Taxation
1 What is taxation?
Taxation is a compulsory contribution by individuals and businesses to state revenue. It is the main way in which a government raises the money it needs to fund public expenditure – roads, schools, hospitals, defence and the rest of a country’s infrastructure.
Governments also use taxation to influence economic decision-making and to promote social values and priorities. A government that wants businesses to invest in new technology can offer tax reliefs on that investment; a government that wants to discourage smoking can tax tobacco heavily. Because every government makes different choices, no two countries’ tax systems are identical.
Exam approach
Specific national tax rules are not examinable in F1. Questions are set in fictitious countries (“Country X”) and always give you the tax rules and rates to apply. What you must know are the general principles of how taxation works.
F1 applies no national tax law: a question always gives you the rules and the rates to use. The recordings illustrate with one country’s statutes, which is illustration and nothing more.
Introduction to taxation: Adam Smith’s four canons are equity, certainty, convenience and economy (see “The principles of a good tax system”), so in the first example the answer is C — Simplicity, not certainty. Corporate and personal taxes are covered only in these notes.
Indirect taxation: several minutes of national VAT curiosities — children’s clothes, e-books, snack foods, council tax, a foreign wealth threshold — are illustrative only.
Direct taxation: the 25% rate comes from the question, not from “the old syllabus Country X”, and the income-tax bands and flat corporate rate are illustrations.
Capital taxes: the “$6,000” chattels figure is one country’s statute; these notes state it as a monetary threshold set by the jurisdiction.
2 The principles of a good tax system
The classic statement of what makes a good tax comes from the economist Adam Smith, whose four “canons of taxation” are still the standard reference point:
Canon | Meaning |
Equity | The tax burden should be fair, reflecting each taxpayer’s ability to pay – the wealthier the taxpayer, the more they can afford to contribute. |
Certainty | Taxpayers should know how much tax they must pay, when, and how – the liability should not be arbitrary. |
Convenience | Payment should be easy for the taxpayer – collected at a time and in a manner that suits them (for example, deducted from wages at source). |
Economy (efficiency) | Collection should be cheap – the cost of administering the tax should be small relative to the revenue it raises. |
Modern writers usually add further desirable characteristics – these are later additions, not part of Smith’s four canons:
Simplicity – rules that are easy to understand and comply with leave fewer loopholes and lower compliance costs.
Flexibility – the system should adapt as the economy and business practice change.
Economic effects – tax policy should consider its effect on different business sectors, for example encouraging investment in machinery or technology through tax breaks: less tax now, but more profit – and more tax – in the future if the investment succeeds.
3 Direct and indirect taxation
Direct taxes
A direct tax falls directly on the person or entity expected to pay it – there is no intermediary between the taxpayer and the tax authority. The two direct taxes on companies in the F1 syllabus are:
Tax on trading income – tax paid by a company on its taxable profits.
Capital taxes – tax paid by a company on the taxable gains it makes when it disposes of an asset for more than its original cost.
Indirect taxes
An indirect tax is levied on one part of the economy with the intention that the burden is passed on to another. Sales tax is the prime example: the customer bears the tax, but the business selling the goods collects it and pays it over to the government.
Corporate and personal taxes
The other way to cut the same cake is by asking who the taxpayer is. A corporate tax is charged on an entity — normally on its trading profits and on the capital gains it makes — and is assessed on the entity itself, which files its own return and pays out of its own bank account. A personal tax is charged on an individual: on employment income, on the profits of a trade carried on personally, on investment income, and in many jurisdictions on personal capital gains and on gifts and inherited wealth.
Three differences are worth holding on to:
Collection – corporate income tax is normally self-assessed and paid in instalments or after the year end. Personal tax on employment income is usually deducted at source by the employer, who pays it over on the employee’s behalf together with social security contributions from both employee and employer.
Rate structure – personal income tax is commonly progressive, with bands of income taxed at rising rates. Corporate income tax is more often proportional: one rate whatever the size of the profit.
