Designing Net Asset-Based Income-Splitting Rules under Dual Income Tax

Consider a model where an all-equity CHC maximizes the present value of the revenue flow to its shareholders net of taxes and issues of new equity, while taking into account both firm-level taxation and individuallevel taxation. The CHC has no access to international equity markets and is therefore dependent on financing provided by domestic investors.

The firm produces using capital as the only input and finances from retained profits and new equity Q. Its operating profit is denoted by π(K) and it spends the accruing resources on dividends D, investment I, and corporate taxes T_f. The firm’s budget constraint is 1π(K)+Q=D+I+Tf

The profit function is strictly concave (π′(K) > 0 and π″(K) < 0). Debt financing is ruled out and all prices are normalized to one in our calculations.⁸ D and Q are both chosen to be non-negative. The lower boundary for Q implies that the CHC cannot distribute profits through repurchases of shares. This constraint is not grounded in current regulations, rather it is an assumption chosen to simplify the analysis. However, the actual practice among Nordic CHCs supports it. Such firms rarely buy back shares. They usually have a small stock of initial equity, collected at the time the firm was set up, and a larger stock of accumulated profits.

Observe that the model contains one single means to remunerate the owner, profit distributions, D, paid out from after-tax profits. This is in contrast with some previous papers on the Nordic DIT, which have carefully modelled the differences in the tax treatment of wages and dividends and allowed the firm to choose the tax-optimal way to remunerate the owner (Lindhe et al., 2002; Hietala and Kari, 2006; Koivisto, 2021). In our model, D can be interpreted to represent the tax-optimal remuneration channel with its personal-level tax rate, defined below, summarizing all relevant tax consequences arising from that choice.

We allow for the firm’s fiscal depreciation to differ from its economic depreciation. The firm’s capital stock, K, depreciates at an exponential rate δ, while the accounting stock of capital, A, depreciates at an exponential rate α (fiscal depreciation), which may differ from δ. The equations of motion for capital and the accounting stock of capital read as follows: 2K.=I−δK 3A.=I−αA

Corporate taxes are paid on profits after fiscal depreciation. By denoting the corporate tax rate by τ_f, the corporate tax reads as follows: 4Tf=τf[π( K)−αA]

We do not rule out the CIT tax liability from being negative, which can be interpreted to imply that a full loss offset is available in one way or another. This assumption departs from practices in most actual tax systems, which commonly allow losses to be carried forward but still falls short of full loss-offset. Hence, our model is quite stylized in this respect.

To model owner-level taxation in a simple form, let us assume that tax is paid on dividends at the rate τ_d and on all other forms of capital income at the proportional effective rate τ_c.⁹ The tax rates generally satisfy τ_d = τ_c ≥ τf.¹⁰ In our model there is another difference between the tax treatment of dividends and other types of capital income. An equity allowance, iA, is deducted from dividend income.¹¹ Here, i is called the imputed rate of return (or normal rate of return) and A is the accounting stock of capital. Thus, the tax on dividends reads as follows:¹² 5TD=τd(D−iA).

We allow the base of the dividend tax to be positive or negative.¹³ Again, this means that full loss offset is provided either by crediting the negative tax liability or, more conveniently, by allowing carry-forward of unutilized allowances with interest. This assumption implies that taxation is symmetric with respect to profits and losses. Observe that while both Sweden and Norway have carry-forward rules in their dividend tax systems, Finland does not allow any unutilized dividend allowances to be carried forward. Hence, our model draws a very stylized picture of the Finnish splitting rules in this respect.

We will return to this topic in the discussion section and deal with several issues such as: Why is symmetric tax treatment of income important for neutrality? How does this aspect tend to affect the design of other aspects of a neutral tax system? And what are the likely implications of the Finnish practice of not allowing carry-forward?

Dividend income net of taxes is hence: 6DNet=D−TD=(1−τd)D+τdiA.

