Accounting for Taxation Jigjiga Management and Public Service College

College of Management and Public Service

Department of Accounting and Finance

Module Title: Accounting for Taxation

Compiled by: Adem Mohammed

December 2024 G.C.

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Accounting for Taxation Jigjiga Management and Public Service College

Contents
Contents...........................................................................................................................................1
Unit One: An Overview of Tax.....................................................................................................3
1.1. Meaning of Tax....................................................................................................................3
1.2. General Characteristics of Tax.............................................................................................4
1.3. Objectives of Taxation..........................................................................................................5
1.3.1. Specific Objectives.......................................................................................................5
1.3.2. General Objectives......................................................................................................5
1.3. Principles of Taxation.......................................................................................................7
1.4. Types of Taxes................................................................................................................10
1.4.1. Direct Taxes............................................................................................................11
1.4.2. Indirect Taxes.........................................................................................................13
1.4.3. Differences between Direct and Indirect Taxes......................................................15
1.5. 1mpact , Shift And Incidence of Tax..............................................................................16
1.5.1. Impact of Tax.........................................................................................................17
1.5.2. Incidence of Tax.....................................................................................................17
1.5.3. Shifting of Tax........................................................................................................18
1.5.4. Effects of Taxation.................................................................................................18
Unit Two: Taxation System........................................................................................................25
2.1. Proportional, Progressive And Regressive Tax Systems................................................25
2.1.1. Proportional Tax System:............................................................................................26
2.1.2. Progressive Tax System:.............................................................................................28
2.1.3. Regressive Tax System:..............................................................................................31
2.1.4. DEGRESSIVE TAX SYSTEM...................................................................................32
2.2. Advalorem And Specific Duties.....................................................................................33
2.2.1. Advalorem Duty:.........................................................................................................34
[Link]. Advantages of Advalorem Duty:......................................................................34
[Link]. Disadvantages of Advalorem Duty:..................................................................34
2.2.2. Specific Duty:..............................................................................................................35
2.2.3. Differences between Advalorem Duty and Specific Duty:.........................................35
2.3. Single Point and Multi-Point Tax Single Point tax............................................................37
2.3.1. Single Point Tax:.............................................................................................................37
2.3.2. Multi-Point Tax:..............................................................................................................37

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2.3.3. Difference between Single Point Tax and Multi-point Tax:.......................................37

2.4. Types of Tax Rates............................................................................................................39
Unit Three: Tax Evasion, Avoidance and Black Money..........................................................41
Introduction...............................................................................................................................41
3.1. Tax Avoidance And Evasion..........................................................................................42
3.2. Causes of Tax Evasion....................................................................................................44
3.3. Remedies for Tax Evasion..............................................................................................45
3.4. Black Money...................................................................................................................46
3.5. Impact of Black Money in Ethiopian Economy..............................................................48
3.6. Sources of Black Income................................................................................................50
3.7. Sources Generating Black Money...................................................................................51
Unit Four......................................................................................................................................64
Direct and Indirect Ethiopian Tax System...............................................................................64
OBJECTIVES OF THE UNIT..................................................................................................64
4.1. Direct taxes Law and Accounting Treatment in Ethiopia...............................................64
Rental Tax = Taxable income X Tax rate less Adjustments.........................................................78
4.2. Indirect Taxes................................................................................................................101
4.4.2. Computation Base for TOT...........................................................................................117
4.4.4. Tax Period......................................................................................................................118
4.5. Excise Tax........................................................................................................................120
4.6. Customs Duty and computation Taxes imposed on imported Goods...........................122
Additional Information:.......................................................................................................130

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Unit One: An Overview of Tax

Introduction

This unit try to cover highlight on the basics of taxation accounting with global understanding
such concepts are the definition of tax, the characteristics of tax, objectives of taxation and list
and discuss principles of taxation and also explains in detail about different types of tax. In
addition to the aforementioned concepts with global perspective about tax, the unit also try to
associate these basics with Ethiopian context in the final part of the unit.
Objective of the unit

After completion of this unit learners will be able:

 Define the word taxation

 Discuss and explain the various characteristic of taxation
 List and explain the different principles of taxation
 Understand the different types of taxes
1.1. Meaning of Tax

A tax is “a compulsory charge imposed by the Government without any expectation of direct
return in benefit ".

In other words, a tax is a compulsory payment or contribution by the people to the Government
for which there is no direct return to the taxpayers. Tax imposes a personal obligation on the
people to pay the tax if they are liable to pay it. The general public should be taxed according to
their ability to pay, and the people in the same financial position should be taxed in the same
way without any discrimination.
Thus, tax can be defined as, "an involuntary fee or more precisely, "unrequited payment", paid
by individuals or businesses to a government (central or local)". Taxes may be paid in cash or
kind (although payments in kind may not always be allowed or classified as taxes in all
systems). The means of taxation, and the uses to which the funds raised through taxation should
be put, are a matter of hot dispute in politics and economics, so discussions of taxation are
frequently tendentious.

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A good tax system should not affect the ability and willingness of the people to work, save and
invest. If not, it will affect the development of trade and industry and the economy as a whole.
Thus, a sound tax system should contribute in the economic development of a country.

 “Tax” is a mandatory contribution by citizens to the

state’s government without expecting from the
government in return to their contribution.

1.2. General Characteristics of Tax

A tax has the following characteristics:

Tax is a Compulsory Contribution: Tax is a compulsory contribution by the taxpayers to the
Government. The people whom the tax is levied cannot refuse to pay the tax. Once it is levied
they have to pay it. Any refusal in this regard leads to punishments.
Benefit is not the Basic Condition: For the payment of tax, there is no direct return or quid
proquo to the taxpayers. That is, people cannot expect any return in benefit for the amount of tax
paid by them. Because, there is no relation between the amount of tax paid by the people and the
services rendered by the Government to the taxpayers.
Personal Obligation: Tax imposes a personal obligation on the taxpayers. When a person
becomes liable to pay the tax, it is the duty of him to pay it and in no way he can escape from it.
Common Interest: The amount of tax received from the people is used for the general and
common benefit of the people as a whole. Now the Government has to render enormous range of
social activities, which incur heavy expenditure. A part of the expense is sought to be raised
through taxation of various types. Thus, taxes are said to be the sharing of common burden by
the people.
Legal Collection: Tax is the legal collection. It can be levied only by the Government both
Central and State.
Element of Sacrifice: Since the tax is paid without any return in benefit, it can be said that there
is the prevalence of sacrifice in the payment of tax.
Regular and Periodical Payment: The payment of tax is regular and periodical in nature. It is
levied for a fixed period usually a year. Thus, almost all the taxes are annual taxes. The payment
of taxes should be regular also.

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No Discrimination: Tax is levied on all people without any discrimination of caste, creed etc.
but according to their ability to pay.
Wide Scope: Tax is levied not only on income but also on property and commodities. To
enhance the revenue and to bring all the people under the tax net, the Government imposes
various kinds of taxes. This enhances the scope of taxes.

1.3. Objectives of Taxation

Government levies and collects taxes for various objectives. These objectives may be specific or
general.

1.3.1. Specific Objectives

The basic purposes of levying taxes are as follows:
1. To support the operation of that government itself.
2. To influence the macro economic performance of the economy, the government's strategy
for doing this is called its fiscal policy.
3. To carry out the functions of the government such as national defense and providing
government services.
4. To redistribute resources between individuals or classes in the population. Historically
the nobility was supported by taxes on the poor modern social security systems and
intended to support the poor by taxes on the rich.
5. To modify patterns of consumption or employment within an economy by making some
classes of transaction more or less attractive.
1.3.2. General Objectives
Taxes are compulsory payments to the Government by the taxpayers. In the beginning,
Government imposed taxes for three basic purposes viz., to cover the cost of administration,
maintaining law and order in the country and for defense.
But, in modern days, there has been a sea change in the Government’s expenditure pattern.
Today, the Government is in the position to restore social justice in the society by way of
providing various social services like education, employment, pension, public health, housing,
sanitation and the development of weaker sections of the society. Thus, Government requires
more amount of revenue than before.

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Let us discuss the general objectives of taxation hereunder:

Raising Revenue: The basic purpose of taxation is raising revenue. To render various economic
and social activities, Government requires large amount of revenue. To meet this enormous
expenditure, Government imposes various types of taxes in addition to the non-tax revenue.
Removal of Inequalities in Income and Wealth: The welfare state aims at the removal of
inequalities in income and wealth. By framing suitable tax policy, this end can be achieved. It is
stressed in the Canon of Equality. In Ethiopia, the progressive taxation on income is the suitable
examples in this regard.
Ensuring Economic Stability: Taxation affects the general level of consumption and
production. Hence, it can be used as an effective tool for achieving economic stability. That is,
by means of taxation the effects of trade cycle i.e. inflation and deflation can be controlled.
During the period of boom or inflation, the excess purchasing power in the hands of people leads
to rise in the price level. Raising the existing tax rates or imposing additional taxes can remove
such excess purchasing power. Then the abnormal demand will be reduced and the economic
stability can be achieved. At the same time, by providing grants, tax exemptions and
concessions, production can be encouraged thereby inflation is controlled.
Likewise, during the period of depression or deflation, the role of tax policy in the economy is
important. Reduction in the existing tax rates and removal of certain taxes, consumption can be
induced which in turn results in increasing demand. This encourages business activities, and the
economic growth can be achieved.
Thus, through properly devised tax system, the economic stability can be achieved by
controlling the effects of trade cycle.
Reduction in Regional Imbalances: It is normal that certain parts of the country are well
developed, whereas some other parts or states are in backward conditions. To remove these
regional imbalances, the Government can use tax measures. By way of announcing various tax
exemptions and concessions to that particular backward regions or states, the economic activities
in those areas can be induced and accelerated.
Capital Accumulation: Tax concessions or rebates given for savings or investment in provident
funds, life insurance, unit trusts, housing banks, post offices banks, investment in shares and

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debentures of certain companies etc. lead to large amount of capital accumulation which is
essential for the promotion of industrial development.
Creation of Employment Opportunities: More employment opportunities can be created by
giving tax concessions or exemptions to small entrepreneurs and to the industries adopting labor-
intensive techniques. In this way, unemployment problem can be solved to certain extent.
Preventing Harmful Consumption: Taxation can be used to prevent harmful consumption. By
way of imposing heavy excise duties on the commodities like liquors, cigars etc. the
consumption of such articles is reduced to a considerable extent.
Beneficial Diversion of Resources: The imposition of heavy duties on nonessential and luxury
goods discourages the producers of such goods. The resources utilized for the production of
these goods may be diverted into the production of other essential goods for which various tax
concessions are given. This is called as beneficial diversion.
Encouragement of Exports: Now-a-days export oriented industries are encouraged by way of
providing various exemptions like 100% relief from income tax, free trade zones etc. It results in
the large earnings of foreign exchange.
Enhancement of Standard of Living: By way of giving various tax concessions to certain
essential goods, the Government enhances the standard of living of people.

 The main goal of collecting tax by any government is

directly related to economic development and improvement
of citizens living standard by bridging the economic
imbalance between the riches and the poor.

1.3. Principles of Taxation

[

The Government requires funds for the performance of its various functions. These funds are
raised through tax and non-tax sources of revenue. Imposing tax on income, property and
commodities etc. raises tax revenues. In fact, tax is the major source of revenue to the
Government. According to Adam Smith, "a tax is a contribution from citizens for the support of
the Government".

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No one likes taxes, but they are a necessary evil in any civilized society. Whether we believe in
big government or small government, governments must have some resources in order to
perform their essential services. So how does one go about evaluating a particular tax?
Taxation is an important instrument for the development of economy of the country. A good tax
system ensures maximum social advantage without any hardship on taxpayers. While framing
the tax policy, the government should consider not only its financial needs but also taxable
capacity of the community. Besides the above, government has to consider some other principles
like equality, simplicity, convenience etc. These principles are sometimes called as "Canons of
Taxation". The following are the important canons of taxation.
I. Principles Advocated by Adam Smith
1. Principle of Equality.
2. Principle of Certainty.
3. Principle of Convenience.
4. Principle of Economy.

II. Principles Advocated by Others

5. Principle of Productivity.
6. Principle of Elasticity.
7. Principle of Diversity.

8. Principle of Simplicity.
9. Principle of Expediency.
10. Canon of Co-ordination.
11. Canon of Neutrality.

Below is presented detail discussion of each cannon which are advocated by Adam Smith and
other well-known scholars in economics.

Principle of Equality: According to this principle of Adam Smith, "the subjects of every state
ought to contribute toward the support of the Government, as nearly as possible, in proportion
to their abilities". That is, a good tax system should be based on the ability to pay of the people.
That is, all people should bear the public expenditure in proportion to their respective abilities.
Tax burden should be more on the rich than on the poor. Since the rich people can pay more for

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public welfare, more tax should be collected from richer section and less tax from the poor. The
ability to pay may be determined either on the basis of income and wealth or on the basis of
consumption i.e. luxury or necessity. In simple terms, canon of equality implies that when ability
to pay is taken into consideration, a good tax should distribute the burden of supporting
government more or less equally among all those who benefit from government.
Principle of Certainty: Another important principle of taxation advocated by Adam Smith is
certainty. According to him, "the tax which each individual is bound to pay ought to be certain
and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, should
be clear and plain to the contributor and every other person". It means the time, amount and
method of payment should all be clear and certain so that the taxpayer can adjust his income and
expenditures accordingly. This principle removes all uncertainties in the payment of tax and
ensures smooth functioning of the tax department.

Principle of Convenience: In the canon of convenience, Adam Smith states that, "every tax
ought to be levied at the time or in the manner in which it is most likely to be convenient for the
contributor to pay it". That is, the tax should be levied and collected in such a way that is
convenient to taxpayer. For example, it may be in installments, land revenue may be collected at
the time of harvest etc. This principle reduces the tendency of tax evasion considerably.
Principle of Economy: The next important canon of taxation is economy. According to Adam
Smith, "every tax ought to be so contrived as both to take out and keep out of the pockets of the
people as the little as possible over and above what it brings into the public treasury of the
state". This principle states that the minimum possible amount should be spent on tax collection
and the maximum part of the collection should be brought to the Government treasury.
Thus the principle of ‘Economy' is naturally sub-divided into two parts viz.,

1. ‘Taxation should be inexpensive in collection', and

2. ‘Taxation should retard as little as possible the growth of wealth'.

Principle of Productivity: According to C.F. Bastable, the tax system should be productive
enough i.e. it should ensure sufficient revenue to the Government and it should encourage
productive activity by encouraging the people to work, save and invest.

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Principle of Elasticity: The next principle advocated by Bastable is elasticity. The taxes should
be flexible. It should be levied in such a way to increase or decrease the tax revenue depending
upon the need. For example, during certain unforeseen situations like floods, war, famine,
drought etc. the Government needs more amount of revenue. If the tax system is elastic in nature,
then the Government can raise adequate funds without any extra cost of collection.
The tax system should be elastic is a desirable canon of taxation. It may, indeed, be regarded as
the agency for realizing at once "Productivity" and "Economy". Where the public revenue does
not admit of easy expansion or reduction according to the growth or decline of expenditure, there
are sure to be financial troubles. For this purpose some important taxes will have to be levied at
varying rates. The particular taxes chosen will vary according to circumstances, but the general
principle of flexibility should be recognised and adopted.
Principle of Diversity: According to this principle, there should be diversity in the tax system of
the country. The burden of the tax should be distributed widely on the entire people of the
country. The burden of the tax should be decentralized so that everyone should pay according to
his ability. To achieve this, the Government should impose both direct and indirect taxes of
various types. It should not depend upon one or two types of taxes alone.
Principle of Simplicity: This principle states that the tax system should be simple, easy and
understandable to the common man. If the tax system is complex and vague, the taxpayer cannot
estimate his tax liability and it will cause irregularities in the payments and leads to corruption.
Principle of Expediency: According to this principle, a tax should be levied after considering
all favorable and unfavorable factors from different angles such as economical, political and
social.
Principle of Co-ordination: In a federal set up like Ethiopia, Federal and State Governments
levy taxes. So, there should be a proper co-ordination between different taxes imposed by
various authorities. Otherwise, it will affect the people adversely.
Principle of Neutrality: This principle stresses that the tax system should not have any adverse
effect. That is, it shouldn’t create any deflationary or inflationary effects in the economy.

1.4. Types of Taxes

Taxes are sometimes referred to as direct or indirect. The meaning of these terms can vary in
different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to

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those taxes that are paid by the person who earns the income. By contrast, the cost of indirect
taxes is borne by someone other than the person responsible for paying them. For example, taxes
on goods are often included in the price of the items, so even though the seller sends the
payments to the government, the buyer is the real payer. Indirect taxes are sometimes described
as hidden taxes because the purchaser of goods or services may not be aware that a proportion of
the price is going to the government.

1.4.1. Direct Taxes

A direct tax is paid by a person on whom it is levied. In direct taxes, the impact and incidence
fall on the same person. If the impact and incident of a tax fall on the same person, it is called as
direct tax. It is borne by the person on whom it is levied and cannot be passed on to others. For
example, when a person is assessed to income tax or wealth tax, he has to pay it and he cannot
shift the tax burden to anybody else. In Ethiopia, Government levies the direct taxes such as
income tax, tax on agricultural income, professional tax, land revenues, taxes on stamps and
registrations etc. From the above discussion, it can be understood that the direct taxes levied in
Ethiopia take the form of taxes on income and property.

[Link]. Advantages of Direct Taxes

Direct taxes have the following advantages:

I. Ensures the Principle of Ability to Pay: Direct taxes are based on the principle of
ability to pay. They fall more heavily on the rich than on the poor. The tax burden is
distributed on different sections of the society in a just and equitable manner.
II. Reduces the Social and Economical Inequalities: Direct taxes reduce a disparity in the
distribution of income and wealth. By adopting the progressive tax system, rich people
pay on higher rates of adopting the progressive tax system, rich people pay on higher
rates of taxation, while the poor pay on lower rates or given exemptions. This reduces the
gap between the poor and rich to a considerable extent.
III. Certainty: Direct taxes satisfy the canon of certainty. In direct taxes, the time of
payment, mode of payment, the amount to be paid etc. are made clear. Both the taxpayers
and the Government know the amounts to be paid and the Government can estimate the
revenue from these taxes.

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IV. Economy: The cost of collection of these taxes is low because the government adopts the
different methods of collections like tax deduction at source, advance payment of tax etc.
Besides, the taxpayers pay the amount of tax directly to government. Thus, the principle
of economy is achieved in the case of direct taxes.
V. Elasticity: Direct taxes are elastic in nature. For example, when the income of the people
increases, the tax revenue also increases. Moreover, during the unforeseen situation like
flood, war etc. the government can raise its revenue by increasing the tax rates without
affecting the poor.
VI. Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the
taxpayers feel the burden of tax directly, they are interested in seeing that the
Government properly spends the money. They are conscious of their rights and
responsibilities as a citizen of the State.
VII. Control the Effects of Trade Cycles: Direct taxes control the effects of trade cycles.
They can be used as a tool to mitigate the effects of inflationary and deflationary trends
by raising or reducing the tax rates.

[Link]. Disadvantages of Direct Taxes

The following are the disadvantages of direct taxes:
I. Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in
measuring the ability to pay tax. Paying capacity of the people cannot be measured
precisely. The levy is highly influenced by the policies of the Government.
II. Difficulties in the Formulation of Progressive Tax Rates: Direct taxes take the form of
progressive taxation i.e. the tax rates increase with the rise in income. It is very difficult
to formulate the ideal progressive rate schedules in this regard, since there is no scientific
base.
III. Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal formalities
such as submission of the income returns, disclosing the sources of income etc.
Moreover, he has to follow numerous accounting procedures which are difficult to
comply with. Further, direct taxes have to be paid in lump sum and at times, advance
payment of tax has to be made. This causes much inconvenience to the taxpayers.

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IV. Possibility of Tax Evasion: The high rates of direct taxes create the tendency to evade
more. There is possibility for tax evasion by fraudulent activities. Thus, it is said that the
direct taxes are the taxes on honesty.
V. Limited Scope: The scope of the direct tax is very limited. In Ethiopia, most of the
people come under or below the middle-income category. If only direct tax is followed,
these people cannot be brought into the tax net because of the basic exemption given.
Thus, the Government cannot depend upon direct tax alone.
VI. Disincentive to Work, Save, and Invest: When the taxpayer earns certain level, they
have to pay more, because of the higher rate of taxes attributed to the higher slabs. This
will in turn discourages them to work further, save and invest.
VII. Expensive to Collect: Under direct taxes, each and every taxpayer is separately assessed.
Thus, the large number of taxpayers to be contacted and assessed and the prevention of
tax evasion make the cost of collection more expensive.

1.4.2. Indirect Taxes

Under indirect taxes, the impact and incidence fall on different persons. It is not borne by the
person on whom it is levied and can be passed on to others. For example, when the excise duty is
levied on the manufacturer of cement, he shifts the burden of tax to the consumers by raising the
selling price. Here the impact of excise duty falls on the manufacturer and the incidence on the
ultimate consumers. The person who is required to pay the tax does not bear its burden. Thus,
indirect taxes can be shifted.
[Link]. Advantages of Indirect Taxes
Indirect taxes have the following advantages:
I. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is
included in the selling price of the commodities, the consumer pays the tax when he
purchases them. He pays the tax in small amounts (installments) and does not feel its
burden. Thus, indirect taxes are quite convenient and less burdensome.
II. Wide Scope: While the people with income and wealth above a certain limit, are brought
under the levy of direct taxes, indirect taxes are paid by all both poor and rich. Under
indirect taxes, everybody pays according to their ability. The tax burden is not imposed
on to the small section but it is widely spread. Thus, the indirect tax has wider scope.

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III. Elastic: The revenue from the indirect taxes can be increased. Whenever the Government
wants to raise its revenue, or lower it, it can be achieved by increasing and decreasing the
rates of taxes on the commodities whose demand is inelastic.
IV. Tax Evasion is Not Possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult. If the person wants to
evade the tax, it can be done only by refraining the consumption of the particular
commodity.
V. Substantial Revenue: Indirect taxes yield substantial revenue to both Central and
State Governments. The developing countries like Ethiopia are heavily dependent on indirect
taxes. Direct taxes have a limited scope in these countries because of low per capita income.
VI. Progressive: Indirect taxes can be made progressive by imposing lower rates of taxes or
giving exemption to the necessary articles and heavy taxes on luxurious articles. Thus,
indirect taxes also confirm the principle of equity.
VII. Effective Allocation of Resources: Indirect taxes have great influence in the allocation
of resources among different sectors of the economy. Resources allocation can be made
effective by imposing heavy excise duties on low priority goods and by granting relief to
industries producing high priority goods. This results into mobilization of resources from
one sector to another positively.
VIII. Discourages the Consumption of Articles Injurious to Health: Indirect taxes
discourage the consumption of certain commodities, which are harmful to health. By
imposing very high rates of taxes on commodities like liquors, drugs, cigarettes etc.,
which are harmful to health, their consumption can be reduced.
[Link]. Disadvantages of Indirect Taxes
The following are the disadvantages of indirect taxes:

I. Ability to Pay Principle is Violated: Indirect taxes are not directly connected to the
taxpayers' ability to pay. Therefore, both the rich and poor equally pay the tax. Thus, the
principle of ability to pay is violated. Indirect taxes are regressive in nature.
II. Uncertainty: If indirect taxes are not levied on the commodities of common
consumption and levied only on luxurious articles, they tend to be inelastic. The quantity
demanded will be affected by the imposition of the taxes. Thus, the revenue generated
from them is uncertain.

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III. Discourages Saving: Indirect taxes are included in the selling price of the commodities.
Hence, the people have to spend more on the purchase of the goods. This, in turn affects
the savings of the people.
IV. High Cost of Collection: Indirect taxes are uneconomical as they involve high cost of
collection.
V. Civic Consciousness is Not Created: Under indirect taxes, taxpayers don’t feel the
burden of the tax. They are not aware of their contribution to the State. Thus, indirect
taxes do not create the civic consciousness in the minds of the people.
VI. Inflationary: The indirect taxes cause an increase in the price all around. The increase in
the prices of raw materials, finished goods and other factors of production creates
inflationary trends in the economy.
1.4.3. Differences between Direct and Indirect Taxes
Direct and Indirect taxes differ among themselves on the following grounds:
1. Shiftability of the Burden of Tax: In the direct taxes, the impact and incidence fall on the
same person. It is borne by the person on whom it is levied and is not passed on to others.
For example, when a person is assessed to income tax, he cannot shift the tax burden to
anybody else, and he himself has to bear it. On the other hand, in the case of indirect taxes,
the impact and incidence fall on different persons. It is not borne by the person on whom it is
levied. The burden of the tax can be shifted. For example, when the manufacturer of cement
pays excise duty, he can shift the tax burden to the buyers by including the tax in the price of
the cement.
2. Principle of Ability to Pay: Direct taxes conform to the principle of ability to pay. For
example, now people having income above Birr.150 pm, only is liable to pay income tax.
But, indirect taxes are borne and paid by the weaker sections of the society also. As such,
these taxes do not conform to the principle of ability to pay.
3. Measurement of Taxable Capacity: In the case of direct taxes, tax-paying capacity is
directly measured. For example, the taxable capacity for income tax is measured on basis of
the income of the individual. On the other hand, in the case of indirect taxes, taxable capacity
is measured indirectly. The luxurious articles are levied at the higher rate of taxes on the
assumption that they are purchased by the rich people. However, low rate is charged on the
articles of common consumption.

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4. Principle of Certainty: Direct taxes ensure the principle of certainty. Both the Government
and the taxpayer know what amount is to be paid and the procedures to be followed. But in
the case of indirect taxes, it is not possible. The taxpayer does not know the amount of tax to
be paid and the Government cannot predict the quantum of revenue generated from the
indirect taxes.
5. Convenience: Direct taxes cause much inconvenience to the taxpayers since they are to be
paid in lump sum. But the indirect taxes are paid by the consumers in small amounts as and
when they purchase the commodities. Moreover, the taxpayers need not follow any legal
formalities in the payment of tax. Thus, indirect taxes are more convenient to them.
6. Civic Consciousness: People felt the burden of direct taxes directly. The taxpayer is
conscious of his contribution to the Government and interested in knowing whether the tax
paid by him is properly used or not. In this way, it creates civic consciousness among the
taxpayers. But indirect taxes do not raise such consciousness among the taxpayers, because
they pay the taxes indirectly.
7. Nature of Taxation: Direct taxes are progressive in nature. The rates of taxes go up with the
increase in the tax base i.e. income of a tax payer. But rich and poor irrespective of their
income equally pay indirect taxes. Thus, they are regressive in nature.
8. Removal of Disparity in Income and Wealth: Since the direct taxes are progressive in
nature, they reduce the disparities of income and wealth among the people to a considerable
extent. But indirect taxes have a negative effect. Actually they are widening the gap between
the rich and poor when they are levied on the goods of common consumption.
Examples: The examples for direct taxes are income tax, wealth tax, gift tax, estate duty etc.
The examples for indirect taxes are customs duty, excise duty, sales tax, service tax etc.

