Chapter 2 Part 1 - Tax Accounting 2 PDF

## CHAPTER TWO ### TAX ON COMMERCIAL & INDUSTRIAL PROFITS Dr. Rana Mahmoud ### A- Conditions for imposing the TOC & IP: #### 1- Income source: - The net profit derived from the self-utilization of both labor and capital for achieving gain. - The taxpayer should not subject to the direction or contr...

## CHAPTER TWO ### TAX ON COMMERCIAL & INDUSTRIAL PROFITS Dr. Rana Mahmoud ### A- Conditions for imposing the TOC & IP: #### 1- Income source: - The net profit derived from the self-utilization of both labor and capital for achieving gain. - The taxpayer should not subject to the direction or control of someone else, that is, his own master. #### 2- Profit Concept: - Income is consisted of any type of gain, benefit, profits, or other increase in wealth. - It is not exempted by the Egyptian law. - It is measured according to the accrual basis. ### 3- Realization of Profits in Egypt: - It is imposed on the profits belong to any Egyptian firm operating in Egypt. - Any foreign firm carrying a business in Egypt. ### 4- Tax collection: - It is required at the date of return submitted by the taxpayer - The advance payment of tax may be required by state. - It uses a progressive tax rate. ### 5- Taxable year: The TOC & IP is imposed on the net profit incurred during the period of twelve months ending on December, 31 regardless of the financial year of the firm. ### B- Scope of Taxable C & IP: #### 1- Profits of Commercial and Industrial profits: - It is imposed on profits derived from buying goods to sell them at profit. - From converting raw material to goods by manufacturing process and selling products with a view to earn profits. #### 2- Profits of Sole-Firm and Partnerships: It is imposed on the profits of sole-firm, limited partnerships, general partnerships, and corporation. #### 3- Profits of Operations of Brokerage & Commission: It is imposed on the amount paid to any individuals or companies as a commission or brokerage. #### 4- Profits of Lease of Shops & Machines: It is imposed on the profits derived from letting out a commercial or industrial, mechanical, and electronic machine. #### 5- Profits of Disposing of Capital Assets: It is imposed on the profits derived from sale or disposing of capital assets (i.e., capital gain). #### 6- Profits of Ordinary Transactions in Buildings and Land: It is imposed on profits derived ordinarily from activities of purchase or construction of premises with the purpose of selling them, and activities of dividing plots of building-lands and disposing of them. #### 7- Total Value of Built Premises or Lands: It is imposed on the total value received from built premises or lands (is not the realized profit). ### C- Exemptions from Tax on Commercial & industrial profit #### 1- Bee Breeding Firms: The profit derived from activities of bee breeding are exempted from tax. #### 2- Firms of Lands Preparation for Cultivating: The profits derived from these activities are exempted from tax for ten years as the first taxable year following the date where the land is considered to be productive. #### 3- Special Insurance Funds: The profits derived from various activities of these funds, which are established to provide for the payment of life, sickness, accident, or other benefits to members or their dependents are exempted from TOC & IP. #### 4- Established Firms Financed by Social Fund of Development: The profits of these firms are exempt from TOC & IP through five years as of the date of starting the activity. ### D- The Tax Treatment of net profit for commercial & industrial activity * Measurement of Taxable Net Profit: Taxable net profit (TNP) is measured by matching **taxable revenues** with the related **allowable deductions**, under the tax statute, incurred in obtaining these revenues. ### A- Measurement of Taxable Revenues: Profit for tax purposes includes three types: operating revenues, irregular revenues, and gains from dealing in fixed assets (Capital gains). These three types of revenues and gains are examined in the following titles: #### 1- Tax Treatment of Operating Revenues: An operating revenue is inflows of assets resulting from the entity's primary business activities. Thus, the taxable