The same profit can be taxed twice – a company pays corporate income tax on its profit; when what is left is paid out as a dividend, the shareholder may be taxed again on the dividend received. A system that ignores this is a classical system; one that gives the shareholder credit for some or all of the tax the company has already paid is an imputation system. The cross-border version of the same problem is dealt with in Chapter 14 as underlying tax.
F1 examines corporate taxation in computational detail. Personal taxation is examined at the level of these distinguishing features — you are not asked to compute an individual’s tax bill.
Taxable person
The person accountable for the payment of a tax. It may be an individual or a business entity: a company earning taxable profits is the taxable person for the tax on those profits.
Incidence
The incidence of a tax is the distribution of the tax burden – who actually bears the cost. It has two elements:
Formal incidence – falls on the person or business that has direct contact with the tax authorities. For a sales tax this is the business that collects the tax and pays it over.
Effective (actual) incidence – falls on the person or business that ultimately bears the cost of the tax. For a sales tax this is the final consumer.
Competent jurisdiction
The authority whose tax laws apply to an individual or a company. A company resident in a country and taxed under that country’s laws is within that country’s competent jurisdiction.
Good taxation
Which one of the following is not one of Adam Smith’s characteristics of a good tax?
A | Certainty |
B | Equity |
C | Simplicity |
D | Efficiency |
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Indirect tax
An indirect tax is a tax that:
A | Is levied on an individual |
B | Is based on earnings of an individual |
C | Is paid indirectly to the tax authorities |
D | Is levied on one person with the intention that it is passed on to another |
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4 Types of taxation
Progressive taxes – take an increasing proportion of income as income rises (typical of personal income tax, where higher earnings fall into higher rate bands).
Proportional taxes – take the same proportion of income as income rises (typical of a flat-rate corporate income tax).
Regressive taxes – take a decreasing proportion of income as income rises (a fixed duty per item takes a bigger share of a low earner’s income than of a high earner’s).
The key word is proportion. To classify a tax, work out tax paid as a percentage of income at different income levels and see whether that percentage rises, stays constant or falls.
Types of taxation
ABC and XYZ are two businesses that are resident in the same tax jurisdiction.
ABC has taxable profits of $45,000 and has a tax liability of $4,500.
XYZ has taxable profits of $70,000 and has a tax liability of $8,750.
What type of tax could this be said to be?
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5 Indirect taxation
Indirect taxes are charged in one of two ways:
Unit taxes – based on the number or weight of items, e.g. an excise duty of so much per litre of spirits or per 1,000 cigarettes.
Ad valorem taxes – based on the value of the items, e.g. a sales tax charged as a percentage of the selling price.
The main families of indirect tax are:
Excise duties – charged on the quantity of particular commodities (typically alcohol, tobacco, oil products and motor vehicles). An excise duty is a unit tax and, because it falls on goods being consumed, also a consumption tax.
Import duties – charged on goods brought in from overseas, on top of any excise duty.
Consumption taxes – charged on the purchase of goods or services, whether by an individual or a company; sales tax/VAT is the most important example.
Taxes on capital – a property tax charged on the value of land and buildings, or a wealth tax charged on the value of a person’s or company’s assets (often only above a threshold of net wealth) – are charged on what is owned, not on what is spent. Whether such a tax is direct or indirect therefore depends on its legal design in the jurisdiction concerned: where the person assessed is also the person who bears the burden it has the features of a direct tax, while a levy collected from one party and passed on to another has the features of an indirect one. The syllabus asks for the features of direct and indirect taxes, not for a fixed label on every named tax, and a question will give you whatever classification it wants you to apply.
Objective-test questions like asking you to classify a tax in several ways at once. Work from the features, and stick to the cases that are not in doubt: an excise duty is an indirect tax, a unit tax and a consumption tax; a sales tax or VAT is an indirect, ad valorem, consumption tax, because it is collected from the seller and borne by the consumer; corporate income tax is a direct tax, assessed on and borne by the company itself. Where a tax could be designed either way — property and wealth taxes are the standard example — the question has to tell you how it works before it can ask you to classify it.