1.5. 1mpact , Shift And Incidence of Tax

The burden of a tax does not always lie on the person from whom it is collected. In many cases,
it is borne by the other people also. Thus, the person who initially pays the tax may not be
actually bearing its money burden as such. Hence, it is necessary to know who bears the
immediate burden of tax and who bears the ultimate burden of tax. According to the law, the tax
is collected from a particular individual or business unit, which has paid the tax in the first

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instance and may transfer it to someone else. If such a shifting of tax takes place, the original
taxpayer has served only as a collecting agent.
In the process of taxing, three concepts are involved. They are as follows:
1. A tax may be imposed on some person.
2. It may be transferred by him to another person i.e. second person.
3. It may be ultimately borne by the second person.

1.5.1. Impact of Tax

The impact of a tax is on the person who pays the tax in first instance. In other words, the person
who pays the tax to the government in the first instance bears its impact. Therefore, the impact
of a tax is the immediate result of the imposition of a tax on the person who pays it in the first
instance. It refers to the immediate burden of the tax and not to the ultimate burden of the tax.

1.5.2. Incidence of Tax

Incidence of a tax means the final or ultimate resting place of the burden of the tax payment. It
refers to the point at which "tax chickens finally come to the roost ". That is, the location of the
ultimate tax burden. The incidence of a tax is different from its impact, which refers to the point
of original assessment.
If an individual who pays the tax in the first instance finds that he cannot transfer or shift the
burden of the tax to anybody else, then the incidence as well as the impact is on the same person.
If the original or the first taxpayer is able to transfer or shift the tax burden to someone else, then
the shifting of tax will be taken place. For example, the Government levies a tax say, excise duty
on cement and collects the tax from the manufacturer of cement. Now, the impact of the tax is on
the manufacturer. If he is able to pass on the money burden of the tax to the wholesaler by means
of raising the price, then the manufacturer has shifted the tax i.e. he transferred the money
burden to the wholesaler. This process continues and ultimately the consumer bears the money
burden of the tax. Hence, the incidence is on the final consumer.

There are two major economic principles in the analysis of taxation. They are: (i) the incidence
of the tax, and (ii) its effects on economic efficiency (referred to as the excess burden or welfare
cost of the tax). These principles are applicable to all taxes.
Concepts of Tax Incidence:

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The main issue in the economic analysis of any tax is the identification of the individual or
group of individuals on whom the burden of the tax rests. This is the incidence of the tax. There
are two concepts of tax incidence. They are as follows:
Legal Incidence: The individual or group of individuals who have the legal responsibility for
paying the tax to the government bears the legal incidence of the tax.
Economic Incidence: The individual or group of individuals, whose real income, welfare or
utility is reduced by the tax, bears the economic incidence. The economic incidence is
independent of the legal incidence; that is, those who bear the legal incidence may be different
from those who bear the economic incidence. When the economic incidence differs from the
legal incidence, the burden of the tax is said to be "Shifted". The effects of a tax on the
allocation of resources and on the distribution of income depend on the economic incidence, not
the legal incidence.

1.5.3. Shifting of Tax

It refers to the process by which the money burden of a tax is transferred from one person to
another. Whenever there is a shifting of taxation, the tax may be shifted either forward or
backward.
A producer, upon whom a tax has been imposed, may shift the tax burden to the consumer or to
the factors of production. If the producer shifts the tax burden to the consumer, it is known as
"Forward Shifting". On the other hand, if the producer shifts the tax burden to the factors of
production i.e. to the suppliers of raw materials etc., it is known as "Backward Shifting". The
backward shifting can be taken place by compelling the supplier to reduce the price of raw
materials etc.
Differences between Impact and Incidence:
1. The impact refers to the initial money burden of the tax. But the incidence refers to
ultimate money burden of tax.
2. The impact is felt by the person from whom tax is collected. But the incidence is felt by
the person who actually pays tax.
3. Impact can be shifted. But incidence cannot be shifted.

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1.5.4. Effects of Taxation

Now-a-days, revenue rising is not the only purpose of taxation. In a Welfare State, taxation has
also been used as a tool of monetary policy to achieve socio-economic objectives. It is used to
promote economic growth by controlling the effects of trade cycles and regulating the
production and consumption. It has also been used to reduce the inequalities of income and
wealth.
Thus, in the modern context, the effects of taxation, which are shown in Figure 3.3, may be
summarized as follows.

[Link]. Effects of Taxation on Production

All taxes must evidently come from the produce of land and labour, since there is no other
source of wealth than the union of human exertion with the material and forces of nature. But the
manner in which equal amounts of taxation may be imposed may very differently affect the
production of wealth. Taxation, which lessens the reward of the producer necessarily, lessens the
incentive to production; taxation, which is conditioned upon the act of production, or the use of
any of the three factors of production, necessarily discourages production. Thus taxation, which
diminishes the earnings of the labourer or the returns of the capitalist, tends to render the one
less industrious and intelligent, the other less disposed to save and invest. Taxation, which falls
upon the processes of production, interposes an artificial obstacle to the creation of wealth.
Taxation which falls upon labour as it is exerted, wealth as it is used as capital, land as it is
cultivated, will manifestly tend to discourage production much more powerfully than taxation to
the same amount levied upon labourers, whether they work or play, upon wealth whether used
productively or unproductively, or upon land whether cultivated or left waste.
Taxation can influence the production of a nation by influencing four basic factors.
They are as follows:

1. Ability to work, save and invest.

2. Willingness to work, save and invest.
3. Diversion or allocation of resources between industries and places.
4. On the size of the industries.

Let us discuss these factors one by one.

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Effects on the Ability to Work, Save and Invest:

Taxation transfers the money income from the public to the government and thereby reducing
their purchasing power. The reduction in purchasing power reduces their ability to obtain
necessaries and luxuries of life.
Thus, the levy of taxes on people reduces their consumption of necessaries and comforts, which
lowers the standard of living. When the standard of living is affected, their efficiency and ability
to work will also be adversely affected. This effect is strongly felt by the poor people. But the
efficiency and ability to work of rich people is not so much affected by taxation.
The savings of the people depends upon their income. When income is reduced by taxation,
savings will also be reduced. The ability of the people to invest largely depends upon their
savings. When their savings are reduced by taxation, their ability to invest is also automatically
reduced by taxation.
Effects of Taxation on willingness to Work, Save and Invest:

Taxation affects the desire of the people to work, save and invest. If the willingness of the
people to work, save and invest is affected by taxation, the production will automatically be
affected. It is universally recognised that direct taxes have more adverse effect on the willingness
of the people to work, save and invest.
It is argued on the grounds of psychological reactions of the people. That is, when the higher
progressive taxation is levied, the Government takes the major portion of their additional
earnings back. This may create a tendency in the minds of the people not to take risk to work
hard to earn such a meagre income.
However, reasonable taxation may not have any such bad effect on the desire to work, save and
invest.

Effects of Taxation on the Diversion of Economic Resources:

While the volume of production of a country depends upon the ability and willingness to work,
save and invest, the pattern of production depends upon the allocation of economic resources
between different industries and regions. Taxation can be used in the diversion of economic
resources among the industries and regions. Thus, taxation can influence not only the size of
production but also the pattern of production.

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The diversion may be beneficial diversion or harmful diversion. Taxation on the commodities
that are injurious to the health like cigarettes and liquors may discourage their consumption,
which in turn affects their production. The factors of production engaged in these industries may
be diverted to some other industries producing goods of common consumption etc. This is a
"Beneficial Diversion".
The taxation on the goods of common consumption will increase their price. Hence, the
consumption of such goods may be reduced. This will affect the production of these
commodities, and the resources used in their production may be diverted to the production of
some other commodities which may be in the nature of luxury or harmful to health. Thus, such a
diversion of resources is harmful and is socially not desirable. It is known as "Harmful
Diversion".

Effects on the Size of Industries

When taxes are imposed without any discrimination on the commodities produced by both small
and large-scale industries, the production of small-scale industries will be highly affected. This is
because there cannot be any economies of large-scale operation. Thus, the cost of production of
these industries will normally be high. If taxes are levied on par with the large-scale industries,
the total selling price of small sized industries will increase further. This will affect the
competitive efficiency of small-scale industries, which in turn affects the production, and
survival of these industries. Hence, tax concessions should be given to encourage the production
of these industries.

[Link]. Effects of Taxation on Distribution:

An important objective of taxation in most of the welfare states is to reduce the inequalities of
income and wealth and to bring about an equal society. The effects of taxation on the
distribution of income and wealth among the different sections of the society, depends upon two
important factors. They are as below:
1. Nature of Taxation, and
2. Kinds of Taxes.

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1. Nature of Taxation
The nature of taxation influences the distribution of tax among the different sections of the
society. It includes proportional regressive and progressive nature of taxation.
I. Effects of Regressive Taxation on Distribution: Under regressive taxation, the
burden of taxation falls more heavily upon the poor than on the rich. Regressive
taxation may increase the inequalities on the distribution of income and wealth.
Hence, the burden of taxation is higher on the poor than on the rich. In effect, this
system widens the gap between the rich and the poor.
II. Effects of Proportional Taxation on Distribution: Under the proportional taxation,
taxes are levied uniformly upon the rich and the poor. When the tax rate remains the
same, it creates inequalities between them. However, if there is any increase in the
income of these sections, the inequalities in distribution of income will also increase.
The burden of taxation falls more heavily upon the poor than on the rich.
III. Effects of Progressive Taxation on Distribution: Under the system of progressive
taxation, the tax rates go up with the increase in the income. Thus, in this system, the
inequalities in the income and wealth will be reduced. The major portion of the
income and the wealth of the rich is taken away by way of higher tax rates. Hence,
the progressive tax system tends to reduce the inequalities in the distribution of
income and wealth.
2. Kinds of Taxes.
The effects of taxation depend upon the kinds of taxes i.e. direct or indirect taxes.
I. Effects of Direct Taxes on Distribution: Direct taxes take the form of taxation on the
income and property. It attempts to reduce the income of the richer sections and transfers the
income to the Government. The Government may use these resources to raise the standard of
living of the poor. Therefore, all those taxes, which fall heavily upon the higher income groups,
can have favourable distributional effects.
II. Effects of Indirect Taxes on Distribution: Indirect taxes are levied on commodities.
They fall heavily on the lower and middle-income groups who spend a large portion of their
income on commodities. In such a situation, indirect taxes have adverse distributional effects.
However, indirect taxes may be made progressive if the necessaries are exempted from taxation
or levied on low tax rates, and luxuries are subjected to higher rates of taxes.

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[Link]. Effects of Taxation on Consumption:

Taxes increases the price of the taxed goods relative to the prices of untaxed or lower taxed
goods. The increase in the relative price affects the taxpayer in two ways.
1. Income Effect: The tax reduces the taxpayer's purchasing power or real income. It takes
resources away from the taxpayer and transfers them to the government. This is often referred to
as the direct burden of the tax.
2. Substitution (or Price) Effect : The tax creates an incentive for the taxpayer to
substitute less preferred but untaxed or lower-taxed goods for the more-preferred taxed good.
The loss in consumer utility from this substitution is the excess burden (or welfare cost) of the
tax.
Taxation influences the consumption as well. Such influence can be studied on the following
grounds:
1. Influence the Allocation of Resource of Individuals

Every individual has limited money income and allocate it to different uses. Taxation affects
their allocation directly or indirectly. For example, the income tax reduces the money income of
a consumer and forces him to buy a smaller volume of goods and it reduces the standard of
living of the consumers. Likewise, a levy of indirect taxes on the goods of common consumption
will affect the allocation of individual resources. Thus, taxes influence the allocation of
resources of individuals.
2. Effects of Taxation on Consumption and Employment

Taxation reduces the purchasing power of the people and it reduces their consumption. The
decline in consumption leads to decrease in effective demand for the goods and services, which
in turn affects the production of these commodities. Ultimately, the reduction in consumption
leads to a reduction in employment opportunities. For example, due to rise in price, instead of
getting two different commodities, the individual may buy more quantity of any one commodity
to maximise the utility and his satisfaction.

3. Effects of Taxation on Consumption during Inflation and Depression

Taxation has different effects in times of inflation and depression. During the time of inflation,
the purchasing power of the people is reduced by a raise in the rates of existing taxes or

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imposition of new taxes. This would control the consumption and therefore, help in bringing up
stability in prices.
During the period of depression, taxation may be reduced. As the result of the reduction on
direct tax rates, the people will have more disposable income and higher purchasing power and a
decrease in indirect taxes leads to the reduction of selling prices. Both of them encourage the
total consumption of the people and thereby the economic activities are induced in the country.
4. Regulatory Effect of Taxation on Consumption:
Taxation may be used to regulate the production and consumption. Consumption can be
regulated by taxing the production and use of certain commodities. For example, the object of
some taxes may be to reduce the consumption of certain harmful commodities such as liquors,
cigars etc.

Unit Summary

Tax is a compulsory charge by the government on individuals without any direct reciprocal
service. Taxes are as old as human beings. Despite the old-aged nature of taxes, their imposition
has never been smooth. Theories and principles that were supposed to improve tax systems and
enable the creation of good tax systems have been coined by several authors and thinkers. Those
principles and theories have guided tax policy makers and legislators and they have improved
taxes and tax systems tremendously. Nevertheless, none of them have been perfect to be free of
criticisms and they have not succeeded in creating a perfect tax system. Sometimes the
prevalence of trade-offs among the accepted principles of a good tax system has created
challenges in realizing a good tax system. That makes the development of taxes is a continuous
and unfinished process. So far we have got a grasp of the basic concepts of taxation and tax law.
It is expected that the knowledge obtained here will be used to evaluate the contents that are to
be discussed in the subsequent chapters. Once one has acquainted with the basic notions of
taxation in this unit, he/she will be confronted by detailed chapters covering various types of
taxes that are currently in use by the government of Ethiopia. The following chapters will discuss
various types of taxes such as the Income-tax, the Value Added Tax, the Property Tax, the Stamp
Duty tax, the Turnover Tax, the Customs Duties, and other related taxes that are in use currently.

Self-Checking questions

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Part I-Multiple Choice Questions

Choose the correct answer from the given alternatives for each of the following questions
1. Public finance has to do with all of the following activities of the government
except_____________.
A. Stabilization activities B. Allocation activities
C. Competition with private sector D. Distribution activities
2. Which of the following is not the economic role of the government?
A. Increase employment B. Fiscal policy to curb or prevent undesirable wants
C. Balanced regional development D. Reduction in economic inequalities
3. The most important source of revenue to the states is_____.
A. Gants B. Taxes C. Donations D. Loan
4. The income of the state is referred to as ____________________.
A. Public revenue B. Public debt C. Public expenditure D. Public
loan
5. Which is the main objective of a tax?
A. Increase in consumption B. Increase in production
C. Raising public revenue D. Reduction in capital formation
Part II. Discussion questions
1. Define public finance clearly.
2. Discuss how public finance is different from public finance.
3. Explain the roles of the government in the economy.
4. Elucidate the scope of public finance

Unit Two: Taxation System

Introduction

This unit will cover the concept of tax systems, the different types of tax duties and discuss and
explain about the different types of tax points. The unit also will cover and discuss on tax rates
and tax bases particularly associated with Ethiopian tax law.

Objective of the unit

In completion of this unit, learners will be able to:

 List, explain and discuss various types of tax systems

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 Discuss advantages and disadvantages of the different tax systems

 Explain about advolerm and specific duties
 Differentiate between single and multiple tax points
 Understand the term tax rate and tax income base according to Ethiopian context

2.1. Proportional, Progressive And Regressive Tax Systems

The ability to pay taxes can be accurately measured with net income. It may be considered as an
appropriate basis for the allocation of tax burden between different sections of the society. To
determine the appropriate tax system, various factors are to be considered. The tax systems may
be summarized as follows:
1. Proportional Tax System.
2. Progressive Tax System.
3. Regressive Tax System.

Let us now discuss each of the above tax system in detail.

2.1.1. Proportional Tax System:

A proportional tax, also called a flat tax is a system that taxes all entities in a class typically
either citizens or corporations at the same rate (as a proportion on income), as opposed to a
graduated or progressive scheme. The term “Flat Tax” is one where the tax amount is fixed as a
function of income and is a term mainly used in the context of income taxes.
Advocates say that a flat tax system may arguably have most of the benefits of a progressive tax,
depending on whether the flat rate is combined with a significant threshold. Usually the flat tax
is proposed to kick in at a certain income level, or to exempt income below that level, so that the
lowest-income members of society pay no income tax. Technically, this is a two stage
progressive tax rather than a flat tax.

Advocates of a flat tax claim that it will end unfair discrimination. They also argue that flat taxes
are easier (and cheaper) to administer and comply with than complex, graduated taxes. Most
political parties that advocate the introduction of a flat tax are on the right of the political
spectrum.
Those who oppose a flat tax claim that it will benefit the rich at the expense of the poor. One
argument is that, since most other taxes (sales taxes etc.) tend to be regressive in practice,

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making the income tax flat will actually make the overall tax structure regressive (i.e. lower-
income people will pay a higher proportion of their income in total taxes compared with the
affluent). Another argument can be made by looking upon the value of money to various groups
and not simply the rate of taxation. While the monetary value of a dollar (or other unit of
currency) is the same for everyone, it is clearly “Worth” a lot more to someone who is
struggling to afford food than to a millionaire. Taxing everyone at the same rate ignores the fact
that richer people can give up more of their income, without ill effects. Moreover, it is debatable
whether a flat tax would substantially simplify the tax system.
This implies that the rates of taxation should be the same regardless of the size of the income i.e.
"the system in which the rates of taxation remain constant as the tax base changes".
Mathematically, it can be defined as follows: "The amount of tax payable is calculated by
multiplying the tax base with the tax rate".

 Tax Payable= Tax Base X Tax Rate

Thus, in the case of proportional tax systems "Multiplier remains constant with the changes in
multiplicand (income)".
Economically, it can be explained as follows:

Example of Proportional Tax System:

Tax Base ( in Birr)

Tax Rate in % Amount of Tax (in Birr)
5000 10 500
10,000 10 1000
15,000 10 1500
25,750 10 2575
40,000 10 4000
75,500 10 7550
Table 2.1 - Proportional Taxation
Graphically, it can be explained as follows:

Tax Rate(in %)

Tax Base (in birr)

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FIG. 2.1 - PROPORTIONAL TAX SYSTEM

Advantages of Proportional Tax System:
Proportional tax system has the following advantages:
1. It is simple in nature.
2. It is uniformly applicable.
3. Proportional taxation leaves the relative economic status of taxpayers unchanged.
4. It will avoid mistakes and drawbacks of progressive tax system.

Disadvantages of Proportional Tax System:

The following are the demerits of proportional tax system:

1. Inequitable Distribution: A system of proportional taxation would not lead to an

equitable and just direction of the burden of taxation. This is because it falls more heavily on the
small incomes than on the high incomes.
2. Inadequate Resources: The system of proportional taxation means that the tax rates for
the rich and poor are the same. Hence, the government cannot obtain from the richer sections of
the society as much as they can give.
3. Inelastic in Nature: Proportional tax system is inelastic in nature, because the
government cannot raise the rate whenever it wants to raise the revenue. Proportional tax system
suffers from the defects of inequitable distribution of the tax burden, lack of elasticity and
inadequacy of funds for the increasing needs of the modern government. Hence, it is not
practically and universally accepted.

2.1.2. Progressive Tax System:

A progressive tax or graduated tax is a tax that is larger as a percentage of income for those with
larger incomes. It is usually applied in reference to income taxes, where people with more
income pay a higher percentage of it in taxes. The term progressive refers to the way the rate
progresses from low to high.
Each taxpayer faces two tax rates, his average income tax rate (the proportion of income spent in
income taxes) and his marginal rate (the portion of each additional Birr in income that would be

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taken away in taxes). Progressivity of the income tax (higher rates for higher segments of
income) means that marginal tax rates are generally higher than average rates.

Thus, the progressive tax system can be defined as "a system in which rates of taxation would
increase with the increase in income i.e. higher the income, higher would be the rate of tax".

The rates of taxation increases as the tax base increases. This can be explained mathematically as
follows. The amount of tax payable is calculated by multiplying the tax base with tax rate as
shown below:
Tax Payable= Tax Base X Tax Rate

In this case, "the multiplier increases as the multiplicand (income) increases".

Economically, this can be explained as under:

Progressive Tax System

Employment income Income Tax (per month)
payable
From Birr to Birr %
0 600 Exempt threshold
601 1650 10
1651 3200 15
3201 5250 20
5251 7800 25
7801 10900 30
Over 10900 **** 35
Table 2.2 Progressive Taxation
From the above example, we can easily understand about the progressive tax system where the
rate of tax increases with the increase in tax base.

Graphically, it can be explained as follows:

Tax Rate (in %)

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Tax Base (in birr)

Fig. 2.2 – Progressive Tax System

[Link]. Advantages of Progressive Tax System

It is argued that if the utility gained from income exhibits diminishing marginal returns, then for
the tax burden to be vertically equitable, those with higher incomes must be taxed at higher rate.
The advantages of progressive tax system include the following:
1. Equality in Sacrifice: Under progressive tax system, the rate of taxation increases as the
tax base increases. That is, the burden of taxation is heavy upon the rich than on the poor. People
with higher income tend to have a higher percentage of that in disposable income, and can thus
afford a greater tax burden. Thus, this system secures equality in sacrifice by ensuring the
principle of ability to pay.
2. Reducing the Inequalities of Income and Wealth: Progressive tax system serves as a
powerful instrument for reducing the inequalities of income and wealth.
3. Economy: In the progressive system, the cost of collection does not increase with the
increase in the rate of taxes. Hence, it is justified on the grounds of economy.
4. Elastic: Progressive tax system is elastic in nature to meet the increasing public
expenditure. The government can easily raise its revenue by increasing the rates of taxes. In the
case of progressive taxation, raising the rates for the higher status alone can raise more revenue.
5. Stabilising the Economy: Progressive tax system may be helpful in preventing the
inflationary trends in the economy as it reduces the disposable income and purchasing power of
the people. Thus, the inflationary trends can be checked and the economic stability can be
achieved.

[Link]. Disadvantages of Progressive Tax System:

The following are the demerits of progressive tax system:

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1. Ideal Progression is Impossible: The main drawback of progressive taxation is that it is

difficult to frame an ideal graduated progression in tax rates. They are arbitrary depending on the
government’s need for additional funds without taking into account the burden of people with
different incomes.
2. Progressive Taxation - a Graduated Robbery: Progressive taxation is an unjust mode
of taxation and a graduated robbery.
3. Disincentive to Work: It is argued that too progressive a tax rate acts as a disincentive to
work.
4. Discourages Savings and Investments: Very high rates of progressive taxes used to
discourage savings and investments. Since a major portion of the income is taken away by the
state by way of taxes, the incentives to produce more and earn more are lost.
5. Shifts the Total Economic Production of Society: The progressive tax system shifts the
total economic production of society away from capital investments (tools, machinery,
infrastructure, research etc.) and toward present consumption goods. This could happen because
high-income earners tend to pay for capital goods (through investment activities) and low-
income earners tend to purchase consumables. Since, progressive tax system discourages savings
and investments the shifting of economic production of society could happen. Smithian theory
says that spending more on consumption goods and less on capital goods will slow the rise of the
standard of living.

2.1.3. Regressive Tax System:

In regressive tax system, the amount of tax is smaller as a percentage of income for people with
larger incomes. Many taxes other than the income tax tend to be regressive in practice. For
example, most sales taxes (since lower income people spend a larger portion of their income),
excise duty etc. are regressive in nature if they are levied on the goods of common consumption.

Thus, regressive tax is a tax, which taxes a larger percentage of income from people whose
income is low. It places more burden on those with lower incomes. It is the system in which the
rate of tax declines with the increase in the income or value of property. Larger the assessee’s
income or property, the lower the percentage that he pays as tax in regressive taxation.

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"The tax rate decreases as the tax base increases". The amount of tax payable is

calculated by multiplying the Tax Base with Tax Rate.

Tax Payable= Tax Base X Tax Rate

The schedule of regressive tax rate is one in which the rates of taxation decreases as the tax base
increases. The following table and diagram will explain the concept of regressive taxation.

Regressive Tax System

Income Rate of Tax (%) Tax To be
Birr Paid (Birr)
5000 20 1000
8000 15 1200
15000 12 1800
20000 10 2000
Table 2.3 Regressive Taxation

Diagrammatically, it can be explained as follows:

Tax Rate (in %)

Tax Base (in birr)

Fig. 2.2 – Progressive Tax System

As regressive taxes fall more heavily on the poor section of the community, than on the richer
section, it violates the principles of equity and social justice. That is, through regressive taxation,
principle of equity and social justice cannot be followed. In a welfare country like Ethiopia,
whose object is to establish a socialistic state without inequalities in the distribution of income
and wealth, regressive taxation has no place.

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Even non-income taxes can regressive relative to income. The regressivity of a particular tax
often depends on the propensity of the taxpayers to engage in the taxed activity relative to their
income. To determine whether a tax is regressive, the income elasticity of the goods being taxed
as well as the income-substitution effect must be considered.

2.1.4. DEGRESSIVE TAX SYSTEM

Under this system, the rate of tax is mildly progressive up to a certain limit and thereafter it may
be fixed at a flat rate.
The amount of tax payable is calculated by multiplying the Tax Base with the Tax Rate.

 Tax Payable= Tax Base X Tax Rate

The concept of degressive taxation can be explained with the help of the following table.

Tax Base Tax Rate Tax Liability

Income (in % ) (Birr)
(Birr)

4000 20 % 8, 000
6000 21 % 12, 600
12000 22 % 26, 400
15000 23 % 34, 500
20000 23 % 46, 000

Diagrammatically, it can be explained as follows:

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Tax Rate
(%)

Tax Base - Income (Birr)

Fig. 2.4. Degressive Taxation

This system is not popular and is universally not applicable.

2.2. Advalorem And Specific Duties

There are two kinds of duties levied on the commodities. Generally, it is levied on the goods
crossing the national boundaries. They are:

1. Advalorem duty - on the basis of value.

2. Specific duty - on the basis of measurement.

2.2.1. Advalorem Duty:

It is levied on the basis of value of the commodities. Advalorem means, "In proposition to
value". This is levied as a certain percentage on the value of commodity to be taxed. For
example, when a TV set is imported, customs duty may be levied at say 200 % on the value of
the TV set. The weight, length or bulky of the goods imported are irrelevant for this purpose.
Thus duty payable will be calculated only on the total value of the goods to be taxed and not on
its weight, length, bulky etc.

