What is Tax Accounting?
Tax accounting refers to the methods and policies used for the preparation of tax returns and other statements needed for tax compliance. So tax accounting is basically accounting for taxation purpose. In most of the countries, there are frameworks and guidelines for arriving at a taxable profit which differs from accounting or book profit. Also, tax policies in each country differ with Generally Accepted Accounting Principles on various items. This variation leads to the generation of Deferred Tax assets and liabilities. Also, there are separate guidelines for VAT (Value Added Tax) accounting, transfer pricing and cross border transactions which all fall under tax accounting.
Components of Tax accounting
The reason for doing Income Tax accounting is arriving at taxable profit and tax payable by making adjustments in the book profit arrived by accounting principles. All these working and adjustments form part of the Tax return and these statements are kept for Tax audits. There are various components of accounting for taxation, some of which are discussed below –
#1 – Deferred Tax asset
Is generated when there is a difference in book profit and taxable profit arises due to a timing issue. There are expenses like provision for doubtful debts which are considered for deduction in accounting in the current year, however, these are allowed for a deduction for taxation only when the amount is declared as bad debt which can happen in coming years.
In this case, the taxable profit will be higher compared to accounting profit and the person or organization will pay more taxes this year which. The extra amount paid as tax on incremental profit due rejection of provision amount for deduction is considered as deferred tax which will be realized in coming years.
#2 – Deferred Tax liability
Deferred Tax Liability is generated when the person or organization has to pay fewer taxes in the current year due to the timing difference. For example – let’s consider that an asset of $10,000 is being depreciated in accounting books under (SLM) straight-line method for 8 years – the depreciation each year will be $1,250 ($10,000/8).
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However, if the tax rules state that assets have to be depreciated @20% (WDV) written down value method. The depreciation for taxation purpose in second year will be $1,600 (($10,000 – 2000 i.e. 20% for first-year) = $8,000*20% = $1,600)).
Here the organization will get an extra deduction of $350 ($1,600-$1,250) for taxation purpose. If we consider the tax rate to be 30%, the deferred tax liability here is $105 ($350*30%).
#3 – VAT Accounting
Most of the countries a Good & Service Tax (GST) or VAT (value-added tax) which forms part of almost all the invoices issued. Now, this should not be considered as expenses directly because the organizations get an Input Tax credit on the amount already paid. To claim those inputs, the tax authorities lay certain condition regarding the format of invoice, name, and registration of the company, details of the second part, etc and all these conditions have to be met by tax accounting team before claiming VAT/GST input credit.
It is one of the most important parts of Tax accounting as an organization could lose millions of dollars if input credits are not availed in prescribed time and manner.
#4 – Transfer Pricing
In today’s world of globalization, many companies open their branches in various parts of the world. Transfer pricing is monitored by a policy called Arm’s Length Pricing which advocates the fair-trade policy across the globe. In simple words, it says that a related part or person should not avail good or services at a lower cost than the price at which it has been sold to an unrelated third party.
Also if an organization has set up an only offshore office where people are working and no other business is being done in that country. As per the Transfer pricing policy, the organization has to pay a certain percentage (8-15%) of Tax on the expenses incurred in operating the offshore office. Transfer pricing is one of the fast-paced and challenging tax accounting components in today’s world.
#5 – Categorisation of Income
Accounting considers all the receipts and payments for calculating the accounting profit. However, not all the receipts are related to business and the rate of tax differs depending on the type of receipt it is.
Let’s consider below example –
In table 1 the extract from accounting books is shown and in the second table shows how the tax accounting has to categorize the type of income as the Income taxes rates differ on types of Income.
Advantages of Tax accounting
- Categorization of Income for application of correct tax rate.
- Statutory compliance adherence.
- Losses of current and previous years can be set off in future periods by filing Tax returns.
- Tax audit facilitation.
- Self-assessment and tax payments in a timely manner.
Disadvantages of Tax accounting
- Needs extra time and resources for the work.
- Tax professionals charge dearly to organizations.
- There are changes in tax policies almost every year.
Important Points to Note
Every time there is a change in policies, tax rates, etc. the organizations/individual must keep themselves updated and accounting software should be amended accordingly.
Tax accounting is pivotal to any business or individual as it provides a framework to declare the correct income and pay appropriate taxes. In case of ambiguity, a tax professional should be consulted to avoid any miss in tax compliance as there are fines and penalties for tax defaulters. Tax accounting also works for tax avoidance by selecting which method works best for each type of businesses or individual.
This has been a guide to Tax Accounting and its meaning. Here we discuss various components of accounting for taxation including deferred tax assets & liabilities, VAT, Transfer pricing, its advantages, and disadvantages. You can learn more about accounting from the following articles –