Taxable Income This chapter addresses the starting point ol any income tax: the definition of income as the base of the tax (the subject matter on which tlie ta\ is imposed). First, we discuss the two main concepts! of taxable income, source concept and accretion concept, and the two main ways used by countries with income taxes to define the tax base, by exclusion (a "global definition of income) or by inclusion (a "schochilar" definition). The chapter then reviews some of the major problems ol defining income- in the U.S. income tax system and juxtaposes the U.S. solutions against those used by other countries. Finally, we discuss the realization requirement which has been described as the "Achilles' heel" of the income tax.1 I. TAXABLE INCOME DEFINITION: GLOBAL vs. SCHEDULAR AND SOURCE vs. ACCRETION The definition of taxable income can be based upon either the accretion concept or the source concept.-1 The accretion concept derives Írom the so-called "Haig/Simons" definition of income, under which a person's annual income is the value ot what she could consume in that year while keeping het wealth constant. Equivalently, it is equal to actual consumption plus the change William D Andrews, The Achilles Hee! of Hie Compfckensive. Income Tax. in New Dm k no\si\ luHitM ľwľniui ku; mi 1980s, at 278.280-85 (Charles ľ. Walker & Mark V Bloomfield odv. l%3). 1 Vk iok Tmi'koxvi. Comparative Tax I w Í33 (Kluwer 2003) distinguishes between accretion, source, and lru*t concept. Sec also Paul I fahn Wueller. Conceptsej Taxable Income I. s? Pout.Sci. Q.. 1938,83; Kľvtn I Iolmes Tut taKOBrt or 1\< o\n . A Mi i i i-Discii*li\aiu Anaiysisi Amsterdam; IB! i"1 20IU I. IS , CIOISAI PEKSPLCTIVFSON INCOME TAXATION LAW in wealth.3 This concept has been adopted in the United States/ where any realized accession of wealth is income unless it is specifically excluded. The source concept of income has been developed by the Italian economists De V'iti De Marco and Quarta, and it has been adopted by Italy and manv other civil law countries. It has also been adopted b\ Certain Common law countries such as the United Kingdom. I he source concept ot income provides that a certain item is income onlv when it derives from a specific source, most likely an economic one. Another important distinction exists with regard to the definitional structure ot taxable income. Any tax system can define taxable income in a global way (e.g.. United States) or in a schedular wa\ (e.g.. Italy/. Taxable income is defined in a global way when any item of income is included in taxable income unless specifically excluded. Taxable income is defined in a schedular way when an item of income is not taxable income unless specifically included in a specific schedule. One mav think that income tax systems that define taxable income in a global way would follow the accretion concept (as is the case in the United States and Brazil), while a tax system that defines taxable income in a schedular wav would rather prefer the source concept (as is the case in France, Germany, Italy, Spain, and the United Kingdom) The logic works as follows: in a schedular system, income is taxable onlv if there is a specific "scheduled" source for such income. On the other hand, global systems will not look for a specific source for the income. All that matters is the accumulation of income (the source of which does not matter). Hence, "accretion' is the key concept here. As much as we would have liked to end this description now, the source/ schedule vs. accretion/global distinction is much generalized, many limes misleading. In fact, both Australia and Canada define income in 1 S&' K< •mi k i M. Hah,, fin Cosci ri or Imomi i < onoviic and Lic.ai Asi'k is. Tilt It oirai Incoml Ia\ 2(>, the Supreme Court held that "income mav be defined as the gain derived ;rom labor, from capital, or from both combined "' I his definition ■•' 11) Compensation tor sen ices, including fees, commissions, fringe benefits, and similar items: (2) Cross income derived trom business; (3) Cains derived froth dealings in property: Ui Interest: ni Rents. (6) Royalties; (~> Dividends) isi Alimom and separate maintenance payments; Annuities; (10) Income fipm life insurance and endowment contracts; 11! i Pensions; 112) Income from discharge ot indebtedness; (13j Distributive share oi partnership gross income: l I4i Income in respei l ol a decedent; and (15) Income trom an Interest in an estate or trust. Most ol tho categories ■.•numerated • Uniform taxation, 16 Y\. Tax Rev 59 (1996K " See Regulations fin the implementation Of the Individual Income Tax Liu< of the People < Republic cj China, available at hue Wvw.chlnatax.gOT.ch/n6669073 nhMiyOrtS/^NK.W-l.hrml (last visited on November K 2lKW). 22 / Gl OBAL PERSPECTIVES ON INCOMU T.WAI ION LAW operation, income from contracted or leased operation of enterprises i>r institutions, remuneration from personal services, author's remuneration, royalties, interests, div idends, bonuses, income from lease of property, income from Iriinsfef of property, contingent income, and other income specified as taxable by China's Ministry oi Finance, To .1 certain extent, the possibility lor the Chinese Ministry oi Finance to specify it an item of income becomes taxable makes the Chinese income tax system similar to a global systém. In tact, new items ot income can be rapidly (but not immediately) added as taxable items or income, The reverse (global systems converging toward schedular Ones) is aho true, l-'or example, the United States follows .1 glob.il approach, but there are so mam excluded items ol income in tile US Code thai it 1-possible to s.iy that the svstem partially converged toward a schedular system. I'he most obvious example is the different treatment of labor (i.e., "ordinary") income as compared to capital gains. Both are, in essence, "income" but are taxed differently, each under it own "schedule," each defined according to the source from which it is derived. Despite this considerable convergence, there are still differences at the margin between global and schedular systems, and there persists some tendency to t.ix items in the former that are ex. luded in the latter. New forms of income arise over time as the economy changes (e.g., income from derivative financial instruments) When courts confront the question ot whether such new items should be taxed, their decision to tax depends on whether the system they operate in is global or schedular. This example illustrates a broader phenomenon that underlies the whole topic of comparative taxation and gives it some ot its appeal, It is also important to note- that "source" remains highly relevant even in global systems due to the international nature ot business transactions. In an international transaction, even where only "global" systems are involved, source will define which jurisdiction gets the priority in taxation and will also affect the classification on the transaction for tax purposes (for example, as an interest or a dividend payment). At least from a functional perspective, the design problems facing an income lax are, to a significant extent, identical across jurisdictions. Therefore, it is not surprising to find a degree of com ergence that makes all income tax systems look alike, even without any showing of conscious borrowing (although that exists as well in some areas, such as international tax). However, jurisdictions also differ in their underlying history and legal culture, and thus it is understandable that convergence will never be complete.3' In tact, the widespread phenomenon ol -v I his is generally true for all comparative legal studies, as suggesied by sluclies on the cutnergeni e <>r divergence- ol the common and civil law traditions. Mathias Reimann, The Prpgressand Faüure ef Compärittive Law in the sc. diu/ Halfof the Ttoentktti Century. 