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[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” fullwidth=”off” specialty=”off”][et_pb_row admin_label=”Row”][et_pb_column type=”1_2″][et_pb_text admin_label=”Text” background_layout=”light” text_orientation=”center” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”] [button link=”http://www.frs102.com/members/premium-toolkit/” type=”big” color=”red”] Return to Main Index[/button] [/et_pb_text][/et_pb_column][et_pb_column type=”1_2″][et_pb_text admin_label=”Text” background_layout=”light” text_orientation=”center” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”] [button link=”http://frs102.com/members/premium-toolkit/section-29/” type=”big” color=”red”] Return to Section 29 Home[/button] [/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” fullwidth=”off” specialty=”off” transparent_background=”off” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” padding_mobile=”off” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” gutter_width=”3″][et_pb_row admin_label=”Row”][et_pb_column type=”4_4″][et_pb_text admin_label=”Main Body Text” background_layout=”light” text_orientation=”justified” use_border_color=”off” border_color=”#ffffff” border_style=”solid”]Recognition of deferred tax
Extract from FRS102: Section 29.6–29.17
Timing differences
29.6 Deferred tax shall be recognised in respect of all timing differences at the reporting date, except as otherwise required by paragraphs 29.7 to 29.9 and 29.11 below. Timing differences are differences between taxable profits and total comprehensive income as stated in the financial statements that arise from the inclusion of income and expenses in tax assessments in periods different from those in which they are recognised in financial statements.
29.7 Unrelieved tax losses and other deferred tax assets shall be recognised only to the extent that it is probable that they will be recovered against the reversal of deferred tax liabilities or other future taxable profits (the very existence of unrelieved tax losses is strong evidence that there may not be other future taxable profits against which the losses will be relieved).
29.8 Deferred tax shall be recognised when the tax allowances for the cost of a fixed asset are received before or after the depreciation of the fixed asset is recognised in profit or loss. If and when all conditions for retaining the tax allowances have been met, the deferred tax shall be reversed.
29.9 Deferred tax shall be recognised when income or expenses from a subsidiary, associate, branch, or interest in joint venture have been recognised in the financial statements, and will be assessed to or allowed for tax in a future period, except where: (a) the reporting entity is able to control the reversal of the timing difference; and (b) it is probable that the timing difference will not reverse in the foreseeable future. Such timing differences may arise, for example, where there are undistributed profits in a subsidiary, associate, branch or interest in a joint venture.
Permanent differences
29.10 Permanent differences arise because certain types of income and expenses are non-taxable or disallowable, or because certain tax charges or allowances are greater or smaller than the corresponding income or expense in the financial statements. Deferred tax shall not be recognised on permanent differences except for circumstances set out in paragraph 29.11.
Measurement of deferred tax
29.12 An entity shall measure a deferred tax liability (asset) using the tax rates and laws that have been enacted or substantively enacted by the reporting date that are expected to apply to the reversal of the timing difference except for the cases dealt with in paragraphs 29.15 and 29.16 below.
29.13 When different tax rates apply to different levels of taxable profit, an entity shall measure deferred tax expense (income) and related deferred tax liabilities (assets) using the average enacted or substantively enacted rates that it expects to be applicable to the taxable profit (tax loss) of the periods in which it expects the deferred tax asset to be realised or the deferred tax liability to be settled.
29.14 In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the profit or retained earnings is paid out as a dividend to shareholders of the entity. In other jurisdictions, income taxes may be refundable or payable if part or all of the profit or retained earnings is paid out as a dividend to shareholders of the entity. In both of those circumstances, an entity shall measure current and deferred taxes at the tax rate applicable to undistributed profits until the entity recognises a liability to pay a dividend. When the entity recognises a liability to pay a dividend, it shall recognise the resulting current or deferred tax liability (asset), and the related tax expense (income).
29.15 Deferred tax relating to a non-depreciable asset that is measured using the revaluation model in Section 17 Property, Plant and Equipment shall be measured using the tax rates and allowances that apply to the sale of the asset.
29.16 Deferred tax relating to investment property that is measured at fair value in accordance with Section 16 Investment Property shall be measured using the tax rates and allowances that apply to sale of the asset, except for investment property that has a limited useful life and is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the property over time.
29.17 An entity shall not discount current or deferred tax assets and liabilities
OmniPro comment
Deferred tax is recognised on a timing difference plus approach. Deferred tax represents the future consequences of transactions and events recognised in the current and prior periods financial statements. The reason why deferred tax is recognised is due to the fact that this future tax will be payable even where the company decides to cease trading i.e. it is certain the future tax will have to be paid or will be refundable.
The provision for deferred tax ensures the tax charge shown eliminates any timing differences i.e. the tax charge would usually be the profit before tax multiplied by the tax rate less any permanent differences. Any timing differences are deferred on the balance sheet.
Permanent differences
Permanent differences occur as a result of certain types of expenditure/income being posted as a charge/credit in the profit and loss but are added back/deducted in the tax computation as it was never tax deductible/taxable for tax purposes i.e. the tax authorities will never allow a deduction for these costs. As these are permanent they do not come within the scope of deferred tax unless they arise on a business combination as stated section 29.10 and 29.11 above.
Examples of permanent differences are:
- Customer entertainment
- Charitable donations not above a certain value
- Amortisation/depreciation on assets not allowable for capital allowance purposes
- Expenses deemed to be capital in nature for tax purposes but no capital allowances are allowed to be claimed
- Certain payments made on leases
- Write off/provisions against investments, fixed assets (where they are not allowable for capital allowance purposes)
Temporary differences
Timing differences arise due to expenses being charged to the profit and loss account or OCI in a period but are not allowable for tax purposes until future periods or where the expense has been allowed for tax purposes but has not hit the profit and loss account by the year end.
