C. Principles of taxation Flashcards
Which 4 characteristics of good tax did Adam Smith propose in the Wealth of Nations?
fair-reflect person’s ability to pay
absolute no arbitrary
convenient-easy to pay
efficient-low collection costs
What are 3 major principles of good tax?
equity-fairly levied between tax payers
efficiency-cheap and easy to collect
economic effects-how it is collected
What ten principles did the American Institute of CPAs list as good tax policy?
equity and fairness transparency and visibility certainty economy in collection convenience of payment simplicity appropriate government revenues minimum tax gap neutrality economic growth and efficiency
What is direct tax?
imposed directly on person/enterprise required to pay the tax
i.e on salaries, profits, chargeable assets, income tax, capital gains tax, corporation tax
What is indirect tax?
tax imposed on one part of the economy but tax burden is passed to another
e.g sales tax such as VAT, burden on consumer but paid by store
What is a tax base?
something that is liable for tax
e.g income, capital, wealth, consumption
What is incidence?
The distribution of the tax burden i.e who is paying the tax
Formal vs actual incidence
Formal:direct payment to authorities
Actual/effective :end up bearing cost of tax
With VAT, formal incidence on shop but actual on customer
Who is the taxable person?
person accountable for the tax payment i.e individual or entity
What is a competent jurisdiction?
tax authority that has the legal power to assess and collect taxes
- tax law is enforceable by sanctions (fines/imprisonment)
- usually combined responsibility of the central govt and local authorities
What is hypothecation?
certain taxes are devoted entirely to certain types of expenditure e.g road tax, congestion charge pays for transport in area
What is the tax gap?
gap between the tax collectable and what is actually collected
authorities aim to minimise this
What are the 3 types of taxes?
Progressive: as income increases, proportion % increases
-UK income tax
Proportional:same % as income rises
Regressive:as income increases, proportion % decreases
-UK NI contributions
What are the sources of tax rules?
- legislation produced by national govt e.g Finance Acts of UK
- Precedents based on previous legislation e.g UK tax bulletins
- Directives from intern. bodies e.g EU guidelines on VAT
- Agreements between different countries such as double tax treaties e.g US/UK (avoid paying twice)
What are the two types of direct tax?
Tax on trading income:tax base is profits of main business activity
Capital taxes:gains made on disposal of investments and other non-current assets
How is tax on trading income calculated?
accounting profit LESS income exempt disallowable expenses accounting depreciation LESS tax depreciation = taxable profit
How is capital gains tax calculated?
some countries base it on cost, some allow for inflation
in the UK, cost is indexed using RPI
Chargeable gain= proceeds-costs to sell-cost of original asset-costs to buy-enchancement costs-indexation allowance
Types of indirect tax?
unit tax:on number of/weight of items e.g excise duties
ad valorem taxes:based on value of item e.g sales tax
Examples of indirect tax?
Excise duties Property taxes Wealth taxes Consumption taxes - single and multi stage Cascade tax VAT
What is excise duties?
tax on certain items to discourage purchase, pay for extra costs e.g healthcare or tax luxuries
i.e alcohol, tobacco, motor vehicle tax
What characteristics make a commodity more suitable for excise duties?
few large producers
inelastic demand with no close substitutes
large sales volumes
easy to define products covered by duties
What are property taxes?
tax based on capital value or annual rental value of property
USA also taxes on cars, livestock and boats
What is a wealth tax?
tax on an individual’s or their enterprise’s total wealth (including pension funds, insurance policies and works of art)
What is consumption tax?
tax imposed on consumption of good and added to purchase price.
2 types:
single stage:at one level of production
multi-stage:charges each time product is sold i.e cascade tax or VAT
What is cascade tax?
tax taken at each stage of production and is a business cost as no refunds are provided by govt
-multistage
What is VAT?
