Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Introduction – Main types of taxation
Corporate income tax and dividends
Deferred taxation
International taxation
Transfer pricing
Tax havens
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Taxation as costs
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Social security charges
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Local/regional taxes
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National corporate income taxes
Taxation on behalf of a third party
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Value added tax
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Reconciliation statement:
Accounting profit before tax
Add back: disallowed expenses
Deduct: special tax allowances and nontaxable income
= Taxable profit
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Problem of potential double taxation of dividends due to concurrent corporate and personal taxation
Solutions:
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Profits paid to shareholders are taxed at a lower rate than those retained in the company, or
Tax credit on the dividend for shareholders
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Deferred taxes
Income statement perspective on deferred taxes
Balance sheet perspective on deferred taxes
Presentation of deferred taxes in the financial statements
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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:
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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Income statement:
(or benefit) complements cost deferred tax cost current tax
Balance sheet: and deferred tax assets deferred tax liabilities reflect future tax consequences of transactions that were not treated identically for taxation and financial reporting purposes
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Income statement perspective on deferred taxes
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Cfr. Reconciliation statement - two types of differences:
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Permanent differences
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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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
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Financial statements: 5,000 in 20X1 and in 20X2
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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Illustration – Income tax calculation
20X1
20,000
20X2
20,000 Pre-tax profit
(includes depreciation expense)
Timing difference
(accelerated depreciation)
Taxable profit
Tax due at 50%
- 5,000 + 5,000
15,000 25,000
7,500 12,500
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Illustration – Income statement effect without deferred taxes
Pre-tax profit
Corporate income taxes due
Net profit after tax
20X1
20,000
20X2
20,000
- 7,500 - 12,500
12,500 7,500
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Illustration – Income statement effect including deferred taxes
Pre-tax profit
20X1
20,000
20X2
20,000
Total tax expense:
°Taxes due
°Deferred tax expense
°Deferred tax income
Net profit after tax
-
-
7,500
2,500
-
12,500
+2,500
10,000 10,000
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Illustration – Deferred taxes on the balance sheet
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Deferred tax expense => Deferred tax liability
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Indicates that profit in the financial statements has in the past been higher than for tax purposes
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Liability: reflects future taxation on the difference
– postponement of tax payments to future periods
At reversal of timing difference:
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Deferred tax income in income statement
Settlement of deferred tax liability
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Alternative illustration – Provision not accepted for tax purposes
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Deferred tax income => Deferred tax asset
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Indicates that profit in the financial statements has in the past been lower than for tax purposes
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Asset: reflects future tax savings on the difference
– taxes paid, but recoverable in future periods
At reversal of timing difference:
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Deferred tax expense in income statement
Use of deferred tax asset
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Balance sheet perspective on deferred taxes
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Deferred taxation based on balance sheet values
‘ Temporary differences and liabilities
’: differences between balance sheet values and tax values of assets
Tax value (tax base) = the amount at which the asset or liability is recognised for tax purposes
Temporary differences are broader than timing differences
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Two types of temporary differences:
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Taxable differences that result in deferred tax liabilities – taxable amounts in determining taxable profit of future periods
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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)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

Illustration - Tax deductible accelerated depreciation (repeat)
20X1 20X2
(a) Accounting balances
Asset carrying amount 1 January
Additions
Accounting depreciation
Asset carrying amount 31 December
(b) Tax values
Asset tax base 1 January
Additions
Tax depreciation
Asset tax base 31 December
(c) Temporary differences
0
10,000
-5,000
5,000
0
10,000
-10,000
0
5,000
5,000
0
-5,000
0
0
0
0
0
0
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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:
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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Taxation is administered on a company-bycompany basis and calculated on individual subsidiaries’ accounts
International taxation presents both threats and opportunities
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Structuring of international transactions in the most tax efficient way
Avoiding double taxation (double tax treaties)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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Transfer prices are the prices at which goods and services change hands between subsidiaries of a group
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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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’)
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Frequently used by a MNC to provide international services (like finance, insurance) to the group
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Do not generally benefit from tax treaties with other countries
Costs are not negligible and substantial throughout is needed to create tax savings
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts

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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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts