| Many groups are facing mandatory changes to the basis of accounting as the EU enforces international accounting standards. There is discussion at present as to the implications of such standards for taxation liabilities of companies. Those implications may be more limited in scope than might be expected. |
IInternational accounting standards (IAS) will be the mandatory basis for the preparation of consolidated accounts for most EU based quoted companies for accounting periods beginning on or after 1 January 2005. Given the predominance of 31 December year ends, the full impact will be felt for the accounts year ended 31 December 2005.
What are the tax implications?
One of the major elements of a company’s profits on which corporation tax is charged is income from the conduct of a trade. Financial accounts generally are concerned with total profits, and not with a sub-set such as trading income. The tax on trading income is based on precise statutory wording, but the wording failed to define what was meant by income from a trade.
In the nineteenth century judges concluded that the concept of income from a trade was essentially a commercial concept and therefore that commercial understanding of income was relevant. This immediately created a link between a company’s accounts and its tax computation, since the principles upon which the company’s accounts are prepared reflect an understanding of what, in commercial terms, constitutes the profits from a trade.
From the beginning the linkage between accounts and taxation was incomplete. An early court decision held that the depreciation of fixed assets or of capital expenditure generally was not a permitted deduction in the computation of taxable income. This decision was on the basis that it was in the nature of “income” that receipts of a capital nature, or expenditure or expense of a capital nature, could not fall to be taken into account in its computation. No commercial person would be likely to take the same view of depreciation, as a proper expense, in computing income from a trade.
As accounting principles became more sophisticated and numerous, the courts both in Ireland and in the UK made it clear that whereas they would take account of generally accepted accounting principles in considering how income was to be computed, they did not consider that those accounting principles determined the matter. The courts reserved to themselves the right to determine and apply “correct principles of accounting” which could differ from the generally accepted accounting principles of any particular period.
“Correct principles of accounting” generally required that income be realised before it could be taken into account in computing tax. Thus it was not permissible to include unrealised increases in market value in the valuation of closing trading stock, in computing a tax liability. Accounting standards, particularly in more recent times, have had less difficulty with that concept.
Courts versus Accountants
There have been numerous cases in which the courts determined trading income otherwise than in accordance with the income computed in accounts. The Irish courts in the Mac Giolla Riogh case denied a deduction for a write down in income bearing securities held on revenue account, where accounting principles did recognise an expense. Two other cases stand out. One is an Irish case involving PJ Carroll & Company and the other is a UK case, Gallagher v Jones.
In the Carrolls case the taxpayer company had prepared its accounts in accordance with current cost accounting. This was the approved method at the time for accounting for inflation, which was then in double digits. No one disputed that their accounts were prepared in accordance with generally accepted accounting principles.
The Irish courts rejected the principles on which the accounts had been prepared as being appropriate to compute taxable profits. The courts did not permit the revaluation of closing stock to reflect unrealised increases in market value, nor did they permit a deduction for the cost of goods sold to reflect adjustments to bring the historic costs in line with the impact of inflation between the time of purchase and the time of sale. In other words, the courts rejected any attempt to tax unrealised profits or increases in value, and rejected any claim for deductions for an expense not actually incurred, but notional in nature.
Gallagher v Jones was a UK case which concerned a finance lease of some barges, with significant up-fronted lease payments, followed by a lengthy period of relatively nominal lease payments. The issue was whether the payments fell to be regarded as deductible expenses of the periods in which they became legally payable (and were paid), or whether they should be reallocated on some basis over the period during which the lease provided the use of the barges to the company.
The taxpayer company had prepared its accounts in accordance with the generally accepted accounting principles relating to finance leases, so that its accounts appeared to reflect not the leasing of equipment, but the purchase of equipment, financed by outstanding consideration carrying interest. Its accounts reflected an interest expense incurred by it, and it reflected depreciation of the barges. Its accounts did not reflect the lease payments per se as an expense.
The court decision on the case was a curious one. It agreed with the Inland Revenue that the lease payments should be deducted proportionately over the periods in which the accounts reflected the (notional) interest and depreciation expenses. But it did not follow the accounting treatment by giving a deduction for the interest, and granting capital allowances in respect of the plant which would be the correct treatment had the barges actually been purchased as the accounts suggested. The deduction given was for the lease payments and the interest and depreciation reflected in the accounts were not regarded as having any reality as expenses for tax purposes. Thus on the one hand some regard was had to accounting treatment, and on the other hand, the accounting standard relating to finance leases was largely set aside for tax purposes.
The position adopted by the Inland Revenue subsequently was that the case was confirmation for the view that the timing of recognition of income or of expenditure would be influenced by accounting treatment, but that the actual nature of a transaction entered into, and the distinction between expenditure or income of a capital or of a revenue nature, did not fall to be significantly influenced by accounting treatment.
Statutory Overrides
As mentioned above, accounting principles are primarily relevant because the word “income” is not defined in the Taxes Acts in the context of a trade. However the Taxes Acts contain numerous specific statutory requirements relating to the computation of income. For example, capital allowances are provided subject to specific statutory requirements being met. Contributions to employee pension funds are deductible only on the basis of a specific statutory provision. Some expenses may be statutorily recategorised as being akin to dividends and thus not deductible eg certain profit participating interest. There is a specific statutory regime regarding foreign exchange gains and losses in many situations. These are but a few of numerous occasions when the Taxes Acts make specific rules that impact on the computation of taxable income. Accounting principles have almost no relevance to the application of these statutory rules.
Accounting principles also have no relevance to the computation of tax other than on trading or professional income. Income charged under other heads of charge in the Taxes Acts are computed without reference to accounting principles. A similar position applies regarding capital gains.
The future?
At the present time discussions are ongoing in the Revenue Commissioners with a number of bodies to explore the tax implications of the adoption of the new accounting standards. The Revenue Commissioners, naturally, are anxious to ensure that the accounting standards do not lead to a reduction in tax revenue. They will also have an interest in the tax treatment of any prior year adjustments which may arise as a result of a change in accounting bases.
It remains to be seen how these discussions will proceed. Nonetheless the outline given above of the legal background to the interaction between tax law and accounting principles is important, in order to understand the context of the discussions. Existing case law does appear to place limitations on the extent to which changes in accounting principles can lead to any automatic impact on tax computations in the absence of new legislation.
It may be the case, that given many financial institutions account on a mark to market basis at present, that the impact of the new standards in such companies may be more significant. This position will be explored in a further article. |
Brian Daly, Editor, KPMG Tax Monitor
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| Article appeared in the July 2004 issue.
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