Taxation of Business Income and the Methods of Profit Determination

Question 1

4 different types of businesses subject to tax

Answer 1

1. Sole proprietorship (individual)
2. Partnership
3. Corporation
4. Other legal entities, e.g., trust, government)

Question 2

What is a legal entity not subject to tax?

Answer 2

Non-profit organizations like FIFA, churches

Still need to file tax returns despite not paying taxes

Question 3

Sole proprietorship vs. partnership vs. corporation: who owns the business?

Answer 3

Sole proprietorship: the manager
Partnership: partners
Corporation: shareholders

Question 4

Sole proprietorship vs. partnership vs. corporation: separation of managers and owners?

Answer 4

Sole proprietorship: No
Partnership: No
Corporation: Usually (not necessarily)

Question 5

Sole proprietorship vs. partnership vs. corporation: liability of owner?

Answer 5

E.g., do the owners have to whole responsibility, for example if they make debt, do they have to pay with their own money or are only liable for a limited amoumt?

Sole proprietorship: Unlimited
Partnership: Unlimited
Corporation: Limited (shareholders only liable for the money they agreed to invest)

Question 6

Sole proprietorship vs. partnership vs. corporation: Separate taxation of businesses and owner?

Answer 6

Sole proprietorship: No

Partnership: No

Corporation: Yes (a corporation is a separate taxpayer who pays corporate tax; business owners only have to pay tax on what they (choose to) receive from the business as dividends

Question 7

Business income in global vs. schedular system

Answer 7

Global system: distinguishing business income from employment income doesn’t matter as it is taxed the same

Schedular system: distinguishing business income matters because you pay a different tax rate

Question 8

Definition of business income

Answer 8

Commercial or industrial activity of an independent nature undertaken for profit

Question 9

Business income vs. employment income: deducting expenses+ consequence

Answer 9

For employment income, you cannot deduct exactly your expenses, only a flat rate

For business income, you can deduct all your expenses

-> beneficial to try to earn business income instead of employment income (e.g., switching from being an employee to a consultant in own firm)

Question 10

What does the NL do to prevent people from claiming to be entrepreneurs to claim business income?

Answer 10

You can register as entrepreneur under commercial law, but does not automatically mean you are taxed as one; looking at number of clients

Question 11

How can the same type of income be considered as business or investment income depending on the sector?

Answer 11

Investment income are for banks usually considered business income since earning interest is part of their business

Question 12

Is capital gains business income or not (civil law vs. common law)?

Answer 12

Civil law: only if it is part of their business (e.g., income from selling houses because business is about buying and selling houses -> capital gains, but if a company relocates and sells their house, it is not)

Common law: only included if achieved with a profit-making intention, and excluded if a one-off transaction (e.g., sale of immovable property)

Question 13

UK vs. Germany: is capital gains taxed?

Answer 13

UK: generally not, but separate capital gains tax (trust concept of income)

Germany: capital gains on sale of business assets is taxed; also a separate private capital gains tax (source concept of income)

Question 14

Two kinds of profit-determining systems

Answer 14

1. Receipts and outgoings system: Common-law origin: starting point is gains and expenses recognized for tax purposes (looking at flows of income)
2. Balance sheet system: civil law origin (EU): starting point is taxpayers’ financial accounts (looking at value of assets; differences in stock rather than flows of income)

Outcome is basically the same, but two ways to go about it

Question 15

How to calculate taxable business income?

Answer 15

Assets end of year - assets beginning of year + dividends - capital contributions

Dividends is money that owners take out of the company which lowers assets -> must be taken into account to tax profits

Positive = taxable income
Negative = losses

Question 16

What does both a cash-basis system and an accrual-basis system tell us about?

Answer 16

When to recognize income; timing issues regarding income and deductions

Question 17

Cash-basis system (+ example from lecture)

Answer 17

Income is derived when it is actually received, expenses when paid

Electrician is contracted is fix lights at university - completes job in December 2022 and gets paid in 2023 -> he declares income in 2023 when he receives the money

Question 18

Accrual-basis system (+ example from lecture)

Answer 18

Income is derived when the right to receive the income arises and expenses are incurred when the obligation to pay arises

Electrician is contracted is fix lights at university - completes job in December 2022 and gets paid in 2023 -> he declares income in 2022 as that is when the right to receive it arises (when he does the actual job)

Question 19

Uncertainty regarding payment: cash vs. accrual

Answer 19

You sell a TV with money-back within 30 days guarantee

Cash-system: you earn money when you sell the TV
Accrual-system: you earn money when the 30-day guarantee has run out

Question 20

For what type of businesses is cash vs. accrual often used?

Answer 20

Cash-basis often applicable for smaller businesses and sole proprietorships -> easier to administer and comply with, but must come up with transition-rules

Accrual-system often used for bigger businesses -> usually required under commercial code or accounting law

Question 21

Why is the accrual-system “better”?

