Changes in either tax status or rates, definitely affect the financial statements of the company particularly its tax expense, and should be reported. The changes may occur during an interim reporting period, either because a tax law change mandated a mid-year effective date, or because tax law changes were effective at year-end but the reporting entity has adopted a fiscal year-end other than the natural year (December 31). What is the effect, and how should it be reported?
Reporting the Effect of Tax Status Changes
When the tax status change becomes effective, the consequent adjustments to deferred tax assets and liabilities are reported in current tax expense as part of the tax provision relating to continuing operations.
The most commonly encountered changes in status are those attendant to an election, where permitted, to be taxed as a partnership or other flow-through enterprise. (This means that the corporation will not be treated as a taxable entity but rather as an enterprise that “flows through” its taxable income to the owners on a current basis. This favorable tax treatment is available to encourage small businesses, and often will be limited to entities having sales revenue under a particular threshold level, or to entities having no more than a maximum number of shareholders.)
Enterprises subject to such optional tax treatment may also request that a previous election be terminated. When a previously taxable corporation becomes a nontaxed corporation, the stockholders become personally liable for taxes on the company’s earnings, whether the earnings are distributed to them or not (similar to the relationship among a partnership and its partners).
As issued, IAS 12 did not explicitly address the matter of reporting the effects of a change in tax status, although (as discussed in earlier editions of this book) the appropriate treatment was quite obvious given the underlying concepts of that standard. This ambiguity was subsequently resolved by the issuance of SIC 25, which stipulates that in most cases the current and deferred tax consequences of the change in tax status should be included in net profit or loss for the period in which the change in status occurs.
The tax effects of a change in status are included in results of operations because a change in a reporting entity’s tax status (or that of its shareholders) does not give rise to increases or decreases in the pretax amounts recognized directly in equity.
The exception to the foregoing general rule arises in connection with those tax consequences which relate to transactions and events that result, in the same or a different period, in a direct credit or charge to the recognized amount of equity. For example, an event that is recognized directly in equity is a change in the carrying amount of property, plant, or equipment revalued under IAS 16.
Those tax consequences that relate to change in the recognized amount of equity, in the same or a different period (not included in net profit or loss) should be charged or credited directly to equity.
The most common situation giving rise to a change in tax status would be the election by a corporation, in those jurisdictions where it is permitted to do so, to be taxed as a partnership, trust, or other flow-through entity.
If a corporation having a net deferred tax liability elects nontaxed status, the deferred taxes will be eliminated through a credit to current period earnings. That is because what had been an obligation of the corporation has been eliminated (by being accepted directly by the shareholders, typically); a debt thus removed constitutes earnings for the formerly obligated party.
Similarly, if a previously nontaxed corporation becomes a taxable entity, the effect is to assume a net tax benefit or obligation for unreversed temporary differences existing at the date the change becomes effective. Accordingly, the financial statements for the period of such a change will report the effects of the event in the current tax provision. If the entity had at that date many taxable temporary differences as yet unreversed, it would report a large tax expense in that period.
Conversely, if it had a large quantity of unreversed deductible temporary differences, a substantial deferred tax benefit (if probable of realization) would need to be recorded, with a concomitant credit to the current period’s tax provision in the statement of comprehensive income. Whether eliminating an existing deferred tax balance or recording an initial deferred tax asset or liability, the income tax footnote to the financial statements will need to fully explain the nature of the events that transpired.
In some jurisdictions, nontaxed corporation elections are automatically effective when filed. In such a case, if a reporting entity makes an election before the end of the current fiscal year, it is logical that the effects be reported in current year income to become effective at the start of the following period.
For example, an election filed in December 2011 would be reported in the 2011 financial statements to become effective at the beginning of the company’s next fiscal year, January 1, 2012. No deferred tax assets or liabilities would appear on the December 31, 2011 statement of financial position, and the tax provision for the year then ended would include the effects of any reversals that had previously been recorded. Practice varies, however, and in some instances the effect of the elimination of the deferred tax assets and liabilities would be reported in the year the election actually becomes effective.
Changes in Tax Rates and Status Made in Interim Periods
Tax rate changes may occur during an interim reporting period, either because a tax law change mandated a mid-year effective date, or because tax law changes were effective at year-end but the reporting entity has adopted a fiscal year-end other than the natural year (December 31). The IFRS on interim reporting, IAS 34 has essentially embraced a mixed view on interim reporting—with many aspects conforming to a “discrete” approach (each interim period standing on its own) but others, including accounting for income taxes, conforming to the “integral” manner of reporting.
Whatever the philosophical strengths and weaknesses of the discrete and integral approaches in general, the integral approach was clearly warranted in the matter of accounting for income taxes. The fact that income taxes are assessed annually is the primary reason for concluding that taxes are to be accrued based on an entity’s estimated average annual effective tax rate for the full fiscal year.