50 Am. .1. Comp. L t>7\ (2U02). Taxable Income cross-border tax arbitrage depends on the persistence ot differences between the tax rules of different countries, even if they .til attempt to tax income. In essence, t.ix arbitrage refers to the exploitation by taxpayers of the differences among tax systems to lower their overall tax liability II. TAXATION OF FRINGE BENEFITS No income ta\ system can locus exclusively on cash compensation paid to employees without raising significant efficiency and fairness issues. If only cash compensation is taxed, workers would tend to ask for noncash compensation. A negative twofold result follows: workers would receive noncash fringe benefits instead of other items upon which they place greater value, which is inefficient, also, workers with similar incomes would be taxed differently depending on whether they received income in cash or in other torm, which is unfair. Different countries have responded to this issue in different wavs. depending on the fringe benefits involved! As a general matter, in most systems (the United States included), fringe benefits are included in income. Specifically, they are included in the employee's income and usually deductible for the employer.-'1 From a fairness perspective, this is probably the best solution because horizontal equit) requires that similarly situated taxpayers be treated alike. Despite this general concept, in most (if not all) tax systems, some fringes are excluded (which again raises fairness questions with respect to these specific fringes). This is one area in which the global vs. sched-ular issue matters: under schedular systems, fringes must be specifically included or they are not taxable, while in the United States and other global systems, all fringes are taxable unless specifically excluded (I.R.C. $ 132; § 119). These marginal differences are discussed below with reference to specific fringes. Admittedly, faxing noncash fringe benefits is difficult. There is the issue of valuation, which is frequently difficult to perform; especially when the items are restricted (the value in such a case is obviously less than fair market value, but by how much?). The general valuation rules ot the law apply to the valuation ol the benefits in kind. The valuation process becomes even more complicated in countries that do not have a set of detailed rules for performing valuations. Another issue with : As it will be shown, the Australian tax system constitutes an exception on this regard. 24 / GI.OHAI IMKSPF'Cl IVl-S l >\ IXC OMF IAXATION I WV fringe benefits is that the business and personal aspects of a fringe benefit, such as usf of a company car, may be difficult to separate. Before commencing in analyzing the various ways in which different in\ systems approach the problems presented by fringe benefits, one notable exception to the general rule (i.e., that fringe benefits are taxable ii> the employer) must be emphasized: the Australian tax system, which applies a comprehensive svstem of surrogate taxation with respect to fringe benefits. In general, under Australian law, any benefit provided by an employer to an employee with respect to the employment is included in the employer's income - The major advantage of this approach is administrative simplification; the problem of valuation is shifted from employee to employer, and it is much easier to audit employers than employees because ol their limited numbers. I he major disadvantage is that the wrong person is taxed, and there is always the concern as to whether the tax is passed onto employees in the form of tower wages (which depends on market conditions). In general, Australian economists have concluded thai it took au hik" lor the new fringe benefit tax to be reflected in wages. As noted, however, in most other countries, hinge benefits are taxed to employees, and the mam challenge is dealing with the administrative attd valuation difficulties raised by this method In most countries, the value of fringe benefits is measured through a comparison to fair market \ aim- or retail prices. I or example, in Russia, the law require-, onh that goods and services be valued at the market price of similar goods and services, increased In the appropriate amount of value-added tax (VAT) and excise duties. However, the fair market value of mam fringes is hard to establish, especially in the case of fringes provided for the use of multiple employees (such as company retreats), It one does not adopt the Australian approach of shifting the burden to the well-informed (and better regulated I employer, one might try to take the valuation difficulties head-on bj Irving to prescribe statutory rules lor valuation. For example, in Brazil, benefits in kind are fully taxable and valued .11 their cost to the employer or at market value,*3 except those which are specifically exempted, such as food and transportation vouchers, and uniforms or special clothing tor work, freely provided by the employer, or the difference between the price charged and the market value ol the goods - Sec ' ringn Benefit l.i\ A guide etttployei s and lax /in>/bs-ical asset (car, dwelling, etc.), the amount of taxable income is calculated according to the price specified in the purchase documentation or as determined bv tax authorities. 1 he taxable value ot the benefits may be incorporated into the taxation ot employees' wages on an average monthly basis of the employees' required service period. I he payment of income tax by an employer on behalf of an employee is also regarded as a taxable remuneration. The employee is taxed on the grossed-up amount.21 A middle BSty to deal u ith the valuation problem is to simply attach a standard value to certain fringes ("valuation tables") and include it in the employee's income, this method is applied in Italy-" forcompany-provided cars and in the United States, ~ the United Kingdom, Sweden, and Germanv for Innges such as company cars, meals, and lodging A similar approach is taken in Israel: each year the Tax Authority publishes a "value ot use" table which specifies the amount to be added to employees' income for each type of vehicle provided bv the employer. The valuation problem mav lead countries to omit hard-to-value or small fringes for simplicity reasons,2* but excluding fringes altogether leads to a violation of horizontal equity. Suppose, tor example, that A gets taxable income of 10,000 and an excluded Fringe ot 1000, while B gets II.(Hit.) m taxable income and buys the fringe with after-tax money. Assuming a flat tax rate ot 30 percent, A is left with 7000 cash (10,0(10 taxable income taxed at a 10 percent rate) plus the fringe at hand, while B remains with 6700 cash 111.000 taxable income taxed at the 30 percent rate minus the 1000 spent to purchase the fringe) phis the fringe. I hi' valuation problem can also lead to a violation ot vertical equity, for example, bv a nontaxed fringe given only to senior, highly paid employees. z* Ali i & Aunoi n. (titpra note 22. at 17.1 The Trench s\ stem is similar. 3 IBDT. Asia-Pacific Taxation: China, http:/ .'ww vv.ibid.org/ portal/Product tiap.html. '• FRANCES! (i TESAURO, Isi m/lOM in mm nu i mm iario. Pari i SPECIAL! 67 (Utei 20081. H hat the author underlines ,i- fringe benefits are generally taxed in Italy lor two main reasons- anti-avoid.uue purposes and efficiencv (improve the productivity of emplo\ ees or l>> develop I .nth hi I employees! At it Ac Ahnoi r>. supra note 22, at 172-74, lre.is. Keg. 1.61-21; 1.1"2-1-S: see KBS p •'" Roth administrative and compliance costs would be lower. 26 / GLOBA1 PERSPECTIVES ON INCOME TAXATION LAW Possible solutions to the fairness issues include the U.S. method ot limiting the exclusion lor highly paid employees.