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The contrasting perspectives on income  measurement

The contrasting perspectives on income measurement

A FRIEND of mine once asked me, if a firm uses the same overall method of accounting in preparing its financial records and to prepare its tax returns shouldn’t that firm’s annual net income per books of accounts equal current year taxable income as per the tax return.

The answer to this question is usually NO. For most business ventures, book income and taxable income are different numbers. Discrepancies between the two incomes computations occur because certain transactions are treated one way under the International Financial Reporting Standards (IFRS) under which the Financial Statements are prepared and another way for a tax accounting purposes as per the income tax act.

One explanation for the inconsistent treatment is the contrast in perspective on the income measurement that shape financial accounting principles and the tax laws. Business Managers have one attitude towards the measurement of income for financial statement purposes and a different attitude toward the measurement of income for tax purposes.

Businesses have incentives to report as much book income as possible. Their compensation and even their job security may depend on the level of earnings reported to existing and potential investors in the firm/company.

However, IFRS is based on a principle of conservatism, when in doubt financial statements should delay realization of income and accelerate the realization of losses.

This is being prudent and aims at curbing any tendency on the part of the management to inflate books income by overstating revenues and understating expenses.

In contrast to their expansive attitude toward book income, managers typically want to deflate the taxable income (and resultant tax liability) reported to the government. The Tanzania Revenue Authority are aware of this measurement bias.

The Income Tax Act, 2004 (CAP 332 RE 2019), embraces a principle of conservatism, but one that operates to prevent managers from understating gross income and overstating tax deductions.

The contrary principles of conservatism brought about by the IFRS and the income tax legislation lead not many of the book/tax differences.

The natural tension between income measurement under the IFRS and income measurement under the Income Tax Legislation mainly exists for firms/companies that prepare financial statements for external users and income tax returns for the government.

Small firms privately owned who account for their income taxes under the presumptive method and only prepares accounts for their internal use only may have minimal or even no difference between their book income and taxable income.

The other reason for the differences in the tax computation of financial statement income and the tax return income tax computation is that precise measurement of income is not the sole objective of the tax law. It’s the Government’s wish that the tax law is consistent with public policy and political concerns.

The provisions in the Income Tax Legislation that achieve this consistency have nothing to do with income measurement. For example, contributions to a political party or candidate for public office, lobbying expenses are not tax deductible in the computation of taxable income.

However, firms /companies certainly must account for these business expenses in the accounting of business expenses. Therefore, they may be deductible for accounting purposes but not deductible for tax purposes.

Because Government does not want to indirectly subsidize partisan efforts to influence legislative matters, the expenses do not reduce taxable income regardless of the firm’s method of accounting for tax purposes.

The Income Tax Act, 2004 (CAP 332 RE 2019), under section 11, the Act has specifically restricted deductions of some business expenses for tax purposes.

The Income Tax Act, under section 11, restricts deductibility of certain expenditures which include consumption expenditure incurred by the business or excluded expenditure incurred by the business.

It should be noted that there are exceptions. For purposes of clarity, consumption expenditure has been defined to mean any expenditure incurred by any person in the maintenance of himself, his family or establishment, or for any other personal or domestic purpose on the other hand Excluded expenditure has been defined to mean • Tax payable under the Income Tax Act 2004.

• Bribes and expenditure incurred in corrupt practice;

• Fines and similar penalties payable to a Government or a political subdivision of a Government of any country for breach of any law or subsidiary legislation;

• Expenditure to the extent to which incurred by a person in deriving exempt amounts or final withholding payments;

• Distributions by an entity; or

• Withholding tax paid by a withholder; and

• Expenditure of a capital nature that is expenditure that secures a benefit lasting longer than twelve months. Businesses also incur interest expenses.

In the case of interest expenses tax deductibility, the interest incurred by the business during a particular year of income under a debt obligation must be incurred wholly and exclusively in the production of income from a business or investment to be deductible for tax purposes.

Where the debt obligation was incurred in borrowing money, the money is employed during the year of income or is used to acquire an asset that is employed during the year of income wholly and exclusively in the production of income from the business or investment; or in any other case, the debt obligation is incurred wholly and exclusively in the production of income from the business or investment.

However, it should be noted that the total amount of interest that an exempt controlled resident entity may deduct in accordance with section 11(2) of the Income Tax Act [CAP. 332 R.E 2019) for a year of income should not exceed the sum of interest equivalent to debt-to-equity ratio of 7 to 3.

An entity is an exempt controlled resident entity for a year of income if it is resident and at any time during the year of income twenty five percent or more of its underlying ownership is held by entities exempt under the Second Schedule of the Income Tax Act [CAP. 332 R.E 2019), approved retirement funds, charitable organizations, non-resident persons or associates of such entities or persons.

The key deciding factor for tax deductibility of business or investment expenditure is the expenditure must be incurred during the year of income, by the business wholly and exclusively in the production of taxable income from the business or investment.

Tax deduction is not allowed for expenditure of a capital nature. Expenditure of a capital nature means expenditure that secures a benefit lasting longer than twelve months.

Overall, it should be noted that the tax law may disallow a deduction for certain business expenses because of the public perception that the expenses themselves are in some way inappropriate.

Businesses cannot deduct fines or penalties paid to a government for the violation of any law, nor can they deduct illegal bribes or kickbacks paid in the course of a business transaction.

• The writer, Godvictor Lyimo is the President of Tanzania Association of Accountants (TAA) reachable via godvictorl@yahoo.co.uk and Phone: 0787514014

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Author: Godvictor Lyimo

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