Mind the GAPs in IAS12 Deferred Taxation

Article by Clare Kearney, BSc, MA, FCA, Current Examiner for P2 Advanced Corporate Reporting

Introduction

The guidance for reporting taxation in financial statements is addressed in IAS12 Income Taxes.
IAS12 was issued in October 1996. Since it was first published it has been the subject of much
review, comment and revision. In 2019 alone, there was further development in this area with the
publication of three separate statements on this area: IFRIC23 Uncertainty over Income Tax
Treatments, ED deferred tax related to assets and liabilities arising from a single transaction and
finally ESMA’s (European Securities and Markets Authority) Public Statement Considerations on
recognition of deferred tax assets arising from the carry forward of unused tax losses.

Deferred tax liabilities are commonly found in capital intensive industries such as electricity, utility,
manufacturing and others where fixed assets are depreciated at a higher rate for tax purposes than
for accounting purposes.

This note provides a summary of the existing rules of IAS12 in relation to deferred taxation.

Background

So let us begin with a recap of the current rules. IAS12 is divided into two main guidance areas these
being Current Taxation and Deferred Taxation. Current Tax is the income tax payable (or
recoverable) in respect of the taxable profit (or loss) for a period while deferred taxation relates to the
future tax consequences of current transactions and events. This teaching note concentrates on
deferred taxation. The principal rule of IAS12 deferred taxation is that an entity accounts for the tax
consequences of transactions and other events in the same way and in the same accounting period
that it accounts for the transactions and other events themselves.

Before we get into the technicalities of IAS12 it is worth noting three important points for students.
First of all IAS12 is a difficult accounting standard. It requires a different way of thinking. The
terminology can be overwhelming and difficult to understand. It is a subjective accounting standard
and one is never quite sure if one is on solid ground when applying the provisions. There has always
been unease with this accounting standard and this applies to both students and practitioners. In fact,
one of the most recent IASB pronouncements in this area IFRIC23 addresses the issue of uncertainty
in relation to deferred taxation. It is acknowledged that entities do not always know how their tax
authority may view a particular treatment applied in their tax returns. IFRIC23 states that ‘where it is
considered not probable that the tax authority will accept the tax treatment used or planned to be
used, the effect of uncertainty should be estimated using either the most likely amount or the
expected value method, depending on which method better predicts the resolution of the uncertainty.’
So rest assured if you are feeling unsure, you are not alone.

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Secondly, this teaching note is written with Advanced Corporate Reporting (ACR) students in mind,
not taxation practitioners. A recent Deloitte finding on taxation suggests that the responsibility for tax
accounting often falls into the gap between the tax practitioner and the tax accountant. Nobody quite
wants it but it has to be done. With this general aversion in mind and the subjectivity of the issue (and
to offer you a little guidance) it is only fair to point out that if deferred taxation is to be examined in
ACR, that it will be clearly specified in the examination requirements and the relevant taxation rules
will be outlined where necessary. This might give you a little comfort when approaching your studies.

Finally, one of the major issues I have found in teaching deferred tax is the wording of the standard. It
can be hard enough to grasp the concepts of IAS12 but this is made even more difficult by the way
the Standard is written. The problem is that IAS 12 is balance sheet driven (also known as the
valuation approach). The standard therefore focuses on the cumulative position. Although this general
approach is consistent with the Conceptual framework, which focuses on the financial position rather
than the income statement, it does not help the learner to grasp what is already a challenging issue.
What this means for preparing deferred tax calculations for an accounting period is that one needs to
think in layers. Begin with identifying the cumulative temporary differences at the end of the financial
period as identified from the closing statement of financial position, deduct the cumulative temporary
differences that were there at the start of the year (from the opening statement of financial position)
and this will give you the changes during the financial period.

Deferred Taxation – three sections

For the purpose of this teaching note I have broken IAS12 into three separate sections:
1. Deferred tax liabilities/assets arising from single entity transactions and events.
2. Additional entries for Groups.
3. Deferred tax assets/liabilities arising from other transactions and events

1. Deferred tax liabilities/assets arising from single entity transactions and events.

Deferred taxation occurs when the tax rules of a jurisdiction result in the tax effect of an accounting
transaction occurring in a different period to the transaction itself. We have already stated that the
principal rule of IAS12 is that an entity accounts for the tax consequences of transactions and other
events in the same way (and in the same accounting period) that it accounts for the transactions
themselves. In other words the financial statements will include the tax effects of all of its transactions
and events whether or not the taxation has actually been levied on them. Where taxation is charged in
the accounts but has not yet been levied by the tax authorities then a gap arises. Deferred taxation
bridges this gap.

