Revenue Note for Guidance

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Revenue Note for Guidance

76A Computation of profits or gains of a company – accounting standards.

Summary

This section consists of five subsections which set out the methodology for computing a company’s Case I and Case II profits, each of which is discussed in detail below. This section provides that, for the purposes of Case I or Case II, a company’s taxable profits are to be computed in accordance with generally accepted accounting practice subject to any adjustment required or authorised by law. It is important to remember that it is the profits of the company’s trade or profession which are assessable to tax under Case I and Case II of Schedule D, not the accounting profits of the company itself. For example, separate rules apply to the computation of a company’s chargeable gains (see section 78).

It should also be noted that the income of an Irish resident company from a trade carried on wholly abroad, although chargeable to corporation tax under Case III of Schedule D, is computed in accordance with the rules of Case I of Schedule D (see section 77). Similarly, the profits or gains of certain Irish-resident securitisation vehicles, although chargeable to corporation tax under Case III of Schedule D, are also computed in accordance with the rules of Case I of Schedule D (see section 110).

Details

General principle

(1) For the purposes of Case I or Case II, the profits or gains of a trade or profession carried on by a company are to be computed in accordance with generally accepted accounting practice subject to any adjustment required or authorised by law in computing such profits or gains for those purposes. It is important to remember that it is the profits of the company’s trade or profession which are assessable to tax under Case I and Case II of Schedule D, not the accounting profits of the company itself. For example, separate rules apply to the computation of a company’s chargeable gains (see section 78).

Generally accepted accounting practice

‘Generally accepted accounting practice’ is defined in section 4 as either:

International Financial Reporting Standards (IFRS); or
Irish generally accepted accounting practice (Irish GAAP).

IFRS and Irish GAAP consist of ‘accounting standards’. Accounting standards set out the detailed accounting rules for recognising and measuring income and expenses, assets and liabilities in a company’s financial statements. In simple terms, ‘recognition’ refers to when an item is included in the accounts and how it is recorded (e.g., as income or expense) while ‘measurement’ determines the value of the item for accounting purposes.

Profits or gains computed in accordance with generally accepted accounting practice

Profits or gains computed in accordance with generally accepted accounting practice means all items of income and expense recognised during the period in determining profit or loss. Entities are required to recognise all items of income and expense in a period in profit or loss unless generally accepted accounting practice requires or permits otherwise [IAS 1.88/FRS 101/section 5.2(b) of FRS 102/section 5.4 of FRS 105].

Where a separate income statement is presented (which may be identified using another term such as ‘profit and loss account’ or ‘statement of profit or loss’), all items of income and expense recognised during the period in determining profit or loss will be reflected in the income statement. The ‘profit or loss before tax’ figure as per the income statement forms the starting point for the Case I/Case II computation.

Where a single statement of comprehensive income is presented (which may be identified using another term such as ‘statement of profit or loss and other comprehensive income’), items of other comprehensive income are excluded from the Case I/Case II computation because they do not represent ‘profits or gains computed in accordance with generally accepted accounting practice’. The ‘profit or loss before tax’ figure as per the statement of comprehensive income forms the starting point for the Case I/Case II computation.

Prior period adjustments

When a company:

  • changes its accounting rules; or
  • corrects certain accounting errors,

IFRS and Irish GAAP usually require companies to apply the new accounting rules and correct errors ‘retrospectively’. This means that the opening balances and prior period comparative figures in the financial statements are restated to what they would have been if the new accounting rules had always applied or if the error had never been made. Retrospective application can give rise to large accounting adjustments to previously reported figures for profit or loss; these are commonly referred to as ‘prior period adjustments’ (PPAs) or ‘prior year adjustments’ (PYAs). PPAs represent the difference between: (i) the accounting profit as originally reported and taxed; and (ii) the restated accounting profit.

PPAs affect the balance sheet (or ‘statement of financial position’) rather than the current period’s profit or loss account (as shown in the ‘income statement’/profit and loss account’/‘statement of profit or loss’). The taxation of PPAs is governed by:

  • subsection (3): where the PPA results from a change in accounting policy;
  • subsection (4): where the PPA results from the adoption of an accounting standard or the adoption of an amendment of an accounting standard; and
  • subsection (5): where the PPA results from the correction of a ‘material’ or ‘fundamental’ accounting error.

Subsection (5) also sets out the tax treatment of accounting errors which are neither ‘material’ nor ‘fundamental’. Please see below for further details including an explanation of key terms such as ‘accounting policy’ and ‘accounting standard’.

Adjustments required or authorised by law

As previously noted, the profits or gains of a trade or profession carried on by a company for the purposes of Case I or Case II are to be computed in accordance with generally accepted accounting practice subject to any adjustment required or authorised by law in computing such profits or gains for those purposes. “Law” for these purposes is not defined but it would include statute law, statutory instruments, and any directly applicable EU law. It would also include case law because case law involves a decision by the courts as to what statute law means. While Revenue produced materials, such as Notes for Guidance and Tax and Duty Manuals, explain how Revenue interprets the law, such materials are not law.