-" The French system uses certain coefficients to value the benefit included, depending on the employee's income level. Thus, it a certain fringe benefit is given to both low-income and high-income taxpayers, the low-income taxpayer will include less in her income than her high-paid Counterpart. The fact that most countries generally include noncash benefits in income provokes the following intriguing comparative questions; What are the exceptions? I low broad is the exclusion? And specifically, what kind of benefits escapes taxation? Are fringes ol different character excluded in different countries? A few examples are worth mentioning. A ma|oi fringe in some countries is health-care expenses or insurance paid by the employer. In the United Stales, these are excluded or deferred to a certain extent by the employee and immediately deductible to the employer '" However, in other countries with developed health-care systems, such as Sweden, this fringe is included in income (or not included but also not deductible to the employer). Ibis contrast is understandable given the different background conditions (weak health care outside theemplov ment context in the United States, strong in Sweden! and pro* ides .1 striking example as to how different political contexts (private versus state-supported health care) create variations in tax rules. Such differences can provide us with a methodological rallying point from which to launch a comparative discussion. A functional approach would start by questioning what the social function is, which the above-discussed laws are intended to fulfill. Presumably, the theoretical discussion would go that countries wish to maintain the health of their citizens. From a comparative perspective, such research would fry to evaluate whether the best way lo achieve this goal is to give lax preferences or to grant free state-sponsored health care. On the other hand, the cultural perspective would not address it as a question of functional efficiency but rather as a question ol cultural societal difference. It would try lo identity the societal values that have grown slate-sponsored health-care systems in one place and health-related tax subsidies in another. It may well be, according to such an approach, that both solutions are right, each in its localized context. Finally, a critical approach would try to expose which political or sectorial interests are advanced by each approach and to explain how other interests are *" Sir Code $ 132(jl. Code § 106(a), $ 162(a). ; Auli & Akmii i), mij'mi nolo 22. at 172. Taxable Income marginalized in the process, Namelv. who are the beneficiaries of each -v -tern, and how did thev affect the creation of such systems? I-"or exam-pie. who would be on the 'receiving side" of a privately held health care svstem, and what arguments does such a party make when reforms are considered? Another context-dependent example invokes certain working conditions related to fringes. It is plausible to argue that a tax system reflect-different cultural and social values by the benefits it chooses to exclude. For example, one mav compare the benefits excluded bv Code §132 in the United States to the benefits excluded in other countries. In Germany, social policv dictates that cash payments for birth of a child, extra pay lor overtime work on holida) s, and "happy work force" payments are all excluded, while in Japan, length of service gifts are excluded.'- No similar excluded fringes can be found in the United States. In China, wages and salaries do not include allowances and subsidies paid by employers in accordance with state regulations. III. IMPUTED INCOME FROM OWNER-OCCUPIED HOUSING We must start bv tackling the very basic definition of income imputation, since such concept is almost completely neglected in the U.S. Code Imputed income is income that a taxpayer derives from providing goods or services to herself. For example, when a person lives in her own house, she is providing the value of housing to herself, and at the same time saving the amount -he would otherwise have to pay as rent. When she tends her own garden, she earns as imputed income what she would otherwise have to pay a gardener. Under the Haig/Simons definition of income, imputed income should be taxed, since it clearly represents a wealth accretion. Nevertheless, most countries do not tax most forms of imputed income, primarily because to do so would be both administratively difficult (because ot valuation issues) and politically unpopular/' However, in many countries, there has been some attempt to tax imputed income because omitting it altogether would create a harsh distinction between, tor example, homeowners and renters, '•' Ai 1.1 & Arnold, supra note 22. at i ~i " Administrative difficulty is. in essence,a functional argument, while political impropriety i> a cultural-comparative our. 2S CI OIIAL I'llNl'lc TIYl'sON l\l U\ll fAXATION LAW (The United States, Canada, Brazil, and China never seriously considered taxing the imputed in< onus ol owner-occupied homes. A simple example can i larifv the consequences ot not taxing imputed income: Assume A and B both have IflOk of after-tax money. A buys a house for I0(lk and then lives there At the end oi the year, A sells the house to a third party tor 103k. B invests the l(K)k in Bonds which pay 8k a \ ear hut also rents a practically identical house to A's house tor ?k a year. Both earn 30k a vear. At the end of year 1: A if raxed investment yields: 3 (house S(interest) appreciation) Xnnt.ivi'il imputation: 5 (tenl saved) 0 Salary earned: silk 50k taxable Income: 53k s8k Nondeductible rent paid: (?) Clearly B is taxed more heavily than A, even though—from a pure financial perspective—they are in the same situation. In other words, refraining from taxing A's imputed income clearly creates an unbalance in horizontal equity. This scenario represents a policy choice to encourage home ownership over residential leasing. Two straightforward solutions to bring A and 13 to equality would be to either (I) include as income the imputed rent saved by A. comparing his income to B's 58, or (2i deduct the rent paid by B, thus comparing his taxable income to A's 33. The first would simply rebalance the equi-lies while the latter would represent a shift in policy choices toward inducing residential leasing rather than ownership. I heie are various reasons why imputed income from owner-occupied housing is not taxed in the L niled States. Valuation difficulties—ISince in man) countries, houses are being valued tor other purposes such as property and estate taxes.M one may think that valuation difficulty is not a sufficient reason to exclude imputed income Irom tax. However, many countries have taxed imputation in the past but abandoned it at least partially due to administrative reasons. For example, in 1987, Germany tried and abandoned a tax on the imputed value of homes, finding that rental valuation was seldom accurate and often undervalued. Since interest and maintenance costs were deductible against imputed rent, losses were generated It is certainly arguable that Irom a financial perspective, the verv lew ol property taxes is a crude form ei imputation. Taxable Income bv taxpayers, which were used td offset other income. ' Australia and France abandoned a tax on the imputed value of homes for similar reasons. Similarly, Israel abolished the taxation ol imputed income from home ownership in 1963. So it seems that valuation plays at least a partial role in the justification for nontaxation of imputed income, but given the ubiquity of valuing housing, it cannot be a complete explanation. Political fetid historical) consideration—Given the fact that valuation difficulties alone do not justifv nontaxation. other simple explanations come to mind: imputed income was never taxed, so whj tax it now? Indeed, one could easily imagine the political outcry which would arise if imputed income taxation were presented suddenl) in Canada or the United States. But this is not a good tax policy argument. freedom of choice—Another justification is that B could simplv buy a house, just as A did; it B did not have the money to purchase a house, he could borrow it and be in the same position, given the deductibUit) of mortgage interests. However, again, this rationale is not tax related. Even it fairness is not a problem under this argument, we mav encourage investment in housing. Under such circumstances, where it can be plausibly argued that there is no good justification from a pure tax perspective for nontaxation of imputed income, it is not surprising that other countries have found various ways to tax imputed income from owner-occupied houses. I his thus diminishes, at least to a certain extent, the negative results in the example described above. As we