A deferred tax asset exists where:
- The company has charged an expense/deduction to the profit and loss account during the period but it has not been allowed for tax purposes in that period but it will be allowed as a tax deduction in the future (i.e. the tax authorities will allow the deduction in the future). Examples would include:
- Instances where capital allowances are claimed over a life greater than the life the asset is depreciated over.
- Losses carried forward
- Pension deductions only allowed on a paid basis
- General accruals/provisions not allowable until paid
- Capital items expensed, added back in the tax comp but allowed for capital allowance purposes
- Revaluation of assets downward
- Profit/loss on disposal of assets allowed for capital allowance purposes
A deferred tax liability exists where:
- The company has obtained a tax deduction in the current or prior accounting period but it has not been charged to the profit and loss account at that time. Examples would include:
- Instances where capital allowances are claimed over a life shorter than the life the asset is depreciated over
- Revaluation of assets upward
- Income has been recognised in the current or prior accounting period but was not taxed in the tax computation in that period but will be taxable at a future time e.g. interest receivable
Section 29 requires all timing differences to be recognised as deferred tax on the balance sheet with the exception of timing differences arising from:
1) Unrelieved tax loses (i.e. deferred tax asset) where it is not probable that future taxable profits will exist to utilise these tax losses carried forward. Before these losses can be recognised as a deferred tax asset it must be probable (more likely than not that there will be taxable profits to utilise the tax losses). Section 29.7 makes it clear that the very existence of unrelieved tax losses is strong evidence that there may not be other future taxable profits against which the losses can be relieved. Therefore when assessing whether the deferred tax asset should be recognised care should to be taken to review future projections (it is not enough to just look at prior year results as a basis for future years) and assess how long it will take to recover these losses based on those projections or if in fact it is possible to recover these. Consideration also needs to be given as to whether the losses expire at a point in time. It may be possible to look at future tax strategies to prove the recoverability of losses forward if it is probable these will be put in place.
Example 3A
Company A has losses forward of CU200,000. The projected profits over the next 6 years is CU100,000. In this example given that it is going to take 6 years to recover only CU100,000 of the losses, the entity should at a maximum recognise a deferred tax asset of CU100,000. Whether to recognise this CU100,000 will depend on the strength of projections and how accurate the Company has been with projecting in the past.
The adequacy of providing for a deferred tax asset in relation to unrelieved assets should be carried out at each reporting period.
2) Assets where the conditions for retaining the tax allowances have been met. This applies where an asset has a certain tax life and after that tax life has elapsed no tax clawback arises. Examples where this applies would include: capital allowances on hotels, industrial buildings, certain property based incentives.
Example 4: Conditions for retaining tax allowances have been met
Company A purchased an industrial property 25 years ago for CU500,000. This property is being depreciated for tax purposes over 50 years but capital allowances are being claimed for tax purposes over 25 years after which no claw back arises for previous tax deductions claimed. Assume the deferred tax rate is 10%. Therefore in the accounts at the end of year 25 the deferred tax liability recognised was:
|
|
CU |
|
NBV Per Accounts (CU500,000/50yrs*25yrs)= |
250,000 |
|
Tax Written Down Value (CU500,000/25yrs*0yr left)= |
(0 ) |
|
Deferred Tax Liability |
250,000 |
|
Deferred Tax Rate @ 10% |
25,000 |
At the end of year 26, the previous years deferred tax liability can be released in full as the tax life is over and no balancing charge/allowance can arises following a sale.
3) Income/expenses from an associate, joint venture, branch or subsidiary recognised in the group’s consolidated financial statements will be assessed for tax purposes in the future but the reporting entity can control the reversal of the timing difference and it is probable the timing difference will not reverse in the foreseeable future. This would be applicable where there are undistributed profits in the associate, joint venture, branch or subsidiary.
4) Goodwill recognised in a business combination.
Measurement
Section 29 states that deferred tax should be measured at the tax rates enacted or substantively enacted at the balance sheet date. See example 1 above where this is illustrated.
In measuring deferred tax an entity is required to apply the enacted rate that is expected to apply to the reversal of the timing difference (i.e. the sales tax rate or the trading rate), except in the case of timing differences arising from the:
- revaluation of non-depreciable assets. In this case the sales tax rate (the tax rate on sale of the asset) should be used to measure the deferred tax liability as required by Section 29.15. An example of this type of asset is land.
- recognition of investment properties at fair value (which is accounted for in accordance with Section 16). In this case the sales tax rate (the tax rate on sale of the asset) should be used to measure the deferred tax liability as required by Section 29.16.
Other than the two items mentioned above consideration of the manner in which the asset will be recovered/liability settled should be given. The manner in which the asset can be recovered or liability settled is key in deciding whether to apply the sales tax rate or the trading tax rate. The entity should consider the expected manner of recovery at each reporting date to assess if it is necessary to change the rate used. There are three ways in which an asset can be recovered:
- through use in the business or
- through sale of the asset or
- through use and sale of the asset
Section 29 does not specifically deal with the above in detail.
Manner of recovery through use
Where the asset is expected to be recovered through use, then it would be reflected in the depreciation charged during the assets life and it would usually be expected to have a nil residual value. The rate to be used in measuring deferred tax would be the trade rate in this instance. Examples of assets under this class may include:
- depreciable assets used in its trade
- current assets and liabilities relating to the trade
Manner of recovery through sale
Where the asset is expected to be recovered through eventual sale, then the tax rate to use would be the rate that would be applicable on sale. Examples of assets under this class may include:
- investments in equities (<20% ownership)
- investment in subsidiaries/associates/joint ventures
- investment property
- land
Manner of recovery – dual use
Where the asset has a dual use, Section 29 does not detail the rate that should be used so therefore it is an accounting policy choice as to how best to treat such a situation and judgement will be required. It may be necessary to ascertain the residual value and apply the sales tax rate on this element and apply the trading tax rate to the element that is depreciated.
