Accelerated capital allowances

Tax relief for capital expenditure on plant and machinery might be provided through capital allowances, which are a form of standardized tax depreciation. Capital allowances are deducted from accounting profit to arrive at taxable profit, and the amount of depreciation charged in the financial statements is disallowed in the tax computation.

Depreciation for tax and accounting purposes is the same over the asset’s life but differs from year to year. This gives rise to temporary differences between the asset’s carrying amount and its tax base. The capital allowances often depreciate the asset at a faster rate for tax purposes than the rate of depreciation charged in the financial statements; this results in carrying amounts over the tax base. The temporary differences created are referred to as ‘accelerated capital allowances’.

Origination and reversal of temporary differences in case of accelerated capital allowances An entity buys a machine in 20X1 for C100,000. The asset is expected to be recovered fully through use over five years. Depreciation is charged on a straight-line basis for accounting purposes and is C20,000 per annum. The rate of capital allowances is 25% per annum on a reducing balance basis. The machine will be scrapped at the end of its useful life; and the entity will use any unclaimed capital allowances against future trading income. The temporary difference will arise as follows: Per financial statements 20X1 20X2 20X3 20X4 20X5 C’000 C’000 C’000 C’000 C’000 Carrying amount of asset 100 80 60 40 20 Depreciation charge 20 20 20 20 20 Book written-down value (A) 80 60 40 20 0 Per tax computation Carrying amount of asset 100 75 56 42 32 Capital allowance 25 19 14 10 8 Tax written-down value = Tax base (B) 75 56 42 32 24 Temporary difference (A) – (B) 5 4 (2) (12) (24) Originating (reversing) Capital allowance allowed 25 19 14 10 8 Depreciation charged 20 20 20 20 20 5 (1) (6) (10) (12) A temporary difference of C5,000 originates in year 1. This begins to reverse from year 2 onwards. At the end of year 1, the asset’s carrying amount is C80,000 and its tax base is C75,000. To recover the carrying amount of C80,000, the entity will have to generate taxable income of at least C80,000; but it will only be able to deduct capital allowances of C75,000. The difference of C5,000 gives rise to a taxable temporary difference on which deferred tax is provided. This temporary difference unwinds as the benefit of lower current tax in the first year (that is, where capital allowances exceed depreciation) reverses from year 2 onwards; at this point, capital allowances have fallen below depreciation. From year 2 onwards, the current tax assessed and recognised in profit for the period is higher than the total amount due on the profit reported in the financial statements. The cumulative deductible temporary difference at the end of year 5 will gradually reverse from year 6 onwards as it is utilised against future trading income.

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Impact of change in rates at which capital allowances are granted A change in legislation can change the rates at which capital allowances are granted. Such changes could affect the tax base of the asset on which deferred tax is measured. If an entity has taken into account the phasing of the reversal of temporary differences when recognising deferred tax, it will need to take into account changes in the timing of capital allowances. This change is accounted for in the period when the change in rates was substantively enacted.

Impact of change in tax allowances for existing and new assets In a number of jurisdictions, legislation has been amended so that tax allowances can no longer be claimed for existing and new assets (that is, to reduce the tax depreciation rate to zero). The removal of future tax depreciation on an existing asset significantly reduces its tax base where deferred tax is measured on a use basis, because future deductions are no longer available. The deferred tax liability for the existing asset increases, and there is often a tax expense in the income statement in the accounting period when substantive enactment occurs.

Government grants

The accounting treatment of government grants, and their treatment for tax purposes, can give rise to temporary differences. These temporary differences need to be considered to determine if they give rise to deferred tax assets or liabilities.

Government grants relating to assets are presented in the balance sheet, either as deferred income or by deducting the grant in arriving at the asset’s carrying amount. Grants given as a contribution towards an asset’s cost of acquisition might be non-taxable.

Grants might be, in effect, taxed by reducing the cost of fixed assets for capital allowance purposes. Other grants, such as revenue-based grants, are sometimes taxable on a cash-received basis.

Deferred tax consequences of non-taxable grants relating to assets If the grant relating to an asset is not taxable, it has a tax base of nil and gives rise to a deductible temporary difference on initial recognition. This needs to be considered in two situations. First, if the grant is deducted from the asset’s carrying amount, a deductible temporary difference arises, because the carrying amount is less than the asset’s tax base, which is cost. Second, if the grant is set up as deferred income, the difference between the deferred income and its tax base of nil is a deductible temporary difference. However, a deferred tax asset cannot be recognised, because of the initial recognition exception. It would not be appropriate to recognise the tax benefit associated with this temporary difference on initial recognition, where the income from the grant itself is recognised over a number of periods. Apart from any temporary difference relating to the asset, there could also be a deductible temporary difference relating to the grant. Where the grant is deducted from the asset’s cost, any taxable temporary difference relating to the asset (for example, where tax deductions exceed accounting depreciation) needs to be calculated. This would be the difference between the asset’s net book value excluding the grant (that is, gross cost less accumulated depreciation calculated on the gross cost) and its tax writtendown value, also excluding the grant (that is, gross cost less tax allowances claimed).

Deferred tax consequences of taxable grants relating to assets The nature of the deferred tax adjustment depends on how the grant is treated for tax and accounting purposes in case of grants relating to an asset that are taxable. The deferred tax calculation is relatively straightforward where the grant is deducted from the cost of fixed assets for financial reporting and tax purposes. In such cases, the capital allowances for tax purposes are calculated on a reduced cost. If the grant is treated as deferred income, but deducted against the asset’s cost for tax purposes, the deferred tax calculation consists of two components: a deferred tax asset that arises on the unamortised grant; and an amount that is netted off against the deferred tax liability arising on the accelerated capital allowances. In practice, the balance on the deferred income account reduces the asset’s book value for the purpose of calculating the temporary difference.

Capital allowances restricted by amount of grant An entity buys a fixed asset for C120,000. The asset qualifies for a grant of C20,000; the grant is treated in the financial statements as a deferred credit. The asset has a useful economic life of five years. The entity claims capital allowances (25% reducing balance), but these are restricted by the amount of the grant. The temporary differences for deferred tax purposes are calculated as follows: Per financial statements 20X1 20X2 20X3 20X4 20X5 C C C C C Cost of asset 120,000 96,000 72,000 48,000 24,000 Depreciation (24,000) (24,000) (24,000) (24,000) (24,000) Net book value 96,000 72,000 48,000 24,000 – Unamortised deferred income 16,000 12,000 8,000 4,000 –   Per tax computation 20X1 20X2 20X3 20X4 20X5 C C C C C Cost of asset 120,000 Less grant (20,000) Cost net of grant 100,000 75,000 56,250 42,187 31,640 Capital allowances @ 25% (25,000) (18,750) (14,063) (10,547) (7,910) Tax base 75,000 56,250 42,187 31,640 23,730 Temporary difference Net book value of fixed asset 96,000 72,000 48,000 24,000 – Unamortised grant (16,000) (12,000) (8,000) (4,000) – 80,000 60,000 40,000 20,000 – Tax base (75,000) (56,250) (42,187) (31,640) (23,730) Cumulative temporary difference 5,000 3,750 (2,187) (11,640) (23,730) The temporary difference profile will be the same if the grant is deducted directly from the asset’s cost and the net amount is written off over five years.

Deferred tax consequences of revenue-based grants C Non-taxable revenue-based grants have no deferred tax consequences. The amortised credit to the income statement does not enter into the determination of taxable profits. A temporary difference will arise between its carrying amount and its tax base where a revenue-based grant is taxable. A revenue-based grant might be taxed on receipt but amortised over a period for financial reporting purposes. In such cases, it gives rise to a deductible temporary difference that is the difference between the carrying amount of the unamortised balance and a nil tax base. A deferred tax asset is recognised on the deductible temporary difference if it is probable that the entity will earn sufficient taxable profit in later accounting periods (as the deferred credit unwinds through amortisation), so that it will benefit from the reduction in tax payments. A grant that was taxed on receipt might become repayable, and the repayment qualifies for tax relief in the year when the repayment is made. Any deferred tax asset previously carried forward should be immediately written off as part of the tax charge.

Example Debt instruments measured at fair value Debt instruments At 31 December 20X1, Entity Z holds a portfolio of three debt instruments: Debt instrument Cost Fair value Contractual interest rate CU CU A 2,000,000 1,942,857 2.00% B 750,000 778,571 9.00% C 2,000,000 1,961,905 3.00% Entity Z acquired all the debt instruments on issuance for their nominal value. The terms of the debt instruments require the issuer to pay the nominal value of the debt instruments on their maturity on 31 December 20X2. Interest is paid at the end of each year at the contractually fixed rate, which equalled the market interest rate when the debt instruments were acquired. At the end of 20X1, the market interest rate is 5 per cent, which has caused the fair value of Debt Instruments A and C to fall below their cost and the fair value of Debt Instrument B to rise above its cost. It is probable that Entity Z will receive all the contractual cash flows if it continues to hold the debt instruments. At the end of 20X1, Entity Z expects that it will recover the carrying amounts of Debt Instruments A and B through use, ie by continuing to hold them and collecting contractual cash flows, and Debt Instrument C by sale at the beginning of 20X2 for its fair value on 31 December 20X1. It is assumed that no other tax planning opportunity is available to Entity Z that would enable it to sell Debt Instrument B to generate a capital gain against which it could offset the capital loss arising from selling Debt Instrument C. The debt instruments are measured at fair value through other comprehensive income in accordance with IFRS 9 Financial Instruments (or IAS 39 Financial Instruments: Recognition and Measurement). Tax law The tax base of the debt instruments is cost, which tax law allows to be offset either on maturity when principal is paid or against the sale proceeds when the debt instruments are sold. Tax law specifies that gains (losses) on the debt instruments are taxable (deductible) only when realised. Tax law distinguishes ordinary gains and losses from capital gains and losses. Ordinary losses can be offset against both ordinary gains and capital gains. Capital losses can only be offset against capital gains. Capital losses can be carried forward for five years and ordinary losses can be carried forward for 20 years. Ordinary gains are taxed at 30 per cent and capital gains are taxed at 10 per cent. Tax law classifies interest income from the debt instruments as ‘ordinary’ and gains and losses arising on the sale of the debt instruments as ‘capital’. Losses that arise if the issuer of the debt instrument fails to pay the principal on maturity are classified as ordinary by tax law. General On 31 December 20X1, Entity Z has, from other sources, taxable temporary differences of CU50,000 and deductible temporary differences of CU430,000, which will reverse in ordinary taxable profit (or ordinary tax loss) in 20X2. At the end of 20X1, it is probable that Entity Z will report to the tax authorities an ordinary tax loss of CU200,000 for the year 20X2. This tax loss includes all taxable economic benefits and tax deductions for which temporary differences exist on 31 December 20X1 and that are classified as ordinary by tax law. These amounts contribute equally to the loss for the period according to tax law. Entity Z has no capital gains against which it can utilise capital losses arising in the years 20X1–20X2. Except for the information given in the previous paragraphs, there is no further information that is relevant to Entity Z’s accounting for deferred taxes in the period 20X1–20X2. Temporary differences At the end of 20X1, Entity Z identifies the following temporary differences: Carrying amount Tax base Taxable temporary differences Deductible temporary differences CU CU CU CU Debt Instrument A 1,942,857 2,000,000 57,143 Debt Instrument B 778,571 750,000 28,571 Debt Instrument C 1,961,905 2,000,000 38,095 Other sources Not specified 50,000 430,000 The difference between the carrying amount of an asset or liability and its tax base gives rise to a deductible (taxable) temporary difference. This is because deductible (taxable) temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position and its tax base, which will result in amounts that are deductible (taxable) in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Utilisation of deductible temporary differences With some exceptions, deferred tax assets arising from deductible temporary differences are recognised to the extent that sufficient future taxable profit will be available against which the deductible temporary differences are utilised. IAS 12 identify the sources of taxable profits against which an entity can utilise deductible temporary differences. They include: future reversal of existing taxable temporary differences; taxable profit in future periods; and tax planning opportunities. The deductible temporary difference that arises from Debt Instrument C is assessed separately for utilisation. This is because tax law classifies the loss resulting from recovering the carrying amount of Debt Instrument C by sale as capital and allows capital losses to be offset only against capital gains. The separate assessment results in not recognising a deferred tax asset for the deductible temporary difference that arises from Debt Instrument C because Entity Z has no source of taxable profit available that tax law classifies as capital. In contrast, the deductible temporary difference that arises from Debt Instrument A and other sources are assessed for utilisation in combination with one another. This is because their related tax deductions would be classified as ordinary by tax law. The tax deductions represented by the deductible temporary differences related to Debt Instrument A are classified as ordinary because the tax law classifies the effect on taxable profit (tax loss) from deducting the tax base on maturity as ordinary. In assessing the utilisation of deductible temporary differences on 31 December 20X1, the following two steps are performed by Entity Z. Step 1: Utilisation of deductible temporary differences because of the reversal of taxable temporary differences Entity Z first assesses the availability of taxable temporary differences as follows: (CU) Expected reversal of deductible temporary differences in 20X2  From Debt Instrument A 57,143  From other sources 430,000 Total reversal of deductible temporary differences 487,143 Expected reversal of taxable temporary differences in 20X2  From Debt Instrument B (28,571)  From other sources  (50,000) Total reversal of taxable temporary differences  (78,571) Utilisation because of the reversal of taxable temporary differences (Step 1)  78,571 Remaining deductible temporary differences to be assessed for utilisation in Step 2 (487,143 – 78,571) 408,572 In Step 1, Entity Z can recognise a deferred tax asset in relation to a deductible temporary difference of CU78,571. Step 2: Utilisation of deductible temporary differences because of future taxable profit In this step, Entity Z assesses the availability of future taxable profit as follows: (CU) Probable future tax profit (loss) in 20X2 (upon which income taxes are payable (recoverable)) (200,000) Add back: reversal of deductible temporary differences expected to reverse in 20X2 487,143 Less: reversal of taxable temporary differences (utilised in Step 1)  (78,571) Probable taxable profit excluding tax deductions for assessing utilisation of deductible temporary differences in 20X2 208,572 Remaining deductible temporary differences to be assessed for utilisation from Step 1 408,572 Utilisation because of future taxable profit (Step 2) 208,572 Utilisation because of the reversal of taxable temporary differences (Step 1)  78,571 Total utilisation of deductible temporary differences 287,143 The tax loss of CU200,000 includes the taxable economic benefit of CU2 million from the collection of the principal of Debt Instrument A and the equivalent tax deduction, because it is probable that Entity Z will recover the debt instrument for more than its carrying amount. The utilisation of deductible temporary differences is not, however, assessed against probable future taxable profit for a period upon which income taxes are payable. Instead, the utilisation of deductible temporary differences is assessed against probable future taxable profit that excludes tax deductions resulting from the reversal of deductible temporary differences. Assessing the utilisation of deductible temporary differences against probable future taxable profits without excluding those deductions would lead to double counting the deductible temporary differences in that assessment. In Step 2, Entity Z determines that it can recognise a deferred tax asset in relation to a future taxable profit, excluding tax deductions resulting from the reversal of deductible temporary differences, of CU208,572. Consequently, the total utilisation of deductible temporary differences amounts to CU287,143 (CU78,571 (Step 1) + CU208,572 (Step 2)). Measurement of deferred tax assets and deferred tax liabilities Entity Z presents the following deferred tax assets and deferred tax liabilities in its financial statements on 31 December 20X1: (CU) Total taxable temporary differences 78,571 Total utilisation of deductible temporary differences 287,143 Deferred tax liabilities (78,571 at 30%) 23,571 Deferred tax assets (287,143 at 30%) 86,143 The deferred tax assets and the deferred tax liabilities are measured using the tax rate for ordinary gains of 30 per cent, in accordance with the expected manner of recovery (settlement) of the underlying assets (liabilities). Allocation of changes in deferred tax assets between profit or loss and other comprehensive income Changes in deferred tax that arise from items that are recognised in profit or loss are recognised in profit or loss. Changes in deferred tax that arise from items that are recognised in other comprehensive income are recognised in other comprehensive income. Entity Z did not recognise deferred tax assets for all of its deductible temporary differences at 31 December 20X1, and according to tax law all the tax deductions represented by the deductible temporary differences contribute equally to the tax loss for the period. Consequently, the assessment of the utilisation of deductible temporary differences does not specify whether the taxable profits are utilised for deferred tax items that are recognised in profit or loss (ie the deductible temporary differences from other sources) or whether instead the taxable profits are utilised for deferred tax items that are recognised in other comprehensive income (ie the deductible temporary differences related to debt instruments classified as fair value through other comprehensive income). For such situations, IAS 12 requires the changes in deferred taxes to be allocated to profit or loss and other comprehensive income on a reasonable pro rata basis or by another method that achieves a more appropriate allocation in the circumstances.

Compound financial instruments

IAS 12 contains guidance on calculating deferred tax about compound financial instruments that are accounted for under IAS 32. Compound financial instruments are instruments that an entity has issued that contain both a liability and an equity component (e.g. issued convertible debt). In the case of convertible debt, the separate components are a liability component (representing borrowing with an obligation to repay), and an equity component (representing the embedded option to convert the liability into equity of the entity).

Under IAS 32, the equity and liability components of a compound instrument are accounted for separately – the proceeds of the issue are allocated between the separate elements. The amount initially recognized as a liability is the present value of the cash flows discounted at a market rate for equivalent debt without the equity feature.

Because the holders of the compound instrument are effectively purchasing an equity interest, the coupon on the compound instrument is almost always lower than it would be for the equivalent debt without the equity feature. Therefore, the value assigned to the debt portion of the compound instrument will be lower than the total proceeds received.

For example, CU100 proceeds from the issue of a convertible bond could be allocated CU90 to debt and CU10 to equity – the carrying amount of the liability component (CU90) is less than the face value of the instrument (CU100).

In some jurisdictions, the tax base of the liability component on initial recognition is equal to the initial carrying amount of the sum of the liability and equity components (i.e. CU100 in the above example). If the instrument were settled at an amount equal to the carrying amount of its liability component (which is generally less than the face value and, therefore, less than the tax base), a taxable gain arises, and so a deferred tax liability arising from this taxable temporary difference is recognized.

In the example cited above, if the bond were settled for CU90 (its carrying amount), a gain of CU10 would arise which could be taxable.

IAS 12’s ‘initial recognition exception’ does not apply in this situation – a deferred tax liability should be recognized. This is because the temporary difference arises not from the initial recognition of the instrument, but rather from the separate recognition of the equity component.

Because the equity component of the compound financial instrument is recognized directly in equity, the deferred tax liability arising is also recognized directly in equity. The deferred tax should be charged directly to the carrying amount of the equity component.

However, as the discount associated with the liability component of the compound financial instrument unwinds, the reduction of the associated deferred tax liability is recognized in profit or loss and not directly in equity. The recognition of the deferred tax credit in profit or loss is consistent with the recognition of the associated expense in profit or loss related to unwinding the discount on the liability component.

In jurisdictions where any gain on settlement of the liability would not be taxable, the tax base of the liability is always equal to its carrying amount, and no temporary difference arises.

Convertible note accounted for as a compound instrument – deferred tax implications – example On 31 December 20X0, Company R issues a convertible note with a face value of CU10,000 that matures in three years. There is no interest payable during the period, but the holder has the option to convert the note into a fixed number of shares at the end of the three-year period. Had Company R issued debt with no conversion rights that matured in three years, the interest rate on the bonds would have been 9 per cent. Under IAS 32, the note is split into its liability and equity components. Using a discount rate of 9 per cent (i.e. the rate at which Company R could have issued equivalent debt with no conversion rights), the present value of the instrument is CU7,722. This is taken to be the value of the liability component, giving rise to an amount recognised directly in equity of CU2,278. There are no tax consequences if the note is repaid at its face value, and a taxable gain arises if the note is settled for less than its face value. Therefore, the tax base of the instrument is CU10,000. The tax rate is 17.5 per cent. If the liability were settled at its carrying amount (CU7,722), a taxable profit would arise. Thus, on the initial separation of the liability and equity components, a taxable temporary difference of CU2,278 arises. This gives rise to a deferred tax liability of CU399 (CU2,278 × 17.5%). This amount is netted against the amount recognised in respect of the equity component of the note. The following entries are recognised at the date of issue of the convertible note. CU CU Dr Cash 10,000 Cr Convertible note payable 7,722 Cr Equity 2,278 Dr Equity 399 Cr Deferred tax liability 399 To recognise the issue of the convertible note. Each year, imputed interest on the liability will be recognised, increasing the carrying amount of the liability component and reducing the associated deferred tax liability. The reduction in the deferred tax liability is recognised in profit or loss. The movements over the life of the convertible note can be summarised as follows. 20X0 CU 20X1 CU 20X2 CU 20X3 CU Liability and interest Opening liability 7,722 8,417 9,174 Imputed interest (9%) 695 757 826 Closing liability 7,722 8,417 9,174 10,000 Deferred tax liability Convertible note carrying amount 7,722 8,417 9,174 10,000 Tax base 10,000 10,000 10,000 10,000 Taxable temporary difference 2,278 1,583 826 – Deferred tax liability (at 17.5%) 399 277 145 – Deferred tax income (profit or loss) – 122 132 145

Impact of IFRS 9 or IAS 39 hedging requirements on non-financial items The recognition of a ‘basis adjustment’ for a non-financial asset or liability in accordance with IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) may cause the carrying amount of the asset or liability to be different from its tax base. This may occur when the tax value ascribed to the asset or liability under the relevant tax jurisdiction is determined other than by reference to the carrying amount in the financial statements (e.g. the basis adjustment is not recognised for tax purposes at the same time as the carrying amount of the asset is adjusted for accounting purposes). Deferred tax should generally be recognised for the temporary difference arising from the difference between the carrying amount in the financial statements and the tax base. When the different accounting and tax treatments are due to a basis adjustment, the temporary difference arises after the initial recognition of the asset or liability. Accordingly, the initial recognition exceptions in IAS 12 (taxable temporary differences) and IAS 12 (deductible temporary differences) do not apply and deferred tax should be recognised (subject to IAS 12’s general recognition criteria).

Recognition of temporary differences arising from ‘basis adjustments’ to non-financial items under cash flow hedging arrangements – example On 4 January 20X2, Company D has forecast purchases of 100,000 kg of cocoa on or about 31 December 20X2 from a Brazilian supplier, Company B, for a price of US$180,000. Company D’s functional currency is sterling, and Company B has a US$ functional currency. On 4 January 20X2, Company D designates the cash flow of the forecast purchase as a hedged item and enters into a currency forward contract to buy US$180,000 for £100,000 (i.e. locking in an exchange rate of US$1.8:£1). At inception of the hedge, the derivative is on-market (i.e. fair value is zero). The terms of the currency forward contract and the forecast purchase match each other, and the entity designates the forward foreign exchange risk as the hedged risk. On 31 December 20X2, the transaction occurs as expected. The fair value of the forward contract is positive £12,500 because the US dollar has continued to strengthen against sterling. The forward contract has been fully effective in hedging the forward rate of the forecast transaction and, accordingly, all of the gain of £12,500 has been recognised in other comprehensive income. Company D is required to reclassify such gains and losses and include them in the initial cost of the non-financial asset in accordance with IFRS 9. (For entities that have not yet adopted IFRS 9, the treatment is available as an accounting policy choice in accordance with IAS 39.) The cocoa inventories are recognised in Company D’s financial statements at £100,000, being the cash payment of £112,500 (US$180,000 translated at the spot rate on 31 December 20X2), net of the gain on the forward contract of £12,500. The applicable tax rate is 30 per cent and the local tax law does not permit a reduction of the inventories for the gain on the hedging instrument. Accordingly, the tax base of the inventories is £112,500. Company D should, subject to the normal recoverability criteria, recognise a deferred tax asset of £3,750 (£12,500 × 30 per cent) in respect of the temporary difference (£112,500 tax basis less £100,000 carrying amount) arising from the inclusion of the hedging gains in the initial cost of the inventories. Because the £3,750 arises on the reclassification of the hedging instrument gain (rather than on initial recognition of the inventories), the initial recognition exception does not apply. Under local tax law, fair value gains and losses on the hedging instrument result in taxable gains and losses when they are realised. The journal entries to be recorded as at 31 December 20X2 are as follows. Journal entry 1 £ £ Dr Forward contract 12,500 Cr Other comprehensive income 12,500 To recognise the unrealised gain on the forward contract in other comprehensive income. Journal entry 2 Dr Other comprehensive income 3,750 Cr Deferred tax liability 3,750 To recognise the tax consequences arising from the unrealised gain on the forward contract.   Journal entry 3 Dr Inventories 112,500 Cr Cash 112,500 To recognise the purchase of cocoa as inventory. Journal entry 4 Dr Cash 12,500 Cr Forward contract 12,500 To recognise the settlement of the forward contract.   Journal entry 5 Dr Deferred tax liability 3,750 Cr Current tax payable 3,750 To reverse the deferred tax liability associated with the cash flow hedge asset and recognise the current tax liability resulting on settlement of the forward contract (net entry). Journal entry 6 Dr Cash flow hedge reserve (equity) 12,500 Cr Inventories 12,500 To recognise the gain on the forward contract as a ‘basis adjustment ‘for the inventories.   Journal entry 7 Dr Deferred tax asset 3,750 Cr Cash flow hedge reserve (equity)* 3,750 To recognise the deferred tax asset arising from the temporary difference on the inventories. *  Under IFRS 9, the basis adjustment (in this case, the transfer of the amount accumulated in the cash flow hedge reserve to the initial cost carrying amount of the inventories) is not a reclassification adjustment under IAS 1 and thus does not affect other comprehensive income. Similarly, the deferred tax amount accumulated in the same reserve is recognised as a deferred tax asset (resulting from the basis adjustment, as explained above) without affecting other comprehensive income. The effect of the journal entries above on the statement of financial position can be summarised as follows. Account balances immediately before settlement of the purchase of the inventories and settlement of the forward contract (entries 1 and 2) Purchase of the inventories and settlement of the forward contract and related income tax (entries 3, 4 and 5) Application of ‘basis adjustment’ (entries 6 and 7) Account balances immediately after the settlement of the purchase of the inventories and settlement of the forward contract £ £ £ £ Cash (100,000) (100,000) Inventories 112,500 (12,500) 100,000 Deferred tax asset 3,750 3,750 Forward contract asset 12,500 (12,500) – Current tax liability (3,750) (3,750) Deferred tax liability (3,750) 3,750 – Cash flow hedge reserve (8,750) * 8,750 – * The cash flow hedge reserve account balance immediately before settlement represents the net impact of gains and losses on the forward contract and the corresponding deferred tax amounts up to the date of settlement.

Leases

Under IFRS 16, the lessor conveys the right to control the use of an asset to the lessee in return for a payment or series of payments for an agreed period. A lease contract might not provide for legal title to the leased asset to pass to the lessee.

A hire purchase contract has similar features to a lease, except that the hirer can acquire legal title by exercising an option to purchase the asset on fulfillment of specified conditions. Lease transactions might give rise to temporary differences and might have deferred tax consequences.

Leases – lessee

A lessee normally recognizes an asset and a lease liability when it enters into most leases under IFRS 16. Recognition of the asset and liability has no immediate tax impact in many jurisdictions, and tax deductions are often received when the lease payments are made. IAS 12 does not specifically address the tax effects of leases. There are two principal approaches to deferred tax accounting for lessees.

One approach considers the lease as a single transaction in which the asset and liability are integrally linked, so there is no net temporary difference at inception. The other approach considers the asset and the liability separately, in which case there might be a temporary difference in initial recognition. The choice of approach is a matter of accounting policy, to be applied consistently.

Deferred tax consequences for the lessee of a lease which is off balance sheet Assets acquired under lease contracts give rise to temporary differences between the carrying amount and tax base. No deferred tax problems normally arise in accounting for a lease that is accounted for using the short-term or low-value exemptions under IFRS 16. The amount that is charged to rentals by the lessee in its income statement is likely to be the same as the amount charged in arriving at the taxable profit. An exception to this is where accrued rentals, deferred rentals or lease incentives give rise to temporary differences.

Two approaches for the lessee to recognising deferred taxes arising on a lease which is on balance sheet IAS 12 does not specifically address the tax effects of on-balance sheet leases, and there are two principal approaches to the deferred tax accounting in practice. The choice of approach is a matter of accounting policy, to be applied on a consistent basis. One approach considers the lease as a single transaction in which the asset and liability are integrally linked, so there is no net temporary difference at inception. Subsequently, as differences arise on settlement of the liability and the amortisation of the leased asset, there will be a net temporary difference on which deferred tax is recognised. A deferred tax asset would be subject to IAS 12 recognition criteria. The second approach considers the asset and the liability separately. The temporary difference on each item (the difference between the carrying amount and a tax base of nil) does not give rise to deferred tax, since the initial recognition exception (IRE) applies. Some take the view that the IRE does not apply under the second approach. IAS 12 refer to the initial recognition of an asset or liability. An asset and a liability are recognised at the same time, with equal and opposite temporary differences. This approach results in a similar net deferred tax amount recognised in the balance sheet to that recognised under the first approach, but disclosures are different, because both the deferred tax asset and deferred tax liability should be presented in the notes at their gross amounts. Subsequent changes to the lease asset and liability will need to be considered whenever the IRE applies. Management will need to analyse the movements in the temporary differences to see if they are due to subsequent changes in the amount that gave rise to the temporary differences on initial recognition, or whether they are new temporary differences on which deferred tax is recognised. The Interpretations Committee considered the deferred tax implications of finance leases in 2005 and noted that there was diversity in practice in applying the requirements of IAS 12 to assets and liabilities arising from finance leases. The Committee agreed not to develop any guidance, because the issue fell directly within the scope of the IASB’s short-term convergence project on income taxes. This project was suspended. However, the Committee considered the issue again in 2018 and suggested that the IASB should propose a narrow-scope amendment to IAS 12 to exclude, from the scope of the IRE, transactions in which both a deferred tax asset and a deferred tax liability for the same amount would be recognised. The IASB will consider this recommendation and might propose an amendment to IAS 12.

