In this article we will discuss about the basis of tax computation:- 1. Introduction to the Basis of Tax Computation 2. Tax Rate 3. Tax Base 4. Accounting Policies 5. Tax Allowances and Disallowances 6. Tax Incentives 7. Assessment and Withholding Taxes.
Introduction to the Basis of Tax Computation:
The taxable income or tax base and the tax rate determine the tax liability for the tax period. The tax base is computed by deducting the related costs incurred in the acquisition of the earnings from the gross revenues. The tax rate is then applied to this chargeable profit. A change in either the rate or the base affects the tax payable.
The effective tax rate is defined as the actual tax payable as a percentage of the total pre-tax income (not taxable income). Although the tax liability is a combination of the tax base and the tax rate, their definitions vary widely.
The domestic tax systems in the world may be grouped into eight broad families of income tax laws. Under these systems, certain countries have a single tax system for all taxpayers (“global system”), while other countries provide separate tax laws for different taxpayers and different items of income (“scheduler system”). Many of them follow a hybrid system, which contains the characteristics of both methods.
Thus, some jurisdictions apply a global system with a single comprehensive definition of income for all taxpayers, and subject them to the same tax rate structure irrespective of the nature of the income. Other jurisdictions classify the taxable income into a number of broad categories under a scheduler system.
The schedules split the tax base into particular categories often with different tax rates for each class of taxpayer and/or income. The tax rules may also differ for different taxpayers (e.g. individuals or companies), and for different classes (e.g. business, investment or employment income) and types (e.g. dividends, interest, royalties, etc.) of income.
Certain countries define their tax base under the global system (Examples: Australia, Colombia, the United States), while others follow the scheduler system (Examples: France, Germany, India, Italy, Japan, Spain, the United Kingdom).
Often, a combination of the two systems is used. Under a composite system, the income in each schedule is computed separately and then a global tax rate is applied on the total income. The use of withholding tax on passive income has led to a partial use of the scheduler system in countries, which follow the global system.
Broadly, common law countries follow the scheduler system while civil law countries prefer the global system. The main difference between the two legal systems is that while civil law relies on statutes or enacted legislation, the common law accepts unmodified law based on past judicial decisions or judge-made law. The legal system also affects the tax computations.
While common law countries generally tax the accounting profits, civil law countries compute the taxable income on the difference in the balance sheets (as adjusted for dividends) at the beginning and end of the period. Moreover, the countries that use the global system normally do not tax capital gains separately. Both are taken as part of the aggregate taxable income or profits.
Tax rates and the way they are applied also vary between countries. Some of the tax rate systems in use are:
(a) Flat Rate or Fixed Percentage of Taxable Income:
Under the flat rate system, the tax is levied as a fixed percentage of income (also called proportional rate). Different rates may apply depending on the character of the income, the type of activity or the nature of ownership. In some countries, the taxable income below a certain minimum level or capital base is subject to a lower tax rate.
For example, the United Kingdom applies a lower “small income” rate of 19% if the taxable profit of a company is less than UK£300,000, with a tapered relief up to UK£1,500,000. Japan applies a flat rate of 30% to companies with a capital over JPY 100 million, while small and medium-sized companies pay 22% on the first JPY 8 million of taxable income.
A federal tax rate of 12% applies to small private companies in Canada on the first Can. $300,000 of active business income.
(b) Progressive Rates or an Increase in Tax Rates at Higher Slabs:
Progressive tax rates or a higher rate as taxable income increases are commonly used for personal taxes to maintain the vertical equity based on the ability to pay. Certain countries also compute their corporate taxes on a progressive tax system.
The tax levied on the higher income may be either at the higher rate on the entire income, or only on the excess over the next lower income bracket. Under the latter method, the effective tax rate is less than the marginal tax rate on the top income slab.
Some countries allow the taxpayer to elect the lower of either the tax payable at the marginal rate applied to the total taxable income, or the tax due on the previous tax bracket plus the income in excess of this bracket (Examples: Kuwait, Qatar, Taiwan).
A few countries use a hybrid method, where certain income brackets or “slabs” are taxed at a progressive rate on the excess, while other slabs have a flat rate for the entire income (Examples: Luxembourg, the United States).
(c) Digressive Rates, or Decreases in Tax Rates, at Higher Income Levels:
The higher income slabs are taxed at a lower tax rate. The digressive method is very rarely used.
(d) Tax-Exempt or Nil Taxation:
Many countries exempt (partly or fully) the income from approved business activities or geographical areas. Normally, the preferential tax rates apply as incentives for foreign capital, employment generation or technology transfers. Export earnings are partly or fully tax-exempt or taxed at concessional rates in several countries.
Tax-exemption may also be given to certain types of income, e.g. charities, mutual funds, windfall gain, income of diplomats, etc. A taxpayer remains liable to tax, although he is not subject to tax. These situations differ from tax-free jurisdictions that do not impose any tax on income. Normally, no deduction is given for expenses when the related income is tax-exempt.
(e) Surtaxes or Surcharges:
Income or corporate tax may contain additional tax levies (as a surtax or surcharge) that are computed either as a separate tax, or as a percentage of the corporate tax. They are generally imposed as short-term supplements to the national taxes, or as local or municipal taxes. Some countries treat the surtax or surcharge for local or municipal taxes as a tax-deductible expense for corporate tax.
Other countries adjust the tax base for local taxes. For example, Canada grants 10% federal rate abatement on the taxable income subject to provincial taxes. The United States calculates the US state taxes on the profits, net of federal tax.
(f) Taxes on Capital or Wealth Tax:
Several countries impose a capital tax, which is based on the net worth or assets employed by a company. For example, large Canadian corporations with capital over Can $50 million pay a creditable federal capital tax (“large corporations tax”).
In many Latin American countries, the net worth tax is deemed as an alternative minimum tax, and the amount is creditable against the regular corporate tax liability. Mexico imposes a minimum tax of 1.8% on net assets (“TNA”).