[Link]. Advantages of Advalorem Duty:

Advalorem duty is recommended for the following reasons:

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1. Value of the Commodities can be Easily Found Out: Customs duty under this form is
imposed on the value of commodities. The value of imported articles can be more easily found
than their weight, size, bulky etc.
2. Keeps the Tax Burden Steady: Advalorem duty keeps the burden of tax steady. During
the times of boom, the tax liability tends to rise and in times of recession, the tax liability also
goes down.
3. Higher Revenue during Inflation: Advalorem duty brings higher revenue during the
periods of rising prices, because when the price tends to increase the revenues yield also
increases.
[Link]. Disadvantages of Advalorem Duty:

The following are the important drawbacks of advalorem duty:

1. Difficult to Administer: Advalorem duty is very difficult to administer. Under this form,
customs duty is imposed on the value of the commodity. But in practice, it is very difficult to
estimate the value of thousands of articles imported from a large number of countries.
2. Difficult to Estimate Value: Even if the value of goods is ascertained, there is a chance for
controversy whether F.O.B. (Free on Board) or the C.I.F. (Cost Insurance Freight) or local
selling price should be taken into account for levy of duty.
3. Difficult to Predict Quantum of Revenue: The Government cannot correctly predict the
quantum of revenue yield from customs duties since under the advalorem basis, revenue yield
will rise or fall depending on the rise or fall of the value of goods. Hence, there is no certainty
with regard to the rationalization of budget estimate of this revenue.
2.2.2. Specific Duty:

It is levied as to the weight, length, bulky or some other unit of measurement of the commodity
concerned. The value of goods imported or exported is not important for this purpose. Only
weight, length, bulky etc. of the commodities decide the quantum of duties.

[Link]. Advantages of Specific Duty:

1. Less Chance of Tax Evasion: Specific duty is imposed on units of measurement, which are
easily ascertainable. So, there is less chance of tax evasion.

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2. Easy to Administer and Collect: Specific duties are easier to administer and collect. Once it
is possible to identify the goods, it is easy to administer and collect.
3. Certainty in the Amount of Duty: Specific duty helps the importer to know exactly the
amount of duty he will have to pay in respect of consignment. For example, when he imports
certain quantities of oil, he can easily and correctly calculate the amount of duty, as it is
related to the quantity of oil imported.
4. Certainty in the Quantum of Revenue: Government can also easily predict the quantum of
revenue yield from customs duties, because these are related to quantity of the goods to be
imported.
[Link]. Disadvantages of Specific Duty:
1. Static in Revenue Yield: Specific duties keep the revenue yield static in nature
i.e. it will not generate large volume of revenue during the inflationary periods.
2. Tax Burden Increase in Depression: Tax burden of specific duties increases in depression.
In time of recession, specific duties tend to increase the tax burden, because there is an
overall downward trend in prices, taxes will be imposed only on the basis of the
commodities’ weight or length or bulky etc., and not on the actual value of the commodity.

2.2.3. Differences between Advalorem Duty and Specific Duty:

Advalorem duty is levied on a certain percentage on the value of the commodity to be taxed and
weight, length or bulky of the goods are not important for this purpose. Specific duty is levied
according to the weight, length, bulky or some other unit of measurement of the commodity
concerned.

Comparison Criteria Advalorem Duty Specific Duty

Basis of Levy Advalorem duty is levied on the Specific duty is levied as to the
certain percentage on the value weight, length, bulky, etc. of the
of commodity to be taxed. commodity to be taxed.

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Administration of Duty It is very difficult to administer. It is easier to administer and collect.

Thus the duty is levied on the Once it is possible to identify the
value of commodity. But, in goods, it is easy to levy and collect
practice it is very difficult to tax.
estimate the value of thousands
of commodities imported from a
large number of countries

Prediction of Quantum Under advalorem duty, the Under specific duty, the Government
government cannot correctly can easily predict the quantum of
Revenue
predict the quantum of revenue revenue yield.
yield

Chance of Tax Evasion Under advalorems duty, the Under specific duty, unit of
government cannot correctly measurement of commodities i.e
predict the quantum of weight, length, bulketc, can be
revenue yield. ascertained at any time. Hence there is
less chance of tax evasion.

Tax Burden Advalorem duty keeps the Specific duty does not keep the tax
burden of tax steady i.e during burden steady. For example, in time of
the times of boom the tax recession, there is an overall
liability tends to rise in time of downward trend in prices, tax will be
recession, the liability also goes imposed only on the basis of
down. commodities weight, length etc, and
not on the value of the commodity.
Hence, specific duty increase the tax
burden during that period.

Revenue Yield Advalorem duty brings higher Under specific duty, revenue yield is
revenue during the period of of static in nature.
rising prices. Because when the

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price tends to increase, the

revenue yield also increases.

2.3. Single Point and Multi-Point Tax Single Point tax

2.3.1. Single Point Tax:

Single Point taxation means imposition of tax at only one point between the production and the
sale of goods to ultimate consumers. The tax is levied at only one point between the point of
production (first point) and the point of ultimate sale to consumption (final point). At the first
point, sales tax for example is levied, when the sale of commodity takes place for the first time
in the territorial limit of the concerned State. At the final point, the tax is imposed at the last
stage of sale to the consumers. Thus, a single point tax is levied either at the first stage or at the
final stage.

2.3.2. Multi-Point Tax:

Multi-point taxation means that the tax is levied at all stages of sale of the commodity. Tax is
levied and collected whenever goods are sold at every point of sale.

2.3.3. Difference between Single Point Tax and Multi-point Tax:

The following are the differences between Single Point Tax and Multi-point Tax systems:

1. Facility of Collection: Single point tax is easy to enforce and collect, but multipoint tax is
difficult to enforce and collect because of number of points at which it is collected.
2. Payment of Tax on Tax: Under single point tax system, tax is paid on the price of the product,
which does not include tax as one of its component. Hence, the payment of tax on tax is not
occurred, whereas in multi-point tax system in each subsequent point, tax is paid on the price
which includes the tax paid at the proceeding points also. Thus, the payment of tax on tax is
occurred.
3. Point of Levy: Under single point tax system, the tax is levied at only one point either at the first
point or at the final point, whereas under multi-point tax system, the tax is levied at all points of
sale till it is sold to the consumers.

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4. Capital Requirements: In single point sales tax system, the capital requirements are low. But in
multi-point sales tax, the manufacturer or dealer of every stage is required to raise capital not
only for the actual cost of manufacture or purchase but also for payment of tax. As a result,
interest on such additional capital also becomes a part of the cost at this point and which has a
further rise in price. Hence, the capital requirement under this system is high.
5. Price for the Consumer: Under single point tax, the price paid by the consumer is less than the
price paid under multi-point tax system. The price paid by the consumer under multi-point sales
tax includes cost of the products and tax paid by the previous sellers. The price paid by the
consumer under multi-point sales tax is more than price paid under single point tax.

6. Quantum of Revenue: From the revenue angle, single point system generates less amount of
revenue when comparing with multi-point tax system. In multi-point tax system, more revenue
can be raised than that of the single point tax system.
7. Chance for Tax Evasion: Under single point tax system, the possibility for tax evasion is more,
whereas under Multi-point tax system, it is difficult to evade tax.
8. Rate of Tax: Usually, under single point tax system, the rate is high, whereas in the case of
multi-point tax system, the rates of taxes are low.
9. Administration: The number of dealers to be assessed under single point tax is very small.
Hence, it is convenient to administer this system. But the administration of multi-point tax is
difficult because large number of dealers is to be dealt with.
10. Exemption: The number of goods exempted under single point tax is more. But the number of
goods exempted under multi-point tax is less.

2.4. Types of Tax Rates

1. Statutory Rate:

The Statutory rates are the rates imposed by the statute or Laws or Proclamations. For example
in Ethiopia the following are the statutory rates for Income tax under Income tax Proclamation.

Schedule A
Employment income Income Tax (per month)
payable
Over Birr to Birr %

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0 600 Exempt threshold

651 1650 10
1651 3200 15
3201 5250 20
5251 7800 25
7801 10900 30
Over 10900 **** 35
2. Marginal Rate

The Marginal rates are the rates imposed on each additional Birr earned within each tax bracket.
Example: [Link] has the actual income of Birr 11,400. The deductions and exclusions as per
Income Tax Proclamation amounts to Birr.4145.50. His taxable income = 11,400-4145.50=
7255.

His tax liability:

-0 % on first 600 Birr = 0
-10 % on next 1050 Birr = 105
-15 % on next 1550 Birr = 232.5
-20% on next 2050 Birr = 410
-25% on next 2550 Birr = 637.5
-30% on next 3100 Birr = 930
-35% on balance---- 500 Birr = 17.5
Total Tax liability 2,332.5

Here, in this case, Marginal Tax Rate = 30%

3. Average Rate:
Average tax rate is the fraction of total income earned that is paid in taxes. It is not our income
per se, but our income as determined by the Proclamation.

Average tax rate = tax paid / Taxable Income x 100

= 2332.5/ 10800 x 100 = 21.59%

4. Effective Rate

Effective tax rate is calculated as follows:

Effective rate = tax paid / actual income x 100

Effective rate = tax paid / actual income (2332.5 / 11400) x 100 = 20.46%

Unit Summary

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This unit provides a brief introduction to the Tax System. With all its imperfections, there is a
system underlying all of the taxes. This unit provides a brief overview of the tax system by
focusing on the different types of tax systems. In addition to tax systems, the unit also covers the
different types of tax points, tax rates and tax income bases. An attempt is also made to indicate
gaps in each of these themes and the resultant effect in making the tax system disorganized,
incoherent, inefficient, inequitable, and unpredictable. Well drafted and logically organized tax
laws are critical for the proper understanding and implementation of a tax system. This unit
further highlighted the importance of different types of tax duties and advelorm in Ethiopia.

Unit Review Questions

Part I-Discussion and Explanation Items
Instruction- Discuss and explain correctly the following questions
1. Explain tax rates and tax bases in a tax system of a country.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
2. Write down the three types of tax system and briefly explain each.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

3. Write the difference among the three tax systems

4. What the difference between single and multiple tax points?

__________________________________________________________________________
__________________________________________________________________________

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__________________________________________________________________________
__________________________________________________________________________
Part II-Workout Question

1. Hodon and Abdi are married, file a joint federal tax return, and have taxable income of Birr
240,000. How much will be their tax liability if progressive tax system is used?
2. Let us assume that Ahmed and Zemzem have taxable income of Birr 38,450 and file an
income tax return as a married couple. How much will be their tax liability? How much will
be the average and marginal tax rate?

Unit Three: Tax Evasion, Avoidance and Black Money

Introduction

In this unit the author tries to provide detail understanding about tax evasion, tax avoidance and
black money which are illegal acts performed by tax payer in any place in this world. First and
for most clear definition of the three commonly known wrong doings by any tax payer will be
addressed in the first part of the unit. Then the unit will provide the basic difference among tax
avoidance and tax evasion with clear and supporting practical real world examples. In addition to
this the unit will also discuss in detail about why tax payers engaged in black money activities
and also the main causes and the resulting effect of black money in a given county economy by
taking practical examples from Ethiopia. Second part of this unit will cover real and practical
examples with regard to tax evasion, tax avoidance and black money in the context of Ethiopian.
Furthermore, the unit will also cover what remedies should be given to control and maintain the
level of tax evasion and tax avoidance which are deliberate and illegal action by tax payers.

Objective of the unit

After completing this unit, learners will be able to:

 Define tax evasion, tax avoidance, and black money

 Discuss about different types of tax evasions in Ethiopia
 Explain about tax avoidance in brief

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 Mention the main cause of tax evasion, tax avoidance and black money

III.1. Tax Avoidance And Evasion

Tax avoidance and evasions constitute a problem in almost all the countries of the world. Tax
avoidance is different from tax evasion, while evasion is against the law; avoidance is within the
ambit of law.
Tax evasion is the general term for efforts by individuals, firms, trusts and other entities to evade
the payment of taxes by breaking the law. Tax evasion usually entails taxpayers deliberately
misrepresenting or concealing the true state of their affairs to the tax authorities to reduce their
tax liability, and includes, in particular, dishonest tax reporting (such as under declaring income,
profits or gains; or overstating deductions).

By contrast tax avoidance is the legal exploitation of the tax regime to one's own advantage, to
attempt to reduce the amount of tax that is payable by means that are within the law whilst
making a full disclosure of the material information to the tax authorities. Tax avoidance may be
considered as either the amoral dodging of one's duties to society or the right of every citizen to
find all the legal ways to avoid paying too much tax. Tax evasion, on the other hand, is a crime
in almost all countries and subjects the guilty party to fines or even imprisonment.

Tax Your Bain

What is tax Avoidance? ____________________________________________________

[Link] Avoidance:

Tax avoidance means, “tax-payer may resort to a device within the ambit of law to divert the
income before it accrues or arises to him”.
“Tax Avoidance has to be recognised that the person whether poor or wealthy has the legal
right to dispose of his income so as to attract the least amount of tax”.

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The tax avoidance can be defined as “escaping from the tax liability by using the available
loop-holes of the tax laws”.
Thus, tax avoidance means legal minimization of tax burden by the taxpayers.

Examples for Tax Avoidance:

The following are the examples for tax avoidance:

1. Suppose a taxpayer’s total income exceeds the maximum tax-free amount, then he has to
pay the tax on such excess amount. But if he invests the excess amount in any of the
approved schemes for which there is a relief in the tax law, he can save on tax altogether.
2. An individual sells his let out house property (long-term capital asset) for Birr.2,00,000
making a capital gain of Birr 60,000. This capital gain would normally be taxed. But, if
he invests the sale proceeds in a particular manner stipulated by law, he need not pay any
tax.
3. Divorcing the wife on paper so that her income is not added together with husband’s
income is also a common device for tax avoidance.

[Link] Evasion

Tax evasion means fraudulent action on the part of the taxpayer with a view to violate civil
and criminal provisions of the tax laws. It can be defined as “tax evasion implies the activities
involving an element of deceit, mis-representation of facts, falsification of accounts including
down right fraud”.
Thus, it may be said that the tax evasion is tax avoidance by illegal means i.e. tax evasion is
against the law and is an unsocial act.
There are two forms of tax evasion. They are as follows:

1. Suppression of income, and

2. Inflation of expenditure.

Examples for Tax Evasion:

The following are the examples for tax evasion:

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1. A trader makes a sale for Birr.20, 000 and does not account it, in his books under sales.
He is evading tax.
2. An individual lends his money of Birr.50, 000 to another person at 20% interest per
annum and does not include this income in his total income.
3. Under-invoicing of sales and inflation of purchases.

4. A manufacturing business employs 30 workers but include 2 more additional namesake

workers (not in actual) in the muster roles. The sum shown as paid to such additional
namesake workers will amount to evasion.
Human intelligence devices new methods of evasion and the Governments are constantly trying
to remove the loopholes in the tax laws.

Tax Your Bain

What is tax Evasion? ____________________________________________________

III.2. Causes of Tax Evasion

The following are the important causes for Tax evasion:

1. Multiplicity of Tax Laws: A number of laws enacted for the recovery of a variety of taxes often
leads to widespread tax evasion.
2. Complicated Tax Laws: Complicated tax laws are another reason for tax evasion. The tax laws
contain a number of exemptions, deductions, rebates, relief, surcharges and so on. For example:
the Income Tax Act has 28 chapters and 298 sections including sub-sections. So, such
complication in tax-laws is also a root-cause for the tax evasion.
3. High Rates of Taxation: High rates of taxes cause widespread tax evasion, because the greater
the risk undertaken for the purpose of tax evasion, the greater is the reward.
4. Inadequate Information as to Sources of Tax Revenue: Lack of adequate information as to
the sources of revenue also contributes to tax evasions. In Ethiopia, small businessmen and
farmers rarely maintain any accounts of their income.

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5. Investment in Real Property: Investment in real property, both movable and immovable, and
concealment of its true ownership have also been a major cause for tax evasion. All these
facilitate the channelizing of black money into profitable ways.
6. Ineffective Tax Enforcement: Lack of proper training and efficiency for the authorities
enforcing the tax laws is also a major cause for widespread tax evasion.
Deterioration of Moral Standards: There has been deterioration in standards of moral
behaviour of people since independence. The values, which formed the basis of Society, are
shown little respect. In this modern competitive world, the deterioration of moral standards,
among the people leads to falsification of accounts, mis-representation of facts and fraudulent
behavior.

III.3. Remedies for Tax Evasion

If steps are not taken to reduce tax evasion, it may cause irreparable harm. The following are the
remedies to prevent tax evasion.
1. Thorough Overhauling of Tax Laws: One of the main reasons for tax avoidance and
tax evasion is loose drafting of tax laws which contain several loop-holes and weak points that
enable the tax evaders to carry on the unlawful activities. Hence, it is necessary to re-draft the
tax laws thoroughly without any loopholes and weak points.
2. Reduction in Tax Rates: The prevalence of high rates is the first and foremost reason
for this tax evasion. Hence, the rate of tax should be reduced to a reasonable level.
3. Replacement of Sales Tax & Excise Duties with VAT: As the crosschecking is
possible in the case of VAT, it is more effective. Hence, such tax can be introduced instead of
sales and excise duties.
4. Tax on Agricultural Income: Agricultural income is exempted from income tax and for
this reason it is used to convert the black money into white. In recent years, agricultural farms
and orchards, and vineyards have come to be acquired by industrialists; film stars etc. because
this enables their owners to whiten their black money. Tax evasions can be avoided by taxing the
agricultural income at normal rates.
5. Maintenance of Proper Accounts: Maintenance of proper accounts should be made
compulsory for persons whose business and professional income exceeds a prescribed limit. In
the Income Tax law, a provision to this effect has been introduced recently.
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6. Introduction of Expenditure Tax: In Ethiopia, expenditure tax is levied in the form of

commodity taxation such as excise duties, VAT, Turnover tax etc. There is no personal
expenditure taxation. However, it is recognised by all that if a tax is based on personal
expenditure and if all effective machinery is devised to investigate and ascertain personal
expenditure, tax evasion can considerably be reduced.
7. Tightening of Tax Enforcement: This may be said to be the crucial remedy if the
penalties for violation of tax laws are strictly enforced, incidence of tax evasion could
automatically be reduced.
III.4. Black Money
[

Black money is a complex phenomenon. It has various connotations such as unaccounted

incomes, tax-evaded incomes, undisclosed wealth and unrecorded gain and suppressed or
number two accounts transactions. It is earned by violating the laws and going against the
conscience by the very name itself. We can understand how the money is earned and this money
carries a secret behind it.

The parallel economy or black economy as it is also known, is generally considered to be that
area of economic activity, which remains “Underground”, concealed from the vision and
approach of the State authorities responsible for earning economic policies and implementing
them. It is usually referred to those perfectly legitimate activities, resulting in transactions either
in kind or for payment, between individuals, which are then hidden, from the tax authorities.
Activities in the black economy are therefore, primarily undertaken with a view to evade the
payment of various direct and indirect taxes, especially the latter.
As the term and definition of the black economy is self-explanatory, obviously one can only
estimate the size of the parallel economy, but even conservative estimates are mind-boggling.
After having asked a number of analysts, economists and people in the various financial
institutions, the figure that keeps popping up is that the parallel economy is easily three times as
large as the legitimate or documented economy. While the figure does force us to think and
reflect upon the ethical decay in society it also hints at the benefits if this sector of the economy
could somehow be documented or channeled. However, the possible benefits of this are not

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really as significant as most people are led to believe by the estimated size of the parallel
economy
[Link] Income and Black Wealth:
The National Institute of Public Finance and Policy of India in its report makes a distinction
between the black income and the black wealth. Conceptually, the black income is a flow and
the black wealth is a fund or stock. The black income is generated over a period of time. The
black wealth is an accumulated unaccounted income at any given point of time. The black
money is black wealth held by the public in terms of currency as well as liquid bank deposits. A
large portion of black wealth is held in the form of real estate, gold jewellery, stocks in business,
benami financial transactions, cash, inventories and foreign currencies and undisclosed holdings
of foreign assets.
This black income in a macro sense is defined as the aggregate of taxable incomes not reported
to tax authority. In essence, income-evading taxation is referred to as black income. Evasion of
taxes of all varieties (excise duties, customs duties and sales tax) leads to black income. Second,
black income could arise from both “Reportable” and “Non-reportable” sources. Non-
reportable black income is called so because the manner in which it is generated is illegal e.g.
income from crime, bribery, black marketing, wealth (jewellery, business assets, foreign
currency, real estate-especially benami transactions). Reportable black income is generated
through legitimate activities or transactions but is suppressed and not reported to the tax
authorities so as to evade taxes that will be levied on it. Third, black income activity not only
generates black income but also results in black consumption and black saving. Black saving
when accumulated leads to Black Wealth.
[Link] Economy and Black Money:

“Parallel Economy” or “Black Economy” refers to the functioning of an unsanctioned

sector in the economy whose objectives run parallel to, or in contradiction with the declared
social objectives.
The black economy is said to have taken birth during the Second World War. In scarcity
conditions, controls on the distribution and prices of goods in short supply led to the emergence
of black markets and hoarding. Black market prices, which were higher than the controlled

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prices, led to the emergence of “Black Incomes”, popularly called “Black Money” or “Number
Two” income.
Dr. Raja Chelliah defines the black money income as “the sum total of transactions
deliberately kept out of the books of accounts by household and business in the economy”.
We can define Black money as “that the money which has not been brought into account, the
income not shown to the authorities wholly or partially i.e. unaccounted property or money can
be called black money”.
Black income now comprises a significant and fast growing element in many economies. It
is today an all-pervasive phenomenon that requires serious attention. When we talk of black
income, an important point to be noted here is that it is not limited to the evasion of income tax;
it is a heterogeneous category that extends to bribes, smuggling and even leakage.
III.5. Impact of Black Money in Ethiopian Economy
The effects of the black money are considered significant on the basis of the following:
a) Significant size compared to other major sectors or the size of the government.
b) White economy cannot act as a proxy for the total economy.
c) Economic laws applicable to the totality of the economy and not a part of it.
d) Sectoral implications.
e) Failure of policy linked to it.
f) Has led to a change in the economic policy paradigm.

[Link] Economic Impact of Black Money:

The black money has the following macro effects on the economy:
a) Failure of planning and resource mobilization and contradiction amongst other policies.
b) Growth and stagnation and income distribution effect.
c) Investment, unemployment and the multiplier.
d) Inflation.
e) Forces a change in the fiscal policy regime.
f) Various budgetary deficits and debt trap.
g) Raises transactions costs and leads to a high cost economy in spite of a low wage.
h) Savings and investment raises. Consumption propensity falls.
i) Import propensity rises.
j) Monetary Policy, Velocities of circulation and stability properties of the multipliers.

[Link] Economic Impact of Black Money:

The black money has the following micro effects in the economy.

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a. Aspects of Policy Failure.

b. Social Sectors. Poor left at the mercy of the markets.
c. Criminalization of society.
d. Impact on National Security.
e. Social Waste. Like ‘digging holes and filling holes’.
f. Impact on the work ethic.
g. Impact on the quality of products and exports.
h. Reduces the individual's faith in state intervention.
i. Increases the alienation of the individual from society. Reduces faith in social actions.
The ‘usual is the unusual and the unusual the usual'.

[Link] or Estimation of Black Money:

It is widely accepted that most of the country’s problems arise mainly from the tendencies
unleashed by the large and growing unaccounted “Parallel Economy”. Any estimate of the size
of undeclared clandestinely (secretly) held wealth; current income and capital flights would
exceed the marginal levels of our savings and BOP deficits. Effective restraint of the black
economy therefore becomes very important, as this would go a long way in improving the
quality of growth. But for this an estimate of the “Parallel Economy” is a must.

Measuring black income is not an easy task. This may be due to non-availability of reliable data.
A number of individual and institutional efforts have been directed towards measurement of size
and growth of black income in Ethiopia. To examine this serious national problem the
Government of Ethiopia has made many efforts from time to time for estimating and control of
black money. It is difficult to know the exact holdings of black money. But, from the several
guesswork and estimates, it is evident that black money is of a high magnitude in the Ethiopian
economy and has been expanding at a rapid rate over the last two decades.

There are several alternative approaches to the estimations of black income. They are as follows:
1. Expenditure Approach.
2. Fiscal Approach.
3. Monetary Approach.
4. Physical input Approach.
5. Labour-market Approach.
6. National accounts Approach.

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III.6. Sources of Black Income

There are many ways and sources of generating black income that it is very difficult to list them
all. Black money is also earned from perfectly legal and legitimate activities, but when the
income is fully or partly concealed in order to evade the taxes, it is treated as black money.
The various research committees have identified that the following are the items, which
generally deemed to generate black money:

1. Evasion of Personal Income Tax.

2. Evasion of Corporation Tax.
3. Real Estate Transactions.
4. Excise Duty Evasion.
5. Customs (Import) Duty Evasion.
6. Evasion of Sales Tax.
7. Black Income from Smuggling.
8. Black Income from Exports.
9. Black Income from Public Expenditure.
10. Black Income from Private Corporate Investor.
11. Film Industry.
12. Professions.
13. Constructions.
14. Selling of Licenses and Permits.
15. Other sources of black income are:
(a) Gambling.
(b) Bribes including illegal commissions, “cuts” and kickbacks.
(c) Black marketing in goods in short supply such as steel, copper, coal and other items
of industry quota of raw materials and imports. There is also the black market sale of
import licenses and foreign exchange at a premium.
(d) Financial transactions in the unrecognized sector of the money market.
(e) Hotels and Restaurants.
(f) Unaccounted stock market profits on black transactions carried on in the private
account of stockbrokers.
(g) Income earned through the adulteration of food items, drugs, country liquor,
production and sale of cheap imitations, forgeries and frauds of various kinds.
(h) Publishing Piracy.
Hereunder, we shall discuss the important sources of generating black money in detail.

Tax Your Brain

What is black money? _________________________________________________

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III.7. Sources Generating Black Money

[Link] of Income Tax:

When we talk of evasion of income tax, it could mean both personal income tax and corporation
income tax. Income tax can be evaded by the following ways:
1. Suppressing True Income: It is well known that a large part of black income comes
through illegitimate sources, whether it is bribes, smuggling, black marketing or other
such sources. Professionals like lawyers, doctors, architects, businessmen and even film
stars and film producers are examples where the sources are legitimate but income is
suppressed to evade tax.
2. Manipulating Business Expenditures and Profits: The corporate sector indulges in
under-reporting of profits, overstating expenditures, non-reporting of production and
excise, raising fictitious bills on companies. While under-reporting of profits helps evade
tax, non-reporting production helps generate black income in cash and generally
increases the promoters’ wealth.
3. Misuse of Tax Exemptions and Deductions: It is known that agricultural income is
exmpted from tax. Many people divert their income to purchase of agricultural land,
show high agricultural profits and avail tax exemptions. It is possible that the profits
come from non-agricultural operations and are taxable but misuse of a facility helps
evade tax and create black income.

