Taxation

ACCA Director Author

Taxation

Taxation

14.1 Names for Tax Authorities in Different Countries/Areas

Tax authority names vary from country to country. For example, the tax authority in the UK is called HMRC (Her Majesty’s Revenue and Customs). In Hong Kong, the tax authority is called IRD, for Inland Revenue Department. In the USA, the tax authority is the IRS (Internal Revenue Service) while in Singapore, the tax authority is the IRAS (Inland Revenue Authority of Singapore).

14.2 Tax Law

Businesses and individuals need to follow tax law in their own jurisdiction. For example, in the UK, most major tax legislation including Income Taxes, Capital Allowance Tax and Corporation Tax are passed by the UK parliament. Changes to the tax law following the government budget will be reflected in the UK Finance Act every year. The detailed Finance Act can be found on the UK government legislation website http://www.legislation.gov.uk.

14.3 Corporation Tax Calculation

When businesses make profits, they need to pay corporation tax, i.e., taking the taxable profit of the business and then multiplying by the corporation tax rate. In some countries, if the business has suffered a loss in the current year, the loss could be used to offset the previous year's taxable profit and claim the tax refund from the government. Similarly, tax losses may be carried forward to offset future profits.

Example of trading losses:

Company A has made £400,000 taxable profits in the current year and the corporation tax rate is 19%. Company A estimates that the corporation tax is £76,000 which is calculated as £400,000 x 19%.

Company B incurred the trading loss of £300,000 in the current year; according to the tax law, the trading loss can be carried back to offset the previous year’s trading profit, to obtain a refund from the tax authority.

Let’s assume Company B’s last year’s trading profit was £300,000 and the tax rate 20%. In the current year, Company B does not make any tax payments because there are no profits. Company B could receive the £60,000 tax refund calculated as £300,000 x 20%, i.e., last year’s profit was £300,000, and the company could use the current year’s loss of £300,000 to offset against it. Hence, the tax of £60,000 paid in the last year can be claimed back from the tax authority.

In some countries, the use of trading loss is an example of the tax planning strategy. The trading loss may be used to offset the previous year’s profit, to claim the refund. However, if there are no trading profits available in previous years, the trading loss could be carried forward to offset future profits, to reduce the future tax payments. However, in Hong Kong, trading losses can only be carried forward to set off against future trading profits. In the UK, trading losses can only be carried back for two years.

14.4 Tax Return

Each year, a business needs to complete a tax return indicating the amount paid to the tax authority. The tax return can be completed either in paper format or via an online form. The company may pay its tax bill in one instalment or in several, according to the tax rules in different countries. For example, in the UK, if the taxable profits are up to £1.5 million in the year, a single tax payment to the HMRC will need to be made. This payment is due nine months and one day after the end of the accounting period.

If the taxable profits are more than £1.5 million, depending on their accounting periods, the tax payments may be settled in three or four instalments. For example, a company with a standard accounting period of twelve months will pay in four instalments. A company with an accounting period of nine months (less than twelve months) will normally pay tax in three instalments. However, if the business has just commenced trading (that is, producing Financial Statements for the first time) or in administration (business to be liquidated soon), the accounting period can be extended to a maximum of eighteen months. The calculation of the tax due by instalments now becomes quite complicated. The business will first need to estimate the total tax liability payable in the first and remaining instalments. As the accounting period extends, the business will need to revise the estimated payable tax liability. In this case, the company may have underpaid or overpaid its tax liability in previous instalments. In this case, the company needs to top up the amount which is underpaid or to claim the refund from the tax authority for the amount overpaid. This is called under- or overpayment of tax.

Other examples where the business under or overpays tax may include errors made, or it could be the case that the transfer price set for the sale of goods among group entities is not at fair value, and hence the tax authority requires additional adjustments to be made regarding the taxable profit.

The business will also need to consider interest charged by the tax authority for the amount underpaid, or to claim the interest income back from the tax authority for the amount overpaid, and this really depends on the tax rules in different countries.

14.5 Deadline and Penalty for Late Payment

The business will also need to consider the deadline for the corporation tax payment. In the UK, the deadline by which the business needs to pay its corporation tax is nine months and one day after the accounting year end. The penalty will be applied if the business has missed the deadline to pay its tax.

