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EUROPEAN COMMISSION

DIRECTORATE-GENERAL TAXATION AND CUSTOMS UNION


Analyses and tax policies
Analysis and Coordination of tax policies

Brussels, 7 September 2005


Taxud E1 RD

CCCTB\WP\016\doc\en
Orig. EN

COMMON CONSOLIDATED CORPORATE TAX


BASE WORKING GROUP (CCCTB WG)

Concept of the 'tax balance sheet'

Meeting to be held on Friday 23 September 2005


Centre de Conférences Albert Borschette
Rue Froissart 36 - 1040 Brussels

WORKING DOCUMENT

B-1049 Bruxelles / B-1049 Brussel - Belgium. Office: MO59 06/017.


Telephone: (32-2) 299.11.11; direct line (32-2) 296.10.75. Fax: (32-2) 295.63.77.
E-mail: taxud-e1@cec.eu.int
Introduction and purpose of the note

1) In its meeting of 2 June 2005 the Group inter alia considered the definition of
depreciable assets. As in previous meetings issues concerning the link between
financial accounts and the determination of the taxable income in Member States, the
practical rules for compiling the taxable corporate income and the required supporting
documentation re-surfaced. In this context, the Commission services expressed their
preparedness to draft an explanatory note on the concept of the 'tax balance sheet'. This
concept is used for the determination of the taxable income and for the tax
documentation in some Member States but not, or at least not under this terminology,
in many others.

2) The present paper is thus intended to clarify the concept of the 'tax balance sheet' and
its distinction in comparison to the financial accounts balance sheet. It also raises the
related issue of the potential consequences of a possible move away from tax and
accounting dependency, resulting in a situation in which the financial accounts are no
longer systematically connected with the tax accounts. The intention is essentially one
of clarification and awareness-raising, not to raise a separate debate.

3) Given that the concepts of 'tax balance sheet' and 'dependency' have predominantly
been developed in Germany, the German rules form the basis of the document,
although the concepts are, in variations, also in use in other countries. The
Commission services wish to thank the German experts for their comments on the
working document.

The basic concept of a 'tax balance sheet' in Germany

4) As a principle, all non-commercial and non-trade income is determined on a cash-


basis. This also applies, for example, to the determination of profits from liberal
professions/independent personal services (however, there exists an option for accrual
accounting). On the other hand, in principle all trading income is determined on an
accrual basis. Hereby, the taxable income from a trading activity is defined in German
tax law as the difference between the net value of a company at the end of a business
year and net value at the end of the preceding business year, plus the withdrawals, such
as dividends, less the contributions, e.g. an increase in share capital. Being based on
historical book values, this difference does not include unrealised profits and losses.
Such a profit determination on an accruals basis, which involves the establishment of a
“tax balance sheet”, is obligatory, for all tax payers, who have an obligation to keep
books, as for example as a merchant from a commercial law point of view, or who
exceed certain rather low turnover or profit thresholds.

5) A tax payer has to draw up an “original” tax balance sheet, when he does not have any
commercial law obligation to keep books (not a merchant in the meaning of the
Commercial Code), but either exceeds the thresholds or voluntarily prepares a “tax
balance sheet”. In this case, only the tax provisions for the posting and evaluation of
the assets and liabilities have to be observed. Such a “derived” tax balance sheet could

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even be prepared without a profit and loss account, i.e. without double bookkeeping
and thus could be based solely on the inventory at the end of each tax year.

6) A “derived” tax balance sheet has to be prepared for all tax payers with trading income
which are obliged to keep books from a commercial law point of view. The Income
Tax Act prescribes that such a “derived” tax balance sheet has to be prepared in
accordance to the German GAAP, thus prescribing that the determination of the
taxable income in the framework of a tax balance sheet is linked to the financial
accounts, unless special tax rules apply. This is important as numerous businesses are
under no obligation to publish detailed financial accounts.

