Taxation in Finance and Accounting

This book is designed to be an introduction to taxation, particularly for readers in the field of Finance and Accounting. Taxation is part of everyone’s regular routine, as it affects individuals at both the personal and professional levels, as well as organizations and firms. Taxation is becoming more and more relevant. This chapter explains how governments around the world have been increasing their public expenditures over the last decades, especially in the OECD countries. This led to an increase in taxation revenues, but also in fiscal deficits, which thus led to higher levels of public debt. This chapter details how the book is organized and briefly describes the main objectives and topics of each of the chapters. The aim of the book is to cover almost all the relevant basics of taxation. Other books and materials should be consulted for further learning, and national-level learning of taxes, in particular, should be addressed to learn about specific issues regarding each tax.

This chapter describes the main principles and concepts of taxation. It discusses the definition of taxation and taxes, the main characteristics of a tax system, and the sources of tax legislation. The classification of taxes, taxable events, and the application of taxes on time and the respective jurisdiction, as well as tax enforcement, are also discussed. In addition, several issues specifically related to the structure of taxes are also analyzed, namely: the incidence of the tax, tax exemptions, as well as the concept of taxpayers, tax period, the tax base, and the amount of tax and tax rates. With regard to government, this chapter examines tax expenditures, tax avoidance and evasion, and the tax gap, as well as tax administration and administrative tax procedures. The issue of tax competition and, on the contrary, tax harmonization are discussed, mainly at the OECD and the EU level. The topic of environmental taxes is also covered. Finally, we also analyze the basis of the relationship between ethics and taxation.

Taxation has a significant impact on Economics. On the one hand, taxation impacts on microeconomics (especially in the areas of demand and supply, labor supply, and microeconomic efficiency). On the other hand, taxation also impacts on macroeconomics, mainly in the following areas: public finance (deficit, public debt, and revenues), inequality, externalities, changes in the IS-LM model, and the issue of tax effort. This chapter provides an overview of the impact of taxes on such topics.

Taxes are a substantial and relevant part of accounting. They impact on the balance sheet as assets and liabilities. They can be assets if there is a refund of taxes and if the firm has deferred tax assets. They can be a liability concerning taxes that are already assessed but need to be paid the following year (i.e., they are a liability, but there was no failure in terms of tax compliance) and as taxes that surpass the payment limit (i.e., the firm failed in terms of the tax compliance). They also impact on the P&L, as taxes can be a cost or, in the case of corporate tax, they are subtracted from pre-tax profits (EBT) in the calculation of post-tax profits (net income). In this chapter, we analyze the main concepts, the impact of taxes on the balance sheet and P&L, how to account for corporate tax and VAT, and also the issue of deferred tax assets.

Taxes have a strong impact on the three main decisions (Investment, Financing, and Dividends) of Corporate Finance and, therefore, on creating shareholder value. Taxes should be a vital concern for managers, particularly in the Finance Department. Taxes impact decisions regarding investment, as tax payments reduce the NPV and a project’s return. However, the way firms calculate tax costs, tax benefits, and tax deductions can all reduce tax costs and mitigate such effects from taxes. In turn, taxes impact financing decisions. The relative tax debt advantage influences the capital structure of a firm. The use of debt (with limits) may provide a reduction in the cost of capital twice over: the interest rate being lower than the cost of equity and the tax benefit of deducting interest costs (when dividends are usually not deducted, however, such a marginal benefit, which only occurs if the tax benefits exceed the marginal financial distress costs). This increases shareholders’ returns and the value of the firm. The dividend decision (whether to pay to shareholders through dividends or shares buybacks) is also affected at the income tax level if there is any difference in taxation of dividends or of capital gains as income.

Almost all countries have a personal income tax, which taxes individuals’ income, such as salaries, rents, pensions, dividends, profits, and interest, among other income. In this chapter, we explain the main principles that most income taxes around the world follow, namely: the definition of the several types of income, the issue of residence and tax obligations in the taxpayer’s country of residence, and also in countries where the taxpayer is non-resident, but also earns income, as well as the issue of the tax period. Furthermore, we also discuss the income tax structure and the objectives of the income tax. Finally, the relevant topic is the type of income tax rate: proportional, “flat-rate,” progressive, or negative income tax. According to the economic literature, we then analyze each type of tax rate, how they work, and the main advantages and disadvantages of each tax rate. A few examples and exercises are also provided.

