tax liability without profit anyway, these first three years do not reduce taxes, they merely prevent the holiday period from being used up before a firm becomes profitable.
The General Department of Taxation (GDT) made some improvements to the registration process by scrutinizing investors’ finger prints to identify their identity.
This may be somewhat overestimated, because it may include taxes that would be refunded or recovered, most importantly VAT exemptions on inputs, but on a smaller scale CIT that is paid on distributions. Also, the benefits of job creation by such investments are not quantified and hence not included in these estimated.
In principle, the framework also allows including taxes at the level of the shareholder (or the home country). We ignore those, however, because they differ by the origin of investor, and because they are often avoided, for example, by holding investments through a country that exempts foreign earnings.
Investment allowances, tax credits, and depreciation are all related. The difference between an allowance and a credit is simple algebra: the value of a tax credit equals the value of an allowance times the tax rate. The allowance can either be granted in addition or instead of depreciation. Ultimately what matters is the present discounted value of the combination of all applicable features.