shall see, the solutions were partly affected bv policy considerations. Methods of taxation of imputed income include the direct taxation and the indirect taxation of imputed income. Direct taxation of imputed income—In many European countries, tax is levied on the ownership of residential homes. In Italy, "reddito foiul'nvio," the imputed income from the ownership ol land and buildings, is taxable. \\ ith an exception for the first residential house, according to Art. 2o, Presidential Law Degree n. l<17/lt>.S6 (" /ttatc Guide—Belgium, available at http://www.deUiitte.iem,' dll • artivlr/iUWC Md,'..253D3214°.C52(K-ui,-..2S3rjlll4Klfs(tHl.html. r At 11 & Arnold, supra note 22. at 1*2. Taxable Income / 31 income is taxed, the valuation of imputed rent is set at deliberately low values and may be offset by mortgage interest, thus generating a loss which may be used to shelter other income. Going back to our example, let's assume now that A and B both borrowed 100k, at an annual interest of 5 percent. A used his proceeds to buy his house, and B used it to invest in a bond. Also assume the notional (low) imputed rent is only 2,5 percent. Under the Dutch system, the results are as follows: _____A_B_ Taxed investment yields: 3 (house appreciation) 8 (interest) Taxed imputation: 2.5 (notional income) 0 None deductible rent paid: 0 (51 Deductible mortgage interest: 5 0 Salary earned. 5pk 50k Taxable income: 50.5k 58k Thus, the Dutch system is heavily aimed at inducing borrowing for home purchase. Indirect taxation of imputed income—In japan, the general rule is that home owning imputation is not taxed However. Japan's unique system of depreciation gives an economic effect as if it does. Home owners must adjust the basis in their homes as if they took depreciation deductions, but, actually, they are not allowed to utilize any of the deduction on a yearly basis. It cannot be used to shield income from other sources. The sole purpose of the deductions is to decrease the basis in the house. The effect is that the value of imputation is taxed but deferred until disposition, doing back to our example, let's assume that A deducted 5k ot the adjusted basis of the house. ■\ It Taxed investment S (3k house appnx iation + 5k deduction 8 (interest) yields: rev ,ipturv) Mon taxed 5 (rent saved) 0 imputation: Nondeductible rent 0 (5) paid. Salary earned: 50k 50k taxable income: 58k "sk J2 GLOBAL PERSPECTIVES ON INCOME TAXATION LAM Although at a first glance the- system might look. tan. consider what happens it A (as expected) does not sell his house alter one vvar hut rather alter five years. So, at the end of year 5: \ B Taxed investment yields: 4! (I6kw house appreciation 8 (interest) > 2^k deduction) Nontaxed imputation: Vent saved) I) Nondeductible rent paid: 0 i?) Salary earned: 50k ^'k Taxable income: "Ik ;sk I lus form oi concentrating the entire taxation at once creates a "lock-in effect" that makes people less inclined to move. This is a particular policy choice for which compatibles are hard to find. In summary, there seem to be no good tax policy reasons behind the U.S. approach ol ignoring imputed income from housing, and there are various waysol actualh taxing such income. It is obvious that the choice not to tax imputed income is not tax driven and that the tax system is being used to .ulvance (as in many Other cases* nontax goals. Nevertheless, it seems unlikely that the United States tax system will change in Ibis regard, given the likeh political outcry Even tin: mortgage interest deduction, which is less defensible, has survived reform efforts. IV. WINDFALLS Under U.S. tax law. Windfalls (e.g., a $20 bill found on the street) are taxable income under the genera] concept of accretion of wealth and taxing all income "from w hatever source derived." Similarly under Brazilian law, taxable income also includes any increase in the taxpayer's net wealth that is not a product ol labor or capital, or a combination of (he two. I hese solutions are compatible with the accretion concept of income. However, from a comparative perspective, this straightforward treatment (adopted by both the United States and Brazil) of windfalls is quite unique. In most other systems, windfalls are excluded from income. Ibis is understandable for schcdular systems since Windfalls tj ptcall) tall but-side the schedules. But windfalls tend to be excluded even in global tax systems that define taxable income as any item of income with a source. In fact, windfalls do not have a "source."* Taking into account ' pereeni appreciation a year " This is similar to the U.S. treatment before Clrii.-hii.v iiM.« Taxable inc. In Canada, Australia, and tin- United Kingdom, common law o tries that historically began as schedular tax systems, personal windfall'- are not included in taxable income. The justification tor such exclusion is based on the notion that it economic gain is to he defined as "income.'' it must have a "source": Over Forty vears after C IJenshow Glass, the supreme (. ourt oi t_.tn.ida has recently confirmed in a number of i ases that accretions to wealth such as windfalls that lack a source do not have I he character of income for tax purposes. Indeed, the concept oi income adopted bv the US, Supreme Court in Glenshaw Glass explains the different organization oi material found in basic Canadian tax texts compared to Iheh American counterparts. In Canada we are familiar with text-, and casebooks that div idc fhe discussion ol income into the trait it ie.ua I sources of employment, property; business, and capil.il gains; basil Amen, an texts are much more likelv to discuss tin- characteristics ol a global concept of gross income and then discuss separately deductions and the recognition ol cains and losses 1,1 Indeed, Canadian cases such as Queen vs Cntiiswick (-11' VR. 296) employ a strict approach, according to which "income from a source will be that which is typically earned by it or which typically Bows from it as the expected return." Obviously, windfalls do not typically produce income nor expected return 41 It is likelv that this quest tor source reflects the fact thai the systems derived from the United Kingdom were originally schedular systems, in which each schedule represented a different source ot income I hie-, although schedular and global systems have converged in manv aspects, and previously, schedular countries have adopted global regimes, the origins of each system can still be perceived in the treatment of items such as windfalls. w Kim Brooks, Book Review: Tin Stories: At) InrDepth Uvknt Ten Leading Federal Income Tax Cases I'md L. Cannt. Li. \ew York: Foundation Press, 2fX)3, 2s Queen L. I. 703 (20031. ' In the CanKU'bCk case, the respondent o\\ nect shares in a Canadian corporation, which the majority of its -.hares were owned bv a L.S. company, Pursuant to a plan of acquisition ot the Canadian corporation by a third party, and in order to please dissenting shareholders c if the Canadian corporation I including the plaintiff), the I .S. parent company offered to bio the shares ol the Canadian corporation or, as an alternative, to pay the minority shareholders >t 11 per share. I he plaintiff elected to keep his shares and received S2.I44 from the L S. cotnpam 1 he issue was w hether this amount was income m the respondent's hands. I he Federal Court oi Appeal held that it wasn't, that since the payment "was ol an unusual and unexpected kind one could not sot OUf to earn as income from shares, and it was from a source to which the respondent had no reason to look for income from his shares tn the I nited States, such a pav men! would clearly be income. 