IAS 12, INCOME TAXES

By Graham Holt

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IAS 12, Income Taxes, deals with taxes on income, both current tax and

deferred tax. Income tax accounting is complex, and preparers and users find

some aspects difficult to understand and apply. These difficulties arise from

exceptions to the principles in the current standard, and from areas where the

accounting does not reflect the economics of the transactions.

The current tax expense for a period is based on the taxable and deductible

amounts that will be shown on the tax return for the current year. Current tax

assets and liabilities for the current and prior periods are measured at the

amount expected to be paid to or recovered from the tax authorities, using the

tax rates and tax laws that have been enacted or substantively enacted by the

date of the financial statements.

A mismatch can occur because International Financial Reporting Standards

(IFRS) recognition criteria for items of income and expense are different from

the treatment of items under tax law. Deferred taxation accounting attempts to

deal with this mismatch. The IAS 12 standard is based on the temporary

differences between the tax base of an asset or liability and its carrying amount

in the financial statements.

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

purposes, based on the expected manner of recovery. IAS 12 focuses on the

future tax consequences of recovering an asset only to the extent of its carrying

amount at the date of the financial statements. Future taxable amounts arising

from recovery of the asset will be capped at the asset's carrying amount.

For example, a property may be revalued upwards but not sold, creating a

temporary difference because the carrying amount of the asset in the financial

statements is greater than the tax base of the asset. The tax consequence is a

deferred tax liability.

Deferred tax is provided in full for all temporary differences arising between the

tax bases of assets and liabilities and their carrying amounts in the financial

statements. There are exceptions where the temporary difference arises from:

• Initial recognition of goodwill.

• Initial recognition of an asset or liability in a transaction that is not a business

combination and that affects neither accounting profit nor taxable profit.

• Investments in subsidiaries, branches, associates and joint ventures where

certain criteria apply.

Deferred tax assets and liabilities are measured at the tax rates that are

expected to apply to the period when the asset is realised or the liability is

settled and discounting of deferred tax assets and liabilities is not permitted.

The measurement of deferred tax liabilities and deferred tax assets reflects the

tax consequences of the manner in which the entity expects to recover or settle

the carrying amount of its assets and liabilities. The expected manner of

recovery for land with an unlimited life is always through sale, but for other

assets the manner in which management expects to recover the asset, either

through use or sale or both, should be considered at each date of the financial

statements.

A deferred tax asset is recognised to the extent that it is probable that taxable

profit will be available against which the deductible temporary difference can be

used. This also applies to deferred tax assets for unused tax losses carried

forward. Current and deferred tax is recognised in profit or loss for the period,

unless the tax arises from a business combination or a transaction or event that

is recognised outside profit or loss, either in other comprehensive income or

directly in equity in the same or different period.

For example, a change in tax rates or tax laws, a reassessment of the

recoverability of deferred tax assets or a change in the expected manner of

recovery of an asset have tax consequences that are recognised in profit or loss,

except to the extent that they relate to items previously charged or credited

outside profit or loss.

That, at least, is the current position on current and deferred taxation under

IFRS. The proposed amendments to IAS 12 issued in March 2009 would have

made significant changes. However, after considering the unenthusiastic

feedback, the International Accounting Standards Board (IASB) has decided not

to proceed with its proposals but to focus on practical issues with the existing

standard. The IASB and the Financial Accounting Standards Board (FASB) will

consider fundamentally reviewing the accounting for income taxes some time in

the future. In the meantime, the IASB is undertaking a limited-scope project to

see which issues can be addressed in the shorter term.

The project aims to resolve problems without changing the fundamental

approach under IAS 12, and without increasing differences with US GAAP. The

project will cover the following:

• deferred tax arising from property remeasurement at fair value;

• uncertain tax positions;

• introduction of a step to consider whether the recovery of an asset or

settlement of a liability will affect taxable profit;

• recognition of a deferred tax asset in full and an offsetting valuation allowance

to the extent necessary;

• guidance on assessing the need for a valuation allowance;

• guidance on substantive enactment of tax laws; and

• allocation of current and deferred taxes within a group that files a consolidated

tax return.

