Let’s talk about tax.

Or more particularly let’s talk about accounting tax expense.

Now dear readers the most unlikely thing has happened. A tax free week in the media. No Matt Nippert on charities – just for the moment I hope – no Greens on foreign trusts. No negative gearing and – thankfully – no R&D tax credits. So with nothing topical atm – we can return to actually useful and non-reactive posts. And yes I am the arbiter of this. Although the whole Roger Douglas and his #taxesaregross does warrant a chat. Need to psyche into that a bit first though.

So I am now returning to my guilt list. Things I have been asked to write about but haven’t . That list includes land tax; estate duties; some GST things; raising company tax rate; minimum taxes; and accounting tax expense. 

And so today picking from the random number generator that is my inclination  – you get accounting tax expense.

At the Revenue when reviewing accounts one of the things that gets looked at is the actual tax paid compared to the accounting income. This percentage gives what is known as the effective tax rate or ETR.  And yes there are differences in income and expense recognition between accounting and tax but for vanilla businesses –  in practice  – not as many as you would think. 

Now it is true that a low ETR can at times be easily explained through untaxed foreign income or unrealised capital profits. But it is also true that for potential audits it can be a reasonable first step in working out if something is ‘wrong’. Coz like it was how the Banks tax avoidance was found. They had ETRs of like 6% or so when the statutory rate was 33%. 

So when I ran into a May EY report that said foreign multinationals operating in New Zealand had ETRs around the statutory rate – I was intrigued. 

Looking at it a bit more – it was clear that it was a comparison of the accounting tax expense and the accounting income.  Not the actual tax paid and accounting income. Now nothing actually wrong with that comparison but possibly also not super clear cut that all is well in tax land.

And I have been promising/threatening to do a post on the difference between these two. So with nothing actually topical – aka interesting – happening this week; now looks good.

Now the first thing to note is that the tax expense in the accounts is a function of the accounting profit. So if like Facebook NZ income is arguably booked in Ireland  – then as it isn’t in the revenues; it won’t be in the profits and so won’t be in the tax expense.

Second thing to note is that the purpose of the accounts is to show how the performance of the company in a year; what assets are owned and how they are funded. One key section of the accounts called Equity or Shareholders funds which shows how much of the company’s assets belong to the shareholders.

And the accounts are primarily prepared for the shareholders so they know how much of the company’s assets belong to them.  Yeah banks and other peeps – such as nosey commentators – can be interested too but the accounts are still framed around analysing how the company/shareholders have made their money.

And it is in this context that the tax expense is calculated. It aims to deduct from the profit – that would otherwise increase the amount belonging to shareholders – any amount of value that will go to the consolidated fund at some stage. Worth repeating – at some stage.

First a disclaimer. When IFRS came in mid 2000s the tax accounting rules moved from really quite difficult to insanely hard and at times quite nuts. Silly is another technical term. That is they moved from an income statement to a balance sheet approach. Now because I am quite kind the rest of the post will describe the income statement approach which should give you the guts of the idea as to why they are different. Don’t try passing any exams on it though.

Now the way it is calculated is to first apply the statutory rate to the accounting profit. And it is the statutory rate of the country concerned. That is why it was a dead give away with Apple – note 16 – that they weren’t paying tax here even though they were a NZ incorporated company. The statutory rate they used was Australia’s.

Then the next step is to look for things called ‘permanent differences’. That is bits of the profit calculation that are completely outside the income tax calculation. Active foreign income from subsidiaries; capital gains and now building depreciation are but three examples. So then the tax effect of that is then deducted (or added) from the original calculation. 

For Ryman – note 4 – adjusting for non-taxable income takes their tax expense from from $309 million to $3.9 million. That number then becomes the tax expense for accounting. 

But there is still a bunch of stuff where the tax treatment is different:

• Interest is fully tax deductible for a company. But – if that cost is part of an asset –  it is added to the cost of the asset and then depreciated for accounting. And the depreciation will cause a reduction in the profits over say – if a building – 40-50 years. So for tax interest reduces taxable profit immediately while for accounting 1/50th of it reduces accounting profits  over the next 50 years. 

• Replacements to parts of buildings that aren’t depreciable for tax can – like interest – receive an immediate tax deduction. But for accounting a new roof or hot water tank are added to the depreciable cost of the building and written off over the life of the asset. 

• Dodgy debts from customers work the other way.  Accounting takes an expense when they are merely doubtful. But for tax they have to actually be bad before they can be a tax deduction. 

These things used to be known as timing differences as it was just timing between when tax and accounting recognised the expense.

And then the difference between the actual cash tax and the tax expense becomes a deferred tax asset or liability. It is an asset where more tax has been paid than the accounting expense and a liability where less tax has been paid than the expense.

And the fact that these two numbers are different does not mean anyone is being deceptive. They just have different raisons d’etre. Now if anyone wants to know how much actual tax is paid – the best places to look are the imputation account or the cash flow statement. The actual cash tax lurks in those places.

But yeah it does look like actual tax. I mean it is called tax expense.

Your correspondent has memories of the public comment when the banking cases started to leak out. I still remember one morning making breakfasts and school lunches when on Morning Report some very important banking commentator was talking. He was saying that the cases seemed surprising coz looking at the accounts the tax expense ratio seemed to be 30%. [33% stat rate at the time]. But that 3% of the accounting profits was still a large number and so possibly worthy of IRD activity.

Dude – no one would have been going after a 3% difference. 

In those cases conduit tax relief on foreign income was being claimed on which NRWT was theoretically due if that foreign income were ever paid out. So because of this the tax relief being claimed never showed up in the accounts as it was like always just timing.

Except that the wheeze was there was no actual foreign income. It was all just rebadged NZ income. And yeah that income might be paid out sometime while the bank was a going concern. So it stayed as part of the tax expense. Serindipitously giving a 30% accounting effective tax rate while the actual tax effective tax rate was 6%.

And a lot of these issues are acknowledged by EY on page 13 of under ‘pitfalls’. 

So yeah foreign multinationals – like their domestic counterparts – may well have accounting tax expense ratios of 28%. But whether anyone is paying their fair share though  – only Inland Revenue will know.

Andrea