What kind of tax reform Ukraine needs
30.01.2008
Igor Beloyvan, Alt
The Cabinet of Ministers resigned to the new Rada at the end of 2007 had performed a significant spade-work directed to reform the tax system of Ukraine. Thus, the new Cabinet is now facing the issue whether to finalize that work, to propose its own version of changes or, alternatively, to leave everything as it is at the moment. The latter option seems the most improbable. The inevitable changes raise the only question – how fundamental they are going to be.
It should be clear now that I am driving at the Tax Code which sooner or later is to be voted for by the Rada and signed by the President. As well known, the former Cabinet developed its version of the Code, had it through all stages of internal review and passed to the Rada for approval as effective legislation.
The Code proposed by the Cabinet, in my opinion, not only introduces fundamental changes to the tax system of Ukraine but also redirects its philosophy.
The roots of the story come from February 2007 when Conception of Tax System Reform in Ukraine was adopted. This document contains one key paragraph:
"the principal shortcoming of the tax legislation comes to existence of economically unjustified differences between income and expenses recognized for the purposes of taxation by corporate tax and VAT and those recognized for the purposes of financial result reported in financial statements; this fact makes impossible to prepare the tax return on the basis of accounting data".
This paragraph is the key one since it defines the concept, i.e. direction, of changes in the system of taxation. It surprisingly accumulates two problems at the same time that have been accompanying the accounting profession in Ukraine for the last 10 years:
- Is there any place for differences between tax and financial results; and
- If so, what kind of differences it should be.
The paragraph cited above is written in the way as if all differences are to be eliminated and, as a result, the Ukrainian accountants are granted the chance to prepare the tax returns of their companies based exclusively on the accounting data.
It is obvious that the authors of Conception were driven by emotions rather than by professional approach. But the most surprising fact has appeared to be that this general appeal to unify the tax and financial accounting picked up a lot of supporters at the level of State Tax Administration as well as among practicing accountants. It looks really astonishing that for 10 years of the law "On Corporate Tax" being in effect the great layer of accounting profession has failed to notice that to unify the tax and financial accounting is not possible.
To be more precise, it is possible if to get rid of National Accounting Standards (NAS) and instead come up with the detailed accounting Instruction that would exhaustively list all economic transactions and possible double entries to record them in the Chart of Accounts. The existence of any other transactions is to be disregarded as impossible. That would mean a come back in our history prior to the year 1997 when the major tax reform was introduced. But if this is our way to go then we do need neither the Tax Code nor NASs.
It is also possible if the rate of corporate tax is to be applied to financial profit before taxation taken from the income statement prepared in accordance with the requirements of NAS. But such approach destroys the competitive environment in economy turning taxation into one of the instruments of market competition. In result, we will never get the "true and fair" financial reporting since all the management decisions will be directed to minimization of the tax burden.
The differences between profit before taxation in the corporate tax return and in the income statement all have a conceptual nature and get created by the objectives these two reporting environments pursue:
| Tax return: |
Financial reporting: |
| 1. Contains only facts and events which have already occurred; |
1. Contains facts that have already occurred as well as estimated results of future events; |
| 2. Always gets supported with relevant source documents; such documents, as a rule, are issued (signed) by a third party; |
2. Contains facts supported with source documents as well as arbitrary valuations of management; significant amount of documents gets generated within the company based on assumptions of experts, consultants and management; |
| 3. Gets prepared applying clearly defined in legislation tax requirements and rules which make impossible any subjective approach to be used by a tax payer at the time of preparation; |
3. Gets prepared applying the general principles of accounting and standards of financial reporting; both just outline the general requirements for information disclosure and leave a lot of space for arbitrary judgment; |
| 4. Treats equally all the tax payers through application of the same requirements and rules to the same transactions in order to preserve the conditions of fair competition. |
4. Every company applies its own accounting policy that complies with requirements of accounting standards and at the same time greatly affects its financial results for the period. |
As a general conclusion, it can be said that the tax return is a result of application of clearly defined rules to the facts supported in documentary form. To the contrary, the income statement reports the economic result of the business activity for a period determined by application of accounting policy, principles and standards.
When preparing the tax return we always look back at the past and there is no possibility to make any changes in that past. The financial reporting is strongly affected by interpretation of post balance sheet events. In addition, the management often reconsiders its attitude to the events which existed at the balance sheet date.
In other words, the tax return always looks backwards but the financial reporting – onwards. As a result, all the differences between these two reporting environments can be only of economic nature. To what extent these differences are justified fully depends upon the conception and quality of tax legislation.
