Tax Principles

1
Tax Principles Creative Accounts

• Introduction to Business Accounting
• Week 7

2
Role of businesses

• Pay Tax
• Collect Tax
• National/Regional (Jurisdictional) variations on
• Tax rules
• Tax rates
• Tax computations

3
Tax Regulation

• Tax Jurisdiction
• Area within which rules apply
• Competent Authority
• Authority responsible for administration
  collection of Tax
• Sources of Rules
• Domestic legislation (Common or Codified)
• Case Law (in common law countries)
• Statements of Practice by Tax Authority
• Supranational Regulations (eg EU)
• International Treaties (eg double taxation
  agreements)

4
Direct or Indirect?

• Direct Tax suffered directly by Taxable Person
• (ie the person/entity intended to pay the tax)
• Indirect Tax is not levied directly on a
  specific Person who is intended to pay the tax.
• The initial person on whom it is levied is not
  the ultimate sufferer of the tax.

5
Direct or Indirect? Examples 1

• Income tax
• levied on the earnings and investment income of
  individuals, whether from wages or salaries, or
  from the profits of a trade, profession or
  vocation or on capital gains
• Corporation tax
• levied on the profits of companies, investment
  income and capital gains
• Inheritance tax
• Levied on deceaseds estate subject to certain
  qualifying circumstances

6
Direct or Indirect? Examples 2

• Value-added tax
• levied on the provision of goods and services at
  varying rates based on the output
• value of such goods and services
• Excise duties
• levied on particular goods such as petrol,
  tobacco and alcohol
• National insurance effectively a payroll tax
  levied on both employers and employees
• Council tax
• a form of quasi-personal tax which has replaced
  the Community Charge, which
• itself replaced the domestic rate system of
  taxation and is a local rather than a
• national tax
• Local business rate
• a local tax on businesses which replaced the
  previous rate
• system, but based on property values

7
Employee Taxes

• Income tax under PAYE
• National Insurance Contributions
• National Insurance split in to 2 types
• EmployEES contributions
• EmployERS contributions

8
International Tax

• Tax Residence
• Resident (generally where registered) tax on all
  profits wherever earned
• Country of operation taxed on profits earned in
  that country
• Double taxation of some earnings

9
Double Taxation Agreement

• Defines which country has the right to tax what
  types of income
• These agreements apply to people who are legally
  subject to tax liability in 2 different countries
  In double taxation agreements, the rule is that
  the country of residence taxes the income but
  also grants an allowance for the income on which
  the other country has the right to tax

10
Goings on even as we speak

• July 24th 2006
• UK Government News Network announced
• Programme to 31 March 2007
• We plan to complete work on new DTAs with
  Macedonia, Moldova, Poland, Slovenia and
  Thailand.

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Or alternatively

• Tax Havens
• Very low or zero tax offshore companies
  incorporated in jurisdictions often described as
  tax haven islands, such as the differing types of
  offshore company that can be formed in offshore
  company formation centres such as the BVI or
  British Virgin Islands, Belize or the Seychelles
• Territorial Taxation
• Operate/Register in countries with favourable tax
  rates
• Eg Hong Kong

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Withholding Tax

• Tax withheld deducted and paid to Tax authority.
  Recipient gets income net of tax.
• Eg savings interest (private individuals not
  companies)
• CITDS scheme (Construction Industry Tax Deduction
  Scheme)

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Enforcing Tax Rules

• Companies are required to
• Calculate tax liability
• Calculate and deduct employee taxes
• Collect and pay indirect taxes
• (Can be extended to self employed)

14
Enforcing Tax Rules

• Therefore to facilitate this
• Competent Tax Authority needs to ensure
• Correct maintenance of records
• Timely and correct returns
• Correct payment of tax by specified deadlines
• And that it has sufficient powers to enforce
  these activities
• This is done by statutory powers

15
Statutory powers

• Generally
• Powers to query and inspect records
• Rights of Entry and search in relation to this
• Exchange of information with other competent
  authorities
• Powers to charge interest on late/under payments

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Powers to Investigate

• In UK Taxes management Act 1970 (as amended) lays
  down powers eg
• S.20 (1) power to call for documents from those
  under investigation
• S.20 (3) power to call for documents from a third
  party concerning a named person under
  investigation
• S.20 (8A) power to call for documents from a
  third party concerning un-named person(s)/classes
  of people under investigation
• S.20 A powers to call for papers of a tax
  accountant
• S.20 BA orders for the delivery of documents
• S.20 C entry with warrant to obtain documents

