In this post, I am going to talk about standard applies to the accounting for income tax, adapted from IAS 12. It uses a liability method and adopts a balance sheet approach. Instead of accounting for the timing differences between the accounting and tax consequences of revenue and expenses, it accounts for the temporary differences between the accounting and tax bases of assets and liabilities. The Accounting Standard adopts a full-provision balance sheet approach to accounting for tax. It is assumed that the recovery of all assets and the settlement of all liabilities have tax consequences and that these consequences can be estimated reliably and are unavoidable.
The main reason why deferred tax has to be provided for is that International Financial Reporting Standards (IFRS) recognition criteria are different from those that are normally set out in tax law. Thus there will be income and expenditure in financial statements that will not be allowed for taxation purposes in many jurisdictions. A deferred tax liability or asset is recognized for future tax consequences of past transactions. There are some exemptions to this general rule.
To start it, let me give you a case example:
An entity has the following assets and liabilities recorded in its balance sheet at December 31, 20X8:
Plant and equipment 5
Trade receivables 3
Trade payables 6
The value for tax purposes of property and for plant and equipment are $7 million and $4 million respectively. The entity has made a provision for inventory obsolescence of $2 million, which is not allowable for tax purposes until the inventory is sold. Further, an impairment charge against trade receivables of $1 million has been made. This charge does not relate to any specific trade receivable but to the entity’s assessment of the overall collectibility of the amount. This charge will not be allowed in the current year for tax purposes but will be allowed in the future. Income tax paid is at 30%.
The question is: How to calculate the deferred tax provision at December 31, 20X8?
Here is how:
Carrying value Tax base Temporary difference
$m $m $m
Property 10 7 3
Plant and equipment 5 4 1
Inventory 4 6 (2)
Trade receivables 3 4 (1)
Trade payables 6 6 –
Cash 2 2 –
Therefore, the deferred tax provision will be $1 million × 30% = $300,000.
Because the provision against inventory and the impairment charge are not currently allowed, the tax base will be higher than the carrying value by the respective amounts. Every asset or liability is assumed to have a tax base. Normally this tax base will be the amount that is allowed for tax purposes. Some items of income and expenditure may not be taxable or tax deductible, and they will never enter into the computation of taxable profit. These items sometimes are called permanent differences.
Generally speaking, these items will have the same tax base as their carrying amount; that is, no temporary difference will arise. For example: if an entity has on its balance sheet interest receivable of $2 million that is not taxable, then its tax base will be the same as its carrying value, or $2 million. There is no temporary difference in this case. Therefore, no deferred taxation will arise.
Current Tax Liabilities And Assets
The Standard also deals with current tax liabilities and current tax assets. An entity should recognize a liability in the balance sheet in respect of its current tax expense both for the current and prior years to the extent that it is not yet paid.
Accounting For Deferred Tax
To account for deferred tax under IAS 12, first prepare a balance sheet that shows all the assets and liabilities in the accounting balance sheet and their tax base. Also show any other items that may not have been recognized as assets or liabilities in the accounting balance sheet but that may have a tax base. Then take the difference between these values and the accounting values, and calculate the deferred tax based on these differences. Most taxable differences arise because of differences in the timing of the recognition of the transaction for accounting and tax purposes.
- Accumulated depreciation that differs from accumulated tax depreciation
- Employee expenditure recognized when incurred for accounting purposes and when paid for tax purposes
- Costs of research and development, which may be expensed in one period for accounting purposes but allowed for tax purposes in later periods
Often where assets and liabilities are valued at fair value for accounting purposes, there is no equivalent measurement for tax purposes. For example, property, plant, and equipment may be revalued to fair value, but there may be no adjustment to the tax value for this increase or decrease.
Similarly, assets and liabilities can be revalued on a business acquisition, but for tax purposes, again, there may be no adjustment to the value.
Accounting Process for Deferred Tax
The process of accounting for deferred tax is:
- Determine the tax base of the assets and liabilities in the balance sheet.
- Compare the carrying amounts in the balance sheet with the tax base. Any differences will normally affect the deferred taxation calculation.
- Identify the temporary differences that have not been recognized due to exceptions in IAS 12.
Apply the tax rates to the temporary differences.
- Determine the movement between opening and closing deferred tax balances.
- Decide whether the offset of deferred tax assets and liabilities between different companies is acceptable in the consolidated financial statements.
- Recognize the net change in deferred taxation
An entity has revalued its property and has recognized the increase in the revaluation in its financial statements. The carrying value of the property was $8 million and the revalued amount was $10 million. Tax base of the property was $6 million. In this country, the tax rate applicable to profits is 35% and the tax rate applicable to profits made on the sale of property is 30%.
