Taxation, Accounting and Transparency:

The Interaction ofFinancial and Tax Accounting

Martina Baumgatel

3. Transparency of the International Accounts andInfluence of Transparency on Tax Planning

3.1 Actual versus Effective Tax Rate

As the tax burdenconstitutes a cost factor to all business activities, the effective tax rateplays an important role for management, and not just the current tax payments haveto be looked at. The local accounting principles, but much more IAS/IFRS and U.S.GAAP lead to showing the “right” tax burden, taking temporary differences betweenaccounting and taxation as well into account, followed by numerous information ontaxes. This transparency of the accounts further leads to analysts challenging thetax burden and management needs for explanations of the tax line.Thus,information that was only a decade ago due to the tax secrecy in a lot ofcountries confidential constantly becomes more and more public.

Take the concept ofdeferred tax assets and tax liabilities. Postponed or up-front tax payments dueto differences in calculating taxable profits and losses which reverse over thetime loose importance. These timing differences lead only to temporary tax savings/taxburden and as a consequence, a deferred tax liability/tax asset has to beaccounted for. The accounts show in these cases the overall tax burden that wouldarise based on the accounts of the prevailing year (i.e. current taxes and deferred taxes).

An example for timingdifferences which lead to setting up a tax asset are write downs that are notat once cknowledged for tax purposes, but reverse over time. As current taxesare higher than the tax burden that matches with the accounts, a deferred taxasset can be set up. A deferred tax liability may result from reserves whichare tax deductible according to national law, but constitute equity according toIFRS/U.S. GAAP.

According to international accountingprinciples, a tax asset on losses carried forward has as well to be set up:loss carry forwards lead to potential tax savings in the future, as theunderlying net business expenses are therefore not lost, but can be usedagainst future, not yet realized profits. However, the company has to examine therealization possibility of this tax asset, and in case that realization seemsnot/not fully realistic, make a total/partial valuation allowance.

Let me give twoexamples for permanent differences and their impact on the effective tax rate:Tax exempt dividends or capital gains lead to a tax rate below the actual taxrate in the prevailing country. The effective tax rate takes this into account.In case of additional profit distributions or capital gains that were notplanned the effective tax rate is even lower than the expected effective taxrate. Interest expenses, which in some countries are not tax-deductible if indirect connection with tax exempt
incomelead to a higher effective tax rate than the normal local tax rate. If refinancingis shifted to another location (e.g. debt push down), and the interest burden is in thiscountry deductible, then the overall tax burden decreases.

Of course one hasalways to be aware of so-called quasi-permanent differences, i.e. differences thatnever reverse due to the prevailing individual situation of the company: As anexample, the minimum taxation in Germany might lead to a situation, especiallywith regard to volatile businesses, that loss carry forwards can be used up intheory, but not in practice, as profits have always to be integrated to 40% intaxable income regardless of a still existing loss carry forward.

3.2 Disclosures and Notes to the Accounts

In the internationalaccounts, an explanation of the main drivers of the effective tax rate(compared to the expected tax rate) is done in a so-called “reconciliation”. Asfar as this information has to be disclosed (e.g. Form 20-F), this transparency leads to adeeper analysis and understanding of the tax situation, as well as of business decisions:e.g. in case of hightax-exempt income the analysts might assume that extraordinary (not operating)income was earned (e.g. additional profit distribution or additional capitalgains).

In case tax assets onloss carry forwards are written down, this might be a consequence of tooaggressive multi year plans in the past. However, it might also be the consequenceof tax rate changes (e.g. the tax reform 2008 in Germany will lead to a write downon tax assets on losses and other temporary differences of around 25%),as thetax rate differential is 10% (40% to 30%). If the company that suffers thewrite down as a consequence of the tax rate decrease shows operating profits,this effect should then be interpreted in a positive way, as this means a lowertax burden in case of profitability in the future. Thus the hit has rather tobe taken as a one time effect.

A write back on deferred tax assets on lossesmight have different reasons as well: It might be a consequence ofoverachieving on plans and targets and therefore higher taxable operatingincome. It might be the consequence of structures to use up losses, e.g. buying in of incomeor selling of loss carry forwards to external parties.

And of course,effects of tax audits might be open to the analysts in case of materiality aswell. In this context, the question might arise, whether or not tax planning wastoo aggressive. The setting up of tax contingency reserves might also havequite different reasons: It can be an indicator for too aggressive taxplanning, but as wellof uncertain tax interpretation or change in jurisdiction.

3.3 Possibilities and Boundaries for Tax Rate“Management”

Of course, earningsas well as tax rate “management” is strictly forbidden. But with e.g. postponing oraccelerating business decisions in cases where the tax treatment does notfollow the accounting treatment, the effective tax rate could of course be influenced.E.g., the decision toadditionally sell tax-exempt stock might be taken shortly prior or afteryear-end, leading to effects on the effective tax rate in the old or newbusiness year. Tax planning strategies, e.g. the sale of loss carry forwards if possible–, might lead to a revaluation of tax assets and therefore to a lower effectivetax rate. But companies always have to bear in mind that too aggressive tax planningmight lead to high contingency reserves or tax expenses for prior years, yet aloneperhaps interest on delayed tax payments.

In the insurance markets as well as in thehedge fund area, a market for insuring tax risks is currently developing.However, taking out insurance of tax risks – if possible at all – is verycomplex. First of all, the contracts and documentation behind require a lot ofthoughts, are technically complex and must reflect all possible risks – in orderto avoid problems with the insurer afterwards. Second, the advantage of insuringtax risks is still questionable from the insurer’s side. Offering insurance doesonly make sense if the insurer is more convinced than the insured thatpotential negative tax consequences do not arise. Otherwise, the premium couldbe as high as the discounted worst case scenario, which would be unacceptablefor the insured. Finally the insurer will always look for a self-retention ofthe insured, or at least for the full right to settle the case with the taxauthorities, as otherwise the insurer’s position might be rather weak. This tosome extent contradicts the interests of the insured, who very often seeks toget rid of the whole risk, or will at least try to further on lead thenegotiations with the fiscal authorities.

From an accountingpoint of view, insurance of tax risks might influence the effective tax rate aswell: Insurance premiums as well as claims settlements lead to expenses/incomein the pre-tax result. However, it depends on the prevailing jurisdiction andprevailing single case whether or not the insurance premium is tax deductible.The same is true for any claims settlements: If these payments are taxable, itis necessary to get an insurance cover on the “grossed-up” amount, as taxpayments on settlements would otherwise lead to losses even in case ofinsurance. Any tax payments as a consequence of settlement very likely go ingeneral through the tax line. This would result in a distortion between pre-taxincome and tax line. So, even if from an economic point of view insurance oftax risks could make sense, the effects on the effective tax rate have to beevaluated as well, even if these effects are potentially not decisive for thedecision to take out insurance on tax risks.