[Link] of Excise Tax:

Excise Taxes are duties or taxes on the domestic manufacture of commodities. These are
divided between Union excise duties and State excise duties. For the Central government tax
revenues alone, Union Excise taxes are the second most important source of revenue, next only
to customs duties.
Excise duty evasion is both widespread and large in many countries. The most common
methods of evasion are:
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1. Suppression of Production: This is especially true of small-scale industries such as

electrical goods, steel furniture and utensils, plastics and art silk fabrics. It also takes place in
medium-scale and large-scale industries. This can be done either by not fully accounting for raw
materials or not keeping statutory records fully up-to-date.

2. Under Valuation: This is quite true of the organised sector and can be done with the
help of under-invoicing the product or even showing certain expenses as technical expenses.
Floating of benami agencies that either raise supplementary invoices or collect the differential in
value from dealers is another method.
3. Misclassification of Goods: Tariff rates provide numerous classifications and sub-
classifications carrying different rates of duty. Thus people indulge in misclassification as well
as wrong declaration of goods. High-duty excisable goods often get billed as non-taxable items
and then the difference in the market values of two kinds of items gets recovered in black.

[Link] of Customs Duties:

Methods of evasion of customs duties are broadly the same as those for excise duties (taxes) on
the flow of goods traded both imports and exports of a country. Customs duties are levied and
collected by the Central Government. Methods of custom duty evasion are:
1. Under Valuation: This is done by under-invoicing of imports, usually by arrangement
with the foreign supplier of goods who, mostly, willingly obliges the importer, pays in foreign
currency the full difference between the actual price and the lower invoiced price of the goods
imported.
2. Misclassification/Wrong Declaration of Goods: False declarations about goods
imported in the documents submitted to the customs are made and higher-duty goods are cleared
on payment of lower duty charged on the wrongly declared goods.

Self-Check

1. What are the ways in evading income tax? ________________________________

2. Explain the difference between tax evasion and tax avoidance_________________
3. What are the common methods of Excise tax evasion?_______________________
4. Write down the common methods of custom duty evasion____________________

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[Link] Controls and Foreign Exchange Leakage:

Excessive Import and Export Controls have also led to several kinds of illegal activities, such as
the generation and use of unauthorised foreign exchange (through the faking of invoices) and
smuggling. A rush for licenses also results in corruption, favouritism and bribes.
Foreign exchange leakage occurs as a result of high import tariffs or comprehensive foreign
exchange control. These can occur through under-invoicing of exports, overinvoicing of imports,
inward remittances of foreign exchange through illegal channels, smuggling of goods such as
silver, animal skins, antiques, narcotics and illegal purchase of foreign exchange from foreign
tourists and others visiting Ethiopia.
Although a number of steps have been taken to control black income, foreign exchange leakage
and corruption continue to be a disturbing feature of many economies.
[Link]:
Smuggling refers to the illegal import or export of goods. The numerous controls and tariffs
create profitable opportunities for trade by smugglers in several goods. It is generally said that
the smuggling of goods into the country is more serious than the latter. Smuggling has, over the
years, expanded at such a high rate that it has even attained the title of the “Third Economy”.
Affluent sections of society whose wealth has increased rapidly - mainly through black income
provide a ready market for smuggled goods. We can thus say that all factors responsible for
growth of black income activities in the economy also encourage the increased smuggling of
goods in a country by creating a demand for these goods. Smuggling causes loss of revenue to
the Government (through evasion of customs duty, excise duty and income and wealth taxes),
large illegal outflows of foreign exchange and result in large amassing of funds by smugglers.
These funds are not put to any socially productive use or investment.
[Link] and Distribution Controls:
Wherever operative, price and distribution controls, besides attaining the primary objective of
keeping the price of essential commodities “Under Control”, have also been responsible in
leading to black marketing operations i.e. the sale of goods at higher than listed prices,
unaccounted sales -or, sales without bills or cash memos. Sometimes price and distribution
controls also lead to excessive hoarding of essential commodities.

[Link] Licensing:

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Industrial licensing has also contributed to creation of black income in many economies.
Excessive industrial licensing over the years had put up barriers to the entry of fresh capital and
enterprise. A few large industrial houses were preferred. Moreover, excessive delay and red-
tapism in the process of clearing applications for licenses have also been prevalent. In many
cases, this has been taken as indications for bribes. The Government had not organised any
separate machinery to monitor the actual implementation of industrial licensing. Therefore, there
have been many violations and creation of black income.
[Link] Sources:
1. Urban Real Estate: Transactions in urban real estate generate a large amount of black
income every year. There could be many frauds in this business. First, there could
understand the value of a transaction to evade a large part of tax liability. Second,
encroachment on public land; third, acquisition of raw land for resale as housing plots,
developments of this land for setting up a colony, sale of plots or houses or flats
constructed on it, exceeding the legally permissible limit of the built up area on a given
plot of land. All these-specifically, understanding the value of all such transactions-lead
to black gains. Another method is to under-report rents. Benami transactions are rampant,
as is the role of “Black Money” in the acquisition of urban real estate.
1. Leakage from Public Expenditure and Property: These leakages take the form of
illicit, and undeclared commissions or bribes (kickbacks or cuts). Also, most of the time,
allocated funds for various anti-poverty programs never reaches the targeted people. Another
aspect is pilferage or misappropriation of State Property.
2. Bribes: Bribes as a source of black income are common. These are used mainly to
influence the decision of the authority dealing with a case, or the power to approve or
recommend an application or even to forward case files. This phenomenon of bribe taking leads
to the spread of corruption from one work place to another.

7.8. Causes of Black Money

There are several causes for the generation of black money in the economy. The major
contributory factors in this regard may be stated as under:
1. High Rates of Taxation: High rates of taxation are basically responsible for inducing tax
evasion and consequent black money generation in the country. The prevailing high rates of
taxation the economies are one of the main causes of black money.
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2. Corrupt Business Practices: The corrupt business practice such as smuggling and other
restrictive trade practices cause the existence of black money in the country. In an economy
under the environment of scarcities, controls and inflation, hoarding and black marketing are
always profitable which apparently generate black incomes.
3. Controls and Regulations: Though the Governments resorts to the economic policy of
controls with a good intention of dealing with the problem of shortage and effecting a fair
distribution of essential goods with equity, their improper implementation vitiates the very
purpose of controls. In many countries, the Government fixed up prices of various essential
consumer goods like kerosene, wheat flour, vegetable ghee, drugs, etc. Their prices are
controlled and the distribution is regulated. Along with various controls on imports and exports,
tight exchange control is also implemented. Such controls are implemented with licenses,
permits and quotas. Thus there have been statutory controls combined with the bureaucratic and
administrative controls. These allpervasive economic controls are also responsible for the
intensification of black money attuned evils like corruption, procedural wrangles, delays,
artificial scarcity, fraud, suppression etc. involved in the very network of the bureaucratic public
administration.
4. Political Corruption: This makes the fight against black income growth very difficult
and is closely linked with evasion of taxes and customs duties. The political bribing of party and
Government members is a common phenomenon. Donations to political parties were banned in
1968 and this has prompted businessmen to fund political parties, especially the ruling party,
with black money. Politics is the main weapon for fighting social ills; and when this weapon
itself gets corrupted, chances of tackling black income get bleak. The Politics-business-crime
nexus that exists in our society is a result of, and further accentuates black income generation.
5. Bureaucratic Corruption: Controls breed corruption. Loose and dishonest public
administration becomes an easy prey of corruption.
Corruption and black incomes are inter-linked. Corruption makes it easy to earn and enjoy
black money. Today, “Speed Money”, “Secret Commission”, “Paper Weight”, “Mithai”,
“Hush Money” have become almost a routine for getting any work done, legal or illegal, at
official levels.
6. Prohibition: Certain activities are usually forbidden by law such as gambling,
production of illicit liquor, smuggling, traffic in illegal drugs, lending at exorbitant interest

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charges, money lending without proper license etc. When some individuals wish to undertake
these activities, these will apparently go unreported and incomes so earned would be totally
black.
7. Public Expenditure: the Government itself lives in the Glass House, as the rapid growth
of its spending over the last two decades has been a major contributory factor in generating black
money. Due to the rapid rise of public spending for multiple Governmental programmes and
activities, the unscrupulous elements in public service and public life could find ample
opportunities for amazing black income and wealth by dubious methods.
8. Inflation: The genesis of black money can also be found in the persistent inflation in the
country, which has enhanced incentives and opportunities to earn such incomes. Inflation
inevitably leads to growth of parallel markets and strengthens propensities to hide incomes and
to evade taxes. Since inflation causes capital erosion, there is always a temptation to maintain
dual accounts for tax evasion by “Diverting portion of inventories and output from white
channels to black channels of deployment”. As the matter of fact, inflation is both the cause as
well as consequence of the growth of black money in many economies.
10. Deficiencies of the Tax System: There are various lacunas in the tax system that
encourages generation of black income. First, high personal Income Tax Rates cause people to
try and evade taxes, and thus lead to generation of black income. The dilemma for the
Government is that even efforts at lowering tax rates do not lead to larger payments of income
tax by the higher income groups. Although there are a number of tax laws pertaining to income
tax, sales tax, stamp duties, excise duties etc. enforcement is weak due to widespread corruption
in these departments.
11. Quotas, Controls and Licenses: The “License, Quota, that has dominated the system of
controls has often led to the initiation of various ways of escaping these and, thus, the generation
of black income.
12. Generation of Black Income in the Public Sector: There are huge investments marked
for the public sector in every five-year plan. The usage of these has to be monitored by the
bureaucrats in Government departments and public sector undertakings. A symbolic relationship
often develops between the contractors, bureaucrats and politicians. Costs are often artificially
escalated and underhand deals generate black money.

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13. Inadequacy of Powers: The inadequacy of the powers given to the tax enforcing
authorities is another important cause for black money.
14. Weak Deterrence: Despite of adequate legal provisions to curb the growth of black
economy in, it has persisted because of weak deterrence against tax evasion in practice. No
serious action has been taken against detected cases of tax evaders. Till recently, too trivial
penalties were imposed, too few prosecutions have been launched and even fewer have been
convicted.
15. Ineffective Enforcement of Tax Laws: Ineffective enforcement of tax laws is also a
cause for black money. Lack of proper training and inefficiency of the department people led to
the creation of black money.
16. Lack of Publicity: Another reason for wide spread black money is said to be the secret
provision of direct tax laws. At present, the department is statutorily prohibited from disclosing
any information relating to a person’s assessment. Thus, even if a person is caught and penalised
for keeping black money, he can keep it as secret from every one.
17. Deteriorated Public Morality: Moral values and social attitudes of many people have
changed during recent years. In today’s society black marketers, smugglers, corrupt politicians,
public officials and tax evaders are not condemned, but rather admired and envied for possessing
black money power.
18. Demonstration Effect: The conspicuous consumption and luxurious life style of black
moneyed people have created a sort of demonstration effect on many others to inspire for such
consumption patterns.

[Link] of Black Money

Black money is a socio-economic evil. The existence of rapidly growing black money in our
economy has grave and disastrous consequences. The major effects of black money are
discussed below:
1. Dual Economy: The out growth of black money over a long period of time has given rise
to the perpetual growth of economic dualism comprising “Parallel” economy (black money

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economy) operating side by side with the “Official” or “Reported” economy on the country.
The black economy represents not less than one fifth of the aggregate economic transactions.
There is also interaction between the reported and unreported activities such that it is difficult to
identify black money from the white money economy. Such a “Parallel Economy” will ruin the
entire economic development of the country.
2. Under-estimation: A large underground economy and growth of black income lead to
under-estimation of the true size and incorrect picture of the economy by the officially complied
national income data. Since unreported economy is apparently excluded from the official records
of the GNP the estimates of savings and consumption of nations to the national income and
measurement of other macro-economic variables would be biased and misleading for accurate
policy making and planning considerations.
3. Loss of Revenue to the Government: Black money is largely attributed to tax evasion.
Its direct impact is the loss of the Government revenue. Since the Government fails to get
sufficient tax revenue due to large-scale tax evasion, it is forced to resort to high taxation and
deficit financing which again carry their ill-economic effects.
4. Under-mining the Equity: When the Government resorts to progressive direct taxation
to maintain equity in the distribution of the tax burden, the tax evasion and growth of black
money affect the very concept of social justice by not allowing the desirable reduction in
inequalities of incomes. Again, when underground activities like smuggling etc. could not be
taxed, the Government will impose higher taxes on officially sanctioned activities. Further, the
tax evasion will also equally enjoy the public services without paying the due contribution; to
that extent also social enquiry is undermined. The honest have to bear high tax burden to make
up for the deficit in revenue caused by the tax evasion of black money makers.
5. Widening the Gap between the Rich and the Poor: Growth of the black economy
causes regressive distribution of income in the society. When the black money grows faster, rich
becomes richer and the poor become poorer. By way of concentration of income and wealth in
few hands, the black money widens the gap between the rich and the poor.
6. Lavish Consumption Spending: Black money is disposed off by lavish spending on
travels and tours, entertainment, ostentatious articles, financing of extravagant elections etc. This
has also lead to many social evils and deteriorated the values of life of the common people.

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7. Distortion of Production Pattern: The black money has altered the choice coefficients
in the market in favour of luxuries, which lead to the diversification of productive resources
from essential goods to the non-essential goods.
8. Distribution of Scarce Resources: Black money holders are always in a position to put
their prior claim over the scarce goods in the market due to their readiness and ability to pay
more, thereby depriving the honest and poor people from their legitimate share. This obviously
reduces the net economic welfare of the society at large.
9. Deteriorate the General Moral Standards of the Society: Black money is largely
responsible for the deterioration of general moral standards of the society. Black income
generation implies a deviation from the accepted norms in society and from the point of view of
the society is unethical.
Socially, we can say that the structure and ethos of a society undergoes a massive change.
Social values of honesty, hard work, thrift and simplicity get eroded. Even the political
institutions and organisations lose their credibility, as they also gradually become a part of the
entire system of black income generation.
10. Average Effect on Production: As a consequence, the consumption pattern is titled in
favour of the rich and elite, at the cost of encouraging production of articles of mass
consumption. A rise in overall consumption leaves fewer resources for investment in priority
areas, having an adverse effect on production.

Self-Check Questions

1. List and briefly explain some of the effects of black money?

________________________________
2. Write down and discuss each causes and effects of black money ____________________________

III.7.10. Remedies for the Black Money:

The menace of ever raising black money in Ethiopian economy is very high. It is accepted by
all that tax evasion generate black money. Such staggering extent of black money has activated a
parallel economy in the country and it affects the vital sectors of the economy. The Government

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in the past has already tried certain measures with little success. If steps are not taken
immediately to reduce the black money, it may ruin the entire economy of the country.
The important remedial measures for controlling black money are given below:
1. Demonetization: Demonetization of currency of high value could help to unearth the
black money to a large extent. However, in order to solve the problem arise on account of
demonetization, proper step should be taken. It is advocated for eroding a substantial part of
black liquidity on the presumption that black income held in cash will not be presented for
conversion. Demonetization may succeed in reducing the quantum of black money but it cannot
prevent the generation of black money altogether.

2. Voluntary Disclosure Scheme: The Government may adopt the policy that those who
voluntarily disclose their black income of the past to the taxation authorities will not be punished
and penalties may be waived or minimised.
3. Raids: Income tax department's powers have to be considerably enlarged and it should
be empowered to conduct raids on the premises and properties of the taxpayers or any other
individuals and can seize the unaccounted income and wealth and take necessary legal actions
against the tax evaders.
4. Rationalization of Controls: Since ill-devised controls are major causes of black
money, it is essential to rationalise the control system. Recently, the Government has taken some
steps in this direction by easing the licensing policy etc. But still there are many cumbersome
rules and formalities and unnecessary control in many areas, which need to be effectively
rationalised.
5. Taxation Reforms: Ethiopia needs a rationalised tax structure. A reduction in marginal
tax rates, simplification of tax structure, taxation laws and improvements in tax administration
will be helpful in the reduction of black money.
6. Vigorous Prosecution: The research also recommended that the department should
completely re-orient itself to a more vigorous prosecution policy in order to instill a wholesome
respect for the tax-laws in the minds of the taxpayers.
7. Rewards and Awards: In order to encourage the honest taxpayers and create a positive
attitude in the minds of the people towards the payment of tax, this can be adopted.

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The other qualifications considered for the purpose of the award are that the person
concerned should not only pay the highest tax but should also file the returns in time, prompt
payment of taxes including self-assessment tax without default, no penalty for concealment of
income should have been levied, no prosecution for offenses under the Tax Proclamations and
related provision of Criminal Code should have been launched, no search undertaken under the
Direct Tax laws should have been conducted, and should have been co-operative with the
department in the completion of assessments.
Besides the above, no official patronage or recognition or awards should be given to persons
who have been penalized for keeping the black money or in whose case prosecution proceedings
have been taken.
9. Publicity: In view of the deterrent effect, the nature of all persons in whose cases
penalties have been imposed for the concealment of income, wealth etc. should be published in
the gazettes as well as in the press, giving details of their names, addresses and the amount of
penalties etc. If the assessee is a company or firm, the names of all the Directors of the Company
or Partners of the firm should be published.
10. Arousing Public Conscience: A special drive should be undertaken to arouse public
conscience by enhancing the co-operation of the leaders in various walks of life.
11. Other Measures:

I. People should be educated with regard to real object of collections of taxes through
press, radio, TV, and films.
II. Steps should be taken to convince the taxpayers that the money collected through
taxes is not spent wastefully but put to proper use.

Unit Summary
First part of the unit has covered the basic concepts of tax evasion, tax avoidance and black
money which are the common problem in any country tax system. The unit has clearly defined

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what tax avoidance, tax evasion and what black money are under tax law of Ethiopia by
presenting contextual practical example for each tax illegal act on the eye of tax law.

Second part of the unit has explained and discussed on the difference between tax evasion and
tax avoidance by providing real practical example in the case of Ethiopia. The aforementioned
unit also has discussed why tax payers evade and avoid tax and explain the common type of tax
evasion and avoidance.

The last section this unit has provided the best remedial solutions to minimize tax evasion and
tax avoidance under the tax law of Ethiopia. Furthermore, the unit has explained the commonly
known causes and effect of black money and provided those remedies to resolve black money
according to Ethiopian context.

Unit Review Questions

Part I-Multiple Choice Questions

Instruction- Choose the correct alternative from the given alternatives for the following
questions and circle your answers.

1. Concealment of income or false claims to reduce tax liability are cases of _____________
A. Tax Evasion C. Tax Avoidance
B. Tax Planning D. Tax management
2. Using the loopholes of law to reduce tax is known as
A. Tax Evasion C. Tax Planning
B. Tax Avoidance D. Tax Management
3. Reducing tax liability, utilizing the deductions, exemptions or reliefs allowed in the Act and
Rules is known as____________________.
A. Tax Management C. Tax Avoidance
B. Tax Evasion D. Tax Planning
4. Profits earned from an illegal business are________________________.
A. taxable C. tax Free
B. ignored by Tax Authorities D. treated as other income
5. _________________is the casual income.
A. Interest received C. Dividend income

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B. Pension received D. Winning from lotteries

6. Compliance of the legal requirements in connection with the tax is the essence of________.
A. Tax evasion C. Tax planning
B. Tax avoidance D. Tax management

Part II- Discussion and Explanation Questions

Instruction-Discuss and explain in brief the following questions

1. What are the causes of black money? Explain each in short.

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. What distinguish tax evasion with tax avoidance?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

Unit Four
Direct and Indirect Ethiopian Tax System
Introduction

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The following unit will cover the different types of direct and indirect taxes applied under
Ethiopian law. The unit will explain and discuss in the commonly used and implemented direct
taxes in the Ethiopian tax system. The unit will primarily have focused on covering schedule “A
“employment income tax, schedule “B” rental income tax and schedule “”C business income tax
as direct takes. In addition to these types of income tax, the unit has also dealt with income tax
calculation from other sources of income labeling as Schedule “D” income category in order to
subject individuals or businesses for taxation purpose.
The second part of this unit will cover major categories of indirect taxes with different treatment
for each type of tax. Most genuinely the unit will give more discussion on Value Added
Tax(VAT) implemented in the Ethiopian context. In addition to VAT accounting, the unit also
will cover tax accounting treatment of TOT (Turn Over Tax), of Excise tax, and Custom Duty
tax. In the unit all taxes under each major category will be explained and discussed theoretically
and supported by practical tax calculations examples. Thus, learners clearly will understand and
internalize all those direct and indirect taxes.

OBJECTIVES OF THE UNIT

After completing this unit targeted learners will be able to:

 Define direct and indirect taxes

 Classify different taxes as direct and indirect
 Calculate schedule “A”, “B”. “C’ and ‘D’ direct income taxes
 Calculate VAT. Excise Tax, TOT and Custom Duty indirect taxes

4.1. Direct taxes Law and Accounting Treatment in Ethiopia

Under The Ethiopian tax system of direct taxes, scheduler tax system, in which the tax liability
of a taxpayer is determined based on the schedule of each income. This implies the loss incurred
in one schedule is not allowed to compensate from the income generated in the other schedule.

Accordingly as it is depicted in article 8 of the income tax pro 979/16, direct taxes are classified
in to five schedules.

 Schedule ‘A’, income from employment;

 Schedule ‘B’, income from rental of buildings;
 Schedule ‘C’, income from business;
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 Schedule ‘D’, other income;

 Schedule ‘E’, exempt income.
Ethiopia levies tax on residential jurisdiction basis. As per the income tax proclamation, every
resident of Ethiopia who gets income from within the country or abroad is charged under the act
on transferring the amount to Ethiopia. That is the income tax is applied to the Ethiopian
resident taxpayer on their world wide income. According to the Income Tax Proclamation,
residence of Ethiopia includes resident individual; resident body; and the Government of the
Federal Democratic Republic of Ethiopia, and any Regional State or City Government in
Ethiopia.

 A resident of individual is an individual who has a domicile in Ethiopia; is a

citizen of Ethiopia who is a consular, diplomatic, or similar official posted
abroad; and is present in Ethiopia, and continuously or intermittently, for more
than 183 days in a one-year period.
 A resident body is a body that is incorporated or formed in Ethiopia; or has its
place of effective management in Ethiopia.
Moreover, the tax system of the country is also applied to non-residents with respect to their
Ethiopian source of income. That is foreign resident is liable to pay tax to Ethiopian tax
authority for its income generated in the territory of the country.

Residential tax levy jurisdiction can create double taxation problem and thus double taxation
avoidance treaty is required between countries. Foreign tax credit is allowed by the income tax
proclamation for a resident that derives foreign source of during a given tax period. However,
the tax credit will not exceed the tax payable in Ethiopia.

4.1.1 ACCOUNTING FOR EMPLOYMENT INCOME TAX

[Link]. Employment Income Tax in Ethiopia

Income as defined in the proclamation includes every sort of economic benefit including non
recurring gains in cash or in kind from whatever source derived and in whatever form
paid, credited or received. Taxable income shall mean the amount of income subject to tax
after deduction of all expenses and other deductible items allowed as per the law.

“Employee” means an individual engaged, whether on a permanent or temporary basis, to

perform services under the direction and control of another person, other than as an independent
contractor, and includes a director or other holder of an office in the management of a body, and
government appointees and elected persons holding public offices;

[Link]. What is Employment Income Tax?

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Employment income includes any payment or gain in cash or in kind received from
employment by the employee subject to certain exemptions.

According to Pro 979/16 of Art 12 Employment income includes the following excluding the
exempted incomes under schedule ‘’E’’

a) Salary, wages, an allowance, bonus, commission,

b) The value of fringe benefits received by an employee in respect of a past, current,

or future employment*;

c) Employees termination compensation

*As it is indicated in the income tax regulation No 410/2017 Article 8 the list of fringe benefit
includes the following:

 debt waiver;
 household personnel;
 housing or accommodation
 discounted interest loan;
 meal or refreshment;
 private expenditure;
 property or service;
 an employee share scheme;
 vehicle;
 residual fringe benefit

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However, the amounts of tax the aggregate tax liability on fringe benefit shall not exceed 10%
the basic salary of the employees (for detail refers the regulation).

[Link]. The Employment Income Tax Rate: Article 11

The employee's income tax system divides taxable income into different tax brackets. These are
a range of income bands with different tax rates. The tax payable on income from employment
shall be charged, levied and collected at the following rates:

Employment Income Deductions for

Employment Income
short cut method
(per month) Birr
Tax Rate

0 –600 0% 0
601-1,650 10% 60
1,651-3,200 15% 142.50
3,201-5,250 20% 302.50
5,251-7,800 25% 565
7,801-10,900 30% 955
Over 10,900 35% 1500

Employment income tax (EIT) = (Taxable income)* the tax rate in which the taxable income
falls- deduction allotted for the given rate

Taxable income= Gross income less Direct Exemption except the Common Exemption that is
600 birr

[Link]. Employment Income Exemption Indicated in Schedule “E”

List of exempted employment income allowances indicated in the proclamation (Art 65) and
income tax regulation (Art 54) and relative directives includes the following:

 The first six hundred birr (600 birr) of monthly income tax of the employees
 An allowance in lieu of means of transportation granted under a contract of
employment with limit that will be issued by the ministry directive. Currently 25%
of the basic salary but not exceeded 2,200 birr is free from tax
 Transport expenses and per diem payments to an employee travelling on a tour of
duty subjected to limit currently per diem payment is exempted up to 4% of the basic
salary of the employee or 225 birr which is the higher

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 a cash indemnity allowance paid by an employer to an employee, but only to the

extent that the allowance compensates the employee for shortfalls on money counts;
 Employment income of not exceeding five years paid to expatriate professionals
recruited for transfer of knowledge by investors engaged in export business in
accordance with a directive to be issued by the Minister;
 Income from employment received by unskilled employee working for the same
employer whether continuously or intermittently for not more than thirty (30) days
within any twelve [Link] period.
 An amount paid by an employer to cover the actual cost of medical treatment of an
employee including Premium payments made by an employer on behalf of an
employee under employees, medical insurance scheme
 Hardship allowance subject to limit issued by the ministry directive
 Food and beverages provided for free to an employee by an employer conducting a
mining, manufacturing, or agricultural business subjected to limit issued by the
ministry
 Allowances paid by the Government of the Federal Democratic Republic of
Ethiopia to employees engaged in public service in a foreign country
 Allowances paid to members and secretaries of boards of public enterprises, public
bodies, or study groups established by the Federal or a State Government or City
administration;
 contributions by an employer to a pension, provident, or other retirement fund for
the benefit of an employee provided the monthly total of contributions does not
exceed 15% of the monthly employment income of the employee;
 an amount exempt from tax to the extent provided for under an international
agreement example remuneration of diplomatic personnel of foreign countries
 a public award for outstanding performance in any field or an award granted under
Article 135 of the Tax Administration Proclamation
 an amount as compensation for personal injury or the death of another person
 a scholarship or bursary for attendance at an educational institution
 maintenance or child support payments
 salaries paid to domestic servants
[Link]. Declaration and Payment of Employment Income Tax

As it is indicated in article 88 of the income tax, proclamation the obligation to fill employment
income tax is given to employer. That is the employer shall withhold tax from the gross amount
of each payment of employment income made to the employee at the rate applicable to the
employee. In addition, if an employer is aware that an employee has more than one employer
and that the other employer, or none of the other employers, is withholding tax based on the
aggregated employment income, the employer shall withhold tax based on the aggregated
employment income and shall file the withholding employment income tax declaration within 30
days after the end of months in which the withholding income was paid.

