Reporting the financial performance of a range of entities (C3.3)

SBR Exam Deferred Tax Questions:

Scope of Deferred Tax:

1. Property, Plant, and Equipment (PPE)

Depreciation:

Example: Accounting depreciation may be higher than tax depreciation (e.g., straight-line vs. accelerated depreciation methods). This creates a Deferred Tax Liability.
Example: Accounting depreciation may be lower than tax depreciation. This creates a Deferred Tax Asset.

2. Intangible Assets

Amortization: Similar to depreciation, differences in amortization methods between accounting and tax can create deferred tax liabilities or Assets.
Impairment: If an intangible asset is impaired for accounting purposes but not for tax purposes, it creates a Deferred Tax Asset.

3. Inventory

Valuation: Differences in inventory valuation methods (e.g., FIFO vs. LIFO) between accounting and tax can create deferred tax liabilities or Assets.
Write-downs: If the inventory is written down to net realizable value for accounting but not for tax purposes, it creates a Deferred Tax Asset.

4. Investments

Revaluation Gains: If an investment is revalued upward for accounting purposes but the tax base remains unchanged, it creates a Deferred Tax Liability.
Impairment Losses: If an investment is impaired for accounting purposes but not for tax purposes, it creates a Deferred Tax Asset.

5. Provisions

Pension Obligations: If pension expenses are recognized earlier for accounting purposes than for tax purposes, it creates a Deferred Tax Asset.
Warranty Provisions: If warranty expenses are recognized earlier for accounting purposes than for tax purposes, it creates a Deferred Tax Asset.

6. Deferred Revenue

Recognition Timing: If revenue is recognized earlier for accounting purposes than for tax purposes, it creates a Deferred Tax Liability.

7. Goodwill

Impairment: While goodwill is not tax-deductible, its impairment loss can create a Deferred Tax Asset if it is deductible for tax purposes.

8. Revaluation Surplus

Gains: Revaluation gains on assets generally increase the carrying amount but do not affect the tax base, creating a Deferred Tax Liability.

9. Share-Based Payments

Expense Recognition: Differences in the timing of expense recognition for share-based payments between accounting and tax can create deferred tax liabilities or Assets.

10. Tax Losses

Carryforward of Losses: If a company incurs tax losses in one period, these losses can be carried forward to offset future taxable income, creating a Deferred Tax Asset.

Determining Deferred Tax Asset or Liability:

To determine whether a temporary difference will result in a deferred tax asset or liability, you can use the following rule:

Carrying Amount of Asset/Liability - Tax Base of Asset/Liability = Temporary Difference

Positive Temporary Difference: Indicates a deferred tax liability.
Negative Temporary Difference: Indicates a deferred tax asset.

Here are 10 examples to illustrate this:

1. Revaluation of an Asset:

Scenario: A company revalues a building, increasing its carrying amount on the balance sheet. However, the tax base remains unchanged.
Calculation: Carrying Amount (Increased) - Tax Base (Unchanged) = Positive Temporary Difference
Result: Deferred Tax Liability

2. Impairment Loss on an Asset:

Scenario: A company records an impairment loss on an asset, reducing its carrying amount. The tax base remains unchanged.
Calculation: Carrying Amount (Decreased) - Tax Base (Unchanged) = Negative Temporary Difference
Result: Deferred Tax Asset

3. Depreciation Differences:

Scenario: A company uses accelerated depreciation for accounting purposes but straight-line depreciation for tax purposes.
Calculation:

Early Years: Carrying Amount (Lower due to accelerated depreciation) - Tax Base (Higher due to straight-line depreciation) = Negative Temporary Difference (Deferred Tax Asset)
Later Years: Carrying Amount (Higher due to accelerated depreciation) - Tax Base (Lower due to straight-line depreciation) = Positive Temporary Difference (Deferred Tax Liability)

4. Inventory Write-down:

Scenario: A company writes down inventory to its net realizable value. This is recognized for accounting purposes but not for tax purposes until the inventory is sold.
Calculation: Carrying Amount (Decreased) - Tax Base (Unchanged) = Negative Temporary Difference
Result: Deferred Tax Asset

5. Pension Contributions:

Scenario: A company recognizes pension expense for accounting purposes but can only deduct it for tax purposes when the contribution is actually made.
Calculation: Carrying Amount (Liability for future contributions) - Tax Base (Zero until payment) = Negative Temporary Difference
Result: Deferred Tax Asset

6. Deferred Revenue:

Scenario: A company receives payment for goods or services in advance. This is recognized as revenue for tax purposes but not for accounting purposes until the performance obligation is fulfilled.
Calculation: Carrying Amount (Liability for unearned revenue) - Tax Base (Zero until revenue is recognized) = Positive Temporary Difference
Result: Deferred Tax Liability

7. Goodwill:

Scenario: Goodwill arises on the acquisition of a subsidiary. It is recognized for accounting purposes but not for tax purposes.
Calculation: Carrying Amount (Goodwill) - Tax Base (Zero) = Positive Temporary Difference
Result: Deferred Tax Liability (However, IAS 12 specifically excludes recognizing a deferred tax liability for goodwill.)

