Workbook on IAS 12 Income taxes

Objective

The accounting profit may differ from the taxable profit as each is compiled according to its own set of rules and regulations.

Tax is often only collected in arrears or in advance. When this happens, there will be timing differences between when the profit is reported and when the tax on it is paid. This generates a tax liability (or tax asset).

IFRS 12 sets out to overcome this problem in terms of presentation so that financial statements prepared under different tax regimes include the effect of taxes at the appropriate time.

IAS 12 prescribes the accounting treatment for income taxes, and the tax consequences of:

(1) Transactions of the current period that are recorded the financial statements; and

(2) The future liquidation of assets and liabilities that are recorded only the balance sheet.

If liquidation of those assets and liabilities will make future tax payments larger or smaller, IAS 12 generally requires an undertaking to record a deferred tax liability (or deferred tax asset).

IAS 12 requires an undertaking to account for the tax consequences of transactions, in the same manner that it accounts for the transactions:

For transactions recorded in the income statement, any related tax consequences are also recorded in the income statement.

For transactions recorded directly in equity, any related tax consequences are also recorded directly in equity (for example, property revaluations under IAS 16).

The recognition of deferred tax assets, and liabilities, in a business combination affects the amount of goodwill arising in that combination.

IAS 12 also covers:

Recognition of deferred tax assets arising from unused tax losses, or unused tax credits,
Presentation of income taxes, and
Disclosure of information relating to income taxes.

Scope

IAS 12 should be applied in accounting for income taxes including:

All domestic, and foreign, taxes based on taxable profits.
Taxes, such as withholding taxes payable by a subsidiary, associate, trade investment or joint venture on distributions to the reporting undertaking.

IAS 12 does not deal with the methods of accounting for government grants, or investment tax credits (see IAS 20).

However, IAS 12 does deal with the accounting for temporary differences that may arise from such grants, or investment tax credits each of which alter the timing of when the tax is payable.

Deferred Tax – basic idea

Deferred tax is an accrual for tax, receipt or payment, created when the economic activity and the tax impact are either in different periods, or do not completely match in amounts or time period.

Accounting for tax is simpler when the transaction is booked for both accounting and tax purposes in the same year. In such a case income tax is recorded and no deferred tax needs to be accrued.

If a transaction takes place in year 1 and tax is paid in year 2, year 1 will show a transaction without a tax charge, and year 2 will show a tax charge without a transaction:

In this example, a financial asset (at fair value through profit and loss) is purchased for 1.000 in Year 1 and revalued at 1.100 at the period end, recording a profit of 100. The financial asset is then sold in Year 2 for 1.100, its revalued amount.

	Year 1	Year 2
Income	100	0
Tax expense @ 20%	0	-20
Net profit	100	-20

The tax expense is a direct result of the income in period 1. Readers of financial statements should be made aware that a tax charge will be levied in the following year.

Deferred tax is used to identify future tax payments generated by transactions in the current year – it is an accrual for tax, and like all accruals, will be reversed when the tax is actually paid.

	Year 1	Year 2
Income	100	0
Tax expense @ 20%	0	-20
Deferred tax @ 20%	-20	20
Net profit	80	0

The deferred tax reverses over time (and will thus disappear). This provides a more comprehensive picture to readers. Without the deferred tax accrual, profits in Year 1 would be overstated, with the risk that dividends might be higher than the undertaking could afford.

In this case, it creates an accrual of the tax charge in year 1 to link with the timing of the transaction.

It is reversed in year 2 to reflect that tax has been accrued in year 1, even though it was charged in year 2.

On the balance sheet, this deferred tax would be shown as a liability (accrual) at the end of period 1. It will disappear at the end of period 2.

EXAMPLE - tax is paid on receipt of the money in period 1, but only treated as income in period 2.
	Year 1	Year 2
Income	0	100
Tax expense @ 20%	-20	0
Net profit	-20	100
In year 1 there is a tax charge without a transaction. In year 2 there is a transaction without a tax charge. Again, we use deferred tax to link the transaction to the tax charge.
	Year 1	Year 2
Income	0	100
Tax expense @ 20%	-20	0
Deferred tax @ 20%	20	-24
Net profit	0	80
In this case, deferred tax accrues a tax credit in year 1 to carry forward the tax paid to period 2 to link with the timing of the transaction. The accrual is reversed in year 2. On the balance sheet, this deferred tax would be shown as an asset (or prepayment of tax) at the end of period 1. It will disappear by being reversed at the end of period 2.

EXAMPLE - the cash is received and taxed in year 1, but the income is split between years 1, 2 and 3. This might occur when an advance payment is received for a long-term contract.
	Year 1	Year 2	Year 3
Income	200	200	200
Tax expense @ 20%	-120	0	0
Net profit	80	200	200
The income is the same for each year, but the net profit changes due to the tax payment. The income in years 2 & 3 is taxed in the first year. Deferred tax is used to apportion the tax charge to match the income:
	Year 1	Year 2	Year 3
Income	200	200	200
Tax expense @ 20%	-120	0	0
Deferred tax @ 20%	80	-40	-40
Net profit	160	160	160
The total tax charge for year 1 will be 40 (120 minus 80), so the Income Statement for each year will be the same. The deferred tax reduces the tax charge in year 1, but increases it in years 2 & 3.

EXAMPLE -expenses attract tax credits (‘tax income’). If a transaction takes place in year 1 and tax is credited in year 2, year 1 will show a transaction without a tax credit, and year 2 will show a tax credit without a transaction:
	Year 1	Year 2
Expense	-100	0
Tax income @ 20%	0	20
Net profit	-100	20
The tax income, or benefit of paying less tax due to the expense, is a direct result of the expense in period 1. Readers of financial statements should be made aware that tax will be credited in the following year. Deferred tax is used to accrue future tax credits generated by transactions in the current year.
	Year 1	Year 2
Expense	-100	0
Tax income @ 20%	0	20
Deferred tax @ 20%	20	-20
Net profit	-80	0
On the balance sheet, this deferred tax would be shown as an asset at the end of period 1. It will disappear at the end of period 2 by being reversed.

EXAMPLE- tax is credited on payment of the money in period 1, but only treated as an expense in period 2.
	Year 1	Year 2
Expense	0	-100
Tax income @ 20%	20	0
Net profit	20	-100
In year 1 there is a tax credit without a transaction. In year 2 there is a transaction without a tax credit. The tax will be shown as a prepayment. Again, we use deferred tax to link the transaction to the tax credit.
	Year 1	Year 2
Expense	0	-100
Tax income @ 20%	20	0
Deferred tax @ 20%	-20	20
Net profit	0	-80
In this case, it accrues a tax credit in year 1 to carry forward the tax paid to period 2 to link with the timing of the transaction. It is reversed in year 2.

EXAMPLE- an advance payment on a construction contract. The cash is paid and credited for tax in year 1, but the expense is split between years 1, 2 and 3.
	Year 1	Year 2	Year 3
Expense	-200	-200	-200
Tax income @ 20%	120	0	0
Net profit	-80	-200	-200
The expense is the same for each year, but the net profit changes due to the tax credit. The expense in years 2 & 3 is credited for tax in the first year. Deferred tax is used to apportion the tax credit by accrual to match the expense:
	Year 1	Year 2	Year 3
Expense	-200	-200	-200
Tax income @ 20%	120	0	0
Deferred tax @ 20%	-80	40	40
Net profit	-160	-160	-160
The total tax credit for year 1 will be 40 (120 minus 80), so the Income Statement for each year will be the same, matching the economic reality. The deferred tax reduces the tax credit in year 1, but increases it in years 2 & 3.

1	2	3	4	5	6	7	8	9	10	11	12	13
Calculation	(2)/10		(2)-(4)	(2)/12		(2)-(7)	(4)-(7)	(9) x 24%	(3 - 6) x 24%	(6) x 24%	(11)+(12)
YEAR	COST	DEPRECIATION EXPENSE	NET	TAX ALLOWANCE (CREDIT)	TAX BASE	TIMING DIFFERENCE	DEFERRED TAX-BALANCE SHEET	DEFERRED TAX-INCOME STATEMENT	CURRENT TAX	TOTAL TAX
		Year	Cum		Year	Cum
1	6 000	600	600	5 400	500	500	5 500	100	24	24	120	144
2		600	1200	4 800	500	1000	5 000	200	48	24	120	144
3		600	1800	4 200	500	1500	4 500	300	72	24	120	144
4		600	2400	3 600	500	2000	4 000	400	96	24	120	144
5		600	3000	3 000	500	2500	3 500	500	120	24	120	144
6		600	3600	2 400	500	3000	3 000	600	144	24	120	144
7		600	4200	1 800	500	3500	2 500	700	168	24	120	144
8		600	4800	1 200	500	4000	2 000	800	192	24	120	144
9		600	5400	600	500	4500	1 500	900	216	24	120	144
10		600	6000	0	500	5000	1 000	1 000	240	24	120	144
11				0	500	5500	500	500	120	-120	120	0
12				0	500	6000	0	0	0	-120	120	0

EXAMPLE - the purchase of a building in year 1. See table above.