Several countries impose a wealth or net worth tax on individuals. For example, France imposes a tax on individual wealth over EUR 15 million at rates up to 1.8%. Spain levies wealth tax at rates up to 2.5%. India charges a 1 % tax on taxable wealth over IRs 1.5 million. Pakistan, Saudi Arabia and Yemen impose a zakat or Islamic wealth tax.
Certain countries levy a capital duty on new or additional contributions to the capital of companies. (Examples: Austria (1%), Belgium (0.5%), Ireland (0.5%), Luxembourg (1%), Liechtenstein (1%), the Netherlands (0.55%), Spain (1%), Switzerland (1%), Taiwan (0.025%), Uruguay (1%)). This duty is not normally creditable for tax purposes.
(g) Presumptive Taxes:
Several countries impose a presumptive tax in situations where the taxable income cannot easily be ascertained or computed. It involves the use of indirect means to ascertain the tax, which is then presumed as payable.
The reasons for its use vary. It may be to curb tax evasion or avoidance, or to reduce the compliance costs particularly on low turnover or income groups. The tax is often levied on deemed income or profits from certain sources.
It is collected either on assessment or by a withholding tax when the amount is paid. It may be levied under the domestic law or at the discretion of the tax authorities, and may or may not be rebuttable by the taxpayer. The method provides a convenient tax assessment and collection mechanism, but it could be an incentive to pay a fixed (and lower) tax, irrespective of the actual tax liability.
The presumptive methods vary from the use of a minimum tax under the law to income estimation by the tax authorities. In many cases, it is computed as a percentage of the assets, gross revenue or deemed profits. For example, the Dominican Republic levies a presumptive tax on the deemed income of companies engaged in insurance, transportation, film distribution and communications.
Guatemala charges nonresident transport companies a final tax at 5% of gross revenues. Saudi Arabia imposes tax on a deemed profit of 15% of gross revenues, if no financial statements are presented. Similarly, Russia applies a notional margin of 20% of expenses, if the tax authorities are unable to determine the profit of a permanent establishment or branch.
Certain jurisdictions apply a presumptive tax on the deemed revenues earned by foreign airlines and shipping companies (Examples: Bangladesh, India, Iran, Pakistan, Peru). Similar deemed taxation is often applied on the gross receipts of nonresidents from oil-related activities.
Construction, assembly and similar projects are subject to a final withholding tax on payments to nonresidents in Pakistan. Hungary taxes unregistered branches of foreign companies, either on their net profits or at 12% of expenses, whichever is higher. Several countries impose a tonnage tax as an alternative to regular corporate income tax on profits for shipping activities.
Presumptive tax is also applied to individual taxpayers. In some countries, it is based on “outward signs of lifestyle”. For example, Switzerland allows individuals to elect for a lump-sum tax based on expenses (i.e. standard of living) rather than on the actual taxable income.
Austria grants various tax exemptions to qualifying foreigners taking up Austrian residence. France taxes nonresident individuals on their French source income on a lump-sum basis. The amount is equal to three times the market rental value of their property in France, provided it is owned for at least a year.
(h) Minimum Alternative Tax:
Many countries charge a minimum annual tax based on the profits, gross revenues or net worth of the taxpayer. The taxpayer is liable to pay a minimum alternative tax, if the computed tax liability is less than this figure. In certain jurisdictions, the excess over the actual tax liability may be used to offset current or future corporate tax over an indefinite or specified period. Special rules often apply for the start-up years of operations.
The minimum tax may be either a presumptive tax or a requirement that the tax allowances and deductions do not reduce the tax payable below a minimum figure (Examples: India, the United States). For example, Nigeria applies a minimum tax on companies based on the highest amount computed on specified percentages of gross profits, net assets, paid-up capital or turnover.
India levies it at 7.5% of book profits. In Colombia, it is based on 6% of net equity. Pakistan imposes a minimum income tax at 0.5% of gross revenues. France levies a minimum corporate tax based on turnover. Senegal imposes a minimum tax of FCFA 500,000 (FCFA 1,000,000 if the turnover exceeds FCFA 500 million).
Tunisia has a minimum tax payable of TD 2,000 or 0.5% of turnover, if higher. In Morocco, the minimum tax is the greater of DH 1,500 or 0.5% of the annual turnover. The minimum corporate tax is 2% of gross income in the Philippines. Certain countries also apply an alternative minimum tax on individuals (Examples: Canada, South Korea, The United States).
(i) Higher Tax Rate on Undistributed or Distributed Profits:
Several countries impose additional taxes either to reduce or raise the level of profit distributions.
Examples to discourage profit distributions:
1. Argentina imposes a final withholding tax of 35% on the excess, if any, of the dividend payment or branch remittances over retained taxable profits of the company.
2. In India, domestic companies pay an additional 12.5% tax (plus surcharge) on distributed profits.
3. Liechtenstein levies a surcharge of up to 5% if the dividend distribution exceeds 8% of taxable capital.
4. Norway provides a deferred tax regime for shipping companies and levies the tax only when they distribute the profits.
5. South Africa taxes corporate income at 30% rate; the companies also pay a secondary tax at 12.5% on the dividend distributions.
Examples to encourage profit distributions:
1. Germany taxed undistributed profits at 40% and imposed a lower rate of 30% on distributed profits of companies through a 10% tax refund (pre 2001).
2. Panama imposes a deemed dividend tax of 4% of the net profits if no dividends are declared during the year.
Some countries levy an additional tax on the retained earnings of closely held companies, unless they can justify the profit retentions on commercial considerations (Examples: India, Ireland, Philippines, South Korea, Taiwan, the United Kingdom, and the United States).
The controlling interest in such companies allows them to defer the payment of dividends and avoid the tax liability due on the shareholders of the company.
For example, the Philippines levies an “improperly accumulated earnings tax” of 10% if a company (with certain exceptions) accumulates profits and does not distribute them to the shareholders. In Taiwan, a company must pay a 10% tax on the retained profits if its undistributed earnings exceed 100% (200% for government-approved industries) of the issued share capital.
