Which of the following cash outflows cannot be deducted from the operating income to derive the taxable income?
A Dividends paid
B Interest paid
The correct answer and explanation is :
Correct Answer: A. Dividends paid
Explanation:
To determine taxable income, a business starts with its operating income (also called earnings before interest and taxes, or EBIT) and then adjusts it by adding or subtracting certain items such as interest expenses, depreciation, and other deductions or additions allowed under tax laws. However, not all cash outflows are deductible for tax purposes.
Let’s break down the options:
A. Dividends Paid
Dividends are payments made to shareholders from the profits of the company. While dividends are a cash outflow, they are not considered a business expense and cannot be deducted when calculating taxable income.
The logic is that dividends represent a distribution of profits, not a cost of generating those profits. The company earns a profit, pays taxes on that profit, and then distributes the after-tax earnings as dividends to shareholders. Therefore, the tax law does not allow dividend payments to reduce taxable income. This is part of what’s called the double taxation of corporate income—once at the corporate level (on taxable income) and again at the shareholder level (when dividends are received and taxed as personal income).
B. Interest Paid
Interest paid on business loans is considered a legitimate expense of operating the business and is tax-deductible. This includes interest on bonds, bank loans, or any other form of borrowed capital used in the business.
This deductibility of interest reflects the idea that interest is a cost of obtaining financing and should be treated like any other business expense that is necessary to generate income. Thus, interest expense is subtracted from operating income before calculating taxable income.
Summary:
- Dividends paid = not tax-deductible
- Interest paid = tax-deductible
Thus, the correct answer is A. Dividends paid because they cannot be deducted from operating income to derive taxable income.