6 Value added tax (VAT)
VAT (in some countries called GST) is the form of sales tax operated in many jurisdictions. It is an indirect, ad valorem, consumption tax collected in stages along the supply chain: each registered business charges VAT on its sales (output tax), reclaims the VAT on its purchases (input tax), and pays the net difference to the tax authorities.
Although collected in stages, VAT is ultimately a tax on the final consumer of the goods – the effective incidence falls on the consumer, while the formal incidence falls on the registered businesses that collect it.
6.1 VAT rates
Each supply of goods or services made in the course of business falls into one of the following types of supply:
Standard rated – taxed at the standard rate.
Higher rated – taxed at an appropriate higher rate (where the jurisdiction operates one).
Zero rated – taxed at a rate of zero (jurisdictions often zero-rate social essentials such as children’s clothing or basic foods).
Exempt – not taxed at all (public transport fares are a common example).
Zero rated and exempt look identical to the customer – no VAT is added in either case – but they are very different for the business:
An entity making zero-rated supplies is making taxable supplies (at 0%), so it can register for VAT and reclaim the input VAT on its purchases.
An entity making wholly exempt supplies cannot register for VAT and therefore cannot reclaim any input VAT.
6.2 Partially exempt trades
An entity that makes a mixture of standard-rated, zero-rated and exempt supplies can register for VAT, but its right to reclaim input tax is restricted:
Input tax relating to standard-rated and zero-rated supplies can be reclaimed in full.
Input tax relating to exempt supplies cannot be reclaimed.
Input tax incurred for the business as a whole (heat, light and similar overheads) is reclaimed pro rata to the taxable proportion of supplies.
VAT
AB is resident in Country X, where monthly VAT returns are required. At the end of each month, AB pays the net VAT due to the local tax authorities.
In the last month, AB purchased raw materials costing $120,000, excluding VAT, which is chargeable at the standard rate of 15%.
The raw materials were converted into two products, X and T. Product X is zero rated and Product T is standard rated for VAT purposes.
Product X was sold for $90,000 and Product T for $130,000, both excluding VAT.
Calculate the amount of VAT that AB should pay, assuming there to be no other VAT-related transactions.
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7 Direct taxation
7.1 Corporate income tax
Companies pay corporate income tax on:
Profits from trade and other activities
Gains on the sale of investments and assets (capital gains – covered later in this chapter)
Other non-business income
Accounting profit and taxable profit
Accounting profit – the profit calculated under accounting rules (IFRS or local GAAP). Accounting conventions such as accruals and substance involve judgement, so accounting profit is inherently subjective.
Taxable profit – the profit calculated under the tax authority’s own rules, to which the rate of tax is applied to give the tax liability. Tax authorities dislike subjectivity, so their rules are prescriptive.
The corporate income tax computation therefore starts from the accounting profit and adjusts it to the taxable trading profit. Income and expenses of non-trading activities are removed from the computation – they are either taxed under different rules or not taxed at all.
$ | |
Accounting profit | X |
Less: non-trading income | (X) |
X | |
Add: disallowable expenditure | X |
Adjusted trading profit | X |
Less: tax depreciation (capital allowances) | (X) |
Taxable trading profit | X |
Non-trading income (deduct)
The following are removed from the accounting profit because they are not trading income:
Rental income (usually taxed under separate rules for property income)
Interest receivable (usually taxed under separate rules for investment income)
Dividends received
Capital profits, e.g. the gain on the sale of an asset (taxed as a capital gain instead)
Disallowable expenditure (add back)
Expenditure that is a legitimate accounting expense but that the tax authorities refuse as a deduction:
Client entertaining (staff entertaining is usually allowable)
Depreciation and amortisation – too subjective; replaced by the tax authority’s own tax depreciation
Taxes paid to other public bodies
Donations to political parties
Allowable expenditure (no adjustment)
Ordinary business costs are allowable, so no adjustment is needed. Commonly listed examples:
Interest paid for trading purposes
Staff wages and employer social security contributions
Legal expenses, audit and accountancy costs
Advertising and trade subscriptions
Repairs
Taxes paid to lower levels of government (e.g. local business levies)
Income tax computation (1)
Company M is resident in Country X and makes an accounting profit of $350,000 during the year. This included depreciation of $45,000 and disallowable expenses of $20,000. The corporate income tax rate in Country X is 25%.
