IAS 12 Income Taxes (detailed review)

Objective

This standard deals with the accounting treatment for income taxes. It provides the guidelines to account for the main issues related to income taxes such as the accounting for the current and future tax effects of:

• The  recovery and settlement of the carrying value of assets and liabilities which are reflected in the financial statements of the entity and
• The transactions and events which are recognized in the financial statements of the entity during the current period.

The standard also provides guidelines to account for any unused tax losses or tax credits which are available to the entity including the requirements for presentation of income taxes and related disclosures in the financial statements.

Scope

The requirements of this standard are applicable to account for the income taxes which are chargeable upon taxable profit of the entity such income taxes may relate to local or any foreign tax jurisdiction.

Definitions

Accounting Profit or Loss

The profit or loss which is reported by the entity for a period using accounting rules before the deduction of tax expense are termed as accounting profits.

Taxable Profit or Loss

The profit or loss for a period which is determined as per the rules of tax authorities is termed as taxable profit or loss. It is the profit or loss upon which income tax is payable or recoverable.

Tax expense or income

It is the aggregate of current tax and deferred tax which is used for the determination of profit or loss for the period.

Current tax

It is the amount of income taxes payable or recoverable, related to the taxable profit or loss for the current accounting period.

Deferred Tax Liability

It is the amount of income tax payable in future related to the taxable temporary differences which arise in the current period.

Deferred Tax Asset

It is the amount of income tax recoverable in future related to:

• The deductible temporary differences,
• The unused tax losses and unused tax credits

Temporary Difference

The difference between the carrying value of the asset or liability and the related tax base which is determined as per the rules of tax laws is termed as temporary difference. It can be taxable temporary difference or deductible temporary difference.

Taxable Temporary Differences

These are the temporary differences which make the future tax payments larger by being taxable in the later accounting periods upon the recovery or settlement of the carrying value of related asset or liability.

Deductible Temporary Differences

These are the temporary differences which make the future tax payments smaller by being tax deductible in the later accounting periods upon the recovery or settlement of the carrying value of related asset or liability.

Tax Base

The value of an asset or liability which is determined as per the rules of tax authorities is termed as tax base.

Tax Base of Asset

The entity will determine the tax base of an asset as:

• If future economic benefits of the asset are taxable, its tax base will be determined as ‘the amount which will be allowable as expense for the tax purposes’ against the taxable economic benefits related to such asset that an entity would obtain upon the recovery of the carrying value of that asset.

• If future economic benefits are non-taxable, its tax base will be equal to its carrying value.

 

Examples

a) A plant has a cost of $1,000. The entity has already been allowed a tax depreciation of $300 in determination of taxable profits in the current and previous years. The remaining cost will be available as a tax deductible in future years either in the form of depreciation or as a deduction on disposal. The economic benefits generated by the plant and any disposal gain are taxable.

The tax base of this plantis $700 as the amount which will be allowable as tax expense in future related to this plant is $700.

b) The entity has an Interest receivable with a carrying value of $500. The related interest income will be taxed when it is received in cash.

The interest receivable will have a tax base of nil as the amount which will be allowable as tax expense in future related to this interest receivable is nil.

c) The entity has a trade receivable with a carrying value of $10,000. The revenue related to the receivables has already been included in determination of taxable profit of the current period.

The tax base of the trade receivables is $10,000 i.e. equal to its carrying value as the future economic benefits of the asset are non-taxable

d) The entity has a dividends receivable from its subsidiary with a carrying value of $50,000. However, dividends are non-taxable in the entity’s jurisdiction.

The tax base of the dividends receivable is $50,000 i.e. equal to its carrying value as the future economic benefits of the asset are non-taxable

Tax Base of Liability

The entity will determine the tax base of a liability as follows:

a) The liabilities for which tax deduction is allowable upon payment, its tax base is determined as ‘its carrying value, less the tax deduction (if any) that will be available upon payment for the tax purposes in future’.

b) The liabilities for which no tax deduction is allowable upon payment, the tax base will be equal to its carrying value.

c) For income in advance which is taxed on cash or receipt basis, its tax base will be determined as ‘its carrying value, less any amount of income not taxable in future’.

d) For income in advance which is taxed on accrual basis, the tax base will be equal to its carrying value

Examples

a) An accrued interest expense has a carrying value of $5,000. The related interest expense will be deductible for tax purposes when it is paid in cash.