Depreciation is charged in years 1-10, after which the building is fully depreciated. The tax allowance is spread over years 1-12.

In years 1-10, depreciation is more than the tax allowance. In years 11 and 12, tax credits are received even though no depreciation is charged. This creates timing differences.

By charging deferred tax in years 1-10, and crediting deferred tax in years 11 and 12, the total tax for years 1-10 is equalised each year and matches the depreciation. In years 11 and 12, there is no total tax which matches the lack of depreciation in these years.

	DR/CR	0	1	2	3	4
Balance Sheet
Cost		3000
Amortisation			-1000	-1000	-1000	0

Off-Balance-Sheet
Tax		-3000
Amortisation			750	750	750	750

Tax Base		-3000	-2250	-1500	-750	0

Income Statement

Amortisation			1000	1000	1000	0
Tax @ 24%			-180	-180	-180	-180
			820	820	820	-180
Deferred tax
Net profit/loss

In the above example, a computer is bought for 3.000 with an economic life of 3 years, but the tax benefit will be spread over 4 years. The tax base is shown as the tax benefit less is accumulated amortisation. (The income statement is an extract, excluding other items.)

This creates 2 problems of presentation: the loss after tax is NOT at 76% (100-24), and in year 4 there is a tax credit without any economic activity.

	DR/CR	0	1	2	3	4
Balance Sheet
Cost		3000
Amortisation			-1000	-1000	-1000	0

Off-Balance-Sheet
Tax		-3000
Amortisation			750	750	750	750

Tax Base		-3000	-2250	-1500	-750	0

Income Statement

Amortisation		100%	1000	1000	1000	0
Tax @ 24%			-180	-180	-180	-180
			820	820	820	-180
Deferred tax
Net profit/loss		76%	760	760	760	0

The first step is to calculate the net loss as 76% of the expense for each period.

	DR/CR	0	1	2	3	4
Balance Sheet
Cost		3000
Amortisation			-1000	-1000	-1000	0

Off-Balance-Sheet
Tax		-3000
Amortisation			750	750	750	750

Tax Base		-3000	-2250	-1500	-750	0

Income Statement

Amortisation		100%	1000	1000	1000	0
Tax @ 24%			-180	-180	-180	-180
			820	820	820	-180
Deferred tax	CR		-60	-60	-60	180
Net profit/loss		76%	760	760	760	0

The second step is to compute the deferred tax as the difference between the net loss and the loss after tax. Identify whether the entry for Year 1 is a debit or a credit.

	DR/CR	0	1	2	3	4
Balance Sheet
Cost		3000
Amortisation			-1000	-1000	-1000	0

Off-Balance-Sheet
Tax		-3000
Amortisation			750	750	750	750

Tax Base		-3000	-2250	-1500	-750	0

Income Statement

Amortisation		100%	1000	1000	1000	0
Tax @ 24%			-180	-180	-180	-180
			820	820	820	-180
Deferred tax	CR		-60	-60	-60	180
		76%	760	760	760	0
Balance Sheet
Deferred tax	DR		60	60	60	-180
Asset / liability???

Cumulative			60	120	180	0

The entry to the balance sheet for each year is computed by double entry bookkeeping:

	Year 1	Year 2	Year 3	Year 4
Income Statement	-60	-60	-60	180
	Credit	Credit	Credit	Debit
Balance Sheet	60	60	60	-180
	Debit	Debit	Debit	Credit

The cumulative figure shows the number that will be seen in the balance sheet.

In this example, the balance sheet entry is a debit. A debit in the balance sheet is an ASSET, so the result is a deferred tax asset.

At the end of year 4, the balance on the balance sheet is eliminated – a control check that the deferred tax accrual has been reversed.

The cumulative figure shows the number that will be seen in the balance sheet.

Tax Accounting – the process

Tax accounting comprises the following steps:

i) calculate and record current income tax payable (or receivable);

ii) determine the tax base of assets and liabilities;

iii) calculate the differences between (the accounting) carrying amount of assets and liabilities and their tax base to determine temporary differences;

iv) identify temporary differences that are not recorded due to specific exceptions in IFRS;

v) calculate the net temporary differences;

vi) review net deductible temporary differences and unused tax losses to decide if recording deferred tax assets is correct;

vii) calculate deferred tax assets and liabilities by applying the appropriate tax rates to the temporary differences;

viii) determine the movement between opening and closing deferred tax balances;

ix) decide whether offset of deferred tax assets and liabilities between different group undertakings is appropriate in the consolidated financial statements; and

x) record deferred tax assets and liabilities, with the net change recorded in income or equity as appropriate.

The current tax expense (or income) is the amount payable (or receivable) as calculated in the tax return, plus any adjustment to deferred tax.

The current tax expense is recorded in the income statement, except any tax relates to a transaction that is recorded in equity rather than the income statement.

For example, any tax related to the revaluation of property, plant and equipment should be recognised in equity.

Dividends

The income tax consequences of dividends are linked more directly to past transactions, or events, than to distributions to owners.

Therefore, an entity recognises the income tax consequences of dividends in profit or loss for the period.

. An entity recognises the income tax consequences of dividends

when it recognises a liability to pay the dividend.

EXAMPLE- Tax expense split between the income statement and equity. Your tax computation shows an expense of $87m for the year, of which $3m relates to a property revaluation under IAS 16.
	I/B	DR	CR
Tax expense – income statement	I	84m
Tax expense-revaluation reserve	B	3m
Tax accrual	B		87m
*Tax expense split between the income statement and equity*

If the tax already paid exceeds the tax due for the period, the excess will be recorded as an asset, assuming it is recoverable.

EXAMPLE- Tax expense: Prepayment You have paid $100m as a tax prepayment. Your tax computation shows an expense of $87m for the year, of which $3m relates to a property revaluation.
	I/B	DR	CR
Tax prepayment	B	100m
Cash	B		100m
*Recording tax prepayment*
Tax expense – income statement	I	84m
Tax expense-revaluation reserve	B	3m
Tax prepayment	B		87m
*Tax expense split between the income statement and equity, matched against the tax prepayment*

A tax loss, that can be carried back to recover tax of a previous period, should be recorded as an asset in the period in which the tax loss occurs.

EXAMPLE- Tax loss: asset Your tax computation shows a loss of $6m for the year, which can be carried back to recover tax of a previous tax period.
	I/B	DR	CR
Tax recoverable	B	6m
Tax income	I		6m
*Recording recoverable tax loss*

The tax base of an asset or liability is the amount attributed to it for tax purposes.

The depreciation for an item of property plant or equipment on an accounting basis may differ from the calculation on a tax basis.

EXAMPLE- Different depreciation rates for accounting and tax

Your building is to be depreciated over 20 years for accounting purposes, but the tax authorities insist on a minimum life of 30 years for this type of building.

Whilst the accounting records will reflect the 20-year depreciation period, the tax base will use the 30-year depreciation model.

i) Revenue received in advance

Special rules apply to liabilities that represent revenue received in advance.

The tax base is equivalent to:

-the liability's carrying amount, if the revenue is taxable in a subsequent period;

EXAMPLE- Revenue received in advance Revenue is taxed in a later period. In year 1, it has a tax base of 100.
	I/B	DR	CR
Cash	B	100
Deferred revenue	B		100
*Receipt of cash-period 1*
Deferred revenue	B	100
Revenue	I		100
Tax expense @ 20%	I	20
Current tax liability	B		20
*Revenue recognition and tax expense-period 2*

-nil if the revenue is taxed in the period received.

EXAMPLE - Tax base of long service leave provision

Issue

The tax base of a liability is its carrying amount less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of revenue that will not be taxable in future periods.

How should management calculate the tax base of a long service leave provision?

Background

Entity C’s management has recognised a liability under IAS 19 for accrued long service leave of 150,000 at the balance sheet date. No deduction will be available for tax until the long service leave is paid.

Solution

Management should calculate the tax base of the long service leave provision as follows:

Carrying amount 150,000

Future deductible amounts (150,000)

(a deduction will be received for tax purposes when paid)

Future taxable amounts

Tax base -

Entity C has a deductible temporary difference of 150,000 (150,000 - nil). Management should recognise a deferred tax asset in respect of the deductible temporary difference.

ii) Amounts not reflected in the balance sheet

Deductible or taxable amounts may arise from items that are not recorded in the balance sheet.

Research and development costs may be expensed in the current period, but deductible for tax purposes over subsequent periods. The tax base reflects the amount of the deduction that can be claimed in future periods.

iii) Investments within groups

The acquisition of an investment in a subsidiary, associate, branch or joint venture will give rise to a tax base for the investment in the parent undertaking's financial statements. The tax base is often the cost paid.