17
Powers to Charge Interest

• Interest usually above commercial rates has a
  purpose
• A main aim in charging interest under sections
  86 or 88 TMA 1970 is to ensure, so far as
  possible, that those who pay their tax late are
  in no better position than those who pay the full
  amount
• (IR Tax Bulletin 7)

18
Tax Avoidance and Tax Evasion

• Tax avoidance Taking advantage of legal or
  arguably legal tax loopholes.
• Tax evasion The intentional misrepresentation or
  concealment of a person's tax obligations
• Tax evasion is clearly illegal whereas tax
  avoidance falls into 2 categories
• Intentional relaxation of regulations to offer
  incentives
• Legal exploitation of weakness in the legal
  system to reduce tax liability

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Direct Taxes on Company Profits and Gains

• Companies pay taxes on
• Profits
• Capital Gains

20
Profits Capital Gains

• Profits arise from trading activities and other
  sources of revenue income (interest, etc)
• Capital Gains arise from the disposal of capital
  assets
• Tangible and intangible assets
• Long-term investments
• Tax is calculated by applying the appropriate
  rate of tax to both profits and capital gains

21
Tax Years

• In UK tax year for companies runs from
• 1st April to 31st March
• Tax payable is based on the profits and capital
  gains of the Accounting Year ending in the Tax
  Year

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Tax Years

• Example
• Acme Ltd 's accounting year runs from 1st June to
  31st May
• Taxable Profits were
• A) 1st June 2002 to 31st May 2003 50,000
• B) 1st June 2003 to 31st May 2004 60,000
• C) 1st June 2004 to 31st May 2005 80,000
• For Tax Year ended 31st March 2004 what was
  Acmes taxable Profit?
• Tax Year runs 1st April 2003 to 31st March 2004
• Accounting Year 1st June 2002 31st May 2003

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Beta Ltd

• Suppose Beta Ltd had the following Taxable
  Profits
• 1st January 2002 to 31st December 2002 3m
• 1st January 2003 to 31st December 2003 4m
• 1st January 2004 to 31st December 2004 6m
• What is the taxable profit chargeable to the tax
  year 2005?
• Tax year runs 1st April 2004 to 31st March 2005
• Therefore accounting year
• 1st January 2004 to 31st December 2004 6m

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Profit Division by Time Basis

• Profits divided by Time Basis if Tax Rate changes
• Tax rates for tax years ended
• 31st March 2003 27
• 31st March 2004 29
• 31st March 2005 31
• How much tax would Acme Ltd pay in tax year 2004?
  
• How much tax would Beta Ltd pay in tax year 2005?

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Profit Division by Time Basis

• Acme Ltd
• Split on time basis
• 1st June 2002 31st March 2003 10 months _at_ 27
• 1st April 2003 31st May 2003 2 month _at_ 29
• So
• 50,000 X 10/12 X 27 41,666 X 27 11,250
• 50,000 X 2/12 X 29 8,333 X 29 2,417
• 13,667

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Beta Answer

• Beta Ltd
• 1st January 2004 31st March 2004 3 _at_ 29
• 1st April 2004 31st December 2004 9_at_ 31
• 6m X 3/12 X 29 1.5m X 29 435,000
• 6m X 9/12 X 31 4.5m X 31 1,395,000
• 1,830,000

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Tax and Dividends

• Anteater Ltd has profits of 700,000
• It pays interest on loans of 50,000
• It pays dividends to shareholders of 100,000
• What is its Taxable Profit (TP)?
• Accounting profit 700,000
• Less interest 50,000
• 650,000 (A)
• Less dividends 100,000
• 550,000 (B)

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Tax and Dividends

• Assume Corporation Tax (CT) 30
• Anteater Ltd pays 650,000 X 30 Tax 195,000
• Assume Income Tax (IT) rate 25
• Shareholders will pay 100,000 (dividends) X 25
  25,000
• Tax on Dividends then is
• 100,000 X 30 30,000
• 100,000 X 25 25,000
• 55,000
• Gives effective rate of tax on dividends of 55 !!

