Welcome back to the the "All About The Profit & Loss Statement" series. We will be concluding the series by covering the topic of corporate income tax. There is nothing certain in life but death and taxes, they say. In Singapore, the income tax calculation for businesses seems relatively straightforward, just apply a 17% tax rate on pre-tax income... or is it?
For this article, we will be discussing some essential information central to income tax. However, to fully appreciate the issue of taxation, it goes beyond corporate finance and into the complex world of tax regulations. With that being said, let us proceed and do leave a like or comment!
TABLE OF CONTENT
What is Corporate Income Tax
Taxable Income vs Net Income
What is Next after Tax?
WHAT IS CORPORATE INCOME TAX?
The corporate income tax refers to the tax levied by the government on the pre-tax earnings after deducting for all business expenses. After the tax is accounted for, the residual amount, also known as net income, is then available for reinvestment into the firm in the form of retained earnings or distributed to shareholders.
The government also collects other forms of tax from businesses, such as property, withholding and GST (for non-GST-registered companies). The tax proceeds received are then used to fund the public sector's spendings and provision of public goods, such as infrastructure investments.
There are 2 tools which the authorities can influence the level of economic activity in their country, namely the monetary and fiscal policy. A quick refresher on the last article on interest, the monetary policy is used by the nation's central bank to influence the money supply. Making money easier to obtain spurs the aggregate demand and private investment, stimulating economic growth.
Another tool, which is termed fiscal policy, is controlled by the government. A government can influence the level of economic spending and guide the country to achieve strategic goals, such as restructuring the economy to meet the challenges of the digital economy and managing climate change, through taxation, public spending and investment. In Singapore's context, a manager should pay notice to the government's annual budget, as it gives an indication of where public spendings are likely to flow into. By having context on which sector the government is encouraging and discouraging, businesses can then better position themselves to benefit.
A government generally does not affect the level of tax revenue by increasing or lowering the tax rate as it brings uncertainty to the business community. Instead, they influence the net tax revenue through a combination of tax policies, exemptions, tax credits, tariffs, etc.
TAXABLE INCOME VS NET INCOME
The net income measures how effectively the business is generating sales and how efficiently it is managing its expenses, and it can be computed after the business tax expense, along with other expenses, are accounted for. It is then adjusted to compute the business's income tax payable.
A business has to reconcile the tax expense and payable. The former is meant for financial reporting purposes and is prepared in accordance with GAAP (generally accepted accounting principles) while the other is for tax reporting in accordance with IRAS regulations. The source of difference could be temporary or permanent in nature.
Permanent differences between income tax expense and tax payable can be explained by non-taxable revenue, non-tax-deductible expenses, and tax credits. This is a non-exhaustive list of non-tax-deductible expenses, non-taxable revenues, and tax credits that results in permanent differences between financial and tax reporting as of 31 Dec 2019. (Source: IRAS articles on Business Expenses and Taxable and Non-Taxable Incomes)
Capital gain on sale of fixed assets
Remuneration paid to related parties not working in the company
Private expenses and interest expense incurred on private loans
Motor expenses for S and RU plated cars
Fines and penalty expenses
Excessive employee's medical expenses
Voluntary CPF contributions
Dividend paid on preference shares
Partial tax exemptions for businesses which income is below a certain threshold
Eugene is the manager of Spring Interior Inc. He receives a notice to file the business's tax returns and proceeds to do so by using the net income as a starting point. He then queries transactions marked as non-taxable income and non-tax-deductible expenses for the last financial year. The company's reported net income is $100 and the income tax expense is $20. The prevailing tax rate is 20%.
The tax payable for the period is $28 ($140 x 20%) and the difference is due to permanent and temporary differences.
Generally for tax reporting, its treatment differs from financial reporting as the former adopts principles of "cash accounting" in which the cash profit is taxed (cash income less cash expense) while the latter adopts accrual accounting and requires incomes and expenses to be recognized when earned and incurred. So it may result in temporary differences which are then recorded as Deferred Tax Assets (DTA and Liabilities (DTL).
DEPRECIATION & CAPITAL ALLOWANCE
Capital allowance replaces depreciation charges, which cannot be claimed under IRAS, allowing the claiming of tax relief against profits for the expenses incurred ONLY on the cost of qualifying plants and machinery, not on all capital expenditures. IRAS defines "plants and machinery" as 1) Not for resale purposes, 2) Functions as apparatus for carrying out business and 3) Not part of the premise in which the business is conducted. Certain capital expenses related to leasehold improvements are still claimable and amortization expenses associated with intangible assets with infinite lives are not claimable.
If the business is GST registered, the capital allowance claimable will be BEFORE GST and conversely, net of GST if the business is not GST-registered. There are 3 methods to compute capital allowance.
