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EUROPEAN COMMISSION DIRECTORATE-GENERAL TAXATION AND CUSTOMS UNION Analyses and tax policies Analysis and Coordination of tax policies Brussels, 7 September 2005 Taxud E1 RD CCCTB\WP\016\doc\en Orig. EN COMMON CONSOLIDATED CORPORATE TAX B A SE WORKI N G GROUP (CCCT B WG) Concept of the 'tax balance sheet' Meeting to be held on Friday 23 September 2005 Centre de Conférences Albert Borschette Rue Froissart 36 - 1040 Brussels WORKING DOCUMENT B-1049 Bruxelles / B-1049 Brussel - Belgium. Office: MO59 06/017. Telephone: (32-2) 299.11.11; direct line (32-2) 296.10.75. Fax: (32-2) 295.63.77. E-mail: firstname.lastname@example.org 1 Introduction and purpose of the note 1) In its meeting of 2 June 2005 the Group inter alia considered the definition of depreciable assets. As in previous meetings issues concerning the link between financial accounts and the determination of the taxable income in Member States, the practical rules for compiling the taxable corporate income and the required supporting documentation re-surfaced. In this context, the Commission services expressed their preparedness to draft an explanatory note on the concept of the 'tax balance sheet'. This concept is used for the determination of the taxable income and for the tax documentation in some Member States but not, or at least not under this terminology, in many others. 2) The present paper is thus intended to clarify the concept of the 'tax balance sheet' and its distinction in comparison to the financial accounts balance sheet. It also raises the related issue of the potential consequences of a possible move away from tax and accounting dependency, resulting in a situation in which the financial accounts are no longer systematically connected with the tax accounts. The intention is essentially one of clarification and awareness-raising, not to raise a separate debate. 3) Given that the concepts of 'tax balance sheet' and 'dependency' have predominantly been developed in Germany, the German rules form the basis of the document, although the concepts are, in variations, also in use in other countries. The Commission services wish to thank the German experts for their comments on the working document. The basic concept of a 'tax balance sheet' in Germany 4) As a principle, all non-commercial and non-trade income is determined on a cash- basis. This also applies, for example, to the determination of profits from liberal professions/independent personal services (however, there exists an option for accrual accounting). On the other hand, in principle all trading income is determined on an accrual basis. Hereby, the taxable income from a trading activity is defined in German tax law as the difference between the net value of a company at the end of a business year and net value at the end of the preceding business year, plus the withdrawals, such as dividends, less the contributions, e.g. an increase in share capital. Being based on historical book values, this difference does not include unrealised profits and losses. Such a profit determination on an accruals basis, which involves the establishment of a “tax balance sheet”, is obligatory, for all tax payers, who have an obligation to keep books, as for example as a merchant from a commercial law point of view, or who exceed certain rather low turnover or profit thresholds. 5) A tax payer has to draw up an “original” tax balance sheet, when he does not have any commercial law obligation to keep books (not a merchant in the meaning of the Commercial Code), but either exceeds the thresholds or voluntarily prepares a “tax balance sheet”. In this case, only the tax provisions for the posting and evaluation of the assets and liabilities have to be observed. Such a “derived” tax balance sheet could 2 even be prepared without a profit and loss account, i.e. without double bookkeeping and thus could be based solely on the inventory at the end of each tax year. 6) A “derived” tax balance sheet has to be prepared for all tax payers with trading income which are obliged to keep books from a commercial law point of view. The Income Tax Act prescribes that such a “derived” tax balance sheet has to be prepared in accordance to the German GAAP, thus prescribing that the determination of the taxable income in the framework of a tax balance sheet is linked to the financial accounts, unless special tax rules apply. This is important as numerous businesses are under no obligation to publish detailed financial accounts. 7) In accordance with the basic approach set out above, the basis for computing a company’s taxable income is its commercial (financial) balance sheet, with adjustments prescribed by tax law. As commercial law generally permits greater latitude in the valuation of assets, accruals, reserves and liabilities than tax law, amendments may need to be undertaken to these balance sheet positions for tax purposes. As a result of this the balance sheet for tax purposes, i.e. the 'tax balance sheet', is based on the commercial (financial) balance sheet, but contains specific adjustments to certain items as required by tax law. 8) These adjustments, which are effectively made outside the balance sheet as such, refer to either the capitalization of assets / accrual of assets, or the evaluation of assets / liabilities. As a matter of fact, the main differences between the financial accounting and the determination of the taxable income refer to the tax treatment of options concerning the capitalization / accrual and evaluation of assets and liabilities. The most important difference, introduced by case law, provides for: • an obligation for capitalization for tax purposes, where the financial accounting provides for an option for capitalization; • a prohibition of accrual for liabilities, where the financial accounting provides for an option for accrual. This affects especially the tax treatment of the goodwill, where another enterprise has been acquired, and the tax treatment of overhead cost for production and material, since for these issues the financial accounting provides for an option of capitalization, which results into an obligatory capitalization for tax purposes. Furthermore, regarding the evaluation of assets, the amount of depreciation allowed might differ between the method used for financial accounting balance sheet and tax accounting balance sheet. For financial accounting purposes, an asset has to be depreciated in a systematic way – for tax purposes the useful life and the possible annual depreciation is prescribed by the tax law or by decrees from the tax administration.1 Further typical adjustments include the elimination of non-deductible items and tax-exempt income. 1 Other examples for such difference include: temporary value reductions of financial assets (optional depreciation in financial accounting / prohibition in tax accounts); temporary value reductions of current assets (optional depreciation in financial accounting / prohibition in tax accounts); provisions for patent violation (obligatory in financial accounting / special rules in tax accounting); provisions for employee jubilee payments (obligatory in financial accounting / special rules in tax accounting); pension provisions 3 9) The 'tax balance sheet' is thus crucial for compiling and documenting the taxable income of companies in Germany. In practical terms, the tax balance sheet can be established • either by adjusting the financial balance sheet by means of additions, corrections, etc.; • or by compiling a separate, proper tax balance sheet; • or by compiling a 'single' (identical) balance sheet that serves both the purpose as financial balance sheet and as tax balance sheet. A 'single' balance sheet is only possible if the options in the financial accounts are used in accordance with the obligatory tax rules and when unavoidable differences are documented in supporting additional calculations. Nowadays this practically only the case for relatively small companies. 