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:
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.
The debate is open....