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Journal of the Australasian Tax Teachers Association |
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THE TAXATION AND ACCOUNTING INTERFACE IN NEW ZEALAND
JIM GORDON[*]
This article examines the legislative interface between accounting and taxation in New Zealand. It does not discuss, except in passing, the use of accounting concepts by the courts to decide tax cases.
The issues concerning whether New Zealand’s Income Tax Act 1994 (‘Tax Act 1994’) should more widely rely on accounting profit are considered, and a number of reasonably obvious problems with this suggestion are raised. The article then goes on to examine the Act’s specific reliance on accounting principles and standards. There is also a brief discussion about potential further reliance on accounting standards for tax purposes.
II NEW ZEALAND’S INCOME TAX SYSTEM – A BRIEF HIGH LEVEL OVERVIEW
The Tax Act 1994 has English antecedents in the area of the calculation of income by trustees.[1]This predicates, among other things, a capital / revenue boundary. New Zealand does not generally tax capital gains nor allow deductions for capital losses or expenditure.[2] This is the case even though the Tax Act 1994 states that ‘the gross income of any person includes any amount derived from a business’[3]and ‘the gross income of a person includes any amount that is included in gross income under ordinary concepts’.[4]This is on the basis that the term ‘gross income’ does not include capital amounts.[5]
Obviously, the Tax Act 1994 has a number of overlays of greater or lesser significance over this trust basis. An example is the general separation and aggregation of income and deductions, rather than the returning of income from a business activity on a net basis (although mathematically the answer is the same).
It has been suggested by some commentators that this structural separation of income and deductions means that some of the common law with which we have been familiar is no longer relevant.[6]The Tax Act 1994 does not now (if it ever did) focus on ‘net business income’. Thus cases that deal with ‘net income’ are now arguably irrelevant, although this has yet to be fully tested. The New Zealand tax system does rely on case law in the area of the capital / revenue boundary and in determining the timing of income derived and expenditure incurred, and will continue to do so.
Another overlay is the treatment of financial arrangements which completely ignores the derived and incurred rules, and instead focuses on income from financial arrangements as it would be defined by an economist (yield-to-maturity or market value based).[7]
Tax depreciation is calculated on statutory rates that are based on estimated economic life (as in financial reporting), but it may be straight line or diminishing value. These depreciation rates are then generally loaded by 20 per cent (that is, accelerated depreciation).
However, a number of provisions are not deductible:
∞ provisions for doubtful and bad debts (bad debts have to be specifically written off to be deductible); and
∞ provisions (whether incurred or not) for employee remuneration.[8]
Other provisions are deductible:
∞ insurance industry ‘incurred but not reported’ type provisions; and
∞ warrantee provisions.
A References to Generally Accepted Accounting Principles
The Tax Act 1994 makes no general reference to income as per the financial reports or as calculated under New Zealand’s Generally Accepted Accounting Principles (‘GAAP’). There are, however, more specific references to GAAP that are referred to below. More relevantly, there are two references to specific accounting standards, being trading stock and research and development.
III FINANCIAL REPORTING IN NEW ZEALAND
A Statutory Financial Reporting
The relevant statutory requirements for companies are those imposed by the Companies Act 1993 (NZ) and the Financial Reporting Act 1993 (NZ) (‘FRA ’) (that require all companies to prepare financial reports). In numerical terms, a substantial number, if not a majority, of companies are ‘exempt companies’ that are allowed to produce simplified financial reports.
A company is an exempt company if:
∞ it is not a subsidiary;
∞ it has no subsidiaries;
∞ it is not an overseas company carrying on business in New Zealand;
∞ its assets do not exceed NZD 450 000; and
∞ its turnover does not exceed NZD 1 000 000.
Exempt entities must report in the form specified in the Financial Reporting Order 1994 (NZ),[9]but there are no GAAP or ‘true and fair’ requirements. Some of these reports may still comply with GAAP if the preparer is a chartered accountant and there is no significant impediment to such compliance. All other companies, and a number of other entities, are reporting entities, or the equivalent, and have to prepare financial reports that comply with GAAP, with an overlay that they must contain sufficient information to be ‘true and fair’.[10]
It is interesting that the New Zealand Parliament in 1993 perceived that compliance with GAAP might not necessarily result in financial reports that are ‘true and fair’.[11](However, refer below for more discussion on this.) GAAP is defined for the FRA in section 3 of that Act.
