IFRS convergence and tax avoidance
Part II. Finding the right path
AUGUST / 2022
Having defined the key ideas around IFRS convergence, tax avoidance and the social aspects of taxation in part I of this series, it is clear that there is a degree of incoherence that needs to be resolved.
IFRS convergence and tax avoidance: conflicting views
The benefits of IFRS convergence are transparency and comparability through international cooperation. Meanwhile tax avoidance exploits the lack of transparency and international coordination creating a conflict between IFRS convergence efforts and tax avoidance practices.
This incoherence has been recognized globally and initiatives such as the OECD/G20 Inclusive Framework on BEPS have been developed to address tax avoidance and exploitation of legislative discrepancies through international cooperation in the same way as the IAASB is driving reporting convergence (e.g. the Norwalk agreement and IMF and World Bank packages for East Asian economies post-1998 financial crisis).
However, there are a number of studies which found a different type of conflict between IFRS convergence and tax avoidance. Braga (2017: p.410) notes that mandatory IFRS adoption leads to increased pre-tax earnings (due to accruals earning management) and encourages profit shifting practices to reduce the resulting higher tax liabilities. In this case IFRS convergence is inducing tax avoidance rather than preventing it. Additionally, in spite of great progress being made in harmonizing reporting standards under the leadership of IAASB, there are still questionable accounting and reporting practices used by companies which often play a significant role in financial crises and can be traced to either creative accounting decisions (e.g. accruals management) or obscure transaction structuring – the beloved techniques of tax avoidance.
IFRS itself is open to interpretation allowing for base erosion. The standards can be interpreted in a way that is convenient for structuring a transaction to reduce tax liabilities or apply accounting policies to manipulate deductible expenses or classification of income. Hence if a company wants to avoid tax it can find gaps and loopholes in the standards to be able to justify its accounting choices independent of the degree of global reporting standards harmonization.
For example, IFRS determines the calculation and composition of shareholder value indicators such as EPS or EBITDA. These are greatly impacted by the amount of tax the company pays. It is in the interest of the company to avoid paying as much tax as possible to present favorable EPS or EBIDTA to its shareholders (OECD, 2013: p.30-31). In the context of a single entity and jurisdiction, the significance of IFRS in its conflict with tax avoidance is in the content and principles of the standards themselves. The role of IFRS in this case is the provision for the accounting treatment of certain transactions which comprise the tax base and can be interpreted in various ways so that tax avoidance techniques can be used to erode the tax base, reduce the amount of tax payable and impact EPS or EBITDA. Even in the context of IFRS convergence, the same indicator such as EPS and EBITDA may be different in substance across different companies and jurisdiction due to tax avoidance.
The benefits of IFRS convergence are transparency and comparability through international cooperation. Meanwhile tax avoidance exploits the lack of transparency and international coordination creating a conflict between IFRS convergence efforts and tax avoidance practices.
This incoherence has been recognized globally and initiatives such as the OECD/G20 Inclusive Framework on BEPS have been developed to address tax avoidance and exploitation of legislative discrepancies through international cooperation in the same way as the IAASB is driving reporting convergence (e.g. the Norwalk agreement and IMF and World Bank packages for East Asian economies post-1998 financial crisis).
However, there are a number of studies which found a different type of conflict between IFRS convergence and tax avoidance. Braga (2017: p.410) notes that mandatory IFRS adoption leads to increased pre-tax earnings (due to accruals earning management) and encourages profit shifting practices to reduce the resulting higher tax liabilities. In this case IFRS convergence is inducing tax avoidance rather than preventing it. Additionally, in spite of great progress being made in harmonizing reporting standards under the leadership of IAASB, there are still questionable accounting and reporting practices used by companies which often play a significant role in financial crises and can be traced to either creative accounting decisions (e.g. accruals management) or obscure transaction structuring – the beloved techniques of tax avoidance.
IFRS itself is open to interpretation allowing for base erosion. The standards can be interpreted in a way that is convenient for structuring a transaction to reduce tax liabilities or apply accounting policies to manipulate deductible expenses or classification of income. Hence if a company wants to avoid tax it can find gaps and loopholes in the standards to be able to justify its accounting choices independent of the degree of global reporting standards harmonization.
For example, IFRS determines the calculation and composition of shareholder value indicators such as EPS or EBITDA. These are greatly impacted by the amount of tax the company pays. It is in the interest of the company to avoid paying as much tax as possible to present favorable EPS or EBIDTA to its shareholders (OECD, 2013: p.30-31). In the context of a single entity and jurisdiction, the significance of IFRS in its conflict with tax avoidance is in the content and principles of the standards themselves. The role of IFRS in this case is the provision for the accounting treatment of certain transactions which comprise the tax base and can be interpreted in various ways so that tax avoidance techniques can be used to erode the tax base, reduce the amount of tax payable and impact EPS or EBITDA. Even in the context of IFRS convergence, the same indicator such as EPS and EBITDA may be different in substance across different companies and jurisdiction due to tax avoidance.