10) As mentioned above, this basic approach holds for both entrepreneurs and partnerships which are subject to personal income tax (for the commercial income) and corporations subject to corporate income tax. The first group represents the overwhelming majority of businesses in Germany. As these businesses usually do not publish financial accounts, the 'tax balance sheet' which offers less options and aims at a stricter valuation practice is particularly important for them and is often also used for non-tax purposes, e.g. loan negotiations with banks. 11) It is important to note that tax balance sheets or at least the valuations contained therein are also used as a point of reference for the assessment of trade tax (with an average tax rate of around 12%) and inheritance tax (e.g. concerning the valuation of shares in non-quoted companies). 'Dependency'2 and 'reversed dependency'3 12) The precise relation between the financial balance sheet and the tax balance sheet is in principle governed by the principles of 'dependency' and 'reversed dependency' which have however been drastically loosened in Germany over the last years. By definition, the concept only applies to the individual accounts of a company. 13) The principle of 'dependency' means that financial accounting standards also have to be used for the 'tax balance sheet' - provided there are no diverging proper tax rules. As such, this principle does not conflict with the IAS/IFRS. The principle of 'reversed dependency' provides that the use of options in the tax balance sheet presupposes an analogous treatment in the financial balance sheet. This connection, which is obviously not provided for in the IAS/IFRS (as it is not in national GAAP), would lead to (obligatory in financial accounting / special rules in tax accounting). Another example concerns provisions for anticipated losses which are disallowed for tax purposes from 1997. Any such provision stemming from earlier years must be dissolved at the rate of 25% in the first financial year ending after 31 December 1996 and 15% in the following 5 financial years. 2 "Maßgeblichkeit" 3 "Umgekehrte Maßgeblichkeit" 4 conflicts where the treatment of IAS/IFRS and the tax base differ without there being matching options that would it make possible to ensure an identical treatment in both types of accounts without infringing neither the financial accounting nor the tax accounting rules. 14) The concept of dependency dates back to the end of the 19th century (introduction in Germany in 1874). Its rationale was - and essentially still is - a simple determination of the tax base and the possibility to use reliable profit determination standards. The reversed dependency is much younger and was introduced in Germany in 1954, with subsequent refinements in 1965 and 1985. However, via these later changes more and more tax elements gradually were introduced in the financial accounts, even in derogation of the financial accounting rules, thus compromising the original objective of a simple and reliable determination of the taxable profit. It is important to note that the use of 'dependency' is closely related to general company law and in particular to issues like capital maintenance, solvency, creditor protection and profit distribution. 15) Given that the IAS/IFRS are now obligatory for the consolidated accounts of stock- listed companies and rapidly gaining importance also for individual accounts and other companies the question arises how dependency and reversed dependency can in future be matched with tax accounting. Given the (investor-driven) earlier profit recognition of the IAS/IFRS maintaining the dependency principle could lead to earlier taxation and consequential cash-flow effects. The concrete effect on companies depends however on many factors like the availability of losses; profitability etc. Moreover, the use of IAS/IFRS might also have positive refinancing effects, setting off tax-driven cash-flow disadvantages. 16) It is nevertheless hard to imagine that the dependency principle, let alone the principle of reversed dependency, can be matched with the implementation of a single tax base and the continuous use of 25 different national accounting standards and rules. The wide-spread use of IAS/IFRS complicates the issue further, without however as such making the use of 'dependency principle' impossible. As explained in other working documents several IAS/IFRS concepts e.g. that of 'fair value accounting', directly conflict with well-established tax principles, e.g. the one of taxing only realised profits. Ultimately, however, it is the fact that twenty five different national financial accounting rules cannot be directly linked with a single identical common tax base that is at the core of the issue. In the context of a common consolidated corporate tax base the continuation of 'dependency' and 'reversed dependency' therefore conceptually seems to be almost impossible. Conclusion 17) The concept of a 'tax balance sheet' as explained above is not used in most other Member States which establish the tax base via adjustments (additions/reductions) to the profit registered in the financial accounts. Instead of a 'balance sheet approach' they follow a 'profit/loss approach' that compares income and expenses. This may or may not take the form of a formalised reconciliatory statement, mostly in the tax declaration or an annex thereto. It will be necessary to analyse in more detail which consequences, if any, this different technical approach, which as such does not involve any difference 5 in substance, may have for the further work on the CCCTB and its practical implementation. 18) In particular thought will need to be given to the question of whether or not for the CCCTB Member States will be able to continue with differing concepts for compiling the taxable income or not. Moreover, the implicitly different approach to the collection of tax accounting data may influence the stance on further discussions, such as 'income and revenue'. Finally, this could be of importance for gathering the data needed for the design and operation of the formulary apportionment system that is linked to the CCCTB. It is suggested to come back to the issue in due course, when more advances for instance in these areas have been made. 19) Most Member States apply the 'dependency principle' and many also the 'reversed dependency principle'. The preliminary conclusion from the analysis so far however strongly hints at problems with the continuation of these principles for companies using the CCCTB. This is in line with the results of other work already carried out on this issue such as the joint (DG Taxation and Customs Union and DG Internal Marlket as it was then known as) meeting with Member State tax and accounting experts in March 2004.