Effect of change in classification of assets
Section 29 provides no detail on what rate is to be used where investment property is classified from investment properties due to an inability to measure fair value due to undue cost or effort. In this particular circumstance consideration should be given to the manner in which the asset can be recovered. Given that this property had been measured at the sales tax rate while accounted for as an investment property asset under Section 16, it would not be unreasonable to assume the sales tax rate should be used in this instance.
Determining the value of timing difference
The amount to be considered for deferred tax is the difference between the tax base cost and the assets carrying amount. The tax base cost can be the tax written down value where capital allowances can be claimed on the assets or base cost of the asset where the asset is to be recovered through a sale.
Where deferred tax is measured on a sales tax rate basis, Section 29 would require that the tax cost would incorporate any indexation allowed for tax purposes. The difference between the carrying amount of the asset in the accounts and the indexed base cost is the deferred tax timing difference. However indexation cannot create or increase a loss. In the foregoing examples we have ignored inflation.
Example 5: Indexation of base cost – non depreciable asset
Company A purchased a piece of land for CU100,000 in 1990. Assume the carrying amount in the accounts is CU500,000 following a revaluation. Under local tax rules, indexation is allowed to be applied when determining the tax to be paid on the sale of the land. If we assume that indexation allowed is 2.5 times the original cost and the deferred tax rate on sale is 20%, the deferred tax asset to be recognised at the year end is:
CU500,000 – (CU100,000*2.5 times)= CU250,000 * the sales tax rate of 20%= CU50,000
Note if no revaluation had of been booked in the accounts, then no deferred tax would be recognised as there is no difference between the carrying amount in the accounts and the tax base cost. Also if the above was a loss, the loss would be restricted to the actual loss excluding indexation. Whether a deferred tax asset should be recognised for the loss will be determined by whether the entity believes the capital loss can be utilised in the foreseeable future.
Steps involved to working out deferred tax
- Identify the timing differences at the balance sheet date
- Quantify the timing difference and whether it is a deferred tax asset or liability.
- Calculate the timing difference before applying the deferred tax rate
- Apply the tax rate to step 3
- Decide where to post the deferred tax. The deferred tax posting should be posted to either the P&L, OCI/revaluation reserve. The posting will be to wherever the depreciation/revaluation etc was posted.
Some examples of timing differences:
Timing differences on depreciable fixed assets including revaluations (accelerated/decelerated capital allowances).
A timing differences arises on property, plant and equipment due to the fact that an item of PPE might be depreciated in the accounts at a different rate to which a deduction is allowed for tax purposes in the form of capital allowances. The general rule in this regard is:
- Where the NBV of the PPE > the tax written down value (TWDV) of PPE for tax purposes, then a deferred tax liability exists. The reason for this being a liability is due to the fact that in the future there will be more depreciation charged to the accounts which will not be allowed for tax purposes.
- Where the NBV of the PPE < the tax written down value (TWDV) of PPE for tax purposes, then a deferred tax asset exists. The reason for this being an asset is due to the fact that in the future there will be less depreciation charged to the accounts but there will still be a deduction allowed for tax purposes.
Where an asset is allowable for tax purposes the way in which the deferred tax should be calculated at each year end is:
- Determine the NBV of the assets at period end
- Determine the TWDV of the asset at period end
- Take the NBV from the TWDV to give the deferred tax asset/liability or for costs which have already been expensed and are being allowed differently for tax purposes take the actual amount to be deducted/taxed in the future
- If NBV>TWDV then a deferred tax liability exists and vice versa.
- Apply the deferred tax rate based on the expected use of the asset. The deferred tax should follow where the depreciation/revaluation was posted
- Post the difference between the prior year deferred tax and the current year as a charge/credit to P&L.
Example 6: Allowable for tax and depreciable
At the start of year 1, Company A purchased a machine for CU100,000 which is fully allowable for capital allowance purposes. The asset is written off over a life of 10 years for accounting purposes and a life of 8 years for tax purposes. As a result of the mismatch in the life for tax and accounting purposes a timing difference arises as the depreciation charged to the profit and loss each year differs from the capital allowances used to reduce profit in the tax computation for that year. Assume trading tax rate of 10% and the profit before tax is CU50,000. To determine the timing difference at the end of year 1, do the following:
|
|
CU |
|
NBV of Machine (CU100,000/10yrs*9yrs)= |
90,000 |
|
TWDV of Machine (CU100,000/8yrs*7yrs)= |
(87,500) |
|
Deferred Tax Timing Difference – Liability |
2,500 |
|
Deferred Tax Liability (CU2,500*10%) |
250 |
Journal to post at the end of year 1 is:
|
|
CU |
CU |
|
Dr Deferred Tax in Profit and Loss |
250 |
|
|
Cr Deferred Tax Liability |
|
250 |
Being journal to recognise deferred tax.
The reason for the difference is that depreciation was booked in the accounts of CU10,000 in the year whereas CU12,500 was allowed in the tax computation. Applying the accounting profit of CU50,000 and taking the current tax rate at 10% would give a profit of CU5,000 to be shown in the tax line in the accounts. However the actual tax charge is CU4,750 (50,000 accounting profit + depreciation addback of CU10,000 less capital allowance deduction of CU12,500 multiplied by 10%). Therefore by accounting for the deferred tax this CU4,750 is increased to CU5,000 so as to eliminate the effect of this timing difference in the P&L for the year which is what Section 29 tries to achieve.
