University of Economics, Prague. IFRS as a Basis for Corporate Income Tax in Small Open Economy. David Procházka

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1 University of Economics, Prague Faculty of Finance and Accounting Department of Financial Accounting and Auditing IFRS as a Basis for Corporate Income Tax in Small Open Economy David Procházka Department of Financial Accounting and Auditing Faculty of Finance and Accounting University of Economics, Prague W. Churchill Sq. 4 Prague, Czech Republic Web: <prochazd@vse.cz>

2 Agenda Paper s agenda Models of linkage between taxation and accounting systems Specifics of financial reporting regulation in the Czech Republic Specifics of income tax regulation in the Czech Republic Switching to IFRS as a tax base in the Czech Republic - opportunities, risks, advantages, disadvantages - empirical evidence Slide 2/20

3 Accounting taxation models 1 Theoretical background Fig. 1: Alternative systems of taxation in connection to regulatory framework of financial reporting Consolidated FS: IFRS Individual FS: IFRS Individual FS: Local GAAP Individual FS: Choice Taxes-Accounting Independent Taxation: IFRS Taxation: Local GAAP Taxation: Local GAAP Taxation: IFRS Taxation: Local GAAP Slide 3/20

4 Accounting taxation models More approaches how to design the mutual relation of accounting and taxation systems Following IFRS adoption across the EU, shall IFRS be allowed to be a tax base under real-life taxation systems? The issue is rather political than economic; decision should be made on some (sound) arguments Proper analysis should evaluate the impact of IFRS taxation at least on: - companies - tax administrator - national economy Complex qualitative analysis OK; complex quantitative analysis: - relatively OK when estimating the impact on tax administrators - under some restrictions feasible for companies (Eberhartinger & Klostermann, 2007) - probably impossible for national economy (reasons later) Slide 4/20

5 Specifics in the Czech Republic 2 Regulation of financial reporting and taxation in the Czech Republic 2.1 Adoption of the IFRS in the Czech Republic Regulation (EC) 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards Act on accounting requires a mandatory application of the IFRS in: - consolidated financial statements of companies listed on EU capital markets (see Regulation) - individual financial statements of those publicly traded companies In addition, Act on accounting enables a voluntary application of the IFRS in: - consolidated financial statements of non-listed companies - individual financial statements of non-listed companies, which are subject of IFRS consolidation (change in force from 2011) Slide 5/20

6 Specifics in the Czech Republic Fig. 2: Individual financial statements according to the Czech accounting legislation (from 2011) O n l y I F R S CAS + IFRS or only IFRS O n l y C A S Slide 6/20

7 Specifics in the Czech Republic 2.2 Corporate income tax in the Czech Republic Pursuant 23, article 2 of Act on income taxes the determining of the tax base is based on the accounting income, always without the influence of international accounting standards... A taxpayer, who prepares its statutory financial statements in accordance with International Accounting Standards, as approved by the European Union, shall determine its accounting income for the purposes of this Act with reference to specific legal act (i.e. Act on accounting) Tax officers have to be aware about all differences between IFRS and CAS Slide 7/20

8 3 Empirical evidence 3.1 Limitations of quantitative analysis tax administration Irrelevancy of IFRS for taxation purposes could be justified by the taxation theory => reference to the equal treatment of all taxpayers But is a tax officer able to treat IFRS entities and Non-IFRS entities equally? Tab. 1: Local GAAP vs. IFRS from the point of tax administration IFRS Local GAAP Amount Possible to check? Yes Yes Same Easily Yes Yes Different Fairly Yes No xxx Fairly No Yes xxx Impossible The equal treatment cannot be guaranteed how can you check anything for its non-existence? In addition; IFRS entities are supposed to maintain additional evidence based on local GAAP just for tax purposes => higher costs than Non-IFRS entities => can we still talk about equal access? Consequence: equal treatment is a just fiction, when having both IFRS and Non-IFRS entities Slide 8/20

9 3.2 Limitations of quantitative analysis companies The absolute amount of taxation itself is not the only factor considered by companies Let s suppose we have two possible taxation projections for next 3 years: - Scenario A = (40;0;100) - Scenario B = (50;50;50) Holding discount rate constant: PV A Tax expense Tax expense j (1 ) (1 i) n A n j PV j B j 1 i j 1 B j Scenario A seems to be better from the point of discounted total tax burden, but its expected utility (Neumann & Morgenstern, 1944) may be contrariwise EU (Scenario A) EU (Scenario B) because companies do not consider only the absolute amount of tax expense, but also the costs, Slide 9/20