If the revaluation took place at the entity’s year end of December 31, 20X8, what is the deferred tax liability on the property as of that date?
The answer is $1.2 million. Why? The carrying value after revaluation is $10 million, the tax base is $6 million, and the rate of tax applicable to the sale of property is 30%; therefore, the answer is $10 million minus $6 million multiplied by 30%, which is $1.2 million.
Consolidated Financial Statements
Temporary differences can also arise from adjustments on consolidation. The tax base of an item is often determined by the value in the entity accounts, that is, for example, the subsidiary’s accounts.
Deferred tax is determined on the basis of the consolidated financial statements and not the individual entity accounts. Therefore, the carrying value of an item in the consolidated accounts can be different from the carrying value in the individual entity accounts, thus giving rise to a temporary difference. An example is the consolidation adjustment that is required to eliminate unrealized profits and losses on intergroup transfer of inventory. Such an adjustment will give rise to a temporary difference, which will reverse when the inventory is sold outside the group.
IAS 12 does not specifically address how intra-group profits and losses should be measured for tax purposes. It says that the expected manner of recovery or settlement of tax should be taken into account.
A subsidiary sold goods costing $10 million to its parent for $11 million, and all of these goods are still held in inventory at the year-end. Assume a tax rate of 30%.
The question is: What are the deferred tax implications?
The unrealized profit of $1 million will have to be eliminated from the consolidated income statement and from the consolidated balance sheet in group inventory. The sale of the inventory is a taxable event, and it causes a change in the tax base of the inventory. The carrying amount in the consolidated financial statements of the inventory will be $10 million, but the tax base is $11 million. This gives rise to a deferred tax asset of $1 million at the tax rate of 30%, which is $300,000 (assuming that both the parent and subsidiary are resident in the same tax jurisdiction).
Temporary Differences Not Recognized For Deferred Tax
There are some temporary differences that are not recognized for deferred tax purposes. These arise from:
- the initial recognition of certain assets and liabilities
- investments when certain conditions apply
The IAS does not allow a deferred tax liability for goodwill on initial recognition or where any reduction in the value of goodwill is not allowed for tax purposes. Because goodwill is the residual amount after recognizing assets and liabilities at fair value, recognizing a deferred tax liability in respect of goodwill would simply increase the value of goodwill; therefore, the recognition of a deferred tax liability in this regard is not allowed. Deferred tax liabilities for goodwill could be recognized to the extent that they do not arise from initial recognition.
An entity has acquired a subsidiary, and goodwill arising on the transaction amounts to $20 million. Goodwill is not allowable for tax purposes in the entity’s jurisdiction. Tax rate for the entity is 30% and the subsidiary is 60% owned.
The question is: What is the deferred tax liability relating to goodwill and would taxable temporary difference arise if goodwill was allowable for tax purposes on an amortized basis?
The answer is Zero. A deferred tax liability should not be recognized for any taxable temporary difference which arises on the initial recognition of goodwill. Where goodwill is deductible for tax purposes on an amortized basis, a taxable temporary difference will arise in future years being the difference between the carrying value in the entity’s accounts and the tax base.
The second temporary difference not recognized is on the initial recognition of certain assets and liabilities which are not fully deductible or liable for tax purposes. For example: if the cost of an asset is not deductible for tax purposes then this has a tax base of nil.
Generally speaking this gives rise to a taxable temporary difference. However, the Standard does not allow an entity to recognize any deferred tax that occurs as a result of this initial recognition. Thus no deferred tax liability or asset is recognized where the carrying value of the item on initial recognition differs from its initial tax base. An example of this is a nontaxable government grant that is related to the acquisition of an asset. Note, however, that if the initial recognition occurs on a business combination, or an accounting or taxable profit or loss arises, then deferred tax should be recognized.
An entity purchases plant and equipment for $2 million. In the tax jurisdiction, there are no tax allowances available for the depreciation of this asset; neither are any profits or losses on disposal taken into account for taxation purposes. The entity depreciates the asset at 25% per annum. Taxation is 30%.
The question is: How is the deferred tax position of the plant and equipment on initial recognition and at the first yearend after initial recognition?
The asset would have a tax base of zero on initial recognition, and this would normally give rise to a deferred tax liability of $2 million @ 30%, or $600,000.This would mean that an immediate tax expense has arisen before the asset was used. IAS 12 prohibits the recognition of this expense. This could be classified as a permanent difference. At the date of the first accounts, the asset would have been depreciated by, say, 25% of $2 million, or $500,000. As the tax base is zero, this would normally cause a deferred tax liability of $1.5 @ 30%, or $450,000. However, this liability has arisen from the initial recognition of the asset and therefore is not provided for.