(j) Special Tax Rates:
Some examples of special taxes and tax rates include:
1. Australia, India and New Zealand impose a separate “fringe benefits tax” on the employer for various non-cash perquisites given to employees.
2. Estonia taxes only income that is distributed. The distribution tax is levied on the gross amount of the distribution of certain specified payments.
3. Liechtenstein levies a graduated rate varying from 7.5% to 15% based on the company’s return on net worth.
4. Norway imposes an “active shareholder tax” if resident shareholders own two-thirds of the shares and actively participate in the company’s business. The company may reimburse the tax as a non-deductible expense.
Higher tax rates than the regular corporate rate may also be applied in other special cases. Bangladesh levies a higher tax rate on unlisted and nonresident companies. Bulgaria taxes commercial banks at a 50% rate. India taxes the profits of branches of foreign companies at a higher 40% rate.
A company incorporated in the Solomon Islands is taxed at a 35% rate, while foreign companies, even if they are resident in the Islands, pay a higher 50% rate. Special tax rates apply to gold mining companies in South Africa. Similar higher rates are often applied in the case of income from oil exploration and production in several countries.
Many countries encourage foreign investments through lower tax rates. For example:
a. China grants reduced tax rates for foreign investments located in the Special Economic Zones and Coastal Open Economic Regions.
b. Israel levies a lower tax rate on approved enterprises depending on the level of foreign ownership.
c. Singapore offers a concessional tax rate on a wide range of approved business activities.
d. Vietnam provides lower rates for foreign-owned companies based on the type of business activity, export commitment, employment level, technology considerations, etc.
The charging provision under the domestic law specifies:
(i) The person liable to tax,
(ii) The tax period to which the charge relates since the tax is imposed by reference to a period,
(iii) The taxable income or the tax base, and
(iv) How the tax payable should be calculated.
The charging provision applies to the taxable income or tax base and not to the gross income. Moreover, it excludes any income exempt from taxes. The tax base is affected by how the taxable income is computed. Some countries follow a global tax approach, under which they apply the same tax rules and the same tax rate to all categories of income, while other countries use a scheduler system.
The latter system classifies the income by broad categories or schedules under different heads of income, computes taxable income differently for each schedule and usually subjects them to different tax rates. In practice, all global systems contain some scheduler elements and vice versa. Most tax systems lie somewhere between the scheduler and global systems.
Under the scheduler system, the total income is often split between active income and passive or capital income. Income from capital includes income from passive investments such as rentals from immovable property, dividends from shares in a company, interest from loans and bonds, rental payments from leasing of property, capital gains, etc.
It differs from active income, such as business income (manufacture, trading, provision of services, etc.), employment income (i.e. from labour) or income from independent personal services. Generally, lower tax rates are levied on unearned income while earned income from business or employment income is taxed at higher progressive tax rates.
The charging provisions impose tax only on the persons who have taxable income for the relevant tax period. As income tax is imposed on a periodic basis, the tax base is affected by the rules relating to the fiscal or tax year. These rules vary widely. For example, some countries insist on a statutory tax year for corporate tax purposes. The calendar year must be used as the statutory tax year in many jurisdictions.
A few countries have specified fiscal year-ends. Others require the financial or accounting year to be used for tax purposes. Many countries allow the taxpayer to select any 12-month accounting period as the tax year, either with or without prior approval from the tax authorities.
Finally, there are a few countries that base the tax year on the financial accounts for the year, which had ended in the previous tax year (Examples: Fiji, India, Isle of Man, Malta, Mauritius, Singapore, Sweden).
The tax base may be computed on the cash or accrual basis of accounting, or some combination thereof. Under the “cash method”, the income is taken into account when the taxpayer has unrestricted access, directly or indirectly, to the money or the property involved. Similarly, expense deductions are given when the payee has unrestricted access to the funds.
The timing rules allocate the income and expenses of the taxpayer to tax periods. The rules usually vary for different taxpayers and for different items of income and expenses.
The tax accounts for business income generally follow the accrual method where the income earned during the accounting period and the related expenses are matched. Several countries allow the cash basis for small businesses, employment income or individuals.
Countries follow different approaches when preparing their accounts. Moreover, the rules differ depending on their purpose.
The three main types of accounts are:
1. Commercial accounts:
These financial statements are usually prepared to determine the profit of each entity under local generally accepted accounting principles (GAAP) in a country. The rules normally form part of the country’s commercial or company law to protect the rights of shareholders and creditors.
One of their key principles is the “prudence” principle, i.e. to provide for all future losses and recognise profits only when they have been earned.
2. Capital market statements:
Usually entities listed on a stock exchange are required to submit accounts under prescribed accounting and reporting standards as information to, and for protection of, investors (and other stakeholders). The guiding principle is “fair presentation” or “true and fair view”. The listed holding companies are often required to submit their consolidated worldwide results.
3. Tax accounts:
These accounts are prepared to determine the tax payable for a given tax period. Specific rules are used to determine the tax liability. The rules vary widely and are generally given in the domestic tax law of each jurisdiction.
These rules may not be based on fiscal considerations only. They often reflect other economic, and even social and political, objectives. Taxation is used widely as an instrument of domestic public policy by countries.
These different accounts serve different purposes, have different objectives and are based on different principles. For example, commercial and capital market statements look at a group of companies as a single global economic entity, whereas tax accounts are normally based on a separate domestic legal entity.
Moreover, tax rules are often designed to influence the behaviour of taxpayers by granting them incentives or using disincentives for non-fiscal reasons.
Some of the other significant differences in tax accounts include:
(a) The realisation principle, which enables taxes to be paid only when funds are realised or available.
(b) The equity principle, which ensures that taxes payable are fairly imposed on different classes of taxpayers, and
(c) The timing rules that govern the recognition of income and expenses, loss carryovers from other years and other tax rules.
