Narrowing the Gap Between Tax Law and Accounting Humayun Chaudhary a DISSERTATION SUBMITTED to the FACULTY of GRADUATE STUDIES I
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Narrowing the Gap between Tax Law and Accounting Humayun Chaudhary A DISSERTATION SUBMITTED TO THE FACULTY OF GRADUATE STUDIES IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY GRADUATE PROGRAM IN LAW OSGOODE HALL LAW SCHOOL YORK UNIVERSITY TORONTO, ONTARIO July 2019 © Humayun Chaudhary, 2019 ABSTRACT Accounting income and taxable income are both designed to capture the economic activities of an entity based on their own rules and assumptions. Despite all the differences in reporting objectives and measurement methods, accounting income forms the starting point for determining taxable income. This suggests that much of accountants’ use of consistency and matching principles flows through to the legal measure of taxable income. This thesis argues that the principles in some select areas of financial reporting can be sanctioned more explicitly and enacted into the Income Tax Act (ITA) in determining the taxable income of corporations. It also recommends a new reporting schedule that requires taxpayers to disclose greater reconciliation between accounting and taxable incomes in a limited number of areas subject to any statutory or legal provisions to the contrary. The book–tax income gap can be divided into two components: a conceptual gap in computing income or profit and a second gap arising from policy-based deductions and/or aggressive tax planning. The conceptual gap is mostly due to different rules for the calculation of income based on section 9 of the ITA and case law in contrast to the rules for calculating book income based on accounting principles, such as International Financial Reporting Standards (IFRS). The second type of gap arises due to policy-based deductions in the ITA that may allow for more or less generous deductions or write-offs compared to accounting rules. This gap can also be caused by aggressive tax planning. This thesis contributes to the literature by exploring economic, accounting, and legal definitions of income in a setting with more recent business transactions. It estimates the gap between accounting income and taxable income based on the historical data of Canadian companies and the reasons why they may have diverged in recent years. It also argues why narrowing the gaps may be desirable – at least in some select areas. While this study was being conducted, the federal government introduced an elective mark-to-market regime for derivatives – an illustration of one of this dissertation’s recommendations. ii ACKNOWLEDGMENTS Praise be to God, Lord of the worlds, the Compassionate and Merciful. I wish to thank my supervisor, Professor Amin Mawani, for his mentorship and guidance throughout this process. His thoughtful analysis, critical insights, and commitment are inspirational. I would like to thank my supervisory committee, Professor Jinyan Li, and Professor Thaddeus Hwong, for their valuable feedback. I also want to thank my examination committee members, Professor Colin Campbell, Professor Sonia Lawrence, and Professor Joanne Magee for offering constructive feedback and examining. As a graduate program director, Professor Lawrence provided me with full support and advice. I extend my gratitude to Professor Neil Brooks and Professor Liora Salter for being sources of inspiration and encouragement. This journey started with the encouragement from Professor Hassan Qudrat-Ullah and mentorship from Professor Adriano Solis – both from the Faculty of Liberal Arts. I am also thankful to Rob Giberson – the Associate Dean at Sheridan College – who always accommodated my teaching schedule to allow me to work on this project. I owe a great deal to the support of staff in the graduate program office and library at Osgoode Hall. I further express my appreciation to my friends Azeem, Qamar, and Arshad who always encouraged and supported me in different ways throughout this journey. This acknowledgment would not be complete without the words of love and gratitude to my spouse and children for all their patience and support during this journey. I especially wish to thank my spouse Rabia for her unwavering support, love, and strength. iii TABLE OF CONTENTS Abstract………………………………….……………………………….….……...………ii Acknowledgments……………………….………………………………….……...………iii Table of Contents………………………………………….…………….…………....……iv List of Tables…………….………………………………………………….……....…….vii List of Figures…………………………………………………………….………………viii 1 Introduction .................................................................................................................. 1 2 Two Types of Gaps....................................................................................................... 6 2.1 The Conceptual Gap in Computing Income .......................................................... 