International accounting: technical feature

Christopher Nobes believes there are still some major questions going unanswered where IFRS, tax and the EU are concerned

As is well-known, an EU regulation of 2002 requires the use of International Financial Reporting Standards (IFRS) for the consolidated statements of listed companies, generally by 2005. The regulation also allows member states to extend the use of IFRS compulsorily or optionally to unlisted companies or unconsolidated statements. This article considers the effect on taxation of using IFRS.

If the use of IFRS is confined in a particular country to consolidated financial statements, there would be no direct effect on taxation because tax is not based on the consolidated statements (even group tax reliefs work on special partial consolidations for tax purposes).

In countries with a very close link between tax and financial reporting (e.g. Germany), IFRS will either not be allowed for unconsolidated reporting or will only be allowed if reports using traditional domestic rules continue to be prepared side-by-side. However, in many countries (perhaps including Denmark, Ireland, the Netherlands and the UK, and EU entrants such as Cyprus and Malta), we can expect IFRS to be allowed for unconsolidated financial reporting in 2005, and eventually to be required.

The adoption of IFRS will change the net profit figure, so it will change the starting point for the calculation of taxable income. The changes would include marking to market for some investments (IAS 39), for investment properties (IAS 40) and for biological assets (IAS 41). Hundreds of other differences between IFRS and current domestic rules could affect profit. Presumably, the tax authorities will not just sit back and allow all these to affect taxable income, but will need to assess them and to change tax laws to retain control over the calculation of taxable income.

There is a particular complication if IFRS is merely allowed but not required: different companies will have different measures of profit, and therefore different starting points for tax calculations. This obviously could not be permitted, so clear systems of standardised adjustments from profit (both domestic and IFRS) are needed, and urgently.

There is an argument that efficiency would be served if tax were to follow financial reporting as closely as possible. However, this must surely be outweighed by other arguments:

• the purpose of financial reporting (to help investors to predict future cash flows) is quite different from the purposes of tax, so the rules need to be different
• IFRS are set by an international body that has no interest in tax, so how could a national tax authority meekly allow its tax base to be altered when IFRS change?
• at the extreme, the IASB seems to be planning to abolish the traditional concept of net income, so tax authorities will have to have their own rules
• the closeness of tax and financial reporting in some countries leads in practice to reporting being dominated by tax rules and tax objectives, and we surely would not want to allow the resulting 'pollution' of financial reporting.

A more subtle point is that several EU countries are converging their financial reporting rules towards IFRS. It is vital to distinguish between (i) a country adopting IFRS for some purposes for some companies, and (ii) a country converging its national rules towards IFRS. In the EU, we are all doing (i) and some of us are doing (ii). Convergence also brings the implication that the tax authorities should presumably be paying attention to (and perhaps adjusting for) the effects on net profit.

Into these disturbed waters, the EU has thrown another enormous rock: the possible use of IFRS as a consolidated tax base for EU-wide activities. A consultation document on this was issued in Brussels in February 2003. The background is that the Commission has been seeking for decades to make progress on the harmonisation of corporate taxation. Proposed directives have been issued since the 1970s on the harmonisation of tax rates and of tax credits for dividends. No real progress has been made, because critics always point out that harmonisation of rates is somewhere between pointless and dangerous unless the definitions of taxable income are harmonised. The EU-wide use of IFRS might solve the problem.

However, the present proposals seem hopelessly ambitious. They would entail three revolutions:

• Tax would be based on consolidated profits not those of individual legal entities, as is the case in nearly all countries. This would add to tax calculations all the consolidation issues presently avoided.
• Tax would be based on an EU-wide consolidation, but no such consolidation is prepared at present.
• Taxable income would presumably have to be clearly separated from financial reporting (a revolution for most EU countries), because unadjusted IFRS is unsuitable as a tax base and is becoming increasingly unsuitable as it moves towards subjective fair values and away from relying on realisation.

One especially alarming question by the Commission is: 'The current endorsement procedure of IAS provides member states with the necessary level of 'control' over accounting standards in the EU. Could it be extended or supplemented to provide sufficient taxation input for IAS to form the starting point for the tax base?'

The first sentence alludes to the EU endorsement mechanism for IFRS. It raises the appalling spectre that the EU might try to influence IFRS or reject certain IFRS for EU purposes because they were unsuitable for tax.

It should be said that the Commission is only asking questions at present, and provides well informed discussion of the issues. However, we should certainly make clear our opposition to tax pollution, and then we might be better off turning our attention to the urgent practical question for each country of the appropriate tax response to IFRS adoption or convergence.

Underlying all this, there is a disturbing lack of a conceptual framework for tax. What are the objectives when defining taxable income? What characteristics should taxable income have? Analogous questions have been addressed for financial reporting in Conceptual Frameworks or Statements of Principles. These have then influenced the accounting standards. We need a coherent framework for tax, and this is an issue to which I will turn in a subsequent article.

Christopher Nobes is PwC professor of accounting at the University of Reading, UK.