Justice Oliver Wendell Holmes wrote that taxes are what we pay for a civilized society. Governments must fund programs, and the primary source of funding is taxation. From a macroeconomic perspective, the business of taxing is equivalent to governmental decisions on how to draw the required resources away from the nation’s households and businesses for public purposes. The money raised through taxation is the vehicle by which real resources are transferred from private goods to collective goods. The goals may encompass financing public projects, redistributing wealth, or encouraging and discouraging certain investment activities deemed to be in or contrary to the public interest.
An alternative perspective is to view the taxing authority as an uninvited investment partner to all contracts. This partner does not negotiate separate terms for each contract but, rather, announces a general set of rules and standard contractual terms that all taxpayers must follow. As a partner to all transactional profits, the government indirectly monitors its claims through the tax audit process.
Taxes and Business Strategy: A Planning Approach was written for a specific audience—individuals who are studying for a graduate business degree or have successfully secured investment professional status in such fields as investment banking, corporate finance, strategic consulting, money management, or venture capital. Most of the authors are finance and accounting professors; two also hold partnership interests in professional equity investment firms. They have expressly limited their objective to providing a solid understanding of the environmental contexts that give rise to tax-planning opportunities, which they treat as part of the strategic component of overall corporate decision making.
Another audience that may benefit from the book, however, is tax specialists. Lawyers and Certified Public Accountants, who must interpret, apply, and report in compliance with the tax rules, regulations, and procedures, could profit greatly by studying the larger perspective of investment and economic decision making that the authors advocate.
That broader outlook recommended by the authors is expressed in three main themes:
- The tax planner must consider a proposed transaction’s tax implications from the viewpoint of all parties to the transaction, including the uninvited but mandated partner;
- the tax planner must understand the distinction between explicit tax payments to the government and implicit, indirect tax payments that arise because of lower before-tax rates of return on tax-favored investments; and
- the tax planner must recognize that taxes are only one component of a myriad of business costs that must be predicted, evaluated, and considered in structuring business investments.
Chapter 1 introduces the book’s objectives by defining planning and strategy. It briefly discusses some of the topics to be covered, including choice of legal entity in which to undertake production as well as investment and financing activities. The appendix to Chapter 1 and Chapter 2’s material succinctly outline the basic tax formula for individuals and corporations and describe certain fundamentals of tax law.
Once the reader has been introduced to certain key concepts—the progressive nature of U.S. statutory tax rates and legislators’ use of tax law to implement desired social and economic policies—the authors explore nuances of tax law ambiguity to demonstrate how the planner can lawfully rearrange or manipulate transactions to avoid bad tax results.
The authors carefully explain three types of tax-planning strategy:
- converting ordinary income into capital gains (which are subject to lower tax rates) and exploiting other favorable statutory calculations, such as netting against short-term or long-term capital losses;
- shifting transactions and tax consequences among or between taxpayers, as do salary earners who invest in retirement vehicles, create irrevocable trusts, or make outright gifts to family members in order to assign future income to lower tax rates;
- shifting tax consequences between and among time periods by deferring or postponing income and by accelerating deductions, or if tax rates are scheduled to increase or decrease in the future, reversing deferrals.
The authors do not shy away from explaining basic legal doctrines that the judiciary uses in deciding tax controversies, such as constructive receipt, assignment of income, the business purpose test, and the substance-over-form doctrine. Tax planners should understand the degree to which taxpayers must, should, or may rely on various interpretations of the U.S. Tax Code that the IRS promulgates through its powers as a federal administrative agency. Without getting overly complicated, the authors distinguish Treasury regulations, IRS rulings and procedures, private letter rulings, and technical advice memoranda while at the same time providing the finance professional a basic understanding of how the judiciary decides tax cases and controversies.
A chapter that compares tax accounting rules with financial statement accounting disclosures under Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, is quite informative without burdening the reader with all of this area’s complexity. The discussion will most likely need to be revised, however, in light of the newly issued pronouncement of the Financial Accounting Standards Board, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes.
After the authors have finished describing the accounting and legal foundation of the tax system, the tax formula, and the tax model, they move on to an array of sophisticated financial and investment analyses that incorporate taxation and its various puzzles.
The authors carefully define frictions, such as transaction costs and other information-related impediments, and assume their nonexistence to describe tax arbitrage—that is, the process of holding tax-favored vehicles long while selling tax-disadvantaged vehicles short. They modify the capital asset pricing model by redefining the before-tax difference between the realized return on the market and the risk-free rate. Specifically, the authors introduce after-tax risk premium calculations on risky assets to incorporate the implicit tax on the returns to assets. For example, the difference between the before-tax return on a fully taxable bond and the risk-adjusted before-tax return on a tax-favored municipal bond is the implicit tax. In competitive equilibrium, the total tax paid on any investment is the sum of the explicit and implicit taxes. The authors argue that investors would quickly use tax arbitrage to bid away any differences between one savings/investment vehicle that dominated another vehicle by providing higher after-tax returns. Ultimately, the authors demonstrate, the U.S. Tax Code contains built-in prohibitions that prevent taxpayers from leveraging tax-deductible debt into tax-exempt municipal bonds. Numerous complex prohibitions under U.S. Internal Revenue Code Section 163(d) are mentioned, but certain entity-type restrictions under Section 465 relating to the at-risk rules are not.
Chapters 6–9 expand on the dynamic tax-planning process by focusing on marginal tax rates, transaction costs, compensation issues, and retirement vehicles. A corporate strategy of overfunding pension plans is explained by the difference in before-tax and after-tax rates of return. Generally, the risk-adjusted rate of return on assets in the pension fund will exceed the rate of return on marginal investments undertaken in the corporate account. Taxes and Business Strategy is replete with analyses of the incentives that motivate managers and investment professionals to integrate the tax variable in business decision making.
Chapters 10–17 cover multinational tax planning, corporate formation, mergers and acquisitions, the Subchapter S corporation versus the basic C corporation, and corporate divestitures. The book concludes with a chapter on estate and gift-tax planning.
Even at close to 600 pages, Taxes and Business Strategy has some gaps. For one thing, large publicly traded corporations have dramatically increased their use of limited liability companies, vehicles formerly used mainly by small-business startup companies. Real estate investments generally should be placed in these vehicles. Furthermore, most hedge funds, a rapidly growing category, are operated as limited liability companies. In light of these developments, a separate chapter would probably have been warranted to discuss in detail the intricacies of the taxation of partnerships and other pass-through entities, such as the S corporation. From a teaching perspective, this addition would expand the material to the extent that a two-course model would be justified.
Nevertheless, Taxes and Business Strategy is an excellent excursion into the world of taxation that differs sharply from the traditional accounting and law school approaches found in most university curricula. Too often, academic finance textbooks minimize the importance of taxation by assuming the nonexistence of taxes or simplifying the analysis to the point at which taxes are effectively ignored. The book succeeds as a basic primer for investment professionals and MBA graduate students who plan to enter the world of finance. Practicing professionals at all levels could also benefit greatly from the authors’ broad perspective.