Taxes are essential for breaking a loop of the rich becoming richer and the poor poorer. Taxes accomplish this through the moderation of potential extreme wealth accumulations by redirecting wealth away from the rich and contributing financially to the public or community good, which redistributes wealth toward the poor. It generally occurs through social welfare expenditures, such as health care and public education. In theory, taxes should bring stability to the economic and social systems.
However, the actual situation is often substantially different from the theoretical perspective; such is the case with regressive tax systems. Almost every local and state government collects more taxes from low-income families than from high-income in relation to their incomes. For example, property taxes in terms of low-income families are vastly disproportionate compared to high-income families (Strand & Mirkay, 2020). In this context, the reduction of after-tax incomes of low-income families tends to be much more profound, which contributes to the disparities in income and overall wealth inequality (Wamhoff & Gardner, 2018).
Among the primary reasons for that is the governments’ heavy reliance on sales and consumption taxes (Strand & Mirkay, 2020). It often affects families with low income because they spend a larger portion of their income on consumables rather than investments or savings. Moreover, if localities and states begin to cut or avoid raising taxes, they still search for additional revenue, which results in an increased reliance on fees – drivers’ licenses and costs or toll fees for roads (Strand & Mirkay, 2020). Consequently, tax cuts do not benefit low-income families but only increase the system’s regressivity.
It is undoubtedly hard to deliver tax cuts where they are needed the most. For the lowest income families, who tend to spend rather than save an increase in their disposable income, the government’s priority should be to support people directly: to create new jobs, protect incomes, and provide funding support to reskill. However, it does not mean tax cuts should be simply ignored – they must be far better targeted.
References
Strand, P. J., & Mirkay, N. A. (2020). Racialized tax inequity: Wealth, racism, and the US system of taxation. Northwestern Journal of Law & Social Policy, 15(3), 265. Web.
Wamhoff, S., & Gardner, M. (2018). Federal tax cuts in the Bush, Obama, and Trump years. Institute on Taxation and Economic Policy, 11.
Sara in her individual capacity has incurred attorney fees and other costs of $ 11,000 in connection with her litigation with the Texas County Board for changes in zoning law so that her three parcels of land comprising of 30 acres could gain in value which was only $ 15,750 per acre before her appeal. During the pendency of her appeal in the court of law, the Texas County changed the zoning law permitting two residences per acre as against the original law of only one residence per every two acres. And as expected, the value of her land increased to $ 25,000 per acre. To recall, the property Sara received from her mother was only worth $ 15,750 attributable to the then prevailing pattern of land zoning. Stagnation in the land value was due to the said zoning that restricted to one residence per every two acres. Hence, she applied to Texas County in 2010 for changes in the zoning which however was rejected. Sara went on an appeal in 2011 as constitutional challenge of the Texas County’s zoning law which was unsuccessful. Then in October 2011, she appealed to Texas County District Court. By November 2011, the County suo moto effected change in the zoning law allowing two residences per every acre from February 2012 onwards.
Issues identified
The issue now is about the tax treatment of her attorney fees and other costs which she incurred half in 2010 and another half in 2011. Tax treatment means whether expenditure is deductible from one’s income for income tax purposes. In order to decide on deductibility, it should be decided whether the given expenditure is a revenue expenditure or capital expenditure. If former is the case, the expenditure is deductible. If latter, it can only be capitalized. This again depends on whether the expenditure is incurred in the course of business or in individual capacity for personal purposes. Obviously, Sara has incurred attorney fees and other costs in her individual capacity and hence tax law applicable to individual shall be examined in this case.
Conclusion
In Sara’s case, the origin of the claim led her to incur attorney fees and other costs, and hence the expenditure must be capitalized as per Sections 263.
Authorities & Reasoning
Section two hundred sixty three and 263 “A” provide for capitalization of expenditure incurred for betterment of real estate. Thus, attorney fee and other costs incurred for defending or perfecting title are eligible for capitalization by being added to the value of the property and not by being deducted from the income of the individual for relevant period. If this rule is to be followed, Sara has incurred expenses for litigation which have led to the Texas County making changes in zoning norms thus increasing the value of her property. Hence her attorney fees and other costs of $ 5,500 + 5,500 should be added to the value of land as at the end of each year 2010 & 2011respectively regardless of legal outcome in 2012. (CCH (1), (2), Wolters Kluwer, 2013).
