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BRANCH ACCOUNTING.

18. This study deals primarily with the allocation of profit to branches — that is to say, to establishments of any kind, whether belonging to an individual, a partnership or a corporation. Since a properly organised subsidiary corporation constitutes a separate legal entity, even though it is controlled through stock ownership or otherwise, it should be treated as such, and it should keep separate accounts relating to its own activities. If the parent enterprise, however, treats the subsidiary company as a branch and includes it as such in its own accounting — and tax officials testify that this is sometimes done — then, in many countries, the officials will regard the parent enterprise as the taxpayer and the subsidiary as a mere branch. In determining the income allocable to the subsidiary in such case, the procedure followed may be essentially the same as that described herein with regard to branches. It is recognised that special tax problems arise out of the parent-subsidiary relationship, and that an accounting study of these problems would be desirable, but since a complete treatment would be impossible, it will not be attempted. For tax purposes, however, a subsidiary must ordinarily be regarded either as an independent concern or as a branch. There can hardly be an intermediate concept.

GENERAL ACCOUNTING REQUIREMENTS.

19. The purpose of separate accounting is to maintain accounts for the branch or branches of an enterprise in each tax jurisdiction which will reflect the income directly allocable thereto and provide the essential data for the apportionment of items of income or expense which cannot be directly allocated. The limited apportionment of various items of income or expense or of the joint profit on specific goods which is a necessary part of separate accounting must, however, be distinguished sharply from general apportionment which involves the division of the net income of a whole enterprise. There is no one system of branch accounting by which proper allocations of profit may be accomplished in all cases. Methods of accounting for branches of foreign enterprises naturally differ, depending upon the functions exercised by a branch, its size, the general plan of organisation, and other factors. Routine methods of accounting for branch establishments are, however, so well understood that they need not be presented here. Further information on this aspect of branch accounting may be readily obtained from textbooks on the subject or from accounting and trade periodicals. Although the routine procedures may vary among enterprises, there are a few general requirements which should be met if branch accounts are to be used effectively in the determination of taxable income. The variety of tax laws and regulations in different countries is so great, however, that no statement even of general requirements will be applicable in all jurisdictions.

1. Each branch or group of branches within a single tax jurisdiction should be organised as a separate accounting unit with an adequate set of accounts and records.

20. In order to treat a branch as a separate accounting unit, it must be thought of as a distinct business entity which can and does have transactions with other branches of the organisation as well as with independent concerns. The concept of a branch as a separate accounting unit may be maintained even though inter-branch transactions are not priced on the same basis as transactions with independent concerns, and even though all accounts are not kept on the branch books. The branch, however, must be credited for goods shipped or services rendered to any other branch, and it must be charged for all goods or services received.

21. Although the concept of the branch as a separate accounting unit can be maintained even though all branch records are kept at the home office, such an arrangement makes the problem of verification more difficult for tax authorities in the country of location of a branch. The policy of centralising all branch accounts in one office is often followed, especially for domestic branches, in order to save book-keeping expense and to provide a more complete control over branch operations. The centralisation of the accounts of branches of foreign enterprises in this manner, however, is less common because of the distance from the home office, the differences in currencies and customs, and other factors which make it necessary for such branches to operate with a considerable degree of independence. In the foreign field, completely centralised accounting can be most conveniently used for consolidating the accounting work of branches located in the same country.

22. In order to meet tax requirements, it is apparent that a branch must keep some records even though a complete set of accounts is kept at the home office. These records would ordinarily show branch sales and expenses locally paid, though they might not show the cost of goods handled by the branch or expenses incurred by the home office for the benefit of the branch. If supplementary schedules submitted annually by the home office are adequate for the determination of branch profit, there should be no disposition to require the branch to keep a complete set of accounts. Such a requirement might force a company to maintain a costly accounting staff where native book-keepers would suffice, or to disclose information which the management does not wish to give to branch employees. This situation exists in particular at the smaller branches located in oriental countries. Larger branches are likely to have some formal accounts, though not necessarily a complete schedule of accounts from which a balance-sheet and profit-and-loss statement can be prepared.

23. A branch which does have an accounting staff may keep only the current operating accounts. Fixed asset accounts are quite commonly kept at the home office in order to avoid the necessity for making foreign exchange conversions. Where this is done, the branch may keep a memorandum record of fixed assets and their related depreciation accounts and compute its depreciation charges therefrom, or depreciation may be charged on the receipt of advices from the home office. Sometimes such charges are omitted entirely from the branch books.

24. If a branch maintains a staff to keep its current operating accounts, however, the amount of additional book-keeping expense required for keeping a complete set of records should not be large. For tax purposes, this undoubtedly has some definite advantages. Accounts locally kept can be audited and verified more easily and doubtful items more readily explained. It may be stated, therefore, as desirable though not absolutely necessary that each branch (or group of branches) seeking to be taxed on its own accounts should keep such records as will permit the preparation of complete financial statements from the branch books. The real test of adequacy, however, is not what records are kept, but rather how full a disclosure is made by the branch records and home office schedules combined.

