CORRELATION BETWEEN ANNUAL ACCOUNTS AND INCOME TAX REPORTING

Prof.dr.sc.Ferdo SpajićGraduate School of Economics & Business

ZagrebUniversity of Zagreb

fspajic@efzg.hr

The correlation between financial accounts and tax reports arises from the fact that taxes are an integral part of assets and liabilities reported in financial accounts. Taxes as a part of assets and financial liabilities of a taxpayer reported in the company balance sheet affect their financial position. Within the legal framework, but also other conditions, the taxpayer in his decision-making tries to influence the possibility to minimize financial tax liabilities or, which is most often the case, the postponement of payment of tax liability. Positive tax impacts of those decisions affect financial position and the status reported in financial accounts.

COMPETENCE OF BUSINESS RECORDS

The provisions of the Corporate IncomeTax Act influence direct correlation of tax returns and financial accounts of taxpayers. They stipulate that the tax base is determined on the basis of data reported in business records maintained pursuant to accounting regulations and financial accounts drawn up on the basis of those regulations.

The correlation between accounting and financial accounts in profit tax reports is also expressed in the definition of tax base in Article 5 of the Corporate Income Tax Act.

„The tax base is the profit determined according to accounting regulations as a difference between revenue and expenditures prior to computation of the profit tax, increased and decreased [1] pursuant to the provisions of this Act“.

[1] Article 33 of the Corporate Income Tax Act (Official Gazette Nos. 177/04 and 90/05)

It arises from the quoted definition of the tax base that the profit or loss reported and determined in accounting are the baseline for the computation of the tax base and tax liabilities for a business year. revenue and expenditures as elements of financial accounts and for purposes of establishing the tax base are established according to accounting regulations. The change of regularity, i.e., correctness of determining the tax base by the tax authority and others also includes checking the regularity and correctness of reported revenue and expenditures in accounting of the taxpayer in relation to the accounting regulations.

ACCOUNTING REGULATIONS

As of January 1, 2006 the accounting regulations that those obliged to pay profit tax apply in establishment of revenue and expenditures for financial accounts and for tax purposes are International Financial Reporting Standards (IFRS). According to Article 18 of the Accounting Act (Official Gazette No. 146/05) IFRS in the Republic of Croatia are applied by:

- all large legal persons, - all companies whose securities are listed

at stock exchanges or are preparing for listing at the stock exchange and listing for public limited companies, pursuant to the provisions of the Securities Market Act.

Other legal persons and physical persons – payers of profit tax:

may opt for application of IFRS in full or financial reporting standards passed by the

Financial Reporting Standards Board in line with IFRS.

IFRS and standards to be passed by the Financial Reporting Standards Board are published in the Official Gazette.

ALTERNATIVE???

It arises from the quoted provisions of the Corporate Income Tax Act which provide for the manner of the determining of the tax base and the provisions of the Accounting Act that the legal framework for determining of the tax base for one group of taxpayers will be IFRS, whereas for the other group the legal framework will be the Financial Reporting Standards to be passed by the Financial Reporting Standards Board.

We believe that from the aspect of determining the tax base it is not acceptable to divide taxpayers. We also believe that IFRS are not an appropriate legal framework for determining the tax base. It is a profitable project of a non-profit organization which will never be completed, and which has to be applied for taxation purposes in Croatia as well. A better solution was including into tax regulations, for purposes of determining the tax base, the measurement and recognition principles from the International Accounting Standards (IAS-2, IAS-11, IAS-18 and others except for IAS-39). In this case all the 74,000 taxpayers of profit tax in Croatia would apply a clear and the same legal framework for assessing the revenue and expenditures for tax purposes.

DIFFERENCES BETWEEN PROFIT OR LOSS AND TAX BASE

It arises from the definition of the tax base and other provisions of the Corporate Income Tax Act that permanent differences between profit or loss identified in accounting (which will be reported in financial reports) and the tax base in Croatia may be a consequence of:

- permanent differences in expenditures, - permanent differences in revenue. temporary differences between profit or loss in

accounting and the tax base may be a consequence of: - temporary differences in expenditures, - temporary differences in revenue.

