What is Tax Planning and Tax Management?

Tax planning is all about making sure you take advantage of every legal deduction
and credit to minimize your tax bill.
Tax management, on the other hand, is about reducing the taxes you owe each
year. It's more proactive than reactive, you work to keep your taxable income as low as
possible, so you owe less.

What is Tax Management?

Tax management refers to the management of finances, for the purpose of paying
taxes. Tax Management deals with filing Returns in time, getting the accounts audited,
deducting tax at source etc. Tax Management helps in avoiding payment of interest, penalty,
prosecution.
Importance of Tax Management in an Organization
Strategically managing tax involves financial analysis and decision-making while
proactively controlling your organization’s tax position so that legal requirement are met.

What is Tax Planning?

● Tax planning is the analysis of a financial situation or plan to ensure that all
elements work together to allow you to pay the lowest taxes possible.
● Tax planning should be an essential part of an individual investor's financial plan.
Reduction of tax liability and maximizing the ability to contribute to retirement plans
are crucial for success.
● A plan that minimizes how much you pay in taxes is referred to as tax efficient.
Importance of Tax Planning
Tax planning’s importance is evident in the amount of money that can be saved by
taking steps to minimize the tax burden. Those steps will change as a business grows or a
person advances in a career. However, the need to strategic tax planning remains from
beginning to end.

FEATURES OF TAX PLANNING

Reduction in tax liability. one of the most important features of tax planning is to reduce
tax liability. Every individual has done his financial plan so he can reduce his tax amount and
can save for his future plans.
Advance planning. one has to arrange his tax plans at the beginning of the financial year
because no one can plan to reduce his tax liability day before filing an income tax return.
Investment in the right direction. with the help of tax planning one can invest his money in
the right direction by choosing the right policy. Investment in any assets or policy will not
help in saving money from taxes, for this right investment should be done.
Dynamic in nature. tax planning has to be done every year because of the new
implementation of policies introduced by the government. One has to modify his tax plans at
the beginning of every financial year.

METHODS OF TAX PLANNING

Short-range Tax Planning - short-range tax planning involves year to year planning to
complete some specific and limited objects.
Long-range Tax Planning - unlike short range tax planning, long-range tax planning are
those activities undertaken by an assessee, which does not pay off immediately. This starts
at the beginning or the income year to be followed around the year.
Permissive Tax Planning - a strategy that helps you plan your tax saving investments such
that you can claim the maximum permissible deduction limit under different sections of the
Income Tax Act, 1961.
Purposive Tax Planning - involves using tax-saving instruments with the specific purpose
of getting the maximum tax benefit by making correct investment selections, suitable
replacements of assets, and diversifying income and business activities.

AREAS OF TAX PLANNING

For implementing tax planning one can use different ways to save his tax money. There are
some areas where we can plan to reduce our tax liability:
Reducing Taxable Income. one can use government schemes and programs to reduce his
taxable income, it will directly reduce his tax liability. One should try to minimize his taxable
income to reduce his tax amount.
Deduction planning. there are many deductions provided by a taxation law. One should
implement and plan those deductions. The major area of the deduction is available under
Sec.80C where one can claim a deduction for life insurance, mutual funds, home loan
interest and many more.
Investment in tax planning. assessee can invest in policy for future plans and save his
money from tax.
Year-end planning strategies. one can reduce his tax liability for the next year by
prepaying those expenses which will be imposed next year and can make a strategy before
starting the new financial year.

Tax planning is an essential part of any financial plan for individuals, families or businesses.
Proper planning allows you to understand which tax benefits you qualify for. You might be
able to take advantage of:
Deductions: Tax deductions allow you to reduce your taxable income. They’re usually
expenses you incur throughout the year, which you can subtract from your total income. A
deduction might include a charitable donation.
Rebates: Rebates are a form of a refund, which occur after a retroactive tax decrease.
Congress sometimes offers rebates to help stimulate the economy during financial
recessions. They’re also used to incentivize environmentally friendly practices.
Credits: Credits allow you to subtract from the total you owe. If you’re a student, a low-
income family or you have children, you may qualify for a tax credit.
Concessions: A tax concession is a government reduction in the amount a certain group of
people owes. They’re usually used to incentivize certain behavior.
Exemptions: Exemptions reduce or eliminate someone’s responsibility to pay. Dependent-
related exemptions allow you to reduce your taxes by a certain amount for each child or
other relative under your care.

DIFFERENT TYPES OF TAX PLANNING:

Federal income tax planning: It’s wise to plan your federal income taxes. Federal income
tax deductions might include student loan interest, college savings and charitable donations.
Retirement tax planning: With proper planning, you can reduce your tax liability and
maximize your income post-career. This involves best utilization of an individual retirement
account or 401(k) plan and careful calculation of your Social Security benefits.
Estate tax planning: When someone passes away, their estate may be subject to federal
estate taxes. Those who fall into this category require estate tax planning to preserve their
estate’s value. Some states also demand an estate tax, sometimes at lower value
thresholds.
Small business tax planning: Small business and self-employed workers have unique tax
responsibilities. Applying the right deductions is critical. For instance, if you work out of a
home office, you may be eligible for a deduction. You might also deduct the cost of vehicles,
office equipment, travel and other business-related expenses. If you’re starting a new
business, it’s important to take advantage of any tax relief.

SAVANT FRAMEWORK
SAVANT is an acronym for strategy, anticipation, value-adding, negotiating, and
transforming. For a transaction to be properly tax managed (and thus best increase firm
value), managers should consider all of these aspects.
THE SAVANT PRINCIPLE
To add value to each transaction, decision makers need to stay focused on
the firm’s strategic plan, anticipating tax impacts across time for all parties affected by
the transactions. Managers add value by considering the impacts when negotiating the
most advantage arrangement, thereby transforming the tax treatment of items to the
most favorable status.
Ultimate aim is to maximize shareholder’s value.

Strategy
The overall plan for deploying resources to establish a favorable position and to achieve
short-term and long-term objectives of an entity, consistent with the ultimate aim of adding
value to the entity.
OPERATIONAL STRATEGY - short-term (day to day operation)
CORPORATE STRATEGY - long-term (5 years from now)
INTERNATIONAL STRATEGY - plans to adapt to the changing environment of business
focused more on international business expansion.

Anticipation
Thinking and/or talking about something ahead of time, and either taking action in
order to be prepared or being ready to respond a the time the unforeseen circumstances,
unexpected result, abrupt changes in legislation, and envolving trends keeping in mind the
value to be added to the entity.

Negotiation
Bargaining or discussing an issue (tax or otherwise) until an agreement is reached,
preferably upon the terms and conditions which add value to an entity:
Example: Shifting of taxation
Forward shifting - from seller to buyer
Backward shifting - from seller to supplier
Onward shifting - the combination of forward shifting and
backward shifting

Transformation
 Taking the appropriate (and legally feasible) courses of action with the view of
changing the nature, function, condition, and ultimately, the tax effects of certain
transactions, to one which would add more value to an entity.

TITLE I
ORGANIZATION AND FUNCTION OF THE BUREAU OF INTERNAL REVENUE
SEC. 2. Powers and Duties of the Bureau of Internal Revenue. - The Bureau of Internal
Revenue shall be under the supervision and control of the Department of Finance and its
powers and duties shall comprehend the assessment and collection of all national internal
revenue taxes, fees, and charges, and the enforcement of all forfeitures, penalties, and fines
connected therewith, including the execution of judgments in all cases decided in its favor by
the Court of Tax Appeals and the ordinary courts. The Bureau shall give effect to and
administer the supervisory and police powers conferred to it by this Code or other laws.

The Bureau of Internal Revenue is divided into:

National Office
General direction, guidance and control of the entire operations
Field Offices (Regional Offices)
Execute and implement the national policies and programs prescribed by the
National Office

BIR NATIONAL OFFICE

It consists of:
1. The Commissioner
2. The 6 Deputy Commissioners (4 Deputy under Section 3 of the NIRC and 2 under
the Executive Order 430 by the former President Arroyo).
3. The 14 assistant commissioners (who assist the deputy commissioners).

FIELD OFFICES
● The Philippines has been divided into Regional Offices (ROs) which directly execute
and implement the national policies and programs prescribed by the National Office
for the enforcement of the internal revenue taxes.
● A regional office covers several provinces (including cities). Each regional office is
responsible for directing and coordinating the operation of the following divisions:
a. Assessment
b. Human Resource
c. Collection
d. Finance
e. Monitoring
f. Administrative Division
g. Legal
● Each regional office is headed by a Regional Director (RD).
● He administers and enforces internal revenue laws and regulations within his
assigned regional area, in conformity with the delegation of authority from the
Commissioner.
● He is assisted by the Assistant Regional Director (ARD).
 ● Under the regional offices are the Revenue District Offices (RDOs) headed by the
Revenue District Officers who are under the direct control and supervision of the
Regional Director.
● Each of the revenue district office is composed of field men and examiners
performing assessment work and collection agents and clerks performing collection
work.

A. TAX REMEDIES
(1) On the part of government, theses are courses of action provided by or allowed in the
law to implement the tax laws or enforce tax collection;
(2) On the part of the taxpayer, these are legal actions which a taxpayer can avail of to seek
relief from the undue burden of oppressive effect of tax laws, or as a means to check
possible excesses by revenue officers in the performance of their duties.

B. Assessment Process
Tax Audit or Investigation
The BIR conducts an audit by issuing Letter of Authority (LOA).
Letter of Authority
Is an official document that empowers a Revenue Officer to examine and scrutinize a
taxpayer’s books of accounts and other accounting records, in order to determine the
taxpayer’s correct internal revenue tax liabilities.
Persons Authorized to issue LOA
Taxpayer
- Under the jurisdiction of the National Office
- Under the jurisdiction of the regional offices
Person Authorized
- Commissioner of Internal Revenue (CIR)
- Regional Director

ISSUANCE OF NOTICE OF DISCREPANCY (NOD)

Notice of Discrepancy (NOD)
Under RR 22-2020, if a taxpayer is found to be liable for deficiency ta or taxes in the
course of investigation conducted by a Revenue Officer, the taxpayer shall be informed
through a NOD. The NOD aims to fully afford the taxpayer with fair opportunity to present
and explain his side on the discrepancies found.
ISSUANCE OF PRELIMINARY ASSESSMENT NOTICE (PAN)
Preliminary Assessment Notice (PAN)
A PAN is a communication issued by the Regional Assessment Division or by the
Commissioner or his duly authorized representative informing a taxpayer who has been
audited of the findings of the revenue officer.
Remedy of the Taxpayer
The taxpayer has 15 days to reply contesting the finding in the PAN.
Effect of failure to reply
The taxpayer is considered in default and the BIR will then issue a Final Letter of
Demand (FLD) and a Final Assessment Notice (FAN) calling for payment of the taxpayer’s
deficiency tax liability, inclusive of the applicable penalties (RR 18-2013).

ISSUANCE OF FORMAL LETTER OF DEMAND (FLD) AND FINAL ASSESSMENT

NOTICE (FAN)
The FLD/FAN shall be issued by the Commissioner or his duly authorized
representative. The FLD/FAN calling for payment of the taxpayer’s deficiency tax or taxes
shall state the facts, the law, rules and regulations, or jurisprudence on which the
assessment is based; otherwise, the assessment shell be void (RR 18-2013)
When Issued?
1. The taxpayer failed to respond to the PAN; or
2. The reply to the PAN was found to be without merit.

Remedy of the Taxpayer

1. File a protest to the CIR or his authorized representative within 30 days from date of
receipt of the FAN.
Types of Protest
Request for Reconsideration
Refer to a plea of re-evaluation of assessment on the basis of existing records
without need of additional evidence. It may involve both a question of fact or of law or both.
Request of Reinvestigation
Refer to a plea of re-evaluation of an assessment on the basis of newly discovered or
additional evidence that taxpayer intends to present in the reinvestigation. . It may involve
both a question of fact or of law or both.
2. Submit all supporting documents within 60 days from filing of protest (in case of
request for reinvestigation under RR 18-2013).

FINAL DECISION ON A DISPUTED ASSESSMENT (FDDA)

If the BIR do not agree with the protest, then a Final Decision on Disputed
Assessment (FDDA) will be issued, where the taxpayer has the right to elevate the case to
the CTA.

Remedy of the Taxpayer

DENIAL OF PROTEST
WAYS TO DENY PROTEST
1. Direct denial of protest
2. Indirect denial of protest - If the CIR or his duly authorized representative fails to
act on the taxpayer’s protest within 180 days from date of submission, the protest
may be considered denied.
DENIAL OF APPEAL BY THE CTA AND SC
Remedies of the Taxpayer
If the appeal to the CTA Division is denied, file an appeal to the CTA en banc within
15 days from the receipt of the decision.
If the appeal to the CTA en banc is denied, file an appeal with the Supreme Court
(SC) Division within 15 days from receipt of the decision, then, finally, to the SC en banc.

C. COLLECTION
The BIR may avail of the remedy of collection when the assessment becomes final,
executory and demandable.
METHODS OF COLLECTION
The BIR can collect delinquent internal revenue taxes through the following means:
1) Distraint – the seizure by the government of government of personal property, tangible or
intangible to enforce the payment of taxes.
a. Actual Distraint - personal property is physically seized by the BIR and offered for
sale at public auction. The property is sold to the highest bidder and the proceeds of
the sale are applied to the payment of the tax due.
Garnishment - is the distraint of bank accounts.
b. Constructive Distraint - the person in possession of personal property is made to
sign a receipt, undertaking that he will preserve the property and will not dispose of
the property without the express authority of Bureau of Internal Revenue (BIR).
2) Levy
The seizure by the government of real properties and interest in or rights to such
properties in order to enforce the payment of taxes.
3) Judicial proceedings
a. Filing of civil case for collection
b. File a criminal case (TAX Evasion)

D. COMPROMISE
GROUNDS
1. A reasonable doubt as to the validity of the claim against the taxpayer exists; or
2. The financial position of the taxpayer demonstrates a clear inability to pay the
assessed tax.
All criminal violations may be compromised except:
1. Those already filed in court; or
2. Those involving fraud
MINIMUM AMOUNTS
1. For cases of financial incapacity, a minimum compromise rate equivalent to 10% of
the basic assessed tax; and
2. For the cases, a minimum compromise rate equivalent to 40% of the basic assessed
tax.
INSTANCES WHEN APPROVAL OF THE EVALUATINO BOARD ID REQUIRED
1. Where the basic tax involved exceeds one million pesos; or
2. Where the settlement offered is less than the prescribed minimum rates
COMPOSITION OF THE EVALUATION BOARD
1. CIR
2. Four Deputy Commissioners
E. ABATEMENT OR CANCELLATION OF TAX LIABILITY
GROUNDS
1. The tax or any portion thereof appears to be unjustly or excessively assesses; or
2. The administration and collection costs involved do not justify the collection of the
amount due.
F. SUSPENSION OF THE RUNNIG OF THE STATUTE OF LIMITATIONS
The prescriptive period for assessment and the beginning of distraint or levy or a
proceeding in court for collection of any tac deficiency may be suspended under the
following situations:
1. taxpayer’s request for reinvestigation was granted;
2. Taxpayer cannot be located in the address given in the return;
3. No property of the taxpayer can be located; or The taxpayer is out of the country

G. CIVIL PENALTIES
In addition to the basic tax assessed on the taxpayer, the following civil penalty also
be collected:
1. Surcharge
2. Interest
● Deficiency Interest
● Delinquency Interest

H. REFUND OF TAXES
REQUISITES:
1. A tax was erroneously or illegally collected by the BIR;
2. The taxpayer should file a written claim for refund or tax credit with the CIR within 2
years from the date of payment of the tax or penalty; and
3. If the claim for refund is denied by the CIR, file a petition for refund with the CTA:
a. Within 30 days from receipt of the denial; and
b. Within two years from the date of the payment of the tax or penalty

CHAPTER 1: FRAMEWORK OF UNDERSTANDING TAXES IN THE PHILIPPINES

Overview:
The provisions on Philippine national internal revenue taxes are codified in the National
Internal Revenue Code (the “Tax Code”) as amended by RA 10963 beginning January 1,
2018 or the Tax Reform for Acceleration and Inclusion (the “TRAIN”). The national internal
revenue taxes are administered by the Bureau of Internal Revenue (“BIR”).

On or before the commencement of business, a Philippine corporation must register with the
appropriate revenue district office having jurisdiction over the principal place of business of
the corporation as stated in its articles of incorporation. A person maintaining a head office,
branch or facility is also required to register with the revenue district office having jurisdiction
over the head office, branch or facility. The term “facility” here includes sales outlets, places
of production, warehouses and storage places.

Module Objectives:
At the end of the topic, the learner will be able to:
• Understand the importance of taxes in decision making
• Know the types of taxes
• Understand the basic principles of taxation
• Know the sources of tax laws
• Know the SAVANT Framework

Course Materials:
A. Income Tax
1. Regular Income Tax
A domestic corporation is taxable on all income derived from sources within and without
the Philippines.The general corporate income tax rate on taxable income is 30%. For
purposes of computing taxable income, the Tax Code allows certain deductions. In lieu of
an itemized deduction, the Tax Code allows a standard deduction of 40% of the gross
income.
2. Minimum Corporate Income Tax
Under the Tax Code, a minimum corporate income tax (“MCIT”) of 2% of the gross income
of a corporation is imposed beginning on the 4th taxable year immediately following the
corporation’s commencement of business operations, when such MCIT is greater than the
tax computed using the 30% regular or normal tax rate. Any excess MCIT over the regular
income tax is carried forward and credited against the regular income tax of the corporation
for the three immediately succeeding taxable years.
3. Final Tax on Passive Income
Philippine tax laws subject certain passive income of domestic corporations to a final tax, as
follows:
Income Tax Rate Basis

Interest on currency bank 20% Section 27(D)(1), Tax Code,

deposit and, yield or any as amended
other monetary benefit from
deposit substitutes and from
trust funds and similar
arrangements from sources
within the Philippines

Royalties derived from 20% Section 27(D)(1), Tax Code,

sources within the as amended
Philippines

Interest income from a Section 27(D)(1), Tax Code,

depository bank under the 15% as amended
expanded foreign currency
deposit system

Net capital gains from the 15% Section 27(D)(2), Tax Code,
sale, exchange or other as amended
disposition of shares of
stock in a as amended
domestic corporation other
than through the stock
exchange
 Dividends received from a Exempt Section 27(D)(4), Tax Code,
domestic corporation as amended

Gain on sale, exchange or 6% Section 27(D)(5), Tax Code,

disposition of lands and/or as amended
buildings which are not
actually used in the
business of a corporation
and are treated as capital
assets

The sale, barter or exchange of shares of stock listed and traded through the stock
exchange is subject to stock transaction tax at the rate of 6/10 of 1% (or 0.6%) of the gross
selling price or the gross value in money of the shares of stock.

