Calculating the taxable result of a sole proprietorship or a transparent partnership
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Understanding the interaction between accounting and taxation is fundamental as accounting elements determine the tax base and the amount of tax businesses have to pay.
Moreover, proper bookkeeping is required where the tax authorities offer the taxpayer a choice between two tax regimes.
The accounting result is used as a basis to calculate the taxable result. It is then adjusted by means of additions and deductions where the tax rules differ from the accounting rules (certain expenses may not be tax deductible, and certain income may not be taxable).
This is the principle of basing the tax balance sheet on the accounting balance sheet: the tax balance sheet is derived from the commercial balance sheet and in principle they are identical, except where there are derogations under tax law (in which case the tax rules take precedence).
Major accounting rules affecting taxation
'Income-expenses' accounting
Businesses use full accrual basis accounting and not cash basis accounting meaning that they must recognise receivables acquired and payables due independently of their date of collection or payment.
Examples:
- an invoice sent in December of year N is settled in January of year N+1. The accounting income is recorded in year N; the same applies to the taxable income;
- the advance payment made by the business at the beginning of renovation works does not yet constitute an accounting expense because the works have not yet started. It is therefore not a tax expense either. The accounting and tax expense will be recorded when the works are completed.
Distinction between financial years
Only the income and expenses relating to a given financial year should be charged to that year.
Examples:
- a delivery made in December of year N is taxable in year N, even if the invoice is not issued until January of N+1;
- conversely, an invoice issued before the delivery or provision of services does not yet count as accounting (and tax) income;
- total rent of 90 is paid in advance in November of year N for the months of November, December and January. The accounts for year N will only record the rent paid for November and December as an expense, i.e. 2 x 30 = 60.
Currencies and nominal value
Tax accounts are kept in euro according to the principle of nominal value. Transactions in foreign currencies are converted into euro at the exchange rate prevailing on the date the transaction is concluded. Receivables and payables in foreign currencies are converted into euro at the exchange rate prevailing on the closing date of the balance sheet; unrealised foreign exchange gains are ignored and unrealised foreign exchange losses are recorded.
Examples:
- 10 items at a price of USD 100 per item are sold to an American customer. The exchange rate at the time of the sale is USD 1 = EUR 0.9. Turnover is 10 x 100 x 0.9 = EUR 900;
- The business has a receivable of USD 100 from this customer. On the date of the sale USD 100 was worth EUR 90, so this amount appears in the accounts. At the accounting year-end, USD 100 is worth EUR 100 due to a fall in the euro. The business therefore has an unrealised foreign exchange gain which it will ignore for accounting and tax purposes;
- Now we will take the same example, but this time USD 100 is worth only EUR 80. Since the business was exposed to the risk of incurring a foreign exchange loss, this expense of EUR 10 will be recorded for accounting and tax purposes.
The concept of taxable result
Full accrual basis accounting determines the taxable profit by comparing successive balance sheets. The underlying philosophy is the taxation of any gain due to the activity of the business during the financial year.
Dividing the life of the business into financial years is both necessary (an operating balance must be established at regular intervals) and artificial (the break at the end of a financial year does not relate to a break in the operations or the activities of the business). It is normal practice to carry forward certain items beyond the financial year end to give continuity to the results. This is why the final taxable result of one year in the life of the business is calculated by deducting losses carried forward from the previous financial year from the commercial profit of the new financial year.
Carryforwards, i.e. charging the deficit from one financial year against the profits of subsequent financial years, are allowed with no restrictions in terms of duration, provided that the taxpayer keeps the accounts properly.
Calculation method
- Take the balance sheet net assets at the end of the financial year. Deduct the balance sheet net assets at the beginning of the financial year from this amount.
- From the amount thereby obtained, deduct any contributions received by the business during the financial year. Contributions increase the net assets but are not a gain produced by the business itself; only elements produced by the business constitute taxable gains.
- Finally, add the private withdrawals made by the entrepreneur during the financial year, because although they reduced the net assets at the end of the financial year they are not a business loss.
Business profit (loss) =
Net assets at the end of the financial year
- Net assets at the beginning of the financial year
- Additional contributions during the financial year
+ Private withdrawals during the financial year
Example: a taxpayer operating a sole proprietorship has drawn up the following balance sheets:
Opening balance sheet on 1 January |
N : total assets 1000 – liabilities 400 |
|---|---|
Closing balance sheet on 31 December |
N : total assets 1130 – liabilities 430 |
The taxpayer carried out the following transactions during year N:
Withdrawal of a cash amount from the business account |
360 |
|---|---|
Payment of a private insurance policy from the business account |
20 |
Payment of income tax from the business account |
60 |
Removal of goods from the business inventory for private use |
10 |
New contribution from an inheritance to the business |
200 |
Net assets at the end of the financial year = 1130 – 430 |
= 700 |
|---|---|
Net assets at the beginning of the financial year = 1000 – 400 |
= 600 |
+ private withdrawals = 360 (cash) + 20 (private insurance) + 60 (personal income tax) + 10 (in kind) |
= 450 |
- new contributions (inheritance) |
= 200 |
= profit for the financial year: 700 – 600 + 450 – 200 |
= 350 |
Business assets
An entrepreneur is not at liberty to decide what he wishes to be considered as an asset of the business. The assets used in the operation of the business must be itemised in order to distinguish them from the private assets of the entrepreneur because they fall under a different tax regime.
