Evolving Connections Between Tax and Financial Reporting in Italy

Abstract

We analyze the evolution of the relationship between tax and financial reporting in Italy after the mandatory introduction of International Financial Reporting Standards (IFRS) in 2005. Italy represents an interesting case study among European countries, with domestic generally accepted accounting principles (GAAP) oriented towards creditor protection and characterized by a close connection of financial and tax accounting. Unusually, the adoption of IFRS is compulsory for the unconsolidated financial statements of listed companies, but the process of alignment of domestic GAAP to IFRS, that has affected some countries, has had little effect on Italy. Thus, two accounting systems, IFRS and Italian GAAP, are used for the preparation of unconsolidated financial statements by different categories of companies and, as a consequence, two different linkages between tax and financial reporting emerge. In order to assess the degree and the direction of the book-tax linkages we use the methodology developed by Lamb, Nobes and Roberts (1998. International variations in the connections between tax and financial reporting, Accounting and Business Research, 28(3), pp. 173–188). IFRS and tax reporting show a high degree of disconnection, while Italian GAAP, in line with the accounting tradition of most continental European countries, are closely related to tax rules. The analysis points out a rapidly evolving situation, with links between accounting systems and taxation becoming tighter, mainly because of the changes in tax law introduced during the last few years.

JEL Classification:

• H20
• H25
• M41

Acknowledgements

We especially thank Christopher Nobes and Antonio Majocchi for helpful suggestions. The results of the analysis were discussed and shared with Carlo Rossi (PricewaterhouseCoopers), Riccardo Zeni (KPMG) and the CFOs interviewed within the project ‘International accounting principles and macro level impacts deriving from a change in the accounting rules’, lead by CrESIT (University of Insubria). Grants from Ministero dell'Università e della Ricerca Scientifica (MIUR) and from University of Insubria (FAR) are gratefully acknowledged.

Notes

From now on, IFRS will refer both to International Financial Reporting Standards and to the International Accounting Standards issued before 2001. Throughout the paper the IFRS considered are the version endorsed by the EU. The expression ‘unconsolidated financial statements’ is used to identify the financial statements prepared by a company as a stand-alone legal entity. Referring to the IASB definitions, unconsolidated financial statements denote either the separate financial statements or the individual financial statements according to paragraph 4 of International Accounting Standard 27 (revised 2008), Consolidated and Separate Financial Statements.

For a comparison between accounting and taxation objectives see, for example, Spengel (2003) and Schön (2004).

See Gammie et al. (2005).

The most important adjustments required by tax law refer to depreciation and amortization, provisions and interests expenses. See the appendix for further details.

Presidential decree 22 December 1986, Articles 83 and 109 (Section 4).

Though the mandatory adoption of IFRS for the unconsolidated financial statements started from 2006, an earlier adoption was permitted from 2005.

Article 2435 bis, Italian Civil Code.

AIDA data set (Bureau van Dick) contains information from the consolidated and unconsolidated financial statements of Italian companies as deposited in the Chambers of Commerce.

Legislative decree 28 February 2005, no. 38.

Legislative decree 17 January 2003, no. 6.

For example, as far as Italian GAAP are concerned, the substance over form principle does not apply to financial leases.

EU Directives 2001/65/EC, 2003/51/EC and 2006/46/EC.

One explanation for the slow convergence to IFRS can be found in the characteristic of the Italian industrial structure, mostly formed by small and closely held companies. With reference to these subjects, the need to protect creditors overrides the need to provide investors with market-oriented information.

Law 24 December 2007, no. 47 and Decree 1 April 2009, no. 48, respectively.

Financial Act 2008 explicitly refers to IFRS qualification, classification and temporal imputation criteria, by using terms that are unfamiliar to the accounting language.

The paper focuses on corporate income tax (Imposta sul reddito delle società). From 1998, Italian companies are subject also to a regional business tax (Imposta regionale sulle attività produttive) that levies companies' earnings before interests and taxes, excluding the deduction of labor cost, write-down of receivables, depreciation of fixed assets other than amortizations, provisions for risks and other provisions. With the Finance Act 2008, the Italian legislator established that IRAP tax basis is exclusively driven by financial reporting, regardless of the set of accounting standards adopted.

The fiscal treatment of leases represents a clear example of the acceptance of IFRS qualification criteria and refusal of IFRS valuation criteria. Notwithstanding the legal form of the contract, for leases that meet the conditions for being classified as finance leases under IAS 17, depreciation charges and interest costs are deductible but the amount of these deductions is subordinated to the current fiscal limits. TUIR (‘Testo Unico delle Imposte sui Redditi’), Article 102, paragraphs 1 and 2; TUIR, Article 96.

Legislative decree 12 December 2003, no. 344.

This legislative intervention aimed at correcting the tax pollution of financial reporting caused by the accounting practice of charging the income statements with certain values with fiscal relevance only.

We shared the classification in Table 3 with two partners of major accounting firms and with a selection of CFO from Italian companies of different industries and dimensions. In particular, we discussed with them the hypothesis on the accounting practices that we derived, a priori, by investigating primary and secondary sources concerning tax and accounting rules and by observing financial statements data.

However it should be noted that, as shown by Gee et al. (2010), the tax effects could spread through to consolidated financial statements.

See Note 3.

The term ‘non-consolidation purchased goodwill’ is used in Lamb et al. (1998) and refers to goodwill arising in the unconsolidated financial statement as a result of asset purchases (avviamento). The purchased goodwill arising from the consolidation of investments in subsidiaries in the consolidated financial statements is referred to as ‘goodwill on consolidation’ (differenza di consolidamento).

IAS 11 requires the use of the percentage of completion method if some specific conditions are satisfied (i.e. if the advancement status can be estimated). Though there can be some room for discretion, as emerged during the consultations with the accounting experts interviewed, auditors are usually quite strict on IAS 11 application and the percentage of completion method is usually applied whenever the required conditions hold.

This arena specifically concerns the classification of lease arrangements. With reference to the deductible amounts, it should be noted that depreciation charges and interest costs are deductible within the limits clearly established by the Italian Tax Code (TUIR, Article 102, paragraph 2 and Article 96).

The coefficients, depending on industry and asset type, are established by a decree of the Ministry of Economics (decreto ministeriale 31 December 1988).

Nevertheless, IAS 23 requires, since January 2009, the capitalization of interest costs if certain requirements are fulfilled, and therefore a Case III (Accounting Leads) would be detected nowadays.

At a first sight, this situation might seem comparable to the one observed in Lamb et al. (1998) for what concerns the German case. However, though in Germany the use of inventory flow assumptions generally coincides for tax and accounting, this does not have to be the case. This leads to a Case IV (Tax Leads) since, in practice, companies adhere, for simplicity, to the tax rules also for financial reporting purposes. Differently, in Italy, the values (and hence the method) used for financial reporting purposes must be used also for tax purposes, and given that there are potential fiscal advantages in choosing one specific method, a Case III† emerge.

Legislative Decree no. 225/2010, converted into Law no. 10/2011, modifies Article 4 of Decree 38/2005.

As allowed by tax law (TUIR, Article 102, paragraph 5).