This is a liability for which tax deduction will be available upon payment, therefore the tax base of this accrued interest expenses is nil which is determined as the carrying value of $5,000 less deduction available upon payment of $5,000.

b) An accrued expense has a carrying value of $10,000 included in the current liabilities. The related expense has already been deducted in determination of taxable profit of the current period.

This is a liability for which no tax deduction will be available upon payment therefore the tax base of the accrued expense is $10,000 i.e. equal to its carrying value.

c) The entity has accrued fines and penalties with a carrying value of $3,000 included in its current liabilities. The fines and penalties are not allowed as expense for the tax purposes.

This is a liability for which no tax deduction will be available upon payment therefore the tax base of the accrued expense is $10,000 i.e. equal to its carrying value

d) The entity has an income in advance having carrying value of $40,000 included in its current liabilities. The related revenue was taxed when it was received in cash.

The income in advance is taxed on cash basis therefore its tax base is nil determined as the carrying value of $40,000 less amount not taxable in future $40,000.

Note:

In some circumstances, certain items have a tax base but these are not recognized in the form of asset or liability such as, research expense is recognized as expense in the statement of profit or loss in the period in which it is incurred but it may not be allowable for the tax purposes until a future period. Therefore, the research expense will have a carrying value of nil while its tax base will be the amount the tax authorities will allow as a deduction in future periods.

Tax Base in Consolidated Financial Statement

The entity will determine the temporary differences in consolidated financial statements by identifying the carrying values of assets and liabilities from the consolidated financial statements and then comparing such carrying values with the relevant tax bases.

For the tax base in consolidated financial statements, if the entity’s tax jurisdiction allows the filing of a consolidated tax return then the tax base will be determined in accordance with the consolidated tax return in such jurisdictions. However, In case of other jurisdictions, the tax base will be determined in accordance the individual tax returns of each entity in the group.

Recognition of Current Tax Liability or Asset

The tax which is calculated upon the taxable profits of the current period is termed as current tax. It will be recognized as a liability in the statement of financial position to the extent it is unpaid at the end of reporting period

• If the amount paid in advance related to current tax is more than the estimated tax liability for the year, any excess will be recognized as current tax asset.

• If there is a tax loss in the current accounting period and the entity is allowed to carry back that tax loss against the profits of the previous period, the entity will recognize the resultant relief as a current tax asset in the period in which the related tax loss occurs.

Recognition of Defer Tax

The recognition of the asset and a liability reflects that the entity will recover or settle the underlying carrying value of such asset or liability in future in the form of inflows or outflows of economic benefits. If it is highly likely that recovery or settlement of such carrying value will result in future tax payments higher or lower than the amounts, if such recovery or settlement are non-taxable, in such a situation IAS 12 requires the  entity to recognize a deferred tax liability or defer tax asset except in the limited circumstances.

Recognition of Deferred Tax Liability

The entity is required to recognize the deferred tax liability for all the taxable temporary differences except for the following taxable temporary differences relating to:

a) The goodwill arising in a business combination on its initial recognition and

b) An asset or liability on its initial recognition if:

i) It neither effects accounting profit nor the taxable profits at the time of transaction and 

ii) The transaction is not a business combination

Normally temporary differences arise when income or expense is recorded in the accounting profit of current accounting period but is considered in determination of taxable profit in a future accounting period. Below are some examples of taxable temporary differences and which result in deferred tax liability:

a) The accrued interest income is accounted for in accounting profit on accrual basis but in some tax jurisdictions such accrued interest income is included in the taxable profit when related cash is received. Therefore the difference between carrying value of receivable in the statement of financial position and its tax base of nil will be a taxable temporary difference.