Deferred tax fills the gap (or almost fills the gap) between actual tax charge for a period based on tax
laws and the tax expense based on the financial accounts. In this way, deferred tax fulfils the
matching principle as determined by the Conceptual Framework.

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 Take the following simple example:

X plc reports accounting profits of €100,000 for the year ended 31.12.19. Taxation is 10% per
annum. The tax charge as levied by the Tax Authority for the same period is €9,000.
Tax charge based on accounting profits (€100k*10%) €10,000
Tax charge based on taxable profits €9,000
Difference to bring tax charge in line with accounting profits €1,000

The Journals for this include:

• Db Tax Expense €9,000
Cr Bank/Tax Liability €9,000
With the current tax expenses
• Db Tax Expense €1,000
Cr Deferred tax Liability €1,000
With the additional tax charge to bring the tax expense in line with the accounting profits

Classification of differences between financial statements and taxation levied by the tax
authority.
So, let us turn our attention to what types of transactions lead to these differences. IAS12 classifies these
differences into a number of different groups:

Permanent Temporary

Entertainment Timing Other

expenses (Reported (Other
Fines/penalties profit) reserves)
Other non-
taxable items • Depreciation/ Capital Allowances • Revaluation gains/losses
No deferred
Taxation • Accrued receivables/expenses • Actuarial gains/losses
• Prepaid Revenue • Other (depending on
• Development expenditure information presented)
• Pension obligations
• Share options expensed
• Others (depending on
information presented)
Charged at current rates and opening balances
updated annually for changes in tax Rates

No discounting

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(i) Permanent and Temporary Differences:
The majority of differences between the accounting profits and taxable profits are temporary in
nature. This means that transactions and events may appear in the financial accounts in one
period but are taxed in a different period. Deferred taxation is calculated on those temporary
differences in the year that the accounting transaction arises (and reversed in the year the tax is
actually levied). However, other transactions and events give rise to permanent differences –that
is they are included in the financial statements but will never give rise to a tax effect. No deferred
tax is provided on permanent differences as differences are permanent. They will never reverse.
We say therefore that deferred taxation almost bridges the taxation gap.

(ii) Timing and Other

Temporary ‘timing’ differences are those temporary differences that affect the reported profit
figure. Any deferred taxation arising from timing differences are included in the reported tax
expense in the profit and loss account for the period. Temporary ‘Other’ differences are those
temporary differences that arise on entries that were posted to accounts other than to profit figure
for the period. For example, revaluation gains/losses by-pass the reported profit and are posted
directly to reserves. Any deferred tax arising will be posted to that same reserve.

Temporary differences (either timing or other) that give rise to additional tax charges are
classified as Temporary Taxable differences while differences that give rise to a deduction in tax
charges are called Temporary Deductible differences.

Examples

Item Account Tax This means This is Accounting

(examples) Base Base Known as
PPE Book Capital If capital allowances> depreciation then TWV is lower than NBV Taxable Provide Deferred tax liability
Depreciation Allowance AND therefore accounting profits are > taxable profit Timing
and and Must provide for deferred tax to bring tax expense up to level of tax difference
(NBV) (TWV) on accounting profit
Deferred Revenue Revenue is Revenue Accounting profits are < taxable profits Deductibe Provide Deferred tax asset
included in included for Must provide for deferred tax relief to bring tax down to level Timing
liabilities and tax based on accounting profits difference
not in profit
Revaluation surplus Gain recognised Gain is taxed Accounting gains are > taxable profits Taxable Provide Deferred tax liability
on non current asset for accounting only on Must provide for deferred tax to bring tax expense up to level of tax Other
purposes disposal of based on accounting profit difference
asset
Entertainment Expenses Expenses Expense is Accounting profits are < taxable profits Permanent No deferred taxation
included for NOT tax difference on permanent differences
accounting deductible
Share Options Share options Share options Accounting profits are < taxable profits Deductibe Provide Deferred tax asset
expensed when Tax deductible Must provide for deferred tax relief to bring tax down to level Timing
Granted when exercisedbased on accounting profits difference
Tax Rates and Discounting
Deferred tax liabilities are taxed at current rates and any balances carried forward from previous
years are updated to reflect changes in tax rules and rates. Deferred tax balances are never
discounted. The reason given for this is that the effort necessary to identify the timing of reversals of
timing differences would far outweigh any benefit from its application. Although this helps to ease the
accounting for deferred taxation it is an area that gives rise to a wider issue that being the
inconsistency this presents in the application of discounting principles across all accounting
standards.

