Taxation of Business Income and the Methods of Profit Determination Flashcards
4 different types of businesses subject to tax
- Sole proprietorship (individual)
- Partnership
- Corporation
- Other legal entities, e.g., trust, government)
What is a legal entity not subject to tax?
Non-profit organizations like FIFA, churches
Still need to file tax returns despite not paying taxes
Sole proprietorship vs. partnership vs. corporation: who owns the business?
Sole proprietorship: the manager
Partnership: partners
Corporation: shareholders
Sole proprietorship vs. partnership vs. corporation: separation of managers and owners?
Sole proprietorship: No
Partnership: No
Corporation: Usually (not necessarily)
Sole proprietorship vs. partnership vs. corporation: liability of owner?
E.g., do the owners have to whole responsibility, for example if they make debt, do they have to pay with their own money or are only liable for a limited amoumt?
Sole proprietorship: Unlimited
Partnership: Unlimited
Corporation: Limited (shareholders only liable for the money they agreed to invest)
Sole proprietorship vs. partnership vs. corporation: Separate taxation of businesses and owner?
Sole proprietorship: No
Partnership: No
Corporation: Yes (a corporation is a separate taxpayer who pays corporate tax; business owners only have to pay tax on what they (choose to) receive from the business as dividends
Business income in global vs. schedular system
Global system: distinguishing business income from employment income doesn’t matter as it is taxed the same
Schedular system: distinguishing business income matters because you pay a different tax rate
Definition of business income
Commercial or industrial activity of an independent nature undertaken for profit
Business income vs. employment income: deducting expenses+ consequence
For employment income, you cannot deduct exactly your expenses, only a flat rate
For business income, you can deduct all your expenses
-> beneficial to try to earn business income instead of employment income (e.g., switching from being an employee to a consultant in own firm)
What does the NL do to prevent people from claiming to be entrepreneurs to claim business income?
You can register as entrepreneur under commercial law, but does not automatically mean you are taxed as one; looking at number of clients
How can the same type of income be considered as business or investment income depending on the sector?
Investment income are for banks usually considered business income since earning interest is part of their business
Is capital gains business income or not (civil law vs. common law)?
Civil law: only if it is part of their business (e.g., income from selling houses because business is about buying and selling houses -> capital gains, but if a company relocates and sells their house, it is not)
Common law: only included if achieved with a profit-making intention, and excluded if a one-off transaction (e.g., sale of immovable property)
UK vs. Germany: is capital gains taxed?
UK: generally not, but separate capital gains tax (trust concept of income)
Germany: capital gains on sale of business assets is taxed; also a separate private capital gains tax (source concept of income)
Two kinds of profit-determining systems
- Receipts and outgoings system: Common-law origin: starting point is gains and expenses recognized for tax purposes (looking at flows of income)
- Balance sheet system: civil law origin (EU): starting point is taxpayers’ financial accounts (looking at value of assets; differences in stock rather than flows of income)
Outcome is basically the same, but two ways to go about it
How to calculate taxable business income?
Assets end of year - assets beginning of year + dividends - capital contributions
Dividends is money that owners take out of the company which lowers assets -> must be taken into account to tax profits
Positive = taxable income
Negative = losses
What does both a cash-basis system and an accrual-basis system tell us about?
When to recognize income; timing issues regarding income and deductions
Cash-basis system (+ example from lecture)
Income is derived when it is actually received, expenses when paid
Electrician is contracted is fix lights at university - completes job in December 2022 and gets paid in 2023 -> he declares income in 2023 when he receives the money
Accrual-basis system (+ example from lecture)
Income is derived when the right to receive the income arises and expenses are incurred when the obligation to pay arises
Electrician is contracted is fix lights at university - completes job in December 2022 and gets paid in 2023 -> he declares income in 2022 as that is when the right to receive it arises (when he does the actual job)
Uncertainty regarding payment: cash vs. accrual
You sell a TV with money-back within 30 days guarantee
Cash-system: you earn money when you sell the TV
Accrual-system: you earn money when the 30-day guarantee has run out
For what type of businesses is cash vs. accrual often used?
Cash-basis often applicable for smaller businesses and sole proprietorships -> easier to administer and comply with, but must come up with transition-rules
Accrual-system often used for bigger businesses -> usually required under commercial code or accounting law
Why is the accrual-system “better”?