In Lee D. and Marjorie L. Hustead v. Commissioner (1994), taxpayers’ claim to treat attorney fees and other costs incurred for constitutional challenge as a deductible expenditure was rejected. This was an identical case in which petitioners had challenged zoning norm that allowed only one residential dwelling per acre. Later on, the township changed the zoning norm to permit 4 dwellings per acre. This led to an increase of fair market value of petitioners’ land by 85 %. Although they had capitalized expenditure they incurred for challenging the original zoning, they claimed the said costs in their income tax returns as deductible expenditures which the respondents rejected as per section 263A. However, the court held that section 263 would apply and still the expenditure could only be capitalized. In view of the above position, Sara can only capitalize the fees paid to attorney and other costs as part of expenses incurred for the purpose of increasing the land value as contemplated under Section 263.
References
AICPA-Store (2007). Treatment of Legal Fees Incurred by Individuals. Web.
CCH (1) Wolters Kluwer (2013) Current Internal Revenue Code, SEC. 263. Capital Expenditures. Web.
CCH (2), Wolters Kluwer (2013) Current internal revenue code, sec. 263a Capitalization and Inclusion in inventory costs of certain expenses. Web.
Lee D. and Marjorie L. Hustead v. Commissioner, 68 T.C. 374 (1994).
Arguments in favor of corporate formations as taxable events: Taxable events refer to financial transactions that are likely to lead to tax consequences. In most cases, taxable events involve transactions that lead to financial gains or losses. A corporate formation may be categorized as a taxable event. This assertion arises from the fact that it is an exchange transaction. Therefore, the parties to the transaction should recognize losses and gains. Categorizing corporate formations as taxable events enables a country to increase its tax revenue. Moreover, taxing corporate formations simplifies the process of administering tax law. The tax administrator does not have to weigh options on whether corporate formations are taxable or not. Recognizing corporate formation as taxable events enables taxpayers to structure their transactions effectively. Consequently, they are in a position to avoid specific requirements of section 351.
Argument refuting the claim: Categorising corporate formations as taxable events may have adverse effects on start-up companies. One of the ways through which this aspect may occur is by reducing the firm’s capital via the income tax that the transferor pays during the process of transferring an asset. Secondly, corporate formations should not be taxed for there are no economic gains or losses during the transfer process. The transfer process only involves a change in property or asset ownership. Therefore, it is not right to recognize economic gains or losses at this stage. Moreover, the contemporary structure in the US does not allow taxpayers to realize losses, which gives the government more in terms of taxes. Taxing corporate formations would prohibit investors from incorporating their enterprises due to the associated tax consequences and this move may affect the economic growth of a country adversely.
The complexity of the tax system
Designing an effective tax system is one of the most important aspects that governments should consider. Simplicity and fairness are amongst the most important elements that should guide the process of designing the tax system. However, achieving these goals is challenging; for example, ensuring simplicity in the federal income tax system is difficult, which arises from the fact that it would entail foregoing other important objectives. One of the ways to make the income tax law simple is by designing it in such a way that it becomes similar to a flat tax rate. However, this move may result in unfair treatment to some taxpayers and to illustrate this argument, consider two taxpayers, X and Y, whose total annual income is $100,000. If the two individuals are required to pay income tax at a flat rate of 20%, each of them will pay $20,000 annually as income tax. However, consider a scenario where party B suffers from severe illness hence incurring $60,000 in medical expenses in a year.
This scenario presents a major challenge in determining whether the two individuals should be subjected to the same annual income tax. The variation to this scenario arises from the definition of the term ‘fairness’. Making the federal income tax simple should not be the priority of governments in their effort to reform the tax system. In summary, one can assert that complexity is a necessary element in the tax system. Therefore, governments should focus on ensuring that the internal revenue code developed contributes towards the maximization of the revenue collected to enhance countries’ efforts to achieve economic growth.
Tax can be termed as a levy or fee that is charged by a government on products and income of the people in that state. Tax is either direct or indirect tax. Direct tax is the levy on an individual’s or corporate’s income. Indirect tax on the other hand is charged on the prices of goods and services offered in the country. The government normally has a body that is bestowed with the responsibility of collecting taxes on its behalf (Web-book, n.d, p.1). The tax collected is principally used to finance the expenditure of the government, for instance, paying of government officials and provision of essential services to the residents of the country.
