Chapter 16: Taxation of Income from Business and Investment

Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)

Chapter 16, Taxation of Income from Business and Investment

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Taxation of Income from Business and Investment

Lee Burns and Richard Krever

Lobbyists know that a 0 percent tax rate on capital income is not, in fact, the lowest possible rate.

—Joel Achenbach

I. Introduction

This chapter addresses the design and drafting of the income tax law as it applies to

business and investment income.

While employment is an activity exclusively engaged in by individuals, business and

investment activities may be engaged in by individuals or legal persons. Consequently, the rules

for taxing income from business and investment cut across the taxation of individuals and legal

persons. Countries with separate tax laws for individuals and legal persons need to coordinate

the rules for taxing business and investment income, even though these may not always be

uniform.

Regardless of the overall design of the income tax,

it is common to provide special

rules for taxing business or investment income. These rules primarily relate to the tax base,

timing of the recognition of income and deductions, and collection of tax. By far the most

important are the timing rules. Particularly in the business context, these rules must negotiate the

difficult terrain that bridges financial accounting and taxation. While uniformity between tax and

financial accounting may seem desirable, countries have adopted quite different approaches:

some countries have achieved substantial uniformity; in others, tax and financial accounting are

substantially independent.

Note: Contributions to this chapter were made by Frans Vanistendael. The appendix is by Victor Thuronyi, with

contributions by David Williams.

Global, schedular, or composite; and single or separate tax laws for individuals and legal persons. See supra ch.14,

sec. II.

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Chapter 16, Taxation of Income from Business and Investment

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II. Business Income

The characterization of an amount as business income is important in both schedular and

global income tax systems.

Under a schedular system, it is common for separate taxes to be

imposed on employment, business, and investment income. Consequently, the characterization of

an item of income determines which tax regime applies to it. Under a global system, there is

often a notional schedular breakdown of income types under which business income is

specifically mentioned as a type of income that is included in gross income. Even if the notion of

income is completely global, special rules, particularly tax accounting rules, may apply to

business income. Other types of income derived by individuals may be calculated using different

rules.

The starting point in determining whether an item of income is business income is to

determine whether the activity giving rise to the income is properly characterized as a business.

This issue is considered first below, followed by a discussion of inclusion rules related to

business income. The third topic covered in this section is deductions for business expenses.

A. Definition of Business

In the absence of a definition in the income tax law, the term “business” will have its

ordinary meaning.

In broad terms, a business is a commercial or industrial activity of an

independent nature undertaken for profit.

The concept of a business may overlap with the notion

of employment for tax purposes.

Whether this is the case will depend on the definition of

employment that is included in the law. For administrative reasons, employment should be

defined for income tax purposes to include all continuing service relationships where most or a

significant part of the service provider’s income is derived from one customer and that income

essentially represents remuneration for the service provider’s labor.

This will include some

independent contractor relationships (i.e., relationships that are within the ordinary meaning of

business). Where employment is defined in these broad terms, the definition must be coordinated

with the definition of business so that the same economic activity is not characterized as both a

See also supra ch. 14, sec. IV.

E.g., LSO ITA §§ 17(1)(c), 20; UGA ITA §§ 18(1)(c), 21.

E.g., LSO ITA § 20.

E.g., EST IT § 9; IDN LCIT § 4; SGP ITA § 10.

See supra text at notes 24 and 25.

If the nonresident withholding tax rules do not apply, then it is often fairly easy to structure the transaction so that

the income derived by the nonresident has a foreign source.

See supra ch. 18, note 9.

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Chapter 16, Taxation of Income from Business and Investment

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Supplementary definitional rules for annuities, interest, rent, and royalties are discussed

below. The definition of dividends is discussed in chapter 19, section VI.

A. Annuities

In common law jurisdictions, annuities were originally developed in the context of trust

law, where they were used to impose a support obligation on an estate. The obligation required

the estate to pay a fixed stipend to a beneficiary, using both income derived by the estate and

capital, if income was insufficient to satisfy the payment obligation. Commercial or purchased

annuities are a more recent development. A taxpayer purchasing a commercial annuity provides

an "annuity provider" with a capital sum that is returned with compensation conceptually similar

to interest in fixed payments over a specified term or, in the case of a life annuity, over the

taxpayer's life.

A taxpayer must be allowed to recover the cost of purchasing an annuity, so that only the

profit portion of the gain is taxed. The usual procedure is to recognize the cost of the annuity on

a pro rata basis over the life of the annuity. The cost recognized as a portion of each annuity

payment is determined by dividing the cost by the total number of payments for a fixed annuity

and by the total number of estimated payments for a life annuity. This can be done by first

prorating the payments and recognizing only a part of each payment as income or by recognizing

the entire annuity payment as income and allowing an offsetting deduction for the cost

component attributed to the payment.

This method of cost recovery results in a deferred taxation of annuity income. This

deferral makes annuities an attractive investment vehicle for both individuals and businesses. In

particular, it is possible to structure an ordinary commercial loan so that it takes the legal form of

an annuity, and thereby take advantage of deferred taxation. From an economic perspective,

fixed-term annuities are in many respects the functional equivalent of a “blended” loan in which

the borrower repays the loan principal over the period of the loan. In a blended loan, each

payment contains a return of principal and an interest component, but the interest component of

the initial payments is high compared with the repayment of principal, while the interest

component of the last payments is small, since most of the principal on which interest is

calculated has been repaid by the time of those payments. Given the functional similarity

between blended loans and annuities, commercial lenders may try to characterize an ordinary

commercial blended loan as an annuity in order to defer recognition of interest income by

recognizing interest income in equal installments over the life of the transaction rather than

predominately in the initial payments.

Under normal circumstances, a borrower would prefer to enter into an ordinary loan

arrangement than an annuity arrangement, because the former entitles the borrower to larger

deductions in the early period of the loan. However, if the borrower is a tax-exempt person (or is

in a net operating loss position), a loan offers no advantages over an annuity because there will

be no tax advantage from recognizing the higher interest component at the beginning of the loan.

E.g., AUS ITAA (1936) § 27H; ZAF ITA § 10A. See infra sec. VI(A)(4).

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If the borrower is indifferent between a loan and an annuity, the lender may suggest the annuity

option and offer a reduced rate of interest in return for the deferral opportunity.

Many common law jurisdictions vulnerable to this practice have enacted antiavoidance

provisions to prevent exploitation of the annuity rules in this manner. The simplest solution is to

restrict the annuity treatment described in section III(A), above, to limited categories of annuities

such as retirement annuities and to define other annuities as ordinary compound interest blended

payment loans for tax purposes, whatever the legal designation given to them by the parties. This

will allow tax authorities to notionally dissect annuity payments into interest and principal

components, as if the payments were made pursuant to an ordinary commercial loan contract.

B. Interest

Interest is the compensation earned by a creditor for the use of his or her money during

the period of the loan. Fundamental to the ordinary notion of interest is that there is a debt

obligation. To make this clear, interest may be defined by reference to a debt obligation with a

separate definition of debt obligation in the law that includes accounts payable and obligations

arising under promissory notes, bills of exchange, debentures, and bonds.

As indicated above, modern commercial law contracts make it possible to convert interest

on debt or quasi-debt obligations into a variety of other forms, including discounts and premiums

in respect of loan principal. Thus, interest is often defined for tax purposes to include commonly

used interest substitutes such as discounts and premiums. However, even terms such as these

have a recognized legal meaning, and, like the notion of interest itself, characterization as

discount or premium may be avoided. Consequently, it is suggested that the definition of interest

include a general formula to more effectively cope with the flexibility available to taxpayers in

the way they structure their financial transactions. For example, interest could be defined to

include “any other amount that is functionally equivalent to interest.”

C. Royalties

The definition of “royalties” for tax purposes is complicated by the fact that the term has

diverse meanings across jurisdictions, and, even within a jurisdiction, may be applied to

fundamentally different types of payments. One meaning is a payment for the use of a person’s

intellectual property. Thus, an author may be paid royalties for the right to print and sell books

containing the author’s copyrighted material, a musician may be paid royalties for the right to

produce and sell tapes or compact discs containing the musician’s work, or an inventor may be

paid royalties for the right to produce and sell the inventor’s patented system. Royalties may also

be payable for the right to sell products bearing a trademark or copyrighted identification marks,

or for the right to use know-how. In each of these cases, royalty payments are normally based on

output (so much for each unit sold or produced).

E.g., UGA ITA § 3 (definitions of interest and debt obligations).

E.g., UGA ITA § 3 (definition of interest).

See generally Murray v. ICI Imperial Chemical Industries Ltd. [1967] 2 All E.R. 980, at 982–83.

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Chapter 16, Taxation of Income from Business and Investment

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A related type of royalty is a payment for the sale of intellectual property. Rather than

licensing a publisher to print a book with an author's work, the author may sell the copyright to a

publisher, with the proceeds from the sale being paid as royalties based on sales. In essence, the

sort of royalty is fundamentally different from the first one in that it is consideration for a sale,

not payment for the use of the recipient's property. However, despite the legal difference, there

may not be much of an economic difference in some cases. For example, the sale may cover only

a limited geographic area or a limited period of time and may therefore have essentially the same

effect as a license covering this area and period of time.

A third type of royalty is paid for the exploitation of natural resources connected with

land, most commonly mineral resources (including petroleum), gravel, or timber. Calculation of

the amount of royalties payable is normally based on the quantity or value of the resources taken,

for which these royalties are effectively a purchase price.

Because royalties encompass so many different types of payments, the characterization of

amounts as royalties for tax purposes varies from jurisdiction to jurisdiction. In particular, not all

countries classify royalties as a category of income in its own right. Some countries classify

some kinds of royalties as rental income

or, for royalties received by individuals for intellectual

property created by personal exertion, as income from independent labor.

Other countries

classify royalties as investment income subject to the same basic rules as interest income.

The definition of royalties for tax purposes may also be influenced by international

practice. There is a definition of royalties in article 12 of the OECD Model Treaty, which applies

to transactions between the Contracting States. This definition has been included in the domestic

tax law of many countries either generally or in relation to the taxation of nonresidents.

The

article 12 definition includes payments for the use of, or right to use, intellectual property rights

or know-how. It also includes payments for the provision of technical assistance ancillary to the

use of intellectual property rights or know-how.

The definition does not include natural

resource royalties. This is because such royalties are treated as income from immovable property

under the OECD Model Treaty and, therefore, are dealt with under article 6 rather than under

article 12. This reflects a distinction between royalties related to property that has its origin

AUT EStG § 28 (1)3; DEU EStG § 21(1).

NLD WIB § 22/1 (b).

BEL CIR § 17 par.1/4.

See generally infra ch. 18, sec. IV(E).

Prior to 1992, the definition of royalty in the OECD Model Treaty also included amounts received for the use of,

or right to use, any industrial, commercial, or scientific equipment (i.e., amounts received under a lease of movable

property). The OECD Model Treaty was amended in 1992 to exclude such amounts from the definition of royalties

with the intention of bringing them within the business profits article. Notwithstanding this, the definition of

royalties in the domestic tax law of some countries still includes such amounts. See, e.g., AUS ITAA (1936) § 6;

KEN ITA § 2; LSO ITA § 3; UGA ITA § 3; ZMB ITA § 2.

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outside the jurisdiction (such as technology rights), for which there may be limited source-

country taxing rights, and royalties related to immovable property located in the jurisdiction

(such as the taking of natural resources), for which there are full source-country taxing rights. If

natural resource royalties are excluded from the domestic law definition of royalties, they may be

included in the definition of rent (which is not usually subject to nonresident withholding tax) or

treated as a separate category of income.

A definition of royalty based on the use of, or right to use, certain rights can be avoided

by structuring the transaction as a disposal of the right. For this reason, some countries also

define royalties to include the gain arising on the disposal of rights or property covered by the

royalty definition.

D. Rent

Under ordinary principles, rent is an amount received as consideration for the use or

occupation of, or right to use or occupy, immovable property or tangible movable property. As

indicated above, the scope of the definition of rent for the purposes of the income tax may

depend on the definition of royalties. If rent from the lease of movable property is included as a

royalty, then the definition of rent may be confined to consideration for the lease of immovable

property. Similarly, for the reasons given above, natural resource royalties may be treated as rent

rather than as royalties.

As with transactions involving the payment of interest, it may be possible to structure a

leasing transaction so as to convert rent into other forms, such as premiums on leased premises.

Thus, a definition of rent for income tax purposes should include commonly used rent

substitutes, such as premiums.

IV. Issues of Tax Accounting

A. The Tax Period

1. Annual Measurement of Taxable Income

Given that the income tax is imposed on an annual basis, it is necessary to specify the

income tax year. The tax year will normally be specified as the calendar year, or as a fiscal year

set to complement the government's fiscal year. In the discussion below, this is referred to as the

“normal tax year.”

In many jurisdictions, taxpayers may be permitted to substitute a different 12-month

period as their tax year.

However, allowing taxpayers to choose a tax year that differs from that

JPN Corp TL § 138(7); KEN ITA § 2; UGA ITA § 3. See further infra ch. 18, sec. IV(E).

E.g., UGA ITA § 2 (definition of rent).

E.g., AUS ITAA (1936) § 18; EST IT § 6; IDN LCIT § 12; LSO ITA § 49; UGA ITA § 40.

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of other taxpayers may result in some revenue loss if taxpayers are able to exploit the

inconsistency.

It is suggested, therefore, that a taxpayer should be allowed to use a substitute

tax year only with the permission of the tax administration, and, for this purpose, a procedure for

applying for permission should be provided in the law or regulations. Permission should be

granted only when the taxpayer demonstrates a legitimate need to use a substitute tax year.

ensure that there is no loss or unacceptable deferral of tax resulting from the move to or from a

substitute tax year, the tax administration should be allowed to prescribe conditions for the use of

the substitute tax year. The right to apply for permission to use a substitute tax year may be

restricted to corporate taxpayers or may extend to other business taxpayers (although cases

where a sole trader can demonstrate a need to use a substitute tax year are likely to be rare).

A taxpayer using a substitute tax year may wish to cease to do so or to change to another

substitute period (perhaps as a result of takeover). A procedure for making such changes may be

provided, and, ordinarily, the rules outlined above should also apply to such applications.

Special rules are needed for "transitional" years when a taxpayer changes its tax year. The

transitional period should be specified as the period commencing at the end of the taxpayer’s last

complete tax year to the beginning of the changed tax year. This ensures that the different years

mesh with the rest of the legislation and prevents transitional problems, such as an extended tax

year (greater than 12 months) when a taxpayer changes from one tax period to another.

The tax law is typically enacted (and amended) for application to the normal tax year. For

example, changes to the income tax law may be stated to apply to the calculation of tax liability

for a particular year and all subsequent years. Where taxpayers may use a substitute or

transitional tax year, it is necessary to specify the law that is to apply to that tax year. For

example, it may be provided that the law applicable to a normal tax year applies also to a

substitute or transitional tax year that commences during the normal tax period.

2. Loss Carryovers

The annual measurement of income from economic activity that extends over a number

of years is likely to lead to fluctuating measurements over the years, and this, combined with

fluctuations in economic performance, may result in tax years in which allowable deductions

exceed gross income (i.e., a taxpayer suffers a net loss for the year).

The tax law may provide for a net loss to be carried forward and allowed as a deduction

in a subsequent tax year or carried back and allowed as an additional deduction in a previous tax

year. The carryback of a net loss requires reopening the taxpayer’s assessment for the prior tax

year. From a theoretical perspective, taxpayers may be allowed virtually unlimited carryback and

An example is the use by a partnership of a substitute tax year to defer tax. See infra ch. 21, sec. II(B)(4). Another

example involves taxpayer A paying at the end of its tax year a deductible expense to taxpayer B. If B is on a

different tax year, B may not be taxed on the payment until later.

For example, a case for using a substitute tax year may be established by a corporate taxpayer where the taxpayer

belongs to a group of taxpayers (including foreign entities) with a group balance date for business accounting

purposes that differs from the normal tax year.

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carryover of net losses for recognition in years other than the years in which they are suffered,

but this theoretical case is tempered by two practical considerations.

First, there are significant divergences between the actual tax system adopted in any

jurisdiction and the theoretical ideal. So long as it is impossible to guarantee the integrity of a

comprehensive income tax base, safeguards against "bottomless holes"

must be adopted; limitations on loss carryback or carryover are important elements in the

safeguard armory.

Second, unlimited carryback or carryover of net losses is possible only with sophisticated

administrative resources, resources much greater than those available to taxpayers and

administrators in most jurisdictions. For this reason, it is suggested that only loss carryovers be

allowed. There may be some advantage in setting the loss-carryover period to coincide with the

period in which the tax administration can amend an assessment (this period will also usually

coincide with the period for which a taxpayer is required to keep records), but a longer period

may also be specified. In countries where loss carryover is limited, examples of periods allowed

are 5,

and 20

years.

Under a schedular income tax, carryover of losses will be provided for by reference to

classes of income separately dealt with in the schedules. Even under a global income tax,

carryover of losses may be to some extent schedularized.

Further, the carryover of losses by

See generally Dale Chua, Loss Carryforward and Loss Carryback, in Tax Policy Handbook 141 (P. Shome ed.

1995). Examples of unlimited loss-carryforward rules are AUS ITAA (1997) § 36-15; GBR ICTA § 393 (there is

also a three-year loss-carryback rule in ICTA § 393A); NZL ITA § 188; ZAF ITA § 20; SGP ITA § 37; ZMB ITA §

30. Other countries with unlimited carryovers include Belgium, Germany, Ireland, Luxembourg, and Sweden. See

Commission of the European Communities, Report of the Committee of Independent Experts on Company Taxation

242 (1992).

For example, a large backlog of loss carryovers, which resulted from a combination of factors,

such as inadequate definition of inflation adjustment and abuse of tax holiday provisions,

threatened to undermine the corporate income tax in Argentina in the late 1980s and early 1990s.

See vol. 1, at 464–65.

See, e.g., EST IT § 21; FRA CGI §§ 156(I) and 209(I); HUN CTDT § 17(1); IDN LCIT § 6 (the Minister of

Finance may decree that an eight-year period applies to specific types of businesses). Five-year periods are also

allowed in Denmark, Greece, Italy, Japan, Portugal, and Spain. See Commission of the European Communities,

supra note 92, at 242.

See CAN ITA § 111 (a three-year carryback rule also applies); CHE LIFD § 67(I); Commission of the European

Communities, supra note 92, at 242.

See IND ITA § 72.

See USA IRC § 172.

See infra sec. IV(B)(5) (foreign currency losses); VI(B) (capital losses); USA IRC § 469 (passive activity losses).

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companies (and other entities as appropriate) whose ownership changes may be restricted to

prevent trafficking in “loss” entities.

B. General Timing Issues in the Recognition of Income and Deductions

1. Method of Accounting

The use of a tax year to measure, on a year-by-year basis, income from economic activity

that extends over more than one tax year requires rules to allocate income and expenses to

particular tax years. Under both the balance-sheet method and the receipts-and- outgoings

method, the allocation of income and expenses is made by reference to cash- or accrual-basis

accounting systems. Both systems measure income when it is derived and recognize expenses

when they are incurred, but the time at which a taxpayer is considered to have derived an amount

or incurred an expense can differ significantly under the two systems.

Under the cash-basis system, income is derived when it is actually received by, or made

available to, or applied to the benefit of, the taxpayer, and expenses are incurred when they are

paid. Under the accrual-basis system, income is derived when the right to receive the income

arises, and expenses are incurred when the obligation to pay arises.

Practices for determining the appropriate method of tax accounting to be applied by a

taxpayer vary. In some countries, the law leaves the matter to be determined according to

financial accounting principles

100

or by the courts.

101

In other countries, the tax law may, within

limits, give taxpayers a choice in the method of accounting to be applied.