Differences between the tax base and the carrying amount will arise in the periods after acquisition due to changes in the carrying amount. The carrying amount will change, for example, if the investment is accounted for using the equity method, or if an impairment charge is recorded.

EXAMPLE- Investment in subsidiary and impairment You buy a subsidiary for $70m. Trading is poor, and you book an impairment charge of $10m. The tax base is $70m, representing the cost. It is not adjusted for the impairment charge, creating a difference between the tax base and the carrying amount of $10m.
	I/B	DR	CR
Investment in subsidiary	B	70m
Cash	B		70m
*Recording purchase of subsidiary*
Impairment of subsidiary	I	10m
Investment in subsidiary	B		10m
Tax income (deferred tax) @ 20%	I		2m
Deferred tax asset	B	2m
*Recording impairment charge and (deferred) tax charge.* *The deferred tax asset will be released when the investment is finally liquidated and the loss is allowed for tax.*

iv) Expected manner of liquidating assets and liabilities

The measurement of deferred tax liabilities and assets should reflect the way in which management expects to liquidate the underlying asset or liability.

For example, in some countries a different tax rate may apply depending on whether management decides to sell or use the asset.

However, the deferred tax liabilities or assets associated with non-depreciable assets (such as land) can only reflect the tax consequences that would follow from the sale of that asset.

This is because the asset is not depreciated. Therefore, for tax purposes, the carrying amount (or tax base) of the non-depreciable asset reflects the value recoverable from the sale of the asset.

Calculate temporary differences

The concept of temporary differences is central to deferred tax accounting. This means that the difference will eventually reverse. Temporary may not mean short-term: it may take many years until the accruals are completely reversed.

Temporary differences arise when the carrying amount of an asset or liability differs from its tax base.

A deductible temporary difference generates a deferred tax asset

(which will reduce future payments) and a

taxable temporary difference gives rise to a deferred tax liability

(which will increase future payments).

Taxable temporary differences occur when tax is charged in a period after the accounting period suffers the expense in the financial accounts.

Taxable temporary differences arise when:

-an asset's carrying amount is greater than its tax base; or when

-a liability's carrying amount is less than its tax base.

Many taxable temporary differences arise because the transaction is recognised in different periods for tax and accounting purposes.

EXAMPLE- Deductible Temporary Difference interest revenue is included in pre-tax accounting profit on a time-apportionment basis but may be taxable on a cash basis.
	I/B	DR	CR
Cash	B	300
Interest revenue	I		100
Deferred interest revenue	B		200

Tax expense @ 20%	I	20
Deferred tax asset	B	40
Current tax liability	B		60
*Receipt of cash and tax payment -period 1 Partial recognition of revenue and tax*
Deferred interest revenue	B	100
Interest revenue	I		100
Tax expense @ 20%	I	20
Deferred tax asset	B		20
*Interest revenue and tax expense recognition -period 2 (Same for period 3)*

EXAMPLE- Taxable Temporary Difference i) interest revenue is included in pre-tax accounting profit when accrued but may be taxable on a cash basis.
	I/B	DR	CR
Interest receivable	B	700
Interest revenue	I		700
Deferred tax liability	B		140
Tax expense @ 20% (deferred tax)	I	140
*Recognition of revenue and application of deferred tax- period 1*
Cash	B	700
Interest receivable	I		700
Tax expense @ 20%	I	140
Cash – tax payment	B		140
Deferred tax liability	B	140
Tax expense	I		140
*Receipt of cash and tax payment- period 2*

The tax laws of the undertaking's operations will determine the temporary differences. Deductible temporary differences occur when tax is charged in a period after the accounting period suffered the expense in the financial accounts.

Deductible temporary differences arise when:

-an asset's carrying amount is less than its tax base; or when

-a liability's carrying amount is greater than its tax base.

Like taxable temporary differences, many deductible temporary differences arise from differences in the timing of recording the underlying transaction for accounting and tax purposes.

Deductible temporary differences examples:

EXAMPLE- Deductible Temporary Difference i) accumulated depreciation differs from cumulative tax depreciation as depreciation may be accelerated for accounting purposes. Accumulated depreciation is 150 but cumulative tax depreciation is 100.
	I/B	DR	CR
Depreciation	I	100
Accumulated depreciation	B		100
Current tax (reduction) 50 @ 20%	B	10
Tax income	I		24
Deferred tax asset	B	10
*Depreciation and lower tax credit -period 1*
Depreciation	I	100
Accumulated depreciation	B		100
Current tax (reduction) 150 @ 20%	B	30
Tax income	I		20
Deferred tax asset	B		10
*Depreciation and higher tax credit -period 2*

EXAMPLES- Deferred tax on share options

1. E plc has granted share options to key employees both before and after 7 November 2002. On adoption of IFRS 2, Share-based Payment, E plc is not opting to apply the standard fully retrospectively so no expense will be recognised in the income statement in respect of those share awards granted before 7 November 2002.

Under UK tax legislation, a tax deduction, equal to the intrinsic value of the options at exercise date, will be available to E plc when the employees exercise their options and receive the shares.

Does this give rise to a deferred tax asset during the period between the options being granted and exercised? If the amount of that deferred tax asset changes in the future, will the change be recognised in profit or loss or directly in equity?

IAS 12 requires deferred tax to be recognised on all temporary differences. That is, the difference between the tax base and the accounting carrying amount of assets and liabilities.

In respect of the options granted after 7 November 2002, a temporary difference arises between the tax base of the share option that has been recognised in the income statement (based on the future tax deductions) and its carrying value in the balance sheet (nil because the IFRS 2 share-based payment expense is offset by a corresponding credit entry in retained earnings). This gives rise to a deferred tax asset.

Similarly, a deferred tax asset will arise in respect of the options granted before 7 November 2002.

The tax base of these options, like those granted more recently, is based on the future tax deductions. The carrying value of the options in the balance sheet is, again, nil because there is no share-based payment expense.

On first-time adoption of IFRS, the credit entry in respect of this deferred tax asset will be recognised in equity.

The tax deduction will, on exercise of the option, be equal to the intrinsic value of the options at the exercise date, which cannot be known for certain until the date of exercise. Therefore, the tax base (that is, the amount of the tax deduction to be obtained in the future) should be estimated on the basis of the information available at the end of the period (the entity’s share price at the balance sheet date).

At each balance sheet date, the deferred tax asset will be re-estimated on the basis of information available at that time and the movements in the asset recognised in profit or loss for share options granted after 7 November 2002 (except to the extent that the deferred tax exceeds the total IFRS 2 charge, in which case movements are recognised in equity) and in equity for share options granted before that date.

2. Deferred tax on share-based payments

Entity A is resident in a country where equity-settled share-based payments are deductible for tax purposes. The tax authorities allow the entire tax deduction on the grant date of the award.

Entity A grants an equity-settled share-based payment award to its employees on the last day of its 2007 financial year. The award vests in three years’ time. On grant date, the full tax deduction is provided by the tax authorities. Since no service has been provided when the year-end financial statements are drawn up, entity A records no expense in terms of IFRS 2.

Should entity A recognise deferred tax in respect of the award in its year-end financial statements?

There are no recognised assets or liabilities in the accounts of entity A in respect of this award. The initial recognition exemption however does not apply since the taxable profit has been affected by this transaction (para 22(b) of IAS 12)

There is no recognised asset or liability in that example either, yet a deferred tax asset is recognised since, in the future, the company will pay less tax than it should based on its accounting profit.

Entity A should therefore recognise a deferred tax liability in its 2007 financial statements.

Fair Value Adjustments

Differences arising from fair value adjustments, whether on acquisition or otherwise, are treated the same as any other taxable and deductible differences.

In simple terms, sales generally generate a tax charge. Revaluations (fair value adjustments) generate a deferred tax charge (an accrual for tax).

Differences arising from fair value adjustments examples:

EXAMPLE - Fair Value Adjustments i) financial instruments are carried at fair value, but no matching revaluation may be made for tax purposes.
	I/B	DR	CR
Financial instrument	B	100
Gain – fair value adjustment	I		100
Tax expense (deferred tax) @ 20%	I	20
Deferred tax liability	B		20
*Revaluation of financial instrument*

EXAMPLE - Deferred tax on available-for-sale equity investments

An entity holds an available-for-sale investment, ie, shares in a listed company. The tax base of the shares is £500, which was the amount initially paid for the shares.

The fair value of the shares at the year end is £1,000. At the balance sheet date, the entity expects to sell the shares in five years and receive dividends of £500 during this five-year period. Dividends are not expected to impair the carrying amount of the investment when paid.

Dividends are non-taxable. Based on the current tax legislation, if the shares were sold after five years, capital gains tax at a rate of 10% would be payable on the excess of sales price over cost.