7) In accordance with the basic approach set out above, the basis for computing a
company’s taxable income is its commercial (financial) balance sheet, with
adjustments prescribed by tax law. As commercial law generally permits greater
latitude in the valuation of assets, accruals, reserves and liabilities than tax law,
amendments may need to be undertaken to these balance sheet positions for tax
purposes. As a result of this the balance sheet for tax purposes, i.e. the 'tax balance
sheet', is based on the commercial (financial) balance sheet, but contains specific
adjustments to certain items as required by tax law.

8) These adjustments, which are effectively made outside the balance sheet as such, refer
to either the capitalization of assets / accrual of assets, or the evaluation of assets /
liabilities. As a matter of fact, the main differences between the financial accounting
and the determination of the taxable income refer to the tax treatment of options
concerning the capitalization / accrual and evaluation of assets and liabilities. The most
important difference, introduced by case law, provides for:
• an obligation for capitalization for tax purposes, where the financial accounting
provides for an option for capitalization;
• a prohibition of accrual for liabilities, where the financial accounting provides for
an option for accrual.
This affects especially the tax treatment of the goodwill, where another enterprise has
been acquired, and the tax treatment of overhead cost for production and material,
since for these issues the financial accounting provides for an option of capitalization,
which results into an obligatory capitalization for tax purposes. Furthermore, regarding
the evaluation of assets, the amount of depreciation allowed might differ between the
method used for financial accounting balance sheet and tax accounting balance sheet.
For financial accounting purposes, an asset has to be depreciated in a systematic way –
for tax purposes the useful life and the possible annual depreciation is prescribed by the
tax law or by decrees from the tax administration.1 Further typical adjustments include
the elimination of non-deductible items and tax-exempt income.

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Other examples for such difference include: temporary value reductions of financial assets (optional
depreciation in financial accounting / prohibition in tax accounts); temporary value reductions of current
assets (optional depreciation in financial accounting / prohibition in tax accounts); provisions for patent
violation (obligatory in financial accounting / special rules in tax accounting); provisions for employee
jubilee payments (obligatory in financial accounting / special rules in tax accounting); pension provisions

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9) The 'tax balance sheet' is thus crucial for compiling and documenting the taxable
income of companies in Germany. In practical terms, the tax balance sheet can be
established
• either by adjusting the financial balance sheet by means of additions, corrections,
etc.;
• or by compiling a separate, proper tax balance sheet;
• or by compiling a 'single' (identical) balance sheet that serves both the purpose as
financial balance sheet and as tax balance sheet. A 'single' balance sheet is only
possible if the options in the financial accounts are used in accordance with the
obligatory tax rules and when unavoidable differences are documented in
supporting additional calculations. Nowadays this practically only the case for
relatively small companies.

10) As mentioned above, this basic approach holds for both entrepreneurs and partnerships
which are subject to personal income tax (for the commercial income) and
corporations subject to corporate income tax. The first group represents the
overwhelming majority of businesses in Germany. As these businesses usually do not
publish financial accounts, the 'tax balance sheet' which offers less options and aims at
a stricter valuation practice is particularly important for them and is often also used for
non-tax purposes, e.g. loan negotiations with banks.

11) It is important to note that tax balance sheets or at least the valuations contained
therein are also used as a point of reference for the assessment of trade tax (with an
average tax rate of around 12%) and inheritance tax (e.g. concerning the valuation of
shares in non-quoted companies).

'Dependency'2 and 'reversed dependency'3

12) The precise relation between the financial balance sheet and the tax balance sheet is in
principle governed by the principles of 'dependency' and 'reversed dependency' which
have however been drastically loosened in Germany over the last years. By definition,
the concept only applies to the individual accounts of a company.