Illustration of the two approaches for the lessee to recognising deferred taxes arising on a lease which is on balance sheet An entity leases a car under a three-year lease contract. Lease payments are spread evenly over the lease term. Cost of the car C10,000 Expected residual value C0 Economic life of the car 3 years Tax rate 30% Interest rate 5% The asset is depreciated on a straight-line basis over three years. The leased asset and liability recognised in the balance sheet and income statement are as follows: Initial recognition Year 1 Year 2 Year 3 Balance sheet: Asset 10,000 6,667 3,334 – Liability (10,000) (6,831) (3,501) – Income statement: Depreciation – 3,333 3,333 3,334 Interest – 428 267 96 Total – 3,761 3,600 3,430 Assume that tax deductions will be received when the lease payments are made, so there is no deduction for asset depreciation or finance costs. There are two principal approaches for determining the deferred tax in respect of the leased asset and liability in the lessee’s financial statements, and these are illustrated below: Approach 1 – Leased assets and liabilities as integrally linked Initial recognition Year 1 Year 2 Year 3 Temporary differences: Carrying amount of asset 10,000 6,667 3,334 – Carrying amount of liability (10,000) (6,831) (3,501) – Net carrying amount of lease – (167) (167) – Tax base of asset – – – – Tax base of liability (carrying amount less deduction) – – – – Net tax base of lease – – – – Deductible temporary difference – (164) (167) – Deferred tax asset @ 30% – 49 50 – Initial recognition The asset’s tax base is nil because there are no associated tax deductions from recovering the asset. The liability’s tax base (carrying amount less future deductions) is also nil because the lease payments are deductible in future. So the net tax base of the lease is nil. Because the net carrying amount of the asset and liability is nil, there is no temporary difference associated with the net amount of the lease. Subsequent changes The asset is depreciated and the liability decreases as rental payments are made. Because the asset and liability carrying amounts decrease at different rates, a net liability arises. The tax base of the net liability remains nil, so the net book liability that arises results in a deductible temporary difference. A deferred tax asset is recognised subject to IAS 12’s recognition criteria. Approach 2 – Leased assets and liabilities considered separately Initial recognition Year 1 Year 2 Year 3 Temporary differences: Carrying amount of asset 10,000 6,667 3,334 – Tax base – – – – Taxable temporary difference 10,000 6,667 3,334 – Covered by initial recognition exception (IRE) 10,000 6,667 3,334 – Remaining deductible temporary difference not covered by IRE – – – – Total deductible temporary difference – – – – Carrying amount of liability (10,000) (6,831) (3,501) – Tax base (carrying amount less deduction) – – – – Deductible temporary difference (10,000) (6,831) (3,501) – Covered by IRE (10,000) (6,831) (3,501) – Remaining deductible temporary difference not covered by IRE – – – – Total deductible temporary difference – – – – Deferred tax asset @ 30% – – – – Initial recognition The asset’s tax base is nil because there are no associated tax deductions from recovering the asset. This results in a temporary difference equal to the asset’s carrying amount on initial recognition. The liability’s tax base (carrying amount less future deductions) is also nil. This results in a temporary difference equal to the liability’s carrying amount on initial recognition. These temporary differences are covered by the IRE; so no deferred tax arises on initial recognition. Subsequent changes The temporary differences decrease as the asset is depreciated and the liability is repaid. Both temporary differences were covered by the IRE, and subsequent changes are also covered by the IRE, and so no deferred tax is recognised.

Finance leases – lessor

A lessor in a finance lease de-recognizes the leased asset, and the amount due from the lessee under the finance lease is recognized in its balance sheet as a receivable at an amount equal to the lessor’s net investment in the lease.

Tax deductions, in many jurisdictions, continue to be available for the depreciation of the leased asset, with the lease payments taxed on receipt. A lessor should consider the de-recognition of the leased asset and the recognition of the finance lease receivable as a single linked transaction.

Deferred tax consequences of finance leases for the lessor The de-recognition of the leased asset and the recognition of the finance lease receivable should be considered as a single transaction, in which the finance lease receivable and the leased asset are linked. At inception, the tax base of the leased asset might be equal to or different from the carrying amount of the lease receivable. Deferred tax is recognised to the extent that there is a temporary difference. Subsequently, the temporary difference will change or arise, and the corresponding deferred tax should be recognised. An alternative, in which the lessor considers each item separately and applies the initial recognition exception (IRE) to the initial temporary difference arising on the lease receivable, is not acceptable. The substance of this transaction is the exchange of one asset (the fixed asset) for consideration (lease receivable), with any difference recognised in profit or loss, and so the IRE would not apply.

Deferred tax on finance lease for the lessor An entity leases a car that it owns under a three-year finance lease contract. Lease payments are spread evenly over the lease term. Carrying amount of the car C9,000 Selling price of the car C10,000 Economic life of the car 3 years Tax rate 30% Interest rate 5% The asset is depreciated on a straight-line basis over three years for tax purposes. The leased asset is de-recognised, and a lease receivable is recognised in the balance sheet and income statement as follows: Initial recognition Year 1 Year 2 Year 3 Balance sheet: Asset (Previous carrying amount: C9,000) – – – – Lease receivable (Selling price of the car) 10,000 6,831 3,501 – Income statement: Gain 1,000 – – – Interest income – 428 267 96 – 428 267 96 Total 1,000 428 267 96 1,000 428 267 96 Assume that tax deductions are available over time, when the leased asset is depreciated for tax purposes, and the rental payments are taxable when received. The following illustrates the approach for determining the deferred tax in respect of the leased asset and lease receivable in the lessor’s financial statements: Leased assets and receivable integrally linked Initial recognition Year 1 Year 2 Year 3 Temporary differences: Carrying amount of leased asset – – – – Carrying amount of lease receivable 10,000 6,831 3,501 – Net carrying amount of finance lease 10,000 6,831 3,501 – Tax base of leased asset 9,000 6,000 3,000 – Tax base of lease receivable – – – – Net tax base of the finance lease 9,000 6,000 3,000 – Taxable temporary difference 1,000 831 501 – Deferred tax liability @ 30% 300 249 150 – Initial recognition The leased asset is de-recognised, but it is not sold for tax purposes, so its tax base remains unchanged. The lease receivable’s tax base is nil, because lease payments are taxable in the future as they are received. So the net tax base of the finance lease equals the tax base of the leased asset. The temporary difference associated with the net amount of the finance lease arises from the recognition of a gain that affects the profit or loss, so it is not covered by the initial recognition exception and a deferred tax liability should be recognised. Subsequent changes The asset is depreciated for tax purposes, and the lease receivable decreases as rental payments are received. The temporary difference associated with the net amount of the finance lease decreases over time, as does the taxable temporary difference.

Decommissioning assets and obligations

Decommissioning costs arise in several industries – for instance, in the electricity and nuclear industries, abandonment costs in the mining and extractive industries, and environmental clean-up costs. IAS 37 and IAS 16 require management to recognize a provision for the obligation to decommission an asset and to capitalize a corresponding amount as part of the cost of the asset. The asset is depreciated over its useful life. In many jurisdictions, this will have deferred tax implications.

Accounting for deferred taxes on decommissioning liabilities The initial recognition of the decommissioning liability and related asset generally has no immediate tax impact in most territories. Both the tax base of the asset and the tax base of the liability are nil, because in some jurisdictions the tax deduction for the decommissioning cost is only available where an entity incurs the expenditure. We consider that there are two principal approaches for the deferred tax accounting. The choice of approach is a matter of accounting policy, to be applied on a consistent basis. Under both approaches, the deferred tax accounting applies to discounted carrying amounts for assets and liabilities; so, on initial recognition, the tax deductions are based on the discounted amounts, rather than the gross amounts payable in the future. IAS 12 focuses on the future tax consequences of recovering an asset or settling a liability at its carrying amount, which is the discounted amount. One approach considers that the decommissioning assets and liabilities are integrally linked and should be viewed on a net basis. No deferred tax arises at inception, but a temporary difference arises subsequently, as the asset carrying amount decreases due to its depreciation and the liability carrying amount increases due to the unwinding of the discount. Deferred tax would be recognised on this temporary difference. Any deferred tax asset would be recognised subject to IAS 12 recognition criteria. The alternative approach allocates the future tax deductions to the liability. The asset’s tax base is nil, because there are no associated tax deductions. So there is a temporary difference equal to the asset’s carrying amount on initial recognition. The liability’s tax base (that is, carrying amount less future deductions) is also nil. So there is a temporary difference equal to the liability’s carrying amount on initial recognition. For decommissioning obligations (and related assets) arising outside a business combination, and which do not affect accounting profit or taxable profit on initial recognition, these temporary differences will be covered by the initial recognition exception (IRE); so no deferred tax arises on initial recognition. For later changes to decommissioning assets and liabilities, management will need to determine how to account for them under the relevant approach. The two approaches will not necessarily give the same results, due to the intricacies of the IRE. In particular, where the IRE applies, management will need to analyse the movements in the temporary difference. This is to see if they are due to reversals of the amount that gave rise to the temporary difference, or whether they are new temporary differences on which deferred tax is recognised. Similar to approach one, the above alternative assumes the application of the IRE. There is an additional view that the IRE does not apply under approach 2. This is based on the fact that IAS 12 refer to “the initial recognition of an asset or liability”. An asset and a liability are recognised at the same time, with equal and opposite temporary differences. Under this view, a deferred tax liability would be recognised in respect of the taxable temporary difference on the decommissioning asset, and a deferred tax asset would be recognised (subject to IAS 12’s recognition criteria) in respect of the deductible temporary difference on the decommissioning liability. Subsequent changes to the decommissioning asset and liability would also have a deferred tax impact, because the IRE has not been applied. Given that different approaches are acceptable, an entity should disclose the accounting policy for deferred tax on decommissioning obligations and follow it consistently. This approach results in a net deferred tax amount that is similar to the amount recognised in the balance sheet under approach 1; but disclosures are different, since the deferred tax asset and deferred tax liability should be presented in the notes at their gross amounts.

Deferred tax on decommissioning asset and obligation under the two approaches An entity will incur decommissioning costs of C1 million relating to its plant in three years’ time. The plant was not acquired as part of a business combination. The applicable discount rate is 8% and the tax rate is 30%. Expected decommissioning cost in three years’ time C1,000,000 Expected decommissioning cost (discounted) C794,000 Under IAS 37, the decommissioning asset and liability are recognised at C794,000 on initial recognition. The asset is depreciated on a straight-line basis over three years. It is assumed that there are no changes in estimates. The decommissioning costs recognised in the balance sheet and income statement are as follows: Initial recognition Year 1 Year 2 Year 3 Balance sheet: Asset 794 529 264 – Liability (794) (858) (926) (1,000) Income statement: Depreciation (total = 794) 265 265 264 Interest (total = 206) 64 68 74 Total (= 1,000) 329 333 338 Assume that tax deductions will be received when the expenditure is incurred. There are two main approaches for determining the deferred tax in respect of the decommissioning asset and liability. These approaches are illustrated below. Approach 1 – Tax deductions allocated to the decommissioning asset Initial recognition Year 1 Year 2 Year 3 Temporary differences: Carrying amount of asset 794 529 264 – Carrying amount of liability 794 858 926 1,000 Net carrying amount the decommissioning assets and liabilities – (329) (662) (1,000) Tax base of asset – – – – Tax base of liability (carrying amount less deductions) – – – – Net tax base of the decommissioning assets and liabilities – – – – Deductible temporary difference (329) (661) (1,000) Deferred tax asset @ 30% – 99 198 300 Initial recognition The asset’s tax base is nil, because there are no associated tax deductions. The liability’s tax base is also nil because of the future tax deduction when the liability is settled (the tax base of the liability equals its carrying amount less future deductions). So the net tax base of the decommissioning asset and liability is nil. Because the net carrying amount of the asset and liability is nil, there is no temporary difference associated with the net amount of the decommissioning asset and liability. Subsequent changes As the asset is depreciated and the liability increases because of the unwinding of the discount, a net liability arises and increases over time. The net tax base of the asset and liability remains nil, so the net liability that arises results in a deductible temporary difference. A deferred tax asset is recognised (subject to IAS 12’s recognition criteria). Approach 2 – Tax deductions allocated to the decommissioning liability Initial recognition Year 1 Year 2 Year 3 Temporary differences: Carrying amount of asset 794 529 264 – Tax base – – – – Taxable temporary difference 794 529 264 – Covered by initial recognition exception (IRE) (794) (529) (264) – Remaining taxable temporary difference not covered by IRE – – – – Carrying amount of liability 794 858 926 1,000 Tax base (carrying amount less deductions) – – – – Deductible temporary difference (794) (858) (926) (1,000) Covered by IRE 794 794 794 794 Remaining deductible temporary difference not covered by IRE – (64) (132) (206) Total deductible temporary difference – (64) (132) (206) Deferred tax asset @ 30% – 19 40 62 Initial recognition The asset’s tax base is nil, because there are no associated tax deductions; so there is a temporary difference equal to the asset’s carrying amount on initial recognition. The liability’s tax base is also nil because of the future tax deduction when the liability is settled (the tax base of the liability equals its carrying amount less future deductions). So there is a temporary difference equal to the liability’s carrying amount on initial recognition. Assuming that the decommissioning obligation (and related asset) does not arise from a business combination, these temporary differences will be covered by the IRE; so no deferred tax arises on initial recognition. Subsequent changes As the asset is depreciated, the temporary difference that was covered by the IRE is reduced; the reduction is also covered by the IRE, and so no deferred tax asset is recognised. The unwinding of the discount on the liability increases the temporary difference; it is not a reduction of the initial amount, but rather the creation of a new temporary difference. It is not covered by the IRE, so a deferred tax asset is recognised (subject to IAS 12’s recognition criteria).

Deferred tax consequences of tax deductions available on some decommissioning liabilities In some situations, tax deductions are available on some (but not all) of the decommissioning expenditure. Management needs to understand the basis for the tax deductions in order to determine the deferred tax implications. If the tax deduction relates to (or is a proxy for) specific types of expenditure, it might be necessary to treat this expenditure as a separate component of the decommissioning asset and liability for the purpose of allocating the deductions. There might be no relationship to specific expenditure, but tax deductions are given instead, as a percentage of total expenditure. The tax base is determined using that percentage figure.

Post-retirement benefits

Pension costs and other post-retirement benefits are recognized under IAS 19 as service is provided by the employee. Tax relief on employers’ pension contributions is often given in the period when they are paid, rather than when the costs are recognized in the financial statements. In some cases, tax relief on large contributions might be spread over a period.

Tax relief for unfunded plans or other unfunded benefits (such as post-retirement healthcare) is often given when the pensions or other benefits are paid. This results in temporary differences.

Considerations for recognising deferred taxes relating to pension obligations A deductible temporary difference arises between the carrying amount of the net defined benefit liability and its tax base. The tax base is usually nil, unless tax relief on contributions paid is received in a period subsequent to payment. In most cases, this deductible temporary difference will reverse, although it might take a long time. This is particularly relevant for defined benefit pension plans, unfunded pensions and post-retirement benefit plans. A deferred tax asset is recognised for these temporary differences if it is recoverable. A deferred tax asset should be recognised to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. The question arises whether deferred tax liabilities resulting from other temporary differences can be taken into account in determining the recoverability of the deferred tax asset relating to pensions. A deferred tax asset for a pension obligation cannot be recognised simply because there are sufficient taxable temporary differences at the balance sheet date. The timing of reversal of such taxable temporary differences also needs to be taken into account. Management will need to schedule the reversal of temporary differences to justify recognising the deferred tax asset. In many jurisdictions, the entity needs to have plans in place to eliminate the pension deficit, and simply making the normal contributions will not eliminate the deficit. Recognising a tax asset in respect of the pension obligations should take into account the expected timing of regular and one-off contributions necessary to eliminate the deficit. If the entity has incurred losses in the past and also in the current period, this could impact the recognition of tax assets. For example, if the entity continues to make losses in the next few years, but the amount of the reversal of the existing taxable temporary differences in those years is not enough to create taxable profits (with the effect that any pension contributions made in those years simply add to the tax loss), the deferred tax asset might not be recoverable. For an assessment of the likelihood that taxable profits will be available where there has been a history of trading losses. A taxable temporary difference will arise and a deferred tax liability will be recognised where a net defined benefit asset arises (for example, in respect of a surplus in the pension plan).

Allocation of current and deferred taxes to pension-related costs recognised in profit or loss and outside profit or loss IAS 19 requires actuarial gains and losses to be recognised as they arise, outside profit or loss. Pension cost accounting might give rise to current tax (tax relief on contributions) and deferred tax (on the temporary difference between the net defined benefit asset or liability and its tax base). There might be no direct relationship between the components of pension cost reported in the performance statements and the contributions and benefits paid in a period. Current and deferred tax need to be allocated between the performance statements. Current and deferred tax should be recognised outside profit or loss if the tax relates to items that are recognised outside profit or loss. However, IAS 12 does not specify a method of allocating current and deferred tax relating to post-retirement benefits. It can sometimes be difficult to determine the amount of current and deferred tax that relates to items recognised outside profit or loss. The following approaches might be acceptable: To allocate tax relief on pension contributions so that the contributions cover profit and loss items in the current year first, and actuarial losses in the same period second. If contributions exceed those items, tax relief relating to the excess is credited in profit or loss (unless it is more appropriate to allocate it to other comprehensive income (OCI). To allocate the tax relief between profit and loss and OCI on a reasonable pro rata basis. To allocate the tax relief to OCI where payment (tax relief) made is for specific purposes relating to an amount recognised in OCI. For example, a special contribution is made to fund a deficit arising from an identifiable cause (such as an actuarial loss in a previous year).

Allocation for a defined benefit asset with an actuarial loss Change in defined benefit asset Current tax relief (30%) Deferred tax liability (30%) C C C Brought forward 120 (36) Contributions 70 (21) Income statement – net pension cost (60) 18 – Other comprehensive income – actuarial loss (20) 3 3 3 (21) 3 Carried forward 110 – (33) Current tax relief of C21 arises on contributions paid of C70. This is allocated first to cover pension cost of C60 reported in the income statement (resulting in a credit of C18 in the tax charge). The balance of the contributions paid of C10 is allocated to the actuarial loss. This results in current tax of C3 being credited in other comprehensive income. Deferred tax of C3 is attributable to the balance of the actuarial loss of C10. This is credited in other comprehensive income.

Allocation for a defined benefit liability with an actuarial loss Change in defined benefit asset Current tax relief (30%) Deferred tax liability (30%) C C C Brought forward (200) 60 Contributions paid 80 (24) Income statement – net pension cost (70) 21 – Other comprehensive income – actuarial gain (20) – (6) (50) 24 (9) Carried forward (210) – 63 Current tax relief of C24 arises on contributions paid of C80. This is allocated first to cover pension cost of C70 reported in the income statement (resulting in a credit of C21 in the tax charge). The balance of the contributions paid of C10 is allocated to the actuarial loss. This results in current tax of C3 being credited in other comprehensive income. Deferred tax of C3 is attributable to the balance of the actuarial loss of C10. This is credited in other comprehensive income.

Defined benefit liability with an actuarial gain If there was an actuarial gain, the whole of the current tax relief of C24 would be credited in the income statement. None of the current tax can be allocated to other comprehensive income, because there is no debit in other comprehensive income. Thus, the initial C21 (30% of C70) is allocated to the income statement, nil is allocated to other comprehensive income, and the excess of C3 is allocated to the income statement. Deferred tax attributable to the actuarial gain would be charged in other comprehensive income, as shown below. Change in defined benefit liability Current tax relief (30%) Deferred tax asset (30%) C C C Brought forward (200) 60 Contributions 80 (24) Income statement – net pension cost (70) 24 (3) Other comprehensive income – actuarial gain 20 – (6) (50) 24 (9) Carried forward (170) – 51

Receipt of tax relief on additional contribution The facts are the same as in previous FAQ. Further, an additional contribution of C100 is paid and tax deductions were received in the period. Change in defined benefit liability Current tax relief (30%) Deferred tax asset (30%) C C C Brought forward (200) 60 ‘Normal’ contributions paid 80 (24) Additional contributions paid 100 (30) Income statement – net pension cost (70) 21 – Other comprehensive income: Current year actuarial loss (20) 3 3 Relating to previous actuarial losses – 30 (30) (90) 54 (27) Carried forward (110) – 33 The tax deductions on the normal contribution of C80 and the additional contribution of C100 are all received in the period (that is, no spreading of deductions). Current tax relief of C24 on the ‘normal’ contributions is allocated first against the pension cost in the income statement, and the balance is allocated against the actuarial loss. Further current tax deductions of C30 are received on the additional contribution; so there is an excess deduction to be considered. This excess would go to the income statement, unless another method of allocation is more appropriate. The treatment of the deferred tax in relation to the additional contribution will depend on the reason for making that contribution. It is likely that the additional contribution is funding past actuarial losses. So, it is necessary to determine where the underlying items – giving rise to the deficit that is being funded – were originally recognised. This is done by backwards-tracing the items in the income statement. Thus, the tax movement is allocated to other comprehensive income, as illustrated above. However, if the additional contribution was made to fund current year actuarial losses as well as previous actuarial losses, C3 would be allocated to other comprehensive income (to cover the C10 of actuarial loss made in the current year that is not yet tax-affected). There is an excess deduction of C27, after allocating to the net pension cost in the income statement and any actuarial losses in other comprehensive income. Again, this should be allocated to other comprehensive income where the contribution was made to fund the accumulated actuarial losses. Notably, this has the same outcome as the allocation method illustrated in the table above. An element of judgement will be needed in considering why the additional contribution was made. It will be necessary to backwards-trace further if the deductions received in the year exceed the current and prior year actuarial losses that had not been allocated current tax deductions. If it can be established (using backward-stracing) that the tax deductions relate to prior year actuarial losses, the excess tax deductions will be recognised in other comprehensive income, and there will be a corresponding reversal of deferred tax (as shown above). Current tax deductions, or subsequent changes in any related deferred tax asset, will not necessarily also be recognised in equity on the basis that a pension liability recognised on transition to IFRS was charged to equity.

Tax relief on additional contribution spread across more than one accounting period The facts are the same as in previous FAQ. Further, the tax relief for the additional contribution of C100 is spread over three periods; that is, only one-third of the relief on the additional contribution is received in the current period. Change in defined benefit liability Current tax relief (30%) Deferred tax asset (30%) C C C Brought forward (200) 60 ‘Normal’ contributions paid 80 (24) Additional contributions paid 100 (10) Income statement – net pension cost (70) 21 – Other comprehensive income: Current year actuarial loss (20) 3 3 Relating to previous actuarial losses – 10 (10) (90) 34 (7) Carried forward (110) – 53 Note that the deferred tax balance at the period end is not 30% of the pension balance. Assuming that a deferred tax asset has been recognised in relation to the pension liability at the beginning of the period, part of this deferred tax asset reverses as a result of the tax deductions received in the period. But, if the contributions paid do not receive tax relief in the period, a corresponding portion of the deferred tax asset on the opening pension liability will continue to be carried forward (assuming that the recognition criteria are met); and this portion will reverse in the future when the tax deductions are received. The deferred tax asset can be summarised as: C On pension liability at year end (110 × 30%) 33 Outstanding deductions on contributions made (100 × 30% × 2/3) 20 Total deferred tax asset 53 In terms of the pension liability’s tax base, the tax base of a liability is its carrying amount less any amount that will be deductible for tax in future periods. So the deductible temporary difference will be equal to the future deductible amounts. If, in arriving at the pension liability of C110, contributions of C100 had been paid in the period on which tax relief is spread over three years (with tax relief on C33 received in the current year), the tax base will be the carrying amount of the liability (C110) less future deductible amounts (C110 + C67 = C177), resulting in a tax base of minus C67. In other words, the carrying amount in the balance sheet is a liability; but the tax base is an asset (of C67), representing the deductions receivable in the future for payments made and payments to be made. This gives a deductible temporary difference of C110 – (– C67) = C177 (that is, equal to the future deductible amounts). A deferred tax asset of C177 × 30% = C53 should be recognised to the extent that it is probable that the deferred tax asset will be recovered.

IFRIC 14 includes guidance on how entities should assess the recoverability of a defined benefit pension surplus. An entity measures the amount of the refund net of the tax if a pension surplus refund is subject to a tax other than income tax.

But, if a surplus refund is subject to income tax, the deferred tax liability relating to the pension surplus is determined under IAS 12 and recognized separately from the pension asset.

Additional considerations with respect to taxes related to refund of pension surplus IAS 1 requires information to be disclosed about key sources of estimation uncertainty. IFRIC 14 states that such information could include restrictions on the current realisability of the surplus. It could also include the basis used to determine the amount of the economic benefit available. The manner of recovery also impacts deferred tax accounting in jurisdictions where refunds of surplus are subject to income tax at a different rate from the normal corporate income tax rate. The right to a refund or the right to a reduction of future contributions needs to exist in order to recognise a pension asset. IAS 12 requires the entity to consider its expected manner of recovery in determining the relevant tax rate and tax base for calculating the deferred tax liability relating to the pension asset. So the entity could have a ‘right’ to a refund from the plan (and immediately pass the IFRIC 14 test), but it might expect to realise the economic benefits of the surplus through reductions in future contributions. For instance, this might be the case where a lower tax rate applies to reduced contributions than to a refund. The entity will need to confirm that it has sufficient capacity to reduce future contributions over the scheme’s remaining life where it expects to recover the surplus through reduced contributions. In some cases, the entity might expect to recover the pension asset in part through reduced contributions and in part through a refund. The appropriate tax rates and tax bases should be used to determine the deferred tax liability for each part of the expected recovery.

Share-based payment transactions

Equity-settled transactions

IFRS 2 requires entities to recognize the cost of equity-settled share-based awards to employees based on the fair value of the award at the date of grant, spread over the vesting period. Any deduction for tax purposes of equity-settled transactions often does not correspond to the amount charged to profit or loss under IFRS 2, and it might arise in a later accounting period.

A deductible temporary difference arises between the tax base of the remuneration expense recognized in profit or loss (that is, the amount permitted by the tax authorities as a deduction in future periods) and its carrying amount of nil on the balance sheet (the credit is recognized in equity). This gives rise to a deferred tax asset.

The future tax deduction is sometimes based on the share price at the date of exercise, and the price is not known until that date. The amount of the tax deduction to be obtained in the future (that is, the tax base) in these circumstances should be estimated based on the information available at the end of the period. Thus, the measurement of the deductible temporary difference should be based on the entity’s share price at the balance sheet date.

Management will estimate the future tax deductions available based on the share options’ intrinsic value at the balance sheet date. The estimate of the tax deduction should be based on the number of options expected to be exercised (as opposed to the number of options outstanding at the balance sheet date). This will give the best estimate of the amount of the future tax deduction.

The amount of the future tax deduction is unlikely to be the same as the remuneration expense recognized in profit or loss and credited to equity. Where the amount of the estimated future tax deduction exceeds the cumulative amount of the remuneration expense, this indicates that the tax deduction relates to an equity item as well as the remuneration expense. The excess deferred tax should be recognized in equity, based on the principle that the tax should follow the item. This also applies to any excess current tax that arises in the year of exercise.

Excess deferred tax on an equity-settled share-based award On 1 January 20X3, 100,000 options are issued with a fair value of C360,000. The vesting period is three years, and all options are expected to be exercised. All of the share options are exercised in year 4. The tax rate is 30%. The intrinsic value of the share options (that is, market value of the underlying shares less exercise price), at the end of years 1, 2 and 3 and at the date of exercise in year 4, is C330,000, C300,000, C380,000 and C400,000, respectively. The total staff cost recognised in each of the first three years is C120,000. At the end of year 1, the estimated corresponding tax benefit available in the future is C33,000 (30% × ⅓ × C330,000); this is calculated using the intrinsic value at the balance sheet date. The gross amount giving rise to the tax benefit is C110,000, which is less than the cumulative remuneration expense of C120,000 recognised to date; so the entire amount of the estimated future tax benefit of C33,000 is recognised in the income statement. At the end of year 2, the cumulative amount of the estimated tax benefit available in the future is C60,000 (30% × ⅔ × C300,000). The gross amount giving rise to the tax benefit of C200,000 is less than the cumulative remuneration expense of C240,000 recognised to date; so the entire amount is recognised through the income statement. The amount recognised in year 2’s income statement is C27,000 (C60,000 − C33,000). At the end of year 3, the cumulative amount of the estimated tax benefit available in the future is C114,000 (30% × C380,000). The amount giving rise to the benefit of C380,000 exceeds the cumulative remuneration expense of C360,000 recognised to date; so the excess expected future tax benefit of C6,000 (30% × C20,000) is recognised in equity. The cumulative position at the end of year 3 is shown below: Income statement Equity Balance sheet Dr (Cr) Dr (Cr) Dr (Cr) Year Expense Current tax Deferred tax Current tax Deferred tax Current tax Deferred tax C C C C C C C 1 120,000 – (33,000) – – – 33,000 2 120,000 – (27,000) – – – 60,000 3 120,000 – (48,000) – (6,000) – 114,000 Cumulative position at end of year 3 360,000 – (108,000) – (6,000) In year 4, all 100,000 options are exercised. The actual current tax deduction obtained is C120,000 (30% × C400,000 intrinsic value at the date of exercise). This amount exceeds the tax effect of an amount equal to the cumulative remuneration expense of C360,000; so the excess current tax of C12,000 (30% × C40,000) is recognised in equity. The deferred tax asset of C114,000 at the end of year 3 is reversed through the income statement and equity. The double entry is as follows: C C Dr Current tax claim (balance sheet) 120,000                Cr Current tax (income statement) 108,000                Cr Current tax (equity) 12,000 Dr Deferred tax (income statement) 108,000 Dr Deferred tax (equity) 6,000                Cr Deferred tax (balance sheet) 114,000   Income statement Equity Balance sheet Dr (Cr) Dr (Cr) Dr (Cr) Expense Current tax Deferred tax Current tax Deferred tax Current tax Deferred tax C C C C C C C Cumulative position at end of year 3 360,000 – (108,000) – (6,000) – 114,000 Movement in year 4 – (108,000) 108,000 (12,000) 6,000 120,000 (114,000) Total 360,000 (108,000) – (12,000) – 120,000 – The overall position is shown below: The tax credit recognised in the income statement of C108,000 is equal to the tax benefit calculated by applying the applicable tax rate of 30% to the remuneration expense of C360,000 recognised in the income statement over the vesting period. Any excess tax deduction received is recognised in equity. A comprehensive example of an equity-settled transaction is also included in example 5 of Appendix B to the standard.

