A European example of the difficulty of recognizing a deferred tax asset for unused tax losses
Here’s another of the issues from some extracts of enforcement decisions recently issued by the European Securities and Markets Authority (ESMA) (for more background see here):
- “The issuer is a commercial bank. In the consolidated IFRS financial statements for 2011, the issuer recognised a net deferred tax asset of CU 21.6 million (representing 18.6% of its total equity), where CU 4.1 million represented taxable temporary differences and CU 25.7 million represented the carry-forward of unused tax losses. According to the local tax regulation there is no time limit regarding the period to which the unused tax losses can be used. The issuer disclosed that it expected that future taxable profits before tax would be available, within a period of seven years, against which the unused tax losses could be utilised.
- This view was based on the budgets for the years 2012-2018. It expected a substantial reduction in impairments of loans, compared to the historical losses with a substantial effect on the future taxable profit, and low rates of impairment of loans compared to the impairment losses of other banks.
- The enforcer disagreed with the full recognition of deferred tax asset arising from the carry forward of unused tax losses and considered it to be recognizable only to the extent of its taxable temporary differences.”
Tax assets and going concern uncertainties
The explanation for this decision cites various problems. The issuer had recognized material losses for the last four years, and would have had to generate a quite dramatic turnaround during the seven year period. Its budgets suggested this was likely, but the enforcer (as ESMA likes to put it) looked at its budgeted results for the past two years, and concluded the issuer “was not capable of making accurate forecasts in the past.” And then, the issuer had disclosed a material uncertainty about its ability to continue as a going concern. As ESMA drily puts it: “Material uncertainty about the ability of the issuer to continue as a going concern should be considered when considering the recognition of a deferred tax asset.”
Indeed, one imagines that in the great majority of situations, that would be the beginning and end of the discussion: to say the least, there’s some artistry involved in arguing that it’s probable that sufficient future taxable profit will be available to utilize unused tax losses, while simultaneously disclosing that the ability to continue at all is subject to significant doubt. I suppose such an argument would have to be built on trying to exploit the inherent imprecision of terms like “probable” and “significant”: for example, you might rationalize that you have a 10% chance of going out of business (likely enough to warrant disclosing significant doubt in that regard), a 20% chance of limping on in loss-making mode, and a 70% chance of completing a magnificent turnaround (this being enough to conclude that a test based on “probability” of profits is in fact met). Perhaps such an argument would be possible where everything depended on the occurrence or non-occurrence of one or two make-or-break specific events. But for an entity like a bank, highly susceptible to the messy fluctuations and vagaries of the real world, it’s hard to see how that would hold together.
Evidence of budgets
To justify recognizing a deferred tax asset relating to unused tax losses, IAS 12 requires “convincing evidence” about the availability of sufficient taxable profit. The ESMA report seems to suggest that the issuer’s budgets might have constituted such convincing evidence, if its examination of past practices in this area had turned up a history of greater accuracy. This might seem a bit unlikely though: after all, even if the budgets for 2010 and 2011 had been perfectly accurate, they would have been accurate about the magnitude of the loss, which might seem to be fundamentally different than being accurate about the magnitude of big future profits. In such a situation, many practitioners would likely conclude that “convincing evidence” would always have to come from the real world rather than from internal expectations – perhaps from signed contracts or suchlike (again, probably less likely to be identified for an entity such as a bank).
With regard to the key issue of impairment losses on loans, the report says the issuer “had presented future budgets primarily based on general assumptions about interest income and economic improvement indicators, rather than documentation showing what was expected to influence the future income and therefore enable the use of the deferred tax asset.” But again, one wonders if any documentation relating to “expectations” about future “influences” would ever be enough to provide the required quality of evidence.
This is only to say that the ESMA report, if anything, might seem (perhaps simply out of a concern for even-handedness) to overstate the likelihood that a deferred tax asset can be recognized in a situation of ongoing losses. Still, the overall message is clear enough: such assets come with significant red flags attached, and need to be supported with painstaking care and objectivity.
The opinions expressed are solely those of the author