All developed countries have some form of income tax system that calls for companies to pay to the government a certain portion of their earnings, as defined. For income tax purposes, the definition of taxable income will differ from the definition of “pretax book income” for financial-accounting purposes in countries that do not require book-to-tax conformity. In some cases, these differences are due to the timing of revenue or expense recognition for tax versus financial-reporting purposes. This situation gives rise to an issue as to whether the effect associated with a given item of revenue or expense should be recognized during the period in which the item appears on the income statement or during the period in which it appears on the tax return. To recognize the expense during the period in which the item appears on the income statement gives rise to an associated asset or liability (referred to as deferred tax) on the balance sheet. In theory, it also results in a stabilized effective tax rate.
For certain countries, the issue of whether deferred taxes should appear on the balance sheet does not arise, because financial reporting of revenues and expenses generally follows the tax recognition in the financial statements; consequently, relatively few timing differences arise. Examples of countries that historically have generally not been required to deal with the issue of deferred taxes are Germany and Japan. This post overviews the financial effects of differences in the accounting for income taxes on a broder scoop [an international overview]. Follow on…
A major shift in reporting by enterprises in all developed countries has been toward the presentation of consolidated financial statements. Because the book/tax conformity rules do not normally apply on consolidation, deferred taxes are increasingly becoming part of the financial landscape in these countries too. In Japan, recognition of deferred taxes has been required since 1999.
In most countries, timing differences do arise between book and tax recognition of certain items of revenue and expense. An example of this is different depreciation methods used for book and tax purposes. When the variations are caused by items of revenue or expense included in the determination of book income in one period and taxable income in another period, the two most often used methods to record deferred taxes are the deferral method and the liability method.
The objective of the deferral method is to match tax expense with pretax book income. Deferred taxes are based on the effect of past tax differences; they are not updated for subsequent events or changes in tax rates. This approach was most prevalent in Canada. However, Canadian entities must use the liability method in determining deferred tax beginning in 2002.
The alternative is the “liability method” How does it work? Here are why:
- The focus of deferred tax accounting under this method is the balance sheet, whereas the focus of the deferral method is the income statement.
- The objective of the liability method is to determine the amount of future taxes payable or receivable on the basis of cumulative temporary differences between the book and tax basis of assets and liabilities at the balance sheet date.
- Deferred taxes on temporary differences are accrued on the basis of tax rates expected to be in effect when the differences reverse.
- Amounts previously deferred are subsequently adjusted when tax rates change.
Countries in which variations of this method are followed include the Netherlands, the United Kingdom, Italy, and the United States. It is interesting to note that standard setters have taken different approaches to limiting the recognition of deferred taxes. For example, in the United Kingdom, a deferred tax provision is required to be recorded when it is reasonable to assume that the circumstances that gave rise to these differences will reverse in the foreseeable future.
The original IAS 12, “Accounting for Taxes on Income,” permitted either the deferral method or the liability method to be applied, but the revised IAS 12, “Income Taxes,” approved in 1996, mandates a comprehensive liability method.
The revised IAS 12 is similar to U.S. GAAP. However, certain differences will arise, for example, with respect to the determination of the enactment date of a change in tax rates and with respect to intercompany profit eliminations. The revised IAS indicates that deferred tax assets and liabilities should be measured according to tax rates that have been enacted or substantively enacted at the balance sheet date. The substantively enacted concept is intended to acknowledge that in some jurisdictions, such as Australia, Canada, and the United Kingdom, announcements by the government have the substantive effect of actual enactment even though the tax rate change may not occur for several months. This is because in their systems of parliamentary democracy, the party with the majority in parliament has a high degree of certainty that the tax rate change it announces will be passed.
While final outcome of the U.S. legislative process may not always be so easily predicted, there have been instances where, through announcements of support, it is virtually certain that a tax bill will be passed by Congress and signed into law by the president. Under U.S. GAAP, however, the tax rate change must have been enacted before it is booked. Actual enactment does not occur until an act is finally passed into law (i.e., signed into law by the president or given Royal Assent in a commonwealth country). Thus, substantive enactment and actual enactment may occur in two different reporting periods.
Conceptually, there are strong arguments for and against the substantive-enactment- date concept, and few would take the position that the IAS approach is unreliable.
Intercompany profit eliminations give rise to “temporary differences” in cases where the gain is recognized for tax purposes but deferred for book purposes until realized. The issue is whether the tax effect of the temporary difference should be measured by reference to the seller’s tax rate or the buyer’s tax rate. Using the seller’s tax rate removes any income statement effect of the sale in the period in which it occurs by eliminating the gain and deferring the tax paid on the gain in the seller’s tax jurisdiction. Of course, the temporary difference actually reverses in the buyer’s tax jurisdiction when the buyer sells (or uses) the asset. For example, if the sale proceeds equal the buyer’s tax basis, then for book purposes the buyer realizes the deferred gain and the associated tax benefit of the temporary difference.
Conceptually, since the tax basis of the asset is deductible in the buyer’s tax jurisdiction, the buyer’s tax rate is a better measure of the tax consequences of the temporary difference. But if the temporary difference is set up at the buyer’s tax rate, any difference between the tax rates of the seller and the buyer would result in a credit or debit in the income statement in the year of sale, despite the fact that the gain was unrealized for book purposes.
Under the revised IAS approach, the temporary difference would be measured at the buyer’s tax rate. This approach was previously adopted in the United States under SFAS No. 96, “Accounting for Income Taxes,” but was ultimately rejected when SFAS No. 109 replaced SFAS No. 96 in 1992. Under SFAS No. 109, the tax effect of the intercompany profit is measured at the seller’s tax rate. The FASB referred to this issue as giving rise to a “conflict of concepts” and decided to prohibit recognition in the buyer’s tax jurisdiction. The weight of technical and practical issues makes it easy to see how different standard-setters could reach different conclusions on this matter.
The area of income tax accounting clearly illustrates the difficulty of harmonizing standards among different countries when the economic substance of the event is similar across all countries but the standards were determined at different times, by different groups of people, that had different objectives and constituencies to satisfy. Conversely, the issues described in this post also illustrate why greater cooperation between the major standard-setting bodies and the IASB (e.g., on joint projects) may provide a forum for a reduction of unnecessary differences.