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Different Systems

• Classical System of Taxation
• Tax jurisdictions address taxation of dividends
  in different ways
• Classical System
• Full Imputation System
• Partial Imputation System
• Shareholder Relief Systems

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Full Imputation System

• Dividend is taxed as part of company profits
• Shareholder receives
• Net Dividend AND
• Tax Credit ( to tax paid on dividends by the
  company)
• Shareholder is TAXED on the GROSS dividend
• (ie net dividends received tax credit)
• But is assumed to have paid tax to amount of
  tax credit

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Aardvark Ltd

• CT 31
• IT 25
• Aardvark Ltd has taxable profits of 7m and pays
  a dividend of 2.5m
• Tax paid by Aardvark Ltd 7m X 31 2,170,000
• When it pays dividends of 2.5m
• Tax relating to this is calculated as
• Net dividends X Imputed tax rate on dividends
• (100 imputed tax rate)

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Aardvark Ltd

• Imputed tax rate 31
• Therefore
• Tax 2.5m X 31
• (100-31)
• 1,123,188
• Net Dividend 2,500,000
• Tax credit 1,123,188
• Gross Dividend 3,623,188
• check 3,326,188 X 31 1,123,188

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Taxable Profit

• Companies taxed on profits of an accounting year
• Some adjustments may need to be made
• Difference between
• Accounting Profit
• Taxable Profit
• Some expenses may not be allowable for tax
  purposes
• Expenses may be allowable for tax purposes but in
  different year
• Income in financial accounts may be recognised
  for tax purposes but in different year

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Revenue and Capital

• Revenue expenditure is chargeable against taxable
  profit
• Capital expenditure treated as non-current asset
• Disallowable Revenue Expenditure
• Most Business expenditure
• Most donations to charity
• All political donations
• Cost of write off of loan to employee considered
  irrecoverable
• Changes in allowances for doubtful debts

35
Gnu Ltd

• Gnu Ltd has an accounting profit of 550,000
• After deducting 10,000 donation to UKIP,
  15,000 expenses for directors Xmas party,
  increase in doubtful debts provision of 20,000
  and 20,000 urgent repairs to factory. Dividends
  amounted to 50,000. CT rate is 35
• How much tax must Gnu Ltd pay?

36
Answer to Gnu

• Accounting Profit 550,000
• Add back UKIP payment 10,000
• Add back Xmas party 15,000
• Add back Inc in D debts 20,000
• 45,000
• Taxable Profit 595,000
• X 35 tax payable 208,250

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Disallowable Capital Expenditure

• Capital Expenditure is (usually) expenditure on
  non-current assets
• There are items
• Found in Balance Sheet
• Depreciated over their useful economic lives
• Tax treatment
• There is a tax depreciation charge allowable
  against tax

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Non-current assets (Fixed assets)

• Tax bases
• Tax depreciation
• Accounting depreciation

39
Reasons to manipulate accounts illustrative
examples

• You are required to explain the likely motivation
  a company's directors might have to manipulate
  its reported profit
• (a) upwards or
• (b) downwards or
• (c) it is not possible to tell as it depends upon
  the particular circumstances, in the following
  situations.

40
Reasons to manipulate accounts illustrative
examples

• 1 A company that faces a high (and difficult to
  meet) security analysts' (consensus) profit
  forecast.
•  UPWARDS
• 2 A listed company which prepares interim
  financial statements.  
• POSSIBLY UPWARDS
• 3 A recently taken-over company.  
• DOWNWARDS
• 4 A company whose directors are considering
  changing the status of the company from private
  to publicly listed. That is they are planning an
  Initial Public Offering (IPO).
• NOT POSSIBLE TO TELL depends on true profits

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Reasons to manipulate accounts illustrative
examples

• 5 A large regulated utility company.  
• DOWNWARDS
• 6 A company operating in an economy that is
  moving into recession.
• UPWARDS 
• 7 A company whose trade unions are about to
  submit a large wage demand.
• DOWNWARDS 
• 8 A company which is rumoured to be subjected to
  a hostile take-over bid in the next few weeks.   
• UPWARDS

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Reasons to manipulate accounts illustrative
examples

• 9 A company that is performing below its industry
  average.
• UPWARDS
• 10 A company whose directors are on a profit
  related bonus scheme.
• DEPENDS ON SCHEME  
• 11 A company that is in fairly permanent decline.
  
• UPWARDS 
• 12 A company that has borrowed heavily and is
  highly geared.
• UPWARDS  

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Reasons to manipulate accounts illustrative
examples

• 13 A company that operates in an industry known
  for highly volatile profits.
• DEPENDS - Smoothing 
• 14 A company that is faced with severe foreign
  competition.
• DOWNWARDS  
• 15 A divisional company whose director's are
  planning a 'buy-out'.
• LIKELY DOWNWARDS  
• 16 A company that is looking to reduce its tax
  bill.
• DOWNWARDS