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However; if an employee has more than one employer for a calendar month or a self withholding
obligation, the employee shall file a tax declaration within 30 days from the end of every three
months (Art.96). That is an employee employed by an international organization or working in
an embassy, diplomatic mission, or other consular establishment in Ethiopia of a foreign
government or employed by an entity exempt by law from tax withholding obligations shall
withhold tax from the employment income received from such entities.

The statement shall be in the form and furnished in the manner prescribed by the Tax Authority

[Link]. Payroll Records and Preparation

Payroll register: - this is a multi column register (form) for the payment of salaries at the end of
the payroll period. The source document for preparing the payroll register includes, Letter of
employment, Letter of Promotion, Letter of Demotion, Attendance list, Time card and Relevant
payroll and labor proclamation.

Payroll Components includes: Employee Name and Employee ID, Earning Columns (parts),
Deductions, Net pays, Signature

1. Earning

A. Basic Earning /Salary/: Monthly salary of an employee that is paid for carrying out the
normal work of employment. Basic earning refers to the amount agreed between the employer
and the employee at a time of employment, and will be clearly stated in the letter of employment.
Basic salaries are the bases for making other calculation in relation to earning like bonus,
compensations, severance pay, overtime…etc..
B. Allowance: - Additional monthly payment to the employee for one of the following reasons
 Position allowance or Acting allowance: - Sum paid for a person for assuming a certain
position.
 Housing allowance: - a monthly allowance paid to an employee to cover for house
facility, when the employer is obliged to provide house but falls to do so and taxable
income.
 Transportation /fuel/ allowance: - an allowance paid to an employee for to cover the
cost of transposition from office-home-office or work related transportation costs.
 Cash indemnity allowance: - allowance paid for cashiers to cover the risk of possible
cash shortage. Cash indemnity is used to cover accidental shortage not intentional
shortages,
 Hardship allowance: - an allowance paid to an employee for in convenience caused by
the employer in the form of unexpected transfers, hazardous working areas …etc.

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 Desert Allowance: - a monthly allowance given to an employee assigned to a relatively

hot region. All hot regions (places) may not entitle an employee to a desert allowance.
 Representation allowance: - Allowance paid to employees whose work requires them to
entertain customers and gusts..
C. Over time payment: - is a payment for extra hours worked beyond the regular working
hours
Labor Proclamation Number 42/1985 E.C. (1993G.C.): Defines the basic legal frame work
for contract of employment, regular working hours limit, overtime rates, compensation pay,
leave benefits, employment termination procedures …etc.
 Maximum regular working hour’s 8hrs/day, or forty eight hours a week, but the current
practice is maximum 44 hours per week and 192 hours per month. i.e.:

o Monday to Friday 8hours per day X 5 = 40hours

o Saturdays 4 hours per day = 4hours
44 hours

Or there are 22 days in a month; 22 X 8hours /day = 176 hours

There are 4 Saturdays in a month; 4 X 4 hours/day = 16 hours

192 hours

Over time payment = regular hourly salary rate* rate for the duration of overtime work

Regular hourly rate = monthly basic salary divided by normal working hours per month

Overtime rate

Ordinary time: from 6 in the morning (AM) to o’clock to 10 o’clock in the evening (PM)

Over time rate =1.25 * Regular hourly rate

Late hours: from 10PM up to 6 AM, Over time rate =1.5 * Regular hourly rate

Weekly rest days: Over time rate =2 * Regular hourly rate

Public holydays: Over time rate =2.5 * Regular hourly rate

D. Bonus: - is a material (money) reward for better or best performance by managers or other
employees. Bonus could be based on net income for managers or based on monthly salary
(basic salary) for other employees. Bonus to top manager is most of the time based on
annual income of the business enterprise.

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2. Gross /earning/ Salary: - is computed by totaling all the earning i.e. Basic Salary + Allowances,
if any + Overtime payment, if any + Severance pay, if any + compensation, if any + bonus, if
any + … etc.
3. Taxable income: - includes all earning except for non taxable incomes as specified under
exemption discussed above.
4. Deduction: - These are subtractions form the gross earning, so as to identify the net pay of an
employee.
a. Statutory deduction: - deduction enforced or imposed by low.
Currently, Pension contribution in Ethiopia applies to both public & private employees as per of
the following rate (Proc. No. 714/2011)

 7% (of the basic salary) by the employee

 11% (of the basic salary) by the employer.
Voluntary deduction: - these are not imposed but are voluntary deductions Example: Credit
association, credit purchase …etc.

b. Others: - Like court order, fines, absence …etc.

5. Net pay: - the net pay is the difference between the gross earning of an employee and the total
of the deductions.
6. Signature: - When an employee receives his/her pay he will sign to confirm that he have
received the net pay.
[Link]. Computation of Employment Income Tax

Employment income tax payable by an employee is determined by multiplying the employee’s

monthly taxable income by prescribed employment income tax rates. Even if there are different
methods used to calculate employment income tax payable, for the sake of this course we will
use the short cut method.

Employment income tax = (Taxable income)* the tax rate in which the taxable income falls-
deduction allotted for the given rate

Taxable income= gross income less direct exemption except the common exemption that is
600 birr

Example 1: suppose ABC Company has the following employees and assume that the normal
working hours per week are 44 hours.

No Employees name Basic salary Over time work Transportation

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allowance

1 Tadesse Abate 4500 - -

2 Tedros Ephrem 6000 4 hours in the ordinary time and -

10 hours in the late time

3 Adane Tesfaye 12,000 12 hours in the weekly rest days 2,500

Required:

A. Compute the gross earning

B. Compute the taxable income
C. Compute the pension fund contribution by the employee and employer
D. Compute the employment income tax
E. Compute the net payee
F. Prepare the payroll
Solution:

1. Tadesse Abate
A. Gross earning =4500
B. taxable income is also =4500
Deductions
C. Pension contribution
By the employee: 7%* of basic salary=0.07*4500=315
By the employer: 11% of the basic salary=0.11*4500= 495
D. EIT=taxable income * tax rate- deduction(adjustments)
4500*0.20-302.50= 597. 50
E. Red Cross society contribution 20 birr
F. Net pay= gross earning - pension contribution- income tax- Red Cross society
contribution: 4,500-315-597.50 -20 = 3,567.50
2. Tedros Ephrem
A. Gross earning =basic salary+ over time
Over time per hour = basic salary/monthly working hours
=6000/ (192hours) = 31.25
Ordinary over time = 10*31.25*1.25=390.625
Late time overtime = 15*31.25*1.5=703.125
Total over time payment= 1,093.75
Gross earning = 6,000+1,093.75= 7,093.75
B. Taxable income is also =7,093.75
C. Pension contribution

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By the employee: 7%*of basic salary=0.07*6000=420

By the employer: 11% of the basic salary=0.11*6000= 660
D. EIT=taxable income * tax rate- adjustments
7093.75*0.25-565= 1208.44
G. Net pay= gross earning- pension contribution- income tax- Red Cross society
contribution: 7093.75 – 420 - 1208.44 - 20= 5445.31
3. Adane Tesfaye
A. Gross earning =basic salary+ over time+ fuel allowances+ position allowance
Over time per hour = basic salary/monthly working hours
=12,000/ (192hours) = 62.50
Weekly rest days over time payment = 12*62.50*2=1,500
Gross Earning = 12,000+1,500+2,500 +500 = 16,500
B. Taxable income =Gross earning – fuel allowances exemption
C. The fuel allowance is exempted up to 25% of the basic salary but not exceed 2,200 birr.
0.25*12,000=3000 this is higher than the maximum limit 2,200
D. Therefore only 2,200 birr is exempted while the rest of transport allowance (2500-
2000=300) is taxable.
Taxable income= 16,500 - 2,200=14,300
Deduction
E. Pension contribution: By the employee: 7%*of basic salary=0.07*12,000=840
By the employer: 11% of the basic salary=0.11*12,000= 1320
F. EIT=taxable income * tax rate- adjustments 14,300*0.35-1,500= 3,505
Credit association contribution = 12,000*0.10= 1,200
Computation of Employment Income Tax on Bonus

Computation of bonus has the following steps:

A. Determine the amount of bonus to be paid for the employees

B. Calculate the monthly tax amount using the basic salary
C. Divided the bonus amount in 12 months because bonus is paid for outstanding performance
that employees achieved in the year. However if the employees have service duration of
less than 12 months the amount of bonus should divided to the numbers of months in which
the employees serves in the year.
D. Calculate the monthly income tax using the taxable income you get in “C”
E. Find the difference of the monthly income tax you get in step “D” and “B” and multiply by
12 months or by the service duration of the employees in the year expressed in months.
This is the total tax to be paid from the bonus.
F. Net pay= total bonus-tax amount on the bonus

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Example two: Consider the employees of the ABC plc. The management of the company
decided to give bonus two months’ salary for permanent employs worked more than six month
and 1 month basic salary for theses that are hired after January1 for the year 2008 E.C.

No Employees Name Date of Employment Basic Salary Total Bonus

1 Tadesse Abate Jan 30/2008 EC 4500 4500

2 Tedros Ephrem Sep 11/2007 EC 6000 12,000

Required:
A. Compute the total tax that must be paid from the bonus of the employees
B. Compute the net bonus paid to each individual
Solution
1. Tadesse abate
A. Taxable income using the basic salary
4500*0.20-302.50=597.50
B. The total bonus is divided to the service duration during the year that is
4500/5=900
By adding to the basic salary you will get (4500+900=5400)
C. The income tax after bonus is 5400*.25-565=780
D. Total tax from bonus (780-597.50)*5=937.50
The net pay =bonus-tax (4500-937.50=3562.50

2. Tedros Efrem
A. Taxable income using the basic salary
6000*0.25-565=935
B. The total bonus is divided to 12 months 12,000 /12=1000
By adding to the basic salary you will get (6000+1000=7000)
C. The income tax after bonus is
7000*.25-565=1185
D. Total tax from bonus (1185-935)*12=3000
The net pay =bonus-tax (12,000-3000=9000

4.2.8. Accounting Treatment for Employment Income Tax

To explain the journal entries consider the above ABC plc payroll register and recorded in the
general journal as follows.

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Dat
e Items post ref. Debit Credit

28,093.7
salary expenses 5

19,947.8
Cash 1

Employees Pension cont. payable 1,575

Employment income tax payable 5,310.94

Credit association contribution

payable 1,200.00

Red cross society contribution payable 60

To record the employees’ pension contribution and employment income tax

Dat
e post ref. Debit Credit

Payroll expenses 2,475

Employer Pension cont. payable 2,475

To record the employer pension contribution

Date post ref. Debit Credit

Employees Pension cont. payable 1,575

Employer Pension cont. payable 2,475

Employment income tax payable 5,310.94

Credit association contribution

payable 1,200.00

Red cross society contribution payable 60

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Cash 10,620.94

When it is declared and paid to tax authority

4.1.2. Accounting for Rental Income Tax

Rental income tax includes all forms of income arising from rent of building and rent of furniture
and equipments if the building is furnished. In Ethiopia the rules for rental income tax is
indicated in the income tax pro. 979/16 from Art 13 up to Art 17, the income tax proclamation
classifies income from renting of building as Schedule B income.

There are different parities that involve in renting of the building: the lessor and lessee. The
lessor is the owners of the building and provides rental service to another person. The lessee is
an individual or an entity who rents the building directly from the lessor. The lessee is the
physical processor and users of the building.

However there may be sub-lessor that is a third party who leases a building directly from the
lessee for residential, business or any other use. In this circumstance the lessee becomes a sub-
lessor is a person or entity who further leases the whole or part of the building with the
permission of the lessor.

[Link]. Taxable Rental Income Tax

According to the income tax, proclamation taxable income from renting of building includes the
gross amount of income derived by the taxpayer from the rental of a building for the year
reduced by the total amount of deductions allowed to the taxpayer for the year. The gross
income from rental of building includes:

 All amounts derived by the taxpayer during the year under the lease agreement, including
any lease premium or similar amount;
 All payments made by the lessee during the year on behalf of the lessor according to the
lease agreement;
 The amount of any bond, security, or similar amount that, during the year, the taxpayer is
entitled to retain as a result of damage to the building and that has not been used by the
taxpayer in repairing the damage to the building;
 The value of any renovation or improvement made under the lease agreement to the
building when the cost was borne by the lessee in addition to the rent payable to the
taxpayer.

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More over if, a taxpayer leases a furnished building, the gross amount of income derived by the
taxpayer from the lease of the building shall include any amount attributable to the lease of the
furniture or equipment. The taxable rental income does not include exempted incomes.

[Link]. Rental Income Tax Rates

The rental income tax rates are two types. The first rate is applicable to bodies at flat rates of
30% of their rental income tax. The second rate is applicable to individual taxpayers in the
following manner.

Rental Income Deduction or

Taxable Rental Income
Adjustments for
(per year) Birr
Tax Rate short cut method

0 -7,200 0% 0

7,201-19,800 10% 720

19,801-38,400 15% 1,710

38,401-63,000 20% 3,630

63,001-93,600 25% 6,780

93,601-130,800 30% 11,460

Over 130,800 35% 18,000

Rental income tax (RIT) =Taxable income*Tax rate-Adjustments

[Link] Computation of Rental Income Tax

The computation of rental income tax is two types for these who do not have an obligation to
maintain books of accounts and for theses who maintains books of accounts (category A and
B tax payers).

In computing the taxable rental income for a tax year of a taxpayer who does not maintain
books of account, a deduction (rental expenses) shall be allowed for the following amounts:

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a) any fees and charges, but not income tax, levied by a State or City Administration in respect
of the land or building leased and paid by the taxpayer during the year;

b) an amount equal to fifty percent (50%) of the gross rental income derived by the taxpayer
for the year as an allowance for the repair, maintenance, and depreciation of the building,
furniture, and equipment.

In computing the taxable rental income for a tax year of a taxpayer who maintains books of
account, a deduction shall be allowed for any expenditures to the extent necessarily incurred
by the taxpayer in deriving rental income and paid during the year including:

a) The cost of the lease of land on which the building is situated;

b) Repairs and maintenance;

c) Depreciation of the building, furniture and equipment;

d) Interest and insurance premiums; and

e) Fees and charges, but not income tax, levied by a State or City Administration in
respect of the land or building leased.

Here if the allowable deduction exceeds the gross income earned from renting of the building,
there is a Rental Loss. Hence loss carry forward is allowed for the tax payers and the detail of
loss carry forward scheme is discussed in section 4.4 of this chapter.

The taxable rental income of a sub-lesser of a building for a tax year shall be the difference
between the total rental income received by the sub-lesser during the year and the total
rental income paid to the lesser of the building plus other expenses to the extent necessarily
incurred by the sub lesser to generate the income. Here, the owner of a building who allows a
lessee to sub-lease the building shall be liable for the rental income tax payable by the lessee if
the lessee fails to pay the tax.

Gross Income from leasing activities XXX

Less: Allowable deductions XX

Taxable income XXX

Rental Tax = Taxable income X Tax rate less Adjustments

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[Link]. Rental Income Tax on Advance Collection

The amount of rent income received or receivable by a lessor for the rental service of the tax
year is normally a basis to compute the rental income tax due for that tax year. In certain
circumstances a lessor may receive from the lessee rent payments in advance that covers a period
longer than one year. The computation of rental income tax due on advance payment depends up
on the category of tax payers.

If the lessor maintains books of account (category A and B tax payers), accrual basis of
accounting is applied recognize the transaction of the rental activities. According to accrual
basis of accounting if a lessor receives advance rent payment that cover more than one year from
the lessee, the lessor rental income tax such receipts is computed in the tax year in which the rent
services is actually rendered. In other words the unearned rental income is differed to the tax
year that the rental service will be rendered.

If the lessor does not maintains books of account (category C tax payers), cash basis concept
is applied for his rental operation. The amount of rental income tax liability is computed in the
period in which the advance payment is received. Here, the advance payment covers more than
one year tax period; the tax is calculated for each year by perorating the advance collection to the
number of the years that covers it.

[Link]. Declaration and Payment of Rental Income Tax

The time allowed for declaration of taxable income and payment of taxes the same as that of
schedule ‘C’ tax. Remember that a taxpayer who has taxable income from rent shall declare the
income (Art 83).

 Category A taxpayers Within 4 months after the end of fiscal year

 Category B taxpayers Within 2 months after the end of fiscal period
 Category C taxpayers Within 1 month after the end of the fiscal period
[Link]. Record Keeping Obligations Related to Rental Income: the income tax proclamation
979/2016 clearly indicates the record keeping obligation related to Category of “A” and “B”
taxpayers engaged in renting of buildings. That is these taxpayers who are liable for tax under
Schedule “B” shall keep the following record of accounts:
 Rental income received;
 Fees and charges paid to a State or City Administration in relation to the building;
 Any expenditures incurred in relation to the building;
 A register of rental buildings showing the acquisition date, the cost of acquisition, any
costs of improvement in relation to the building, and the current net book value of the
building;
 Any sub-lease arrangement in respect of the building.

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[Link]. Journalizing Transaction Related to Rental Income Tax

Transaction related to the payment of rental income tax is recognized as follows:

General Journal

Dat
e Description Items post ref. Debit Credit

Rental income tax expenses xxxxxxx

Rental income tax payable Xxxxx

If there is withholding rental income tax the transaction is

recognized as follows

Dat
e Description Items post ref. Debit Credit

Rental income tax expenses Xxxxxxx

Prepaid withholding rental income tax Xxxxx

Rental income tax payable Xxxxx

Illustration1: suppose w/ro Ayan has rented her building in July 1, 2015 E.C. for monthly rent
of birr 12,000 and leases on land paid to JJ city administration during the year was birr 5,000. In
addition, she was category “C “tax payer.

Required: Compute the annual rental income tax of w/o Ayan for the year ended July 1, 2015
E.C

Solution: Gross rental income: ……………………….12,000*12= 144,000

Less allowable deductions
Lease on land…………………………….…………………….. (5000)
Repair, maintenance and Depreciation

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(50% of the gross rental income)……….0.5*144,000……….(72,000)

Taxable Income ………………………………………………. 67, 000
Tax payable …………… (67,000*0.25- 6780)………………….9,970

Illustration 2: Suppose Ahmed PLC has rented his building found in Jijiga, Arada Kebele 04 for
monthly rental of Birr 140,000 in June, 2015 EC. The company also provides the following
financial information in relation to the building:

 Cost leases paid on land………………………………...14,0000

 Book value of the building at the end of fourth year…….8,000,000
 Insurance premiums paid on the building ………………..40,0000
 Outstanding loans taken for construction (at 9.5% interest)….3,000,000
 Wages of building administrators and cleaning expenses……..90,0000
Required: Compute the Rental income tax paid at the end of the year 2015 E.C and journalize
the rental income tax at July 1, 2015 E.C..

Solution: Gross rental income ……………..( 140,000*12)…………………………..1,680,000

Less allowable Deductions:

 Leases paid on land…………………………14,0000

 Depreciation expenses on building………….400,000
(.05*8,000,000)
 Insurance premium………………………….40,0000
 Interest expenses(.095*3,000,000)…………..285,000
 Wages and general expenses…………………90,000………………………….(829,000)
Taxable Income …………………………………………………………………………851,000

Since the taxpayer is Body the rental income tax rate applied is 30%

Rental Income tax (851,000*0.30) ……………………………………………………255,300

Journal entry

Item
Date Description s post ref. Debit Credit

255,30
Sense 30,2015 Rental income tax expenses 0

Rental income tax payable 255,300

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When the rental income tax is declared and paid to the tax authority within the four months after
the end the year, the transaction will be recorded as follows:

Item
Date Description s post ref. Debit Credit

255,30
OCT. 20, 2015 Rental income tax payable 0

Cash in bank 255,300

4.1.3. ACCOUNTING FOR INCOME TAXES FROM BUSINESS

One of the major tax revenue sources to the Ethiopian government is undoubtedly business
income tax (business profit tax) that the government charges from the annual gross of business.
Currently the tax which, is collected from business income is computed per schedule “C”.
Accordingly this section is devoted to indicate the basic concept, computation and accounting
treatment of transactions related to Ethiopian business income tax law in accordance to the new
income tax proclamation of 979/2016, tax administration proclamation 983/2016 and income tax
regulation No 410/17 and Tax Administration Regulation 407/2017.

[Link]. Category of Taxpayers, and Tax Reporting period

For the purposes of payment of business tax, taxpayers are categorized in to three namely,
Category A, Category B, and Category C.

Category ‘A’ includes any company incorporated under the laws of Ethiopia or in a foreign
country (Bodies) and individual tax payers having annual Sales turnover of Birr 1,000,000.00
and above. Those who are categorized under ‘A’ have to maintain all records and accounts which
will enable them to submit a balance sheet and profit and loss account disclosing the gross profit,
general and administrative expenses, depreciation, and provisions and reserves (together with the
supporting vouchers). Pay tax within 4-month period starting from end of their tax year
(from Hamle 1 to tikimit 30).
Category ‘B’ includes those individual taxpayers having annual sales turnover of more than Birr
500,000.00 and less than Birr 1,000,000.00. They have to submit the profit and loss statement
together with the supporting vouchers. Pay tax with in 2 month period of time starting from
end of their tax year (from Hamle 1 to Nehasie 30).

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Category ‘C’ includes all taxpayers who are not classified under the other two categories and
whose annual turnover is estimated at Birr 500,000.00 or less. Pay tax with in 1 month period
of time starting from end of their tax year (from Hamle 1 to 30). They pay tax based on
standard assessment schedule annexed to the income tax regulation Here theses tax payer
engaged in business transport service shall pay the withholding tax from employment income
together with their business income tax.
[Link]. Preservation of Books and Accounts
Every businessman (except category C) is required to preserve all books of accounts and other
records and documents for a period of not less than 5 years for category “A” tax Payer and
For 3 Years for category “B” tax Payer after the year of income to which such books and
documents relate.

Particularly in accordance the income tax proclamation (ITP) of article 59, Category ‘A’ tax
payers liable for business income tax shall keep books of account prepared in accordance with
the financial accounting reporting standards and, in particular shall keep the record of:

 business assets and liabilities of the taxpayer,

 all daily income and expenditures;
 all purchases and sales of trading stock, and services provided;
 trading stock on hand at the end of the taxpayer’s tax year,;
 Any other document relevant in determining the tax liability of the taxpayer
On the other hand Category ‘B’ taxpayers liable for business income tax shall keep the
following: a record of daily income and expenditures; all purchases and sales of trading
stock; salary and wages register and any other document relevant in determining the tax liability
of the taxpayer.

Category ‘C’ taxpayers may keep a record of gross income and other records that category B
taxpayers required to maintain. In addition, if these taxpayers are employing a worker shall keep
documents showing any amount of employment income paid to the employee and any amount
withheld in tax from such income (Income tax regulation Art 59). Category C tax payer that
maintains books of accounts may pay their tax accordingly if the books of account maintained
are accepted by the tax authority.
[Link]. Methods of Tax Accounting (Article 64)
The period of tax assessment is one fiscal year. The fiscal year starts on Hamle 1 and ends on
Sene 30. The body can change the accounting year only with the permission of the tax authority.
When the tax period of a body is changed (with the permission) the period between the previous
tax period and the new period will be treated as a ‘transitional period’.

Category “A” taxpayers are required to use international financial reporting standards
(IFRS) particularly accrual basis of accounting to record their business transactions.

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Category “B” shall follow simplified methods of accounting that is cash basis of accounting to
account for business income and deductible expenditures. The rate of depreciation applicable to
the depreciable assets and business intangibles of the taxpayer shall be 100%; and deduction is
allowed for the cost of trading stock acquired during the year. However, as per the income tax
regulation Art 58 these taxpayers can voluntary account on accrual basis of accounting
provided that they comply with the requirement set under international financial reporting
standards.

Long-term Contracts (Art 32): A taxpayer accounting for business income tax on an accrual
basis shall include amounts in business income and claim deductions for expenditures arising
under a long-term contract for a tax year based on the percentage of the contract completed
during the year. The computation will be made based on cost to cost method.
Change in Accounting Method: A taxpayer may apply to the Authority, in writing, for a
change in the taxpayer’s method of accounting and the Authority may, by notice in writing,
approve the application but only when satisfied that the change is necessary to properly compute
the taxable income of the taxpayer. If a taxpayer’s method of accounting changes leads to the
change in the Category of the taxpayer, the taxpayer shall make adjustments in the tax year of
change to items of income, deduction, and credit, and to any other items affected by the change,
so that no item is omitted and no item is taken into account more than once.