b) Under accounting rules, the entity capitalize a development expenditure and then it is amortized over the related accounting periods in calculation of accounting profits but such expenditure may be allowed as whole for the tax purposes in the period in which it is incurred. Therefore, the difference between carrying value of Development expenditure in the statement of financial position and its tax base of nil will be a taxable temporary difference.

c) The entity may choose to revalue its non-current assets and related revaluation surplus is incorporated in carrying values of such non-current asset which will result in increase in carrying values while no equivalent adjustment is made to the related tax base. Hene, the difference between carrying value of non-current asset including revaluation surplus in the statement of financial position and its lower tax base will be a taxable temporary difference.

The entity will recognize a deferred tax liability for all the taxable temporary differences. However, the entity will not recognize any deferred tax liability related to the following taxable temporary differences:

1. Deferred tax Liability relating to Goodwill

Goodwill is determined as the excess of cost of investment determined as per the requirements of IFRS 3 including the fair value of non controlling interest over the fair value of net assets acquired in a business combination and is recognized in the consolidated financial statements
 

• However, the decrease in carrying value of goodwill is normally not permitted as a deductible expense for the tax purposes in many tax jurisdictions, and the cost of goodwill is also not allowed as a tax deductible expense in such jurisdictions even a subsidiary is to dispose of it’s all the business operations. Therefore, goodwill has a tax base of nil in those jurisdictions as no expense is allowable by tax authorities against the carrying value of goodwill.

• The difference between the carrying value of goodwill in the consolidated financial statements and its tax base of nil in accordance with the rules established by tax authorities will be taxable temporary difference. However, IAS 12 does not allow to record any related deferred tax liability as the recognition of the deferred tax liability relating to the taxable temporary difference on goodwill would result in increase in carrying value of goodwill.

The entity is also required not to recognize any deferred tax liability due to the decrease in carrying value of goodwill subsequently because it is regarded as the part of initial recognition difference.

• The entity is required to recognize any deferred tax liability relating to the taxable temporary difference on goodwill if it is not the part of initial recognition difference.

For example, if goodwill acquired in a business combination has a carrying value of $500 and in the entity’s tax jurisdiction goodwill is deductible for tax purposes at a rate of 10 % each year from the year of acquisition.

On initial recognition, the goodwill has a carrying value of $500 and its tax base will also be $500 as carrying value is deductible for the tax purposes. Hence, there is no temporary difference on initial recognition.

However, if the carrying value of goodwill at reporting date remains at $500 while its  tax base will be decreased by 10% and it will be $450[$500 – ($500 × 10%)], this will give rise to a taxable temporary difference of $50 at reporting date. The entity will recognize the resulting deferred tax liability as that taxable temporary difference at reporting date is not the part of initial recognition difference on the goodwill.

2. Deferred Tax liability on Initial recognition of Asset or Liability

 
In certain circumstances, there is a taxable temporary difference on initial recognition of an asset or liability in the financial statements. This is the case if all or part of the cost of an asset is not allowed as a tax deduction in determination of taxable profits. The accounting treatment for those taxable temporary differences depends on the type of the transaction as follows:

a) if the asset or liability arises from a transaction other than a business combination and it neither affects accounting profit nor the taxable profit, in such a situation the entity will not recognize any related deferred tax liability either on initial recognition or subsequently because it will require the adjustment to the carrying value of that asset or liability with an equal amount which would result in financial statements being less transparent.

Example

An entity has purchased a plant with a cost of $5,000 and it will be depreciated over 10 years under accounting rules. However, there is no tax deduction available for the tax purposes for such type of plants. Tax rate is 30%.

On initial recognition, the plant has a carrying value of $5,000 while its tax base is nil, as there is no tax deduction available, it will give rise to a taxable temporary difference of $5,000 on initial recognition but entity will not recognize any deferred tax liability as it neither affects accounting profit nor the taxable profit and transaction is not a business combination.