4. Improperly Accumulated Earnings Tax

In addition to the other taxes imposed on domestic corporations, the Tax Code imposes a
10% tax on “improperly accumulated taxable income” of corporations formed or availed for
the purpose of avoiding the income tax with respect to its shareholders or the shareholders
of any other corporation by permitting earnings and profits to accumulate instead of being
divided or distributed. This tax, however, does not apply to publicly-held corporations, banks
and other non-bank financial intermediaries and insurance companies.

“Improperly accumulated taxable income” means taxable income adjusted by:

(i) income exempt from tax;
(ii) income excluded from gross income;
(iii) income subject to final tax;
(iv) the amount of net operating loss carry-over deducted; and reduced by the sum of:
(i) paid; and
(ii) income tax paid for the taxable year.

The fact that a corporation is a mere holding company or an investment company is prima
facie evidence of a purpose to avoid the tax upon its shareholders or members. As a general
rule, however, the fact that earnings or profits of a corporation are permitted to accumulate
beyond the reasonable needs of the business is determinative of the purpose to avoid the
tax upon its shareholders or members unless the corporation, by clear preponderance of
evidence, proves the contrary. The phrase “reasonable needs of the business” includes the
reasonably anticipated needs of the business.

B. Value-Added Tax
Value-added tax (“VAT”) is a tax on consumption levied on the sale, barter, exchange or
lease of goods or properties and services in the Philippines and on importation of goods
into the Philippines. VAT is imposed upon the seller, who may pass on the same to the
buyer, transferee or lessee of the goods, properties or services.

VAT is based on the gross selling price or gross value in money of the goods or properties
sold, bartered or exchanged, or the gross receipts derived from the sale or exchange of
services or the use or lease of properties. With respect to the importation of goods, VAT is
based on the total value used by the Bureau of Customs in determining tariff and customs
duties, plus customs duties, excise taxes, if any, and other charges. Where the customs
duties are determined on the basis of the quantity or volume of the goods, VAT shall be
based on the landed cost plus excise taxes, if any.

For a transaction to be subject to VAT, the sale, exchange, barter or lease of goods,
properties or services or the importation of goods must be in the course of trade or business.
The phrase “in the course of trade or business” means the regular conduct or pursuit of a
commercial or economic activity, including transactions incidental thereto, by any person
regardless of whether or not the person engaged therein is a non-stock, non- profit private
organization or government entity. Services rendered by non-resident foreign persons are
automatically considered as being rendered in the course of trade or business.

As a general rule, VAT is imposed at the rate of 12%. There are, however, sales which are
subject to VAT at the rate of 0%. These include export sales or services, foreign currency
denominated sales, and sales to persons or entities whose exemption under special laws or
international agreements to which the Philippines is a signatory effectively subjects such
sales to zero rate. Certain transactions, however, are exempt from VAT.

C. Donor’s Tax
Donor's tax is imposed upon the transfer by any person of property by gift as provided
under Section 98 of the Tax Code.

While the Tax Code does not define transfer of property by gift, donation is defined in Article
725 of the Civil Code as an act of liberality whereby a person disposes gratuitously of a thing
or right in favor of another, who accepts it.
Donation has the following elements:
(a) the reduction of the patrimony of the donor;
(b) the increase in the patrimony of the donee; and
(c) the intent to do an act of liberality or animus donandi. In a sale transaction where the
fair market value of the property sold exceeds its selling price, the excess is considered a
donation even in the absence of animus donandi.

Under the Tax Code, prior to the amendments by TRAIN, total net gifts made during the
calendar year before January 1, 2018 are subject to the following donor’s tax.
If the net gift is:

Over But not over The tax shall Plus Of the excess
be over

Php 100,000 Exempt

Php 100,000 200,000 0 2% Php 100,000

200,000 500,000 2,000 4% 200,000

500,000 1,000,000 14,000 6% 500,000

 1,000,000 3,000,000 44,000 8% 1,000,000

3,000,000 5,000,000 204,000 10% 3,000,000

5,000,000 10,000,000 404,000 12% 5,000,000

10,000,000 1,004,000 15% 10,000,000

When the donee or beneficiary is a stranger, the tax payable by the donor shall be thirty
percent (30%) of the net gifts. For the purpose of donor’s tax, a 'stranger', is a person who
is not a:
(1) Brother, sister (whether by whole or half-blood), spouse, ancestor and lineal descendant;
or
(2) Relative by consanguinity in the collateral line within the fourth degree of relationship.

Note, however, that starting January 1, 2018, the donor’s tax is imposed at the rate of 6%
computed on the basis of the total gifts in excess of two hundred fifty thousand pesos (PhP
250,000) exempt gift made during the calendar year, regardless of whether or not the donee
is a stranger.

The Donor’s Tax Return (BIR Form No. 1800) must be filed within thirty (30) days after the
date the gift (donation) is made.

D. Documentary Stamp Tax

The documentary stamp tax (“DST”) is an excise tax levied on documents, instruments, loan
agreements and papers evidencing the acceptance, assignment, sale or transfer of an
obligation, rights, or property incident thereto.

The tax is paid by the person making, signing, issuing, accepting or transferring the
documents. However, whenever one party to the taxable document enjoys exemption from
the tax, the other party thereto who is not exempt shall be the one directly liable for the tax.

The tax return must be filed and the tax due paid at the same time within five (5) days after
the close of the month when the taxable document was signed, issued, accepted or
transferred. In lieu of the foregoing, the tax may be paid either through purchase of DST
stamp and actual affixture, or by imprinting secured stamp on the taxable document through
the web-based Electronic Documentary Stamp Tax (eDST) System.

Failure to stamp a taxable document does not invalidate the same. However, it shall not be
recorded or admitted or used as evidence in any court until the requisite stamp is paid.
Furthermore, no notary or other officer authorized to administer oaths shall add his jurat or
acknowledgment to the document unless the proper documentary stamp has been paid.

Examples of documentary stamp taxes applicable and relevant to the Company, and their
corresponding rates, are:

Transaction Tax Rate Until Dec. Tax Rate From Jan. Legal Basis
 31, 2017 1, 2018 onwards

Original issue of One peso (Php1.00) Two pesos Sec. 174, Tax Code
shares on each two hundred (PhP2.00) or Sec. 51, Tax Reform
pesos (P200), or fractional part for Acceleration and
fractional part Acceleration and Inclusion Act
thereo, off the par thereof, of the par (“TRAIN”)
value, of sich shares value, such shares
of stock. of stock.

Sale or Transfer of Seventy-five One peso and fifty Sec. 175, Tax Code
shares of certificates centavos (Php0.75) centavos (PhP1.50) Sec. 52, TRAIN .
of stock on each two hundred on each Two
pesos (Php200) or hundred pesos
fractional part (PhP200) or
thereof, of the par fractional part
value of such thereof, of the. par
certificate of stock. value of such
certificate of stock.

Lease of Property Three pesos •Six pesos Sec. 194, Tax Code
(Php3.00) for the (PhP6.00) for the Sec. 67, TRAIN
first two thousand first Two thousand
pesos (Php2,000), or pesos (PhP2,000),
fractional part or fractional pesos
thereof, and an (PhP2,000), or
additional one peso fractional part
(Php1,00) for every thereof, and an
one thousand pesos additional Two peso
(Php1,000) or (PhP2.00) for every
fractional part One Thousand
thereof, in excess of pesos (PhP1,000) or
the first two fractional part
thousand pesos thereof, in excess of
(Php2,000) for each the first Two
year of the term of thousand pesos
said contract or (PhP2,000) for each
agreement. year of the
(PhP2,000) for each
year of the term of
said contract or term
of said contract or
agreement.

E. Assessment of National Internal Revenue Taxes

The Philippines follows the pay-as-you-file system in the enforcement and collection of
taxes. In the pay- as-you-file system, the taxpayer determines the amount of tax due, files
his return and pays the tax based on his own computation.The pay-as-you-file system
obliges the taxpayer to conduct selfassessment in order to determine and declare the
amount to be used as the basis for the computation of the tax liability, any deductions
therefrom, and finally, the tax to be paid. The tax due is paid at the time the return is
filed. However, the BIR is empowered to ascertain the correctness of the tax return filed and
consequently, the amount of tax paid.
1. Prescriptive Period for Assessment
The assessment for national internal revenue taxes must be made within three years from
the last day provided by law for the filing of tax return. When a return is filed beyond the
period laid down by law, the period will commence to run on the day the return is filed.
However, if the return is filed before the last day of filing, the three-year period will be
counted on such last day. Section 222 of the TaxCode provides exceptions on the three
year prescriptive period to assess internal revenue taxes. In case of false or fraudulent
return with intent to evade tax or in case of failure to file a return, the tax may be
assessed within a ten-year period commencing from the discovery of the falsity, fraud or
omission. In addition, the BIR and the taxpayer may agree in writing to an assessment
beyond the three-year period, provided that the agreement was entered into before the
expiration of such period.

A “false return” is that which contains wrong information due to mistake, carelessness or
ignorance; while a “fraudulent return with intent to evade tax” is a crime involving moral
turpitude as it entails willfulness and fraudulent intent on the part of the individual.
Fraud may be established by the:
(a) intentional and substantial understatement of tax liability by the taxpayer;
(b) intentional and substantial overstatement of deductions or exemptions; or
(c) the recurrence of the foregoing circumstances.
As for “failure to file a return,” the mere omission is already a violation regardless of the
fraudulent intent or willfulness of the individual.

The running of the prescriptive period for making an assessment and the beginning of
distraint or levy is suspended for the period during which:
(a) the BIR is prohibited from making an assessment or beginning distraint or levy or a
proceeding in court and for 60 days thereafter;
(b) the taxpayer requests for a reinvestigation which is granted by the BIR;
(c) the taxpayer cannot be located in the address given by him in the return;
(d) the warrant of distraint and levy is duly served and no property could be located; and (e)
when the taxpayer is out of the Philippines.

2. Procedure in the Issuance of Deficiency Tax Assessment

a. Letter of Authority
The BIR has the power to issue a Letter of Authority (“LOA”) against a taxpayer pursuant to
Section 5 of the Tax Code which shall authorize the BIR, in ascertaining the correctness of
any entry in the tax return, or in making a return where none has been filed, or in
ascertaining the liability of any person for internal revenue taxes, or in collecting tax liability
or in determining tax compliance, to:
(a) examine any book, paper, record, or other data which maybe relevant or material to the
inquiry;
(b) obtain on a regular basis any relevant information concerning a taxpayer from any
person other than the taxpayer whose tax liability is in question;
(c) summon the person liable for tax or required to file a return or any officer or employee of
such person to appear before the BIR or its duly authorized representative and to produce
relevant books, papers, records or other data, and to give testimony; (
d) take the testimony of the person concerned under oath; and
 (e) cause revenue agents to canvass any revenue district or region and inquire after and
concerning all persons therein who may be liable for internal revenue taxes and all persons
owning, managing or in possession of any taxable object.

As a general rule, the taxpayer’s books of accounts and accounting records may be
audited only once every taxable year except in the following instances:
(a) fraud, irregularity, or mistakes, as determined by the BIR;
(b) the taxpayer requests re-investigation;
(c) verification of compliance with withholding tax laws and regulations;
(d) verification of capital gains tax liabilities; and
(e) in the exercise of the BIR’s power under Section 5(B) of the Tax Code to obtain
information from other persons in which case, another or separate examination and
inspection may be made.

b. Notice of Informal Conference

After the examination of the taxpayer’s books of accounts and accounting records pursuant
to the LOA, a notice of informal conference, informing the taxpayer that the findings of the
audit indicate that deficiency taxes has to be paid, must be issued to the taxpayer.The
informal conference must afford the taxpayer an opportunity to know the results of the
investigation and to refute the same.A second conference is allowed to enable the taxpayer
to examine his position and gather evidence to support his claim.46 The taxpayer is given a
period of 15 days within which to respond, counted from the receipt of the notice of informal
conference, otherwise, the taxpayer will be considered in default.47 In such a case, the
matter will be endorsed with the least possible delay to the Assessment Division of the BIR
for review and issuance of deficiency tax assessment, if necessary.

c. Preliminary Assessment Notice

The Assessment Division of the BIR will determine if there is sufficient basis to issue a
deficiency tax assessment. If there is, a Preliminary Assessment Notice (“PAN”) will be
issued to the taxpayer, atleast by registered mail. A PAN informs the taxpayer of the audit
findings of the Revenue Officer after a review of the said findings.

Notice of Informal Conference and PAN are not necessary in the following instances:
(a) when the finding for any deficiency tax is the result of mathematical error in the
computation of the tax appearing on the face of the tax return filed by the taxpayer;
(b) when a discrepancy has been determined between the tax withheld and the amount
actually remitted by the withholding agent;
(c) when a taxpayer who opted to claim a refund or tax credit of excess creditable
withholding tax for a taxable period was determined to have carried over and automatically
applied the same amount claimed against the estimated tax liabilities for the taxable quarter
or quarters of the succeeding taxable year;
(d) when the excise tax due on excisable articles has not been paid; or
(e) when an article locally purchased orimported by an exempt person, such as, but not
limited to, vehicles, capital equipment, machineries and spare parts, has been sold, traded
or transferred to non- exempt persons.

d. Formal Letter of Demand and Assessment Notice

 If the taxpayer fails to respond within 15 days from receipt of the PAN, the taxpayer will be
considered in default. A Formal Letter of Demand (“FLD”) and Assessment Notice will
thereafter be issued by the concerned office. An Assessment Notice is a declaration of
deficiency taxes issued to a taxpayer who fails to respond to the PAN or whose reply thereto
was found not to be meritorious. The FLD must state the facts, the law, rules and regulations
or jurisprudence on which the assessment is based. It must also include a demand for
payment of deficiency taxes, otherwise, the FLD and Assessment Notice will be void.

e. Administrative Protest
A taxpayer has 30 days from receipt of the FLD and Assessment Notice to protest the
same administratively through either a request for reconsideration or a request for
reinvestigation. All the relevant supporting documents to the protest must be submitted
within 60 days from filing of the request for reinvestigation. Otherwise, the assessment will
become final, executory and demandable.

f. Appeal to the Court of Tax Appeals

If the BIR denies the protest, in whole or in part, the taxpayer may appeal to the Court of
Tax Appeals (“CTA”) Division within 30 days from the receipt of the decision by filing a
petition for review. Otherwise, the decision will become final and demandable. A taxpayer
may likewise appeal a disputed assessment without awaiting the decision of the BIR. If the
BIR or its duly authorized representative fails to act on the protest, a petition for review may
be filed within 30 days from the expiration of 180 days counted from the date of
submission of the required documents in the case of a request for reinvestigation or from the
submission of the request for reconsideration. Otherwise, the assessment shall become final
and demandable.If the taxpayer is not satisfied with the decision of the CTA Division, a
motion for reconsideration can be filed with the CTA Division within 15 days from receipt of
the decision. If the taxpayer is still dissatisfied with the decision, a Petition for Review can
be filed with the CTA En Banc within 15 days from receipt of the decision. From the decision
of the CTA En Banc, a motion for reconsideration can be filed within 15 days from receipt of
the decision.Please note that there is a slight difference in the availment of these remedies
when it comes to VAT especially in the period of appeal.

g. Appeal to the Supreme Court

The decision of the CTA En Banc can be questioned before the Supreme Court by filing a
Petition for Review within 15 days from receipt of the decision.

F. Collection of National Internal Revenue Taxes

Once the assessment becomes final, executory, and demandable by failure to protest the
same administratively and/or judicially, or the protest or appeal is denied or decided against
the taxpayer, the government may avail of the following remedies to collect deficiency taxes:
(a) distraint of personal property; (b) levy of real property; (c) civil action; and (d) criminal
action.
Revenue Memorandum Order (“RMO”) No. 39-200755 authorizes the immediate issuance
and service of warrants of distraint and garnishment and/or levy upon the issuance of the
final decision on the disputed assessment against the taxpayer by the Commissioner of
Internal Revenue or the Regional Director of the BIR or by the CTA Division or CTA En
Banc of its decision upholding the assessment against the taxpayer. The BIR has a period
of three years from expiration of the period within which to assess a taxpayer. On the other
hand, the BIR has a period of five (5) years from the date of the said assessment to collect
the assessed tax. In case of false or fraudulent return with intent to evade tax or in case
of failure to file a return, the BIR has five years following the assessment of tax to collect
the same.

II. Local Business Taxes

The provisions on local business taxes are codified in the Local Government Code of 1991
(the “Local Government Code”). Under Section 129 of the Local Government Code, each
local government unit (“LGU”) has the power to create its own sources of revenue and to
levy taxes, fees and charges. LGUs usually have their own Revenue Code levying taxes,
fees and charges which must not contravene the Local Government Code.

A. Community Tax
Every corporation is required to pay annually not later than the last day of February a basic
community tax of PhP500.00 and an additional tax which in no case shall exceed
PhP10,000.00, depending on the amount of gross receipts or earnings during the preceding
year. The community tax must be paid in the place where the principal office of the juridical
entity is located. In determining the gross receipts or earnings for purposes of this additional
tax, dividends received from another corporation are included.

B. Business Taxes
Corporations also have to pay the annual business tax and other fees imposed by the LGU
having jurisdiction over the corporation. These local taxes and fees must be paid within the
first 20 days ofJanuary each year. They may also be paid in four quarterly installments.

The rates of business tax vary depending on the business of the corporation and on the
amount of gross sales or receipts. Municipalities in Metropolitan Manila Area may levy taxes
which must not exceed by 50% the maximum rates prescribed for municipalities outside the
Metropolitan Manila Area.The taxes levied by cities may exceed the maximum rates
prescribe for other municipalities by not more than 50%.

For businesses maintaining or operating branch or sales outlets in various LGUs, the sale is
recorded in the branch or sales outlet making the sale or transaction and the tax thereon will
accrue and be paid to the LGU where such branch or sales outlet is located. In cases
where there is no branch or sales outlet inthe LGU where the sale or transaction is made,
the sale should be recorded in the principal office and the taxes due will accrue and be paid
to such LGU.

For manufacturers, assemblers, contractors, producers and exporters with factories, project
offices, plants and plantations, the following sales allocation must be followed in determining
the amount of business taxes due for each LGU:
(a) 30% of all sales recorded in the principal office is taxable by the LGU where the principal
office is located; and
(b) 70% of all sales recorded in the principal office is taxable by the city or municipality
where the factory, project, office, plant or plantation is located.

Where the plantation is located at a place other than the place where the factory is located,
the 70% mentioned in the preceding sentence will be divided as follows:
(a) 60% to the LGU where the factory is located; and
(b) 40% to the LGU where the plantation is located.

Where a manufacturer, assembler, producer, exporter or contractor has two or more

factories, project offices, plants and plantations located in different LGUs, the 70%
mentioned above will be prorated among the locAlities where the factories, project offices,
plants and plantations are located in proportion to their volume of production during the
period for which the tax is due.

