How Changes in the Income Tax Act Will Affect the Taxation of Undistributed Earnings
Written By: Tony Lin
There are significant differences between tax accounting and financial accounting, including matters of timing (when assets are realized and recognized) and the longevity of assets, which lead to inconsistency between the two when it comes to undistributed earnings. It is not uncommon, even, for companies to report a net loss in their financial statements, and yet have to pay a 10% surtax on undistributed earnings. On May 5 2006, however, the Legislative Yuan passed an amendment to the Income Tax Act that takes financial accounting as the basis for calculating the 10% surtax, bringing the undistributed surplus for tax purposes in line with the amount of earnings a corporation actually retains. The question addressed in this article is: Which corporations will be most affected by the recent rule changes?
- Companies with many investments in other companies
Long-term investments valued by the equity method:
Gains and losses on investments valued by the equity method are unrealized in the year that they are recognized, so they are not included when calculating income tax. Investment gains from distributions of surpluses by investee companies are either included in income calculations (overseas company dividends) or not included in income (dividends from domestic companies that fall under Article 42 of the Income Tax Act). Before it was amended, the Income Tax Act’s rules required filing the 10% income surtax in the year following the one in which the distributed dividends were received.
The amended rules are based on after-tax net earnings as stipulated in the Business Accounting Law, so although they are recognized in the current year, you do not need to pay income tax on them. Instead, the 10% surtax must be paid in the following year.
Stock dividends issued by investee companies not valued by the equity method:
Under the old rules, when an investee company not valued by the equity method distributed stock dividends, the dividends were not recognized as income in the year they were received, but the surtax had to be filed the next year. Overseas stock dividends were counted as income and declared in the year received, so they were already subject to the surtax. The revised rules, however, revert to the Business Accounting Law, which takes after-tax net earnings as the accounting basis, so investment gains do not need to be recognized in the year earnings occur. When cash dividends are received, since they have already been entered as after-tax earnings, it is necessary to include the in calculating the surtax; if they are dividends in the form of shares, they are not entered as after-tax earnings, so it is not necessary to include then in calculating the surtax.
Gains and losses on investments valued by the equity method are unrealized in the year that they are recognized, so they are not included when calculating income tax. Investment gains from distributions of surpluses by investee companies are either included in income calculations (overseas company dividends) or not included in income (dividends from domestic companies that fall under Article 42 of the Income Tax Act). Before it was amended, the Income Tax Act’s rules required filing the 10% income surtax in the year following the one in which the distributed dividends were received.
The amended rules are based on after-tax net earnings as stipulated in the Business Accounting Law, so although they are recognized in the current year, you do not need to pay income tax on them. Instead, the 10% surtax must be paid in the following year.
Stock dividends issued by investee companies not valued by the equity method:
Under the old rules, when an investee company not valued by the equity method distributed stock dividends, the dividends were not recognized as income in the year they were received, but the surtax had to be filed the next year. Overseas stock dividends were counted as income and declared in the year received, so they were already subject to the surtax. The revised rules, however, revert to the Business Accounting Law, which takes after-tax net earnings as the accounting basis, so investment gains do not need to be recognized in the year earnings occur. When cash dividends are received, since they have already been entered as after-tax earnings, it is necessary to include the in calculating the surtax; if they are dividends in the form of shares, they are not entered as after-tax earnings, so it is not necessary to include then in calculating the surtax.
- Companies that have already recognized investment gains by the equity method prior to December 31, 2004, but have not received dividends
Application of the revised regulations begins with declaration of 2005 undistributed earnings, and under the new rules taxable income is no longer the basis for calculation. Therefore, if no dividends have been received, it is no longer necessary to pay the surtax on investment gains recognized in previous years. By the same token, investment losses recognized in previous years could be deducted from taxable income, under the old rules, provided that the investee company had not yet written off its loss or undergone a capital reduction. But with the revised regulations, companies are unable to deduct investment losses from undistributed earnings.
The effect of all this during the transition period awaits clarification by the Ministry of Finance.
The effect of all this during the transition period awaits clarification by the Ministry of Finance.
- Companies with significant disparities between their financial and tax statements
In order for financial accounting to express financial conditions fairly and properly, it is necessary to perform valuations of certain unrealized assets and liabilities, such as when one assesses unrealized gains or losses on financial instruments, asset impairment losses, unrealized foreign exchange gains or losses, etc. Because of their unrealized nature, the gains and are not included in the calculation of taxable income, and the losses cannot be claimed against other income. Under the former regulations, the gains were also excluded from calculation of the 10% surtax on undistributed earnings. However, the revised rules require that they be entered into calculation, albeit in the following year.
Other effects
- Corporate income tax payable in the current year is no longer allowed as a tax credit;
- The amount by which "income basic tax" exceeds ordinary income tax may not be claimed as a tax credit;
- Limits on allowed credits may no longer be exceeded by having legally valid receipts;
- A financial loss in the next year may be claimed as a credit.
Does this revision, with the taxation of undistributed earnings reverting to the regulations in the Business Accounting Law, ultimately help or hurt profit-seeking enterprises? In the short term, we may see some firms benefit while others are harmed. From a more distant perspective, however, the plusses should clearly outweigh the minuses, since firms will no longer have to lose sleep over discrepancies in their reporting-the result of inconsistent rules. And they will not have to worry that the sheer complexity of the rules on the 10% surtax might lead to their being fined by the tax authorities if they should make some mistake or other. In short, the benefits of consistency should make this change a positive one.