The value of the firm, V, is determined by the following no-arbitrage condition (1−τc)rV=DNet+(1−τg)(V.−Q),

where r is the market rate of interest, which is determined in the world capital markets and its level is therefore given in the domestic economy. τ_g is the accrual-equivalent tax rate on capital gains satisfying τ_g < τ_c, and V. is the rate of change of V with respect to time. The condition requires that in equilibrium the shareholder is indifferent between holding shares or exchanging them for bonds yielding the after-tax return (1–τ_c)r. We can now write the objective of the valuemaximizing firm as follows: 7max{D,Q}V0=∫0∞[ γDNet−Q ]e−ρt dt

where γ=11−τg, and ρ=1−τc1−τgr is the firm’s after-tax discount rate. Hence, the firm maximizes the revenue flow from the firm to the owner net of taxes and new equity issues.

We start the analysis by considering a streamlined version of DIT, where:

• –

  the personal tax rate on capital income is proportional and aligned with the corporate tax rate, τ_c = τ_f

• –

  the excess-return part of dividends is taxed at the proportional rate (τ_d) that equals the common capital and corporate income tax rates, τ_d = τ_c = τ_f = τ

• –

  the normal return part of dividends is calculated using net assets as the asset base, and this income is tax-exempt at the shareholder level

These properties mostly satisfy the characteristic features of the prototype DIT system outlined in Sørensen (1994) and discussed in Appendix 1. The only deviation is that τ_d is proportional instead of being determined by the progressive tax schedule for labor income.¹⁴ In this section we insert this simple tax rate constellation in the previous section’s model and use the approach of the influential article by Boadway and Bruce (1984) to derive the conditions under which this tax system shows neutrality with respect to various decisions of the firm.

There are at least two innovations to be highlighted in the Boadway and Bruce (1984) study. First, they assume that the opportunity cost of investment that they propose is deducted from corporate profit and is calculated based on the value of the assets in the fiscal accounts. Using the asset values after fiscal depreciation reported in financial accounting makes the results applicable to the real world. Another innovative and interesting aspect they show is that with an appropriately chosen imputed rate of return the system satisfies neutrality and also removes the distortions arising from differences between fiscal depreciation and economic depreciation.

One convenient aspect of the analytical approach of Boadway and Bruce (1984), which we utilize in this section, is its simplicity. The conditions for neutrality are obtained by first writing an expression for the value of the firm and then considering under what conditions the expression is reduced to equal the corresponding condition in an environment with no taxation. We show, using the streamlined tax rate constellation defined above, that this approach is pertinent and gives a condition for the size of the imputed rate of return (splitting rate) that realizes the desired neutrality properties.

While this subsection derives the conditions for investment neutrality following the (simple) approach by Boadway and Bruce (1984), the result is extended to more general cases in the next section. Regarding the simple case, our result is captured in Proposition 1.

Proof: see Appendix 2

Hence, under certain conditions concerning the tax rates and the imputed rate of return, the net assetbased splitting system becomes neutral with respect to the firm’s investment decision. In this simple model the system is in fact equivalent to the ACE corporation tax. Therefore, it also exhibits ACE’s well-known property that fiscal depreciation rates have no effect on investment (Boadway and Bruce, 1984, and Devereux and Freeman, 1991).

Observe that in our model ρ depends on tax rates, ρ=1−τc1−τgr, implying that the cost of capital is not entirely independent of tax rates. However, if capital gains were taxed on an accrual basis either generally or in the margin, then τ_g = τ_c => ρ = r. Therefore, the possible non-neutralities are linked to the tax treatment of capital gains, not to corporate taxation or the splitting system. If τ_g = τ_c is achieved using accrual taxation or some other means, the tax system of Proposition 1 can be shown to be neutral also with respect to the choice between new share issues and retained earnings.

In the following sections we will develop the results further and give interpretations for the results.

Above we employed a methodology similar to Boadway and Bruce (1984). Even if this allows us to derive the optimal conditions in a convenient way, it still has its own restrictions, and while the neutrality conditions become more complicated, it is better to use other tools. In what follows we generalize the above result, derive an additional result regarding the effects of fiscal depreciation allowances and provide the intuition and reasoning behind the results. For this we need to augment the model and employ dynamic optimization.