gross profit (TGP) is sales minus cost of goods sold. **Diagram:** ``` Taxable profit / \ / \ / \ / \ / \ / \ / \ / \ Taxable Operating irregular Capital revenue revenue revenue gains | | | | | | | | Sales C.G.S. revenue ``` #### a. Tax Treatment of Sales: Sales are the principal source of operating revenues. Revenue from the sale of merchandise is considered as taxable revenue in the period in which the merchandise is delivered to the customer, whether sales are cash or credit sales, and should be a real transaction. In addition, sales transaction (sales, discount, returns, and allowances) are correctly journalized and posted to related accounts. #### b. Tax treatment of cost of goods sold: Three factors used in determining the cost of goods sold: net cost of purchases which denotes the total cash and credit purchases of goods for resale after deducting purchase discount and purchase returns and allowances, or finished good, ending inventory, beginning inventory. C.G.S = Net Purchase (purchase - purchase return - purchase discount) + Beginning Inventory - Ending inventory ### Example: The net profit of a firm for the year ended Dec. 31, 2019 was L.E. 60,000, the tax examination revealed the following information: 1. There are sales of L.E. 15,000 which are not recorded, their costs are L.E. 12,000. 2. The firm delivered goods at a cost of L.E. 16,000 to a local branch these goods, were recorded as sales at a price determined by the basis of (cost + 40%), 20% of these goods are still on hand (not sold). 3. The firm delivered goods to a selling agent at a price of L.E. 25,000, which was determined by the basis of (cost + 30%). These goods recorded as sales although a portion remains on hand. The price of this part is L.E. 10,000. 4. The firm traded in goods for furniture the price of the furniture was L.E. 5,000, the goods recorded as sales for L.E. 3,500. 5. The owner withdrew goods for his personal use, this transaction was not recorded, the cost of these goods was L.E. 8,000 & their price was L.E. 8,500. **Required:** Make the necessary adjustments to arrive to TNP. **Answer:** 1. Sales=15,000 not recorded Profit: - Sale price (-) cost - 15,000 - 12,000 - L.E. 3,000 - Profit of 3,000 was not recorded so, it must be added to ANP. 2. Goods delivered to a local branch. Cost = L.E. 16,000 Sale price: - cost + 40% of cost - 16,000 + 40% of (16,000) - L.E. 22,400 Profit = 22,400 – 16,000 = 6,400 Unrealized Revenue = 6,400 × 20% = L.E. 1,280 3. Sale price = cost + 30% of cost - 25,000 = cost + 0.3 of cost - 25,000 = 1.3 cost - ... cost = 19,230 L.E. These goods are recorded as sales although a portion still on hand. It's price L.E. 10,000. % of goods still on hand= 10,000/ 25,000 = 40% still on hand Profit: - 25,000 - 19,230 - 5,770 40% of this profit is not realized so it must be deducted from ANP. Profit of unsold goods = 5,770 × 40% = L.E. 2,308 4. The firm traded in goods for furniture Price of furniture = L.E. 5,000 Goods were recorded as sales for = L.E. 3,500 Difference in value of goods exchanged for furniture L.E. 1,500 - Must be added to ANP. 5. Note: When the owner withdrew goods for personal use, we record these goods at cost & ignore sale price because he is the owner. So, cost L.E. 8,000 & price L.E. 8,500 & this goods aren't recorded so add 8,000 to ANP. Note: If these goods were recorded at sale price L.E. 8, 500. So, we will deduct L.E. 500 because for the owner, it will be recorded at cost not sale price. **Adjustment of ANP** |Item|Value| |-----|-----| |Net profit|60,000| |**Add:**| | |Profits of goods sold & not recorded|3,000| |Difference in value of goods exchanged for furniture|1,500| |Withdrawal for goods by owner at cost|8,000| |**Total Add:**|12,500| |**Less:**| | |Unrealized profit for the goods which are not sold by local branch|1,280| |Unrealized profit for the goods which are not sold by selling agent.|2,308| |**Total Less:**|3,588| |**TNP**|68,912| ### Example 2: The net profit of Nemo firm for the year ended December 31, 2020 was L.E. 51,500. The tax examination revealed the following information: 1. There were sales amount of L.E. 14,000 which were not recorded at all the cost of these sales was L.E. 10,000. 