25. Branch account classifications should be as nearly uniform as possible and in agreement with the classification used by the home office. Such uniformity facilitates the preparation of consolidated statements for the enterprise as a whole, and increases the probable accuracy of expense apportionments.

II. The accounting system of a branch should meet the special legal and tax requirements of the country in which it is located.

26. In some countries, the commercial code, or the tax law, contains certain requirements regarding the keeping of accounts, and these, of course, must be followed by branches as well as by independent concerns. Other countries make only a general requirement that accounts shall be kept in such a way as to reflect the true income. Such requirements are so general in their application that they fix no definite standard of accounting practice.

27. More pertinent to the problem of allocation is the segregation of branch income and expense into two classes:

28. The net income definitely allocable to a given country is the excess of definitely allocable gross income over the amount of related expense. Income of this character is made up of such items as income from real estate, interest, dividends, salaries and royalties on patents and copyrights. In the tax laws of many countries, such items of income are subject to special rules of assessment or to specific schedular taxes. The twenty odd treaties which have been concluded between the various European Governments for the prevention of double taxation follow this general classification rather closely, and, since these items can be ascribed to a definite source, they can usually be allocated without difficulty.

29. The principal problem of allocation arises in connection with income from trade, commerce or industry, particularly with respect to goods manufactured, processed or produced in one country and sold in another. It is not enough that income of this character should be separated from definitely allocable income. The income and expense attributable to joint activities must be carefully analysed in order to permit of a satisfactory allocation. Usually this requires some departmentalisation of accounts, though, in certain industries, departmentalisation is impossible and statistical methods must be substituted in analysing operating results. Railroads, for example, cannot set up separate accounts for the expenses relating to freight and passenger traffic. In manufacturing and mercantile enterprises, however, departmentalisation by major lines of product is usually feasible. It is necessary if profits are to be allocated equitably to branches handling different products. If a sales branch, for instance, handles three distinct lines of product, one of which is obtained from independent sources, one from a purchasing branch of the enterprise in another country, and one from a foreign manufacturing establishment of the enterprise, it is probable that no satisfactory basis for allocation can be found unless separate accounts are kept for each of the three lines. Any method of allocating or apportioning the profits of the three lines combined would necessarily be arbitrary. Even where all of the products come from a single foreign manufacturing plant of the enterprise, the need for departmentalisation usually exists, since the margin of profit, volume of business, method of selling, and other factors may be different for each line.

30. The principles of departmentalisation are simple enough in the abstract, but many complexities arise when they are applied under actual business conditions. In general, departmental divisions should correspond to lines of product handled and to divisions of authority within an enterprise. Each concern, however, must arrange its departments according to the requirements of its own organisation. No one plan will fit all companies even in the same industry. After the accounts have been departmentalised, and after allocations of income and expense have been made, the results may properly be combined on a single tax return covering all the operations of a branch. In many cases, however, the accuracy of the allocations will depend in no small degree upon the care with which departmental lines have been maintained in the underlying accounts.

III. The accounts of each branch should contain a complete analysis of inter-branch and inter-company transactions.

31. Since it is these intra-company and inter-company transactions which cause most of the difficulty in the attempt to use branch accounts for tax purposes, it is particularly important that a complete summary of all such transactions should be obtainable. If one branch deals with other branches of the same company, these inter-branch transactions are usually passed through the home office current account. It is easier, as a rule, for the home office to reconcile one current account with each branch than to reconcile and adjust a number of inter-branch accounts. If this system is followed, each current account will contain a complete record of all transactions of that branch with other branches of the company, with the possible exception of transactions settled in cash.

32. Although there are advantages in handling all inter-branch transactions by the method indicated, it may sometimes be more convenient to open separate accounts for transactions between two branches which deal regularly with each other. If one branch regularly supplies the other with merchandise there can be no objection to direct charging between the two, provided the intra-company character of such transactions be not concealed. If the shipping branch simply debits an account receivable and credits sales for the goods transferred and the receiving branch merely debits purchases and credits an account payable, there is some danger of overlooking the fact that an intra-company transaction has taken place and that the prices charged for the goods are not determined by agreements with independent concerns. All inter-branch transactions, even those currently settled in cash, should be cleared through the home office current account or a special branch current account in order to indicate the intra-company character of the transactions.

33. Ordinarily, the home office current account shows the entire equity of the home office in the branch assets. When branches are placed on a capitalised1 basis, however, this current account may be split into two or more parts, one of which will be the permanent capital of the branch, and another the real current account in which the routine inter-branch transactions are recorded. The methods of effecting this division are discussed in the chapter on interest.2

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IV. All transactions (a) between a branch and independent concerns and (b) between a branch and other branches or subsidiaries of the same enterprise should be supported and explained by vouchers or other documents.

34. The keeping of vouchers supporting transactions with independent concerns is as important for internal audit as it is for verification by tax authorities. This is the accepted practice of business concerns. The failure of a branch to produce vouchers for certain transactions should be viewed in the same light as a similar failure on the part of an independent concern.