Designing a tax system for a country is normally a very difficult decision for the law makers and tax agencies. The government is therefore compelled to lay down factors that will guide it in selecting the tax system to use (Web-book, n.d, p.1). This will be steered by factors such as transparency and simplicity of the system. If the tax system is detailed and complicated, it leaves room for legal evasion of tax which is a loss of revenue to the country. An example is the sales tax that was earlier on charged on transactions. This system had loopholes because tax was charged if the goods were sold but not charged if the goods were transferred to a branch of the company. If the government uses the value added tax system then all possible loopholes will be sealed leaving the government with more revenue.
The tax system should also be easy to understand. This will help citizens to know and precisely understand what they are being taxed on. This will make remittance of tax easier and simpler as people will know what and how much they are supposed to pay in form of taxes. It should also be stable, in that it does not change or fluctuate yearly or periodically. If the tax system is stable it will not cause inconveniences in financing of public expenditure. A change in the tax system causes a decline or an improvement in the amount of revenue collected, thereby resulting in a surplus or deficit is revenue (Seto, 2009, p.1). The system should also be unavoidable, implying that all people comply in paying of the taxes. In the past, there have been instances of people avoiding or underpaying their taxes. The system should be free of inter-governmental leakages, implying that the state and the local tax system should share information. This will create transparency and accountability between the two.
A good tax system should be efficient to ensure that all taxes are collected accordingly (Seto, 2009, p.1). The system should also not interfere with the private economic decisions. Adequacy should be observed for the government or state to be able to meet its targets on public expenditure. Last but not least, the tax system should also be fair on the mode of payment. This means that there should be considerations for the high income earners and low earners. A good tax system is the one that ensures that people with higher incomes pay more than their counterparts with less income (Seto, 2009, p.1). This is due to the fact that if low income earners are overtaxed they are left with little income hence having difficulties in living a decent life.
As much as the state requires tax revenue to finance its public expenditure, it should ensure that the system has the right measures put in place. This being public money, it should be well spent and accounted for.
Kim leased an office building to USA Corporation under a ten-year lease specifying that at the end of the lease USA had to return the building to its original condition if any modifications were made. USA changed the interior of the building, and at the end of the lease USA paid Kim 30,000 instead of making the required repairs. Does Kim have to include the payment in gross income?
Problem Solution
Gross income does not include the value of real property due to structures erected or other improvements made by a lessee after a lease, as stated in Section 109. A lessee must include in their gross income any rent they receive from a lessor. Gross revenue does not include any amounts used to improve the property or rent received (Berdon, 1946). In the given scenario, the question that will be depicted is whether or not the thirty thousand dollars that the United States of America Corporation paid Kim should be included in her gross income. According to Section 109 of the Internal Revenue Code, rental income is a payment the lessee makes to the lessor (Berdon, 1946). The amount of rent now owed is the price that must be paid to have the right to occupy the property.
The case I choose to discuss is Boston Fish Market Corp., where one of the tenants should decide whether or not to pay the petitioner in 1968 to meet the tenant’s obligation to return certain leased premises to the original, preleased condition (United States Tax Court, n.d.). This decision is part of the tenants’ commitment to restoring the premises to the preleased condition (United States Tax Court, n.d.). If this were the case, it would be subject to the gross income requirements of Section 109 or the taxable amount corresponding to the amount obtained through the sale.
Now, in the case of Sirbo Holdings Inc. v. CIR, 31 AFTR 2d 73-1005, 73-1 USTC 9312 (2nd Cir., 1973), the question that needs to be answered is whether or not the tenant’s fee to its landlord of $125,000 in fulfillment of the tenant’s commitment to reinstate leased premises to their prelease condition is entitled. In whole or in part, to long-term capital gains treatment under Section 1231 of the Internal Revenue Code (US Court of Appeals for the Second Circuit, n.d.). As a result, the commissioner concluded that the petitioner’s amount should be treated as regular taxable income. In 1944, Sirbo leased one of its buildings to CBS.
