CHAPTER 15 International taxation

Contents  Introduction – Main types of taxation  Corporate income tax and dividends  Deferred taxation  International taxation  Transfer pricing  Tax havens

Main types of taxation  Taxation as costs  Social security charges  Local/regional taxes  National corporate income taxes  Taxation on behalf of a third party  Value added tax

Value added tax  Imposed on customers at each stage of a product’s value-added chain, based on the value added at that point  Gross amount of VAT on sales and on purchases is netted in the accounting system and net amount is paid periodically to the tax authorities  Not part of revenue or expenses, but included in receivables and payables (cash flow effect)

Corporate income tax  Income tax payable = Taxable profit * Tax rate (f.i. 30%)  Taxable profit is not equal to accounting profit  Differences? Some expenses are not allowed tax-wise (entertaining, fines, excess depreciation, excess provisions, etc.) Special tax allowances (for capital investment, environmental protection, etc.) Income that is non-taxable  Deferred taxes arise from these differences

Taxable profit Reconciliation statement: Accounting profit before tax Add back: disallowed expenses Deduct: special tax allowances and non- taxable income = Taxable profit

Taxation of dividends  Problem of potential double taxation of dividends due to concurrent corporate and personal taxation  Solutions:  Profits paid to shareholders are taxed at a lower rate than those retained in the company, or  Tax credit on the dividend for shareholders

Deferred taxation  Deferred taxes  Income statement perspective on deferred taxes  Balance sheet perspective on deferred taxes  Presentation of deferred taxes in the financial statements

Deferred taxes  Differences between objectives of measuring (accounting) profit for financial reporting purposes and basic tax raising motives of measuring taxable profit  Accounting rules regarding income taxes:  Tax effects of transactions are recognised in the financial statements in the same period as the related business transactions themselves  Current income tax cost (taxable profit * nominal tax rate) is only part of these tax effects

Deferred taxes (cont.)  Income statement: deferred tax cost (or benefit) complements current tax cost  Balance sheet: deferred tax assets and deferred tax liabilities reflect future tax consequences of transactions that were not treated identically for taxation and financial reporting purposes

Income statement perspective on deferred taxes  Cfr. Reconciliation statement - two types of differences:  Permanent differences  Timing differences  Timing differences arise because the timing of income and expenses in the income statement occurs in different period from taxable profit  Timing differences arise in one period and reverse in one or more subsequent periods

Illustration – Tax deductible accelerated depreciation  Purchase of a fixed asset (€10,000) with tax incentive (accelerated depreciation) in 20X1  Useful life = 2 years and no residual value  Depreciation  Financial statements: 5,000 in 20X1 and in 20X2  Tax calculation: 10,000 in 20X1 and 0 in 20X2  Pre-tax profit of 20,000 in 20X1 and 20X2 and tax rate of 50 per cent

Illustration – Income tax calculation 20X120X2 Pre-tax profit (includes depreciation expense) 20,000 Timing difference (accelerated depreciation) - 5,000+ 5,000 Taxable profit15,00025,000 Tax due at 50%7,50012,500

Illustration – Income statement effect without deferred taxes 20X120X2 Pre-tax profit20,000 Corporate income taxes due - 7, ,500 Net profit after tax12,5007,500

Illustration – Income statement effect including deferred taxes 20X120X2 Pre-tax profit20,000 Total tax expense: °Taxes due °Deferred tax expense °Deferred tax income - 7, , ,500 +2,500 Net profit after tax10,000

Illustration – Deferred taxes on the balance sheet  Deferred tax expense => Deferred tax liability  Indicates that profit in the financial statements has in the past been higher than for tax purposes  Liability: reflects future taxation on the difference – postponement of tax payments to future periods  At reversal of timing difference:  Deferred tax income in income statement  Settlement of deferred tax liability

Alternative illustration – Provision not accepted for tax purposes  Deferred tax income => Deferred tax asset  Indicates that profit in the financial statements has in the past been lower than for tax purposes  Asset: reflects future tax savings on the difference – taxes paid, but recoverable in future periods  At reversal of timing difference:  Deferred tax expense in income statement  Use of deferred tax asset

Balance sheet perspective on deferred taxes  Deferred taxation based on balance sheet values  ‘Temporary differences’: differences between balance sheet values and tax values of assets and liabilities  Tax value (tax base) = the amount at which the asset or liability is recognised for tax purposes  Temporary differences are broader than timing differences

IAS 12 Income taxes  Two types of temporary differences:  Taxable differences that result in deferred tax liabilities – taxable amounts in determining taxable profit of future periods  Deductible differences that result in deferred tax assets – amounts that are deductible in determining taxable profit in future periods  Deferred tax asset / liability is measured as the temporary difference multiplied by the tax rate (applicable when asset is realised or liability is settled)

Illustration - Tax deductible accelerated depreciation (repeat) 20X120X2 (a) Accounting balances Asset carrying amount 1 January Additions Accounting depreciation Asset carrying amount 31 December 0 10,000 -5,000 5, ,000 0 (b) Tax values Asset tax base 1 January Additions Tax depreciation Asset tax base 31 December 0 10, , (c) Temporary differences5,0000

Illustration - Tax deductible accelerated depreciation  Temporary difference of 5,000 in 20X1  Taxable or Deductible ? Tax base of asset < Book value of asset Future accounting depreciation will be higher than tax depreciation Future taxes due will be higher than expected on accounting profit => Taxable temporary difference Deferred tax liability of 2,500 (50 per cent tax rate) Deferred tax expense of 2,500  Reversal in 20X2  Settlement of deferred tax liability  Deferred tax income of 2,500

Presentation of deferred taxes in financial statements  Separate presentation of deferred tax assets (liabilities) in balance sheet  Classified as non-current balance sheet items  Tax expense (income) related to ordinary activities presented on the face of the income statement  Additional disclosures in the notes:  Details on major components of tax expense  Numerical explanation of relationship between tax expense and accounting profit  Details on temporary differences and related deferred tax assets and liabilities

International taxation  Taxation is administered on a company-by- company basis and calculated on individual subsidiaries’ accounts  International taxation presents both threats and opportunities  Structuring of international transactions in the most tax efficient way  Avoiding double taxation (double tax treaties)

Transfer pricing  Transfer prices are the prices at which goods and services change hands between subsidiaries of a group  Artificially fixing transfer prices is a way of determining where profits are taxed  Double tax treaties usually state that transfer prices must be “at arms’ length” or at market rates  Intra-group charges (like royalties for use of intellectual property and interest charges) are also usually structured according to a tax treaty

Tax havens  Tax havens typically offer low tax or flat rate tax for companies which are resident but whose activities are external to the haven (‘off-shore’)  Frequently used by a MNC to provide international services (like finance, insurance) to the group  Do not generally benefit from tax treaties with other countries  Costs are not negligible and substantial throughout is needed to create tax savings

Offshore financial centres  Near relatives of a tax haven, but benefit from double tax treaties with major trading countries  The corporate tax they levy is sufficiently high for developed countries not to treat them as a tax haven, but sufficiently low so as still to be attractive to companies