C. Assessment of Local Business Taxes

1. Prescription of Local Business Taxes
Local taxes, fees or charges must be assessed within five years from the date they
became due. In case of fraud or intent to evade the payment of taxes, fees, or charges, the
same may be assessed within ten years from discovery of the fraud or intent to evade
payment.The running of the prescriptive period will be suspended for the time during which:
(a) the treasurer is legally prevented from making the assessment or collection; (b) the
taxpayer requests for a reinvestigation and executes a waiver in writing before expiration of
the period within which to assess or collect; and (c) the taxpayer is out of the country or
otherwise cannot be located.
2. Procedure Governing Protest of Assessment
The procedure for protesting an assessment of local business tax by the City/Municipal
Treasurer is as follows:
(a) issuance by the Treasurer or his duly authorized representative of a Notice of
Assessment;
(b) filing of a written protest by the taxpayer within 60 days from receipt of the Notice of
Assessment;
(c) rendering of decision by the City/Municipal Treasurer within 60 days from filing of the
written protest;
(d) filing by the taxpayer of an appeal to the Regional Trial Court within 30days from
receipt of the denial of the protest or from the lapse of the 60 day period within which to
decide the protest;
(e) filing of a Motion for Reconsideration with the Regional Trial Court within fifteen (15)
days from notice of the decision;
(f) filing of a Petition for Review with the CTA Division within 30days from receipt of the
Regional Trial Court’s decision;
(g) filing of a Motion for Reconsideration with the CTA Division within 15 days from notice of
the decision;
(h) filing of a Petition for Review with the CTA En Banc within 15 days from receipt of the
decision;
(i) filing of a motion for reconsideration within 15 days from receipt of the decision with the
CTA En Banc; and
(j) filing of a Petition for Review with the Supreme Court within 15 days from receipt of the
decision.

D. Collection of Local Business Tax

Local business taxes may be collected within five years from the date of assessment by
administrative or judicial action. The civil remedies for collection of local taxes may be: (a) by
administrative action through distraint of goods, chattels, or effects, and other personal
property of whatever character, and bylevy upon real property or interests in or rights to
real property; and (b) by judicial action.

III. Real Property Tax

The Local Government Code authorizes provinces to levy real property tax on real property
such as land, building, machinery and other improvements at the rate not exceeding 1% of
the assessed value of the said property annually while for cities, including municipalities
within the Metropolitan Manila Area at the rate not exceeding 2% of the assessed value of
the property.81 In addition, provinces, cities, including municipalities within the Metropolitan
Manila Area may levy and collect an annual tax of 1% on real property as Special Education
Fund (“SEF”) over and above the real property tax.82 The real property tax accrues on the
first day of January every year.83 The real property tax and the additional tax for the SEF
may be paid in four installments without interest: the first installment payable on or before
March 31; the second installment on or before June 30; the third installment on or before
September 30 and the last installment on or before December 31.

In case of failure to pay the said taxes on the dates mentioned above, the taxpayer will be
liable to pay interest at the rate of 2% per month on the unpaid amount until full payment is
made. However, the total interest should not exceed 36 months. In addition, the real
property tax and the tax for the SEF constitutes a lien on the real property superior to all
liens, charges or encumbrances in favor of any person which can be enforced by
administrative or judicial action and will only be extinguished upon payment of taxes, and
related interests and expenses.

A. Collection of Real Property Tax

Real property tax must be collected within five years from the date they become due. In
case of fraud orintent to evade the payment of taxes, fees, or charges, the action for
collection must be instituted within ten years from discovery of the fraud or intent to evade
payment. The running of the prescriptive period will be suspended for the time during which:
(a) the treasurer is legally prevented from collecting the tax;
(b) the owner of the property or the person having legal interest therein requests for a
reinvestigation and executes a waiver in writing before expiration of the period within which
to collect; and
(c) the owner of the property or the person having legal interest therein is out of the
country or otherwise cannot be located.

B. Protest of Real Property Tax

Generally, a protest can only be entertained if the taxpayer pays the real property tax. The
words “paid under protest” must be annotated on the tax receipts for payment of real
property tax. The protest must be filed within 30 days from payment of the real property tax
to the provincial, city treasurer or municipal treasurer. The protest must be decided by the
treasurer within 60 days from receipt thereof. Any owner or person having legal interest in
the property who is not satisfied with the action of the treasurer may, within 60 days from the
date of receipt of the decision or from the lapse of the 60 day period without any decision,
appeal to the Local Board of Assessment Appeals (“LBAA”) by filing a petition.The LBAA has
120 days from receipt thereof to decide the appeal. If the owner of the property or the person
having legal interest therein or the assessor is not satisfied with the decision of the LBAA, an
appeal to theCentral Board of Assessment Appeals (“CBAA”) may be filed..
A party adversely affected by a decision or ruling of CBAA in the exercise of their appellate
jurisdiction may appeal to the CTA En Banc by filing a petition for review within 30 days
from receipt of the questioned decision or ruling. From the decision of the CTA En Banc, a
motion for reconsideration can be filed within 15 days from receipt of the decision. The
decision of the CTA En Banc can be questioned before the Supreme Court by filing a
Petition for Review within 15 days from receipt of the decision.

Importance of Taxes in Decision Making

Sometimes taxation, and thus tax planning, is one of the most important factors in decision
making. Tax planning can affect decision making in even the most commonplace of settings.
Considering the vastness of tax types here in the Philippines, one could maximize the
potential of tax planning if one has knowledge of each and every types herein presented. A
bewildering array of taxes, imposed by a variety of governments, can have significant
impacts on the results of decisions made. It is correct to say that no person will ever know all
the tax rules nor anyone will know what will be the effect of taxes to every decision. But
suffice it to say that having a critical mass of knowledge will allow one to ask the right
questions.

CHAPTER 2: THE SAVANT FRAMEWORK

Overview:
To produce revenue, investors should have assets. To increase firm value, managers
engage in transactions. Of course, firm value can increase for other reasons. On the other
hand, for every transactions that managers and owners would enter, there is always its
invisible partner – the government. In strategic tax management, when a firm chooses
transactions, it keeps tax management in mind. This transactions approach—the SAVANT
framework

Strategy Anticipation Value- adding Negotiating Transforming

Module Objectives:
At the end of the topic, the learner will be able to: • Be able to use the SAVANT Framework
to guide tax planning • Know each element of SAVANT Framework At the end of the topic,
the learner will be able to: Course Materials: SAVANT stands for Strategy, Anticipation,
Value-adding, Negotiating and Transforming. STRATEGY Tax management should strive to
enhance the firm’s strategy and should not cause the firm to engage in tax-minimizing
transactions illegally that deter it from its strategic plan. Tax evasion as a willful act can be
punished criminally here in the Philippines. A key to a successful organization is having a
simple yet effective strategy with efficient implementation. One could think that in order not
to pay taxes, the firm should also minimize profits. Though it may be correct technically but
this is one good example of inconsistent strategy. From the business point of view, it may be
aligned with SWOT analysis, that is, matching Strengths and Weakness to business’
Opportunities and Threats.

STRATEGY
A strategic management curves the firms path on where it wants to go. Typically, the firm’s
business-level strategy is typically detailed in operations-level, corporate-level, and
international-level strategies. At the operations level, the firm’s strategy involves gaining
advantage over competitors to create value for its customers through its products or
services. In its competitive analysis, the firm needs to understand whether it has a tax
advantage or disadvantage in relation to its rivals. Corporate strategy focuses on
diversification of the business. Ideally, diversification strategies improve the structural
position or process execution of existing units, or, in a new business unit, stresses
competitive advantage and consumer value. International strategy focuses on taking
advantage of corporate and business strengths in global markets. It requires an
understanding of local countries and relies on working with foreign governments..

ANTICIPATION
As the firm curves out its strategy, they should also anticipate actions that may be done by
their competitors, markets and even the government. Tax firms are advising their client
based on what the government will legislate together with the market behavior. In short, they
are anticipating tax changes. For example, in anticipation of the implementation of the
TRAIN Law in January 1, 2018, most firms delayed their December expenses until January
to minimize the impact of larger tax rates. Firms should also attempt to anticipate price
effects resulting from tax changes. The magnitude of price effects depends on a number of
conditions. These include the elasticities of supply and demand and whether additional
suppliers can enter the market.

VALUE ADDING
Every goal of an effective tax management for each transaction should at least add value.
Financial Statement analysis, together with others, is one which the management can derive
if there’s value-adding. For example, if the net present value of cash flows is positive, then
for a certain period, will translate to positive financial earnings.

On a year to year basis, investors as well as creditors monitor the firm’s financial
performance. Popular method would be the financial statement analysis such as Return on
Equity (ROE) and Earnings per share (EPS). However, both risk in business and tax law
changes should be taken into consideration. Therefore, it is correct to say that for value
adding purposes, this is somehow flexible and should be assess over time.

NEGOTIATING
Negotiating tax benefits and costs is a function with the other who has also control on their
functions. That is to say, contracting with another which is not a governmental authority.
Before an entity enters into a contract with another, the firm’s tax management has to think
of how they can minimize their tax exposure legally by way of shifting burdens to another or
shared tax costs. This ability is called as tax shifting. This can be done by negotiating
purchase price and transacting with PEZA registered to enjoy their benefits, among others.

TRANSFORMING
Tax management should effectively think of ways how to transform certain tax types to
another. Like for instance, a non-deductible expense to a deductible one, a taxable income
to a gain and expenses into losses. We have learned that losses on sale of capital assets
are deductible only to the extent that the company has capital gains. Ordinary losses cannot
be, hence, deductible from this. One could think converting their capital losses to ordinary
losses.
TAX MANAGEMENT
Effective tax management is putting all together the SAVANT Framework in all its endeavors
and important business transactions. This means the management has to assess from time
to time the change in tax environment to see what has change and eventually adjust the
strategy. As discussed, tax law changes in 2018 made a great impact in the tax
environment. Tax rate changes has paved the way for the adjustment of many firms in every
industry to adopt. Taxes constantly evolve through deliberate government policy and through
administrative and judicial modifications and interpretation. With Internet availability,
important changes can be monitored constantly.

CHAPTER 3: CHOOSING A LEGAL ENTITY, RISK MANAGEMENT, RASING CAPITAL

AND TAX MANAGEMENT
Overview:
In the Philippine setting, one could choose whether to put up a sole proprietorship,
partnership or corporation type of business. Tax management, in this various types, has
different tax impact. Though one could think of minimizing tax liabilities, tax management
aims to manage the burden of having this.

In most important business decisions, there are two key financial considerations: risk and
return. Each financial decision presents certain risk and return characteristics, and the
combination of these characteristics can increase or decrease a firm’s share price. In the
most basic sense, risk is a measure of the uncertainty surrounding the return that an
investment will earn. Investments whose returns are more uncertain are generally viewed as
being riskier. More formally, the term risk is used interchangeably with uncertainty to refer to
the variability of returns associated with a given asset.

Module Objectives:
• Apply SAVANT to Entity Choice
• Determine application of the Framework in specialized legal forms

The entity choice for tax purposes should be based on a strategic planning process that
considers a host of nontax strategic goals as well. Considering the entity’s strategic plan,
they have to consider also those non-tax attributes such as:

Course Materials:
1. Risk Management
2. Managerial Control
3. Raising Capital
4. Pretax Return

Capital Raising
Raising capital essentially means getting the money you need to grow your business from
investors. Raising capital is another way of talking about financing your business. You can
raise capital through investors, or you can take out debts, like loans or credit cards, to
finance your business venture.
When most people think of capital in business, they think of tangible assets, like
manufacturing equipment or the building that’s used to manufacture goods. It’s true that
these are forms of capital. But capital also refers to financial assets, including funds that are
held in an account, that are used to build wealth in your business. Note that materials that
are consumed or used as part of a process aren’t capital.
Capital as investments that generate wealth and can be sold off can be a brand name or
software. Also, a piece of manufacturing equipment because it will generate wealth and can
be sold off as assets. Equipment is still capital, even though it depreciates in value. Equity
capital in the form of investments doesn’t have to be paid back and is used to grow wealth
in the business.

Management Control
Unlike in a sole proprietorship which he has the sole control of the business, the other type
of business such as partnership and corporation invites more decision makers that will make
judgment on the firm’s venture. Thus, they will all be decision makers responsible to the path
where thebusiness will go. Investors and shareholders are able to have a voice only through
voting. From there, the latter has to choose who will represent their voices.

Anticipation and Timing Issues

In a corporate setting, it can control the timing of income to its shareholders. For example, a
corporation normally can choose not to pay dividends. (Similarly, the corporation can choose
to repurchase its shares rather than paying dividends.) This allows shareholders to control
when to reap the benefits of corporate earnings in their decisions about when to sell shares
but they have to consider the probable imposition of improperly accumulated earnings tax.

The SAVANT FRAMEWORK

For example, you and your friend want to start a business. Putting it all together: Raising
Capital and Management Control. Let us use the SAVANT Framework for better
understanding.

STRATEGY
In order to retain control, you probably invite other people to raise capital but not to include
them as partners but rather investors to the firm. In some cases, a limited partner may be
true but then again, this kind of partner may exercise certain control in the management of
the business.

ANTICIPATION
In anticipation of a new tax law change, you probably retain or rather put up an Ordinary
Partnership rather than a General Professional Partnership for better tax set up. This can be
assessed through allowed deductibles and difference in tax rates for income purposes.

VALUE ADDING
Ordinary Partnership is treated as an ordinary corporation. For every business transaction,
the way a corporation does is no way different except the absence of shares of stock. In this
regard, one could think that a good financial performance will reap better benefits minus the
various tax types a corporation is more exposed. To recap, an ordinary corporation, though
the same tax rates of 30% is relieved of paying dividends, IAET and the like. This can help
add value to the firm as the business transaction are basically the same as if a corporation.

NEGOTIATING
Because of the nature of the business, you anticipate tax net operating losses for the first
few years just like a corporation. Though there is no difference in tax exposures, one could
think that an Ordinary Partnership will have better standing as it has less tax types to pay
and not as complex as a corporate set-up.

TRANSFORMING
In the event of liquidation, an Ordinary Partnership has to liquidate only the assets and
distribute the remaining assets to the Partners once the creditors are paid and settled. In a
corporate set-up, the shareholders are the last to be paid up once the secured and
unsecured creditors are settled. One could imagine the difficulty of liquidating a corporation
than ordinary partnership. Also, as an ordinary asset, it can be deduced that any losses may
be deducted to other ordinary losses unlike in a corporate set-up where shareholders treat
their earnings as a passive income. This is not deductible but an income subject to final
taxes, hence, will never be deductible.

CHAPTER 4: FINANCING A NEW VENTURE

Overview:
There are two basic forms of strategies for financing a business: internal financing and
external financing. Internal financing is a strategy where the company uses its retained
earnings to finance its new venture. Retained earnings are accumulated net income since
the corporation was formed that is retained after all distributions of dividends to stockholders.
Companies that purchases new property, plant, and equipment out of cash flows from
operations are using an Internal financing strategy.
On the other hand, External financing is a strategy whereby cash comes from sources
other than the firm’s own positive cash flow. It comes in two different forms: debt or equity.
Debt financing may be in the form of short-term borrowing (e.g. purchase on account) or
long-term borrowing (e.g. bonds payable). Equity financing includes selling of business
interest to outside sources such as selling common stock to either new shareholders or
existing ones or selling partnership interest to new investors or receiving new contributions
of capital from existing partners.

Course Materials:
INTERNAL FINANCING
A company may use this strategy when it has available retained earnings to finance a firm’s
growth. However, as part of its long-run planning, an organization may plan to transition
from external to internal financing eventually.

Strategy
Retained earnings are not generally subject to payout and control restrictions compared to
external financing. Debt financing requires periodic payment of interest. Equity financing will
dilute earnings per shares as well as control.

Anticipation
Anticipated tax law changes affect internal financing choice. For example, if income taxes
are expected to increase, the company must retain sufficient earnings to cover the expected
increase in income tax payments. Similarly, anticipated tax decreases will release additional
funds for internal financing.
Using internal financing, the company can control the timing of tax benefits and deductions
in response to anticipated changes in the taxes. With the anticipated decrease in corporate
income tax from 30% to 25% until 2022, followed by a 1% reduction yearly until 2027, the
company can anticipate the loss on tax savings on planned plan expansion, and act
accordingly without lags to commit investment.

If the company is planning to acquire a property, plant, and equipment that costs P20 million
with a residual value of 10% of the cost and a useful life of 10 years, the lost tax savings
would be

Year of Acquisition. 2020. 2022. 2027

Current Tax Rate. 30%. 30%. 30%
Anticipated Rates. 30%. 25%. 20%
Difference. - 5%. 10%
Depreciation
(P20 M x 90% / 10). P1,800,000. P1,800,000. P1,800,000
Tax Benefit. - 90,000. 180,000

The table shows the tax benefit that would be derived from acquiring the property. There is a
tax benefit because the depreciation from the property is tax deductible, thereby, reducing
the income tax payable.

Based on the foregoing, if the company acquires the property in 2022 where the corporate
tax rate dropped to 25%, it would lose P90,000 tax savings compared to when the property
was acquired in 2020 where the tax rate is still 30%. When the property was acquired in
2027, the company would lose P180,000.

The decision to acquire the property would not solely depend on tax savings. The company
would still need to consider other circumstances to compute the net benefit of the
acquisition.

If the company has sufficient fund, it could readily acquire the property in 2020 without using
external financing. If internal funds are not sufficient, it can borrow from the banks or issue
new equity. But it may totally forego the tax savings and wait until internal funds are
available if it thinks the costs of new debt or new equity are higher than the tax savings. Note
that there is less danger of losing such tax benefits if the firm uses internal financing.

Value-Adding
The value added through internal financing is potentially higher than from external financing.
This is because neither the enhanced cash flows nor the increased value of the firm is
shared with anyone other than the original owners.

Negotiation
Negotiation of tax benefits is not really affected by the use of internal financing, but, as also
discussed later, it is an important factor in structuring debt financing.

Transforming
While there are no direct transforming advantages to internal financing, there is a definite
advantage in the absence of transaction costs (as discussed in the next section). However,
increases in firm value are not usually taxed until there is an exchange transaction, such as
a sale of corporate stock. Thus, an internal financing strategy that bolsters the value of a
firm’s equity held by existing owners can be quite tax advantaged.

EXTERNAL FINANCING: DEBT VERSUS EQUITY

Debt may be in the form of short-term debt or long-term debt. Short term debts are expected
to be settled within a year. It is characterized overall by higher interest rates than long-term
debt but can be interest free. Suppliers usually offer a credit term of 30 days where buyers
can purchase on account and can pay interest free for 30 days. Long-term debt consists of
bonds (secured by specific assets) and debentures (not secured by specific assets).