DEFERRED TAX LIABILITIES
DTL are liabilities that are created when the taxable income is less than the accounting book income. One prominent cause of DTL is the difference between the capital allowance claimed in tax returns and the depreciation expenses disclosed in the financial statements.
Eugene purchases a laptop worth $48. Under the capital allowance rule, Spring Interior Inc. is allowed to claim 100% of the cost in the first year. But when preparing financial statements, Shin deems that the expected service lifespan of the asset is 3 years and adopts a straight-line depreciation method with zero residual value.
DTL is going to increase the tax payable for future periods. We shall illustrate its mechanics by assuming that Spring Interior Inc.'s taxable incomes before factoring for DTL in the years 2 and 3 are $100. By claiming capital allowance and creating a DTL, Eugene can defer $6.40 worth of tax expense to later years, allowing him to conserve cash earlier after the onset of a costly CAPEX.
DEFERRED TAX ASSETS
DTA is created when the accounting book income is lesser than the taxable income. A common cause is the inclusion of non-cash expenses, such as bad debt and warranty expenses, in the accounting book to comply with GAAP while they are treated as non-tax-deductible expenses by IRAS.
For example, Eugene sets aside $20 worth of warranty expenses to rectify possible construction defects. He expects to incur $12 of actual repair expense in the 2nd year and $8 in the 3rd year. We shall illustrate its mechanics by assuming that Spring Interior Inc.'s taxable incomes before factoring for DTA in the years 2 and 3 will be $100.
DTA is going to decrease the future tax payable. We shall illustrate its mechanics by assuming that Spring Interior Inc.'s actual repair expenses are $12 and $8 for year 2 and 3 respectively. By recording a non-tax-deductible expense in the book and creating a DTA, Eugene is effectively prepaying the tax of $4.00 to cover the period before actual expenses incur.
Tax-loss arises when the company experiences a loss during the year. Tax-losses is a DTA that can be carried forward to offset future taxable incomes, carried back to offset current taxable income or transferred to related companies under the group.
It can be carried forward indefinitely but to utilize it to offset future income, the organization has to satisfy the shareholders' test, when there is no substantial change to shareholders and shareholding. So it is challenging to buy a company just to utilize its accumulated tax-loss.
To realize the benefits of DTA, a company must have positive taxable income to offset against. As IFRS mandates that a DTA is to be recognized to the extent that it is probable that it will be realized, when the realization of DTA is not probable, it has to be written-off.
The benefits of DTA can be realized only when the company has a positive taxable income. If a company is expected to be loss-making in the foreseeable future, such as businesses experiencing a period of sustained high-growth (effectively prepaying OPEX and CAPEX to ready the business for higher revenue) or decline (sunset industries), an external user might remove DTA from the balance sheet asset when analyzing the firm's finances.
When a high-growth company is expected to continue investing in fixed assets in the foreseeable future, DTL is likely to keep increasing. For analytical purposes, it might be better to remove DTL from leverage and add it to equity, to give a clearer picture of the organization's financial prospects.
INTERNATIONAL TRANSFER PRICING
Transfer pricing (TP) is the rate that goods, services, and intangibles are transacted between related parties and it can be done internally and externally. If the transaction happens within the entity, such as when HR charges other departments for handling their HR affairs, it is considered internal TP. Please note that internal TP has ZERO effect on tax.
When the transaction takes place between related business entities such as between a parent company and its foreign subsidiaries, it might be motivated to use TP to manage its corporate tax and tariff exposures. The illustration below explains how a company may use TP to reduce its tax exposure.
The next example illustrates how companies may use TP to reduce tariffs when conducting international trade. The parent company wants to sell to Country C but it imposes a high level of tariffs on imports.
The last example elaborates how companies may use TP to circumvent capital control, especially when repatriating profits as most nations implement capital control to regulate the flow of capital between the international and domestic capital market.
Understandably, TP is highly regulated to ensure that it is conducted at arm's length. This rule dictates that the transfer prices between related parties should be equivalent to prices that unrelated parties would have charged in the same or similar circumstances. Therefore, it requires business acumen and intimate knowledge of complex international tax laws to execute a successful external TP strategy.
WHAT IS NEXT AFTER TAX?
In addition to measuring the effectiveness, the business is generating sales and how efficient it is at managing expenses, it can be interpreted as the residual amount that is available to be distributed to shareholders using dividend or reinvested in the business as retained earnings.
Under the one-tier corporate tax system adopted in Singapore, dividends are not taxable on the individual level if trade or business is carried out in Singapore. If the company is a recipient of a dividend from a local or overseas subsidiary, it is reported under "Other income" after EBIT and subjected to income tax.