2. The firm delivered goods with a cost of L.E. 20,000 to one of its local branches. These goods were recorded as sales, at a price determined by the basis of (cost + 30%) 25% of these goods are not sold. 3. The firm delivered goods to a selling agent at a price a pro-forma invoice equals L.E. 27,000, which was determined by the basis of (cost + 35%). These goods were recorded as sales although a part of these goods remain on hand. The price of this part at the pro-forma invoice is L.E. 13,500. 4. The first traded-in goods for furniture. The sticker price of the furniture is L.E. 6,000. The goods were recorded as sales amount of L.E. 5,000. 5. The owner withdrew goods for his personal use. This transaction was not recorded. The cost of this goods is L.E. 5,000 while its sticker price is L.E. 5,200. **Required:** Make the necessary adjustments to measure the taxable net profit of the firm for the taxable year 2020. **Steps to answer:** 1. Get cost, net sale price 2. Profit = cost - sale price 3. Price of inventory on hand = total price of inventory **Answer:** 1. Sales 14,000 of 10,000 was not recorded so; - Profit = sale price - cost - 4,000 was not recorded so it must be added to net profit 2. Goods delivered to a local branch cost LE. 20,000 Sales price: - 1.3 = LE. 26,000 - Profit = 26,000 - 20,000 = LE. 6,000 Although there is 25% of these goods still on hand, so there is 25% of profit is unrealized. Unrealized profit = 25/100 * 6,000 = LE. 1,500 3. Goods delivered to selling agent. Price: -27,000 = 1.35 cost - Remaining part = 13,500 on hand = 50% of 27,000 So, there is 50% of profit unrealized - 27,000 -> 1.35 - ?? -> 100% - Cost = 27,000/1.35 = 20,000 Profit= price - cost - 27,000 - 2,000 - 7,000 50% unrealized So, unrealized profit = LE. 3,500 must be subtracted from net profit. 4. Price of furniture = LE. 6,000 Goods recorded as Sales for = 5,000 Difference in value of goods exchanged for furniture LE. 1,000 - Must be added to net profit 5. Owner withdrew goods for personal use & it's not recorded. So, it will be recorded at cost LE. 5,000 added to net profit. **Measurement of the TNP:** |Item|Value| |-----|-----| |Net profit|51,500| |**Add:**| | |Gross profit on goods sold, which are not recorded (14,000-10,000)|4,000| |Difference in the value of goods exchanged for furniture as the transaction should be recorded at the sticker price of the furniture (6,000 - 5,000).|1,000| |Withdrawals of goods at cost|5,000| |**Total Add:**|10,000| |**Less:**| | |Unrealized profit for the goods which are not sold by local branch as this branch is not an independent entity (20,000 × 25% × 30%)|1,500| |Unrealized profit for the goods which are not sold by selling agent, this profit is not taxable as the sales transaction is incomplete (13,500 × 1.35) × 35%|3,500| |**Total Less**|5,000| |**Taxable net profit**|56,500| ### Example 3: Net profit of Jamal proprietorship for the year 2018 was L.E. 12,000. So, if you learn that result of tax examination showed that the following: 1. Sales invoices of L.E. 1,500 unrecorded in sales account. The cost of these sales was L.E. 1,200. 2. Purchases include an amount of L.E. 1,800 for a purchase invoice recorded twice in the books. 3. Goods in trust agents were recorded among sales at 150% of their cost, through it proved at end of year, that part of these goods costing L.E. 1,500 still remained unsold by agents. 4. Goods drawn by proprietor not recorded in the books. Their cost amounted to L.E. 600 while its market value L.E. 750. **Required:** Make the necessary adjustments to determine taxable net profit for the year 2018. **Answer:** 1) - Sales = 1,500 - Cost = 1,200 - Gross profit = 300 Not recorded to net profit so, it must be added. 2) We record purchase price twice, so we reduced the net profit of the company. So, we will add L.E. 1,800 to net profit. 3) Gross profit = 1,200 x 25/100 = 300 - So, market value = cost + Gross profit - 1,200 + 300 - 1,500 - So, add 300 gross profit to net profit. 5) Drawing by owner is recorded at cost LE. 600. So, add L.E. 600 to profit. **Net profit according to income statement** |Item|Value| |-----|-----| |Net profit according to income statement|12,000| |**Add:**| | |Gross profit on goods sold, which are not recorded (1,500 - 1,200), because not recording sales invoices leads to reduction of net profit subject to tax by an amount equal to its gross profit.