Background – the SBR context
This exposure draft became an examinable document at SBR from the September 2020 sitting. It was issued in July 2019 and seeks to make an amendment to IAS12 Income Taxes in order to enhance the faithful representation of accounting for deferred tax. It is also designed to improve comparability as a few reporting entities already account for deferred tax in the way that the ED proposes.
First however, let us remind ourselves of the principles of deferred tax, before considering the proposed amendment.
Deferred tax liabilities are recognised on all taxable temporary differences.
Accounting for deferred tax is rooted in the matching concept. By accounting for deferred tax we are ensuring that the gains / losses and their tax effects are accounted for in the same period.
IAS 12 Income Taxes seeks to achieve this by requiring that a deferred tax liability is recognised on all taxable temporary differences between the carrying value of assets and liabilities and their corresponding tax base.
Thus, when an asset is revalued upwards; the carrying value of the asset increases but as no current tax liability will be assessed the tax base remains the same. So, a revaluation gain creates a taxable temporary difference and thus the need to account for a deferred tax liability. In recognising the deferred tax liability (the credit) the corresponding entry is a tax charge (the debit) which will match with the accounting gain that has been recognised on the revaluation.
Thus, by accounting for deferred tax on a revaluation gain we are ensuring the tax effects of the gain are reported in the same period as the gain itself and not when the tax is either assessed or actually paid. Matching.
Exceptions to the rule that deferred tax liabilities are recognised on all taxable temporary differences
Now there are three exceptions to the rule in IAS 12 Income Taxes that a deferred tax liability is recognised on all taxable temporary differences. The exception that concerns us relates to the initial recognition of an asset/liability (other than in a business combination) which, at the time of the transaction, does not affect either the accounting or the taxable profit.
When this exception is currently applied, no deferred tax is accounted for when a lessee enters a right of use lease. And no deferred tax is accounted for when a provision is made to decommission assets in the future. This is because under the current requirements of IAS 12 Income Taxes, both transactions initially create an equal opposite asset and liability that does not on initial recognition affect either the accounting or the taxable profit.
The problem that arises.
In both circumstances the subsequent accounting will result in depreciation and a finance cost that will be charged to profit and reduce the accounting profit. However, for tax purposes both the depreciation and finance costs will be disallowed, as non-cash expenses, and no immediate tax relief granted. For lessees tax relief will be granted when the actual lease rentals are paid. In the case of decommissioning, again tax relief will be granted on payment. The pattern of these payments will not be the same as the expenses passing through profit.
Where no deferred tax is provided on the initial recognition of right to use leases and provisions for decommissioning, this will mean that the expenses arising and their tax effects would not be accounted for in the same period. There will be no application of the matching concept. The reporting entity will have an erratic effective rate of tax.
Consequently, the Board is proposing amendments to the exception and so require reporting entities to recognise deferred tax on temporary differences that arise on right to use leases and provisions for decommissioning.
Such a change is welcome. It follows the spirit of IAS 12 Income Taxes and will enhance the faithful representation of the way that tax is reported.