I couldn’t agree more with the dictionary’s definition of the word ‘taxing’ as something difficult or requiring a lot of thought or effort. Such an adjective best describes what each taxpayer has to go through prior to filing their tax returns. It requires a clear understanding of the existing tax laws and regulations and diligence in complying with various requirements imposed by the local tax authority. So the concern here is this: how can one file an accurate tax return without having a mastery of existing tax laws and regulations?
As an external auditor by profession, I have had the privilege of working with a number of corporate clients from multinational companies to small and medium-sized entities. One of the areas we carefully examine is the company’s compliance with tax laws and regulations, including a review of the company’s income tax computation. As independent auditors, the level of work that we perform is driven by our risk assessment, or put simply, we focus and perform more work on areas we believe are prone to errors or where are our clients’ financial statements could potentially be exposed to risks of material misstatements. Tax compliance issues or tax exposures are matters that oftentimes catch the attention of management, and why wouldn’t they be interested when these exposures carry onerous penalties and interests, not to mention potential criminal or civil liabilities?
Leave it to the tax experts
Managing tax compliance is as equally important as meeting your company’s sales targets or monitoring costs and expenses to make sure that desired financial results meet the shareholders’ expectations. Failure to manage this process oftentimes haunt executives long after they have reported the results to business owners and declared dividends based on what they perceived to be available profits at that time. Yet, a number of CEOs and CFOs I know delegate the responsibility of tax matters to their accounting managers or tax consultants. I don’t blame them; compliance can be quite taxing.
Business transactions and the related accounting and tax rules have become increasingly complex. Accordingly, having a dedicated tax department or engaging seasoned tax practitioners has now become a necessity rather than a luxury for multinational companies and local conglomerates. But does it mean that management’s responsibility ends with getting the right people to manage tax compliance? Frankly, the answer is no. The responsibility for the accuracy of tax returns rests with the company’s executives who ultimately signs off on the required Statement of Management’s Responsibility that is filed together with the income tax return. Business executives have to be sufficiently involved in monitoring the Company’s compliance with prescribed tax rules and regulations and making the necessary judgment in areas of taxation where the rules are not exactly black and white.
Not even the large multinationals and conglomerates that have the financial resources to hire experienced tax managers are spared from deficiency tax assessments. The massive volume and complexity of transactions entered into by these companies, practical challenges in complying with tax regulations and unambiguous tax laws, among others, make it virtually impossible to achieve full compliance. If it’s virtually impossible to achieve full compliance, then why bother? Don’t get me wrong. Just like any other battle, I would rather have the right resources in place to make sure those risks and exposures are reduced to an acceptable level.
Income tax in your financial statements
Business transactions are recorded in the financial accounts of the company using a set of generally accepted accounting principles, while tax returns are prepared based on existing tax laws and regulations. Just like husbands and wives, accounting principles and tax laws do not always agree. But what makes the relationship work is that they bridge the gap and reconcile at the end of the day. The reconciliation, which is a required disclosure in the financial statements, would help users better understand why the company is paying at a higher or lower tax rate compared with the statutory tax rate.
The amount of income taxes that the taxpayer is required to pay for the current period based on existing tax laws and regulations is reflected as the current income tax expense in the company’s financial statements. The differences between accounting and tax can be either permanent or temporary, with the latter often resulting in a recognition of a deferred tax asset or liability in accordance with PAS 12, Income Taxes.
Deferred tax assets, just like any other asset, embody future economic benefits that are controlled by management in order to fully utilize its benefits. I will get back on this point after going through the scenario below.
Let’s take a look at Telco Company providing services to millions of subscribers. In the ordinary course of business, it is inevitable that a number of subscribers will default on their monthly subscription. Accounting principles on financial instruments dictate that the company should recognize a loss based on management’s estimate of the amount that will not be collected. If these losses are inevitable and considered as ordinary costs of doing business, does it follow that these losses can be claimed as deductible expenses in determining taxable income?
The answer is No. Tax laws do not allow mere provisions or estimated expenses as deductible expenses. These bad debts can only be claimed as deductible expenses when the taxpayer can prove that actual losses have been sustained. As a matter of proof, the taxpayer has to comply with the substantiation requirements under the tax code before these are allowed as deductible expenses.