The underlying principles of financial accounting are not always compatible with the basic principles and practices used in the field of taxation.
Therefore, the taxable profit, as computed in the tax accounts, is usually not the same as the commercial profits, as shown in the financial statements. The financial or commercial profits are determined under generally accepted accounting principles or commercial code. The tax base is computed either independently under the tax rules or based on adjusted financial accounts under the tax code.
The two methods, which are commonly used for computing the tax accounts of companies, are:
(i) Gross income less allowable deductions (“tax rules”):
This method does not rely on the financial or commercial statements. It uses the financial data and adjusts them, as appropriate, to meet the differing objectives of the tax accounts. Both the gross taxable income and the allowable expenses are defined under the domestic tax law.
Thus, the same books of accounts as the financial statements are used for tax accounting, but the special tax rules significantly modify the accounting principles.
In a few countries, the taxable profit is calculated under the principles of “sound business practice”, as defined in their tax rules. These principles differ from the financial accounting rules.
Although in practice the differences may not appear to be significant, the taxable profits are not necessarily based on the financial statements and may differ. For example, the rules may not allow a deduction for unrealized losses even when there is a strong probability that they will be incurred and the amount can be quantified.
(ii) Accounting profit (“accounting rules”):
Taxable profits are based on the accounting profits in the financial statements, as adjusted under specific tax rules. The accounting profits are taken either as a change in net worth in the balance sheet or from the profit and loss account.
Under the net worth approach, the book and tax income are closely linked. The tax accounts accept the value of the assets and liabilities stated in the commercial balance sheet. The taxable profit is the difference in the shareholders’ funds reported in the opening and closing balance sheets, as adjusted for capital contributions and dividends payments.
This method is used in many civil law jurisdictions. Under the profit and loss approach, the accounting profit in the financial statements forms the starting point for the tax computations. This income is adjusted as required by statute, judicial decisions and/or revenue practices. Several countries use this method.
Tax rules in countries often provide for the deferral of tax on certain items of income or expense. They are recognised for book purposes in a particular year but are included for tax purposes in a different year. These tax adjustments create timing differences in tax payments or a “deferred tax liability”.
Some examples of tax deferral include:
a. The income or payment of tax is spread over several years to prevent hardship, especially in cases where a taxpayer’s income is very high in a particular year.
b. Additional or accelerated depreciation allowances are granted on business assets to encourage investment by reducing the taxable income of earlier years with a corresponding increase in later years.
c. Rollover relief allows deferral of capital gains tax liability.
A few countries require the tax computation to be based on inflation-adjusted accounts. Some countries also demand that the accounts be audited for tax purposes. The extent of the adjustments required in the commercial accounts to arrive at the taxable profits varies.
In some countries, the financial and tax accounts are virtually identical since the accounting practices are largely influenced by the tax rules. Certain countries prepare the financial statements independently of the tax rules and, therefore, require significant adjustments under their tax laws to compute the taxable profits.
There are also countries that prepare the financial statements under the accounting principles and standards but need few adjustments to meet the tax requirements. Finally, many countries adhere to the form of the transaction in the determination of the taxable income, while others look at the substance and adjust the accounts accordingly for tax purposes.
The tax base is affected by several other factors, such as accounting policies, exempt income, special tax allowances or disallowances, non-deductible or limited-deduction expenses, losses brought forward, etc. Different countries follow different accounting principles for tax purposes, allow or disallow different deductions and grant different tax incentives and exemptions.
The adjustments to the commercial accounts may be permanent or just create a timing difference when certain expenses are deductible for book purposes but not tax purposes, and vice versa. Some of these issues are described in the following sub-sections.
Although they are not binding, the Courts usually accept that the financial statements prepared according to the generally accepted accounting principles give a true statement of the commercial profits for the relevant period. The tax rules do not always follow the same accounting policies as used for financial reporting purposes.
Differing accounting policies can and do affect the tax computations, and the taxable profits. Some general accounting policies that have a significant impact on the tax base relate to inventory valuation, depreciation policies, lease accounting and treatment of foreign exchange gains and losses.
(a) The inventory valuation rules acceptable for tax purposes by countries vary widely. For example:
1. Lower of cost or market value:
Austria, Belgium, Brazil, Cameroon, Canada, Congo, Denmark, Egypt, Fiji, France, Gabon, Germany, Greece, Guatemala, Guinea, Israel, Italy, Ivory Coast, Japan, South Korea, Luxembourg, Monaco, Netherlands, Philippines, Portugal, Puerto Rico, Senegal, Switzerland, Thailand, Trinidad and Tobago, Taiwan, the United States, Yemen.
2. Lower of cost or net realisable value:
Botswana, Czech Republic, Hong Kong, Iceland, Ireland, Kuwait, Lebanon, Malaysia, Malta, Pakistan, Singapore, South Africa, Sri Lanka, Tanzania, Uganda, the United Kingdom.
3. Lower of cost, market value or replacement value:
Australia, Finland, India, South Korea, Mauritius, Mozambique, Papua New Guinea, New Zealand, Uruguay.
4. Inflation-adjusted cost:
Chile, Colombia, Ecuador, Israel, Mexico, Peru, Venezuela.
5. Historic cost only:
China, Japan, New Zealand, Norway, Spain, Sweden, Tunisia
6. Any acceptable basis used consistently (no rules specified):
Angola, Bangladesh, British Virgin Islands, Bulgaria, Djibouti, Gibraltar, Libya, Mozambique, Nigeria, Oman.
(b) The term “cost” normally includes the related expenses and charges directly and indirectly incurred in bringing the asset to its present condition and location. However, this definition is not followed in all countries.
While certain countries require that the inventory costs must be based on full absorption costing (i.e. direct and indirect production overheads), some countries only accept direct costing (i.e. the sum of direct material, direct labour and variable factory overhead costs). In the United Kingdom, the Courts give the option to the taxpayer to use either the full absorption or direct costing method.
