KPMG tax news - September 2016
Representation expenses is a topic that warrants frequent analysis and discussion, in particular seeking to establish what types of expenses should be considered representation, advertising or non-business costs.
This article discusses a topic that has received relatively less attention but is nevertheless no less contradictory, namely, how to calculate the adjustment in the corporate income tax (CIT) return and which accounting method is the most appropriate to calculate the adjustment. Thus, the definition and description of representation expenses is provided here only as a brief general overview.
In accordance with the CIT Law, a taxpayer has to increase taxable income for CIT purposes by 60% of the amount used for representation costs.
In accordance with the CIT Law, representation expenses are taxpayer’s expenses to build its image and maintain it at the level accepted in the society. According to the Law these expenses include costs for organizing public conferences, receptions and meals as well as costs to make items representing the taxpayer. However, as this definition is not complete and in-depth, there is often room for interpretation as to whether a particular expense should be treated as an advertising expense, which is fully deductible, a representation expense or an expense for the entertainment of employees or clients/potential clients.
The important distinctions that can be of assistance in identifying what expenses should not be considered representation costs are:
- Whether the expenses are made for the benefit of employees or clients. If the sole benefit is related to the entertainment of employees in general such expenses are to be subject to payroll taxes if it is possible to attribute them to particular employees, or treated as non-business expenses (if not attributable to particular employees). If the expenses are client related, in general these would be treated as representative costs;
- Whether the costs are related to the image and promotion of the company in general or promotion of a particular product or service. If the expenses are incurred in order to advertise a specific product or service they should be treated as advertising costs rather than representation expenses and allowed in full.
It is important to note that the treatment of costs for CIT and value added tax (VAT) purposes should be consistent. If the costs are treated as representative expenses in the VAT calculation and only 40% of input tax is deducted, they should be treated in the same way in the CIT calculation, and vice versa.
Accounting treatment of representation expenses
In our practice, we have come across three different ways how companies treat representation expenses in their accounting systems. Not only do these ways differ in terms of accounting entries but they also can result in different amounts of non deductible representation expenses by which taxable income is increased in CIT returns.
The first approach, widely used by companies, is simple and presents more benefits to the company. For instance, a company purchases representation goods for EUR 121, including value added tax (VAT) of EUR 21. To calculate the amount of non-deductible input tax 60% of the invoiced VAT amount (EUR 12.6) is booked in the expense account. In this case, the accounting treatment of representation expenses requires only two accounts - one for the 40% of deductible input tax and the other for expenses and the non-deductible input tax. An example is provided in the table below.
In order to determine the part of representation expenses by which taxable income should be increased the total of account 7xxx is multiplied by 60% (EUR 112.60 x 60%= EUR 67.56). As a result, taxable income in the CIT return is increased by 60% of representation expenses and 60% of non-deductible input tax (i.e. 36% of the total input tax). From the accounting perspective, this approach is convenient and it is not provided for in law that non-deductible input tax should be accounted for in a separate account.
The other approach is the one suggested by the State Revenue Service (SRS) and presented in its methodology ‘On calculation and payment of corporate income tax’. This SRS methodology refers to the above example and states that “in determining the part of representation expenses by which taxable income should be increased, one should calculate 60% of the amount used for representation expenses (i.e. the total amount of the invoice): 100 x 0.6 + 21 x 0.6 = EUR 72.6. When CIT is calculated taxable income is increased by the part of representation expenses amounting to EUR 72.6”. It appears that the SRS is of the opinion that the entire amount of non-deductible input tax (60% of the total input tax) should be included in the amount of correction for calculating taxable income. This approach results in a greater increase in taxable income than under option 1.
For the sake of accounting transparency and to achieve the desired result companies need to set up a dedicated account for non-deductible input tax. An example is provided in the table below.
Another approach would be to set up a dedicated account for the non-deductible part of representation costs, including non-deductible input tax.
It is stipulated in the CIT Law that taxable income should be increased by 60% of the amount used for representation expenses. By this definition representation expenses include only 60% of input tax because 40% of input tax is returned by the state (and this amount is therefore not used for representation expenses and has not been disclosed in the income statement as expense). Thus it appears that the former approach is more compliant with law. At the same time, the approach proposed by the SRS ensures that the amount of correction of taxable income for equal representation expenses is equal both for companies that conduct fully VAT taxable transactions and deduct full input tax and those that conduct VAT non-taxable transactions and are therefore unable to deduct input tax.
Even though the first approach is more beneficial for the company and is not in contradiction with the CIT Law, a company should take into account that by choosing this approach there might be disagreement with the SRS and there is risk that as a result of audit the SRS could try to calculate higher amounts of CIT payable.
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