Following the expiration of that lease, Sirbo awarded CBS a new lease for the theater they were renting at the time. By 1968, the Sirbo lease had required that CBS bring all of the properties back to the condition they had been in 1947. A settlement was signed on January 31, 1964, but it ended up dating back to December 31, 1963, that stated CBS had given Sirbo $125,000 for the release of any claims, harm, or damage. This was done in exchange for releasing any claims, injury, or damage (US Court of Appeals for the Second Circuit, n.d.). With time, CBS made additional theater changes so it could be used as a television studio. They were obligated to include the payment of $125,000 in their total gross income due to Sirbo’s acceptance of the money.
There are certain similarities between the Kim case and the Sirbo case. Both of them deal with the process of leasing their building to a business and, at the end of the lease, having any modifications made to the structure reverted to its initial state. This is a problem for both of them. Because Kim and Sirbo accepted cash payments from their lessees before making improvements to the property and did not return it to its former condition, they are exempt from the requirements of Section 109. This provision does not apply to them.
In conclusion, Section 109 of the Internal Revenue Code provides that a lessor of property is not allowed to include in their gross income any revenue that is received from sources other than rent upon the expiration of their lease. Excluding cash transfers from gross income was not intended to be a purposeful application of this rule. Consequently, Kim would be required to include it in the total gross revenue.
This tax plan has been proposed by Herman Cain who is a Republican Party member and a presidential candidate for the 2012 presidential elections in the United States of America. This newly proposed tax regime aims at replacing the federal tax system with a 9% personal income tax, 9% retail sales tax, and another 9% value-added tax. The most appealing element of this tax plan is that it addresses issues related to economic resources. Gravel (2008) observes that an effective tax plan should be able to address the importance of economic resources. The present tax system should be done away with largely because it is retrogressive towards economic growth (Gravel, 2008). So far, some economic critics are foreseeing mischief in this tax plan. They have dismissed it as a mere campaign tool.
This tax plan has been applauded by various groups. Those who support it argue that it can enhance transparency and simplicity. It is capable of revolutionizing the economy of United States of America. So far, the proposals by Herman Cain can provide a tax burden relief to the American public if followed by the letter. Basically, it is being perceived as a significant shift from the retrogressive tax systems that have continued to load more financial burden on taxpayers. Indeed, one of the outstanding attributes of this tax plan is that it attempts to level down all major tax deductions. Grouping all the taxes into three main categories is important instead of having numerous cuts in an individual’s income.
However, some critics have argued that this tax plan is only suitable for rich people. The Democrats have pointed out that this tax plan is for those who are rich. Similar claims have been put forward by a section of the Republicans. The focus is on how this kind of leverage would benefit low-income earners. He argues that most people would be able to pay less tax. At face value, the tax plan sounds quite fine. However, questions are emanating from this kind of leverage.
Perry Tax Plans
Rick Perry is another presidential aspirant under the Republican Party. His tax plan aims at instituting a flat tax rate of 20%. It also allows taxpayers to choose whether to continue with the current tax regime or go to a simpler flat tax. According to Perry, this kind of balance on the budget will not only be fair to the taxpayers. It will also be simpler and less complicated. Perry’s tax plan has identified several weaknesses in the current taxation system. For instance, some people are exempted from high taxes because they belong to the lower levels of earning. A good tax system must be cost-effective (Lambert, 1993). In other words, taxpayers should be cushioned against paying higher taxes that are not commensurate to their incomes.
The good element in this tax plan is that it brings about total change to the payment of tax. Individuals who are earning more than the US $1 million would have their tax payment slashed to 20% only. In addition, this tax plan may not be compulsory. In essence, it gives people a chance to choose the tax rate they would most prefer. For this reason, therefore, the poor may opt to remain with the existing tax system if they feel that they would be oppressed. On the other hand, high-income earners would have an option of going to this flat tax rate.
However, this tax plan may be retrogressive at some point. For instance, the tax plan is seen to be targeting those within the high-income brackets. If the tax plan is to be used to benefit all, only millionaires would benefit from it. Even though it gives an option to the poor to remain with the current tax system, it does not cushion them against the current challenges in taxation.
References
Gravel, M. (2008). Citizen power: A mandate for change. Bloomington: Author House Publishers.
Lambert, P. J. (1993). The distribution and redistribution of income. New York: Manchester University Press.