Equity financing may be in the form of contribution in cash or in property by partners in a

partnership or issuance of capital stock by a corporation. Owners of common stock most
often have voting control of the corporation, yet, they have residual interest in the assets of
the corporation. Owners of preferred stock usually have no voting rights but must be paid a
specific dividend before common stock get its shares.

Strategy
Managers search for an optimal capital structure in the long run. The optimal capital
structure depends on the objective of the organization. A not-for-profit organization will
minimize its debt financing wile a for-profit organization will seek optimal debt-to-equity mix
to maximize shareholders’ wealth.

Value-Adding
A key aspect of debt financing is leverage. Debt adds value when debt increases operating
cash flows in excess of the required periodic payments of interest and repayments of
principal. Also, firms with higher effective tax rates benefit more from debt because of the
tax shield.

For example, ABC Company and XYZ Company have the following financial information:
ABC Company XYZ Company
Sales. P100 million. P100 million
Net Income. 10 million. 10 million
Assets. 10 billion. 10 billion
Debt. 2 billion. 7 billion
Common Stock. 7 billion. 2 billion
Retained Earnings. 1 billion. 1 billion

ABC Company may have a higher credit rating because of lowered debt. ABC’s appears to
have a healthier financial standing. In turn, higher credit rankings usually result in lower
costs of acquiring additional external financing. However, XYZ Company has a lower cost of
capital. If we assume that these companies operate in the Philippines and are subject to
corporate income tax rate of 30%, and the debt and equity investors demand a 10% pretax
return, the cost of capital would be:
 ABC Company XYZ Company
Cost of Debt
Debt. P2 billion. P7 billion
Pre-tax Required Returm. 10%. 10%
Total. 200 million. 700 million
Tax Savings. (60 million). (210 million)
Net Cost of Debt. 140 million. 490 million
Cost of Equity.
Common Stock. P7 billion. P2 billion
Pre-tax Required Return. 10%. 10%
Total Cost of Debt. 700 million. 200 million
Total Cost of Debt and Equity. 840 million. P690 million

Under ABC’s capital structure, total annual cost of capital is P840 million. XYZ’ total annual
cost of capital is P690 million. XYZ saves P150 million compared to ABC. Overtime, this
extra cash flows, when reinvested, would give XYZ significant advantage over ABC. This is a
trade-off in the long run for having a healthier-appearing financial structure.

The higher the relative use of debt, the greater the risk of bankruptcy or costly debt
renegotiations. Debt financing is riskier than equity because of required periodic payments.
However, an income tax can act to mitigate some of this risk for investors, and this lowered
risk can be passed on to the firm in the form of lower interest rates. On the other hand,
dividends are not tax deductible.

However, value-added decreases at some point because of lenders charging higher interest
rates for additional loans as the firm’s risk of default increases.

From the point of view of providers of fund, investing in equity is riskier than investing in
debt. If the creditor defaults on debt, the remaining balance becomes a tax-deductible loss to
the lender. If the lender is in the business of making loans, the loss is fully deductible. But if
the lender is not in that business such as investment in bonds, the loss is considered a
capital loss, which is deductible only to the extent of capital gain. Moreover, interest income
from long-term investments (including bonds) issued by banks is tax-exempt. The gain from
the sale of a long-term investment (maturity of five years or more) is likewise tax exempt.

Investing in equity is riskier, yet, there are possible tax offsets to reduce risk. Share price
appreciation is not taxable until the investments are sold. In case the stocks investments
were sold directly to another investors, any gain or loss on such a sale is considered capital
gain or loss. If the sale results in a capital loss, such a loss shall be deductible only to the
extent of capital gains from the same type of transaction during the same period. The
resulting net capital gains shall be subject to 15 percent capital gains tax. Moreover, in case
of liquidation, only 50% of the capital gain is subject to basic income tax subject to holding
period of more than 12 months. But if the shares are sold through local tax exchange, a
stock transaction tax of 0.6% on the gross selling price shall be imposed, not income tax.
Even if the sale results in a loss, such a loss is not deductible for tax purposes.
For example, On January 1, 2021, Mr. A invested in P1 million for common stock in a start-
up company. The information on the company’s earnings and appreciation of the investment
is shown below.

End of Year Net income of the Value of the Mr. A’s

Company Investment

2021 P500,000 P1,500,000

2022 P1,000,000 P2,000,000

2023 P1,500,000 P3,500,000

If at the end of 2023, Mr. A sold his investment to Mr. B for P5,000,000, Mr. A will pay
P600,000 capital gains tax.

Proceeds. P5,000,000
Cost of Investment. (1,000,000)
Capital Gain. 4,000,000
Capital Gain Tax Rate. 15%
Capital Gain Tax. P600,000

In case the company was liquidated at the end of 2023 and Mr. A received P5,000,000, the
tax implication would be:

Proceeds. P5,000,000
Cost of Investment. 1,000,000
Total Capital Gain. 5,000,000
Holding period (50% if held for more than 12 months). 50%
Net Capital Gain subject to Basic Income Tax. 2,500,000

The net capital gain will form part of Mr. A’s gross income. If this is the only income of Mr. A,
the income tax payable using the graduated tax rates would be:

First P2,000,000. 490,000

Next P500,000 x 32%. 160,000
Income Tax Due. 650,000

Moreover, if the shares of stock of the company is traded in a local stock exchange, the gain
on sale is not subject to income tax. But the sale transaction shall be subject to stock
transaction tax of 0.6% on the gross selling price. Hence, Mr. A would pay stock transaction
tax of P30,000 (P5,000,000 x 0.06%) if he sold the stocks through a stock exchange.

In sum, a company may secure more debts to get the advantage of a leveraged company
while only facings it disadvantages of having a higher financial risk. Moreover, the equity
investors may also find several alternatives of infusing capital to the company while
minimizing risks and maximizing shareholders’ wealth.

Negotiating
Tax benefits from losses suffered by start-up companies are good negotiating tool.
Businesses that suffer operating losses can get immediate tax benefits by carrying those
losses back to offset profits. Net Operating Loss (or the excess of allowable deduction over
gross income) may be carried over as deductions from gross income for the next three
consecutive years immediately following the year of such loss. If these tax deductions can
be transferred to investors, they will effectively reap a higher return on capital.

For example, if a start-up company suffered P1,200,000 loss, the value of the write-off to
the new investor group is P360,000 (P1,200,000 x 30% Corporate Income Tax Rate). This
is akin to return on capital without receiving any cash flows from operation. Therefore, this
should be an acceptable investment, at least for year 1. From the firm’s perspective, debt at
the early stage has no tax benefit, so it should be willing to use debt only if the pretax cost is
lower than the after-tax cost of equity financing.

Anticipation
The company should anticipate macroeconomic changes that will affect interest rates or
taxlaw changes affecting interest deductions or tax rates on investors. For example, the
TRAIN Law increases capital gains tax on direct sale of shares from previous 5% to 10% to
a flat rate of 15%. This means it would have been better off selling shares of stocks to
another investors before January 1, 2018, the effectivity of the TRAIN Law when the rate is
relatively lower. Moreover, under the TRAIN Law transfer of property pursuant to Section
40(C)(2) of the NIRC is already exempt from VAT, hence, a sole proprietorship or a
partnership may defer the incorporation of its business until January 1, 2018 to avail the tax-
free exchange of property to a corporation by a person in exchange for stock or unit of
participation in such a corporation of which as a result of such exchange said person, alone
or together with others, not exceeding four (4) persons, gains control of said corporation. If
the company expects that interest rate will go up, the company is better off issuing debt now.

With respect to timing issues, a key factor is how the firm’s (and potential investors’) tax
status is expected to change in the near future. If the company expects a decrease in
corporate income tax, then tax deductions for interest payments are of little use, and the
after-tax cost of equity capital may be cheaper than that for debt. If the capital gains tax
decreases, the investor will also favor a common stock investment.

However, suppose the capital gains tax decreases but the company remains in a high tax
bracket, there would be a conflict of interests between the investors and the company. The
investors would favor common stock while the company favors debt. The firm and potential
investors thus must negotiate tax benefits in the form of adjusting pretax cash flows.

In addition to timing, the time-value aspect of tax benefits is important in the capital structure
decision. For investors, timing of payments can be engineered so that payments are made in
a taxminimizing way. Dividends can be paid when tax rates decline, or limited dividends can
be paid, so that much of the stock’s return is in the form of appreciation. Thus, taxes are
postponed and thus transformed into (lower-taxed) capital gain income.
For example, a company earns 10% return. If a shareholder has P1,000,000 worth of stocks,
it implies that the shareholder should receive P100,000 dividends each year. Since the
investor is subject to 10% final tax on dividends, he is better off receiving the dividends for
five years than selling the stock for P500,000 gain. If the investor has 10% required rate of
return, the after-tax present value of these alternatives is:

Alternatives. Cash Flows. Present Value. Applicable Tax. After-Tax

Present
Factor. . Value of Cash Flows

Yearly Dividends. 100,000. 3.7908. 10%. 341, 170.81

Sale at the end of Year 5 500,000. 0.6209. 15%. 263, 891.56
Advantage of receiving yearly dividends. 77,279.25
Yearly dividends: 100,000 x 3.7908 x (1-10%)
Sale at the end of year 5: 500,000 x 0.6209 x (1-15%)

Dividends are subject to 10% final tax while the net capital gain on direct sale of shares to
buyer is subject to 15% capital gains tax.

However, if the company can plow the dividends back to boost its operation, where after 5
years, the shares could be sold at P700,000, the after-tax present value of these alternatives
is:

Alternatives. Cash Flows. Present Value. Applicable Tax. After-Tax

Present
Factor. . Value of Cash Flows

Yearly Dividends. 100,000. 3.7908. 10%. 341, 170.81

Sale at the end of Year 5 700,000. 0.6209. 15%. 369, 448.19
Advantage of receiving yearly dividends. 28,277.38

In this case, the investor is better off instead receiving no dividends for five years and then
selling the stock. Thus, if a corporation’s shareholders are willing to accept nominal
dividends in return for stock appreciation, the firm can dramatically increase the present
value of stock financing by paying out dividends only after a certain length of time.

However, a closely held corporation must be careful not to accumulate excessive earnings
as it is subject to Improperly Accumulated Earnings Tax of 10%.

The above situation cannot be applied in interest payments merely by paying interest at
maturity since interest income must be recognized periodically.

Effect of Clienteles
The optimal choice for capital structure is highly influenced by the tax status of investors in a
firm’s debt or equity. This is particularly the case where the investor clientele includes those
who do not pay tax at all. For example, dividends received from a domestic corporation are
tax-exempt. There are certain exempt corporations under Section 30 of the NIRC. These are
 1. Labor, agricultural or horticultural organization – non-profit
2. Mutual savings bank or cooperative bank – non-stock, non-profit, operated for mutual
purposes
3. Beneficiary society, order, or association – operating for the exclusive benefits of their
members; includes fraternal organization operating under the lodge system; or mutual aid
association or a nonstock corporation organized by employees providing life, sickness,
accident, or other benefits exclusively to the members
4. Cemetery company – owned and operated exclusively for the benefit of its members
5. Non-stock corporation or association organized and operated exclusively for religious,
charitable, scientific, athletic, or cultural purposes or for the rehabilitation of veterans,
provided that no part of its income or asset belong to or inure to the benefit of any individual
6. Business league, chamber of commerce, or board of trade – Non-profit; no part of net
income inures to the benefit of an individual
7. Civic league or organization – Non-profit; operating exclusively for the promotion of
social welfare
8. Non-stock and non-profit educational institutions
9. Government educational institutions
10. Organizations of a purely local character whose income consists solely of assessment,
duties and fees collected from their members to meet expenses; includes farmers’ or other
mutual typhoon or fire insurance company, mutual ditch or irrigation company andmutual or
cooperative telephone company
11. Farmers’, fruit growers’, and like association – whose primary function is to market the
product of their members

In contrast to the situations just presented, tax-free investors may prefer current
distributions, such as dividends, to delayed cash flows (e.g., waiting to sell appreciated stock
to transform income into capital gains). They also may be indifferent to interest versus
dividends. If a firm knows that its clientele will be tax exempt, it can issue debt or equity
based on its own needs, disregarding investor tax status.

Transaction Cost Effects on Value-Adding

Debt offerings typically are cheaper than equity (5% versus 10%, depending on
circumstances). Because these costs are present at each offering, it makes sense for the
firm to try to anticipate future capital needs in order to minimize the number of issuances.

Transforming
By issuing stock or securities that are convertible to equity, firms can enable either
themselves or their investors to transform ordinary income into capital gains or taxable
income into nontaxable income.

CHAPTER 5: NEW PRODUCTS: DEVELOPMENT, PROMOTION, AND ADVERTISING

Overview:
For a business to stay competitive, it must deliver products or services that are perceived to
be better, less expensive, or more convenient. Given competitors with the same objectives,
this implies a constant evolution in products. This chapter examines the tax aspects of this
process using the SAVANT framework.
Course Materials:
NEW PRODUCTS AND PRODUCT IMPROVEMENT
The typical product/process development process typically consists of research and
development, then, promotion and advertising.

Market Research. - Product or Services. - Test Marketing. - Final Product or Process

Research and Development. Promotion and Advertising

The taxpayer may elect to claim Research and development expenditures as ordinary and
necessary expenses or as deferred expenses,

Ordinary and necessary expenses which are not chargeable to the capital account require
that it must be
a. Paid or incurred by the taxpayer during the taxable year
b. In connection with his trade, business, or profession and
c. The expenditures so treated shall be allowed as deduction during the taxable year when
paid or incurred

Research and development expenses may be treated as deferred expenses or expenses

chargeable to capital account (optional on the part of the taxpayer) and requires that it must
be
a. Paid or incurred by the taxpayer in connection with his trade, business, or profession
b. Not treated as expenses
c. Chargeable to capital account but not chargeable to property of a character which is
subject to depreciation or depletion.

In computing taxable income, the deferred expenses shall be allowed as deduction ratably
distributed over a period of not less than 60 months as may be elected by the taxpayer. The
deduction begins with the month in which the taxpayer first realizes benefits from such
expenditures.

Moreover, Republic Act No. 7459, known as Investors and Invention Incentives Act of the
Philippines, provides incentives to Filipino investors. Inventors, as certified by the Filipino
Inventors Society and duly confirmed by the Screening Committee, shall be exempt from
payment of license fees, permit fees and other business taxes in the development of their
particular inventions. This is an exception to the taxing power of the local government units.
The certification shall state that the manufacture of the invention is made on a commercial
scale.

Inventors shall exempt from paying any fees involved in their application for registration of
their inventions.

To promote, encourage, develop and accelerate commercialization of technologies

developed by local researchers or adapted locally from foreign sources including inventions,
any income derived from these technologies shall be exempted from all kinds of taxes during
the first ten (10) years from the date of the first sale, subject to the rules and regulations of
the Department of Finance: Provided, that this tax exemption privilege pertaining to invention
shall be extended to the legal heir or assignee upon the death of the inventor.
The technologies, their manufacture or sale, shall also be exempt from payment of license,
permit fees, customs duties and charges on imports.

An important part of strategic analysis is the company’s tax status. If the company is in a net
operating loss (NOL) carryforward situation, the tax advantages of deductions may be low or
nonexistent. Conversely, if the company is in the highest income tax bracket, cost and risk
sharing is maximized. In that case, depending on the tax status of the company can choose
whether to claim Research and development expenditures as ordinary and necessary
expenses or as deferred expenses.

For example, Corporation A spent 1,000,000 in R&D in 2020. The R&D cost can be
amortized over 5 years. If the corporation is subject to 30% corporate income tax rate for the
next 5 years, the tax benefit derived from this deduction could be:

Treatment of 2020 2021 2022 2023 2024

R&D Cost

Deducted in 300,000
Full

Deferred 60,000 60,000 60,000 60,000 60,000

Charges

If Corporation A claimed the entire R&D, the tax saving is 300,000 (1,000,000 x 30%).
Moreover, Corporation A may treat it as deferred expense and amortize over 5 years as
follows:
= R&D Cost / amortization period
= 1,000,000 / 5 years
= 200,000

The amortization depends on the useful life or legal life of the asset. Here, we assume a
fiveyear useful/legal life. The tax benefit is 60,000 per year (200,000 x 30%).

The full deduction could be an advantage if the company is paying the regular corporate
income tax. But if the company is in a net operating loss (NOL) carryforward situation, it
would still pay the minimum corporate income tax. If the corporation will remain in several
years as such, a better option is to spread out the allowed deduction to stretch out the tax
benefits since NOLCO and excess MCIT can only be carried over three years.

To overcome the possible competitive disadvantage if the company is in the loss situation,
the company may shift the spending to another corporation. For example, a firm that expects
to be in a loss position could isolate its R&D spending in a 100%-owned profitable
subsidiary.
Suppose a high-tech firm wants to spend P5 million of R&D but is in an NOL situation. In the
case, the company cannot utilize the allowable deductions for the year.

Company P. Company S. Company S

Gross Income. 50,000,000. 50,000,000. 50,000,000
Profit (loss) before R&D. 0. 20,000,000. 20,000,000
R&D Costs. (5,000,000). - (5,000,000)
Taxable Income
(Net loss). (5,000,000). 20,000,000. 15,000,000
Corporate Income Tax. 30%. 30%. 30%
Regular Corporate Income Tax. - 6,000,000. 4,500,000
Minimum Corporate Income Tax
(5,000,000 x 2%). 1,000,000. .
Tax Savings 1,500,000

If Company P can shift the R&D cost to its profitable subsidiary, say Company S, then the
subsidiary can claim tax savings of P1,500,000 (5,000,000 x 30%) in the year the cost was
incurred.

Anticipation
To evaluate potential tax benefits from new product development, actions by competitors
and governments should be anticipated. Tax rate and rule changes also should be
considered in the planning process. For example, if the government plans to decrease
corporate income tax, the company may decide to incur tax deductible, new-product
development costs this year but not next year. Just the opposite might occur if the tax rate is
expected to go up.

Another topic requiring anticipation is the taxation of electronic commerce. The Philippines
House of Representatives has introduced a Bill, the Digital Economy Taxation Act of 2020
(DETA 2020 Bill), which aims to subject the value created in the digital economy to
withholding/income tax and value-added tax (VAT).

Pursuant to the DETA 2020 Bill, digital or electronic goods, services rendered electronically,
digital advertising services, internet-based subscription services, and transactions made on
electronic commerce (e-commerce) platforms will be subject to a 12% VAT. Network
orchestrators and ecommerce platforms will be designated as withholding agents for income
tax and/or VAT purposes. Nonresidents providing digital services will also be required to
establish representative offices or appoint resident agents to carry out business in the
Philippines. The DETA 2020 Bill is subject to further deliberations in the Congress.