102

Whatever practice is

adopted, salary and wage earners would normally account for income and deductions on a cash

basis, and legal persons conducting businesses account for income and deductions on an accrual

basis. Individuals conducting business typically enjoy some flexibility. In particular, it may be

appropriate and simpler for smaller businesses to use cash-basis accounting. However, if small

businesses are allowed to use cash-basis accounting, the threshold between cash-basis and

accrual-basis taxpayers must be set out.

103

See infra ch. 20.

100

See infra appendix (France, Germany).

101

In Australia, the courts have made it clear that a taxpayer’s method of accounting is to be determined according to

legal principles and not according to generally accepted accounting principles. Nonetheless, the courts have

developed legal principles that, in most cases, bear a close relationship to accounting principles.

102

E.g., EST IT § 37 (an individual may use either the cash or the accrual basis of accounting for business income,

but other taxpayers must use the accrual method); LSO ITA § 50 (a taxpayer may account on a cash or an accrual

basis except when gross income for a tax year exceeds a monetary threshold, in which case the taxpayer must

account for business income on an accrual basis in all subsequent years); UGA ITA § 41 (a taxpayer may account on

a cash or an accrual basis, provided that the tax method chosen conforms to generally accepted accounting principles

and subject to the tax commissioner’s power to prescribe otherwise in particular cases).

103

E.g., LSO ITA § 50. See supra note 102.

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When taxpayers are allowed a choice of accounting method, they may change their basis

of accounting, particularly if a threshold is set above which accrual-basis accounting must be

applied. Changes in accounting methods can also arise from changes in the law, which may

require all taxpayers to change the way they treat particular types of transactions.

104

When a

taxpayer changes its method of accounting, transitional measures are needed to prevent lacunae

or overlaps. A lacuna can arise, for example, when a taxpayer changes from a cash to an accrual

basis because amounts billed but not received in the tax year prior to the change may escape

taxation. This is because no amount has been received in the tax year in which the cash method

applied, and no entitlement to receive has accrued in the tax year to which the accrual method

applies.

It is suggested that transitional rules relating to a change in accounting method be drafted

in broad terms because it may not be possible to anticipate every area needing such rules. In

particular, the rules should not be confined to income and deductions because issues may arise in

relation to tax offsets or other aspects of the income tax. A broad rule should permit adjustments

to be made to the income, deductions, offsets, or other items as necessary to ensure that no item

is omitted or taken into account more than once. It is also necessary to specify the tax year in

which the adjustment is to be made. Ordinarily, this would be the first tax year under the

changed method.

105

To properly monitor a change in tax accounting method, it may be provided

that the change can be made only with the permission of the tax commissioner.

To minimize problems of administration, it may be decided to stipulate that once a

taxpayer has been required to use the accrual method, the taxpayer must continue to use that

method even if his or her gross income is less than the applicable threshold in a subsequent year.

Some jurisdictions allow taxpayers to change back and forth between systems provided their

income rises above or falls below the threshold for a number of consecutive years.

106

The timing of recognition of income and expenses is crucial to the calculation of taxable

income under both the receipts-and-outgoings system and the balance-sheet system. Under both

systems, the choice between cash-basis accounting and accrual-basis accounting will have a

significant effect on the measurement of taxable income. So, too, will the rules that govern

exactly when receipts and expenses are recognized under cash- and accrual-basis accounting.

In Anglo-American jurisdictions, the financial accounting rules are typically established

by generally accepted accounting principles devised by the accounting profession through self-

104

For example, suppose the law is changed to require capitalization of certain costs of producing inventory that

could be deducted under prior law as current expenses. An effect of this rule would be to increase the value of

opening inventory for the tax year in which the changed method is first applied. This would lead to a gap because

the opening inventory would exceed the prior year’s closing inventory (valued under the old method).

105

But see USA IRC § 481 (three-year spread).

106

For example, Hungary requires taxpayers who are above the threshold for two consecutive years to change from

cash-basis accounting to accrual-basis accounting and allows, at the taxpayer's option, unincorporated taxpayers to

switch from accrual-basis accounting to cash-basis accounting if their taxable incomes fall below the threshold for

two years. See Act XVIII of 1991, Accounting Act § 13.

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governing autonomous professional bodies. In civil law jurisdictions, the rules may be

established by an accounting act or by the commercial code, supplemented by generally followed

accounting practices or by regulations. In both cases, it may be necessary or appropriate for the

income tax law to specifically address particular types of transactions whose accounting

treatment may be vulnerable to manipulation intended to distort the measurement of taxable

income (usually by accelerating recognition of deductions or deferring recognition of income). It

may, therefore, be desirable both to reinforce fundamental tax accounting rules with clarifying

statements of principle and to adopt more detailed tax accounting rules for particular types of

transactions. The extent to which specific rules need to be articulated for tax purposes, therefore,

will differ from case to case and will depend on the clarity and specificity of the financial

accounting rules. This qualification applies to much of the discussion below. Thus, while it is

suggested that a number of rules be specified for tax purposes, in many jurisdictions it may not

be necessary to provide an explicit tax rule because the matter is already taken care of

appropriately by the accounting rules.

Specific tax accounting issues that may be addressed in the income tax statute are

reviewed below.

2. Currency Translation Rules

A taxpayer’s income, deductions, and offsets

107

must be measured in the national

currency. With the greater integration of the world’s economies, it is increasingly likely that a

taxpayer will derive income or incur expenses in a foreign currency. The income tax law should

therefore include rules for translating amounts denominated in a foreign currency into the

national currency.

The basic rule should provide for currency translation on a transaction-by-transaction

basis. Under such a rule, each receipt of income denominated in a foreign currency should be

translated into the national currency at the time the income is derived. Similarly, each deductible

expenditure denominated in a foreign currency should be translated into the national currency at

the time the expenditure is incurred. The basic rule should be broadly stated so that it can apply

to other amounts taken into account for tax purposes. For example, the translation rule should

apply to foreign tax when a foreign tax credit applies.

If multiple exchange rates apply at the time the foreign currency is to be translated into

the national currency, it is necessary to specify which rate is to apply. For example, when a

buying and selling rate is specified for the relevant day (as is usually the case), it could be

provided that the exchange rate midway between the two for that day is to apply.

108

In other

cases, there may an official exchange rate and a market rate, in which case a discretion may be

provided to the administration to require the taxpayer to use the exchange rate that most

accurately reflects the taxpayer’s income.

107

For an explanation of tax offsets see ch. 14, sec. XI.

108

E.g., UGA ITA § 58.

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A requirement to translate amounts denominated in a foreign currency on a transaction

basis may be too onerous for a taxpayer who enters into multiple transactions in a foreign

currency. For example, a taxpayer may have a foreign branch that engages in many transactions

daily in the foreign country in which the branch is located. The branch’s financial accounts are

most likely to be maintained in the currency of that jurisdiction, and the tax law may allow the

taxpayer to keeps its tax accounts in that currency as well. In this case, the taxpayer will be

permitted to calculate the taxable income of the branch in the foreign currency (referred to as the

“functional currency” of the branch). The taxable income of the branch will be translated into the

national currency at a specific exchange rate. Ordinarily, the rate specified would be the average

exchange rate for the tax year. It may be desirable to permit tax authorities to substitute

alternative translation formulas in special circumstances, such as when dealings are in a

particularly volatile currency.

109

Alternative formulas may include the use of weighted averages

(taking into account when most transactions take place) or even requiring translation by

reference to shorter averaging periods, such as a month, a week, or even a day. Because the

functional currency is the currency of the country in which the branch is located, when the

foreign branch derives amounts denominated in a currency other than that currency, the ordinary

transaction-based rules should apply to translate that other currency into the functional currency.

The currency translation rules apply only for the purpose of reporting in national

currency any foreign currency amounts derived, incurred, or otherwise taken into account for tax

purposes. Foreign currency transactions themselves may generate gains or losses for a taxpayer.

These are discussed in section IV(B)(5), below.

3. Claim of Right

Taxpayers often receive or pay amounts that are disputed or potentially subject to dispute

because, for example, the amount is received by mistake, is erroneously computed, or is the

subject of a controversy about, say, performance or quality. The question is when these amounts

should be recognized as income or deductions.

In the broadest sense, all amounts received and payments made are contingent in that

they may later be subject to dispute. The income tax would not be workable if there were no

recognition of receipts and expenses until the payments were settled (in some cases, this could

involve waiting until the expiration of lengthy statutory limitation periods). To solve the

problem, it is usual to require taxpayers to recognize amounts for which they make an initial

claim of right and expenses that they are initially obligated to satisfy. This rule eliminates

arguments by taxpayers that the recognition of an amount for tax purposes is unclear because its

legal status is uncertain.

A claim-of-right rule may arise under general principles

110

or through specific legislative

provision.

111

Under a claim-of-right rule, the normal tax accounting rules as to when income is

109

See vol. 1 at 460–62.

110

This is the case in the United States. See North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932).

111

E.g., UGA ITA § 45(1).

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derived or expenditures are incurred

112

apply to an amount even if there is a dispute or potential

dispute as to entitlement or obligation.

When a claim-of-right rule applies, an issue arises as to the treatment of repayments

made or received should it ultimately be found that the taxpayer is not entitled to receive, or

obliged to pay, the amount. Two broad approaches may be identified for dealing with such cases.

First, the assessment for the tax year in which the income or expenditure is recognized can be

reopened and adjusted, so that the original inclusion or deduction and the repayment are treated

as a single transaction; or, second, the adjustment can be made in the tax year in which the claim

of right or obligation to pay is withdrawn.

While the first approach may be theoretically correct and is used in some industrial

countries, it may not be administratively feasible for developing and transition countries to adopt

such a rule . Consequently, the second approach is considered preferable.

113

Again, the basis of

the timing of the adjustment will depend on the tax accounting rules applicable to the taxpayer.

In the case of a cash-basis taxpayer, an adjustment is made to eliminate income and expenses

when payments are refunded to the appropriate party. In the case of an accrual-basis taxpayer,

the adjustment is made when the claim of right is given up. It will be necessary to coordinate the

claim-of-right rules applicable to deducted expenditure with the general rules on recoupment of

deductions.

114

4. Price Uncertainty

It is not uncommon in commercial transactions for the determination of the price to be

subject to some contingency. In this case, the uncertainty relates not to the existence of a right to

receive or obligation to pay, but to the amount that is ultimately receivable or payable.

115

Contingent prices may be based on either "positive" contingency conditions or "negative" ones.

Positive contingency conditions usually establish a fixed base price and a further payment

obligation in line with criteria such as productivity and profitability. For example, mining rights

may be sold for a lump sum or installment payments plus an amount for each ton in excess of a

floor amount mined. Similarly, a business may be sold for a lump sum or installment payments

plus a percentage of profits for a given period following the sale.

A negative contingent price establishes a fixed base price that is subject to downward

variation if a condition is not met. For example, mining rights may be sold for a lump sum or a

112

See supra sec. IV(B)(1).

113

This approach was adopted by the courts in the United States (U.S. v. Lewis, 340 U.S. 590 (1951). In certain

circumstances, under IRC § 1341, an adjustment is made to the current year based on the tax reduction that would

have resulted by excluding an amount from income in the prior year.

114

See ch. 14, sec. III(D)(2).

115

See supra sec. IV(B)(3), and infra sec. IV(C)(1) and (D)(1) for the treatment of amounts due

or payable that are subject to uncertainty as to legal rights or obligations.

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series of installment payments that presume a certain tonnage will be available. In the event that

the property produces less than the amount expected, the price will be adjusted downward by a

particular amount for each ton.

A simple way of dealing with positive contingent prices is to dissect the sale price into

two components—a right to receive or an obligation to pay a fixed amount (either as a lump sum

or in installments) and a right to receive or an obligation to pay additional amounts contingent

upon the occurrence of a specific event—and to recognize the two elements separately. The fixed

amounts are recognized according to normal tax accounting rules (including those relating to

installments, if relevant). The later contingent amounts are treated as though they attach to

contingent rights or obligations that crystallize when the condition precedent to further payments

is satisfied.

Negative contingency obligations are treated similarly in respect of the initial fixed

payment or payments, but offsetting deductions or adjustments are made available when it

becomes clear that the original payment was not correct.

While the approach suggested above for ignoring contingencies until the time they are

resolved may result in some use of contingent terms to defer accrual of income, it is suggested

that, from an administrative point of view, this is the most appropriate way for most developing

and transition countries to deal with contingent amounts.

5. Foreign Currency Exchange Gains and Losses

While the translation of foreign-currency-denominated amounts is dealt with above, this

section deals with gains and losses on foreign currency exchange transactions (and similar

transactions described below). The primary issue in relation to such gains and losses is timing;

although, for those income tax systems derivative of U.K. principles there may also be

characterization issues (i.e., whether the gain or loss is recognized under general principles or

whether specific statutory recognition rules are needed).

The simplest type of foreign currency gain or loss is that realized in respect of foreign

currency holdings. A taxpayer may have foreign currency holdings as a consequence of engaging

in international transactions. For example, a taxpayer may receive foreign currency as payment

for services rendered or goods supplied or may acquire foreign currency to meet a business

expenditure.

116

Alternatively, a taxpayer may keep foreign currency holdings as a hedge against

inflation or as an investment. In each case, the foreign currency is an asset of the taxpayer so that

a gain or a loss will accrue as the value of the foreign currency fluctuates relative to the local

currency during the period in which the foreign currency is held.

From the perspective of a comprehensive income tax base, the ideal tax treatment of

foreign currency holdings is an annual valuation and recognition of gains and losses on an

116

While the foreign currency translation rules discussed in section IV(B)(2), above, apply in determining the

amount in national currency of the income derived or the expenditure incurred in these cases, the taxpayer may

actually hold the foreign currency for longer than the exchange day.

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accrual basis. Many industrial countries are moving toward recognizing gains and losses related

to financial instruments through an annual valuation commonly known as "mark to market."

117

accrual-basis taxation is adopted for financial instruments, it may be important to recognize

foreign exchange gains and losses on both the asset and the debt side on an accrual-basis as well,

so as to avoid serious distortions in the treatment of financial instruments generally. This is

particularly important in highly inflationary economies.

118

However, unless the remainder of the

income tax system measures gains consistently on an annual accrual basis, accrual-basis taxation

of foreign currency holding gains and losses may be out of step with the remainder of the income

tax system and may impose a considerable administrative burden on revenue authorities with

limited experience in relatively sophisticated accrual measurement systems.

For these reasons, foreign currency holding gains and losses are often taken into account

on a realization basis. Provided that foreign currency is treated as an asset, all dealings in foreign

currencies (acquisitions, disposals, and conversions into other foreign currencies) can be dealt

with by the provisions for recognizing income and losses that apply to ordinary property

transactions.

A second source of foreign currency gains and losses arises from foreign currency loans

and debt claims. Under a realization-based system, no special rules are needed for interest

payments or interest receipts. If these are made in foreign currency, they are translated into local

currency under the general translation rules. With respect to repayment of principal, provision

should be made for lenders and borrowers to recognize as a gain or a loss (as appropriate) the

difference between the value in local currency of a loan principal at the time the loan is made and

its value in local currency at the time it is repaid. Once again, however, if accrual-basis taxation

is used for financial instruments, it may be more appropriate to recognize foreign exchange gains

and losses on an accrual basis as well, by incorporating these changes into the annual valuation

rules for obligations and debt claims denominated in foreign currency.

Special rules may be needed for rollovers or refinancing of foreign debt, which arises

when a foreign debt owed by a taxpayer is rolled over or refinanced by a new loan in the same

foreign currency from the same lender. In theory, there is no reason to treat this arrangement any

differently from one in which a borrower repays a foreign currency loan by borrowing from a

completely different borrower. However, in some jurisdictions, this type of arrangement may be

treated for tax purposes as an extension of the original loan and may thus not be recognized for

the purpose of measuring foreign currency gains or losses.

A third type of foreign currency gain or loss arises as a by-product of the separation of

income and expense recognition and actual receipt or payment in accrual-basis accounting.

Accrual-basis taxpayers will initially record the amount of income derived in a foreign currency

or expenses incurred in a foreign currency by translating those values into their national currency

117

For example, Canada, New Zealand, and the United States have adopted accrual-basis taxation for some financial

instruments, and Australia proposes to do so.

118

See vol. 1, ch. 13.

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at the time the income is derived or the expense incurred.

119

If there has been movement in the

national currency against the foreign currency between those times and the times at which

income is actually received or expenses paid, the amounts recorded in the taxpayer's accounts

and the amounts actually received or paid will differ, and an adjustment must be made to

“correct” the original amount recorded.

There are, in theory, three ways this can be done. First, the taxpayer's accounts can be

reopened and recalculated, with the actual income received or expenses paid (as translated to the

national currency) substituted for the amount originally recorded by the accrual-basis taxpayer.

However, in many cases this correction requires reopening a previous year's accounts. As has

been explained earlier, it is very rare for tax systems to adopt procedures involving reopening

accounts of previous years because of the administrative burden this imposes on both taxpayers

and tax officials.

A second solution is to correct the taxpayer's accounts by attributing the difference

between the income or expense originally recorded and the amount actually received or paid to

the specific account to which the amount relates. Thus, if an income amount turns out to be more

or less than originally recorded, it is corrected by adding an amount to income or subtracting (as

an allowable deduction) an amount, depending on which way the currency moved. Similarly, if

an ordinary deduction turns out to be more or less than originally recorded, the correction takes

the form of an addition to income or an additional deduction, as the case may be. If the amount

refers to the acquisition of property—either inventory, depreciable property, or nondepreciable

property—the correction is made to the relevant property account. That is, if the expenditure is

on inventory, an adjustment is made to the closing value of inventory in the year in which the

expense is paid and the currency difference crystallized. Similarly, if the expenditure is on

depreciable property, the tax value of the asset is adjusted in that year, and if the expenditure is

on non-depreciable property, the cost base is adjusted in that year.

The second solution is the preferable option from a theoretical perspective, because it

achieves the correct timing recognition of currency rate differences attributable to the purchase

of property. Because the difference is attributed to the actual property acquired, it will be

recognized in line with the recognition of the expense generally—for example, if the expense is

for depreciable property, the cost of the property is adjusted and correctly recognized over the

life of the property. Similarly, if the expense is for nondepreciable property, the corrected cost is

recognized when there is a disposal of the property.

Whatever its theoretical merits, the second solution is not commonly used, probably

because of the administrative costs it involves. The third solution, adopted in most jurisdictions,

is by far the simplest from an administrative perspective. Under the third approach, when a

foreign currency difference crystallizes because previously recorded foreign currency income is

received or a previously recorded foreign currency expense is paid, the difference is simply

recognized as a foreign currency gain or loss without any attempt to change underlying accounts

by attributing the amount to the underlying transaction.

119

See supra sec. IV(B)(2).

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A realization system of recognizing foreign currency gains and losses should be

accompanied by a quarantining system. This can be accomplished by treating foreign currency

gains and losses as capital gains and losses, so that foreign currency losses are subject to the

same limitation as capital losses.

120

Such a quarantining system is necessary to prevent taxpayers

from entering into "wash" transactions intended to generate paper foreign exchange losses

without any real change in the taxpayer's economic position. Without a quarantining system, if

the local currency falls in value against a foreign currency in which a taxpayer has borrowed, the

taxpayer with the foreign debt can trigger a recognition of a paper loss simply by refinancing the

loan. By borrowing an additional amount in the foreign currency sufficient to repay the loan

principal, the taxpayer is able to extinguish the original debt and claim a deduction for the

difference between the value of the principal in local currency when the loan is made and the

value at the time the loan is "repaid."

Quarantining rules will not be needed if foreign exchange gains and losses are taken into

account on an accrual basis. In this event, depending on the rules for interest income and expense

and any inflation-adjustment rules, it may be appropriate to provide that foreign exchange gains

and losses are treated as interest income and expenses, respectively. The rationale for this is that

the exchange difference plus the actual interest paid on a foreign currency debt will be roughly

equivalent (on an ex ante basis) to interest paid in domestic currency on a domestic currency

debt. If foreign currency losses are not treated as interest expenses, then transactions can easily

be structured to circumvent limitations on the deductibility of interest expense.