How much deferred tax (if any) should the entity recognise at the balance sheet date?

The principle in IAS 12 is that an entity should recognise deferred tax based on the expected manner of recovery of an asset, or liability, at the balance sheet date.

The dividends are expected to be derived from the investee’s future earnings rather than from its existing resources at the balance sheet date. Given that there is no impairment expectation arising from the dividends, the entity does not expect the carrying amount at the balance sheet date to be recovered through future dividends but rather through sale.

This is important since the expected manner of recovery will determine the deferred tax treatment.

The carrying amount of £1,000 has a corresponding tax base of £500 on sale. There is a taxable temporary difference of £500 at the balance sheet date. The applicable tax rate is the capital gains rate of 10%. The entity should recognise a deferred tax liability of £50 relating to the shares.

EXAMPLE - Recognition of capital losses

Entity F (a UK company subject to UK tax) has a portfolio of properties and has capital tax losses arising from that portfolio. In the current year, entity F has revalued its land and buildings resulting in a (capital gains tax) deferred tax liability being recognised in respect of land and buildings.

Entity F does not expect to realise the capital gain arising from the revaluation for a number of years. Is entity F required to recognise a deferred tax asset now in respect of the capital losses under IAS 12?

IAS 12 uses the word shall when it states that deferred tax assets shall be recognised for all deductible temporary differences to the extent that taxable profit will be available against which the deductible temporary difference can be utilised.

Entity F is required, therefore, to recognise a deferred tax asset in respect of the capital losses if those losses can properly be utilised against the future crystallisation of the capital gains.

The fact that there is no current intention to realise the capital gain through the sale of the properties does not affect the recognition of the deferred tax liability. The difference between the tax base, which remains the same despite the revaluation, and the revalued carrying amount of the asset, is a temporary difference that gives rise to a deferred tax liability.

Entity F should offset the presentation of the deferred tax liability arising from the revaluation and the deferred tax asset in respect of the capital losses if they meet the criteria in IAS 12. In other words, there is a legal right to offset the deferred tax assets and liabilities and they relate to the same taxation authority.

As long as these criteria are met, there is no requirement to schedule the reversal of the temporary differences to ensure that the timing matches.

On acquisition, assets of the company purchased should be fair valued. This will reflect their market value rather than their book value. These values will be used in the consolidated accounts.

Normally any change in value will not immediately create a tax charge or tax credit. Deferred tax should reflect the value change. Revaluations (fair value adjustments) generate a deferred tax charge (an accrual for tax).The net difference will increase or decrease goodwill.

Temporary differences will arise from consolidation when the carrying amount of an item in the consolidated financial statements differs from its tax base. The tax base is often based on the carrying values and tax charges of the individual group members.

Temporary differences will arise from consolidation examples:

(In consolidated accounts, profits that have been generated from moving inventory from one unit to another are eliminated, unless the inventory has left the group. This removes unrealised profits.)

EXAMPLE – Consolidation i) unrealised profits resulting from intra-group transactions are eliminated on consolidation but not from the tax base.
	I/B	DR	CR
Revenue-Intra-group sales	I	5000
Cost of sales-Intra-group purchases	I		5000
Cost of sales-reduction of intra-group profit	I	400
Inventory	B		400
Deferred tax asset	B	80
Tax income (deferred tax) @ 20%	B		80

Provision against loss of investment	I	300
Investment	B		300
Deferred tax asset	B	60
Tax income (deferred tax) @ 20%	I		60
*Intra-group transactions eliminated on consolidation*

EXAMPLE – Consolidation the retained earnings of controlled undertakings are included in consolidated retained earnings, but taxes are paid on profits when distributed to the parent.
	I/B	DR	CR
Net assets of subsidiary	B	4000
Profits/retained earnings	I/B		4000
Deferred tax liability	B		800
Tax expense (deferred tax) @ 20%	I	800
*Retained earnings of controlled undertakings included in consolidated retained earnings*

EXAMPLE – Consolidation iii) investments in foreign undertakings that are affected by changes in foreign exchange rates. The carrying amounts of assets and liabilities are restated for accounting purposes for changes in exchange rates, but no similar adjustment is made for tax purposes. (See IAS 21.)
	I/B	DR	CR
Net assets of subsidiary	B	6000
Foreign currency gain - equity	B		6000
Deferred tax liability	B		1200
Tax expense (deferred tax) @ 20% -equity	B	1200
*Foreign currency gain of controlled undertakings included in consolidated retained earnings*

EXAMPLE – Deferred tax on subsidiary loan

Entity C, a French entity with a euro functional currency, has a Russian subsidiary, entity D, with a rouble functional currency. Entity C has made a US dollar loan to entity D, which qualifies as part of C’s net investment (quasi-capital) in D in accordance with IAS 21.

A temporary difference exists between the book value and the tax base of the loan for the parent, C, and the subsidiary, D. There also exists a temporary difference in respect of the loan on consolidation.

The book value of the loan is nil on consolidation because the amount receivable by the parent eliminates against the amount payable by the subsidiary.

However, the tax base of the parent’s loan receivable and the tax base of the subsidiary’s loan payable are not eliminated because they relate to different tax jurisdictions and are of different values.

Management is considering the accounting for the temporary differences and deferred tax in the parent’s separate financial statements, in the subsidiary’s separate financial statements and in the consolidated financial statements.

No, deferred tax should be recognised in the parent’s separate financial statements in respect of the temporary difference between the book value of the loan and the tax base of the loan. This is because IAS 12 does not permit the recognition of deferred tax by a parent in respect of investments in subsidiaries provided certain conditions are met.

The conditions are:

for taxable temporary differences that the parent can control the timing of the reversal of the temporary difference; and it is probable that the temporary difference will not reverse in the foreseeable future.
for deductible temporary differences, it is not probable that the temporary difference will reverse in the foreseeable future; and that there will be taxable profit against which the deductible temporary difference can be utilised.

Similarly, no deferred tax is recognised in the consolidated financial statements. The exceptions provided by IAS 12 apply in the consolidated financial statements provided the conditions set out above are met.

However, deferred tax should be recognised in the separate financial statements of the subsidiary in respect of the temporary difference that arises on the loan from the parent. The exceptions in IAS 12 only apply for investments of investors and not for corresponding loans payable by the investees.

EXAMPLE –Deferred tax- sales to associates

Entity A has a 31 December year end. A acquired a 40% interest in an associate, entity B, on 31 December 20X5 for 500,000. On the same date, A sold goods costing 60,000 to B for 70,000. B still holds all these goods in inventory at the year-end.

Entity B did not earn any profits on 31 December 20X5 so there is no share of B.s profits for A to recognise when applying equity accounting.

However, A recognises an adjustment in its consolidated financial statements to eliminate its share of the unrealised profit of 10,000 arising on the sale of inventory to B.

This consolidation adjustment is:

Dr: Share of results of associates (40% x 10,000) 4,000

Cr: Investment in associate 4,000

B will probably sell the inventory in the next 12 months. If so, the deductible temporary difference associated with the unrealised profit will reverse in the next 12 months.

Entities A and B reside in different tax jurisdictions and pay income tax at 40% and 30% respectively.

What deferred tax adjustments should A’s management recognise in respect of the inventory sold by A to B?

Entity A should recognise a deferred tax asset of 1,600, provided it is probable that it will have taxable profits against which to utilise this deferred tax.

The adjustment to eliminate A’s share of the unrealised profit on sale of inventory to B creates a temporary difference in respect of the carrying amount of A’s investment in B in A’s consolidated financial statements.

The temporary difference relates to A’s asset (its investment in B). It is therefore A’s tax rate that is used to calculate the deferred tax.The temporary difference is calculated in accordance with IAS 12 as:

Accounting base of investment in B (500,000 - 4,000) 496,000

Tax base of investment in B 500,000

Deductible temporary difference 4,000

Deferred tax asset (4,000 x 40%) 1,600

EXAMPLE –Accounting for a tax revaluation

Entity B operates in country X. B has undertaken a group restructuring during the current year and as a consequence the tax authorities have allowed a revaluation of the fixed assets to market value at the date of the reorganisation for tax purposes.

However, the reorganisation is not a business combination for IFRS purposes and so there has been no change in the IFRS carrying value of the fixed assets.

Consequently the tax base on all the fixed assets concerned has increased and is now higher than the IFRS book values.

How should entity B account for this change in tax values of the fixed assets in its consolidated financial statements?

The differences between the IFRS book values for the fixed assets and the tax values represent temporary differences.

The temporary differences will potentially result in the recognition of deferred tax assets. B should therefore assess whether it is probable that the deferred tax assets will be recovered and recognise them to the extent that it is probable.

The recognition of the deferred tax assets will result in the recognition of deferred tax income in the income statement.