One important aspect of the tax system in the previous section was that the corporate tax rate (τ_f) coincided with the general tax rate on capital income (τ_c). At the same time, the normal return part of dividends was tax-exempt in the hands of the shareholder. These features were also key aspects of the prototype model of DIT defined in Sørensen (1994) and they are still retained by Norway in its DIT application.

The key novelty of the tax system in this section is that the corporate tax rate is allowed to be lower than the capital income tax rate. In more detail and more generally, we study the following setting: τ_d ≥ τ_c ≥ τ_f. In order to be able to maintain the principle of Sørensen’s (1994) prototype model that the normal return part of dividends is taxed effectively at the rate of τ_c, we augment the tax system with a new element: a share s ≥ 0 of normal return on equity is included in the owner’s taxable income. Dividend income net of taxes now becomes: 8DNet=D−[ τcsiA+τd(D−iA) ]=(1−τd)D+(τd−τc s)iA.

To achieve the outcome that normal return is taxed effectively at rate τ_c, s should be chosen as follows: 9τf+(1−τf)sτc=τc⇔s=τc−τf(1−τf)τc.

Observe that when chosen this way s = 0 when τ_c = τ_f and s > 0 when τ_c > τ_f.

In sum, by introducing the parameter s we may have a tax system that satisfies most aspects of the tax rate constellation of the prototype DIT even if τ_f < τ_c.

The Lagrangian for our optimization problem reads as follows: 10L=1−τd1−τgD+τd−τcs1−τgiA−Q+q1[ (1−τf)π(K)+τfα A+Q−D−δK ]+q2[ (1−τf)π(K)+Q−D−(1−τf)αA ]+λ1D+λ2Q

The marginal condition corresponding to equation (A8) for the augmented model can be written as follows (see Appendix 2 for the derivation): 11F′(K)=π′(K)−δ=ρ1−τf[ 1−τfα−δρ+α ]−τd−sτc(1−τf)(1−τd)i[ 1−α−δρ+α ]

where F′(K) is the marginal rate of return after true economic depreciation. The interpretation of the condition goes as follows: The first of the two terms on the right-hand side stands for the effective cost of equity financing, where ρ1−τf is the unit cost of equity, and the bracketed term is the share of marginal investment that is financed with equity. The term τfα−δρ+α reflects the deferral of corporate taxes due to accelerated depreciation and is interpreted as the (average) share of investment financed by deferred taxes. Thus, we may consider that that part of the investment is financed with equity and the rest from deferred taxes. The latter element has a zero unit cost, and therefore does not show up.¹⁵

The second term on the right-hand side is the effect of the equity allowance on the cost of capital. The bracketed term can be rewritten 1−α−δρ+α=ρ+δρ+α. The expression gives the average share of the firm’s capital stock which in effect qualifies for the equity allowance. The higher the rate of fiscal depreciation, α, the smaller the average value qualifying for the allowance and the smaller the value of the allowance. Hence, since the capital base is net assets of the firm, high accelerated depreciation reduces the capital base and therefore reduces the effects of the equity allowance on the incentive to invest.

To move on to considering the neutrality properties of the general model, let us rewrite equation 11 in the following way: 12F′(K)=ρ1−τf−τd−sτc(1−τf)(1−τd)i+[ α−δρ+ατd−sτc(1−τf)(1−τd)i−α−δρ+αρτf1−τf ].

The bracketed term on the right-hand side collects the two terms which reflect the channels through which accelerated fiscal depreciation affects the cost of capital. The latter term within the brackets describes the saving in corporate tax due to accelerated depreciation, and the first term gives the effect of depreciation allowances on the size of the effect of the equity allowance. We observe that the two elements are of opposite signs: accelerated depreciation decreases the cost of capital via corporate income tax but increases it via personal-level taxation of dividends.

