International Accounting Standards (IAS) and a consolidated tax base by ijk77032

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									                  EUROPEAN COMMISSION
                  DIRECTORATE-GENERAL
                  TAXATION AND CUSTOMS UNION
                  TAX POLICY
                  Co-ordination of tax matters




                     Consultation Document
  The application of International Accounting
Standards (IAS) in 2005 and the implications for
 the introduction of a consolidated tax base for
         companies’ EU-wide activities.
                                   February 2003



                                        Note
This paper is intended for consultation of all interested parties on the application
of International Accounting Standards (IAS) in 2005 and the implications for the
introduction of a consolidated tax base for companies’ EU-wide activities.
The sole purpose of consulting the public on this issue is to provide input to the
discussion, gather relevant feedback and assist the Commission services in
developing their thinking on the subject.
This document does not necessarily reflect the views of the Commission of the
European Communities, nor does it signify that the Commission is committed to
any official initiative in this area.

Comments are invited on the document by 4 April 2003.
Please write to:

     Mr TC Neale
     European Commission
     DG Taxation and Customs Union
     Office: MO 59 6/12
     B-1049 Brussels, Belgium

     E-mail: taxud-company-taxation@cec.eu.int

     Tel.: +32-2-295 4705
     Fax: +32-2-295 6377
                                 Contents

Summary

1 Introduction

2 Background Issues

     2.1    European Tax Conference Results

     2.2    What are IAS

     2.3    Community Regulation

     2.4    Current practice in Member States

     2.5    Application of IAS

     2.6    General Principles of IAS

     2.7    Individual IAS

3 Possibilities, conclusions, and questions

     3.1    The source of IAS and taxation legislation

     3.2    The underlying principles

     3.3    The number of companies involved

     3.4    The method of consolidation

     3.5    Issues of dependency

     3.6    Regulations and Recommendations

     3.7    Other possibilities:        Societas Europaea

     Appendices I, II, III, IV




                                    2
                                     Summary
This paper examines the possibilities which the introduction of IAS as a common set
of accounting standards in the EU might afford for the establishment of a common
consolidated tax base. It explains the background to the Commission’s interest and
examines the general principles of IAS and identifies some of the more important
issues arising in individual IAS. It is clear that IAS accounts would represent at the
most a starting point for arriving at a tax base and not the tax base itself. Given the
scale of adjustments which would be required it is questionable whether or not using
IAS accounts as a starting point would be the most efficient way forward to
establishing a common tax base.

In order to clarify some of these doubts a number of specific questions are raised for
comment although views on any other points of interest are welcome. The specific
questions are as follows -

Concerning the ‘legislative’ framework for the preparation of IAS -

The current endorsement procedure of IAS provides Member States with the
necessary level of ‘control’ over accounting standards in the EU. Could it be
extended or supplemented to provide sufficient taxation input for IAS to form
the starting point for the tax base? (section 3.1)

Concerning the general principles which underpin IAS –

Are IAS too ‘investor orientated’ for the tax administration to use them as the
primary source for determining the taxable base? To what extent do the IAS
principles of materiality, fair value and ‘substance over form’ conflict with
taxation principles? Could any conflict be resolved by the provision of
supplementary supporting schedules provided specifically for taxation purposes?
(section 3.2)

Concerning the number of companies likely to adopt IAS -

If only a limited number of companies use IAS is it appropriate to design a
common tax base around IAS? (section 3.3)

Concerning the potentially most significant attraction of a common tax base, the fact
that it is consolidated, and the IAS Regulation is specifically directed at consolidated
accounts –

Which of the two approaches is preferable – adjusting IAS consolidated accounts
to arrive at a consolidated tax base; or creating a tax specific method of
consolidating the accounts of individual subsidiaries? (section 3.4)

Concerning the principle of dependency, an issue which is not unique to a common
tax base derived from IAS accounts –



                                           3
Is ‘dependency’ sustainable if a common tax base is adopted across the EU? Can
the additional features currently secured via dependency, be provided without
requiring dependency? (section 3.5)

Given the number of fundamental questions raised concerning the use of IAS some
consideration is also given to alternative methods of establishing a common tax base.
In particular the possibility of creating a series of ‘Tax Recommendations’ is
suggested, which could themselves make use of IAS –

If using IAS as a starting point for a common base is too ambitious does the
existing framework for introducing IAS provide a useful example for how
specific tax Recommendations could be introduced? Should such
Recommendations seek to define only the tax base itself or seek to explain how to
adjust IAS based figures to arrive at the recommended tax base? (section 3.6)

Finally, the particular situation of the Societas Europaea is discussed which because
of its specific form could be an example of how IAS could be exploited from a tax
base perspective without some of the difficulties which a wider application might
involve.

Is the SE an appropriate corporate vehicle for establishing a pilot project for a
common tax base based on IAS? If yes, what additional practical steps would be
required to implement this? (section 3.7)




                                         4
       International Accounting Standards (IAS) and a
    consolidated tax base for companies’ EU-wide activities.

1 Introduction

As from 20051 some 7000 companies whose securities are admitted to trading on a
regulated market in any EU Member State (‘listed companies) will be required to
prepare their annual consolidated financial statements in accordance with a common
set of accounting standards – International Accounting Standards (‘IAS’)2. Prior to
this date companies, subject to compliance with the Accounting Directives,3 may
apply a range of accounting standards depending on local regulations established by
their countries of incorporation and/or the stock exchanges on which their shares are
listed. The advantages of a common set of standards have been widely researched
including from the company, the investor and the regulator perspectives. However,
less research has been devoted to the taxation implications, and in particular the
possibilities which a common set of accounting standards might afford for the
establishment of a common consolidated tax base.

In this context it is worth recalling the three key elements essential to the concept of a
consolidated tax base:
• It is ‘consolidated’, which means that the traditional concept of separate
    accounting by subsidiary or by branch, or by different Member State is no longer
    necessarily relevant for tax purposes; and cross border mergers or asset transfers
    may no longer necessarily involve ‘exit’ or capital gain charges.
• As some activities may have losses and some profits there will inevitably be an
    offset of profits and losses between activities in different Member States, ie cross
    border loss consolidation.
• Since tax rates are determined by, and revenues accrue to, individual Member
    States a consolidated tax base will have to divided between Member States
    according to an agreed mechanism.