The types of adjustments that might be required or authorised by law in computing profits for tax purposes include the disallowance of capital expenditure that may have been taken into account in computing accounting profits, the disallowance of entertainment expenses, the deduction of capital allowances, and the special rules applying to PPAs (as discussed below). The key point is that the accounting treatment is influential but not necessarily determinative of the correct tax treatment.

Transitions from former Irish GAAP to: (i) IFRS or (ii) current Irish GAAP

(2) By virtue of this subsection, Schedule 17A provides for transitional arrangements where both of the following conditions apply:

  • that, in respect of an accounting period, the profits or gains of the company’s trade or profession are computed in accordance with ‘relevant accounting standards’ (within the meaning of Schedule 17A) – subsection (2)(a); and
  • that, for previous accounting periods of the company, the profits or gains of the company’s trade or profession were computed in accordance with accounting standards other than ‘relevant accounting standards’ (within the meaning of Schedule 17A) – subsection (2)(b).

Schedule 17A defines ‘relevant accounting standards’ as IFRS and Irish GAAP to the extent that Irish GAAP is stated to embody IFRS. Therefore Schedule 17A applies to a change from former Irish GAAP to either IFRS or current Irish GAAP (to the extent that current Irish GAAP is stated to embody IFRS). Prior to the introduction of current Irish GAAP, Schedule 17A also applied where a company adopted a former Irish GAAP standard which embodied IFRS (e.g., FRS 25 or FRS 26) for the first time.

Please refer to Schedule 17A for further details if required. However, as companies are no longer permitted to use former Irish GAAP (and hence cannot transition from former Irish GAAP or adopt former Irish GAAP standards which embodied IFRS), Schedule 17A is effectively now obsolete and has been replaced by subsection (4).

Changes in accounting policy

(3) Subsection 3 applies when a company changes an accounting policy. Accounting policies are the specific principles, bases, conventions, rules and practices applied by a company in preparing and presenting financial statements [IAS 8.5 and IAS 8.35/FRS 101/section 10.2 of FRS 102/section 8.2 of FRS 105]. For example, where a company sells goods, it needs an accounting policy for valuing its closing inventory (stock on hand). In accordance with both IFRS [IAS 2.9] and current Irish GAAP [FRS 101/section 13.4 of FRS 102/section 10.3 of FRS 105], inventory should generally be valued at the lower of cost and net realisable value. The company’s accounting policy for inventory therefore needs to confirm that it complies with this principle and to specify how cost is to be measured, for example, on a first in, first out (FIFO) or weighted average basis. Irish company law (paragraph 30 of Part III of Schedule 3 of The Companies Act 2014) prohibits the use of last in, first out (LIFO) for stock valuation, as do IFRS [IAS 2.25] and current Irish GAAP [FRS 101/section 13.18 of FRS 102/section 10.17 for FRS 105].

In accordance with IFRS and current Irish GAAP, an entity is only allowed to change an accounting policy if the change is required by a particular accounting standard or the change results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows [IAS 8.14/FRS 101/section 10.8 of FRS 102/section 8.7 of FRS 105].

This subsection incorporates in statute existing practice, based on case law principles, which provides that there should be neither a tax-free uplift nor a double charge to tax because of a change from one valid basis to another for good commercial reasons.

Adoption of an accounting standard/amendment of an accounting standard

(4) As previously noted, IFRS and Irish GAAP consist of ‘accounting standards’. Accounting standards set out the detailed accounting rules for recognising and measuring income and expenses, assets and liabilities in a company’s financial statements. Accounting standards provide a standardised way of describing the company’s financial performance, thus allowing comparisons over time and between companies.

The Companies (Accounting) Act 2017 permits a company to change from Irish GAAP to IFRS or from IFRS to Irish GAAP once every five years. Where a company changes from Irish GAAP to IFRS, it must adopt all relevant IFRS accounting standards. Similarly, where a company changes from IFRS to Irish GAAP, it must adopt the most relevant Irish GAAP accounting standard.

In addition, where the IASB issues a new accounting standard or makes changes to an existing accounting standard, companies using IFRS (and FRS 101) are obliged to adopt the new standard or the amendment of the accounting standard to remain compliant with IFRS/FRS 101. Similarly, the FRC intends to carry out triennial reviews to identify any required improvements to their standards, having regard to users’ experience of applying the previous versions of the standards as well as developments in IFRS. Following each review, the FRC issues updated versions of its existing accounting standards and companies using Irish GAAP are obliged to adopt the relevant amendment of an accounting standard to remain compliant with Irish GAAP.

Furthermore, a company may need to adopt an accounting standard for the first time where its circumstances change. For example, where a company enters into a new type of transaction for the first time, the appropriate accounting treatment of the transaction may not be specified in the accounting standards that the company has applied to date. The company would therefore be required to adopt whatever accounting standard deals with the transaction in question. Although that standard in question may not be newly issued by the IASB/FRC, it will be new to the company.