Even if we observe complex effects of accelerated depreciation on the cost of capital, with a suitable choice for the normal rate of return, i, we can make the cost of capital independent of accelerated depreciation. Choosing the normal rate of return as follows: 13i=τfτd−sτc(1−τd)ρ,

causes the bracketed term in equation 12 to take the value of zero, and the two first terms to merge into ρ. Hence, the marginal condition for investment becomes: 14F′(K)=ρ,

which is effectively the same as condition (A8), where there was no corporate or dividend taxation at all (τ_d = τ_f = 0), and it is also independent of the accelerated depreciation. Let us formulate our neutrality result as our Proposition 2.

Now let us concentrate on some interesting special cases of the above general model. Table 1 describes three of these cases.¹⁶ These cases relate to the Finnish tax system. The simple case collects some aspects of the original Finnish income-splitting system applied in years 1993–2004.¹⁷ Case 2A refers to a tax reform proposal launched by a tax committee in 2010. Case 3A roughly corresponds to the current Finnish incomesplitting system.

Table 1:

Tax Rates	Parameter s	Optimal Normal Rate of Return
Simple Case: (τd = τc = τf = τ)	s = 0	i = (1–τ)ρ	Finland 1993-2004 (original)
Case 2A: τd = τc>τf	s=τc−τf(1−τf)τc	i = (1–τf)ρ	Ministry of Finance Proposal in 2010
Case 3A: τd>τc>τf	s=τc−τf(1−τf)τc	i=τfτd*(1−τd)ρ;τd*=τd−τc−τf1−τf	Current Finnish System (applied from 2005 on)

The first row of the table describes the simple case with equal tax rates, studied in section 2.2. In this case s = 0. Neutrality is achieved by choosing the normal rate of return to be the after-tax interest rate, i = (1–τ)ρ.

The second row of the table (Case 2A) describes the case where the corporate tax rate is lower than the personal-level tax rate on capital income. It assumes that the lower tax rate at the firm level is compensated by taxing a share of normal dividends distributed to the owner. This share depends on both firm-level and personal-level tax rates: s=τc−τf(1−τf)τc. In this case, the optimal imputed rate of return is i = (1–τ_f)ρ. This case closely corresponds to the reform proposal of a tax committee in Finland (Ministry of Finance, 2010; Eerola and Kari, 2010). The committee proposed keeping the net asset-based splitting method but reforming the prevailing parametrization of the system. It proposed taxing excess dividends as capital income at the standard rate (instead of as labor income), including a compensating share of normal dividends in taxable capital income, and reducing the imputed rate of return to close to the after-corporate-tax interest rate.

The third row of Table 1 (Case 3A) considers the case where excess dividends are taxed at a higher rate than other forms of capital income, τ_d>τ_c. Assume first that the rate is proportional. In this case a neutrality-yielding i is i=τfτd−sτc(1−τd)ρ, where s=τc−τf(1−τf)τc and ρ=1−τc1−τgr.

If the tax rate on excess dividends is progressive, with τ_d representing the marginal tax rate, and if CHC owners are spread across the tax brackets of the tax schedule, the system cannot be made to satisfy the same neutrality properties as the cases above. The cost of capital varies across different owners depending on the marginal tax rate on excess dividends. The current Finnish and Swedish splitting systems tax excess dividends as labor income at progressive rates and therefore face this challenge.

Cases 2A and 3A in Table 1 show how particular choices of nominal rates of return imply neutrality properties of a tax system under the condition that some share of normal dividends distributed to the owner are included in owner-level taxation (s > 0). In Appendix 2 we show that the neutrality properties are also achieved when this share is zero (s = 0). These results show an intriguing relation between the choices of the share of normal distributed dividends included in owner-level taxation (s) and the normal rate of return (i).

Next, we provide calculations for the selected special cases illustrated in Table 1. These calculations use Finnish tax parameters.

