Question

Why do economists argue that the tax definition of corporate profits overstates the true profits of corporations? How can this mis-definition of profit affect the financial structure of the corporation? In what sense does the corporate income tax subject corporate profits to double taxation?

Answer 1

The provisions applicable to ascertain the business or corporate profit in the financial statements are significantly different from the provisions applicable to calculate the taxable profit of corporates. The taxable profit of corporates are calculated using the income tax provisions applicable in the country whereas accounting profit, i.e. profit as per financial statements are determined in accordance with the accounting standards acceptable in the country. The rate of depreciation allowed for income tax purposes are often lower than the rate of depreciation used to calculate the corporate profit in financial statements as per the accounting standards. Similarly, number of expenditures and apportions are disallowed while computing taxable profit. Such disallowed items include transfers made to general and specific reserves, provisions made for expected future losses, warranty expenses, depletion and amortization expenses and others. Thus, economists argue that the tax definition of corporate profits overstate the true profits of business and corporations.

The financial structure of corporations are affected in the following ways due to the mid-definition of profit:

1. The actual profit and taxable profit differs.
2. Creation of deferred tax liabilities and deferred tax assets due to the differences in accounting and taxable profits.          
3. The management decisions in respect of different projects are changed due to the mid definition of profits.

Double taxation:

There are number of taxes which are already paid on purchases and sales, for example while raw materials are purchased number of taxes are already included in the invoice which is paid. Similarly at the time of sales there are number of additional taxes already paid and credited to the Government. Even the employees pay income taxes on the amount of salaries which are paid by an entity. Thus, despite the payment of these taxes an entity requires to determine the taxable profit of the entity from its business operations to pay income taxes accordingly on the taxable profit calculated in accordance with the income tax provisions in the country.

Thus, the corporate income tax subjects corporate profits to the effects of double taxation.