Charged each time a product is sold but can be claimed back from govt (input tax)
VAT payable=output tax-input tax
output tax=VAT charged on sales
input tax=VAT paid on purchases
What are the 4 different taxable supplies?
Standard rated-taxed at standard VAT rate
Higher rated- taxed at a higher rate
Zero Rated- taxed at a rate of 0% e.g basic food, kids clothes
Exempt- not subject to VAT e.g finance and insurance
Why is it important to identify to type of supply?
So you can claim back input tax on taxable supplies i.e zero and standard rated goods and services
Exempt supplies cannot be charged to customer or as input tax as they are outside of VAT system
What is selling price exclusive and inclusive?
Taxable supplies net price(exclusive) and gross price (inclusive)
How is VAT calculated if exclusive price is provided?
VAT=exclusive price x tax rate
How is VAT calculated if inclusive price is provided?
(inclusive price /100+tax rate) x tax rate
What is VAT registration?
When a taxable person is making a taxable supply
Must register after a certain taxable turnover is reached: issue VAT invoice keep appropriate VAT records charge VAT to customer claim back VAT on those purchases complete quarterly VAT return
What can UK VAT not be recovered on?
cars (unless resale)
entertaining (unless for staff)
What is taxed in income tax?
earnings i.e salaries, bonuses, commissions, benefits in kind
What is a benefit in kind?
non-cash benefits e.g company car, living accommodation. loans, private medical insurance
Who selects basis of assessment for income tax?
individual country
France-tax amount earned in previous year
Switzerland-average of previous 2 years earnings
UK-amount received in current tax year
What deductions can employees make from income tax?
certain expenses which are wholly, exclusively and necessary for employment
i.e business travel, contributions, pension plans, charity donations, professional subscriptions
Who pays social security taxes?
employees and companies based on salaries
What is PAYE?
Pay-As-You-Earn-tax withheld on salaries that is paid directly to authorities
What are the benefits of a PAYE system?
- tax collected at source so taxpayers unlikely to default
- regular payments made which helps govt cash flow
- authority only deals with employer
- administration costs borne by employer, not govt
Who collects property taxes and mortgage payments in the US?
Banks
How is employee tax calculated?
salary bonus commission benefits LESS subscriptions LESS pension contributions LESS charity donations LESS personal allowances =Taxable income
What records need to be kept in regards to corporate income tax?
records that support financial statements and any adjustments made when completing tax returns
What records should be kept regarding sales tax?
records of all sales and purchases records:
- orders and delivery notes
- purchase and sales invoices
- credit and debit notes
- purchase and sales books
- import and export documents
- bank statements
- cashbooks and receipts
- VAT account
What records do overseas subsidiaries need?
docs about transfer price policy between subsidiary and parent
-prices charged for intercompany good/services
What records are kept regarding employee tax?
- detailed record of employee tax and social security combinations
- number of year end returns and deductions
- tax authorities set deadlines for tax payment and submission
- self-assessed tax is confirmed by authorities
What is the minimum retention period of records?
UK:six years for all records relating to earning and capital gains
-so they can be challenged if necessary
When is the payment of tax made?
depends on tax rules and type of tax
- not always when filed, might be sooner or later
- interest charged on late payment
What power do tax authorities have?
- impose penalties/fines
- review and query filed returns
- request special reports if there are inaccuracies
- examine previous years e.g US can go back 20 yrs
- enter and search premises or seize ocuments
- pass on info to foreign tax authorities
What is tax avoidance?
minimise tax liabilities within Scope of the Law
eg set up subsidiary overseas in low tax economy
What is tax evasion?
illegal manipulation of tax system to avoid paying tax
e.g claiming deduction, under declaring income, fictitious expenses
How do tax authorities prevent tax avoidance and evasion?
