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A Conceptual Framework for the Taxable Income of Businesses, and How to Apply it under IFRS
PricewaterhouseCoopers Professor of Accounting
University of Reading
Introduction
'In this world nothing can be said to be certain, except death and taxes.'
Benjamin Franklin, letter dated 13 November 1789
Context
Even the two certainties of the above quotation can now be questioned. The discovery of the contents of the human genome raises intriguing doubts about the former; and although it seems certain that some form of taxation will always be with us, corporate tax rates may continue their dramatic fall (perhaps to zero?) and the traditional starting point of the corporate tax calculation (i.e. pre-tax profit for financial reporting) is to be abolished. A further important change is that the details of the calculation of financial reporting income are to be changed in 2005 by the adoption in the European Union (EU) of International Financial Reporting Standards (IFRS). In this report, the abbreviation IFRS is used to refer to the regime of using these standards for financial reporting. Although IFRS is required by the EU for listed companies' consolidated statements only, member states are allowed to extend this compulsorily or optionally to unlisted companies and to unconsolidated statements. Any extension to unconsolidated statements will lead to effects on tax calculations: taxable income will change or tax/reporting linkages will change, or both.
Purpose and scope
This report is designed to examine the present linkages between business income tax and financial reporting, and to ask whether they are ideal. The impact of adopting IFRS in a tax-neutral way will also be assessed.
Having noted an absence of a conceptual framework for the calculation of the taxable income of businesses, this report will propose one and then compare it with existing tax systems and with a starting-point of income measured under IFRS.
The report considers especially the situation of individual tax-paying entities (typically, companies) rather than group accounting, which is largely irrelevant for tax. Particular attention is given to the UK and Germany because (in 2003) they have the two largest EU economies and because they exhibit very different tax/reporting linkages. The EU is of special relevance because of the forthcoming adoption of IFRS for certain purposes. Tax/reporting links in other EU countries are generally rather like those of the UK (e.g. in Denmark, Ireland and the Netherlands) or rather like those of Germany (e.g. in Belgium, France and Italy). Reference to the United States is made where this is useful.
In general, the position at 31 December 2002 or at 31 March 2003 is analysed, as explained from time to time. Subsequent developments may affect the analysis.
Content
Chapter 2 looks at the current operational links between tax and financial reporting for two countries that show markedly different degrees of linkage: Germany (close linkage) and the UK (many disconnections).
Chapter 3 examines the advantages and disadvantages of linkage, and concludes that the weight of argument favours disconnection of tax from financial reporting. The advantage of administrative simplicity is outweighed by the fact that tax and financial reporting have different purposes and by the risk of tax pollution and reduced flexibility.
The current links between financial reporting and tax are an obstacle to the adoption of IFRS for the financial reporting of individual companies. Chapter 4 looks at the adjustments that would be needed to the calculation of taxable income in the UK and Germany if IFRS were adopted.
If income is to be measured specifically for the purpose of taxation, as proposed in chapter 3, this implies the need for a conceptual framework upon which the calculation can be based. Indeed, since all tax systems envisage at least some adjustments from financial reporting income, the need for a framework is already implied. Chapter 5 looks at the limited previous research on this and at the analogy of the financial reporting framework. Chapter 6 then proposes a framework for tax and derives some rules from it for a number of accounting topics.
Chapter 7 compares the proposed tax base to the existing tax systems of three countries: the US, Germany and the UK. Then there is a specification of the standardised adjustments that would be necessary from IFRS to the proposed tax base.
Each chapter ends with a summary. These can be added together to make an executive summary. Finally, the report has a bibliography, a list of abbreviations used and three appendices containing support for some of the content of the chapters.