In September 2010, an IASB exposure draft proposed an exception to the

existing principle for measuring deferred tax assets or liabilities arising on

certain non-financial assets measured at fair value. The exception applies to:

• investment property measured using the fair value model in IAS 40;

• property, plant and equipment or intangible assets measured using the

revaluation model in IAS 16 or IAS 38; and

• investment property, property, plant and equipment or intangible assets

initially measured at fair value in a business combination if the fair value

or revaluation model was used when the underlying asset was

subsequently measured.

Deferred tax assets and liabilities are currently measured on the basis of:

• the expected manner of recovery (asset) or settlement (liability); and

• the tax rate expected to apply when the underlying asset (liability) is

recovered (settled).

The expected manner of recovery or settlement may affect the calculation of the

tax base or the applicable tax rate or both. In such cases management's

intentions are key in determining the amount of deferred tax to recognise.

The issue is that it can be difficult and subjective to determine the expected

manner of recovery. The IASB's proposed exception to this measurement

principle applies to investment property, property, plant and equipment, and

intangible assets measured using the fair value or revaluation model in

accordance with relevant IFRSs. Under this exception, the measurement of

deferred tax assets and liabilities reflects a rebuttable presumption that the

carrying amount of the underlying asset will be recovered entirely through sale.

The presumption could be rebutted only when there is clear evidence that the

underlying asset's economic benefits will be consumed by the entity throughout

the asset's economic life.The IASB has proposed this exception to the

measurement principle that disregards management's intention unless there is

clear evidence to support consumption through use. It will affect entities holding

investment property, property, plant and equipment or intangible assets

measured at fair value where the capital gains tax rate is different from the

income tax rate, and/or the tax base from sale is different from tax base from

use. The deferred tax liability will be reduced significantly where there is no

capital gains tax. Judgment will be required to determine whether clear evidence

exists. SIC 21, Income Taxes - Recovery of Revalued Non-Depreciable Assets,

will be withdrawn by the amendment.

Assets measured at cost, or other assets measured at fair value such as financial

instruments, are not in the scope of the IASB's exposure draft. However, it is

unclear why the same principles do not apply to these assets. The result is that

there will be a different approach to deferred tax accounting by entities with

identical assets and tax rates but different accounting policies.

The IASB's exposure draft requires full retrospective application, with early

adoption permitted. Complexities might therefore arise if the underlying assets

were acquired in a business combination.

Example

An entity has investment property overseas that is currently out on rental. The

entity has decided that it may sell the property. The property is measured at fair

value under IAS 40. In the overseas country, there are different tax rates

depending on whether an entity recovers an asset through use (30%) or sale

(20%). The entity anticipates that it will recover 40% of the property's economic

benefits through use. The fair value/carrying amount of the property is $5m,

$2.5m of which is the land value. The tax base is $3m, which is split equally

over land and buildings.

Temporary

difference Tax rate

Deferred

tax

liability

Land $1m 20% $200,000

Building - recover

through use $400,000 30% $120,000

Building - recover

through sale $600,000 20% $120,000

Total $2m $440,000

Solution

Given that the entity has a dual intention of use and sale with respect to the

recovery of the asset, the deferred tax calculation could reflect that dual

intention. Part of the buildings may be recovered through usage, in which case

the deferred tax liability for that part would be calculated using a 30% tax rate.

Note that the expected manner of recovery for land with an unlimited life is

always through sale.

However, the exposure draft proposals have a rebuttable presumption that the

carrying amount of the property will be recovered through sale, so the deferred

tax liability would be calculated in total as $(5-3)m @ 20%, i.e. $400,000. The

entity could use the tax rate applicable for recovery through use of 30% only to

the extent it had clear evidence that it would recover the carrying amount of the

investment property through usage.

It is clear that the exposure draft proposals could result in a significant change

in the deferred tax calculation. A series of piecemeal changes to IAS 12 could

have a significant impact on deferred taxation balances.

Graham Holt is an examiner for ACCA and executive head of the

accounting and finance division at Manchester Metropolitan University

Business School