Author:
Grant Gilmour, CPA (Canada, BC) CPA (USA, Arizona)
Integra Tax World Newsletter Editor
E: [email protected]
With Contributions from:
Franz Schweiger, BF Consulting Austria
Dr. Filip Schade, Wagemann + Partner, Germany
David Lucas, Bright Grahame Murray, United Kingdom
Victor Serrao, Pitmen, Brazil
Wayne Soo, Fiducia LLP, Singapore
Edited by:
Mark Saunders, BA FCA
Chief Operating Officer Integra International
E: [email protected]
This is a question that tax practitioners around the world are often asked. Business owners and investors and really everyone would like the calculation of tax to be as simple as INCOME multiplied by 10 PERCENT gives TAX. And income is often reported and audited by the other “type” of accountant, the Financial Accountant. Business owners are going to ask why don’t we use the same number(s) in both cases? Calculating tax and calculating reported income? The answer is often political and often to create “fairness”. If a number for accounting income will create tax but that same number does not create cash flow to pay that tax, is it fair? And more often we are talking about the opposite. If a number that creates an expense for accounting doesn’t match the cash flow, is it fair to allow that for tax calculation? We are not going to have a discussion of “fairness” in this article. Instead we are going to focus on “reconciliation”. This is a term that has special meaning to both types of accountants, tax practitioners and Financial Accountants. It also has wide meaning as the process of becoming aware of a difference and then measuring it and then doing something with that difference.
Reconciliation is found in tax reporting around the world and in financial statements that fit both local accepted accounting principles and International Financial Reporting Standards (IFRS). If you look at publicly available financial statements you will see a note to the tax number that reconciles the amounts reported for tax to the amounts reported for accounting. If you are a tax practitioner like I am you will also find a schedule in the domestic tax return of each tax paying business that “reconciles” income for accounting reporting to income for tax reporting.
- In Canada it is called a Schedule 1
- In the USA it is called Schedule M-1
- In Austria it is called form K 1 for corporations
- In Germany it is called form GK for corporations
- In Brazil it is called ECF, which stands for Escrituração Contábil Fiscal, or Tax Accounting Records
- In the UK there is the tax computation (which doesn’t have a statutory reference) which is part of the tax return submission which shows the calculations behind the numbers in the form CT 600. The tax reconciliation is required to be included in the tax computations to show the movements from accounting profit to taxable profit (otherwise there would be questions).
- In Singapore it is called form C-S and there is a version for small entities with revenue below S$500,000 called C-S Lite.
You get the idea. National governments want to calculate tax on numbers that make sense to their economies and their constituents. International companies need to report numbers that are consistent as possible between countries and markets.
The format changes from country to country and because I am Canadian I am going to work with the Canadian example in this article. However the principles are the same worldwide.
Starting number
At some point the two documents, the tax reporting and the accounting reporting will have the same number on them. In the Canadian case it is IFRS income as reported. If it is not IFRS then there is a “tick-box” on the tax filing to advise the reviewer that it is calculated differently.
Lets’ say Financial Accounting reported income is $1,000,000
Then the process of reconciliation begins. Numbers are taken away and replaced with other numbers. The result being a different “taxable income” than “accounting income”. But importantly each difference can be identified and measured.
Common differences
Depreciation
By far the most common difference I have seen is depreciation or amortization of assets. This is often the result of tax policy but also can be the result of different “philosophies” on depreciation. When the US Tax cuts and jobs act of 2017 became law one important element was immediate depreciation or write off of capital acquisitions. This meant that an asset with a lifetime of many years for example was a tax deduction in the first year. This put pressure on other governments to do similar things and Canada responded with a similar provision.
Here is an illustration of the result of purchasing $300,000 of assets with a straight-line depreciation for accounting over ten years.
The tax return would “add back” to income one tenth of the asset cost. This would have been reported as current year depreciation of $30,000.
The tax return would deduct the full purchase price of $300,000.
The result would a reduction in taxable income by $270,000 when compared to accounting income.
Accrual income
Often there are arguments to recognize income or not recognize income for accounting that don’t correlate to the principles for tax reporting. This is sometimes the stuff of fraud. But we are not talking about that here. The fraudulent reporting of income is a different topic. However there is a concept that if income is uncertain or based on future events that have not happened perhaps accounting rules will recognize some or all of that profit, but tax rules will allow you to delay recognition. After all a businessperson is unlikely to want to pay tax on revenue he has not actually had cash flow from.
Let’s say a $400,000 of future sales was recognized for accounting. But none of that is recognized for tax.