8. Provision for Lawsuits:

Scenario: A company recognizes a provision for a potential lawsuit. This is recognized for accounting purposes but may not be deductible for tax purposes until the actual payment is made.
Calculation: Carrying Amount (Provision Liability) - Tax Base (Zero until payment) = Positive Temporary Difference
Result: Deferred Tax Liability

9. Long-Term Contracts:

Scenario: A company uses the percentage-of-completion method for accounting purposes but the completed contract method for tax purposes.
Calculation:

Early Years: Carrying Amount (Higher under percentage-of-completion) - Tax Base (Lower under completed contract) = Positive Temporary Difference (Deferred Tax Liability)
Later Years: Carrying Amount (Lower under percentage-of-completion) - Tax Base (Higher under completed contract) = Negative Temporary Difference (Deferred Tax Asset)

10. Share-Based Payments:

Scenario: A company grants share-based payments to employees. The accounting treatment and tax treatment can differ, leading to temporary differences.
Calculation: The specific calculation will depend on the accounting method used (e.g., fair value method, intrinsic value method) and the tax rules applicable to share-based payments.

Deferred Tax in Group Financial Statements:

When dealing with deferred tax in the context of group financial statements, it's crucial to remember that a group of companies, from an accounting perspective, is not a single taxable entity. Instead, each individual company within the group is subject to its own tax obligations. Therefore, deferred tax calculations and recognition must consider the tax positions of each individual company.

Key Points:

Group vs. Individual Entity:
- Group: The consolidated financial statements present the financial performance and position of the entire group as a single economic entity.
- Individual Entities: Each company within the group is a separate legal entity and files its own tax returns.
Carrying Amount vs. Tax Base:
- Carrying Amount: Refers to the value of an asset or liability as it appears on the consolidated financial statements.
- Tax Base: Refers to the value of an asset or liability as it is recognized for tax purposes in the individual company's tax returns.

Examples of Deferred Tax Implications in Group Financial Statements:

Intra-group Transactions:
- Scenario: Parent company (P) sells goods to its subsidiary (S) at a profit.
- Impact:
  - Consolidated Financial Statements: The intra-group profit is eliminated, reducing inventory value in S.
  - Tax Base: S's inventory is still recorded at the higher transfer price for tax purposes.
  - Result: A temporary difference arises, leading to a deferred tax asset in the consolidated financial statements.
Fair Value Adjustments:
- Scenario: When acquiring a subsidiary, assets and liabilities are typically revalued to fair value.
- Impact:
  - Consolidated Financial Statements: Assets may be revalued upwards, increasing their carrying amount.
  - Tax Base: The tax base of the assets may remain unchanged.
  - Result: A temporary difference arises, leading to a deferred tax liability in the consolidated financial statements.
Goodwill:
- Scenario: Goodwill arises on the acquisition of a subsidiary.
- Impact:
  - Consolidated Financial Statements: Goodwill is recognized as an asset.
  - Tax Base: Goodwill is not tax-deductible.
  - Result: A temporary difference arises, leading to a deferred tax liability. However, IAS 12 specifically excludes recognizing a deferred tax liability for goodwill.
Impairment Losses:
- Scenario: A subsidiary suffers an impairment loss on an asset.
- Impact:
  - Consolidated Financial Statements: The asset's carrying amount is reduced.
  - Tax Base: The tax base may remain unchanged if the impairment loss is not tax-deductible immediately.
  - Result: A temporary difference arises, leading to a deferred tax asset in the consolidated financial statements.
Revaluation of Property, Plant, and Equipment (PPE):
- Scenario: A subsidiary revalues its PPE upwards.
- Impact:
  - Consolidated Financial Statements: The PPE's carrying amount increases.
  - Tax Base: The tax base remains unchanged.
  - Result: A temporary difference arises, leading to a deferred tax liability in the consolidated financial statements.

Key Considerations:

Tax Rates: Deferred tax is calculated using the expected future tax rates of the individual companies within the group.
Jurisdictional Differences: Tax laws and regulations can vary significantly across different jurisdictions, impacting the calculation and recognition of deferred tax in group financial statements.