These potentially represent fundamental changes in individual Member States’ tax
policy. However, this document does not seek to address the ‘why’, which will
inevitably have, in addition to the technical issues, a political dimension. It addresses
the ‘how’, ie the technical practicalities (excluding those related to the allocation by
an agreed mechanism) with the purpose of:
• identifying the key issues
• examining some of the possibilities arising from IAS
• indicating some possible conclusions, and
• invites comment and opinion from interested parties.
1
  Regulation (EC) No. 1606/2002 (OJ L243 11 September 2002)
2
  The International Accounting Standards Committee Foundation (‘IASCF’) was re-organised in 2001
and a number of terms changed, for example International Accounting Standards or IAS are now
officially known as International Financial Reporting Standards (‘IFRS’). For convenience the old,
more well known, terms and acronyms are used in this document. A full list is contained in Appendix I
3
  Accounting Directives – principally 78/660/EEC & 83/349/EEC, although a proposal for modernising
these has been made by the Commission, COM(2002)259.


                                                 5
The results of the consultation, including a summary of the comments received,4 will
be published and will provide valuable input to DG Taxation and Customs Union’s
work on the European Commission’s planned follow up Communication on Company
Taxation later in 2003.

Comments may be submitted by 4 April 2003. They may be sent either electronically
to the following email address taxud-company-taxation@cec.eu.int or by post to Mr
TC Neale, European Commission, DG Taxation and Customs Union, Office MO 59
06/12, B-1049 Brussels, Belgium. Telephone 00 32 2 295 4705, Fax 00 32 2 295
6377.




4
  The identity of persons making responses may be made public unless you say you want to keep your
identity confidential.


                                                 6
2 Background

In October 2001 two documents concerning company taxation in the European Union
were published. The European Commission issued a Communication on Company
Taxation5 (‘the Communication’) and the associated services of the European
Commission issued a Company Tax Study6 (‘the Study’). These set out the
background to, and the case for, a consolidated tax base for companies’ activities in
the European Union. Four different approaches were discussed (Home State Taxation,
a Common Consolidated Base, European Union Company Income Tax, and a
compulsory harmonised tax base). However, the choice between them was left open
pending further research into the practicalities of the different methods.

The Study also contained a section7 devoted to financial accounting which covers
three important issues:

•   Member States currently have fundamentally different approaches to the
    relationship between accounting and taxation related to the degree of
    ‘independence’. At one extreme ‘independence’ means that, ‘income
    determination for accounting purposes is, in principle, independent of income
    determination for tax purposes.’8 At the other extreme, ‘Dependence means that
    either the financial accounts follow the tax rules or income determination for tax
    purposes is determined by the choices made in financial accounts.’9 Independence
    is prevalent in Denmark, Ireland, the Netherlands and the UK10, whereas
    dependence is prevalent in varying degrees in the other Member States, in
    particular Germany.

•   IAS are to be compulsory for the consolidated accounts of all listed EU companies
    from 2005 onwards.11

•   Even if the independence of financial accounting and tax accounting were to
    become the norm within the EU, there would remain a number of transactions
    where both the accounting treatment and the taxation treatment is particularly
    complex and currently varies across the EU. These includes certain leasing
    contracts and mergers and acquisitions. The movement towards ‘fair value
    accounting’, with an increased emphasis on valuing assets and liabilities at the
    market value in financial accounts can be expected to accentuate these problems.



5
  Towards an Internal Market without tax obstacles – A strategy for providing companies with a
consolidated corporate tax base for their EU-wide activities. COM (2001) 582
6
  Company taxation in the internal market. Commission staff working paper. SEC 1681 23 October
2001. ISBN 92-894-1695-5
7
  Part IV, section 3, The importance of financial accounting for remedying tax obstacles in the internal
market. pp 399-405
8
  ibid
9
  ibid
10
   This may change, see A review of small business taxation, a technical note by the Inland Revenue
March 2001 and the summary of responses 27 November 2001.
11
   Regulation (EC) No. 1606/2002 (OJ L243 11 September 2002)


                                                   7
In the section12 of the Study devoted to a preliminary analysis of the different
approaches for a comprehensive solution under the heading ‘Common (consolidated)
tax base’ a possible common European tax base is discussed and it is noted that, ‘The
agreed set of common European rules could take agreed European accounting
standards as a starting point’13 This idea is picked up again in the Communication
where with reference to the introduction of IAS, ‘Although not directly related to
taxation….this development may generally help the future development of a common
corporate tax base and to some extent the IAS may serve as a useful point of
reference’14.


2.1 The European Conference on Company Taxation

The issue was debated at the European Conference on Company Taxation in April
2002 in the session on ‘The means for achieving a common tax base’ with particular
reference to the question, ‘What is the link between the common tax base and
accounting rules and what role can International Accounting Standards play?’. The
implementation of IAS for listed EU companies was recognised as a major issue, but
to what extent this development could be taken advantage of for tax purposes was less
clear. A number of speakers contributed to the debate and a number of general points
were raised.

IAS were perceived as having different goals from tax accounts, being more
concerned with reporting performance and with identifying future potential. The
financial statements are considered primarily as a tool to provide information to the
markets who reward the maximisation of profits, largely judged in relation to a ‘true
and fair’ criteria. Tax accounts are prepared for a different purpose and statutory
compliance is the main criteria with the minimisation of profits being rewarded by
lower tax charges. If a common base were restricted to some of the core elements then
IAS could provide a suitable starting point when consolidated figures were required.
As regards individual subsidiaries the extent to which IAS was also used for these (the
Regulation requires IAS only for consolidated accounts, Member States may permit
or require their use in the financial statements of subsidiary companies) was identified
as a potential influence on the use of IAS financial statements as part of a tax base.
The Commission Services concluded that the opportunities created by the introduction
of IAS across the EU needed further study, with particular emphasis on the tax
implications.15

In conclusion, the coincidence of the agreement on the Regulation requiring the
introduction of IAS by some 700016 companies in 2005 and the Commission’s
conclusion that EU companies should have a consolidated tax base for their EU wide
activities, has led to a great deal of interest in an ‘IAS common tax base’. On the

12
   Section 13 Options for comprehensive approaches to EU company taxation.
13
   Ibid Section 13.2 p463
14
   Section 5, p18
15
   Director General Mr Vanden Abeele ‘Closing Remarks’ at the European Conference on Company
Taxation
16
   There are approximately 7000 EU listed companies, most of which will have to use IAS in 2005;
most rather than all because those who are already using recognised international accounting standards
(principally US GAAP) can defer the changeover by two further years.