[Link]. Depreciation of Business Asset and Business Intangible

Depreciable asset means tangible movable asset or a structural improvement to immovable asset
that:

(1) Has a useful life exceeding one year;

(2) Is likely to lose value as a result of normal wear and tear, or obsolescence; and
(3) Is used wholly or partly to derive business income
As it is stipulated in the income tax regulation of Art 36 to 41, both diminishing value
(declining balance method) and straight line method is allowed to compute the depreciation
amount. The Business intangible and structural improvement should be depreciated only
under straight line method. Here structural improvement means a building or any other addition
or alteration to immovable asset that becomes part of, or is permanently affixed to, the
immovable asset including a road, driveway, car park, fence, or wall.
Rate of Depreciation
Depreciable Tangible Asset Straight line rate Diminishing value rate

Computer, software and data storage equipment 20% 25%

Green house 10% Not allowed
Structural improvement other than greenhouse 5% Not allowed
Any other depreciable assets 15% 20%

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Depreciable assets used in mining and petroleum 25% 30%

development operation

Here under diminishing value method depreciation is computed by applying the rate on the Net
book value of the asset at the beginning of the year.
The rate of depreciation applicable for business intangible includes the following:
 Preliminary expenditure (25%): an expenditure that provides an advantage or benefit
for a period of more than one year, incurred before the commencement of a business but
not including expenditure incurred to acquire any tangible movable or immovable asset.
 Business intangible useful life more than 10 year except preliminary expenditure=
10%
 Any other business intangible 100% divided by the useful life of the intangible
If the balance of depreciable asset of the taxpayer is not more than two thousand birr the amount
shall be fully allowed deductable from the income of the tax year.
Repair and improvement expense allowable as deduction if it is not exceeded 20% of the net
book value of the asset at the end of the tax year. However, if the improvement made to the fixed
asset exceeds 20% of the net book value of the asset at the end of the tax year, the whole cost of
improvement or repair shall be added to the net book value of the asset.
Depreciation on assets such as fine art, antiques, jewelry, trading stock etc (which are not subject
to wear and tear) are not allowed. Likewise, gain obtained as a result of revaluation of assets
shall not use as a basis for determining depreciation base.
For assets for which the pooling method is used, the rate is applied to the depreciation base for
the determination of depreciation. Depreciation base is the book value of the asset on the opening
day of the tax period, increased by the cost of acquisition, creation, renewal etc during the period
and reduced by the sales price of the asset disposed during the period. Loss incurred during the
period due to natural calamity and other involuntary conversion will also be considered for the
computation of depreciation base. Any compensation received for these purposes will be
deducted from the book value. While determining the depreciation base, if it becomes negative,
it will be added to the taxable income.
[Link]. Taxable Business Income
The taxable business income of a taxpayer for a tax year shall be the total business income of the
taxpayer for the year reduced by the total deductions allowed per the tax law.
1. Allowable Deductions
In order to determine taxable income under Schedule ‘C’, the following items of expenditures
are permissible.
A) Direct cost of producing the income such as the direct cost of manufacturing,
purchasing, importation, selling and such other similar costs.
B) General and administrative expenses incurred for earning, securing and
maintaining the income
C) Depreciation expense computed in accordance the income tax regulation

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D) Bad Debt Expenses To be a deductible item, the amount must have been included
previously in income, the debt must have been written off in the books, and legal
actions have been taken for the collection of the debt
E) Insurance Premium payable on insurance directly connected with the business
activity.
F) Expense incurred for the promotion of business. The maximum limit for this
expense will be set by directives to be issued by ERCA.
G) Commission paid for services rendered, provided that the amount shall not exceed
the normal rates provided by other similar businesses or persons.
H) A loss on disposal of a business asset (other than trading stock) disposed of by the
taxpayer during the year
I) Representation expense not exceeding 10% the income of the employees
J) Medical expense incurred for employees including premium payments under
employees health insurance scheme
K) Expenditures incurred in the provision of food and beverage services by Hotels,
restaurants, or other similar establishments for their employees, to the extent limit
sated by the ministry directives
L) Lease payment made for business asset held under a capital goods lease agreement is
deductable business expenditure
M) Head Office Expenses: Payment made by a permanent establishment doing business
in Ethiopia to its parent non- resident body in reimbursement of actual expenses
incurred by the parent non-resident. Body for the benefit of the permanent
establishment shall be deducted to the extent that such expense was incurred in
deriving, securing or maintaining business income.
N. Interest expense: A deduction for any interest incurred by the taxpayer in a tax year
is allowed to the extent that the taxpayer has used the proceeds or benefit of the debt
or other instrument or agreement to derive business income.
Here deduction is not allowed if Interest paid or payable by a taxpayer in excess of
the rate used between the National Bank of Ethiopia and commercial banks increased
by 2 percentage points; unless the interest is paid or payable to a financial institution
recognized by the National Bank of Ethiopia; or a foreign bank permitted to lend to
persons in Ethiopia. Moreover, interest paid or payable by a taxpayer to a related
person who is a resident of Ethiopia except when the interest is included in the
schedule ‘D’ of the related person is not allowed as deduction from business income.

O. Charitable Donations under the following conditions.

a. If they are given to welfare organizations that have a record of outstanding
achievement and have a good accounting system showing the utilization of
resources.

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b. If the payments are made under emergency call issued by Gov’t to defend
sovereignty and integrity and to prevent manmade or natural catastrophe,
epidemic or any other similar cause
c. If the donation is made in support of education, health, environment
protection or provided in the form of humanitarian aid other than for the
taxpayer owns employees.
(Note: Grants and donation will be allowed as deduction only if it does not
exceed 10% of the taxable income)
P. Special Reserves: Financial institutions are permitted to deduct special reserves
from taxable income in accordance with the directives issued by NBE.
Q. Reinvestment of Profit: A Regulation by the Council of Ministers allows a
deduction of reinvestment of profit (of a resident company or registered partnership)
not exceeding 5% of the taxable income every year.
2. Non - allowable deductions and losses
All those expenses, which are not wholly or exclusively incurred for the business activity,
shall not be allowed as deductions per the provisions of law. Such expenses include:
a) An expenditure of a capital nature

b) An increase in the share capital of a company or the basic capital of a registered

partnership;

c) Voluntary pension or provident fund contributions in respect of an employee in excess

of 15% of the monthly employment income of the employee;

d) Dividends and paid-out profit shares;

e) An expenditure or loss to the extent recovered or recoverable under a policy of

insurance, or a contract of indemnity, guarantee, or surety;

f) A fine or penalty imposed, or punitive damages awarded, for violation of any law,
regulation, or contract;

g) An amount that a person has transferred, in its financial accounts, to a reserve or

provision for expenditures or losses not yet incurred but expected to be incurred in a
future tax year;

h) Income tax paid under this Proclamation or under a foreign tax law, or recoverable
value added tax;

i) Representation expenditures of an employee in excess of 10% of the employment

income of the employee;

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j) Expenditure incurred in the provision of entertainment, except:

(1) When the person’s business involves the provision of entertainment; or

(2) to the extent that the expenditure is allowed as a deduction under a Directive issued
by the Minister relating to food provided for free to employees by an employer
conducting a mining, manufacturing, or agricultural business;

k) A donation or gift except as provided for in Article 24 of this Proclamation;

l) Personal consumption expenditure;

m) A loss on the disposal of a business asset by a taxpayer to a related person;

n) Expenditure to the extent disallowed under Regulations to be issued by the Council of

Ministers.

[Link]. Business Income Tax Rates

The rate of business income tax applicable to a body is [30%]. While, the rates of business
income tax applicable to an individual are:

Taxable Business Income Business Income Deductions for Short

(per year) Birr cut method
Tax Rate
0 - 7,200 0% 0
7,201-19,800 10% 720
19,801-38,400 15% 1710
38,401-63,000 20% 3630
63,001-93,600 25% 6780
93,601-130,800 30% 11460
Over 130,800 35% 18000

Business Income Tax = Taxable business income* tax rate less deductions

[Link]. Declaration and Payment of Tax

The following is the procedures for the declaration of taxable income by taxpayers

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A) Taxpayers categorized as ‘A’ are required to declare their taxable income within
four months from the end of the tax period. They are required to submit statement
of financial position and profit loss statements.
B) Those taxpayers who are categorized as ‘B’ are required to declare their taxable
income within two months from the end of the tax period. . They are required to
submit profit loss statements.
C) Category C taxpayers shall declare taxable income together with the annual
turnover, and the amount derived from the sources other than the main operation,
within one month after the end the tax year. The taxable income of category C
taxpayers will be determined through a standard assessment. The presumptive
business tax to be paid by category 'C" taxpayers shall be calculated in accordance
with the SCHEDULE attached to the income tax regulation
Declarations are to be made in prescribed forms prescribed by the tax authority accompanied by
the required supporting evidences. If a taxpayer engages in business in more than one region,
taxable income shall be declared in the respective regions.

[Link]. Assessment of Tax

Assessment is a tax review by a tax official of the tax declaration and information provided by a
taxpayer and a verification of the arithmetical and financial accuracy of the declared tax liability.
The procedure for the assessment of business income tax takes two forms, A) assessment by
books of accounts, and B) assessment by estimation. Assessment by books will be done for those
who maintain books of accounts (Category A&B). The revenue authority makes assessment by
estimation when the taxpayers do not maintain the books or when the submitted books are not
acceptable. This is also done if the taxpayer fails to declare his/her taxable within the time
required. Tax, of those taxpayers who have different sources of income, will be assessed on the
aggregate of all income.
[Link]. Loss Carry forward (Article-26):

If the total amount of deductions allowed to a taxpayer for a tax year exceeds the total business
income of the taxpayer for the year, the amount of the excess shall be the taxpayer’s loss for the
year. In such case the taxpayer can carry the amount of the loss forward to the next following tax
year to be deducted in computing the taxpayer’s taxable income for that following year. The loss
will be carried forward for a maximum of five consecutive years after the year in which the loss
is incurred. The taxpayer is allowed to carry forward only two tax period losses. Here the loss
earliest year shall be deducted first and loss carry forward is allowed only if the taxpayer
maintains books of accounts showing the loss are audited and acceptable by the tax authority.

Loss Carry Back: When, at the end of the final tax year of a long term contract, a taxpayer has a
final year loss in relation to the contract that the taxpayer is permitted to carry forward under
Article 26 but if it is unable to do so for the reason that the taxpayer ceases to carry on business
in Ethiopia at the end of the contract, the taxpayer may carry the loss back to the preceding tax

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year and the loss shall be allowed as a deduction and carried back ward till the loss is fully
deducted. .

If during a tax period the direct or indirect ownership of the share capital or the voting
rights of body changes more than fifty percent (50%), by value or by number, loss carry
forward and back is not allowed.

[Link]. Foreign Tax Credit

If a resident taxpayer has foreign income taxable under “Schedule C” in respect of, which the
resident has paid foreign income tax, the taxpayer shall be allowed a tax credit (referred to as a
“foreign tax credit”). The amount foreign tax credit is equal to the foreign income tax paid; or
the business income tax payable under Schedule ‘C’ in respect of the foreign income. Here,
foreign tax credit shall be allowed when:

 The resident taxpayer has paid the foreign income tax within 2 years after the end
of the tax year in which the foreign income was derived by the taxpayer or within
such further time as the Authority allows and
 The resident taxpayer has a receipt for the tax from the foreign tax authority.
If a foreign tax credit of a resident taxpayer for a tax year is not fully credited for the year, the
excess credit shall not be refunded, carried back to the preceding tax year, or carried forward to
the following tax year.

Foreign Business Losses (Art 46): in relation to a resident taxpayer for a tax year, means the
amount by which the deductible expenditures incurred by the taxpayer in deriving foreign
income taxable under Schedule “C” exceeds the amount of that income for the year. If a resident
taxpayer has a foreign loss for a tax year, the amount of the loss can carried forward to the next
five consecutive tax year and allowed as a deduction against the taxpayer’s foreign income
taxable under “Schedule C” for these years. The tax payer is allowed only to carry forward
losses foreign income only two tax period losses.
[Link]. Withholding Income Tax (Art 88 to 93)

In theory withholding tax is defined as the amount of tax to be withheld by the party making
payment to another party and to be transferred or paid to the tax authority as per the tax law. The
purpose of withholding tax could be to accelerate tax collection of the government. Withholding
income tax indicated in the Ethiopian tax law includes the following.

A. Withholding tax from imported goods: A taxpayer under Schedule ‘C’ importing goods for
commercial use shall make an advance payment of business income tax to the Authority
equal to 3% of the CIF value of the goods.
B. Withholding of Tax from Domestic Payments (Art 92): Except micro enterprises, bodies
having legal personality, government agencies, non-profit organizations, or non-
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governmental organizations and other tax payers required to withhold tax by a directive of
the authority, shall withhold tax at the rate of 2% of the gross amount of a payment made for
the following:
 The supply of goods in Ethiopia involving more than 10,000 Birr in one transaction
or supply contract;
 The supply of services involving more than 3,000 Birr in one service contract
Here if the supplier of the transaction has failed to provide their TIN and trade license to the
withholding agent, the withholding agent shall withhold tax at the rate of 30% of the gross
amount of the payment made.

The withholding agent has the obligation to issue serially numbered receipts to persons from
whom the tax is withheld. The agent shall supply the name and TIN of the taxpayer, the amount
withheld and the total amount of payment made. For this purpose, the records showing the
payment made and the tax withheld on payment should be maintained by withholding agent in
his office. It is also required that such records should be kept for a period of 5 years and should
be submitted to the tax authority as and when required by them.
C. Withholding of Tax from Employment Income: An employer paying employment income
to an employee who is subject to employment income tax shall withhold tax from the gross
amount of each payment of employment income made to the employee
D. Withholding of Tax from Payments to Non-residents: indicated in schedule D
E. Withholding of Tax from Dividends, Undistributed profit, repatriated profit, Interest,
and Royalties:
F. Withholding of Tax from Games of Chance Income
G. Self-withholding: for employees who works in organization that don’t have withholding
obligation
Payment of Withholding Tax: Tax that a withholding agent is required to withhold from
withholding income shall be paid to the tax authority within 30 days after the end of the month in
which the withholding income was paid
[Link]. Method of Preparing Tax Returns
Business normally prepares business income tax returns (that is profit and loss statements for tax
purpose) to determine and report their taxable business income per the income tax legislation.
There are two methods used to prepare the tax returns.
Independent approach: business prepares a separate income statement for income tax
reporting. The preparation of business tax return ignores the tax exempted business income and
non deductable expenses as indicated in the tax law in the following format.
Names of the taxpayer
Business income tax return
For the tax period ending June 30, 20xx
Admissible business income
Net Sales……………………………………………………………………..……xxxx
Less cost of goods sold……………………………………………………………xxxx

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Gross profit…………………………………………………………………………xxxx
Add other admissible incomes
Income from lease of business……………………………………………..…..…….xxx
Gain on foreign exchange ………………………………………..………….……..xxxx
Commission income ……………………………………………………………….xxxx
Recovery of bad debt expenses previously write off……………………………….xxxx
Gross taxable profit………………………………………………………………....xxxx
Less tax deduction expenses
Selling and distribution expenses…………………… . xxxx
Utility expenses……………………………………….. xxxx
Salary and fringe benefit expenses…………………… .xxxx
Interest expenses ………………………….………… xxxx
Depreciation expenses ………………....…….………... xxxx
Advertizing expenses ……………………..…….…… xxxx
Donation expenses………………………….….………...xxxx
Tax business income ……………………………………………………………...xxxx
Less provision for tax………………………………..……… xxxx
Net profit tax after tax………………………………………………………………xxx

Dependence approach: in the dependence approach the annual accounting profit determined for
financial reporting purpose abased on IFRS or GAAP is taken as the primary basis for the
determination of taxable business income subjected to adjustments per the relevant provision of
the tax law. This approach does not require keeping a separate set of record for income tax
reporting purpose.

Name of the taxpayer

Business income tax Return
For the tax period ending June 30/ 20xx
Pre tax accounting income in the income statement…………………………..xxxx
Adjustments
Add back
Non deductable expenses but deducted in the income statement.............. ….xxxx
Admissible income but no include in the income statement…………..……...xxxx
Deduct
Deductable expenses but not charged in the income statement….……….…..xxxx
Exempted incomes but included in the income statement………….….….….xxxx
Tax business income ……………………………………………………..……...…xxxx
Less : provisions for income tax of the period ……………………………….…….xxxx
Net profit after tax ……………………………………………………….…………xxxx
Illustration

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1. Mr. James is a foreign citizen neither domicile nor a habitual residence in Ethiopia. He
comes to Ethiopia for the first time on Ginbot 11, 2008 E.C for three months to give training
in connection with the shooting of cinematography film in. A.A. For this, he has been paid
remuneration of Br 50,000 by master company, an Ethiopian company. Mr. James comes to
Ethiopia for the second time on Meskerm 7, 2009 E.C. for the same job and left Ethiopia on
Tir 30, 2009 E.C. During this time, he has been paid birr 85,000 by master company.
Required:

A. Determine the residential status of Mr James for the tax year 2008 E.C.
B. Is his income chargeable to income tax in Ethiopia? And if your answer is yes under
what schedule he is liable to pay tax?
C. What would the residential status of Mr James for the tax year of 2009?

Solution
A. During the tax year of 2008 E.C. Mr James stayed only for 50 days only (Ginbot
11 to Sene 30, 2008 E.C). This implies he did not satisfy the condition for resident
taxpayer indicated in the income tax proclamation. Therefore, Mr James is non-
resident for the tax year of 2008 E.C.
B. Yes, he is liable to pay a tax based on source of income principle, which is taxed
under schedule “D”. That is income on non-resident’s generated through
providing technical services by nonresident to Ethiopian taxpayer subjected to tax
at rate of 15% in the form of withholding tax.
C. In the tax year 2009 E.C Mr James stayed in Ethiopia for184 days implying that
he is a resident for the tax year of 2009 E.C. and his worldwide income is
subjected for tax.
2. Adane merchandise enterprise PLC has the following buildings
 Office building acquired in July, 2005 E.C. at the cost of birr 1,500,000
 Factory building acquired in September 1, 2008E.C at the cost of birr
10,000,000 birr
Required: Compute the depreciation expense for the tax year ending June, 30/ 2008 E.C.

Solution

Deprecation of building is 5% straight line.

Depreciation expense for office building is 1,500,000*0.05= 75,000 and Factor building
is 10,000,000*0.05=500,000 per year. So depreciation expense of building for the year
2008 E.C is birr 575,000.
3. XYZ plc financial statement shows the following information (the company diminishing
value)

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 The cost of computers birr 185,000 and accumulated depreciation in June, 30/ 2007 E.C
birr 120,000.
 During the 2008 E.C tax period the company under takes the following transactions.
 Three computer and printer was purchased at the cost of Birr 30,000
 Software products costing Br 10,500 was purchased
 Seven used computers with cost of Br 48,000 and accumulated depreciation Br
45,000 was sold for Br 18,000
 Compensation of Br 3,000 was received from the vender since two of the computers
acquired during the current tax year were slightly damaged during in transit. The
company incurred Br 1,000 to maintain the computer and place them in workable
condition.
Solution

Depreciation Base

Beginning Book value balance of the pool (185,000-120,000)………………………….Br 65,000

Plus

 Purchase of cost of computer, printer and maintenance cost………Br 30,000

 Purchase cost of software product……………………………… Br10,500 40,500
Aggregate value of the pool ………………………………………………………………105,500

Less

 Sales Proceeds …………………………………………………… (18,000)

 Compensation received ……………………………………… (3,000) (21,000)
Depreciation base for the tax Year ending June 30, 2008 E.C ……………………………84,500

Depreciation expense = 84,500*0.25= 21125

4. The following was extracted from HM plc fixed asset record maintained for financial
reporting purpose for the tax years ended June, 30 2007 E.C (use diminishing value)
 The cost of pool machines at the beginning of tax year 2007 E.C. was 1,800,000 and
accumulated depreciation Br 500,000
 The company acquired new machine costing Br 50,000 in the tax year 2007 E.C
 The company had sold two used machines during the tax year, 2007 as follows
Acquisition cost Accumulated Selling proceeds
depreciation

200,000 170,000 83,800

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95,000 90,000 48,000

Required: compute the depreciation expenses deductable from gross business income of the tax
year 2007 E.C.

Solution

Book value of the pool machinery at the beginning of tax year (1,800,000-500,000) ..1,300,000
Plus: acquisition cost during the year………………………………………………..……50,000
Aggregate value of the pool……………………………………………………………1,350,000
Less: sales proceeds from disposal during the year…………………………………… (131,800)
Depreciation Base at end of tax year 2007 E.C…………………………………………1,218,200
Depreciation expense for the tax year (1,218,200*0.20)…………………………………243,640
5. On January 2008 E.C. Belaye General Importer was imported trading goods costing Br
1,000,000, fright incurred Br 310,000 and insurance charges Br 120,000. Determine the
amount withholding tax paid by the tax payer.
Withholding tax on import= 3% of CIF 0.03*(1,000,000 + 310,000+ 120,000) = Br 42,900

6. During the tax year ended 2008 E.C Glorious PLC under takes the following transaction and
determine whether or not the transaction are subjected to withholding income tax
A. On Jan 1, 2008 sold electronic items to XYZ plc for one transaction Br 9,000
There is no income tax to be with hold because the transaction is less that Br 10,000
B. On march 15, sold electronic items on account Br 20,000 with term 3/30,n/120 to XYZ
plc in a single transaction.
There is no income tax to be with hold because payment has not been effected.
C. On April 10, the company collected the outstanding receivables for sales made in March
15, the entity receives Br 19,000 in cash after deduction of the withholding tax Br 400
(0.02*20,000) and cash discount 3% 0f 20,000 Br 600.
Here the withholding tax is 2% of the gross amount does not affected by sales
discount.
D. on April 30, the company sold electronic items to HM plc for cash of Br. 20,000 in one
invoice. The company receives Br 19,600 after deduction of WIT of Br 400.
E. On June, 25 the company provided maintenance service to XYZ plc for cash of Br 5,000.
In this case the payer with holds 2% of the gross payment Br 100.
If we assume that the taxable business income of Glorious PLC is Br 50,000 the total
business income tax liability of the taxpayer will be (0.30*50,000) less WIT paid during the
tax year(500) = Br 14,100.

7. Suppose X Bank Ethiopia Share Company has its head office located in A.A and its financial
statement for the tax year ended June 30, 2008 E. C shows the following information.

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Particulars Head Office Kenya South Sudan Tanzania

Taxable Business income (in Br) 100,000 100,000 30,000 60,000
Tax rate of respective countries 30% 20% 30% 40%
Required: compute the business income tax payable to the Ethiopian tax authority.
Solution

Particulars Head Office Kenya South Sudan Tanzania

Taxable Business income (in Br) 100,000 100,000 30,000 60,000
Tax rate of respective countries 30% 20% 30% 40%
Income tax liability to respective countries 30,000 20,000 9,000 24,000
Income tax liability to the Ethiopian tax
authority on foreign source of income (A) _ 30,000 9,000 18,000
Less foreign tax credit (B) _ 20,000 9,000 18,000
Business income tax payable to Ethiopian tax
authority 30,000 10,000 _ _
That is Br 40,000 business income tax payable to the Ethiopian Tax authority.

8. The HM plc financial statement for the tax year ending June 30, 2008 E.C shows the
financial information.

HM PLC
Income Statement
For the year ended, June 30, 2008 E.C
Net Sales Br.327, 000
Less: Cost of Goods Sold 155,000
Gross Profit 172,000
Less: Operating Expenses:
Salaries and Wages Br.22, 000
Representation 6,000
Utilities 3,100
Supplies 1,200
Advertising 9,100
Entertainment 2,200
Depreciation 20,000
Interest 2,500
Miscellaneous 1,300 67,400
Operating Income Br.104,600
Additionally the following information was obtained for tax reporting purpose.

 The Br.55, 000 ending inventory cost was determined based on the FIFO method. If the LIFO
or Average Cost method had been used, the amount would have been Br.58, 000 and
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Br.52, 000, respectively.

 Salaries and wages comprise Br.1, 000 disallowable provident fund of employer’s
contribution.
 Representation expense calculated at 25% of basic salaries of the employees.
 The Br.15, 000.00 depreciation was reported on the original cost of the Br.120, 000.00
building; and the Br.5, 000.00 depreciation was also reported on the original cost of the Br.50,
000 vehicles. The accumulated depreciation at the beginning of the tax year for Building and
vehicle was Br 45,000 and Br 30,000 respectively. The company used straight line method for
Building and declining balance method for depreciating the vehicle.
 The interest is on Br.25,000, and 10% simple annual interest borrowed from a recognized
financial institution By NBE in 2008 E.C. The highest interest rate by NBE and commercial
banks for the current year was 6%.
Required: Compute the business income tax payable for the tax year using independent and
dependent approach.

Solution:

1. In accordance to the tax law taxpayer should use weighted average for inventory valuation
as a result the cost of goods sold is understated by 3,000 birr
2. The salaries and benefit are overstated by 1,000
3. Since only 10% of the basic salaries of the employees are allowable as representation
allowance to be deducted from the gross income, that is only 2,400 are allowable
deductions, as a result the representation allowance is overstated by 3,600.
4. For building the depreciation rate is 0.05 and using straight line method the annual
depreciation will be 120,000*0.05= 6000 and the depreciation rate for vehicle is 20% if we
use the diminishing value method and the depreciation expense of the year will be (50,000-
30,000) *0.20= 4,000. This implies the total depreciation allowable as deduction will be
6000+4000=10,000 and hence the depreciation is overstated by 10,000.
5. The full interest expense is allowed as deduction because it is paid to financial institutions
recognized by NBE.
6. Entertainment expense is not allowed as deduction
Independent approach

HM PLC
Tax Return
For the year ended, June 30, 2008
Net Sales Br.327, 000
Less: Cost of Goods Sold 158,000
Gross Profit 169,000

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Less: Operating Expenses:

Salaries and Benefits Br.21, 000
Representation 2,400
Utilities 3,100
Supplies 1,200
Advertising 9,100
Depreciation 10,000
Interest 2,500
Miscellaneous 1,300
(50,600)
Taxable Income Br.118,400
Less: Provision for business income tax (118,400*0.30)………..…………….…………
(35,520)
Profit after tax……..……………………………………………………………………….82,880

Using dependent approach

HM PLC
Tax Return
For the year ended, June 30, 2008

Accounting profit----------------------------------------------------------------------------------Br
104,600
Add back
Salaries and Benefits -------------------------------------------Br.1, 000
Representation ------------------------------------------------------3,600
Depreciation--------------------------------------------------------10,000
Entertainment expenses -------------------------------------------2,200
Deduct: Cost of goods sold -------------------------------------------(3,000)
Taxable business income 118,400
Less Provision for business income tax (118,400*0.30) …………………………….. (35,520)
Profit after tax…………………………………………………………………………… 82,880

4.1.4. Other Income (Schedule “D” Tax)

Incomes which are not specifically included under Schedule “A”, Schedule B and Schedule C is
categorized under this schedule. Schedule D income includes;

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[Link]..Income of NON-RESIDENTS

A non-resident who has derived an Ethiopian source dividend, interest, royalty, management fee,
technical fee, or insurance premium shall be liable for non-resident tax at the rate specified as
follows:
 For an insurance premium or royalty 5% of the gross amount of the premium or
royalty;
 For a dividend or interest, 10% of the gross amount of the dividend or interest;
 For a management or technical fee, 15 % of the gross amount of the fee
However, the income generated by non-residents through permanent establishment cannot be
taxed under this category. Rather, it is taxed under schedule “C” or “D”.
[Link]. Taxation of Non-resident Entertainers

A non-resident entertainer or group of non-resident entertainers who has derived income from
the participation by the entertainer or group in a performance-taking place in Ethiopia shall be
liable for income tax at the rate of 10% on the gross income derived from the performance
without deduction of expenditures. Here, entertainer” includes musician and sports person;
“group” includes a sporting team; and “performance” includes a sporting event.

[Link]. Taxation of Royalties

Royalty refers to a payment of any kind received as a consideration for the use of or the right to
use any copyright of literary, artistic or scientific work, including cinematography film, and
films or tapes for radio or television broadcasting, any patent, trademark, design or model, plan,
secret formula, or process, or for the use or for the right to use of any industrial, commercial or
scientific equipment, or for information concerning industrial, commercial or scientific
experience.

Royalties is subject to a tax at a flat rate of 5%. The withholding agent who effects royalty’s
payments, withholds the foregoing tax and accounts to the Tax Authority. However, if the payer
resides abroad and the recipient is a resident, the recipient must pay the tax on royalty income.
This tax is final in lieu of income tax.

