A simple consolidation
Posted by Christie Malry on May 17, 2012 at 11:36 pm
This blog post aims to show a simple, but plausible, consolidation. A consolidation is where a group of companies presents its overall results as if they were a single company.
So, imagine the following situation: P has a single subsidiary S. P is located in a country where the tax rate is 35% and S is located in a country where the tax rate is 25%. S makes a markup of 25% on its sales to P and P makes a markup of 33% on its sales to external customers. In the year we're looking at, S sells $40,000 of goods to P. P has sales of $32,000, leaving it with $16,000 of goods in stock at the year-end.
If P has marketing expenses of $1,000 and admin expenses of $500, and S has R&D costs of $400 and admin expenses of $1,000, and P has interest payable of $2,000, then we get the following consolidation:
| P | S | Interco sales | PURP | DT on PURP | Consol | |
|---|---|---|---|---|---|---|
| Turnover | $32,000 | $40,000 | ($40,000) | $32,000 | ||
| Cost of sales | ($24,000) | ($32,000) | $40,000 | ($3,200) | ($19,200) | |
| Gross profit | $8,000 | $8,000 | ($3,200) | $12,800 | ||
| R&D | $0 | ($400) | ($400) | |||
| Marketing expenses | ($1,000) | ($1,000) | ||||
| Administration | ($500) | ($1,000) | ($1,500) | |||
| Net profit | $6,500 | $6,600 | ($3,200) | $9,900 | ||
| Interest | ($2,000) | ($2,000) | ||||
| Profit before tax | $4,500 | $6,600 | ($3,200) | $7,900 | ||
| Tax - current | ($1,575) | ($1,650) | ($3,225) | |||
| Tax - deferred | $1,120 | $1,120 | ||||
| Profit after tax | $2,925 | $4,950 | ($3,200) | $1,120 | $5,795 |
A little bit of explanation of the adjusments is needed here. The "Interco sales" adjustment is required to eliminate the sales in S against the cost of sales in P. The PURP ("provision for unrealised profit") adjustment is to remove the profit in inventory on goods purchased from S. This is because, from a group perspective, no profit has been realised. In addition, from a group perspective, this adjustment reduces the carrying value of inventory. But from P's perspective, these goods have a higher tax base, based on the price it paid S for the unsold goods. Therefore in the group books it is necessary to recognise a deferred tax asset for the difference between the group book basis and P's tax basis. This reduces the overall total consolidated tax rate.
You'll see that the group has an effective consolidated tax rate of 26.65% ($2,105 / $7900). This is quite a long way from P's tax rate and only just a bit higher than S's tax rate. But the assumptions we made in creating this scenario are fairly anodyne. Also, we have presumed no other book-tax differences.
Does this look like tax avoidance to you? Does it give you confidence that an informed observer could identify tax avoidance in a similar situation?
I have to say I don't believe it.