                                                  8
surface the idea seems very attractive, but there has been little detailed research on
what this would actually mean in practice.


2.2 What are IAS?

IAS are issued by the International Accounting Standards Board (IASB). The IASB is
appointed by the International Accounting Standards Committee Foundation (IASCF)
which is a private foundation registered in the USA but based in the UK. There are
currently thirty four in force supported by thirty one Interpretation documents17.
During 2002 the Preface was revised, four Exposure Drafts were issued proposing
amendments to fifteen of the existing thirty four, and proposing two additional
standards. Seven Member States already permit listed companies to prepare their
consolidated accounts in accordance with IAS, and four of these also permit IAS for
subsidiary accounts in certain circumstances18. They are essentially accounting
standards, not necessarily designed with taxation as a principle concern. There has
been a tendency to permit more than one method of accounting for certain
transactions although there is now a concerted drive to remove and reduce the number
the number of options to ensure greater certainty in, and comparability between,
financial statements.


2.3 The Community Regulation

The Community Regulation requires listed companies to prepare their consolidated
accounts with effect from 2005 in accordance with IAS. The Regulation introduces an
endorsement procedure for new and or modified IAS via an Accounting Regulatory
Committee (composed of the Commission and Member States) assisted by an
accounting technical committee of experts, the European Financial Reporting
Advisory Group (EFRAG) - a private sector initiative. Formally there is therefore the
possibility for Member States to reject or amend individual IAS (on a qualified
majority basis). The standard setting process within the IASB involves a high degree
of consultation and therefore it is generally expected, and certainly hoped, that the
Community, via the Accounting Regulatory Committee will be able to accept new
IAS and avoid discrepancies between IAS ‘proper’ and IAS ‘Community approved’.

Unlisted companies remain subject only to the less demanding Accounting
Directives.19 Member States may either permit or require unlisted companies to use
IAS in their consolidated accounts, and may also permit or require listed and/or
unlisted companies to use IAS in their individual accounts. It is worth noting that no
provision is made for consolidated accounts to distinguish between EU and non-EU
activities or subsidiaries etc.




17
   On May 15 2002 a 400 page Exposure Draft was issued proposing changes to 12 Standards. Two
more are in the process of being updated and a further Exposure Draft will be released soon.
18
   Austria, Belgium, Germany, France, Finland, Italy, Luxembourg; and Austria, Belgium, Finland and
Germany.
19
   Principally Council Directives 78/660/EEC & 83/349/EEC


                                                 9
2.4 Current practice in Member States

As a general rule all individual companies are required to prepare annual financial
statements (or ‘accounts’). These are prepared in accordance with local approved
accounting standards, (sometimes referred to as Generally Accepted Accounting
Principles - GAAP) which may in some cases include IAS. These GAAP will also
require in certain circumstances consolidated accounts, and individual stock
exchanges also have rules about when and how consolidated accounts are prepared.

For taxation purposes the situation is rather different. Depending on the degree of
‘dependency’ the ‘tax accounts’ may be very similar to, or quite different from, the
financial accounts. Indeed this range of ‘dependency’ has traditionally been a key
factor in agreeing EU legislation on accounting. The recent proposal20 to update the
Accounting Directives to remove any incompatibilities with IAS is a good example of
this. The changes are implemented by way of giving Member States the option to
permit or require certain changes to ensure that national accounting requirements for
unlisted companies can be gradually aligned with IAS thereby avoiding sudden
accounting changes which might have unforeseen taxation consequences in certain
Member States. As a general rule tax accounts or returns are required for each
separate subsidiary whereas consolidated accounts, where they are relevant for tax
purposes, are strictly national, ie there is no cross-border consolidation21. Where
individual companies have activities in more than one country the right to tax the
income depends on the local legislation, subject to any specific bilateral double
taxation agreement between the respective states. There is no specific Community
legislation relating to double taxation agreements between Member States, although
the general principles stemming from the basic EU Treaties apply.


2.5 Application of IAS

The introduction of IAS is a major exercise. Those companies who currently use
either their local GAAP or US GAAP for preparing their consolidated accounts will
have to change. Considerable work has already been carried out and the major
accounting firms have produced a number of booklets about the differences between
IAS and US GAAP, UK GAAP, French GAAP, etc.22 These focus on the different
accounting treatments and the likely changes that the introduction of IAS will have on
the financial statements of EU listed companies. A study has also been produced on
the differences between IAS and the Accounting Directives.23 As long as IAS remains
unacceptable for USA listed companies, these will still have to file statements in
accordance with US GAAP and companies with listings in the USA and the EU will
have to produce two sets of financial statements.

20
   COM(2002)259 – Proposal for a Directive amending Council Directives 78/660/EEC, 83/349/EEC
& 91/674/EEC on the annual and consolidated accounts of certain types of companies and insurance
undertakings.
21
   With the exception of certain cases in Denmark and France.
22
   For example IFAD GAAP 2001 October 2001, International Accounting Standards Similarities and
Differences IAS, US GAAP and UK GAAP PricewaterhouseCoopers September 2001,
23
   Examination of the conformity between IAS 1 to IAS 41 and the European Accounting Directives,
DG Internal Market & Financial Services April 2001.



                                               10
The extent to which companies will use IAS beyond their consolidated accounts is
currently unclear. As regards use for subsidiary accounts this depends in the first
instance on whether or not Member State legislation permits this. As regards use for
management accounts this is solely at the companies’ discretion. A recent survey24
suggests that between 70% and 80% of listed companies think IAS should be
available to subsidiary companies, and more than 70% use or plan to use IAS for their
internal management accounting. However, there is no data available on how many
unlisted groups or individual companies plan to switch to IAS although the
assumption is that there will be very few. The accounts of these individual
subsidiaries and companies not part of a listed group (estimated at approximately 5
million) will remain subject to the EU Accounting Directives and local regulation.