Timing and time value issues are important here, too. Sales and purchases of new products
can be timed in order to increase tax benefits, using the methods discussed previously.

For example, the company wants to buy a machine for P1 million with a useful life of 5 years.
If the company is aware that the tax rates will go up by 5% next year, the tax benefit of
postponing the acquisition is P50,000 (P1 million x 5%). Conversely, if the tax rate will
decrease by 5%, the loss tax savings on postponing the acquisition would be P50,000.
Value-Adding
Like any other investment, product development must pass the value-adding test.

Suppose the company can spend P1 million either on new product development that will
generate P500,000 additional pre-tax profits annually for five years or for a new machine
depreciated over five years that will save P500,000 per year in operating costs. Which
investment should be made if the cost of capita is12% and the corporate income tax rate is
30%?

The cash flows from the new product would be:

Year 1 Year 2 Year 3 Year 4 Year 5

Additional 500,000 500,000 500,000 500,000 500,000

Pre-tax
Income

Additional (150,000) (150,000) (150,000) (150,000) (150,000)

Tax on
Operating
Income

Tax Benefit 300,000

Net Cash 650,000 350,000 350,000 350,000 350,000

Flow

PV Factor 0.89 0.8 0.71 0.64 0.57

578,500 280,000 248,500 224,000 199,500

R&D Cost (1,000,000)

NPV 530,500

The R&D Cost can be deducted in full in the year it was incurred assuming the company is
profitable.

If the company spends it for machine that can generates P500,000 savings, the comparative
NPV would be:

Year 1 410,000 410,000 410,000 410,000

Additional 500,000 500,000 500,000 500,000 500,000

Pre-tax
Income

Additional (150,000) (150,000) (150,000) (150,000) (150,000)

Tax on
 Operating
Income

Tax Benefit 60,000 60,000 60,000 60,000 60,000

Net Cash 410,000 410,000 410,000 410,000 410,000

Flow

PV Factor 0.89 0.8 0.71 0.64 0.57

364,900 328,000 291,100 262,400 233,700

R&D Cost (1,000,000)

NPV 480,100

The comparison suggests that new product development through R&D is a better investment
than acquiring new machine because of the tax benefits.

Adjusting Value-Adding for Risk. Many aspects of product development are risky in the
sense that the manager does not know if it will be a commercial success. However, tax law
can act as a risk-sharing partner by absorbing part of the cost. If the company spends P10
million on an R&D project and the investment fails, the tax benefit would be P3 million (P10
million x 30% corporate income tax). This means the company has 70% of the risk and the
government has the other 30%. If the investment is extremely risky, managers are very risk
averse, or the firm is in a low tax bracket, the tax benefits may be insufficient in and of
themselves to adjust for risk.

Value-Adding and Transactions Costs. The costs of starting a new product are currently
deductible unless they are capital in nature. Because intangibles must be written off more
slowly than R&D, they are potentially more expensive. Suppose a firm can spend P10 million
either to buy an existing patent from another firm or develop the product internally. If bought,
the intangible asset would be amortized over 5 years. The tax savings at a 10% discount
rate are (P10 million/5) × (3.79) × (.30) =P2,274,000. If the R&D is done internally and all
costs are eligible for deductions, the tax savings are P3,000,000 (P10 million x 30%).

Negotiating
Like other areas of taxation, promotion involves interaction with other parties in which tax
benefits can be part of the negotiations. If the firm is in an NOL carryforward setting, it may
want to back-load payments in an advertising contract so that more payments are made in
years in which the firm is taxable and thus the payments are currently tax deductible. If the
firm is taxable and the advertising firm is in an NOL-carryforward situation, the firm can
instead front-load payments in return for a lower price on the overall contract. One popular
negotiation method involves contracts with celebrities and athletes. Here the firm can sign a
contract with the individual that arranges payments in a manner that reduces taxes.
Typically, actual cash payments are back-loaded, but the firm may be able to take tax
deductions (on the accrual basis) on an accelerated basis.

By engineering tax benefits, the firm implicitly changes a product’s price. By promoting the
product’s tax advantages, the firm can segment the market.
In private markets, buyers and sellers can directly negotiate price to take advantage of the
tax benefits. Other negotiations can occur to transfer benefits between buyer and seller. For
example, Company A can negotiate either to buy or lease a machinery from Company B.
Assume that the cost of the machinery is P1 million. The machinery has an expected life of
five years. Company A can either buy the machinery outright or lease them over five years
for 250,000 per year. In case of lease, the Company need to spend additional P80,000 for
installation costs for easy dismantling at the end of the lease term. The cost of capital is
10%.

Purchase
Year. Cash Flow Item. At 30%. NOL
0. Purchase Price. (1,000,000). (1,000,000)
1. Present Value of Tax. 54,545.45. -
2. Benefit on Depreciation. 49,586.78. -
3. (1,000,000 / 5 x PV. 45,078.89. -
4. Factor, Single Payment x. 40,980.81. -
5. 30%). 37,255.28. -
Net Present Value. (772,552.79). (1,000,000)

Lease
Year. Cash Flow Item. At 30%. NOL
0. (80,000). (80,000)
1-6. Lease Payments
(250,000 x PV Factor Annuity
x (1-30%), if applicable). (663,387.68). (947,696.69)
Net Present Value. (743,387.68). (1,027,696.69)

Based on the foregoing, Company A may negotiate to lease the property rather than buying
it if the company is in the tax-paying position. But if it is in NOLCO-position, Company A is
better off buying.

Other pricing methods of promotion include coupons (discounts) and rebates. For tax
purposes, they simply reduce reported sales revenue when exercised. For financial-
accounting purposes, they are recognized (accrued) as expenses when issued, based on an
estimate of how many will be exercised.

One other aspect of promotion should be mentioned: free samples. As long as they are
small, they are tax free to the recipient and tax deductible to the firm. Otherwise, they could
be treated as donations, which are not deductible; unless, they qualify as deductible
charitable and other contributions.

If supplier is in a high tax status, it can save taxes by selling on an installment basis as taxes
would be due when collections are made. Conversely, if it enjoys low corporate income tax
or in NOLCO-position, it may negotiate with its customers to accelerate purchases. Note that
such negotiations depend on market power.
For example, in December, a customer places an order for P500,000 goods, which the
supplier has 50% profit margin. If the Supplier will go into a NOLCO situation next year, it will
be subjected to 2% MCIT, rather then the 30% RCIT. Hence, negotiating a delay in the sale
will give the company a tax benefit of P65,000 (240,000 – 175,000).

December 2020. January 2021

Gross. P500,000. 250,000. P500,000. 250,000
Profit. x 50%. x 50%
Tax P250,000. (75,000). P500,000. (10,000)
x 30%. x 2%. .
Net Cash Flow. 175,000. 240,000

Moreover, the supplier must also take into account the opportunity cost associated with
receiving the proceeds from the sale in December. If the supplier can invest the proceeds of
P500,000 and earn 10% or P50,000, still, the supplier has the advantage of P15,000
(P65,000 – P50,000) in delaying the sale. But if the supplier can earn 15% or P75,000, then
entering into sale contract with the customer is more advantageous.

If the firm is in a low tax status, it may prefer to pay employees deferred compensation.
Alternatively, if workers are in a relatively high tax bracket, they may prefer tax-advantaged
components of their compensation. The firm may be able to provide less cash compensation
in return. Management, in particular, may be amenable to such deferred compensation
schemes as stock options, which generate limited (or deferred) tax deductions to the firm,
but the firm may need to pay less overall compensation as a result

Machinery and equipment buyers can be negotiated with by using sales versus leases,
installment sales, and componentization of purchase prices. Leases can be used if the buyer
is in a low tax bracket. The same is true for installment sales. By providing tax benefits to the
buyer, the selling firm may be able to negotiate a higher sales price.

Splitting the purchase price into components also can save taxes. An example of
componentization of purchase prices is a computer equipped with software. Bundled, the
entire purchase price is depreciated together over the useful life. Separated, the software
can be written off over much shorter periods. Other examples include structures (such as
hotels, pubs, and retirement homes) that contain furniture and fixtures that can be written off
over a much shorter life than the building.

For example, a computer system costs P500,000 with a useful life of 5 years. This will be
depreciated for P100,000 per year. If the 100,000 is attributable to software that can be
amortized over two years, then the depreciation of the hardware would be P80,000
(400,000/5) a year. And the software would be depreciated for P50,000 a year. The NPV
difference of the tax benefits from this scheme assuming cost of capital of 10% is

Year Bundled Separated

1 100,000 x 30% 27,272.73 100,000 x 30% 35,454.55

 x 0.909 x 0.909

2 100,000 x 30% 24,793.39 100,000 x 30% 32,231.40

x 0.909 x 0.909

3 100,000 x 30% 22,539.44 100,000 x 30% 18,031.56

x 0.909 x 0.909

4 100,000 x 30% 20,490.40 100,000 x 30% 16,392.32

x 0.909 x 0.909

5 100,000 x 30% 18,627.64 100,000 x 30% 14,902.11

x 0.909 x 0.909

113,723.60 117,011.94

3,288.34

The difference, 3,288, can be directly part of the negotiated sales price.

Transforming
There are few opportunities for the firm to convert sales income into tax-favored capital
gains. However, if a new product turns out to be unsellable, all costs of unsold inventory,
supplies, and equipment can be written off as ordinary losses.

Suppose a company purchases P1 million of specialized equipment to make a new product.

If the product fails and the machine is unsellable, the firm can write off the machine that
year. In the 30% tax bracket, this is a P300,000 cash inflow, which is much higher than the
NPV of writing off the machine over five or seven years.

Firms seeking conversion can try using the collapsible corporation technique. Here, instead
of selling products individually, a product is developed in an entity and the entity is sold.
Classic examples are having a corporation make a film, develop software, or purchase a
cellar of newly bottled wine. When the film is finished, the software works, or the wine is
sufficiently aged, it is not sold directly. Instead, the common stock of the corporation is sold.

This will be treated as sale of capital asset. The sale of shares of stock not treaded in local
stock exchange is subject to capital gains tax of 15% on net capital gain.

SAVANT AND RESEARCH AND DEVELOPMENT

Because R&D is risky, managers sometimes like to separate it into a separate entity (such
asa subsidiary corporation or an LLC). This can get the R&D off the parent company’s
financial statements, which may also be useful for hiding R&D from competitors.

If an R&D subsidiary corporation is used, the related tax benefits will not be recognized
unless either the subsidiary has income.

In terms of timing and time value, the firm may want to perform R&D in years without NOL
carryforwards.
CHAPTER 6: ATTRACTING AND MOTIVATING EMPLOYEES AND MANAGERS:
COMPANY AND EMPLOYEE TAX PLANNING
Overview:
Although direct wages form the vast bulk of employer payments, a multitude of schemes
have been used for compensating employees. These plans all have the same basic goal: to
improve labor productivity over that derived from simply paying wages. However, they reflect
two fundamental approaches to accomplishing this. The first is based on better matching
rewards with employee needs. Some of these schemes—such as lifetime employment—are
rooted in the classical economist’s conception of the diminishing marginal utility of money.
Others—such as job enrichment and job sharing—are more specifically based on the
perceptions of differences in employees’ desires as they become more wealthy or secure,
as suggested by management theories like Maslow’s Hierarchy of Needs.

The second fundamental approach is to align employee performance more with a firm’s
strategic goals. Some of these plans, such as piecemeal bonuses for machinists or
assembly-line workers, reflect Taylor’s conception of the value of rewarding measures of
enhanced tangible output. Bonuses for managers, such as those based on Drucker’s theory
of Management by Objectives, instead increasingly have been targeted at specific, less
tangible objectives. These have often been developed during the firm’s strategic planning
process, sometimes by the managers themselves.

Taxes have also been a key factor in designing nonwage forms of employee compensation.
This has particularly been the case when the need to attract and motivate managers is
paramount. As with investments, it is not just what one earns that matters, but also what one
keeps. It is the expected after-tax net present value of an employee’s total compensation
that matters. Using the SAVANT framework, this chapter explores differential tax treatments
of nonwage forms of employee compensation. This is done with an eye toward enhancing
worker productivity and the net presentvalue of an employee’s compensation at the least
after-tax cost to employers.

Module Objectives:
After successful Completion of this module, you should be able to:
1. Understand the forms of compensation
2. Distinguish executive and nonexecutive employee compensation
3. Know the limits on deductibility on executive compensation
4. Apply SAVANT to executive compensation

Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:
Schemes for compensating executives/managers have become important in many
companies’ strategic plans. This may be because executive/managerial talent has become
increasingly scarce as firms have become more complex, causing firms to compete for talent
at the top by offering lucrative compensation packages. The scope of these packages can
be seen in annual surveys reported in the business press.

The results of surveys like these can vary because compensation packages for managers
differ widely. They often consist of a mix of factors thought to match both employees’ and
employers’ varying needs. The array of factors can be generalized, however, into six basic
components:
1. Annual base wages
2. Year-end bonuses, based on company financial performance measures, such as net
income or economic value-adding (EVA)
3. Long-term equity participation, most commonly through stock options
4. Deferred compensation
5. Fringe benefits like Housing benefits, Vehicle benefits, Expense account benefits and
other taxable fringe benefits
6. Employment security arrangements, such as employment contracts and golden
parachutes (payments triggered by changes in the firm’s ownership)

There are advantages and disadvantages to each component in satisfying employee needs
and motivating labor productivity. For example, salary can be adjusted annually. But
because it is contracted for ahead of time, salary is not ideal as a direct motivator for future
performance. Annual bonus payments can fill this role better, particularly if tied to attaining
specific strategic objectives for the year. Equity compensation may be more preferable,
particularly for senior executives, because the most important objectives may be long term in
nature, and because the rewards are congruent with the basic shareholder goals of
enhancing the value of the firm’s shares.

In addition, components are taxed in different ways. For example; number 5, Taxable Fringe
benefits given to managers/supervisors are subject to Fringe Benefit tax (FBT) at rate of
35% (for resident or citizen) of gross up monetary value of benefits given by employer as
provided under the Tax Code; while fringe benefits given to rank and file are not subject to
35% FBT (instead, subject to Basic income Tax).

For Philippine employees, Employers must observe a range of payroll compliance

regulations, which include monthly withholding obligations. The three main statutory
contributions deducted from employee salaries each month are:

• Social Security: General social insurance covering sickness, disability, maternity and old
age.
• PhilHealth: The Philippine Health Insurance Corporation scheme aims to provide access
to quality medical and health care services for all employees.
• Home Development Mutual Fund: A housing program designed to provide short term
loans and access to housing programmes for all workers in the Philippines.

EXAMPLE:
Suppose a company can hire either one upper-level supervisor for 100,000 or two middle
staff or rank and file employees for 50,000 each (basic salary). Both will be given a taxable
fringe benefits (housing) with monetary value of 100,000 for one supervisor or 50,000 each
to two middle staff or rank and file employees.

Description: (Year 2020) One Supervisor Two Rank and file

 employee

Basic Salary 100,000 50,000 each (100,000)

Taxable fringe benefits 100,000 50,000 each (100,000)

Fringe benefit tax expense

(100,000 / .65 x .35) 53,846 Zero (0)

PhilHealth-employer 900 750 each (1,500)

contributions (per table)
(50,000 x .03 x ½-750 share
of employer)

SSS Contributions-employer 1,630 1,630 each (3,260)

Pag-ibig Contributions- 100 100 each (200)

employer

Total expenses 255,476 204,960

Net difference 51,516

In this simplified example, the employer saves around 51,516 in payroll expenses which
includes fringe benefit taxes and other benefits by using two senior rank and file staff instead
of one supervisor. The savings is about 25% of payroll costs of two rank and file employees.
Over several employees, this could result in considerable employment tax savings

Employee Leasing
One way to reduce employment and transaction costs related to employment is through
employee leasing. Here a company hires whomever it wants, but leases the employees from
a company that specializes in leasing employees. This is depicted in Exhibit below. Here the
firm pays only (tax-deductible) leasing fees to the leasing firm and is not responsible for
employee benefits or payroll taxes. Instead, the leasing firm pays such costs. In many cases,
leasing firms provide a lower level of benefits because these firms are smaller, newer, or
less unionized. If so, these lowered costs can be passed on to buyers in the form of lower
leasing fees. Managers should bear in mind, however, that while leasing may appear to be
cost effective, it may not make good business sense. This is because (especially if done to
an extreme) there is potentially less control over employee availability, effort, and skill. In
addition, firms lose some of the advantages of long-term employee status: innovation, risk
taking, and loyalty.
PUTTING IT ALL TOGETHER: APPLYING SAVANT TO EXECUTIVE COMPENSATION
You are on the compensation committee of a Fortune 500 company, and you are trying to
hire xecutive away from a competitor. You estimate that the executive would bring $5 million
per year of additional value-added to the corporation. Your firm has a tax NOLCO which is
due to expire this year. The company’s financial earnings are positive.

The executive’s current compensation at the competitor firm is $1 million in salary.

What sort of contract should be offered?

Strategy
Hiring the executive away from the competitor is a major strategic advantage. To keep her
from going back to the competitor, a contract to tie her to the firm is needed; stock options
may be the way to accomplish this goal.

Anticipation
You may want to assure her that your stock’s value will go up in response to her
performance and that the firm anticipates no debt or equity issuance in the near future..
Timing and time-value issues are important here, too. For example, because of the expiring
NOL, it is better for the firm to defer compensation until the next year.

Value-Adding
The (after-tax expense) financial-accounting charge to earnings should not exceed $5 million
per year, regardless of the form taken. Adjusting for Risk The fact that she has a pure cash
contract at the competitor may indicate some risk aversion. Thus, some portion of the
contract may have to be in cash.

Transactions Costs
You estimate it will cost 100,000 in legal and accounting fees to draw up a compensation
package.

Negotiating
Because of the expiring NOLCO this year, you would prefer to defer more compensation
until next year. This argues in favor of bonuses or options. However, you may have to pay
her more to accept such deferred compensation. Also, the fact that she receives all-cash
compensation currently may mean she is in a low bracket. In this case, she would see no
tax advantage to stock options. Attracting and Motivating Employees and Managers:
Company and Employee Tax Planning 207
CHAPTER 7: MARKET PENETRATION: OPERATING IN DIFFERENT AREAS
Overview:
Most firms start out in one geographic area and then expand to other jurisdictions as local
demand, costs, and marketing dictate. Indeed, one of the major impacts of the rise of
electronic commerce has been the enhanced ability of small firms to reach foreign markets.
The Web is one factor that may be leading to the end of distance in business transactions.
Another one notable feature has been the emergence of the micro-multinational: new
organizations with little capital but global reach. Large firms may have physical operations in
many states and decide to move into additional ones based on the same dictates. Or they
may do so for strategic presence: If Burger King opens restaurants in a new city, McDonald’s
may do so soon to avoid loss of competitive advantage.

