CIMA F1 Principles of taxation: practice questions with answers

Question 1

Adam Smith's canons of taxation describe the characteristics of a good tax. Which canon requires that the amount of tax due, and the time and manner of payment, should be clear to the taxpayer rather than arbitrary?

1. A Certainty
2. B Equity
3. C Convenience
4. D Efficiency

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Answer: A. Adam Smith's four canons: equity (fair, based on ability to pay), certainty (the amount, timing and method of payment are clear, not arbitrary), convenience (collected at a convenient time and in a convenient way) and efficiency/economy (low cost of collection and compliance relative to revenue raised).

Question 2

The government of Country K introduces an excise duty on soft drinks. The duty is collected from, and paid to the tax authority by, the drinks manufacturers. Manufacturers pass most of the duty on to consumers by raising their selling prices. Which of the following correctly describes the incidence of the duty?

1. A Formal incidence falls on consumers; effective incidence falls mainly on manufacturers
2. B Formal incidence falls on manufacturers; effective incidence falls mainly on consumers
3. C Formal and effective incidence both fall on manufacturers
4. D Formal and effective incidence both fall on the tax authority

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Answer: B. Formal (legal) incidence is on the person legally liable to pay the tax to the authority - here the manufacturers. Effective (actual) incidence is on the person who finally bears the economic cost - here mainly consumers, because manufacturers raise prices. Indirect taxes such as excise duties are designed so that the burden can be passed on.

Question 3

Which of the following is an example of tax evasion rather than tax avoidance?

1. A Bringing forward the purchase of new plant into the current year so that tax depreciation can be claimed earlier
2. B Investing surplus funds in government savings products whose interest is exempt from tax
3. C Omitting cash sales from the company's records so that they are not reported to the tax authority
4. D Moving a genuine manufacturing operation to a region that offers a lower rate of corporate income tax

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Answer: C. Tax avoidance is the use of legal methods to minimise tax, for example using allowances, exemptions and the timing or location of genuine activity (although aggressive avoidance may be challenged by anti-avoidance rules). Tax evasion is illegal: deliberately misleading the tax authority, for example by suppressing income or inflating expenses.

Question 4

Many countries require employers to deduct income tax from their employees' pay and pass it to the tax authority (a pay-as-you-earn or employee withholding system). Which of the following is an advantage of this system for the tax authority?

1. A Employees can claim tax deductions for all of the expenses they incur in doing their jobs
2. B Employers bear the employees' income tax as an additional cost of employing staff
3. C Employees' tax for the year is settled in a single payment after they file an annual return
4. D Tax is collected at source and regularly through the year, which reduces the risk of non-payment and evasion

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Answer: D. Under an employee withholding (PAYE) system the employer calculates and deducts income tax (and usually social security contributions) each time it pays employees and pays the amounts to the tax authority. Advantages for the tax authority include: regular cash flow, collection at source (employees cannot spend the tax first), a lower risk of evasion and bad debts, and much of the administrative cost falls on employers. The employee still bears the tax.

Question 5

The government of Country M introduces a new tax on airline tickets and announces that all of the revenue raised will be spent only on environmental projects. Which term describes linking the revenue from a particular tax to specific government spending in this way?

1. A Hypothecation
2. B Tax incidence
3. C The tax gap
4. D Fiscal drag

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Answer: A. Hypothecation means ring-fencing (earmarking) the revenue from a tax for a particular purpose, such as using road taxes for road building or an aviation tax for environmental projects. It can make a new tax more acceptable to the public, but reduces the government's flexibility in allocating revenue.

Question 6

Wigton Co, resident in Country X, is expanding into Country Y, which has a double tax treaty with Country X based on the OECD Model Tax Convention. Which of the following is most likely to create a permanent establishment of Wigton Co in Country Y?

1. A A warehouse in Country Y used solely to store spare parts, an activity of a preparatory or auxiliary character for Wigton Co
2. B Sales made in Country Y through an independent agent acting in the ordinary course of the agent's own business
3. C A building site in Country Y for a construction project that will last four months
4. D A branch office in Country Y from which Wigton Co's own staff negotiate and conclude sales contracts

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Answer: D. Under the OECD Model a permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on, including a branch, office, factory or workshop. Exclusions include facilities used solely for storage, display or delivery where the activity is preparatory or auxiliary, independent agents acting in the ordinary course of their business, and building sites lasting 12 months or less. Profits of a permanent establishment can be taxed in the country where it is located.