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Sunday, April 10, 2011

Accounting tail wagging the tax dog-how accounting choices affect tax liability

Most people would know from Accounting 101/Tax 101 that USA corporations prefer LIFO basis of inventory accounting(prohibited by international accounting norms under IFRS) to save on their taxes in an inflationary scenario. But this just scratches the tip of the iceberg. There are many more serious implications of passing that accounting entry in your books, even if the tax records are maintained on a separate basis. Some of them are:-
  1. Where accounting profits serve as an alternate basis of taxation-for example India imposes a 'Minimum Alternate tax' on the book profit(of course post certain adjustments for unrealized profits/losses)
  2. Many countries mandate a reconciliation between the tax income and accounting income(or even the statutory tax rate and the effective tax rate paid by the company). Any major difference could invite a visit from the tax man.
  3. Tax law typically stipulates penalties/fines/withdrawal of amnesty scheme options etc in cases where intention to evade taxes is proven. Where the substance over form doctrine in accounting mandates treatment overriding the legal form like
    1. Characterizing leases as finance/operating irrespective of documentation
    2. More importantly, The IAS 32 requirement on the issuer of financial instruments to classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.  Specially where quasi equity instruments are structured to achieve the maximum tax benefit(read debt) but the company accounts for them as equity as per IFRS, the tax authorities could make out a case that the company was fully cognizant of the potentially differing treatment. 
  4. In countries like Germany/France, where book profits serve as the taxation basis, companies straddle a thin line between inflating their profits(for external reporting) and minimizing tax payments. 
  5. In case of withholding tax on international transactions, or even for some related party transactions, and more recently for Indian indirect tax liability(under service tax), the book entries take precedence over the date of the actual transaction.
  6. Where separate businesses of the same legal entity are taxed differently,  then segment accounting and internal transfer pricing becomes much more important. An interesting example in this regard in the case of Ganesh Polytex was mentioned by me earlier at http://financeandcapitalmarkets.blogspot.com/2011/01/reducing-tax-payment-via-overhead.html
 While managers would engage internal accounting staff and external tax advisors to address these problems, a broad level understanding of the major issues pertinent to that geography is essential, to ensure that that 'big picture view' does not fall afoul of the tax man.

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