Goodwill and Deferred Tax: A Special Case

Goodwill arises in the context of business combinations (acquisitions). It represents the excess of the purchase price over the fair value of the identifiable net assets acquired.

Goodwill is a consolidation concept: It is not recognized as an asset in the individual financial statements of the acquired or acquiring company.
Theoretically, a deferred tax liability should arise for goodwill:
- Goodwill has a carrying amount in the consolidated financial statements.
- Goodwill is generally not tax-deductible.
- This creates a temporary difference between the carrying amount and the tax base (zero).
- Based on the general rule for deferred tax, a positive temporary difference should lead to a deferred tax liability.

However, IAS 12 specifically excludes the recognition of a deferred tax liability for goodwill.

Here are 5 examples to illustrate this point:

Acquisition of a Subsidiary:
- Company A acquires 100% of Company B for $1,000,000.
- The fair value of B's identifiable net assets is $800,000.
- Goodwill arising on acquisition: $1,000,000 - $800,000 = $200,000
- Theoretically, a deferred tax liability should arise on this $200,000 goodwill.
- However, IAS 12 prohibits the recognition of this deferred tax liability.
Impairment of Goodwill:
- If goodwill is subsequently impaired, the impairment loss is recognized in profit or loss.
- Theoretically, a deferred tax asset might be recognized for the tax deductibility of the impairment loss.
- However, the accounting treatment of goodwill impairment and its tax implications can be complex and may vary depending on specific circumstances.
Disposal of a Subsidiary:
- When a subsidiary is sold, any remaining goodwill is included in the calculation of the gain or loss on disposal.
- Theoretically, the tax implications of the goodwill on disposal should be considered.
- However, the tax treatment of goodwill on disposal can vary depending on the specific circumstances of the sale.
Changes in Tax Rates:
- Changes in tax rates would not directly affect the deferred tax liability for goodwill, as none is recognized.
- However, changes in tax rates can have an indirect impact on the valuation of the acquisition and, consequently, the amount of goodwill recognized.
Accounting for Business Combinations:
- The accounting for business combinations, including the recognition and measurement of goodwill, is a complex area with specific standards and interpretations.
- Understanding these standards is crucial for proper accounting for goodwill and its related deferred tax implications (or lack thereof).

Key Takeaway:

While theoretically, goodwill could give rise to a deferred tax liability, IAS 12 specifically excludes its recognition. This is a unique exception to the general rule for recognizing deferred tax liabilities for taxable temporary differences.

Fair Value Adjustments and Deferred Tax in Business Combinations:

When a company acquires a subsidiary, the subsidiary's assets and liabilities are typically revalued to their fair value at the acquisition date. These fair value adjustments can create temporary differences that give rise to deferred tax liabilities or assets.

Key Points:

Fair Value Adjustments: Differences between the carrying amounts of the subsidiary's assets and liabilities on its books and their fair values at the acquisition date.
Tax Base: The tax base of an asset or liability is its value for tax purposes.
Temporary Differences: Arise when the carrying amount of an asset or liability in the consolidated financial statements differs from its tax base.

Examples:

Revaluation of Property, Plant, and Equipment (PPE):
- Scenario: A subsidiary owns land with a carrying amount of $100,000 on its books. At the acquisition date, the fair value of the land is determined to be $150,000.
- Impact:
  - Consolidated Financial Statements: The land is recorded at $150,000, resulting in a $50,000 increase in its carrying amount.
  - Tax Base: The tax base of the land remains at $100,000.
  - Result: A temporary difference of $50,000 arises, leading to a deferred tax liability in the consolidated financial statements.
Revaluation of Intangible Assets:
- Scenario: A subsidiary owns a patent with a carrying amount of $20,000 on its books. The fair value of the patent at the acquisition date is determined to be $35,000.
- Impact:
  - Consolidated Financial Statements: The patent is recorded at $35,000, resulting in a $15,000 increase in its carrying amount.
  - Tax Base: The tax base of the patent may remain unchanged or may be subject to specific tax rules for intangible assets.
  - Result: Depending on the tax treatment of the patent, a temporary difference may arise, leading to either a deferred tax liability or a deferred tax asset.
Revaluation of Liabilities:
- Scenario: A subsidiary has a provision for a lawsuit with a carrying amount of $50,000 on its books. At the acquisition date, the fair value of the lawsuit liability is determined to be $70,000.
- Impact:
  - Consolidated Financial Statements: The lawsuit liability is recorded at $70,000, resulting in a $20,000 increase in its carrying amount.
  - Tax Base: The tax base of the liability may remain unchanged or may be subject to specific tax rules for provisions.
  - Result: Depending on the tax treatment of the liability, a temporary difference may arise, leading to either a deferred tax liability or a deferred tax asset.
Goodwill:
- Scenario: The acquisition price exceeds the fair value of the subsidiary's net assets.
- Impact:
  - Consolidated Financial Statements: Goodwill is recognized as the excess of the purchase price over the fair value of the net assets acquired.
  - Tax Base: Goodwill is generally not tax-deductible.
  - Result: A temporary difference arises, leading to a deferred tax liability. However, as mentioned earlier, IAS 12 specifically excludes the recognition of a deferred tax liability for goodwill.
Revaluation of Financial Assets:
- Scenario: A subsidiary holds financial assets that are revalued to fair value at the acquisition date.
- Impact:
  - Consolidated Financial Statements: The financial assets are recorded at their fair value.
  - Tax Base: The tax base of the financial assets may differ from their fair value, depending on the specific type of financial asset and applicable tax rules.
  - Result: A temporary difference may arise, leading to either a deferred tax liability or a deferred tax asset.