- reduce opportunity e.g deduct at source, use 3rd part reporting
- simplifying tax structure by minimising relief, allowances and exemptions
- increase detection through auditing returns & payments
- developing good communication between authorities and enterprises
- changing societal views on evasion/avoidance by maintaining an honest and customer friendly system which encourages increasing commitment
- reducing lost revenue by reviewing penalty structure
What is accounting profit?
profit before tax shown in SOPL in the annual financial statements
What is income exempt from tax/taxed under other rules?
any incomes, including accounting profit, which does NOT relate to the main trading activity that is taxed under other rules or tax exempt
i.e rental income, dividend income, interest receivable
What are disallowable expenses?
expenses deducted from accounting profit that should be added back to be taxed
ie allowable under accounting standards but cant be claimed
e.g entertaining customers, gift aid payments, political donations
What is depreciation?
added back as it is an accounting entry that is not allowed for tax purposes as it is too subjective (firms choose way to depreciate)
it is replaced with tax depreciation
What is tax depreciation/capital allowances?
replacement of depreciation, often given on a reducing balance basis
given if asset is owned at the accounting date i.e no time apportionment for mid-year acquisitions
How can capital allowances be used to incentivise new investments?
by offering 100% first year capital allowance, the entire tax value is allowed in first year of acquisition
What is written down value?
cost of the asset less accumulated tax depreciation
What is a balancing allowance (BA)?
a tax loss on disposal
What is a balancing charge (BC)?
tax profit on disposal
Are BA and BC added or deducted from accounting profit?
add BC (accounting profit) and less BA (accounting loss)
How do you calculate accounting profit/loss?
proceeds less carrying amount (SOFP)
if proceeds> carrying=profit
if proceeds < carrying amount = loss
How do you calculate balancing charge (/allowance)?
proceeds less tax written down value (TWDV)
if proceeds>TWDV=balancing charge=tax profit on disposal
if proceeds< TWDV=balancing allowance=tax loss on disposal
What happens when an entity makes a trading loss?
tax year will be nil
-must claim loss relief based on rules of the country’s tax regimes
What ways can an entity relieve a loss?
IMPORTANT TO CHECK TAX REGIME
- carry losses forwards against future profits of the SAME trade
- carry losses backwards against previous profits
- offset losses against group company profits
- offset losses against capital gains of the same period
In what order should companies relieve trading losses against previous and future profits?
First previous years in full, then following years with leftovers in full
During trading losses on cessation of business, how can companies generate a tax refund?
by carrying loss back against profits of previous years
What is the UK’s Terminal Loss Relief?
enables losses to be carried back 3 years
What are capital tax gains?
made on the disposal of investments and other non-current assets e.g stocks and shares
How do you calculate chargeable gain that is subject to capital tax gains?
proceeds (costs to sell) =net proceeds (cost of original asset) (costs to buy) (enhancement costs) (indexation allowance) =chargeable gain
Costs that can be deducted from proceeds of capital gains?
- original cost of purchasing asset
- costs of buying asset i.e legal fees, estate agent fees
- costs to sell the assets i.e legal and estate agent fees
- enhancements/improvements i.e extensions
- indexation allowance depending on regime
How to relieve capital losses?
- carry forward against future capital gains
- carry back against previous capital gains
- offset against trading income in current period
What is rollover relief?
enabling entity to postpone paying tax on a gain if it reinvests the same proceeds in a replacement asset
What is a group?
when one entity controls another entity, commonly through acquisition of a certain amount of ordinary shares (>50%)
-parent acquires subsidiary
What are the 2 issues a group must consider for tax purposes?
- group loss relief
- appropriations of profit
What is tax consolidation?
enables a tax group to be recognised, allowing trading losses to be surrendered between different entities
-accounting group is usually diff from tax group
What are capital losses?
- usually cant be surrendered between group entities
- can transfer ownership of asset at nil gain/loss
How can firms use group relief?