If the tax allowable depreciation totals $30,000, what is the tax payable?
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Income tax computation (2)
Company B is resident in Country X and makes an accounting profit of $360,000 during the year. This includes non-taxable income of $35,000 and depreciation of $40,000. In addition, $10,000 of the expenses are disallowable for tax purposes. The corporate income tax rate in Country X is 25%.
If the tax allowable depreciation totals $30,000, what is the tax payable?
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7.2 Accounting depreciation vs tax depreciation
Accounting depreciation and amortisation are subjective: straight line or reducing balance, over lives and at rates chosen by management. That is why they are disallowable in the tax computation.
Tax depreciation (in some countries called capital allowances) follows the same broad idea – spreading relief for the cost of an asset over time – but at rates and on bases laid down precisely by the tax authorities, removing all subjectivity. Common features, which a question will always spell out, include:
First-year (accelerated) allowances – a higher rate in the year of purchase to encourage investment.
Writing-down allowances – an annual percentage, straight line or reducing balance, in later years.
When an asset is sold, its sale proceeds are compared with its tax written-down value (cost less all tax depreciation claimed):
Balancing allowance – proceeds below tax written-down value: the shortfall is an extra deduction, like a loss on disposal for tax purposes.
Balancing charge – proceeds above tax written-down value: the excess is taxable, clawing back allowances already given.
Tax depreciation
Sunflower commenced business on 1 January 20X7 and entered into the following transactions for plant and machinery:
Purchases | $ | |
1 January 20X7 | Industrial building | 260,000 |
1 January 20X7 | Stitching machine (plant) | 47,000 |
1 January 20X9 | Packing machine (plant) | 58,000 |
Sales | ||
1 January 20X9 | Stitching machine bought on 1 January 20X7 | 9,500 |
1 January 20X9 | Industrial building bought on 1 January 20X7 | 240,000 |
Sunflower qualifies for accelerated tax depreciation in the first year on the plant at the rate of 50%. The second and subsequent years will be at 25% on the reducing balance method.
The industrial building qualifies for an annual tax depreciation allowance of 5% of cost on the straight line basis.
Calculate Sunflower’s tax depreciation for the three years ended 31 December 20X7, 20X8 and 20X9.
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7.3 Trading losses
If a business makes a trading loss instead of a trading profit, no tax is payable for that year. The loss is not wasted: loss relief lets the business use it to reduce tax on other profits. The methods of relief a jurisdiction may allow include:
Carry forward of the trading loss to offset against future trading income
Offset against other income and gains of the same accounting period
Offset against other income and gains of one or more previous accounting periods (carry back)
Group relief
Group relief
Where companies are members of the same group, many jurisdictions allow one group company to surrender its trading loss to another, which deducts it from its own taxable profits. The group is being taxed in line with its economic substance – a single business – rather than strictly company by company. The detailed conditions (how much ownership makes a “group”, how much loss can be surrendered) vary by jurisdiction and would be given to you in a question.
8 Gains on the sale of assets and investments (capital taxes)
Taxable capital gains of a company are subject to corporate tax. A capital gain is the taxable profit on the disposal of an asset or investment.
Most assets and investments are chargeable assets, but jurisdictions typically exempt some. Which exemptions apply is a matter of national law, and a question will state the ones you are to use. Examples commonly quoted:
Private motor cars, in the jurisdictions that exempt them
Certain government and corporate debt securities, where the jurisdiction defines a qualifying class
Low-value chattels – tangible movable property bought and sold below a monetary threshold set by the jurisdiction
Wasting chattels – tangible movable property with a predictable life shorter than the period the jurisdiction sets (50 years in several systems); a racehorse is the usual illustration
Exempt disposals
Some disposals are exempt however large the gain, because no consideration passes:
Gifts to charities of land, buildings and certain works of art
Gifts of any type of asset to government institutions and museums
The capital tax computation
$ | |
Sale proceeds | X |
Less: costs of disposal | (X) |
Net proceeds | X |
Less: original cost (indexed where allowed) | (X) |
Less: enhancement costs, e.g. improvements (indexed where allowed) | (X) |
Chargeable gain | X |
Points to note:
Allowable costs include the original purchase price, incidental costs of purchase (e.g. legal fees), enhancement expenditure such as an extension – but never repairs, which are a trading expense – and the costs of selling the asset.