Does this mean that IFRS harmonization is not a sufficient safeguard against tax avoidance?
In answer to the question above a second aspect of the conflict between IFRS convergence and tax avoidance should be considered. This is when IFRS convergence cannot exists independently of counter-tax avoidance measures. Where IFRS convergence is based on international integration and tax avoidance thrives on the lack of harmonized standards there is a clear need for harmonization of the IFRS and tax requirements.
It may seem that the two are not that closely related. However, unless it is recognized that tax avoidance is in part an accounting issue and hence an obstacle to convergence due to lack of uniformity and consistency of tax legislation across jurisdictions, IFRS and counter-tax avoidance initiatives will continue to exist as half-measures for transparency and comparability.
Fortunately, OECD/G20 BEPS project already includes provisions for tax accounting. Action 12 of BEPS package requires disclosure of aggressive tax planning and Action 4 is aimed at resolving base erosion as a manipulative accounting practice (OECD, 2017: p.19-20). IAASB is also addressing the issue of tax avoidance through more rigorous disclosure requirements.
In answer to the question above a second aspect of the conflict between IFRS convergence and tax avoidance should be considered. This is when IFRS convergence cannot exists independently of counter-tax avoidance measures. Where IFRS convergence is based on international integration and tax avoidance thrives on the lack of harmonized standards there is a clear need for harmonization of the IFRS and tax requirements.
It may seem that the two are not that closely related. However, unless it is recognized that tax avoidance is in part an accounting issue and hence an obstacle to convergence due to lack of uniformity and consistency of tax legislation across jurisdictions, IFRS and counter-tax avoidance initiatives will continue to exist as half-measures for transparency and comparability.
Fortunately, OECD/G20 BEPS project already includes provisions for tax accounting. Action 12 of BEPS package requires disclosure of aggressive tax planning and Action 4 is aimed at resolving base erosion as a manipulative accounting practice (OECD, 2017: p.19-20). IAASB is also addressing the issue of tax avoidance through more rigorous disclosure requirements.
Solving the tax puzzle
Corporations do not exist in a vacuum and are interconnected with society, the government and a global network of stakeholders. In this respect the view on tax avoidance is straight-forward. It is a practice that is harmful for the individual tax payer shifting the tax burden from corporations to labor to fill the gaps in the budgets. It is also impacting investment in public goods by reducing tax revenues. It is a socially irresponsible practice eroding economic growth a welfare.
However, when questions of making tax avoidance illegal arise, this decision cannot be made on the basis of social impact alone without considerations of drivers of global capital markets. Tax avoidance is still a measure to reduce costs and provide value to shareholders as well as free resources for investment back into the company which is critical for a sustainable business regardless of additional social responsibility perspective.
Considering the two opposing views of tax avoidance, instead of making tax avoidance an illegal practice and reducing the firm’s ability to manage its operations effectively, and withstand abusive tax regimes in some jurisdictions, the best way forward is the removal of incentives and need to avoid tax.
One possible way to do so is through international tax harmonization already underway and its complimentary coordination with international financial reporting harmonization to build transparency of both accounting principles, methods and disclosure requirements and a non-abusive transparent tax system uniform across all jurisdictions so that companies do not have the incentive to exploit the gaps in tax rules. Ultimately, the goal is to align the aims of both IFRS and international tax to achieve a system that cannot be manipulated.
Corporations do not exist in a vacuum and are interconnected with society, the government and a global network of stakeholders. In this respect the view on tax avoidance is straight-forward. It is a practice that is harmful for the individual tax payer shifting the tax burden from corporations to labor to fill the gaps in the budgets. It is also impacting investment in public goods by reducing tax revenues. It is a socially irresponsible practice eroding economic growth a welfare.
However, when questions of making tax avoidance illegal arise, this decision cannot be made on the basis of social impact alone without considerations of drivers of global capital markets. Tax avoidance is still a measure to reduce costs and provide value to shareholders as well as free resources for investment back into the company which is critical for a sustainable business regardless of additional social responsibility perspective.
Considering the two opposing views of tax avoidance, instead of making tax avoidance an illegal practice and reducing the firm’s ability to manage its operations effectively, and withstand abusive tax regimes in some jurisdictions, the best way forward is the removal of incentives and need to avoid tax.
One possible way to do so is through international tax harmonization already underway and its complimentary coordination with international financial reporting harmonization to build transparency of both accounting principles, methods and disclosure requirements and a non-abusive transparent tax system uniform across all jurisdictions so that companies do not have the incentive to exploit the gaps in tax rules. Ultimately, the goal is to align the aims of both IFRS and international tax to achieve a system that cannot be manipulated.
References:
- Braga, R.N. (2017) “Effects of IFRS adoption on tax avoidance.” R. Cont. Fin. – USP. 28(75), 407-424.
- OECD (2017) Background Brief. Inclusive Framework on BEPS. OECD. 1-23.
- OECD (2013) Addressing Base Erosion and Profit Shifting. OECD. 3-91.
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