13) The principle of 'dependency' means that financial accounting standards also have to
be used for the 'tax balance sheet' - provided there are no diverging proper tax rules. As
such, this principle does not conflict with the IAS/IFRS. The principle of 'reversed
dependency' provides that the use of options in the tax balance sheet presupposes an
analogous treatment in the financial balance sheet. This connection, which is obviously
not provided for in the IAS/IFRS (as it is not in national GAAP), would lead to

(obligatory in financial accounting / special rules in tax accounting). Another example concerns provisions
for anticipated losses which are disallowed for tax purposes from 1997. Any such provision stemming from
earlier years must be dissolved at the rate of 25% in the first financial year ending after 31 December 1996
and 15% in the following 5 financial years.
2
"Maßgeblichkeit"
3
"Umgekehrte Maßgeblichkeit"

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conflicts where the treatment of IAS/IFRS and the tax base differ without there being
matching options that would it make possible to ensure an identical treatment in both
types of accounts without infringing neither the financial accounting nor the tax
accounting rules.

14) The concept of dependency dates back to the end of the 19th century (introduction in
Germany in 1874). Its rationale was - and essentially still is - a simple determination of
the tax base and the possibility to use reliable profit determination standards. The
reversed dependency is much younger and was introduced in Germany in 1954, with
subsequent refinements in 1965 and 1985. However, via these later changes more and
more tax elements gradually were introduced in the financial accounts, even in
derogation of the financial accounting rules, thus compromising the original objective
of a simple and reliable determination of the taxable profit. It is important to note that
the use of 'dependency' is closely related to general company law and in particular to
issues like capital maintenance, solvency, creditor protection and profit distribution.

15) Given that the IAS/IFRS are now obligatory for the consolidated accounts of stock-
listed companies and rapidly gaining importance also for individual accounts and other
companies the question arises how dependency and reversed dependency can in future
be matched with tax accounting. Given the (investor-driven) earlier profit recognition
of the IAS/IFRS maintaining the dependency principle could lead to earlier taxation
and consequential cash-flow effects. The concrete effect on companies depends
however on many factors like the availability of losses; profitability etc. Moreover, the
use of IAS/IFRS might also have positive refinancing effects, setting off tax-driven
cash-flow disadvantages.

16) It is nevertheless hard to imagine that the dependency principle, let alone the principle
of reversed dependency, can be matched with the implementation of a single tax base
and the continuous use of 25 different national accounting standards and rules. The
wide-spread use of IAS/IFRS complicates the issue further, without however as such
making the use of 'dependency principle' impossible. As explained in other working
documents several IAS/IFRS concepts e.g. that of 'fair value accounting', directly
conflict with well-established tax principles, e.g. the one of taxing only realised profits.
Ultimately, however, it is the fact that twenty five different national financial
accounting rules cannot be directly linked with a single identical common tax base that
is at the core of the issue. In the context of a common consolidated corporate tax base
the continuation of 'dependency' and 'reversed dependency' therefore conceptually
seems to be almost impossible.

Conclusion

17) The concept of a 'tax balance sheet' as explained above is not used in most other
Member States which establish the tax base via adjustments (additions/reductions) to
the profit registered in the financial accounts. Instead of a 'balance sheet approach' they
follow a 'profit/loss approach' that compares income and expenses. This may or may
not take the form of a formalised reconciliatory statement, mostly in the tax declaration
or an annex thereto. It will be necessary to analyse in more detail which consequences,
if any, this different technical approach, which as such does not involve any difference

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in substance, may have for the further work on the CCCTB and its practical
implementation.

18) In particular thought will need to be given to the question of whether or not for the
CCCTB Member States will be able to continue with differing concepts for compiling
the taxable income or not. Moreover, the implicitly different approach to the collection
of tax accounting data may influence the stance on further discussions, such as 'income
and revenue'. Finally, this could be of importance for gathering the data needed for the
design and operation of the formulary apportionment system that is linked to the
CCCTB. It is suggested to come back to the issue in due course, when more advances
for instance in these areas have been made.

19) Most Member States apply the 'dependency principle' and many also the 'reversed
dependency principle'. The preliminary conclusion from the analysis so far however
strongly hints at problems with the continuation of these principles for companies
using the CCCTB. This is in line with the results of other work already carried out on
this issue such as the joint (DG Taxation and Customs Union and DG Internal Marlket
as it was then known as) meeting with Member State tax and accounting experts in
March 2004.