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By the end of this article, you would understand the concept of Effective Tax Rate (ETR) and know how to tactfully use to manage and prevent excess tax cash outflows from your company and pay appropriate levels of taxes.
The idea of the blog is to simplistically explain a concept and therefore I may not be using technical jargons or a 100% accurate financial language. Certain technical jargons, I cannot avoid due to the sheer importance and widespread usage.
Before we start with the explanation, three aspects need to be understood by the reader
- Current taxes – Current tax is the level of tax that needs to be paid legally as per the computation of tax for the year under consideration. Such taxes are computed on the taxable profits computed as per the taxation laws, which could be different than the book profits as per the accounting principles. This means the level of current tax may not always be equal to the rate of tax by the taxation law.
- Deferred Tax – Deferred tax being an accounting concept is the taxation on the temporary difference between the book profits and the taxable profits that have a characteristic of reversal and adjustments in the future year. Such deferred taxes are recognised following the principle of matching concept, accrual and conservatism.
- Profit before tax – Profit before taxes is the profit that is shown in the profit and loss statement of a company (on which taxes are deducted) current as well as deferred)
Effective tax rate = (Current tax + Deferred tax) / Profit Before taxes
ETR as a principle is an effective blend of the taxation regulations and the accounting principles for a jurisdiction.
In absence of any Permanent differences between the tax and accounting books of accounts (for example tax holidays), ideally, the ETR should be equal to the tax rate of a country. This means, in case a company aims to permanently resort to a tax saving mechanism, it should use certain legally provided tax breaks and holidays to bring the ETR below the tax rate of a Country. Kindly note that such aspects are tagged as tax planning, being completely legal and are far off from the tax avoidance net.
The key to effective tax management is a continuous control on the ETR, if, in contrast to tax breaks, certain permanent tax disallowances creep in the tax computation, the treatment could jack up the ETR to a level higher to than what should be paid legally by the company to the Government.
It is often said that every 1% saving in taxes is equivalent to the efforts of a salesperson to get a growth of 30% to the company. Therefore, for a company at a group level, it is extremely essential to focus on the concept of ETR.
Now something for the tax authorities (world-wide application) – If a tax office focuses on the aspect of ETR, they would be in better position to qualitatively analyse the tax computation of the taxpayers and turnround a case in a record time.
I would be more than happy to practically demonstrate the use of ETR, on request, for the corporates and the tax authorities.
In case the reader has any doubt or would like me to write a blog on a specific topic of your choice, you can leave your comments and I would try my level best to address the same.
CA. Akshay Kenkre