Currently Member States plan to retain their national arrangements for accounting
standard setting and/or approval and this strongly suggests that the majority of such
companies will continue to apply national GAAP. Even where Member States permit
IAS accounts it is difficult to see what advantages such a change would bring to the
majority of EU companies, unless they were active in more than one Member State
and use of IAS gave access to a form of common tax base. Therefore in the short term
the use of IAS is likely to be relatively limited. This may become problematic from a
comparative perspective as there is currently a concerted effort to update IAS and to
reduce the number of options available. As things stand unless local national
standards are also updated this may drive them further away from IAS. To what
extent comparability between the accounts of such companies is necessary is
debatable in any case. Local standard setters may, in any case, seek to align their
standards more closely with IAS which, where there is a high level of dependency
between ‘financial’ and ‘tax’ accounting may have wider repercussions on individual
Member States’ tax bases.

To date there have been few specific studies on the tax implications of introducing
IAS although some work is now underway. In Germany the issue is now being
studied and in the UK the Inland Revenue is currently examining the possibility of
using the financial accounts of certain small and medium sized enterprises as the
taxable base, although this is based on the assumption that the accounts are prepared
under UK GAAP. The UK has also recently published a consultation document25
which, although again not primarily concerned with IAS, has important implications
for the relationship between financial accounting and ‘tax’ accounting. The main
thrust of the document is one of simplification of the UK tax system, predicated on a
much closer relationship. No specific study has yet been published on the differences
between IAS and the existing tax rules for establishing the tax base across the EU,
although there have been a number of comparisons between the 15 different Member
State tax bases. Many detailed differences have been identified although overall the
differences do not appear significant.26



24
   2005 - Ready or not, survey by PricewaterhouseCoopers 7 June 2002, see Appendix II for a
summary.
25
   Reform of Corporation Tax. A consultation document August 2002.
26
   The Company Tax Study found that the tax rate rather than the tax base was the main influence on
the overall effective rate of tax in individual Member States.


                                                 11
2.6 General Principles of IAS

The IASB Framework is not a standard in its own right but it sets out the concepts
that underline the preparation and presentation of financial statements, and hence has
a major influence on the IAS. As the conceptual framework it is therefore the logical
place to start an analysis of the possibilities that IAS may have for establishing a
common consolidated base. Four main points arise – the concepts of the ‘user’, of
materiality, substance over form, and the application of ‘fair value accounting’.

As regards the ‘user’ although tax computations are considered as special purpose
financial reports and as such outside the scope of the Framework (para 6) the
possibility of applying the Framework to such reports ‘where …requirements permit’
is acknowledged. Similarly, governments, for the purpose of determining taxation
policies are specifically identified as ‘users’ of IAS financial statements (para9f).
However, from the list of identified users and their information needs it is clear that
IAS financial statements are in principle more ‘investor orientated’ that ‘tax
administration orientated’.

The paragraphs on Materiality (29 and 30) raise more serious concerns. Materiality is
essentially defined as a threshold or cut-off point where an omission or misstatement
could influence economic decisions taken by users. Tax computations are currently
required in most cases to be accurate to a single unit of currency and although a tax
authority could be considered to be a user, there is clearly no requirement for IAS
financial statements to be prepared to such accuracy. Even if authorities were to
accept an increase in their existing thresholds it is not simply a question of numeric
accuracy. Companies would also have to accept a requirement to provide more
detailed supporting information if requested, where, for example, an item of
expenditure of particular tax relevance has not been separately identified. A further
issue is that of comparability. The level of materiality for a large MNE is clearly
different to that for an SME and it would be difficult for a tax authority to apply
different levels to different tax payers. Accounting records also contain numerous
estimates, eg accruals and prepayments, which may turn out to be inaccurate. When
the underlying transactions are completed the estimates are corrected (usually in the
following period) and over time under and over estimates are rectified. Depending on
the materiality of these adjustments these timing differences could create difficulties
as regards establishing a tax base.

The ‘substance over form27’ principle (para 35) is also problematic. Although it is
applied to varying degrees for taxation purposes across the EU there is no standard
approach. Creating a common tax base inevitably means that some tax authorities
would have to change their current approach in some areas, but whether the IAS
approach, which places great emphasis on this principle, is the best method is
debatable. In particular where accounting dependency exists it could have major
implications for commercial accounting law.

The definitions of Assets, Liabilities and Equity are relatively straightforward given
that a reasonable level of disclosure of the particular treatment is generally required

27
  The clearest example of this is probably an asset on a ‘finance lease’ where although the asset is
rented rather than owned it is generally accounted for as an asset.


                                                   12
For example, transfers to tax reserves, which are to be recorded as reserve movements
rather than as expenses, are specifically mentioned as potentially relevant to users and
hence would require disclosure. Individual IAS on specific accounting treatments also
in general require a high level of disclosure as to the policy and methodology adopted.

However, gains on assets are considered to be no different from revenue (para 75) and
unrealised gains are specifically included in this definition (para 76). The inclusion,
and the taxation, of such gains (or losses) in profits, ie the ‘fair value approach to
accounting’ would be a fundamental departure from current taxation practice.
Although the practice of separate disclosure of such items is acknowledged, whether
this would be sufficiently detailed to enable appropriate amendments to be made to
arrive at the tax base is debatable. One Member State is currently reviewing the
taxation of such gains28 but the taxation of unrealised gains, and the granting of relief
for unrealised losses is far from being established practice.


2.7 Individual IAS29

It is beyond the scope of this paper to provide a complete analysis of each IAS and a
comparison of how the accounting treatment compares to the current taxation
regulations in each of the fifteen Member States. However, a short summary of some
of the more important points for taxation follows:

IAS 1 Presentation of Financial Statements
Materiality and aggregation, offsetting and the limited use of the ‘true and fair’
override. For example a large MNE might routinely expense all asset expenditure
below €1000 whereas a smaller company might recognise as capital expenditure items
of a much lower value.

IAS 2 Inventories
Although ‘first in, first out’ (FIFO) or weighted average cost formulae are identified
as the benchmark treatment ‘last in, first out’ (LIFO) is an allowed alternative. As the
stock valuation effects profits then the choice of method can effect the profit reported.

IAS 8 Net Profit or Loss for the Period, Fundamental Errors and changes in
Accounting Policies
Changes in accounting estimates should be reflected prospectively, corrections of
fundamental errors should be treated as prior period adjustments (although
recognition in the profit and loss account is an allowed alternative), and a change in
accounting policy should be treated retrospectively (although recognition in the profit
and loss account is an allowed alternative). This could create problems if a number of
transactions were effectively treated via reserves rather than reported in the profit and
loss account.

