Deferred tax – amending the initial recognition exemption

(Well, sometimes there’s no point trying to think of a catchy title…)

The IASB has issued for comment Deferred Tax related to Assets and Liabilities arising from a Single Transaction, an exposure draft of proposed amendments to IAS 12, with comments to be received by November 14, 2019

The exposure draft expresses itself primarily with reference to accounting for leases under IFRS 16, but it also applies to decommissioning obligations, and perhaps in other situations too. IAS 12.15 requires recognizing a deferred tax liability for all taxable temporary differences, except to the extent that the deferred tax liability arises from the initial recognition of goodwill; or from the initial recognition of an asset or liability in a transaction which isn’t a business combination and which at the time of the transaction affects neither accounting profit nor taxable profit or loss. The standard explains that in the absence of this exemption, an entity would recognize the resulting deferred tax liability or asset and (to make it work) adjust the carrying amount of the originating asset or liability by the same amount, thus making the financial statements “less transparent” (this was required under old Canadian GAAP).

A jurisdiction will likely allow tax deductions when a company makes lease payments, but not when it recognizes depreciation and interest expense arising from the mechanics of IFRS 16. IFRS doesn’t prescribe whether these tax deductions should be regarded as applying to the lease asset or to the lease liability, leaving the assessment to the issuer’s judgment based on the local tax laws and other relevant factors. If the issuer determines that the tax deductions relate to the lease asset, then no temporary differences arise – the asset amount to be depreciated for accounting purposes will equal the amount to be charged for tax purposes, and the repayment of the liability will have no tax consequences. However, if the tax deductions relate to the lease liability, then neither of those statements is true, and temporary differences do arise. However, if the initial recognition exemption applies, then the deferred tax consequences of these temporary differences needn’t be recognized.

The IASB identified differences in practice on whether the exemption was considered to apply or not. The reference to “initial recognition of an asset or liability in a transaction which is not a business combination” doesn’t necessarily apply smoothly in a situation where an asset and liability are being recognized simultaneously, but obviously isn’t entirely irrelevant to it either. But as the exposure draft observes, the impact of not recognizing deferred tax at the outset is undesirable: “financial statements would reflect the tax effects of the lease in profit or loss as the tax deductions become available for tax purposes, rather than as the entity recovers the lease asset and settles the lease liability (as would be the case if the entity were to recognize deferred tax assets and liabilities in respect of the lease). This would be inconsistent with the general principle in IAS 12…and result in a difference between the effective tax rate and the applicable tax rate for the transaction.”

The IASB decided then to specify that the exemption doesn’t apply in this case, primarily by adding the following paragraph into IAS 12:

  • A transaction that is not a business combination may lead to the initial recognition of an asset and a liability and, at the time of the transaction, affect neither accounting profit nor taxable profit (tax loss). Equal amounts of taxable and deductible temporary differences may arise from the initial recognition of that asset and liability. In that situation, on initial recognition of the transaction, an entity recognizes:
  • (a) a deferred tax asset for the deductible temporary difference to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized.
  • (b) a deferred tax liability for the taxable temporary difference. However, the amount of the deferred tax liability shall not exceed the amount of the deferred tax asset…

That last sentence, limiting the amount of the deferred tax liability to that of the asset, reflects that while the two will usually be the same amount, they might sometimes differ. The exposure draft provides an example of a decommissioning liability which might be settled (and on which a tax deduction might arise) only after the end of the related asset’s useful life. In this case, a portion of the temporary difference related to the corresponding asset might reverse in periods for which no conclusion can be drawn about the existence of sufficient taxable temporary differences, limiting the recognition of the deferred tax asset. But to recognize a deferred tax liability greater than a corresponding deferred tax asset would only work by adjusting the carrying amount of the related asset as the other side of the entry, thus resulting, the exposure draft notes, in the outcome the recognition exemption was designed to prevent.

The exposure draft proposes that the amendments will be applied retrospectively, except, on that last point, an entity may choose to assess the recoverability of deferred tax assets only at the beginning of the earliest comparative period presented, based on the facts and circumstances at that date.

The opinions expressed are solely those of the author

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