Expenses, which are not a taxpayer’s usual and required expenditures, are not taxable under income statutes and regulations for calculating net earnings according to the P.290 U.S. 115 act (Welch v. Helvering, 1933). There is a slight variation between regular and basic expenses that the corporation occasionally overstates. According to Section 162 of the Internal Revenue Code, expenditures of a commercial liability by a non-corporate insurer are not taxable. In general, paying someone else’s debts is not a cost that is taxable under Article 162.
Discussion
The E. L. Welch Company was involved in the cereal industry in the trial of Welch v. Helvering. Their unintentional insolvency led to the relief from their obligations. Then, they entered into a deal with the Kellogg Company, and over five years, they made large repayments under that agreement. According to the Internal Revenue Commissioner’s decision, the installments made throughout the years to the Kellogg Company, deductions from regular earnings, and basic expenses did not happen. The investment from the company’s intention was to build reputation and trust. The resolution by the board prevailed, and the payments were not taxable.
In the trial of Thompson, Jr., he bought 50 percent of Cardinal Gem Coal Company, Inc., while his father held the remaining half. After the enterprise had financial setbacks, Thompson took over the company and attempted unsuccessfully to sell off the company’s property to pay off creditors. Cardinal Gem eventually filed for bankruptcy and was liquidated. He had a solid ethical need to repay the loans (Cornell Law School, 2010). The prosperity of Thompson & Litton, which was his own company, was negatively impacted by this. According to one of the sessions’ reports regarding one of the agreements with consumers, the customer is a debtor of Cardinal Gem. Cardinal Gem’s outstanding bills embarrassed the petitioner.
Eventually, they cleared off the loan, received the agreement, and made money. In this issue, the petitioner reported reimbursements of Cardinal Gem’s obligations on his tax filing. The determination was that the settlement served Thompson and Litton’s commercial interests (Thompson v. Commissioner, 1983). It was established out of a feeling of personal dignity, moral responsibility, and fairness to previous lenders but serviced no significant corporate advantage of Thompson and Litton. The compensation paid to Cardinal Gem Coal firm, Inc. debtors, was not taxable because there was no direct commercial tie.
William A. Thompson, Jr.’s situation is analogous to Richard Penn’s. Richard also thought the company’s accomplishment was directly related to his profile. Since Richards specialized in real estate development, many of the Oil Company’s debtors were also its lenders. He believed there was a connection between the oil company’s insolvency and his firm’s decline. As a result, he used the firm’s accrued earnings to pay his creditors. Therefore, the question was whether Richard could deduct the amount from his taxable income or not. There was no immediate monetary tie between the petroleum company and the corporation because of the direct reimbursements to the oil company’s lenders rather than the firm’s borrowers. The settlement of another obligation does not qualify, as a regular or essential expenditure is deductible under section 162 of the IRC.
Conclusion
In summary, amounts paid out of consciousness to uphold one’s moral principles or for other reasons have no advantage for the company. Since Richard believed that the oil firm was to blame for his firm’s decline, he was able to compensate the company’s lenders. Richard made this contribution out of integrity; it was not a regular or essential expenditure. Additionally, it was a debt owed to a different firm, which is not taxable according to Internal Revenue Code subsection 162.
A consumption tax is a duty on goods and services spent by a household. It can be of direct forms like sales and value-added taxes or indirect forms like expenditure taxes.
Frank consumption tax suggestion involves taxpayers summing up their total incomes on a return form and only Frank would offer saving exemptions from this taxable income thus leaving consumption as the taxation base. It also considers a large standard deduction thus cutting on nonluxury rents and foods (Frank, 2011).
Strengths of progressive consumption tax
First, it instills a savings culture in residents as they are mandated to open accounts for tax-exempt earnings. This discourages excessive consumption. In addition, consumption tax encourages the capital formation and work thereby increasing economic growth.
Third, consumption taxes have a wider base, easier to implement as all consumption levels are taxed and it is considered a major revenue source for government and local authorities.
Fourth, consumption taxes do not alter spending tradition, behavior patterns, and scarce resource allocation. It is based on the assumption that consumption is already taxed and so it does not matter which product is consumed.
Fifth, consumption taxes increases productivity, capital stock, and the size of the economy which is directly related to its treatment of depreciation (Frank, 2011).
Sixth, progressive consumption tax minimizes inequality in consumption spending. It also has an inverse implication on wealth inequality as the rich could take advantage of this savings exemption.