IAS 11 Construction Contracts



28
   Reform of Corporation Tax – a consultation document. Issued by UK Treasury & Inland Revenue
August 2002
29
   See Appendix III for a complete list of IAS


                                               13
Revenues and costs should be measured by stage of completion (the ‘percentage-of-
completion method’) although the ‘cost recovery’ method is allowable if the outcome
of a contract cannot be estimated. The method adopted obviously effects the timing of
profit recognition and hence profits for a particular year.

IAS 14 Segment Reporting (principally of relevance if the consolidated financial
statements were to be used for establishing key data in a formula apportionment
approach to sharing a consolidated EU tax base between Member States)
The primary segment can be either organisational or geographical. 10% materiality
thresholds apply and segments need equal only a minimum of 75% of consolidated
income. A geographical analysis would potentially be more useful for any subsequent
allocation method but a non analysed element of 25% could create problems.

IAS 16 Property, Plant and Equipment
Assets to be depreciated on a systematic basis over their useful lives. The method
should reflect the pattern in which the economic benefits are consumed by the
enterprise. Assets should be periodically re-valued to fair value, the profits accounted
for in reserves although future depreciation should be charged in the profit and loss
account. Revaluation losses should be charged to the profit and loss account.
Although this establishes a principle for the calculation of depreciation, taxable
depreciation has traditionally been much more tightly defined ensuring comparability
between enterprises and certainty.

IAS 17 Leases
Finance leases, those which transfer substantially all risks and rewards to the lessee,
should be capitalised and depreciated. Lease payments should be analysed between
‘capital’ – reducing the liability on the balance sheet and ‘finance’ – charged to the
profit and loss account. This ‘substance over form’ principle is currently not applied
in a consistent way across the EU and may in itself not provide sufficient certainty for
a taxable base.

IAS 22 Business Combinations
Although business combinations are presumed to be acquisitions and accounted for
using the ‘purchase method’ of accounting, the ‘pooling of interests method’ is
allowed in certain circumstances. The (current) existence of choice in this area is
unlikely to be appropriate for the calculation of the taxable base.

IAS 23 Borrowing Costs
The benchmark treatment is to expense borrowing costs but capitalisation is an
allowed alternative in certain circumstances. Capitalisation is unlikely to be a
favoured option if it leads to a loss of interest tax deductions and the tax implications
may adversely effect the exercise of accounting judgement when selecting the method
to adopt.

IAS 27 Consolidated Financial Statements,
Defines which companies should be consolidated and how the consolidation should
be carried out. Although the principles are well established for accounting purposes
applying them for taxation would be a major change. Practically all companies where
more than 50% of the shares are owned, and some where less than 50% are owned are
to be consolidated. The consolidation is such that 100% of the assets and liabilities,


                                           14
and 100% of the revenues and expenses of each subsidiary are included in the
consolidated results. The effects of intra group trading are removed, thereby removing
problems of transfer pricing, but the minority interests are identified (and removed)
only as a net figure which would create problems for establishing tax base. For
example 100% of the sales and expenses of a 51% subsidiary would be included line
by line, with a single adjustment reversing out 49% of the net profit or loss. Under the
IAS Regulation the consolidated accounts would include all subsidiaries, EU and non
EU, and therefore if the consolidated accounts were to form the starting point for a
tax base the first adjustment would be to exclude non EU subsidiaries. Both of these
issues: minority interests and non EU interests would have to be resolved together
with an acceptance of a ‘pure’ 100% offset of profits and losses across the EU to
arrive at an EU base for subsequent division according to an agreed mechanism.

IAS 28 Investments in Associates
Enterprises which are not subsidiaries or joint ventures, but over which a company
has significant influence are to be accounted for under the equity method ie the
proportionate share of profits or losses is accounted for whether or remitted as a
dividend. Ownership of more that 20% of the equity is presumed to indicate
significant influence. The distinction between accounting for an investment as an
associate rather than a subsidiary could have much greater implications if tax
consolidation were available for subsidiaries but not associates and the definitions
might not be sufficiently robust and certain for tax purposes.

IAS 32 Financial Instruments: Disclosure and Presentation
The analysis of financial instruments into liabilities and equity is to reflect substance ,
not form. See comment on IAS 39.

IAS 36 Impairment of Assets
An impairment loss should be recognised whenever the recoverable amount of an
asset is less than its book value. Assets include goodwill, intangible assets, property,
plant and equipment. The loss should be recognised as an expense in the profit and
loss account. Valuation is based on present value calculations. See comment on IAS
39.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Provisions should be recognised in certain circumstances ie charged in the profit and
loss account but contingent liabilities and assets should only be disclosed in the notes
to the accounts. Unavoidable future costs on a contract which will produce no net
economic benefit are to be treated as provisions, ie charged to the profit and loss
account. If all provisions were to be tax deductible then again this accounting
definition might not be robust enough for taxation purposes.

IAS 38 Intangible Assets
The benchmark treatment for qualifying assets is historical cost, but an allowed
alternative treatment is to capitalise at the ‘fair value’, where the value can be
determined by reference to an active market. Depreciation is to be charged over the
useful life which is presumed to be less than 20 years. See comments on IAS 39.

IAS 39 Financial Instruments : Recognition and Measurement



                                            15
Initially to be measured at cost, most are then subject to periodic revaluation to ‘fair
value’. The entire revaluation gain or loss on the financial asset or liability may be
recognised in the profit and loss account; or only the gains on losses on trading
instruments with non trading items being accounted for in equity pending realisation.
Derivatives which are not designated hedging instruments are to be classified as
trading and hence accounted for in the profit and loss account. Applying IAS 32, 36,
38, 39 and 40 all imply the recognition of unrealised profits and losses, which even in
accounting terms has generated controversy. The taxation, or relief for such
unrealised transactions, would represent an even greater change to taxation policy and
it is unlikely to receive widespread support.

IAS 40 Investment Property
Either the fair value model, where revaluation gains or losses are recognised in the
profit and loss account; or the cost method may be used. See comments on IAS 39.

In summary the above examples illustrate some of the potential problems in using
IAS accounts as a starting point for a consolidated tax base. Alternative accounting
methods are allowed for inventory: LIFO or FIFO in IAS 2, for contracts: percentage
of completion or cost recovery in IAS 11, for borrowing costs: expense or
capitalisation in IAS 23 and for intangibles and investment properties: cost or fair
value in IAS 38 and 40. Substance over form is applied for leases in IAS 17 and for
Financial Instruments in IAS 32. Depreciation on property, plant and equipment is to
be charged over the useful life, but this could be based on a re-valued amount due to
the fair value principle in IAS 16. Fair value is also the principle for financial
instruments in IAS 32 and for calculating the impairment of assets in IAS 36.

In most cases disclosure requirements are such that the effect on profits of expensing
rather than capitalising transactions, of re-valuing assets and liabilities, of increasing
depreciation, of recognising profits and losses etc can be established by the user of the
accounts. However, there is a potential tension between financial reporting, where
high profits are rewarded; and tax ‘accounting’ where low profits are rewarded via a
lower tax charge. Strengthening the link in the consolidated IAS accounts could lead
to more balanced reporting but might lead to accounting decisions being based more
on the principles of tax deferral and reduction than on sound ‘true and fair’ accounting
principles.


3      Possibilities, conclusions, and questions


3.1 The source of IAS and taxation legislation

Although the consultation process is relatively well developed IAS are ultimately set
by IASC under the auspices of IASCF which is a private foundation. However, the
adoption of IAS within the EU is subject to a community endorsement process which
operates on a qualified majority basis. This could be extended to provide specific
taxation input either via a form of ‘sub-committee’ attached to the existing
Accounting Committee or by a completely separate ‘Taxation Endorsement
Committee’ established under a ‘Taxation’ Regulation. Currently individual Member
States determine their own tax base, whether by specific tax legislation or by a


                                           16
mixture of accounting and taxation legislation. Such an endorsement procedure
incorporated into a Regulation would enable ‘tax’ legislation to be amended relatively
rapidly; as is the case currently in individual Member States. However, this degree of
flexibility might be considered to be excessive, reducing as it would do the level of
parliamentary scrutiny in Member States. In contrast to Regulations which are
directly applicable in Member States and therefore require no further enabling
legislation, Directives require transposition by each Member State into domestic
legislation. Legislation by Directive would therefore ensure parliamentary scrutiny in
Member States but at the expense of making any amendments time consuming and
more difficult to achieve.

Aligning taxable income more formally with accounting income could therefore in
some Member States be considered to involve a potential loss of control by linking
taxation to what recently has been a moving target as accounting standards are
amended, improved and created etc. It could also have a ‘knock-on’ effect on the
process of agreeing accounting standards which, depending on the number of
reconciling items between IAS and ‘tax’ accounts, could take on a new significance.
Changes which might increase or decrease the taxable base would take on an
additional increased significance and it might be more difficult to reach agreement.

The current endorsement procedure of IAS provides Member States with the
necessary level of ‘control’ over accounting standards in the EU. Could it be
extended or supplemented to provide sufficient taxation input for IAS to form
the starting point for the tax base?


3.2 The underlying principles

Each Member State has a detailed set of taxation principles which forms the basis for
their respective tax codes. The establishment of a consolidated base would necessarily
require greater co-ordination between Member States and agreement over the
application of these detailed principles. Such issues have to be resolved regardless of
the ‘method’ of establishing a consolidated tax base but when considering IAS as a
starting point there are, in addition, some fundamental or underlying principles which
must be addressed.

Both IAS and Member State taxation legislation seek to measure net income and, by
requiring periodic reporting, to allocate income and expenses to particular periods.
However, IAS accounts are directed primarily towards the investor user rather than
the tax administration. Three further specific features of IAS pose a particular
challenge for taxation: materiality, fair value and ‘substance over form’. As regards
materiality the principle questions are whether or not it would be acceptable for
different sized companies to have different levels of materiality, and whether or not
IAS accounts would be sufficiently accurate. As regards fair value the questions are
whether or not taxation should also be based on ‘fair value’, ie taxation and relief of
unrealised gains and losses; although in theory it should be relatively straight forward
to adjust IAS accounts to arrive at realised profits and losses. Finally, the substance
over form principle is not currently widely used for taxation purposes, although there
are examples of its adoption.



                                          17
Are IAS too ‘investor orientated’ for the tax administration to use them as the
primary source for determining the taxable base? To what extent do the IAS
principles of materiality, fair value and ‘substance over form’ conflict with
taxation principles? Could any conflict be resolved by the provision of
supplementary supporting schedules provided specifically for taxation purposes?


3.3 The number of companies involved

Out of approximately five million companies in the EU some 7000 are listed and will
be applying IAS in their consolidated accounts. To what extent Member States will
permit or require non-listed companies, or the individual subsidiaries of listed
companies to utilise IAS is currently uncertain. If a consolidated tax base were
introduced based on IAS accounts then there would be a clear incentive for companies
with cross border activities to opt for IAS – to access the possibility of cross border
loss relief. However, for those unlisted companies with no cross border activities there
does not seem to be any particular incentive to change their existing accounting
standards; nor does there to be seem any particular disadvantage in having domestic
companies and internationally active companies applying different accounting
standards. However, if an IAS derived tax base were only available to companies with
cross border activities the principle of equality of treatment between companies as
regards the calculation of the tax base could be an issue in some Member States.

If only a limited number of companies use IAS is it appropriate to design a
common tax base around IAS?


3.4 The method of consolidation

A key element essential to the concept of a common tax base is that of consolidation –
ie cross border profit and loss offset. Two possibilities exist: either the IAS
accounting consolidation is used as the starting point, or a separate set of rules for the
tax consolidation is established and applied to the individual subsidiaries, who must
also apply IAS for the sake of consistency. Both approaches would require additional
tax specific analysis. Starting with an IAS consolidation would result in a single
accounting requirement plus a reconciliation obligation, whereas a separate set of tax
consolidation rules could lead to a form of dual consolidation accounting. The former
would include removing non-EU subsidiaries and providing additional analysis of
minority interests; which might involve significant additional work. However, the
latter would involve a specific tax consolidation procedure and if this were to be
designed it could presumably equally be applied to the existing (non IAS) accounts of
subsidiaries.

Which of the two approaches is preferable – adjusting IAS consolidated accounts
to arrive at a consolidated tax base; or creating a tax specific method of
consolidating the accounts of individual subsidiaries?