6. Bad Debts

For tax purposes, debts fall into two broad categories. The first comprises amounts

recognized by an accrual-basis taxpayer as income on an account yet to be satisfied.

121

The

second consists of amounts due on a loan provided by the taxpayer. Both types of debts represent

a liability to the debtor and an asset to the creditor. In the ordinary course of events, if the debt

proves unrecoverable, the creditor should be able to recognize a deduction or loss when the debt

or loan is written off as unrecoverable. However, it is usual for special rules to be adopted to deal

with both types of debt.

In some jurisdictions, losses on assets such as debts owing to the taxpayer will not be

addressed by the general rules for measuring business income. In other jurisdictions, the loss

may otherwise be recognized, but a specific rule is adopted to control the timing of loss

recognition or to impose conditions on the recognition. The primary purpose of the special rule

applying to loans that subsequently become uncollectible is to control the timing of the loss

recognition. In some jurisdictions, only taxpayers in the business of money lending are allowed

to recognize bad debts related to loans.

122

120

See infra sec. VI(B).

121

A cash-basis taxpayer who has provided a customer with goods or services may find it impossible to collect

payment. Usually, tax systems provide no special rules for debts in this situation, although the taxpayer may be able

to recognize the loss under general provisions or, in some cases, under capital gain and loss rules.

122

E.g., AUS ITAA (1997) § 25-35; CAN ITA § 20(1)(p) (moneylenders and insurers); IND ITA § 36(1)(a), (2) .

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There are two approaches to the calculation of bad debt deductions: the charge-off

method and the reserve method.

123

Under the charge-off method, taxpayers are able to recognize

bad debts only on previously recognized income amounts or on nonrecoverable loans when the

debt owing to the taxpayer is determined to be worthless. The reserve method, by way of

contrast, allows a taxpayer to partially recognize debts when they become doubtful and before

they are fully written off for financial purposes. In other words, under the reserve method,

taxpayers will be allowed a bad debt deduction for an outstanding loan before the debt is

formally treated as nonrecoverable.

It is suggested that the charge-off method should be used by all taxpayers other than

financial institutions to recognize losses on loans. The difficulty in applying the reserve method

is that it requires an accurate estimation of debts that are most likely to prove worthless. Because

of the nature of their business and the standards imposed by external regulatory bodies requiring

continuous monitoring and maintenance of accurate information on outstanding loans owed to

them, financial institutions should be able to determine with a reasonable degree of accuracy the

percentage of loan debts owed to them in the tax year that will ultimately prove bad. Further, the

determination of the bad debt reserve can be based on the classification of the institution’s loans

made according to the rules of the central bank or other regulatory agency. It should be possible

to ensure, therefore, that the bad debt reserve claimed by the financial institution accurately

reflects potential bad debts. For other taxpayers, under the reserve method, the bad debt reserve

is likely to be an arbitrary percentage of outstanding debts at the end of the tax year.

124

For many

taxpayers, such a rule simply results in an unwarranted deferral of recognition of a portion of the

taxpayer’s income to the following tax year.

The key issue in applying the charge-off method for recognizing a deduction for a bad

debt is when a debt has become worthless (as discussed below, this is also relevant for the

reserve method). Determining whether a debt is bad usually involves considering all the

circumstances, including continual nonperformance, adequacy of security, and the financial state

of the debtor. To prevent abuse, the law could provide that a taxpayer must have reasonably

pursued without success certain avenues for recovery before the debt is written off for income

tax purposes.

Where a bad debt deduction has been allowed under the charge-off method and the

taxpayer subsequently recovers or part of the debt, the amount recovered should be reincluded in

gross income. Reinclusion in gross income may be pursuant to a specific rule to that effect or a

rule applicable to the recoupment of deductions generally.

The reserve method contrasts with the charge-off method in that it allows recognition of

some losses on debts before they are written off as nonrecoverable. Under this method, a reserve

123

See generally Julio Escolano, Loan Loss Provisioning, in Tax Policy Handbook 145 (P. Shome ed. 1995).

124

In countries that use the reserve method, the law may stipulate that the bad debt reserve is such amount as the

administration considers reasonable given the taxpayer’s circumstances. With such a rule, though, the practice often

develops that the administration allows all taxpayers to claim an arbitrary amount as the bad debt reserve. Taxpayers

who want to claim a reserve in excess of that amount then have to make a case to the tax commissioner.

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is established as an allowance against the eventuality that some outstanding (nonperforming)

loans may prove to be uncollectible. The bad debt deduction in the reserve method thus includes

recognition of doubtful debts that have not turned Αbad in the sense of being written off. The

method uses a formula that takes into account debts that are sufficiently doubtful at the end of a

year to be recognized for commercial financial accounting purposes under relevant financial

institution rules, doubtful debts that are finally recognized as nonrecoverable and written off

during the year, and recoveries of debts previously written off.

Under a normal reserve method, regardless of how the actual reserve is calculated, the tax

deduction for bad debts is computed as follows

(i) Closing reserve (amount of doubtful debts at end of year), less

(ii) opening reserve (amount of doubtful debts at end of prior year), plus

(iii) debts written off during the tax year, less

(iv) recoveries of previously written off debts, equals

(v) bad debt deduction for the tax year.

The closing reserve for one year becomes the opening reserve for the following year.

Determining the tax deduction for loan losses based on a reserve method may appear, at first, to

provide a double deduction for loan losses. Each loss, however, is deducted for tax purposes only

once. There is no double deduction because, once loans are written off, there is no end-of-year

reserve with respect to those loans. The end-of-year reserve relates only to loans outstanding on

the books at the end of the year. When a previously written-off amount is subsequently

recovered, the deduction otherwise allowed must be reduced by the recovered amount. Thus, the

previous deduction is reversed.

For example, suppose a taxpayer has at the end of its first year of doing business $1,000

of doubtful debts. No debts have been written off during this year. The taxpayer’s bad debt

deduction for the year would be calculated as follows:

Closing reserve = $1,000

Opening reserve = 0

Bad debt deduction = $1,000

Further debts that become doubtful during year 2 will be taken into account in

determining the amount of the reserve, as will debts that were recognized as doubtful in year 1

and actually written off as nonrecoverable in year 2 and formerly doubtful debts that

subsequently proved recoverable. If the taxpayer had another $1,000 of debts that became

doubtful in the second year and wrote off half of the previous year’s doubtful debts ($500) while

collecting one-fourth of the previous year's debts that had been classified as doubtful, the second-

year reserve deduction would be calculated as follows:

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(i) closing reserve ($1,250), less

(ii) reserve at the beginning of the tax year ($1,000), plus

(iii) debts written off during the tax year ($500), equals

(iv) bad debt deduction for the tax year ($750).

The closing reserve for year 2 is the amount of doubtful debts remaining at the end of the

tax year. This would comprise $250 from the previous tax year ($500 of the previous year's

doubtful debts are no longer doubtful, because they have been written off, and $250 are no

longer doubtful because they were subsequently collected) plus $1,000 arising in year 2).

Some of the previous year’s reserve amount representing doubtful debts ($500 worth) has

actually been written off. The reserve is reduced by that amount, and the same amount is

included directly in the bad debt deduction by adding it to the formula for deduction of bad

debts.

Where a previously written-off amount is subsequently recovered, the deduction

otherwise allowed must be reduced by the recovered amount. Thus, if we assume in year 3 that

the taxpayer encounters another $1,000 of doubtful debts as of the end of the year, writes off no

further debts, and recovers $200 of a previously written-off debt, the taxpayer’s doubtful debt

deduction for year 3 would be

(i) closing reserve (amount of doubtful debts remaining, $2,250), less

(ii) reserve at the beginning of the tax year ($1,500), plus

(iii) debts written off during the tax year (0), less

(iv) recoveries of previously written-off debts ($200), equals

(v) bad debt deduction for the tax year ($550).

Note the closing reserve for year 3 (and thus the opening reserve for year 4) takes into

account doubtful debts, but is not affected by recoveries, while it was affected by debts written

off. Debts written off will no longer be included in the reserve, while recoveries have no effect

on the amount of doubtful debts held by a taxpayer. All that has happened is that part of a

previous deduction has been reversed.

C. Timing Issues in the Recognition of Income

1. Income Subject to Potential Claims or Charges

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Financial accounting attempts to measure the income of a continuing business over an

extended period. Tax accounting, by contrast, measures annual net gains to determine a net

amount that should bear a tax liability. The different objectives of the two accounting systems

explain why they often diverge significantly with respect to their treatment of income when there

is some doubt about the taxpayer's right to retain the income or when the receipt of income is

tied to possible future outgoings.

Cases for which there may be some doubt about the taxpayer's right to retain the income

fall into two categories. The first is attributable to the attendant risk in business that once a

service or product has been delivered, the customer may demand a refund because of

dissatisfaction with the service or product. This category is addressed through the claim-of-right

rule discussed in section IV(B)(3).

The second type of doubt arises in respect of income that relates to the future provision of

services or goods. An example of doubt about a taxpayer's right to retain income is the receipt of

an up-front payment for a service or product that will be delivered over a period of years—for

example, under a contract to provide continuing lessons or a contract for a multiyear magazine

subscription. Similarly, a taxpayer may accept a refundable deposit for delivery of a product or

service in a future year. An example of a case where the receipt of income is tied to possible

future outgoings is the sale of a product, such as a car, subject to a multiyear warranty. Financial

accounting rules often treat both types of situation similarly, while it is not unusual for tax

accounting rules to prescribe greatly different treatment of the two situations.

Financial accounting rules tend to spread recognition of income over the periods during

which the retention right is uncertain or the possibility of related expenses remains. This is

normally done through reserves. Where a business derives income in either of these situations, it

will establish a notional reserve in its financial accounts to indicate that part of the income

received is not available for use or distribution, but rather is being held to satisfy a possible

repayment obligation or to cover anticipated future costs associated with the income. The net

income reported for financial accounting purposes will not include amounts in reserves.

Tax accounting rules often distinguish between the two situations and sometimes allow

taxpayers to defer recognition of income that is subject to possible repayment while denying

deferral of income merely because its receipt may give rise to future expenses.

The rule allowing taxpayers to defer recognition of income that is subject to possible

repayment may reside as a general tax accounting principle established by the courts or may be

incorporated into the tax legislation if it is not normal for the courts in a jurisdiction to adopt tax

accounting rules outside the statute. Where the rule is based on judicial doctrines, it is usually

established by interpreting the term "derived" with respect to income as meaning a right to retain

income without the risk of return. Thus, in the case of a prepayment for the provision of future

services, a taxpayer will be treated as deriving the income not when it is received but rather on a

year-by-year basis, as services are provided and customers lose their rights to refunds.

125

If the

rule is established through legislation, it is important that the onus be placed on the taxpayer to

demonstrate, on the basis of previous experience or statistical evidence, that there is a genuine

125

For example, the rule is established by judicial doctrine in Australia.

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risk that the taxpayer's customers will cancel the contract for future services or products and

upon cancellation will be entitled to a refund of amounts previously paid.

126

This approach is not universal. In some countries, tax authorities have interpreted tax

accounting principles to require immediate recognition of prepaid amounts. This approach may

be modified in particular instances.

127

However, taxpayers are usually not required to recognize

refundable deposits or security deposits (such as those paid to utility companies to guarantee

payment of accounts or to landlords to cover possible damage to the premises). Rather, these are

treated as akin to loans or receipts over which the taxpayer has no claim of right.

128

The focus on annual measurement explains why tax accounting rules make no similar

provision for potential future expenses, such as warranty expenses connected with current

derivation of income. Once again, the lack of recognition for possible future obligations can be

the result of judicial doctrines or specific statutory prohibitions.

129

This approach is consistent

with the concept of economic performance discussed in section IV(D)(1), below.

2. Installment Sales

Where a taxpayer sells property on an "installment" basis, payment may be made over a

number of tax periods. Some jurisdictions have allowed both cash-basis and accrual-basis

taxpayers to recognize income from the sale over the period of payments, under the so-called

installment method.

130

Where this system is used, taxpayers recognize gain on a pro rata basis

over the payment period, assuming that each payment contains an equal return of cost and each

payment therefore also contains an equal percentage of the total profit realized.

131

The installment method involves a number of serious tax policy problems. Some

problems are relevant to all disposals of property, while others are relevant only to disposals that

126

E.g., CAN ITA § 20(1)(m), which requires that payment be for goods or services that it is "reasonably

anticipated" will have to be delivered or rendered after the end of the year. See also USA IRC § 455 (deferral of

prepaid subscription income).

127

E.g., in the United States, tax authorities have interpreted tax accounting rules to deny deferral of income related

to goods and services to be provided in future years, but have adopted some exceptions, such as a ruling that allows

taxpayers to recognize income for services over two years in some cases (Rev. Proc. 71-21, 1971-2 CB 349) and to

defer recognition of payment for the sale of some types of inventory and other specified assets (Treas. Reg. § 1.451-

5).

128

See supra sec. IV(B)(3).

129

See, e.g., CAN ITA § 20(7).

130

E.g., USA IRC § 453.

131

It has been observed that the U.S. rule results in a reduction of tax liability compared with a vendor who receives

the whole price at the time of disposal. This is because no account is taken of the effect of time on the value of

money in determining the amount of each taxable installment. See Marvin A. Chirelstein, Federal Income Taxation

284–85 (1994).

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give rise to capital gains, particularly if capital gains are treated preferentially relative to other

gains.

If capital gains are treated more preferentially than to interest income, vendors may seek

to disguise all or part of the interest component of installment payments as a capital gain by

raising the total price and reducing the interest charged. To combat this, special measures may be

needed to "carve out" the implicit interest component of each payment so it can be taxed as

interest.

132

Even if capital gains receive no tax preference compared with interest income and

appropriate interest is charged on installment payments, or if gains on the disposal of property

are treated as business income, the installment basis of income recognition can lead to serious

inequity and inefficiency. This is because it effectively subsidizes vendors providing vendor

finance relative to vendors who sell for cash, leaving the purchasers to finance the acquisition

from third-party lenders. The taxpayer selling on an installment basis (and thus providing vendor

finance) can defer recognition of gain and payment of tax until payments are made, while the

vendor selling for up-front consideration enjoys no tax deferral. If the tax savings from deferral

are passed on in part to the purchaser (through a lower sale price or interest rate), installment sale

vendors will also enjoy a market advantage compared with those unable to finance the sale of

their own property.

The solution to this problem that some jurisdictions have adopted is to recognize the

entire sale price at the time an installment sale contract commences.

133

This has the effect of

treating the installment sale as a sale for full value to the purchaser, supplemented by a loan from

the vendor to the purchaser.

3. Long-Term Contracts

It is not uncommon for businesses to enter into contracts that extend beyond the tax

period and that require both performance and payment to be made over the life of the contract.

These contracts are referred to as long-term contracts.

In a long-term contract, the total payment to be received by the taxpayer is often set out

in the contract.

134

In a sense, the taxpayer is therefore "entitled" to receive the money upon

entering into the contract, although the taxpayer is not entitled to actual payment at that time.

However, unlike with an installment sale, the taxpayer has not performed all that is required

under the contract. The various rationales set out earlier for up-front recognition of gain on an

installment sale do not apply to long-term contract arrangements, because the arrangement is not

a substitute for the up-front payment that would otherwise take place, as with an installment sale.

132

E.g. AUS ITAA (1936) § 256; CAN ITA § 16(1); USA IRC § 63(b).

133

E.g., AUS ITAA (1936) § 160ZD(1)(a); USA IRC § 453(b)(2), (e), (g), (k) (providing circumstances under which

installment method does not apply).

134

This will not always be the case. For example, a contract may be of the cost-plus type or may involve an

incentive fee.

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In economic terms, it may be appropriate to recognize a certain amount of income upon signing

the contract based on the present value of the profit that the taxpayer is expected to make.

However, this amount will often be impossible to measure.

The adoption of specific rules for long-term contracts can avoid confusion, particularly

for accrual-basis taxpayers, about the recognition time for income and deductions arising under a

long-term contract. Two accounting methods commonly used for long-term contracts are the

percentage-of-completion method and the completed-contract method. Under the percentage-of-

completion method, profit is recognized in proportion to the progress made on the contract

during the relevant accounting period. In other words, the profit is recognized as it "emerges"

over the life of the contract. Under the completed-contract method, profit is not recognized until

the contract is substantially performed. Accounting standards now clearly favor the percentage-

of-completion method as a better measure of "periodic accomplishment" over the life of the

contract. From a tax perspective, the completed-contract method gives rise to an unwarranted

deferral of tax.

The principal issue under the percentage-of-completion method is, not surprisingly, how

to measure the percentage of the contract completed during the taxable year. A relatively

administrable, although somewhat arbitrary, rule is to assume that the percentage of completion

equals the percentage of total contract costs incurred during the year.

135

Example

Contractor enters into a construction contract to be completed over three years. Under

the contract, Contractor expects to incur expenses of $50,000 and to derive gross income

of $1,500,000, for a taxable net profit of $1,000,000. In the first year of the contract, the

contractor incurs expenses of $200,000. Contractor's expected taxable net profit is

allocated to each tax year in a pro rata fashion, using the ratio of actual expenditure to

expected total expenditure as the key. Thus, in this example, the recognized taxable profit

in the first year would be $1,000,000 x $200,000/$500,000 = $400,000. If expenses of

$200,000 were also incurred in the second year, recognized taxable profit in that year

would also be $200,000.

Long-term contracts that envisage performance and payment made over a number of tax

years fall into the broad categories of fixed-price and cost-plus contracts. Under the former, the

total consideration for the contract is agreed on before work begins; under the latter, the

customer agrees to pay the taxpayer a consideration based on costs incurred plus a profit

margin.

136

The formula used to determine annual recognition of profits under the percentage-of-

completion method will initially use estimates of total profit in fixed-price contracts or total

profit and total costs in cost-plus contracts. As the contract proceeds, the calculation must be

135

E.g., UGA ITA § 46.

136

A variant is the cost-plus-incentive-fee contract, where the contractor’s profit margin may vary depending on the

extent of cost overruns, timeliness of completion, or other factors. The various kinds of contracts are described here

for information; they should not be defined as separate categories for tax purposes.

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revised to reflect the changed base figures and an adjustment made for what turned out to be the

incorrect amounts previously recognized. An adjustment may also need to be made where

profits change because, for example, the contractor is paid an "incentive fee" for early

completion.

The correction for changed expenses or profit can be done two ways. Some jurisdictions

use a sophisticated "look back" method to reallocate contract profits over the years of the

contract at the time it is completed.

137

While this method is useful for minimizing tax avoidance,

it is probably too complicated to be advisable for most developing and transition countries. A

simpler alternative is to revise the calculation and make adjustments when the change becomes

known. The revision approach can lead to a loss in one year even though the total project yields

a profit. The phenomenon can be illustrated using the example provided above and assuming

costs in the final year run to $300,000 instead of the expected $100,000.

Example

If there were no cost overrun in the final year, the contractor's taxable income for the third year

would be $1,000,000 x $100,000/$500,000 = $200,000. However, if the costs were $300,000,

the total profit on the project would be only $750,000 ($1,500,000 gross payment less $750,000

total expenses). The taxpayer has already recognized $800,000 in profits in previous years.

Thus, in the third year of the contract, the taxpayer would recognize a loss of $50,000.

The loss recognized in the final year can be dealt with under the normal rules for loss

carryovers. One problem that may emerge for developing and transition countries is that the

contract may be the taxpayer’s only income-producing activity in the country, so that there is no

benefit in a loss-carryover rule. To overcome this problem, a special loss- carryback rule for

long-term contracts can be formulated.