14.6 Taxable Profits Calculation

What are taxable profits? Taxable profits are calculated based on the accounting profit, i.e., the profit before tax figure. To calculate the taxable profit, we need to start with the profit before tax, and adjust any income exempt from tax, as well as expenses disallowed for tax purposes. Let me explain what these are.

From time to time, and according to the differing tax laws, the income included in the profit may not be subject to corporation tax. For example, in the UK, according to the 2019 tax law, if a business has income from selling patented products, part of the income can be exempt from corporation tax. Regarding expenditure, in most countries, entertaining expenses deducted from the accounting profits should be added back, because these expenses are not allowed by the tax authority to reduce the business tax bill; these are called disallowable expenses.

14.7 Reconciliation of Accounting and Taxable Profits

Example:

A company has made an accounting profit of £300,000, and the corporation tax rate is 19%. Within that profit, there is £20,000 income which is exempt from tax, and £30,000 expenses disallowed for tax purposes.

Hence, the taxable profit can be calculated as £300,000 minus the £20,000, and then adding back £30,000—which gives us £310,000. Therefore, we apply the corporation tax rate of 19% on the £310,000 taxable profit which gives us a £58,900 corporation tax expense.

14.8 Accounting Treatment for Corporation Tax

The following journal entry is based on the International Accounting Standard number 12 or IAS 12 Income Taxes. As at the year end, the financial accountant needs to estimate what will be the total tax due/owed to the tax authority. The business may have a tax accountant who computes the corporation tax to be paid in the form of the tax return, and the financial accountant then needs to record this transaction in the Financial Statements. Let’s say that according to the above example, the estimated corporation tax to be paid to the tax authority is £58,900. The accountant will need to make the following journal entry:

Dr Corporation income tax expense (P/L) £58,900

Cr Current tax payable (SFP) £58,900

The debit side of the entry goes into the statement of profit or loss, to reduce the net profit. This is to reflect the fact that the business has made a profit in the year. Hence, it needs to match the related expenses with the income to finally calculate the net profit. The credit side of the entry goes into the statement of financial position, to increase the liability, and the business needs to settle this before the deadline. Therefore, it is included in the current liability section of the statement of financial position, as taxation will be paid within one year after the Financial Statement’s year end.

14.8.1 Underpayment of Corporation Tax

Suppose that the tax authority inspects the company’s tax return and finds that the company has underpaid £500 in respect of the last year’s profit. The business should then make the following journal entry in the current year’s Financial Statements:

Dr Corporation income tax expense (P/L) £500

Cr Current tax payable (SFP) £500

This is to increase the current year’s expense and the related liabilities by £500. The debit side to increase the current year’s expense and the related liabilities by £500. The debit side of the above entry should be taken across to the current year’s statement of profit or loss, but not last year’s. It is a change in accounting estimate, because the accountant has made the best estimate of how much income and expense should be recognised in the last year’s Financial Statements. Hence, the difference in estimating the tax liability paid should be accounted for ‘prospectively’, i.e., the adjustment should be made based on when the error is found and, in this case, the current year.

14.8.2 Over Payment of Corporation Tax

Suppose the business has overpaid £500 tax regarding the last year’s profit. The double entry should be carried out as follows:

The overpayment of tax results in a decrease in the tax liability and expense by £500.

14.8.3 Payment to the Tax Authority

In the UK, payment to the tax authority could be made by online or telephone banking, BACS transfer or direct debit.

When the £59,400 tax payment is settled, the following entry should be made:

Dr Current tax payable (SFP) £59,400

Cr Bank (SFP) £59,400

This is to reduce the tax liability due and the bank asset by £59,400.

14.8.4 Tax Rates or Tax Laws Which are Enacted or Substantively Enacted

Suppose from the above example, the accounting year end is 31st December, and on 30th September, the tax authority has announced that the new corporation tax rate is to be revised to 18% from 5th January next year onwards. Therefore, when estimating the total tax expense for the current period, the new tax rate of 18% should be used, because the new tax rate has been substantively enacted or announced by the end of the reporting period. In the UK, the tax rate is set for each year from 1^st April, in the Finance Act usually prior to this date.