- to save tax(surrendering entity must pay lower rate)
- enable relief to be gained(surr. entity may only be able to carry losses forward meaning they must wait for loss relief so can transfer to speed up relief)
What are appropriations on profit?
dividends cannot be deducted in arriving at an entity’s taxable profits and are therefore taxable in the hands of the entity
i.e tax relief not given on dividend
How can dividends be taxed twice?
once by entity, then by shareholder as income tax
How is double taxation of dividends dealt with?
- classical system
- imputation system
- partial imputation system
- split rate system
- re-characterising debt
Why is re-characterising debt important to groups?
- interest is tax deductible, dividends are not
- advantageous for groups to transfer funds from one entity to another in the form of interest on intercompany loans rather than dividends
- countries address this by limiting the amount of interest that is tax deductible
- interest in excess is classified as a dividend
What is thin capitalisation rules?
rules which govern the amount of interest that is eligible for tax relief
How has the digital world changed taxation?
- which tax jurisdiction to follow?
- what happens when taxed in multiple countries?
What is a corporate residence?
entities pay tax on worldwide income in country they are deemed to be a resident in i.e where head office/board meetings are
How does digital business challenge corporate residence?
Where is online activity ‘based’
-ethical issue of where to base company
When does double taxation occur?
taxed where they earn and where they are located
-there is usually tax relief for this
What are the 3 main methods of double taxation relief?
exemption:countries agree which types of income are exempt/partially exempt
tax credit:tax paid in one country may be allowed as credit in another, normally restricted to lower of the foreign
deduction:deducting foreign tax from foreign income so only net amount is taxed
What are the different types of overseas operations within a group?
subsidiary
- separate entity for tax purposes, holding company will only pay tax on any dividends received
- loss relief not available for group as sub pays tax under different regime
- overseas sub cannot claim the same tax depreciation as the parent on any assets, assets transferred from parent may be subject to capital gains liability
branch
- extension of activity and all profits subject to HQ tax law
- loss relief is available for the group
- assets can be transferred between the branch and holding comp at no gain/no loss
- branch can claim tax depreciation on all assets
What are the types of foreign tax?
witholding tax
- deduct tax at source on items such as interest, royalties, capital gains
- net income is received by beneficiary abroad
underlying tax
-dividend paid out of post tax profits
-amount of profit distributed has already been taxed
-if entity received dividend from an overseas subsidiary, the dividend will be taxed twice i.e underlying tax
(tax on profits/profit after tax) x gross dividend
What does the OECD model state about business profits of an enterprise?
that it will only be taxable in a state if an enterprise has a permanent establishment in that country
What is a permanent establishment according to the OECD?
- factory
- workshop
- office
- branch
- place of management
- mine, oil or gas well, place of extraction of natural resources
- construction project or building site if it lasts more than 12 months
FWBCOMP
What does the OECD model suggest for an entity with permanent establishments in many countries?
the entity is resident in the country of its effective management
What is transfer pricing?
group situations when either goods are sold inter-company at a favourable price or loans are made on favourable terms
- profits are distorted
- might be an attempt to avoid tax ie move profits to lower tax regime
- damage public perception of group
What are the rules for transfer pricing?
- Goods and services
- adjustment will be made in the corporate tax computation for the entity gaining the tax advantage to reflect that profit would have been achieved is the transaction was done at arms length
- charge goods at full price - Provision of loan finance
- amount provided connected company exceeds the amount a third party would be willing to provide, loan is not at arms length (not at normal commercial terms)
- this is THIN CAPItALISATION
- any interest charged on the excess is not allowable for tax purposes so is disallowed
What is indexation allowance?
is a relief given on the disposal of capital assets.
- based on RPI between when cost was incurred and disposal of asset
- adjusts gain for inflation so reduces taxable amount
What are the following systems of appropriation:
- classical system
- imputation system
- partial imputation system
- split rate system
- classical system:taxed twice from firm and shareholder
- imputation system:firm pays tax credit to shareholder
- partial imputation system:tax credit offered but only for part of underlying corp income tax
- split rate system:charge lower rate of corp income tax on distribute profits