                                           18
3.5 Issues of dependency

Currently there are different levels of accounting and tax dependency or
independency in the EU. However, the introduction of a common consolidated tax
base would seem to require a common approach, and therefore an element of change
in some or all Member States. The IAS Regulation has avoided this by dealing only
with consolidated accounts, enabling Member States to continue to require that
subsidiary company accounts be prepared in accordance with local legislation.
However, if the tax base is derived from IAS accounts, consolidated or otherwise this
approach no longer seems tenable. Either commercial law would have to be brought
into line across the EU so that the IAS derived base could be ‘dependent’ or a degree
of independency would have to be introduced across the EU ie the formal link
between commercial financial accounting and tax accounting would have to be
broken or at the least relaxed for those participating companies.

Is ‘dependency’ sustainable if a common tax base is adopted across the EU? Can
the additional features currently secured via dependency, be provided without
requiring dependency?



3.6   Regulations and Recommendations

The use of IAS has been introduced by a Community Regulation, ie it is mandatory
and directly applicable in all Member States. If IAS were to provide the starting point
for a common tax base then logically a similar framework could be utilised, ie a
Regulation providing for an endorsement committee etc. However, given the range of
issues which need to be addressed concerning IAS, plus the whole subject of how best
to divide the common base between Member States which is not covered in this
paper, an alternative method to promote a common base could be via Commission
Recommendations. These would not have the force of law but would provide a ‘best
practice’ for Member States to apply in their individual tax legislation. As Member
States’ tax legislation moved towards a more co-ordinated approach the establishment
of a common base would therefore be facilitated.

Recommendations could still make use of IAS by recommending how accounting
figures established under IAS could be best adjusted to arrive at the taxable base.
Starting with IAS accounting data would provide the advantage of a commonly
understood accounting base, as opposed to the current range and variety of individual
Member State         generally accepted        accounting      practices.     Conversely,
Recommendations might be more straightforward to draft in terms only of the desired
tax output, ie by simply defining the tax base. For example the recommended tax
depreciation schedules for certain assets could be set out, instead of starting from IAS
derived accounts and specifying how these should be adjusted to arrive at the
recommended tax base.

Such a programme of ‘Recommendations’ would necessarily require the
establishment of some form of expert committee and the IAS accounting example
could provide a useful precedent, in particular with its involvement of the private
sector via EFRAG.


                                           19
If using IAS as a starting point for a common base is too ambitious does the
existing framework for introducing IAS provide a useful example for how
specific tax Recommendations could be introduced? Should such
Recommendations seek to define only the tax base itself or seek to explain how to
adjust IAS based figures to arrive at the recommended tax base?


3.7 Other possibilities: Societas Europaea (SE)

As from 8 October 2004 companies will be able to form an SE. However, there is
concern that without any specific tax regime interest for companies will be limited.
Depending upon the options chosen by the Member State in which the SE has set up
its registered office, the SE may or may not use IAS as a reporting basis in its annual
and consolidated accounts (unless the SE is listed in which case its consolidated
accounts must be prepared on the basis of IAS). However, given the freedom for SEs
to change their place of registration in theory it would only require one Member State
to permit the use of IAS by an SE for it to become a possibility.

It could be possible to introduce a type of consolidated tax base specifically for SEs as
a sort of ‘pilot project’. If a new SE were to use IAS from incorporation then many of
the difficulties concerning the methodology of consolidation (such as whether to use
the consolidated accounts as the starting point or whether to design a tax method of
consolidating individual subsidiaries) could be avoided. In its purest form an SE could
operate as a single company across the EU, without any subsidiaries, and there would
be no need for accounting consolidation as such. Nor, if its activities were restricted to
within the EU, would there be a problem with isolating non-EU activities.

Under such a scenario the IAS accounting result for the SE as a whole could then be
adjusted as necessary to arrive at the final taxable base. The advantage of using IAS
would be that all SEs would be using the same accounting standards and the
adjustments should therefore be more straightforward to define. Although agreeing
the ‘adjustments’, ie the components of the common tax base, and the allocation
mechanism would be significant tasks the current situation is equally complex.
Without any new legislation a new SE which operates in a number of Member States
will have to establish separate tax accounts in accordance with local legislation in
each of Member States where it operates and fulfil all the existing local tax
compliance requirements including establishing arms length transfer pricing between
activities in different Member States.

Is the SE an appropriate corporate vehicle for establishing a pilot project for a
common tax base based on IAS? If yes, what additional practical steps would be
required to implement this?




                                           20
                                                                    Appendix I

                Glossary of terms and abbreviations

IASCF   International Accounting Standards Committee Foundation
        Established 1973 by professional accountancy bodies from France,
        Germany, Netherlands, Ireland, Australia, Canada, Japan, Mexico, and
        USA.

IASB    International Accounting Standards Board
        Established 2001, 14 individuals appointed by IASF. Issues IFRS.
        Successor to IASC which issued IAS

IFRS    International Financial Reporting Standards
        Formerly IAS

IFRIC   International Financial Reporting Interpretations Committee
        Prepares Abstracts, formerly Interpretations

IASC    International Accounting Standards Committee
        Succeeded in 2001 by IASB, issued IAS

IAS     International Accounting Standards

SIC     Standards Interpretation Committee
        Succeeded in 2001 by IFRIC, prepared Interpretations

EFRAG   European Financial Reporting Advisory Group (EFRAG)
        Private sector initiative – provides input to the Accounting Regulatory
        Committee which under Regulation No 1606/2002 endorses IAS for
        EU application

MNE     Multinational Enterprise

SME     Small or Medium sized enterprise

MS      Member State (of the EU)




                                   21
                                                                          Appendix II
‘2005 – Ready or not’.
Survey by PricewaterhouseCoopers published 7 June 2002

A survey on attitudes towards, and preparedness for, the introduction of International
Accounting Standards (IAS) in 2005 was carried out. A sample of 667 listed
companies responded, representing just under 10% of the 7000 companies who will
have to apply IAS from 2005. Of the 667 (100% of the sample), 314 (47%) operated
globally, 153 (23%) operated across the EU and 200 (23%) operated nationally, ie
principally within one Member State.