Answer 21

In a cash-system, you can postpone your own payment which leaves more scope for planning when you have to pay taxes -> businesses will always try to pay later because having more money now means you can make more money in the future

But state doesn’t want to wait until businesses want to pay tax, and investors want their money when the earn it, not when the business wants to give it

Question 22

Expenses: fines, bribes, other taxes, gifts

Answer 22

Fines and bribes are non-deductible! Other taxes are sometimes deductible, so is gifts if necessary to make a profit

Question 23

What is depreciation?

Answer 23

A reduction in the value of your capital assets

Question 24

What are capital expenses?

Answer 24

Acquisition of assets or benefits with a life extending beyond the tax period (e.g., buying machines, cars, houses etc.)

Question 25

Why are capital expenses not immediately deductible for the entire amount?

Answer 25

To avoid tax planning; if a company makes a big amount of money in one year, they can just buy capital expenses to avoid paying as much tax

Question 26

How are capital expenses deductible?

Answer 26

With depreciation rules - cost can be deducted over the lifetime of the asset

If a machine costs 20,000 euros and is expected to last 10 years, you can deduct 2,000 euros each year

Question 27

Why do some countries are accelerated depreciation rules?

Answer 27

Deducting expenses quicker than the actual depreciation is usually done if you want companies to invest more -> sacrificing tax revenue to increase investments

Question 28

Relationship between tax accounting and commercial accounting regarding profits

Answer 28

Depends on the country; some countries have a close relationship between the two and profit determination is highly based on profit reported for accounting purposes - in Germany, businesses can use balance sheets for both accounting and tax purposes

Others have independent relationship; in US you cannot use commercial accounting as a basis for calculating tax; instead everything is defined in tax law

Question 29

What does the relationship between tax accounting and commercial accounting depend on?

Answer 29

Who is responsible for developing accounting standards - the government (close relationship) or the private sector (independent)

Question 30

For the EU, what is the relationship between tax accounting and commercial accounting?

Answer 30

Convergence through International Financial Reporting Stanbdards to harmonize accounting standards across countries

Question 31

Why does it matter what the relationship is between tax accounting and commercial accounting?

Answer 31

Accounting rules can provide more or less flexibility with respect to timing, regulating taxpayers’ incentive to delay recognition of income and speed up recognition of expenses

Question 32

How has taxation of corporations changed over time?

Answer 32

In beginning of 20th century, corporations were taxed under same income tax laws as individuals. Now, separate laws

Question 33

Civil law vs. common law and the definition of the legal entity

Answer 33

Civil law: status of an entity as legal person is relevant to imposition of corporate law

Common law: legal entity or not is less relevant

Question 34

The corporate tax rate is usually…

Answer 34

Flat, nor progressive

Question 35

Why is the corporate tax rate usually flat?

Answer 35

The pure amount of income that a corporation makes it not necessarily linked to the ability-to-pay of the individuals employed

E.g., small business vs. big business can make the same amount of profit, but ability-to-pay is smaller when a lot of people are involved

Question 36

How does the NL tax corporations?

Answer 36

Two brackets; profits up to 395,000 euros are taxed 15% and profits above is taxed 25.8%

Question 37

The corporate tax rate over time has gone…

Answer 37

Down -> race to the bottom among different countries

Question 38

What is double taxation regarding corporate income tax?

Answer 38

Corporations and owners are taxed separately -> double taxation as a company pays corporate tax, and then the owners pay tax on the money they receive from dividends

Question 39

How to deal with double taxation of corporate income and dividends + 1 issue: classical system

Answer 39

Taxation at both corporate and taxholder level

Issue: increases incentive for tax planning (distributing money through interest payments rather than dividends or lending money to a company instead of owning stocks)

Question 40

If a company makes 1000 euros that you as a shareholder want to take out + 30% corporate tax rate - what is difference between making it a dividend payment and making it an interest payment?

Answer 40

Dividends: 30% of 1000 is 300 -> 1000-300=700 euro payout

Interest: Deducting 700 as an expense + paying 30% of the remaining 300 in tax, meaning getting 210 euros in dividends -> 700+210 = 910 euro payout

Question 41

How to deal with double taxation of corporate income and dividends: Imputation system

Answer 41

Shareholders receives a credit for tax paid a corporate level (lessening the second tax round)

Issue: how to deal with tax incentives? The shareholder has to pay what the corporation didn’t pay

Question 42

How to deal with double taxation of corporate income and dividends: Distribution-based corporate income tax

Answer 42

Only shareholders are taxed, e.g., corporate income tax only levied when profits are distributed

Not very prevalent (only Estonia)

Question 43

What is group taxation?

Answer 43

When some countries allow groups of enterprises to aggregate income and losses (e.g., Shell is not just one corporation, but 1000s who do one specialized thing -> aggregate losses and income)

Question 44

Why is it beneficial for corporations to have group taxation?

Answer 44

If one company makes a profit and the other a loss, they can balance each other out -> lower overall tax burden

Question 45

Who usually has group taxation?

Answer 45

OECD countries

Question 46

What is the Common Consolidated Corporate Tax Basis?

Answer 46

EU initiative for group taxation; e.g., a company makes profits in NL but loss in France would be able to use loss to offset profits

But would need a different way to allocate profits across EU

No agreement yet, but step toward long-term goal of an EU corporate taxation system