Deferred tax consequences in case of graded vesting The deferred tax in respect of an equity-settled share-based payment award should be calculated for each separate award (or tranche of an award, where some options have been exercised and deferred tax is being reversed) and not for all awards in total. Each separate award has its own tax base (that is, the tax deductions that will be received on exercise of the options). This tax base is compared to the carrying amount of each separate award to calculate the temporary difference. Deferred tax should be recognised, where appropriate. The movement on the deferred tax for each grant is allocated between profit or loss and equity, based on the cumulative share-based payment charge recognised in profit or loss. An appropriate method (for example, weighted average or FIFO) should be used on a consistent basis to identify options that have been exercised or settled. Where the tax is allocated between profit or loss and equity, each award should be considered separately. The allocation should not be done on a total basis, because this could mask underlying movements in relation to specific awards.

Allocation of deferred tax movements on separate awards An entity has two share-based payment awards. Tax deductions will be received based on the market value of the shares at the date of exercise. The cumulative share-based payment charge under IFRS 2 and the expected tax deductions (measured using the share price at the balance sheet date) for each scheme are given below. It is assumed that the recognition criteria for deferred tax assets are met and the tax rate is 30%. Award 1 Award 2 Total C’000 C’000 C’000 Cumulative charge (income statement) 100 100 200 Expected tax deduction 160 80 240 Deferred tax asset (30% of expected tax deduction) 48 24 72 Allocation performed on a grant-by-grant basis For award 1, C100 of the tax deduction relates to the charge recognised in the income statement. The remaining C60 of tax deduction is an equity item. C’000 C’000 Dr Deferred tax asset 48 Cr Income statement (100 × 30%) 30 Cr Equity (60 × 30%) 18 For award 2, the tax deduction expected is lower than the cumulative charge in the income statement. The full deduction is seen as relating to the charge in the income statement. C’000 C’000 Dr Deferred tax asset 24 Cr Income statement (80 × 30%) 24 The total credit recognised in the income statement is C54; and a credit of C18 is taken to equity. Allocation performed on a total basis On a total basis, it appears that C200 of the tax deductions relate to charges recognised in the income statement. The allocation of the tax deduction would credit the income statement with C60 (200 × 30%) and take the balance of C12 directly to equity. Allocation on a total basis would result in the tax credit in the income statement being overstated; so it is not considered acceptable.

The allocation between profit or loss and equity is also relevant where a deferred tax asset in respect of a share-based payment is reduced because the share price has fallen. The reduction of the deferred tax asset needs to be analysed to determine how much of the reduction should be recognised in equity and how much in profit or loss.

The reversal of deferred tax assets and liabilities should be recognised in the statement in which the asset was recognised initially.

Allocation of deferred tax where share price has fallen An equity-settled share-based payment award for employees vests after four years of service. An award is made for 2,000 shares. The fair value of the award at the date of grant is C6 (per share). The entity expects all of the shares in the scheme to vest. So, under IFRS 2, the accounting expense is C3,000 (2,000 shares × C6 = C12,000 × ¼) per annum for four years. At the end of year 2, the cumulative IFRS 2 charge is C6,000. The share price at the end of year 2 is C10, but it drops to C7 by the end of year 3. The position at the end of years 2 and 3 is summarised below: End of year 2 End of year 3 Number of equity instruments earned for IFRS 2 purposes 1,000 1,500 Cumulative IFRS 2 charge C6,000 C9,000 Share price (= tax value per share) C10 C7 Tax base C10,000 C10,500 Deferred tax (@ 30%) C3,000 C3,150 The movement in deferred tax in year 3 is analysed as follows: Cumulative IFRS 2 charge Tax base Deferred tax Income statemen t Split Equity  C’000 C’000 C’000 C’000 C’000 Opening balance 6,000 10,000 3,000 1,800 1,200 Closing balance 9,000 10,500 3,150 2,700 450 Movement 150 900 (750) There is a deferred tax credit of C900,000 in the income statement, reflecting the deferred tax on the share-based payment charge of C3,000,000 in the period. Where the share-based payment’s tax base reduces, but does not fall below the cumulative accounting charge under IFRS 2, the excess tax deduction is reduced; so it is recognised in equity. The deferred tax charge of C750,000 in equity comprises: A charge of C900,000, being the impact of the drop in share price on the opening deferred tax asset (1,000 shares × (C10 – C7) × 30%). A credit of C150,000, being the excess tax credit on the award earned in the period (500 shares × (C7 – C6) × 30%). If the share-based payment’s tax base falls below the cumulative accounting charge, the full amount that was previously recognised in equity will be fully reversed. The movement in the income statement will comprise a tax credit in respect of the share-based payment charge and a charge in respect of any reduction in the tax base below the cumulative accounting charge.

Tax impact on account of lapsed share options In certain jurisdictions, a tax deduction is given when the share options are exercised and there might be no tax deduction if share options lapse after the vesting date and are not exercised. But the share-based payment charge in the income statement, for options that lapse after vesting, is not reversed. So, where share options have lapsed after vesting and no tax deduction is available, the total current tax credit in the income statement will be less than the share-based payment charge tax-effected at the standard rate of tax. This reflects the fact that part of the share-based payment charge has not received a tax deduction, because the related share options lapsed after vesting.

Share options lapsing after vesting On 1 January 20X3, 100,000 options are issued with a fair value of C360,000. The vesting period is three years and all options are initially expected to be exercised. The tax rate is 30%. The intrinsic value of the 100,000 share options (that is, market value of the underlying shares less exercise price) at the date of exercise in year 4 is C400,000. (At the end of years 1, 2 and 3, it is C330,000, C300,000 and C380,000 respectively.) During years 1, 2 and 3, the expected tax benefit is recognised. The cumulative position at the end of year 3 is shown below: Income statement Equity Balance sheet Dr (Cr) Dr (Cr) Dr (Cr) Year Expense Current tax Deferred tax Current tax Deferred tax Current tax Deferred tax C C C C C C C 1 120,000 − (33,000) − − − 33,000 2 120,000 − (27,000) − − − 60,000 3 120,000 − (48,000) − (6,000) − 114,000 Cumulative position at end of year 3 360,000 −(108,000) − (6,000) In year 4, 85,000 of the share options are exercised and 15,000 lapse without being exercised. The actual current tax deduction obtained is C102,000 (30% × C400,000 total intrinsic value at the date of exercise × 85/100). The accounting charge in the income statement relating to the 85,000 options that are exercised is C306,000 (360,000 × 85/100); so the tax effect relating to this charge is C91,800 (306,000 × 30%). The deferred tax asset of C114,000 at the end of year 3 is reversed through the income statement and equity. The double entry is as follows: C C Dr Current tax claim (balance sheet) 102,000 Cr Current tax (income statement) 91,800 Cr Current tax (equity) 10,200 Dr Deferred tax (income statement) 108,000 Dr Deferred tax (equity) 6,000 Cr Deferred tax (balance sheet) 114,000 The overall position is shown below: Income statement Equity Balance sheet Dr (Cr) Dr (Cr) Dr (Cr) Expense Current tax Deferred tax Current tax Deferred tax Current tax Deferred tax C C C C C C C Cumulative position at end of year 3 360,000 – (108,000) – (6,000) – 114,000 Movement in year 4 – (91,800) 108,000 (10,200) 6,000 102,000 (114,000) Total 360,000 (91,800) – (10,200) – 102,000 – In the original example, when all of the options were exercised, the overall tax position in year 4 was as follows: nil in the income statement (comprising a current tax credit of C108,000 offset by a deferred tax charge of C108,000); and a net tax credit of C6,000 to equity, because of the increase in share price since the end of year 3 (comprising a current tax credit of C12,000 offset by a deferred tax charge of C6,000). Since only 85,000 options are exercised and the remaining options lapse, the overall tax position in year 4 is: A net charge of C16,200 in the income statement. This comprises a current tax credit of C91,800 (360,000 × 85/100 × 30%) and a deferred tax charge of C108,000 reversing the previously recognised asset. This net charge reflects the fact that the expected tax credit on 15,000 options was not received. A net credit of C4,200 in equity. This comprises a current tax credit of C10,200, being the excess tax credit on the 85,000 options that were exercised ((400,000 – 360,000) × 85/100 × 30%) and a deferred tax charge of C6,000 reversing the previously recognised asset.

Accounting where tax deduction relating to share-based payment award is received upfront In some jurisdictions, a tax deduction in respect of a share-based payment award is received upfront or part way through the vesting period. The receipt of the tax deduction crystallises the amount. So, remeasurement based on share price would not apply after this point, but there are implications for the deferred tax accounting. IAS 12 does not specifically address the situation where the tax deduction is received before the related accounting expense. However, the general rules for recognition of deferred taxes apply, and the receipt of an upfront tax deduction in respect of share-based payments gives rise to a deferred tax liability.

Tax deduction received upfront An equity-settled share-based payment award for employees vests after three years of service. An award is made for 1,000 shares. The fair value of the award at the date of grant is C120 (per share). The entity expects all the shares in the scheme to vest. So the accounting expense under IFRS 2 is C40,000 (1,000 shares × 120 = C120,000 × ⅓) per annum for three years. Under the tax rules of the entity’s jurisdiction, the entity receives a tax deduction upfront (at 30%) for the total number of options based on an amount (C140) that exceeds the fair value of the award at the date of grant. So the amount deductible for tax purposes is C140,000 (1,000 × 140). A deferred tax liability of C42,000 (140,000 × 30%) is recognised on the tax deduction received upfront. This is unwound over the three-year vesting period. A deferred tax credit of C12,000 (40,000 × 30%) is recognised in the income statement each year, in line with the IFRS 2 charge. This results in a total of C36,000 tax credit being recognised in the income statement. The excess tax deduction of C6,000 (42,000 – 36,000) is recognised in equity. In our view, this amount is also unwound over the three-year vesting period (that is, a tax credit of C2,000 per annum is recognised in equity). This is consistent with the unwinding of the deferred tax credit recognised in the income statement.

Tax impact for share-based payments in a group situation In group situations, some parent entities might recharge their subsidiaries where those subsidiary entities’ employees participate in the parent entity’s share option schemes. Tax accounting issues arise in the group when the subsidiary receives a tax deduction on the recharge and not when the employee exercises the options. In some cases, the tax relief on the recharge is clearly linked to the share-based payment (that is, it is based on an amount derived from the share-based payment, such as the option’s intrinsic value or fair value, and there is no other tax relief for the share-based payment). Our view is that the tax relief in the consolidated financial statements is treated in accordance with IAS 12. Where the tax deductible amount is not greater than the share-based payment expense, the tax relief is reflected in the consolidated income statement. Any excess of the tax relief over the amount of the tax effect of the IFRS 2 charge is reflected in equity. If the recharge is not clearly linked to the share-based payment, the tax deduction on the recharge should be credited to the consolidated income statement (in the same way as tax deductions on management recharges in general). Whether or not a deferred tax asset is recognised in the consolidated financial statements for the expected tax deductions on recharges depends on the arrangement between the parent and the subsidiary. If the recharge is made at the parent’s discretion, a deferred tax asset is not recognised. This is because a tax deduction will not arise unless there is a recharge. Where a parent agrees to make a recharge when options are exercised, a deferred tax asset should be recognised (subject to meeting IAS 12’s criteria) over the period of service in relation to any expected tax deductions that are considered recoverable. The expected tax deduction for the recharge can be regarded as a tax deduction in respect of the share-based payment charge to the extent that it is recharged.

Cash-settled transactions

Cash-settled share-based payment transactions (such as share appreciation rights issued to employees) give rise to a liability and not a credit to equity. The fair value of the liability is remeasured at each reporting date until the liability is settled.

A deductible temporary difference might arise if the liability’s carrying amount exceeds the liability’s tax base (that is, the carrying amount less any amounts that will be deductible for tax purposes in the future); this would result in a deferred tax asset (subject to IAS 12’s recognition criteria). The tax effects of such transactions are always recognised in the income statement.

Revaluation of non-monetary assets

Some entities revalue their non-monetary assets, such as land and buildings. In some jurisdictions, the revaluation or other restatement (increase or decrease) of an asset to fair value affects taxable profit (loss) for the current period. The tax base of the asset is adjusted and no temporary difference arises.

The resulting current tax that arises on the revaluation is recognised. In other jurisdictions, the revaluation or restatement of an asset does not affect taxable profit in the current period; as a result, the asset’s tax base is not adjusted.

The increase or decrease does not enter into the determination of taxable profit for the current period; but the future recovery of the carrying amount will result in a taxable flow of economic benefits to the entity, and the amount that is deductible for tax purposes will differ from the amount of those economic benefits.

The difference between the carrying amount of a revalued asset and its tax base is a temporary difference; and it gives rise to a deferred tax liability or asset. The resulting deferred tax expense or income arising from the revaluation is recognised in other comprehensive income. This is true, even if:

• The entity does not intend to dispose of the asset. In such cases, the asset’s revalued carrying amount will be recovered through use; and this will generate taxable income that exceeds the depreciation that will be allowable for tax purposes in future periods.
• Tax on capital gains is deferred where the proceeds of the asset’s disposal are invested in similar assets. In such cases, the tax will become payable on sale or use of the similar assets.

Considerations in measuring the liability arising on asset revaluation The precise nature of the liability that arises on an asset’s revaluation depends on the asset’s taxation status. In some jurisdictions, assets that do not attract tax depreciation (such as land) give rise to chargeable gains or losses for tax purposes if they are sold above or below their tax-indexed cost (that is, original cost uplifted by an indexation allowance, where applicable). For accounting purposes, such assets are sometimes revalued but rarely depreciated. Depreciable assets, however, might or might not be revalued. If such an asset is revalued in excess of cost and sold at the revalued amount, a further tax liability – in addition to any liability arising on the capital gain – might arise if the asset was eligible for capital allowances. This further liability (which arises by way of a balancing charge in some jurisdictions) is designed to claw back any tax depreciation previously claimed in respect of the asset. The measurement of the liability also depends on the manner in which the entity expects to recover the carrying amount of an asset that has been revalued in the financial statements – whether through use, sale, or use and sale (that is, ‘dual manner of recovery’). The following paragraphs consider the deferred tax consequences of revaluing assets and the different ways in which the entity expects to recover the revalued carrying amounts.

Roll-over and holdover reliefs In some jurisdictions, the tax arising on a taxable gain, where certain assets used for trading purposes (such as properties) are disposed of, might not need to be paid immediately if the sale proceeds are reinvested (within specified time limits) in other qualifying assets. Roll-over relief reduces the ‘base cost’ of the replacement asset by the taxable gain ‘rolled over’. A higher taxable gain will arise on disposal of the replacement asset (and higher tax might become payable) than if the original gain had not been rolled over. It might be possible to claim roll-over relief on the gain when the replacement asset is sold, so that tax on that gain does not need to be paid. This situation can theoretically continue indefinitely, and it will depend on the specific tax rules. In contrast, the holdover relief delays payment of tax on the original gain where reinvestment of the proceeds satisfies certain conditions. The taxable gain on disposal of the old asset is not deducted from the new asset’s cost. Instead, the current tax on the gain is delayed (that is, ‘held over’) and is payable at a future date. The tax on the gain held over might be current or deferred, depending on the specific local tax rules. Where roll-over relief is claimed, a deferred tax liability might need to be recognised on the new asset (often similar in amount to the current tax that did not need to be paid on the old asset). The new asset’s tax base has been reduced; so tax might become payable when the new asset is sold or used. The new asset’s reduced tax base is likely to result in a temporary difference when compared with its carrying amount in the financial statements. A temporary difference that results from roll-over relief is not covered by the initial recognition exception. It does not arise from the asset’s initial recognition, but instead it arises as a result of relief given on an asset that was previously disposed of. Current tax remains payable in the future if holdover relief is claimed. If the entity discounts current taxes, the carrying amount of the tax payable could be materially reduced if the deferral period is significant.

Roll-over relief An entity disposes of a building which (without roll-over relief) would result in a taxable gain of C400,000. The entity invests in a new building at a cost of C2,500,000. It claims roll-over relief, so that no taxable gain or loss arises on disposal of the old building. Instead, the taxable gain on the old building reduces the acquisition cost of the new building that will be allowable for tax purposes when it is sold. So the new building’s tax base (on a sale basis) is as follows: C’000 Acquisition cost 2,500 Rolled-over gain (400) Tax base (sale basis) 2,100 Tax rate applicable to gain on disposal = 30%. Assuming that there are no tax deductions for use of the building, the deferred tax position on initial recognition (in various scenarios) is as follows: Residual value = C1 million Residual value = nil Residual value = C2.5 million Use Sale Use Sale Use Sale C’000 C’000 C’000 C’000 C’000 C’000 Carrying amount 1,500 1,000 2,500 – – 2,500 Tax base – original cost – 2,500 – 2,500 – 2,500 Rolled-over gain – (400) – (400) – (400) New tax base – 2,100 – 2,100 – 2,100 Taxable/(deductible) temporary difference 1,500 (1,100) 2,500 (2,100) – 400 Less: initial temporary difference (1,500) 1,500 (2,500) 2,500 – – Remaining taxable temporary – 400 – 400 – 400 difference not covered by the IRE Deferred tax liability @ 30% – 120 – 120 – 120 A temporary difference that results from roll-over relief is not covered by the initial recognition exception (IRE). So the amount of the temporary difference covered by the IRE excludes the amount attributable to roll-over relief. It is calculated as the carrying amount less the tax base resulting from original cost (that is, C2.5 million). Management should, therefore, recognise a deferred tax liability of C120,000 on the taxable temporary difference resulting from roll-over relief of C400,000. But the resulting taxable temporary difference might enable otherwise unrecognised deferred tax assets on the same (for example, related land) or other assets to be recognised, if IAS 12’s criteria are met.

Cash-settled transactions

Cash-settled share-based payment transactions (such as share appreciation rights issued to employees) give rise to a liability and not a credit to equity. The fair value of the liability is remeasured at each reporting date until the liability is settled.

A deductible temporary difference might arise if the liability’s carrying amount exceeds the liability’s tax base (that is, the carrying amount less any amounts that will be deductible for tax purposes in the future); this would result in a deferred tax asset (subject to IAS 12’s recognition criteria). The tax effects of such transactions are always recognised in the income statement.

Revaluation of non-monetary assets

Some entities revalue their non-monetary assets, such as land and buildings. In some jurisdictions, the revaluation or other restatement (increase or decrease) of an asset to fair value affects taxable profit (loss) for the current period. The tax base of the asset is adjusted and no temporary difference arises. The resulting current tax that arises on the revaluation is recognised.

In other jurisdictions, the revaluation or restatement of an asset does not affect taxable profit in the current period; as a result, the asset’s tax base is not adjusted.

The increase or decrease does not enter into the determination of taxable profit for the current period; but the future recovery of the carrying amount will result in a taxable flow of economic benefits to the entity, and the amount that is deductible for tax purposes will differ from the amount of those economic benefits.

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

The resulting deferred tax expense or income arising from the revaluation is recognised in other comprehensive income. This is true, even if: The entity does not intend to dispose of the asset.

In such cases, the asset’s revalued carrying amount will be recovered through use; and this will generate taxable income that exceeds the depreciation that will be allowable for tax purposes in future periods.

Tax on capital gains is deferred where the proceeds of the asset’s disposal are invested in similar assets. In such cases, the tax will become payable on sale or use of the similar assets.

Upward revaluation of depreciable assets An entity acquired a building in a business combination at a cost of C1,000,000 on 1 January 20X1. The useful life of the building is 20 years, and it will be depreciated to a residual value of C150,000. The building is eligible for allowances of 50% initial allowance and 4% writing down allowance (WDA) each year (up to a total of C500,000) until disposal. On disposal, the proceeds are liable to capital gains tax, subject to a deduction where that cost exceeds capital allowances previously claimed. The tax rate for capital gains and income is 30%. In each of the four years until revaluation, the deferred tax provided is calculated as shown below. Note that the example deals only with the deferred tax on the buildings – a dual manner of recovery expectation is applied, and the residual value is attributed to the carrying amount of the sale element on initial recognition. There are no changes to the estimated residual value in years 1 to 4. The land element is not a depreciable asset. In the tables: NBV = net book value; TB = tax base; TD = temporary difference; DTL = deferred tax liability; DTA = deferred tax asset. Use element NBV TB TD DTL/(DTA ) C C C C At 1 January 20X1 850,000 1,000,000 (150,000) (45,000) Depreciation/tax allowances – initial + WDA (42,500) (540,000) 497,500 149,250 At 31 December 20X1 807,500 460,000 347,500 104,250 Depreciation/tax allowances – WDA (42,500) (40,000) (2,500) (750) At 31 December 20X2 765,000 420,000 345,000 103,500 Depreciation/tax allowances – WDA (42,500) (40,000) (2,500) (750) At 31 December 20X3 722,500 380,000 342,500 102,750 Depreciation/tax allowances – WDA (42,500) (40,000) (2,500) (750) At 31 December 20X4 680,000 340,000 340,000 102,000 Sale element NBV TB TD DTL C C C C At 1 January 20X1 150,000 0 150,000 45,000 At 31 December 20X1, 20X2, 20X3 and 20X4 150,000 – 150,000 45,000 The tax base on sale is determined using the tax base expected to be available on the sale element at the date of sale. This is cost of C1,000,000, less tax depreciation claimed while the building is in use (C1,000,000). The tax base on sale is not shown as cost less tax depreciation claimed to date at each balance sheet date, because this would result in double counting of the tax base between the use and sale elements. Rather, the tax base in each calculation is based on management’s expectation of how tax deductions will be received. The deferred tax liability of C45,000 represents the tax that management expects to pay on recovery of the building’s residual value. This deferred tax liability will remain on balance sheet until the building is sold. Scenario 1 – Entity expects to recover the revaluation uplift of the building through use At the beginning of 20X5, the building is revalued to C1,400,000; a revaluation gain of C570,000 is recognised. Management still considers the residual value of the building to be C150,000. So the carrying amounts for the use and sale elements are C1,250,000 and C150,000 respectively. As such, the revaluation will affect the use calculation only. Use element NBV TB TD DTL C C C C At 31 December 20X4 680,000 340,000 340,000 102,000 Revaluation 570,000 − 570,000 171,000 At 1 January 20X5 1,250,000 340,000 910,000 273,000 Depreciation/tax allowances – WDA (78,125)* (40,000) (38,125) (11,438) At 31 December 20X5 1,171,875 300,000 871,875 261,562 * The building has a remaining useful life of 16 years at the date of revaluation; so depreciation is C1,250,000/16 = C78,125. This is equal to the annual depreciation on historical cost plus an uplift for the revaluation gain: C42,500 + C570,000/16 = C78,125. Sale element NBV TB TD DTL C C C C At 31 December 20X4 150,000 – 150,000 45,000 Revaluation − − − − At 1 January 20X5 and 31 December 20X5 150,000 – 150,000 45,000 The journal entries at 1 January 20X5 and 31 December 20X5 are as follows: Dr Cr 1 January 20X5 Dr Property, plant and equipment – cost 400,000 Dr Property, plant and equipment – accumulated depreciation 170,000 Cr Revaluation reserve 570,000 Dr Revaluation reserve – tax at 30% (income tax rate) on C570,000 171,000 Cr Deferred tax liability 171,000 31 December 20X5 Dr Depreciation charge 78,125 Cr Property, plant and equipment – accumulated depreciation 78,125 Dr Deferred tax liability – use (B/S) 11,438 Cr Deferred tax charge – use (I/S) 11,438 The deferred tax liability of C171,000 arising on the revaluation surplus is added to the opening balance of C102,000 brought forward. This gives the total of C273,000 shown above. In addition, the deferred tax liability is reduced by C11,438 (C273,000 − C261,562) during 20X5, because the temporary difference of C38,125 (C78,125 − C40,000) is reversed. This reduction is credited to the income statement rather than the revaluation reserve, because the entity expects to recover through use the carrying amount of the revalued asset of C1,250,000 (C1,400,000 less the residual value of C150,000). The entity might decide to transfer an amount from the revaluation reserve to retained earnings, which represents the difference between depreciation based on the asset’s revalued amount and depreciation based on the asset’s cost. If the entity makes such a transfer, the amount transferred is net of any related deferred tax. In the above example, the entity would transfer C24,937 (that is, C78,125 (depreciation based on revalued amount) − C42,500 (depreciation based on cost) = C35,625 less tax of C10,688 (30% of C35,625)). Scenario 2 – Entity expects to recover the revaluation uplift of the building through use and sale The building has been revalued, as in scenario 1 above. But management now considers the residual value to be C200,000. The entity expects to recover the uplift to the building’s carrying amount through use and sale. The impact of the revaluation and change in residual value is illustrated as follows: Use element NBV TB TD DTL C C C C At 31 December 20X4 680,000 340,000 340,000 102,000 Revaluation 520,000 − 520,000 156,000 At 1 January 20X5 1,200,000 340,000 860,000 258,000 Depreciation/tax allowances – WDA (75,000)* (40,000) (35,000) (10,500) At 31 December 20X5 1,125,000 300,000 825,000 247,500 * The building has a remaining useful life of 16 years at the date of revaluation; so depreciation is C1,200,000/16 = C75,000. This is equal to the annual depreciation on historical cost plus an uplift for the revaluation gain: C42,500 + C520,000/16 = C75,000. Sale element NBV TB TD DTL C C C C At 31 December 20X4 150,000 – 150,000 45,000 Revaluation 50,000 − 50,000 15,000 At 1 January 20X5 and 31 December 20X5 200,000 – 200,000 60,000 The journal entries at 1 January 20X5 and 31 December 20X5 are as follows: Dr Cr 1 January 20X5 Dr Property, plant and equipment – cost 400,000 Dr Property, plant and equipment – accumulated depreciation 170,000 Cr Revaluation reserve 570,000 Dr Revaluation reserve – tax @ 30% 171,000 Cr Deferred tax liability – use basis 156,000 Cr Deferred tax liability – sale basis 15,000 31 December 20X5 Dr Depreciation charge 75,000 Cr Property, plant and equipment – accumulated depreciation 75,000 Dr Deferred tax liability – use (B/S) 10,500 Cr Deferred tax charge – use (I/S) 10,500 The deferred tax movement of C171,000 arising on the revaluation surplus recognised on 1 January 20X5 impacts both the sale and use calculations, as shown above. The reduction in the deferred tax liability during 20X5 that arises from depreciation is recognised in the income statement rather than the revaluation reserve (as discussed in scenario 1). To the extent that the asset is recovered through use, a transfer could be made between the revaluation reserve and retained earnings (as discussed in scenario 1). The transfer is C22,750 (that is, C75,000 (depreciation based on revalued amount) – C42,500 (depreciation based on cost) = C32,500 less tax of C9,750 (30% of C32,500)). Scenario 3 – Entity changes its manner of recovery expectation from dual manner of recovery to sale Following on from scenario 1, at 31 December 20X6 (two years after revaluation), the entity changes its expectation from recovering the building’s carrying amount through the dual manner of recovery (use and sale) to sale. The sale is imminent as at 31 December 20X6; so the building’s full carrying amount at that date is expected to be recovered through sale. Use element NBV TB TD DTL C C C C At 31 December 20X5 1,171,875 300,000 871,875 261,562 Depreciation/tax allowances – WDA (78,125) (40,000) (38,125) (11,437) 1,093,750 260,000 833,750 250,125 Change in expected manner of recovery (1,093,750)(260,000)* (833,750)(250,125) At 31 December 20X6 − − − − *No further capital allowances are available if the building is no longer in use. Sale element NBV TB TD DTL C C C C At 31 December 20X5 150,000 – 150,000 45,000 Change in expected manner of recovery 1,093,750 260,000 833,750 250,125 At 31 December 20X6 1,243,750 260,000* 983,750 295,125 * The tax base on sale is equal to cost (C1,000,000) less capital allowances claimed during the period in which the building is in use of C740,000 (that is, initial allowance of C500,000 plus six years’ allowance of C40,000). As in scenario 1, the reduction in the deferred tax liability by C11,437 (C261,562 − C250,125) during 20X6, that arises from depreciation, is credited to the income statement; this is because the entity expects to recover the building’s carrying amount through use. A transfer could be made between the revaluation reserve and retained earnings, which would be a further C24,937, as in scenario 1. However, at 31 December 20X6, the entity changes its expectation about the manner of the building’s recovery from the dual manner of recovery to sale. This gives rise to the following additional journal entry: Dr Cr Dr Deferred tax liability – use 250,125 Cr Deferred tax liability – sale 250,125 The change in expected manner of recovery has no impact on net assets in this case. But the overall deferred tax liability would be affected if the tax base on sale was subject to adjustments for inflation, or if the tax rates for income and capital gains were different. This change would generally be recognised in the income statement; but, where it relates to deferred tax recognised on a previous revaluation gain, it would be recognised in other comprehensive income. The deferred tax balance of C295,125 reflects the tax consequences that would follow if the entity sold the asset at its carrying amount at the balance sheet date. In other words, if the asset is sold at its carrying amount of C1,243,750, the total taxable profit would be C983,750 (that is, C1,243,750 less C260,000, being the original cost of C1,000,000 less capital allowances claimed of C740,000), on which tax @ 30% = C295,125 would be payable. Scenario 4 – Entity sells revalued building Following on from scenario 3, suppose that the entity sells the building at 1 January 20X7 for C1,500,000 and pays tax at 30% on the taxable profit: Taxable profit Accounting profit C C Sales proceeds 1,500,000 1,500,000 Tax base/carrying amount before sale 260,000 1,243,750 Taxable/accounting profit 1,240,000 256,250 Tax @ 30% on taxable/accounting profit 372,000 76,875 Current tax is generally included in profit or loss, unless it arises from a transaction or event that is recognised (in the same or a different period) in other comprehensive income or directly in equity. Under the principle that deferred tax should follow the related item, the journal entries for the current tax and for the release of the deferred tax liability of C295,125 (see scenario 3) are as follows: Dr Cr Dr Current tax (I/S) 1 201,000 Dr Current tax (other comprehensive income) 2 171,000 Cr Current tax (B/S) 372,000 Dr Deferred tax (B/S) 295,125 Cr Deferred tax (I/S) 3 124,125 Cr Deferred tax (other comprehensive income) 2 171,000 1 Current tax recognised in the income statement of C201,000 is the difference between the total current tax payable of C372,000 and the amount recognised in other comprehensive income of C171,0002. 2 Current tax recognised in other comprehensive income is calculated as the previously recognised gain of C570,000 × 30% = C171,000, which equals the deferred tax previously recognised in other comprehensive income. 3 The deferred tax released of C124,125 represents the deferred tax previously recognised in the income statement, being the difference between the total deferred tax liability of C295,125 and the amount previously recognised in other comprehensive income of C171,000. The tax impact can be summarised as follows: Tax charge in income statement Current tax 201,000 Deferred tax – release (124,125) Total tax charge in income statement 76,875 Tax charge in other comprehensive income Current tax 171,000 Deferred tax – release (171,000) Total tax charge in other comprehensive income − The total tax charge of C76,875 in the income statement is the same as tax payable on the accounting profit. No reconciling difference arises, because the deferred tax liability reflects the manner in which the entity expected to recover the carrying amount of the property (that is, through sale). After the building’s sale, the revaluation surplus is realised, and the entity will transfer the original surplus of C399,000 (that is, C570,000 net of tax of C171,000) from the revaluation reserve to retained earnings. (This assumes that no annual transfer has been made – see last paragraph of scenario 1).