In order to form part of the business assets, an asset must satisfy 2 conditions: the asset must belong to the business manager and it must serve the business.
The asset must belong to the business manager
According to this principle, only assets owned by the business manager can form part of the business assets; in other words, assets that creditors can seize if necessary.
The legal owner of an asset might not also be the economic owner. In this case, economic ownership will prevail. Whoever has effective power over the asset will therefore be considered to be its owner.
Example: lease contract: if, according to the contract, the lessee becomes the owner of the asset at the end of the agreement, the entrepreneur can include it in the business assets as from the start of the contract.
The asset must serve the business
Certain assets, by their very nature, serve the business while others can only be used for private purposes and others can serve both the private needs of the taxpayer and his business.
Assets that are professional by nature
These always form part of the business assets even if the entrepreneur wishes otherwise (example: manufacturing workshop).
Assets that can be considered to be business assets
Assets which, although not generally intended to serve the business, are nevertheless likely to serve this purpose in the business sector concerned (example: building rented out by the company). The entrepreneur can choose whether such assets form part of the private assets or business assets (in which case the accounts must be kept properly and the asset must be recorded therein).
Assets that are private by nature
These are assets that cannot serve the business and therefore cannot form part of the business assets (example: private residence).
Mixed use assets
These are assets used by the entrepreneur for both business and private purposes. Whether they form part of the private or business assets of the taxpayer depends on whether they are movable or immovable assets. Movable assets form part of the business assets or private assets at the discretion of the entrepreneur. Mixed use assets are divided into two parts: one part allocated to the business assets and the other to the private assets.
Valuation of business assets
Each asset is valued when it enters the business assets. The overall assets are valued at the end of each financial year. Valuation requires knowledge of the rules and restrictions laid down by the relevant tax laws. These rules apply to business assets as well as liabilities.
General valuation rules
There are 3 reference values:
- the purchase cost is the price paid by the business to acquire the assets plus any additional costs (transport cost, customs duties, etc.);
- the cost price or production cost is the cost of purchasing the supplies and materials used plus all direct expenses (expenses associated with a given product). Indirect production costs (overheads not associated with a specific product) may be added at the discretion of the entrepreneur;
- the going concern value is the price that the buyer of an entire business attributes to the purchase. The going concern value is presumed to equal:
- the replacement cost of the asset for movable assets;
- the net value of the asset for depreciable fixed assets;
- the purchase cost for non-depreciable fixed assets.
Restrictions under tax laws
The restrictions vary depending on whether the item in question is a business asset or liability, in addition to which there are some exceptions.
Assets
There is more than one possible value. Assets can be valued at the purchase cost or the production cost (minus any depreciation). In addition, when the going concern value of the asset is lower than the purchase cost or production cost, the taxpayer may opt for a value adjustment and value the item at the lower value (not compulsory).
Liabilities
These are valued at their purchase cost. When the going concern value is greater than this amount, the taxpayer may record an additional liability and opt for the going concern value of the item (this rule is only valid for tax purposes and any losses must be entered in the accounts; where appropriate, the taxpayer must draw up 2 separate balance sheets, one based on accounting criteria and the other establishing his choices regarding taxation).
Exception with regard to fungible assets
In theory, valuations are carried out individually, item by item. For fungible assets (stock, transferable securities, etc.), the entrepreneur cannot assign an individual purchase cost to each unit held. For these assets, the taxpayer can choose between 3 approximate valuation methods:
- the weighted average cost (WAC) method;
- the First In, First Out (FIFO) method;
- the Last In, First Out (LIFO) method (see 'Composition and valuation of stock').
Special regime for small businesses
The taxation of businesses is based on full accrual taxation (see 'Accounting and taxation'). Only those working in the liberal professions and taxpayers making a profit in agriculture or forestry benefit from a simplified method for determining profits, known as the cash basis accounting system. However, all traders are obliged to keep full accrual accounts.
Nevertheless, small businesses may benefit from an exemption and opt for cash basis accounting (comparison of cash received and cash paid out) if they do not exceed any of the following 3 criteria:
- annual turnover: EUR 50,000;
- balance sheet total: EUR 12,500;
- commercial profit: EUR 1,500.
