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Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)Chapter 16, Taxation of Income from Business and Investment16Taxation of Income from Business and InvestmentLee Burns and Richard KreverLobbyists know that a 0 percent tax rate on capital income is not, in fact, the lowest possible rate.—Joel AchenbachI.IntroductionThis chapter addresses the design and drafting of the income tax law as it applies tobusiness and investment income.While employment is an activity exclusively engaged in by individuals, business andinvestment activities may be engaged in by individuals or legal persons. Consequently, the rulesfor taxing income from business and investment cut across the taxation of individuals and legalpersons. Countries with separate tax laws for individuals and legal persons need to coordinatethe rules for taxing business and investment income, even though these may not always beuniform.Regardless of the overall design of the income tax,1 it is common to provide specialrules for taxing business or investment income. These rules primarily relate to the tax base,timing of the recognition of income and deductions, and collection of tax. By far the mostimportant are the timing rules. Particularly in the business context, these rules must negotiate thedifficult terrain that bridges financial accounting and taxation. While uniformity between tax andfinancial accounting may seem desirable, countries have adopted quite different approaches:some countries have achieved substantial uniformity; in others, tax and financial accounting aresubstantially independent.Note: Contributions to this chapter were made by Frans Vanistendael. The appendix is by Victor Thuronyi, withcontributions by David Williams.1Global, schedular, or composite; and single or separate tax laws for individuals and legal persons. See supra ch.14,sec. II.-1-
Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)Chapter 16, Taxation of Income from Business and InvestmentII.Business IncomeThe characterization of an amount as business income is important in both schedular andglobal income tax systems.2 Under a schedular system, it is common for separate taxes to beimposed on employment, business, and investment income. Consequently, the characterization ofan item of income determines which tax regime applies to it. Under a global system, there isoften a notional schedular breakdown of income types under which business income isspecifically mentioned as a type of income that is included in gross income. Even if the notion ofincome is completely global, special rules, particularly tax accounting rules, may apply tobusiness income. Other types of income derived by individuals may be calculated using differentrules.The starting point in determining whether an item of income is business income is todetermine whether the activity giving rise to the income is properly characterized as a business.This issue is considered first below, followed by a discussion of inclusion rules related tobusiness income. The third topic covered in this section is deductions for business expenses.A.Definition of BusinessIn the absence of a definition in the income tax law, the term “business” will have itsordinary meaning.3 In broad terms, a business is a commercial or industrial activity of anindependent nature undertaken for profit.4 The concept of a business may overlap with the notionof employment for tax purposes.5 Whether this is the case will depend on the definition ofemployment that is included in the law. For administrative reasons, employment should bedefined for income tax purposes to include all continuing service relationships where most or asignificant part of the service provider’s income is derived from one customer and that incomeessentially represents remuneration for the service provider’s labor.6 This will include someindependent contractor relationships (i.e., relationships that are within the ordinary meaning ofbusiness). Where employment is defined in these broad terms, the definition must be coordinatedwith the definition of business so that the same economic activity is not characterized as both a2See also supra ch. 14, sec V.3While the word business is commonly used in income tax laws, some countries use other expressions, such as“entrepreneurship”, to identify independent economic activity. See, e.g., EST IT § 9(1) (income derived fromentrepreneurship).4Some systems have distinguished a trade from a profession or vocation. See, e.g., GBR ICTA § 18 (sched. D, caseI (trade) and case II (profession or vocation)). See also supra ch. 14, sec V. As discussed in ch. 14, it is preferablenot to draw such a distinction. Therefore, business should be defined to include both trade and professionalactivities. E.g., AUS ITAA (1997) § 995-1; CAN ITA § 248; IND ITA § 2(13); KEN ITA § 2; ZMB ITA § 2.5In the United States, employment is considered to be a business, but other systems generally do not follow thisapproach. This is in any case largely a semantic point in the United States, which distinguishes the business ofemployment from other businesses.6See supra ch. 14, sec. IV(A).-2-
Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)Chapter 16, Taxation of Income from Business and Investmentbusiness and an employment for income tax purposes. This could be achieved by providing that abusiness does not include an employment.7B.Definition of Business IncomeThe definition of business income may serve a number of purposes in a global orschedular income tax system, for example, to identify a category of income for which specialdeduction or timing rules apply. It may also be used to characterize a particular item of incomeas business income where the income may otherwise be characterized as investment income. Animportant purpose of the definition in jurisdictions with a less than comprehensive judicialconcept of income (e.g., those that rely on U.K. jurisprudence) is to broaden the tax base.The relationship between income characterization and timing rules is an important factorin the design of the income tax rules applicable to business income. In turn, the timing rulesdepend on the relationship between tax and financial accounting rules. Because of theimportance of this latter relationship in determining business income for tax purposes, thisrelationship is discussed first below. There then follows a discussion of specific inclusion rulesrelating to business income.1.Financial Accounting and Business Income TaxationTwo basic models are used to determine the taxable income arising from businessactivities (referred to as “taxable business income”) of a taxpayer8 for a tax period: the receiptsand-outgoings system and the balance-sheet system. Under the receipts-and- outgoings system,generally used in common law countries, the determination of taxable business income is basedon the calculation of all recognized income amounts derived by a taxpayer in the tax period andall deductible expenses incurred by the taxpayer in the tax period. Under the balance-sheetmethod, common in many European civil law