Tax deferral refers to instances where a taxpayer can delay paying
tax
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
es to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes.
Corporate tax deferral
Corporations (or other enterprises) may often be allowed to defer taxes, for example, by using
accelerated depreciation. Profit taxes (or other taxes) are reduced in the current period by either lowering declared revenue now, or by increasing expenses. In principle, taxes in future periods should be higher.
Income tax deferral
In many
jurisdiction
Jurisdiction (from Latin 'law' + 'declaration') is the legal term for the legal authority granted to a legal entity to enact justice. In federations like the United States, areas of jurisdiction apply to local, state, and federal levels.
J ...
s,
income tax
An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Tax ...
es may be deferred to future periods by a number of means. For example, income may be recognized in future years by using income tax deductions, or certain expenses may be provided as deductions in current rather than future periods. A 2010 study documents the large extent to which U.S. taxpayers accelerate their deductible state tax income taxes by prepaying them in December, instead of their normally due January of the following year.
In jurisdictions where tax rates are
progressive – meaning that income taxes as a percentage of income are higher for higher incomes or
tax bracket
Tax brackets are the divisions at which tax rates change in a progressive tax system (or an explicitly regressive tax system, though that is rarer). Essentially, tax brackets are the cutoff values for taxable income—income past a certain poin ...
s, resulting in a higher
marginal tax rate
In a tax system, the tax rate is the ratio (usually expressed as a percentage) at which a business or person is taxed. There are several methods used to present a tax rate: statutory, average, marginal, and effective. These rates can also be ...
– this often results in lower taxes paid, regardless of the
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
.
Tax-deferred
retirement accounts exist in many jurisdictions, and allow individuals to declare income later in life; if the individuals also have lower income in retirement, taxes paid may be considerably lower. In
Canada
Canada is a country in North America. Its ten provinces and three territories extend from the Atlantic Ocean to the Pacific Ocean and northward into the Arctic Ocean, covering over , making it the world's second-largest country by tot ...
, contributions to
registered retirement savings plans or RRSPs are deducted from income, and earnings (
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distin ...
,
dividends and
capital gains) in these accounts are not taxed; only withdrawals from the retirement account are taxed as income.
Other types of retirement accounts will defer taxes only on income earned in the account. In the United States, a number of different forms of retirement savings accounts exist with different characteristics and limits, including
401k
In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodical employee contributions come directly out of the ...
s,
IRA
Ira or IRA may refer to:
*Ira (name), a Hebrew, Sanskrit, Russian or Finnish language personal name
*Ira (surname), a rare Estonian and some other language family name
*Iran, UNDP code IRA
Law
*Indian Reorganization Act of 1934, US, on status of ...
s, and more.
As long as the individual makes withdrawals when he or she is in a lower tax bracket (that is, has a lower marginal tax rate), total taxes payable will be lower.
On the other hand, some people (primarily business owners) may choose to do the ''opposite'' of deferring their tax liabilities by "prepaying" personal income tax that would otherwise be payable in future years. For example, if it is known that tax rates will be increasing in a future tax year, a business owner can reduce his total tax liability by paying himself/herself a higher salary and/or bonuses in the current tax year, even if he or she has to loan the business money to do so. In most jurisdictions, the principal of such loans can be collected by the owner tax free at any time, thus allowing the owner to be paid a lower salary than would otherwise be the case once the tax rate increases. Alternatively, the owner of a new or struggling business can be paid a higher salary than his or her company can nominally afford to pay in hopes that when the business is more profitable, the amount of taxes owing in higher tax brackets will be less or none at all. At the very least, it is usually advisable for business owners to at least pay themselves enough salary to use up all of their basic personal exemptions for a given tax year, since these exemptions typically cannot be deferred to a future tax year. However, if applied aggressively, this can be a risky strategy depending on the jurisdiction – if the business fails, the owners' ability to benefit from the nominal write-offs and losses accrued in earlier years might be limited or non-existent.
International tax deferral
Taxes on profits derived from foreign investments may also be deferred via the retention and reinvestment of corporate earnings in foreign lower-tax countries. The advantages of this kind of tax deferral can be attributed to two partially interdependent effects, the tax rate effect and the interest effect:
The ''tax rate effect'' is based on the fact that as long as the profit of a (supposed) subsidiary is not distributed to the domestic (corporate or individual) shareholder, the profit is not taxed in the shareholder's country. If the foreign tax rate is lower than the domestic one, profits can thus be retained in order to shelter them from domestic taxation. In case of exemption of foreign profits (as it is e.g. the case for corporate shareholders in Germany), this tax rate advantage is final.
The ''interest effect'' derives from the fact that if the foreign tax rate is low, the tax rate effect on the net yield is growing with time as the amount of additional interest increases exponentially (interest advantage). Therefore, given equal gross yields, e.g. regarding mobile financial assets, it is more profitable to invest in low-tax countries: The net yield is higher in a low-tax country than in a high-tax country and hence the capital grows at a faster rate. That interest effect cannot be wholly eliminated, even if there is additional taxation upon distribution (e.g. like in a shareholder relief system or with the credit method).
[Schreiber, Ulrich/Ebert, Michael (2012): ''International Financial Accounting and Business Taxation'', University of Mannheim.]
References
See also
*
Companies of the United States with untaxed profits
*
Individual Retirement Account
An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's e ...
*
Deferred compensation
*
401k
In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodical employee contributions come directly out of the ...
{{DEFAULTSORT:Tax Deferral
Tax avoidance