Book-tax difference management is one of the major tasks that financial managers and auditors need to deal with during the annual corporate income tax (CIT) reconciliation season, also called annual CIT filing, which has to be done before May 31 every year. Failing to properly deal with book-tax differences could lead to unnecessary tax losses and penalties. Companies are advised to seek professional assistance if they are not familiar with book-tax differences in China.
Book-tax difference refers to the discrepancies between China’s accounting standards (CAS) and tax laws. To put it simply, book-tax difference means that for the same transaction, the tax treatment and timing of recognition as stipulated by the tax laws are different from the accounting treatment as stipulated by the accounting standards.
Such differences mostly come from the different goals served by the accounting standards and tax laws. While the purpose of accounting is to accurately and truly reflect the financial situation of an enterprise, the tax laws mainly ensure the tax revenue of the jurisdiction. Thus, the two regulatory systems differ in accounting elements and measurement principles.
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Why should businesses pay attention to book-tax differences?
This is mostly for the sake of tax compliance.
In China, a basic principle of taxation is that a company shall be taxed on its “income before tax”, which means a net amount of “taxable income” arrived by subtracting allowable expenses and costs from the total revenue. However, the amount of income before tax is not simply equal to the amount of CAS-compliant net profits on the accounting books.
There are many differences between the two ways of assessing income. Failure to identify these differences may cause underpayment of taxes or result in a series of consequences, including but not limited to fines, late fees, unfavorable tax records, or even criminal punishments.
By understanding the book-tax differences, businesses could be in a better position to deal with tax in an efficient and effective manner, without causing unnecessary loss or triggering punishments.
What are the common book-tax differences?
The most common book-tax differences are categorized into two types:
- Temporary differences
- Permanent differences
Temporary differences arise when a transaction is accounted for in the same amount under CAS and the tax laws but in different periods. Temporary differences will generate additional taxable income adjustments in the CIT return, and recognition of Deferred Tax Assets (DTA) or Deferred Tax Liability (DTL) shall be reflected in the financial statement.
For example, the initial book basis for financial reporting and the initial tax basis for tax calculation, regarding an asset or a liability, is typically the amount of consideration paid to acquire an asset or the amount of consideration received upon incurring a liability. However, the initial basis may subsequently be adjusted for depreciation, amortization, appreciation, or impairment, for which there are different requirements under CAS and tax laws.
Permanent differences arise when a transaction is accounted for in a different manner or is a different amount under CAS and tax laws. Permanent differences will affect the amount of the CIT payable, but not give rise to DTAs and DTLs.
For example, if a cash expenditure results in an expense for financial reporting purposes but is not allowed for a tax deduction for tax purposes, the company’s taxable income shall be higher than the accounting profit.
The following sections illustrate some common temporary and permanent differences that arise with regard to the recognition of assets, liabilities, income, and expenses.
Differences in assets
For fixed assets, the book basis and tax basis for the acquisition of a capitalized fixed asset for both financial reporting and tax purposes are similar. However, the tax law generally recognizes the tax basis of assets more strictly than the accounting cost to protect taxes. In some cases, the initial tax basis of the asset could be less than the initial accounting cost, because tax recognition means that subsequent costs are eligible for a pre-tax deduction.
For example, for fixed assets or raw materials purchased, enterprises can still recognize them as assets in accounting even if they fail to obtain qualified invoices in accordance with the tax law. However, in this case, the tax basis of the asset shall be zero (i.e., the asset is not recognized by tax laws). It will result in a permanent difference that will increase the taxable income by the same amount.
A temporary difference can also arise from corporate restructurings, such as mergers. Under the tax laws, a special tax deferral treatment applies to group restructurings if certain conditions are met. When this special tax treatment is allowed for mergers, the merged enterprise will determine the tax basis of its assets and liabilities based on the original tax basis of the enterprises being merged. It means that the merged enterprise is not required to recognize any gain or loss when merging the assets and liabilities. However, the book basis of assets and liabilities shall be determined either at cost or at fair market value under the accounting standards on business combinations.
For the subsequent measurement of assets, accounting and tax laws also have some differences. For fixed assets depreciation, accounting standards are more flexible on the depreciation method—both straight-line method and accelerated depreciation method are acceptable, and the useful life can be reasonably determined based on the nature and usage of the asset. In contrast, under tax laws, the depreciation method of fixed assets is mainly the straight-line method, and the accelerated depreciation method can only be adopted under the conditions stipulated by the tax law. Plus, tax laws have requirements on the minimum useful life of fixed assets based on specific categories.
For example, Company A purchases a laptop with cash of RMB 10,000 and capitalizes it for accounting purposes. Company A assesses that this laptop can be used for one year, so it depreciates in two years. However, according to tax law provisions, Company A shall depreciate the laptop over three years (standard method) or expense it in a lump sum (the preferential accelerated depreciation method). After one year, the laptop will have a book basis of RMB 5,000 (RMB 10,000/2 years = RMB 5,000) but will have a tax basis of RMB 3,333 (RMB 10,000/3 years = RMB 3,333) or 0 for tax purposes, depending on whether the preferential treatment is adopted. Since the expenses will be recognized in different periods, a temporary difference arises in the treatment of this asset, and it shall result in an adjustment of the accounting profit when computing the CIT.