138

The definition of a long-term contract subject to the long-term contract income-

recognition rule should include any contract for the manufacture, installation, or construction of

property (including a contract for the performance of services related to such manufacture,

construction, or installation), provided the expected term of the contract extends over more than

six months and the contract is not completed in the tax year. This would ensure the rule applies

to, for example, the construction of buildings, bridges, dams, pipelines, tunnels, and other civil

engineering projects; construction management contracts in relation to such projects; the

construction of major items of plant; and contracts for the refurbishing of hotels and other

business premises. The long-term contract rules would not apply to most service contracts,

however.

D. Timing Issues in the Recognition of Expenses

137

E.g., U.S.A. IRC § 460.

138

E.g., UGA ITA § 46 (loss carryback allowed only with the permission of the tax

commissioner).

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1. Economic Performance and Recognition of Expenses

A fundamental principle that merits reinforcement is the nexus between legal and

economic liability for accrual-basis taxpayers and between payment and economic liability for

cash-basis taxpayers. It was noted earlier that an accrual-basis taxpayer is normally understood to

have incurred an expense when the obligation to pay arises, and a cash-basis taxpayer is treated

as having incurred an expense when it is paid. It is important that the “obligation to pay” for

accrual-basis taxpayers and "amount paid" for cash-basis taxpayers be interpreted in an

economic sense, not a strict legal contractual sense.

This means that the act of legally entering into a contract that will obligate a taxpayer to

make future payments should not in itself cause an accrual-basis taxpayer to be treated as if it

had incurred the payments. In an economic sense, an obligation to make payment in the future is

not actually “incurred” until there has been an economic performance that gives rise to the

obligation to pay. While a taxpayer may commit to make a payment in the future for services to

be provided in the future, the obligation is not actually incurred until the services are provided, as

the obligation is only contingent prior to the provision of services. For example, a taxpayer can

enter into a long-term contract to rent premises for a number of years. The rental obligation with

respect to each of the future years is not actually incurred until those years. Similar principles

apply to cash-basis taxpayers who actually make payments for services or goods that will be

received over several years. Insofar as the payment relates to future years, it does not represent

an expense incurred at the time of payment. Rather, it is akin to a security deposit to the recipient

to guarantee the price for the goods or services to be delivered in the future. If, for some reason,

the contract is terminated before delivery, the taxpayer should be entitled to a refund, either

under the contract itself or under contract law principles in most jurisdictions.

The basic deduction provisions in many income tax systems may not be interpreted to

operate in this strict way. In particular, immediate deductibility under the general deduction

provision is normally not restricted to expenditures that are consumed in a tax period.

139

Consequently, in the absence of a specific rule to the contrary, an accrual-basis taxpayer that

enters into a long-term commitment for the purchase of goods or services may be allowed to

deduct the entire amount payable under the contract. Similarly, a cash-basis taxpayer who makes

a prepayment for the future delivery of goods or services may be able to deduct the entire

amount paid. To prevent this result, some countries have added to their income tax laws a

supplementary rule, sometimes known as an economic performance rule, to reinforce the

principles that accrual-basis taxpayers should recognize expenses as incurred when the

obligation to pay has crystallized and not when the agreement creating the obligation is entered

into, and that cash-basis taxpayers should recognize expenses as paid when the contracted good

or service is provided and not when initial consideration is given to the supplier. The economic

performance rule provides that an expense will not be treated as incurred before economic

performance with respect to the expense occurs.

139

An exception is Indonesia, where it is provided that costs of earning income that have a useful life of more than

one year may not be deducted at once, but rather are to be deducted under the amortization rules. The position under

the Indonesian income tax conforms closely to the theoretical model outlined in the text. See IDN IT §§ 6(1)b, 9(2),

and 11(10).

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If it is thought that a general economic performance rule applicable to all taxpayers is not

needed because under general principles accrual-basis taxpayers are considered to have incurred

expenses only in the years in which goods or services are provided, then a prepayment rule

applicable to cash-basis taxpayers should be provided.

140

2. Accruing Liabilities

A taxpayer's ongoing business will normally give rise to accruing liabilities that will not

have to be satisfied until a future tax year. Common examples include the liability of borrowers

to pay compounding interest when a debt matures, the liability of insurance companies to pay

insurance claims related to the current year when the claim is settled in a future year, the growing

liability of extractive industries to restore property when mining is completed, and the obligation

of employers to pay future benefits to employees on the basis of current work.

No consistent approach is universally adopted to address these issues. It is generally the

case that accruing liabilities that give rise to actual debts can be recognized as they accrue. This

is true, for example, with a compounding interest obligation, where compounded interest is

treated as a new deposit by the lender. While there are exceptions to the rule, discussed below,

taxpayers generally are not permitted to recognize accruing liabilities where no actual debt is

created by the accruing liability. In some cases, however, tax legislation may allow recognition

for specific types of accruing liabilities, such as to fund environmental restoration or to provide

pension or retirement benefits to employees where the funds are notionally allocated to a reserve

by the taxpayer.

The simplest statutory approach to the problem is to enact a general rule that, subject to

specific exceptions,

141

denies taxpayers deductions for an accruing liability until the liability has

crystallized into an actual obligation to pay or created an actual debt of the taxpayer. Possible

exceptions can then be considered on a case-by-case basis where the interests of the taxpayers

can be balanced against the revenue costs of the exceptions. Appropriate conditions can be

attached to each exception allowed. For example, to qualify for recognition of an accruing

liability, a taxpayer may be required to establish an actual reserve in its accounts and insulate

those funds from encroachment to satisfy other liabilities of the taxpayer.

3. Repairs and Improvements

An area that gives rise to disputes in a number of jurisdictions is that of expenditures for

repairs and improvements. It is common for income tax systems to distinguish between expenses

for these two purposes and to allow deductions for the former, while the latter are capitalized

into the cost base of the assets to which they relate and recognized over time through the

140

E.g., AUS ITAA (1936) §§ 82KZL–82KZO.This applies to all types of prepayments, but does not apply where

the benefit is provided within 13 months of the date the expenditure was incurred, where the prepayment is required

by legislation or court order, or where the prepayment is less than A$1,000.

141

Such as for bad debts of financial institutions. See secs. IV(B)(6) and VI(D).

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depreciation system or as part of the cost base when calculating a gain or loss on final disposal is

calculated.

From an income tax perspective, the distinction between repairs and improvements is

quite artificial. The complicated and contradictory case law in many jurisdictions illustrates well

how impossible it is in practice to establish mutually exclusive camps and to classify

categorically work on assets as either repairs, improvements, or acquisitions of new subassets

that are incorporated into larger assets.

142

Even if a satisfactory method of distinguishing repairs,

improvements, or acquisition of replacement parts can be devised, the distinction is unlikely to

yield appropriate tax treatment; as often as not, the classification has no relevance to the life of

the benefit acquired, which is the principal criterion determining recognition and timing for

business expenses.

The application of the expense recognition principle—recognition over the life of the

benefit—is almost impossible to apply to many repairs, alterations, or improvements, because

there is often no way in which the effective life of these benefits can be estimated. Accordingly,

a surrogate formula is needed to determine the tax treatment of such outgoings.

The simplest rule is one that eliminates the need to distinguish between repairs,

improvements, or the installation of replacement parts through the use of a simple mathematical

formula (sometimes known as a repair allowance).

143

The formula system presumes that, on

average, the amount of repairs needed will bear a relatively fixed relation to the total value of

depreciable property. Any excess over this amount can be presumed to be an improvement.

Thus, it is logical to presume that high expenditures relative to the value of the relevant property

are likely to give rise to benefits that enjoy a life approximating that of the underlying property,

while low expenditures relative to the value of that property are likely to enjoy briefer lives. For

example, expenditures on repairs or improvements that exceed, say, 5 percent of the value of an

asset can be considered to be the purchase price of a long-term benefit and added to the cost base

of the asset, while expenses less than that threshold can be considered to be costs incurred to

derive short-term benefits and deducted immediately.

144

If the traditional approach of immediate write-offs for repairs and capitalization of

improvements is adopted in preference to a repair allowance, a special rule for initial repair

expenses should be considered. Where a taxpayer acquires a used asset and incurs initial repair

expenses to prepare the property for use in the taxpayer's business, it is arguable that the initial

expenses should be wholly capitalized and treated as part of the acquisition price for the asset. If

the vendor incurs the repair expenses and sells the property in a ready-to-use form, the costs

would be directly incorporated into the cost of the asset. A purchaser should not be able to

accelerate deductions by purchasing property not ready for use and then repairing the property to

bring it to usable form.

142

See infra ch. 17, sec. II(B).

143

See infra ch. 17, note 50.

144

Where a pooling depreciation system is used (see infra ch. 17, sec. III(G)), the 5 percent threshold can be applied

by considering expenditures on all assets in a pool relative to the value of the pool.

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There are three ways in which a rule of this kind can be formulated. First, one could

establish a bright-line rule under which all repairs within, say, six months of an asset’s placement

in service are treated as capital costs, regardless of the facts of the individual case. Alternatively,

one could establish a presumption that repairs undertaken within a certain period are capital in

nature, which the taxpayer can rebut by showing that the repair is genuinely a repair rather than a

set-up cost. A third approach is to adopt a cost formula similar to the repair allowance described

above. For example, the rule can apply only to repair costs incurred within one year of the

acquisition of an asset and allow a deduction for repair costs of up to 5 percent of the original

acquisition cost while requiring taxpayers to capitalize repair costs in excess of that amount

incurred within that year.

4. Inventory

Income tax systems commonly measure gains and losses from the acquisition and

disposal of inventory separately from gains and losses arising from the disposal of other

property.

145

The essential purpose of tax accounting rules relating to inventory is to ensure that a

deduction is not allowed for the cost of acquiring inventory until the inventory is sold.

146

This

policy objective is consistent with the general rules regarding gains and losses from the disposal

of nonwasting assets, but separate rules are adopted for inventory in recognition of the continual

turnover of this type of property.

As with other tax accounting rules, the rules relating to inventory may be based on

commercial accounting standards or may be specified in the tax law or in regulations. An initial

issue that should be addressed in the inventory rules is what is encompassed in inventory and

thus subject to those rules.

147

In some jurisdictions, inventory is not defined and, therefore, takes

its normal commercial meaning.

148

In other jurisdictions, it is defined, but in terms largely

declaratory of its normal commercial meaning.

149

Essentially, inventory is anything that is turned

over in the ordinary course of business (i.e., it is the things in which a business trades). Inventory

may be bred or grown (such as livestock and agricultural produce), manufactured, purchased, or

otherwise acquired (such as through a barter transaction). Inventory is not confined to finished

goods. It includes goods in the process of production (i.e., work in process), and raw materials

and supplies that are to be consumed directly or indirectly in the production of goods.

Inventory is not limited to tangible movable property. In particular circumstances,

immovable or intangible property can be inventory. Generally, there is nothing in the intrinsic

nature of any particular item that gives it the character of inventory. The same item may be

145

See generally Dale Chua, Inventory Valuation, in Tax Policy Handbook 139 (P. Shome ed. 1995).

146

See supra sec. II(C)(2).

147

In jurisdictions that rely on British legal concepts, inventory is commonly referred to as "trading stock."

148

Singapore is an example of such a jurisdiction.

149

E.g., AUS ITAA (1997) § 70-10.

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inventory in the hands of one person but not in the hands of another. For example, a motor

vehicle may be inventory in the hands of a motor vehicle dealer but not in the hands of a person

who purchases it from the dealer. In fact, a person may hold the same type of item in different

capacities. For example, the private motor vehicle of a motor vehicle dealer will not be part of

the inventory of the dealer, nor will a vehicle acquired to deliver parts or pick up customers.

150

The system used to defer recognition of the cost of inventory will depend on whether the

income tax system generally uses the receipts-and-outgoings method or the balance-sheet

method to determine business income. There are two equivalent systems for measuring the cost

of inventory in jurisdictions in which the receipts-and-outgoings method is used to calculate

taxable business income. The simpler of the two systems is based on financial accounting

principles.

151

In this case, a deduction is allowed for the cost of goods sold during the tax year

calculated according to the following formula:

(Opening inventory + cost of purchases) - closing inventory.

An equivalent system used in some jurisdictions is to allow a deduction for the cost of

inventory acquired during the tax year, followed by a re-inclusion in gross income of the value of

closing inventory.

152

The re-included amount is the excess for the tax year of closing over

opening inventory. Where opening inventory exceeds closing inventory, a deduction should be

allowed for the excess to ensure that expenses incurred in prior years are recognized when stock

is eventually sold.

153

It should be provided that the value of closing inventory for a tax year becomes the value

of opening inventory for the next tax year. Items included in inventory should follow the

accounting rules for purchases and sales. Thus, if the taxpayer has recognized the cost of

inventory that is not yet physically received, it should nevertheless be included in inventory, and,

if the taxpayer has recognized income from the sale of inventory, it should not be included in

inventory, even if physically on hand at the close of the year.

In many jurisdictions, taxpayers are able to value closing inventory at the lower of cost or

market value. Thus, if the market value of inventory falls below its cost,

154

a taxpayer can

recognize the loss in the tax year in which it occurs without actually disposing of the inventory.

In some jurisdictions, taxpayers can also use the higher of market value and cost to value closing

150

It is possible that an asset may change status. For example, a motor vehicle dealer may take his or her private

motor vehicle into inventory, or vice versa. The tax consequences of a change in status of an asset are discussed in

sec. V(E)(1), below.

151

E.g., UGA ITA § 47.

152

E.g., AUS ITAA (1997) § 70-35.

153

A variation on this approach applies in New Zealand where taxpayers are allowed a deduction for the cost of

inventory and a deduction for the value of opening inventory, while the value of closing inventory is included in

gross income. See NZL ITA §§ 85, 104.

154

This may arise, for example, because of damage, deterioration, or obsolescence.

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inventory, to bring forward recognition of gain prior to disposal.

155

There is no persuasive policy

reason in favor of the latter concession, and it may be used for tax minimization or avoidance

purposes by generating gains to offset losses that might not otherwise be recognized for tax

purposes. Accordingly, while the choice between the lower of cost or market value may be

incorporated into the inventory rules, a choice of higher cost or market value is not

recommended.

In the ordinary case, closing inventory will be valued at cost. Two particular issues arise

when valuation is based on cost: first, the identification of amounts included in the cost of

inventory that is manufactured or constructed by the taxpayer; and second, the valuation of

closing inventory where the cost of inventory has varied and it is not possible to trace individual

items of stock.

The first issue with cost concerns the extent to which ancillary costs such as labor costs

or factory overhead costs should be included in the cost of manufactured or constructed

inventory. If such costs are included in the cost of manufactured or constructed inventory, they

will not be recognized until the inventory is sold. Two basic models are used to determine the

cost of manufactured or constructed inventory. Terminology differs from jurisdiction to

jurisdiction, but the fundamental features of the two models are similar across tax systems.

Under the simplest method—commonly known as the prime-cost method—the cost of inventory

is the sum of direct material costs, direct labor costs, and variable factory overhead costs. Direct

material costs are the cost of materials that become an integral part of the inventory produced.

Direct labor costs are the costs of labor directly involved in the production of inventory. Variable

factory overhead costs are those factory overhead costs that vary directly with the volume of

production. Under the more complex method–the absorption-cost method–a percentage of fixed

factory overhead costs (such as rent) is included in the cost of inventory. Where absorption

costing is used, rules must be adopted to distinguish costs that are attributable to the inventory

and costs that should be considered general overhead expenses (and are thus deductible without

reference to the inventory provisions).

156

Different rules may be adopted for cash-basis and accrual-basis taxpayers with respect to

the amounts included in the cost of inventory. A cash-basis taxpayer may be allowed to

determine the cost base of inventory using either the prime-cost or the absorption-cost method,

while accrual-basis taxpayers are usually required to use the absorption-cost method.

157

155

E.g., AUS ITAA (1997) § 70-45; NZL ITA § 85(4).

156

Ordinarily, general, administrative, and selling expenses are not included in the cost of inventory. See, e.g., USA

IRC 263A and the regulations thereunder (in 1986, the types of expenses required to be included in the cost of

producing inventory were substantially broadened). As an economic matter, however, all costs incurred by a firm

should ultimately be recovered as part of the cost of production, so that arguably all expenses of a firm should be

allocated to costs of production. Such a rule would also be simpler to administer, because it would minimize the

requirement to draw distinctions among different types of costs. See Victor Thuronyi, Tax Reform for 1989 and

Beyond, 42 Tax Notes 981–96 (Feb. 20, 1989).

157

E.g., UGA ITA § 47(5).

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The second issue that arises when valuation is based on cost relates to the identification

of items of inventory that are on hand at the end of the tax year. This is necessary where the cost

of acquiring, constructing, or manufacturing different units of inventory has varied. For unique

products, businesses can trace the actual movement of stock and thus ascertain the exact cost of

closing inventory. More commonly, businesses buy and sell generic stock, and there is no record

of the movements of individual items. Thus, for inventory other than unique traceable stock, a

presumptive tracing rule must be applied. While a number of variations are used in different

jurisdictions, most fall into one of three inventory tracing methods, the first-in-first-out (FIFO),

average-cost, or last-in-first-out (LIFO) system. Under the FIFO method, the cost of inventory on

hand at the end of the tax year is determined on the assumption that items purchased or produced

first are sold first, so that the items on hand at the end of the year are those last purchased or

produced. Under the average-cost method, the cost of inventory on hand at the end of the tax

year is determined by reference to the weighted-average cost of all items on hand at the

beginning of the tax year and purchases during the year. Under the LIFO method, the cost of

inventory on hand at the end of the tax year is determined on the assumption that items

purchased last are sold first, so that items on hand at the end of the year are the earliest items

purchased or produced. In a period of moderate inflation, the use of the LIFO method for valuing

trading stock will provide taxpayers with a simple compensation for the effects of inflation on

measuring profits.

158

However, the LIFO method is complex and results in undervaluation of

inventory.

159

5. Research and Development

The longevity of benefits derived as a result of expenditure on research and development

is incapable of measurement at the time the expense is incurred. It may be presumed, however,

that some long-term benefit is realized as a consequence of any research and development

expense. For example, even if a research and development outlay yields no direct, relevant

results, the expenditure may provide long-term benefits by narrowing down options and

suggesting possible paths for other research initiatives.

Because it is not possible to estimate accurately the useful life of benefits resulting from

research and development expenses, a hypothetical life must be adopted. In many jurisdictions,

doubts about the longevity of benefits from research and development expenses are resolved in

the taxpayer's favor through the use of relatively short amortization periods, or immediate

deductions, for these outgoings.

160

Such treatment is also seen as a tax expenditure (i.e., tax

concession) that encourages research and development.

161

An additional argument in favor of

158

Special rules for valuing closing inventory apply under comprehensive inflation adjustment systems. See vol. 1,

ch. 13.

159

See McLure et al., The Taxation of Income from Business and Capital in Colombia 239–40 (1990).

160

E.g., AUS ITAA (1936) § 73B (immediate deductions range from 100 percent to 125 percent of the relevant

expenditure incurred); LSO ITA § 40 (immediate deduction); UGA ITA § 33 (immediate deduction); USA IRC §

174 (at the taxpayer’s election, research and experimental expenditures may be immediately deductible or amortized

over five years).

161

See generally Stanley S. Surrey & Paul R. McDaniel, Tax Expenditures 211–12 (1985).

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allowing an immediate deduction for research and development costs is that it may be difficult to

distinguish them from other general business expenses. There are, however, disadvantages to the

use of an amortization period for research and development outgoings that is significantly shorter

than the period applicable to other capital expenses. Most important, generous treatment of

research and development expenses will lead to taxpayers recharacterizing expenses as research

and development outlays to accelerate the deduction of these expenses. This may happen, for

example, with equipment that is used both in manufacturing products and in developing new

products. To limit the scope for recharacterization, it may be provided that research and

development expenditure does not include the cost of acquiring a depreciable or intangible asset,

the cost of acquiring land or buildings, or the expenditure incurred for the purpose of

ascertaining the existence, location, extent, or quality of a natural deposit.

A possible hybrid approach is to prescribe a limited amortization period for research and

development expenses and to allow an immediate deduction of that part of the expense that is

attributable to any project or line of inquiry pursued by research if the project is abandoned

without generating results.