PERMANENT DIFFERENCES

permanent differences in expenditures emerge because the amounts of expenditures reported in accounting for tax purposes are permanently non-tax deductible expenditures. In the procedure of determining the profit tax base the amounts of permanently tax non- deductible expenditures increase the accounting profit. The effect of non-tax deductible expenditures is also evident in the higher rate of the share of profit tax in accounting profits in comparison with the prescribed profit tax rate.

Permanent differences between accounting profit and the tax base in revenue most frequently emerge in inclusion into the revenue of a company of the amounts which were already taxed, such as dividends and shares in profit. Each taxpayer has to provide in his accounting the necessary data on expenditures and revenue which have a characteristic of permanent differences.

TEMPORARY DIFFERENCES

temporary differences in expenditures are differences between accounting profit and the tax base because tax deductible expenditures are included in different periods (different years) in assessing business results (accounting profit or loss). In revenue, temporary differences emerge in revenues which are included in the calculation of company’s performance and profit tax base, but in the establishment of the profit tax base and accounting profit they are included in different business years. temporary differences emerge in one or more periods, and are cancelled in one or more periods. Tax impacts of temporary differences are reported in the accounting of profit tax payers as an assets item (deferred tax assets) or as a liabilities item (deferred tax liabilities).

In tax regulations in Croatia temporary differences which result in tax impacts reported in liabilities as deferred payment of corporate income tax are not allowed. This arises from the provisions which specify that only the amounts of expenditures reported in accounting as operating expenditures may be recognized as expenditures for tax purposes. In revenue those are the provisions according to which all amounts of revenue reported in accounting as operational revenue are considered as revenue for tax purposes.

The procedure of determining the tax base in the profit tax report in the condensed and adjusted form:

Starting value in accounting Total revenue, Total expenditure, Profit, or loss, Increase of the starting value

INCREASED PROFIT OR DECREASED LOSS FOR PERMANENT DIFFERENCES – PERMANENTLY non-tax deductible EXPENDITURES:

70% OF REPRESENTATION COSTS 30% COSTS INCURRED IN RELATION TO OWN OF RENTED MOTOR

VEHICLES AND OTHER MEANS OF PERSONAL TRANSPORTATION OF EXECUTIVES, MANAGERS, AND OTHER EMPLOYED PERSONS, IF SALARY IS NOT CALCULATED ON THE BASIS OF THE USE, EXCEPT FOR INSURANCE AND INTEREST COSTS

GIFT EXPENDITURES AMOUNTING TO MORE THAN 2% OF EARNED revenue IN THE PREVIOUS YEAR,

HIDDEN INCOME PAYMENT, COSTS OF FORCED TAX COLLECTION OR OTHER EXPENSES, COSTS RELATED TO PRIVATE LIFE Of SHAREHOLDERS AND MEMBERS OF

THE COMPANY, PENALTIES PRONOUNCED BY A COMPETENT BODY, DEFAULT INTEREST BETWEEN RELATED PARTIES, INTEREST calculated by related parties above the level determined by

the Minister of Finance, depreciation of cars and other vehicles for personal transportation

above HRK 400,000, ALL OTHER EXPENDITURES NOT DIRECTLY RELATED TO MAKING

PROFIT.

