It is an odd, and sometimes welcome part of my work that people send me papers they have written on various aspects of accounting, tax and economics for me to comment upon. Sometimes I am just too busy to comment; on occasion what I am sent is too bizarre to work out how to comment constructively, and on occasion I get opportunity to engage. One such occasion was in the last week, when my levels of fatigue with most work meant I was open to reading more than average, and so turned to a lengthy paper sent my someone (it is not fair to name them) who is proposing to, in their view, simplify UK corporation tax by basing it entirely on declared profits.
As much as I think corporation tax is an absolutely essential part of any tax system (as I explain this morning) I thought it worth sharing my reply because as proposals go this is one of the most likely to create opportunities for massive tax abuse and injustice that I have come across for some time precisely because profit, particularly as recorded by International Financial Reporting Standards, is one of the most malleable measures ever created and therefore wholly unsuitable as a tax base, although I strongly suspect the person sending the proposal was honourable in his objectives:
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Thanks for your mail, and attachments. I regret that when I read this "With very few exceptions accounting profits determined in accordance with GAAP equate to realised profits under The Companies Acts." my heart sank. This is factually not true and so undermines all that follows in your proposal. The problem with IFRS and standards related to it is that it almost wholly lacks substance. It does not, for example, measure income but movement in value between one period and the next. That is not profit and it is certainly not a measure of capacity to pay tax. In itself that makes IFRS and US GAAP 'income' meaningless for almost any purpose, let alone taxation.
But it is worth than that: IFRS does not define a capital maintenance concept, which is fundamental to any meaningful accounting system. Is it phsical capital it is maintaining, or financial? And is it current value, or historic? And who for who anyway? Shareholders? Bondholders? The entity, and in that case, what is the entity? Remember, IFRS is not designed for single entities, but for groups - and they are not taxed. But it has also, via it's refusal to address the issue of related party transactions completely failed to address major issues of international tax concern. And in leaving choices on all these issues to the directors of a company - as it does - it has no comparability or consistency concept within it - both of which are essential to taxation.
So, the result is that you are proposing to tax what is in effect a movement in asset worth, whether realised or not, determined on a basis arbitrarily set by the directors of a company. To suggest as you do at the beginning of the paper that IFRS measures realised profit could not be further from the truth in theoretical terms as a result. It emphatically does nothing of the sort, and never will. Indeed, its failure to do so is why successful challenge is now being raised against the UK related FRSSE because it very clearly does not meet the Companies Act requirement to preserve financial capital in the interests of the shareholders: it is that deficient.
But even if these issues could be addressed there would remain fundamental problems. First of all tax does have, and must have, a clear capital maintenance concept. This has to be the maintenance of financial capital - any tax that does not take into account capacity to pay fails any test of acceptability and any concept of tax justice. This is a standard potentially incompatible with IFRS.
And then, very clearly, there is the fact that you are making another fundamentally false assumption about tax, in that you appear to assume that it is simply about raising revenue and so ask no question of what transactions should or should not be encouraged or discouraged via the tax system, but I think this absolutely essential. Combine this fact with the arbitrariness of what companies may choose to do and expense and still comply with modern company law and by implication you are simply suggesting that companies may define their own tax base and I can think of no better recipe for abuse.
After all this I still have a remaining problem. After 35 years as an accountant I still have no idea what profit is and that is not by chance, it is because there is no such thing. Profit is, after all, a residual. It is the net effect of income less expenses when stated for tax purposes (although not for IFRS, of course). I can define taxable income. I can define deductible expenses. But there is no way I can define profit, and have already hinted enough at reasons for that, although I could elaborate further. The important point is that if profit cannot be defined for tax, except as a residual of other transactions which we can define, we cannot tax it: we can only tax the residue of taxable income less allowable expenses which is not in any sense the same thing.
So what does all this mean? Firstly IFRS is wholly unsuitable as a tax base.
Second, profit is a meaningless concept for tax.