According to Tables A1 and A2, the parameter values for the Finnish tax system are τ_f = 20%, τ_c = 30%, τ_d = 0.75 ∗ τ_w = 0.75 ∗ 55% = 41.25% (thus τ_d > τ_c > τ_f). For the calculations we use two different pre-tax interest rates: a risk-free interest rate of r = 4% and a risky interest rate of r = 9.4%.¹⁸ The accrual-equivalent tax rate on capital gains is calculatedby using Devereux–Griffith methodology (which yieldsτ_g = 23.4%).¹⁹

The upper panel of Table 2 provides the firm’s after-tax discount rate (ρ), the parameter s²⁰ and the optimal imputed rate of return for selected special cases with the risk-free interest rate r = 4%. In the simple case, in which all relevant tax rates are equal to the tax rate on capital income (30 %), the discount rate remain sat 3.7% and the normal rate of return is i = 2.6%.

Table 2:

	ρ	s	i	Tax rates	s	Optimal normal rate of return, i	Note
Risk-Free Interest Rate, r = 4 %
Simple Case	0,037	0	0,026	τd = τc = τf = τ	s=0	i = (1–τ)ρ
Case 2A	0,037	0,417	0,029	τd = τc > τf	s>0	i = (1 – τf)ρ
Case 3A	0,037	0,417	0,015	τd > τc > τf	s>0	i=τfτd*(1−τd)ρ	τd*=τd−τc−τf(1−τf)
Risky Interest Rate, r = 9.4 %
Simple Case	0,080	0	0,056	τd = τc = τf = τ	s=0	i = (1 – τ)ρ
Case 2A	0,080	0,417	0,064	τd = τc > τf	s>0	i = (1 – τf)ρ
Case 3A	0,080	0,417	0,033	τd > τc > τf	s>0	i=τfτd*(1−τd)ρ	τd*=τd−τc−τf(1−τf)

In Case 2A the tax rate on excess dividend (τ_d)is aligned with the tax rate on capital income (τ_d = τ_c = 30%), but the corporate tax rate differs from these two (τ_f = 20%). Following this change the optimal imputed rate of return becomes slightly larger than in the simple case. Also, the parameter s becomes non-zero (s=τc−τf(1−τf)τc=0.417).

Case 3A roughly corresponds to the current Finnish practice. Excess dividends are taxed at rates higher than the tax rate on capital income. The calculations in Table 2 assume that the owner’s MTR on earned income corresponds to the top rate of the progressive tax schedule, in which case the marginal tax rate on excess dividends is 41.25%. For this tax-rate structure the optimal imputed rate of return is 1.5%, much lower than in the two cases discussed above. Hence, the optimal level of the imputed rate of return is quite sensitive to the MTR of excess dividends.

The lower panel of Table 2 studies the optimal choice for the normal rate of return when the risky interest rate is used. The results show that the normal rate of return should be chosen to be 3.3%-6.4%, depending on the case. These are larger than the corresponding numbers with a risk-free interest rate.

To sum up, the calculations provided in Table 2 suggest that the optimal normal rate of return (i) should be roughly either at the level of 2 or 3 percent, or at the level of 3 to 6 percent, depending on the choice of pretax interest rate. The two reference interest rates should be interpreted to give the lower and upper boundaries for the optimal normal rate of return.

The results following from using a risk-free interest rate are quite far from the Finnish time-invariant splitting rate of 8 percent, which is stipulated in Finnish tax law. The results that are based on the risky interest rate are closer to the current choice, but still below it, even in current environment of relatively high interest rates. Another issue is that the share (s) of normal dividends that should be included in the owner’s taxable income, currently 25% (or 85%) in Finland, is also far from the neutrality-yielding level of 41.7%.

In sum, the optimal parameter values differ from those in the current Finnish tax system. Both the normal rate of return i (8% in the Finnish system) and the share s of normal return on equity to be included in the owner’s taxable income (25% or 85% in the Finnish system; see Appendix 1) differ between the Finnish system and the neutral design. Moreover, the current Finnish system has a euro-limit for non-listed company dividends (EUR 150,000) that partially determines the tax treatment of dividends exceeding this limit. That euro-limit does not have any role in a neutral tax system. It just makes another undesired distortion in the tax system.