Subsection 4 applies where an accounting standard or an amendment of an accounting standard is adopted for the first time, for example:

  • where a company preparing accounts in accordance with IFRS adopts an IFRS standard or an amendment to an IFRS standard for the first time, or
  • where a company preparing accounts in accordance with current Irish GAAP adopts a current Irish GAAP standard or an amendment to a current Irish GAAP standard for the first time, or
  • where a company transitions from current Irish GAAP accounting standards to IFRS accounting standards, or
  • where a company transitions from IFRS accounting standards to current Irish GAAP accounting standards.

This subsection legislates for the case law principles that no taxable income or deductible expenditure is to be double counted or to fall out of the charge to tax because of the adoption of an accounting standard or an amendment of an accounting standard for the first time. In addition, companies are required to calculate a transitional adjustment upon adoption of an accounting standard or an amended accounting standard for the first time; this is known as the ‘relevant amount’. The ‘relevant amount’ is then taxed or deducted (as the case may be) over a five-year period following the transition. This is consistent with the approach applied by Schedule 17A to changes from former Irish GAAP to IFRS or current Irish GAAP.

Correction of accounting errors

(5) Subsection 5 applies to the correction of accounting errors. Errors are omissions from, and misstatements in, an entity’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that:

  1. was available when financial statements for those periods were authorised for issue; and
  2. could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements [IAS 8.5/FRS 101/Appendix I to FRS 102/Appendix I to FRS 105].

Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud [IAS 8.5/FRS 101/section 10.20 of FRS 102/section 8.15 of FRS 105].

Former Irish GAAP defined a ‘fundamental’ error as an error of such significance as to destroy the truth and fairness and hence validity of a set of financial statements [FRS 3.63]. The concept of a ‘fundamental error’ does not exist in current Irish GAAP or IFRS; instead, they use the term ‘material error’. Materiality is an accounting concept. Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. [IAS 8.5*/FRS 101/Appendix I to FRS 102/Appendix I to FRS 105].

  • * = On 31 October 2018, the IASB announced that the IFRS definition of materiality has been amended with effect from 1 January 2020 (although companies can choose to early apply the new definition). The new definition states that information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those financial statements which provide financial information about a specific reporting entity.

The general position under former Irish GAAP was that:

  1. prior period errors that are not fundamental are accounted for in the period they are identified (i.e., the correction is included in the profit or loss account for that period) [FRS 3.60]; and
  2. all fundamental prior period errors must be corrected retrospectively (i.e., as a PPA) in the first set of financial statements authorised for issue after their discovery [FRS 3.63].

The general position under current Irish GAAP and IFRS is that:

  1. prior period errors that are not material are accounted for in the period they are identified (i.e., the correction is included in the profit and loss account for that period); and
  2. all material prior period errors must be corrected retrospectively (i.e., as a PPA) in the first set of financial statements authorised for issue after their discovery [IAS 8.42/FRS 101/section 10.21 of FRS 102/section 8.16 of FRS 105].

This subsection incorporates in statute existing practice based on case law principles. These provide that, in the case of a change from a non-valid basis to a valid basis (such as the correction of an error), the accounting profits must be computed on the new valid basis. Any adjustments which need to be made to previous periods’ tax computations in order to compute taxable profits on a valid basis must be done by changing the computations for those periods. These changes can only be made subject to the normal statutory time limits for the correction of errors. Section 959V(6) imposes a general four-year time limit (with some exceptions) so this would operate to impose the same time limit on this subsection by virtue of paragraph (h) of this subsection.

As previously noted, the concept of a ‘fundamental error’ does not exist in current Irish GAAP or IFRS. However, this subsection sets out the tax treatment of ‘fundamental errors’ because, for many companies, their 2013, 2014 and 2015 ‘accounting periods’ were still within the statutory time limit for amending returns when this subsection was enacted and the accounts for those years could have been prepared in accordance with former Irish GAAP.

This subsection refers to ‘an accounting period which commences on or after 1 January 2013’ and ‘an accounting period which commenced before 1 January 2013’. The legislation requires a distinction between accounting periods commencing before and after 1 January 2013 because new assessing rules were introduced in Finance Act 2012 (Part 41A) to replace the previous rules (Part 41) which applied to accounting periods beginning before 1 January 2013. Part 41A introduced a system of “full” self-assessment for direct taxes which applies from the 2013 tax years (for income tax) and for accounting periods commencing on or after 1 January 2013 (for corporation tax).

Part 41A, including section 959V, refers to a ‘return’ and a ‘self-assessment’ for a ‘chargeable period’ (which, for a company, is an ‘accounting period’ – see section 959A). However, “full” self-assessment did not exist prior to 1 January 2013. Therefore, for section 959V to apply to accounting periods beginning before 1 January 2013, the references to ‘self-assessment’ must be deleted and references to section 959Z must be replaced with references to section 956 (the equivalent section which applied before the introduction of ‘full’ self-assessment).

Relevant Date: Finance Act 2019