1. Taxation in Company Accounts
Chapter 16
Taxation in Company Accounts

2. 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.

3. 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

4. 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?

5. 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

6. 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.

7. 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.

8. 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

9. 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

10. 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”

11. 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).

12. 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

13. 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.

14. 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.

15. Deferral method illustrated
Figure Deferred tax provision (depreciation allowance) using deferral method
Note: The 1999 & 2000 tax allowances (depreciation) are calculated at 25%

16. Summary of deferred tax provision using deferral method
Figure Summary of deferred tax provision using the deferral method
Note: The 1999 & 2000 deferred tax provisions are calculated at the new tax rate of 24%

17. Deferred tax provision using liability method
Figure Deferral tax provision using the liability method
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.

18. Accounting treatment over life of an asset
Assume
Equipment costs 10,000
Straight-line depreciation over 5 years
Tax capital allowance (depreciation rate) is 25% per annum straight-line
Taxable profit 5,000 in year 0
Tax rate 40%.

19. p.420 (p.292)
EXAMPLE ● An enterprise buys equipment for £10,000 and depreciates it on a straight-line basis over its expected useful life of five years. For tax purposes, the equipment is depreciated at 25% per annum on a straight-line basis. Tax losses may be carried back against taxable profit of the previous five years. In year 0, the enterprise’s taxable profit was £5,000. The tax rate is 40%. The enterprise will recover the carrying amount of the equipment by using it to manufacture goods for resale. Therefore, the enterprise’s current tax computation is as follows:

20. Accounting treatment current tax expense
Year
Taxable income(depreciation) 2,000 2,000 2,000 2,000 2,000
Dep’n for tax purposes (25%) 2,500 2,500 2,500 2,
Tax profit (loss) (500) (500) (500) (500) 2,000
Current tax exp/(inc) at 40%* (200) (200) (200) (200)
In years 1-4, tax payable is 200 less than the accounting tax expense (total 800 over 4 years).
In year 5, there is no tax depreciation allowance, so tax payable is 800 more than accounting tax expense – which counters the underpayment in years 1-4

21. Accounting treatment temporary timing differences
This shows how the difference between the carrying amount using accounting depreciation and the tax base amount creates the taxable temporary difference

22. Accounting treatment income statement entries
The company’s income statements will look like:

23. Critique – do not provide deferred taxation
Not a legal liability until it accrues
Tax expense should be equal to amount based
on income tax return for year
Accrue as a payable any unpaid tax
Disclose in a note differences between income tax bases and amounts in the accounts
Confuses investors.

24. Critique – provide deferred taxation
Investors used to uncertainty of future cash flows
Tax attaches to taxable income not accounting income
Deferred tax achieves income smoothing
IASB Framework sees deferral as applying accrual concept
IASB Framework states ‘accounts inform of obligations to pay cash in the future’.

25. References
Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting
15th Edition chapter 16