A further temporary difference not recognized relates to investments in subsidiaries, associates, and joint ventures. Normally deferred tax assets and liabilities should be recognized on these investments. Such temporary differences often will be as a result of the undistributed profits of such entities. However, where the parent or the investor can control the timing of the reversal of a taxable temporary difference and it is probable that the temporary difference will not reverse in the foreseeable future, then a deferred tax liability should not be recognized. This would be the case where the parent is able to control when and if the retained profits of the subsidiary are to be distributed.
Similarly, a deferred tax asset should not be recognized if the temporary difference is expected to continue into the foreseeable future and there are no taxable profits available against which the temporary difference can be offset.
In the case of a joint venture or an associate, normally a deferred tax liability would be recognized, because normally the investor cannot control the dividend policy. However, if there is an agreement between the parties that the profits will not be distributed, then a deferred tax liability would not be provided for.
Deferred Tax Assets
Deductible temporary differences give rise to deferred tax assets. Examples of this are tax losses carried forward or temporary differences arising on provisions that are not allowable for taxation until the future. These deferred tax assets can be recognized if it is probable that the asset will be realized. Realization of the asset will depend on whether there are sufficient taxable profits available in the future.
Sufficient taxable profits can arise from three different sources:
- They can arise from existing taxable temporary differences. In principle, these differences should reverse in the same accounting period as the reversal of the deductible temporary difference or in the period in which a tax loss is expected to be used.
- If there are insufficient taxable temporary differences, the entity may recognize the deferred tax asset where it feels that there will be future taxable profits, other than those arising from taxable temporary differences. These profits should relate to the same taxable authority and entity.
- The entity may be able to prove that it can create tax planning opportunities whereby the deductible temporary differences can be utilized.
Wherever tax planning opportunities are considered, management must have the capability and ability to implement them. Similarly, an entity can recognize a deferred tax asset arising from unused tax losses or credits when it is probable that future taxable profits will be available against which these can be offset.
However, the existence of current tax losses is probably evidence that future taxable profit will not be available. The evidence to suggest that future taxable profits are available must be relevant and reliable. For example, the existence of signed sales contracts and a good profit history may provide such evidence. The period for which these tax losses can be carried forward under the tax regulations must be taken into account also.
Where an entity has not been able to recognize a deferred tax asset because of insufficient evidence concerning future taxable profit, it should review the situation at each subsequent balance sheet date to see whether some or all of the unrecognized asset can be recognized.
The tax rates that should be used to calculate deferred tax are the ones that are expected to apply in the period when the asset is realized or the liability settled. The best estimate of this tax rate is the rate that has been enacted or substantially enacted at the balance sheet date.
The tax rate that should be used should be that which was applicable to the particular tax that has been levied. For example, if tax is going to be levied on a gain on a particular asset, then the rate of tax relating to those types of gain should be used in order to calculate the deferred taxation amount.
Discounting On Deferred Tax
Deferred tax assets and liabilities should not be discounted. The reason for this is generally because it is difficult to accurately predict the timing of the reversal of each temporary difference.
Current And Deferred Tax Recognition
Current and deferred tax should both be recognized as income or expense and included in the net profit or loss for the period. However, to the extent that the tax arises from a transaction or event that is recognized directly in equity, then the tax that relates to these items that are credited or charged to equity should also be charged or credited directly to equity. For example, a change in the carrying amount of property due to a revaluation may lead to tax consequences which will be credited or charged to equity.
Any tax arising from a business combination should be recognized as an identifiable asset or liability at the date of acquisition. Current tax assets and current tax liabilities should be offset in the balance sheet only if the enterprise has the legal right and the intention to settle these on a net basis and they are levied by the same taxation authority.
The tax expense relating to profit or loss for the period should be presented on the face of the income statement, and the principal elements of the expense should also be disclosed. There are certain conditions set out in IAS 12 as to the situations where setoffs of deferred tax assets and liabilities can occur.
Tax Consequences Of Dividends
There are certain tax consequences of dividends. In some countries, income taxes are payable at different rates if part of the net profit is paid out as dividend. IAS 12 requires disclosure of the potential tax consequences of the payment of dividends. The Effect of Share Payment-Based Transactions In some jurisdictions, tax relief is given on share-based payment transactions. A deductible temporary difference may arise between the carrying amount which will be zero and its tax base which will be the tax relief in future periods. A deferred tax asset may therefore be recognized.