The deferred tax to be recognised in the profit and loss in year 2 is obtained by taking the deferred tax timing difference at the end of year 2 from the timing difference at the end of year 1.
|
|
Year 1 |
Year 2 |
|
NBV (CU100,000/10yrs by number of years remaining) |
CU90,000 |
CU80,000 |
|
TWDV (CU100,000/8yrs by number of years remaining) |
CU87,500 |
CU75,000 |
|
Deferred Tax Timing Difference Liability |
CU2,500 |
CU5,000 |
|
Deferred Tax Liability (amount*10%) |
CU250 |
CU500 |
Journal to post at the end of year 2 is:
|
|
CU |
CU |
|
Dr Deferred Tax in Profit and Loss |
250 |
|
|
Cr Deferred Tax Liability (CU500-CU250) |
|
250 |
Being journal to recognise deferred tax.
Example 7: Asset allowable for tax, depreciable and revalued
At the start of year 1, Company A purchased an industrial building for CU100,000 which is fully allowable for capital allowance purposes. The asset is written off over a life of 10 years for accounting purposes and a life of 8 years for tax purposes. At the start of year 2 the asset was revalued to CU150,000. As a result of the mismatch in the life for tax and accounting purposes a timing difference arises as the depreciation charged to the profit and loss each year differs from the capital allowances used to reduce profit in the tax computation. Assume trading tax rate of 10%. To determine the timing difference, do the following:
The deferred tax liability at the end of year 1 is as per example 6 above as the numbers are the same. At the end of year 2 the timing difference is as follows:
|
|
Cost |
|
NBV of building |
CU133,333* |
|
TWDV of Building (CU100,000/8yrs*6yrs)= |
(CU75,000) |
|
Deferred Tax Timing Difference – Liability |
CU58,333 |
|
Deferred Tax Liability (CU58,333*10%) |
CU5,833 |
*carrying amount of the building at the end of year 1 was CU90,000 plus the revaluation at start of year 2 to bring the value up to CU150,000. Therefore an adjustment of CU60,000 was posted to the revaluation reserve. At time of revaluation the asset is depreciated over the remaining life of 9 years. NBV at the end of year 2 is therefore = CU150,000/9yrs*8yrs=CU133,333
Posting of movement in deferred tax:
Movement = deferred tax liability at end of year 1 of CU250 less deferred tax liability at end year 2 of CU5,833
However where a revaluation is recognised, the deferred tax on initial recognition of the CU60,000 follows how the revaluation was treated under Section 17. Section 17 requires the revaluation to be posted to OCI/revaluation reserve. Therefore the deferred tax on initial recognition of CU6,000 (CU60,000*10%) should be debit to the revaluation reserve/OCI. The journal required at the end of year 2 is:
|
|
CU |
CU |
|
Dr Revaluation Reserve |
6,000 |
|
|
Cr Deferred Tax Liability |
|
5,583* |
|
Cr Deferred Tax in P&L |
|
417 |
Being journal to correctly classify the deferred tax on initial recognition to the revaluation reserve and the balance to the profit and loss (CU417 is the difference between the depreciation charge posted in the year of CU16,667 (CU150,000/9yrs) less the capital allowance claimed of CU12,500 by the 10% tax rate).
For year 3, the deferred tax journal will be CU417
Example 8: Accounting for revaluations and subsequent movements including deferred tax – depreciable/not allowable for capital allowance purposes
Company A has adopted a policy of revaluation on its PPE. The company purchased an asset for CU500,000 at the start of year 1 and determined the useful life to be 20 years. By the end of year one, there were indicators of a change in market conditions and a valuation exercise was performed which showed the market value at CU525,000. At the end of year 4, a further valuation was performed as the difference in fair value and the carrying value was material, at this time the value was reduced to CU300,000. In year 8, a further valuation was performed which indicated a fair value of CU600,000.
Assume the deferred tax rate is 10% (this is not the sales rate as the asset is depreciated) and the asset does not qualify for capital allowances. Assume the depreciation on the revalued amount is transferred from the revaluation reserve to profit and loss reserves on a year by year basis as the depreciation is charged.
Company A would account for the changes in value in the following way:
At end of year 1:
The carrying value of the asset is CU475,000 (i.e. CU500,000 less depreciation for one year of CU25,000 (CU500,000/20yrs))
|
|
CU |
CU |
|
Dr Fixed Assets (CU525,000-CU475,000) |
50,000 |
|
|
Cr OCI/Revaluation Reserve |
|
50,000 |
From then on the carrying amount of CU525,000 will be depreciated over the remaining life of 19 years (CU27,632 per annum).
Deferred tax
|
|
CU |
CU |
|
Dr OCI/Revaluation Reserve |
5,000 |
|
|
Cr Deferred Tax in Balance Sheet (CU50,000 *10%) |
|
5,000 |
Therefore, the net amount posted to the revaluation reserve is CU45,000 (CU500,000-CU5,000). For year 2 to year 4, the deferred tax will be reduced and posted to the profit and loss account in line with the additional depreciation charged on the uplift in value of CU2,632 (i.e. CU27,632 less depreciation under cost basis of CU25,000).
At end of year 4:
The carrying value of the asset is CU442,104 (i.e. CU525,000 less depreciation of CU27,632 for three years totalling CU82,896)
|
|
CU |
CU |
|
Dr Profit and Loss (CU142,104-CU50,000) |
92,104 |
|
|
Dr Revaluation Reserve (reversal of amount recognised in yr 1) |
50,000 |
|
|
Cr Fixed Assets (CU442,104-CU300,000) |
|
142,104 |
From then on the carrying amount of CU300,000 will be depreciated over the remaining life of 16 years (CU18,750 per annum).