35. Obtaining satisfactory vouchers for intra-company transactions is more difficult. Intra-company charges may be either direct or apportioned. Direct charges include such items as materials, merchandise or supplies transferred, or specific services rendered. Apportioned charges consist of expenses which are incurred for the benefit of two or more branches or divisions of a business and must, therefore, be apportioned among them. Direct charges should be billed in the same way as similar charges would be billed to an outside concern. The pricing of such inter-branch transfers of goods and services will be one of the principal objects of this study, but routine accounting requirements will be met if the price basis is clearly indicated.

36. Since it is very difficult to secure satisfactory evidence in support of apportioned charges, it is desirable, both for the sake of accuracy and for ease of verification, that direct charging should be used wherever possible. Some expenses which must be apportioned will, however, always remain. Since branch books offer no possible means for the independent verification of such charges, it is essential that they be fully explained and that the method of apportionment be clearly indicated. Tax authorities could obtain greater assurance as to the accuracy and the propriety of inter-branch transactions and the reasonableness of apportionments by requiring or accepting the certified statements of recognised firms of public accountants in doubtful cases.

37. The four requirements already given have been stated from the point of view of outlying branches, but most of them will apply to the home office or real centre of management which may be looked upon simply as a central branch. The home office, of course, must keep a complete set of accounts, including the branch current accounts. It should likewise keep a complete file of vouchers, letters, or other documents to support all transactions with branches and with independent concerns. There will also be the same need for explaining the basis and nature of all intra-company and inter-company transactions by which profits might conceivably be diverted to foreign branches or subsidiaries.

38. Trial balances of all branches will be periodically prepared and converted into the currency of the home country in order that consolidated statements may be prepared for the entire enterprise. In computing the amount of income taxable at the home office, these figures for foreign branches are of vital importance. On the return for the home office, the tax authorities may require consolidated figures for the entire enterprise and permit the deduction of income allocated to foreign branches, or they may require figures for domestic business only on the return proper. In any event, an analysis of the results of branch operations will be necessary in order to prevent the diversion of profits. Tax auditors in the country in which the home office is located will naturally find more complete information than is available at branches, but they will, nevertheless, have some difficulty in verifying foreign items. Certified statements prepared by accountants who have audited branch books should be of assistance here. Such statements are commonly obtained in preparing annual reports for the stockholders and there would seem to be no reason why they should not be used also for tax purposes.

FOREIGN EXCHANGE.

39. The fact that the accounts of branches of international enterprises must be kept in different currencies raises a number of exchange difficulties. Accounting procedures have been worked out to care for ordinary differences which appear when the exchanges are relatively stable, but there seems to be no generally used procedure by which the problems arising out of the violent exchange fluctuations of the post-war period can be adequately handled.

40. When goods are transferred between two independent concerns in different countries, the terms of sale require payment in one currency or the other, or on occasion in the currency of a third country. If payment is to be made in the currency of the exporting country, the importer assumes the risk of exchange fluctuations between the actual date of the invoice and the date of payment. If the contract, however, specifies payment in the currency of the importing country, the risk of exchange fluctuations falls on the exporter. When the currency of a third country is specified, both importer and exporter incur risks on exchange. Either party may eliminate his risk by the purchase or sale of the required amount of exchange, but, in all transactions between independents, the responsibility for exchange differences is definitely placed. If an importer or exporter does not hedge his commitments, an account for profit or loss on exchange will appear on the books and the amounts recorded therein will represent real speculative gains or losses.

41. If subsidiary companies are treated as wholly autonomous units, gains and losses on exchange will be determined just as they are between independent concerns. A further adjustment for exchange differences will, of course, be necessary if consolidated statements are prepared, or if the investment in subsidiaries is adjusted to compensate for exchange variations. In branch accounting, however, transactions involving foreign exchange are not as a rule handled in the same way as transactions between independents. The practice seems to be for the exporting branch, usually the home office, to record each transaction in its own currency and to keep a memorandum of the amount, expressed in the currency of the importing branch. The importing branch, in the same manner, records the transaction in terms of its own currency, and may keep a memorandum record of the amount in terms of the other currency. Since this procedure applies both to shipments of goods and to remittances, there is no fixing of responsibility for exchange fluctuations. At the end of each accounting period, the trial balances of all foreign branches are converted into the currency of the country in which the home office is located. Since different rates are used in converting the several items of a branch trial balance, a difference which is supposed to represent the gain or loss on exchange will appear. If the debits exceed the credits after conversion, the difference is called a profit on exchange; if credits exceed debits, however, the difference is recorded as a loss. The gain or loss so determined may be entered in the general profit and loss account of the company; it may be added to or subtracted from the reported profit or loss of the branch; or it may be transferred to a reserve for exchange fluctuations and not treated as a profit or loss at all. Methods of accounting for exchange operations are discussed in detail in Appendix A.

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