[Link]. Income from games of chance

This form of income is derived from winning at games of chance (lotteries, Tom bolas, and other
similar activities). This income is subject to tax at the rate of 15%, except for winnings of less

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than Br. 100 similar to income from rendering technical activities the payer must withhold or
collect the tax and account to the Tax Authority. This tax is final in lieu of income tax

[Link]. Dividends

The taxable Income is income received in the form of dividend from a share company or
withdrawals of profits from a private limited company. Resident of Ethiopia who derives
dividend and non-resident who derives Ethiopian sources dividend that is attributable to a
permanent establishment are liable to pay dividend income tax. Dividend Income is subject to
tax at the rate of 10% of the gross amount of the dividend. The withholding agent (payer) shall
withhold or collect the tax and account to the tax Authority. This tax is final in lieu of income
tax.

[Link]. Income from casual rent

The taxable income under this category is income derived from casual rental of property (land,
building, or moveable asset) not related to a business activity. This type of income is subject to
tax at a flat rate 15% of the annual gross income. This tax is a final tax in lieu of a net income
tax.

[Link]. Interest Income

A resident of Ethiopia who derives interest and non resident who derives Ethiopian source
interest that is attributed to permanent establishment, are liable for income tax at the rate of:

5% of the gross amount of the interest derived from savings deposit with a financial institution
that is a resident of Ethiopia,; or

10% of the gross amount of the interest in any other cases

The payer must withhold the tax and account to the Tax Authority. This tax is a final tax in lieu
of income tax.

[Link]. Windfall Profit:

Windfall profit” means any unearned, unexpected, or other non-recurring gain. The directive
issued by ministry of finance and economic cooperation determines the tax rate imposed on
windfall profit.

[Link]. Gains on Transfer of Certain Investment Assets

Gains obtained from the transfer (sale or gift) of building held for business, factory, and office
and a share of companies is taxable under this category. Such income is taxable at the following
rates:-

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 Building held for business, factory, and office at the rate of 15%, and Shares and Bonds
at the rate of 30%.
 Nonetheless, Gains obtained from the transfer of building held for residence is exempted
from tax provided that such building is fully used for dwelling for two years prior to the
date of transfer.

Computation of Capital Gain Tax

In computing capital gain tax, you should follow the following procedures;

STEP 1. Determine the historical cost of the building or the par-value of the Share, as
appropriate.

STEP 2. Determine allowable deductions which includes taxes paid for the land and the
buildings

STEP 3. Determine proceeds from the transfer of capital assets

STEP 4. Capital gain taxes equals tax rate mentioned above times the amount obtained after
deducting the sum of step1 and step 2 from step 3.

Example:

ABC Co. sold a building, which is held for business for Br. 1,000,000, which is acquired at a
cost of Br. 1, 200,000. Depreciation until time of sale amounts Br. 500,000 and property tax paid
for the building Birr 50, 000.

Required: Calculate the capital gain tax payable by ABC Co.

Solution

Book value of the Building = Cost – Accumulated Depreciation

= 1,200,000 – 500, 000

= 700, 000

Property tax on the building is allowable deduction. Br. 50, 000

Capital gain tax =( Br. 1000, 000 – (Br. 700,000 + Br. 50,000)) 15%

= Br. 250,000 X 15% = Br. 37500

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[Link]. Undistributed profit

Tax shall be paid at the rate of 10% on the net undistributed profit of a body in a tax year to the
extent that it is not reinvested, in accordance with the directive to be issued by the ministry of
finance and economic cooperation.

[Link]. Repatriated Profit

A non-resident body conducting business in Ethiopia through a permanent establishment shall be

liable for tax at the rate of 10% on the repatriated profit of the permanent establishment.

4.1.4 .12. Other Income

A person who derives any income that is not taxable under Schedule A, B, C, or D is liable for
income tax at the rate of 15% on the gross amount of the income.

4.2. Indirect Taxes

Indirect taxes occupy a dominant position, as direct taxes, in the tax policies of many
governments. Especially, in developing countries like Ethiopia the lion share of the government
revenue were collected from indirect taxes. As the term indicates, the tax is not directly falling
for payment on the taxpayer, but is indirectly paid as a part of the price of goods the consumers
consume. In other words the incidence and impact of these taxes lies in different taxpayers.
Indirect taxes which are levied and collected in Ethiopia includes value added tax, turnover tax,
excise tax, custom duty and sure tax.

Accordingly this chapter comprises five section sections. The first section deal with basic
concepts and tax accounting for Value Added Tax, the second section deals with turnover tax,
the third section concerned with excise tax, and the fourth and fifth section deals with customs
duty, surtax and stamp duty in Ethiopia.

4.2.1. Basic Concept of VAT

Value added Tax (VAT) is also known as General sales tax (GST) or Consumption tax.
According to Carl S. Shoup VAT is defined as a consumption tax charged on the value added to
goods and services (or intermediate products by importers, Manufacturers, and traders at each
stages of production and distribution process. the salient elements embodied on the definition
are:

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 VAT is a consumption tax in the sense that individuals pay VAT when they are money
spends on goods and services.
 VAT is imposed on the incremental value of goods and services made at each stages of
production and distribution process.
 VAT is imposed not only on tangible goods but also on services
 VAT has a wider scope: it is levied and collected from importer, producers, wholesalers
and retailers.
 The tax burden is visible at each stages of production and distribution process

[Link]. Advantages and Disadvantages of VAT

The main advantages of VAT include the following:

 Avoids cascading of effect of tax (tax on tax)

 It is more comprehensive and equitable tax system
 Reduces a possibilities of tax evasion since the tax burden is distributed to different
entities
 It is neutral: since the VAT paid on purchase is credited from the collected tax during
sales, it has neutral effect on the production.
 Promotes capital investment and saving since it is consumption tax does not affect saving
and investment.
 Enhances export and there by foreign exchange wealth.
 It generates more revenue to the government since it has a broad base

Even though, VAT has the above merits it is seriously criticized by many scholars. Some of the
drawbacks includes:

 It is regressive in nature in the sense that unless the main basic goods are exempted it
adversely affect the low level income of citizens.
 Moreover, implantation of VAT system requires organized financial system and
advanced economic structure.
 The cost of collection and administration is high.

4.2.2. VAT Related Terms

In order to understand the concept of VAT it is better to make familiar with the following basic
terms:

 Supply/transaction: sales or delivery of goods to another entity and rendering services to

another person.
 Taxable supply/taxable transaction: good and services on which VAT is chargeable
either at standard rate or zero rate.
 Exempted supply: good and services, which are not subjected to charge of VAT, they are
out of the scope of the VAT.
 Mixed supply: providing mixture of taxable and exempted in one supply.

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 Composite supply: occurs when mixture of goods is supplied in such a way that is it is
impossible to separate the supply in to components.
 VAT registered/ taxable person: a person who supply of goods and services and
registered for VAT or liable to be registered by the tax authority.
 VAT return: it is a form filled by the taxable person and submitted to the tax authority
every month.
 Tax point: the time in which the tax is imposed

4.2.3. Principal Components of VAT

VAT has two principal components that are Input VAT and Output VAT.

1. Input VAT: is VAT paid or payable by a taxable person on purchase of goods and services.
It is not the components of the cost of purchase rather it is deducted from the collected VAT
on sales.
2. Output VAT: is the VAT collectable by taxable person at the time of taxable sales. Output
VAT is not a component of sales revenue of the person rather it is a liability to the taxable
person, which is collected by him on the behalf of the tax authority.
3. Net VAT Liability: is the difference between the input VAT and output VAT. When the
output VAT exceeds the input VAT the taxpayer has a Net VAT liability or payable, on the
other hand if the input VAT exceeds the output VAT shows the Net VAT credit/Net VAT
refundable.

4.2.4. Computation of Net VAT Liability

Net VAT liability: is the excesses of output VAT over the input VAT for a given tax accounting
period. It can be computed using one of the following three methods:

Credit/Invoice method: Net VAT liability is equal to Output VAT less Input VAT. This
method widely used in many countries

Subtraction Method: Net VAT liability is calculated by subtracting the cost from the selling
price and applying the tax rate on the difference.

Addition Method: the net VAT liability is calculating by adding the payment made to the
factors of production (wage, rent, interest etc) and profit margin and then applying the tax rate to
the sum.

4.3. VAT in Ethiopia

The introduction of value Added Tax (VAT) is probably the most important tax development in
the world. VAT has been introduced for the first time almost 50 years ago, and its applications
remained confined to a handful of countries until the late 1960’s. Today, VAT is applied in over
120 countries. This makes about 4 billion people or 70% of the world’s populations live in
countries with a VAT. In these countries VAT raises about $18 trillion in tax revenue, roughly a
quarter of all governments revenue. The Federal Democratic Republic of Ethiopia recently has
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joined the over 120 countries of the world that have already adopted VAT into their tax system.
VAT was introduced in Ethiopia by proclamation No 285/2002 with the following main
objectives.

 To collect tax on the value added whenever a sales transaction is conducted .

 To minimize the damage caused by attempts to avoid and trade the tax and ascertain the
profit obtained by tax payables.
 To enhance economic growth and to improve the ratio relationship between gross
Domestic Product and Government Revenue.
 To enhance saving and investment as it is essentially a consumption tax and does not tax
capital.

VAT replaced the former sales tax because of the following deficiencies:

 Sales tax was collected at single stage of production or distribution

 Sales tax is a tax on tax it creates cascading effect and
 VAT reduces tax evasion more than sales tax

4.3.1, Scope of Application for VAT

In Ethiopia VAT is levied, charged and collected on a taxable supply made in Ethiopia by
taxable person for consideration in the course or furtherance of taxable activity carried by the
taxable person during the accounting period. Specifically, taxable supplies fall in the scope of
VAT when the supply is:

 subjected to VAT
 made in Ethiopia or partly in Ethiopia
 made by VAT registered person
 For consideration. Consideration may refer to everything received in return for the supply
of goods or provision of services.
 Made in the normal (ordinary) activity of the business or to develop, advance and
progress of the taxable activity of a business carried by a person who supplies them.

Taxable person per the Ethiopian VAT law includes:

 a registered person – a person who is registered or required to be registered,

 a person carrying out taxable import of goods, with respect to such import,
 a non-resident person who performs services without registration,
 with respect to such services and a VAT withholding agent ( a buyer that purchase
taxable supply from VAT registered persons and obliged by the tax authority to withheld
the required tax with respect to its purchases and pays the tax withheld to the tax
authority.

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4.3.2. Types of VAT Registration

According to VAT law Ethiopia provides three types of registration for its VAT administration
purpose depending up on the criteria to be meet and the nature of the business activity: -
mandatory registration, voluntary registration, and trade sector requirement registration.

A. Obligatory Registration

A person who carries on a taxable activity is required to be registered if:

 At the end of any period of the 12 calendar months the person made taxable transactions
whose value exceeds Br. 1,000,000.
 There is a reasonable ground to expect that the person’s taxable activity shall exceed Br.
1,000,000 at the beginning of any period of 12 calendar months.

B. Voluntary Registration

Even if the annual gross income of a taxpayers is less than Br 1,000,000 in 12 months of VAT
accounting period, the taxpayer can voluntary registered for VAT if the person regularly supplies
or renders services at least 75% of his taxable goods and services to VAT registered persons, in
any 12 months period.

C. Trade Sector Requirement for Registration

Some persons who carry out taxable supply may compulsory registered for VAT regardless of
their annual sales turnover because of the nature of trade sector engaged. Specifically, these
persons that engaged in highly priced and highly demanded taxable activities and trade sectors
that requires high initial capital and which have high production volume. These sectors includes:

 Gold and ornament material traders

 Electronic materials traders
 Importers
 plastic and plastic product manufacturers
 shoe factors
 Contractor above grade 10 (grade 1-9)
 Computer and their accessories traders
 Lather and Lather product manufacturers

4.3.3. Divisional VAT Registration

A registered person may conduct taxable activities in different branches or divisions. In such
cases, the registered person must be registered only in the name of the registered person at its
main address or its head office. However, upon application in writing by a registered person
operating in corporate form, allows the registered person to register one or more of its branches
or divisions as separate registered persons if it is satisfied that the branch or division maintains
an independent accounting system and its distance from its head office is more than 100 km.

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If a division is registered separately it must file a VAT return for each accounting period.
Besides, each separately registered part of the entity is subject to all of the obligations imposed
on a registered person, but it remains a part of the entity.

In line with the above, supplies made by a separately registered division to the head office or
between separately registered divisions are treated as supplied between related persons for tax
purposes, but the supplier must issue tax invoices for those transactions and the recipient can
claim tax credits on the purchases. Expenses allocated by the head office to a separately
registered division may also be treated as taxable supplies by the head office. For purposes of the
registration threshold, the supplies of each separately registered division are included as supplies
of the entity.

Each separately registered division will be issued a taxpayer identification number and VAT
certificate number that identify it as a division of the entity. The registered division, following
separate registration, must issue tax invoices listing its unique taxpayer identification number
and VAT certificate number.

4.3.4. Cancellation of Registration

A registered person can apply to have his registration cancelled he/she ceases to make taxable
transactions. The person must apply in writing for cancellation of registration within 30 days of
the date he ceases to make taxable transactions. He must also indicate if he intends to make
taxable transactions within twelve months from the date of application.

Cancellation of registration can also be initiated by a registered person if at any time after a
period of three years of his most recent registration, his total transaction for the period of 12
months then beginnings are expected to be not more than Br. 1,000,000.

The authority is expected to approve an application for the cancellation unless it has reasonable
grounds to believe that the person will make taxable transactions at any time within 12 months
from the date of cessation.

The cancellation of VAT registration takes effect at the time the registered person ceased to
make taxable transactions or if the registered person has not ceased to do so, at the end of the
accounting period during which the person applies to the authority for cancellation. While the
cancellation of registration generally takes effect on the date of cessation, the authority can
cancel the registration retroactively if it’s satisfied that the person did not make taxable
transactions since the registration took effect.

When registration is cancelled the registered person is deemed to have sold the goods on hand in
a taxable transaction. Any obligation or liability including the furnishing of returns, in respect of
anything done by that person while the person was a registered person, is not affected by
cancellation of registration.

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Following cancellation, the authority will remove the person’s name and all other details from
the VAT register and the person is required to return the issued certificate of registration back to
the authority.

4.3.5. VAT Rates

In Ethiopia there are two types of VAT rates Zero rate and Standard supplies.

Zero VAT rate: it is applied on zero rate supplies. In this case, the input VAT incurred on
purchase to make taxable supply as allowed as to be credited. The taxable persons who supplies
zero rate supplies charges zero rate on its supplies indicating have no VAT liability. The
following supplies/ transaction are subjected to zero rates:

 Export of goods and services

 Rendering international transport services
 Disposal or transfer of taxable activity as a going concern
 Supply of gold to the national bank of Ethiopia (NBE)

Here, these taxpayers eligible to request VAT refund paid on purchase or on row materials used
to produce these good and service subjected to zero rate.

Standard Rate: the standard rate is 15%, which is applied on standard rated supplies. The input
VAT incurred to make taxable supply is allowed to be credited and the taxable person has a
responsibility to charge 15% of output VAT on its taxable activity.

4.3.6. VAT Exempted Supplies

In the case of exempted supplies, the input VAT incurred on purchase cannot be claimed rather it
is included in the cost of purchase. In accordance with the VAT proclamation, regulation and
directives the following good and service supply is exempted from VAT:

a. Supply or import of basic food items such as agricultural crops, milk, flour,
bread, Enjera, and edible palm oil etc
b. rendering educational service and child care services
c. sale or transfer of a used dwelling, or the lease of dwelling;
d. rendering of financial services;
e. supply or import of national or foreign currency (except for that used for
numismatic purposes), and of securities;
f. The import of good to be transferred to the National Bank of Ethiopia.
g. The rendering by religions organizations of religious or church related
services;
h. The import or supply of prescription drugs specified in directive issues by the
Minister of Health, and the rendering of medical services.
i. The supply of goods and rendering of service in the form of humanitarian aid,
as well a import of goods transferred to state agencies of Ethiopia and public

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organizations for the purpose of rehabilitation after natural disasters, industrial

accidents, and catastrophes;
j. The supply, kerosene, and water;
k. Goods imported by the government, organizations, institutions or projects
exempted from duties and other import taxes to the extent provided by law or
agreement.
l. Supplies by the post office authorized under the Ethiopian Postal Services
Proclamation, other than services rendered for a fee or commission.
m. The provision of transport;
n. Permits and license fees;
o. The import of goods to the extent provided lender schedule 2 of the customs
Tariffs Regulations;
p. The supply of goods or services by a workshop employing disabled
individuals if more than 60% of the employees are disabled;
q. The import or supply of books and there printed materials to the extent
provided in regulations.

4.3.7. Value of Taxable Supplies

Value of the taxable supply is the amount of the taxable supply on which the VAT base is
charged.

 Value of taxable supplies for price consideration= Purchase cost/production cost

excluding input VAT+ Profit margin. In other words, it is the difference between the
Selling price and Input VAT.
 Value of taxable supplies on import is (CIF value + customs duty + excise tax)
 The value of taxable supply in case of exchange and free supply we will considers the
fair market value of the goods
 The value of supplies on own uses the cost of the goods and services
 The value of supplies in case of transfer of assets as going concern= the acquisition cost
of the assets
 The value of taxable supplies for VAT inclusive price = the Price divided by (1.15)

Adjustment of the Value of a Taxable Transaction

Adjustment of the value of a taxable transaction in relation to a taxable transaction made by a

registered person is necessary when:

a. the transaction is cancelled;

b. the nature of the transaction is changed;
c. the previously agreed consideration for the transaction is altered, whether due to a
reduction of prices or for any other reason; or
d. the goods or services are returned in full or in part to the registered person.

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If a registered person has, as a result of occurrence of one or more of the events described above
must provide a VAT invoice, and the amount of VAT shown on the invoice is incorrect, or
shown an incorrect amount of VAT on a VAT return, then appropriate adjustment should be
made.

4.3.8. Tax Credit

Parts of the supplies made by a registered person during a tax period are taxable transactions, the
amount of tax creditable is determined as follows:

a. in respect of a supply or import received which is directly allocable to the making of

taxable transactions, the full amount of tax payable/paid in respect of the supply or
import is allowed as a credit;
b. in respect of a supply or import received which is directly allocable to the making of
exempt transactions, any amount of tax paid in respect of the supply or import is not
allowed as a credit
c. In respect of a supply or import received which is used both for the making of taxable
and exempt transactions, the rules of apportionment of the credit will be determined by a
directive to be issued by the Minister of Revenue.

Moreover, no credit is allowed for VAT on a taxable transaction to or import of a passenger

vehicle by a person unless the person is in the business of dealing in, or hiring of, such vehicles,
and the vehicle was acquired for the purposes of such business. Tax credit is allowed, however,
if the person is engaged in the business of transporting passengers for hire and the vehicle was
acquired and is licensed for that purpose.

 “passenger vehicle” means a road vehicle designed or adapted for the transport of eight
or fewer seated persons, including a double cab which, and
Credit is not allowed on a taxable transaction to, or import by, a person of goods or services
acquired for the purposes of entertainment or providing entertainment, unless the person is in the
business of providing entertainment and the supply or import relates to the provision of taxable
transactions involving entertainment in the ordinary course of that business. For a tax credit to be
allowed the person must be engaged in the business of providing taxable transactions involving
transportation services and the entertainment is provided to passengers as part of the
transportation services.

 “Entertainment” means the provision of food, beverages, tobacco, accommodation,

amusement, recreation, or hospitality of any kind by a registered person whether directly
or indirectly to any person in connection with a taxable activity carried on by the
registered person.

4.3.9. Claiming Input VAT at the Time of Registration

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Input VAT incurred on purchase before VAT registration can be claimed to be credited at the
time of registration if the following condition satisfies:

 the input VAT must be incurred or payable and must be related to goods and or
services ,and capital asset acquired for business
 the goods and or capital asset must be on hand and not fully consumed at the time of
registration
 the good and capital asset must have been purchased or imported not more than six
months prior to the date of registration

Example: Hanan Super market has been registered for VAT on 1 Jan 2008 E.C. the taxpayer
incurs the following VAT on purchase before registration.

 July 10 ,purchase computer inventory excluding VAT at Br 50,000 from VAT registered
tax payers
 August 10, pay Br 20,000 for service received including VAT
 Sep 14, purchase Vehicle at cost of 500,000 plus VAT
 Oct 19, purchase inventory at Br 100,000 plus VAT of which 50,000 of inventory value
excluding VAT was on hand at the time of registration.

Required: compute the VAT claim at the time of registration

Solution

VAT incurred on inventory on hand…………………….50, 000*.015=7,500

VAT incurred on Vehicle ………………………………500,000*0.15=75,000
Pre-registration input VAT claim………………………………………82,500

4.3.10. Input VAT Claim at the time of Deregistration

When a registration is cancelled the goods on hand are considered to be sold at their cost
implying that the input VAT will be the same as the output VAT. On the other hand the inputs
VAT claim for fixed assets on hand at the time of deregistration is determined by considering
acquisition cost, book value, total useful life and remaining useful life. Here the book value
deemed as selling cost of the capital asset at the time of registration.

Book Value= (remaining useful life/total useful life) *Acquisition cost

Total useful life for building and construction is 20 years, computer and related assets 4 years,
and other capital assets five years.

VAT creditable= Book value*0.15

4.3.11. Input VAT Claim in making Taxable and Exempted supplies

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According to the VAT Law, input VAT incurred to make taxable supply is fully credited or
claimed. But, the Input VAT incurred on purchases which is used to make exempted supplies is
not allowed to be credited rather it is considered as cost of purchase.

In case of Input VAT incurred on purchase used to make composite supply, the input VAT
claimed is determined by the following formula

Input VAT claimed = Total input VAT*(value of total taxable supplies divided by total
value of supplies)

If the total value of taxable supplies over total value of supplies is greater than 90% full amount
of the Input VAT is claimed.

5.2.12. Input VAT Claim for Capital Asset under Construction

No input tax credit is allowed for VAT incurred by registered person on a building or other
capital assets under construction for the purpose of taxable activity. However, if such asset is
completed and used for the purpose of the registered person taxable activity and starts to
generate income, the input tax is credited starting from the month that the asset starts to generate
income.

Alternatively the input tax incurred by the registered person can be capitalized as cost of the
capital asset constructed and subjected to the depreciation in accordance with the income tax
law.

4.3.13. Tax Accounting for VAT

Tax accounting for VAT includes recording of VAT transactions, computation of Net VAT
liabilities and preparation and declaration VAT return.

1. Filing tax return

Every registered person is required to file a VAT return with the Authority for each accounting
period, whether or not tax is payable in respect of that period and pay the tax for every
accounting period by the deadline for filing the VAT return. The VAT return for every
accounting period must be filed with no later than the last day of the calendar month following
the accounting period.

In cases where a registration takes place with retroactive effect, the registered person is required
to pay VAT for taxable transactions taking place since the coming into effect of the registration
and is entitled to a VAT credit according to credit procedures for registered persons. In addition,
the corresponding transactions are to be reflected on the first return filed by the registration
person and are considered as taking place during the month to which the return relates. In this
event, the registered person is entitled to issue VAT invoices for the transactions shown on the
return.

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2. Form and Manner of Filing Returns

A return must be made in the form and furnished in manner prescribed by the Authority, and
must include the information necessary to calculate the tax payable for the accounting period and
be furnished in the manner prescribed by the Authority.

3. VAT Refund System

If at least 25 percent of the value of a registered person’s taxable transactions for the accounting
period is taxed at a zero rate, the Authority will refund the amount of VAT applied as a credit in
excess of the amount of VAT charged for the accounting period within a period of two months
after the registered person files an application for refund, accompanied by documentary proof of
payment of the excess amounts.

In the case of other registered persons, the amount of VAT applied as a credit in excess of the
amount of VAT charged for the accounting period is to be carried forward to the next five
accounting periods and credited against payments for these periods, and any unused excess
remaining after the end of this five month period will be refunded by the authority within a
period of two months after the registered person files an application for refund, accompanied by
documentary proof of payment of the excess amounts.

If the Authority does not pay the refund by the date specified in the proclamation, for a
registered person who has overpaid tax and hence entitled to a refund, then, the Authority will
pay the person entitled to the refund, interest set at 25% (twenty five percent) over and above the
highest commercial lending interest rate that prevailed during the preceding quarter. In general,
if the Authority does not pay the refund in a timely manner it must pay interest calculated from
the date on which the refund was due until the date on which the payment of the refund is made.

The proclamation provides, however, that the Authority is not obliged to refund excess credits if
the amount to be refunded is not more than 50 Birr. If the amount eligible for refund is 50 Birr or
less, this amount can be carried forward and credited against tax due in the subsequent
accounting period.

Where a registered person applying for a tax refund has failed to furnish a required return, the
Authority may withhold payment of any amount refundable until the registered person furnishes
such return.

4. Recognition of VAT Transactions

 Taxable import Transaction

Inventory or other account……………… xxxx

Prepaid WIT………………………………xxxx

VAT Account (receivable)……………….xxxx

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L/C or cash…………………………xxxx

Inventory cost includes Invoice cost or the estimated valued determined by ERCA, insurance
cost, freight charge, excise tax, customs duty, surtax, cost of customs warehousing, inspection
and other costs.

 Taxable Local Purchase

Inventory or other specific assets…………xxx

VAT account………………………………xxx

Cash or pyable………………………………………xxx

WIT payable*……………………………………......xxx

*if it meets the criteria indicated in the WIT

 Local sales
Cash (receivable)……………….xxxx

Prepaid WIT*……………………xxxx

Sales……………………………………xxxx

VAT account (payable)………………...xxxx

 Exported Transaction
Cash (receivables)………………………xxxxx

Sales………………………………xxxx

4.3.14. VAT Withholding by Buyer

To minimize the damage that may cause by attempting to evade VAT and to ascertain the
collection of accurate VAT by the gov’t introduced VAT withholding by VAT amendment
proclamation No 609/2008.

Accordingly, the following entities are considered as VAT withholding agents:

 Federal gov’t organizations or agencies

 Regional gov’t agencies
 City administration agencies and
 Public enterprise

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These VAT withholding agent is obliged to withhold the required amount of VAT that should
have been paid to a taxable supplies on the transaction if the value of the transaction exceeds Br
5,000 and must be declare and pay to the tax authority with 30 days from the end of the month
in which the VAT is withheld.

Recording sales made to VAT withholding agent

Cash or receivable………………………..…xxxx

VAT withheld……………………………….xxxx

Prepaid WIT…………………………………xxxx

Sales………………………………………………..xxxx

VAT account……………………………………….xxxx

Illustration 1: LG Company is a VAT registered taxpayer located in A.A and its books of
account for October, 2008 E.C shows the following transaction excluding VAT.

 Purchase of Inventory from VAT registered Br 1,500,000 and non VAT registered Br
30,000
 Import inventory at CIF value Br 2,500,000 , Excise tax and customs duty Br 265,000
 Selling and admin expenses incurred Br 432,000 and 32, 000 was for entertainment
 Sales 900,000 units at VAT exclusive price Br 6 to local market and export 300,000 units
at VAT exclusive price Br 6.5 per unit.