B Professional Requirements
Where general purpose financial reports are prepared or audited by a member of the Institute of Chartered Accountants (‘ICANZ’),[12]there are obligations imposed on that member regarding the use of GAAP.
However, this raises the immediate question of what constitutes a general purpose financial report?’. Or, put another way, what does not constitute a general purpose financial report?’. Together with exempt companies, special purpose financial reports (for example, reports prepared for a bank or the Inland Revenue Department) are excluded and do not need to comply with GAAP.
General purpose financial reports can comply with differentially specified GAAP. In general, if an entity:
∞ is not publicly accountable;
∞ was there is no separation between the owners and the governing body; and
∞ is not large; then differential (simplified) reporting exemptions apply.
An entity is ‘large’ for this purpose if it exceeds any two of the following:
∞ total revenue of NZD 5 million;
∞ total assets of NZD 2.5 million;
∞ 20 employees.
Paragraphs 5.1 and 5.2 of ICANZ’s explanatory foreword define GAAP, and then go on to discuss ‘fair presentation’ (its equivalent of ‘true and fair’). Compliance with GAAP is necessary to produce general purpose financial reports that are ‘true and fair’. The Foreword notes that:
in rare circumstances that compliance with [GAAP] does not result in the financial reports giving a true and fair view, additional information and explanations are to be provided in order to give a true and fair view.
It seems that the FRA’s ‘true and fair’ overlay to GAAP is therefore probably technically redundant.
The ICANZ definition of GAAP for its members is effectively the same as the FRA’s definition of GAAP. This is because, in effect, both point to the ICANZ pronouncements, which in turn incorporate the Accounting Standards Review Board’s Financial Reporting Standards. The Accounting Standards Review Board is a creation of the FRA.
C No Requirement to Use GAAP
In addition to financial reports for exempt companies and special purpose reports, people who are not ICANZ members have no obligation to follow GAAP, except for non-exempt company reports. Such non-members deal with a significant number of small business reports, albeit that they are frequently prepared for tax purposes and as such are probably special purpose reports.
D General Use of GAAP for Financial Reporting
Numerically, therefore, it seems that a small portion of the financial reports of all businesses comply with GAAP.[13]Further, it seems likely that this lack of any requirement to comply with GAAP results in financial reports that may not be ‘true and fair’ as the auditor would understand this term.
The smaller the business is, the less likely its financial reports will comply with GAAP. Further, the more onerous GAAP becomes, or is perceived to become, the more, it appears, special purpose reports will be prepared.
IV TAX AUTHORITIES RELIANCE ON FINANCIAL REPORTS
A common goal of a number of governments and their tax authorities is that of tax simplification. The question is fairly asked as to whether the authorities could rely on financial reports and use them as a basis for taxation, either by taxing the ‘net income before taxation’ disclosed by the financial reports, or by further adjusting that net income figure?.
There are a number of potential issues with this — the financial reports would, among other things, have to be consistently prepared from year to year, be verifiable and in the interests of equity between taxpayers, produced to a common standard. These issues could be addressed by the more widespread use of GAAP.
Another issue would be the lessening of the ability of government to offer taxation incentives if the reported ‘net income before taxation’ was to be taxed. Accelerated deduction-type incentives such as depreciation or film expenditure could be problematic.
Also, taxation could start to lead the development of GAAP, which would be inappropriate, especially given the number of stresses and strains that already exist with in the evolution of GAAP. It is interesting that differential GAAP already recognised, presumably subject to the ‘true and fair’ overlay, that the 20 per cent depreciation loading and the use of straight line or diminishing value rates is acceptable.
Further, in New Zealand, a current government focus is on simplification for small business, that is, the sort of business that is unlikely to currently report in compliance with GAAP. Given the compliance cost effect, imposing a GAAP requirement (with the objective of addressing some of the problems identified above) could be expected to result in a significant increase in compliance costs for this group, rather than the reduction that is being sought.
A Financial Reports as a Starting Point for ‘Net Income’
Except where special purpose financial reports are prepared that lead directly to ‘net [taxable] income’,[14]the starting point for the taxation reconciliation is always the financial report’s ‘net income before taxation’. This figure is then adjusted by a variety of items to produce ‘net income’.
To this extent it could be said that financial reports are therefore relied upon. However, given that the nature of the adjustments required will vary depending on the quality and contents of the financial reports, this reliance is somewhat superficial. Every item of income and expenditure that in net terms comprises taxable income should comply with the requirements of the Tax Act 1994. In practice, this leads to a number of reconciling items.
