Taxation in Company Accounts Chapter 16 Taxation in Company Accounts

By the end of the chapter, you should be able to: discuss the theoretical background to corporation tax systems; critically discuss tax avoidance and tax evasion; prepare deferred tax calculations; critically discuss deferred tax provisions.

Corporation tax systems Classical (normal) system: Shareholders taxed twice – once on company’s taxable profit, and again on dividends received Imputation system: Shareholders only taxed on dividend income. Tax paid by company is credited to the shareholder Partial imputation system: Only part of company tax paid is treated as a tax credit

Classical system Profits taxed Dividends paid from tax paid profits, and are taxed again in hands of shareholders. Therefore, dividends are taxed twice. Discourages distribution of dividends?

After tax profits earned by company can be: Imputation system After tax profits earned by company can be: Retained or Distributed Tax paid by company treated as payment of tax on dividend received. Therefore dividends are only taxed once

Corporation tax systems – avoidance and evasion Tax planning is to be encouraged, and it is for an accountant to point out the opportunities to use it. Tax evasion is illegal and an accountant is under obligation to prevent it from happening. ‘Avoidance’ means reducing your tax liability legally. In the UK and other countries there has been much discussion and public comment on companies and wealthy individuals minimising the tax they pay, sometimes by artificial tax avoidance schemes. There has been public criticism of the very small UK Corporation Tax paid by some large international companies with significant activities in the UK.

Evasion’ means avoiding tax illegally, i.e. breaking the law. In attempting to combat evasion and artificial avoidance schemes tax legislation has become increasingly complex – its very complexity providing the opportunity to design yet more ingenious mechanisms to reduce the tax liability. Evasion is the illegal (and immoral) manipulation of business affairs to escape taxation. An example could be the directors of a family-owned company taking cash sales for their own expenditure. It is easy to understand the illegality and immorality of such practices. Increasingly the distinction between tax avoidance and tax evasion has been blurred.5 When politicians complain of tax evasion, they tend not to distinguish between evasion and avoidance

IAS 12 income taxes: major components disclosure Current tax expense for period Under/over provisions Previously unrecognised tax losses Temporary difference of prior period Tax expense relating to changes in accounting policy.

Fundamentals The Tax Act (law relating to tax) which governs the accounting for tax liability is not the same as IFRS which governs financial reporting. As a result, taxable income reported to the Tax Department (using cash basis accounting) may not be the same as pre-tax profit that is reported to shareholders (using accrual accounting). The amount of tax liability due to the Tax Department may not be the same as income tax expense that is reported on the income statement.

Fundamentals Accounting income per IFRS ≠ Taxable income per Income Tax Act Accounting income → Income tax expense (current and future) Taxable income → Income tax payable and current income tax expense Income tax expense ≠ Income tax payable

Current tax expense illustration In the illustration, accounting profits and taxable profits differ because of different treatments of items under accounting standards and tax law. Timing difference Permanent differences

Current tax expense illustration In the illustration, expenses not allowed for tax purposes are added back to the accounting profit for tax purposes. Expenses allowed for tax, that are not claimed in the accounting profit are then deducted to get “taxable profit”

IAS 12 income taxes – deferred taxation Permanent differences: Arise because the transaction is recognised as either accounting profit or as taxable profit, but not as both. Examples include: Penalties and fines. These expenses occur when a business breaks civil, criminal, or statutory law (and gets caught!). The company deducts any fines assessed against book income, but Tax Authority disallows a penalty/fine expense for tax purposes. Meals and entertainment. Companies can expense 100% of the cost to provide business-related meals and entertainment that they incur in the normal course of business for book purposes, but for tax purposes, the business can expense, at most, only part (say 50% of that cost).

IAS 12 income taxes – deferred taxation Timing (temporary) differences: Arise when revenues, or expenses, are recognised for accounting purposes in a different time period to when they are recognised for tax purposes Accrual basis vs cash basis Capital allowances (depreciation) Capital investment incentive effect Deferred tax provisions. Two methods of accounting for these Deferral method Liability method

Deferred tax – alternative methods Deferral method Tax effect debited/credited to income statement Effect of changing tax rates ignored Total provision has differences calculated at different tax rates.

Deferred tax – alternative methods Liability method Total amount of potential liability recalculated each time the tax rate changes Keep record of the entries made to the provision Apply current rates of tax Adjust the provision.

Deferral method illustrated Figure 16.1 Accounts: Straight line 10 years Tax is calculated at 25% of carrying balance in this example called allowance

Summary of deferred tax provision using deferral method Figure 16.2 Summary of deferred tax provision using the deferral method

Deferred tax provision using liability method Figure 16.3 Note: Because the tax rate has fallen to 24%, the liability for tax has changed, so under this approach, the deferred tax provision for each year is recalculated at the new tax rate, i.e. the 24% rate is used for all years to calculate the deferred tax.

References Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting 18th Edition chapter 16