This credit cannot be reported in equity as IAS 12, Income Taxes, only allows deferred tax to be recognised in equity if the corresponding IFRS entry was also to equity. This is not the case here as the revaluation was not recognised at all for IFRS purposes.

Not all temporary differences are recognised as deferred tax balances.

The exceptions are:

i) goodwill and negative goodwill;

ii) initial recognition of certain assets and liabilities; and

iii) certain investments.

Goodwill

Goodwill is the residual amount after deducting assets and liabilities at fair value from the purchase price in an acquisition.

IFRS do not permit the recognition of a deferred tax liability for goodwill when its amortisation/impairment is not deductible. (If it is fully deductible, there is no timing difference, so no deferred tax arises.) Since March 2004, goodwill can no longer be amortised under IFRS

A deferred tax liability in respect of goodwill is not permitted, because it would increase the value of goodwill.

Generally, goodwill is a group accounting concept. In most countries, it is the individual companies that are taxed, not the group. It is quite rare for goodwill (and its amortisation or impairment) to be items that attract tax relief.

Where authorities do tax a business combination, deferred tax may arise.

If an item (income or expense) is not taxable, it should be excluded from the calculations as a permanent difference (see above).

Taxable temporary differences also arise in the following situations:

Certain IFRSs permit assets to be carried at a fair value or to be revalued:

- if the revaluation of the asset is also reflected in the tax base then no temporary difference arises.

- if the revaluation does not affect the tax base then a temporary difference does arise and deferred tax must be provided.

Negative Goodwill

IAS 12 does not permit the recognition of a deferred tax asset arising from deductible temporary differences associated with negative goodwill, which is treated immediately as income (see IFRS 3).

It is therefore a permanent difference (see above) and deferred tax does NOT apply.

Initial recognition of certain assets and liabilities

The second exception relates to a temporary difference that arises from the initial recognition of an asset or liability (other than from a business combination) and affects neither accounting income nor taxable profit.

This exception will apply in limited circumstances, such as:

i) assets for which no deductions are available for tax purposes and will be recovered through use. For example, some tax authorities do not tax the gain or loss on disposal of an equity investment; the tax base of such an investment is therefore zero; and

ii) assets which have a tax base that is different from the cost base at acquisition. For example, an asset which attracts an investment tax credit.

This may also apply when a non-taxable government grant related to an asset is deducted in arriving at the carrying amount of the asset but, for tax purposes, is not deducted from its tax base; the carrying amount of the asset is less than its tax base, and this gives rise to a deductible temporary difference.

Government grants may also be set up as deferred income (see IAS 20), in which case the difference between the deferred income, and its tax base of nil, is a deductible temporary difference. Whichever method of presentation an undertaking adopts, the undertaking does not record the resulting deferred tax asset.

This exception does not apply to a compound financial instrument that is recognised as both debt and equity.

The deferred tax impact of the temporary difference on the debt component is recognised as part of the carrying amount of the equity component.

Certain investments

Undertakings should recognise deferred tax assets or liabilities for investments in subsidiaries, associates and joint ventures except in the following situations:

i) deferred tax liabilities should not be recorded where the parent (or investor) is able to control the timing of the reversal of the temporary difference, and it is probable that the temporary difference will not reverse in the foreseeable future; and

ii) deferred tax assets should not be recorded if the temporary differences are expected to continue to exist in the foreseeable future.

EXAMPLE-Control of timing of dividends

These conditions may be met where a parent has control over a subsidiary's dividend policy and has decided that undistributed profits will not be distributed in the foreseeable future.

Investors should usually record deferred tax liabilities for associates and joint ventures, unless there is an agreement between the parties that profits will not be distributed in the foreseeable future.

EXAMPLE-Associate

You have a 40% share of a company. It has been agreed that dividends will be paid annually, if cash is available. Deferred tax should be calculated for any timing differences.

This reflects the tax that would be paid in the parent undertaking if dividends are received from group companies, especially foreign investments.

The assumption is that the profits made by these investments will be paid to the parent, and that deferred tax needs to be provided.

To avoid providing deferred tax, the parent must show that such dividends will not be paid

Deferred Tax Assets

Deferred tax assets arising from deductible temporary differences must be reviewed to determine to what extent they should be recognised. The realisation of deferred tax assets depends on taxable profits being available in the future.

EXAMPLE-Unusable deferred tax assets You have a deferred tax asset of $1m. The firm is continually generating losses, and the directors decide to liquidate the firm over the next two years. Further losses are anticipated in the next two years. The deferred tax asset should be written off, unless there is a realistic method to transfer it to another firm that can use it.
	I/B	DR	CR
Deferred tax asset	B		1m
Tax expense	I	1m
*Write off of deferred tax asset*

Taxable profits (on which tax will be paid) arise from three sources:

i) Existing taxable temporary differences: taxable temporary differences exist relating to the same tax authority and the same taxable undertaking.

To qualify as a deferred tax asset, these differences should reverse in the same period as the expected reversal of the deductible temporary difference; or in the periods into which a tax loss arising from a deferred tax asset can be carried back or forward.

EXAMPLE-Usable deferred tax assets You have a tax loss of $10m. The firm will have a tax liability next year from a taxable temporary difference of $15m. A deferred tax asset should be recorded, as it will reduce next year’s payment.
	I/B	DR	CR
Deferred tax asset	B		10m
Tax income	I	10m
*Creation of deferred tax asset from a tax loss*

ii) Future taxable profits: the undertaking may recognise a deferred tax asset where it anticipates sufficient future taxable profits.

iii) Tax-planning activities: undertakings commonly engage in tax-planning activities to use tax assets.

Tax-planning activities manage taxable profit so that existing tax losses and credits do not expire. Tax-planning activities usually attempt to move taxable profit between periods to use credits and losses.

Tax-planning opportunities should be considered in determining whether recognition of a deferred tax asset is appropriate. They should not however be used as a basis for reducing a deferred tax liability until it is settled.

Unused tax losses and credits

An undertaking may record a deferred tax asset arising from unused tax losses (or credits) when it is probable that future taxable profit will be available against which the unused losses (and credits) may be utilised.

Tax losses, however, may indicate that future taxable profit will not be available. This would be the case if the undertaking is continually trading at a loss.

Outstanding sales contracts and a strong earnings history, exclusive of a loss (for example from the sale of an unprofitable operation), may provide evidence of future taxable profit.

EXAMPLE - Interim financial statements - change in estimate

Issue

Income tax expense is recognised in each interim period based on the best estimate of the weighted average annual income tax rate expected for the full financial year. Amounts accrued for income tax expense in one interim period may have to be adjusted in a subsequent interim period of that financial year if the estimate of the annual income tax rate changes [IAS34].

How should management account for the change in interim tax estimates in the subsequent financial statements?

Background

Entity A has unused tax losses carried forward at 31 December 20X2 of 3,000,000. A’s management did not recognise a deferred tax asset in the 20X2 annual financial statements because of uncertainties regarding the utilisation of those losses. Forecasts showed no expected taxable profits for the next three years.

Management took the same view in the first quarter of 20X3 after incurring further losses. Management therefore did not recognise a deferred tax asset in respect of the losses. The losses carried forward at 31 March 20X3 were 3,060,000.

Management signed a new 3-year contract with a major customer during the second quarter of 20X3.The contract provided a significant increase in plant utilisation. Management revised their profit forecasts based on this new contract and predict that the tax losses will be fully utilised in 24 months.

Management therefore have a valid basis for recognising a deferred tax asset for the whole of the tax losses carried forward in the second quarter interim financial statements.

Solution

Management should recognise a deferred tax asset for the whole of the tax losses carried forward, with the corresponding deferred tax credit recognised in the second quarter income statement.

The event that has caused the recognition of the deferred tax asset is the signing of the contract in the second quarter. Recognition of the deferred tax in the second quarter is appropriate even though the income to be generated from the contract will not be earned until future quarters.

The undertaking should record a deferred tax asset only to the extent that it has sufficient taxable temporary differences to match it, or where there is strong evidence that sufficient taxable profit will be available.

EXAMPLE - Deferred tax assets for losses

Entity C has significant tax losses, having made trading losses for the last two years and is considering how much of this can be recognised as a deferred tax asset. The budgets and forecasts for the next five years show a return to profitability in year four.

What factors should be taken into account when determining whether a deferred tax asset can be recognised?

IAS 12 does not specify a time period in which recognised tax losses should be recovered. Therefore, there should be no arbitrary cut-off in the time horizon over which an assessment of recoverability is made, whether or not budget information is available after a certain period.

Only if it is not probable that future taxable profit will be available at all is a deferred tax asset not recognised. Otherwise, a deferred tax asset is recognised to the extent it is considered probable there will be future taxable profits.

Where an entity has a history of recent losses, it recognises a deferred tax asset only where there are sufficient taxable temporary differences or where there is convincing other evidence that there will be future taxable profits; such a history may be strong evidence that future taxable profit will not be available.