B Reconciliation Between Accounting and Tax for New Zealand Companies
The major reconciling items (permanent and timing) for large New Zealand companies that are audited are:
∞ depreciation (small value assets, software development costs, depreciation rates and gain / loss on sale adjustments) (both permanent and timing);
∞ trading stock (almost always timing);
∞ tax exempt dividends (permanent);
∞ gross-up for useable imputation credits (permanent);
∞ other dividend adjustments (for example, conduit) (permanent);
∞ employee remuneration provisions (almost always timing);
∞ other non-deductible provisions (for example, bad debts, ACC and trading stock) (almost always timing);
∞ goodwill amortisation (permanent);
∞ ‘use-of-money’ interest which is often mistakenly part of tax expense (permanent);
∞ gross-ups for foreign income (for example, foreign non-resident withholding tax on interest) which is often not done for accounting purposes (permanent);
∞ non-deductible expenditure (usually capital but expensed, for example legal costs/services) (permanent);
∞ capital gains / losses (permanent);
∞ entertainment expenditure (permanent);
∞ financial arrangement adjustments (often only for financial institutions) (timing);
∞ life and general insurers’ adjustments (various);
∞ income and expenditure long line and exp for/in relation to long-term construction contracts (timing); and
∞ more specific adjustments for forestry, specified minerals and oil and gas (usually permanent).
One could argue that some of these adjusting items, for example the non-resident withholding tax gross-up and use-of-money interest, should not need adjustment if correctly dealt with in the first place. However, because the amounts are typically immaterial for financial reporting purposes, they must then be separately dealt with for taxation purposes.
Smaller entities’ (non-audited) reconciling items typically include:
∞ gross-ups for credits on dividends received (if the gross-ups are not already in the reports), but, in this context, a number of smaller business will simply not receive dividends; and
∞ entertainment expenditure.
Typically financial arrangements are not included because for the more usual financial arrangements, the taxation requirements are the same as what good, or even reasonable, reporting would require. Depreciation is also not included because smaller entities use tax rates of depreciation – both the exempt companies’ requirements and the differential reporting requirements allow this.
It seems that there is little scope for useful tax simplification by relying more on financial reports or general purpose financial reports that comply with GAAP, partially because it is the bigger entities that have to complete the most adjustments, and partially because the reconciling items can vary significantly from taxpayer to taxpayer.
V TAX ACT REFERENCES TO GAAP AND ACCOUNTING STANDARDS
As indicated above, the Tax Act 1994 contains a number of references to GAAP. These are generally to ensure that accounting concepts such as timing, assets, income and such like are properly defined. The references include:
Section CD 3A which deals with the timing of certain monetary remuneration provisions’ movements according to GAAP treatment;
Subpart CG which deals with attributed foreign income of controlled foreign companies and foreign investment funds, and, for example, refers to shareholders funds and after tax accounting profit measured according to GAAP;
Section DK 5 which provides that general insurers’ provisions for claims must have regard to GAAP;
Subpart EE which contains the trading stock valuation rules, refers to GAAP, and requires the use of Financial Reporting Standard (‘FRS’) 4 for larger taxpayers (accounting for inventories);
Subparts FG – FH which deals with thin capitalisation and excess interest allocation rules and refer to GAAP; and
Section OB 1 which contains the Tax Act 1994’s definitions and regularly refers to GAAP.
GAAP is itself defined in section OB1 of the Tax Act 1994 as the FRA section 3 definition. Specific Tax Act 1994 references are also made to two FRSs.
A Trading Stock
The Tax Act 1994 values trading stock, with modifications, with direct reference to the FRS 4 valuation of inventories.
At a high level, the modifications:
∞ exclude consumables because the Tax Act 1994 has its own treatment;
∞ reduce perceived revenue risks;
∞ reduce small taxpayers’ compliance costs; and
∞ exclude partially completed services.
The use of FRS 4 in this fashion means that the year-end add-back for trading stock can include items that are simply not deductible for tax purposes. Alternatively, the timing of the deductions might be different for taxation and accounting.
The best example of this is depreciation of manufacturing plant. The FRS calculation will be based on accounting depreciation and ignore tax depreciation. Ordinarily this will result in timing differences (resulting from the different accounting and taxation depreciation rates). However, where the plant has been revalued for accounting purposes, the difference is more permanent (albeit it that it must eventually reverse). While this is conceptually unusual, in practice it does not seem to have produced any problems.