Downward revaluation of depreciable assets

The tax consequence of the impairment loss when a depreciable asset is revalued downwards is similar to depreciation, and it either reverses a taxable temporary difference or creates a deductible temporary difference. This could give rise to a deferred tax asset or a reduction in the deferred tax liability.

The treatment will depend on the asset’s tax base just before the downward revaluation was recognised. Where a depreciable asset that was revalued upwards is subsequently revalued downwards, the downward revaluation will first reverse the previous upward revaluation, and any excess reversal will then be recognised in profit or loss.

Downward revaluation of depreciable assets The facts are the same as in scenario 3 in previous FAQ. However, on 31 December 20X6, two years after revaluation and immediately before sale, the asset is revalued downwards to C600,000. The entity expects to recover the full carrying amount of the building through sale. There is no use element as at 31 December 20X6, because the expected manner of recovery is solely through sale. The impact of the devaluation on the sale element is shown below: Sale element NBV TB TD DTL C C C C At 31 December 20X6 (before impairment) 1,243,750 260,000 983,750 (295,125) Impairment loss (643,750) − (643,750)(193,125) At 31 December 20X6 600,000 260,000 340,000 102,000 C570,000 (of the impairment loss of C643,750) reverses the earlier revaluation surplus and is recognised in other comprehensive income (debited to the revaluation reserve); the balance of C73,750 is debited to the income statement. The corresponding tax credits of C171,000 (30% of C570,000) and C22,125 (30% of C73,750) are similarly recognised in other comprehensive income (credited to the revaluation reserve) and in the income statement. If the entity has transferred an element of the C570,000 revaluation surplus from the revaluation reserve to retained earnings, the amount of the impairment debited directly to the revaluation reserve would be capped at the amount of revaluation surplus remaining in the revaluation reserve at the time of the impairment.

Upward revaluation of non-depreciable asset

Deferred tax needs to be recognised on the taxable temporary difference when a non-depreciable asset (such as land) is revalued above the tax-deductible amount on sale (including any inflation allowance).

The asset is not depreciated, so no part of the asset’s carrying amount is expected to be recovered through use. The carrying amount of a nondepreciable asset can only be recovered through sale.

Upwards revaluation of non-depreciable asset On transition to IFRS, entity B elected to remeasure its land and buildings at fair value at the date of transition, as permitted by IFRS 1. This fair value was subsequently used as deemed cost for the purpose of historical cost accounting. Entity B does not have a policy of annual revaluations. One of entity B’s assets is a piece of land. The tax base of the land is its original cost when acquired by entity B, increased each year in line with the retail price index. There is a temporary difference between the revalued accounting base and the tax base of the land. The temporary difference will reduce over time as the tax base is increased by changes in the retail price index. Management expects to hold the land for the foreseeable future, and it expects that the land’s tax base will exceed the accounting base before the land is disposed of. In this situation, management should recognise deferred tax in respect of the land, based on the difference between the accounting base and the tax base at the balance sheet date. Management should not anticipate future changes in the land’s tax base arising from changes in the retail price index.

Indexation of tax base on revalued non-depreciable asset An entity acquired a plot of land for C1,000,000 on 1 January 20X1, when the tax-indexed cost was also C1,000,000. On disposal, the proceeds in excess of indexed cost are subject to capital gains tax @ 30%, which is also the rate of tax on income other than capital gains. The price index for calculating indexation allowances increases by 2% in 20X1 and 2.5% in 20X2. But the tax rules state that indexation allowance cannot create or increase a loss. The deferred tax asset recognised in each of those years (if sufficient taxable profits are available) is calculated as follows: NBV TB TD DTL(DTA ) C C C C At 1 January 20X1 1,000,000 1,000,000 – – Increase in tax-indexed cost @ 2% (see note below) – – – At 31 December 20X1 1,000,000 1,000,000 – – Increase in tax-indexed cost @ 2.5% (see note below) – – – At 31 December 20X2 1,000,000 1,000,000 – – The land is carried at cost during 20X1 and 20X2. If the land is sold at its carrying amount of C1,000,000 at the balance sheet date, the amount deductible for tax purposes is its original cost, without the benefit of the indexation allowance. The tax rules applicable to the entity state that indexation allowance cannot create or increase a loss. So the tax base is not increased by indexation of C20,000 (2%) in year 1 and C25,500 (2.5%) in year 2; and a temporary difference does not arise. During 20X3, the entity revalued the land to C1,500,000, when the indexation allowance has increased by 3%. The tax effect of the revaluation is calculated as follows: NBV TB TD DTL (A) C C C C Cost 1,000,000 1,000,000 Accounting revaluation 500,000 Increase in tax-indexed cost in previous periods* 45,500 Increase in tax-indexed cost in current period @ 3% 31,365 At 31 December 20X3 1,500,000 1,076,865 423,135 126,940 *The increase in the land’s carrying amount, as a result of the revaluation, means that the tax base is increased by the indexation allowance arising in year 1 (C20,000) and year 2 (C25,500), because this no longer creates a loss. The revaluation surplus of C500,000 is recognised in other comprehensive income (credited to the revaluation reserve), but the deferred tax liability recognised in other comprehensive income (in the revaluation reserve) is C126,940 (C423,135 @ 30%), because the surplus includes a tax-free amount of C76,865 resulting from inflation since the asset was acquired.

Sale of revalued non-depreciable asset Following on from previous FAQ, suppose that the land is sold during 20X6 for C2,000,000. There is additional indexation allowance of C23,135 up to the time of sale, so the indexed cost is C1,100,000. Assume that the tax effect of the indexation allowance in the period of sale is recognised in other comprehensive income. The entity pays tax at 30% on the taxable profit, as follows: Taxable profit Accounting profit C C Sales proceeds 2,000,000 2,000,000 Tax base/carrying amount before sale 1,100,000 1,500,000 Taxable/accounting profit 900,000 500,000 Tax @ 30% 270,000 150,000 The journal entries for the current tax and for the release of the deferred tax liability of C126,940 are as follows: Dr Cr Dr Current tax (I/S) 1 150,000 Dr Current tax (other comprehensive income) 2 120,000 Cr Current tax (B/S) 270,000 Dr Deferred tax (B/S) 126,940 Cr Deferred tax (other comprehensive income) 3 126,940 1 Current tax recognised in the income statement of C150,000 is the difference between the total current tax payable of C270,000 and the amount recognised in other comprehensive income of C120,000; and it represents the gain in the income statement of C500,000 @ 30%. 2 Current tax recognised in other comprehensive income is calculated as the tax on the gain previously recognised in other comprehensive income reduced by indexation; that is, gain of C500,000 less indexation of (C76,865 + C23,135) = gain of C400,000 @ 30% = C120,000. 3 The reversal of deferred tax of C126,940 represents the deferred tax previously recognised in other comprehensive income. No deferred tax was previously recognised in the income statement, so there is no reversal in the income statement. Tax charge in income statement Current tax 150,000 Deferred tax – release – Total tax charge in income statement 150,000 Tax charge in other comprehensive income Current tax 120,000 Deferred tax – release (126,940) Total tax credit in other comprehensive income (6,940) The tax credit in other comprehensive income of C6,940 arises because of an additional tax-free amount of C23,135 (C1,100,000 − C1,076,865) that has arisen during the year before the disposal date, as a result of indexation (C23,135 @ 30% = C6,940). IAS 12 does not specify how this additional indexation should be allocated. This example assumes that the indexation is treated consistently with the previous indexation, and is regarded as relating to the accounting gain that has been recognised in other comprehensive income. But other methods of allocation might be appropriate, depending on the entity’s accounting policy (for example, allocating the indexation pro rata between the gain recognised in the income statement and the gain previously recognised in other comprehensive income).

Downward revaluation of non-depreciable asset

A deductible temporary difference arises from a downward revaluation of a non-depreciable asset in excess of any previous upward revaluation.

If capital losses can only be offset against capital gains, a deferred tax asset is not normally recognised unless a deferred tax liability has been recognised for capital gains on upward revaluations of other assets or other taxable temporary difference.

If a downward revaluation of a non-depreciable asset simply reverses a previous upward revaluation of the same asset, the tax effect recognised should reverse the tax effect that was previously recognised for the upward revaluation.

Revaluation for tax purposes

An asset can sometimes be revalued for tax purposes. The revaluation might or might not be reflected for accounting purposes. An asset revaluation for tax purposes might relate to an accounting revaluation of an earlier period (or to one that is expected to be carried out in a future period).

The tax effects of the adjustment of the tax base are recognised in other comprehensive income in the periods in which they occur if there is (or will be) a revaluation for accounting purposes. If an asset revaluation for tax purposes does not relate to an accounting revaluation of an earlier period (or to one that is expected to be carried out in a future period), the tax effects of adjusting the tax base are recognised in profit or loss.

Impact of correlation between accounting revaluation and tax revaluation The impact of changes in the tax revaluation is only recognised in other comprehensive income if a relationship is established between the accounting revaluation and the tax revaluation. That relationship does not have to be one of perfect correlation. The reporting entity needs to establish the relationship where a general basis of indexation for tax purposes applies to all entities. It might be helpful to consider how valuations of the relevant class of assets have correlated with the tax index in the past, as well as any indicators that suggest changes in that correlation in the future. Also, where significant amounts are involved, the entity should have regard to the ‘significant judgements’ disclosure requirements, as required by IAS 1. If an entity’s accounting policy is to revalue an asset (so that a revaluation surplus is taken to reserves in the same or a previous period) – and a relationship between the accounting revaluation and the tax revaluation has been established – and the tax base is revalued, we consider that (to the extent that the tax revaluation is not greater than the cumulative accounting revaluation) the tax revaluation arguably relates to the earlier accounting revaluation. As a result, the effect of the adjusted tax base is recognised in other comprehensive income. But, if the tax revaluation exceeds the cumulative accounting revaluation, it is a matter of judgement as to whether the tax revaluation relates to an accounting revaluation expected in the future. If it is judged to be so, the effect of the adjusted tax base is recognised in other comprehensive income; otherwise, it is recognised in profit or loss. If it is clear that the tax basis revaluation does not relate to the accounting revaluation, the effect of the tax revaluation is taken to profit or loss. This might arise if the basis for the asset’s tax revaluation bears no relationship to asset price development in the market (for example, the tax basis is general inflation but the class of assets has had a reducing fair value in the past – as has been the case for technology products). The tax revaluation might be expected to be upwards, but the accounting revaluation would not be. An entity’s accounting policy might be to carry an asset at depreciated cost. If the tax base is revalued for tax purposes, the effect of the tax base’s revaluation is recognised in profit or loss, because it does not relate to a prior accounting revaluation and none is anticipated in future periods. The effect of adjusting the tax base is recognised in other comprehensive income where an entity’s accounting policy is to revalue an asset and there is a related tax revaluation.

Asset carried at cost but subject to tax revaluation Entity A acquires an asset which has an initial tax base equal to its cost. The asset’s tax base is increased each year by an amount based on asset price inflation. Entity A accounts for the asset using a policy of cost (that is, with no accounting revaluation) under IAS 16. If a tax revaluation is available in this situation (that is, the tax revaluation can create or increase a loss), the impact of the increase in the tax base as a result of the tax revaluation is recognised in profit or loss. It does not relate to an accounting revaluation that has been recognised in other comprehensive income.

Asset subject to both accounting and tax revaluation Entity A acquires an asset which has an initial tax base equal to its cost. The asset’s tax base is increased each year by an amount based on asset price inflation. Entity A accounts for the asset using a policy of revaluation under IAS 16. To the extent that the increase in the tax base, as a result of the tax revaluation, is no greater than the cumulative accounting revaluation surplus recognised in other comprehensive income, the tax revaluation arguably relates to an earlier accounting revaluation; as a result, the effect of the adjusted tax base is recognised in other comprehensive income. The tax revaluation arising in the period of the asset’s disposal is allocated between the income statement and other comprehensive income.

Asset carried at cost but tax base reduced by rolled-over gains Entity A acquires an asset, and the initial tax base is reduced by rolled-over gains. The asset’s reduced tax base is increased each year by an amount based on asset price inflation. Entity A accounts for the asset using a policy of cost (that is, with no accounting revaluation) under IAS 16. If the tax base of an asset carried at cost has been reduced by rolled-over gains (so that it is lower than the accounting cost) and the tax revaluation is given on the reduced tax base, the increase in the tax base as a result of the tax revaluation is recognised in profit or loss. This is because it does not relate to an accounting revaluation that has been recognised in other comprehensive income. The tax revaluation reduces the deferred tax arising on the rolled-over gain. But the impact of the change in tax is not ‘backwards-traced’, for accounting purposes, to the previously rolled-over gain (this is because it is not related to the roll-over, even though it is reversing its effect).

Asset subject to accounting revaluation and tax base reduced by rolled-over gains Entity A acquires an asset, and the initial tax base is reduced by rolled-over gains. The asset’s reduced tax base is increased each year by an amount based on asset price inflation. Entity A accounts for the asset using a policy of revaluation under IAS 16. The accounting is similar to previous FAQ (for revalued assets), except that the tax revaluation will be lower; this is because it is given on a lower tax base. To the extent that the increase in the tax base as a result of the tax revaluation is no greater than the cumulative accounting revaluation surplus recognised in other comprehensive income, the tax revaluation arguably relates to an earlier accounting revaluation; as a result, the effect of the adjusted tax base is recognised in other comprehensive income. In other words, the accounting in this scenario is similar to that in previous FAQ, but it will take longer for the tax revaluation to reach the accounting revaluation gain, because it is given on a lower tax base. We do not consider that the impact of the tax revaluation, up to the accounting cost of the asset (that is, to the extent of the rolled-over gain), should first be taken to the income statement. This would suggest that the tax revaluation relates to the reinstatement of the cost (that is, it somehow replaces the impact of the roll-over election). We do not believe that this is the case. The roll-over reduces the amount of tax revaluation that is available, but otherwise the scenario is similar to the example in previous FAQ for revalued assets, and similar accounting should apply. The above accounting will apply unless the tax revaluation exceeds the accounting revaluation gain. To the extent that the increase in the tax base as a result of the tax revaluation exceeds the cumulative accounting revaluation, it is a matter of judgement as to whether the tax revaluation relates to an accounting revaluation expected in the future, or whether it is reinstating the tax base back to initial cost and reducing the deferred tax arising on the rolled-over gain. In such a case, this element is similar to the example in previous FAQ, and it would be recognised in profit or loss.

Accounting for tax impact on assets acquired in business combination The accounting in the parent’s consolidated financial statements will be the same, whether the acquired entity had revalued the property before acquisition by the group or whether the property was revalued on acquisition, when: an asset is acquired in a business combination; and the asset’s tax base is lower than its fair value at the acquisition date. In both cases, under IFRS 3, the asset’s fair value at the acquisition date is the deemed cost from the acquiring group’s perspective; and any deferred tax liability arising as a result of the lower tax base at the acquisition date will form part of the goodwill calculation.

Assets acquired in a business combination with a subsequent accounting policy of carrying assets at cost Entity A acquires an asset in a business combination. The asset’s tax base is lower than its fair value at the acquisition date. The asset’s initial tax base is increased each year by an amount based on asset price inflation. The tax base at acquisition date reflects the tax revaluation to date. Entity A accounts for the asset using a policy of cost (that is, based on the asset’s fair value at the acquisition date, with no subsequent accounting revaluation) under IAS 16. If the asset’s tax base is lower than its fair value at the acquisition date, the deferred tax liability forms part of the goodwill calculation in the consolidated financial statements. Any subsequent increase in the tax base as a result of tax revaluation is recognised in profit or loss, because it does not relate to an accounting revaluation that has been recognised in other comprehensive income.

Assets acquired in a business combination with a subsequent accounting policy of revaluation Entity A acquires an asset in a business combination. The asset’s tax base is lower than its fair value at the acquisition date. The asset’s initial tax base is increased each year by an amount based on asset price inflation, and the tax base at the acquisition date reflects the tax revaluation to date. Entity A accounts for the asset using a policy of revaluation under IAS 16. There are several acceptable accounting treatments (described below) for determining how the impact of the tax revaluation is allocated to the performance statements. The accounting treatment selected should be applied on a consistent basis. (a) The tax revaluation is first applied to any shortfall between the asset’s ‘cost’ and tax base at the acquisition date. This might or might not result from a roll-over election and/or higher fair value than original cost to the acquired entity. Either way, from the acquirer’s perspective, the asset has a lower tax base. This method reflects the natural order in which the revaluation arises (that is, the fair value revaluation at acquisition arises before any post-acquisition revaluation, and so the tax revaluation is first allocated against the fair value adjustment). To the extent that the increase in the tax base as a result of tax revaluation builds the tax base up to the fair value at the acquisition date, the accounting treatment is similar to previous FAQ. The increase in the tax base is recognised in profit or loss, because this element does not relate to an accounting revaluation that has been recognised in other comprehensive income. Then, to the extent that any further increase in the tax base as a result of tax revaluation is no greater than the cumulative post-acquisition accounting revaluation surplus recognised in other comprehensive income, the tax revaluation arguably relates to an earlier accounting revaluation, and so the effect of this adjustment to the tax base is recognised in other comprehensive income. Note that, if the tax indexation exceeds the accounting revaluation, the comments in previous FAQ will apply. (b) The tax revaluation is first considered to relate to any post-acquisition revaluation gain. So the impact is recognised in other comprehensive income. This is consistent with the general principle for revalued properties, where the tax revaluation is first considered to relate to the accounting revaluation. To the extent that the increase in the tax base as a result of the tax revaluation is not greater than the cumulative accounting revaluation surplus recognised in other comprehensive income, it arguably relates to the accounting revaluation that has been recognised in other comprehensive income. So the effect of the adjusted tax base is recognised in other comprehensive income. To the extent that the increase in the tax base as a result of the tax revaluation exceeds the cumulative accounting revaluation recognised in other comprehensive income, it would be considered to relate to the element of revaluation arising on acquisition (that is, the fair value adjustment). In that case, the increase in the tax base as a result of indexation would be recognised in profit or loss. To the extent that the tax revaluation exceeds the cumulative accounting revaluation (recognised in other comprehensive income and arising on acquisition), it is a matter of judgement as to whether the tax revaluation relates to an accounting revaluation expected in the future. If it does, the effect of the adjusted tax base would be recognised in other comprehensive income; otherwise, it would be recognised in profit or loss. a. The tax revaluation would be allocated pro rata. The tax revaluation would be allocated pro rata to the revaluation arising on acquisition (that is, change in tax recognised in profit or loss) and the post-acquisition accounting revaluation (that is, change in tax recognised in other comprehensive income).

Impact of transition provisions of IFRS 1 If an asset is carried at a revaluation (‘deemed cost’) under the transitional rules of IFRS 1, but the entity has no ongoing accounting policy of revaluation, the effect of changes in the tax base are recognised in profit or loss. This accounting treatment applies regardless of whether a deferred tax liability was recognised on transition to IFRS or later. The fact that a deferred tax liability recognised on transition to IFRS was charged to equity (as part of the transition adjustment) does not mean that changes in the liability will also be recognised in equity. Instead, management should use the entity’s current accounting policies to determine where the items that gave rise to the original deferred tax would have been recognised if IFRS had applied in the earlier periods. The changes in the deferred tax should be recognised in profit or loss if it is not possible to assess where the items that gave rise to the original deferred tax would have been recognised if IFRS had applied in the earlier periods. An entity might recognise an asset at a revalued amount (‘deemed cost’) on transition to IFRS, in lieu of cost, but it does not otherwise treat the asset as revalued. There is no revaluation surplus shown in the financial statements where the entity does not have an accounting policy of revaluing its assets. In our view, changes in the related deferred tax liability arising as a result of tax revaluation are not regarded as relating to an accounting revaluation recognised in other comprehensive income in this case. So the impact of the tax revaluation should be recognised in profit or loss. Similarly, an entity might have recognised deferred tax relating to a business combination on transition to IFRS and taken it (under IFRS 1) to retained earnings. If the entity does not have an accounting policy of revaluing its assets, it results in a one-off entry in lieu of adjusting goodwill (which IFRS 1 only permits in limited circumstances). A later tax revaluation does not relate to an accounting revaluation that has been recognised in other comprehensive income. So the increase in the tax base as a result of tax revaluation would be recognised in profit or loss.

Revaluation of properties

When a property is revalued under IAS 16, its carrying amount is increased or decreased, but there is generally no effect on the tax base of the property. As a result, deferred tax balances arise. Generally, the recognition of deferred tax arising on a revaluation is consistent with the treatment of the revaluation itself.

Upward revaluations

The upward revaluation of a property accounted for under IAS 16 generally gives rise to a deferred tax liability.

By increasing the carrying amount of the property, the entity is acknowledging that it expects to generate returns in excess of the original carrying amount, which will lead to future taxable profits, and so tax payable.

When an upward revaluation is recognised, the deferred tax liability arising is calculated by reference to the expected manner of recovery of the property. The upward revaluation is recognised in other comprehensive income (unless it represents the reversal of a downward revaluation previously recognised in profit or loss). The deferred tax expense should, therefore, also be recognised in other comprehensive income.

Over the period of use when the temporary difference reverses, the release of the deferred tax liability will be credited to profit or loss. The deferred tax liability recognised at the date of revaluation represents a provision for the tax expected to arise on those benefits.

The release of the deferred tax liability to profit or loss over the period in which those future economic benefits (i.e. taxable profits) are earned offsets the current tax expense in those years to the extent that it was anticipated at the date of the revaluation.

Deferred tax impact of property revaluation – example An item of property, plant and equipment is acquired for CU1,000. It is depreciated for tax and accounting purposes over five years. At the end of the third year, it is revalued to CU1,200. The value of the property is expected to be recovered through use in a taxable manufacturing activity. The tax rate is 30 per cent. Carrying amount Tax base Temporary difference Deferred tax liability Movement for the year  CU CU CU CU CU  01/01/20X1 1,000 1,000 – – – 31/12/20X1 800 800 – – – 31/12/20X2 600 600 – – – 31/12/20X3 1,200 400 800 240 240 31/12/20X4 600 200 400 120 (120) 31/12/20X5 – – – – (120) The required journal entries at the end of 20X3 are as follows. CU CU Dr Property, plant and equipment 200 Dr Property, plant and equipment – accumulated depreciation 600 Cr Gain on revaluation (other comprehensive income) 800 Dr Income tax (other comprehensive income) 240 Cr Deferred tax liability 240 To recognise the required entries at the end of 20X3. In both 20X4 and 20X5, the following entry will be recorded, to reflect the reversal of the temporary difference arising on revaluation. CU CU Dr Deferred tax liability 120 Cr Income tax (profit or loss) 120 To recognise the tax effect of the reversal of the temporary difference arising on revaluation.

Downward revaluations and impairment losses

Recognition of downward revaluations and impairments of properties accounted for under IAS 16 is either in profit or loss or other comprehensive income, depending on where previous gains and losses recognised on the property have been presented.

The write-down of a property for accounting purposes can give rise to a deferred tax asset, or a reduction in a deferred tax liability, depending on the tax base of the property. Any deferred tax asset arising is recognised to the extent that it is probable that sufficient taxable profit will be available in the future to allow the benefit of that deferred tax asset to be recovered.

Recognition of deferred tax arising on revalued property, plant and equipment – subsequent downward valuation When a property accounted for in accordance with IAS 16 has previously been revalued, and a downward valuation subsequently occurs that is recognised in other comprehensive income (i.e. to the extent that the subsequent downward valuation does not exceed the amount held in the revaluation surplus in respect of that same asset), the deferred tax effects previously recognised in other comprehensive income are reversed through other comprehensive income. If the downward revaluation exceeds the amount of revaluation surplus, the excess is recognised in profit or loss. In such circumstances, the deferred tax movement should also be split between amounts recognised in other comprehensive income and profit or loss. Impairments are treated in the same manner as downward revaluations. For example, an item of property, plant and equipment is acquired for CU1,000. It is depreciated for tax and accounting purposes over 10 years on a straight-line basis. The value of the property is expected to be recovered through use in a taxable manufacturing activity. The entity is a profitable manufacturing entity with its deferred tax assets fully recognised. At the end of the third year (when the carrying amount is CU700), the asset is revalued to CU1,050 but no adjustment is made to its tax base. At the end of the sixth year, when the carrying amount of the asset is CU600 (i.e. CU1,050 – (3 × CU150)), it is revalued downward to CU200. The tax rate is 30 per cent. Initially, the revaluation uplift and the related deferred tax are recognised in other comprehensive income and accumulated in the revaluation reserve. Each year a transfer is made from the revaluation reserve to retained earnings equal to the depreciation of the revaluation surplus net of tax. At the time of the downward revaluation, the balance in the revaluation reserve is CU140. This is calculated as follows. CU  Original revaluation uplift 350 Deferred tax thereon (CU350 × 30%) (105) 245 Three years’ depreciation on net uplift (CU245 × 3/7) (105) 140 Therefore, the first CU200 of the downward revaluation is recognised as a loss in other comprehensive income, net of CU60 related tax. The remaining downward revaluation of CU200 is recognised in profit or loss (along with CU60 related tax). The downward revaluation reduces the carrying amount below the tax base, resulting in a deferred tax asset which is recognised because the entity has forecast taxable profits. Carrying amount Recognised in Historical cost Revaluation uplift Tax base Temporary difference  Deferred tax liability (asset)  Movement for the year  Other comp. income  Profit or loss  CU CU CU CU  CU  CU  CU  CU  20X0 1,000 – 1,000 – – – – – 20X1 900 – 900 – – – – – 20X2 800 – 800 – – – – – 20X3 700 350 700 350 105 105 105 – 20X4 600 300 600 300 90 (15) – (15) 20X5 500 250 500 250 75 (15) – (15) 20X6 200 – 400 (200) (60) (135) (60) (75) 20X7 150 – 300 (150) (45) 15 – 15 20X8 100 – 200 (100) (30) 15 – 15 20X9 50 – 100 (50) (15) 15 – 15 20Y0 – – – – – 15 – 15 If a decision is subsequently taken to dispose of the property, then the deferred tax implications will need to be re-examined. Because the temporary difference is calculated on the basis of management expectations as to the manner of recovery of the property, when those expectations change the deferred tax position may also change.

Properties to be recovered through disposal – ‘clawback’ of tax depreciation It may be anticipated that the carrying amount of a revalued property will be recovered through sale (whether based on management intent or on the presumptions established in IAS 12 for non-depreciable properties and investment properties). In such cases, the deferred tax implications are determined on the basis of the tax consequences of disposal of the property. It may be that the profit on disposal will be fully taxable, in which case the deferred tax liability arising on any revaluation of the property will be equal to the revaluation uplift multiplied by the tax rate. However, frequently, the taxation of capital gains is on a different basis (e.g. the taxable gain arising may be limited to the amount of tax depreciation previously claimed). This is often referred to as a ‘claw-back’. In such circumstances (i.e. when the disposal is not itself subject to income tax, but any deduction for tax depreciation previously claimed is taxable as a ‘claw-back’), the tax base is the carrying amount less future taxable amounts. This may or may not be equal to the cost less tax depreciation to date. For example, a building (classified as property, plant and equipment) is acquired for CU1,000 on 1 January 20X1. No deferred tax arises on initial recognition of the property, which is to be depreciated (both for tax and accounting purposes) over five years. At the end of 20X1, when its carrying amount and tax written down value is CU800, the property is remeasured to its fair value of CU1,200. At that date, it is expected that the carrying amount of the property will be recovered through disposal. If the property were disposed of, the taxable gain arising would be limited to the amount of the tax depreciation previously claimed. The tax rate is 30 per cent. At 31 December 20X1 Carrying amount (fair value) = CU1,200 Tax base = CU1,000* Temporary difference = CU1,200 – CU1,000 = CU200 Deferred tax liability = CU200 × 30% = CU60 * The tax base is the carrying amount of CU1,200 less future taxable amounts (i.e. the allowances that would be clawed back on disposal) of CU200. In these circumstances, the tax base for IAS 12 is not equal to the tax written down value of CU800 (cost less accumulated tax depreciation to date). Therefore, at the end of 20X1, a deferred tax liability of CU60 is recognised; because it relates to the revaluation of the property, the debit of CU60 is recognised in other comprehensive income.

Investment Properties

Investment properties are held to earn rentals and/or for capital appreciation. An entity can choose to measure the investment property at cost or at fair value under IAS 40.

IAS 12 includes a presumption that an investment property measured at fair value is recovered entirely through sale. This presumption is rebutted if the investment property is depreciable and is held within a business model whose objective is to consume substantially all of the investment property’s economic benefits over time rather than through sale.

The presumption cannot be rebutted for an investment property (or portion of an investment property) that would be non-depreciable if IAS 16 were applied (such as freehold land).