Difference in liabilities
For liabilities, there is no provision on tax laws because liability is not directly deductible before tax. However, liabilities are often closely linked to costs and expenses. So, more often than not, the book-tax differences in liabilities are actually the book-tax differences due to costs and expenses.
In practice, the costs and expenses corresponding to the actual liabilities can be deducted before tax if the documents in accordance with the provisions of tax laws are obtained. For example, where an enterprise leases an office space but fails to pay the rent due to financial difficulty, the liability corresponding to the rent can still be deducted if the enterprise has obtained the invoice from the landlord. On the other hand, where the enterprise hasn’t received the qualified invoice from the landlord, this part of the liability cannot be deducted before tax, even if the enterprise recognizes the liability in accounting.
Besides, according to tax laws, contingent liabilities or accrued expenses are liabilities that an enterprise has not actually incurred and thus shall not be tax-deductible until they are settled. They are temporary differences.
The amount payable to government authorities, such as fines and penalties, is however not tax-deductible, thus it shall be treated as a permanent difference.
Differences in income
Tax laws and accounting standards have different definitions of income.
Generally, the scope of income under tax laws is much larger than that in accounting standards. For example, for transactions deemed to be sales (for example, distribution to shareholders as dividends, transfer to creditors in payment of a debt, and so on), the revenue is not regarded as income in accounting, but is regarded as income according to tax laws. Moreover, advance payment may also be regarded as income by tax laws if certain conditions are met.
On the other hand, there are also revenues recognized as income in accounting, but not by tax laws. For example, interest income from treasury bonds and income from qualified investments in Chinese companies are regarded as income in accounting, but not regarded as taxable income in tax laws as they are tax-exempt.
Furthermore, the accounting standards and tax laws have differences in the timing of revenue recognition. For example, where an enterprise receives payment for goods in advance and issues an invoice, tax laws require that the income should be confirmed when issuing invoices (under the value-added tax (VAT) regulations) or on the due dates as agreed in written agreements (under the CIT law), while accounting standards require the revenue to be recognized when the control of goods is transferred to the customer.
Differences in costs and expenses
Under CAS, expenses can be recognized when the outflow of economic benefits in the course of ordinary activities is likely to result in a decrease in enterprise assets or an increase in liabilities, and the outflow of economic benefits can be measured reliably. So, there are very few restrictions on the recognition of expenses, except when expenditure provides future economic benefits and can be capitalized and amortized in future periods, which can be recognized by satisfying the “likely” condition. Such expenses shall be accounted for on an accrual basis rather than on a cash basis, and there are no deduction limits.
However, under the tax laws, such as the CIT Law and the CIT Implementation Regulation, there are several requirements for expenses to be pre-tax deductible. For example, for employee welfare expenses, only the part actually paid and less than 14 percent of the total amount of employee salaries and wages can be deducted before tax.
On the other hand, there are some tax incentives that allow enterprises to get a super deduction on their expenses incurred for certain activities. For example, for manufacturing enterprises (except tobacco manufacturing), an additional 100 percent of R&D expenses could be deducted from the taxable income, thus the tax basis can be 200 percent of the actual costs for CIT purposes.
Difference in measurement principle
The measurement principles of accounting and taxation serve their own purposes. The purpose of accounting is to accurately and truly reflect the financial situation of the enterprise, so in addition to historical cost, other measurement methods such as replacement cost, net realizable value, present value, and fair value measurement may also be used at the end of the accounting period for assets impairment provisions. Under tax laws, the tax basis is generally based on the historical cost principle or cash basis.
How to deal with book-tax difference?
Since the recognition principle and the measurement principle are different under CAS and tax laws, enterprises should understand and identify temporary differences and permanent differences and accurately adjust the “accounting profits” in the financial statements to the “taxable income” in the tax return.
As to how to identify book-tax differences, where the difference is temporary because the definition of such difference always means the difference between the book basis and tax basis of an item, the comparison of book basis and tax basis is often the best way to identify them.
Many companies prepare CAS-compliant balance sheets and compare them with some worksheets that are prepared on a tax basis (for example, in the case of fixed assets, intangibles, R&D expenditures, and business combinations).
In some instances, there may be a book basis but no tax basis, as in the case of bad debt provisions, which are not tax deductible until they incur. In other instances, there may be a tax basis but no book basis, as in the case of purchasing fixed assets that are below the capitalization threshold for accounting purposes but can be capitalized for tax purposes under tax laws.
However, where the difference is not temporary, meaning that the “profits” in accounting and “taxable income” in tax laws are different due to their different approach to calculating gains, expenses, or losses, such permanent differences are usually not tied to an asset or liability, and therefore cannot be identified with a particular asset or liability in financial reporting. To identify these differences, enterprises shall review the profit and loss items one by one to evaluate whether a difference in timing of recognition, deduction limit, tax exemption, and super deduction exists. If the business transactions are complex, it is wise to engage a qualified tax agent to prepare or review your tax return.
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at email@example.com.
Dezan Shira & Associates has offices in Vietnam, Indonesia, Singapore, United States, Germany, Italy, India, and Russia, in addition to our trade research facilities along the Belt & Road Initiative. We also have partner firms assisting foreign investors in The Philippines, Malaysia, Thailand, Bangladesh.
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