|300| |Purchases invoice recorded twice, because recording purchase invoice twice leads to reduction of net profit subject to tax by an amount equal to its value.|1,800| |Difference in value of goods recorded by mistake in account of purchase refunds, because these goods should be recorded at market value (1,500 - 1,200)|300| |Withdrawals of goods at cost, because not recording these goods leads to reduction of net profit subject to tax by an amount equal to its cost.|600| |**Total Add**|3,000| |**Total**|15,000| |**Less**| | |Unrealized profit of goods not sold by sales agents, as remaining goods trust were valued at market or cost price whichever is less (1,500 × 50% ÷ 100)|750| |**Total Less**|750| |**Taxable net profit**|14,250| **Accounting profit:** 12,000 **Add:** 2,700 **Less:** (750) **Taxable net profit:** 13,950 ### (b) Treatment of C.G.S. **Remember that:** - (A) In full costing method, the production cost = VC + FC - (B) Variable costing method, the production cost = VC - FIFO = first in first out (so E.I. from last prices) - LIFO = last in first out (so E.I. from first prices) **Note:** Ending inventory in case that it is not recorded, not included, we do compare between cost & market value & we take the less & add to ANP. - *C/U by full or variable costing method - * Ending inventory value by: FIFO or LIFO Methods ### Example four: The net profit of a partnership was L.E. 300,000 the tax examination revealed the following information. 1. Raw materials to a cost of L.E. 5,000 was recorded in the purchase journal but not included in the ending inventory because it was in transit. 2. The form has been using in the preceding years - (full costing with LIFO method) But in the current year, it switched. - To (variable costing with FIFO method) The following information is about finished goods of the partnership: - Beginning inventory of FG 2,500 units at a cost of LE. 10,000 - Production was 60,000 units. - Sales was 50,000 units. - Overhead cost LE. 300,000 (60% are variable) **Required:** Determine TNP **Steps to answer:** 1. Determine Ending inventory units - Beginning inventory + production = available for sale - c.g.s 2. Determine cost per unit under 2 methods (depend on problem) 3. Determine difference in value of E.I depend on coasting and valuation method. **Answer:** 1. Volume of ending inventory (No. of units): - Beg. Inventory = 2,500 units - (+) production = 60.000 units - Units available for sale = 62,500 units - (-) sales = (50,000) - Ending inventory of FG = 12,500 units 2. Cost per unit under 2 methods: - Full costing - Variable costing |Item|Full costing|Variable costing| |-----|-----|-----| |Variable overhead|180,000|180,000| |Fixed overhead|(300,000- 180,000)| - | |Total production cost|300,000|180,000| |No. of units produced| 60,000 | 60,000 | |Cost/ unit| $5 | $3 | 3. Valuating Inventory - Taxable inventory (LIFO): - Cost |Item|Value| |-----|-----| |Ending inventory|10,000| |2,500 unit from Beg. Inventory| |10,000 unit from production|(10,000 × 5)| |Cost of ending inventory using LIFO "with full costing method"|60,000| - Accounting inventory (FIFO) "with variable costing method" - Ending Inventory 12,500 -> from production - (12,500 × 3) = 37,500 - 22,500 difference added to net profit LE **Explanation:** - (A) Beginning = 2,500 - Production = 60,000 Take care that sales 50,000 units FIFO; so we take ending from production 12,500 x $3 - (B) LIFO last in first out - 2,500 -> 10,000 - Beg 2,500 - Production 60,000 - Remaining from production = 10,000 units × 5 = 50,000 L.E. 4. Measuring TNP |Item|Value| |-----|-----| |Net profit|300,000| |RM not recorded as ending inventory because it was in transit|5,000| |Difference in the valuation of ending inventory|22,500| | **TNP**|327,500| ### *Tax treatment of irregular revenues:* Capital gains, subsidies, recovered bad debts, and compensations are examples of irregular revenues, according to art. no.27. They are subject to tax and are included in taxable profit. ### **A- Capital gains:** UTOC & IP is imposed on gains derived from dealing in capital assets. The following points should be