34 / CI OHM I'i KM'I CI IVES ON INCOME TAXATION I \U Another interesting example with this respect is the Israeli system. Even though windfalls are generally excludable under Israeli law. the Income Tax Ordinance particularly addresses so-called "random business income" and presi ribes that it is taxable it it is of "the nature of trade." Israeli courts have struggled quite a bit over the years to define "the nature of trade," but it is quite clear that income such as the one described in the Canadian QtTftSWick case WOtddhave bevn taxable in Israel. Israeli courts developed a series ol characteristics that when present, will tend to cause the windfalls to be includable. Generally. an\ income that is derived from the investment of either human or monetary capital, made with the anticipation of making profits While taking risk thai is economic in nature, will be taxable. Thus, compensation paid lot a plaintiff, for example, as a result of a successful class action, was ruled lo bo includable in income.4' Since in Gmis-tcick, the taxpayer derived the income as a result of equity investment in a corporation, she would have been taxable in Israel. In Israel, probably, only literal windfalls (such as money found on the street), which had almost no chance of reoccurring, may escape taxation. The idea stemming from this comparison is that even in systems in which windfalls are not taxed, there may be a spectrum ot opinions as to what exactly "windfalls" are from an income taxation perspective. As noted above, in a scheduler system, one must point to a specific schedule in which windfall is included, in order to make if income. Attaching a windfall to an identifiable "schedule" is indeed a task tor the creative and inspired. The result is that in most scheduler systems, windfalls aren't taxed unless they can be classified under a specific schedule (The Netherlands I. or if the windfall was derived in a business setting (Germany) such .is money found in the business premises, or if the windfalls are listed in the other income category (Italy).1' One unique schedular system that found a way to tax windfalls is the Japanese S) stem, in which windfall income is taxed under the schedule of "occasional income." such a broad residual category moves the Japanese sv stem further toward a global regime, since almost any non-scheduled item can fall into the residual schedule. This phenomenon ind icates that some degree of convergence can indeed be found between global and schedular regimes. V. DAMAGE AWARDS4"1 This subchapter addresses two basic issues: (1) taxation of damage awards lor personal injury, which presents the general issue ot i: ITA tli»/'04 Keren HWra i>. Oan District Assessment Offkei (I'M. 11 /19/2006). 41 For instance, lottery wins are listed and therefore taxable, while money found in the street is not listed and therefore is mil taxable. u Set' generally The Web Guide Book fob I'krsonal Initio Compinsauon in taxable Income / 35 distinguishing true compensation from taxable income; and (2) the "damage awards" that receive favorable treatment—only compensation for physical injuries or also nonphvsical injuries. A. Taxation of damage awards The general question of taxation ot damage awards revolves around two issues: (] t the general treatment tit damage awards (are damage awards includable?) and (2) the case of deferred damage compensation. 1. The treatment of damage awards Under U.S. Code § liM and the U.S. case law. compensatory damage awards are excluded from income, whilepunitive damages are included. Arguable, from a pure tax perspective, the policy embedded in Code § 1(14 seems to be incorrect. Code § 104 excludes nil (nonpunitive) damage awards (we will deal with the definition of damage awards later). Such a broad exclusion is not compatible with basic income tax principles. Namely, such awards usually represent, at least in part, compensation for lost income that otherwise would have been taxable. One might argue that at least the portion of the award attributable to "otherwise earned income" should be taxed. On the other hand, social v allies may support the current policy.'" Similarly, under Brazilian law. the following payments related to damage awards are exempt from income tax* : compensation tor injury, disability, or death or an asset damaged or destroyed as a result of an accident, until the limit ol judicial condemnation, except for payment of continuing obligation in relation to the accident; and compensation lot-accidents at work. I he following are also not taxable: compensation for repairing damaged property due to termination of contract, payments madetocivil servants asan incentive toadhere to voluntary employ ment termination programs/" compensation paid and the notice for dismissal I iRon, published by the I'.m-F.uh'i'i.in Organization of Personal Injury hiuyers. and available on its Web site at http. ■ / www.peopit.com/ pdl WobCuidehookl.pdf?iik,i7S-.,il|-,,..2;nctiiame -I'crsnn.il 11 lerei natter: till Guide ] An extended hard-cover v ersion ot Tin Gi idi was also published as by Kluwer Publishing under the title l'i rsonai Injur) Compensation in Ll ROI'l- A t OXII' VRAI IV I til. 11)1 r>.< Ci IMI'I XS VI ION TW/Vltl r IN I I ROI'I AN Countries ro Victowsof Accidents (M. Bona & P. Mead eds., 2003). 4" Tor a comprehensive discussion on lax polio considerations with respect to damage swards see Douglas A, Kahn. Compensatory and Punitive Damages tor A Por-oiia! bvum 1« /a.v V> \ot 7e fin % 2 Fi.a. Tax Klv. 127 iIWi Art. 39(DC) Brazilian Income Tax I aw htips ■ www.planalto.gOV.br ccivil j (3 / decreto / U.wo.htm. 1 Although the law states that only payments made by state-owned companies to its employers are tax exempt, the courts has extended tha: right to employees that adhere to employment termination programs carried i.LOBAI PURSI'I VT1YI SON INCOME IA NATION I AW or termination of employment contract and compensation received tor settlement of loss or theft on insured goods. On the other hand, in several tax systems, the portion of the award representing loss of income is taxed as ordinary income for example, according to the Italian system, damage awards are taxable to the extent that they compensate for the loss ol taxable income and are included in the same category of income that they compensate for. On the other hand, damage awards that compensate patrimonial losses [datnnus emergens) are not taxable.*s Belgium ha- adopted a similar approach: "Under Belgian law . . | lhe| part ol the personal injury award which replaces am loss of income is taxed. Generally, loss of future earnings is calculated on the basis of net wages . . . Personal injury awards tor pecuniary losses are taxed in the same manner as the income they replace."'" Israel lakes also a similar approach. 1 he Supreme Court clearly stated thai damage awards are only taxable as long as they compensate for the loss ot otherwise taxable income"' (note that any excess compensation may still be taxed, as we have seen, as income with the nature of trade). The Dutch system is somewhere in between a total exemption ot damage awards and the taxation of all awards replacing lost earnings. "When calculating loss of earnings, the starting point is the net income ot the victim, after deduction of tax, social insurance and pension contributions. Where the net loss is known, the influence of taxation is minimal.""1 Consider the following example: A was injured and was awarded damages bv a court order. Due to his injuries, he was absent from work tor a month, a period in which he would have earned 10,1)00 Euros, I lis tax rate is 50 percent, which would have led him with ^000 Euros net income for that month. Assume A receiv ed S20,000 in damage awards— how much lit any) is taxable under the U.S., Italian, Belgian and the Dutch system-? In the United States, under § 1114, the entile amount is excludable. Under the Italian and Belgian sv stems, $10,000 is includable since it represents lost income. Under the Dutch sy stem, only S5U0U. the net loss alter tax, is taxable. The idea behind the Dutch system is Companies, The rationale is that the employee is giving up Ins right and, therefore, 'he payment is not an accession to Wealth (or income lor that niatter), but a simple reimbursement of the employee's net worth. '■ Article6,paragraph 2, I'Ullv 1 Tin Gum , s.'i/'rrt rtpte 44, at p. IV v CA t71 /67 The Assessment Office* ol Large Businesses v Gordon 21 I'.D. 18611%7). 