Key Considerations:

Tax Rates: Deferred tax is calculated using the expected future tax rates of the subsidiary.
Jurisdictional Differences: Tax laws and regulations can vary significantly across different jurisdictions, impacting the calculation and recognition of deferred tax on fair value adjustments.

Provisions for Unrealised Profits (PUPs) and Deferred Tax

Scenario:

Intra-group Transaction: Parent company (P) sells goods to its subsidiary (S) at a profit.
Year-end Inventory: Some of these goods remain unsold in S's inventory at the end of the accounting period.

Consolidation Adjustments:

Elimination of Intra-group Profit:
- The profit included in S's inventory from the intra-group sale is eliminated in the consolidated financial statements.
- This adjustment reduces S's inventory value to the original cost paid by P.
Deferred Tax Asset Recognition:
- Tax Base: S's inventory is recorded at the higher transfer price (including the intra-group profit) for tax purposes.
- Carrying Amount: In the consolidated financial statements, the inventory is recorded at the original cost (excluding the intra-group profit).
- Temporary Difference: This creates a negative temporary difference (carrying amount < tax base).
- Deferred Tax Asset: A deferred tax asset is recognized to reflect the future tax benefit that will arise when the inventory is eventually sold outside the group.

Example 1:

P sells goods to S for $100, having purchased them for $80.
S has $50 of these goods in inventory at year-end.
Unrealised Profit: $20 (profit on the goods still in S's inventory)
Consolidation Adjustment: Reduce S's inventory by $20.
Deferred Tax Asset: If the tax rate is 25%, the deferred tax asset is $5 ($20 profit x 25%).

Example 2:

P sells goods to S for $1,000, having purchased them for $800.
S has $600 of these goods in inventory at year-end.
Unrealised Profit: $200 (profit on the goods still in S's inventory)
Consolidation Adjustment: Reduce S's inventory by $200.
Deferred Tax Asset: If the tax rate is 30%, the deferred tax asset is $60 ($200 profit x 30%).

Key Points:

Matching Principle: Recognizing the deferred tax asset ensures that the tax benefit associated with the intra-group profit is recognized in the same period as the elimination of the profit in the consolidated financial statements.
Timing Difference: The deferred tax asset reflects the timing difference between the recognition of the intra-group profit for tax purposes and its elimination for accounting purposes in the consolidated financial statements.

Deferred Tax Measurement

Tax Rates: Deferred tax is typically measured using current tax rates, as they are generally considered a reasonable approximation of future tax rates. Estimating future tax rates can be highly uncertain and unreliable.
Discounting:
- Deferred tax assets and liabilities are not discounted.
- While it might seem logical to discount them to reflect the time value of money (similar to other long-term liabilities), IAS 12 prohibits this.
- Reason: Determining the precise timing of future tax payments or recoveries is highly complex and subjective. Discounting would introduce significant uncertainty and potential for inconsistency in accounting.

Deferred Tax and the Conceptual Framework

IAS 12 Approach:
- Focuses on a "balance sheet" approach.
- Recognizes deferred tax based on the difference between the carrying amounts and tax bases of assets and liabilities (valuation approach).
- Aligns with the Conceptual Framework's emphasis on recognition.
Matching Principle:
- Overriding accounting issues is ensuring that tax consequences are recognized in the same period as the related item in the financial statements.
- Example: Revaluation surplus - Recognize tax charge (deferred tax liability) in the same period.
Inconsistency with the Framework:
- The Conceptual Framework defines a liability as having a "present obligation."
- Deferred tax liabilities, such as the one arising from a revaluation gain, may not always represent a present obligation (e.g., no immediate obligation to sell the revalued asset).
- This creates an inconsistency between IAS 12 and the Conceptual Framework's definition of a liability.