considered in respect of tax treatment of these gains: - Capital gains may occur during the firm life time or at liquidation. - Capital gains that result from property revaluation are tax exempted if it is exchanged for shares in a corporation. - To encourage the firm to replace its old machinery, art NO.20 allows the firm to deduct all capital gains resulting from the replaced machinery from the profit of the current fiscal year or years after, given that the replaced machinery should have been purchased during the same year, and the firm should keep regular account books. - The realized gains (or losses) are a mathematical difference between the sale value and taxable book value. ### **B- Subsidies:** They are sums received by the taxpayer from the government or any party to achieve economic or social objectives. If the subsidy is in a form other than cash, the fair market value of the subsidy is taxable. ### **C- Bad debts recovered:** - If the bad debts are allowable as a deduction for the previous year, they would be included in the taxable profit the year in which they are received. - They would not be included if they were not allowable as a deduction for the previous year. ### **D- Compensations:** They are sums received for damages suffered by the taxpayer, according to the courts or insurance policy. - If the compensations awarded by the courts, it would be included in the taxable profit on a cash basis. - If it is received from an insurance company for damaged goods, the whole amount is included in taxable profit, while if it was received for damaged fixed assets, the excess amount received over the book value are included in taxable profit. ### **Second: Application of Tax treatment on Irregular revenue** #### **(1) Capital Gains:** Capital gain = Sale price - Book value Book value = Cost - Acc. Depreciation |Item|Tax office|Firm|Called| |---|---|---|---| |Taxable capital gain| < Accounting capital gain | Overstatement of capital gain should be deducted from TNP | ### **Notes:** 1. In problems when it says P & L account - Debited = It's loss - Credited = It's gain 2. In sale of investment When the tax office makes an adjustment for investment (shares) - If this investment is temporary - We will use the market value (Book value) - If this investment is long-term investment- We will use the par value ### **Example:** The net profit of Manar proprietorship for the year ended on 31/12/2019 was L.E. 8,000. The tax examination revealed the following information: 1. The firm sold machines on 31/9/2019 for L.E. 9,800 and paid L.E. 50 removal costs. These machines were bought second hand for L.E.19,500 and installation costs of L.E. 500 were paid to a local contractor. These machines were put into service at 1/1/2016 and the depreciation rate for accounting purpose is 20% while the rate according to the tax provisions is 15%. The profit and loss account was credited by the capital gains. 2. The firm received L.E. 16,000 from an insurance company as a compensation for the damage of a truck in an accident on 1/1/2019. The book value of the truck at that date was L.E. 15,000 while its approved value by taxation district office is 18,000. The Profit and Loss account was credited by the capital gains. 3. The Profit and Loss account was credited by L.E. 2,800 as a gain on sale of temporary investment. This gain related to 1,000 shares which were sold at L.E. 28,000 and brokers commission was L.E. 200. The par value of the share was L.E. 25. The book value of shares was L.E. 24,500. **Required:** Make the necessary adjustments to measure the TNP. **Steps to answer:** 1. Get accumulated depreciation till the date of sale. 2. B.V = cost -A/D 3. COMPARE B.V BY SALE PRICE TO GET GAIN / LOSS **Answer:** |Item|Value| |-----|-----| |Net profit according to income statement| 8,000 | |**Add:**| | |Understand gain on the sale of temporary investment. The book value should be considered for tax purpose|500 | |**Total Add:**|500 | |**Less**| | |Overstatement of capital gain on the sale of machines as the increase of its adjusted cost |3,750| |Capital gain from the compensation received for the damage of a truck this gain is unrealized for tax purposes|1,000| |Capital loss on the damage of