When policymakers determine the normal rate of return, they must decide whether to include a risk premium in the rate of return. According to the economic literature, this decision depends critically on the tax treatment of losses. In the following, we explain why this connection exists and then ponder its implications for the design of Finland’s splitting system.

From an efficiency point of view, the imputation rate should be set to equal the discount rate the firm uses to discount the flow of tax benefits from equity allowances. If this principle is followed, the present value of tax savings equals the savings of full expensing, i.e. of a cash flow tax, which is known to be neutral with respect to investment decisions (Boadway and Bruce, 1984; Devereux and Freeman, 1991). Whether the discount rate should include a risk premium and how large it should be, depends on the riskiness of the flow of tax benefits. This, on the other hand, critically depends on how the tax system treats profits and losses. If full loss offset is provided, e.g., by crediting the negative tax liability or by allowing carry forward of unutilized allowances with interest, the firm can be certain of the tax consequences of tax allowances. Therefore, in such a fully symmetric tax system the flow of benefits from an equity allowance should be discounted using a riskfree interest rate (Fane, 1987; Bond and Devereux, 1995, 2003), and this interest rate should be chosen as the imputed rate of return. If the tax system is not perfectly symmetric, e.g. due to constraints in loss-offset rules or missing interest compounding, equity allowances are risky and a risk premium should be included in the discount rate. In this case, the imputation rate should also include a risk premium.

In Norway’s RRA model and in the ACE proposal in the Mirrlees Review (2011), considerable effort has been put into making systems as symmetric as possible. Both systems allow unutilized allowances to be carried forward with interest. The systems are not perfectly symmetric, however, and therefore the proposals have deemed it appropriate to include a small risk premium in the imputation rate.²¹ Norway’s policymakers (Sorensen, 2005) and the Mirrlees Review (2011) considered the interest rate on short-term government debt to be the appropriate reference rate. Recently, a tax committee in Norway (NOU, 2022) assessed that the appropriate rate might rather be the interest rate on 10-year government bonds.²² Giffith et al. (2010), on the other hand, proposed using the average interest rate on corporate bonds as the imputation rate of the ACE allowance.

While Sweden and Norway have improved the symmetry of their dividend tax systems by allowing carry forward of unutilized allowances, Finland has not included that element in its splitting system. One consequence of this is that the taxation of dividends is less symmetric than in Finland’s Nordic counterparts. Therefore, the imputation rate in Finland should include a higher risk premium compared to e.g., in Norway. How large this risk premium should be is not easily determined. This is because, in the case of a large deviation from symmetry, there seems not to be any readily available reference interest rate. In Section 2.4 we assumed that the appropriate reference interest rate might be in a range between the risk-free rate and the average interest rate on corporate bonds. We leave this issue to be developed further in future discussions.

Besides yielding neutrality with respect to investment, symmetric taxation of dividend income may improve neutrality in other ways as well. In the literature, Norway’s carry forward system is seen to lead to neutrality in the tax treatment between dividends and sales of shares, and also to remove the lock-in effect associated with standard capital gains taxes (Sorensen, 2005; Lindhe and Södersten, 2012). One related but less discussed issue is neutrality with respect to the timing of dividend distributions. Kari and Laitila (2016) show that without a carry forward system, a graduated dividend tax schedule may lead to tax-motivated dividend distributions. Several studies have indeed observed that a substantial share of CHCs in Finland distribute exactly the maximum amount of leniently taxed normal dividends (Kari and Karikallio, 2007; Ministry of Finance, 2010). Kari and Laitila (2016) argue that such behavior, apparently induced by the lacking carry forward of unutilized allowances, may reduce the funds available for financing investment in CHCs that are not able to finance from external sources and may thus cause efficiency losses. Therefore, adopting carry forward rules should improve the efficiency of Finland’s splitting system and could be a source of other benefits as well.