Third, far from moving to IFRS as a tax base we need to move away from such a fundamentally flawed accounting system that has created almost meaningless, arbitrary, non-comparable, uncertain reporting that also fails in the fundamental duty of any accounting system, which is to protect creditors. This is why I am working in developing Tax Reporting Standards for this very reason. The first was, of course, country-by-country reporting, but it is very clear that if we are to effectively tax corporations - and I have no doubt we must - this has to be the direction of travel, for which the EU's CCCTB is a useful, if incomplete, precedent.
I am sorry - I only read a few pages of what you wrote, and came out with these fundamental concerns, which I am happy to discuss.
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The debate is open....
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Actually Richard I think it would have been fairer to supply my name as author of the paper, and also to refer to the reply which I sent to your e-mail
“I have also long been interested in the question of what is “profit” and what should be the tax base for business. This was more than an academic interest when I was closely involved with the Herbert Smith tax case before the courts (- I was Head of Tax there at the time), when it became clear to me that courts could not see that tax had developed its own concept of profit independently of any accounting concept of profit, (which is not saying that tax could not choose where accounting standards provided alternatives, or that tax could not legislate for specific situations). Further I came to believe that tax could not do this – one had to start with a measure of profit determined on some accepted basis of accounting, and then make adjustments from that base as appropriate for tax.
You quite rightly fulminate against IFRS as producing the correct answer for tax. We agree on this! I am very conscious that accounting standard setters behind these developments are equally vehement that they are not trying to do anything to help the tax world.
You will see on page 7 of my paper I express my reservations against IFRS , ( and it seems that is a very widespread concern about the way IFRS often applies, not just from the tax perspective), and I have tried in Part D of the Business Tax Act to identify those situations where IFRS should not apply, and historic cost accounting should apply instead.
Is that not the heart of the issue?”
I expected that Richard would have been more positive about my proposal. Is it not consistent with his agenda that companies would need to show and justify how one moves from the profit shown in their accounts to taxable profit. But Richard’s abandonment of the concept of profit entirely for tax purposes is not in my view justified or helpful.
If anyone is sufficiently interested I would invite them to look at the “Tax Simplifier” blog on the Centre for Policy Studies website, which has a link to the papers under discussion.
David Martin
David
I did not name you as I never name people with whom I correspond without their permission – and I had not sought it
I have to also say that any proposal that might be published by the Centre for Policy Studies -a hard line right wing neoliberal fundamentalist think tank that appears to be dedicated to increasing inequality in the UK – is hardly likely to find favour here
And you miss my point, as lawyers usually do because in my experience since almost none (like almost all economists) have any clue as to how IFRS, or almost any other GAAP, measures and reports profit. I am not so worried about reporting how accounting profit is adjusted to taxable profit, although it would be interesting to know that. What worries me is that something so arbitrary as IFRS profit – where directors are free to choose their own capital maintenance concepts (and I mean, concepts) can ever be a basis for tax. It can’t – and nor can accounting profit when any mumbo jumbo may be charged against profit and be acceptable in law but not for any known taxing system
I’m sorry David – you’ve started with a false perception of what tax is and a wholly mistaken view that tax simplification is a Holy Grail with some merit to it and almost no accounting knowledge at all and from that have drawn conclusions that rank in my opinion as nonsense – unless your goal is to permit corporate tax abuse, which I hope it is not.
Of course I have no sympathy with such an idea: this proposal will be treated a manna from heaven by all tax abusers and will be rightly opposed, I hope, by any right thinking person. Trying to add caveats, as you do, to a very bad idea will never make it a good one. They just represent apologies for getting it wrong in the first place.
Best
Richard
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“…any tax that does not take into account capacity to pay fails any test of acceptability and any concept of tax justice.”
As well as corporation tax on unrealised profits, that’s income tax, CGT and IHT out of the window, then. Oh, and VAT.
You get dry tax charges all the time in all those taxes. But better to have some dry charges (one can always borrow to pay the tax) than to have the enormous potential for abuse that cash accounting would bring you.
“Profit is, after all, a residual. It is the net effect of income less expenses when stated for tax purposes (although not for IFRS, of course). I can define taxable income. I can define deductible expenses. But there is no way I can define profit…”
So from the axioms:
1) P = A – B
2) A is defined
3) B is defined
you are unable to calculate P? Where does the uncertainty come from?