Deferred tax
|
|
CU |
CU |
|
Dr Deferred Tax in Balance Sheet (CU5,000 less ((CU2,632 * 10%) * 3 years) = CU789) |
4,211 |
|
|
Cr OCI/Revaluation Reserve |
|
4,211 |
Note deferred tax asset on the write down is not recognised on the basis that it is not reasonable that future economic benefits will be derived from the capital losses.
At end of year 8:
The carrying value of the asset is CU225,000 (i.e. CU300,000 less depreciation of CU18,750 for 4 years totalling CU75,000)
|
|
CU |
CU |
|
Dr Fixed Assets (CU600,000 mkt value-CU225,000 NBV) |
375,000 |
|
|
Cr Profit and Loss (CU92,104 previously posted-CU25,000 See note 1) |
|
67,104 |
|
Cr Revaluation Reserve (CU375,000-CU67,104) |
|
307,896 |
Deferred tax
|
|
CU |
CU |
|
Dr OCI/Revaluation Reserve |
10,000 |
|
|
Cr Deferred Tax in Balance Sheet ((CU600,000-CU500,000 original cost) * 10%) |
|
10,000 |
From then on the carrying amount of CU600,000 will be depreciated over the remaining life of 12 years.
Note 1: The amount that can be credited to the P&L is reduced by the additional depreciation that would have been charged had the asset not been revalued downward in the past i.e. original cost prior to downward revaluation of CU500,000 / useful life of 20 years= CU25,000 * 4 years = CU100,000. This compares to depreciation charged while the asset was being depreciated on the reduced amount of CU75,000 (year 5 to year 8 – CU300,000/UEL of 16 years* 4 years) = CU25,000
Treatment of depreciation on upward revaluation
The revaluation surplus included in equity may be transferred directly to retained earnings when the surplus is realised i.e. disposed of, retired from use or as the asset is used by the entity. The transfer is made through reserves and not through the profit and loss. In relation to a transfer being completed as a result of the asset being used by the entity, the amount to be transferred is the difference between the depreciation charged to the profit on loss on the revalued amount compared to the depreciation that would have been charged if revaluation had not occurred.
Example 9: Transfer of depreciation on revalued amount from profit and loss reserves
Taking the above example, at the end of year 2 for the depreciated asset, the additional depreciation charged of CU2,632 (CU27,632-CU25,000) as a result of the revaluation and the related deferred tax credit on this of CU263 (CU2,632*10%), would be transferred from P&L reserves to the revaluation reserve. The below would be shown in the statement of changes to equity in the financial statements.
|
|
Year 2 |
|
Revaluation Reserve at 01/01/Year 2 |
45,000 |
|
Transfer from Profit & Loss Reserve (CU2,632-CU263) |
(2,369) |
|
Revaluation Reserve at 31/12/Year 2 |
42,631 |
|
Profit and Loss Reserves at 01/01/Year 2 |
50,000 |
|
Transfer to Revaluation Reserve |
2,369 |
|
Profit and Loss Reserves Reserve at 31/12/Year 2 |
52,369 |
2) Accounting for deferred tax on non-depreciable land (Section 29.15)
Example 10: Accounting for initial and subsequent revaluations on non-depreciable assets – i.e. on land
Company A has adopted a policy of revaluation on its PPE. The company purchased land for CU500,000 at the start of year 1. By the end of year 1, there were indications of a change in market conditions and a valuation exercise was performed which showed the market value at CU525,000. At the end of year 4, a further valuation was performed as the difference in fair value and the carrying value was material, at this time the value was reduced to CU300,000. In year 8, a further valuation was performed which indicated a fair value of CU700,000.
Assume the deferred tax rate on a sale is 20%
Company A would account for the changes in value in the following way:
At end of year 1:
|
|
CU |
CU |
|
Dr Fixed Assets (CU525,000-CU500,000) |
25,000 |
|
|
Cr OCI/Revaluation Reserve |
|
25,000 |
Deferred tax
|
|
CU |
CU |
|
Dr OCI/Revaluation Reserve |
5,000 |
|
|
Cr Deferred Tax in Balance Sheet (CU25,000* 20%) |
|
5,000 |
Therefore, the net amount posted to the revaluation reserve is 20,000.
At end of year 4:
|
|
CU |
CU |
|
Dr Profit and Loss |
200,000 |
|
|
Dr OCI/Revaluation Reserve (being the amount previously recognised) |
25,000 |
|
|
Cr Fixed Assets (CU525,000-CU300,000) |
|
225,000 |
Deferred tax
|
|
CU |
CU |
|
Dr Deferred Tax in Balance Sheet (CU25,000 * 20%) |
5,000 |
|
|
Cr OCI/revaluation Reserve (CU25,000 * 20%) |
|
5,000 |
Note deferred tax asset on the write down of the land is not recognised on the basis that it is not reasonable that future economic benefits will be derived from the capital losses.
At end of year 8:
|
|
CU |
CU |
|
Dr Fixed Assets (CU700,000-CU300,000) |
400,000 |
|
|
Cr Profit and Loss (i.e. reversal of amounts previously recognised in P&L) |
|
200,000 |
|
Cr OCI/Revaluation Reserve (CU400,000-CU200,000) |
|
200,000 |
Deferred tax
|
|
CU |
CU |
|
Dr OCI/Revaluation Reserve (CU200,000 * 20%) |
40,000 |
|
|
Cr Deferred Tax in Balance Sheet ((CU400,000-CU200,000) * 20%) |
|
40,000 |
Treatment of depreciation on upward revaluations
The revaluation surplus included in equity may be transferred directly to retained earnings when the surplus is realised i.e. disposed of, retired from use or as the asset is used by the entity. The transfer is made through reserves and not through the profit and loss. In relation to a transfer being completed as a result of the asset being used by the entity, the amount to be transferred is the difference between the depreciation charged to the profit on loss on the revalued amount compared to the depreciation that would have been charged if revaluation had not occurred.
