Building trust in tax disclosures

An increasing number of companies have chosen to disclose their OECD country-by-country reporting (CbCR) reports to the public. Many more will be thinking about doing so in the lead-up to EU Public CbCR (pCBCR), due to take effect in 2024.

Tax numbers are complex, increasing the risk of creating a misleading impression to the general public. While disclosure itself tends to set a framework of goodwill between business and civil society, if presented in a raw manner, tax numbers may generate anxiety and not contribute to building trust.

Some of the sources of that anxiety are as follows:

• Numbers don’t necessarily reconcile or add up to 100%. For instance, an OECD CbCR does not add to 100% of group profit. This is because the rules allow for the use of local GAAP, which will more closely match a local tax return. The standard GRI 207, Tax 2019, recognises this problem and requires a reconciliation with the consolidated financial statements.
• The language used is a mixture of highly precise accounting terms and modified terms that are not readily accessible to a lay person. The fundamental terms used in CbCR are ‘tax paid’ and ‘tax accrued’. These do not necessarily match terms in the statutory accounts of tax expense, including current and deferred tax expense in the P&L and current tax payable in the balance sheet. Again, mismatches create concern, but also the concepts are not easily explained.
• A significant indicator is the concept of effective tax rate (ETR). At low levels of profitability or losses, this indicator produces odd effective tax rates. If one takes a recent CbCR report from a major public company group with 84 entities, the ETR for the group was 30% for 2019. The top 10 entities, which comprised 94% of the cumulative profit, had an ETR range of between 1% and 85% and an average of 28% for that band. The next 74 entities, comprising 6% of the group profit, had a range of between approximately -200% and +200% with an average for the band of 82%.
• For tax paid, there is a latent timing mismatch because the payment of tax lags behind derivation of profits. For a group with rising profits, the level of tax paid will seem low. For a group with volatile profits and losses, the level of tax paid relative to those profits and losses seems odd.
• There are other items that are relevant to the presentation of consolidated financial statements. Some of those include mismatches between group profit and group profit before the share profit of joint ventures and associates; circumstances where there are extraordinary items; the recognition and derecognition of deferred tax assets and liabilities; and FX movements between the tax liability paid or accrued and the currency of the CbCR or consolidated accounts.

Common features

There are two common features of CbCR-type disclosures. They are the tax paid in a year and the tax accrued for a year.

Tax paid
The concept of tax paid is, in one sense, quite simple: how much tax was paid to revenue authorities in that specific year? Tax tends to be paid in the year after profit is earned. If profits are rising, then what is disclosed might seem to be an underpayment of tax compared with a country’s statutory rate. But when profits fall or a company moves into losses, then the amount of tax paid compared with the level of profit can seem quite ridiculous if considered in isolation and unexplained.

Indeed, the fact that there may be significant tax paid relative to profit usually does not assuage fears but creates new ones, because the tax paid number relative to profits does not make intuitive sense. A diagrammatic representation may reduce these fears and help build trust.

Tax accrued
The concept of tax accrued is also, on the face of it, simple: it is based on a matching principle. If one takes profits for this year, the question is what is the tax referable to that profit. This will include any taxes paid in relation to that profit this year and in future years. At its most basic, an ETR is based on this calculation: tax accrued divided by tax profit for a year.

This calculation takes into account tax benefits that are of a permanent nature, such as specific incentives including R&D benefits, and tax detriments of a permanent nature, such as where an item is not deductible either now or in the future. Such items will change tax accrued.

Where an item ultimately has the same treatment for the determination of tax liabilities and accounting profit, but these items are recognised in different periods, then there are ‘temporal differences’. These may give rise to benefits such as where depreciation on capital assets is allowed for tax purposes earlier than the accounts, or detriments such as where there is a doubtful debt that is recognised for tax purposes and not accounting purposes when it becomes doubtful.

A temporal tax benefit leads to an increase in tax liability in the future relative to tax payable on that future profit (a deferred tax liability), whereas a temporal tax detriment leads to a decrease in a future tax liability (a deferred tax asset).

Improving communication

These concepts can be explained as follows: ‘tax paid’ could be split between tax paid for last year’s profits, for profits before last year (prior-year adjustments) and for profits in the future (instalments paid in advance). There may also be refunds and unanticipated additional tax liabilities. A basic diagrammatic framework may be readily understandable.

On ‘tax accrued’, a similar picture can be drawn where, in relation to a year, permanent benefits and detriments are represented diagrammatically, as well as temporal advantages and disadvantages.

A reconciliation between tax paid and tax accrued (which is provided for in the pCBCR) can add to the picture.

Art or science?

Current tax expense and deferred tax expense in the financial accounts are terms of high art. They can give rise to significant differences between the tax charge in the statutory accounts and the notion of tax accrued in CbCR-type reports. Even where the numbers are similar, they are unlikely to be identical, which invites concerns.

In the public company mentioned above, for the 2019 year the tax charge in the statutory accounts was 36%, which comprised 30% for current tax, 5% deferred tax and 1% for prior-year adjustments. The tax paid in the cashflow statement, the tax paid in the CbCR and the tax accrued in the CbCR were all different but reasonably close, ranging from 30% to 32%.

However, 2020 was a loss year for this group and the numbers became much more difficult to present in simple percentages. The group made a loss of nearly US$30bn and paid tax of nearly US$4bn, reflecting the time lag. This presents a negative tax paid rate of 13%. It might seem odd that this would be the same rate if it made a profit of US$30bn and had a refund of US$4bn in tax.  The effective tax rate based on current tax expense (usually similar to accrued tax) was 20%, which was a credit. This shows how confusing a loss environment can be.