Carried at fair value

There is a presumption that an investment property carried at fair value will be recovered entirely through sale, even if it qualifies for tax depreciation. An investment property might not qualify for tax depreciation and no part of the property’s cost is deductible against taxable rental income.

Instead, the cost of the property (uplifted by an allowance for inflation, where applicable) is allowed as a deduction against sales proceeds for the purpose of computing any taxable gain arising on sale.

Deferred tax for investment properties carried at fair value should generally be measured using the tax base and rate that are consistent with recovery entirely through sale, and using capital gains tax rules – or other rules regarding the tax consequences of sale (such as rules designed to claw back any tax depreciation previously claimed in respect of the asset).

If the presumption is rebutted, deferred tax should be measured reflecting the tax consequences of the expected manner of recovery.

Transfer from investment property held at fair value to property, plant and equipment An entity acquired an investment property on 1 January 20X7. The building element of the property is valued at C50 million. Management initially expects to use the building for 10 years to generate rental income, with no residual value. The initial expectation is that the building will be sold at the end of year 10 to recover its tax base. The presumption that it will be recovered through sale is not rebutted. For tax purposes, the asset’s cost is not deductible against rental income; but any sales proceeds are taxable after deducting cost. The tax rate is 30% for taxable income and 40% for chargeable capital gains. On initial recognition, no temporary differences arose. During years 1 to 5, changes in the building’s fair value were credited to profit or loss. The entity also recognised deferred tax on the changes in fair value in profit or loss. Five years after acquisition, the property was transferred from investment property to property, plant and equipment, following a change in use. At the date of transfer, the building’s fair value and the corresponding deferred tax liability were C60 million and C4 million (40% of C10 million) respectively, and the building was estimated to have a remaining life of 20 years with a nil residual value. An investment property carried at fair value is transferred to property, plant and equipment. The property’s fair value at the date of transfer becomes its deemed cost for subsequent accounting under IAS 16. So, no adjustment is made to the carrying amount at the date of transfer. But the building will now be expected to be recovered through use and sale. A taxable temporary difference of C60 million will arise in relation to the use element (carrying value of C60 million, less tax deductions through use of nil), of which C50 million would have been originally covered by the initial recognition exception (IRE) if the property had always been classified as property, plant and equipment. A deductible temporary difference of C50 million will remain on the sale element (tax deductions through sale of C50 million, less expected residual value of nil), but this would also have been covered by the IRE. So, a deferred tax liability of C3 million (30% of C10 million) should be recognised due to the difference in the tax rates between capital and income. This reduction of C1 million in the deferred tax balance is recognised through the income statement. At the end of the year, the building’s use element would have a depreciated carrying amount of C57 million. This would give rise to a taxable temporary difference at that date of C57 million. Of this amount, C47.5 million arose on initial recognition (being the original temporary difference on initial recognition of C50 million, less a year’s depreciation charge of C2.5 million). The remaining C9.5 million arose after initial recognition; so deferred tax should be provided on this amount. This results from the C10 million uplift in the building’s valuation (that occurred after initial recognition), less a year’s depreciation charge against this (of C0.5 million). So the deferred tax balance at the end of the year would be C2.85 million (30% of C9.5 million). This reduction of C0.15 million in the deferred tax balance (from C3 million to C2.85 million) is recognised through the income statement. The deferred tax liability will continue to reverse at the rate of C0.15 million per annum until it has been reversed in full over the building’s remaining useful life. Assuming no change in residual value or tax base for the building’s sale element, there would be no impact on the deferred tax calculation for the sale element.

Transfer from property, plant and equipment to investment property held at fair value A building was purchased on 1 January 20X7 for C50 million, with a useful life of 25 years and an estimated residual value of nil. The building was used in the business. It was classified as property, plant and equipment. For tax purposes, the asset’s cost is not deductible in use, but any sales proceeds are taxable after deducting the cost. The tax rate is 30% for taxable income and 40% for chargeable capital gains. On initial recognition, a carrying amount of nil was attributable to the building’s sale element. This created a deductible temporary difference. A taxable temporary difference existed in relation to the building’s use element; but no deferred tax was recognised, because these differences were covered by the initial recognition exception. Five years after acquisition, the property was transferred from property, plant and equipment to investment property, following a change in use. At the date of transfer, the property’s depreciated cost was C40 million (C50 million less five years’ annual depreciation of C2 million). The property’s fair value at the date of transfer amounted to C60 million. The presumption that the property will be recovered through sale will apply after the transfer. The difference between the fair value and the property’s depreciated cost is treated in the same way as a revaluation under IAS 16 when an entity transfers an owner-occupied property to investment property that will be carried at fair value. In other words, the difference of C20 million (C60 million less C40 million) is credited to the revaluation reserve and recognised in other comprehensive income. The entity also recognises deferred tax on the revaluation surplus charged to the revaluation reserve in other comprehensive income. The deferred tax could be calculated by reference to the C10 million difference between the revised carrying value and the tax base through sale. Some take the view that the deferred tax could be calculated by reference to the full uplift of C20 million at the date of transfer (because C10 million of the C50 million of cost on initial recognition has already reversed through the depreciation charge).

The presumption also applies where investment property is acquired in a business combination and the acquirer later uses fair value to measure the investment property.

Carried at cost

An investment property that is carried at cost is depreciated in the normal way over its useful economic life for accounting purposes. The rebuttable presumption that the asset will be recovered through sale does not apply.

The expected manner of recovery might be through a combination of use and sale. The asset’s carrying amount is split between the use and sale elements, and these carrying amounts are compared to the respective tax bases.

If the only tax deduction available for the property is on sale, the tax base of the building’s use element carried at cost would be nil on initial recognition and in all future periods.

Dual manner of recovery for investment property carried at cost An entity purchased a building on 1 January 20X7 for C50 million that had a useful life of 25 years and an estimated nil residual value. For tax purposes, the asset’s cost is not deductible against taxable rental income; but any sales proceeds are taxable after deducting cost at the date of sale. The tax rate is 30% for taxable income and 40% for chargeable capital gains. A carrying amount of nil would be attributed to the sale element of the building on initial recognition, creating a deductible temporary difference of C50 million on the sale element. A taxable temporary difference would arise on the use element on initial recognition, being the carrying amount of C50 million less the tax base of nil. At the end of year 1, assuming the residual value was still nil, the element of the asset to be recovered through use would have a depreciated cost of C48 million (C50 million less C2 million depreciation charge). The temporary difference on the use element at the balance sheet date is C48 million; but no deferred tax is provided, because this amount is part of the C50 million temporary difference that arose in relation to the use element on initial recognition. It follows that no deferred tax liability will arise on the building’s use element where the investment property is carried at depreciated cost. At the end of year 1, the deductible temporary difference for the building’s sale element would remain; but, as with the taxable temporary difference above, this will be covered by the initial recognition exception – so no deferred tax is recognised.

Intangible assets

Intangible assets with indefinite useful lives are not amortised. This might be the case with, for example, trademarks or brands.

There is no specific guidance on the expected manner of recovery for intangible assets with indefinite useful lives. The future economic benefits arising from the indefinite-lived asset will eventually be consumed, but the timing of that consumption is uncertain.

The requirement to test intangible assets with indefinite lives for impairment at least annually is an acknowledgment that recovery through use might occur.

The intangible asset can be used to generate income on an ongoing basis in the business. The expected manner of recovery of intangible assets with indefinite lives is a matter of judgment; it is specific to the individual facts, and it should reflect management’s expectations.

Factors to be considered while evaluating deferred tax impact of indefinite-lived intangible assets In some circumstances, the tax base of an intangible asset with an indefinite life can be determined solely on a sale basis. Recovery through sale might be acceptable if revenues generated by intangible assets with indefinite lives are not (and are not expected to be in the future) a recovery of the asset’s carrying amount. But the following factors should be considered: Recovery through sale cannot be presumed for intangible assets that have been the subject of an impairment write-down – such a writedown is evidence of recovery through use. If the asset’s carrying amount is subject to impairment in the future, the expected manner of recovery could change to recovery through use. This will have an impact on deferred taxes recognised in current earnings, in addition to the impact of the impairment. Management might need to disclose the presumption of recovery through sale to comply with IAS 1, which requires disclosure of judgements made by management that have significant effects on amounts recognised.

Financial instruments

Deferred tax balances could arise on financial instruments. An entity should consider the expected manner of recovery for each instrument and the associated tax implications to measure and report the deferred tax.

Instruments might be recovered through use, through sale, or through a combination of both (that is, a dual manner of recovery).

Generally, financial assets that are held for trading purposes will be recovered through sale, whereas financial assets that are intended to be held to maturity will be recovered through use.

The measurement and reporting of deferred tax related to financial assets that might be held and then sold will often require more careful analysis that might warrant a dual manner of recovery in some circumstances.

Deferred tax and financial assets carried at amortised cost An entity acquires a 5% bond with a nominal value of C100,000 at a discount of 20% to the nominal value; the bond is repayable in five years’ time at a premium of 20% to the nominal value. The costs of acquisition are C5,000, and interest is received annually in arrears. The entity expects to hold the bond to maturity. The costs of acquisition are taxed as part of the cost of the bond, interest is taxed when received, and any profit on redemption (proceeds less cost) is taxed on redemption. Net purchase cost of bond C Nominal value 100,000 Discount on issue (20,000) Cost of acquisition 5,000 Total 85,000 Total receivable over life C Nominal value 100,000 Redemption premium 20,000 Interest @ 5% for five years 25,000 Total 145,000 The total return on the bond over five years is C60,000 (C145,000 – C85,000). This amount should be amortised over the period to maturity, using the effective interest method. The effective interest rate is 12.323% that exactly discounts the future cash inflows over the five-year period to the net proceeds received. Year Amortised cost at beginning of the period Effective interest @ 12.323 % * Interest received Amortised cost at end of the period Tax base Temporary difference C C C C C C 1 85,000 10,474 (5,000) 90,474 85,000 5,474 2 90,474 11,149 (5,000) 96,623 85,000 11,623 3 96,623 11,906 (5,000) 103,529 85,000 18,529 4 103,529 12,757 (5,000) 111,286 85,000 26,286 5 111,286 13,714 (5,000) 120,000 85,000 35,000 60,000 (25,000) *Carrying amount of the bond × effective interest rate. The cost of the bond for tax purposes is C85,000 (C80,000 initial cost plus C5,000 costs), and it is deductible against total redemption proceeds; so this is the asset’s tax base throughout the bond’s ownership. The entity provides deferred tax each year on the taxable temporary difference between the amortised cost and the tax base, as shown above. Just before redemption, the amortised cost will have risen to C120,000; so there will be a taxable temporary difference of C35,000. Current tax payable on the taxable gain of C35,000 (proceeds of C120,000 less tax cost of C85,000) will be offset by the release of deferred tax provided on this taxable temporary difference during the period for which the bond is held. The tax base of C85,000 would change each year if the investment also qualifies for indexation allowance. The temporary difference calculated above would include the effects of indexation. In certain jurisdictions, the tax authorities assess tax on the basis of the effective interest (consistent with the manner in which the bond is accounted for each year); the asset’s tax base at the end of each year would be equal to its carrying amount, and no deferred tax would arise.

All entities are required or permitted under IFRS 9 to measure certain financial assets and liabilities at fair value, and changes in fair values are reported through profit or loss or in other comprehensive income.

If financial assets are measured at fair value, with adjustments recognized through profit or loss, tax laws might recognize the gains and losses arising from changes in fair value as they are recognized.

Gains and losses would be subject to current tax when they are recognized, and no deferred tax would arise.

However, the gains and losses might be taxed only when they are realised. A temporary difference arises between the asset’s fair value and its tax base; and a deferred tax liability or asset (subject to meeting the recognition test) should be recognised through profit or loss.

A financial asset might be measured at fair value, with changes in fair value recognised in other comprehensive income. The tax effects of such gains and losses should also be recognised in other comprehensive income.

Such gains and losses might be taxed in the same period in which they arise in some jurisdictions, in which case an entity would recognise related current tax in other comprehensive income.

Where such gains and losses are taxed when the financial asset is sold, the related deferred tax should be recognised in other comprehensive income.

Accounting for tax impact on the cumulative gain or loss on sale of a debt instrument measured at fair value through other comprehensive income If a debt instrument measured at fair value through other comprehensive income is sold, the cumulative gain or loss previously recognised in other comprehensive income is reclassified to profit or loss. A question arises whether the tax on the gain recognised in other comprehensive income should be reclassified to profit or loss. Although IAS 12 is silent on this, we believe that the tax effects of gains and losses recognised in other comprehensive income should be reclassified to profit or loss in the same period as the gains or losses to which they relate. This treatment of reclassifying any cumulative gains or losses to profit or loss ensures that tax on the gain recognised in profit or loss is the same as the tax paid on that gain.

Expected manner of recovery of an investment in equity security An entity holds shares in a listed entity. The equity security is not held for trading, and the entity made an irrevocable election to present subsequent changes in fair value in other comprehensive income under IFRS 9. The tax base of the shares is C400,000, which was the amount initially paid for the shares. The fair value of the shares at the year-end is C1,000,000. At the balance sheet date, the entity expects to receive dividends of C500,000 over five years and then to sell the shares. The shares are currently trading ex-dividend, and the future distributions are not expected to impair the carrying amount of the investment when paid. Dividends are non-taxable. Based on current tax legislation, capital gains tax at a rate of 10% would be payable on the excess of sales price over cost if the shares were sold after five years. An entity should recognise deferred tax based on the expected manner of recovery of an asset or liability at the balance sheet date. The entity expects to derive the dividends from the investee’s future earnings rather than from its existing resources at the balance sheet date. The entity does not expect the investment’s carrying amount at the balance sheet date to be recovered through future dividends. Therefore, the entity expects to recover the investment through sale. The carrying amount of C1,000,000 has a corresponding tax base of C400,000 on sale. There is a taxable temporary difference of C600,000 at the balance sheet date. Tax is payable at the capital gains rate of 10%. The entity should recognise a deferred tax liability of C60,000 relating to the shares. Applying the dual manner of recovery might be appropriate, if the entity expects that the future dividends will result in a recovery of the investment’s carrying amount. An entity applies the same consideration and accounting for deferred tax on available-for-sale investment under IAS 39.

Deferred tax on fair value gains for an equity security (IFRS 9) An entity acquired an equity security for C10,000. The equity security is not held for trading, and the entity made an irrevocable election to present subsequent changes in fair value in other comprehensive income (OCI). At the year-end, the security’s fair value increases to C12,000. The tax rate is 30%. The change in fair value of C2,000 is recognised in OCI under IFRS 9. Ignoring indexation, the tax arising on this gain at the balance sheet date is C600 (that is, 30% of (C12,000 – C10,000)). A current or deferred tax liability of C600 will be recognised at the balance sheet date (with a corresponding debit recognised in OCI), depending on whether the tax on the gain is payable in the current period or deferred until the investment is sold. The security is sold in the following year at its market value of C11,500. Ignoring any indexation adjustments for tax purposes, the current tax that arises on sale will depend on whether tax was paid or deferred on the earlier gain. Scenario 1 – Gains or losses are taxed in the period in which they arise In the current period, a taxable loss of C500 arises between market value of C11,500 and carrying amount for tax purposes of C12,000; this gives rise to a current tax credit of C150 (C500 @ 30%), assuming that this is recoverable. There would be no deferred tax. The entity would recognise net current tax of C450 in OCI. – Equity* – C Cumulative gain recognised immediately before disposal 1,500 Current tax – in prior period (600) Current tax – in current period 150 Net gain and related tax 1,050 * The amounts shown under ‘equity’ are recognised in OCI. The entity should not subsequently transfer such amounts to profit or loss. However, it might elect an accounting policy to transfer the net gain within equity (for example, retained earnings). Scenario 2 – Gains or losses are deferred and taxed in the period in which the investment is sold In the current period, a taxable gain of C1,500 arises between sales proceeds of C11,500 and carrying amount for tax purposes of C10,000. This gives rise to a current tax charge of C450 (that is, 30% of (C11,500 – C10,000)). Since the cumulative gain previously presented in OCI is not reclassified to profit or loss, there is a question on how to present the current tax charge and deferred tax reversal. IAS 12 is silent on this. One approach is to reverse the deferred tax and recognise an income tax charge in the income statement. This follows the principle of IAS 12. Alternatively, the entity might just reverse the deferred tax and recognise the current tax charge directly in equity. Both treatments ensure that current tax and deferred tax are presented and offset against each other in the same statement. The entity should elect an accounting policy and apply it consistently across periods. Where the entity elects the first approach described above, the impact is illustrated as follows: – Book profit Equity* – C C Cumulative gain recognised immediately before disposal 1,500 Cumulative deferred tax recognised immediately before disposal (450) Current tax** (450) Deferred tax – release** 450 Net gain and related tax – 1,050 *The amounts shown under ‘equity’ are recognised in OCI. Similar to scenario 1, the entity might elect an accounting policy to transfer the net gain within equity (for example, retained earnings). ** Where the entity elects the alternative approach described above, the current tax and release of deferred tax are recorded directly in equity, not OCI.

Deferred tax on fair value gains for an equity security (IAS 39) Assume the same facts as in previous FAQ , except that IAS 39 is applied to account for the financial instrument (that is, the entity classifies the security on initial recognition as ‘available-for-sale’). The accounting treatment for each scenario is as follows: Scenario 1 – Gains or losses are taxed in the period in which they arise The taxable loss in the current period remains C500, which gives rise to a current tax credit of C150. There would be no deferred tax, and the entity would have recognised net current tax of C450 in other comprehensive income (OCI) when the instrument is sold. The entity will then reclassify both the cumulative gain and net tax charge to the income statement. Book Equity* profit C C Gain before reclassification 1,500 Reclassification of gain 1,500 (1,500) Result of sale, as reported 1,500 − Current tax – in prior period (600) Current tax – in current period 150 Current tax – reclassified (450) 450 Net gain and related tax 1,050 – * The amounts shown under ‘equity’ are recognised in OCI. On sales, the entity should then transfer the net gain from OCI to the income statement. Scenario 2 – Gains or losses are deferred and taxed in the period in which the investment is sold The taxable gain in the current period remains C1,500, which gives rise to a current tax charge of C450. The current tax charge is recognised in profit or loss on sale, and net deferred tax previously recognised in OCI (in respect of prior years and movements in the current year prior to disposal) is released through OCI at the same time. Book profit Equity* C C Gain before reclassification 1,500 Reclassification of gain 1,500 (1,500) Result of sale, as reported 1,500 − Deferred tax – in prior period (600) Deferred tax – in current period prior to sale 150 Deferred tax – release 450 Current tax – in current period (450) Net gain and related tax 1,050 – * The amounts shown under ‘equity’ are recognised in OCI.

Deferred tax impact of the expected credit losses for a debt instrument categorised as FVOCI (IFRS 9) Question: Under IFRS 9, debt instruments can be categorised as fair value through other comprehensive income (‘FVOCI’) and measured at fair value. Temporary differences might arise on such instruments, because the carrying amount and its tax base might differ. This results in the recognition of a deferred tax asset or liability. Should the deferred tax impact of the expected credit loss adjustment be recognised in profit or loss? Solution: Yes. If expected credit losses are not tax deductible, a temporary difference will arise when the charge is recognised in the income statement. The deferred tax impact of expected credit losses is recognised in profit or loss. Expected credit losses, interest income and foreign exchange gains or losses are recognised in profit or loss for debt instruments classified as FVOCI as if they were measured under the amortised cost method. The difference between the amortised cost and the fair value is recognised in other comprehensive income. IAS 12 requires an entity to recognise a deferred tax impact in profit or loss if temporary differences have arisen from the items recognised in profit or loss. For example, the deferred tax impact is recognised in profit or loss if recognition of the expected credit losses affects the carrying amount for a debt instrument measured at amortised cost. Consequently, in our view, expected credit losses for a debt instrument categorised as FVOCI affect the carrying amount and temporary difference, and so the related deferred tax impact should be recognised in profit or loss. Deferred tax arising from the recognition of other comprehensive income, such as differences between amortised cost and fair value, is recognised in other comprehensive income.

An entity might use a derivative instrument as a hedging instrument in a cash flow hedge of a forecast transaction that subsequently results in the recognition of a non-financial asset or a non-financial liability.

During the hedging period the derivative is carried at fair value. The portion of the gains and losses that is determined to be an effective hedge is recognised in other comprehensive income.

IFRS 9 requires the gain or loss on the derivative to be removed from the cash flow hedge reserve and added to (or deducted from) the asset’s initial cost when the non-financial asset or non-financial liability is recognised.

A temporary difference will arise on the asset’s initial recognition. If an entity decides to exclude the time value of an option contract, the forward element of a forward or the foreign currency basis spread from the designated hedging instrument, a similar temporary difference might arise.

Cash flow hedge of property, plant and equipment An entity plans to purchase an item of property, plant and equipment (PPE) in a foreign currency. It enters into a foreign currency forward contract before the purchase that meets the criteria for hedge accounting in IFRS 9 (or IAS 39) and is assumed to be a fully effective cash flow hedge. The gain or loss on the forward contract is taxed when the forward contract matures (that is, when the asset is purchased) under the tax rules of the jurisdiction where the entity is based. The entity intends to recover the asset entirely through use; the tax authority grants capital allowances over the asset’s useful economic life, based on its equivalent purchase price in the entity’s functional currency on the date of purchase. The entity removes the gain or loss on the derivative out of the cash flow hedge reserve and adds it to (or deducts it from) the asset’s initial cost under IFRS 9 (or the entity applies the approach as its accounting policy under IAS 39) when it initially recognises the PPE. This adjustment to the PPE’s cost means that its carrying amount differs from its tax base; so a temporary difference arises on recognising the PPE. (a) Does the initial recognition exception (IRE) apply to the temporary difference arising from an asset’s cost adjustment for a cash flow hedge? The IRE does not apply and deferred tax should be recognised. Any tax on settling the forward contract is inherently linked to the purchase of the PPE. This is because the forward contract was a designated hedge for this purchase, and the initial temporary difference on the PPE arises as a result of the hedge accounting. The PPE’s purchase cannot be looked at in isolation. The criteria for the IRE in IAS 12 are not met. (b) How are the tax effect of the gain or loss on the forward contract and the temporary difference on PPE accounted for? Since the entity reclassified cumulative fair value change on the derivative directly from equity (or other comprehensive income (OCI), where the entity elects to do so under IAS 39) to PPE under IFRS 9, there is a question on how to present the current tax and deferred tax reversal related to the derivative. There is a similar question on the deferred tax recognition related to PPE. IAS 12 does not address these questions. One approach is to first reclassify the tax charge related to the derivative directly from equity under IFRS 9 (or OCI under IAS 39) into the income statement. The deferred tax is reversed, and the current income tax charge related to the derivative is also recognised in the income statement. This follows the principle of IAS 12. The entity would then recognise the deferred tax related to PPE in the income statement. Alternatively, the entity might just reverse the deferred tax and recognise the current tax charge related to the derivative directly in equity. It would then recognise the deferred tax related to PPE in equity. Either treatment ensures that the current tax and deferred tax are presented and offset against each other in the same statement. The entity should elect an accounting policy and apply it consistently across periods.

Compound financial instruments

Compound financial instruments (such as convertible notes) might contain liability and equity components: the liability component represents a borrowing with an obligation to repay; and the equity component represents an embedded option to convert the liability into the entity’s equity. The issuer is required to present the liability and equity components separately on its balance sheet.

First, the carrying amount of the liability component is determined by measuring the fair value of a similar liability that does not have an associated equity component. Secondly, this amount is deducted from the fair value of the instrument as a whole, and the residual amount is assigned to the equity component.

In some jurisdictions, the tax base of a compound financial instrument will be its face value. The tax base is not split. Where such an instrument is split for accounting purposes, the carrying amount of the liability component will initially be less than the face value of the instrument as a whole and less than the tax base, so a taxable temporary difference arises.

The initial recognition exception does not apply, even though the tax base of the liability is different from its carrying amount on initial recognition. The taxable temporary difference arises from the initial recognition of the equity component separately from the liability component. A deferred tax liability should be recognised on the taxable temporary difference.

The equity component of the compound instrument is recognised in equity, and the deferred tax liability is also charged directly to equity. The discount associated with the liability component of the compound instrument unwinds through profit or loss.

The reduction in the associated deferred tax liability in the balance sheet (resulting from the reversal of the temporary difference) is also recognised through profit or loss.

Deferred tax on convertible loan where the tax base is not split An entity issues a non-interest-bearing convertible loan for proceeds with a fair value of C1,000 (which is also the loan’s face value) on 31 December 20X4; the loan is repayable at par on 1 January 20X8. The entity evaluates the terms of the bond and concludes that it contains both a liability and an equity component. The entity assigns an initial carrying amount of C751 to the liability component and C249 to the equity component. The entity later recognises imputed discount as an interest expense at an annual rate of 10% on the liability component’s carrying amount at the beginning of each year. The tax authorities do not allow the entity to claim any deduction for the imputed discount on the liability component of the convertible loan. The tax rate is 40%. The temporary differences associated with the liability component (and the resulting deferred tax liability and deferred tax expense and income) are as follows: Year 20X4 20X5 20X6 20X7 C C C C Carrying amount of liability component 751 826 909 1,000 Tax base 1,000 1,000 1,000 1,000 Taxable temporary difference 249 174 91 – Opening deferred tax liability at 40% 0 100 70 37 Deferred tax charged to equity 100 – – – Deferred tax expense (income) – (30) (33) (37) Closing deferred tax liability at 40% 100 70 37 – The entity recognises the resulting deferred tax liability at 31 December 20X4, by adjusting the initial carrying amount of the equity component of the convertible liability. So, the amounts recognised at that date are as follows: C Liability component 751 Deferred tax liability 100 Equity component (C249 less C100) 149 1,000 Later changes in the deferred tax liability are recognised in profit or loss as tax income. So the entity’s income statement is as follows: Year 20X4 20X5 20X6 20X7 C C C C Interest expense (imputed discount) – 75 83 91 Deferred tax (income @ 40%) – (30) (33) (37) – 45 50 54

Considerations for assessing expected manner of settlement for compound financial instruments The deferred tax balances need to reflect the tax consequences arising from the manner in which the entity expects to recover or settle the carrying amount of its assets and liabilities. If there are various settlement options with different tax consequences, the entity needs to assess (at each reporting date) the most likely option that the investors or the issuer will take. For example, management might expect that a convertible instrument will be redeemed or converted early (for instance, in the next accounting period), and the deferred tax liability previously provided does not fully reflect the tax consequences that would follow from conversion or redemption; in that case, the deferred tax liability should be adjusted. Any adjustment should be made through equity or through profit or loss, depending on the tax consequences that would follow from early conversion or redemption. For example, if no tax is payable on early conversion, any outstanding deferred tax liability should be de-recognised by crediting equity; this is consistent with the principle that tax follows the item. On conversion, the liability component is transferred directly to equity, and no gain or loss arises. It is also consistent with the treatment that the reversal of the deferred tax liability does not arise from the unwinding of the discount. The deferred tax balance should only be adjusted for the tax effects of the conversion if there is sufficient evidence that it is probable that the instrument’s holders will convert. This is because the option to convert generally lies with the instrument’s holders. If, however, early redemption of the convertible instrument would have further tax consequences, any adjustment to the deferred tax liability previously provided should be made through profit or loss.

Payments made under equity instruments that give rise to income tax reduction

Some financial instruments have some characteristics of a financial liability but nevertheless are equity instruments for accounting purposes.

Examples include a perpetual bond that carries a coupon that the issuer can defer indefinitely, or commitments that are payable in the event that a dividend distribution is made. Such payments are accounted for as charges to equity, and they are often deductible for tax purposes.

The income tax consequences of distributions to holders of an equity instrument are accounted for in accordance with IAS 12. Income tax that relates to items recognised in equity should be recognised in equity.

However, the tax consequences of dividends to shareholders should generally be recognised in profit or loss, because they are linked to past transactions or events (that is, profits earned in prior periods) rather than to distributions to owners.

The nature of tax-deductible payments on equity instruments should be assessed in each situation to determine if the tax impact is included in equity or in profit or loss; this is because various equity instruments have different features, and tax law varies by country.

Investments in subsidiaries, branches, associates and joint ventures

This section deals with the deferred tax implications of investments in subsidiaries, branches, associates and joint ventures in separate financial statements. Where a parent entity or investor acquires such an investment, it is accounted for in the separate financial statements of the parent or investor at cost (which is the amount paid for the shares or the business), using the equity method or at fair value.

A temporary difference might arise between the investment’s carrying amount in the separate financial statements and its tax base (which is often cost or indexed cost). If an investment is carried at cost, any increase in the investment’s value is not recognised.

If an investment is accounted for under the equity method, the investee’s post-acquisition profits are recognised in the separate financial statements of the parent or investor when the equity method is applied, and this gives rise to a temporary difference.

Changes in the fair value of an investment measured at fair value will also give rise to a temporary difference.

Initial recognition exemption and investments in subsidiaries, branches, associates and joint ventures in separate financial statements The tax base of an investment in a subsidiary, branch, associate or joint venture (‘investment’) is usually equal to its cost, which is the amount at which the investment will be initially recognised in an entity’s separate financial statements. However, there might be circumstances in which the tax base of an investment and its cost for accounting purposes differ, and therefore there might be an initial temporary difference. In our view, an entity that applies the cost or fair value alternatives permitted by IAS 27 to measure its investment also applies the initial recognition exception because recognition of the investment is the initial recognition of an asset in a transaction that is not a business combination (in the investor’s separate financial statements), and which does not affect accounting profit or taxable profit at the time of the transaction. We believe that the reference made in IAS 12 to the exception in IAS 12 – which is subject to different conditions – applies to temporary differences in respect of investments in subsidiaries, branches, associates and joint ventures arising after initial recognition. In our view, an entity that applies the equity method alternative permitted by IAS 27 may also apply either of the two acceptable accounting treatments described for consolidated financial statements.

An entity should recognise a deferred tax liability in its separate financial statements for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint ventures, except to the extent that both of the following conditions are satisfied:

• the parent, investor or venturer 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.