3) Deferred tax on investment properties carried at fair value (Section 29.16)
Example 11: Fair value movements and deferred tax impact
Company A purchased a property on 1 February 2015 for CU200,000 which was rented out on 1 March 2015 and therefore met the definition of investment property. Legal costs of CU10,000 were incurred on the purchase and property assessment costs were incurred of CU5,000. At the 31 December 2015 the fair value was CU250,000. The sales deferred tax rate is 20%. The accounting requirements are as follows:
On initial recognition
|
|
CU |
CU |
|
Dr Investment Property (property assessment costs are not directly attributable) |
210,000 |
|
|
Cr Bank |
|
210,000 |
On 31 December 2015
|
|
CU |
CU |
|
Dr Investment property (CU250,000-CU210,000) |
40,000 |
|
|
Cr Fair Value Movement on Investment Property in P&L |
|
40,000 |
|
|
CU |
CU |
|
Dr Deferred Tax P&L (CU40,000*20%) |
8,000 |
|
|
Cr Deferred Tax in Balance Sheet |
|
8,000 |
Being journal to reflect the movement in fair value during the year including the deferred tax impact
Going forward deferred tax should be accounted on any fair value movements.
4) Pension contributions/royalty charges
From an accounting perspective pension costs/royalty fees are accounted for on an accruals basis. However only pension contributions/royalties paid are allowable for tax purposes. This creates a timing difference. In effect it creates a deferred tax asset as the deductions will be allowable in the tax computation when paid.
Example 12: Pensions/royalties
Company A pays pension contributions for its employees. Total charge posted to the profit and loss in the year was CU100,000, CU20,000 of which had not been paid over to the pension scheme by the year end. Assume tax rate of 10%.
For tax purposes, only the CU80,000 would be allowable. Therefore the remaining CU20,000 will be allowable when it is paid. On this basis a deferred tax asset of CU2,000 should be recognised to reflect this tax asset.
If we assume that a deferred tax asset was in existence in the prior year for CU30,000 in relation to unpaid contributions (i.e. deferred tax asset of CU3,000), the amount to be posted to the profit and loss is a debit of CU1,000 (CU3,000 paid in year re prior year less CU2,000 unpaid at year end).
There are circumstances where a one off lump sum if paid into a pension scheme which is posted directly to the profit and loss for accounting purposes in the period it is paid however for tax purposes it is only allowable over a number of years. This also creates timing differences.
Example 13: Pensions/royalties
Company A paid a one off lump sum to a directors pension scheme of CU200,000 which is expensed in the year for accounting purposes as required. However assume for tax purposes this is only allowed over two years. Assume the tax rate is 10%.
Therefore, a deferred tax asset of CU10,000 (CU100,000*10%) should be recognised at the year-end assuming there are other taxable profits to utilise this or there are other deferred tax liabilities to set this against.
5) Finance leases
Timing differences usually arise where entities hold finance leases. From an accounting perspective in accordance with Section 20 the asset is recognised on the balance sheet and depreciated over its lease life or longer if the asset has a longer useful life, and the interest on the lease charged to the profit and loss. This differs from a tax perspective in that for tax purposes, the depreciation charge, and interest is added back and instead the actual lease payments are allowed. As a result, a deferred tax difference arises.
In order to determine the deferred tax in this case, the following should be performed:
NBV of the leased asset – carrying amount of the finance lease liability on the balance sheet * deferred tax rate.
If NBV of asset is > finance lease liability = deferred tax liability
If NBV of asset is < finance lease liability = deferred tax asset
Example 14: Finance lease
Company A entered into a finance lease for a machine. From an accounting perspective the asset was capitalised as CU30,000 and a finance liability recognised for CU30,000. The total cost including finance charges is CU36,000 over a two year life. At the end of year 1 the NBV of the asset was CU25,000 and carrying amount of the finance lease liability was CU16,000. Details on the postings for the year include:
|
Depreciation |
CU5,000 |
|
Finance Lease Interest |
CU4,000 |
|
Finance Lease Rentals Paid |
CU18,000 |
The deferred tax at the year-end is calculated as follows:
|
NBV of Finance Leased Asset (CU30,000-CU5,000 depreciation) |
CU25,000 |
|
Carrying Amount of Lease (CU30,000-CU18,000 payments+CU4,000 in lease interest) |
CU16,000 |
|
Deferred Tax Liability |
CU9,000 |
|
Deferred Tax at 10% |
CU900 |
The reason for the timing difference is that CU9,000 was only charged to the P&L (i.e. depreciation of CU5,000 and finance interest of CU4,000) whereas a tax deduction was allowed for CU18,000.
6) Unrelieved tax losses
Timing differences arise due to losses being recognised in the statement of comprehensive income in a year but these losses cannot be utilised for tax purposes until future taxable profits exist. Therefore a deferred tax asset should be recognised for this subject to there being taxable profits to utilise these losses in the future.
Before these losses can be recognised as a deferred tax asset it must be probable (more likely than not that there will be taxable profits to utilise the tax losses). Section 29.7 makes it clear that the very existence of unrelieved tax losses is strong evidence that there may not be other future taxable profits against which the losses can be relieved. Therefore when assessing whether the deferred tax asset should be recognised care should to be taken to review future projections (it is not enough to just look at prior year results as a basis for future years) and assess how long it will take to recover these losses based on those projections or if in fact it is possible to recover these. Consideration also needs to be given as to whether the losses expire at a point in time. It may be possible to look at future tax strategies to prove the recoverability of losses forward if it is probable these will be put in place.