Regarding the implementation of the optimal splitting system, a few additional aspects remain. We have shown that the optimal normal rate of return (i) is a function of tax parameters and the pre-tax interest rate (r). Therefore, to be optimal at each point in time, the optimal normal rate of return should change as a response to changes in any of these parameters. The current Finnish system does not respond to parameter changes, while the established practice is that the normal rate of return is adjusted annually with interest rate changes, the prime examples being Norway’s and Sweden’s dividend tax systems and the applications and proposals of the ACE allowance (see Sorensen, 2005; Selin, 2021; Zangari, 2014; Mirrlees Review, 2011). The desirability of not allowing the parameters to change may arise from stability considerations in the tax system. These changes may also increase administrative costs for governments and compliance costs for the firms. However, if the normal rate of return is not aligned with the opportunity cost of equity, the tax system will begin to distort investment decisions. Therefore, adopting the practice of annual adjustments of the key tax parameters should improve the efficiency of Finland’s splitting system.

The optimal parameter values were derived in Section 2 by keeping neutral taxation of investment as the goal. We were more or less silent on income-shifting, which is nevertheless the key motivation behind the splitting rules.

Here, it may be useful to differentiate between two dimensions of income-shifting. One is between wage income and excess dividends and the other is between excess income and normal dividends. This paper is about how the normal-dividend part should be calculated in a net asset-based splitting system. Therefore, the second form of income-shifting is particularly relevant for our analysis.

One situation where the second form of incomeshifting may occur is when the splitting rate is set too high. In that case, the system automatically treats income that ought to be subject to a progressive tax schedule as normal dividends subject to the relatively low tax rate (static income-shifting). A splitting rate that is too high also increases incentives to invest in the firm’s equity and therefore helps to increase the future share of normal dividends even further (dynamic income-shifting).

We argue here that a properly specified splitting rule as outlined above could be used as a tool to deter both static and dynamic income-shifting of the second type. Therefore, reforming the currently constant normal rate of return parameter in Finland to better align with the optimal rule outlined above should reduce opportunities for income shifting.²³ There are a few other aspects that we would like to discuss related to income-shifting. Our discussion has so far assumed that the concept of net assets can be clearly defined so that it cannot be easily manipulated to achieve tax savings. Since the calculations of net assets are based on information (financial accounts of firms and asset values applied in other areas of taxation) that is subject to external auditing and tax supervision, the assumption should not be too strong.²⁴ However, the debate in Finland has paid attention to two types of tax planning which can be considered as income shifting between excess income and normal dividends. One such means is to inflate the asset base by collecting low-yielding nonbusiness assets such as financial assets, apartments, real estates, and art works. Such a tax-planning strategy may be profitable, particularly when the normal rate of return is inappropriately high. In this case, for example, investments in fixed-income funds can bring a high after-tax return at low exposure to risk. One way to solve this problem could be to exclude non-business assets from the asset base. However, since the problem mostly stems from an overly high imputed rate of return, implementing an optimal splitting rule following the ideas in our proposal should be the primary solution.

Recently, the Finnish system has also been found to include possibilities that enable the artificial inflation of net assets by adopting a multilayer corporate group structure.²⁵ Using this possibility may step up the value of net assets, leading to an increase in the share of income taxed as more leniently taxed capital income. While this tax-planning means is linked to the splitting system, it does not warrant changes to the current splitting rules; rather, the focus should be on how net assets is calculated for corporate groups. Tax rules should, of course, be neutral with respect to different ways of organizing business activities.

A further related question is the relevant base for the allowance - net assets or total assets? As our model does not include debt, it implies that the book value of net assets is equal to the book value of total assets. The starting point for this question comes back to the original purpose of the splitting system. This aims to separate two types of compensations, that for own equity invested in the firm and the other for labor input (or the residual). Thus, if the tax base were total assets, it would raise the possibility of increasing the share of compensation considered as remuneration on capital by including debt, even if debt does not relate to own equity. With net assets as the base, the system targets own equity invested more accurately, not equity and debt. Furthermore, from the tax neutrality perspective, the optimal splitting rule outlined above should lead to approximately neutral treatment between debt and equity financing.