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V. Issues Relating to the Taxation of Assets

A number of issues arise in the design of the income tax as it applies to assets.

162

Some

issues may be specific to particular classes of assets,

163

while others may be relevant to all assets.

It is suggested that the asset rules be structured so that the rules common to all assets are

included in a single regime of general application. These rules include those for determining the

cost base of assets, realization and recognition rules, and rules for determining gain or loss on

disposal. In systems based on the balance sheet, they will include rules for determining the

balance-sheet value of assets. Specific rules for particular classes of assets can then build on

these basic rules. This approach not only ensures that rules are provided for all assets, but also

means that there is a fundamental consistency in the basic treatment of different classes of assets.

An alternative approach in some countries is to provide detailed rules for a particular class of

asset (such as investment assets), with much briefer rules provided for other assets. It is

recommended that this approach be avoided.

A separate asset regime of general application is supplementary to the operation of the

inclusion and deduction provisions in the law. It is not the purpose of the regime to bring

amounts to tax or allow amounts as a deduction. Rather, its purpose is to elaborate the meaning

of concepts used in the inclusion and deduction provisions. The main areas that can be dealt with

in a separate asset regime are timing and calculation matters. The timing rules identify the tax

year in which the inclusion and deduction provisions apply to an asset, and the calculation rules

provide for the determination of the taxable or deductible amount. Depending on the asset, the

taxable amount may be a gain calculated by subtracting the cost base of the asset from the

consideration received for the asset, and the deductible amount may be a loss calculated by

subtracting the consideration received for the asset from the cost base of the asset. In other cases,

such as inventory, the taxable amount may be the consideration received, and the deductible

amount may be the cost of the asset. In either case, the asset regime should provide for the

determination of the cost base of, and consideration received for, assets.

The main matters that may be dealt with in a separate asset regime are discussed below.

A. Timing Rules for Realization of Gain or Loss

Ordinarily, gains or losses arising in relation to assets are taxed not as they accrue, but

rather in the tax year in which the taxpayer realizes the gain or loss. In most cases, a gain or loss

is realized at the time the taxpayer ceases to own the asset. While a taxpayer will normally cease

to own an asset as a result of the sale of the asset, there are other ways in which this can occur

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The concept of an asset is used in this discussion in preference to the concept of property that is used in some tax

laws (e.g., IDN IT § 4(1)d (“gains arising from the sale or transfer of property”)). In its ordinary meaning, an asset is

any thing that may be turned to account. Depending on general law meanings, the notion of property may not be

interpreted this broadly. For example, legally enforceable rights that are purely personal in nature may not be

regarded as property.

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For example, specific rules may apply to inventory, depreciated or amortized assets, and assets subject to capital

gains taxation.

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(e.g., as a result of an in-kind exchange, a gift, or a distribution of the asset). Thus, it is suggested

that the concept of disposal, rather than a narrower concept like sale, be used to state the basic

realization rule. In its ordinary meaning, disposal covers all situations in which the ownership of

the asset changes. Even so, an extended definition of disposal will be necessary to cover all

intended realization events in relation to assets, particularly those relating to intangible assets.

The definition of disposal should include the redemption, expiry, cancellation, surrender, loss, or

destruction of an asset. It should also be provided that the disposal of an asset includes a partial

disposal. An example of a partial disposal is the sale of a lot that has been part of a single block

of land that has been subdivided.

The disposal rules may also provide for gain or loss recognition where an asset that is

outside the tax system is brought within the tax system, or vice versa. This can occur because a

change in the taxpayer’s circumstances changes the tax status of assets held by the taxpayer. For

example, a nonresident taxpayer may become a resident taxpayer. If the new country of tax

residence taxes worldwide income, then the change in residence may bring assets held by the

taxpayer at the time of the change within the tax system of the new country residence (these

assets previously being foreign assets of a nonresident). Alternatively, a resident taxpayer may

become a nonresident taxpayer. The effect of the change may be to take some assets held by the

taxpayer at the time of the change outside the tax system of the taxpayer’s former country of tax

residence (these assets now being foreign assets of a nonresident). A similar situation can arise

where an exempt person becomes a taxpayer, or vice versa. This can happen as a result of a

change either in the taxpayer’s circumstances or in the law.

In these situations, there is no change in the ownership of the asset, and so there is no

disposal in the ordinary meaning of the word. If an entry or exit from the tax system is to be

treated as a realization event, then it will be necessary to include deemed-disposal rules to cover

this situation.

164

Comprehensive deemed-disposal rules can be difficult to enforce and may not

be necessary for developing or transition countries.

165

However, it will be necessary to include

some such rules, particularly to prevent taxpayers from obtaining a tax deduction for what is

essentially consumption expenditure (e.g., if a personal-use asset becomes a business asset, there

should be a deemed disposal and reacquisition to ensure the decline in value due to personal use

is not recognized for tax purposes). The effect of a deemed-disposal rule is to treat a particular

event as giving rise to the disposal of an asset for a consideration equal to either the market value

or the cost base of the asset at that time depending on the circumstances.

166

If relevant, the

taxpayer will also be treated as having immediately reacquired the asset for the same

consideration. This then becomes the new cost base of the asset for tax purposes.

164

Rather than artificially "deem" that a disposal has occurred when one has not, an alternative approach is to define

the situations in which gains and losses are brought to account as taxation "events”—see, e.g., AUS ITAA (1997),

proposed Div. 104.

165

It is suggested that this is the case for residence change situations. See ch. 18, sec. VI(E).

166

Market value consideration will be recognized when an asset moves in or out of the tax system (see supra sec.

V(A)), while consideration equal to cost will be recognized in most cases when an asset changes tax status (see infra

sec. V(E)(1)).

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B. Cost Base

The basic rule is that the cost base of an asset is the consideration given for the

acquisition of the asset.

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This should include any borrowed funds used to acquire the asset.

Where the taxpayer has given consideration in kind for the asset, the market value of the in-kind

consideration at the time of the acquisition should be included in the cost base of the asset. The

cost base of an asset should include any ancillary costs incurred in the acquisition of the asset,

such as legal and registration fees relating to transfer of the ownership of the asset, transfer taxes,

agent’s fees, installation costs, and start-up expenses to make the asset operational. The cost base

of an asset should also include any capital expenditures incurred to improve the asset and

expenses incurred in respect of initial repairs.

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When there is a partial disposal of an asset, it is necessary to provide rules to apportion

part of the cost of the original asset to the part of the asset sold. For this purpose, the cost of the

original asset should be apportioned by reference to the market values of the respective parts of

the asset at the time the asset was originally acquired.

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It may be difficult to apply this rule

when an asset was acquired without contemplation of part disposal. The information may thus

not be available at the time of disposal to apportion cost on the basis of market values of the

respective parts of the asset at the time of acquisition. In this case, the original cost can be

assumed to be allocated on a pro rata basis by reference to relative market values of the part sold

and the part retained at the time of disposal.

170

167

While much tax terminology is similar in different countries, this is not the case for “cost base” and its

equivalents. It is in fact more than a difference in terminology, and has to do with differences in the structure of

income tax laws. The United States has an underlying concept of “basis” (and adjusted basis) which is used

throughout the income tax law for such purposes as computing capital gains or depreciation deductions (for

example, the term adjusted basis is used more than 300 times in the Internal Revenue Code). The concept is defined

in USA IRC §§ 1011–1016. Similarly, Australia has the concept of cost base of assets, which is defined in AUS

ITAA (1936) § 160ZH, but this concept is not as pervasive in the tax law as is the American concept; it does not

govern depreciation deductions, for example, which are determined according to the cost of plant. See ITAA (1997)

§§ 42-60 to 42-90. The Canadian approach is similar. See CAN ITA § 54 (adjusted cost base). Most countries do

not have a formal underlying concept of basis. They might refer to the cost or acquisition cost of assets in rules for

determining capital gains. For example, the Spanish law refers to the acquisition value in its capital gains rules. See

ESP IRPF § 46. France similarly refers to the acquisition price. See FRA CGI § 150 H. The United Kingdom uses

the concept of cost both for capital gains purposes and for purposes of determining qualifying expenditure for

depreciation purposes. On the other hand, Germany, like the United States, has an underlying concept for the

valuation of assets, namely Buchwert (book value). The concept of Buchwert is used both for purposes of

computing capital gains and for purposes of the balance-sheet method of determining taxable income (for which see

Appendix infra). See DEU EStG §§ 6, 6b(2). In most cases, the Buchwert of an asset for purposes of German tax

law will correspond to the concept of adjusted basis as used in U.S. tax law.

168

See infra sec. IV(D)(3).

169

E.g., UGA ITA § 53(5).

170

E.g., AUS ITAA (1936) § 160ZI. Another approach, not recommended, is to allocate cost on a pro rata basis

using features of the property sold, such as the size of a part of immovable property sold compared with the size of

the part retained. Given that it is only by chance that there would have been a consistent movement in the market

value of the respective parts of the asset since the original asset was acquired, this approach is likely to lead to

inappropriate allocations of original cost.

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A taxpayer may hold a number of assets of the same type. When the assets have been

acquired for different costs, and the taxpayer disposes of only a part of his or her holdings of the

asset, it will be necessary to know which asset or assets have been disposed of for the purposes

of determining the cost of those assets. Ordinarily, outside of inventory, it should be possible to

identify the particular asset or assets disposed of so that the actual cost of those assets is used.

However, there may be some types of asset for which actual identification is not possible.

Examples include shares of a company that is not obliged to use registration numbers and

holdings of precious metals. For these assets, a presumptive tracing rule needs to be provided.

While several possible tracing rules may apply when the asset is inventory,

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an identification

rule based on first-in-first-out is suggested for noninventory assets.

Cost-base rules should cover two special cases. The first case is where a taxpayer

acquires an asset in circumstances in which the acquisition constitutes the derivation of an

amount included in the taxpayer’s gross income. For example, a taxpayer may be remunerated

with an asset rather than with cash. In this case, the cost base of the asset should be the amount

included in gross income plus any consideration given by the taxpayer for the asset. The purpose

of this rule is to prevent double taxation.

The second case is where a taxpayer acquires an asset in circumstances where the

acquisition of the asset is the derivation of exempt income. In this case, the cost of the asset

should be the exempt amount plus any consideration given by the taxpayer for the asset. The

purpose of this rule is to ensure that the exemption is not clawed back on a subsequent disposal

of the asset.

C. Consideration Received

The basic rule is that the consideration received for the disposal of an asset is the price

received for the asset, including the market value of any in-kind consideration. Where borrowed

funds are included in the cost base of the asset, any relief from the debt by the transferee must be

treated as part of the consideration received on disposal of the asset.

Where a taxpayer disposes of two or more assets for a single undissected consideration, it

is necessary to provide for the apportionment of the consideration among the assets. For this

purpose, the consideration received should be apportioned by reference to the market values of

the assets disposed of as of the time of the disposal.

In some situations, the consideration for a disposal of an asset may be nominal or zero.

For example, a taxpayer may give an asset (such as inventory) to a customer or a client as a

sample or as part of a promotion. Where the parties are genuinely unrelated and the purpose of

the dealing is not to shift value to some related, but tax-preferred transaction between the parties,

the actual consideration received (if any) should be treated as the consideration for the disposal

of the asset. The treatment of non-arm’s-length transactions is discussed in section V(D), below.

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See supra sec. IV(C)(5).

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The consideration rules must correspond to the notion of disposal that applies for the

purposes of the law. For example, it was stated above that the notion of a disposal should extend

to situations where an asset has been lost or destroyed. For these disposals, there may be no

consideration received for the disposed asset, or the taxpayer may have received insurance

proceeds or damages (see below).There are a number of different rules in different jurisdictions

that apply in these circumstances. Often, however, these are explicable by reference to particular

historical factors and are of little precedential value. In the absence of special circumstances, the

simplest and fairest rule is to measure losses arising from such involuntary disposals by reference

to the actual consideration received, if any. If no consideration is received, then the taxpayer will

have incurred a loss on the disposal equal to the cost of the asset.

Where a taxpayer is subject to a deemed disposal in respect of assets moving in or out of

the tax system, a market value rule should apply to the disposal. This means that the taxpayer is

treated as having disposed of the assets for their market value at the time of the deemed disposal

and to have immediately reacquired them for the same amount. This ensures that only the gain or

loss arising while the asset is within the tax system is recognized.

Special rules may be needed for compensation (such as insurance proceeds or damage

awards) received in relation to assets. Where compensation is received in respect of the loss or

destruction of an asset, the amount should be treated as the consideration received for the

disposal constituted by the loss or destruction of the asset. For this purpose, it is necessary to

ensure that the definition of consideration received is drafted broadly so as to cover such

amounts.

Compensation may also be received for damage to an asset where the asset has not been

lost or destroyed. If the amount of the compensation equals the cost of repairs (e.g., fixing the car

after an accident), then no gain should be recognized in relation to the compensation amount.

Where the compensation offsets damage that cannot be repaired, it should be recognized through

a reduction in the cost base of the asset.

D. Non-Arm's-Length Transfers

In the absence of prophylactic measures to control the amount of cost and consideration

for tax purposes, related parties may choose transfer prices in the hope of achieving a variety of

tax objectives—minimizing recognition of gain to defer taxes, inflating gains to absorb losses

that were carried forward, value shifting to transfer gains to a lower bracket or exempt taxpayer,

and so forth. Objectives unrelated to taxation, too, may also influence transfer values. For

example, taxpayers may wish to shift value to improve their balance sheet for the purpose of

obtaining debt finance.

To prevent manipulation of transfer prices, rules for determining the deemed market

value consideration are needed for non-arm's-length transactions. In broad terms, an arm’s-length

transaction is a transaction in which the parties act completely independently of each other and

seek to put their own interest first. A transaction between related parties would be presumed to

be a non-arm’s-length transaction because one or both parties may be willing to subordinate their

own interest to that of the other party or a related third person for the purpose of achieving an

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overall tax saving. However, this is only a presumption because related parties can enter into a

transaction on arm’s-length terms. The nature of the transaction is usually tested by reference to

the price that would be expected if unrelated parties entered into the transaction.

Non-arm’s-length transactions require complementary deeming rules. The person

disposing of an asset in a non-arm’s-length transaction should be treated as having received

consideration for the disposal equal to the market value of the asset at the time of the disposal.

The same amount should then be treated as the cost base of the asset for the person acquiring the

asset.

While gifts are usually non-arm's-length transfers, they raise special conceptual issues.

Genuine gifts occur most commonly within families; most "gifts" outside the family involve

some sort of quid pro quo. The case for treating gifts in the same manner as other non-arm's-

length transactions (i.e., as a disposal for a deemed market value consideration) is strong. Any

other treatment introduces inefficiencies and inequities by distinguishing between persons who

dispose of property or services for arm's-length consideration and make a gift of the proceeds

and those who provide the property or services directly.

The argument commonly raised against deemed market value consideration in respect of

gifts is the alleged liquidity problem faced by the donor. Often, the lack of liquidity is at the

choice of the donor, given that the donor could have disposed of the property at market value. A

secondary argument focuses on the alleged valuation difficulties encountered in a transfer for no

consideration. The problem is no greater than that encountered in any non-arm's-length transfer,

however, and tax administrators can apply to gift transactions the expertise developed to value

all other non-arm's-length transactions.

Similar issues apply to testamentary gifts. While it seems intuitively inappropriate to treat

the taxpayer who makes a gift of property differently from the taxpayer whose property transfers

on death, a distinction between inter vivos and testamentary gifts is not unusual. Often,

jurisdictions that provide a deferral in respect of testamentary transfers impose death duties or

similar taxes, and it may be thought that liquidity problems could be exacerbated as a result of

the two tax liabilities. Similar treatment of inter vivos and testamentary gifts is desirable,

however, in light of the inequities that would follow from a complete exemption from

recognition of accrued gains on death (by means of a cost-base step-up for recipients of property)

and the economic lock-in inefficiencies that would follow from a deferral of recognition (by

means of a cost-base rollover for the recipient). Liquidity problems, if any, can be addressed

through, for example, installment payments of tax subject to ordinary finance charges.

E. Nonrecognition Rules

There may be situations in which a taxpayer has realized a gain or a loss on disposal of

an asset, but recognition of the gain is deferred until a later event occurs. Similar deferral may

apply when property changes its tax status. In some jurisdictions, these nonrecognition rules are

referred to as providing rollover treatment. The tax position of a taxpayer or asset is rolled over

into another taxpayer or asset, as the case may be. This is done by deeming the taxpayer to have

disposed of relevant property for consideration equal to its cost and to have reacquired the

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property (if there has been no actual disposal of assets) or to have acquired replacement property

for consideration equal to the original cost.

Tax laws commonly provide for rollover treatment in four types of situations, described

below.

1. Changes in the Tax Status of Assets

An asset can change its tax status in a number of ways. For example, a trader may take

some stock from inventory for personal use or consumption (or vice versa, although this is much

less common). An item of inventory can also become a business asset of another type, such as

depreciable or amortizable property, or vice versa. Similarly, property acquired as business

assets or inventory may subsequently be held as an investment asset, or vice versa,

172

and in

some cases may thus be subject to different tax rules.

Rollover treatment, which can be applied to most changes of tax status, is the equivalent

of saying that the asset was originally acquired for its ultimate use, and so the interim period in

which the asset was held for some other use is thus ignored. A deemed disposal for cost will

normally lead to no gain or loss recognition. For example, if an item of inventory is removed for

personal consumption by the taxpayer, the taxpayer will be treated as having disposed of the

stock at the time it was taken out of inventory for cost,

173

which will offset the deduction

obtained for the cost of inventory. Some systems (e.g., Germany), however, treat a withdrawal

of assets from business use as a disposal for market value.

174

A special rule is needed when a personal-use asset that would be depreciable property if

it were a business asset is converted to a business asset. If rollover treatment were applied in this

case, the taxpayer would be able to recognize some personal consumption costs for tax purposes.

For example, if a taxpayer converted a machine from personal-use property to inventory, the

decline in value due to personal use could be recognized as a loss if the property were rolled over

at cost. Such conversions should be treated as disposals for market value.

172

This possibility can be confined to individuals carrying on a business, because all assets of a company or

partnership should be deemed to be business assets. See supra sec. II(B)(2).

173

E.g., AUS ITAA (1997) § 70-110.

174

This approach corresponds to the deemed disposal on conversion of assets to business assets–see supra sec. IV

(A).

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2. Disposals Intended to Trigger a Loss

While the income tax system tends to recognize gains and losses only when there is a

disposal of an asset or a prescribed tax event giving rise to a deemed disposal, the value of assets

changes continuously. The realization event aspect of the income tax system can provide

taxpayers with opportunities to reduce tax liability by accelerating recognition of losses on assets

that have declined in value while deferring recognition of gains on assets that have appreciated

over the same period. If the disposals are genuine market transactions to unrelated parties, the

losses will normally be recognized for tax purposes. In some cases, loss recognition will be

denied, however, and rollover treatment will be imposed.

The first loss situation in which rollover treatment is prescribed is for below-cost

transfers to related persons, even if the price reflects market value. Losses are generated even

though the asset continues to be owned by the same group of companies or the same family. To

prevent such artificial generation of a loss, the transferor should be treated as having disposed of

the property at cost, and the transferee should be treated as having acquired the asset for the same

amount. This preserves the accrued loss, which will be realized when the transferee eventually

sells the asset outside the group or family.

The second loss situation in which rollover treatment is prescribed is for "wash sale"

situations. A wash sale is when a taxpayer disposes of an asset that has declined in value and

immediately thereafter acquires the same or a similar asset. The transaction costs may be

minimal compared with the tax savings resulting from the realized loss. The effectiveness of

such transactions can be avoided by prescribing rollover treatment to wash sales that involve the

taxpayer’s reacquisition of the asset within a designated period.