10 stability and predictability of taxation, i.e.: Where: ( ) ( ) ( ) ( ) EU ( taxation) f( t( x ), c,, ) t( x) t( x) - t(x) is the amount of tax expense depending on the definition of taxable income, tax rates, tax bonuses, timing of taxation, etc. - c represents the administration costs for calculating taxation and preparing tax returns - measures expected variance (standard deviation) in tax burden over future periods and is thus an inverse function to the stability of taxation - is a noise term controlling for unknown factors influencing the total tax expense and is thus an inverse function to the predictability of taxation Consequence: we can estimate the influence of IFRS tax base on the amount of total tax expense, but we are unable to detect the change in EU => no inferences regarding Pareto (1906) efficiency Slide 10/20

11 3.3 Limitations of quantitative analysis national economy level Similar conclusions as in case of companies Two scenarios of fiscal revenues streams: - Scenario C = (100;60;0) - Scenario D = (50;50;50) Once again, the Scenario D may be more preferable for public budgets despite it brings less total tax revenues (supposing that D is a more stable and predictable regime than under Scenario C) Allowing IFRS to be a tax base would influence not only fiscal revenues, but it can have other unintentional macroeconomic effects => following comparative advantages (Ricardo, 1817), it may: - attract more FDI (Procházka & Procházková Ilinitchi, 2012) - cause the shift of jurisdiction of multinational firms (Gordon & MacKie-Mason, 1995) - decrease incentives to tax optimisation (Overesch & Heckemeyer, 2013) Slide 11/20

12 Consequence: we are unable to measure a total impact of the change in rules for taxable income on the whole national economy level => mutual relations change all parameters in Walrasian equations of general equilibrium (Walras, 1874) To summarise: we may estimate the differences in expected tax burden (tax revenues) of various systems of taxation, but with no inferences to the change in total social welfare => an arbitrary political decision (hopefully based at least on qualitative analysis) is then inevitable, when choosing the appropriate accounting standards (e.g. allowing IFRS) for tax purposes Some qualitative criteria described in the first part of paper decision makers should assign scores based on relative importance of each criterion Slide 12/20

13 3.4 Data description Empirical evidence performed for year 2010 and 2011, available data on: - total corporate income tax (CIT) collection by state - financial statements from entities with IFRS as statutory accounts Listed companies (total 28 observation in sample): - 46 issuers on PSE - 33 have legal and tax domicile in the CR; remaining 13 with domicile abroad (however 6 originally in the Czech Republic have moved to tax paradises ) - additional 5 companies excluded (reasons in the paper) Voluntary adopters: - only two companies used the option to apply IFRS in their statutory individual FS voluntarily 4 questions need to be resolved to quantify effects of potential shift to IFRS based tax base (having in mind restrictions described above) Slide 13/20

14 3.5 Question 1 Q1: Is the topic relevant at all? Is corporate income tax an important source of tax revenues? Tab. 2: Share of corporate income taxes on total tax revenues and gross domestic product Year Tax rate 41% 39% 39% 35% 35% 31% 31% 31% 31% CIT (millions CZK) Share on tax revenue (%) 12,3% 9,4% 10,6% 9,8% 10,8% 9,8% 11,4% 12,0% 12,5% Share on GDP (%) 4,4% 3,2% 3,7% 3,3% 3,7% 3,3% 3,9% 4,2% 4,4% Year Tax rate 28% 26% 24% 24% 21% 20% 19% 19% CIT (millions CZK) Share on tax revenue (%) 12,3% 12,2% 13,1% 13,1% 12,3% 10,6% 10,1% 9,8% Share on GDP (%) 4,4% 4,3% 4,6% 4,7% 4,2% 3,5% 3,4% 3,4% Steep reduction in tax rate (from 41 % in year 1995 to 19 % in year 2011) Relative share of corporate income tax on total tax revenues (including social security) remains stable; 11.3 % on (arithmetic) average Similarly, a stable share CIT on GDP around 4 % Slide 14/20

15 3.6 Question 2 Q2: Are entities with statutory IFRS statements significant in terms of income taxes? Tab. 3: Share of corporate income taxes by IFRS entities on total corporate taxes collected CIT IFRS entities (millions CZK) CIT all entities(millions CZK) Share (%) 16,5% 17,8% The share is about 17 %, which is not decisive However, a rapid growth of number of companies reporting under IFRS can occur, if it is favourable: - listed companies control 334 Czech subsidiaries - estimates of the total number of entities in question differ ranging from 2,000 to 200,000 companies (which is 40 % of all registered companies in the CR) Slide 15/20