Required: determine the Net VAT liability (VAT Return) for the month of OCT, 2008 E.C

Solution

Output VAT

Sales to local market (900,000*6)*.15…………………810,000

Export (300,000*6.5)*0.00……………………………..0
Total output VAT………………………………………………………810,000
Input VAT

Local purchase (1,500,000*0.15) ............................…... 225,000

Import (2,765,000* 0.15)……………………………….414,750
Taxable expenses (400,000* 0.15)……………………….60, 000
Total Input VAT………………………………………………………………… (699,750)
Net VAT liability…………………………………………………………………110,250
Illustration 2

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Belen PLC is a VAT registered taxpayer that sells electronic materials in A.A. In June, 2008 E.C
the company undertakes the following transaction:

June 1. purchase inventory from YBZ company for cash at price Br 8,000 plus VAT
June 5. purchase inventory from KK plc at Br 18,000 + VAT
June 10. import inventory at C=80,000, insurance 7,000, freight charge 10,000, customs
duty
and excise tax 48,5000. In addition, the company also incurs 2,00 customs ware
house cost before VAT is paid
June 13, purchase consulting service at Br 800+ VAT
June 15, paid telephone bill to ethio-telecom Br 6,000+ VAT
June 18, defective inventory costing 2,000 excluding VAT charges purchased on June 1
from
YBZ company was returned to the supplier
June 20, withdrawal of by an owner inventory costing before VAT Br 2,000 for personal use
June 22, sales of inventory to various customers at price Br 300,000 +VAT and the CGS
was
Br 200,000
June 25, sales of inventory to XYZ plc at 200,000 +VAT and the CGS was Br 110,000
June 28, sales of inventory to A.A university at price 300,000 + VAT and the CGS was
200,000
Required: journalize the above transaction by considering perpetual inventory system

Solution

1. Inventory ………………… 8,000

VAT account ……………..1,200

Cash………………………………9,200

2. Inventory………………………………18,000

VAT……………………………………2,700

Cash………………………………………20,340

WIT payable (0.02*18,000)………………360

3. Inventory…………………………147,500

VAT (147,500*0.15) ……………..22,125

Prepaid WIT (97,000*0.03) ……….2, 910

Cash……………………………172,535

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4. Consulting service expense…………………800

VAT account………………………………..120

Cash…………………………………………920

5. Utility expense………………6,000 Here telecom service is not subjected to WIT

VAT account ……………….…900

Cash…………………………………6,900

6. Cash (Account receivable)………………..2,300

Inventory…………………………………2,000

VAT account……………………………….300

7. Drawing account ……………..2,300

Inventory…………………………………2,000

VAT account……………………………….300

8. Cash………………………….345,000

CGS………………………….200, 000

Sales……………………………..300,000

VAT account …………………….45, 000

Inventory……………………….200, 000

9. Cash…………………………………….226,000

Prepaid WIT (200,000*0.02)……………4,000

CGS…………………………………….110, 000

Sales…………………………………200,000

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VAT account …………………………..30, 000

Inventory………………………………110,000

10. Cash……………………………………….294,000

Prepaid WIT (300,000*0.02)……………….6, 000

VAT withheld………………………….......45,000

CGS……………………………………….200, 000

Sales…………………………………..300,000

VAT account …………………………..45, 000

Inventory………………………………200,000

4.4. Turnover Tax (TOT)

In Ethiopia TOT was introduced by proclamation No 308/2002 so as to enhance fairness in
commercial dealings, to make a complete coverage of the tax system, and to enable the non VAT
registered taxpayers to discharge their responsibility. A turnover tax is imposed on those persons
who are not required to register for VAT, but supply taxable goods and services in the country.
As a result, persons who are engaged in the supply of goods and rendering of service (which are
taxable), and who are not required to register for VAT have to pay turnover tax on the value of
goods they supply or on the value of services they render.

4.4.1. Turn over tax rate:

1. 2% (two percent) on Goods sold locally

2. for Services rendered locally;
I. 2% (percent) on Contractors, grain mills, tractors and combine-harvesters;
II. 10% (ten percent) on others services rendered locally such as consultancy, auditing,
legal advice, hotel, printing, advertising, laundry, etc.
4.4.2. Computation Base for TOT

TOT is calculated and levied on the gross receipt or selling price that the supplier receives from
supply of taxable goods and services. In exchange for supply of goods and rendering services,
the base for imposition of TOT is the market price of goods supplied or services rendered. If the
owner consumes its good and services for its personal use the TOT will be computed by
considering the cost of purchase.

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4.4.3. Turnover Tax Exempted Supplies

Some supplies are exempt from paying turnover tax. While determining the turnover for tax
purposes these items are excluded. The following persons and transactions are exempted from
payment of turnover tax.
 Transactions such as sale, transfer or lease of dwelling house; rendering of financial
services;
 Supply of national or foreign currency and securities;
 Rendering of church related services by religious organizations;
 Supply of drugs (specified by Ministry of Health);
 Rendering of educational and child care services;
 Supply of humanitarian services as humanitarian aid;
 Supply of electricity, kerosene and water;
 Provision of transport;
 Permits and license fees;
 Supply of goods and services of a workshop where more than 60% of the employees
are disabled;
 Supply of books and printed materials; and
 Any other items specified through a directive issued by the MEFEC
4.4.4. Tax Period

Tax period is the period for which the turnover is determined and tax is paid to the concerned tax
authority. The declaration and payment of TOT depends up on the category of tax payers:

 Non VAT registered Category “A” taxpayer are required to declare and pay TOT every
Month
 Non VAT registered Category “B” taxpayer are required to declare and pay TOT
quarterly ( within one month after the end of every three months
 Category “C” taxpayer are required to declare and pay TOT Annually from Hamle1 to
Hamle 30 by Presumptive taxation
4.4.5. Tax Accounting for TOT

Non-VAT registered Category “A” and “B” taxpayers who supplies taxable good and services
are required to maintain books of accounting. The VAT and TOT incurred on purchase by these
taxpayers are considered as cost of purchase. While sales transaction is made these taxpayers
should collect TOT by applying the correct TOT rate. The journal entries made during purchase
and sales are stated as follows.

Purchase of goods and services

Inventory or other account………………………xxxx

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Cash or payable …………………………xxxx

Sales of goods and services

Cash…………………….xxxx

Sales……………………..xxx

TOT payable……………..xxx

Example I: ABC Traders had taxable turnover of Birr 120,000.00 for the three-month ended
on ‘September’ 30, 2007 E.C. Assuming that the taxpayer belongs to category ‘B’, how much
will be the turnover tax payable by the trader? Tax rate 2%
Quarterly turnover Birr 120000
Tax rate 2%
Turnover tax 120000X2% = Birr 2400
Example 2:
HM PLC is a Non VAT registered taxpayer that sells alcohol drinks in A.A. In June, 2008 E.C
the company undertakes the following transaction:

June 1. purchase inventory from YBZ company for cash at price Br 50,000 plus VAT
June 5. purchase inventory from non VAT registered taxpayer at Br 8,000 excluding TOT
June 10. sales inventory to w/ro Genet at Br 60,000 including TOT
June 10. sales inventory to YM PLC at Br 40,000 excluding TOT
Required: Record the above transaction
Solution
1. Inventory ………………… 57,500

Cash………………………………56,500

WIT payable (50,000*0.02)………1,000

2. Inventory………………………………8,160

Cash………………………………………8,160

3. Cash……………………………58,823.52

Sales……………………………………….58, 823.52

TOT payable…………………………….... 1,176.48

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4. Cash……………………………40,000

Prepaid WIT…………………….800

Sales……………………………………….40, 000

TOT payable……………………………...... 800

4.5. Excise Tax

Excise tax is an indirect tax or a specific tax levied and collected on imported and locally
produced goods, which are hazardous to health and causes social problem, demand inelastic
basic good and luxurious goods.

Excise taxes constitute an important source of revenue to the governments in underdeveloped

countries. In Ethiopia, excise taxes have expanded owing to increase in production, and increase
in new products that are coming within the purview of tax. In the industrial development of a
country, excise taxes function as an important tool in developing the economy. Excise tax in
Ethiopia covers only goods produced in the country and goods imported to the country. This
helps reduce the administration cost of collection to a certain extent. Usually excise taxes are
imposed on advelorem basis. It is the determination of duty or tax based on the value of goods.
Ethiopian excise tax is not an exception to this rule.
It has been observed universally that the burden of excise tax is falling heavily on the poor than
on the rich. Care should be taken by governments to prevent this situation. At the same time,
excise tax should not adversely affect production. It should enable increased production and
equitable distribution of wealth and income among different sections of the economy. Tax
policies should be designed to encourage new business units in the manufacture of taxed
commodities or expand the existing units to increase production. Excise taxes are also used to
regulate consumption and production of certain commodities. Imposing high tax rates on
selected items does this. High tax rates on liquor aim at reducing the consumption of liquor,
which reduces external costs because alcoholism generates external costs in the form of
automobile accidents.

With a view to increase the revenue of the government to provide for public goods and services,
and to reduce the consumption of specific goods, the Government of Ethiopia levies excise tax
on selected items of goods that are supplied in the country. The current excise tax proclamation,
which came into effect at the beginning of 2003, contains reduced tax rates and taxable items
compared to the previous proclamations. This may be seen as a step taken by the government to
encourage the local production. As per the excise tax proclamation No 307/2002, the items of
goods that are subject to excise tax in the country are:
 goods imported to the country and

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 goods produced locally

4.5.1. Tax Base for computation of Excise Tax
Each taxpayer is liable to compute his or her tax liability-the amount of money he or she owes.
The base of calculation for goods locally produced is the cost of production multiplied by its
excise tax rate. However, the cost of production means direct labor and raw material cost
incurred in the production process, cost of indirect inputs and overhead costs, but does not
include depreciation costs of machineries.

In calculating excise tax payable on textile and textile products locally produced in a factory and
vehicles assembled locally, the tax paid on import of inputs that are used to produce such goods
shall be deducted.

Likewise, cost + insurance + freight (CIF) + customs duty multiplied by excise tax rate is the
base of computation for goods imported into the country.

4.5.2. Declaration and payment Period

Excise tax on imported items is paid at the time of clearing those goods from customs area.
According to sub article 2(a2) of article 6 of the proclamation 307, excise tax on locally
produced goods is to be paid, not later than 30 days from the date of production. However this
provision is amended by the directive No 18/2009, which allows for the excise tax to be paid
within 30 days of the next month following production.

Note: Please refer the current excise tax rate which is revised as of this year for calculation
purpose.

4.5.3. Stamp Duty

Stamp duty is a tax levied on legal documents or instruments that requires affixing of seals. The
type of documents subject to stamp duty and the practice in relation to this varies throughout the
world. Under the Ethiopian law, the Federal government has the power to levy and collect
federal stamp duty. Stamp duty is regulated by Stamp duty Proclamation No.110/1998 (the
“Proclamation”) as amended by Proclamation No.612/2008.
[Link]. Documents Subject to Stamp Duty
Under the stamp duty Proclamation, the following documents are charged with stamp duty:
 Memorandum and Articles of Association of business organizations, cooperatives or any
other form of associations;
 Award;
 Bonds; warehouse bond;
 Contract and agreements and memorandum thereof;
 Security deeds: any instrument whereby borrower or guarantor gives to a lender a charge
upon a part or the whole of his property;

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 Collective agreement;
 Contract of employment;
 Lease, sub-lease and transfer of similar rights;
 Power of attorney; and
 Document of title to property
[Link]. Exemption from Stamp Duty
Under the Proclamation the documents and bodies are relieved from stamp duty includes, Public
bodies, goods imported for sale by traders, Share certificates and Embassies and Consulates
Who Should Bear the Cost?
In general, the beneficiary of the instrument is liable for the payment of stamp duty:
 In case of a lease, the lessee is liable
 In case collective agreement, the employer and the employee are jointly and severally
liable
 In case of employment contract, the employer is liable
 In case of award, parties to an award are jointly and severally liable
 In case of documents transferring title to property, the transferee is liable
 In case of contract, parties to the contract or agreement are jointly and severally liable
 In case of security deeds, the borrower shall be liable
 A person making (drawing) or issuing an instrument in Ethiopia shall, upon its execution,
be liable for payment of stamp duty; provided , however, when an instrument is made or
issued
[Link]. Stamp Duty Rate
There are two types of stamp duty rates, namely fixed duty and on value duty. Unlike fixed duty,
on value duty is an amount which varies based on the value of the products, services or property
on which it is levied. Since there is no detailed guideline in practice and, as a result of that, tax
officers working on stamp duty report that they require only payment of 1% of the value of the
debt guaranteed even in the event where several assets are given as pledges in a single
instrument.
4.6. Customs Duty and computation Taxes imposed on imported Goods

In Ethiopia generally there are five taxes imposed on imported goods. These includes Customs
duty, WIT, excise tax, VAT and Surtax. In the previous we have discussed the VAT, excise tax
and WIT and hence in this section only customs duty and surtax will be discussed.

4.6.1. Customs Duty

The first of the five taxes levied on import items is customs duty. The term customs duty denotes
taxes imposed on goods entering or leaving the country. ERCA collects customs duty only on
import items as no tax on export is levied. The government waived taxes on export items on
purpose- just to encourage export. However, there is a 150 percent export tax particularly on
certain hides and skins of animals. ERCA collects Customs duty based on the rules stipulated in
the customs proclamation No. 859/2014 and other regulation and directives.

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Customs duty has 6 bands or groups of rates which are applied to imported goods. These bands
of rates are 0%, 5%, 10% 20%, 30% and 35%. From these bands of rates one can see that the
minimum customs duty rate is 0(zero) while the maximum is 35 percent of the CIF (Cost +
Insurance + Freight) value of an imported item. ERCA collects customs duty on a great variety
of goods which can be classified into two categories. The classification is based on the primary
purpose of the imported goods. Those import items used for productive purpose, items to be re-
exported and for public use are classified in category one while import items for all other (non
productive) purpose are classified in category two.

Category 1

Accordingly, raw materials, semi finished goods, producers goods, and import items for public
use such as minibuses, buses etc fall under category one. Raw materials can be processed or
unprocessed materials that would be used as industrial or agricultural input while producers’
goods are goods such as capital goods and others imported by business organization for
productive purposes. To encourage business organizations involved in activities such as
producing goods and services, special privileges are granted to them including the exemption of
customs duty and other taxes. As a result, raw material, and producers goods are largely zero (0)
rated.

Though there is up to a 10 percent customs duty rate applied to some of them. For example the
importation of agricultural production inputs such as a tractor is charged with 10 percent customs
duty rate. The importation of raw material and producers goods are highly encouraged for they
promote domestically produced goods which replace imported goods and helps to save cash flow
out of the country. Generally speaking, the more the imported goods are to be used for
productive purpose, the more would get the customs duty rate near to zero.

Semi finished goods are also classified under category one. These goods are imported into the
country for further processing and their importation is encouraged next to raw materials and
producers goods. ERCA charges semi finished goods at a 10 and 20 percent customs duty rate.

Category 2

Imported goods which are classified in category two are items such as consumer or finished
goods imported for personal use or for a nonproductive purpose. Consumer goods may also be
sub classified into durable and non-durable goods. Durable consumer goods are goods like
automobiles, furniture that have an expected useful life of three or more years. Non-durable
goods such as foods, gasoline, articles of clothing etc that are depleted or discarded relatively
soon. The highest customs duty rates are usually applied to consumer goods. For example, an
automobile is heavily taxed at a 35 percent customs duty rate on the grounds that it is imported
for personal use while ambulances which are primarily used for public use is imported free of

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customs duty and other taxes. The general principle in setting customs rate in Ethiopia is that the
more the imported item is to be used solely for personal use the higher the rate of customs duty
and other taxes. Full information on rates of customs duty on each item to be imported can be
obtained from the Ethiopian Customs Tariff prepared based on the harmonized commodity
description and coding system (H-S).

4.6.2. Surtax
Surtax is the fourth of the five taxes imposed on import items. Surtax was introduced in the
Ethiopian tax system on April 9, 2007. The council of Ministers issued a regulation to levy 10
percent surtax on imported goods. The imposition of surtax was necessitated to build the
financial capacity of the government for interventions to solve the rise in the cost of living which
is affecting consumers with low and medium income level.

Ten percent of the sum of cost, insurance, freight, customs duty, excise tax, and VAT is the base
of computation for surtax on all goods imported into the country. However, the following items
and services are exempted from payment of surtax.

Fertilizer, Petroleum and lubricants, Motor vehicles for freight and passenger and other special
purpose motor vehicles, Air craft, spacecraft and part thereof , capital (investment goods) and
some medicines, raw materials and other goods which are already decided by law to be tax free.

4.6.3. Computation of taxes Imposed on imported Goods

To determine customs duty and other taxes on the imported goods the importer may use the
following seven key steps.

 The first step is to identify the duty paying value of the automobile. The duty paying value of
any import item is the actual total cost of the goods i.e. cost + insurance + freight. Cost
stands for the transaction value and other related costs or payment made in exchange for the
purchase of an item. Insurance represents the money or premium that is paid to deliver the
item to be imported up to a prescribed customs port. Freight is money paid for the
commercial means of transport for delivering the imported item up to the first customs port.
 Step two calculates customs duty payable: by applying the customs duty rate on the duty
paying value
 Step three compute excise tax if the imported item is subjected to excise tax., the importer
multiplies the sum of duty paying value and customs duty by excise tax rate
 Step four compute VAT, In this step, the importer multiplies the sum of duty paying value,
customs duty, excise tax by value added tax
 The fifth step, to calculate surtax, involves multiplying the sum of duty paying value,
customs duty, excise tax, VAT, by surtax rate

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 The sixth step is to calculate withholding tax. In this step, the importer multiplies the duty
paying value by withholding tax rate i.e. 60,000 x 3%. The result is 1800 birr which is the
withholding tax to be paid.
 The last step involves adding the payable customs duty, excise tax; value added tax, surtax,
and withholding tax to arrive at the figure of the total payable customs duty and other taxes.
Among these tax custom duty, excise tax, and surtax are added to the cost of the imported goods
to determine cost per unit in the cost sheet. However, prepaid WIT and VAT cannot be included
in the cost of the imported goods.

Generally the formula for calculating customs duty and other taxes imposed on imported goods
are summarized as follows

DPV =Cost + Insurance + Freight

Customs duty= DPV x CUDU =A

Excise tax= (DPV + A) x EXTA= B

VAT= (DPV + A + B) x VAT=C

Surtax= (DPV + A + B + C) x SURTAX =D

Prepaid WIT= DPV x WHT = E

Total tax payable = A + B + C + D + E

Where, DPV= Duty Paying Value, CUDU= Customs Duty Rate, EXTA = Excise Tax Rate

SURTAX= Surtax, and WHT = Withholding Tax rate

4.6.4. Journalizing imported goods and customs duty and other taxes paid
First the importer must build its cost sheet to determine the cost of the imported goods. The cost
of imported goods includes CIF value, custom duty, excise tax, sure taxes, bank services charges
related to L/C services, and other costs such as transistors’ services charge, transport costs
incurred from the customs office up to the importer warehouse and unloading costs. Once the
cost sheet is build by the importer the transaction will be recorded as follows.

Inventory ……………………………xxxx

Prepaid WIT…………………………xxxx

VAT account………………………...xxxx

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L/C or cash………………………………xxxx

Incase customs data base price higher than the commercial invoice, the customs duty and other
taxes should be computed by using the customs data base price and the difference between the
customs price and commercial invoice is treated as customs difference account during recording
the transaction.

Inventory ……………………………xxxx

Prepaid WIT…………………………xxxx

VAT account………………………...xxxx

L/C or cash………………………………xxxx

Customs difference………………………xxxx

Illustration

AB general importer imports 10 latest Toyota Double Cup Pickup vehicles with Motor Engine
power 3,600, Origin Japan and manufactured in 2016 for resale in A.A. The purchase cost of one
Vehicle was Br 600,000, Insurance Premium paid for all cars BR 100,000 ,Transport costs paid
up to A.A Kality customs office for all vehicles Br 200,000, Bank services charges, Transitory
and other costs incurred Br 200,000. The customs duty rate of such vehicle is 35%

Required:

1. Compute the customs duty and other taxes paid during import when the Ethiopian
customs valuation system (ECVS) indicates the same price
2. Record the transaction
3. Compute the customs duty and other taxes paid on import if the Ethiopian customs
valuation system shows the purchase price per vehicle is Br 700,000
Solution 1.
[Link] of tax Tax Base Rate Tax Payable

Customs Duty 6,300,000 35% 2,205,000

Excise Tax 8,505,000 100% 8,505,000

VAT 17,010,000 15% 2,551,500

Surtax 19,561,500 10% 1,956,150

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Prepaid WIT 6,300,000 3% 189,000

Total Tax Payable 15,406,650

Building the Cost sheet

Bank service
DPV or CIF Customs Excise charge and Total Cost Cos per
value Duty Tax Surtax other costs of Import unit

8,505,00 1,956,15 1,916,61

6,300,000 2,205,000 0 0 200,000 19,166,150 5

2.
Inventory 19,166,150

VAT account 2,551,500

Prepaid WIT 189,000

Cash or L/C 21,906,650

3. Here the tax computation will be conducted using the price indicated in the ECVS
Types of Tax
tax Tax Base Rate Payable

Customs
Duty 7,300,000 35% 2,555,000

Excise
Tax 9,855,000 100% 9,855,000

VAT 19,710,000 15% 2,956,500

Surtax 22,666,500 10% 2,266,650

Prepid
WIT 7,300,000 3% 219,000

Total Tax 17,852,15

Payable 0

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Building the Cost sheet

Bank service
DPV or Customs Excise charge and Total Cost of Cos per
CIF value Duty Tax Surtax other costs Import unit

2,217,66
7,300,000 2,555,000 9,855,000 2,266,650 200,000 22,176,650 5

Inventory 7,300,000

VAT
account 2,956,500

Prepaid
WIT 219000

Cash or L/C 9,475,500

Customs Difference* 1,000,000

*Value of the vehicles per ECVS- Commercial invoice 700,000*10- 600,000*10= 1,000,000

Unit Summary

The unit has covered all types of direct and indirect taxes according to Ethiopian tax law of 2016
with practical illustrations for each tax. The first part of the unit has discussed employment
income tax as schedule “A” how each individual pay tax with different gross income under
Ethiopian tax system. Then the same unit has explained schedule “B” income tax determination
which was directly related to building owners as rental income tax payment. Furthermore, the
unit has covered how individual business owners pay tax to the government registered as
business income tax payer. For those tax payers not registered as VAT payers, they pay business
income tax in accordance with business income tax schedule “C” based on their annual income
earning level.

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The last part of this unit has discussed the various types of indirect taxes. Specifically the unit
gave special attention about the determination of VAT on income derived from the sale goods
and services and imported goods. The unit has also covered accounting treatment of TOT, Excise
Tax and Custom duty.

Self-Assessment Unit Review Questions

Part I-Discussion Questions

1. What are the different types of direct taxes? Explain each type of tax in detail.
_______________________________________________________________________
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2. What are the different types of indirect taxes? Explain each type of tax in detail.
_______________________________________________________________________
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3. What makes direct taxes differs from indirect taxes?
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Part II-Multiple Choice Questions
1. .Ato Abdi Ahmed is a business man who lives in Jijiga town. He has worked in his
retailing shop in Kebele 04 and his annual profit for 2015 E.C. is birr
200,[Link] amount of tax expected to collect from him based on tax rate of
schedule ‘B’ /business profit tax.
2. If XYZ company is a Soap manufacturing business in Jigjiga Town and if the
company paid out Br. 2000,000 VAT inclusive to purchase input, and sale the
product Br.4,500,000 with total employee salary of Br.25,000 and selling and

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administrative expense of Br 50,000 calculate the profit of ABC company. Calculate

Direct and Indirect taxes.

3. Given the following payroll financial data

No Name employees Basic Salary Monthly allowance OT hrs Duration of hrs

(in birr) (in birr) worked worked

1 Abdi Ahmed 15,800 4,200 24 Half of OT hrs on

weekend and the
remaining half from
5-10 p.m in the
evening
2 Ahmed Abdulahi 10,700 2, 800 8 Weekend
3 Alemu Tena 6,500 12 public holiday
4 Zemzem Ahmed 5,500 18 10 ;00pm to 6;00 am

Additional Information:
1. Employees working hours/week is 40hrs.
2. Allowance up to birr 1500 exempted from tax.
3. All employees are permanent
4. Pension contribution by employee and employer 7% and 11%respectively
5. All employees are contributed 10% of their basic salary to credit union except
Abdi who Contributes 5% of basic salary.
Required:
1. Calculate overtime payment of each employee
2. Calculate gross income of each employee
3. Calculate employment income tax of each employee
4. Calculate pension contribution of each employee
5. Calculate net pay of each employee

4. Lem Sugar Factory incurs the following costs and expenses for the production of
sugar in the month of Sene 2015.

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Raw material used ………………………… Br 1,200,000

Labor used ………………………………… 80,000
Repair and maintenance of factory machinery 16,000
Utility expenses . 36,000
Required: Compute excise tax for the month.
5. During the VAT period, shop X (which is vat registered person purchase goods worth
of birr 62,000, including VAT with a 15% VAT rate and sales goods at birr 65,000,
excluding VAT with a 15% VAT. Determine the VAT payable/refund.
6. During the VAT period, NAAHUD shop (which is vat registered person purchase
goods worth of birr 82,000, including VAT with a 15% VAT rate and sales goods at
birr 95,000, excluding VAT with a 15% VAT rate.
7. Kebede company purchased office equipment for birr 120,000.00 exclusive VAT.
The company has five employees to provide service and the employment income tax
is 11,000.00 per month. During the year 2016 the company earned birr 800,000.00
inclusive VAT. Profit tax of the year is birr 50,000.00. Calculate direct and indirect
tax liability for the year 2016.

Reference Materials Reviewed

Aschalew Ashagre, Tax Law Teaching Material Addis Ababa University School of Law,
(2013), [Unpublished]
Dr. P. Ashokkumar, E-Commerce law and its legal Aspects, International Journal of
Law, 4(1), (2018)
Ethiopian Federal Customs Proclamation No. 859/2014
Ethiopian Federal Income Tax Proclamation No. 286/2002.
Ethiopian Federal Income Tax Proclamation No. 979/2016,
Hinnekens, Luc, the Challenges of Applying VAT and Income Tax, (1998)
Rahmat Mohamad, Secretary-General of AALCO, International Law on E-Commerce:
Legal Issues and Impact on the Developing Countries” at the China University of
Political Science and Law, Beijing, China on 27th September 2013.
Kenneth J. Hamner, ‘Taxation of International and Domestic ECommerce: Inevitability,
Structure, Problems and Solutions,’ 1 Fla. St. U. Bus. Rev. (2001),

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Kevin Holmes, International Tax Policy and Double Tax Treaties, an Introduction to
Principles and Application, 2nd edn, IBFD, (2014)
McLure, C. E., and Hellerstein, W., Does Sales-Only Apportionment Violate
International Trade Rules? Tax Notes, September 9, (2002)

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