In most countries, firms and organizations are subject to a corporate tax. The main principles of such a tax (incidence, tax persons, residence, permanent establishment, tax period, and revenues and costs) are largely harmonized at the OECD level. In addition, most countries have a similar conceptual framework of corporate tax whereby firms pay corporate tax based on their accounting pre-tax profits, after tax adjustments. The respective tax adjustments are based on transactions that cannot, or should not, be recorded by the tax rule, but rather by the accounting rule (e.g., not-deductible costs, tax benefits, or operations subject to different treatments between accounting and tax). This chapter also analyses several relevant issues for corporate tax purposes, namely: depreciation, grants, capital gains, tax losses carried forward, loan interest deductions and limits, corporate tax rates, and declarations and payments. Several examples across each topic and exercises are presented at the end.

This chapter analyses the issues related to tax planning and tax management. First, the concepts of both these subjects are defined, as well as the concepts and differences between tax avoidance and tax evasion. In addition, the following subjects are also discussed, with practical examples: tax benefits, tax credits, tax shelters, and tax incentives. Furthermore, the chapter also analyses how depreciation is analyzed in tax planning and how both depreciation and the tax losses carryforward are used by firms in their tax planning. How tax planning impacts investment, finance, and dividends decisions is also addressed, further to Chap. 5. Finally, several exercises are proposed.

Value-added tax (VAT) has become the most common tax on consumption worldwide. In this chapter, the conceptual and practical framework of this tax is explained. This chapter also analyses several key concepts of VAT, for example, the concept of goods and services, VAT-registered persons, complete and incomplete exemptions, VAT-registered base, VAT rates, VAT deduction, and payment and reimburse/credit of VAT.

Furthermore, the rules governing the location of operations for VAT are also explained in detail, as well as rules for exports and imports and the specific rules of the European Union.

The rules for the transaction of goods in the EU are also discussed, namely intra-community transactions and the acquisitions rule for B2B and B2C, together with the rule when the buyer is subject to incomplete VAT exemption or is a public entity that is exempt from VAT. In addition, the specific rules for electricity and gas are analyzed (which are considered for VAT purposes as being a good) and also the rules for selling goods online. “Triangular” and “false triangular” operations are also examined in detail.

The rules for services in the EU are also examined, namely: the two main rules and the exceptions (with the exception always prevailing, if applicable); the exception for services regarding real estate, events, catering, and transport; the exception for services such as consulting, legal, financial, telecom, or advertising; and the exception for the intra-community transport of goods.

Finally, VAT fraud is analyzed, as well as the VAT revenue gap and the issue of VAT and inequality.

Several examples and exercises are provided in this chapter.

International double taxation is more and more relevant nowadays, as economies are becoming more and more integrated, and individuals and firms increasingly operate in more than one country. International double taxation is the obligation for the same taxpayer to pay income or corporate tax in more than one country. In most countries, Double Taxation Agreements (DTA) play a vital role in reducing or eliminating international double taxation. Such DTAs are agreed upon between two countries based on a common framework, usually the OECD Model Tax Convention on Income and Capital. There are more than 3000 DTAs, with most of the OECD countries having dozens each. However, in cases where no DTA exists between two states, the residence state usually has at least one method in place to reduce or eliminate international double taxation for income and corporate tax in the law. Theoretically, four methods exist: total exemption, exemption with progressivity, full tax credit, and partial tax credit. Most states employ the second (exemption with progressivity) for some public functions, although the fourth method is the one mostly used with regard to income earned abroad.

This chapter addresses the issue of transfer prices. This has become more and more relevant in a globalized economy and increasingly in the role of multinational firms. Transfer prices are related to transactions between firms that are considered to be related parties, and as such, transactions may not be directly subject to the “arm’s length principle.” Accordingly, the related transaction price needs to be justified by using a comparable non-related transaction. The OECD model convention on transfer prices is the central pillar of this topic, which establishes five main methods for assessing the transfer price of related transactions. Such a transfer price is based on a non-related transaction that is comparable with the related transaction in question. In turn, transfer price methods are divided into “traditional transaction methods” and “transactional profit methods,” either of which can be used to establish whether the conditions imposed in the commercial or financial relations between associated enterprises are consistent with the arm’s length principle. The traditional transaction methods are the following: the comparable uncontrolled price method or CUP method; the resale price method; and the cost-plus method. The widely used transactional profit methods are the transactional net margin method and the transactional profit split method.

Tax harmonization represents the process of adjusting different tax systems in different jurisdictions (usually different countries) to a common framework. In the context of the European Union, this is particularly relevant, as substantial tax distortions exist regarding economic activity and the four freedoms, namely: free movement of goods; free movement of capital; freedom to establish and provide services; free movement of persons. EU tax harmonization has been carried out at different paces, with indirect taxes (VAT and excise taxes) being almost fully harmonized, however, there is still a substantial lack of harmonization in the case of corporate tax, despite some recent Directives.

This chapter discusses EU tax harmonization at both corporate tax and VAT level, and then proceeds to detail two main proposals of the EU Commission: the CCCTB (Common Consolidated Corporate Tax Base) and the FTT (Financial Transaction Tax).