In the subsequent year the asset will have a carrying value of $4,500 while its tax base will be nil but similarly no deferred tax liability will be recognized as the subsequent difference is the part of same initial recognition difference.

However, if the transaction affects either the accounting profit or taxable profit on initial recognition, the entity will recognize any resulting deferred tax liability.

b) if the asset or liability arises from a transaction which is a business combination the entity will recognize the resulting deferred tax liability and it will affect the value of goodwill or bargain purchase gain.

c) Under IAS 32 Presentation of Financial Instruments, the issuer of a hybrid financial instrument such as convertible Loan Note classifies the instrument into equity and liability component as per the requirements of that standard. However, in some tax jurisdictions the tax base of the liability component of such hybrid financial instrument is equal to the aggregate of initial carrying values of equity and liability component both which will result in a taxable temporary difference on the initial recognition of hybrid financial instrument due to the recognition of equity component separately from the liability component.

Therefore, the exception placed above will not be applied because the hybrid financial instrument affects the equity on its initial recognition, resultantly the entity is required to recognize the related deferred tax liability and it will be charged to the carrying value of the equity component. But the subsequent changes in the value of deferred tax liability will be recognized in the statement of profit or loss.

Recognition of deferred tax Asset

The entity is required to recognize a deferred tax asset for all the deductible temporary differences up to the extent of taxable profits is expected in future, except for the deductible temporary differences relating to:

• An asset or liability, on its initial recognition if:

i) It neither effects accounting profit nor the taxable profits at the time of transaction and 

ii) The transaction is not a business combination

• Below are some examples of deductible temporary differences and which result in deferred tax asset being recognized:

a) The entities recognize the warranty provision as expense as in the period in which sales are made, as per the requirements of IAS 37, but in some tax jurisdictions such warranty provision is allowed as expense for the tax purposes in later periods when a warranty claim is settled in cash. Therefore the difference between carrying value of provision in the statement of financial position and its tax base of nil will be a deductible temporary difference.

b) Research expense is recognized as expense in the statement of profit or loss in the period in which it is incurred but it may not be allowable for the tax purposes until a future period. Therefore, the research expense will have a carrying value of nil while its tax base will be the amount the tax authorities will allow as a deduction in future periods. This will give rise to deductible temporary difference

• The entity will recognize a deferred tax asset related to deductible temporary differences up to the extent of taxable profits expected in future against which those deductible differences will be used.

Deferred Tax Asset relating to Goodwill

If in a business combination the carrying value of goodwill is lower than its tax base, this will give rise to a deductible temporary difference and the entity is required to recognize the resulting deferred tax asset arising on initial recognition of goodwill up to the extent of taxable profit is expected in future against which those deductible temporary difference will be used.

Deferred Tax Implication in a Business Combination

In a business combination transaction the assets and liabilities of subsidiary acquired are recognized at their respective fair values while these fair value increase or decrease have no impact upon the tax base of such assets or liabilities, and the tax base is taken as the carrying value of those assets and liabilities. This results in taxable or deductible temporary difference at the date of acquisition. This standard requires that the entity should recognize any deferred tax liability or asset relating to the differences arising at the date of acquisition and it will affect the carrying value of goodwill or bargain purchase gain.

Deferred Tax Implication for the Assets measured at Fair Value

Certain assets are measured at fair value as per the requirements of relevant standards such as assets under IAS 16 and IAS 38 under revaluation model, investment property under IAS 40 under fair value model and financial instruments under IFRS 9. The increase or decrease in fair value is incorporated in carrying values of such assets by the entity as per the requirements of those relevant standards. However, such fair value increase or decrease have no impact upon the tax base of such assets and the tax base is taken as the carrying value of those assets. This will result in taxable or deductible temporary difference and the entity will account for any resulting deferred tax liability or asset.