1 Tni: ca iui . wpra note 44, at p.74. Taxable Income SB still to tax awards given in lieu of lost earnings, but in a favorable W ay. reflecting the t\ pe of social values underlying the U.S. approach 2. The issue of deferred damage compensation An interesting issue, which mav exemplify' the difference between dit-terent tax svstems, arises in cases where damages are paid in the form of an annuity. Periodic payments resemble periodic income and thus are more "suspect" of being "pure" income rather than damage restoration. § 104(a)(2) of the U.S. I.R.C actually induces periodic payments by excluding the entire periodic amount (even though such pay ments mav include an interest component). Thus, a periodic payment may be even more favorable lor the taxpayer than a single payment. In Germany, however, the concept of taxing damages replacing lost income extends to deterred payments as w oil. but the application ol the lax is narrower. Under the German tax system "annuities for damages will only be subject to income tax where they are paid as compensation for other taxable income." The German system further provides that "Annuities Covering additional expenditure .. . are therefore not taxable pursuant to 22 (1) Income Tax Act (I'StC) as annuities or other recurrent pay nienls although from their outer appearance they are recurrent benefits____| I'|hese principles will also apply to payments lor pain and suffering. . . . The French sy stem goes beyond the German one to include any periodic payments for damage awards in income, as such payments reflect a periodic concept of income." Indeed, it can be argued that periodic payments for damage are less likely "recovery of human capital," because if the payment is aimed at making a person "whole" again, one should expect that an injured person would prefer to be "whole" as soon as possible and not defer his recovery, In Brazil, as mentioned above compensation for injury, disability, or death, or an asset damaged or destroyed as a result of an accident (until the limit of judicial condemnation), is not taxable except for payment of continuing obligation in relation to the accident B. Which "damages' receive favorable treatment?physical? mental? reputation? Section 104 of the US. Code specifically states that only awards for physical damages are excluded I rom income. I his is a result of a change made bv Congress in llH>7 (previously, all nonpunitivo damages -' Tun GUIDE, supra note 44. at p.44.. emphasis added. ;A Atii-t & Arnold, supra note 22, at 192. Vi . CLONAL. PEKSPEC I IVEs ON INCOME TAXATION I AW wen* excluded). The issue was discussed in the much publicized Mttrphu cose. In Murphy, a three-judge panel of the U.S. Court of Appeals for the IXT circuit held that including damages tor nonphysical injuries in income was unconstitutional because such damages w ere not "income" under the Sixteenth Amendment. The result in Murphy launched an intense debate over the question, with most academic commentators sharpl) criticizing the outcome of the case. This eventually led the DC Circuit Court, sitting en banc, to reverse the decision. ' Indeed, other systems (e.g., Belgium) allow tor the exclusion ot damages tor nonphysical injuries. It can be argued that the U.S. system is generous on one hand (excluding, even damages paid m lieu of lost income) and tight on the other hand (excluding only physical damages awards). Other systems balance it the other way: wide definitions fur excludable damages (including damages for mental injuries) but a narrower scope of exclusion (only "punitive" damages excludable). In general, the European approach (including damages in lieu of income and excluding nonphysical nonincome damages) seems more accurate from both tax and tort perspectives. The U.S. approach, as expressed in Murphy, is a distortion of tort principles, which in turn is a result of a prior distortion of tax principles. Two wrongs mav offset each other a bit and give us a better result in the aggregate, but it does not make it right from a pure tax policy' perspective (and gives us a wrong result in individual cases). VI. CANCELLATION OF INDEBTEDNESS The discussion on income resulting from cancellation of indebtedness revolves around two focal points: whether discharge ot indebtedness constitutes taxable income, and, provided that the answer is positive, what exceptions, if any, should be allowed in special cases (such as bankruptcy and insolvency). A. Inclusion of debt relief in gross income When a taxpayer borrows, the loan proceeds are not treated as income because of the offsetting obligation to repay the debt. II the debt is cancelled, the offsetting obligation no longer exists, and the taxpayer sec, e$ . Kt'ssi.u E. Rumom). Income. Taxes Ami Tlte Constitution: Wiry The D.C. Circuit Conn Of Appeals Cot It Right In Murphy, 12 Fokdmam j. Corp. & Pin. I . s,s7 i2iXI7i; Elisabeth A. Rose, Murphy'a \h: Here 7 Iw Circuit Court Should Analyze Section, 104 Uiv\ Ri 111 60 Tax Law. 533 (2007); But sivCjRh.oio I Gkkmain. Taxing Emotional Injury Recoveries: A Critical Analysis Of Murpliy v. Interna! Revenue Service. tiO Ark. I.. Rtv. 185 (2007;. taxable Income realizes a not accretion to wealth. As stated by the U.S. Supreme t ourt in Kirlm Lumber." the result is realization of taxable income (see C ode §61(a)(12|). However, as simple as the principle mav seem, the mentioned tax problem is approached verv differently by global and schedular income tax jurisdictions. Most countries defining income based on the global model consider cancellation of indebtedness taxable income (similar to any other accretion of wealth), unless a specific exception applies. Most countries defining taxable income based on the schedular model consider cancellation of indebtedness taxable income only if it is specifically included in a taxable schedule/" Very broadly, it has been observed, with some exceptions, that in schedular systems, income from the cancellation of indebtedness is taxable Only it the debt is related to the production of business income. On the contrary, cancellation of personal indebtedness (which is indebtedness unrelated to the production of business income) does not constitute taxable income. The principle behind this tax solution is similar to the principle guiding the tax treatment of windfalls. Since the1 taxpayer expectation at the time the loan is made is to repay the debt, debt relief can be seen as an unexpected "windfall." As long as this sort of windfall cannot be attributed to a specific schedule, it remains untaxed. Although a relatively bright line can be drawn between schedular and global systems in this context, then' are some exceptions. Notably, the tax systems of commonwealth countries [Australia, United Kingdom, and Canada) treat forgiveness of indebtedness along the same lines of the distinction between capital and ordinary gains. Cancellation of debt in the context ot business income. Mich as accounts payable, will always be treated as ordinary business income. However, in the capital gains context, the cancellation is applied to reduce tax attributes (such as capital losses, carry-over basis, credits, etc I. 1-or example, in the United Kingdom, cancellation of indebtedness is taxed onh in very specific cases, such as when the debtor and the borrower are related parties An\ other reliel is not taxable, but it reduces tax attributes of the taxpayer. Even it the relief is in excess of the tax attributes, there is no taxable income." In Canada, only half of the relief is included in taxable income. This approach does not treat debt relict on investments as a realization event but also takes the necessary measures to prevent debt reliel from 55 United States v. Kirbv Lumber Co., 2«4 US I (1931). ** Alli It Arnold, supranote 22,at Is:1' "'■ At Lt & ARNOLD, Sttpra note 22. at 190. 