Where there are deferred tax liabilities for the same tax district to offset the deferred tax assets these can also be taken into account.
See example 3A above for an example of same.
7) Fair value adjustments
There may be instances where fair value adjustments result in deferred tax. Examples would include investments carried at market value. The difference between market value and the tax base cost should be accounted for as deferred tax at the sales tax rate and the tax should follow where the market value differences are posted i.e. the profit and loss. This is the same case for investment properties.
Depending on the tax jurisdiction, deferred tax may be required on other fair value adjustments, however usually for trade related items, the adjustments are taxed/taxable in the period they arise. Example 11 illustrates this point.
8) Defined benefit obligations
Section 29 requires deferred tax to be recognised on defined benefit obligations. The deferred tax rate to measure the timing difference is the trading tax rate. Note deferred tax assets are only recognised where it is probable that there will be future pension payments into the scheme.
The reason why timing difference arise is due to the fact that for tax purposes only pension payments which are made can be deducted from the taxable profits. However in accordance with Section 28, the estimated current service costs, interest cost, actuarial gain/loss are recognised in the profit and loss/OCI. These costs are added back for tax purposes. These are allowable in the future when pension payments are made.
Deferred tax should be recognised at the rate in which the timing difference is expected to reverse. Therefore where the pension scheme is in a deficit it would be the expected timing of future contributions by the employer.
The deferred tax asset should be shown separately within the deferred tax asset line in the balance sheet. It should not be netted against the defined benefit carrying amount. The deferred tax on each posting follows where the journals were posted to recognise the movements on the pension liability/asset during the year.
Example 15 below shows the deferred tax calculation and the amount posted to the profit and loss and other comprehensive income in the period. The general rule is that the deferred tax on the actuarial gain/loss and actual versus expected return on plan assets is posted to other comprehensive income. The remainder is posted to the tax line in the profit and loss.
Example 15: Deferred tax on net defined benefit asset/liability
See below extract from an actuarial report detailing the movement in the plan assets during the year. See below the way in which this will be presented in the financial statements and the journals required to reflect these movements. Assume the prior year discount rate was 3.49% and the 2015 discount rate is 2.6%:
Changes in the present value of the defined benefit obligation are as follows:
|
|
2015 |
2014 |
|
|
CU |
CU |
|
Benefit obligation at start of year |
(26,724) |
(26,236) |
|
Current Service Cost |
(615) |
(689) |
|
Interest Cost |
(1,325) |
(1,270) |
|
Plan participants’ contributions |
(334) |
(334) |
|
Actuarial gain/(loss) |
(10,148) |
1,601 |
|
Benefits paid |
313 |
204 |
|
Curtailment |
122 |
0 |
|
Benefit obligation at end of year |
(38,711) |
(26,724) |
Changes in the fair value of plan assets are as follows:
|
|
2015 |
2014 |
|
|
CU |
CU |
|
Fair Value of Plan Assets at start of year |
18,030 |
17,318 |
|
Expected Return on Plan Assets |
1,093 |
1,161 |
|
Employer contribution |
1,250 |
1,535 |
|
Plan participants’ contributions |
334 |
334 |
|
Benefits paid |
(313) |
(204) |
|
Actuarial gain (Actual less expected) |
2,342 |
(2,114) |
|
Fair Value of Plan Assets at end of year |
22,736 |
18,030 |
The net pension liability as at 31 December 2014 and 2015 is analysed as follows:
|
|
2015 |
2014 |
|
|
CU |
CU |
|
Present value of defined obligations |
(38,711) |
(26,724) |
|
Fair Value of Plan Assets |
22,736 |
18,030 |
|
Net Pension Liability |
(15,975) |
(8,964) |
See below the journals required in the entity’s financial statements assuming a deferred tax rate of 10%. How each of the main figures are determined is discussed in the sections that follow.
Example 16: Recognising deferred tax
If we take example 15 above, the net defined benefit pension liability was CU15,975. Therefore the deferred tax asset to be recognised assuming the expected tax rate is 10% is CU1,598 (CU15,975*10%). This is a deferred tax asset as the expense has hit the profit and loss or other comprehensive income but has not yet been allowable for tax. Therefore when the pension contributions are made to reduce this liability they will be allowable for tax purposes.
The same approach should be taken in relation to a net defined benefit pension asset i.e. a deferred tax liability should be recognised. Given that a defined benefit asset is only recognised where it is deemed recoverable, if an asset is shown then it is appropriate to recognise a deferred tax liability for this asset.
9) Consolidation adjustments
In the consolidated financial statements sales by one group company to another are eliminated. The creates a timing difference as the legal entity in the group has been taxed on this, however the profit on this sale has been excluded in the consolidated accounts. Therefore a deferred tax asset should be created for the fact that tax has been paid on this profit but it has not been shown in the consolidated financial statements.
10) Investment in associates, joint ventures, subsidiaries in consolidated accounts
Where income and expenses for these entities are included in the consolidated accounts but they will not be taxable in the Parent Company’s books until a distribution is received or until the investments are sold, this may create a timing difference. As a result, a deferred tax asset/liability should be created. In determining the rate to apply, consideration should be given as to the expected method of recovery of the asset i.e. through sale or through dividend receipts. As noted in Section 29.9, deferred tax cannot be recognised where the parent can control the reversal of the timing difference and it is probable the timing difference will not reverse in the foreseeable future.
In reality deferred tax will always need to be recognised on the difference between the carrying amount (which will include the entities allocation of profits/losses since acquisition) and the book value of an investment in an associate where the asset is likely to be realised on sale as the parent cannot control an associate. This would not be the case if the realisation of the asset is through dividend to be paid where the dividend income for the associate would not be taxable under tax legislation i.e. it would then be a permanent difference and no deferred tax recognised.