jurisdictions, taxable business income is calculatedby comparing the value of the net assets in the balance sheet of the taxpayer at the end of theyear plus dividends distributed by the taxpayer during the year with the value of the net assets inthe balance sheet of the taxpayer at the end of the previous year.9 A positive differenceconstitutes taxable business income, while a negative difference is a business loss.While the two models may sound quite different, in practice, they are similar in manyrespects. In theory, the starting point for the balance-sheet method is the taxpayer’s financialaccounts, while the receipts-and-outgoings system starts with gains and expenses that arerecognized for tax purposes. In practice, however, most taxpayers in receipts-and-outgoingsregimes use accounting records of commercial profits and losses as a starting point to show gross7E.g., AUS ITAA (1997) § 995-1; CAN ITA § 248; KEN ITA § 2.8In this discussion, the reference to “taxpayer” is intended to include a partnership, although, generally, a partnershipis not a separate taxpaying entity. However, it is usual to calculate the taxable income (or the gross income anddeductions) arising from the partnership’s activities as if the partnership were a separate taxpayer in respect of thatincome for the purpose of determining the tax liability of the partners. See generally infra ch. 21.9See infra appendix.-3-
Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)Chapter 16, Taxation of Income from Business and Investmentincome and expenses. The recorded income and outgoings are then adjusted as necessary toreflect the differences between tax and commercial accounting rules. Similarly, while thebalance-sheet method explicitly commences with commercial accounting records, these must beadjusted to reflect differences between tax law and commercial accounting practice. In somecircumstances, the two systems may yield the same determination of taxable business income.Not all business taxpayers are required to compile comprehensive accounting records thatinclude balance sheets. Accordingly, in jurisdictions that use the balance-sheet method tocalculate taxable business income, smaller businesses operated by sole traders and self-employedpersons (particularly those that account on a cash basis)10 may be allowed to calculate income asthe difference between taxable receipts and deductible expenses.11The relationship between the determination of business income for tax purposes andfinancial accounting rules is analyzed in detail in the appendix to this chapter. Those materialsnote that the principal purpose of financial accounting is to provide an accurate analysis of theprofitability of an entity to the managers and owners of an entity, as well as to creditors andpotential outside investors. Income tax, in contrast, is concerned with the measurement of the neteconomic gain of a taxpayer in a fixed period for the purpose of collecting a portion of the gainas tax. These differences explain why classifications used in one system may not be relevant tothe other. For example, because financial accounting is concerned with presenting owners,creditors, and investors with an accurate reflection of the ongoing profitability of an entity, itplaces some emphasis on classifying gains by reference to their regularity.12 Distinctions of thissort that are drawn for accounting purposes are generally not carried over for tax purposes injurisdictions that use the balance-sheet method of calculating taxable income.13 The accountingdistinctions are, however, relevant in some jurisdictions that use the receipts-and-outgoingsmethod of determining taxable income.1410See infra sec. IV(B)(1) for a discussion of cash-basis accounting.11See, e.g., DEU EStG § 4(3) (taxpayers who are not required under commercial law to keep double-entry books anddo not keep such books).12For example, financial accounting may distinguish between ordinary gains and extraordinary gains (which oftenequate to "capital gains" in income tax concepts) to ensure that readers of the accounts are not misled into thinkingthat extraordinary gains will be regularly received by the business. Often, extraordinary gains realized upon disposalof an asset have accrued over many years. See Financial Accounting Standards Board (USA), General StandardsI17.106 and I17.107 for an example of the criteria used in financial accounting to identify extraordinary gains. Thekey criteria in U.S. financial accounting standards are the "unusual nature" of the transaction yielding the gain(I17.108) and the "infrequency of occurrence" of the transaction (I17.109).13However, several countries draw a distinction between capital gains and other business income. See infra ch. 20,sec. III(A).14For example, in common law countries, gains that are characterized as extraordinary gains for accounting purposesare commonly treated as capital gains for tax purposes, where the tax system provides different treatment for capitalgains and ordinary income gains.-4-
Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.)Chapter 16, Taxation of Income from Business and InvestmentA second area in which financial and tax accounting rules differ is the treatment ofincome to which a future liability may attach or income that is related to goods or services to beprovided in future years. This difference is relevant to both methods of determining taxablebusiness income. Financial accounting uses a variety of means to ensure that the calculation ofincome does not present a distorted view of true long-term profitability when a taxpayer’s rightto retain income is contingent on the provision of goods or services in the future or is otherwiseassociated with potential future liabilities.15 Income tax rules, by way of contrast, are not asconcerned with qualifying or deferring recognition of income for the purpose of noting thetaxpayer's future obligations. Instead, they tend to recognize income when the taxpayer hascommand over the gain, while deferring recognition of the consequent obligation until it isactually satisfied.16The relationship between tax and financial accounting is important in the design ofincome tax rules in developing and transition countries. These two types of jurisdictions differfrom each other in key respects in terms of their financial accounting systems, and both types ofjurisdictions differ again from industrial countries.Most developing countries have relatively comprehensive financial accounting rules,usually based on the systems of one or more of the member countries of the Organization forEconomic Cooperation and Development (OECD). In many cases, however, local accountingrules have not evolv
Tax Law Design and Drafting (volume 2; International Monetary Fund: 1998; Victor Thuronyi, ed.) Chapter 16, Taxation of Income from Business and Investment - 1 - 16 Taxation of Income from Business and Investment Lee Burns and Richard Krever Lobbyists know that a 0 percent tax rate on capital income is not, in fact, the lowest possible rate. —Joel Achenbach I. Introduction This chapter .File Size: 726KBPage Count: 80