It may be that the probability of taxable profits decreases the further into the future we look, but any such assessment should be based on the facts. In some cases, it may be clear that no taxable profits are probable after a specific time, for example, where significant contracts or patent rights terminate at a specific date.

In other cases, the assessment should take into account the maximum taxable profits that are considered just more probable than not in each year prior to expiry of the tax losses. This may result in lower estimates for years in the distant future, but it does not mean that those years should not be considered.

Care should also be taken to ensure that the projections on which such assessments are made are consistent with other communications made by management and with the assumptions made about the future in relation to other aspects of financial accounting (eg, impairment testing), except where relevant standards require a different treatment (eg, impairment testing must not take account of future investment).

In addition, in such circumstances, consideration should be given to the disclosures about key sources of uncertainty required by IAS 1, Presentation of Financial Statements.

EXAMPLE - Portfolio provision - deferred tax

Issue

A deferred tax asset should be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised, unless certain limited exceptions apply.

Should a bank’s management calculate a deferred tax asset on the allowance for loan impairment determined on a portfolio basis?

Background

Bank A calculates its allowance for loan impairment on a portfolio basis. The approach is applied to sub-portfolios of loans that either have not been identified as individually impaired or are not individually significant. Impairment and uncollectibility are measured and recognised in the financial statements of the bank in accordance with IFRS 9.

A’s management expect the loan portfolio to increase in future years and the amount of the provision is also expected to increase. Tax relief is obtained only when a specific loan is written off. Management believe that is not likely that the temporary differences will reverse in the medium term, if at all.

Solution

Yes, management should recognise a deferred tax asset.

The allowance for loan impairment affects the carrying value of the loan portfolio and accounting profit. There is no adjustment to the tax base of any loans. Consequently, a deductible temporary difference exists between the tax base of the loan portfolio and its carrying value. Deferred tax should be recognised on this temporary difference.

The undertaking must also consider the time limits for which tax authorities permit such losses and credits to be carried forward, in assessing recoverability.

EXAMPLE - Deferred tax asset on deductible temporary differences based on a business plan

Issue

When there are insufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, a deferred tax asset is recognised to the extent that taxable profit will be available.

Can management recognise a deferred tax asset if the entity does not have a track record of profit generation?

Background

Management of entity C, a car-making entity, undertakes a reorganisation. The reorganisation involves the transfer of C’s IT services department to a separate entity, entity A.

Entity A will have a net deductible temporary difference, because of the transfer of accrued pension costs related to the employees of the IT department.

Management expects A to incur losses for the first year of A’s operations but expects it to become profitable thereafter. The forecast future profit is based on sales to third parties using existing business processes.

Solution

Management should not recognise a deferred tax asset.

A’s performance will depend on sales to third parties, with which management is not experienced. Management should therefore not recognise the deferred tax asset because it is not probable that taxable profits will be available.

When an entity assesses whether taxable profits will be available against which it can utilise a deductible temporary difference, it considers whether tax law restricts the sources of taxable profits against which it may make deductions on the reversal of that deductible temporary difference.

If tax law imposes no such restrictions, an entity assesses a deductible temporary difference in combination with all of its other deductible temporary differences.

However, if tax law restricts the utilisation of losses to deduction against income of a specific type, a deductible temporary difference is assessed in combination only with other deductible temporary differences of the appropriate type

The estimate of probable future taxable profit may include the recovery of some of an entity’s assets for more than their carrying amount if there is sufficient evidence that it is probable that the entity will achieve this.

For example, when an asset is measured at fair value, the entity shall consider whether there is sufficient evidence to conclude that it is probable that the entity will recover the asset for more than its carrying amount.

This may be the case, for example, when an entity expects to hold a fixed-rate debt instrument and collect the contractual cash flows.

Determine appropriate tax rates

Deferred tax assets and liabilities should be measured at the tax rates expected to apply to the period when the asset or liability is liquidated.

EXAMPLE-Tax rates You have a taxable temporary difference of $200m. The rate of income tax is 20%. Although there are rumours that the rate for future years will be lower, no official announcement has yet been made. The current rate must be used. The deferred tax liability will be $200m * 20% = $48m.
	I/B	DR	CR
Deferred tax liability	B		40m
Tax expense – deferred tax	I	40m
*Creation of a deferred tax liability*

The best estimate of the tax rate that will apply in the future is the tax rates that have been enacted (or ‘substantively enacted’) at the balance sheet date.

Tax rates have been ‘substantively enacted’ when draft legislation is nearing the end of the approval process.

When different rates of tax apply to different types and amounts of taxable income, an average rate is used.

EXAMPLE - Use of average rate

Issue

Deferred tax assets and liabilities are measured using the average rates that are expected to apply to the taxable profit (tax loss) of the periods in which the temporary differences are expected to reverse, when different tax rates apply to different levels of taxable income.

Can management use one tax rate for a specific temporary difference and a different, average, tax rate for the remaining temporary differences, when graduated tax rates apply?

Background

Entity A operates in a country where different rates apply to different levels of taxable income.

At 31 December 20X3 the net deductible temporary differences total 30,000. Management expects the temporary differences to reverse over the next seven years. The average projected profit for the next seven years is 60,000.

A deductible temporary difference related to impairment of trade receivables of 25,000 is expected to fully reverse in 20X5, when the related expense will be deductible for tax purposes.

Solution

Yes, management should consider separately the impact of this temporary difference reversing in a single year.

The reversal of this large temporary difference will cause a distortion in the average statutory tax rate. Management should therefore consider its effect separately when calculating the average statutory rate to be used for deferred tax assets and liabilities.

The measurement of a deferred tax asset or liability should reflect the way the undertaking expects to liquidate the asset's carrying value or the liability.

For example, if the undertaking expects to sell an investment and the transaction is subject only to capital gains tax, the undertaking should measure the related deferred tax liability at the tax rate applicable to capital gains, if different from the income tax rate.

Profits may be taxed at different rates depending on whether they are distributed to shareholders. An undertaking should measure deferred tax assets and liabilities using the tax rates applicable to undistributed profits.

When a dividend is subsequently declared and recorded in the financial statements, the undertaking should recognise the dividend's tax consequences to the undertaking (if any).

Deferred tax assets and liabilities must not be measured on a discounted basis.

EXAMPLE - Change in tax status effective during the period

Issue

The carrying amount of deferred tax assets and liabilities may change even though there is no change in the amount of the related temporary differences. This can result, for example, from a change in tax rates or tax laws.

Can management recognise directly in equity the tax consequences of a change in an entity’s tax status effective during the accounting period?

Background

On 31 August 20X2, entity A changed its status from one type of limited company to another. Entity A therefore became subject to a higher income tax rate (30%) than it was previously (25%).

The change in applicable tax rate applies to taxable income generated from 1 September 20X2. The tax rates applicable to a profit on sale of land are also different and amount to 40% compared with 30% previously.

The information below relates to temporary differences that exist at 1 January 20X2 and at 31 December 20X2 (the end of accounting period) and which will all reverse after 1 January 20X3.

Solution

No, the tax consequences of the change in applicable tax rate should be included in net profit or loss for the period, unless they relate to items originally recognised directly in equity.

EXAMPLE - Dividends declared after balance sheet date

Issue

Income taxes might be payable at a higher or lower rate if part or all of the net profit or retained earnings is paid out as a dividend to an entity’s shareholders. Management should, in these circumstances, measure current and deferred tax assets and liabilities at the tax rate applicable to undistributed profits.

Should management apply the tax rate applicable to distributed profits for the portion of net profit corresponding to dividends declared after the balance sheet date?

Background

Management declared in February 20X4 a dividend of 400 payable on 31 March 20X4. Management did not recognise a liability for the dividend at 31 December 20X3 in accordance with the requirements of IAS 37.

The profit before tax was 2,000. The tax rate is 30% for undistributed profits and 40% for distributed profits.

Solution

No, management should apply the tax rate applicable to undistributed profit.

The recognition of the obligation to pay dividends is the trigger that requires management to use the tax rate for distributed profit. Management should therefore recognise a current income tax expense of 600 (2,000 x 30%).

During 20X4 management will recognise a liability for dividends payable of 400. It should also recognise additional tax liability 40 (400 x 10%) as a current tax liability and an increase of the current income tax expense for 20X4.

Determine movement in deferred tax balances

The movements in deferred tax assets and liabilities should be recorded:

-either as deferred tax expense/credit in the income statement;

-or in equity, for those transactions for which the tax effects are recognised in equity.

Subsequent recognition

At each balance sheet date, an undertaking should review unrecorded deferred tax assets to determine whether new conditions will permit the recovery of the asset.

For example, an acquirer in a business combination may not have recorded a deferred tax asset in respect of tax losses.