Example 17: Undistributed profits of a subsidiary
Parent A has a subsidiary Company B. As Parent A controls the dividend policy and it is unlikely to pay a dividend in the foreseeable future, the entity should not recognise deferred tax assuming the asset will be realised from dividends.
11) Assets partly allowable for tax purposes
There will be instances where assets are purchased which are to be used in the trade but part of this asset is not be allowable for tax purposes because it does not meet the definition of plant. In this instance, the depreciation on the non-allowable element is considered a permanent difference and no deferred tax should be provided. In this case the net book value of the non-allowable element is identified and then excluded when comparing the NBV to the TWDV.
Example 18: Assets partly allowable for tax purposes
Company A acquired a car at a cost of CU10,000. Assume under tax rules only CU4,000 is allowable for capital allowances. The asset is depreciated over 10 years and the tax life is also 10 years for the sake of simplicity. The deferred tax to be recognised is:
|
NBV at Year End (CU10,000/10yrs*9yrs) |
CU9,000 |
|
Less NBV of Non-Allowable Element (CU6,000/10yrs*9yrs) |
CU5,400 |
|
NBV of Allowable Element of Asset |
CU3,600 |
|
TWDV at Year End |
CU3,600 |
|
Deferred Tax at Year End |
CUNil |
The same could be the case for other items of plant, a car is just used as an example here.
12) Items expensed which are capital in nature (allowable for capital allowances)
Sometimes certain items are expensed which are capital in nature for tax purposes as they are immaterial to capitalise based on an accounting policy. In these instances this is a timing difference i.e. they have been expensed in the accounts in the year but are added back in the tax computation but allowed for capital allowance purposes.
13) Transition adjustments to a new GAAP
Deferred tax will arise on certain transition adjustments. This deferred tax arises as a result of certain items being included in the prior year comparatives which were not taxed previously or a tax deduction was not obtained in the prior year tax computation as the tax computation was performed under old GAAP. Examples of some of the deferred tax adjustments that arise are detailed in the principal transition adjustment sections below.
Measurement of deferred tax on business combinations
Extract from FRS102: Section 29.11
29.11 When the amount that can be deducted for tax for an asset (other than goodwill) that is recognised in a business combination is less (more) than the value at which it is recognised, a deferred tax liability (asset) shall be recognised for the additional tax that will be paid (avoided) in respect of that difference. Similarly, a deferred tax asset (liability) shall be recognised for the additional tax that will be avoided (paid) because of a difference between the value at which a liability is recognised and the amount that will be assessed for tax. The amount attributed to goodwill shall be adjusted by the amount of deferred tax recognised.
OmniPro comment
Section 29.11 requires that deferred tax be recognised on all fair value adjustments arising in a business combination with the exception of deferred tax on goodwill. Note this only applies to business combinations. Note a group reconstruction is not a business combination so these rules would not apply to that situation. The deferred tax recognised increases goodwill where it is a deferred tax liability. Section 29.10 makes it clear that deferred tax on permanent differences arising on a business combination should also be provided.
When determining the tax rate to measure the timing difference at, consideration should be given to the rate in which the assets are likely to be realised i.e. at the CGT rate or the trading rate.
Example 19: Deferred tax on business combinations
Parent A acquired 100% of the ordinary shares of Company B for CU1,000,000. Assume the deferred tax rate is 10%. Assume deferred tax has been recognised correctly on the book amounts transferred. Details of the book value and fair value at the time of acquisition is detailed below:
|
|
Book value |
Fair value |
|
Property, Plant and Equipment |
CU300,000 |
CU550,000 |
|
Intangible Assets |
CUnil |
CU100,000 |
|
Inventory |
CU150,000 |
CU160,000 |
|
Cash |
CU100,000 |
CU100,000 |
|
Debtors |
CU20,000 |
CU25,000 |
|
Creditors |
(CU100,000) |
(CU100,000) |
|
Deferred Tax |
(CU60,000) |
(CU86,500*) |
|
Total Net Assets |
CU370,000 |
CU748,500 |
|
Consideration |
|
CU1,000,000 |
|
Goodwill |
|
CU251,500 |
The deferred tax to be recognised on acquisition is:
|
Uplift in Property, Plant and Equipment |
CU150,000 |
|
Uplift in Intangible Assets |
CU100,000 |
|
Uplift in Inventory |
CU10,000 |
|
Uplift in Cash |
CUnil |
|
Uplift in Debtors |
CU5,000 |
|
Uplift in Creditors |
CUnil |
|
Total Timing Difference |
CU265,000 |
Once the above exercise is completed management should assess the rate that the asset/liabilities are expected to be reversed. Here the debtors, inventory, property, plant and equipment are going to be reversed during trading as they are trading assets. In relation to the intangible assets, if it is assumed these will be used throughout the trade and have little residual value then the trade rate should be used in measuring the deferred tax. The deferred tax liability to recognise as a result of the uplift in value is:
CU265,000 * 10%= CU26,500. Therefore total deferred tax to be shown in the consolidated financial statements is = CU26,500+CU60,000=CU86,500
From above we can see that the additional liability for deferred tax has increased goodwill by the same amount. The deferred tax will be reduced as the differences reverse year on year (i.e. for PPE and intangibles in the period depreciation/amortisation is charged, for debtors when they are paid, for inventory when they are sold etc.)
Note in the example above if there was a large residual value on the PPE, then it may be appropriate to recognise deferred tax at the sales rate for the value allocated to the residual amount and the remainder would be measured using the trading tax rate. This would then give a different answer for goodwill.
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