by John Hughes
The IASB has issued Recognition of Deferred Tax Assets for Unrealized Losses, an exposure draft of proposed changes to IAS 12 Income Taxes, with comments to be received by December 18, 2014. The press release accompanying the exposure draft was unusually plain and stark, as if reflecting that even the IASB’s publicity wizards couldn’t think of a way to pump up this particular initiative. Indeed, it seems unlikely that many users can obtain much specific value from the numbers attaching to deferred tax or from what’s disclosed about them: the main value of the exercise, it seems to me, is really in avoiding the distortion that would result if the accounting for taxes were based solely on what’s payable for any particular period (whereby, for example, an entity’s reported tax rate might fluctuate materially based on what proportion of its expenditures from one period to the next is subject to accelerated treatment for tax purposes, regardless that all profits are ultimately taxable at the same rate). To that perhaps necessary but not inherently very exciting end, I expect the majority of us should be truly grateful to those brave practitioners who spend their lives immersing themselves in the technicalities of IAS 12, so that the rest of us don’t have to.
The exposure draft addresses a few issues that have been subject to divergent practice by some of those practitioners. Here’s one: “Do decreases in the carrying amount of a fixed-rate debt instrument for which the principal is paid on maturity always give rise to a deductible temporary difference if this debt instrument is measured at fair value and if its tax base remains at cost? In particular, do they give rise to a deductible temporary difference if the debt instrument’s holder expects to recover the carrying amount of the asset by use, i.e. holding it to maturity, and if it is probable that the issuer will pay all the contractual cash flows?” On the one hand, it’s pretty clearly established that a difference between the carrying amount of a revalued asset and its tax base is a temporary difference, giving rise to a deferred tax liability or asset. On the other hand, it might not seem like a temporary difference that’s worth recognizing, as it’ll clearly reverse over the term to maturity of the instrument.
The IASB proposes to stick close to the basic principle, arguing the following: “The economic benefit embodied in the related deferred tax asset results from the ability of the holder of the debt instrument to achieve future taxable gains in the amount of the deductible temporary difference without paying taxes on those gains. In contrast, an entity that acquires (a debt instrument for a principal of say CU1,000) for its fair value (say, CU918) and holds it to maturity has to pay taxes on a gain of CU82, whereas (an entity that acquires the instrument for CU$1,000) will not pay any taxes on the payment of the CU1,000 of principal. The different tax consequences for these two holders of the same instrument should be reflected in the deferred tax accounting for the debt instrument.”
This leads to a related question of somewhat broader applicability: “Does an entity assume that it will recover an asset for more than its carrying amount when estimating probable future taxable profit against which deductible temporary differences are assessed for utilization if such recovery is probable?” In theory, if an entity holds nothing within it except the hypothetical debt instrument described above, and it identifies a theoretical deferred tax asset arising from the temporary difference between its revalued carrying amount and its tax base, then the only future taxable profits against which the temporary difference can be utilized will be those arising from the debt instrument itself, as the fair value rises back to the principal amount. But is it appropriate to take those future profits into account, when the tax accounting for the instrument is based on its current fair value?
Yes it is, says the IASB: “determining temporary differences and estimating probable future taxable profit against which deductible temporary differences are assessed for utilization are two separate steps and the carrying amount of an asset is relevant only to determining temporary differences. The carrying amount of an asset does not limit the estimation of probable future taxable profit. In its estimate of probable future taxable profit, an entity includes the probable inflow of taxable economic benefits that results from recovering an asset. This probable inflow of taxable economic benefits may exceed the carrying amount of the asset.” For another kind of illustration, the Board points out that it would be irrational for a manufacturing entity, for example, to assume its assets will only be recovered for their carrying amounts, if at the same time it anticipates making future taxable profits: “a significant part of the manufacturing entity’s probable future taxable profits results from using those assets to generate taxable profits in excess of their carrying amount.” The Board acknowledges though that “there are cases in which it may not be probable that an asset will be recovered for more than its carrying amount, especially if the asset is measured on the basis of expected cash flows. Examples of this are many assets measured at fair value or assets that have been impaired recently.”
The exposure draft also addresses some related issues, and contains an extended illustrative example. For those who work through all the details of the latter, there may be a special place in accounting heaven.
The opinions expressed are solely those of the author