Seventh, progressive consumption tax reduces the financial pressure on middle-level workers. These workers usually spend beyond their means to equate with their expensive neighborhoods.
Finally, tax incentives may result in economic recession due to a reduction in consumption levels. However, residents would only profit from a provisional consumption tax cut if they spend immediately (Economic policy reforms: Going for growth, 2012).
Weaknesses of progressive consumption tax
First, the higher marginal tax rates dampen productive economic activities. For instance, a 100% marginal tax rate means that hard-working taxpayers are taxed more than lazy ones thus demoralizing workers lowering consumption (Frank, 2011).
Secondly, consumption and sales taxes shift the tax burden to low-income groups. However, the ratio of tax commitment reduces as wealth increases, and citizens who consume all their earnings are taxed at 100 percent while savers and investors are taxed at a remaining balance (Cockfield, 2008; Frank, 2011).
Third, consumption is directly proportional to long-run average income levels. Therefore any abrupt changes in the household income levels within a given year result in payment of higher income. Changes in annual income may originate from the sale of fixed assets like homes, annual bonuses (Frank, 2011).
Fourth, this tax has many exemptions and loopholes which hinder its efficient operations. All savings are tax-exempt thereby contrasting income tax which covers salaries, wages, and income irrespective of its usage (Bird and smart, n.d).
Fifth, a higher and consistent revenue gain requires a higher taxation high taxation rate. But this high rate usually discourages individual investment and savings. Finally, the consumption rates start at a lower level and steeply rise. This usually endangers middle-income earners while low-income earners are tax-exempt although they receive major government benefits.
Financial accounting rules have tended to differ regarding the linking of tax liabilities and payments to reported earnings (Diehl, 2010). Recently, the differences between book and tax earnings have drawn a lot of attention on accounting issues. The deferred tax positions have tended to increase with the increase in the reliance of fair-value accounting over transaction-driven cash basis accounting (Diehl, 2010). This paper seeks to examine whether deferred tax assets (DTAs) and deferred tax liabilities (DTLs) satisfy the definition and recognition criteria for assets and liabilities according to the AASB framework for the preparation and presentation of Financial Statements. The paper will also determine if the answer will change if the asset and liability definitions in the IASB/FASB proposed Conceptual Framework were to be applied.
Definitions and recognition of assets and liabilities according to the AASB Framework for the preparation and presentation of Financial Statements
The AASB framework defines “Assets” as future economic benefits controlled by an entity as a result of past transactions or other past events (AASB, 2008, p. 13 ). The criteria for recognition of assets states that: “an asset is recognized in a financial statement when it’s probable that the future economic benefit embodied in the asset will eventuate, and that the asset has a cost or other value that can be determined reliably” (AASB, 2008, p 22).
The AASB framework defines “liabilities” as future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or events. A liability is “recognized in the statement of financial position when it’s probable that the future sacrifice economic benefits will be required, and when its amount can be measured reliably” (AASB, 2008, p. 25).
How deferred tax liabilities (DTLs) and deferred tax assets (DTAs) arise and whether they fit the definition and recognition of assets and liabilities by the AASB
The total tax expense accrued by a company is equal to its statutory corporate tax multiplied by its taxable book income (Diehl, 2010). The taxable book income, “which often matches with the income earned today, but which is to be taxed at some point in the future, is equal to the pre-tax book income minus the permanent disparities between book and tax income” (Diehl, 2010, p. 15). Permanent differences occur when tax rules and accounting rules differ on constituents of income or expenses. For instance, the reporting of fines and penalties is usually not taxed but is deducted in the computation of book earnings. The permanent book-tax differences do not result in deferred tax assets or deferred tax liabilities because their effects on a company’s accounting earnings are seen.
On the other hand, “the temporary book and tax differences occur when the accounting rules and tax rules do not agree on the time of recognizing a component of income” (Diehl, 2010, p. 16). For instance, the recognition of expenses accrued due to compensation such as bonuses. Various accounting standards often attempt to reconcile efforts and accomplishments and thus factor in expenses incurred even if they are yet to be paid (IASB, 2006).