the truck as the book value for tax purposes is more than the compensation received|2,000| |**Total Less:**|6,750| |**Taxable Net profit**|1,750| **Notes** |Item|Accountin g|Tax| |---|---|---| |1-Capital gain (loss) on sale machines| | | |Sales Proceed (9,800 - 50)|9.750|9.750| |Book value [20,000 - (20,000 × 3.75 × 0.2)]|9.750|8.750| |Book value [ 20,000-(20,000 × 3.75 × 0.15)]|5,000 | | |Capital gain|4,750|1,000| |Overstatement of capital gain (4,750- 1,000)| 3750| | |2-Capital gain (loss) on damage of the truck| | | |Compensation|16,000|(18,000)| |Book value|(15,000)| | |Capital gain (loss)|1,000|(2,000)| |Unrealized gain (2,000 - 1,000)|1,000| | |3- Gain on the sale of temporary investment| | | |Sales price|28.000|28.000| |Broker's commission|(200)|(200)| |Net sales|27,800|27,800| |Par value (Book value)|(25.000)|(24.500)| |Gain|2,800|3,300| |Understand gain (3,300 - 2,800 )|500| | ### **Example (2)** Fathy proprietorship purchased a store for storing its goods at L.E. 90,000 on 1 April 2016, the registration duties was L.E. 4,000 and lawyer fees was L.E. 2,000. On 1 April 2018, the firm spent L.E. 14,000 to renew the store. The store was sold on 31 December 2018 at L.E. 150,000, and the costs of processing the sale was L.E. 15,000. So, if you learn that: - 1- The annual repairs expenses amounted to L.E. 1,000. - 2- The depreciation rate for tax purpose is 5% annually. **Required:** Calculate Taxable Capital gain on the disposal of the store. **Answer:** |Item|Value| |---|---| |Sales Proceeds (150,000 - 15,000)| 135,000| |Book Value = cost - Acc. Dep.| | |Price of purchase| 90,000| |Registration duties|4,000| |Lawyer fees|2,000| |**Cost of store**| 96,000.| |Renewable cost|14,000| |**Total cost**|110,000| |Accumulated depreciation| | |Till April 1, 2018 = 96,000 ×5%×2=|(9,600)| |From April 1, 2018 = 110,000 × 5% × 9/12 =|(4,125)| |**Book Value**|(96,275)| |**Taxable capital Gain**|38,725| Repairs expense are not included in improvement as it is a revenue expenditure. ### **(2) Subsidies:** - Amount or items received from the government for achieving economic & social objectives. **Diagram:** ``` Subsidies / \ / \ / \ / \ / \ / \ / \ / \ / / \ In cash In the form of equipment or goods Included in the taxable net Included in the TNP at fair market profit as it is value ``` ### **(3) Bad debt recovery** Bad debts are allowed to be deducted from TNP, if the firm took legal action & If this debt is approved by the tax office. **Diagram:** ``` 20,000 bad debt / \ / \ / \ / \ / \ / \ / \ 8,000 12,000 Not approved by tax office Approved by tax office - Firm deducted 20,000 as bad debt expense; so, tax will add 8,000 which is not approved & No adjustment for 12,000 approved. ``` **Diagram:** ``` If bad debt recovery is $10,000 / \ / \ / \ / \ / \ / \ / \ 4,000 from (8,000) 6,000 from (12,000) No adjustment because they've Should be added to TNP because been already added are approved **Note:** - If bad debt is allowable as deduction previous year, so they would be included in TNP, if they are received. - Will not be included in TNP if they are not allowable as a deduction previous year. -> Because it is added last year. ``` ### **(4) Foreign Currency Gain** **Diagram:** ``` Foreign Currency Gain / \ / \ / \ / \ / \ / \ Realized gain Unrealized gain Result from change in the Result from translating exchange rate of foreign (reevaluating), foreign currency currency, so it is a gain & to local currency this gain will should be added to TNP not be included in TNP because tax office doesn't agree with that gain ``` ### **(5) Compensation "compensatory award"** It is awarded by the court, this gain should be recorded at cash basis. **Diagram:** ``` Compensation / \ / \ / \ / \ / \ / \ / \ / \ By government (court) By insurance company (policy) Compensation will be included in TNP only at cash basis (amount received) / \ / \ / \ / \ / \ / \ / \ For damage of goods For damage of fixed assets All amount will be included in TNP (we consider as we sold this goods) Only included in the TNP if the amount in excess of Book value. ``` ### **Other revenues which are exempted :** #### **(6) Building and Agriculture land revenue** Revenues which the firm gets from buildings and agriculture lands