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2. Additional deferred taxation entries for Groups.

And it doesn’t end there. Further deferred taxation may arise when business combinations are
introduced. In a business combination, it is not the group itself that is taxed (the group is not a
separate legal entity). Instead tax is levied on each of the individual entities of the group. However
there are additional deferred taxation issues that may affect the group members. The most common
effects include:

Item Account Tax This means This is Accounting

(examples) Base Base Known as
Valuation of assets and Assets and tax base is If fair value > taxation values for assets/liabilities, then Taxable Provide Deferred tax liability
liabilities in a business Liabilities original cost accounting gains> taxable profit Timing
combination measured at Must provide for deferred tax to bring tax expense up to level of tax difference
fair value based on accounting profit/gains
Goodwill on the acquisition Difference Goodwill is not Difference is considered temporary but specific exemption under No Not applicable
of an entity between fair value recognised for IAS12.15(a) Deferred
of assets/liabilities tax purposes Taxation
and purchase
consideration
Carrying amount of Calculated as the Cost of the Differences are temporary but no deferred taxation applied only to thNo Not applicable
investments in subsidiaries, investor share of investment extent that the entity is able ot control the timing of the reversal of Deferred
associates and joint venture net assets of the the differences and it is probable that the reversal will not occur in Taxation
investee plus the forseeable future. IAS12.39
purchased
goodwill
Unrealised profit on unrealised profit Tax base is the Accounting profits are < taxable profits Deductibe Provide Deferred tax asset
intercompany trade eliminated on transfer price Must provide for deferred tax relief to bring tax down to level Timing
consolidation of items based on accounting profits difference

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3. And finally the other transactions and events

And finally there are other miscellaneous transactions and events that may/may not give rise to
deferred taxation liabilities/assets. These may include:

Item Account Tax This means This is Accounting

(examples) Base Base Known as
Unused tax losses Losses Losses are Accounting profits are < taxable profits Deductibe Provide Deferred tax asset
recognised carried forward Must provide for deferred tax relief to bring tax down to level Timing
as incurred to be set against based on accounting profits difference
future taxable However entity must provide evidence which supports the
profits conclusion that future profits will arise
(ESMA Public Statement 2019)

Initial cost of an asset/ Carrying value is Tax base is nil as Accounting > Taxation so should provide deferred tax on temporary No Not applicable
liability other than in a included in no effect on taxable timing difference. However no deferred taxation if Deferred
business combination asset/liability taxable income transaction affects neither accounting profit or taxable profit Taxation
IAS12.15(b)(ii) but note
Eg non taxable government grant ED 2019

ESMA Public Statement: Considerations on Recognition Deferred Tax Assets Arising from the Carry Forward of Unused Tax Losses.

IASB ED 2019 : Deferred tax related to assets and liabilities arising from a single transaction

The Final Comment

As was mentioned at the outset of this teaching note IAS12 has been the subject of much review,
comment and revision. In 2019 alone, there was further development in this area with the publication
of three separate statements on this area. On a wider scale IASB have recently decided to keep
International Accounting Standard 12 Income taxes (IAS 12) unchanged. At the same time, it also
announced that it will halt any further research efforts into whether this standard should be
fundamentally changed. The IASB took this decision after reviewing the results of a research project
aimed at better understanding the needs of users of financial statements. This project was identified
as part of the 2011 Agenda Consultation, at a time when there was increased attention on the
shortcomings of IAS12

However, given what has gone before this, something tells me that the IAS12 story is not over yet.

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