In Brazil, unless an integrated costing system is in place, the finished goods are valued at 70% of the highest sales price, and work-in-progress at 80% of the finished goods cost or at 150% of the highest material content. Argentina values them at the cost price during the last two months of the financial year.
Portugal accepts any approved valuation, including standard costs, and allows the use of the sales price less a normal gross profit margin for inventory valuation. Mexico allows the deduction of the actual costs incurred on purchased materials, labour and overheads, instead of the normal cost of sales for computing net profits.
(c) The method of computing the cost of inventory also varies:
Many countries permit either the actual cost or the average cost for inventory valuation on the first-in, first-out basis. Several of them also allow the last-in, first-out method, while others specifically forbid its use. In many countries, any acceptable method may be used, provided it is applied consistently over time.
For example, Japan and South Korea allow a wide range of inventory costing methods, provided it is reported to the tax office. If it is not reported, Japan accepts the most recent purchase method, while the first-in, first-out method is permitted in South Korea. Base stock method is allowed in the Netherlands, but not the replacement cost method.
(d) Generally, the tax authorities insist that any changes in the valuation method must be made only with their prior approval. In Panama, once a method is adopted, it cannot be changed for five years.
Depreciation or Capital Allowances:
The domestic law normally grants a tax deduction for the capital or depreciation allowances (sometimes called wear and tear allowance) over the economic life of various assets.
There are wide variations in country practices. For example:
(a) The basis for depreciation is the purchase or manufacturing cost, but the rates may be either those used in the accounts, or those determined by the tax law. As several countries impose specific rates or specify minimum or maximum depreciation rates under the tax law, these rates may differ from the rates used in the financial statements.
The difference in the book and tax depreciation leads to deferred tax liability (or deferred tax asset).
(b) The allowable tax depreciation is affected by the method of calculation. There are various methods that can be used, e.g. straight line, declining or reducing balance, sum- of-years’ digit method, etc. Several jurisdictions prescribe the method or methods, which must be used to compute the tax depreciation. Some countries allow one method only, others offer a limited choice, while still others permit any method.
Thus, the straight- line basis is exclusively applied in many countries, while only the declining-balance method is acceptable in certain jurisdictions. Several countries allow both the straight- line and declining-balance methods, provided they are used consistently. A few countries follow the sum-of-years’ digit method (Examples: Costa Rica, Panama, Philippines, Spain).
(c) Depreciation may be computed on a per-item basis or determined in aggregate separately for each category or basket of assets. Some countries require that the fixed assets be “pooled” by categories for calculating the depreciation allowance for each basket. Any disposal proceeds are deducted from the relevant basket. The balancing charge that arises when the “pool” is depleted is added to the taxable income.
(d) The depreciation practices may vary. For example, certain countries give a partial allowance in the year of acquisition (Examples: Australia, Canada, Fiji, Germany, India, Turkey, the United States), while others grant the full allowance for the year of purchase, irrespective of the period of usage or ownership (Example: the United Kingdom).
Some countries grant the depreciation on a prorated monthly basis (Examples: Belgium, France, Japan, Mexico). Certain depreciation allowances may be restricted to new plant and equipment only, and granted not on ownership, but on use. A few countries permit asset revaluations, but they usually disallow the tax depreciation on the excess over the original acquisition cost.
In some countries, the tax rules grant the taxpayers the option to claim the tax deduction for depreciation (Examples: Canada, Italy, Portugal, the United Kingdom), others require that the minimum depreciation must be charged for tax purposes even in loss- making years (Examples: Belgium, France, Germany, India, Luxembourg, Netherlands).
(e) Many countries grant accelerated tax depreciation rates to encourage capital investment, either on all assets or on certain types of assets. Besides higher depreciation rates, incentives may also be given as additional initial or investment allowance, or even as “free depreciation”, where the taxpayer can choose the tax depreciation rate.
Some countries allow an immediate tax write-off of expenditure incurred on minor capital items below a specified “capitalisation limit” (Examples: Austria, Greece, Luxembourg, and the United States). Short- life assets may also be eligible for write-off either as incurred, or within a short period (Examples: Denmark, Finland, Hungary, The United Kingdom).
(f) Not all countries permit the amortization of intangible assets. Such amortization is specifically denied in several countries, while others allow straight-line deductions for tax purposes over a specified period.
The term “intangible assets” usually includes goodwill, going concern value, workforce in place, business books and records, patents, copyrights, formulae, processes, designs, patterns, know-how and formats, customer-based intangibles, supplier-based intangibles, covenants not to compete, franchises, trademarks, trade names, etc.
Leasing involves the use of an asset for a contractual period without the legal ownership. It is a contract “whereby a separation of the ownership of an asset and its usage is established for a certain period of time”. Leasing differs both from a hire purchase agreement, in which the seller retains the title until the full payment is made, and from an installment sale where the title is transferred on the sale but is paid in installments.
The accounting literature distinguishes between operating and financing leases. An operating lease is essentially a rental contract. The lessor takes the ownership risks and rewards. Any subsequent sale to the lessee is made at the fair market value. On the other hand, a financing lease is a technique to finance the asset through regular payments over the economic life of the asset.
The lessee has the economic, if not the legal ownership, with an option to buy the asset at a nominal value at the end of the lease. In some countries, a financing lease is treated as a conditional sales contract with the potential reversion of title to the seller.
Generally, lease transactions give the tax benefits to the lessor as the financier, and not to the lessee as the user of the property. The lessor is entitled to the depreciation and other tax allowances as the owner, who may then pass the tax advantages to the lessee in lower lease rentals. The lessee may claim the lease rental as a tax-deductible expense.
However, certain countries treat a financing lease differently from an operating lease for tax purposes. They look at the substance and not the form. A financing lease is treated as a sale by the lessor at the present value of the future lease payments due to him. The lease payments are analysed as an installment payment towards the cost of the asset and an interest payment on the deferred sale price.