14.8.5 Tax Losses Carried Back

According to IAS 12 Income Taxes, if the business incurs trading losses in the current period which can be carried back to offset previous taxable profits, the company can claim the tax benefit and recognise this as an asset in the Financial Statements.

Example:

In the current year, the business has incurred $30,000 trading losses. According to the tax law, trading losses can be carried back to offset against the previous year’s trading profit. Assume the last year trading profit was $50,000 and the corporation tax rate 20%; the tax benefit can be calculated by using the current year’s trading losses of $30,000 and multiplying this by 20%, to give $6,000.

The following journal for the tax benefit is made:

Dr Current tax receivable (SFP) $6,000

Cr Current tax payable (SFP) $6,000

The debit side represents the current asset, i.e., receivable in the statement of financial position. And this means that the company expects to collect the tax refund from the tax authority, normally within one year. The tax refund is based on the amount of tax the company has paid in the previous year’s account. The business must have reduced its tax liability in the previous year’s account when the tax liability was settled. Because the business now expects to collect the tax refund, this means that the liability should not exist in the first place. Therefore, we need to reverse or credit the current tax payable liability of $6,000.

When the tax benefit is received, the following accounting journal entry should be made:

Dr Bank (SFP) $6,000

Cr Current tax receivable (SFP) $6,000

The corporation tax expense calculation in the statement of profit or loss also includes deferred tax adjustments, but this is outside the scope of this book.

14.9 Income Tax for Employees

14.9.1 Gross Pay and Net Pay for Employees

In most countries, but taking the U.K. as an example, when businesses pay salary to their employees, they are required to withhold the employees’ income tax and only pay out to the employees their net salaries after income taxation deductions. For example, the gross salary of the employee in one month is £5,000; suppose there are no other deductions and assume that the employee needs to pay income tax of £1,030, and that the national insurance contribution paid to the UK government is £402. (Note, national insurance is a specific U.K. tax used to fund the state retirement pension. Many other countries just have one “payroll tax”). The gross salary means the salary before deducting the above income tax and the national insurance contribution payment. Hence, the net or after-tax payment to the employee is £3,568. The following accounting entry is made:

Dr Wage expense (P/L) £5,000

Cr Personal income tax payable (SFP) £1,030

Cr National insurance contribution (NIC) payable (SFP) £402

Cr Bank – payment to employee (SFP) £3,568

The above journal entry is different from what we have seen when calculating the tax payable on the company’s trading profit. Instead of showing this in the income tax expense in the statement of profit or loss, we normally present this in the wage expense in the operating expenses. In the above example, this is the amount of £5,000. We also need to increase the income tax payable liability, because the business collects the employee’s income tax on behalf of the government. Hence, we owe £1,030 to the tax authority.

We are also required to deduct other amounts according to the country’s law, for instance, the national insurance contribution of £402. The national insurance contribution is paid by both employees and the employer.

The employer’s national insurance contribution accounting entry needs to debit the wages expense and credit NIC payable, as described above.

The national insurance contribution payment is made together with the income tax to the UK tax authority (HMRC). Hence the net payment to the employee is £3,568 in cash, i.e., the employee’s take-home pay. To pay the money, we decrease the asset by crediting the bank.

The wage expense should be recognised because according to the matching principle or accruals concept, this expense matches the benefits earned from the employees earning profits for the business.

14.9.2 Employer’s National Insurance Contribution and Other Deductions

If any other deductions need to be effected from employees’ gross salary, i.e., payment to the sports club, social club, or savings plan/scheme, these are all treated the same way as income tax payable. This means increasing the wage expense and liabilities for those deductions.

14.9.3 Income Tax, National Insurance Contribution or Deductions Payments Made

After the business has calculated the employees’ income tax, national insurance contribution liability and other deductions liabilities, the business will then need to pay for them. Hence, the accounting journals would reduce those liabilities and the bank as follows:

Dr Income tax payable (SFP) £1,030

Dr National insurance contribution liability (SFP) £402

Cr Bank (SFP) £1,432

14.9.4 Pay As You Earn (PAYE) System

This system means the employer withholds income tax and national insurance contributions from employees and pays them directly to the HMRC. This system was originally developed by Sir Paul Chambers in the UK in 1944 and is now widely used in other countries such as New Zealand, South Africa, USA, Australia and other countries. PAYE system is also called Pay As You Go (PAYG) withholding system in some countries. However, in Hong Kong, there is no PAYE system. This means the employer does not need to withhold income tax from the employee on behalf of the government. The taxpayer needs to complete the tax return and submit it to the Hong Kong tax authority each year.