Key points to emerge were as follows: –

Of the total sample of 667 (100%):
567 (85%) want local GAAP to converge with IAS, however, in the short term as the
review of IAS is geared towards removing options within individual standards the gap
between local GAAP and IAS will grow until the local GAAP change to the preferred
IAS. The most significant differences between IAS and local GAAP were considered
to be the treatment of Financial Instruments and Deferred Taxation.
380 (57%) favour a pan European or global enforcement mechanism rather than the
current local enforcement (of local GAAP),
98 (15%) of the sample were already using IAS,
569 (85%) had not yet implemented IAS.

Of the 98 (15%) already using IAS:
80 (82%) think ISA should also apply to subsidiary accounts (this is currently only
possible in Austria, Belgium, Finland and Germany),
71 (72%) use IAS for their internal, management accounting,
71 (71%) thought adopting IAS had been beneficial,
60 (61%) said the Financial Statements under IAS were very different in some key
elements.

Of the 569 (85%) who have not yet implemented IAS:
404 (71%) think ISA should also apply to subsidiary accounts,
398 (70%) plan to use IAS for their internal, management accounting.

Although the number already using IAS is relatively low it is striking that for two
issues, perhaps the most important ones for taxation, the responses of users and non
users are very similar, and relatively high: - between 70% and 80% think IAS should
also apply to subsidiary accounts, and 70%+ use or plan to use IAS for their internal
management accounting.




                                          22
                                                                   Appendix III
Proforma Examples of possible taxation adjustments to financial accounts

A typical proforma tax computation where financial accounts and tax accounts are
independent highlights where specific accounting rules on the recognition of
transactions might differ from the taxation rules. For IAS to provide a starting point
for a tax base MS would need to establish both an agreed level of dependency, and an
agreed set of tax base rules.

Profit/(loss) per the accounts   +/(-)
Timing differences               +/(-)
Permanent Differences            +/(-)
Taxable Profit/(loss)            +/(-)

Timing differences [Specific transactions which although taxable/(deductible) in
principle are taxed/(relieved) in a different period from in the accounts] Typically in
the financial accounts there is an incentive to recognise income as early as possible
and to defer the recognition of, or even capitalise, expenses; in the tax accounts the
incentive is reversed.

For example:
Long term construction contracts (IAS 11) – the allocation of revenue and costs to
different periods – per IAS ‘percentage of completion method’. This is not the method
adopted in all MS for tax purposes.

Depreciation (IAS 16, Property, Plant & Equipment) – the timing of asset recognition,
valuation and depreciation. Para 47 ‘a variety of depreciation methods can be used to
allocate the depreciable amount of an asset over its useful life’. MS usually set down
specific methods (which currently differ between MS) and they may also use
depreciation allowances as a form of specific investment incentive.

Permanent Differences [Specific transactions which although recorded as
income/(expenditure) in the accounts are not taxable/(deductible)] In some MS where
revenue and capital transactions are treated differently this would often include those
items which were considered be capital rather than revenue and therefore subject to a
different tax regime.

For example:
Intangible Assets (IAS 38) – the recognition, measurement and depreciation of such
assets as goodwill and patents. In some MS goodwill is depreciable for tax purposes
(giving rise to a potential timing difference), in others it is not. In these depreciation
charged in the accounts would be a permanent difference between accounting and
taxable profit.

Entertaining expenditure – under IAS entertaining as a business expense would
reduce the accounting profit. In many MS as a matter of taxation policy certain
expenses are not tax deductible. In a typical set of consolidated financial accounts
entertaining would not of course be separately identified.




                                           23
Borrowing costs (IAS 23) – under IAS there is an option, these may be expensed, or
in some cases capitalised. In MS specific rules often apply to when interest is
deductible, but it may also be treated as non deductible, giving rise to a permanent
difference if ‘thin capitalisation’ rules apply.

For IAS accounts to provide a starting point for the calculation of a consolidated tax
base each of these issues would have to be addressed and provided for via appropriate
instruments.




                                         24
Current International Accounting Standards                                                                        Appendix IV

Instrument       No       Last    Subject                                                         Revision
                          Revised                                                                 Proposed
                                                                                                  in ED
Preface                      2002   Preface to International Financial Reporting Standards (IFRS)
IAS                1         1997   Presentation of Financial Statements                                   2002
IAS                2         1993   Inventories                                                            2002
IAS                7         1992   Cash Flow Statements
IAS                8         1992   Profit or Loss for the period, Errors & changes in policies            2002
IAS               10         1999   Events after the Balance Sheet Date                                    2002
IAS               11         1993   Construction Contracts
IAS               12         2000   Income Taxes
IAS               14         1997   Segment Reporting
IAS               15         1981   Information Reflecting the Effects of Changing Prices                  2002
IAS               16         1998   Property Plant and Equipment                                           2002
IAS               17         1997   Leases                                                                 2002
IAS               18         1993   Revenue
IAS               19         2002   Employee Benefits
IAS               20         1983   Accounting for Govt. Grants …
IAS               21         1993   The Effects of Changes in Foreign Exchange Rates                       2002
IAS               22         1998   Business Combinations
IAS               23         1993   Borrowing Costs
IAS               24         1984   Related Party Disclosures                                              2002
IAS               26         1987   Accounting & Reporting of Retirement Benefit Plans
IAS               27         1989   Consolidated Financial Statements & Accounting for Investments         2002
IAS               28         2000   Accounting for Investments in Associates                               2002
IAS               29         1989   Financial Reporting in Hyperinflationary Economies
IAS               30         1990   Disclosures for Banks & similar Financial Institutions
IAS               31         2000   Financial Reporting of Interests in Joint Ventures
IAS               32         1998   Financial Instruments: Disclosures and Presentation                    2002
IAS               33         1997   Earnings per Share                                                     2002
IAS               34         1998   Interim Financial Reporting
IAS               35         1998   Discontinuing Operations
IAS               36         1998   Impairment of Assets
IAS               37         1998   Provisions, Contingent Liabilities and Assets
IAS               38         1997   Intangible Assets
IAS               39         2000   Financial Instruments: Recognition and Measurement                     2002
IAS               40         2000   Investment Property                                                    2002
IAS               41         2001   Agriculture
Exposure Draft               2002   Improvements to IAS - covers IAS 1,2,8,10,15,16,17,21,24,27,28,33,40
Exposure Draft               2002   Amendments to IAS 32 & 39
Exposure Draft        1      2002   First Time Application of IFRS (formerly IAS)
Exposure Draft        2      2002   Share-based Payment

								
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