An entity should recognise a deferred tax asset in its separate financial statements for all deductible temporary differences arising from investments in subsidiaries, branches and associates, and interests in joint ventures, to the extent that it is probable that:

• the temporary difference will reverse in the foreseeable future; and
• taxable profit will be available against which the temporary difference can be utilised.

The carrying amounts for such investments can be recovered through distributions or disposal, or both. Management needs to determine the deferred tax implications based on the manner in which it expects to recover the investment.

Investments in tax-transparent entities There are a number of entities that do not pay tax but whose profits are taxable in the hands of the investors. Examples of such entities are partnerships, UK limited liability partnerships (LLPs) and US limited liability companies (LLCs). This type of tax structure can give rise to accounting issues in the investor’s separate financial statements. An entity that invests in a tax-transparent entity (‘the investee’) will initially recognise its investment at cost in its separate financial statements. Its initial tax base will not necessarily be its cost, but the sum of the tax bases of the underlying assets and liabilities within the investee. As such, there might be an initial taxable temporary difference. A question arises as to whether this is covered by the initial recognition exception (IRE), or whether deferred tax should be provided on initial recognition. In our view, the IRE applies. Similar logic would apply for the interaction of the exemptions in IAS 12 where there is an initial deductible temporary difference arising on the investment in the tax-transparent entity.

Investment in branches

A reporting entity that operates a branch recognises the branch’s assets and liabilities in its own financial statements. Deferred tax assets and liabilities that arise in relation to those assets or liabilities are also recognised in the reporting entity’s financial statements. There might be tax consequences if the branch distributes profits or is sold. This is similar to the position for subsidiaries in consolidated financial statements.

A temporary difference might arise between the total carrying amount of the reporting entity’s net assets in the branch and the tax base of the reporting entity’s investment in the branch.

A reporting entity does not recognise a deferred tax liability in relation to its investment in the branch if it controls the reversal of that temporary difference and it does not expect it to reverse in the foreseeable future. This treatment is applicable for separate financial statements as well as consolidated financial statements.

Treatment of tax in consolidated financial statements

The treatment of tax in consolidated financial statements involves the same considerations that apply to separate financial statements. Deferred tax should be provided on temporary differences that arise between the carrying amounts of assets and liabilities reported in the consolidated balance sheet and their tax bases. The tax base is determined in one of two ways:

• by reference to a consolidated tax return, in jurisdictions that require such a return; or
• by reference to the tax returns of each individual entity in the group, in other jurisdictions.

Considerations in computing taxes in consolidated financial statements In a group, the tax positions of the individual group members are unlikely to be similar. Some group members might be profitable, but others might make a loss; this will lead to different tax considerations. Some group members might operate in the same tax jurisdiction, but others might operate in different tax jurisdictions. Consolidated financial statements are prepared as if the parent entity and its subsidiaries were a single entity; so it follows that the group’s tax position needs to be viewed as a whole. A group’s total tax liability is determined by adding together the tax liability assessed under local tax laws and borne by individual group members. Under IFRS 10, a group should follow uniform accounting policies in preparing consolidated financial statements. Adjustments might be required at the consolidation level where an overseas subsidiary has not followed group accounting policies (for example, because of local requirements) in preparing its own financial statements. These adjustments could result in additional temporary differences in the consolidated financial statements, for which deferred tax should be recognised. Adjustments are also required to eliminate various intra-group transactions, so that the group can be treated as a single economic entity. Such adjustments affect the carrying amount of assets and liabilities reported in the consolidated balance sheet; so they give rise to additional temporary differences that defer or accelerate tax (from the perspective of treating the group as a single entity). Such tax effects are recognised as part of the group’s deferred tax. The types of events and transactions that normally give rise to deferred tax adjustments at the group level are as follows: Business combinations that are accounted for as acquisitions, such as: Fair value adjustments. Tax-deductible goodwill. Any additional assets and liabilities that are recognised at the date of acquisition. Deferred tax assets and liabilities that were not recognised by the acquiree as a result of the initial recognition exception. Deferred tax assets in respect of unrecognised tax losses or deductible temporary differences of the acquiree. Deferred tax assets in respect of unrecognised tax losses or deductible temporary differences of the acquirer. Reverse acquisitions. Intra-group transactions eliminated on consolidation. Investments in subsidiaries, associates and joint ventures. Foreign currency translation.

Deferred tax effects of intra-group transactions A subsidiary sells goods costing C60,000 to its parent entity for C70,000; and these goods are still held in inventory at the year end. A consolidation adjustment is required in the financial statements to eliminate the unrealised profit of C10,000 from consolidated income statement and from group inventory. The sale of inventory between the two entities is a taxable event that changes the inventory’s tax basis. The difference between the carrying amount of the inventory of C60,000 in the consolidated financial statements and the appropriate tax base of C70,000 (from the parent’s perspective) gives rise to a deductible temporary difference. If the parent and the subsidiary were resident in the same tax jurisdiction and paid income tax at 30%, a deferred tax asset of C3,000 (C10,000 @ 30%) would be recognised in the consolidated financial statements. The resulting credit to income would offset the tax charge on the profit made by the subsidiary. The deferred tax asset would be recovered when the parent sells the inventory to a party outside the group. However, if the parent and subsidiary were resident in different tax jurisdictions and paid income tax at 40% and 30% respectively, a deferred tax asset of C4,000 (C10,000 @ 40%) would be recognised in the consolidated financial statements. The new tax basis of the inventory (C70,000) is deductible on the buyer’s tax return when the cost of the inventory (that is, C60,000, after elimination of intra-entity profit) is recovered. Since tax is expected to be paid at 40% when the inventory is sold by the intermediate buyer, it follows that the resulting deferred tax asset arising on the deductible temporary difference should be measured at that rate. The resulting tax credit of C4,000 would exceed the tax charge of C3,000 in the consolidated financial statements, and the excess of C1,000 (representing the excess tax benefit attributable to the transferred inventory) would reduce the consolidated tax expense (income) of the period, even though the pre-tax effects of the transaction had been eliminated in full.

Business combinations

The identifiable assets and liabilities of an acquired business are recognised in the consolidated financial statements at their fair values at the date of acquisition (with limited exceptions). The fair values of the individual assets and liabilities are often different from the book values in the acquired entity’s own financial statements.

The tax bases of the assets and liabilities are often unchanged following a business combination. Temporary differences arise in the consolidated financial statements if the tax bases of the related assets and liabilities are different from the carrying amount on consolidation.

For example, a taxable temporary difference arises as a result of the acquisition when the carrying amount of a nonmonetary asset (such as a building of the acquired entity) is increased to fair value at the date of acquisition but its tax base remains at cost to the previous owner.

The deferred tax liability arising from this taxable temporary difference is recognised in the consolidated financial statements, to reflect the future tax consequences of recovering the building’s recognised fair value. The resulting deferred tax liability affects goodwill.

Deferred tax effects of fair value adjustments On 1 January 20X5, entity H acquired all of the share capital of entity S for C1,500,000. The book values and the fair values of the identifiable assets and liabilities of entity S at the date of acquisition are set out below, together with their tax bases in entity S’s tax jurisdictions. Any goodwill arising on the acquisition is not deductible for tax purposes. The tax rates in entity H’s and entity S’s tax jurisdictions are 30% and 40% respectively. Net assets acquired Book values Tax base Fair values C’000 C’000 C’000 Land and buildings 600 500 700 Property, plant and equipment 250 200 270 Inventory 100 100 80 Accounts receivable 150 150 150 Cash and cash equivalents 130 130 130 Total assets 1,230 1,080 1,330 Accounts payable (160) (160) (160) Retirement benefit obligations (100) – (100) Net assets before deferred tax liability 970 920 1,070 Deferred tax liability between book and tax basis (50 @ 40%) (20) Net assets at acquisition 950 920 1,070 Calculation of deferred tax arising on acquisition of entity S and goodwill C’000 C’000 Fair values of S’s identifiable assets and liabilities (excluding deferred tax) 1,070 Less: Tax base (920) Temporary difference arising on acquisition 150 Net deferred tax liability arising on acquisition of entity S (C150,000 @ 40%) – replaces book deferred tax 60 Purchase consideration 1,500 Fair values of entity S’s identifiable assets and liabilities (excluding deferred tax) 1,070 Deferred tax (60) 1,010 Goodwill arising on acquisition 490 The tax base of the goodwill is nil, so a taxable temporary difference of C490,000 arises on the goodwill. No deferred tax is recognised on the goodwill. The deferred tax on other temporary differences arising on acquisition is provided at 40% (not 30%), because taxes will be payable or recoverable in entity S’s tax jurisdictions when the temporary differences are reversed.

Assessment of tax base in case of tax-deductible goodwill Goodwill arising in a business combination is sometimes deductible for tax purposes through amortisation over a number of years, rather than against proceeds from sale of the acquired business. The goodwill is carried on the balance sheet without amortisation. Management needs to determine the appropriate tax base of the goodwill that reflects the manner in which it is expected to be recovered. There might not appear to be an expectation of imminent recovery through use if goodwill impairment is not expected in the foreseeable future. It might be expected that the goodwill will be recovered solely through sale. The cost of the goodwill is not deductible against sales proceeds. If this analysis is appropriate, its tax base is nil, and a taxable temporary difference exists between the carrying amount and the tax base. But no deferred tax should be recognised on initial recognition or later. The expected manner of recovery should be considered more closely. When a business is acquired, impairment of the goodwill might not be expected imminently; but it would also be unusual for a sale to be expected imminently. So it might be expected that the asset will be sold a long way in the future; in that case, recovery through use over a long period (that is, before the asset is sold) might be the expected manner of recovery. Management needs to exercise judgement to determine the expected outcome. This might be a key judgement that should be disclosed. Goodwill is not amortised for accounting purposes. Goodwill arising in a business combination is an asset that can be consumed. The goodwill’s carrying amount needs to be tested for impairment annually and whenever there is an indication that it might be impaired. Any impairment loss is recognised immediately in profit or loss. Where an entity expects to recover the goodwill’s carrying amount at least partially through use (that is, not solely through sale), temporary differences might arise using the tax base that is consistent with recovery through use. Taxable temporary differences arising at the time of the business combination would not be recognised. If goodwill is amortised for tax purposes, but no impairment is recognised for accounting purposes, any temporary differences arising between the (amortised) tax base and the carrying amount will have arisen after the goodwill’s initial recognition; so they should be recognised. In some jurisdictions, the goodwill’s cost is deductible (for tax purposes) only against proceeds from sale of the acquired business. Where the acquiring entity expects to recover the goodwill’s carrying amount through use, a temporary difference arises in use. The goodwill’s carrying amount exceeds its tax base of nil. But no deferred tax is provided on a taxable temporary difference arising on initial recognition of goodwill. If, however, a number of years after acquiring the business, the entity changes its intended method of recovering the goodwill from use to sale, the tax base of the goodwill reverts to its original cost on initial recognition. A deferred tax asset might arise if (after initial recognition) the goodwill has been impaired so that its carrying amount is less than its tax base applicable on sale. An acquired entity might have tax-deductible goodwill from its own prior acquisitions. For accounting purposes, the existing goodwill is included in the goodwill arising on the new acquisition. But, in some jurisdictions, the tax base in the original goodwill remains available to the acquired entity, and it will be deductible over the remaining tax life. A question arises as to how the temporary difference (if any) related to the tax-deductible goodwill is determined. We believe that management needs to establish whether some of the goodwill arising in the new acquisition relates to the tax-deductible goodwill from the prior acquisition. If it does, an appropriate proportion of the new goodwill should be allocated to that entity for the purpose of determining the temporary difference. This approach is consistent with the requirement in IAS 36 to allocate goodwill to groups of cash-generating units for impairment testing purposes. The allocation should be made in a manner consistent with the guidance in IAS 36 (that is, allocated to cash-generating units that are expected to benefit from the synergies of the combination). This approach is also consistent with the requirement in IAS 21 to allocate goodwill to the different functional currencies in the acquired entity. The deductible or taxable temporary difference is based on this allocation.

Tax impact of intangible assets acquired in a business combination An acquirer recognises all identifiable intangible assets of the acquiree at the acquisition date as assets separately from goodwill, regardless of whether they were recognised by the acquiree before the business combination. Deferred tax effects should also be recognised if such additional assets are recognised. The initial recognition exception for deferred tax that applies to goodwill is not extended to such intangible assets arising on a business combination. This is because, unlike goodwill, such intangible assets are not residuals. Also, a reason for not recognising deferred tax on goodwill is to avoid having to gross-up both sides of the balance sheet, because goodwill and the related deferred tax are mutually dependent. Such dependency does not exist for other intangible assets. A deferred tax liability should be recognised based on management’s expectation of the asset’s manner of recovery, even if the intangible asset acquired on the business combination has an indefinite useful life (and is not amortised for accounting purposes and is also not deductible for tax purposes). So, in this situation, the goodwill arising on acquisition would be calculated in the same way as indicated above. The only difference is that the deferred tax liability of C52,000 would remain on the balance sheet, but would be released through profit or loss on sale or impairment.

Deferred tax on intangible assets The facts are the same as in previous FAQ. However, an intangible asset that was not previously recognised by the acquiree was identified on acquisition and measured at its fair value of C130,000. The intangible asset will be amortised over its useful life of 10 years, but the amortisation will not be deductible for tax purposes. C’000 C’000 Fair values of entity S’s identifiable assets and liabilities (excluding deferred tax) 1,070 Intangible asset identified on acquisition and recognised separately from goodwill 130 Fair value of entity S’s identifiable assets and liabilities at acquisition 1,200 Less: Tax base (920) Temporary difference arising on acquisition 280 Net deferred tax liability arising on acquisition of entity S (C280,000 @ 40%) 112 Purchase consideration 1,500 Fair values of entity S’s identifiable assets and liabilities (excluding deferred tax) 1,200 Deferred tax (112) 1,088 Goodwill arising on acquisition 412 The goodwill arising on acquisition of C490,000 has been reduced further by the recognition of a previously unrecognised intangible asset of C130,000, net of its deferred tax effect of C52,000. This gives a net reduction of C78,000. In the periods after initial recognition on consolidation, the deferred tax liability of C52,000 will be released to the income statement at a rate of C5,200 each year (in line with the intangible asset’s recovery through amortisation).

Tax uncertainties in a business combination Contingent liabilities are separately recognised in a business combination where fair value can be measured reliably. Contingent liabilities recognised in acquisition accounting are measured subsequently at the higher of the amount recognised in accordance with IAS 37 and the amount initially recognised less any amortisation recognised under IFRS 15. This differs from IAS 37’s requirements, where a provision is recognised only where the outflow of economic resources is probable. The introduction to IFRS 3 suggests that assets and liabilities falling within the scope of IAS 12 are not subject to the measurement requirements of the standard (see para IN9 of IFRS 3). However, the text of the standard specifies only that deferred tax assets and liabilities in a business combination are excluded from the scope of the measurement guidance and should be accounted for under IAS 12. It is silent about the measurement of current tax assets and liabilities and current income tax uncertainties. The Interpretations Committee decided not to address income tax uncertainties in a business combination when it issued IFRIC 23. We believe that there are two acceptable approaches to accounting for current income taxes in a business combination. IFRS 3 refers to IAS 37 only in the context of contingent liabilities, and income taxes are listed in the introduction to IFRS 3 as an exception to the recognition and measurement principles. It is therefore acceptable for an entity to conclude that the measurement guidance in IFRS 3 does not apply to current income taxes, including current income tax uncertainties. Current income taxes might therefore be recognised and measured under IAS 12 and IFRIC 23. Alternatively, it could be argued that IFRS 3 applies to current income taxes and that the exception to the measurement guidance in IFRS 3 applies only to deferred taxes. It is therefore also acceptable for an entity to recognise and measure current income taxes including current income tax uncertainties at fair value under IFRS 3.

Effects of post-acquisition elections Business combinations often involve a considerable amount of business, legal and tax planning. Tax effects can arise from events ranging from tax-specific elections to more complex reorganisations and business integration actions. These events might alter the income taxes expected to be incurred on recovery of acquired temporary differences. Where such events relate to actions contemplated by the acquirer at or prior to the acquisition date, careful analysis is required to determine whether the tax effects should be included as part of acquisition accounting or should be accounted for outside acquisition accounting. The fair value accounting guidance in IFRS 3 is based on market participant assumptions which exclude the effects of buyer-specific decisions and transactions. But IFRS 3 identifies income taxes as an exception to the fair value measurement principles. IFRS 3 does not directly address whether the tax effects of post-acquisition elections or transactions that are part of an acquirer’s tax planning strategies should be included in acquisition accounting. This determination requires consideration of specific facts and the relevant tax laws, to determine whether the tax effects of a particular event should be recognised as part of, or outside, acquisition accounting. The determination might be straightforward where, for example, the seller and buyer agree to make a tax election to treat a share purchase as an asset purchase for tax purposes, thus providing a step-up in the inside tax bases of acquired assets. The buyer is thus able to acquire, through the acquisition transaction negotiations, assets with stepped-up tax bases, and it should account for the tax election effects in acquisition accounting. But there are circumstances where the determination is not straightforward and might require significant judgement and analysis. These judgements and analyses can be complex, and practice in this area is evolving. We believe that the following factors should generally be considered: Whether the election or transaction is available and contemplated as of the acquisition date, or within the measurement period but based on information and facts that existed at the acquisition date. Whether the election or transaction is primarily within the acquirer’s control, with no significant complexities or uncertainties as to whether the transaction will actually be completed. Whether the acquirer is required to make a payment (separate from consideration exchanged for the business) or forgo tax attributes to obtain the tax benefits; in this regard, the mere realisation or settlement of an acquired deferred tax liability is not considered to be a separate payment. Whether other significant costs will be incurred to implement the transaction.

Tax impact of reverse acquisitions In some business combinations, the acquirer (for accounting purposes) is the entity whose equity interests have been acquired, and the legal parent entity is treated as the acquired entity. These combinations are commonly referred to as ‘reverse acquisitions’. For deferred tax accounting, where a temporary difference arises on the initial recognition of an asset or liability in a business combination, the initial recognition exception (IRE) does not apply. Under reverse acquisition accounting, the legal acquired entity is treated (for the purposes of the consolidated financial statements) as the acquirer, and the legal parent is treated as the acquired entity. So it is the legal parent’s assets and liabilities that are fair valued under IFRS 3. In a business combination, the acquired entity’s assets and liabilities do not qualify for the IRE, but the acquirer is unaffected. This is the case, even if the acquirer for accounting purposes is not the legal acquirer. In other words, the entity that is the legal acquired subsidiary (but which, for accounting purposes, is the acquirer) continues to qualify for the IRE, because its net assets are recognised in the consolidated financial statements at existing book values. The entity that is the new legal parent (but which, for accounting purposes, is the acquired entity) does not qualify for the IRE; so deferred tax is recognised in the consolidated financial statements on any temporary differences on its assets and liabilities. A similar situation arises where a new parent entity is added to an existing group; this is achieved by setting up a new shell entity that issues equity shares to the existing shareholders in exchange for shares in the existing group. Such a transaction is accounted for as a ‘reorganisation’. The new entity’s consolidated financial statements are prepared using the book values from the previous holding entity’s consolidated financial statements where a reorganisation has occurred. Any previous use of the IRE by the previous holding entity would be carried forward into the new consolidated financial statements.

Deferred tax in a reverse acquisition Under IFRS 3, a reverse acquisition is accounted for as a business combination in which the entity that issues securities (the legal acquirer) is identified as the acquiree for accounting purposes on the basis of the guidance of that Standard. In such circumstances, the requirements of IFRS 3 to recognise assets and liabilities of the acquiree at fair value are applied to the assets and liabilities of the legal parent. When accounting for a reverse acquisition, deferred tax should be recognised in the consolidated financial statements in the same way as for other business combinations. In some jurisdictions, tax law may permit the legal parent to adjust the tax values of its assets and liabilities and these amounts should be used to determine the tax base of each item for the business combination accounting. If the tax law permits an adjustment to the carrying amount of the legal subsidiary’s tax values, in IFRS 3 terms these changes relate to the acquirer’s assets and liabilities rather than to those of the acquiree (i.e. because the legal subsidiary is the accounting acquirer); consequently, the deferred tax impact of adjustments to the legal subsidiary’s tax values should be recognised outside of the accounting for the business combination (i.e. in profit or loss or other comprehensive income, as appropriate). In the separate financial statements of the legal parent (if prepared), deferred tax should be measured on the basis of the carrying amounts of the assets and liabilities in those financial statements.

Fair value adjustments With limited exceptions, the identifiable assets, liabilities and contingent liabilities of the acquiree are recognised in the consolidated financial statements at their fair values at the acquisition date. This will often result in different carrying amounts from those recognised in the acquiree’s individual financial statements. However, the tax bases of the assets and liabilities may remain unchanged. For example, when the fair value of an asset at the date of acquisition is higher than its carrying amount in the acquiree’s financial statements, and the asset is recognised at the higher amount for consolidation purposes, the tax base of the asset is unlikely to be affected. In these circumstances, a taxable temporary difference arises as a result of the acquisition. The deferred tax liability arising from the taxable temporary difference is recognised in the consolidated financial statements to reflect the future tax consequences of recovering the recognised fair value of the asset.

Additional assets or liabilities recognised on acquisition On acquisition, additional assets and liabilities may be identified that are not recognised in the financial statements of the acquiree. This will commonly be the case, for example, in respect of intangible assets. When such additional assets or liabilities are recognised, the deferred tax implications should also be recognised. The newly recognised assets or liabilities reflect economic benefits and outflows of the acquiree; therefore, any deferred tax should be measured at the acquiree’s tax rate. These additional assets and liabilities recognised, and any related deferred tax, will be included as part of the identifiable net assets acquired. The recognition of goodwill may also have deferred tax implications.

Additional assets or liabilities recognised on acquisition On acquisition, additional assets and liabilities may be identified that are not recognised in the financial statements of the acquiree. This will commonly be the case, for example, in respect of intangible assets. When such additional assets or liabilities are recognised, the deferred tax implications should also be recognised. The newly recognised assets or liabilities reflect economic benefits and outflows of the acquiree; therefore, any deferred tax should be measured at the acquiree’s tax rate. These additional assets and liabilities recognised, and any related deferred tax, will be included as part of the identifiable net assets acquired. The recognition of goodwill may also have deferred tax implications.

Additional deferred tax balances recognised on acquisition In some circumstances, the deferred tax impact of temporary differences may not have been recognised in the acquiree’s financial statements because those differences fell within one of IAS 12’s recognition exceptions. For example, the differences may have arisen on the initial recognition of an asset or a liability and, consequently, may not have been recognised. In these circumstances, the deferred tax impact of such temporary differences should be recognised in the consolidated financial statements even though it is not recognised in the individual financial statements of the acquiree. These additional deferred tax balances are recognised on acquisition because, from the group’s perspective, the initial recognition of the asset or liability results from a business combination and, therefore, under the rules set out, the deferred tax impact should be recognised.

Deferred tax assets not previously recognised by the acquiree In some circumstances, deferred tax assets (e.g. in respect of tax losses) may not have been recognised by the acquiree due to concerns about the recoverability of the assets in the light of anticipated levels of profitability. However, following the acquisition, in some tax jurisdictions, the losses may become available for use by other group entities, and therefore be considered recoverable. Because the asset is now recoverable from a group perspective, the deferred tax asset is recognised at the time of acquisition. Conversely, as a result of the acquisition, some deferred tax assets previously recognised by the acquiree may no longer be available due to restrictions imposed by tax law following a change of ownership. In such cases, the deferred tax asset should not be recognised in the acquiree’s statement of financial position and would, therefore, result in increased goodwill.

Deferred tax arising on a business combination – example Company K acquires 100 per cent of Company L, which holds two properties and sundry other assets. Property A (carrying amount CU100 in Company L’s financial statements) and property B (carrying amount CU150 in Company L’s financial statements) are, for tax and accounting purposes, depreciated over 10 years and will be recovered through use in taxable manufacturing activities. The tax rate is 30 per cent. The following information is relevant at the date of acquisition. Company K pays cash consideration of CU380 for the acquisition. The fair values of properties A and B are measured at CU130 and CU140, respectively. An additional intangible asset is identified for recognition in respect of patents held by Company L; the fair value of the intangible asset is CU50 and its tax base is nil. Company L has other net assets with a carrying amount of CU30; the fair value of the other net assets is also CU30 and the tax base is also CU30. The tax bases of properties A and B are CU50 and CU150, respectively. A temporary difference arose on the acquisition of property A by Company L and, therefore, no deferred tax liability was recognised due to the initial recognition exception. Company L has tax losses available for offset against the future profits of any group entity amounting to CU20. It is probable that future taxable profit will be available within the group to absorb these losses. No deferred tax asset has previously been recognised by Company L in respect of these tax losses. The goodwill arising on the acquisition of Company L is calculated as follows. Carrying amount in Company L’s financial statements Fair value Tax base Temporary difference  Tax rate Deferred tax liability (asset)  Net assets of Company L CU CU CU CU  CU CU  Property A 100 130 50 80 30% 24 Property B 150 140 150 (10) 30% (3) Intangible asset – 50 – 50 30% 15 Other net assets 30 30 30 – – – Tax loss c/f   –   –   –  (20) 30%  (6) Total 280 350 230 100 30 Deferred tax arising on acquisition (30) Identifiable net assets acquired 320 Consideration 380 Goodwill  60

Intangible assets recognised for accounting but not tax purposes Depending on the tax jurisdiction and on how a business combination is structured, the carrying amounts of goodwill and intangible assets recognised under IFRS 3 may be greater than, less than, or equal to their tax bases. For example, due to differences between accounting rules and tax legislation, the amounts recognised in a business combination as separately identifiable intangible assets under IFRS Standards may not be separately recognised for tax reporting purposes, and may instead be included within goodwill. In a business combination, IFRS 3 requires the recognition, separately from goodwill, of identifiable intangible assets. The local tax laws may not permit the recognition of intangible assets for tax purposes in determining the amount of tax deductible goodwill. In such circumstances, when comparing the carrying amounts of the assets acquired to their respective tax bases in order to identify temporary differences, the intangible assets and goodwill should not be aggregated; they should be analysed separately for IAS 12 purposes. This is so even if it would otherwise appear that the tax base for goodwill corresponds to amounts recognised as intangible assets under IFRS Standards.

Intangible assets recognised for accounting but not tax purposes – example Entity A acquires the net assets of Entity B on 15 September 20X9 in a transaction accounted for as a business combination under IFRS 3. As part of the recognition and measurement of identifiable assets and liabilities, intangible assets (customer lists) of CU15 million are identified and recognised; goodwill of CU5 million is also recognised. For local tax reporting purposes, however, no intangible assets are recognised; instead tax deductible goodwill of CU20 million is recognised. When comparing the carrying amounts of the assets acquired to their individual tax bases for the purpose of computing temporary differences at the date of acquisition, it is not appropriate to aggregate the carrying amounts of the customer lists and the goodwill as recognised in the consolidated financial statements to compare with the tax base of the goodwill. While it would appear that the CU15 million of additional tax deductions available for goodwill equates to the tax base of the customer lists recognised, the intangible assets and goodwill should not be aggregated, but analysed separately under IAS 12. The result is a taxable temporary difference of CU15 million on the intangible assets for which a deferred tax liability is recognised. In addition, a deferred tax asset is recognised for the excess tax deductible goodwill (CU20 million) over the recognised goodwill (CU5 million) to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. The deferred tax asset and liability will continue to be analysed separately over their respective lives.

Post-acquisition recognition of acquiree’s deferred tax assets

At the date of acquisition, there may be tax losses in the acquiree available for carry-forward or deductible temporary differences that do not qualify for recognition as deferred tax assets when the business combination is initially accounted for.

These items may subsequently meet the criteria for recognition, and IAS 12 requires that the entity should recognise such acquired deferred tax benefits that it realises after the business combination as follows:

• acquired deferred tax benefits recognised within the ‘measurement period’ (i.e. within one year after the acquisition date) that result from new information about facts and circumstances that existed at the acquisition date reduce the amount of any goodwill related to that acquisition. If the carrying amount of that goodwill is zero, any remaining deferred tax benefits are recognised in profit or loss; and
• all other acquired deferred tax benefits realised are recognised in profit or loss (or outside profit or loss if otherwise required by IAS 12).

Realisation of tax loss carryforward after a business combination – example Company Q, with a December year end, acquires a new subsidiary, Company R, on 31 March 20X1. Company R has tax losses accumulated in previous periods giving rise to a potential deferred tax asset of CU50 million. In the initial accounting for the business combination, Company Q takes the preliminary view that these losses are not available for offset against the profits of other group entities, and does not recognise a deferred tax asset. The goodwill arising on the acquisition amounts to CU20 million. In February 20X2 (i.e. within the ‘measurement period’), upon request from Company Q, the tax authority provides its opinion that Company R’s losses can be offset against certain of the profits of other group entities – the relevant profits amounting to a deferred tax asset of CU30 million at the date of acquisition. This opinion reflects the tax authority’s view on how the existing tax legislation at the date of acquisition should be applied to the circumstances of Company Q and Company R at that date; accordingly, it is judged to be new information about facts and circumstances that existed at the acquisition date. In the circumstances described, had Company Q sought advice from the tax authority at the time of the acquisition, a deferred tax asset of CU30 million could potentially have been recognised in the initial accounting for the business combination. Under IAS 12, because the additional information was obtained during the measurement period and it reflects facts and circumstances at the acquisition date, goodwill should be adjusted for the subsequent recognition of the deferred tax asset. However, the retrospective adjustment of goodwill is limited to the amount of the goodwill; therefore, only CU20 million is adjusted directly against goodwill in the 20X2 financial statements and the balance of CU10 million is recognised in profit or loss. If the other group entities earn profits subsequent to the date of acquisition against which more of Company R’s losses can be utilised, the effect is recognised in profit or loss.