Andrew
I wonder how wrong you can be and still have any credibility left?
IT, CGT and IHT are all on realisation – almost without exception – the quirks are minor and do not make your case
And if you thought for just a moment A as I define it less B as I define it is definitely not P (profit) but T (taxable income) which is not the same thing at all
If you’re not able to see that I seriously wonder about your professional competence
“Almost without exception”?
Let me give some common examples, from recent experience, off the top of my head:
– Income tax on employment related securities. Employee gets given some shares, tax charge hits. No cash available, and no market for the shares because they’re unlisted.
– Income tax on company cars. Employee is given the use of a vehicle, pays tax on it, no cash is made available to pay that tax. Even worse if the employee gets private fuel.
– CGT on gifts to another person. Unless you can claim business asset holdover, there’s a dry tax charge.
– IHT on anything other than cash. You have an entire industry of people insuring other people against this sort of dry charge.
– VAT on gifts by a business. I recently had a case where a widow wanted to donate a painting to an art gallery, but couldn’t because of the VAT liability.
As for your view of what you said about profit: I think you need to try harder. You have a complete and accurate definition of profit there, but you are choosing to ignore it.
Oh come on Andrew….please stop making my hard bleed for the poor person who does not have to pay for their own car
And no one has to take shares
And the rest are all realisable transactions which people have chosen not to convert to cash
You really are scraping the barrel
No wonder the profession has a bad name
I agree that in most cases those taxes are levied when there is cash available to pay them. However, in many cases they are not, and the structure of each tax does not generally take ability to pay into account.
My point is just that, by the test that you yourself set up, they would be unjust and unacceptable. Which makes me think that your test is inappropriate.
You yourself have no sympathy for a person who gets a “free” car but has to pay tax on it; if you think that tax without cash is fair enough in that situation, then clearly you do not think that your test is correct.
My test is just fine – cash is available in all these cases – it’s just not being taken
I’m sorry, but I don’t see where the cash is in any of the cases I’ve cited. Can you point it out to me?
Every one of them is a movement in a non-cash asset which results in a cash tax charge.
The only one I can think of that might have cash in would be a company car, if you assume that the company is acquiring the car new in order to provide it. In none of the others is there any cash at all.
I made clear: all could have a cash alternative bar shares – and no one is obliged to take them
They can’t have cash alternatives – they’re gifts of the assets themselves. Where is the cash alternative to the gift of a painting that the gallery wants? If the owner of a company wants to give a senior manager 10% of the shares in the (profitable, but cash-poor) company he’s worked in for 20 years, what form would a cash equivalent take and where would the funds suddenly come from?
By saying “no-one is obliged to take them”, what you are basically saying is that it’s fair enough for tax to stop things happening. I would say that if a tax prevents things happening then it’s an unfair and badly designed tax.
The gift can be refused
The asset can be sold
Cash can be offered instead
Of course there is a cash alternative
“Hello, this is the Tate Modern here. We’d very much like to have one of your late husband’s paintings on display.”
“OK, I can give you one of them. Wait a moment, it’s worth £50,000, so it’ll cost me £10,000 in VAT to do that, and I don’t have £10,000 in cash.”
“Well, neither do we. Never mind, then. Bye.”
What’s the alternative?
– Sell the painting to a third party to raise the cash so that the painting can be gifted… oh, wait, she no longer has the painting to gift.
– Offer cash instead? She doesn’t have it; and anyway they want the painting, not cash.
– Lend the painting rather than gifting it? The gallery’s policy is donations or nothing (or else they’d be inundated with “loans” from people who don’t have the storage space).
– Refuse to make the gift? Well, that avoids any tax problems – but as the Tate doesn’t get the painting, it avoids any benefits too.
The tax system has ensured that no-one benefits: a painting stays off display so the public loses out; the country is deprived of an asset worth £50k; and as no tax would have been collected anyway, no revenue has been protected. A resounding success?
In some cases there is a cash alternative. In others there is not. Your view that everything can be reduced to cash seems rather narrow.