The interest element in the lease payments is taxed separately, subject to withholding taxes. The lessee is considered the economic owner for tax purposes and entitled to the tax benefits, including depreciation allowances. Not all countries recognise this distinction between financing and operating leases under their domestic tax law. In several countries, the tax treatment of leases is still unclear.
Under sale and leaseback transactions, the lessee either owns or acquires an asset, which is sold at a fair market value to a financing company and then leased back on a periodic rental basis to cover the capital cost and interest. Although the asset legally belongs to the lessor, the economic interests and risks remain with the lessee.
This form of secured financing is accepted and widely used globally to free up capital locked in assets without the loss of their use for a guaranteed period. Some tax authorities look at sale and leaseback transactions as unacceptable tax avoidance.
The tax treatment on cross-border leases usually follows the principles applicable to domestic leases. The differences in the national treatment in various countries can create tax conflicts. The tax rules may either grant the tax allowances to both the lessor and the lessee (“double dipping”) or create double taxation with no deduction for depreciation in both countries.
Triple dipping is possible, if a taxpayer in a third country, other than the lessor and lessee, is treated as the beneficial owner of the leased equipment for tax purposes. These problems of double (or triple) dip or double taxation require a harmonisation of domestic tax laws.
Juridical double taxation may also arise on the lease rentals that are taxed on a lessor in the State of source and in the State of residence. The host country may either tax the lease fees on a net basis or levy a withholding tax on the gross rentals.
As the profit margins are usually small compared to the gross income, the withholding tax under the gross basis may exceed the profit margin. If a foreign tax credit is given on a net basis in the residence country, it would lead to excess tax credits for the lessor at home.
The domestic tax laws of many countries treat the lease income as business profits, and tax the lessor only if there is a permanent establishment in their country, or if he performs certain business activities. OECD MC 1977 included leases under the royalty article, subject to tax in the State of residence only, unless it was attributable to a permanent establishment in the host State.
The OECD MC has now classified equipment lease income as business profits, which are taxable on a net basis but only if a permanent establishment exists. The UN MC does not provide this safeguard against juridical double taxation on leasing income.
Tax Allowances and Disallowances:
Tax is levied on the net profits, i.e. the income after the deduction of all allowable expenditure incurred in earning the income. Most tax jurisdictions allow deductions for expenditure incurred for the purposes of the trade or business.
The expenditure must be incurred “solely with the object of promoting the business or its profit earning capacity”, i.e. incurred to either produce the income, or to create new business. These expenses should reflect the taxpayer’s own business perspective and not the view of the tax authorities.
The expense deduction rules vary widely. For example:
(a) Some countries require statutory provisions that may be tax deductible. For example, under the Mexican law the employees (except directors, administrators and general managers) have a right to receive 10% of the annual profits of the company as a profit- sharing bonus.
The profits are distributed to the employees pro rata to their salary and the number of days worked by them during the year. The amount is a tax-deductible expense for the company to the extent that it exceeds the non-taxable benefits given to the employees.
(b) Many countries specify the “wholly and exclusively” rule for the deduction of corporate expenses. The disallowed expenses are added back to compute the tax liability. Besides capital expenses, they usually include personal and non-business expenses, but could also comprise legitimate business expenses, if they are deemed excessive, unjustified or unacceptable tax avoidance.
(c) Many jurisdictions disallow, wholly or partly, benefits in kind, such as entertainment, meals’ expenses and other employee fringe benefits. Other common disallowances include business gifts and donations, and expenses relating to the private use of motor vehicles.
(d) While specific services rendered by the parent company may usually be charged (with or without a profit mark-up) to foreign group entities by its parent, the tax treatment of executive and general administrative overheads often varies.
Some countries provide for the distribution of such expenses within the group, while others require such expenses to be charged only to the extent of the direct benefits to the subsidiary, or subject to prescribed limits (Example: India).
(e) Several countries disallow deductions of “self-charged” payments or transfers between the head office and its foreign branches. A company may not make a profit from itself. Therefore, royalties and interest payments to the head office by an overseas branch are disallowed.
Similarly, head office charges may be disallowed, wholly or partly, in the branch accounts. Actual expenses incurred or paid to third parties for the branch are usually deductible.
(f) Generally, no deductions are allowed for the income taxes paid, interest on late tax payments and tax penalties. Bribes and secret payments are tax-deductible in certain countries. Some countries (e.g. Belgium, France) allow them but impose a penalty tax on such payments when made to an undisclosed recipient.
Several countries fully disallow such expenses (Examples: Brazil, India, Italy, the United Kingdom, and the United States).
(g) Revenue expenses are normally tax deductible, but capital expense items are not, unless they can be amortized or depreciated. They may also be subject to separate capital gains tax rules. The distinction usually follows the general accounting principles.
Capital expenses tend to be non-recurring, relatively large and incurred to produce a long-term or enduring benefit. Deferred revenue expenditure and capital improvements also have an enduring value and may be deducted over a matching period of benefits or income flows.
In June 1955, the Royal Commission on the Taxation of Profits and Income in the United Kingdom mentioned in its report that UK Courts generally used certain factors (“badges of trade”) to make their decision. They included:
1. Actual subject of the transaction:
Dealing in commodities is more likely to be a trade than dealing in assets used for investments.
2. Length of ownership:
Property that is traded is normally owned for a short period, while investments are held for a longer period.
3. Frequency and number of similar transactions:
A person who frequently buys and sells one type of property is more likely to be trading than a person who does so only once.
4. Supplementary work:
If a person who sells an asset has carried out any work to increase its value, he is more likely to be trading than if he had done nothing to improve it.
5. Reasons for the sale:
A sale may not be trading if it can be shown to have been made to deal with an unexpected emergency or opportunity.
In some cases, the motive of a transaction is clearly discernible, and a motive may be inferred from the other circumstances in the absence of direct evidence from the person concerned. Other badges of trade also exist. In case of isolated transactions not forming part of a regular trade or business, it may be inferred that the transactions were in the nature of a trade if one or more of the following factors are present:
i. The existence of an organisation;
ii. Production activities;
iii. Special skills or opportunities; or
iv. The fact that the nature of the asset lends itself to commercial transactions.