Recognition and measurement in a business combination of the potential liability arising from an uncertain tax treatment – example Entity A acquires Entity B in a business combination. Entity B has an uncertain tax treatment at the acquisition date which could result in a cash outflow of CU100. Entity B estimates that at the date of acquisition the probability that an outflow will result from the uncertain tax treatment is 30 per cent. Neither IAS 12 nor IFRS 3 addresses specifically how, at the date of acquisition of Entity B, Entity A should account for the potential liability arising from Entity B’s uncertain tax treatment for the purposes of its consolidated financial statements. In the absence of definitive guidance, Entity A should select one of the following alternatives: Option 1 – the potential tax liability could be recognised when the economic outflow is probable (an ‘IAS 12 approach’); or Option 2 – the potential tax liability could be recognised at its fair value at the acquisition date (an ‘IFRS 3 approach’). Entity A should select one of these approaches as an accounting policy choice and apply it consistently in all business combinations. The alternatives are discussed in more detail below. Option 1 – IAS 12 approach This option is based on the view that the uncertain tax treatment is outside the scope of the recognition and measurement requirements of IFRS 3 and that the potential tax liability should be accounted for in accordance with IAS 12. This view is supported by IFRS 3 which states that assets and liabilities falling within the scope of IAS 12 should be accounted for at acquisition in accordance with the recognition and measurement requirements of that Standard rather than in accordance with IFRS 3. If Entity A selects this approach, it applies the method described both initially and for subsequent measurement. Consequently, if Entity A selects this option as its accounting policy, it should not recognise a liability in respect of the uncertain tax treatment at the date of acquisition because, at that date, it is not probable (i.e. probability is assessed at less than 50 per cent) that an outflow of economic resources will occur. If, subsequent to the acquisition date, it becomes probable that an outflow of resources will occur, Entity A will recognise the tax liability at its best estimate of that outflow, with the resulting charge recognised in profit or loss. Option 2 – IFRS 3 approach This option is based on the view that the general principles of IFRS 3 should be applied because IFRS 3 does not explicitly exclude current tax assets and liabilities from the scope of its recognition and measurement requirements. Although, as discussed under Option 1, the introduction to IFRS 3 appears to scope out all tax balances, within the body of the Standard there is no reference to excluding current tax balances – only deferred tax balances in accordance with IFRS 3. IFRS 3 requires the recognition of contingent liabilities at fair value if they can be measured reliably. Under Option 2, Entity A recognises and measures the uncertain tax liability in the business combination by analogy to the treatment of contingent liabilities acquired in a business combination. The tax liability is therefore measured at its fair value at the acquisition date, which takes into account the likelihood that the tax will become payable. Thereafter, in line with the treatment of contingent liabilities under IFRS 3, the liability arising from the uncertain tax treatment should be recognised at the higher of (1) the amount initially recognised, and (2) the amount that would be recognised by analogy to IAS 37.

Tax deductible goodwill of the acquiree in a business combination – example Entity A acquires 100 per cent of Entity B for consideration of CU100. At the acquisition date, Entity B has: goodwill from a previous business combination with a tax base of CU40 in a jurisdiction with a tax rate of 20 per cent; and other identifiable assets and liabilities with a total fair value of CU50. Following its acquisition by Entity A, Entity B will be entitled to continue to claim tax deductions on the previously recognised goodwill and expects to have sufficient taxable profits available to utilise those deductions as they arise. The relevant tax rate is 20 per cent. Because goodwill represents the economic benefits arising from intangible assets that are not individually identified and separately recognised in a business combination, it may not be apparent whether the goodwill recognised on the acquisition of Entity B by Entity A arises from the same factors that gave rise to the goodwill previously recognised by Entity B. There may be circumstances when it is clear that there is no link between the previously recognised goodwill and the goodwill arising on the current business combination. There may be less common circumstances when it is clear that the goodwill recognised by Entity A is the ‘same’ goodwill as that previously recognised by Entity B. However, in most cases, it will not be obvious whether there is a link between the goodwill previously recognised by Entity B and the goodwill arising when Entity A acquires Entity B. In such circumstances, if the pre-existing goodwill tax deductions are to be treated as relating to the goodwill arising on the current acquisition, it must be demonstrated that the factors that gave rise to the pre-existing goodwill continue to exist and contribute to goodwill on the current acquisition. Scenarios 1 and 2 below illustrate contrasting circumstances. Scenario 1 – no link identified Entity B is a holding company with two subsidiaries – one an active manufacturing entity and the other a financial services entity in ‘run-off’ (i.e. no longer operating other than to hold existing financial assets to their maturity). The tax deductible goodwill recognised by Entity B arose on the acquisition of the financial services entity. In this scenario, it is evident that any goodwill arising on the acquisition of Entity B by Entity A relates to the manufacturing subsidiary. Because there is no link between the goodwill recognised by Entity A and the tax deductible goodwill previously recognised by Entity B, for the purposes of Entity A’s consolidated financial statements, the tax base of CU40 does not have an associated carrying amount. The goodwill of CU50 recognised by Entity A (i.e. consideration of CU100 less net fair value of identifiable assets and liabilities of CU50) has a tax base of CUnil, giving rise to a taxable temporary difference of CU50. No deferred tax is recognised in respect of this taxable temporary difference because it arises on the initial recognition of goodwill. In addition, the goodwill previously recognised by Entity B has a tax base of CU40 and a carrying amount of CUnil, giving rise to a deductible temporary difference of CU40 which is not subject to the initial recognition exception. Consequently, subject to IAS 12’s general recognition criteria, a deferred tax asset of CU8 (CU40 × 20%) is recognised in respect of Entity B’s original goodwill. At acquisition, therefore, Entity A recognises a deferred tax asset of CU8, Entity B’s other identifiable assets and liabilities at their net fair value of CU50 and goodwill of CU42. After the acquisition date, as tax deductions are claimed by Entity B in respect of the goodwill, the deferred tax asset reduces and the deferred tax expense in profit and loss offsets the current tax deduction claimed. When all available deductions have been claimed (or have expired unclaimed), no deferred tax asset will remain. Scenario 2 – link identified Entity B is a shell entity which acquired another entity in a transaction giving rise to tax deductible goodwill immediately before, and in anticipation of, its own acquisition by Entity A. In this scenario, it is clear that the goodwill recognised by Entity A is substantially the same as the tax deductible goodwill previously recognised by Entity B. Consequently, the tax deductible goodwill previously recognised by Entity B gives rise to a tax base considered to relate to the goodwill recognised by Entity A. The goodwill of CU50 recognised by Entity A therefore has a tax base of CU40, giving rise to a taxable temporary difference of CU10. No deferred tax is recognised in respect of this taxable temporary difference because it arises on the initial recognition of goodwill. At acquisition, therefore, Entity A recognises Entity B’s identifiable assets and liabilities at their net fair value of CU50 and goodwill of CU50. After the acquisition date, as tax deductions are claimed by Entity B in respect of the goodwill, a deferred tax expense will be recognised in profit or loss and a deferred tax liability will be recognised in Entity A’s consolidated financial statements. The deferred tax expense offsets the current tax deductions claimed. When all available deductions have been claimed (or have expired unclaimed), a deferred tax liability of CU8 (i.e. temporary difference of CU40 not covered by the initial recognition exception at 20 per cent) will remain in place until the goodwill recognised by Entity A is either impaired or disposed of.

Elimination of unrealised intragroup profits – deferred tax effects When a group entity sells goods to another group entity, the seller recognises profits made on those sales in its individual financial statements. If those goods are still held in inventories by the purchaser at the end of the reporting period, the profit recognised by the seller, when viewed from the standpoint of the group as a whole, has not yet been earned, and will not be earned until the goods are eventually sold outside the group. On consolidation, the unrealised profit on closing inventories is eliminated from the group’s profit, and the closing inventories of the group are recognised at cost to the group. The tax consequences to the seller (both current and deferred, if any), however, are not eliminated. If tax is charged on the results of individual entities, and not on the group, the seller will pay tax on any profits generated from the intragroup sales, even though some of those profits may be unrealised from the group’s perspective. Such consolidation adjustments may have a deferred tax impact in the consolidated financial statements. The intragroup elimination is made as a consolidation adjustment and not in the financial statements of any individual reporting entity. Therefore, the elimination will result in the creation of a temporary difference as far as the group is concerned between the carrying amount of the inventories in the consolidated financial statements and the tax base (assumed to be the carrying amount in the purchaser’s individual financial statements). The deferred tax effects arising in respect of this temporary difference should be recognised in accordance with the usual principles. The tax rate to be used when recognising the deferred tax balance arising from the elimination of unrealised profits on intragroup transactions is determined by reference to the tax jurisdiction where the temporary difference will reverse. This will generally be the tax rate in the purchaser’s jurisdiction, because the deduction is available at that rate when the unrealised profit is realised from the sale to an unrelated third party. If the tax rate in the purchaser’s jurisdiction differs from that in the seller’s, the deferred tax recognised may not equal the tax currently payable by the seller.

Elimination of intragroup profits in inventories – example Company P sells inventories costing CU200 to its overseas subsidiary, Company S, for CU300. Company P’s tax rate is 40 per cent, Company S’s is 50 per cent. At the end of the reporting period, Company S still holds the inventories. Company P recognises a current tax liability of CU40 (CU100 × 40%) relating to the profit on sale of the inventories but does not recognise any deferred tax balances because there are no future tax consequences from Company P’s point of view. Company S is entitled to a future deduction for the CU300 paid for the inventories and this is therefore the asset’s tax base from Company S’s perspective. Consequently, in Company S’s individual financial statements, the tax base is equal to the carrying amount and no temporary difference arises. Company P prepares consolidated financial statements and, for financial reporting purposes, gains and losses on intragroup transactions are eliminated on consolidation. Therefore, on consolidation, the carrying amount of the inventories is reduced from CU300 to CU200 (to eliminate the unrealised profit). A CU100 deductible temporary difference arises, representing the difference between the carrying amount (CU200) and the tax base (CU300). A deferred tax asset is calculated by multiplying the temporary difference of CU100 by 50 per cent, because the deduction is available to Company S at that rate when the unrealised profit is realised outside the group on sale of the inventories by Company S. Available evidence supports a conclusion that realisation of the deferred tax asset representing the tax benefit of Company S’s deductible temporary differences is probable. The deferred tax asset arising of CU50 is therefore recognised on consolidation. The impact of this intragroup transaction on Company P’s consolidated financial statements is shown by the following journal entries. CU CU Dr Current tax expense (CU100 × 40%) 40 Dr Deferred tax asset (CU100 × 50%) 50 Cr Current tax payable 40 Cr Deferred tax benefit 50 To recognise the impact of the intragroup transaction. In a subsequent period, Company S sells the inventories that it acquired from Company P to an unrelated third party for the same amount that it had previously paid Company P, i.e. CU300. The journal entry to reflect the sales and related tax consequences to be reflected in the consolidated financial statements of Company P is as follows. CU CU Dr Cash 300 Dr Cost of goods sold 200 Dr Income tax expense 50 Cr Sales 300 Cr Inventories 200 Cr Deferred tax asset 50 To recognise the sales and related tax consequences.

Investments in securities – general Investments in securities can often give rise to significant temporary differences. In order to determine the deferred tax implications for various types of investments, it is necessary to understand the tax rules relating to those investments. Particularly, an entity should take care to understand the tax implications that arise from the recovery of the investment through dividends (‘use’), sale, or a combination of the two. It is then necessary to determine how the carrying amount of the investments will be recovered. When an entity has an investment in an equity instrument it may be appropriate to presume that the carrying amount will be recovered through sale. This will be the case if the dividends anticipated from the investment are not expected to represent a realisation of part of the carrying amount of the investment. Sometimes it will be necessary to consider how a financial asset has been classified under IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39). For example, financial assets measured at amortised cost under IFRS 9 are so classified based on the premise that the entity’s business model objective is to hold those assets to collect contractual cash flows. Similarly, financial assets classified as held-to-maturity under IAS 39 are so classified based on the premise that they will not be sold prior to their maturity. When considering any tax implications, the same assumptions should be used.

Adjustments arising from initial recognition exception taken by the acquiree

The deferred tax effects of temporary differences arising on acquisition might not have been recognised by the acquiree because those differences fell within the initial recognition exception.

The deferred tax effects of such temporary differences should be recognised on consolidation, even though they were not recognised by the acquired entity itself. These deferred tax balances are recognised as a result of the business combination and not from the initial recognition of the asset or liability.

Impact of initial recognition exception taken by the acquiree The facts are the same as in previous FAQ, except that entity S purchased a specialised factory in an enterprise zone where such factories are eligible for tax allowances at 150% of their purchase cost. The factory cost C150,000, and that amount was also its fair value at the date of acquisition. The tax base of the property on initial recognition was C225,000, but no deferred tax asset was recognised on the excess tax allowances of C75,000 because of the initial recognition exception (IRE). C’000 C’000 Fair values of entity S’s identifiable assets and liabilities (excluding deferred tax) 1,070 Specialised property 150 Fair value of entity S’s identifiable assets and liabilities at acquisition 1,220 Less: Tax base (C920,000 + C225,000 on specialised property) (1,145) Temporary difference arising on acquisition 75 Net deferred tax liability arising on acquisition of S (C75,000 @ 40%) 30 Purchase consideration 1,500 Fair values of entity S’s identifiable assets and liabilities (excluding deferred tax) 1,220 Deferred tax (30) 1,190 Goodwill arising on acquisition 310 The goodwill arising on acquisition of C490,000 has been reduced by a further C180,000. This reduction relates to the fair value of the specialised property of C150,000, plus a deferred tax asset of C30,000 arising on the excess tax allowances of C75,000 @ 40%; this amount was not recognised by S because of the IRE. In the periods after acquisition, the deferred tax asset will be released through profit or loss as the excess tax benefit is realised through additional tax allowances.

Unrecognised tax losses of acquiree

An acquirer accounts under IAS 12 for the potential tax effects of an acquiree’s temporary differences and carry-forwards that exist at the acquisition date or arise as a result of the acquisition. A deferred tax asset is recognised for the carry-forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and credits can be utilised.

The acquiree might not have recognised a deferred tax asset in respect of its past tax losses, because it was uncertain whether future taxable profits would be available. The acquirer might determine that it is probable that other entities within the group will have sufficient taxable profits in the future to realise the tax benefits through transfer of those losses, as permitted by the tax laws.

A deferred tax asset attributable to the acquired entity’s losses should be recognised in purchase accounting. The acquired entity’s deferred tax assets are recognised in purchase accounting (even if they had not been recognised before the acquisition), provided that they meet IAS 12’s recognition criteria in the context of the enlarged group.

An entity recognises these deferred tax assets (if the potential benefits of the acquiree’s unused tax losses or other deferred tax assets do not satisfy the criteria for separate recognition when a business combination is initially accounted for but are subsequently realised) as follows:

• Acquired deferred tax benefits recognised within the measurement period (resulting from new information about facts and circumstances that existed at the acquisition date) are applied to reduce the carrying amount of any goodwill related to that acquisition. If the carrying amount of that goodwill is zero, any remaining deferred tax benefits are recognised in profit or loss.
• All other acquired deferred tax benefits realised are recognised in profit or loss (or outside profit or loss, if required by IAS 12).

Unrecognised tax losses of the acquirer

An acquirer might consider it probable that it will recover its own unused tax losses against the future taxable profit of an acquiree. A deferred tax asset is recognised through the income statement, and it has no effect on goodwill arising on the business combination.

The losses are not the acquiree’s losses, and they would not have met the criteria for separate recognition as an identifiable asset. The deferred tax asset should be recognised in the separate and consolidated financial statements of the acquirer. There should be a corresponding credit to the tax charge in profit or loss.

Investments in subsidiaries, branches, associates and joint ventures

This section deals with the deferred tax implications in consolidated financial statements of investments in subsidiaries, branches, associates and joint ventures. In the consolidated financial statements of the parent or investor, the investment is recognised by consolidating the subsidiary’s net assets (line-by-line), or by using the equity method for interests in associates or joint ventures.

A temporary difference might arise between the investment’s carrying amount in the consolidated financial statements (the investment’s net assets) and its tax base (which is often cost or indexed cost). This temporary difference is sometimes referred to as ‘outside basis’ difference. It arises in addition to the temporary differences relating to the investee’s underlying assets and liabilities (sometimes referred to as ‘inside basis’ differences). The temporary difference relating to the investment might arise in a number of situations.

The most common situation is where undistributed profits in the investee increase the carrying value of the parent’s investment in the investee to above its tax cost.

Other situations include a reduction in the investment’s carrying amount to below tax cost due to impairment, and changes in the investment’s carrying amount as a result of changes in foreign exchange rates where the investee has a functional currency different from the reporting currency.

The carrying amounts for such investments or interests can be recovered through distributions or disposal. Management needs to determine the deferred tax implications based on the manner in which it expects to recover the investment.

An entity should recognise a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint ventures, except to the extent that both of the following conditions are satisfied:

• the parent, investor or venturer 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.

An entity should recognise a deferred tax asset for all deductible temporary differences arising from investments in subsidiaries, branches and associates, and interests in joint ventures, to the extent that it is probable that:

• the temporary difference will reverse in the foreseeable future; and
• taxable profit will be available against which the temporary difference can be utilised.

A deferred tax asset might arise in the reporting entity’s consolidated financial statements in relation to its investment in a subsidiary, associate or joint venture.

For example, the carrying amount of the investment might have been written down to its recoverable amount as a result of impairment, but the tax base remains unaffected.

A deferred tax asset that arises should be recognised only if the reporting entity expects that the temporary difference will reverse in the foreseeable future, and it also expects that taxable profit will be available against which the temporary difference can be utilised.

For instance, the temporary difference could be reversed if the investment is sold or if a tax deduction is received for an impairment charge that was previously disallowed.

This deferred tax asset is separate from those that might arise in the financial statements of the subsidiary, associate or joint venture.

Investment in subsidiaries

A parent controls a subsidiary’s financial and operating policies (including its dividend policy). The parent can control the timing of the reversal of the temporary differences arising from that investment (including the temporary differences arising from undistributed profits and from any foreign exchange translation differences). Therefore, the parent entity (and thus the economic entity – the group) does not recognise a deferred tax liability that arises from the investment in the subsidiary, in its separate and consolidated financial statements, if it has determined that the subsidiary’s profits and reserves will not be distributed in the foreseeable future and that the subsidiary will not be disposed of. The total amount of taxable temporary difference should be disclosed if no deferred tax is provided. The group continues to recognise (subject to adjustments arising on consolidation) the deferred tax assets and liabilities that are recognised in the subsidiary’s own financial statements and those that arise from purchase accounting adjustments on acquisition of that subsidiary.

Considerations in recognising deferred taxes on investment in subsidiaries The parent’s management needs to be able to provide sufficient evidence that the undistributed earnings will continue to be reinvested for the foreseeable future as part of the parent’s continuing investment in that subsidiary. This evidence might include documentary resolutions by the parent’s management, formal communication to minority shareholders, and specific plans for reinvesting the funds. Such plans should take into consideration some or all of the following factors: (a) the financial requirements of the parent and the subsidiary; (b) long-term and short-term operational and fiscal objectives; (c) remittance restrictions imposed by governments, financing agreements or others; and (d) tax consequences of any remittances. In practice, most parent entities would not recognise a deferred tax liability in respect of a subsidiary’s undistributed profits. Exceptions are where profits will be distributed in the foreseeable future, or the subsidiary will be disposed of. It is often difficult to determine the amount of further taxes that would be payable on remittance, because it will depend on the following factors: the tax laws and rates in the countries where the parent and subsidiary are located; the terms of the tax treaties (if any) between the two countries; and/or the time when the profits were earned and the level of the parent entity’s local taxable profits at the time of remittance. Difficulties might also arise where the reporting entity has complex structures. For example, a reporting entity with many layers of intermediate holding companies might have several alternative routes for recovering an investment, and each route could have different tax consequences. In such cases, management should judge the manner in which the investment is expected to be recovered, and it should calculate any deferred tax on that basis. Example 3 in IAS 12 illustrates the principles described above.

Deferred tax on investment in subsidiary On 1 January 20X5, entity A acquired 100% of the shares of entity B at a cost of C600,000. At the acquisition date, the tax base (in entity A’s tax jurisdiction) of A’s investment in entity B is C600,000. Reductions in the carrying amount of goodwill are not deductible for tax purposes; and the goodwill would also not be deductible if entity B disposed of its underlying business. The tax rate in entity A’s tax jurisdiction is 30%, and in entity B’s tax jurisdiction it is 40%. Goodwill arising on consolidation is calculated as follows: C’000 C’000 Fair values of entity B’s identifiable assets and liabilities (excluding deferred tax) at 1 January 20X5 504 Less: Tax base of assets acquired and liabilities assumed (369) Temporary difference arising on acquisition 135 Deferred tax liability arising on acquisition of entity B (C135,000 @ 40%) 54 Purchase consideration 600 Fair values of entity B’s identifiable assets and liabilities (excluding deferred tax) 504 Deferred tax liability (calculated as above) (54) 450 Goodwill arising on acquisition 150 No deduction is available in entity B’s tax jurisdiction for the cost of the goodwill. So the tax base of the goodwill in entity B’s jurisdiction is nil. But, under IAS 12, entity A does not recognise any deferred tax liability for the taxable temporary difference associated with the goodwill in entity B’s tax jurisdiction. During the year ended 31 December 20X5, entity B made a profit of C150,000 and declared a dividend of C80,000. The dividend was appropriately authorised; and it was recognised as a liability by entity B at 31 December 20X5. The net assets of entity B at 31 December 20X5 are as follows: C’000 Net assets at 1 January 20X5 (incorporating the above fair value adjustments) 450 Retained profits (net profit of C150,000 less dividends payable of C80,000) 70 Net assets at 31 December 20X5 520 Entity A’s separate financial statements Investment in entity B 600 Tax base 600 Temporary difference nil Entity A recognises a liability for any withholding tax or other taxes that it will incur on the accrued dividend receivable of C80,000. Entity A’s consolidated financial statements At 31 December 20X5, the carrying amount of entity A’s underlying investment in entity B (excluding accrued dividend) is as follows: C’000 Net assets of entity B 520 Goodwill 150 Carrying amount 670 Temporary difference associated with entity A’s investment in entity B is: Carrying amount (as above) 670 Tax base 600 Temporary difference = cumulative retained profits since acquisition 70 Deferred tax liability is not recognised, in relation to entity A’s investment in entity B, if entity A has determined that it will not sell the investment in the foreseeable future and that entity B will not distribute its retained profits in the foreseeable future. However, entity A discloses the amount of the temporary difference of C70,000 that is not expected to reverse in the foreseeable future. If, however, entity A expects to sell the investment in entity B (or that entity B will distribute its retained profits in the foreseeable future), it recognises a deferred tax liability to the extent that the temporary difference is expected to reverse. The tax rate should reflect the manner in which entity A expects to recover the carrying amount of its investment (that is, through dividends or by selling or liquidating the investment). If entity B is dissolved and retained profits are remitted, the realisation of its assets and the remittance of the proceeds could result in capital gains taxes and/or withholding taxes in entity B’s tax jurisdictions and capital gains taxes in entity A’s tax jurisdictions.

Dealing with changes in management intentions about a subsidiary’s undistributed profits A parent’s management might decide to recover the carrying amount of its investment in a subsidiary through future distributions. For example, suppose that a parent entity has not previously recognised a deferred tax liability on a subsidiary’s undistributed profits amounting to C1,000,000. The subsidiary currently expects to generate earnings of at least C200,000 a year for the foreseeable future. So the parent’s management decides to realise earnings (through future dividend payments from the subsidiary) of C200,000 a year. The fact that the subsidiary intends to distribute earnings would initially call into question the ‘reinvestment for the foreseeable future’ assertion. But that assertion might still be sustainable if management can establish that the distributions will be no more than future earnings. There is no need to recognise a deferred tax liability relating to the undistributed earnings that have been brought forward if: the parent can provide sufficient corroborating evidence (as discussed in FAQ 14.128.1 ) regarding the need to reinvest, for the foreseeable future, the undistributed profits that have been brought forward; and it is reasonable to expect the subsidiary to generate annual earnings of at least C200,000. However, if management intends to distribute C200,000 a year (regardless of the subsidiary’s earnings), circumstances will have changed regarding the ‘reinvestment for the foreseeable future’ assertion. This means that a deferred tax liability will need to be recognised immediately (at the applicable tax rate), and there should be a corresponding tax charge in profit or loss

Investments in associates

An associate is accounted for using the equity method of accounting in the investor’s consolidated financial statements. The carrying amount of the investment is initially cost, adjusted for the postacquisition change in the investor’s share of the associate’s net assets. If the investment is expected to be recovered through sale, the tax base is often the amount paid for the shares in the associate or joint venture. A temporary difference arises between the investment’s carrying amount and its tax base. An investor has significant influence over the associate; it has the power to participate in the associate’s financial and operating policy decisions, but it does not have control over those policies. The investor cannot control the associate’s dividend payments. An investor recognises a deferred tax liability in relation to taxable temporary differences arising from the associate’s undistributed profits, unless there is an agreement that the associate’s profits will not be distributed in the foreseeable future.

Such an agreement is unlikely to exist in practice, and a deferred tax liability would be recognised in respect of post-acquisition earnings for most associates. It might not be possible to determine the tax that will be payable when the investment is recovered – whether through distribution of the retained profits or through disposal. The entity should recognise the minimum amount of tax that can be determined.

Deferred tax on investment in associate Entity A acquired 40% of the shares of a foreign entity B at a cost of FC1 million on 1 January 20X5 (FC = foreign currency). At the acquisition date, the tax base (in entity A’s jurisdiction) of entity A’s investment in entity B is C500,000. Entity B made a profit of FC240,000 during the year ended 31 December 20X5. The exchange rate at 1 January 20X5 was C1:FC2, and at 31 December 20X5 it was C1:FC1.6. The tax rate in entity A’s jurisdiction is 30%. Entity B’s net assets FC’000 C’000 Book value = fair values of entity B’s identifiable assets and liabilities at 1 Jan 20X5 1,200 Profit for the year 240 Net assets at 31 December 20X5 1,440 Calculation of goodwill on acquisition Purchase consideration 1,000 Share of entity B’s net assets at acquisition (40% of FC1,200,000) (480) Goodwill arising on acquisition 520 Equity carrying amount of investment in entity B at 31 December 20X5 Share of entity B’s net assets at 31 December 20X5 (40% of FC1,440,000 @ 1.6) 360 Goodwill arising on acquisition (FC520,000 @ 1.6) 325 Equity interest at 31 December 20X5 685 Tax base = cost of shares 500 Temporary difference 185 Temporary difference comprises: Share of retained profits (40% of FC240,000 @ 1.6*) 60 Share of exchange difference on opening net assets – 40% of (FC1,200,000 × (1/1.6 – 1/2)) 60 Exchange difference on goodwill – FC520,000 × (1/1.6 – 1/2) 65 185 * Under IAS 21, a weighted average exchange rate is used for translating the share of profit (see chapter 49 para 42). For simplicity in this example, it is assumed that the weighted average exchange rate is the same as the closing rate. Entity A would recognise a deferred tax liability in its consolidated financial statements as follows: C’000 C’000 Dr Cr Dr Deferred tax expense in profit or loss on share of profits @ 30% 18.0 Dr Deferred tax expense in other comprehensive income on opening exchange difference on net assets @ 30% 18.0 Dr Deferred tax expense in other comprehensive income on exchange difference on goodwill @ 30% 19.5 Cr Deferred tax liability @ 30% on C185,000 55.5

Initial recognition exemption and investments in associates and joint ventures in consolidated financial statements The tax base of an investment in an associate or a joint venture (‘investment’) is usually equal to its cost, which is the amount at which the investments will be initially recognised in an entity’s consolidated financial statements (see chapter 31 para 17). However, there might be circumstances in which the tax base of an investment and its cost for accounting purposes differ, and therefore there might be an initial temporary difference. We consider that there are two acceptable accounting treatments. The first approach is based on the acquisition of an investment being a transaction that does not give rise to an initial accounting or taxable profit. So it does not logically follow that a deferred tax charge should be recognised in profit or loss. We consider that the initial recognition exception in IAS 12 applies because the acquisition of an investment is not a business combination. This means there is no need to account for deferred tax on initial recognition. The alternative acceptable view is that any deferred tax arising on acquisition of an investment is recognised. The question then arises of how to account the other side of the entry relating to the deferred tax. We consider that the other side of the entry is taken to the investment’s equity-accounted share of net assets. IAS 28 requires an investment to be initially recognised at cost. Cost is generally considered to be the amount of cash or cash equivalents paid and/or the fair value of other consideration given. It can be argued that the recognition of deferred tax by the investor is part of the consideration for the acquisition, and so it changes its cost. This approach results in an adjustment to the carrying amount of the equity-accounted investment; so the accounting carrying amount is changed. Any consequential effect on the temporary difference would need to be considered. This accounting treatment could result in an iterative process to arrive at the carrying amount of the equity-accounted investment and the deferred tax liability.

Consolidation issues relating to investments in tax: transparent entities A number of entities around the world are not required to pay taxes themselves; instead, their profits are taxable in the hands of the investors. Examples of such entities are partnerships, UK limited liability partnerships (LLPs) and US limited liability companies (LLCs). Apart from giving rise to accounting issues in the investor’s separate financial statements, this tax structure can give rise to accounting issues in the investor’s consolidated financial statements. One accounting issue relates to the presentation of tax in profit or loss where an investment in a tax-transparent entity is accounted for in consolidated financial statements under the equity method. Consider an investor that has a number of subsidiaries and an investment in an associate. The associate is an LLP, which is not itself subject to tax, but its investors are taxed on their share of the profits. When the associate is included in the investor’s consolidated financial statements, a question arises on the tax impact (current and deferred) of the associate’s profits. There are two alternatives: including them within the associate’s equity-accounted profits and net assets; or reporting them within the group’s tax charge and as part of the group’s current and deferred tax liability. Our view is that the current and deferred tax is reported as part of the group’s tax charge, and the corresponding liability is added to the group’s current and deferred tax liability. This view is supported by the example in IAS 1, which has a footnote explaining that the equity-accounted profit of an associate is “… the share of associates’ profit attributable to owners of the associates, ie it is after tax and non-controlling interests in the associates”. We consider that the current and deferred tax should be reported as part of the group’s tax (and not as part of the associate’s equity-accounted profit and net assets), because the tax does not arise in the associate but is levied instead on the investor. Another deferred tax accounting issue arises on acquisition of a tax-transparent associate. If a taxable temporary difference arises, management needs to consider how to account for that temporary difference. We believe that the two acceptable accounting treatments described are also applicable for investments in tax transparent entities.

