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GAAP and Tax

Taxable income is determined by taking gross income and deducting therefrom exempt income and allowable deductions. A taxpayer's ‘taxable income' may differ significantly from the accounting profit determined in accordance with accounting principles.

Differences arise from certain receipts and accruals included in accounting profit that may be exempt for tax purposes; expenses taken into account for accounting profit that may not be deductible; similarly there may be income deemed to have accrued for tax purposes that is not included in accounting profit and expenses deductible for tax and excluded for accounting.

The fact that accounting principles will be disregarded for tax have been dealt with in a number of cases and is exemplified by the judgment of Centlivres JA in Sub-Nigel Ltd vs. CIR that only deductions provided for in the Income Tax Act are allowed to be deducted from the taxpayer's income.

‘[T]he court is not concerned with deductions which may be considered proper from an accountant's point of view or from the point of view of a prudent trader, but merely with the deductions which are permissible according to the language of the Act...

‘Regard, therefore, must be had to the Act and the Act alone in order to ascertain whether the deductions sought to be made... are permissible.'

The adjustments that are made to the accounting profit to determine taxable income may give rise to the raising of a deferred tax liability or asset, if, broadly speaking, the difference is merely a timing difference and will reverse in future years. Examples would be where the rate of wear and tear or capital allowances on fixed assets for tax purposes differs from the depreciation charged in the books or provisions raised in the books which will only be deductible for tax purposes when actually incurred.

Nevertheless there are instances where generally accepted accounting practice (GAAP) will have an effect on the outcome of a transaction for tax purposes and where the Income Tax Act (“the Act”) specifically makes reference to GAAP.

Trading stock:
The first instance in which GAAP was introduced into the Act was for the purpose of valuation of trading stock. Because of the definition of trading stock as it was at the time, taxpayers argued that it was not necessary to include an allocation of overheads in the value of stock for purposes of determining taxable income. The Act was amended in 1984 to require taxpayers to include in the value of their trading stock the ‘further costs' (overheads) required to be included in terms of generally accepted accounting practice as approved by the Commissioner. According to the Explanatory memorandum the GAAP approved by the Commissioner for this purpose was AC108. AC108 has since been superseded by IAS 2, therefore it is not clear if the principles in AC108 are still applicable for tax purposes or whether the Commissioner has also approved of IAS 2.

Dividends:
Another instance where GAAP will have an effect on the tax consequences of a transaction is pre-acquisition dividends. A dividend, as defined in the Income Tax Act, is any amount distributed by a company to its shareholders. Specifically excluded is any amount distributed by a company to a shareholder to the extent that the companies form part of the same group of companies and the shareholder reduces the cost of the shares held in accordance with generally accepted accounting practice.

To determine where this exclusion will apply for tax it is necessary to look at the accounting principles. In terms of IAS 18 dividends shall be recognised as revenue when the shareholder's right to receive payment is established. However IAS 18.32 limits the application of this paragraph by stipulating that where dividends on equity securities are declared from pre-acquisition profits, those dividends are deducted from the cost of the securities and not recognised as revenue.

Therefore, from a tax point of view the company declaring the dividend will not be liable for STC as no ‘dividend' has been distributed and the shareholder will receive a ‘capital distribution” which will have to be treated as a part disposal of the shares in the subsidiary for CGT purposes.

Other areas where GAAP is specifically referred to in the Act

• Incurral and accrual of interest. While Section 24J requires the calculation of an accrual amount for instruments held or issued, taxpayers are entitled to use an alternative method, which conforms to GAAP, is consistently applied for reporting purposes and the results will not differ significantly from applying the provisions of Section 24J.
• Gains or losses on foreign exchange transactions. Special rules may be applied for “affected contracts” which are, in simple terms, forward exchange contracts taken out where the underlying asset or debt in foreign currency does not exist at the end of the year. While the normal rule for translating “affected contracts” is to use the forward rate in terms of that contract, the Commissioner may allow the alternative rate if that rate is used for accounting purposes in terms of GAAP. Exchange differences on forward exchange contracts to hedge the acquisition of equity shares in certain circumstances may be excluded where the difference is not included for financial reporting purposes in terms of International Financial Reporting Standards.
• A reportable arrangement includes an arrangement that is or will be disclosed as giving rise to a financial liability for purposes of GAAP but not for purposes of the Act (but excluding financial leases). A reportable arrangement also includes an arrangement that does not result in a reasonable expectation of a pre-tax profit. Pre-tax profit is defined as a profit determined in accordance with GAAP.

From the above it can be seen that it is necessary to be familiar with both the generally accepted accounting principles and the relevant tax acts, and to consider the effects of both in determining taxable income as well as the deferred tax to be raised in the financial statements. Though there are numerous instances where the two differ significantly, there are also instances where the Income Tax Act relies on generally accepted accounting principles in determining the amounts to be taken into account.

PLEASE NOTE THE FOLLOWING ERROR WITH REGARD TO THE ABOVE ARTICLE:
This article referred to the correlation between accounting and tax principles for the treatment of pre-acquisition dividends. It stated that according to IAS 18, where dividends are declared out of pre-acquisition profits, they must not for accounting purposes be recognised as revenue, but rather reduce the cost of the investment. From a tax point of view, the shareholder is considered to have received a capital distribution which is subject to CGT and the company declaring the dividend will not be liable for STC as an amount distributed between group companies which has reduced the cost of an investment in terms of GAAP is specifically excluded from the dividend definition. 

IAS 18 was amended, effective for annual reporting periods beginning on or after 1 January 2009,  and no longer differentiates between pre and post acquisition dividends. All dividends received must, from the effective date, be recognised as revenue.  Because there is no longer the distinction between pre and post-acquisition dividends, IAS 36 has added new indicators of impairment which could mean that investments are tested for impairment when dividends are received. Thus IAS 18 does not require the cost of shares held in a subsidiary, to be reduced as a result of a pre-acquisition dividend, however, IAS 36 may require the cost to be impaired if, for example, all profits, including pre-acquisition profits are distributed.  Paragraph (g) of the definition of “dividend” in the Income tax Act excludes from its ambit a distribution “to the extent that the shareholder reduces the cost of the shares in the company in accordance with generally accepted accounting practice as a result of the distribution”.  Therefore there is now uncertainty as to whether the exclusion will apply.  Clearly the cost is not reduced by the dividend in terms of IAS 18. Nevertheless the cost may be reduced in terms of IAS 36 “as a result of the dividend”.  Therefore each case will have to be considered based on its circumstances

Clive Sharwood CA(SA), BCom (Rhodes),HDip (Tax), LLB, is a Tax Consultant at Deloitte, and Andrea Brickett,BCom (Acc), BCom (Hons), is a Snr Tax Consultant at Deloitte.

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Comment(s)

• Anon
  4 July 2010

  The issue regarding accounting and tax is not anything new and has been a topic that most accountants consider all the time. What would have been nice is if the the author provided more analysis on a specific IAS statement and the tax impact thereof. The concept of "accounting" profits is absent in determining taxable income.

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