In the foregoing example, let us assume that the bad debt expense is recorded in year 1 while claiming the expense for tax purposes will happen in year 2. In this scenario, Telco recognizes and pays more income tax in year 1 as a result of not claiming the bad debt expense in the tax return as deductible. Simultaneously, Telco recognizes a deferred tax asset in year 1 from the future benefit of claiming the bad debt expense in year 2. Going back to my previous point, deferred tax assets, like any other assets, need to be properly managed in order to produce future economic benefits. In this example, remiss on the part of the company to retain sufficient documentation to prove that the bad debts expense arose from a valid sale and lack of sufficient documentation to prove that efforts have been exerted to collect the receivables will result in the loss of the future benefits. Telco would never be able to claim these as deductible expenses in future tax filings and will eventually have to derecognize the deferred tax asset in its financial accounts.
This is just one of the many differences between tax and accounting. When going through your financial statements, you would often see a number of deferred tax asset and liability components disclosed in the notes. Each deferred tax asset and liability is unique and would have to be managed differently. There are deferred tax assets that expire within a certain time frame or deferred tax liabilities wherein the timing of settlement is within management’s control. As stewards of a company’s resources, it is important that management understands the nature of each temporary difference in order to control the benefits from deferred tax assets or have sufficient resources to settle deferred tax liabilities.
In my view, there is no better way to learn than to get your hands dirty. Trust me, I never fully understood the concept of taxation until I’ve had the chance to be involved in the details and have someone explain complex tax principles.
Last year, I participated in a 10-kilometer run to show my support for the Integrity Initiative. With no previous experience in running long distances and no preparations for the event, my lower back started to hurt before reaching the first kilometer but I was determined to reach the finish line. Soon enough, it seems the rest of my body was telling me that I was not ready for that race. In case you’re interested, yes I did manage to reach the finish line but I had to pay the price in the days that followed.
Similarly, there are a number of companies who oftentimes find themselves on the losing end of a tax examination where the only realistic outcome is to settle a significant deficiency tax assessment. Questions such as ‘how did it come to this?’ or ‘what could have we done differently?’ are often asked by the owners and chief executives when they are already at the point where there this nothing much that can be done but to accept the consequences.
The April 15 income tax filing deadline is just around the corner. Take this opportunity to discuss tax issues and challenges with your teams. This is the time to ask the right questions and get involved in making the decisions. There is no shame in asking questions or seeking the advice of tax experts or other professional advisors. Go through a tax compliance review to identify practices that can potentially result in tax assessments. There is so much more that you can do now to manage the risks and avoid sticky situations in the end.
Solving our tax woes
Under the current Administration, I have no doubt many will agree that a massive effort has been undertaken by the BIR to run after alleged tax evaders and prescribe more rules to plug tax leakages. Once in a while, you will read news about companies settling massive tax deficiency assessments or the BIR filing tax evasion cases against companies.
What’s interesting here is that despite these efforts, the BIR is always behind its collection targets. Do we need more rules and procedures to force taxpayers to declare and settle the right taxes? Do we need to see more ads from the local tax authority to name and shame alleged tax evaders?
Probably, not. In my view, we need a comprehensive tax reform program that will not only aim to reduce tax rates but would also simplify taxation and make it easy for every Juan to comply. Take away unnecessary and impractical administrative requirements and consider substance over form in tax examinations. Reduce onerous penalties and interests that oftentimes leave the taxpayer with a huge financial burden.
We do not need more rules that will complicate the process then penalize taxpayers later on. We need to replace a complex taxation system that leaves taxpayers vulnerable to abuses by certain individuals. The legislators and the government owe this to the people; it is already hard enough for taxpayers to part away with their hard-earned money.
To go back to my earlier question on how taxpayers can file an accurate tax return, my answer is simple. Do not expect taxpayers to file an accurate tax return if they simply do not understand tax laws and regulations—that would be absurd. I hope I live to see the day when the word ‘taxing’ will have the same meaning as the words effortless, straightforward and easy.
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Nelson Charsegun L. Aquino is a Partner from Assurance and Co-Lead for Methodology and Markets, Key Accounts of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.