Module Objectives:
After successful Completion of this module, you should be able to:
1. Know the general principles of state and local taxation
2. Be able to plan with income taxes, manipulation of plant, workforce, and point of sale
locations
3. Be able to plan appropriate location choice and decide on sourcing versus production
platforms
4. Understand lobbying and tax abatements
5. Be able to calculate the trade-offs with local tax incentives

Course Materials:
GENERAL PRINCIPLES OF STATE AND LOCAL TAXATION
States impose these major taxes on businesses1:
■ Income taxes
■ Property taxes
■ Payroll taxes
■ Other taxes significant in the aggregate: document, capital stock/net worth, real estate
transfer

When a firm operates in multiple locations, its overall business income is subjected to
income tax (30% RCIT or 2% MCIT for corporations and Graduated income tax rate or 8%
Optional income tax rate for Individuals). Nonbusiness income, such as net revenues from
market investments, is typically subject to final tax or basic income tax.

Property taxes are imposed on realty (such as land, buildings, and improvements) and
certain personal property (such as vehicles, aircraft, and boats). In some states, inventory
and equipment are also taxed. Tax rates are typically depends on the LGUs and based on
assessed value or depreciated cost. Assessed value varies by different LGUs and type of
property, usually involving fair market value. Fair market value is based on comparable sales
prices. Certain types of property are often tax exempt, such as realty owned and used by
income-tax-exempt charities.

Income Tax Savings through Restructuring

Restructuring can be done by combining entities. This is useful when one entity operates at
a loss and the other has a profit. (See Example below)
Example:
In the 2nd year of operations; Alpha Corp does business in Manila using 150 million of
property and, in Cebu, using 250 million of property. It generates a total profit of 400,000. On
the 2nd year, Beta Corp operates only in Cebu, having 300 million of property, which results
in a 200,000 loss. As separate entities, the income tax are as follows:

Company Taxable Income Tax Rate Income Tax due

(Loss)

Alpha 400,000 30% 120,000

Beta (200,000) 30% 0 (No MCIT)

If the corporations are combined:

Company Taxable Income Tax Rate Income Tax due

(Loss)

Alpha 400,000 30%

Beta (200,000) 30%

Combined (as one 200,000 30% 40,000

entity)

The total Corporate income tax will be reduced to 40,000 if they will be combined. So, Alpha
may be combined with Beta and reduced income tax by 80,000.

Taxation of Electronic Commerce

Whether you have a traditional “bricks and mortar” business with physical premises or an
online business, tax compliance is a must. Persons doing online business transactions are
required to pay taxes under the Tax Code, as amended.

In 2013, the Bureau of Internal Revenue (BIR) issued a memo on taxpayer obligations for
online business transactions. Revenue Memorandum Circular 055-13 orRMC 055-13
clarifies that, similar to any other type of business in the Philippines, online stores and online
intermediaries are required to pay tax – for their e-commerce activities. RMC 055-13 was
issued as a reminder, with the BIR noting that an “increasing number of consumers are
visiting and purchasing goods and services from such online stores”.

Registering an online business with the BIR

Online businesses must register with the BIR to ensure compliance with their tax obligations.
These obligations are quite similar to that of a traditional business.

1. File a Certificate of Registration

BIR registration may require submission of the following documentation:

• DTI Certificate of Registration (if applicable)

• Occupational Tax Receipt or Professional Tax Receipt from City Hall or Municipal Hall (if
applicable)
• Barangay Clearance
• Proof of Address, e.g. Lease Contract or Land Title Certificate
• Valid identification
• To register, individuals (e.g. freelancers) must complete and submit BIR Form 1901.
Partnerships and corporations must complete and submit BIR Form 1903.

A BIR registration fee of P500 (which can be paid via an Authorized Agent Bank) is also
required.

After submitting the necessary documentation and paying the required fee, a Certificate of
Registration and an “Ask for Receipt” banner will be issued to the taxpayer. The books of
accounts for the business will also be stamped.

Standard taxes filed by online businesses

The Certificate of Registration issued to each taxpayer will confirm what type of taxes the
particular business must pay.

Online businesses will pay similar standard taxes to those of physical businesses.
Importantly, the BIR has confirmed that existing tax laws and revenue issuances on
purchases and sales of goods and services shall apply with no distinction whether the
marketing channel is via the internet or through traditional physical mediums. The following
are just some of the taxes online businesses will pay:
• Monthly and Quarterly Value Added Tax (required for all businesses earning more than P3
Million in a taxable year)
• Quarterly Percentage Tax (businesses earning P3 Million or less annually not subject to
VAT)
• Withholding Tax on Compensation
• Expanded Withholding Tax/Creditable Withholding Tax
• Quarterly and Annual Income Tax Returns

CHAPTER 8: MARKET PENETRATION: COMPANY AND EMPLOYEE TAX PLANNING

FOR OPERATING IN FOREIGN COUNTRIES
Overview:
Globalization of a business allows a number of tax opportunities that can enhance the value
of the firm. The legal form in which a firm operates makes a difference on the timing of
income tax. If the country allows rapid depreciation or tax credits, the firm’s tax bill can be
reduced significantly.

Treaties exist to minimize conflicts between countries, to attract foreign investment, to avoid
double taxation, and for other policy reasons.

Course Materials:
Strategy
The firm’s decision to do business in foreign countries should be consonant with its strategic
plan. Once the firm has decided to go international, an important strategic decision is entity
choice. That is, what legal form (e.g., a corporation, a partnership).

Locational choice should also fit into the firm’s strategic plan. Labor and material costs may
make plant location more desirable in a high-tax area. Alternatively, tax savings resulting
from a treaty or other agreement may influence the choice between two countries, both of
which would otherwise fit into the firm’s strategic plan.Assume that a Philippine manufacturer
in Example establishes an incorporated subsidiary in Singapore. In its first year of
operations, its net income is P10 million.

Assume that this is also its taxable income for both Philippines and Singapore purposes. It
pays a Singapore tax of 17% × P10,000,000 = P1,700,000. Because the Philippine tax rate
is higher (at 30%), the firm would like to set the transfer price as low as possible. However,
this would result in a cash shortfall for the subsidiary, which, at the critical start-up phase, is
not advisable.

Strategy and tax treatment treaties commonly provide for tax rates and tax benefits allowed
only by the host nations. Typically, these treaty-based rates are well below the general tax
rates. Besides setting specific rates and withholding rates, treaties also provide for
information-sharing policies between the tax enforcement agencies of the two countries and
require that at least one of the countries allow a tax credit to mitigate taxpayers’ double
taxation.

On Competitive Strategy. A recurrent theme throughout the text is that by effectively

managing taxes, a firm’s costs decrease, and it can then afford to lower prices and win more
market share. While a competitor may attempt to manage taxes, too, a firm can still have the
advantage if it has better knowledge of taxes in general and of its competitors’ tax status in
particular.

Knowledge of a competitor’s tax rates can give one a better prediction of how the competitor
will act (or react) internationally.

Firm’s Effective Foreign Tax Rate

Competitor’s Effective High Low

Foreign Tax Rate;

High No strategic tax advantage Overseas strategic tax

to either advantage to the firm

Low Overseas strategic tax No strategic tax advantage

advantage to the competitor to either

If a firm has the advantage, it should go into the market (assuming this otherwise makes
good business sense), and the competitor should not (absent any nontax cost advantages
over the firm).
How can a firm lower its effective foreign tax rate? One way is to operate in countries with
lower tax rates, but only if operating there makes overall business sense.

Another way to get tax-strategic advantage over a competitor is through use of the foreign
tax credit limitation rules. Briefly, if a competitor is in an excess foreign tax credit status, and
the firm is not, the firm can generate more foreign income at a lower tax rate.

Resident Citizens and Domestic Corporations are taxable on income derived from
sourceswithin and without. The taxes they paid abroad may be claimed either as Itemized
deductions or Tax credit.

The foreign tax credit is subject to each of the following limitations:

(a) The amount of the credit in respect to the tax paid or incurred to any country shall not
exceed the same proportion of the tax against which such credit is taken, which the
taxpayer's taxable income from sources within such country under this Title bears to his
entire taxable income for the same taxable year; and

(b) The total amount of the credit shall not exceed the same proportion of the tax against
which such credit is taken, which the taxpayer's taxable income from sources without the
Philippines taxable under this Title bears to his entire taxable income for the same taxable
year.

For example, International Corporation, a domestic corporation, has the following data for
the calendar year. the corporation signified its intention to claim tax credits on income taxes
paid to the foreign countries:

Country Gross Income Allowed Tax paid

deductions

Philippines P1,000,000 8600,000 P-

United States 400,000 200,000 80,000

Japan 300,000 200,000 25,000

The corporation can claim a tax credit of P86,000 only.

Taxable Income
Philippine (1,000,000 – 800,000) P200,000
United States (400,000 – 200,000) 200,000
Japan (300,000 – 200,000) 100,000
Total Taxable Income P500,000
Income Tax Rate 30%
Total Income Tax Due 150,000
Foreign Tax Credit (lower between Limit A and B) (85,000)
Income Tax Payable 65,00
Limit A is determined by comparing each country’s proportionate income tax due. The
proportion is computed based on the taxable income derived from without.

Limit. Actual Payment. Allowed Tax Credit

United States 60,000 80,000 60,000
(P200,000/500,000 x 150,000)
Japan 30,000 25,000 25,000
(P100,000/500,000 x 150,000). .
Total Limit A 85,000

Limit B is computed based on the worldwide proportion of income tax due to the taxable
income derived from without.

Limit. Actual Payment. Allowed Tax Credit

Limit B. 90,000 105,000 90,000
(P300,000/500,000 x 150,000)

The allowable limit is the lower between limit A and B.

Anticipation
When the firm decides to go overseas, it predicts implicitly whether tax rates will change
over time. If the firm is offered a tax holiday for a fixed period of time, it must anticipate the
amount of tax increase that will occur at the expiration time. Similarly, firms should forecast
the extent to which existing general tax rates and treaties will change.

Because treaties are bilateral agreements, firms typically look for signals that changes may
occur.

In setting transfer prices, the firm must also anticipate the likelihood of a tax audit and
subsequent tax adjustment occurring. Because there is some latitude in setting such prices,
and the tax authorities know that firms exploit this, audits of transfer prices are common.

Anticipation and Timing.

If the firm anticipates a change in foreign tax rates or rules, it may want to adjust the timing
of its investments. Timing also affects ongoing transactions.

Transfer prices, within reason, can be adjusted periodically to reflect changing relative tax
rates. If the Philippine parent transits into a lower tax rate, either the transfer price or the
quantity of inventory can be adjusted to shift more income into the Philippines.

Anticipation and Time Value. Regarding organizational form, time value is most salient for
corporate subsidiaries. In corporate setting, payment of dividends can be postponed almost
infinitely, such that their net present value (NPV) can be nearly zero. Provided the company
will not accumulate earnings without legitimate purpose. Other organizational forms have no
such advantage. For example, share of partner in a business partnership is deemed
received by the partner, and, hence, subject to final tax of 10%.

Value-Adding
Related to strategy is the fundamental idea that the pretax economics of overseas
investment must be sound. Accordingly, foreign tax incentives should influence location
choice only at the margin. If a planned operation is profitable solely because of tax benefits,
it should be avoided.

Similarly, entity choice is affected by value-adding. On the firm’s balance sheet, joint
ventures, partnerships, branches, and the like are simply reported as an investment asset
and are not shown in detail.

Adjusting Value-Adding for Risk. Foreign ventures pose additional risk management
problems for the firm. Part of this is mitigated by entity choice. Direct export involves minimal
risk; joint ventures and partnerships provide local risk-sharing partners. Branches and
subsidiaries put more of the firm’s operations at risk.

From a nontax perspective, operating risk can be mitigated by organizational form. Forming
a joint venture with a local operation adds the local’s knowledge. Forming as a corporate like
entity also gives the parent firm loss protection against liabilities generated. by the foreign
venture. This advantage should be weighed against the likelihood that, for tax purposes, the
parent’s loss may be classified as a capital loss.

Besides operating risk, a major source of international risk is from currency rate fluctuations.
A risk occurs, for example, if the dollar devaluates and the firm is holding dollars (or has to
pay on a contract not denominated in dollars). A gain can occur if the dollar goes up in
value, and the firm holds dollars at year-end or pays on contracts denominated in other
currencies.

Foreign currency exchange (FOREX) gains/losses from collection of receivables and

payment of liabilities are considered realized and are considered taxable gains/deductible
losses since these are considered completed transactions, but FOREX gains/losses
resulting from year-end conversion of foreign-currency denominated receivables and
payables are considered unrealized gains/losses and should be treated as a temporary tax
difference.

Value-Adding and Transactions Costs. Legal and accounting costs are higher for the
corporate form and lowest for direct exports. These costs vary by country and size of
operation. In addition to import and export duties, there are other transaction taxes to
consider.

Negotiating
Often local officials, especially in developing countries, can be negotiated with. This is
particularly true with regard to property taxes and other localized fees.

Transfer prices on the part of the buying and selling firms may be negotiated. This is
particularly important if managers are evaluated on accounting profits. For example, if the
overseas selling subsidiary (manufacturer) is in a low-tax jurisdiction, tax minimization
implies setting the transfer price high. Yet this hurts the profits of the purchasing firm, which
in turn might result in reduced bonuses for the purchaser’s managers. Thus, tax and
performance objectives may need to be weighed.
One way to manage international taxes is to negotiate with international authorities for relief.
A firm can negotiate local taxes as well as licenses and other fees. Negotiating national
taxes, such as the corporate income tax, is much more difficult to do.

A final area of negotiation is with respect to transferring employees overseas. In some

cases, key employees must be transferred overseas against their preferences. In such
cases, the firm can help persuade them to move through incentives. Note that resident
citizens are taxable on income derived from within and without the Philippines. Non-resident
citizens such as OFW are taxable only on income derived from within. Their salaries abroad
are not subject to Philippine Taxation. Favorable taxes in the foreign country itself may be
part of the negotiation.

Transforming
By utilizing a foreign subsidiary, a Philippine parent effectively transforms taxable income
into nontaxable income by deferral. Income of foreign subsidiary is not taxable in the
Philippines, unless it is declared dividends. Such dividends from foreign corporation forms
part of gross income of a domestic corporation in the computation of taxable income, which
will be subject to regular corporate income tax.

CHAPTER 9: OPERATIONS MANAGEMENT

Overview:
The success of an organization depends highly on customer satisfaction. Customer
satisfaction is achieved through the development of product and service, which have all the
attributes required by the customer base. A successful product or services do not only have
attractive package design but should be also able to provide robust performance. These can
be achieved through (1) production design and process selection; and (2) strategic capacity
planning. These aspects of operations, however, should take into consideration the tax
impact upon the organization.

Course Materials
Production Design and Process Selection

Businesses need to design the products that consumers demand. A good marketing
department can tell the organization what consumers want, and even convince consumers
that they want it. A company with the most wonderful product concept cannot be successful
unless it also can devise a process to profitably manufacturer the product.

A firm’s purchasing decisions involve a number of choices, including three key strategic
decisions. The first deals with sourcing locations, that is, deciding whether suppliers will be
local, national, or foreign. The second is the strategic, that is, whether the firm will seek to
cooperate with suppliers. The third is a matter of timing and determines how often the firm
will make purchase orders for its inventories or materials.

Generally, the second and third strategic decisions have little to no impact on taxes.
However, sourcing location can have a significant tax effect.
Local government units (LGUs) derive their revenues from local and external sources. Local
sources include tax revenues from real property tax and business tax, and non-tax revenues
from fees and charges, receipts from government business operations and proceeds from
sale of assets. External sources, on the other hand, include the Internal Revenue Allotment
(IRA) and other shares from special laws, grants and aids and borrowings.

Under the principle of local autonomy enshrined in our Constitution, the different local
government units are given ample discretion to come up with their own revenue raising
measures, as long as such revenue raising measures do not conflict with the Constitution
and more particularly, the Local Government Code which serves as the basis for the local
tax ordinances to be enacted by each local government unit.

With these in mind, it is discernible that there may be differences among business which
operate in different local governments when it comes to the pricing of goods and supplies.
For example, the selling price of sugar cane will be higher in a local government unit which
imposes a tax on the sale thereof and cheaper where the local government grants
exemption for the same. Clearly, the company will have to take into consideration the
differences in local taxes in deciding where to procure its inventories and materials.

Under the Local Government Code, local government units are empowered to impose the
following taxes:
1. Provinces

a. Tax on business of printing and publication at a rate not exceeding 50% of 1% of the
gross annual receipts for the preceding calendar year. In case of newly started business, the
tax shall not exceed 1/20 of 1% of the capital investment.

b. Tax on a business enjoying franchise at a rate not exceeding50% of 1% of thegross

annual receipts for the preceding calendar year. In case of a newly started business, the tax
shall not exceed 1/20 of 1% of the capital investment.

c. Tax on sand, gravel and other quarry resources at a rate not exceeding 10% of the fair
market value in the locality per cubic meter of ordinary stones, sand, gravel, earth, and other
quarry resources, as defined under the National Internal Revenue Code (NIRC), as
amended, extracte drom public lands or from the beds of seas, lakes, rivers, streams,
creeks, and other public waters within its territorial jurisdiction.

d. Professional tax on each person engaged in the exercise or practice of his/her profession
requiring government examination at a rate not exceeding PhP300.00.

e. Amusement tax payable by proprietors, lessees, or operators of theaters, cinemas,

concert halls, circuses, boxing stadia, and other places of amusement at a rate of not more
than 10% of the gross receipts from admission fees.

f. Annual fixed tax not exceeding PhP500.00 for every delivery truck or van used by
manufacturers, producers, wholesalers, dealers or retailers in the delivery or distribution of
distilled spirits, fermented liquors, soft drinks, cigars and cigarettes, to sales outlets, or
consumers, whether directly or indirectly, within the province.

2. Municipalities

a. Manufacturers, assemblers, repackers, processors, brewers, distillers, rectifiers, and

compounders of liquors, distilled spirits, and wines or manufacturers of any article of
commerce of whatever kind or nature.

b. Wholesalers, distributors, or dealers in any article of commerce of whatever kind or

nature.

c. Exporters, and manufacturers, millers, producers, wholesalers, distributors, dealers or

retailers of essential commodities are subject to not more than one-half (1/2) of the rates
prescribed for manufacturers, wholesalers and retailers of other products.

d. Contractors and other independent contractors.

e. Retailers.

f. Banks and other financial institutions at a rate not exceeding 50% of 1% of the gross
receipts of the preceding calendar year derived from interest, commissions and discounts
from lending activities, income from financial leasing, dividends, rentals, on property and
profit from exchange or sale of property, insurance premium.