The use for tax purposes of FRS 4, and the simplified version the Tax Act 1994 allows, seems to have been widely accepted by taxpayers, although some of the larger ones might like even greater adherence to the standard.
B Research and Development
The current provisions governing the deductibility of research and development link directly into FRS 13. Any expenditure that is expensed under paragraphs 5.1 or 5.2 of the FRS, or written off under paragraph 5.4, can be deducted for tax purposes.
Also, where research and development is less than NZD 10 000, it is not material and is expensed for accounting, it is tax deductible.
It has been suggested that this still leaves an issue with ‘black hole expenditure’: expenditure that is capitalised and amortised under the FRS, but where there is no tax deduction or depreciation. To date there is no empirical evidence that this problem is real. However, time will tell, and further tax policy work is being done on this.
This relatively new treatment of research and development seems to have been welcomed by most affected taxpayers. However, as suggested above, there are still some residual concerns.
C Potential Future Use of Accounting Standards
Further reliance on GAAP to reinforce accounting concepts and on specific accounting standards is inevitable. The most prominent example of this could be long-term construction projects, which, for financial reporting purposes, are governed by FRS 14.
The 1991 Consultative Committee on the Taxation of Income from Capital compared the financial accounting treatment and the tax treatment of long-term construction projects and recommended that the tax treatment of these projects could be aligned with the financial accounting treatment.[15]
The current tax treatment of construction contracts with pre-determined customers is governed by case law. Income on construction contracts is assessable when it is derived in accordance with ordinary principles. Broadly, contractual provisions would determine the timing of revenue derivation under a construction contract. Where a contract provides for the circumstances in which progress payments are made, income under the construction contract is derived when the progress payments are due.
There is currently no specific requirement to match expenses with revenues. In particular, work in progress, once it is affixed to the building, appears not to be trading stock or revenue account property.
The use of accounting treatment as a timing rule for tax purposes would seem to be an appropriate way to tidy this up. However, the matter is not currently under consideration on the Government tax policy work programme.
It seems doubtful that simplification of itself will lead to a general reliance by the Tax Act 1994 on GAAP because of the compliance cost effect on smaller businesses. However, the use of GAAP to help define accounting concepts, such as income and shareholders’ funds, and to time transactions is entrenched and is likely to expand.
Further use of accounting standards to address specific issues such as long-term construction contracts also seems to be likely, albeit not in the immediate future.
Although not discussed in detail in this article, there also will be continued reliance on case law that, in turn, will be supported by accounting concepts to address timing and capital / revenue matters (in particular).
[*] Batchelor of Business Studies, Chartered Accountant, Policy Manager, Inland Revenue Department, New Zealand. This article is based on a Paper presented at the15th Annual Australasian Tax Teachers Association Conference, Faculty of Law, University of Wollongong, 30 January – 1 February 2003. Note: While the author is an employee of Inland Revenue New Zealand, the analysis and opinions presented in this article are those of the author alone and are not those of his employer or the Government.
[1] This has now been replaced by the Income Tax Act 2004, but in the matters covered by this paper there are no substantial changes
[2] Obviously there are a number of areas where this is not scrupulously followed, for example all gains from financial arrangements, except private ones, are on revenue account. However, the capital boundary is retained for capital losses from financial arrangements. Likewise, some land transactions are also on revenue account.
[3] Income Tax Act 1994 (NZ) s CD 3.
[4] Income Tax Act 1994 (NZ) s CD 5.
[5] This is not explicitly stated, but is (at least now) completely, accepted.
[6] Refer later discussion on income from long term construction projects.
[7] The financial arrangements area is the one major area where income and expenditure are not separated, rather they are dealt with in net terms.
[8] The actual rules do allow a deduction for remuneration incurred at balance date that is paid out within a specified period after balance date (refer ss EF 1 and EF 1A of the Tax Act 1994).
[9] Clause 3 and Schedule
[10] Financial Reporting Act 1993 (NZ) s 11(1) and (2).
[11] The 1993 Act indicates this
[12] Institute of Chartered Accountants New Zealand (‘ICANZ’) is now the New Zealand Institute of Chartered Accountants (‘NZICA’).
[13] Estimate by the author, not authoritive in any way.
[14] Income Tax Act 1994 (NZ) s BC 6.
[15] Consultative Committee on the Taxation of Income from Capital (‘Valebh Committee’), Final Report (1991), ch 8 Tax Accounting Issues, Appendix 10 Recommendations.
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URL: http://www.austlii.edu.au/au/journals/JlATaxTA/2005/3.html