14.10 Sales Tax

14.10.1 Different Names for Sales Tax

Sales tax is the tax charged by the tax authority on the sale of goods or rendering of services. The seller collects sales tax from the customer on behalf of the tax authority and then pays this across to the tax authority. In the UK, this sales tax is also called Value Added Tax or VAT. The names may be different in other countries, for instance, in New Zealand, this is called Goods and Services Tax or GST. Some countries do not have sales tax at all, such as Bahrain, British Virgin Islands, Cayman Islands, Hong Kong (China), Iraq, Macau, Maldives, Oman and United Arab Emirates.

14.10.2 How the Sales Tax System Works

The sales tax is paid by the customer and collected by the seller. This is then paid by the seller to the tax authority. Here is an example:

Suppose the manufacturer sells its goods at $200 net of sales tax to the retailer. The retailer then resells its goods at $300 to the final customer. The sales tax rate is 20%.

1. The manufacturer sells goods to the retailer:

Sales tax charged by the manufacturer: $40 ($200 x 20% = $40).

The manufacturer must declare the sale transaction to the government and pay the sales tax when this becomes due, usually every month or every three months. To simplify the sales tax concept, we assume no sales tax is being paid by the manufacturer in this example.

1. The retailer resells the goods to the customer:

Sales tax charged by the retailer: $60 ($300 x 20% = $60).

The retailer has spent $200 buying the goods from the manufacturer as we’ve seen in point one, and the sales tax that the retailer has paid was $40 in point one above. Hence, the total sales tax for the retailer is $20 ($60 - $40).

1. This results in a $60 total sales tax in the whole supply chain, calculated by taking the first $40 and adding the second $20.
2. It is the customer who finally pays the sales tax. In this case, when the retailer sells goods to the end customer, the customer pays $60, calculated by multiplying the sales tax rate of 20% by the selling price of $300. With the manufacturer paying $40 sales tax to the government and the retailer paying $20, this allows the government to keep track of the whole supply chain’s activities.

14.10.3 Tax Exclusive and Inclusive Price

From the above example, sales tax is calculated by multiplying the sales tax rate of 20% by the net sales revenue. Suppose the company has quoted the list price of the goods at $250 and offered $50 trade discounts to the customer. The net sales revenue is calculated by using the list price and deducting the trade discount, which gives us $200 ($250 - $50). The $200 net sales revenue is the tax-exclusive price, i.e., this does not include the sales tax of $40 ($200 x 20%).

However, if the customer buys the goods from the seller, the customer needs to pay both net sales revenue of $200 and the sales tax of $40, i.e., $240 in total. The $240 in total includes both sales revenue and sales tax, and is called tax-inclusive price. It may be useful to have a look at the following percentage structure:

From the above calculation, if we accept that the tax inclusive revenue is $240, and we know that the sales tax rate is 20%, we can work out the $40 sales tax by dividing the tax-inclusive revenue of $240 into 120% and multiplying by 20%. We could also work out the net sales revenue by dividing the tax-inclusive revenue of $240 into 120%, and it gives us $200.

14.10.4 The Sales Tax System in the UK

14.10.4.1 Registering for Value Added Tax (VAT)

If the VAT taxable revenue (that is net of VAT) is more than £85,000, the business must register for VAT with HMRC. The VAT number and effective registration date will be on the VAT registration certificate issued by HMRC. If the business has no VAT number from HMRC, but its revenue has exceeded £85,000, then while waiting for the certificate, the business can increase the product or service selling price and tell customers why. Once the business gets its VAT number, the business can then reissue the invoices showing the VAT amount. This means the business should not show the VAT until the VAT registration certificate is received.