The tax code often tries to limit the number of assumptions in the computation of taxable income and therefore it more readily adopts cash-based accounting for different expenses. A current tax expense can be defined as a firm’s estimate of the taxes that will be reported on its current year’s tax returns (Diehl, 2010). The differences between a firm’s current tax expenses and its total tax expense usually generate the disparities between book and tax. These disparities are identified as deferred tax expenses.
Temporary differences can occur as a result of many diverse circumstances, for instance, the differences between accounting and tax rules. The “deferred tax assets and liabilities are described as the current statutory corporate tax rate times the historical sum of the firm’s temporary differences” (Diehl, 2010, p. 25). If the temporary differences are positive for a given firm, i.e., the cumulative total tax expense exceeds the cumulative current tax expenses. A firm in such a situation has a deferred tax liability (DTL) (Diehl, 2010). DTL means that a company has future taxes to pay on income that has already been booked for accounting.
On the other hand, a company or firm whose taxable income is higher than its book income has a deferred tax asset (DTA) which implies that the company is owed future tax relief (Diehl, 2010). According to the FASB/IASB conceptual framework, the recovery of deferred tax liability is more direct as it is better captured in the tax code. However, the recovery of deferred tax assets is a bit complicated and depends on whether they are previously planned to be reflected in the future financial statements when payment is to be done.
The above description shows how DTA and DTL develop, implying that they can be evaluated and determined. This finding is consistent with the AASB definition and criteria for recognizing Assets and Liabilities in the statement of financial position. The AASB’s definition and recognition criteria for assets and liabilities defer in wording from that of both IASB and FASB but mean the same thing. However, the proposed IASB/FASB definition emphasizes the present rather than the past and future in the definition of assets and liabilities.
Proposed IASB/FASB framework scenario
The working definition of an asset proposed by the IASB/FASB refers to an asset as a “present right or another present privilege, of the entity to a resource that is capable of generating economic benefits to the entity either directly or indirectly” (IASB, 2006, p. 3). The proposed IASB/FASB “definition of liabilities is present obligations to other entities that compel potential outflows or other sacrifices of economic benefits” (IASB, 2006, p. 7).
The newly proposed definitions outlined above do not alter the idea of liabilities and assets in a major way. They only provide a more disciplined way of determining if particular items fit in the definitions (Diehl, 2010). Thus, deferred tax assets (DTAs) and deferred tax liabilities (DTLs) still satisfy the definition and recognition criteria for assets and liabilities even when the proposed IASB/FASB Conceptual Framework (IASB, 2006).
Conclusion
This paper sought to examine whether deferred tax assets (DTAs) and deferred tax liabilities (DTLs) satisfy the definition and recognition criteria for assets and liabilities according to the AASB framework for the preparation and presentation of Financial Statements. It also sought to determine whether that would change with the change in assets and liability definitions in the IASB/FASB proposed Conceptual Framework. The paper has established that both DTAs and DTLs satisfy the definition and recognition criteria for assets and liabilities according to AASB Framework. It has also established that nothing will change if definitions in the proposed IASB/FASB are adopted.
References
AASB. (2008). Definition and Recognition of the Elements of Financial Statements. Victoria: Australian Accounting Research Foundation.
Diehl, K. (2010). How deferred tax assets and liabilities influence US stock prices. Illinois: Western Illinois University.
IASB. (2006). Conceptual Framework: Liability and asset definition. London: IASB.
Our client, Theta, is managed jointly by three sisters (Amy, Beth, and Meg). Amy wants to either redeem or sell her shares depending on the tax implications on these options. She has written to us requesting a comparison of tax implications on the two options so that she can make a decision on whether to sell or redeem the shares.
Issues
The tax implication on the shares that Amy intents to dispose depends on two issues: First, whether Amy sells her shares to Beth and Meg (50 shares each) or to either Beth or Meg, and secondly, whether she redeems the shares under Theta Corporations which can redeem all of it.
Applicable Law
Section 1222 of the Internal Revenue Code (I.R.C), provides for taxation on certain types of gains in a different manner hence enhancing capital gain preference (Legal Information Institute, n.d.). This is in total disfavor of the common ordinary income. On the other hand, capital losses becomes a disadvantage when compared to ordinary losses since when it comes to making deductions, this is only done on capital gains (1211(a)). Under section 1001(a), if Amy sold the appreciated stock to Beth and/or Meg, the difference between the amount of her stock share and her basis constitutes the economic gain ($100,000-$40,000=$60,000). In this case, the sale can only be taxed on the amount realized by Amy over her basis. Under section 1221 of the code, what Amy is selling (stock) is categorized as capital asset hence any gain attained through this sale is referred to as a capital gain.
