Slide 16.1

Taxation in Company Accounts

Chapter 16

Slide 16.2

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.

Objectives

Slide 16.3

Corporation tax systems

• Classical 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 coy is credited to the shareholder

• Partial imputation system:• Only part of company tax paid is treated as a tax

credit

Slide 16.4

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?

Slide 16.5

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

Slide 16.6

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.

Slide 16.7

Fundamentals

The Tax Act (law relating to tax) which governs the accounting for tax liability is not the same as GAAP 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.

Slide 16.8

FundamentalsFundamentals

Accounting income (per GAAP) ≠ 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

Slide 16.9

Current tax expense illustration As the illustration shows, accounting profits and taxable profits differ

because of different treatments of items under accounting standards and tax law.

Slide 16.10

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.

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 Capital investment incentive effect Deferred tax provisions.

Slide 16.11

Permanent DifferencesPermanent Differences

Some items are recordedin Books

but NEVERon tax return

Other items are NEVERrecorded in books

but recordedon tax return

No deferred tax effectsfor permanent differences

Sources of Permanent Differences

Slide 16.12

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.

Slide 16.13

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.

Slide 16.14

Deferral method illustrated

Figure 16.1 Deferred tax provision using deferral methodNote: The 1999 & 2000 tax allowances (depreciation) are calculated at 25%

Slide 16.15

Summary of deferred tax provision using deferral method

Figure 16.2 Summary of deferred tax provision using the deferral methodNote: The 1999 & 2000 deferred tax provisions are calculated at the new tax rate of 24%

Slide 16.16

Deferred tax provision using liability method

Figure 16.3 Deferral tax provision using the liability methodNote: 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.

Slide 16.17

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 rate 40%.

Slide 16.18

Accounting treatment current tax expense

See Example p.420

Year 1 2 3 4 5

Dep’n for Accounting 2,000 2,000 2,000 2,000 2,000

Dep’n for tax purposes2,500 2,500 2,500 2,500 0

Tax profit (loss) (500) (500) (500) (500) 2,000

Current tax exp/(inc) at 40%* (200) (200) (200) (200) 800 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

Slide 16.19

Accounting treatment temporarytiming differences

Slide 16.20

Accounting treatment incomestatement entries

Slide 16.21

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.

Slide 16.22

Critique – provide deferred taxation

Investors used to uncertainty of future cash flowsTax attaches to taxable income not accounting

incomeDeferred tax achieves income smoothingIASB Framework sees deferral as applying

accrual conceptIASB Framework states ‘accounts inform of

obligations to pay cash in the future’.

Slide 16.23

Discussion

What are the arguments for not providing for deferred tax?

What are the advantages to an investor of providing for deferred tax?

What are the implications for the statement of financial position if a company has a consistent annual capital investment programme?

Slide 16.24

Review questions

1. Why does the charge to taxation in a company’s accounts not equal the profit multiplied by the current rate of corporation tax?

4. Deferred tax accounting may be seen as an income-smoothing device which distorts the true and fair view. Explain the impact of deferred tax on reported income and justify its continued use.

5. Discuss the problems in distinguishing tax evasion from tax avoidance.

6.Distinguish between (a) the deferral and (b) theliability methods of company deferred tax.