The taxes that bind: the rules on company profits

Corporation tax, which is imposed on the income or profits of companies that fall within its net, has become an unlikely subject of contentious political debate in recent years.

The ability of multinational companies, not to mention wealthy business figures and well-known pop bands, to organise their global affairs in such a way as to escape the tax aspirations of national governments, is a sore subject at a time of public-service cutbacks and increased taxes for much of the population of the western world.

But while tax avoidance by multinationals may be a simple fact of life, it doesn’t follow that the nature and computation of corporation tax are simple.

So what is the tax, what lowers or increases the size of the bill, and how can the effective tax rate paid by different companies vary so widely?

Irish corporation tax is charged on the income and profits of companies that fall within the Irish tax net; that is, companies that have trading activity in Ireland and what is called a “permanent establishment” here.

There was controversy in the UK recently concerning whether Google, which books its profits in Ireland, had a "permanent establishment" in the UK, where it has hundreds of employees who have contact with customers who end up signing contracts with Google Ireland. The company said it doesn't have a permanent establishment in the UK, and the Irish and UK revenue bodies, as far as we know, agree.

In Ireland there are two rates of corporation tax: 25 per cent and 12.5 per cent. The higher is paid on what are called gains, while the lower rate is levied on trading profits. Gains such as nontrading investment income are taxed at the higher level.

While a company’s profit and loss account may show a profit before tax figure, this can often vary substantially from the figure that is submitted to the Revenue Commissioners for taxation. The reasons for this difference are many in some companies and few in others.

Tax write-offs
These days, one of the most interesting reasons for taxable profits being lower than booked profits is the use of tax write-offs arising from losses carried forward.

A business, such as a bank, that made a catastrophic loss in one year can use this loss over succeeding years to reduce, or eliminate, its tax bill. For example, if a bank that usually makes €100 a year loses €1,000 in one year, it can have tax-free profits of €100 a year for the next 10 years.

There is no time limit for the use of the losses but they must be used as soon as possible, and they must be used in relation to the same, continuing trade. Losses in one company within a group of companies can be shared for tax write-off reasons with other companies within a group.

Banks that have sold assets to Nama are restricted in how much they can write off in a single year.

Because the way a set of accounts arrives at a profit figure can involve items that might not be relevant to the calculation of taxable profits, tax accountants talk about addbacks and deductions, which are added or deducted to the profit figure in the accounts when calculating the profit figure for tax purposes.

So, for example, if the fictional bank referred to above made a profit of €100, it could deduct a tax write-off of €100 arising from a previous year’s losses, and arrive at a figure of €0 for tax purposes.

If the bank had made a general provision of €10 for repairs to its roof, this figure would not be allowed as a taxable expense because the money had not been spent, just provided for. So the €100 profit figure becomes €110 for taxation purposes, after the “addback” of the €10.

As a general rule, expenses deductable for taxation purposes are expenses that have been paid, rather than expenses that have been accrued, and that appear in the accounts, but have not yet paid.

In this way a pension charge – or professional fees, which are not trading expenses – incurred as part of a takeoverwould lead to addbacks that would have to be added to the profit figure given in the accounts when calculating the amount of taxable profits for the year.

Different rules govern the issues of capital allowances and depreciation. A company might have capital allowances that it can deduct from its profit figure when trying to establish its taxable profits. It might also have a depreciation charge that reduced its booked profits but which it must have added back when arriving at the taxable profit figure. This is so that companies can choose the time period over which an asset depreciates, but are obliged to implement general rules when availing of capital allowances. So the depreciation figure might constitute an addback, and the capital allowance account for a deduction, with the net figure increasing or decreasing the taxable profits.

When computing the amount of tax it must pay, a company must separate its trading profits from its nontrading profits, and tax the two figures at the appropriate rates.

The result is that the profit figure that appears on a set of accounts is often very different to the taxable profit figure that is submitted to the Revenue.

Effective tax rate
There has been a lot of talk about the "effective tax rate" paid by companies. This is the figure for the amount of tax paid, divided by the profit figure that appears in the accounts. If a company makes a booked profit of €100 and that is also the amount subjected to the lower rate of corporation tax, it will pay an effective tax rate of 12.5 per cent.

However, if the taxable profits are €50, the effective tax rate will be 6.25 per cent. (€50 taxed at 12.5 per cent makes for a tax bill of €6.25. This figure divided by the booked profit figure of €100 gives an effective rate of 6.25 per cent.)

Multinational groups can have companies based in, for example, Ireland, that have licence-fee obligations to companies in the group that are based in, for example, Bermuda. These arrangements can be constructed in such a way that, although the Dublin company signs contracts for business across Europe and farther afield, and has its permanent establishment in Dublin, the fees payable to its Bermuda associate are such that it makes a relatively small profit, taxable or otherwise. The profits are, in essence, channelled to Bermuda, which does not have corporation tax.