In a famous Supreme Court of the United States case, Eisner vs. Macomber, 252 U.S. 189 (1920), the court ruled in favor of Macomber by declaring that the income tax imposed on her dividends was unconstitutional. This was even when, in this case, the dividends represented the corporations accrued earnings though indirectly (“Eisner v. Macomber”, n.d).
Analysis
Issue 1: whether Amy sells her shares to Beth and Meg (50 shares each) or sells all her shares to either Beth or Meg- Under section 1001(a), if Amy sold the appreciated stock to Beth and/or Meg, the difference between the amount of her stock share and her basis constitutes the economic gain ($100,000-$40,000=$60,000). In this case, the sale can only be taxed on the amount realized by Amy over her basis. The amount realized over her basis in this case is $60,000 hence this is the amount to be taxed following the sale of her shares. Therefore, a 20% tax rate will be imposed on the $60,000 capital gain. In addition, under section 1221 of the code, what Amy is selling (stock) is categorized as capital asset hence any gain attained through this sale is referred to as a capital gain.
Issue 2: whether she redeems the shares under Theta Corporations which can redeem all of them- Two tax consequences can result if Theta Corporation redeems shares from Amy. It is worthy to note that, to the extent of earnings and profits, this redemption will be treated as a taxable income. The first tax implication (a taxable dividend treatment) prevents Theta from paying dividends as a stock redemption, taxable as a capital gain. For instance, Theta can redeem 10% of Amy’s share instead of paying cash dividend to her. In this case, Amy will continue to own all of her stock and will continue exercising her control over Theta Corporation. Therefore, this option would minimize tax burden on Amy and at the same time no reduction of her ownership interest of Theta will be expected. The second tax consequence (exchange treatment) requires Amy to pay a maximum of 20% tax rate on her net capital gain. Since Amy reports a $60,000 long-term gain ($100,000-$40,000), 20% of this gain would go to taxes. This option would have advantage over the taxable dividend treatment option if Amy had capital losses which have not been used. In addition, this option would permit Amy a tax free recovery of her investment in Theta. In contrast, the taxable dividend treatment option does not allow for a tax free recovery of investment. No attribution of stock occurs from either Beth or Meg to Amy because the family attribution rules do not apply to siblings (Internal Revenue Service, 2012). Under section 302 (b) (3), the redemption of Amy’s stock would result in a complete termination of her interest. In the case where Theta Corporation redeems Amy’s shares, a distribution of the remaining shares will be done to Beth and Meg, each controlling half of the stock hence making this a preferable option for the two sisters. At the same time, redemption of Amy’s shares will end up in a $50,000 reduction in earnings and profits of this Corporation as well as a general reduction of paid in capital amounting to $50,000.
Conclusion
The decision on whether Amy should sell or redeem her shares would depend on various factors. First is whether or not she wants to completely terminate her interest in Theta Corporation, Second is whether or not she decides to sell all her shares to Beth and Meg and thirdly whether she redeems all her shares with the Corporation or she just wants to redeem part of it (only a certain percentage). In the first instance, where she is ready to terminate all her interests in Theta Corporation under section 302 (b) (3), she may go ahead and redeem her shares but will be required to comply with a 20% maximum taxation rule on capital gains. Although this option results to a complete termination of Amy’s interest in Theta Corporation, it would be worthy to note that this option permits her to have a tax free recovery of her investments in Theta. In the second option where she decides to sell her shares to Beth and/or Meg, she would again be required to observe the 20% maximum taxation on capital gains. Finally, if she just wants to redeem part of the shares, she can go ahead and redeem a certain percentage, like 10% of her shares with Theta. This final option allows Amy to continue owning her shares and exercising control over Theta Corporation. If she decides on this final option, she will have various advantages including the minimization of tax burden on her and also there will be no reduction of her ownership interest of Theta Corporation. With these three available options, it is pretty clear that the final decision on whether to sell or redeem her shares would possibly come from Amy. The first and the second options are more or less the same when it comes to consequences on taxation. The final option however means that she will continue being part and parcel of the Corporation.