14.10.4.2 VAT Responsibilities

The business registered for VAT must charge the correct VAT amount on its sales, submitting VAT returns, keeping VAT records appropriately and paying VAT due to HMRC. Source documents include the sales day book, cash book, invoices, delivery note, sales orders, debit/credit note and import/export records which can be used to reclaim the input VAT by the business/buyer. These records need to be kept by the business for at least six years. These records can either be stored in paper or electronic format, perhaps via bookkeeping software. HMRC officers can visit the business to inspect the VAT records, and they normally give seven days’ notice telling the business exactly what information they will want to see and how long it is likely to take. The business can ask them to delay the visit. They can also visit the business without appointments at all.

VAT rates for different goods or services:

The following VAT rates for 2019 are taken from the UK government:

The above term ‘supply’ means ‘sale’. This means the VAT sale can be standard-rated, reduced-rated, zero-rated or exempt from VAT.

14.10.4.3 VAT Calculation

The total VAT due to HMRC is calculated by using the VAT charged on sale and subtracting the VAT paid when purchases are made. Here, we can also use another name for the VAT on sale and VAT on purchases, i.e., output value added tax (output VAT) and input value added tax (input VAT).

The total VAT due is calculated by taking the output VAT and subtracting the input VAT.

Example:

Suppose Company D has output VAT on its sale totalling $20,000, and the input VAT can be claimed, totalling $15,000.

The total VAT paid to the tax authority is $5,000 ($20,000-$15,000). VAT-registered businesses may receive tax refunds, i.e., where the input tax exceeds the output tax. Some businesses may try to obtain input VAT refunds by falsifying VAT records, and this is why some governments are paying significant attention to this and imposing severe sanctions on these behaviours.

14.10.5 Accounting Treatment for VAT

14.10.5.1 Seller’s Perspective

A company sells goods to the customer at the net sales revenue of $100 with the sales tax rate being 20%. The company will receive $120 from the customer. The following journal entry is made:

Dr Trade receivables (SFP) $120

Cr Sales revenue (P/L) $100

Cr Sales tax (output VAT) (SFP) $20

This is to increase the trade receivables assets by $120 because these funds will be received from the customer. Correspondingly, the business increases its sales revenue by $100 and the business also collects $20 sales tax from the customer on behalf of the tax authority. Hence the liability goes up by $20. If the business has received cash from the customer, the debit side will be bank instead of trade receivables.

14.10.5.2 Buyer’s Perspective

Suppose Company B has purchased goods from the above company at the net purchase price of $100. The sales tax rate is 20%, making the total amount payable $120. The following journal entry is made:

Dr Purchases (P/L) $100

Dr Sales tax (input VAT) (SFP) $20

Cr Trade payables (SFP) $120

This increases the purchases by $100, representing that the buyer spent $100 purchasing those goods. The business also needs to increase its trade payables liability. At the same time, the business needs to reduce its sales tax liability because these funds should be paid to the tax authority by the customer. To reduce the tax liability, we debit it.

Suppose Company A has an output VAT of $20 and an input VAT of $12. The additional VAT of $8 should be paid to the tax authority. Let’s put them into the ledger account:

The $8 sales tax liability is presented as the current liability in the statement of financial position. Both output VAT and input VAT do not affect the statement of profit or loss values.

14.11 Quick Summary of This Chapter

• Corporation tax calculation: based on taxable profits.
• Trading losses: could be used to offset against trading profits.
• Taxable profits calculation: starting from accounting profit before tax and multiply this by the corporation tax rate.
• Accounting treatment: increase corporation tax expense and tax liability.
• Under payment of income tax: increase corporation tax expense and tax liability.
• Over payment of corporation tax: decrease corporation tax expense and tax liability.
• Payment to the tax authority: decrease tax liability and bank asset.
• Tax rates or tax laws enacted or substantively enacted: use it as the best estimate to calculate the corporation tax expense.
• Tax losses carried back: recognise tax receivable asset and liability. When the refund is received from the tax authority, the liability is reduced.
• Employees: recognise wage expenses in the statement of profit or loss and deductions as liabilities.
• Sales tax: tax charged on sale of products or rendering of service.

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Categories: : Financial Accounting (FA)