Why startups struggle with timing of paying taxes
Operating a business has its own challenges, and one would expect the tax laws to be adaptable enough to accommodate scenario as diverse as possible. Credit sales are common and on numerous occasions, businesses push sales on credit terms so as to meet targets before the year ends. Toward the end of the accounting period (which is often December), instances of mismatch between the accounting period during which credit sales are made and the accounting period during which actual cash is received may occur. Let’s imagine that Company A’s accounting period follows the calendar year. Company A then supplies goods to Company B in December 2021 and receives cash in January 2022. To the uninformed, it makes perfect sense to pay tax on money received, and several firms, particularly start-ups, have fallen victim to this trap.
The aim of this article is to provide guidance on the tax treatment of transactions with mismatching accounting periods between the time sales are made and the time cash on sales is
received. This shall specifically cover income tax and value added tax (VAT). In many cases the income tax law harmonizes accounting treatment and tax treatment such that there are as minimal unreconciled items as possible, hence reducing risks of under or double taxing transactions. For instance, the law requires a company to account for income tax on an accrual basis – which is one of the accounting principles that provides for the recognition of income when earned and expenses when incurred. The implication, in simplest of forms, is that an entity is required to recognize income when goods are transferred, or services rendered. Hence the resulting income tax from the transaction must be paid on an accrual as opposed to a cash basis.
On the other hand, the VAT Act, 2014 establishes its own set of guidelines for accounting for VAT. Prior to imposing VAT on the delivery of goods or services, an entity should determine whether the supply is a taxable supply. To keep the discussion grounded on the subject matter, we will assume that the item supplied by Company A mentioned at the outset qualifies for VAT. The payment of VAT is determined through an evaluation of events. An entity is required to pay VAT on the earlier of the following three (3) events: – (a) the time when the invoice for the supply is issued by the supplier; (b) the time when the consideration for the supply is received, in whole or in part; or (c) the time of supply.
It must be noted that, practically, events above do not always happen simultaneously. In some cases, an entity would be required to pay VAT even before goods are supplied or payments are made, hence the possibility of a mismatch. In the case of Company, A, VAT will be accounted for upon the supply of items on credit. If Company A substantially relies on credit sales, it might face challenges in settling its VAT obligations timely as it will be accumulating VAT liabilities whilst receiving cash in the future.
There is a bigger business objective for every decision, thus underlining the need to factor in tax implications of such decisions when configuring any business’ operational
model. It is necessary to understand when VAT is payable on an accrual vis-à-vis cash basis by evaluating the above mentioned scenarios. Considering that tax laws address different objectives leading to differing bases of taxation, it is crucial for businesses to be aware, plan and account for taxes correctly to avoid exposure originating from failure to pay taxes at the correct phase of a transaction. To sum it up, it is important to understand that the time when cash is received does not necessarily determine a point for taxation. It is also important to understand that the basis applied when computing income tax are not similar to basis used when determining when VAT becomes payable.