Subsequently, the acquired undertaking may however generate sufficient taxable profit to absorb these losses and permit recognition in the consolidated financial statements.

Similarly, an acquiree may have an unrecorded deferred tax asset relating to tax losses. Subsequent to acquisition, these losses are recoverable through utilisation of future taxable profit generated by the acquired group.

This scenario assumes that the tax losses are not cancelled by the change in ownership of the acquiree.)

Subsequent measurement

The carrying amount of deferred tax assets and liabilities will change in subsequent periods with the recognition and reduction of temporary differences.

The carrying amount of a deferred tax asset should be reviewed at each balance sheet date for:

i) changes in tax rates;

ii) changes in the expected manner of recovery of an asset;

iii) changes in future profits.

Presentation

Change in tax status of an undertaking or its shareholder

A change in the tax status of an undertaking or its shareholder (parent) may have an immediate impact on the undertaking's current tax liabilities and assets, and alter its deferred tax assets or liabilities.

EXAMPLES –Change of tax status

Your head office is relocated to another country. It adopts the new country’s tax system.
Your firm changes its legal status from a company to a limited partnership, which requires it to adopt tax rules for limited partnerships.
Your firm is bought by another firm. The tax authorities cancel all brought-forward tax losses due to the change in ownership

The tax consequences of a change in tax status should be included in tax expense, unless the underlying transaction was recorded in equity.

Tax assets and liabilities

Current and deferred tax assets and liabilities should be presented separately on the face of the balance sheet.

Deferred tax assets and liabilities should be classified as non-current.
Offset (netting an asset and a liability)
Current tax assets and liabilities should only be offset when:

-an undertaking has a legal right of offset; and

-intends to settle on a net basis, or

-to liquidate the asset and liability simultaneously.

The legal right only arises when the same tax authority levies the taxes, and that authority accepts settlement on a net basis.

EXAMPLE- IAS 12 disclosures

At the year-end company C, reporting under IFRS, has property, plant and equipment (PPE) with carrying amounts, tax bases and temporary differences outlined in Table 1.These result from assets being deductible for tax purposes in a manner that differs from the depreciation recognised for accounting purposes.

At an effective tax rate of 30%, the PPE in a deferred tax liability position (the property and the office equipment) give rise to a deferred tax liability of £9 and the assets in a deferred tax asset position give rise to a deferred tax asset of £4.50.

The entity has a right to use the deferred tax asset to offset the deferred tax liabilities so, on the face of the balance sheet, the company discloses the net deferred tax liability position of £4.50.

IAS 12 requires disclosure in the notes to the financial statements in respect of each type of temporary difference. The amount of the deferred tax assets and liabilities recognised in the balance sheet for each period presented. Does this mean that the disclosure in the notes to the financial statements should show the gross position (that is, a deferred tax asset of £4.50 and a deferred tax liability of £9?)

No. We do not believe that IAS 12 requires a gross presentation because the deferred tax noted in the above table relates to the same type of temporary difference: that is, differences between depreciation for tax and accounting purposes.

The company has the right to offset the deferred tax asset and liability (so is presenting the net position in the balance sheet) so the amount of that net position relating to the difference between the carrying amount and tax base of PPE (that is, £4.50) should be disclosed as a component of the total deferred tax liability recognised.

Tax assets in consolidated financial statements of one group member may only be offset against a tax liability of another member if there is a right to offset and the group intends to settle on a net basis, or to liquidate the asset and liability simultaneously.

Similar conditions apply to offsetting deferred tax assets and liabilities. Deferred tax assets and liabilities in consolidated financial statements relating to different tax jurisdictions should not be offset.

The group's tax planning opportunities are not usually grounds for offset unless the opportunity relates to income taxes levied by the same tax authority on different group members, and the undertakings intend to liquidate the tax assets and liabilities on a net basis or simultaneously.

Tax expense

Tax expense (income) related to profit from ordinary activities should be presented on the face of the income statement. The main components of the tax expense (income) should also be disclosed (see Disclosure below).

Accounting for Deferred Tax - Detailed Rules

Assets Carried at Fair Value

Standards permit certain assets to be carried at fair value, or to be revalued (for example, IAS 16, IAS 38, IFRS 9, and IAS 40).

In some countries, the revaluation of an asset to fair value affects taxable profit for the current period. As a result, the tax base of the asset is adjusted, and no temporary difference arises.

EXAMPLE-Revaluation of asset that is taxed Your group wishes to revalue its balance sheet prior to a public listing. Its subsidiary will suffer current tax on the revaluation.
	I/B	DR	CR
Property	B	200m
Revaluation reserve	B		200m
*Recording property revaluation*
Tax expense –revaluation reserve	B	48m
Current tax liability	B		48m
*Recording current tax charge on the equity component*

In other countries, the revaluation of an asset does not affect taxable profit in the period, and the tax base of the asset is not adjusted. Such revaluations require deferred tax to be accrued.

The future liquidation of the carrying amount will result in a taxable flow of benefits to the undertaking, and the amount that will be assessed for tax purposes will differ from the amount of those benefits.

The difference between the carrying amount of a revalued asset, and its tax base, is a temporary difference and gives rise to a deferred tax liability, or asset.

EXAMPLE-Revaluation of an IAS 16 asset that is not subject to current tax. Your group wishes to revalue its balance sheet prior to a public listing. Its subsidiary will suffer no current tax on the revaluation.
	I/B	DR	CR
Property	B	300m
Revaluation reserve	B		300m
*Recording property revaluation*
Revaluation reserve - Tax expense	B	60m
Deferred tax liability	B		60m
*Recording deferred tax charge on the equity component*

This is true even if:

(1) the undertaking does not intend to dispose of the asset. The revalued carrying amount of the asset will be recovered through use (for example, depreciation). This will generate taxable income which exceeds the depreciation that will be allowable for tax purposes in future periods; or

(2) tax on capital gains is deferred, if the proceeds of the disposal of the asset are reinvested in similar assets. In such cases, the tax will become payable on sale (or use) of the similar assets.

EXAMPLE - Deferred tax arising from revaluation of land

Issue

A deferred tax liability should be measured at the tax rates that are expected to apply to the period in which the liability is settled.

Which tax rate should management use for calculating the deferred tax liability in respect of revalued land?

Background

Entity A conducts its business in country Z. Management has revalued the land on which the entity’s industrial plant is located, and has recognised the increase from the revaluation in equity [IAS16R.39].

The tax rate applicable to a profit on sale of PPE in Country Z is 30%, and the tax rate applicable to taxable profits earned from using the asset is 40%.

Solution

Management should use the tax rate applicable to a profit on sale of the land, that is, 30%, to determine the deferred tax associated with the property.

The difference between the revalued amount of the land and its tax base is a temporary difference and gives rise to a deferred tax liability [IAS12R.20]. The corresponding deferred tax charge should be recognised in equity because the revaluation increase is recognised in equity.

The land is a non-depreciable asset. The corresponding deferred tax liability that arises from the revaluation is measured based on the tax consequences that would follow from recovery of the land’s carrying amount through sale [SIC-21.5]. This is because the revalued amount of the land is not recovered through an accounting charge such as depreciation.

Items Credited or Charged Directly to Equity

Current tax and deferred tax should be charged, or credited, directly to equity, if the tax relates to items that are credited, or charged, in the same or a different period, directly to equity (see revaluation examples above).

Standards require or permit certain items to be credited, or charged, directly to equity. Examples of such items are:

(1) a change in carrying amount arising from the revaluation of property, plant and equipment under IAS 16 ;

(2) an adjustment to the opening balance of retained earnings, resulting from either a change in accounting policy applied retrospectively, or the correction of an error. IAS 8 has seriously limited this application;

(3) exchange differences, arising on the translation of the financial statements of a foreign undertaking in consolidation; and

(4) amounts arising on initial recognition of the equity component of a compound financial instrument (see IFRS 9).

It may be difficult to determine the amount of current and deferred tax that relates to items credited, or charged, to equity. This may be the case when:

(1) there are graduated rates of income tax, and it is impossible to determine the rate at which a specific component of taxable profit (tax loss) has been taxed;

(2) a change in the tax rate or rules, affects a deferred tax asset, or liability, relating to an item that was previously charged to equity; or

(3) an undertaking determines that a deferred tax asset should be recorded, or should no longer be recorded in full, and the deferred tax asset relates to an item that was previously charged to equity.

In such cases, the current and deferred tax is based on a reasonable pro-rata allocation of the current, and deferred tax in the tax jurisdiction concerned, or other method that achieves a better allocation in the circumstances.

Under IAS 16, an undertaking may transfer each period, from revaluation surplus to retained earnings, an amount equal to:

the difference between the depreciation (or amortisation) on a revalued asset, and the depreciation (or amortisation) based on the cost of that asset.

If an undertaking makes such a transfer, the amount transferred is net of any related deferred tax.