16 3.7 Question 3 Q3: If IFRS are allowed for income tax calculation, which level of income shall be used? Should it be Profit & loss or Total comprehensive income? Tab. 4: Amount of other comprehensive income (relatively to comprehensive income) Company FI OCI 2011 % OCI 2010 % CETELEM ČR, a.s. yes -22,86% -74,32% Czech Property Investments, a.s. no -17,42% -0,90% ČEZ, a.s. no -26,38% 13,22% Česká pojišťovna a.s. yes -98,00% -10,85% Česká spořitelna, a.s. yes -21,47% -19,39% Československá obchodní banka, a. s. yes -98,12% 7,60% Dalkia Česká republika, a.s. no -26,16% -7,98% Energoaqua, a.s. no -28,92% -6,56% GREENVALE, a.s. no 0,00% 0,00% Hypoteční banka, a.s. yes -23,64% -24,01% Raiffeisenbank a.s. yes -28,29% -27,35% UniCredit Bank Czech Republic, a.s. yes 59,42% -54,29% Komerční banka, a.s. yes 34,10% -12,91% Sberbank CZ, a.s. yes -15,33% -6,69% Wüstenrot hypoteční banka a.s. yes -527,17% 0,00% Slide 16/20

17 Company FI OCI 2011 % OCI 2010 % ISTROKAPITAL CZ a.s. yes 0,00% 0,00% Jáchymov Property Management, a.s. no 0,00% 0,00% Philip Morris ČR a.s. no 0,00% 0,00% Pražské služby, a.s. no 0,00% 0,00% Severomoravská plynárenská, a.s. no 0,00% 0,00% Severomoravské vodovody a kanalizace Ostrava a.s. no 0,00% 0,00% SPOLEK PRO CHEM.A HUT.VÝR.,a.s no 0,00% 0,00% Telefónica Czech Republic, a.s. no 0,00% 0,00% TOMA, a.s. no -0,39% -0,75% UNIPETROL, a.s. no 0,00% 0,00% Východočeská plynárenská,a.s. no 0,00% 0,00% VET ASSETS a.s. no 0,00% 0,00% Wüstenrot - stavební spořitelna a.s. yes 0,00% 0,00% Škoda AUTO a.s. no -51,56% -6,90% Tamero invest no 0,00% N/A In 2011, other comprehensive income is zero (with no items) in 14 out of 30 cases In 2010, a similar situation happened in 14 out of 29 cases OCI significant also by non-financial entities (including two biggest Czech companies) Slide 17/20

18 3.8 Question 4 Q4: Are any important differences in profit & loss between Czech GAAP and IFRS with possible impact on taxation? Solution to be found yet; several suggestions of future research Firstly, a model of generalised equations, which will encompass benefits and costs for each interested party under current situation compared to conditions after switch to IFRS: - expanding the theoretical models - starting point for a regression analysis on real data Secondly, a qualitative analysis of differences between IFRS and Czech GAAP: - current Act on income tax is not ready for the switch - many of differences (PwC study about 80 pages) may drop out from the scope of the Act - different structure of CI statement under IFRS and Czech income statement => how to ensure equal access to all taxpayers? Slide 18/20

19 Thirdly, an empirical model proposed by Spengel et al. (2012) approach in the individualised version suggested by Roggeman et al. (2013): - data unavailability for the CR => very rough and imprecise assumptions, which will impair findings significantly Fourthly, a quantitative analysis of differences between Czech GAAP and IFRS profit & loss figures actually reported by Czech companies, which could be done as follows: - by analysing publicly available financial statements for the period of the first implementation of IFRS - by extracting needed data from tax returns in periods following the first implementation Slide 19/20

20 Conclusions Conclusions A quantitative analysis on companies level is needed Data are available only for the period before transition to the IFRS There might to one-time effects from transition => longer time-series is needed => data not available publicly (tax returns are not published) Inspiration in other countries (Slovakia) on practical level => reference point for future research, too However, the aggregate impact on national economy is hardly to assess => quantitative analysis is inevitable before any (political) decision Slide 20/20

University of Economics, Prague. IFRS and Corporate Income Tax in Small Open Economy. David Procházka

University of Economics, Prague Faculty of Finance and Accounting Department of Financial Accounting and Auditing IFRS and Corporate Income Tax in Small Open Economy David Procházka Department of Financial