40 GLOBAL PERSPECTIVES ON INCOME TAXATION LAW becoming a tax-evasion strategy (bv deferring the tax to when the assets u hose basis was reduced are sold). B. Exceptions to inclusion Even though cancellation of indebtedness is taxed m mosl countries as a general rule, both schedular and global systems adopt exceptions when the taxpayer i- bankrupt or insolvent. This is a good example ot tax police convergence. In the United States, Code. =5 108 provides lor attribute reductions in cases oi bankruptcy or insolvency; similar to the treatment generally granted (?) the United Kingdom outside ol the bankruptcy context. Indeed, most countries give some sort ol retiei to taxpayers in financial duress. Even it the extent ot this relief mav vary, generally the nontax-alum ot this debt reliel is accompanied bv a reduction of tax attributes The rationale tor such easement is quite straightforward: if a taxpayer is unable to settle a debt due to financial hardship, he or she will not be able to pay the tax on any income derived from relict Irom the debt. If the aim of any relief Irom debt is to alloyy the borrower to "start Oyer" and be financially rehabilitated, the rationale is thai the tax system should not impede such attempts. However, a remarkable exception is offered by the French system, under which am cancellation ot business indebtedness is included in gross income, even il the taxpayer is insolvent.5* It may well be argued that such an approach may hamper any attempt to recover a distressed business, but it may also serve as a powerful anti-avoidance tool, VII. GIFTS AND BEQUESTS I he treatment ot gilts and inherit,mces, as we shall see, are places where redistributiye ideologies and taxes are mlertyy mod. Political ideologies and political cultures greatly affect taxes on gilts and bequests. The key tax issue involving gilts and bequests is who (il anyone) bears the tax appreciation ot the gilt or deducts the loss il gift is depreciated relatively to the donor's basis I here are at least three approaches to taxing gifts and bequests from an income tax perspective"": (11 no inclusion lor the transleree and no deduction lor the transferor. i2l inclusion for the transferee and Ami & Auxoi ii. iupra note 22, at IW. \i l t & AKNOLD. -lifni note 22, at IS3. We ignore estate taxes for this purpose, although they are ob\ inuslv relevant from a broader social perspective. deduction for the transferor (there is also the possibility here to treat the gift as a simple realization event in which the transferor would have to include any appreciation of the gift in his hands). (3) am combination >1 the first two that would not stand in line with pun* fay theory but •vould encourage other ends or he more administratively feasible. As in most systems, we shall deal separately with personal gifts and commercial gifts, since the issues raised in each are different, 4. Personal gifts and bequests In the U.S., under Code =5 102 and tj 1015, gifts are not deductible and are excluded from income. Thus, gift appreciation is carried over and taxed to the donee, but losses are not carried over under Code ^ 1013. in the case of bequests, Code •$ 1014 provides for ,i stepped-up basis, and therefore the appreciation is not taxed to either transferor oi transferee. Some countries adopted systems similar to the U.S, one. For example, in Brazil, gifts and inheritances received by resident individuals are exempt from income tax."' However, it should be noted that in a schedular system, the issue is raised a bit differently.*' The issue of income inclusion would arise only if the receipt falls within a particular schedule. Thus, in The Netherlands, foi example, the carryov ef of tax attributes of the gift happens only il such a transaction would have been taxable had it not been a gift. Otherwise, this issue is simply ignored. The U.S. system of no inclusion/no deduction can be justified bv the argument that the appreciation will ultimate!) be taxed. I he U.S. approach prevents the possibility of income shifting through "loss gifts" and does not create negative incentives lor "real" gifts made out of pure affection I he Code § 1014 rule is based on the argument that it makes it administratively easv to determine basis, rather than looking for historic basis of the deceased. This is a "mixed" system, since appreciation would always be taxed while losses mav be unusable for fax purposes. It is also inconsistent with Haig/Simons (which would include gifts and bequests in income). "" 1BDF. Latin-American Taxation; Uraztl httpi ' ip-online .ibid org/la/and Art 39 (XV). qI Brazilian Tax law. Regulations. Nevertheless, in order not to be subject to income tax. the beneficiary of ihe or inheritance must keep the historical value thai the jjoods or rights inherited/donated had in Ihe hand oi the donor 'deceased. It the beneficiary chooses to valuate the Roods or rights received at market v aluo. she will lie subject to capital gains tax at the amount oi the positive difference between the two amounts. w Ault & Akxoi p. supra note 22. al 183; 42 / CLOHAI PERSPECTIVES ON INCOME TAXATION LAW The U.S. solution ho> also some disadvantages: the case ol gift* wises administrative difficulties in determining the basis ol the donor in a gift (il il has been a long time since the gift was transferred until the date ot disposition by the transferee). Most obvioush. it defers the tax by not treating the gilt as realization, and in the case of bequests, it provides for exemption. Thus, other systems adopted methods under which gifts, inheritance, or both are taxed. In this respect, countries choose different paths. In most commonwealth countries, gilts are treated as simple realization events. The tax burden, therefore, is laid at the doorstep of the donor. In Australia, tor example, anv inlet VIVOS gill is treated as a realization event. The donor is taken to have received the tair market value (FMV) ol the gift and pavs tax on the excess ol the FMV over the basis."- Hence, no appreciation avoids taxation. As a corollary, the donee is attributed with a FM\ basis in the gift. The same method is implemented in the United Kingdom' ' and in Canada."' Inter vivos gilts are treated, albeit with some exceptions,"" as realization events, The rules are different for bequests. In Australia."' anv capital gains or losses resulted Irom a transfer of property at death are general!) ignored if the assets are transferred to a "beneficiary," which, according to Australian law, is "a person entitled to assets of a deceased estate. [This person] can be named as a beneficiary in a will or can be entitled to the assets as a result of the laws of intestacy (when a person dies without having made a will'."'1* Due to multiple legislative reforms, the calculation ot basis in the hands of the recipient is complex, but the general rule is that the basis carries ov er. So, unlike the United States, no appreciation can avoid tax (even though it may well be deferred, in case of bequests, tor a long time). In Canada, however, transfers at deaths, |us| as inter vivos gilts, are treated as realization e\ ents This is probablv more "tax accurate," and the least favorable for wealthy families, and can also be understood as a means for redistribution of wealth achieving a higher lev el of vertical equity. Other countries, particularly civil law countries, burden the recipient rather than the donor. Tor example, in Russia, there is no inheritance or "-' Australian Taxation Office, Ciidi to Capital Gains Tax 2007, 11 (2007). "• IIM Revenue and Customs, camtai gains vianlal. CC,l2l>22, http:// vvww.hmrc.goy.uk/nianiials. GGI manual / CGI 2°22.htm Canada Revenue Agency, tail UNO Incomi Tax, I'll3(1 ) Rev 07. http:' / www.era-firc gc.ca/l /puh/lg,' p! 13/ pi 13-e.html. '" MM Revenue and Customs. 1 ai'I 1 ai 1, vi\s maslai . CG12923, http www.hmrc.gov.uk manuals/CC 1 manual,-CCi 12923 htm •" Australian Taxation Office. GUIDE 10 Capital Cains Tax 2007, M3-ms |20()7). "" Id at "s Taxable Income 41 £ Ft :.ix (provided that such inheritances are nut awards payable to a raver tor inheritance of intellectual property held b\ the deceased such as copyrights'*). However, gifts of immovable property vehicles, tnd shares received from individuals other than close relatives (i.e.. -raise, parent/child, grandparent/grandchild, or sibling) are subject 0 income tax under the general provisions Lifts received from in J i-. iduai entrepreneurs and legal entities are exempt up to RL R 41 MM per jalendar year. The excess is taxed at the general rales of income lav . 