DECREASED PROFIT OR INCREASED LOSS FOR PERMANENT revenue differences

1. DIVIDENDS AND SHARES IN PROFIT TAX BASE BEFORE temporary differences IN

EXPENDITURES AND REVENUES - Increase in tax base by temporary differences in

expenditures - Increase in tax base by temporary differences in

revenue (in accounting deferred revenue recognition) - Decrease in tax base by cancelled temporary

differences in expenditures - Decrease in tax base for cancelled temporary

differences in revenue - Tax base after included temporary differences

In further procedure the following is reported: - benefits,- exemptions - incentives

PROFIT TAX RATE 20% - PROFIT TAX AFTER DEDUCTION ABOLISHED

(DIVIDENDS AND SHARES OF FOREIGN LEGAL PERSONS)

- ABOLISHED revenue TAX FOR DOMESTIC AND FOREIGN PHYSICAL PERSONS

TEMPORARY DIFFERENCES IN EXPENDITURES

Allowed are only temporary differences whose consequence is the tax impact reported in assets as an assets item – DEFERRED TAX ASSETS;

temporary differences may emerge in tax deductible expenditures for which the tax regulation stipulates the period in which a specific type expenditures is a tax deductible expenditure.

Those are: expenditures incurred by decrease of

raw material reserves, finished products, and commercial goods:

– for this type of expenditures it is stipulated that they are tax deductible expenditures in the period in which the stocks are sold, destroyed, and used otherwise.

Impairment of shares, business shares and other financial assets (non-realized losses):

– for this type of expenditures is is stipulated that they are tax deductible expenditures in the period in which assets are sold, or in the period in which losses were incurred.

Earned and non-earned profits and gains for shares and other financial assets:

- earned profits are included in the tax base - If the taxpayer includes in the revenue the non-

earned profit, then the amount of revenue is included in the tax base.

Decreases in outstanding debts from buyers are:

– tax deductible expenditures if they are not paid up to 15 days prior to the submission of tax return and if 120 days have elapsed from the maturity date until December 31;

- expenditure is tax deductible only if reported in accounting

- non-tax deductible expenditure are decreases of other outstanding debts from buyers if they are not actionable

TEMPORARY DIFFERENCES IN DEPRECIATION

The Corporate Income Tax Act provides for the manner of determining depreciation as the highest annual tax allowable expenditure;

Amortising amount = purchase cost Linear method, individual calculation Highest annual depreciation rates

Annual depreciation rates applied as of January 1, 2005 are:

Construction facilities, ships 10% Main herd 40%

Cars 40% Equipment and vehicles except cars 50% Intangible assets 50% Computers and programs, mobile phones 100% Other assets not mentioned above 20%

By very high annual depreciation rates the Government enables deferring payments of profit tax;

The specific of tax regulation is that it makes deferring the payment of profit tax conditional on deferring recognition of profit.

HOW?

depreciation up to the highest tax allowable amount is tax deductible expenditure equal to the amount reported in accounting

Example:

Purchase cost of a plant is HRK 2,000,000. The expected life is 8 years. Annual depreciation rate is 12.5%, and estimated residue value is HRK 500,000.

The highest annual tax allowable depreciation amount with the 50-pct rate:

Year 1: 2,000,000 x 50/100 = 1,000,000 Year 2: 2,000,000 x 50/100 = 1,000,000

In years three, four, five, six, seven, and eight depreciation is ZERO.

Objectively determined annual amount of depreciation:

Year 1 1.500.000 x 12.5/100 = HRK 187,500Year 2 1.500.000 x 12.5/100 = HRK 187,500Year 3 1.500.000 x 12.5/100 = HRK 187,500In years four, five, six, seven, and eight

depreciation is HRK 187,500 annually.

If a taxpayer wants to defer payment of profit tax by applying the highest annual allowable depreciation rate of 50% on procurement cost, then in accounting of the first year he has to report depreciation as operating revenue of HRK 1,000,000.

CONSEQUENCE: - unreally increased depreciation and

expenditures by 812,500 (1,000,000 – 187,500 = 812,500); - assets are unreally decreased by the same

amount

Capital is decreased (net profit) 812,500 x 80/100 = 650,000 - deferred payment of profit tax 812,500 x 20/100 = 162,500 - hidden temporary differences in depreciation =

812,500 - hidden tax impact; deferred profit tax payment

= 162,500 - deferred net profit = 650,000.HOW TO MAKE BALANCE SHEET RIGHT?????

THANK YOU FOR YOUR ATTENTION!!!