If rate changes have been enacted to take effect later in the fiscal year, the expected effective rate should take into account the rate changes as well as the anticipated pattern of earnings to be experienced over the course of the year. Thus, the rate to be applied to interim period earnings (or losses) will take into account the expected level of earnings for the entire forthcoming year, as well as the effect of enacted (or substantially enacted) changes in the tax rates to become operative later in the fiscal year.
In other words, and as expressed by IAS 34, the estimated average annual rate would “reflect a blend of the progressive tax rate structure expected to be applicable to the full year’s earnings enacted or substantially enacted changes in the income tax rates scheduled to take effect later in the financial year.”
While the principle espoused by IAS 34 is both clear and logical, a number of practical issues can arise. The standard does address in detail the various computational aspects of an effective interim period tax rate, some of which are summarized in the following paragraphs.
Many modern business entities operate in numerous nations or states and therefore are subject to a multiplicity of taxing jurisdictions. In some instances the amount of income subject to tax will vary from one jurisdiction to the next, since the tax laws in different jurisdictions will include and exclude disparate items of income or expense from the tax base. For example, interest earned on government-issued bonds may be exempted from tax by the jurisdiction which issued them, but be defined as fully taxable by other tax jurisdictions the entity is subject to.
To the extent feasible, the appropriate estimated average annual effective tax rate should be separately ascertained for each taxing jurisdiction and applied individually to the interim period pretax income of each jurisdiction, so that the most accurate estimate of income taxes can be developed at each interim reporting date. In general, an overall estimated effective tax rate will not be as satisfactory for this purpose as would a more carefully constructed set of estimated rates, since the pattern of taxable and deductible items will fluctuate from one period to the next.
Similarly, if the tax law prescribes different income tax rates for different categories of income, then to the extent practicable, a separate effective tax rate should be applied to each category of interim period pretax income.
IAS 34, while mandating such detailed rules of computing and applying tax rates across jurisdiction or across categories of income, nonetheless recognized that such a degree of precision may not be achievable in all cases. Thus, IAS 34 allows usage of a weighted-average of rates across jurisdictions or across categories of income provided it is a reasonable approximation of the effect of using more specific rates.
In computing an expected effective tax rate given for a tax jurisdiction, all relevant features of the tax regulations should be taken into account. Jurisdictions may provide for tax credits based on new investment in plant and machinery, relocation of facilities to backward or underdeveloped areas, research and development expenditures, levels of export sales, and so forth, and the expected credits against the tax for the full year should be given consideration in the determination of an expected effective tax rate.
Thus, the tax effect of new investment in plant and machinery, when the local taxing body offers an investment credit for qualifying investment in tangible productive assets, will be reflected in those interim periods of the fiscal year in which the new investment occurs (assuming it can be forecast to occur later in a given fiscal year), and not merely in the period in which the new investment occurs. This is consistent with the underlying concept that taxes are strictly an annual phenomenon, but it is at variance with the purely discrete view of interim financial reporting.
IAS 34 notes that, although tax credits and similar modifying elements are to be taken into account in developing the expected effective tax rate to apply to interim earnings, tax benefits which will relate to onetime events are to be reflected from the interim period when those events take place.
This is perhaps most likely to be encountered in the context of capital gains taxes incurred in connection with occasional dispositions of investments and other capital assets; since it is not feasible to project the timing of such transactions over the course of a year, the tax effects should be recognized only as the underlying events actually do transpire.
While in most cases tax credits are to be handled as suggested in the foregoing paragraphs, in some jurisdictions tax credits, particularly those which relate to export revenue or capital expenditures, are in effect government grants. Accounting for government grants is set forth in IAS 20; in brief, grants are recognized in income over the period necessary to properly match them to the costs which the grants are intended to offset or defray. Thus, compliance with both IAS 20 and IAS 34 would require that tax credits be carefully analyzed to identify those which are in substance grants, and that credits be accounted for consistent with their true natures.
When an interim period loss gives rise to a tax loss carryback, it should be fully reflected in that interim period. Similarly, if a loss in an interim period produces a tax loss carryforward, it should be recognized immediately, but only if the criteria set forth in IAS 12 are met. Specifically, it must be deemed probable that the benefits will be realizable before the loss benefits can be given formal recognition in the financial statements. In the case of interim period losses, it may be necessary to assess not only whether the enterprise will be profitable enough in future fiscal years to utilize the tax benefits associated with the loss, but furthermore, whether interim periods later in the same year will provide earnings of sufficient magnitude to absorb the losses of the current period.
IAS 12 provides that changes in expectations regarding the realizability of benefits related to net operating loss carryforwards should be reflected currently in tax expense. Similarly, if a net operating loss carryforward benefit is not deemed probable of being realized until the interim (or annual) period when it in fact becomes realized, the tax effect will be included in tax expense of that period. Appropriate explanatory material must be included in the notes to the financial statements, even on an interim basis, to provide users with an understanding of the unusual relationship reported between pretax accounting income and the provision for income taxes.