3. Cities

The city government may impose and collect any of the taxes, fees and charges imposed by
the province or municipality. The rates of taxes may exceed the maximum rates allowed for
the province or municipality by not more than 50% except the rates of professional and
amusement taxes which are already fixed.

4. Barangays

The barangay may impose a tax on stores or retailers with fixed business establishments
with annual gross sales or receipts of PhP50,000.00 or less in the case of cities; and
PhP30,000.00 or less, in the case of municipalities, at a rate not exceeding 1% of gross
sales or receipts.

It must be stressed that the foregoing provisions under the Local Government Code are NOT
self-executing. Meaning, each local government unit, through their legislative arm—the
Sanggunian, is still required to enact their local tax ordinance to echo and implement the
provisions of the Local Government Code.

CHAPTER 10: FINANCING ONGOING OPERATIONS AND TAX PLANNING

To finance ongoing operations, firms can generate cash flows from a variety of sources,
including: Operating earnings (i.e., net income from sale of products or services)
• Sale of operating assets (such as plant and equipment)
• Sale of investments (such as stock, bonds, or raw land)
• Short-term borrowing
• Accelerating, factoring, or selling receivables
• Decrease in dividends
• Payment of stock dividends instead of cash dividends
• Stock buybacks (by the firm or management) to reduce dividend
• payouts
• Receipt of dividends from subsidiaries (domestic and foreign)

Operating Earnings

Operating earnings, after payment of taxes, add to retained earnings. However,

accumulation of earnings without legitimate business purpose are subject to improperly
accumulated earnings tax.

Sale of Operating Assets

Gains (losses) on the sale of ordinary assets generally are taxable (tax deductible). Losses
on the sale of operating assets usually are treated as ordinary losses and are fully
deductible.

Losses between related parties are not tax deductible.

Note that depreciation previously taken reduces an asset’s basis. This generally results in
reducing the loss or increasing the gain if the asset is sold. Thus, the tax benefit of
depreciation flows from time value.

For example, ABC Company buys P1 million machine, which has a useful life of 5 years and
no residual value. The Company sell the machine for P900,000 at the end of year 2. The
Company has 30% tax rate and its cost of capital is 10%. The net present value of the sale
transaction is

Year Cash Flow/Tax Discount Discounted

Benefit Factor Cash Flow

Purchase 0 (1,000,000) 1 (1,000,000)

Tax Savings 1 60,000 0.9091 54,546

from [1,000,000 /
Depreciation 5*30%]

2 60,000 0.8264 49,584

[1,000,000 /
5*30%]

Proceeds from 2 900,000 0.8264 743,760

sale
 Tax on Gain on 2 (90,000) 0.8264 (74,376)
sale [(900,000-
60,000) x 30%]

(226,486)

The present value of the tax benefits from depreciation is P104,130 (54,546 + 49,584),
which exceeds the present value of the tax on the gain, P74,376.

Selling operating assets simply to generate cash flow may not make business sense. This is
because unless the asset is traded in for a new asset, its absence will decrease value-
added. Because there is also a financial accounting gain or loss, there is an effect on
earnings that may in turn affect management bonuses. Finally, the timing of any gain on the
sale can be negotiated with the buyer. That is, if the buyer is willing to accept payment over
time, the tax on the gain can be recognized ratably over time.

Sale of Investments

If the asset is not used in business or is considered as capital asset, the resulting difference
between the sales price and the cost basis is considered capital gain or loss. Capital gains
by individual taxpayers are subject to holding period, but corporations are not entitled to
such a holding period. Capital losses are deductible to the extent of capital gain. Excess of
capital loss over capital gains may be carried over the succeeding year but limited to extent
of net income when the capital loss was incurred.

In case the capital asset is share of stock or real property (land/building only, in case of
corporation), they net capital gain or the presumed gain, respectively, are subject to capital
gains tax. For example, a firm sold P10 million worth of share of stocks with a cost basis of
P8 million. The capital gains tax is P300,000 [(P10 million – P8 million) x 15%]. Assuming
the asset sold is land and building. The capital gains tax is P600,000 (P10,000,000 x 6%).

Short-Term Borrowing

Proceeds from and payment of borrowings are not taxable. Interest expenses are tax
deductible. However, Interest payments on short-term debt (such as bank notes) are usually
higher than those on long-term debts. Transaction costs include loan fees, which must be
capitalized and amortized over the term of the loan.

Allowable deductions for Interest expense are reduced by 33% of the interest income
subjected to final tax. This is known as the tax arbitrage rule.

Suppose a firm borrows P1 million on January 1, 2021 to finance its short-term working
capital needs. Interest is at 10%. The firm earns P10,000 interest from bank deposits in 2021
and P20,000 in 2022. The tax savings related to the borrowing are (assume a 30% tax rate):

. 2021. 2022.
Interest Expense (P1M x 10%). 100,000. 100,000
Tax Arbitrage (P10,000 x 33%). (3,300). (6,600)
Allowed Deductions. 96,700. 93,400
Tax Savings. 30%. 30%
. 29,010. 28,020

Accounts Receivable

Offering discounts for early payment (e.g., 2/10 net 30) may affect the timing of cash flows,
but the timing of taxable income recognition is usually unaffected. This is because taxable
income is already recognized under the accrual method for most firms.

Selling and factoring of accounts receivable results in recognizing a tax loss, if the firm has
already accrued the sales revenue for the entire sale. This is because the buyer (factoring
institution) pays less than the actual receivable amount. The firm, subject to cash-flow
needs, may want to engineer the timing of the factoring to coincide with higher-tax-rate
years.

For financial-accounting purposes, bad debts usually are expensed based on an

expectation. However, for tax purposes, bad debts are written off only when the debt
becomes worthless, not when the firm gives up attempting to collect. Because it may take
years for some loans to become worthless, the present value of the tax deduction can be
diminished. Moreover, If the firm is certain that the debt is not collectible, it can postpone
final efforts to prove that the debt is worthless until it is in a high tax bracket. Or it can
accelerate such efforts into higher-tax-bracket years.

Suppose a customer owes P10 million to a firm, which it will never pay. The firm can pay
P50,000 in legal fees to sue and obtain a judgment this year for a fraction of the P10 million.
If the firm is currently in the 30% corporate income tax rate but expects to be in the 25%
corporate income tax rate next year, the net savings of P10 million × (30% – 25%) =
P500,000 makes the P50,000 legal expense worth accelerating the worthlessness.

Decrease in Dividends

Firms can increase internal cash flows by decreasing dividend payments to shareholders. All
other things being equal, shareholders should not mind a lack of dividends, as long as the
firm can invest the money and receive at least as great a return as the shareholder would
have received when investing it. This is because the stock’s value should increase by the
amount of the unpaid dividend plus any return on it.

Delayed or decreased dividends has also tax advantage. Dividends are taxed when
received. However, increase in firms’ value from the reduced dividends may only be realized
when the stock is sold. Retaining cash from reduced dividends also creates a timing
advantage, because shareholders can choose when to recognize income by selling stock in
favorable years (or not at all).

There can be transforming benefits, as well. Dividends are subject to final tax of 10%,
whereas gains on sale of shares of stocks are subject to 15% if sold directly. But if the
shares are traded in local stock exchange, the gain is not subject to income tax.
Stock Dividends

Stock dividends and increase in the value of shares are not considered as income, hence,
not subject to income tax.

Stock dividend is generally exempt from income tax, EXCEPT:

• If a corporation cancels or redeems stock issued as a dividend at such time and in such
manner as to make the distribution and cancellation or redemption, in whole or in part,
essentially equivalent to the distribution of a taxable dividend, the amount so distributed in
redemption or cancellation of the stock shall be considered as taxable income to the extent
that it represents a distribution of earnings or profits (Sec. 73(B), NIRC); or

• Where there is an option that some stockholders could take cash or property dividends
instead of stock dividends; some stockholders exercised the option to take cash of property
dividends; and the exercise of option resulted in a change of the stockholders’ proportionate
share in the outstanding share of the corporation.

Stock splits are nontaxable so long as they are prorated. By providing a greater number of
shares, existing shareholders can sell smaller portions of their holdings, and per-share
purchasing ability is enhanced for both existing and new shareholders.

Stock Buybacks

When the shares are retired, the capital gain or loss derived by the holder shall be subject
to regular income tax rates. The capital gain or loss is the difference between the amount
received and the cost of the shares. On the part of the issuing corporation, the shares so
redeemed or reacquired shall be considered retired and no longer issuable, and hence, no
gain or loss shall be realized by the redeeming corporation.

However, if a corporation voluntarily buys back its own shares, in which it becomes treasury
shares, such sale shall be subject to stock transaction tax if the shares are listed and
executed through the trading system and/or facilities of the Local Stock Exchange.
Otherwise, if the shares are not listed and traded through the Local Stock Exchange, it is
subject to 15% net capital gains tax.

If the firm redeems its own shares (i.e., it purchases treasury stock), it generates a negative
cash flow in the short run. However, in years after the buyback, more cash can be retained
because fewer dividends need be paid. There is an increase in value-adding if earnings per
share increase due to there being fewer shares outstanding.

For example, a firm usually pays 20% dividends on its common shares. If the firm bought
P1,000,000 worth shares of stock, the tax savings (assuming the relevant period is 8 years
and 10% cost of capital) would be:

Purchase Price. (1,000,000)

Present Value of Savings in Dividends
(1,000,000 x 20% x 5.33). 1,066,000
Net Gain 66,000

Receipt of Dividends from Subsidiaries

Dividends paid by a domestic stock corporation to another domestic stock corporation or

resident foreign corporation are not subject to tax. Likewise, dividends are not tax deductible.

Cash and/or property dividends paid by a subsidiary to its foreign parent company are
subject to an FWT of 30% (regular rate) or 15% subject to the “tax sparing rule.” If, however,
the recipient of the dividends is a resident of a country with whom the Philippines has a
treaty, the applicable preferential treaty rate will govern.

Dividends received from a foreign corporation is subject to regular corporate income tax. In
that case, it can be reduced by foreign tax credit, which is the lesser of actual foreign taxes
paid (or deemed paid) or a set limit.

CHAPTER 11: CAPITAL BUDGETING

Overview:

In most companies, in its ongoing operations, a capital acquisition and disposal are
common. Effective tax management / planning for these important transactions could greatly
help companies to significantly reduce after tax cost. Taxes to be considered in the decision-
making process of management includes business taxes, property and income taxes.

Capital budgeting is used by companies to evaluate major projects and investments, such as
acquisition of new plants or equipment. The process involves analyzing a project's cash
inflows and outflows to determine whether the expected return meets a set benchmark.
Income taxes make a difference in many capital budgeting decisions. The project that is
attractive on a before-tax basis may have to be rejected on an after-tax basis.

Income taxes typically affect both the amount and the timing of cash flows. Since net
income, not cash inflows, is subject to tax, after-tax cash inflows are not usually the same as
after-tax net income.

Module Objectives:
After successful Completion of this module, you should be able to:

1. Understand the impact that income taxes have on capital budgeting decisions.
2. Understand the impact that business and local taxes have on capital budgeting decisions.
3. To identify and explain the capital budgeting process.
4. To find out the profitable capital expenditure.
5. To know whether the replacement of any existing fixed assets gives more return than
earlier.
6. To decide whether a specified project is to be selected or not.
7. To find out the quantum of finance required for the capital expenditure.
8. To assess the various sources of finance for capital expenditure.
9. To evaluate the merits of each proposal to decide which project is best
Course Materials:

Definition: Capital budgeting is the method of determining and estimating the potential of
long-term investment options involving enormous capital expenditure. It is all about the
company’s strategic decision making, which acts as a milestone in the business.

Capital Budgeting Process

Capital budgeting, as we know, is a decision making process. It involves the following six
steps:

Identifying Potential Investment Opportunities: The company has various options for
capital employment on a long-term basis. In the initial stage, the management needs to
analyze the strengths and weaknesses of every project for foreseeing the potential of each
option.

Evaluating and Assembling Investment Proposals: In the next step, the management
assembles and compiles all the investment proposals on the grounds of cost, risk
involvement, future profits, return on investment, etc.

Decision Making: Now, the company needs to decide as to which investment option it may
select to suit its pocket and yield a high profit for the company in the long run.

Capital Budgeting and Apportionment: The next step is to classify the investment as per
its duration. The long-term investment is generally considered under capital budgeting. This
step helps in monitoring the performance of an individual investment.

Implementation: After the apportioning of the long-term investment, the company comes
into action for the execution of its decision. To avoid complications and excess time-
consumption, the management should lay out a detailed plan of the project in advance.
Performance Review: The last but the most crucial step is the follow-up and analysis of the
project’s performance. While the company’s operations are steady, the management needs
to measure and correlate the actual performance with that of the estimated one to figure out
the deviation and take corrective actions for the same.

Capital Budgeting Decisions

The organization’s all capital budgeting decisions can be broadly categorized under the
following three types:

FIXED ASSETS ACQUISITIONS

Managers are frequently faced with decision making on purchase of additional fixed assets
and replacement of old equipment. As with other projects, they should have expected net
cash flows with positive net present value.

Year End Tax Planning with Fixed Assets

One aspect of tax planning for a business is how to account for fixed asset purchases in the
most tax efficient manner. There are several methods to plan with fixed assets including the
use of various depreciation methods , section 34 of RA 8424 (Tax Code), in expensing and
the timing of an assets placed in service date.

Allowed Depreciation under Section 34 of RA 8424

Depreciation expense is a tax deduction coming from the fixed assets to reduce the taxable
income of a taxpayer. The deduction is allowed on acquisition of new fixed assets. Sec 34 of
RA 8424 provides:

(1) General Rule. - There shall be allowed as a depreciation deduction a reasonable

allowance for the exhaustion, wear and tear (including reasonable allowance for
obsolescence) of property used in the trade or business. In the case of property held by one
person for life with remainder to another person, the deduction shall be computed as if the
life tenant were the absolute owner of the property and shall be allowed to the life tenant. In
the case of property held in trust, the allowable deduction shall be apportioned between the
income beneficiaries and the trustees in accordance with the pertinent provisions of the
instrument creating the trust, or in the absence of such provisions, on the basis of the trust
income allowable to each.
(2) Use of Certain Methods and Rates. - The term 'reasonable allowance' as used in the
preceding paragraph shall include, but not limited to, an allowance computed in accordance
with rules and regulations prescribed by the Secretary of Finance, upon recommendation of
the Commissioner, under any of the following methods:

(a) The straight-line method;

(b) Declining-balance method, using a rate not exceeding twice the rate which would have
been used had the annual allowance been computed under the method described in
Subsection (F) (1);
(c) The sum-of-the-years-digit method; and
(d) any other method which may be prescribed by the Secretary of Finance upon
recommendation of the Commissioner.

Placed in Service Date

An asset is placed in service generally when it begins to be used in a trade or business. The
company can purchase an asset and not use it in the trade or business right away. That
distinction allows a taxpayer to use the placed in service date as a planning tool.
Depreciation deductions, section 34 require the asset to be placed in service. The planning
opportunity is to defer the start of deductions until a later placed in service date in order to
push expenses into a later tax period to offset projected income. If an entity does not need
the tax deductions, but purchased the fixed assets because of better prices, anticipation of
need of the assets, etc., this is an effective tool to time the deduction of the tax expenses for
maximum use.

Business tax on Purchases of Fixed Assets (VAT at 12%)

In most fixed asset acquisitions, capital acquisitions (such as machinery and equipment) are
subject to business taxes, known as value-added tax (VAT).Most vendor of fixed assets are
VAT registered and imposes 12% VAT to buyers or companies. The capital acquisition
requires large amount of money and related business tax which is additional 12% VAT
above the cost. Although some do not impose these taxes for purchases made from abroad
as long as it is included as VAT exempt transactions under section 109 of the tax code.
Similarly, VAT paid on purchases of fixed assets can be claim as input tax against VAT
output, reducing the VAT payable of companies; however, again, capital acquisition requires
huge investment plus business tax.

One method for postponing business taxes on equipment, reducing capital outlay and
increase savings, is by leasing instead of purchasing it. However, significant tax savings can
occur by delaying sales or use taxes through the use of a leasing company. Normally, if a
company is planning on purchasing equipment, it should expect to pay business tax. One
way to postpone tax is by forming a leasing company, as shown in Exhibit 11.1.
Property Taxes

If the capital expansion involves realty, there will be an increase in property taxes. If the
expansion (or new site) is significant enough, the firm can negotiate with local officials for tax
relief. If the expansion involves a combined purchase of personalty and realty, the firm can
try to allocate the purchase price so that all taxes are minimized.

ANALYSIS FROM A SAVANT PERSPECTIVE

Strategy

Any equipment acquisition should make business sense independent of the tax
consequences. The firm should first consider strategic aspects; for example, will the new
equipment result in the firm gaining competitive advantage by producing products cheaper or
better, or by delivering them faster?

Consider an express delivery business, where most of the productive assets are delivery
trucks. Suppose that the trucks currently are being depreciated over a seven-year life using
the double declining balance method. Now consider the impact if the Philippine government
changes to the three-year useful life category. Because the tax depreciation is more rapid,
the present value of the tax savings generated by depreciation increases, driving down the
after-tax cost of a truck. Should the older trucks be replaced with new? More rapid tax
depreciation on the replacements may translate into lower cost, which may allow the firm to
lower prices to undercut competitors. In addition, from a nontax perspective, the new trucks
may allow faster, safer, more fuel-efficient, and more reliable delivery.

However, even though tax benefits may be substantial it may not make strategic sense to
replace existing trucks. This could be the case if the new trucks would not enable better
customer service. It also might be the case if competitors do not purchase new trucks due to
capital constraints or net operating losses (NOLs) that obviate tax benefits.

Anticipation (Timing)

Will the tax laws on depreciation change? If so, this should affect the timing of transactions.
This especially is the case for year- end acquisitions. If new laws are about to make tax
depreciation more rapid, firms should anticipate the change by evaluating whether delaying
acquisitions until the beginning of the next tax year makes more sense.

Using the delivery service example, suppose that the seven-year depreciable life is expected
to drop to a three-year life for property placed in service in January of the next year. In that
case, from a purely tax perspective, it makes sense for a tax-paying firm to postpone the
acquisitions until January. However, if the firm is in an NOL carryforward status, it would not
make sense to postpone any necessary truck replacements. Indeed, if a competitor is in a
tax-paying position and will delay truck replacements until next year, it would actually give
the firm a temporary competitive advantage because the firm would be the first mover.

The tax aspects of timing normally do not outweigh nontax business :aspects. For example,
suppose the delivery service firm estimated it could gain a 10% increase in market share by
buying new trucks at the end of this year. Unless the net present value (NPV) of the profit on
this increased market share is less than the NPV of accelerating the tax depreciation by one
year, the tax changes should not be sufficient to delay truck replacement. If a manager
expects changes in tax rules, then the year in which for changes both in tax rates and in
depreciation methods. If rates are expected to increase (decrease), acquisitions should be
accelerated (delayed). This is because capital budgeting projects should have positive
pretax cash flows (due to enhanced revenues or cost savings) that yield a positive taxable
income. If tax depreciation is expected to become more (less) favorable, then investment
should be delayed. In evaluating capital projects, after-tax cash flows should be discounted.
Accordingly, accelerated tax depreciation methods increase the NPV of projects. (See
Example 11.2.)