Deferred Tax Implication for Unused Tax Losses and Tax Credits

If an entity has unused tax losses or tax credits to be carry forward to the future periods, the entity will recognize the deferred tax asset related to those unused tax losses and tax credits up to the extent of taxable profits are expected in future against which those unused tax losses and tax credits will be used. However, the entity should also consider the following points:

a) The taxable temporary differences or taxable profits are expected to be probable in future.

b) The events giving rise to loss are unlikely to recur in future.

c) The entity has tax planning tools to create taxable profits or taxable temporary differences in future.

If the unused tax losses or tax credits relate to a subsidiary acquired, and its parent is allowed to use those unused tax losses or tax credits, the resulting deferred tax asset will be recognized by the parent in its own financial statements considering the points mentioned above

However, if the subsidiary will use those unused tax losses or tax credits against its own taxable profits in future, the resulting deferred tax asset will be accounted for as follows:

• If taxable profits are foreseeable at the date of acquisition, the deferred tax asset will be recognized at the date of acquisition and it will affect the goodwill or bargain purchase gain.

• If the taxable profits are not foreseeable at the date of acquisition but become foreseeable within the measurement period as defined in IFRS 3, the deferred tax asset will be recognized at the date of acquisition and it will affect the goodwill or bargain purchase gain.

• If taxable profits are not foreseeable at the date of acquisition but become foreseeable after the measurement period as defined in IFRS 3, the deferred tax asset will be recognized after the date of acquisition and it will not affect the goodwill or bargain purchase gain.

Investments in Subsidiaries, Branches and Associates and Interests in Joint Arrangements

In certain circumstances, if the carrying value of investments in subsidiary, associates or joint venture, which is the proportionate share of parent in the net assets of subsidiary, associates or joint venture plus the carrying value of goodwill, changes from its tax base which is normally the cost of such investment. This will give rise to a taxable or deductible temporary difference. These differences may arise in the following circumstances:

i) If the profits of subsidiary, associates or joint venture are not distributed.

ii) Due to change in foreign exchange rates when subsidiary is located in overseas.

iii) Due to decrease in carrying value of investment in subsidiary, associates or joint venture because of impairment.

The entity will recognize the deferred tax liability related to taxable temporary differences in the above circumstances if:

• The parent is not able to control the time of reversal of temporary differences and
• It should be probable that these differences will reverse in future

The entity will recognize the deferred tax asset related to the deductible temporary differences in the above circumstances if:

• It should be probable that taxable profits or taxable temporary differences will be available in future.
• It should be probable that these differences will reverse in future.

Measurement of Current and Deferred Tax

• The entity is required to measure the current tax using the tax rate which is substantively enacted at the year end.

• The entity is required to measure the deferred tax using the tax rates which are expected to apply to those periods in which asset will be recovered or the liability would be settled.

• This standard requires that the measurement of deferred tax should also reflect the manner in which entity will recover or settle the asset or liability.

• The defer tax shall never be discounted as it is not possible to determine the timing of reversal of the temporary differences with reasonable accuracy.

Recognition of Current and Deferred Tax

The tax income and expense relating to the current and deferred tax should be reported where the gains and losses of underlying item are reported as follows:

• If the gains or losses of the underlying item are reported in the profit or loss, relating tax income or expense will be recognized in profit or loss.

• If the gains or losses of the underlying item are reported outside the profit or loss, relating tax income or expense will be recognized outside the profit or loss i.e. in the statement of other comprehensive income or equity.

Disclosures

The entity is required to disclose the following related to the current and deferred tax:

• The amount of current tax expense or income recognized in the current period.
• Any amount of current tax recognized related to the previous year current tax.
• The amount of deferred tax expense or income recognized in the current period.
• The amount of deferred tax expense or income reversed in the current period.
• The amount of current tax expense or income recognized as a result of change in the tax rates.
• Any amount of current or deferred tax recognized because of change in accounting policy or errors.
• The sum of current or deferred tax recognized outside the profit or loss.
• The basis for the determination of applicable tax rates.
• The amount of deferred tax recognized related to the temporary differences and unused tax losses or credits.
• The tax effects of the undistributed dividend relating to shareholders.