(h) Tax deductions for provisions vary. For example:
1. Some tax jurisdictions do not grant deductions for future loss or contingency provisions; others grant them for specific provisions (Examples: Australia, Egypt, Fiji, India, Israel, Lebanon, Uruguay, Uzbekistan, Venezuela); still others permit deductions for general provisions (Examples: Bulgaria, Croatia, Dominican Republic, France, Gabon, Germany, Italy, Lesotho, Luxembourg, Monaco, Peru, Portugal, Spain).
2. Some countries disallow provisions for bad debts, unless the debt is written off (Examples: Australia, Brazil, Egypt, Fiji, Hungary, India, Israel, Lebanon, Uruguay, Uzbekistan, Venezuela); others allow general or specific bad debt no provisions.
3. The provision for inventory obsolescence is denied, wholly or partly, in certain countries (Examples: Angola, Argentina, China, Ecuador, Venezuela).
4. Some countries permit, or even require, various special provisions as tax-free reserves (Examples: Bangladesh, Finland, France, Germany, Italy, Korea, Mozambique, Netherlands, Portugal, Slovenia, Suriname, Sweden, Taiwan, Tunisia, Turkey).
(i) Certain expenses may be disallowed under anti-avoidance rules. For example, excessive interest cost on related party transactions may not be deductible under thin capitalisation rules. Certain costs may be reallocated under transfer pricing rules.
(j) The expenses are usually disallowed if the related income is tax-exempt or nontaxable. Certain expenses may be deductible only when they are paid (Example: interest payments).
Excess taxation can arise in cross-border operations due to the varying rules for expense deductibility. The domestic law in the home State may follow tax rules that differ from the host State. Local tax knowledge and professional advice are generally needed to ensure that there is no tax waste on unclaimed expenses due to ignorance of foreign laws and practices.
Incentives are measures that make one investment more attractive than another alternative investment. They are meant to provide a more favourable regime to investors. In many cases, they offset the disadvantages that investors face due to high taxes, inadequate infrastructure, bureaucratic rules and/or poor administration in the host country.
They may be given to both domestic and foreign investors or restricted to either of them, i.e. ring- fenced.
Incentives are either financial (e.g. grants, subsidized facilities, low-interest loans, etc.) or fiscal in nature. They promote a general or specific economic or social development objective within a particular region, industry, activity or class of persons.
A common objective is to help national or regional economic development, exports, technology transfers or employment creation. Many countries also give incentives to help develop specific industries or investors, such as manufacturing, agriculture, shipping and shipbuilding, film industry, high technology and research and development centres, financial services, tourism and hotels, software exports, etc.
Tax incentives include tax holidays or exemptions, investment credits or allowances, accelerated depreciation, additional expense deductions, reductions in the corporate or withholding tax rates, tax deferment, relief for expatriate taxes, etc. Weighted deductions may be granted for research and development expenses, approved training expenses, export market expenses, job creation, etc.
Some countries partly or fully tax-exempt reinvested profits (Examples: Brazil, China, Guatemala, Italy, Malaysia, Senegal, Sweden). Certain countries grant tax incentives as fixed tax credit, rather than as a deduction from profits that are taxed progressively at the marginal rate.
The incentives may also include special deductions (partial or full) or allowances for certain expenses. For example, Switzerland permits one-third of the value of inventories to be written off through under-valuation, if it is recorded in the financial books of account. Malaysia and Singapore grant double deduction for employee training, research and development and export expenses.
Many countries provide fiscal incentives to attract inbound investments. Some countries provide tax incentives to encourage outbound investments and develop foreign market opportunities (Examples: France, Germany, Japan, Spain). It is true that tax is not a primary consideration in deciding to invest abroad.
However, once a decision to invest abroad has been made, the investors normally look for the most cost-effective location that meets their business objectives. Several countries give tax incentives to encourage the set-up of holding companies and various group service centres of multinational companies in their jurisdiction.
A major use of incentives is to encourage export-related operations. Many countries provide special zones or Freeport facilities with concessionary or nil customs duties and taxes. At least 800 such zones exist around the world in over 100 different countries.
Since high taxes make countries less competitive in international markets, the export- oriented investments (both manufacturing and services) are particularly influenced by tax incentives. Much of this investment is highly mobile, cost conscious and tax sensitive. Often, the incentives affect both the decision to invest and where to invest.
The effectiveness of tax incentives depends on their tax impact on both the source State of the investment and the Residence State of the investor. The various incentives exempt, defer or reduce the tax costs in the source State.
These measures may not be fully effective for several reasons. For example:
1. The investor may not have enough taxable profits to take advantage of the tax incentives. As a result, the tax benefits may be lost unless they can be carried forward or set off against other income.
2. A new investment normally makes losses in the start-up period. If the tax holiday period is not long enough, there may be no taxable profits to shelter. The tax losses during the period may be lost, unless they can be carried forward beyond the holiday period.
Moreover, the taxes in the post-holiday period may be increased since there are no carry-forward losses available to offset the profits. To be effective, the tax laws should specify that the holiday starts when the cumulative net taxable profits are positive. The depreciation allowances should also be deferred to the post-holiday period.
3. Acceleration of deductions or deferral of income recognition could lead to timing differences that create tax losses (or reduce profits) in earlier years for offset against the profits that arise in future. Again, unless the countries provide that the tax losses (e.g. due to unused depreciation allowances) can be carried forward for a long or indefinite period, these tax benefits of timing differences may be lost.
The tax incentives given in the source State may be recaptured when the Residence State grants relief under the credit method for the foreign taxes on repatriated profits or other income. Unless tax sparing is given under a tax treaty, there is simply a transfer of tax revenue from the source country to the residence country.
Although this incentive is now often restricted and given only for a limited period, many developing countries insist on tax sparing in treaty negotiations.