In a cash-system, you can postpone your own payment which leaves more scope for planning when you have to pay taxes -> businesses will always try to pay later because having more money now means you can make more money in the future
But state doesn’t want to wait until businesses want to pay tax, and investors want their money when the earn it, not when the business wants to give it
Expenses: fines, bribes, other taxes, gifts
Fines and bribes are non-deductible! Other taxes are sometimes deductible, so is gifts if necessary to make a profit
What is depreciation?
A reduction in the value of your capital assets
What are capital expenses?
Acquisition of assets or benefits with a life extending beyond the tax period (e.g., buying machines, cars, houses etc.)
Why are capital expenses not immediately deductible for the entire amount?
To avoid tax planning; if a company makes a big amount of money in one year, they can just buy capital expenses to avoid paying as much tax
How are capital expenses deductible?
With depreciation rules - cost can be deducted over the lifetime of the asset
If a machine costs 20,000 euros and is expected to last 10 years, you can deduct 2,000 euros each year
Why do some countries are accelerated depreciation rules?
Deducting expenses quicker than the actual depreciation is usually done if you want companies to invest more -> sacrificing tax revenue to increase investments
Relationship between tax accounting and commercial accounting regarding profits
Depends on the country; some countries have a close relationship between the two and profit determination is highly based on profit reported for accounting purposes - in Germany, businesses can use balance sheets for both accounting and tax purposes
Others have independent relationship; in US you cannot use commercial accounting as a basis for calculating tax; instead everything is defined in tax law
What does the relationship between tax accounting and commercial accounting depend on?
Who is responsible for developing accounting standards - the government (close relationship) or the private sector (independent)
For the EU, what is the relationship between tax accounting and commercial accounting?
Convergence through International Financial Reporting Stanbdards to harmonize accounting standards across countries
Why does it matter what the relationship is between tax accounting and commercial accounting?
Accounting rules can provide more or less flexibility with respect to timing, regulating taxpayers’ incentive to delay recognition of income and speed up recognition of expenses
How has taxation of corporations changed over time?
In beginning of 20th century, corporations were taxed under same income tax laws as individuals. Now, separate laws
Civil law vs. common law and the definition of the legal entity
Civil law: status of an entity as legal person is relevant to imposition of corporate law
Common law: legal entity or not is less relevant
The corporate tax rate is usually…
Flat, nor progressive
Why is the corporate tax rate usually flat?
The pure amount of income that a corporation makes it not necessarily linked to the ability-to-pay of the individuals employed
E.g., small business vs. big business can make the same amount of profit, but ability-to-pay is smaller when a lot of people are involved
How does the NL tax corporations?
Two brackets; profits up to 395,000 euros are taxed 15% and profits above is taxed 25.8%
The corporate tax rate over time has gone…
Down -> race to the bottom among different countries
What is double taxation regarding corporate income tax?
Corporations and owners are taxed separately -> double taxation as a company pays corporate tax, and then the owners pay tax on the money they receive from dividends
How to deal with double taxation of corporate income and dividends + 1 issue: classical system
Taxation at both corporate and taxholder level
Issue: increases incentive for tax planning (distributing money through interest payments rather than dividends or lending money to a company instead of owning stocks)
If a company makes 1000 euros that you as a shareholder want to take out + 30% corporate tax rate - what is difference between making it a dividend payment and making it an interest payment?
Dividends: 30% of 1000 is 300 -> 1000-300=700 euro payout
Interest: Deducting 700 as an expense + paying 30% of the remaining 300 in tax, meaning getting 210 euros in dividends -> 700+210 = 910 euro payout
How to deal with double taxation of corporate income and dividends: Imputation system
Shareholders receives a credit for tax paid a corporate level (lessening the second tax round)
Issue: how to deal with tax incentives? The shareholder has to pay what the corporation didn’t pay
How to deal with double taxation of corporate income and dividends: Distribution-based corporate income tax
Only shareholders are taxed, e.g., corporate income tax only levied when profits are distributed
Not very prevalent (only Estonia)
What is group taxation?
When some countries allow groups of enterprises to aggregate income and losses (e.g., Shell is not just one corporation, but 1000s who do one specialized thing -> aggregate losses and income)
Why is it beneficial for corporations to have group taxation?
If one company makes a profit and the other a loss, they can balance each other out -> lower overall tax burden
Who usually has group taxation?
OECD countries
What is the Common Consolidated Corporate Tax Basis?
EU initiative for group taxation; e.g., a company makes profits in NL but loss in France would be able to use loss to offset profits
But would need a different way to allocate profits across EU
No agreement yet, but step toward long-term goal of an EU corporate taxation system