Similar considerations apply to transfers made on disposal of an item of property, plant or equipment and any related revaluation surplus.

When an asset is revalued for tax purposes, and that revaluation is related to an accounting revaluation of an earlier period, or to a future period, the tax effects of both the asset revaluation and the adjustment of the tax base are credited (or charged) to equity, in the periods in which they occur.

However, if the revaluation for tax purposes is not related to an accounting revaluation, any tax effects of the adjustment of the tax base are recorded in the income statement.

Current and deferred tax arising from share-based payment transactions

An undertaking may receive a tax deduction that relates to remuneration paid in shares, share options or other equity instruments of the entity. The amount of that tax deduction may differ from the related cumulative remuneration expense, and may arise in a later accounting period.

For example, an entity may recognise an expense for the salaries paid for in share options granted, in accordance with IFRS 2 Share-based Payment, and not receive a tax deduction until the share options are exercised, with the tax deduction based on the entity's share price at the date of exercise.

The difference between the tax base of the employee services received (the amount the taxation authorities will permit as a deduction in future periods), and the carrying amount of nil, is a deductible temporary difference that results in a deferred tax asset.

If the amount of the tax deduction for future periods is not known at the end of the period, it shall be estimated, based on information available at the end of the period.

For example, if the amount that the tax deduction in future periods is dependent upon the undertaking's share price at a future date, the measurement of the deductible temporary difference should be based on the entity's share price at the end of the period.

Revaluations under IAS 16 + IAS 40

If a deferred tax liability or deferred tax asset arises from a non-depreciable asset measured using the revaluation model in IAS 16 or IAS 40, the measurement of the deferred tax liability or deferred tax asset shall reflect the tax consequences of recovering the carrying amount of the non-depreciable asset through sale, regardless of the basis of measuring the carrying amount of that asset.

Accordingly, if the tax law specifies a tax rate applicable to the taxable amount derived from the sale of an asset that differs from the tax rate applicable to the taxable amount derived from using an asset, the former (sale) rate is applied in measuring the deferred tax liability or asset related to a non-depreciable asset.

In the case of IAS 40, this assumption can be rebutted.

Other Comprehensive Income

Deferred tax on revaluation movements listed in Other Comprehensive Income will be included with them in that financial statement. The notes will identify the amount of deferred tax relating to each component.

Disclosure

The major components of tax expense (income) should be disclosed separately.

Components of tax expense (income) may include:

(1) current tax expense (income);

(2) any adjustments, recorded in the period, for current tax of prior periods;

(3) the amount of deferred tax expense (income) relating to the start, and reversal, of temporary differences;

(4) the amount of deferred tax expense (income) relating to changes in tax rates, or new taxes;

(5) the amount arising from a previously unrecorded tax loss, tax credit, or temporary difference of a prior period, that is used to reduce current tax expense;

(6) the amount from a previously unrecorded tax loss, tax credit, or temporary difference of a prior period, that is used to reduce deferred tax expense;

(7) deferred tax expense arising from the write-down, or reversal of a previous write-down, of a deferred tax asset; and

(8) the amount of tax expense (income) relating to those changes in accounting policies, and errors, which are included in the net profit for the period.

The following should also be disclosed separately:

(1) the total current and deferred tax relating to items that are charged, or credited, to equity;

(2) an explanation of the relationship between tax expense (income) and accounting profit, in either, or both, of the following forms:

(i) a numerical reconciliation between tax expense (income) and the product of accounting profit multiplied by the applicable tax rate(s), disclosing also the basis on which the applicable tax rate(s) is (are) computed, or

(ii) a numerical reconciliation between the average effective tax rate and the applicable tax rate, disclosing also the basis on which the applicable tax rate is computed;

(3) an explanation of changes in the applicable tax rate(s) compared to the previous accounting period;

(4) the amount (and expiry date, if any) of deductible temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset is recorded in the balance sheet;

(5) the total amount of temporary differences associated with investments in subsidiaries, branches and associates, and in joint ventures, for which deferred tax liabilities have not been recorded;

(6) for each type of temporary difference, and for each type of unused tax losses and credits:

(i) the amount of the deferred tax assets, and liabilities, recorded in the balance sheet for each period presented;

(ii) the amount of the deferred tax income, or expense, recorded in the income statement, if this is not apparent from the changes in the amounts recorded in the balance sheet;

(7) in respect of discontinued operations, the tax expense relating to:

(i) the gain (or loss) on discontinuance; and

(ii) the profit (or loss) from the ordinary activities of the discontinued operation for the period, with the corresponding amounts for each prior period presented; and

(8) the income tax consequences of dividends that were proposed, or declared, before the financial statements were approved for issue, but are not recorded as a liability in the financial statements

An undertaking should disclose the amount of a deferred tax asset, and the evidence supporting its recognition, when:

the undertaking has suffered a loss, in either the current, or preceding, period in the tax jurisdiction to which the deferred tax asset relates; and
the utilisation of the deferred tax asset is dependent on future taxable profits, in excess of the profits arising from the reversal of existing taxable temporary differences.

In these circumstances, an undertaking should disclose the nature of the potential tax consequences that would result from the payment of dividends to its shareholders.

In addition, the undertaking should disclose the amounts of the potential tax consequences determinable, and whether there are any potential tax consequences not determinable.

These disclosures enable users to understand whether the relationship between tax expense (income) and accounting profit is unusual, and to understand the factors that could affect that relationship in the future.

The relationship between tax expense (income), and accounting profit may be affected by such factors as:

revenue that is exempt from tax,
expenses that are not deductible in determining taxable profit,
the effect of tax losses, and
the effect of foreign tax rates.

In explaining the relationship between tax expense (income) and accounting profit, an undertaking uses an applicable tax rate that provides the most meaningful information to the users.

Usually the most meaningful rate is the undertaking’s local rate of tax.

For an undertaking operating in several countries, it may be more meaningful to aggregate separate reconciliations, prepared using the domestic rate in each individual jurisdiction.

The average effective tax rate is the tax expense (income) divided by the accounting profit.

It would often be impracticable to compute the amount of unrecorded deferred tax liabilities arising from investments in subsidiaries, branches and associates, and joint ventures.

Therefore, IAS 12 requires an undertaking to disclose the aggregate amount of the underlying temporary differences.

Undertakings may also disclose the amounts of the unrecorded deferred tax liabilities, as users may find such information useful.

An undertaking discloses the important features of the income tax systems, and the factors that will affect the amount of the potential income tax consequences (to the undertaking) of dividends, if any.

It may not be practicable to compute the tax consequences from the payment of dividends to shareholders. This may be the case where an undertaking has a large number of foreign subsidiaries.

However, even in such circumstances, some portions of the total amount may be easily determinable. For example, in a consolidated group, a parent, and some of its subsidiaries, may have paid taxes at a higher rate on undistributed profits, and be aware of the amount that would be refunded on the payment of future dividends, from consolidated retained earnings. In this case, that refundable amount is disclosed.

If applicable, the undertaking also discloses that there are additional tax consequences not determinable.

In the parent's separate financial statements, if any, the disclosure of the tax consequences relates to the parent's retained earnings.

An undertaking, required to provide these disclosures, may also be required to provide disclosures related to temporary differences, associated with investments in subsidiaries, branches and associates or joint ventures.

For example, an undertaking may be required to disclose the aggregate amount of temporary differences associated with investments in subsidiaries, for which no deferred tax liabilities have been recorded.

If it is impracticable to compute the amounts of unrecorded deferred tax liabilities, there may be tax consequences of dividends not determinable, related to these subsidiaries.

An undertaking discloses any tax-related contingent liabilities and contingent assets (see IAS 37). Contingent liabilities, and contingent assets, may arise from unresolved disputes with the tax authorities.

Similarly, where changes in tax rates, or tax laws, are enacted, or announced, after the balance sheet date, an undertaking discloses any significant effect of those changes on its current and deferred tax assets and liabilities.

Exchange Differences on Deferred Foreign Tax Liabilities or Assets

Exchange differences that arise on foreign deferred tax assets and liabilities, may be included as part of the deferred tax expense (income).

A more usual presentation would be to include the exchange differences on deferred taxes as part of the foreign exchange gains and losses (see IAS21).

Foreign currency-denominated deferred tax assets and liabilities are non-monetary items that are translated at the closing balance sheet rate, being the date at which they are measured (see IAS21).

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Workbook on IAS 12 Income taxes

Objective

Deferred Tax – basic idea

Tax Accounting – the process

Calculate temporary differences

Deferred Tax Assets

Determine appropriate tax rates

Determine movement in deferred tax balances

Presentation

Tax expense

Items Credited or Charged Directly to Equity

Current and deferred tax arising from share-based payment transactions

Revaluations under IAS 16 + IAS 40

Disclosure

Exchange Differences on Deferred Foreign Tax Liabilities or Assets