In the view of some tax commentators, tax incentives have not been very effective in attracting foreign investments or technologies, and lead to various tax avoidance schemes. Moreover, they believe that if the investment were economically justified, it would have taken place in any event. Therefore, tax incentives should be targeted to specific economic or social objectives that would not have occurred without the incentive.
The Ruding Report issued in 1992 did not favour tax incentives and recommended the use of financial incentives. Tax incentives for geographically mobile activities, such as group financial and service activities have also been attacked by the OECD as harmful tax competition. These activities can be located almost anywhere provided there is a good telecommunications service. Tax factors often play a primary role in deciding the location.
Despite these comments, tax incentives are widely given by countries to foreign investors. Just as countries are free to choose the type of fiscal and social system they prefer, investors should be free to choose among such systems. All other things being equal, the use of tax incentives helps to achieve a competitive advantage in global business activities.
The tax competition among nations should also lead to more efficient tax systems and lower tax costs. In developing countries, tax incentives often help to compensate for their unattractive, or not so attractive, economic or political infrastructure.
A survey of the major companies within the European Union Member States in the nineties mentioned that 75% of the companies in the study were influenced by tax incentives in their investment decisions. The most popular tax incentives were low tax rates and, to a lesser extent, high depreciation rates and tax-favoured distribution centres.
Assessment and Withholding Taxes:
Income may be taxed annually on assessment, or subject to a withholding tax on the payment at the time that it is made to the taxpayer. Generally, business income is assessed on a net income basis (i.e. with expense deductions) at the end of the year while passive income is subject to withholding taxes on the gross amount (i.e. without expense deductions).
Many countries apply a hybrid system combining the assessment and withholding systems for employee taxes. Tax is deducted from their salaries and paid over to the authorities every month, based on the estimated annual income. Any adjustment due to excess tax payable or refundable is made at the end of the year against their tax return.
Under the assessment basis, the taxpayer is normally required to file a tax return giving the information necessary for the tax authorities to determine the liability. This return includes the details of the taxable income, allowable deductions and any other tax reliefs or disallowances.
The tax authorities compute the tax and make a tax demand on the taxpayer for any tax due or give a refund for the excess tax paid. Several countries have adopted a system of self-assessment.
Under this procedure, the taxpayer is required to calculate the tax himself and pay the amount. The authorities only check the assessment. The taxpayer is held responsible for the correct payment of his taxes, and any underpayment is usually subject to interest and/or penalties.
Since tax assessments cannot be made until after the end of the tax year, many countries require advance payment of the tax during the year based on estimates to ensure that it is received as soon as the taxable income is earned. The estimate is based either on the tax paid in the previous year or on an amount adjusted for known changes expected in the amount payable for the year.
Final adjustments are made when the tax return is filed. Under-estimates, if material, may again be subject to an additional interest payment. Under the tax law, it is the statutory duty of every taxpayer, subject to penalties, to ensure that he pays the correct amount of annual tax due on time.
Active business income (including independent personal services) is generally taxed on a net basis on assessment, while the income from passive and dependent personal services is usually subject to a flat withholding tax. The tax is withheld at a fixed rate, either as a final tax with no tax-filing requirement, or as a provisional tax subject to a regular assessment under his tax return.
Generally, a withholding tax is imposed on interest and dividends payments to residents and non-residents. Often, these withholding requirements are extended to royalties and in some cases to rental income and management fees. The withholding method is also applied when the collection of tax is either difficult or subject to delay.
Under the withholding tax regime, the amount of tax due from the recipient as taxpayer is withheld by the payer at source and paid over to the tax authorities on his behalf. The rate may be the full rate under the domestic law or a lower treaty rate. The tax may be final or subject to adjustment against the tax payable on assessment.
The creditable withholding tax ensures the payment of tax at the earliest possible moment. As countries do not normally enforce the tax laws of another jurisdiction, withholding tax is widely used for tax collection when payments are made to nonresidents.
Tax withheld from residents is usually creditable against other taxable income and any excess tax payment is refunded. For nonresidents, the payer is required by law to deduct the appropriate withholding taxes at the time of making the payment.
As the person withholding the tax is responsible for collecting (and sometimes calculating) the tax, he is jointly liable for the tax due from the nonresident payee as a “representative assessee”. The payer may not be allowed to claim the payment as an expense deduction for its tax purposes unless he complies with the withholding tax rules.
The withholding tax may or may not be the final tax. The final tax simplifies the collection of tax, particularly when due from nonresidents. However, if it bears little or no relationship with the tax circumstances of the taxpayer, it may be excessive or inadequate. If it is not the final tax, any excess withholding tax can be reclaimed but only on an assessment at a later date.
A similar situation also arises if the tax is not withheld at the reduced treaty rate but at the full rate, subject to refund. In both cases, there is a cash-flow disadvantage with related costs as the refund procedures can be often difficult and slow.
These procedures normally require the nonresident taxpayer to file a tax return for an adjustment of the tax liability. He must, therefore, notify the tax authorities, provide them with the necessary information to compute the tax, appoint a tax agent if required, and meet other compliance requirements.
Tax on passive income is normally imposed on the gross payment. Therefore, the withholding tax rates generally tend to be lower than the tax rates applicable on active income taxed on a net basis.
As long as the home tax on the gross receipt less expenses is more than the withholding tax in the host country, the total tax liability on the recipient should not exceed his home tax liability, provided a credit is given for the foreign tax.
As mentioned above, there is a cost due to the timing of the tax payments in the host and home countries. The withholding tax is paid to the source State when the income is received, whereas the tax payment in the residence State is deferred until the prescribed due date under the domestic law at home. This deferral itself represents a tax benefit due to the time value of money.
A survey by the Ruding Committee noted that many multinationals regarded withholding taxes as a major concern when making cross-border investments. International tax planners generally choose countries with nil or low withholding tax, or attempt to reduce them by using intermediary entities. A high withholding tax in the source State is considered as a deterrent to international investment and trade.