7 2.1.1 ITA Section 9 and Case Law Versus Accounting Principles ............................ 9 2.1.2 Nature and Examples of the Conceptual Gap .................................................. 32 2.1.3 Explanations for the Existence of the Gaps ..................................................... 54 2.1.4 Narrowing of the Conceptual Gap ................................................................... 87 2.2 Tax and Book Gap in Computing Taxable Income ............................................. 89 2.2.1 Evidence of the Gap ........................................................................................ 90 2.2.2 Explanations for the Existence of the Taxable Income and Book Income Gap 92 2.2.3 Data Source for Further Empirical Analysis ................................................. 116 2.2.4 Issues with Measuring Taxable Income From Financial Statements ............ 117 iv 2.2.5 Algorithms for Estimating Taxable Income From Financial Statements ...... 119 2.2.6 Book–Tax Gap of Canadian Companies: 1993–2014 ................................... 123 2.2.7 Findings ......................................................................................................... 126 3 Narrowing the Conceptual Gap ................................................................................ 134 3.1 What Are the Major Issues and Why the Gap Should be Narrowed? ............... 134 3.2 Economic Income and the Carter Commission ................................................. 137 3.3 Accounting Income Is Closer to Economic Income and the Carter Commission’s Recommendations ................................................................................................................... 150 3.4 Proposed Ways of Narrowing the Gap .............................................................. 167 3.4.1 Complete Alignment...................................................................................... 168 3.4.2 Partial Tax–Book Conformity ....................................................................... 184 3.5 Adjustment of Taxable Income ......................................................................... 187 3.5.1 Specific Incorporation of Paragraphs 12(1) (a) and 20(1) (m) ...................... 189 3.5.2 Addressing Hedging, ESO, and Percentage-of-Completion Methods .......... 192 3.5.3 The UK Approach ......................................................................................... 197 4 Narrowing the Book–Tax Gap ................................................................................. 199 4.1 Why Should the Book–Tax Gap Be Narrowed? ............................................... 199 4.2 Focusing on Aggressive Tax Planning .............................................................. 204 4.3 Why Greater Disclosure Can Be Effective ....................................................... 207 4.4 The US Approach .............................................................................................. 209 v 4.5 Greater Transparency with a Proposed New Canadian Schedule ..................... 212 5 Summary and Conclusion ......................................................................................... 223 6 BIBLIOGRAPHIES ............................................................................................230 vi LIST OF TABLES Table 1: Variation of effective tax rates (ETR) across and within sectors………………114-15 Table 2: Reconciliation of accounting income and taxable income on tax return….……216 vii LIST OF FIGURES Figure 1: Book–Tax Differences–Method 1 ……….…………………………………………………………………………………...126 Figure 2: Book–Tax Differences as a Percentage of Book Income under Method 1 ………………………………………………..…………………………………………..127 Figure 3: Book–Tax Difference as a Percentage of Taxable Income under Method 1 …………………………………………………………………………………………… 128 Figure 4: Book–Tax Difference–Method 2 …………………………………………………………….……………………………….129 Figure 5: Book–Tax Difference as a Percentage of Book Income under Method 2 ….….….….….….….….….….…..….….….….….………………………………..….…..129 Figure 6: Book–Tax Difference as a Percentage of Taxable Income under Method 2 …………………………………………………….……………………………….………130 Figure 7: Temporary Book–Tax Differences…………………………………………………………………………...……131 Figure 8: Average Book–Tax Difference as a Percentage of Book Income………………………………………………...….…………………………..……132 Figure 9: Average Book–Tax Difference as a Percentage of Taxable Income………………………………………….……….….………………………..…….132 Figure 10: Pre-Tax Book Income and Estimated Taxable Income……….…………...…...133 viii 1 Introduction Income is calculated differently for accounting and tax compliance purposes. Accounting income is calculated based on accounting principles, such as generally accepted accounting principles (GAAP) or International Financial Reporting