3. Involuntary Disposals

A nonrecognition rule may apply to an involuntary disposal of an asset when a

replacement asset has been acquired. Examples of involuntary disposals to which this rule may

apply are the loss or destruction of an asset (e.g., through fire or theft) and the compulsory

acquisition of an asset by a government authority. There are usually two conditions to the

application of the nonrecognition rule. The first condition is that the proceeds of the disposal

(such as insurance proceeds) must be used to acquire a replacement asset of a kind similar to the

disposed asset. The second condition is that the replacement asset is acquired within a specified

time of the involuntary disposal, say, one year. The nonrecognition rule should apply only to the

extent that the proceeds of the involuntary disposal are used to acquire the replacement asset. If

the proceeds of the involuntary disposal exceed the cost of the replacement asset, then the excess

of the proceeds over the cost of the replacement asset should be recognized as a taxable gain

arising from the involuntary disposal. Where the nonrecognition rule applies, the cost of the

replacement asset is the cost of the involuntarily disposed of asset plus the amount (if any) by

which the consideration given for the replacement asset exceeds the consideration received on

the involuntary disposal. The nonrecognition rule that applies to involuntary disposals is

illustrated by the following example:

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Example

A taxpayer owns an office building that cost $1,000,000. The building is

destroyed by fire. The taxpayer receives $1,500,000 under an insurance policy,

which is wholly used to acquire a replacement office building. Under the

nonrecognition rule, no gain or loss is taken into account on disposal of the

building to the extent that the insurance proceeds of the disposal are used to

acquire the replacement building. The tax cost of the replacement building is

$1,000,000—that is, the cost of the destroyed building at the date of its

destruction. This means that recognition of a $500,000 gain made by the taxpayer

on disposal of the destroyed building is deferred until the taxpayer disposes of the

replacement building.

If the actual cost of the replacement building was $1,600,000, then the tax cost

of the replacement building would be $1,100,000 (the cost of the destroyed

building plus $100,000 paid by the taxpayer for the replacement building in

addition to the insurance proceeds). Recognition of a $500,000 gain made by

the taxpayer on disposal of the destroyed building is still deferred until the

taxpayer disposes of the replacement building.

If the replacement building had actually cost $1,400,000, then the cost of the

replacement building would still be $1,000,000, but the difference between

the insurance proceeds and the cost of the replacement building ($100,000)

would be included in the taxpayers’s business income. This is because this

part of the insurance proceeds has not been used to acquire the replacement

building. Recognition of the other $400,000 of gain in relation to the

involuntary disposal is deferred until the taxpayer disposes of the replacement

building.

4. Spousal Transfers

A nonrecognition rollover may be provided to facilitate the transfer of assets between

spouses (or former spouses) on the breakdown of a marriage. The transferee spouse takes over

the original cost of the asset so that recognition of any gain or loss that has accrued prior to the

transfer is deferred until a subsequent disposal of the asset by the transferee spouse.

F. Transitional Basis for Assets Previously Outside the Tax Base

The reform of income tax legislation often brings into the tax base gains on assets that

were not previously subject to income taxation. To avoid the retrospective application of the tax

law, transitional measures should prevent or at least minimize the taxation of gains that have

accrued prior to the introduction of the new tax. From a theoretical perspective, the ideal rule is

one that sets the cost of assets previously outside the tax base as their market value at the time

the new tax reform comes into effect. To prevent market confusion and potential disruption

between the unveiling of the new tax rules and their effective date, some jurisdictions that have

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expanded the tax base in this manner have used the market value as of the time the new measures

were unveiled or shortly before.

A rule based on market value when the tax base is broadened is feasible only if market

value information is readily available at that time and accessible, when there is an eventual

disposal of the property. Experience in industrial countries that have adopted this approach

shows that few difficulties emerge when this rule is applied to “publicly listed assets,” such as

publicly traded shares or precious metals, or to assets included in data bases that can be used to

estimate closely the value of an asset at the time of tax reform. An example of the latter is real

estate where property records will show the sale price of neighboring properties sold around the

time of the tax reform. However, valuation is a prime source of dispute and litigation in the case

of assets involving intangible elements such as goodwill (e.g., businesses or shares in private

companies). In industrial countries, these values are normally determined by financial indicators,

such as comparable rates of return in similar businesses. In developing and transition countries, it

is more appropriate to use a surrogate measure of value when the tax base is broadened. The

simplest rule for assets acquired prior to tax reform is to deem cost to be the original cost

adjusted by a factor such as inflation adjustment. Even this surrogate measurement may be

difficult to apply in some cases, for example, when assets have been acquired long before tax

reform or through inheritance.

One country attempted to broaden its tax base by introducing measures on a prospective

basis so that they applied only to assets acquired after a certain date.

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This approach is not

recommended because it creates arbitrary differences in the treatment of assets depending on

when they are acquired. These differences encourage taxpayers to enter into transactions to shift

value from taxed to untaxed assets. Further, this approach creates a lock-in effect in that persons

holding assets acquired before the relevant date are encouraged to hold onto them.

VI. Special Regimes

A. Interest Income and Expenses

It is common for tax legislation to contain special rules for interest income and expenses.

As discussed in section III(B), it is usual to define interest broadly to ensure that amounts

functionally equivalent to interest (such as discounts and premiums) are treated as interest for tax

purposes.

It is necessary to include special timing rules in relation to interest. These rules serve two

purposes. First, they ensure that the different amounts within the broad definition of interest

(such as discounts and premiums) are subject to the same recognition rules. In the absence of

special accounting rules, it might be possible for a taxpayer to recognize a gain relating to a

discount or premium when the gain is realized—that is, upon redemption or repayment of the

loan. Thus, even if the discount or premium is taxed as interest, the recipient may still enjoy a

significant deferral advantage over ordinary interest. Special accounting rules are needed to

175

AUS ITAA (1936) § 160L.

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deem the recipient to derive the gain represented by a discount or premium as if it were

compound interest derived over the life of the loan.

176

Second, special rules are necessary to prevent taxpayers from taking advantage of timing

mismatches that can arise in accounting for the various forms of interest. For example, a

mismatch can arise when a financial institution issues a security to an individual under which the

payment of interest is deferred for, say, five years. In the absence of special rules, the financial

institution may be permitted to deduct the interest expense as it accrues, while the individual

accounts for the interest income when it is paid (under cash-basis accounting). To avoid such

mismatches, it may be provided that both the lender and the borrower must account for interest

income on an accrual basis, regardless of the taxpayer’s general method of accounting. An

exception may be provided if the interest is subject to withholding tax. Both the lender and

borrower may be required in this case to account for the interest on a cash basis.

177

Limitations on the deduction of interest expenses may be desirable for a number of

reasons. In principle, like other expenses incurred to derive business income, interest expenses

should be deductible in full. However, restrictions on interest expenses may be used

• to prevent taxpayers from exploiting the full deductibility of interest in periods of

high inflation;

• to prevent taxpayers, particularly foreign taxpayers, from exploiting different tax

rates on interest and dividends; and

• to prevent taxpayers from exploiting differences in the treatment of interest and

capital gains.

Finally, in common law jurisdictions in particular, special rules may be needed to prevent

taxpayers from exploiting the different treatment of "blended" payment loans and annuities.

178

1. Inflation Benefits

In the absence of special rules on interest deductibility, taxpayers who borrow in a high-

inflation environment may derive a significant tax advantage from debt financing. Most of what

is nominally interest expense may in fact be repayment of a portion of the loan.

179

A system of

176

AUS ITAA (1936) §§ 159GP–159GZ; CAN ITA § 12(3), (4), and (9); ESP § 37 Uno 2(A) (rendimientos

implicitos); but see, to the contrary, FRA CGI § 125-0 A (capitalized interest taxed only at the time of the

expiration (dénouement) of the contract, so that the taxpayer has a timing advantage in capitalizing the interest).

177

Some countries do attempt to apply accrual tax rules although the payment of interest is subject to withholding

tax. When payment of interest is deferred by capitalizing it into discounts, premiums, or other forms of capital gains,

the rules on withholding tax should provide that the tax becomes due by the payor on any portion of the gain,

premium, or discount that has accrued during the taxable period. In such cases, withholding tax is to be paid on an

annual basis before effective payment of the income. See further BEL CIR § § 19 (3), 267.

178

See supra sec. III(A).

179

See vol. 1, ch. 13, sec. IV(A).

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global inflation adjustment can be used to address this problem.

180

However, because most

countries will not adopt such a system, partial adjustment for interest could be considered,

although the case for inflation adjustment of interest expense is not appreciably stronger than the

case for inflation adjustment of the cost of inventory, depreciable assets, and other property. Nor

is there a reason why inflation adjustment rules (or surrogate rules) imposed on borrowers paying

interest expenses should not apply equally to lenders deriving interest income. Selective

recognition of the effects of inflation on only one element of the business income equation will

introduce new and potentially more significant distortions into the income tax system. This fact

should be kept in mind when proposals for adjusting allowable deductions for interest expenses

are evaluated.

2. Thin Capitalization

If the domestic company and shareholder income tax regime is based on a classical tax

system, comprising separate taxation of company income and distributions to shareholders, there

will be an incentive for taxpayers to invest by way of debt instead of equity. Distributions are

thus deductible to the company and are taxed only once in the hands of investors. Extensive

reliance on debt financing is known as thin capitalization.

Adoption of a partial imputation system reduces the incentive to recharacterize equity as

debt and dividends as interest payments. Adoption of full imputation almost eliminates the

distortion in respect of domestic shareholders, provided both dividends and interest are subject to

similar tax treatment. If interest is subject to a different regime, such as low domestic

withholding tax, shareholders in companies deriving income that will not carry imputation

credits are likely to structure their investment as debt in order to convert their returns to interest.

Unless imputation is extended fully to all foreign shareholders, an incentive to engage in

thin capitalization will remain for these taxpayers. Even then, a bias toward debt investment will

exist if the final tax imposed on interest income is different from that imposed on dividends, as is

often the case.

181

Alternative solutions to the problem of thin capitalization as applied to foreign

shareholders are discussed in chapter 18.

182

If rules designed to counter thin capitalization arrangements are to apply to all

shareholders, they are best located in the statutory provisions applicable to companies. If the

rules are to apply only to foreign shareholders, they can be included with other international tax

measures. Thin capitalization rules can also be used in lieu of explicit inflation adjustment of

interest expense, which may be considered too complicated to apply. In this case, the rules

should apply to the deduction of all interest expenses.

180

See vol. 1, ch. 13, sec. IV(D).

181

For example, lower rates of tax on interest, including zero rates, may be prescribed by treaty.

182

See infra ch. 18, sec. (V)(G)(2).

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3. Interest Quarantining

A problem confronted in many tax systems is the difficulty of matching interest expenses

to corresponding income attributable to those interest expenses. Interest is generally deductible

as incurred, while income is recognized as derived. Taxpayers may enjoy considerable tax

benefits if they may deduct interest outgoings in the period before the years in which the

resultant gains are taxed. The benefits are increased if the income qualifies for a preference—

such as partial exemption, special rates, or inflation adjustment—while nominal interest is

deductible in full against nonpreference income subject to ordinary rates of tax.

In some cases, it is relatively easy to identify the period of deferral of income. For

example, an investment asset may yield no current income, its entire return taking the form of

capital gains that will be taxed when they are realized. Another case is when interest expense is

incurred to finance the construction of property, such as heavy equipment, a public utility plant,

or a building. In this case, because of the passage of time, the taxpayer expects the finished

project to be worth at least as much as the incurred costs plus interest on those costs up to the

time the property is placed in service or sold.

Other cases of deferral may be more difficult to identify. For example, a taxpayer may

acquire immovable property for the dual purposes of using it as business premises and deriving

business income during the period of occupancy and of realizing a further gain upon disposal.

Alternatively, a taxpayer may acquire property for the dual purposes of deriving rental income

during the lease period and deriving a further gain when the property is sold at the expiration of

the lease term. In these cases, the property is generating income that is currently taxed, but there

is also an element of appreciation in value that will not be taxed until the gain is realized.

Two measures can be used to minimize the mismatch of interest deductions and

consequent income. First, interest incurred in respect of the acquisition or construction of

property before the property generates income can be capitalized into the cost base of the

property. Second, quarantine rules can be applied to interest incurred to derive dual- element

income, such as rent or business income and capital gain. Because investment income is most

likely to involve dual elements, it is common to restrict quarantining rules to this type of income.

Normally, quarantining will limit interest deductions that are incurred to derive investment

income to the amount of investment income derived during the taxable year, with an indefinite

carryover of undeducted interest. When taxpayers carry on business in a personal (not

incorporated) capacity, it will be necessary to separate business credit from personal credit

183

Some countries, in principle, still permit unlimited deductions of interest even on personal

loans,

184

which result in a considerable loss of revenue.

B. Finance Leases

183

BEL CIR art. 14; CAN ITA § 20(1)(c); FRA CGI art. 31/1 (d); USA IRC § 25. The United States provision is

considered by some commentators to be excessively complicated.

184

See NLD WIB § 45/1 f, with some limitations in arts. 45/3 and 5; CHE: LIFD § 33(1)(a).

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A lease is an agreement under which the owner of an asset (the lessor) grants another

person (the lessee) the right to use the asset for a stated period. As consideration for the right, the

lessee agrees to make rental payments to the lessor. At all times, the legal ownership of the asset

remains with the lessor. The commercial accounting treatment of a lease and its tax treatment

will depend on whether the lease is a "finance lease" or an "operating lease."

A finance lease

185

is an arrangement that is legally structured as a lease, but has the same

economic effect as a sale on credit and purchase of the leased asset. Thus, under a finance lease,

the lessor effectively transfers the benefits and risks of ownership of the leased asset to the lessee

while retaining legal title in the asset. An operating lease is one in which the legal and economic

ownership of the leased asset remains with the lessor so that the lease payments are genuinely for

the use of the leased asset.

Under tax law, three broad approaches to the use of finance leases are adopted. One

approach is to give effect to legal form, so that all leases are effectively treated as operating

leases for tax purposes. This means that the lessor would be treated as the owner of the leased

asset and thus the person entitled to claim depreciation and other deductions relating to

ownership. The rental payments are treated as income of the lessor and a deductible expense of

the lessee.

186

The other two methods broadly accord with commercial accounting treatment of finance

leases. In contrast to the strict legal approach, commercial accounting rules recognize the

economic reality of a finance lease by treating it as a sale and purchase of the leased asset. Thus,

the lessee (not the lessor) is treated as the owner of the asset, which is entered into the lessee's

books as an asset of that taxpayer. The lessor is shown for accounting purposes as having made a

loan to the lessee, the rental payments being treated as payments of principal and interest on the

loan.

Treating a finance lease for tax purposes in the same way as other leases gave rise to

arrangements under which such a lease could be used to transfer tax benefits from a person who

could not use them to a taxpayer who could. Consider, for example, a person who wishes to

acquire an item of substantial plant. The person does not have sufficient funds to self-finance the

acquisition and will thus need to borrow. In the ordinary case, the person will be able to deduct

the interest expense and claim depreciation deductions in relation to the cost of the asset.

Suppose, however, that the person is not in a position to use these deductions, or at least not

immediately. The person may not expect to earn enough income for several years to take

advantage of the deductions, so that the benefit of the deductions is deferred. Alternatively, the

person may be a tax-exempt entity, such as a government instrumentality, which cannot utilize

the deductions at all. Another possibility, particularly in developing and transition countries, is

that the person may be entitled to a tax holiday, and so, again, cannot use the deductions. In these

cases, arrangements can be entered into whereby a financier acquires the asset and leases it to the

185

The term finance lease is commonly used in tax literature. Commercial accounting rules use the term capital lease.

186

See Gustav Lindencrona & Stephan Tolstoy, International Fiscal Association General Report, Taxation of Cross

Border Leasing 21, 30 (75a Cahiers de droit fiscal international) (1990).

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person under a finance lease. Because the financier is the legal owner of the asset, it is entitled to

claim deductions related to ownership. The effect of the finance lease is to transfer the tax

benefits associated with ownership to the financier, although, through the terms of the lease, the

economic benefits and obligations are with the lessee. The availability of the tax benefits means

that the financier is able to provide the lessee with a lower cost of funds. The arrangement,

however, is detrimental to the revenue because it results in the full utilization of what would

otherwise be unused tax benefits.

Tax law treatment of finance leases in a manner similar to accounting treatment can be

accomplished in two ways. In some jurisdictions, courts will use general interpretation principles

to read the tax law as giving effect to the underlying economic form of a lease, not its apparent

legal form. In others, the tax law has been drafted to achieve this result explicitly.

187

It is

recommended that this approach be adopted in developing and transition countries.

Tax laws drafted to achieve a result similar to commercial accounting practice should

make it clear that for tax purposes, the arrangement is treated as a sale on credit from the lessor

to the lessee, and so the lessee is treated as the owner of the property and the lessor as a

financier. The deemed purchase price is the present value of the rental payments to be made

under the lease, and the price is treated as financed through a loan from the lessor to the lessee.

Each payment the lessee makes under the lease is treated as a repayment of principal and interest

under the loan. The interest component is calculated according to actuarial methods on the

principal outstanding at the commencement of each payment period, with the balance of the

payment treated as repayment of the principal.

188

The interest component of each payment is

treated as an interest expense of the lessee and interest income of the lessor.

The central issue is the determination of whether a lease is a finance lease. It is suggested

that several alternative tests based on commercial accounting rules be prescribed. The essence of

these tests is to identify cases where economic ownership of an asset effectively passes to the

lessee. Under these tests, a lease will be treated as a finance lease if any of the following

circumstances is present:

 The term of the lease (including any period under an option to renew) is equal

to or greater than 75 percent of the estimated economic life of the leased asset.

 The lease contains an option to purchase the leased asset at end of the lease

for a fixed or determinable price.

 The estimated residual value of the property to the lessor at the end of the

lease term is less than 20 percent of its fair market value at the

commencement of the lease.

187

E.g., CAN Income Tax Regulation 1100(1.1); LSO ITA § 68; UGA ITA § 60.

188

See supra sec. III(A).

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 The present value of minimum

189

lease payments equals or exceeds 90 percent

of the fair market value of the asset at the commencement of the lease term.

 The leased property is custom-made for the lessee and, at the end of the lease

term, will have little or no value to anyone other than the lessee.

C. Capital Gains

While the concepts of capital gains, their historical basis, and the terminology used vary

from jurisdiction to jurisdiction, distinctions between capital gains and other gains are common.

In many countries, capital gains (or certain categories of gains) are treated preferentially for tax

purposes. Preferences may include lower rates, partial or even complete exemptions, averaging,

and inflation adjustment that are not available for other gains.

190

Even when capital gains are fully taxable in the same manner as other income, the

distinction is often retained for the purpose of quarantining capital losses against capital gains.

Quarantining is necessary because capital gains are taxed on a realization basis. In the absence of

quarantining, taxpayers can defer the recognition of gains and accelerate the recognition of losses

to reduce taxes payable on other income.

In some jurisdictions, the concept of a capital gain is legislatively defined, while in others

(for the most part the United Kingdom and former U.K. colonies), it is largely a judicial concept

defined by tests set out in case law. In former U.K. colonies, in particular, great care must be

taken when drafting the definition of capital gains. One problem almost unique to these

jurisdictions arises from the fact that the flexibility of property and contract law enables

taxpayers to engineer many transactions to give rise to gains that would be characterized by the

courts in some of the jurisdictions as capital gains under the governing judicial concepts and

thereby excluded from the ordinary income tax base. Because these gains are not generated by

disposals of property as those are normally understood, they can be brought into capital gains

provisions only with terribly complex deeming provisions. A far simpler approach is to modify

the definition of income to ensure that these gains are included in the tax base.

191

In many jurisdictions, all gains derived from the disposal of assets by legal persons and

from the disposal of business assets are treated as ordinary business income.

192

Under this

189

The term “minimum lease payments” is intended to include regular “rental” payments plus any supplemental

mandatory payments (e.g., the amount of a lessee guarantee of residual value).