Why did your late husband hold the assets in a VAT registered business? Sorry that makes no sense
And why is the wife now VAT registered?
Are you really trying to be as obscure as possible?
If so, stop wasting my time
He was a professional artist, making VATable supplies.
She is now trying (not very successfully, to be honest) to sell the stock of his old paintings. Any sales she does make are VATable supplies.
I’m not trying to be obscure, I’m just pointing out that there are situations that come up all the time in practice that lead to dry tax charges. You said that tax is on realisation of cash “almost without exception”, but this is one of many exceptions that you aren’t aware of.
I could just as well have expanded on proprietors giving shares to employees, or people giving property to family members, and so forth. Where value passes with no cash changing hands, there is a serious risk of a dry tax charge.
So, she can’t sell the painting
What’s its market worth then?
Close to zero for VAT purposes?
Unless the definition of “market value” for tax purposes assumes that there is a willing purchaser for the asset.
Which of course it does.
Oh come on – I have done this stuff
If you can evidence there isn’t you can prove no market value
Just because some paintings are worth millions HMRC does not yet assume all are
Can we have a real debate?
So you advise that for tax purposes she should declare a painting to be of nil value, when she and a number of other professionals in the art world actually consider it to be worth a significant sum?
That’s not an approach I can endorse.
If no one will but it what’s it worth?
You just said it was unsaleable
Are you making this up?
I didn’t say it was unsaleable, I said that she wasn’t being as successful at selling paintings as perhaps she’d like. Having trouble selling things is of course a problem that has been shared by a number of businesses lately.
Not being able to find a buyer just now is not the same as being unsellable. That’s why definitions of “market value” for tax purposes assume a buyer can be found.
Anyway, thanks for the advice. I’ll bear it in mind in future valuation discussions with HMRC… 🙂
The willing buyer assumption does take comparables into account
Including actual prices….
Exactly. She sells one, and a little later the question of donating one comes up. How can you say the second is worthless, when the first sold for thousands?
You said she couldn’t sell them
Now you say she can
Do you act like this with clients?
I said “not very successfully, to be honest” about her sales.
Which is perfectly true: she’d like to have sold more of them, and last I hears was a bit worried about how she’d be getting by.
You seem to have read it as meaning that she can’t sell any at all, which is an entirely different kettle of fish.
I’m beginning to go to sleep listening to your tale of woe
Fair enough 🙂
I tend to get interested in cases where people seem to be taxed unfairly, but if they bore you, then they bore you. Each to his own.
I was bored by your presentation, not the case
I did such an estate 25 years ago
Richard
What is the highest number of respected professionals abused by you in any one day? Do you keep records on this?
Respect in the way you use the term implies revered, to whom we should defer and offer respect
I do not offer deferment to those whose views are wrong
And I think the whole structure of respect as you refer to it is designed to undermine any element of questioning
I am only interested in speaking truth to power, and that is very different
It includes telling the emperor he is naked when he is
“I can define taxable income. I can define deductible expenses.”
1. Are you sure you can define these? There is nothing in the tax legislation which defines these terms. Sure, there are items that are specifically included (or excluded) from being taxable income (or deductible expenses), but that’s not the same thing.
2. “Taxable income” – presumably income recognised/measured in accordance with GAAP?
Read the EU CCCTB
It does define these terms
And makes very clear GAAP and its definition of the tax base are far apart
Just as accounting standard setters make clear they are not setting standards for tax
So why pretend that what they do has any use for this purpose?
Hi Richard,
Your very sensible and interesting definition of ‘taxable residue’ got me thinking:
‘Taxable income less deductible expenses equals taxable residue’ is correct and concise, but I would add a little extra:
‘Taxable income less deductible expenses less capital allowances equals taxable residue’.
The latter has applied to me as a self-employed bookkeeper who has entered capital purchases on my self assessment form.
This way, as you say, companies can’t use creative accounting to arbitrarily increase or reduce taxable profits (if that makes sense).
Am I making sense? I hope you feel better soon as well Richard
That makes sense
I assumed deductible expenses included CAs