The differences between taxable profit for the tax return and income statement purposes can only outlined very generally:
| |
Financial reporting: |
Tax return: |
| Income |
Recognized on accrual basis when it is a certain level of assurance that such income will be realized (take the form of cash). |
Differences that appear can only be temporary; the situation when income gets taxable but never recognized in financial reporting as income (revenue) in future reporting periods is hard to imagine; in essence, it would mean to tax that income which do not exist from economical standpoint. |
| Expenses |
Recognized on accrual basis when a possibility (risk) of its realization exists (in form of cash). |
Difference that appear can be temporary as well as permanent;
permanent differences are caused by limitations (often partial) imposed on certain expenses to be deductible for the purpose of taxation;
temporary differences are caused by timely variances between clearly defined tax rules and accounting policy applied by a tax payer when preparing its financial reporting. |
The common worldwide trend, and Ukraine is not an exception here, suggests that more fiscal approach is used for the purposes of taxation. The tax law of almost all countries in the world accelerates the recognition of income in time and restricts the expense part if to compare them with the financial reporting. This is done with the economic reasons again to broaden the tax base. All the governments wish to collect more taxes and as soon as possible.
The authors of the Code seem to understand that to get rid of the differences completely will not work. Moreover, the Cabinet approves the Strategy of International Financial Reporting Standards application in Ukraine in October 2007 that only increases the economic differences between the tax return and financial reporting.
If to evaluate the Code in general, than the conclusion can be derived that it resolves some existing issues but gives birth to another ones.
It is true that the current tax system creates such differences between tax and financial accounting which can hardly be explained by the State’s desire to broaden the tax base. They are sooner just complicate life for the accountants and tax inspectors.
The Code should be highly appreciated for the cancellation of special tax rules for foreign exchange gains (losses) and shares (securities) accounting as well as for introduction of straight line tax amortization method to be applied to the fixed assets. In addition, the capital gain (loss) from disposal of identifiable items of fixed assets is now proposed to calculate as presumed in the financial accounting.
A special prize to the authors of the Code should undoubtedly be given for the removal of so called "rule of the first event". That rule has been destroying the accounting of VAT for all these years and immensely complicated the corporate tax return preparation. It should be especially underlined that the authors of the Code propose to narrow the tax base in this case that will certainly lead to reduction of the effective tax rate.
However, at the same time the Code sets a start of new and rather dangerous trends trying to distinguish the differences between tax and financial results by "economically justified" and "economically unjustified":
"if a taxpayer takes a decision to revalue / impair the assets in line with the rules of financial accounting, then such a revaluation / impairment does alter neither the tax base of these assets nor the income and expenses of this tax payer related to acquisition of these".
When the authors of the Code try in such a way to define the possible differences they entrap themselves but not the taxpayers. There is no practical possibility to exactly define and exhaustively list the differences as the impact of NAS on every company is unique and can not be limited in any way. Moreover, it is not the objective of a tax law to define and describe its differences against the standards of financial reporting. The tax law is supposed to be a self-sufficient code of rules that does not need to be reconciled with anything else.
The attempts to define the differences may lead to clear failures. For instance, how to treat the provisions set up in the financial reporting for future losses? This transaction has nothing to do with the revaluation / impairment of the assets but I have a big doubt that the Code’s authors really mean to treat this expense as deductible for the tax purposes in the period of its recognition in financial accounting.
The Code really saves us from some significant unnecessary differences between the tax and financial accounting but does not unifies them in any way. At the same time, it makes the tax legislation much more arbitrary that is its biggest defect.
As an example, the Code allows to apply the principles of NAS 7 "Property, Plant and Equipment" for tax purposes to treat the expenses related to subsequent maintenance of the fixed assets. In other words, to deduct such expenses from taxable income in the period when they are incurred or to amortize them as part of particular fixed asset item in the future periods according to the Code is proposed on the basis of taxpayer’s accounting policy applied for the purposes of financial reporting. Such tax rule, in effect, destroys the financial reporting. In result of such concept, the taxpayers will read very right words about future economic benefits and recoverable value in NAS 7 but will take not economically driven decisions.
In general, the Code is about to ease life significantly for practicing accountants but it still contains some subjective statements and even increases their number. However, the best practice of civilized world requires the tax legislation to be clear and objective since subjectivity causes corruption.
The taxable profit in tax return should not be driven by application of such terms as "operational activity" and "fixed assets used in non-operational activity". It can not be affected by the accounting policy applied by a taxpayer for preparation of financial statements neither since such approach is disastrous for the later. The Code must be a collection of clear and objective rules ambiguous treatment of which is impossible. But this is really a subject of another article.
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