190

See generally John King, Taxation of Capital Gains, in Tax Policy Handbook 155 (P. Shome ed. 1995).

191

Australia provides an excellent example of the problems that can be encountered if capital gains provisions are

used to catch gains that fall outside the judicial income tax base, such as payments for

entering into negative

covenant (noncompetition) agreements and payments for agreeing

not to pursue contractual rights. In Australia, this

was first attempted by resort to complex and highly artificial deeming provisions. The courts rejected them as

virtually meaningless. A second, and more complex, redraft was needed. Rather than simply adding these gains to

the ordinary income tax base, the government now proposes to replace the artificial deeming provisions with

legislation defining capital gains "events."

192

Examples include many European jurisdictions.

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approach, capital gains derived in the context of a business are not subject to any preferences that

may be available to individuals deriving capital gains on investment portfolios. Exceptions may

be made for disposals involving the liquidation of the business, which may be taxed

preferentially.

There is a large body of literature debating whether capital gains should be given

preferred treatment or taxed at all, and it does not seem useful to repeat the arguments here. Any

distinction between capital gains and other gains will of course involve definition problems.

Long experience in OECD countries suggests that a completely satisfactory definition cannot be

found. Inevitably, taxpayers alter their behaviour to exploit tax concessions in ways not

originally intended by the legislation. Transactions are altered to recharacterize income not

subject to the concession as gains that do qualify for special treatment. This, in turn, leads to

calls for complex antiavoidance provisions, to considerable litigation, and to significant dead-

weight losses from energies diverted to tax planning.

At the same time, in the context of limited administrative capacity in developing

countries, there are persuasive arguments for excluding from the tax base many types of capital

gains and losses derived by individuals. Because capital gains and losses may accrue over many

years and are generally recognized on a realization basis, taxpayers may not have maintained

adequate records for calculating the amount of the gain or loss. For this reason, and coupled with

notorious difficulties of enforcement, it may be appropriate to exclude from the tax base most

capital gains realized and losses suffered by individuals, apart from gains and losses attributable

to assets, such as shares and other financial investments and immovable property. Other

exclusions are desirable for tax policy reasons. Thus, for example, losses on personal-use assets

such as cars and appliances whose value declines as a result of use should be excluded to ensure

that taxpayers are not able to recognize capital losses on what is essentially personal

consumption.

193

The drafting approach adopted to achieve exclusion of these gains or losses will depend

on the general drafting structure; whether a jurisdiction is based on a schedular or a global

model; whether the background or judicial concept of income would otherwise include these

gains or losses; and, if the jurisdiction uses a global income tax system, whether global taxation

is achieved by means of separate inclusions for employment, business, and investment income. If

the exclusions are to be legislated through a specific exclusion measure, that provision can refer

to all nonbusiness assets owned by physical persons apart from listed assets (which would then

include intangible property and immovable property). An alternative approach is to exclude

personal-use property other than immovable property, with personal-use property defined as

property acquired primarily for the personal use and enjoyment of a physical person or his or her

family.

193

Examples of jurisdictions with exemptions for these assets include Australia and Canada.

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D. Farming Income

It is not unusual for jurisdictions to provide special rules for determining farming income,

because of, in addition to political considerations

• the possibility that farmers will not retain business records in the same format as

other businesses;

• the practical difficulties in auditing farmers;

• the difficulties of valuing farm produce and livestock inventory; and

• the fact that farmers are more likely than other business persons to take items out

of inventory for family consumption.

An important consideration in the design of the farming tax regime will be the

administrative capabilities of tax authorities. In developing countries in particular, surrogate

measures of income using presumptive criteria may be the most efficient method of determining

tax liability,

194

at the potential cost of some equity.

Special rules will also be needed to deal with consumption of a farmer's own produce.

Several competing policies must be considered in this situation. It is arguable on equity and

efficiency grounds that consumption of self-produced inventory should be treated as a disposal at

market value. This policy would achieve equity between taxpayers who sell their produce to

purchase other types of food in the market and those who consume their own produce. It would

also eliminate a distortion in favor of consuming one's own goods as opposed to participating in

the market. At the same time, however, it is true that persons other than farmers are able to

produce foodstuffs for themselves without tax consequences. If the same treatment were

accorded to farmers, it would be necessary to distinguish inventory from production intended for

personal use. Also, it could be argued that farmers, by virtue of their knowledge of the industry,

could purchase produce for a value much lower than the market price faced by other taxpayers.

These problems are most easily resolved by treating consumption of inventory as a

disposal at cost instead of at market value or, equivalently, by disallowing a deduction for the

cost of self-consumed produce.

E Non–Life Insurance Companies

Under a short-term

195

insurance contract, the insured person will pay a premium to the

insurer as consideration for the insurer, upon the happening of a specified event within a given

time, paying to the insured or a nominated person either an agreed sum or the amount of the loss

caused by the event. The period of cover under the insurance contract is usually one year, after

which the insurance contract is simply renewed. Depending on the sophistication of the local

194

See vol. 1, ch. 12.

195

Short-term insurance as used here includes property and casualty insurance and term life insurance, provided the

term of insurance is not beyond one year or so. Life insurance with longer terms raises other issues that are beyond

the scope of this book.

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non–life insurance market, insurable risks may be limited to loss of property or may extend to

virtually any risk other than loss of life.

The taxable income arising from short-term insurance activities is generally calculated in

the same way as the taxable income arising from other business activities, with premiums

derived included in gross income and claims incurred allowed as a deduction. However, three

features of short-term insurance activities may justify special tax treatment. These are discussed

below.

1. Income-Recognition Rules

Income-recognition rules must take into account that some part of the premiums received

during a tax period will cover risks for a period after the end of that year (referred to as

“unexpired risks”). This is because, in many cases, the period of the insurance policy will not

coincide with the insurance company’s tax year. The accounting practice is for insurance

companies to treat a portion of their short-term insurance premium income received during a

year as relating to unexpired risks as of the end of the year. This amount is not regarded as

having been earned until the following year and, therefore, is excluded from their income for that

year and included in income in the following year. A similar approach may apply for tax

purposes. This may be an aspect of the accrual tax accounting rules,

196

or a specific deductible

allowance may be provided for premiums in respect of unexpired risks (with a re-inclusion rule

for the following year).

197

2. Deduction-Recognition Rules

On the expense side, deduction-recognition rules must take into account the three types of

claims that may arise during a tax year for a company carrying on a short-term insurance

business. The first type of claim is one that arises and is paid out during the tax year. This is

allowed as a deductible expenditure of the company. The second type of claim is one that arises

during the year, but that has not been paid out as of the end of the tax year. This type of claim is

also allowed as a deduction under accrual tax accounting on the basis that the obligation to pay

has arisen during the tax year. The amount of deduction is based on established insurance

practice for assessing the likely amount payable on a claim. The third type of claim is one that is

unreported as of the end of the tax year; it relates to an event that has occurred during the tax

year but that has not been reported to the insurance company, either because a third party has not

made a claim against the insured or because the insured has not reported the claim or the

happening of the event. This type of claim may also be allowed as a deduction under accrual tax

accounting on the basis that the happening of the event crystallizes the liability of the insurance

company to pay, even though the claim has not yet been reported to the company.

3. Contingency Reserves

196

Premiums paid in respect of unexpired risks may be treated as unearned income.

197

E.g., UGA ITA § 17 and fourth sched.; ZAF ITA § 28(2); ZMB ITA §25 and third schedule.

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For financial accounting purposes, companies carrying on short-term insurance retain a

contingency reserve to meet the exceptional level of claims that may arise from a catastrophe. It

is not recommended that a deduction for tax purposes be allowed on the basis of the creation of a

contingency reserve for financial accounts purposes. As noted in section II(B)(1), reserves are

used in financial accounting to provide an accurate picture of the long-term profitability of a

business. Tax accounting, on the other hand, is concerned with the accurate measurement of net

gains on an annual basis. The establishment of a contingency reserve does not represent a

sufficiently certain liability to be recognized for income tax purposes.

VII. Administrative Aspects of Taxing Business

and Investment Income

Taxes imposed on income from business are normally self-assessed,

198

which imposes on

the taxpayer, in the first instance, responsibility for calculating taxable income and the tax due on

that income and for making installment payments at designated times. The taxpayer's

calculations are reviewed by revenue officials when returns are filed and may be subject to

further audit. The self-assessment system may be supplemented by a withholding system

applicable to certain business payments. The withholding system is discussed further below.

A. Advance Payments of Tax

The most crucial element of the system for collecting business tax is the formula for

determining installment payments. The object of the system is to require businesses to pay tax on

a regular basis throughout the year as income is derived, not when final liability is determined

after the end of the tax year. This formula ensures revenue flow to tax authorities, prevents

deferral of tax payment, and minimizes the risk of disbursement of income before the appropriate

proportion is remitted as payment of a tax liability. Related issues are mechanisms for adjusting

payments if the taxpayer's business income changes during the year and reconciliation of

installment payments with the final tax liability.

The frequency with which installments of business income tax must be made varies

significantly among countries. In many jurisdictions, different frequencies are used for different

types of businesses (unincorporated or incorporated) or different sizes of businesses (based on

taxable income or turnover). The use of variable installment payment frequencies has two

objectives: (1) to minimize administrative costs for smaller businesses; and (2) to reduce

financing charges for smaller businesses that face a number of biases in the capital market and,

accordingly, tend to place greater reliance on cash flow to fund ongoing operations. In light of

these objectives, a frequency distinction based on the size of a business is more logical than one

based on legal form. However, rules based on size may be manipulated by taxpayers

establishing multiple companies. This practice may be combatted through consolidation rules,

but this tends to add complexity to the system. An alternative approach is to base payment

schedules on a combination of business size and form. The simplest approach is to use the same

198

In other words, the taxpayer determines (assesses) the amount of tax due and files (lodges) the tax return.

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rule as that used to determine when businesses are required to use accrual accounting, or to use

the same form of rule with a different threshold.

There are four basic models for the formula used to determine business tax installments.

Two systems rely on the previous year's taxable income as the basis for estimating the taxable

income of the current year, and two use data from the current year to estimate total taxable

income for the year.

The simplest system is based on the previous year's taxable income, divided by the

number of installments. (Alternatively, the formula can be based on the previous year's tax

liability, adjusted, if necessary, by any change in tax rates.) A slightly more sophisticated system

is one based on the previous year's taxable income (or tax liability), adjusted by an "uplift" factor

that is based on the actual or projected inflation rate or on a measurement of expected growth in

nominal incomes generally.

199

The simplest system relying on current-year data is based on records of turnover for the

installment period. The turnover for the period is multiplied by the ratio of the previous year's

taxable income to turnover for that year to estimate the probable taxable income that will ensue

from the known turnover for the current year. A more sophisticated system draws on an estimate

of actual taxable income for the year based on income derived and expenses incurred in the year

until the end of the installment period.

Systems for determining installments on the basis of the current year's income provide a

more accurate calculation of a taxpayer's probable total liability for the year and the appropriate

installment payments to be made. However, the potential administrative burden they impose on

taxpayers is considerably greater than for systems based on the previous year's income. Also,

these systems, particularly ones based on a running determination of taxable income for the year,

are possible only if taxpayers have access to relatively sophisticated accounting and tax

expertise. Accordingly, a system based on actual income for the year is more easily applied in

industrial countries than in developing or transition economies. Nevertheless, a number of

transition countries require payment of tax according to results for the current period.

200

Systems based on income of the current year are self-adjusting in terms of changes in

business fortunes. If the taxpayer uses prior-year information to calculate liability for current-

year installments, some adjustment mechanism is needed if the taxpayer's taxable income for the

year is likely to differ significantly from the estimated income on which installments are based.

To protect taxpayers from undue hardship in the event of falling business income, the taxpayer

should have the option of nominating an expected taxable income that is lower than that yielded

by the presumptive formula or of altering the estimate downward if circumstances make this

appropriate during the year. Rigorous interest and penalty measures will discourage taxpayers

from deliberately nominating lower-than-expected incomes to reduce installment payments and

thereby deferring payment of some tax until a final reconciliation payment at the end of the year.

199

The uplift system is used, for example, in Australia for individuals deriving business and investment income.

200

See KAZ TC § 51.

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These measures should impose a charge significantly higher than the prevailing interest rate to

ensure that taxpayers do not use underestimation as a means of securing finance (in effect

"borrowing" tax due until the close of the year). Countries with serious tax collection problems

may not want to provide any option for taxpayers to reduce required installments, if there is a

concern that any reasonable penalty would be ineffective in deterring abuse of such an option.

While most installment systems that are based on taxable income of the previous year

provide taxpayers with the option of substituting a lower estimate of expected income, it is not

usual to require taxpayers to uplift their estimates if financial information during the year

indicates that income will be greater than that yielded by the presumptive formula.

201

Not

requiring taxpayers to uplift provides taxpayers with a deferral advantage in times of increasing

income. To avoid the problem, taxpayers can be required to use an installment calculation system

based on current-year information, such as turnover.

One particular problem with both systems is that of taxpayers commencing business. In

the absence of any special provisions, these systems allow such taxpayers to defer tax on the

income derived in the first year until the end of that year. Because it is common to allow

taxpayers to substitute lower estimates when they believe income is falling, taxpayers leaving

business suffer no corresponding overpayment of taxes when closing business operations.

Although the deferral by taxpayers commencing business undermines the installment system,

most jurisdictions that rely on a formula of installment payments that is based on statistics from

previous years do not make any effort to address the problem. Because taxpayers commencing

businesses are not likely to earn substantial profits in the first year, the approach of not providing

a special rule for these taxpayers is justifiable. However, the absence of a special rule may

provide significant windfall benefits to some categories of taxpayers, such as lawyers or

accountants, who are invited to join the firm as full partners (and hence become business

proprietors). It also opens a potential door to abuse if business owners move the business

operations to a new company on a regular basis (or even annually) to defer payment of tax.

However, this is not likely to emerge as a serious problem until an economy is fairly advanced.

B. Withholding

A domestic withholding system can be applied to payments made to some self-employed

persons, although it is not administratively possible to apply such withholding taxes to all

payments made to those persons. For example, given that the tax is withheld by the payer of the

income, it is not feasible to apply the tax to all payments to a self-employed person with a large

number of small-value customers, particularly nonbusiness (i.e., final-consumer) customers.

Even if such customers complied with their obligations to withhold the tax and remit it to

revenue authorities, matching the large number of small withholdings to particular taxpayers

would be an extremely onerous task for the administration. Withholding tax on self-employed

persons, therefore, is usually confined to those industries with a small number of business

customers. Even then, there is generally a value threshold before withholding applies and,

201

Provisions for uplift estimates need not be explicit. The United States imposes an implicit requirement by levying

additional tax on large corporate taxpayers whose estimated tax payments are less than actual tax. See USA IRC §

6655(d)(2).

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possibly, an exclusion for contracts with nonbusiness consumers. The most common industries to

which withholding tax applies are construction and transportation.

202

An exception may be

provided for taxpayers with a satisfactory compliance record. Consolidation measures may be

needed to prevent taxpayers from splitting contracts into multiple contracts, each generating

payments below the withholding threshold.

203

Withholding on payments to self-employed persons is generally at a flat rate applied

against the gross amount of the payment. Because the rate is applied against gross income, some

amount of deductions is notionally taken into account in determining the rate. This is important

because taxpayers in the industries to which such withholding applies are likely to claim

substantial deductions for the cost of inputs. If the rate of withholding on gross receipts is set too

high, then the withholding tax may ultimately exceed the taxpayer's chargeable income for the

year of assessment, causing serious cash- flow problems for the taxpayer.

Withholding on income derived by self-employed persons who are resident taxpayers

will generally not be a final tax. A taxpayer will be required to file a return showing taxable

income for the tax year and tax payable thereon, and a tax offset will be given for the

withholding tax.

C. Withholding on Income from Capital

Final withholding taxes on gross income are the usual method for assessing nonresidents

on income from capital. A final withholding tax means the recipient is not required to file a

return or face additional assessment in the source jurisdiction with respect to income subject to

the tax. The recipient may be subject to additional tax in the recipient's country of residence. In

most countries, final withholding taxes are imposed on interest and dividends paid to

nonresidents. They are often extended to royalties and less commonly to rental income paid to

nonresidents

204

and to distributions from trusts.

205

The use of final withholding taxes on income from capital paid to resident taxpayers is a

growing phenomenon, but the practice is far less common than for nonresidents. Reluctance to

use final withholding taxes for resident taxpayers primarily stems from equity concerns. The use

of any flat rate will prejudice taxpayers whose incomes would be subject to lower rates if the

ordinary rate structure were applied and will provide a windfall to taxpayers whose incomes

would otherwise be subject to higher rates.

The widespread use of final withholding taxes on different categories of income

effectively creates a schedular system with what are, in effect, separate taxes on different

202

E.g., AUS ITAA (1936) §§ 221YHA–221YHZ.

203

See, e.g., Regulations for the Implementation of the Individual Income Tax Law § 21 (State Council, People’s

Republic of China, Jan. 28, 1994) (consolidation of payments).

204

See, e.g., CAN ITA §§ 212(1)(d), 215(1).

205

See, e.g., CAN ITA § 212(1)(c).

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categories of income. The system may, in fact, become a hybrid system with flat-rate taxes on

some categories of income and progressive rates on others. In theory, the system may be

designed so as to minimize the loss of progressivity by applying withholding taxes as a final tax

only if the taxpayer's income is primarily of the category subject to progressive rates (and

therefore not subject to final withholding taxes)

206

In practice, however, such a system would be

difficult to implement.

There is no doubt that final withholding taxes on income from capital are preferable from

the perspective of administrative simplicity. As was noted in chapter 14,

207

flat-rate withholding

taxes on income from capital may not undermine progressivity as much as feared. The important

point is that, if income from capital is segregated in this manner, taxpayers are unable to

minimize tax by mismatching gains and losses and exploiting inconsistencies in timing or

treatment of different types of expenses and gains. In fact, some studies from Scandinavia hold

that the movement toward "dual income taxes" (i.e., flat-rate taxes on some types of income from

capital and progressive rates on other income) may actually increase progressivity by precluding

taxpayers from exploiting arrangements to minimize their tax in these ways.

The choice between separate withholding taxes or ordinary assessment for income from

capital will depend on a range of political and administrative considerations. Essential to the

effective functioning of either system is a high-integrity taxpayer identification number (TIN)

system. This is important for an ordinary assessment system for auditing purposes. The TIN

system serves several different functions if withholding taxes are used. One purpose is to

facilitate auditing. While tax authorities may no longer be concerned with attributing income

from capital to the correct taxpayer if final withholding taxes are used, they will be interested in

comparing income from capital with other income sources to ascertain whether the taxpayer

declared enough income to explain the investments now generating investment income.

A second purpose of TINs in a system that uses withholding taxes is to give taxpayers the

option of filing in appropriate cases. While optional filing complicates the administration of the

withholding tax, it can be used to protect the interests of lower-income taxpayers who are subject

to ordinary assessment tax rates that are less than the withholding tax rates. It can also be used to

protect taxpayers who incur significant expenses to derive their income from capital. This may

be the case with, for example, taxpayers deriving rental income.

An alternative to optional filing sometimes mooted to protect lower-income taxpayers

from the impact of withholding taxes that are higher than their marginal tax rate is a limited

exemption from withholding. The exemption is usually suggested for interest on accounts in

financial institutions up to a designated amount. However, because it is impossible for financial

institutions to know of other accounts that depositors may hold, higher-income taxpayers are

likely to exploit the exemptions by opening multiple accounts. A high-integrity system of

206

See, e.g., Charles McLure & Santiago Pardo, Improving the Administration of the Colombian Income Tax, 1986-

88, in Improving Tax Administration in Developing Countries 124, 126–27 (Richard Bird & Milka Casanegra eds.

1992).

207

See footnote 28 and accompanying text in that chapter.