The result is that $400,000 of income will be subtracted but no replacement will be included for income tax calculations.
Accrual expenses
Similarly, there are arguments to recognize expenses for accounting that might not be recognized for tax.
A generic example is a provision for a loss or future expense. Most tax reporting requires the loss or future expense to be well documented and supported but accounting treatment will allow an estimate or earlier recognition based on probability not on actual cash flow.
Let’s say an expense has been set up as a prepaid expense of $100,000 for accounting but by the time the tax reporting is filed that expense has only had cash flow of $40,000. The expense might be “added back” and the actual cash flow deducted. This would result in a net increase in taxable income over accounting income of $60,000. I don’t go into details because numerous exceptions and exceptions to exceptions exist. The concept though remains the same. Sometimes a prudent businessperson and the financial accountant will agree that a provision for a future loss or expense should be set up, but local tax law disagrees and requires the cash flow of the loss or expense to have occurred.
In some countries like Austria for example tax reporting is not different than accounting reporting for accrued income and expenses. Tax follows local accounting rules.
Disallowed expenses
In many countries there are rules that I speculate were written to appease non-business voters. These rules limit the deduction on some expenses. Examples are Golf, Meals, Entertainment, Travel, Conventions, Club Dues, Fishing, Automobile. All of these might make sense to a businessperson and non-businessperson. But also on these lists of non-deductible expenses you can find things like donations, pensions, insurance, soft costs, penalties and fines.
Once again I am not going to speculate on why some things are included or not included. Here is an example
The accounting profit includes $90,000 of meals and entertainment. This is subtracted and replaced with 50% of that amount. The result is that the taxable income is now $45,000 higher than the accounting income.
Permanent versus temporary differences
You will have noticed that some of these items like depreciation will eventually self correct. If you depreciate the $300,000 of assets straight line over then years. You will hit zero accounting value in ten years. Likewise the tax value is also zero in ten years. It has been mismatched each and every year to the last year, but the difference has been getting smaller. And reaches zero.
Other items like meals and entertainment are permanently different. The result is that accounting “retained earnings” and tax “ retained earnings” can grow to be very different over the lifetime of a business. This can sometimes be hidden even when we consider the efforts to reconcile each year. Tax and accounting rules don’t ignore these differences but can get very hard to “reconcile” when a final event like a wind up of a business occurs.
Summarizing the differences
Starting accounting profit: $1,000,000
Depreciation / fast write off: $(270,000)
Future revenue: $(400,000)
Prepaid expenses: $60,000
Meals and entertainment: $45,000
Net taxable income: $435,000
If we take that and charge 10 percent tax we get $ 43,500. Which is a lot less than $1,000,000 times 10 percent $100,000. This difference of $56,500 is often referred to as deferred tax. And the tax reconciliation note on the financial statements will discuss this and the likelihood of it becoming “real” tax. You will get that the actual tax is less than half of what a quick estimate might have given you. That is a huge difference and can have a substantial impact on the readers of financial statements and owners of those businesses. They will react differently to the two different amounts.
Sometimes I feel that this discussion and the disclosure is just more confusion on top of confusion for the readers and owners of businesses. My recommendation is to talk to your professional team (Integra Member firms) and ask about the reconciliation done on the tax return. That in my opinion is often a good place to start to understand this confusing and very impactful area of taxation. Please contact your Local Integra member to start the conversation about Taxable Income, what is that?
© 2024 Integra International. All rights reserved. This Article is not intended to provide legal or other advice and you should not take, or refrain from taking, action based on its content. Prior results do not guarantee a similar outcome.
About the Author:
Grant Gilmour, CPA (Canada, BC) CPA (USA, Arizona)
Integra Tax World Newsletter Editor
– Grant Gilmour is our Editor of the Integra Tax World newsletter. He is semi-retired with several Side Hustle Projects, including the Newsletter. Before retirement Grant was an active member of the Board of Integra and ran a Cross Border Tax Specialty Practice in the Metro Vancouver Area of Canada. Grant’s education started with an Honours degree in Genetics, and he has always had an interest in working with clients in the STEM fields. Think of Genius inventors when you think of Grant’s ideal client. Grant is also currently enrolled at Queens University in Canada, studying Immigration Law because his ideal client often was an immigrant as well as STEM business, and you can always learn more. Grant is an active member of Lions Club’s International in his hometown of Fort Langley.
Integra International Bio:
https://www.integra-international.net/find-an-integra-firm/find-firm-profile/name/grant-gilmour/