Investments in joint arrangements

Joint arrangements are classified as joint operations or joint ventures.

The joint operator in a joint operation recognises in its balance sheet the assets that it holds and the liabilities that it has incurred in respect of the joint operation, including its share of assets held jointly and liabilities incurred jointly. The related tax bases would also be included in the joint operator’s tax balance sheet.

Any temporary differences arising between the carrying amounts and the tax bases of the assets and liabilities should be recognised, and deferred taxes should be recognised.

The investor accounts for its investment in a joint venture using the equity method.

Temporary differences would arise between the carrying amount of the investor’s interest (that is, the investor’s capital contributions plus its share of undistributed profit) and the tax base of the investment.

The terms of the contractual arrangement between the venturers on the retention of any profit in the joint venture will determine whether any deferred tax should be provided on the temporary difference.

A deferred tax liability is not recognised if the investor can control the timing of the distribution of its share of the profits and it is probable that the profits will not be distributed in the foreseeable future. The amount of any taxable temporary difference should be disclosed.

Foreign currency translation

Foreign currency assets and liabilities

An entity’s foreign currency monetary assets and liabilities are translated at the end of each reporting period; and the resulting gain or loss is recognised in profit or loss. Such gains or losses might be taxable (or tax deductible) in the period in which they are realised.

The tax base of the asset or liability is not changed as a result of the change in exchange rate.

The difference between the re-translated carrying amount and its tax base (that is, original carrying amount) might give rise to a taxable or deductible temporary difference. The related deferred tax is recognised in profit or loss.

If the exchange differences are recognised outside profit or loss (for example, foreign currency borrowings hedging a net investment in the consolidated financial statements or qualifying as a hedging instrument in a cash flow hedge), the deferred tax is also recognised outside profit or loss.

Foreign currency and deferred tax Entity A sold goods to overseas customers for FC250,000 on 1 November 20X3 (FC = foreign currency). The receivable was still outstanding at 31 December 20X3. Revenue is recognised on an accrual basis, for both accounting and tax purposes. Exchange differences are not assessed for tax purposes in entity A’s country until they are realised. The exchange rates prevailing at the date of sale and at the end of the financial year are as follows: 1 November 20X3 C1:FC1.60 31 December 20X3 C1:FC1.65 Management should calculate the tax base of the receivable balance at 31 December 20X3 as follows: C Carrying amount 151,515 (FC250,000/1.65) Future taxable income −(Tax was assessed when revenue was recognised) Future deductible amount 4,735 (Exchange loss deductible when realised) Tax base 156,250 (FC250,000/1.60) Entity A has a deductible temporary difference of C4,735 (C151,515 − C156,250); management should recognise a deferred tax asset in respect of this temporary difference. Movements in exchange rates change the taxable or deductible temporary differences of foreign currency-denominated assets or liabilities if the exchange gain or loss is not recognised for tax purposes until it is realised.

The entity might hold a non-monetary asset located in a foreign country. The asset’s carrying amount (in the absence of any impairment) is its historical purchase price translated at the exchange rate at the date of purchase.

To the extent that the asset’s realisation (through use or sale) gives rise to tax consequences in the foreign country, the asset’s tax base changes as the exchange rate changes. The carrying amount remains the same. A deferred tax asset (subject to meeting the recognition test) or a deferred tax liability should be recognised on the temporary difference that arises.

Deferred tax impact with respect to foreign subsidiaries, associates and joint ventures Exchange differences arise where the results and financial position of a foreign operation are translated into a presentation currency (for inclusion in the reporting entity’s financial statements) by consolidation, or the equity method. Such exchange differences arise because the income statement items are translated at the average rate, and balance sheet assets and liabilities are translated at the closing rate. Exchange differences also arise where the opening net assets are translated at a different closing rate from the previous closing rate. All such exchange differences are recognised in a separate component of equity in the consolidated financial statements; and they are shown in other comprehensive income. Such exchange differences should not give rise to any temporary differences associated with the foreign operation’s assets and liabilities. This is because the carrying amounts of the assets and liabilities and their respective tax bases will be measured in the foreign entity’s functional currency at the balance sheet date. So any temporary differences arising would have been recognised by the foreign entity as part of its deferred tax balances in its own financial statements. These deferred tax balances (translated at the year-end exchange rate) will simply flow through on consolidation, and no further adjustment is necessary. Although temporary differences do not arise from translation of the financial statements of a foreign operation, they might arise on consolidation. This occurs as a result of the difference between the translated amount of the reporting entity’s net investment in the foreign operation (effectively, the group’s share of net assets) and the tax base of the investment itself in the reporting entity.

Deferred tax impact with respect to foreign branches The foreign branch’s functional currency is the same as that of the reporting entity if the activities of a reporting entity’s foreign branch are carried out as an extension of the reporting entity (rather than being carried out with any significant degree of autonomy). However, changes in exchange rates give rise to temporary differences if the foreign branch’s taxable profit or tax loss (and hence the tax base of its non-monetary assets and liabilities) is determined in the foreign currency. This is because the carrying amounts of the foreign branch’s non-monetary assets and liabilities (which are translated into the reporting entity’s currency at the historical rate) differ from their tax bases (which are translated at exchange rates prevailing at the reporting date). A deferred tax asset (subject to the recognition test) or a deferred liability should be recognised on such temporary differences. The resulting deferred tax is credited or charged to profit or loss. These deferred tax balances relate to the foreign branch, and they are in addition to those that can arise from the reporting entity’s investment in the foreign branch.

Deferred tax and foreign branch An entity operates a foreign branch that has the same functional currency as the entity. At 1 January 20X5, the foreign branch acquires a property for FC540,000 when the exchange rate is C1:FC12 (FC = foreign currency). The asset has an expected useful life of five years and zero residual value. For tax purposes, the asset is written off over three years. The exchange rate at 31 December 20X5 is C1:FC9. The tax rates in the entity’s country and the foreign country are 30% and 25% respectively. At 31 December 20X5, a temporary difference arises in respect of the property as follows: Foreign branch Exchange rate Entity FC C1 = FC C Net book value of property Cost 540,000 12 45,000 Depreciation charge for the year (108,000) (9,000) Net book value 432,000 36,000 Tax base of property Cost 540,000 Tax depreciation claimed (180,000) 360,000 9 40,000 * Temporary difference 72,000 (4,000) Deferred tax @ 25%** 18,000 (1,000) * The tax base is measured at the year-end rate, because this rate gives the best measure of the reporting currency amount that will be deductible in future periods. ** The tax rate is 25% (that is, the rate applicable to the foreign country), because the entity will be taxed on the asset’s recovery in that jurisdiction. A taxable temporary difference arises in the foreign entity, but a deductible temporary difference arises in the reporting entity. This is because (following the change in exchange rate from FC12 to FC9) the foreign currency revenue required to recover the asset’s reporting currency carrying amount is C36,000 @ 9 = FC324,000; but the tax base of the asset remains at FC360,000. This difference of FC36,000 @ 9 = C4,000 gives rise to a deductible temporary difference; a deferred tax asset @ 25% (that is, C1,000) should be recognised in the entity’s financial statements for this temporary difference. If the tax base had not been translated at the year-end rate, it would have been recognised at C30,000 (C45,000 less tax depreciation of C15,000) at the year end. This would have given rise to a temporary difference of C6,000 (C36,000 – C30,000); the entity would have provided deferred tax liability of C1,500 (25% of C6,000) on this temporary difference. But translating the tax base at the year-end rate resulted in a deferred tax asset of C1,000. The difference of C2,500 is attributable to the tax effect of currency translation on the tax base – that is, 25% × (C40,000 – C30,000).

Tax incentives

Governments provide relief from income taxation in many creative ways to encourage specific behaviour. These include:

• Government grants or subsidies that are payable regardless of taxable profits.
• Tax holidays for specified periods of time.
• Tax credits/special deductions.
• Tax credits that are, in substance, reduced rates of income tax on profits arising from some types of investment.
• Investment tax credits.

Tax incentive arrangements require careful consideration to determine the appropriate accounting. Entities must analyse the requirements and terms of each tax credit or incentive to determine whether it falls within the scope of IAS 12 and how it affects the recognition and measurement of deferred tax.

Government grant or subsidy

A credit or incentive that can be realised, regardless of whether an entity has taxable profit or tax payable, is likely to be a government grant and to fall within the scope of IAS 20 and not IAS 12.

The credit or incentive might be recoverable through the tax system to the extent that an entity owes tax, but any excess is received in cash. Grants are accounted for in the same manner whether they are received in cash or as a reduction of a liability to the government.

Tax holidays

The governments or tax authorities of some jurisdictions offer investment incentives by way of temporary reductions in enacted rates (known as ‘tax holidays’). Tax holidays result in tax reductions, regardless of an entity’s level of taxable profit.

A lower tax rate or nil tax rate is normally applied to the taxable profits arising within the tax holiday period. If deferred tax arises on temporary differences that reverse within the tax holiday period, it is measured at the tax rates that are expected to apply during the tax holiday period (that is, the lower tax rate or nil tax rate).

If deferred tax arises on temporary differences that reverse after the tax holiday period, it is measured at the enacted or substantively enacted tax rates that are expected to apply after the tax holiday period.

Tax holidays A jurisdiction grants a tax holiday to specified entities. The tax holiday provides a 0% tax rate for the first two years of the holiday and a tax rate of 20% for the following three years. The normal tax rate is 40%. The tax holiday does not commence until the year in which an entity generates taxable profits (after use of carried-forward losses). The entity does not expect to generate taxable profits (after use of carried-forward losses) for three years. An entity’s forecast taxable profit is as follows: Year 1 Year 2 Year 3 Year 4 C’000 C’000 C’000 C’000 Taxable (losses)/profit in the year (300) 100 200 250 Use of carried-forward losses − (100) (200) − Taxable (losses)/profit after use of carried-forward losses (300) 0 0 250 In this scenario, the tax holiday begins in year 4. (a) At the end of year 1, assuming that the recoverability criteria in IAS 12 are met, should a deferred tax asset in respect of the taxable losses be recognised? The entity is receiving a benefit, because the existence of the unused losses effectively delays the start of the tax holiday period. Without these unused losses (and assuming no taxable profit in year 1), the entity would begin paying taxes in year 4 instead of year 6. So a deferred tax asset of C120,000 (C300,000 × 40%) should be recognised. (b) If the entity does not expect the tax holiday to begin until year 4 (and so it will not pay tax until year 6), should it recognise deferred tax liabilities for any taxable temporary differences on assets or liabilities that will reverse in years 2 to 5? IAS 12 provides the following exceptions to recognising deferred tax liabilities: for the initial recognition of goodwill; for the initial recognition of assets or liabilities that do not affect accounting or taxable profit; and for some specified investment in subsidiaries. IAS 12 does not provide an exception to recognising deferred tax liabilities based on an expectation of future taxable losses. So, deferred tax liabilities should be recognised and measured at the rate that will be in effect when the temporary differences reverse. For the temporary differences reversing before the start of the tax holiday (years 2 and 3), the appropriate rate is the normal tax rate (40%). For the temporary differences reversing during the first two years of the tax holiday (years 4 and 5), the appropriate rate is 0%. The deferred tax on temporary differences reversing in the remaining three years of the tax holiday is measured at 20%.

A temporary difference might arise on the initial acquisition of an asset or liability during the tax holiday period.

For example, an entity might receive an upfront fee during a tax holiday period; and it would recognise a contract liability in accordance with IFRS 15.

The jurisdiction might assess tax on revenue when cash is received; because the tax holiday period provides for a nil tax rate, it might seem that the initial recognition of the contract liability does not impact accounting or taxable profit.

But the initial recognition exception does not apply, because the upfront fee does affect taxable income, even though a nil tax rate is applied as a result of the tax holiday (as opposed to being exempt from tax).

Tax credits / special deductions

Tax credits are additional special deductions received apart from the deductions that normally arise (at standard rates) for expenditure. Tax credits are within the scope of IAS 12, unless they are an ‘investment’ tax credit.

The credit is not recognised until the conditions required to receive the credit are met. Perfunctory conditions do not preclude immediate recognition of tax credits.

Tax credits are recognised in current tax in the year in which they are claimed on the company’s tax return. Tax credits that are unused are recognised as deferred tax assets to the extent that it is probable that future taxable profit will be available against which the unused tax credit can be utilised.

The availability of tax credits does not generally affect the tax rate used to measure deferred tax assets and liabilities. In some cases, tax credits might, in substance, be equivalent to a rate reduction.

Tax credits can also impact the rate at which deferred tax is measured in jurisdictions where different tax rates apply to different levels of taxable income. Deferred tax is measured using average rates expected to apply when the temporary difference is expected to reverse.

If the availability of tax credits or deductions causes forecast taxable income to fall within a lower tax rate band, deferred tax should be measured at that lower rate, because this will be the average rate expected to apply when the temporary difference reverses.

Tax credits might also impact the recoverability of deferred tax assets. It is necessary to consider whether tax credits or special deductions will reduce forecast taxable profits available to utilise the deferred tax asset.

Tax credits that are, in substance, reduced rates of income tax

Some jurisdictions offer tax credits that are, in substance, a reduced rate of income tax on profits arising from specified types of investment. The tax credit might operate in such a way that, in substance, a reduced rate of income tax applies to a specified portion of the entity’s net income.

Facts and circumstances will determine whether the tax credit is, in substance, a reduced rate of income tax. The tax credit is recognised as part of current tax in the year in which the deduction is claimed on the company’s tax return.

However, deferred tax assets and liabilities are measured at the tax rates that are expected to apply in the period when the asset is realised or the liability is settled, based on tax rates (and tax laws) substantially enacted at the balance sheet date.

Accounting for reduced rate of income tax (tax credits) on a specified pool of entity’s income IAS 12 does not contain specific guidance on how deferred tax should be measured where a company can claim tax credits that are equivalent to a reduced rate of income tax on a specified pool of the entity’s net income (often relating to a specific subset of operations or activities). The rate reduction is not an enacted or substantially enacted rate in law but, in substance, the tax credit does achieve an identical result. There are two alternative accounting policy options for the measurement of deferred tax in these circumstances: Deferred tax is measured at the enacted or substantively enacted tax rates (based on legislation). Deferred tax is measured using the average rates expected to apply on realisation or settlement, taking into account the effect of tax credits. Deferred tax is measured at that lower rate for temporary differences that relate to the pool of net income that is taxed at the ‘in substance’ reduced rate. Deferred tax is measured at the normal rate for temporary differences that relate to the pool of net income that is taxed at normal rates. In practice, it is likely that option 2 will be more complex to apply and will require more estimates and judgements to determine which temporary differences will reverse at which rates. IAS 8 requires entities to select accounting policies that are relevant and reliable, and to disclose critical judgements and significant estimates. Management should consider whether option 2 produces a sufficiently reliable accounting result in selecting a policy; and, if so, it should evaluate which of the options provides more relevant information to the users of the financial statements.

If different tax rates apply to different levels of taxable income, deferred tax assets and liabilities are measured using the average tax rates expected to apply when the asset is realised or the liability is settled.

Investment tax credits

The governments or tax authorities of some jurisdictions offer investment incentives by way of tax credits.

These arrangements can be complex in practice, so the characteristics of each arrangement require careful consideration to determine the appropriate accounting. There is no definition in IFRS of investment tax credits, but they are outside the scope of IAS 12 and IAS 20.

The entity should first determine if an arrangement is an investment tax credit. If it is an investment tax credit, the entity should develop an accounting policy and apply it consistently to all similar arrangements.

Three approaches are observed in practice: apply IAS 12 tax credit requirements by analogy; apply government grant accounting by analogy; or use the ‘change of tax base’ approach.

Difference between investment tax credits and other tax credits Management needs to use judgement in assessing the substance of each tax credit scheme. Investment tax credits are generally tax benefits received for investment in specific qualifying assets (other than tax deductions that are available as part of the asset’s tax base in use or on disposal). We believe that this definition should be interpreted narrowly; although, in some circumstances, it might also be applied to credits for investments in qualifying but non-capitalised expenditure, such as research and development. The benefit should not be treated as an investment tax credit where there are substantive additional requirements to be met that are not directly related to the investment. This is because, in substance, the credit is not for investment. Examples of such requirements might include maintaining a certain number of employees or reaching a certain level of export revenues. In evaluating additional requirements, entities should assess whether the conditions are substantive or perfunctory (for example, if the only additional criterion for receiving a tax credit is to maintain at least 200 employees, but the entity needs at least 2,000 employees to operate the qualifying equipment purchased under the scheme, the additional criterion would be perfunctory).

Accounting for investment tax credits There are three possible accounting models to account for investment tax credits, which apply either IAS 12 or IAS 20 by analogy. The most appropriate model to apply will depend on the nature of the credit and the specific circumstances of the entity, including previous policy choices. Tax credit (or flow though) model This treatment is based on the assumption that investment tax credits are often not substantially different from other tax credits. So, it is acceptable to have the same accounting treatment for investment tax credits as previously described for other tax credits. This model would apply equally to tax credits available as a result of qualifying but non-capitalised research and development expenditure. Government grant (or deferral) model This treatment is based on characterising the investment tax credit as being similar to a government grant, and it recognises the tax benefit in pre-tax profit or loss over the related asset’s useful life. The credit results in a reduction to the current tax liability or the recognition of a deferred tax asset (where unused); and, under IAS 20, the benefit (that is, the credit entry) is either: recognised separately from the related asset as deferred income, in which case the deferred income is amortised over the related asset’s life in the income statement as ‘other income’; or recognised as a reduction of the related asset’s carrying amount, in which case the benefit arises through a lower depreciation charge. A new temporary difference between the book and tax base of the asset might arise where a non-taxable grant results in adjustment to the asset’s carrying value but not its tax base. Alternatively, where such a grant is recognised as deferred income, the difference between the deferred income balance and its tax base of nil will also be a temporary difference. Whichever method of presentation is adopted, the resulting deferred tax asset that arises on the initial recognition of the asset or deferred income is not recognised. In the limited circumstances where this approach is adopted for tax credits on qualifying expenditure that does not result in a capitalised asset, the tax credit entry is generally recognised in pre-tax profit or loss when the related expenditure is incurred. An entity should consider potential consequences for subsequent accounting if it considers adopting this accounting model. For instance, where a deferred tax asset resulting from an investment tax credit cannot be recovered because of unexpected tax losses, should the deferred income (or adjustment to the asset’s carrying amount) be reversed? One view separates the future measurement of the deferred tax asset from the deferred income (or carrying amount of the asset). The recovery of the deferred tax asset depends on future profits, and it is not linked to the circumstances that gave rise to the grant. Government grants are not adjusted if the granted assets are impaired. An alternative view is that writing off the deferred tax asset is a repayment of government grant, so the deferred income (or adjustment to the asset’s carrying amount) should be reversed. We consider that either approach is acceptable; and the choice of approach is a matter of accounting policy, to be applied consistently. However, recognising the complexities that might result from this approach, including the impact of any subsequent reversal of any deferred tax asset, many entities might find it preferable to account for such credits as other tax credits, rather than as investment tax credits, unless measurement of the credit is reasonably straightforward, and there is a high expectation of its recovery (for example, where recovery of the tax credit is not dependent on the level of an entity’s future taxable profits). Change of tax base (or IRE) model In some circumstances, it might be acceptable to view the investment tax credit as an increase of the related asset’s tax base where a related asset is recognised on the balance sheet. Deductible temporary difference that arises will qualify for the initial recognition exception (IRE) in IAS 12 if the asset was not acquired in a business combination (and the related asset’s initial recognition does not affect accounting or taxable profit). Therefore, no deferred tax asset is recognised when the tax credit arises, but recognition occurs as a reduction of current tax as the credit is realised.

Uncertainty over income tax treatments

IAS 12 does not specifically address uncertainties in income taxes. An uncertain tax treatment is any tax treatment applied by an entity where there is uncertainty over whether that treatment will be accepted by the tax authority.

IFRIC 23 applies to all aspects of income tax accounting where there is an uncertainty regarding the treatment of an item, including taxable profit or loss, the tax bases of assets and liabilities, tax losses and credits, and tax rates. It does not apply to taxes outside the scope of IAS 12.

An entity reflects uncertainty over income tax treatments in current and deferred tax assets or liabilities, applying the requirements in IAS 12.

How should entities account for interest and penalties on uncertain tax positions? An entity might receive or pay interest or penalties in relation to taxation (for example, where uncertain tax positions are resolved by the tax authorities). Neither IAS 12 nor IFRIC 23 specifically addresses the treatment of interest and penalties associated with uncertain tax positions. The IFRS IC considered whether it should develop guidance and concluded that the benefits of improvements in financial reporting from a project to consider interest and penalties would not outweigh the costs. It therefore decided that it should not develop guidance, and it issued an agenda decision. The IC observed in the agenda decision that entities do not have an accounting policy choice between applying IAS 12 and applying IAS 37 to interest and penalties related to income taxes. If an entity considers that a particular amount payable or receivable for interest and penalties is an income tax, IAS 12 is applied to that amount. If an entity does not apply IAS 12 to an amount payable or receivable for interest and penalties, it applies IAS 37 to that amount. The IC also observed that: an entity discloses its judgement in this respect applying IAS 1 if it has a significant effect on the amounts recognised in the financial statements; and regardless of whether an entity applies IAS 12 or IAS 37 when accounting for interest and penalties related to income taxes, the entity discloses information about those items if it is material, because both IAS 12 and IAS 37 provide disclosure requirements. Entities need to decide whether a particular amount payable or receivable for interest and penalties is an income tax. IC agenda decisions in March 2006 and May 2009 noted that IAS 12 defines income taxes as taxes that are based on taxable profits, and the term ‘taxable profit’ implies a notion of a net rather than a gross amount. Amounts that are not based on taxable profits are not income taxes. For example, an amount payable for interest and penalties might be determined to be an income tax when there is an overall settlement with tax authority and the interest and penalties cannot be identified separately. An amount payable for interest and penalties might be determined to be within the scope of IAS 37 where delaying a tax payment and incurring interest charges and penalties is no different from other financing arrangements and is, in substance, a financing cost, because the amount levied by the taxation authorities is calculated specifically on the delayed tax payments. The views of the relevant securities regulator should be considered as part of the assessment of whether interest and penalties are in the scope of IAS 12 or IAS 37.

Can an entity include liabilities for uncertain tax positions within the scope of IFRIC 23 and IAS 12 in ‘provisions’? IAS 1 requires presentation of liabilities and assets for current tax and deferred tax liabilities and assets, both as defined in IAS 12. The same standard also requires that dissimilar items should not be aggregated. IFRIC 23 requires an entity to reflect uncertainty over income tax treatments in the recognition and measurement of current and deferred tax assets or liabilities, applying the requirements in IAS 12. Current and deferred tax liabilities and assets should be presented separately from provisions. The Interpretations Committee concluded in an agenda decision in 2019 concluded that an entity is required to present liabilities for uncertain tax treatments as current tax liabilities or deferred tax liabilities; and assets for uncertain tax treatments should be presented as current tax assets or deferred tax asset. An entity should not present current and deferred income tax liabilities in the scope of IFRIC 23 and IAS 12, on other lines (for example ‘provisions’ or ‘other liabilities’).

Whether an entity considers uncertain tax treatments separately

Each uncertain tax treatment is considered separately, or together as a group, depending on which approach better predicts the resolution of the uncertainty.

The entity considers how it prepares and supports the tax treatment and the approach that it expects the taxation authority to take during an examination to make this determination.

Is it possible that the ‘unit of account’ in the consolidated financial statements is different to that applied in the individual financial statements? Uncertain tax treatments affect the recognition and measurement of tax in the individual financial statements of the entity with the uncertain tax position. That entity will need to determine whether to consider each uncertainty separately or together with other uncertainties. There will typically be no change in the judgements made in the individual financial statements when the same uncertainty is reflected in the parent’s consolidated financial statements. However, there might be limited circumstances in which the ‘unit of account’ in the consolidated financial statements is different to that applied in the individual financial statements so that a specific uncertainty is considered together with related uncertainties in other entities in the group because that better predicts the resolution of the uncertainty. For example, a tax authority’s decision on one transfer pricing matter might affect or be affected by other transfer pricing matters in the same jurisdiction. There might also be situations in which a parent negotiates and settles tax uncertainties for all subsidiaries in a particular tax jurisdiction collectively. In these situations, uncertain tax treatments might be considered separately in individual financial statements but, for group reporting purposes, similar uncertainties might be grouped together into a single unit of account. The amount recognised on consolidation might not always equal the sum of the amounts recognised in the individual financial statements.

Examination by taxation authorities

An entity should assume that a taxation authority with the right to examine will examine (and have full knowledge of) all relevant information in making those examinations. Therefore, an entity should not consider detection risk in the recognition and measurement of uncertain tax treatments.

Determination of taxable profit (tax loss), tax bases, unused tax losses, unused tax credits and tax rates

IFRIC 23 requires an entity to consider whether it is probable that a taxation authority will accept an uncertain tax treatment. An entity might consider a particular tax treatment and conclude that it is probable that the tax authority will accept the proposed tax treatment in its income tax filing.

If so, the entity determines taxable profit, tax losses, tax bases, unused tax losses/credits and tax rates consistently with the tax treatment proposed in its filing.

An entity might consider a particular tax treatment and conclude that it is not probable that the tax authority will accept the proposed tax treatment in its income tax filing.

If so, the entity should reflect the effect of the uncertainty in determining taxable profit, tax losses, tax bases, unused tax losses/credits and tax rates using one of two methods (the most likely amount or the expected value), depending on which method provides the better prediction of the resolution of the uncertainty.

Measurement is not a policy choice. An entity should make consistent judgements and estimates for both current and deferred tax where an uncertain tax treatment affects both taxable profit used to determine current tax and tax bases used to determine deferred tax.

How should an entity measure its uncertain income tax position when the expected value method is used to reflect the effect of uncertainty for tax treatments The following example accompanies IFRIC 23 and illustrates how an entity might apply the requirements to reflect the effect of uncertainty (see IFRIC 23). Entity A’s income tax filing in a jurisdiction includes deductions related to transfer pricing. The taxation authority may challenge those tax treatments. In the context of applying IAS 12, the uncertain tax treatments affect only the determination of taxable profit for the current period. Entity A notes that the taxation authority’s decision on one transfer pricing matter would affect, or be affected by, the other transfer pricing matters. Applying IFRIC 23, Entity A concludes that considering the tax treatments of all transfer pricing matters in the jurisdiction together better predicts the resolution of the uncertainty. Entity A also concludes it is not probable that the taxation authority will accept the tax treatments. Consequently, Entity A reflects the effect of the uncertainty in determining its taxable profit applying IFRIC 23. Entity A estimates the probabilities of the possible additional amounts that might be added to its taxable profit, as follows: Estimate d additional amount, CU(a) Probability , % Estimate of expected value, CU Outcome 1 – 5% – Outcome 2 200 5% 10 Outcome 3 400 20% 80 Outcome 4 600 20% 120 Outcome 5 800 30% 240 Outcome 6 1,000 20% 200 Sum 100% 650 How should entity A measure its current tax liability? Outcome 5 is the most likely outcome. However, Entity A observes that there is a range of possible outcomes that are neither binary nor concentrated on one value. Consequently, Entity A concludes that the expected value of CU650 better predicts the resolution of the uncertainty. Accordingly, Entity A recognises and measures its current tax liability applying IAS 12 based on taxable profit that includes CU650 to reflect the effect of the uncertainty. The amount of CU650 is in addition to the amount of taxable profit reported in its income tax filing.

How should an entity measure its uncertain income tax position when the most likely amount method is used to reflect the effect of uncertainty when recognising and measuring deferred tax and current tax? The following example accompanies IFRIC 23 and illustrates how an entity reflects the effect of uncertainty on deferred tax and current tax consistently (see IFRIC 23). Entity B acquires for CU100 a separately identifiable intangible asset that has an indefinite life and, therefore, is not amortised applying IAS 38. The tax law specifies that the full cost of the intangible asset is deductible for tax purposes, but the timing of deductibility is uncertain. Applying IFRIC 23, Entity B concludes that considering this tax treatment separately better predicts the resolution of the uncertainty. Entity B deducts CU100 (the cost of the intangible asset) in calculating taxable profit for Year 1 in its income tax filing. At the end of Year 1, Entity B concludes it is not probable that the taxation authority will accept the tax treatment. Consequently, Entity B reflects the effect of the uncertainty in determining its taxable profit and the tax base of the intangible asset applying paragraph 11 of IFRIC 23. Entity B concludes the most likely amount that the taxation authority will accept as a deductible amount for Year 1 is CU10 and that the most likely amount better predicts the resolution of the uncertainty. How should entity B measure its current and deferred tax liability? The tax uncertainty identified by entity B affects both current and deferred tax. In recognising and measuring its deferred tax liability applying IAS 12 at the end of Year 1, Entity B calculates a taxable temporary difference based on the most likely amount of the tax base of CU90 (CU100 – CU10) to reflect the effect of the uncertainty, instead of the tax base calculated based on Entity B’s income tax filing (CU0). Similarly, as required by IFRIC 23, Entity B reflects the effect of the uncertainty in determining taxable profit for Year 1 using judgements and estimates that are consistent with those used to calculate the deferred tax liability. Entity B recognises and measures its current tax liability applying IAS 12 based on taxable profit that includes CU90 (CU100 – CU10). The amount of CU90 is in addition to the amount of taxable profit included in its income tax filing. This is because Entity B deducted CU100 in calculating taxable profit for Year 1, whereas the most likely amount of the deduction is CU10.

Change in facts and circumstances

The judgements and estimates made to recognise and measure the effect of uncertain tax treatments should be reassessed when circumstances change or when there is new information that affects those judgements.

New information might include actions by the tax authority, evidence that the tax authority has taken a particular position in connection with a similar item, or the expiry of the tax authority’s right to examine a particular tax treatment.

The absence of any comment from the tax authority is unlikely to be, in isolation, a change in circumstances or new information that would lead to a change in estimate.