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taxpayer identification numbers will enable tax authorities to identify these cases, but a very

sophisticated system for cross-referencing data is required. Also, additional tax can be collected

only by means of an assessment levied on appropriate taxpayers. The use of mandatory

withholding tax coupled with optional filing by lower-income persons is administratively

simpler, because it transfers the onus for further action to the taxpayer. Such a system would not

be desirable, however, if a large number of additional returns had to be filed. Either system can

be used to identify taxpayers who may be involved in shifting arrangements. Appropriate targets

for antishifting audits can be identified by comparing claims for lower or zero tax rates with

returns of spouses and other family members.

Optional filing for income from capital raises a number of issues. First, it must be

decided whether optional filers can elect to have a lower or zero withholding tax imposed or

whether they are subject to the withholding tax, with the two being reconciled after the tax year

when a return is filed. In that case, a refund of excess withholding tax may be made. Allowing

taxpayers to seek a lower or zero withholding tax rate by submitting an appropriate form to

income payers ensures that there is no overpayment of tax during the year. However, such

taxpayers would have to be required to file returns at the end of the year to ensure that they are

entitled to the lower rates or exemptions they claim. This further filing imposes some burden on

taxpayers and an additional administrative burden on income payers, who must provide revenue

authorities with details of all cases in which taxpayers seek lower withholding rates or

exemptions. It also imposes further administrative burdens on tax authorities, who must cross-

check with individual returns those cases of lower or zero withholding rates in order to ensure

that taxpayers are entitled to the benefits they claim. Measures are needed to discourage

taxpayers from deliberately or inadvertently claiming entitlement to lower or zero withholding

tax rates. These include interest payable on the deferred payment of tax and penalties depending

on the culpability of the taxpayer. Finally, if the choice is between an exemption from

withholding and full withholding, taxpayers subject to tax rates even only slightly below the

withholding rate would enjoy a significant deferral on their tax liability.

If taxpayers are not given the option of seeking lower or zero withholding rates subject to

reconciliation when a return is filed, it must be decided whether refunds of withholding tax

should be accompanied by compensation for the use of the taxpayer's funds prior to the refund.

Compensation in the form of interest imposes additional administrative burdens on tax

authorities, but promotes equity. Only a limited number of persons are likely to file returns to

obtain refunds.

If the system of mandatory withholding tax subject to reconciliation when a return is filed

is adopted, an exception should be made for exempt taxpayers, who should be able to claim an

exemption in any case. Also, the final withholding tax should not be used for interest paid to

financial institutions, because these taxpayers will incur significant expenses to derive interest

income and their net margin on interest payments will be much smaller than the gross payment.

It is not necessary to choose between a final withholding tax and a withholding tax

subject to reconciliation for all classes of income from capital. For example, a final withholding

tax can be imposed on interest income and dividends, while taxpayers subject to a withholding

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tax on rent can be allowed to file a return and seek reconciliation if withholding tax rates are

higher than the taxpayers' personal rates.

The taxation of income from royalties is complicated because royalties encompasses

several conceptually different types of payments, which are classified differently by different

countries.

208

The categorization is important, not so much for the definition of income as for the

deduction of losses and expenses. The extent to which taxpayers incur expenses to derive royalty

income will vary significantly depending on the type of royalty. Depending on the structure of

the tax system and the characterization of royalty income, taxpayers may be entitled to

deductions for itemized expenses, a standard deduction, or no deduction at all. This treatment

will in turn determine whether a withholding tax can be applied to some or all types of royalties.

If royalties are assessed under a schedular tax system or are subject to a final withholding

tax, there is a good case for an effective tax burden in line with the maximum tax rate in the

personal income tax and the normal rate of corporate income tax. Any substantial discrepancy

between the tax rate for royalties and the rates for other income will cause taxpayers to

recharacterize payments as royalties, or as something other than royalties, depending on which

alternative leads to the lowest tax burden. Also, any preferential treatment or rates for royalties

will encourage multinational businesses to withdraw profits in the form of royalties rather than as

dividends or interest.

208

See supra sec. III(C).

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Appendix.Relation Between Tax and Financial Accounting Rules

A. Introduction

Commercial companies keep accounts for the information of their owners and creditors.

These reflect the assets and liabilities of the company on a balance sheet as well as the profits for

the preceding year. The relevance of a company’s profits for commercial accounting purposes

and for tax purposes is broadly similar. For purposes of the income tax, profits are considered to

constitute taxable capacity. Profit is, of course, an imprecise concept. It is a temporal concept,

requiring measurement against a defined period of time. Although the basic purpose of

measuring profit is shared by commercial accounting practices and by the tax rules, the purposes

of tax and financial accounting are not exactly the same. Because of these differences in purpose,

and in the light of different legal and commercial traditions, different countries have developed

different systems for relating the tax rules and the commercial accounting rules.

209

How they do

this is a critical issue for the drafting of the rules for determining business income. At one

extreme, business income can be measured according to an entirely self-contained set of rules

that are included in the income tax law and regulations. At the other extreme, the income tax law

can state simply that income for tax purposes is the same as income as determined under the

rules for commercial accounting. As we shall see, in practice most countries adopt a combination

of rules.

B. Evolution of Commercial Accounting Rules

In the two centuries since joint-stock companies came to be widely used, pressures have

been applied to define how business profits are identified. Membership of businesses has been

drawn more widely, and members now require formal checks on the accounts of their businesses.

External controls have been imposed, usually by legislation, and include independent audits.

Further, many members of a business are portfolio investors, requiring—as do the markets—

greater transparency of performance of a business. These accounting regulations have not been

applied universally: smaller corporate businesses and noncorporate businesses are often

exempted wholly or partly from these obligations.

The original lack of a required form of accounting has been replaced in all OECD

countries by a combination of law and accounting practice designed to produce some consistency

and objectivity in the presentation of company accounts. There are, however, distinct national

differences both in the rules and principles adopted and in the legal or professional forms that

those rules and principles have taken. The tendency in civil law countries has been to adopt rules

within the commercial code or a law on accounting. By contrast, in common law countries, much

of the content of accounting rules has been left for professional bodies or expert committees to

produce.

209

See generally Commission of the European Communities, Report of the Committee of Independent Experts on

Company Taxation 50–51, 195 (1992); Guido de Bont et al., Fiscal Versus Commercial Profit Accounting in the

Netherlands, France, and Germany (1996).

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Accounting laws and practices are being coordinated at regional and international levels,

as well as being imposed more strictly at the national level. A comparative discussion of the

effectiveness of accounting standards for tax purposes may start with an examination of the

International Accounting Standards (IAS), produced since 1973 by the International Accounting

Standards Committee, an autonomous body, but associated with the International Federation of

Accountants (IFAC), a nongovernment body of professional accountants. Some thirty standards

have been issued—a mixture of general principles (e.g., prudence, substance over form, and

materiality)

210

and specific rules (such as the information to be disclosed in financial

statements).

211

Within Europe, the countries of the European Union apply a series of company directives

that require set principles and formats for company accounts.

212

Some officials of the European

Commission attempted to adapt some of these rules into a format to provide a common definition

of the tax base for income tax, but the attempt failed even to secure support within the

Commission and was never officially published.

Progress has been made in recent years, but accounting norms are inconsistent,

incomplete, and evolving. It is too early to expect a common definition of profit at the

international level, although one is starting to emerge. But for public companies in states with

developed capital markets, there are standard formats, principles, and rules for presenting

accounts. The growing internationalization of business reinforces this trend.

C. Current Practice

1. Overview

Some states base their determination of the taxable capacity of companies on the

commercial accounts of those companies. In these states, the precise form of company accounts

is typically laid down in the commercial code. Subject to some specific exceptions in both tax

legislation and jurisprudence, compliance with the commercial law also amounts to compliance

with the tax laws, and tax is levied accordingly. The profit that the company declares to the

market is closely related to the profit on which it is taxed (although, in practice, the extent of the

profit declared to the market may be driven by tax considerations).

Other countries have a tax definition of profits that may be markedly different from the

company's own view of its profitability for the purposes of payments of dividends and

publication to the market. Historically, these countries have taken a more relaxed view to the

detailed form of company accounts for general legal purposes, but have imposed rules requiring

specific accounting treatment of both additions and diminutions to wealth for tax purposes only.

With limited exceptions, what a company does for accounting purposes is totally irrelevant to its

income tax position. As a consequence, the income tax law and regulations must govern in detail

210

IAS 1.

211

IAS 5.

212

See particularly the Fourth Company Directive—78/660/EEC, and the Seventh —83/319/EEC.

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the methods of accounting for all the elements that enter into the determination of taxable

income.

To clarify the matter, we will review the rules applicable in Canada, France, Germany,

the United States, and several transition countries. The topic is a complex one, and the reader

should be warned that the discussion below does not capture all the subtleties of each system,

which would require a much more in-depth examination.

2. Germany

In Germany, the Commercial Code provides that companies of a specific size are

required to keep double-entry books.

213

Fairly detailed rules are provided for how these accounts

are to be kept. If an issue is not specifically governed by a written rule, it is to be resolved

according to principles of orderly bookkeeping.

214

For tax purposes, determination of taxable

income starts with the accounting balance sheet. Specifically, taxable income is determined

under the net worth comparison method.

215

The net worth method uses the net worth (assets

minus liabilities) in the opening and closing balance sheets for the taxable year.

The basic idea of the net worth method is that taxable income is the difference between

closing net worth and opening net worth. It is also, however, necessary to subtract those items

that increase closing net worth but that should not be included in taxable income (e.g., tax-

exempt receipts and contributions to capital) and to add items that decrease closing net worth but

that should not be deductible in determining taxable income (e.g., dividends).

213

The discussion in this section is based on Brigitte Knobbe-Keuk, Bilanz- und Unternehmenssteuerrecht (9th ed.

1993).

214

Handelsrechtliche Grundsätze ordnungsmäßiger Buchführung (GoB).

215

See vol. 1, ch. 13, for further discussion of the net worth method. The net worth method is set forth clearly in the

income tax laws of France and Germany. See FRA CGI § 38; DEU EStG § 4. Under certain circumstances, certain

types of income are determined as the difference between income and expenses, instead of being determined by the

net worth method. Those familiar with the Haig-Simons concept of income, which also uses a net worth concept,

may misunderstand what the net worth method involves. Unlike the Haig-Simons concept, the net worth method

generally does not involve mark-to-market taxation, because it uses the book value, rather than the fair market value,

of assets on the balance sheet in determining net worth (except in cases where book value is determined according to

fair market value).

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Accordingly, taxable profit for the year is

(i) the amount of net worth reflected in the closing balance sheet, less

(ii) the amount of net worth reflected in the opening balance sheet, less

(iii) contributions to capital and other receipts that are not taxable, plus

(iv) withdrawals made in favor of the owners and expenses that are not deductible.

There are two questions for each item of the balance sheet: (1) should the item be

included as an asset (or liability) and (2) if so, how should it be valued? As to both issues, the

general rule is that for tax purposes the treatment in the accounting balance sheet applies unless

there is a specific rule to the contrary in the tax law. In some cases, the taxpayer has a choice

under the accounting rules as to how to treat an item. In these cases, having made an election for

accounting purposes, the taxpayer is bound to follow the same treatment for tax purposes. Once

the return has been filed, changes to the accounting treatment are permitted only under limited

circumstances. If the treatment of an item on the balance sheet is contrary to the accounting

rules, then the taxpayer may make the correction. If the treatment results from an option under

the accounting rules, the taxpayer may change the treatment for tax and accounting purposes

only with the consent of the tax authorities. Even if the tax law specifically authorizes a

favourable treatment of an item, it has been provided that the treatment is not available unless the

same treatment is applied for commercial accounting purposes.

In a number of specific cases, however, the tax law specifies that the treatment of an item

for tax purposes differs from that applicable for accounting purposes. These concern particularly

the allowance of deductions. The tax law also contains relatively extensive rules for valuation of

property, which apply instead of the accounting norms.

The consequence of this legal structure is that, in the absence of a specific rule in the tax

law, the treatment of an item for income tax purposes is governed by the rules in the commercial

code. If this does not contain a specific rule, then the "principles of orderly bookkeeping" apply.

It is the principles of accounting practice, rather than specific tax principles, that are consulted in

disputes about determining taxable income.

3. France

France also uses the net worth comparison method of determining taxable business

income for companies keeping double-entry books.

216

Although tax accounting follows

commercial accounting, the application of this principle has been somewhat different from that

in Germany. This results from the fact that in France the commercial accounting rules were not

codified in the commercial code until relatively recently (1983). Thus, while there was a doctrine

that tax and commercial accounting should be the same, absent express provision to the contrary

216

The discussion in this section is based on Mémento Pratique Francis Lefebvre Comptable 1991, at 28–30 (1990).

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Chapter 16, Taxation of Income from Business and Investment

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in the tax laws, in practice it was left to the tax laws and to courts interpreting the tax laws to

develop accounting principles. Thus, for example, the principle of créances acquises et dettes

certaines (accrued receivables and fixed liabilities)

217

was developed as an interpretation of the

tax law to govern the timing of accrual.

Now that fairly detailed accounting rules have been codified in the commercial code,

France is in approximately the same position as Germany. Future questions about tax accounting

will presumably be handled with reference to the rules of commercial accounting. Of course, if

the legislature does not like court decisions applying those rules for tax purposes, it is always

free to provide specific contrary rules that will apply for tax purposes.

4. United States

The United States represents an example of the opposite extreme from France and

Germany. The tax laws of the United States contain no general principle relating commercial

accounting and tax accounting. This means that all of the principles of tax accounting must be

contained in the Internal Revenue Code and regulations (or must be derived by courts from

interpretation of this legislation). There is a separate concept of tax accounting, which is similar

to commercial accounting in that it follows the principle of continuity: the taxpayer cannot

generally change the method of accounting without the permission of the Internal Revenue

Service. In a few special instances, tax provisions have been made applicable on condition that

the taxpayer follow the same method of accounting for commercial accounting purposes (e.g.,

LIFO).

218

And the minimum tax has been based on income as determined for financial

accounting.

219

But apart from these special provisions, tax rules are independent.

5. Canada

In Canada, the definition of taxable income by reference to generally accepted accounting

principles was proposed but rejected in 1947.

220

Despite the failure to enact this language, the

concept of generally accepted accounting principles has been important in the interpretation of

217

This is approximately equivalent to the "all events" test for accrual accounting in the United States. See Treas.

Reg. § 1.446-1(c)(1)(ii) (“Generally, under an accrual method, income is to be included for the taxable year when

all the events have occurred that fix the right to receive the income and the amount of the income can be determined

with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken into account for

Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the

liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has

occurred with respect to the liability”).

218

See USA IRC § 472(c).

219

See Tax Reform Act of 1986, P.L. 99-514, 100 Stat. 2085, 2326, sec. 701 (1986). The relevant provisions,

codified at IRC § 56(f), were subsequently repealed.

220

See Brian Arnold et al., Canadian Income Tax 290 (19th ed. 1993).

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the income tax law.

221

This means that while there is not strict conformity between commercial

and tax accounting, there should in practice be a fairly close correlation between the two.

6. Transition Countries

Countries in transition have had to address the relation between tax and commercial

accounting rules at a time when both are at an early stage of development. A number of countries

have followed the French/German approach. For example, in the Czech Republic, Latvia, the

Slovak Republic, and Slovenia, the law explicitly refers to commercial accounting as the basis

for tax accounting absent specific provisions to the contrary in the tax law.

222

In Estonia, the

statute says nothing about conformity between financial and tax accounting and delegates to the

Minister of Finance the specification of the accounting rules.

223

However, the regulations issued

under this authority call for income measurement according to the accounting norms, unless

otherwise specified by the tax law.

224

The techniques for linking the definition of taxable income to accounting differ

depending on the form of the definition. If taxable income is defined on the basis of net worth

comparison, there is a reference to the balance sheet in the definition of taxable income, which

can be interpreted without further specification as referring to the accounting balance. In

countries where taxable income is defined as the difference between receipts subject to tax and

deductible expenses, the usual practice is to state that taxable income is the same as commercial

accounting income, with the modifications stated in the tax law.

In Russia, Kazakhstan, and other countries whose tax legislation is influenced by the

Russian legislation, the traditional approach has been for the same set of accounting rules to

apply for all purposes, including taxation. Thus, under the system that applied in the former

Soviet Union, the question of the relation between tax accounting and financial accounting could

not even be raised, because there was simply one accounting system. The system was spelled

out in detail, leaving little or no room for independent judgment by accountants. When new tax

laws were adopted at the time of the splitup of the Soviet Union—and because these were

modified thereafter—the tax laws often did contain accounting rules (referring to income being

determined as the difference between taxable receipts and deductible expenses), which on their

face appeared to make the tax laws independent of the financial accounting norms. However, the

new tax rules were by and large interpreted in the light of prior practice, that is, as requiring the

accounting norms to be applied for tax purposes. At the same time, financial accounting was

undergoing often radical reform to bring it into line with international practice. This reform has

proceeded at quite different paces in different countries that were formerly part of the Soviet

Union. At the time of writing, there is accordingly some uncertainty as to the current or

221

See Brian Arnold, Canada, 10 Tax Notes Int’l 1533 (May 1, 1995); Brian Arnold, Supreme Court of Canada

Discusses Financial, Tax Accounting, 16 Tax Notes Int’l 730 (March 9, 1998).

222

See CZE ITA § 23(2); SVK ITA § 23(2); LVA EIT § 14; SVN PT § 9.

223

See EST IT § 37(1).

224

Instructions on the Payment to the Budget of Income Tax on Enterprises, § 5.1.

Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)

Chapter 16, Taxation of Income from Business and Investment

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prospective relationship between tax and financial accounting in these countries. The situation is

quite difficult during the transition; in some cases, tax laws have been reformed in advance of

accounting reform, so that it is difficult for tax law to refer to accounting practice, which is not

fully developed or appropriate for the new tax legislation.

225

Some advisors would in any event

prefer to separate tax from accounting. Once accounting reform has been undertaken and

accountants have been trained in the new methods, it will be easier to specify a more permanent

relationship between tax and financial accounting.

D. Choice Among Different Approaches

As the above review suggests, the relationship between tax and accounting norms differs

substantially from one country to the next. It cannot be said that there is one right or best practice

for a particular country. The general approach to be pursued in a particular country will be

heavily influenced by tradition, and it is usually best to respect the practice with which tax

officials and accountants are familiar rather than trying to impose something different because it

follows the personal preference of a foreign advisor. Moreover, the state of development of

accounting practice is relevant in deciding the extent to which it makes sense to rely on

commercial accounting rather than on autonomous tax rules. Within each country's paradigm,

however, it is possible to make a number of adjustments so as to assure a solid revenue base. For

example, in countries that will be starting with accounting profit, it is important to limit the

reserves that are deductible for tax purposes. A number of transition countries have adopted the

effective approach of not allowing deductions for reserves unless they are specifically

enumerated in the tax law.

226

The reserves allowed can then be limited to those for bad debts

(perhaps only for banks) and those for insurance companies. Even these reserves should be

carefully circumscribed, but the issues required to do so are beyond the scope of this book.

In addition, in a system that relies generally on the accounting norms, it is possible to

provide for any number of deviations from those norms when considered appropriate for tax

purposes, although administrative convenience should be taken into account. For example,

different rules can be provided for depreciation. To the extent possible, tax and accounting

calculations should be on the same basis so as to reduce unnecessary paperwork. In the case of

depreciation, accounting norms may provide a number of options to the taxpayer. However, from

the point of view of tax policy, it is generally considered preferable to have a single set of rules

that apply to all taxpayers. Therefore, it may in any event be impossible to achieve total

conformity between tax and accounting norms in this regard.

225

This is why the tax codes of Georgia and Kazakhstan, and the enterprise profit tax law of Ukraine, do not refer to

accounting norms (unlike the Latvian law, accounting reform in that country having proceeded at a much more rapid

pace).

226

See ROM PT § 4(3); LVA EIT § 6(3); GEO TC § 52(2); KAZ TC § 18(2).