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. 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

5. 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.

6. 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

7. 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.

8. 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.

9. 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

10. 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

11. 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”

12. 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).

13. 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

14. 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.

15. 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.

16. Deferral method illustrated
carrying
Figure Accounts: Straight line 10 years (accounting year end adjustment)
Tax is calculated at 25% of its carrying balance in this example called
Allowance e.g = 25%*7500

17. Summary of deferred tax provision using deferral method
Figure Summary of deferred tax provision using the deferral method

18. 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.

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