Indexation – some jurisdictions allow the original and enhancement costs to be increased in line with inflation, so that only the real gain is taxed. A question will give you the percentage increase to apply.
Capital tax computation
A company resident in Country X purchases land and buildings in January 20X5 for $155,000, of which $55,000 was attributable to the land. The company incurred in the same month $55,000 for refurbishment of the building, which was classified as capital expenditure according to local tax regulations.
The land and buildings were sold for $425,000 in January 20X9; $100,000 of this price was attributable to the land. The company paid $8,000 in disposal costs, which were allowable for tax purposes.
Local tax regulations allow for indexation of the purchase and refurbishment costs of the building (but not the land). The index increased by 35% between January 20X5 and January 20X9. Capital gains are taxed at the corporate income tax rate applicable in Country X, which is 25%.
Calculate the taxable gain arising on the sale of the land and buildings and the tax payable.
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Rollover relief
Countries may allow the capital gain on a business asset to be deferred when the asset is sold and replaced. The logic: the sale proceeds have been reinvested in the replacement asset, so there is no cash left over with which to pay tax on the gain.
Where a jurisdiction gives the relief, the gain is “rolled over” – deducted from the base cost of the replacement asset. When the replacement asset is eventually sold, its lower base cost produces a correspondingly larger gain, so the tax on the original gain is paid then. The relief defers tax; it does not cancel it. The conditions (which assets qualify, and how long the reinvestment window is) are set by national law and will be given to you in a question.
A company sells a factory at a gain of $20,000 and buys a replacement factory for $150,000, claiming rollover relief. The base cost of the new factory becomes 150,000 − 20,000 = $130,000. If the new factory is later sold for $200,000, the gain is 200,000 − 130,000 = $70,000 – the $50,000 gain on the new factory plus the $20,000 gain deferred from the old one.
Capital losses
Capital losses are calculated in the same way as capital gains. What may then be set against what — and in which order — is fixed by each jurisdiction’s rules, and an exam question states them before it asks you to apply them. A common pattern, and the one used in the examples here, is that a capital loss may be offset only against capital gains of the same accounting period or carried forward against future capital gains, with no carry back and no offset against trading income — and, in the other direction, no offset of trading losses against capital gains.
Capital losses
Country X has the following tax regulations:
Taxable profits are subject to tax at 25%.
Capital gains are added to profits from trading to give taxable profits.
Trading losses can be carried forward indefinitely but cannot be carried back to previous years.
Capital gains/losses cannot be offset against trading profits/losses, or vice versa.
JKL is resident in Country X and has no brought forward losses at 1 January 20X7. JKL has the following results for 20X7 to 20X9:
Trading profit/(loss) $000 | Capital profit/(loss) $000 | |
20X7 | (300) | 400 |
20X8 | 550 | – |
20X9 | 700 | (150) |
Calculate JKL’s corporate income tax due for each of the years ended 31 December 20X7 to 20X9.
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Tax is a compulsory contribution to state revenue, judged against Adam Smith’s four canons — equity, certainty, convenience and economy — to which modern writers add simplicity, flexibility and economic effects. Direct taxes fall on the person meant to bear them; indirect taxes are levied on one party and passed to another, charged either per unit or ad valorem. Corporate income tax starts from accounting profit, deducts non-trading income, adds back disallowable expenditure (depreciation above all) and substitutes the tax authority’s own tax depreciation. On a disposal, proceeds above the tax written-down value give a balancing charge and proceeds below it a balancing allowance. A capital gain is proceeds less indexed cost, enhancement expenditure and disposal costs; capital losses go against capital gains only, and rollover relief defers a gain by deducting it from the base cost of the replacement asset.
9 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Taxation
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