Using the previous delivery service example, suppose each delivery truck costs 100,000.
Ifthe trucks are depreciated under five-year period Straight line method and are scheduled to
move to three-year useful life, assuming there is a 10% cost of capital and 30% income tax
rate, the PV of tax savings will be:

Depreciation x Tax 5-year Useful Life Depreciation x Tax 3-year Useful Life
Rate x PVF Rate x PVF

20,000 x 30% 5,454.60 33,333 x 30% 9,090.91

x .9091 x .9091

20,000 x 30% 4,958.40 33,333 x 30% 8,263.92

x .8264 x .8264

20,000 x 30% 4,507.80 33,333 x 30% 7,513.15

x .7513 x .7513

20,000 x 30% 4,098.00

x .6830

20,000 x 30% 3,725.40

x .6209

Present Value of Tax 22,747.80 Present Value of Tax 26,867.98

Savings Savings

If an 10% income tax rate is factored in, the NPV of the three-year (five-year) tax savings will
go to 22,747.80 (24,867.982). Thus, although the total depreciation on the truck is 100,000
under either method, the shorter life will increase the NPV of tax savings by approximately
9.32 %
Negotiating

Capital budgeting, more so than any other area except mergers and acquisitions, can
involve negotiating tax benefits where (as is typical) a large acquisition is made from one
vendor. For example, a firm in a positive tax bracket may be able to purchase a factory from
an NOL carryforward firm for a below-market price simply because the NOL carryforward
firm does not need the tax benefits. However, if the firm has an NOL, it may lease from a
vendor because the firm does not need the depreciation write-offs. (See Examples 11.3 and
11.4.)

EXAMPLE 11.3

Suppose a firm can buy or lease a new computer system. The system can be leased over
six years with annual lease payments of 100,000 or purchased outright for 436,000 (this is
the present value equivalent of six payments of 100,000 each). If it were in a tax-paying
position, the firm would prefer a lease. This is because there is higher rental expenses to be
deducted from taxable income, giving a lesser income taxes. But what about the seller? If
the seller is in an NOL carryforward position, it might prefer a sale, which triggers all of the
income in the year of sale.

Value-Adding

A project that has a positive net present value will also increase firm earnings-based
performance measures, such as earnings per share (EPS) and economic value-added
(EVA). However, there are collateral financial-statement effects to be considered. If debt
financed, does the debt increase the chance of violating preexisting bond covenants? In the
short run, bonuses may decrease due to increased financial statement depreciation,
especially if bonuses are tied to pretax earnings. (See Example 11.4.)

EXAMPLE 11.4

To see this, assume a Philippine. firm wants to acquire a new building. The building will cost
10 million and will be 90% debt financed (with an 8% mortgage). The firm is subject to 30%
basic corporate tax. Assume that the NPV of tax savings for depreciation is 2 million and that
the PV of principle and interest payments is 20 million. If so, the NPV of the building is:

Down payment <1,000,000>

PV of interest, principal payments <20,000,000>
PV of tax savings (depreciation, interest) 2,000,000
NPV—cost. <19,000,000>

Currently the firm has a year-by-year lease of a building at 2,000,000 per year. Assume the
NPV of this is:

PV of lease payment <30,000,000>

Tax savings: PV of deduction of lease payment 6,000,000
NPV—cost <24,000,000>
Based on the data given, buying the new building increases firm value. This is because the
NPV of the cash flows is higher, and, at least in the long run, financial-accounting measures
(such as EPS and EVA) will also increase.

However, there is a Philippine financial reporting drawback to buying the new building rather
than to continuing the operating lease. In a purchase, the mortgage (as well as the building)
appears on the balance sheet. In contrast, an operating lease is off the books. That is, the
cost of the use of the building is not included in assets, nor is the obligation to make lease
payments included as a liability. Instead, they are merely described in a footnote.

In a purchase, if a mortgage is a significant portion of the firm’s liabilities, it may cause the
firm to violate existing debt covenants. Or, by affecting other financial ratios, it may affect the
firm’s equity and debt ratings. These two drawbacks may be finessed by leasing rather than
buying. (The actual effect on shareholder value is not clear; loan covenants may include
restrictions on leases as well as more tradition debt, and financial analysts may be able to
estimate the impact of leasing on ratios.)

In evaluating whether a project has a positive value-added, transactions costs should be

considered. Involved are items such as information acquisition costs, title transfer fees,
document taxes and commissions (if realty), and professional fees (if an entity is acquired).
(See Example 11.5.)

EXAMPLE 11.5

Suppose a firm wants to buy an existing factory. The cost would be 10 million. The PV of tax
savings would be 5 million (related to depreciation). By replacing the old factory, the PV of
after-tax production cost savings would be 6 million. The firm’s management estimates that,
between travel costs and lost productive time, the cost of managers making two trips to
thoroughly examine the factory would be 500,000. Real estate agent commissions, at 7%,
would be 700,000. What is the NPV of the project?

Up-front cost <$10,000,000>

PV of tax savings 5,000,000
PV of operating cost savings (after-tax) 6,000,000
Transactions costs: Investigative time (after-tax). <500,000>
Realtor’s commission (after-tax). <700,000>
NPV <200,000>

In this particular example, transactions costs have turned a positive NPV project into a
negative one.

If the project involves risk, then such risk should somehow be offset by a higher after-tax
cash flow. Generally speaking, the longer lived the project, the more possible things that
could go wrong, so the higher the risk. Because capital budgeting decisions typically involve
plant or equipment acquisitions that have multiyear lives, risk becomes an issue. This
particularly is the case when comparing investments with differing cash flow variances or
useful lives.
(See Example 11.6.)
Suppose a firm can invest 1 million in one of two projects: a new computer system or R&D
aimed at discovering a specific product. First, examine only corporate income tax effects.
Assume the firm is in the 30% income tax. Projections are:

Computer System R&D - Best Case R&D - Worst Case

Cost (1M) (1M) (1M)

Cost Savings (PV) 3.5M 0 0

Expected revenue 0 7M 0
(PV)

Expected net profit 2.5M 6M (1M)

before tax savings

Tax on profit or tax (875k) (2.1M) 350K

savings

Savings from R&D 0 200K 200K

tax savings

Expected net profit 1,625,000 4,100,000 (450,000)

after tax

Without the tax benefits, the expected value of the R&D project is .5(6,000,000)
–.5(1,000,000) = 2,500,000. This is the same as the riskless project, so a manager with any
degree of risk aversion would chose to invest in the computer system. After tax, however,
the expected value of the riskier R&D project is .5(4,100,000) –.5(450,000) = $1,825,000,
which exceeds the $1,625,000 NPV of the less risky project. The riskier project has a greater
NPV due to tax benefits. The tax system thus provides a risk premium for the riskier project;
that is, it adjusts the (variance on) return.

PUTTING IT ALL TOGETHER: SAVANT CONCEPTS

APPLIED TO CAPITAL BUDGETING
Case:

You are the chief financial officer for a major overnight delivery service. You are considering
replacing your aging fleet of aircraft (Boeing 747s) with new aircraft (Boeing 767s). You need
20 of these aircraft, which cost 10 million each. You can receive 250,000 each, after tax, on
the sale of each old aircraft. Due to increased fuel efficiency and decreased maintenance,
you expect to save 2 million per year per aircraft over their 10-year useful lives. Your cost of
capital is 8%. Assume a 5-year useful life, a corporate tax rate of 30%.

Strategy

If the project has a significant enough positive cash flow, you may be able to drop delivery
prices. Also, there is a promotional advantage to having new aircraft: Customers may
believe that your new fleet is more reliable than that of competition having older aircraft.
Negotiating

Because Boeing is subject to corporate income tax, it may prefer to lease the aircraft to you
and recognize income ratably over time. So, a lease-purchase agreement is called for,
whereby you (based on your intent to purchase the aircraft) treat it as a capitalized lease
purchase. This saves Boeing 5,000,000 in (discounted) taxes, half of which the company
may be willing to pass on to you in the form of lower prices. Also, under a lease, the sales or
use taxes that you would have to pay would be made ratably over time.

Value-Adding and Anticipation

Should value-adding be adjusted for risk? If the lease is cancelable by the lessee, it actually
is less risky than an outright purchase, assuming the aircraft are reliable and your customer
base is unlikely to decrease. Although technically Boeing could cancel the lease, you believe
this unlikely to occur. You also expect no changes in tax rates or depreciation rules, so
accelerating or otherwise adjusting the timing of acquisition is not required. First, examine
the effects of federal taxes. The cash flows by year are expected as shown in Exhibit 11.6
So far, the acquisition’s positive NPV suggests positive value adding.
Exhibit 11.6

Year Description Amount* Discount rate Discounted

at 8% (PVF) Cash flows (in
millions

1-10 Lease (19.5 M) x .3 6.71 (39.254 M)

Payments

1-10 Operating cost 1.4 M 6.71 9.394 M

savings

1-10 Tax 46.8 M

depreciation on
purchase

Net benefit 16.94 M

*Computation of Amounts in the table

Lease Payments = 20 aircrafts x (10M-250K) divided by 10
years = 19,500,000

Operating Cost Savings 2M (1-.3) = 1,400,000

Year Description PVF at 8% Pv of tax benefit

1 39M x .3 .93 10.881 M

2 39M x .3 .86 10.062 M

 3 39M x .3 .79 9,243 M

4 39M x .3 .74 8.658 M

5 39M x .3 .68 7.956 M

Total 46.8 M

Depreciation = (10M-250K) x 20) divided by 5 years life = 39M per year

What of the effect on the firm’s financials? On the balance sheet, the arrangement can be
treated as a capitalized lease, so both assets and long-term liabilities increase by the
present value of the lease payments . Upon investigation, you determine that the increase in
long-term liabilities does not violate any debt covenants. Further, because there is a net
increase in financial accounting income, bonuses for the company’s managers will actually
increase from the arrangement. Finally, in terms of timing, if no changes in rates or rules are
anticipated, the transaction should occur when the economics are sensible.

MAKE OR BUY DECISIONS

Manufacturing firms are frequently faced with the decision of making or buying a component
integral to the manufacture of their products. An advantage of internal manufacture is
complete control over timing and quality of product. However, outsourced components
(particularly if manufactured in low cost countries) can be less expensive, especially if there
is competition in this market. Whether it is less expensive to buy outside or not depends in
part on avoidable overhead costs. Avoidable overhead costs are those that would not be
incurred if the component is outsourced.

(See Example 11.7.)

Suppose that a computer manufacturer has the opportunity to outsource the manufacture of
motherboards. Competitive bids, controlling for quality, yield a best price of 280 per board.
Internal costs to manufacture are 300:

Direct labor 100

Direct materials 100
Overhead:
Indirect materials 30
Factory utilities, insurance, and taxes (Allocated) 70
Because the 70 is unavoidable, the real cost to manufacture internally is 230, before
transactions costs. Note that if the manufacturing is done in a single state, state income
taxes play no role per se; under either manufacture or purchase, costs are deductible.

Tax-related transactions costs may be important if the manufacture or purchase is across tax
jurisdictions. If the good is manufactured by the firm in a different state, stopping
manufacture may mean that the firm’s nexus with the state will disappear. This would
eliminate allocation of the firm’s income to the state. If this state has a higher (lower) tax rate
than the average for the firm’s rest of the operations, cessation of manufacture results in a
negative (positive) transaction cost.
EXAMPLE 11.8
To see how this might work, assume a California firm was buying a component from its
wholly owned subsidiary in Illinois. Financial statistics (in millions of pesos) are:

Illinois Parent (California Mfg. co)

Total production cost

Total revenue

Tax rate 6% 8%

Number of units transferred

= 5M

Taxable income 10M 50M

Property 200M 300M

Payroll 20M 30M

Suppose the parent is considering selling the subsidiary and buying the components from an
unrelated supplier. The effect on apportionment of state income taxes needs to be
considered. First, one should examine state income taxes assuming the subsidiary is
retained:

Apportionment to Illinois: Apportionment to California:

Property 200/500 = .4 Property: 300/500 = .6
Payroll: 20/50 = .4 Payroll: 20/50 =. .4
Sales: =. 0 Sales: =. 2.0
Average .2 Average. .8

Times taxable income x 60,000,000 Times taxable income x 60,000,000

Apportioned TI. 12,000,000 Apportioned TI. 48,000,000
Times tax rate. x .06 x .08
Income tax $ 720,000 $ 3,840,000 3,840,000

Thus, the total income tax burden is 4,560,000. If the subsidiary is sold, all taxable income is
apportioned to California. To keep the example comparable, assume that the parent
company would obtain a purchase price so that its profit from that part of the value chain
would be 10,000,000 (i.e., the current profit of the subsidiary). The state income tax would
be:

Taxable income 60,000,000

Multiplied by Income tax rate × .08
State income tax $ 4,800,000
Example 11.8 shows that by severing its ties with a subsidiary located in a lowertaxed state,
the firm’s state taxes will increase overall. Thus, for the sale to add value, the nontax cost
savings from buying from an outsider must be at least 4,800,000 – 4,560,000 = 240,000
each year.

Note that the reverse would be true were the subsidiary located in a higher-tax-rate
jurisdiction. To see this, suppose the rates were reversed (i.e, the subsidiary is in an 8%
bracket, and the parent is subject to a 6% rate). By keeping the subsidiary, total taxes are
3,600,000: 12,000,000(.08) + 48,000,000(.06). Without the subsidiary, taxes are also
3,600,000: 60,000,000(.06). Although outsourcing may save costs, there are also strategic
considerations. Suppliers can renege on contracts (i.e, adjustment for risk may be
necessary) in the long run, and it may be very costly for the firm to restart manufacture. If,
however, a cooperative supplier relationship can be established, negotiation of tax costs can
occur. For example, if the firm expects to be in a higher tax bracket in the next year, it can
request the supplier to postpone sales on deliveries until then in return for a slightly higher
sales price.

CAPITAL BUDGETING AND PLANT CAPACITY

If the firm needs to expand plant capacity, it may do so by expanding the current plant or by
building additional, separate facilities. Because of the interrelationship of federal,
international, and state and local taxes in many businesses, it is important to consider all of
the taxes in Exhibit 11.4. This is illustrated in Example 11.9.

EXHIBIT 11.4 Differential Tax Impacts of Expand versus Buy Decisions

Expand Existing Plant Build (Buy) Additional

Facilities

Property Taxes Increase Increase, unless tax holiday

obtained

Income Taxes Tax shield from Tax shield Tax shield from Tax shield
from depreciation from depreciation

RISK CONSIDERATIONS

Because capital budgeting involves longer-run horizons, there is inherently more risk that
cash flows may vary from projections. (Note that the depreciation tax shield, absent a
change in the firm’s effective tax rate, is invariant.) Because income taxes decrease with
decreased revenues, they act as a variance (and hence risk) reduction mechanism. (See
Exhibit 11.5.) Example 11.12 quantifies these curves in order to better illustrate this
concept.
Example 11.2:
Consider a firm to invest 10M in advertising to launch a new product. Management is
uncertain about its outcome but feels there is a bell-shaped curve over a range of possible
outcomes.
• Most likely: Net profit = 1,000,000
• Worst case Least likely: Loss of 11,000,000 (Loss of 10M advertising and 1M operating
cost)
• Best case Least likely: Net profit of 20,000,000

Worst case: 25% Most likely: 50% Best case: 25%

probability probability probability

Profit (loss) (11,000,000) 1,000,000 20,000,000

Taxes at 30% 3,300,000 300,000 6,000,000

Profit (loss) after Tax (7,700,000) 700,000 14,000,000

The expected profit will be equal to: 25% x loss of 7.7M + 50% x 700,000 + 25% x
14,000,000. The expected profit is 1,925,000 after taxes. The expected profit before taxes is
2,750,000. Most likely, actual tax effects in situations like that illustrated in Example 11.12
would make the investment more palatable. This is because of the loss reduction aspect of
income taxes.

For example, in the worst-case scenario, a possible $11 million pretax loss is converted into
a 7,200,000 after-tax loss. If the company cannot afford the former loss or a manager’s
evaluation (possibly considering her own bonus based on after-tax earnings) hinges on the
investment, taxes can actually help in a risky capital budgeting project. However, if the loss
creates an NOLCO at the entity level, the effect of income taxes can make the loss less
palatable. This is because of NOLCO restriction on carryover.

NET PRESENT VALUE:

 Net Present Value (NPV) is the value of all future cash flows (positive and negative) over
the entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value
of a business, investment security, capital project, new venture, cost reduction program, and
anything that involves cash flow

Illustration:
The management of Scientific Products, Inc. (SPI), is considering a five-year contract to
build scientific instruments for a large school district. The initial investment required to
purchase production equipment is $400,000 (to be depreciated over 5 years using the
straight-line method, with no salvage value). An additional $50,000 in working capital is
required for the contract. Working capital will be returned to SPI at the end of five years.
Annual net cash receipts from daily operations (cash receipts minus cash payments) are
shown as follows. Since depreciation expense is not a cash outflow, it is not included in
these amounts.

Year 1 $ 50,000
Year 2 $ 60,000
Year 3 $120,000
Year 4 $200,000
Year 5 $130,000

Management established a required rate of return of 10 percent for this proposal. The
company’s tax rate is 40 percent. (The complexities of government tax codes have a
significant impact on the tax rate used. For simplicity, we use a tax rate of 40 percent for this
example.)

Figure 1 NPV Calculation with Income Taxes for Scientific Products, Inc.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total -

(Today) net

Purchas (400,000
e price )

Working (50,000) 50,000

Capital

Net Cash 30,000 36,000 72,000 120,000 78,000

Inflow
after tax

Tax 32,000 32,000 32,000 32,000 32,000

savings
in
depreciat
 ion

Total net (450,000 62,000 68,000 104,000 152,000 160,000

cash )
inflow
(outflow)

PVF at 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209

10%

Present (450,000 56,364.2 56,195.2 78,135.2 103,816 99,344 (56,145.

Value ) 0 0 0 40)

Annual
depreciat
ion:

Cost 400,000

Useful 5.00
life

Deprecia 80,000
tion per
Year

Net cash 50,000 60,000 120,000 200,000 130,000

inflow
before
tax

Tax 40% 20,000 24,000 48,000 80,000 52,000

expense
at

Net cash 30,000 36,000 72,000 120,000 78,000

inflow
after tax

Note: the NPV is $(56,145.40).

Since NPV is < 0, reject the investment. (The investment provides a return less than 10
percent.)