3 percent for residents and 30 percent lor nonresidents) Of course, lor schedular income tax systems, this is true onlv ii the transaction falls within a particular schedule. Otherwise, it is exempt This is the case in Italy, where gifts are generally not taxable (for income :.i\ purposes); unless appreciated assets are gifted w ithin a business or trom a business lo a stockholder. In this case, gains are realized and recognized and are part of the business income schedule if certain requirements are met. In Germany, for example, "[T]hegift tax supplements the inheritance Mx. Il is necessary so that inheritance tax for a future right lo inherit cannot be avoided through gifts amongst the living. It therefore corresponds thai gills amongst the living are subjected to the same measures of taxation as acquisition through death."** Unlike the commonwealth countries, the tax is lev led on the heirs. Every inter vivos gift is subject to a gift tax, payable by the recipient. Taxes are assessed based on the FMV of the gift or bequests." net of any liabilities and expenses incurred in connection with the claim for the inheritance or gift. However, recipients are allowed certain exemptions (for example, 307,000 euros if the recipient is the spouse of the donor), and the tax is levied onlv on the excess over the exemptions China offers another example of a schedular system, where taxable items of individual income tax do not include gifts and inherences. In Israel, gift transactions are exempt as long as the gift is made to the state of Israel or to a relative or when the gift is made "with good faith ' with no expectation that the donee will curry lav or in return. In most ol such cases, the basis simple carries over to the donee. §217118) IxTC. German Ministry of Finance. The liix Department, The Tax Information Center, iKiirniiA.xici TavCifi Tax,tmulnblr nf littp: ' 'wvvw.steuerliches-nt'i'cenler.de/en/003_menu Hnks.''ll02_ISl/005_ertui\db/054_S.-henkErbst index.php. The EC's Taxes in Europe Data Base, Germans—C.api i ai Tax— Km ritaxi eami Gin Tvv (updated 2007). in\tiliiblctit http: / /ec.curop.i.eu taxation ..customs, taxinv getco:itents.do?mode :iormal&kw I -gituvku 2 ■ »xrkw3=-&cell=\'ERrn '_DE—+Capital+tax+-+lnheritaniv-and*Rift+ta\. 4» ' CIOP5AI I'FKSI'IX IIVFSON INCOMI rAXATlON LAW Some countries simplv ignore gifts or inheritance lor tax purposes altogether. Sweden abolished both the inheritance and gitt tax in 2D''4 The onlv relevance tor taxation is that basis is being carried over and that recipients step into the shoes ot the donors. Thus, no country follows the U.S. system, which tnaj itself be subject to change as the estate tax is scheduled tor reform. B. Commercial gifts In a commercial setting, the differences between countries' approaches to the taxation ol gilts (tor income tax purposes) are tar less apparent. As a general rule, most countries adopt the inclusion/deduction rule, which make sense because in a business environment, gilts are rarely made out ol affection, with no valuable consideration expected in return, thus, most countries treat commercial gilts a- a taxable transaction but may allow, in the case ol -mall gitls, certain exemption tor the recipients. In the United States, Code «j 274(b) is in line with the above principle. The disallowance ol deductions makes it clear thai one cannot treat a gift as both not included and deductible at the same time. Ibis forces transfers to be either "real gilts' or "real business expenses." As noted above, this policy i- implemented in most countries. It is interesting though, from a cultural perspective, to note what kinds of exemptions/deductions are allowed lor commercial gift- and what exactly constitutes a "gilt" under local law. For example, in the United States, Lode ts 102(c) completely rejects the notion that transfers in .in employment relationship can be a "gitt " In Germany and France, however, gilts are still gills (even between employer and employee) unless it is shown that the "gift" is directly related to a service rendered (and then it is treated as compensation). Compare Code 274(j) in this respect, which precludes deduction lor achievement awards. Most systems provide do minimis rules where -mall gifts are not includable tor the employee un (lie United States, il may be covered bv Code? 132). In The Netherlands oi in Italy, small gifts given to employees on special occasions are exempted I be de minimis amounts gifted to the employees may be even deducted bv the employer, which create- double benefits that can be seen as a policy in fended to encourage better labor relation- ' Canada CAD 500; Germany—EL K 4<>). Swedish lax Agency, 1 am - is Sw i di x II (2i't¥»i. In Israel, the taxation of inheritani es was abolished ev en earlier—in IWi In the United States, C ode % 274(hi allows de minimis deductii ■'■ is I gifts, made to someone Other than employees, it the logo of the donoi is showh on the gift In other words, it is a small subsid) tor puhlu reli tions expenses. \s noted, in Germany anil Canada, the small deduction is allowed onlv it gifts are made to employees. This is a consequence ot the cultural and political differences in the approach to labour relations issues. VIII.THE REALIZATION REQUIREMENT Realization has been described as the "Achilles' heel" ol the income tax. It is no longer considered a constitutional requirement in the United States, anil there ate several accrual- or mark-to-market based aspects of the U.S. tax s\stem (e.g., the treatment of dealers in securities under Code ^ 475 and the elective mark-to-market regime lor publicly traded PRCs under Code 12('bj. Nevertheless, despite many suggestions to the contrary, the L nited States has remained largely a reali/ation-based system. Moreover, compared to other countries, the scope Ol realization events in the United States has been limited to the actual sale or disposition of property, although the "realization trigger' has been lowered under the Supreme Court's decision in Cottage S»t>/Hgsr3 to include various deemed realizations (such as debt modifications). In both common and civil law countries, while the income tax remains a transactional tax and incorporates a realization requirement, the scope of realization events tends to be broader than in the United Stales. For example, gifts arc considered realization events for property in Australia, Canada, anil I he Netherlands. Heath, which in the United States is not a realization event even though it gives rise to a step-up in basis under Code :? In14. i- a realization event in Canada and The Netherlands. Other realization events involve attempts to police the jurisdictional scope ol the income tax Emigration, which involves lor most countries the cessation of personal jurisdiction to tax. is a realization event in Israel, Australia, Canada, and Germany I tor substantial stock holdings). Withdrawal from a business, which involves the end of business .ev el taxation, is a realization event in Canada, France, Germany, Italy, The Netherlands, and Sweden. Notably, the United States has recent!) after main years ol rejecting such proposals) adopted expatriation as a realization event for high net worth individuals (Code S77AI. Nevertheless, despite the different scope of defining realization, it is - reuorthv that mark-to-market—or accrual-based regimes are quite ■ re. For example, it has been argued that it would be relativelv pas) >>' ■ cottage Swings Association \ s Commissioner, 499 US ^5411991). 4.. l ,1 OKAI I'FRM'K I IVF.SON INCOMF TAXATION I AW adopt such a regime ior the stock ot publicly traded corporations because in that case, there are no liquidity or valuation concerns (the stock can easily he sold, and its \ alue is established every day). Such a reform could enable countries to abandon the corporate income tax l#lth its attendant complexities and inefficiencies. But no country we are familiar with has adopted this proposal, despite its congruence with the ITaig/Simons ideal. It may be that political resistance to paying tax on "phantom income" (which may disappear with the next market downturn) is too entrenched. Realization, it seems, is here to stay.