Income tax systems generally allow a tax deduction, i.e., a reduction of the income subject to tax, for various items, especially expenses incurred to produce income. Often these deductions are subject to limitations or conditions. Tax deductions generally are allowed only for expenses incurred that produce current benefits, and capitalization of items producing future benefit is required, sometimes with exceptions. Most systems allow recovery in some manner over a period of time of capitalized business and investment items, such as through allowances for depreciation, obsolescence, or decline in value. Many systems reduce taxable income for personal allowances or provide a range of income subject to zero tax. In addition, some systems allow deductions from the tax base for items the tax levying government desires to encourage. Some systems distinguish among types of deductions (business versus non-business).
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Nearly all jurisdictions that tax business income allow tax deductions for expenses incurred in trading or carrying on the trade or business. Technical details of the allowance vary, and may be very general for all expenses, or very specific in respect of certain expenses. The amount of particular deductions may be limited based on character or amount, or deductions in aggregate may be limited or reduced. To be deducted, the expenses must be incurred in furthering a business. Generally, a business includes only those activities undertaken for profit.
Nearly all income tax systems allow a deduction for cost of goods sold. This may be considered an expense, a reduction of gross income,[1] or merely a component utilized in computing net profits.[2] The manner in which cost of goods sold is determined has several inherent complexities, including various accounting methods. These include:
Many systems, including the UK, levy tax on all chargeable “profits of a trade” computed under local generally accepted accounting principles (GAAP).[7] Under this approach, determination of whether an item is deductible depends upon accounting rules and judgments. By contrast, the U.S. allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business...”[8] subject to qualifications, enhancements, and limitations. A similar approach is followed by Canada, but generally with fewer special rules. Such an approach poses significant definitional issues. Among the definitional issues often addressed are:
Note that under this concept, the same sorts of expenses are generally deductible by business entities and individuals carrying on a trade or business. To the extent such expenses relate to the employment of an individual and are not reimbursed by the employer, the amount may be deductible by the individual.[11]
Business deductions of flow-through entities may flow through as a component of the entity's net income in some jurisdictions. Deductions of flow-through entities may pass through to members of such entities separately from the net income of the entity in some jurisdictions or some cases. For example, charitable contributions by trusts, and all deductions of partnerships (and S corporations in the U.S.) are deductible by member beneficiaries or partners (or S corporation shareholders) in a manner appropriate to the deduction and the member, such as itemized deductions for charitable contributions or a component of net business profits for business expenses.[12]
Accounting methods
One important aspect of determining tax deductions for business expenses is the timing of such deduction. The method used for this is commonly referred to as an accounting method. Accounting methods for tax purposes may differ from applicable GAAP. Examples include timing of recognition of cost recovery deductions (e.g., depreciation), current expensing of otherwise capitalizable costs of intangibles,[13] and rules related to costs that should be treated as part of cost of goods not yet sold.[14] Further, taxpayers often have choices among multiple accounting methods permissible under GAAP and/or tax rules. Examples include conventions for determining which goods have been sold (such as first-in-first-out, average cost, etc.), whether or not to defer minor expenses producing benefit in the immediately succeeding period, etc.
Accounting methods may be defined with some precision by tax law, as in the U.S. system, or may be based on GAAP, as in the UK system.
Many systems limit particular deductions, even where the expenses directly relate to the business. Such limitations may, by way of example, include:
In addition, deductions in excess of income in one endeavor may not be allowed to offset income from other endeavors. For example, the United States limits deductions related to passive activities to income from passive activities.[20]
Many systems require that the cost of items likely to produce future benefits be capitalized.[21] Examples include plant and equipment, fees related to acquisition of property, and costs of developing intangible assets (e.g., patentable inventions). Such systems often allow a tax deduction for cost recovery in a future period.
A common approach to such cost recovery is to allow a deduction for a portion of the cost ratably over some period of years. The U.S. system refers to such a cost recovery deduction as depreciation for costs of tangible assets[22] and as amortization for costs of intangible assets. Depreciation in these systems is allowed over an estimated useful life, which may be assigned by the government for numerous classes of assets, based on the nature and use of the asset and the nature of the business.[23] The annual depreciation deduction may be computed on a straight line, declining balance, or other basis, as permitted in each country's rules.[24] Many systems allow amortization of the cost of intangible assets only on a straight line basis, generally computed monthly over the actual expected life or a government specified life.
Alternative approaches are used by some systems. Some systems allow a fixed percentage or dollar amount of cost recovery in particular years, often called “capital allowances.”[25] This may be determined by reference to the type of asset or business.[26] Some systems allow specific charges for cost recovery for some assets upon certain identifiable events.[27]
Capitalization may be required for some items without the potential for cost recovery until disposition or abandonment of the asset to which the capitalized costs relate. This is often the case for costs related to the formation or reorganization of a corporation, or certain expenses in corporate acquisitions.[28] However, some systems provide for amortization of certain such costs, at the election of the taxpayer.[29]
Some systems distinguish between an active trade or business and the holding of assets to produce income.[30] In such systems, there may be additional limitations on the timing and nature of amounts that may be claimed as tax deductions. Many of the rules, including accounting methods and limits on deductions, that apply to business expenses also apply to income producing expenses.
Many systems allow a deduction for loss on sale, exchange, or abandonment of both business and non-business income producing assets. This deduction may be limited to gains from the same class of assets. In the U.S., a loss on non-business assets is considered a capital loss, and deduction of the loss is limited to capital gains. Also, in the U.S. a loss on the sale of the taxpayer's principal residence or other personal assets is not allowed as a deduction except to the extent due to casualty or theft.
Many jurisdictions allow certain classes of taxpayers to reduce taxable income for certain inherently personal items. A common such deduction is a fixed allowance for the taxpayer and certain family members or other persons supported by the taxpayer. The U.S. allows such a deduction for “personal exemptions” for the taxpayer and certain members of the taxpayer's household.[31] The UK grants a “personal allowance.”[32] Both U.S. and UK allowances are phased out for individuals or married couples with income in excess of specified levels.
In addition, many jurisdictions allow reduction of taxable income for certain categories of expenses not incurred in connection with a business or investments. In the U.S. system, these (as well as certain business or investment expenses) are referred to as “itemized deductions” for individuals. The UK allows a few of these as personal reliefs. These include, for example, the following for U.S. residents (and UK residents as noted):
Many systems provide that an individual may claim a tax deduction for personal payments that, upon payment, become taxable to another person, such as alimony.[40] Such systems generally require, at a minimum, reporting of such amounts,[41] and may require that withholding tax be applied to the payment.
Some systems allow a deduction to a company or other entity for expenses or losses of another company or entity if the two companies or entities are commonly controlled. Such deduction may be referred to as “group relief.”[42] Generally, such deductions function in lieu of consolidated or combined computation of tax (tax consolidation) for such groups. Group relief may be available for companies in EU member countries with respect to losses of group companies in other countries.[43]
Many systems impose limitations on tax deductions paid to foreign parties, especially related parties. See International tax and Transfer pricing.
Australia: Australian Taxation Office:
Canada:
United Kingdom: HM Revenue and Customs:
United States: Internal Revenue Service: