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Deferred tax: the potential options

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19th May 2011
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One of the tasks faced by the Accounting Standards Board (ASB) in their convergence to an international-based financial reporting framework, notably the Financial Reporting Standard for Mid-Sized Entities (FRSME) is the issue of simplification in certain areas, in particular the revaluation of non-current (fixed) assets, leasing and deferred taxation.

This article looks at the general concept of deferred tax and the options that could be available to the ASB in their quest for simplification.

Deferred tax is probably one of the most disliked concepts by accountants, and probably one of the most confusing for their clients. As accountants are aware, the objective of deferred tax is to iron out the tax inequalities arising as a result of timing differences. For example, in years when corporation tax is saved by timing differences such as accelerated capital allowances, a deferred tax liability is set up in the balance sheet which essentially reverses as and when the timing difference reverse.

FRS 19 and SSAP 15

In the UK FRS 19 ‘Deferred Tax’ was issued in December 2000 and came into effect for accounting periods ending on or after 23 January 2002 with early adoption permissible. It replaced SSAP 15 ‘Accounting for Deferred Tax’, which was withdrawn essentially because it was conceptually inconsistent with other standards as it prescribed a ‘partial provision’ basis of deferred tax.

Most notably, it required deferred tax to be recognised only where it was not expected to remain a permanent feature of the balance sheet, whereas other standards did not have this rule. In addition, SSAP 15 was also inconsistent with international practice as well as the fact that it required the estimation of future transactions which goes against the statement of principles. This led to the birth of FRS 19 which requires deferred tax to be calculated on a full, as opposed to a partial provision, basis. It also requires the calculation to be based on ‘timing’ differences that have originated, but not reversed, at the balance sheet date.

FRSME and IAS 12

FRSME takes a different stance in accounting for deferred taxation. Instead of using the ‘timing difference’ approach, it takes the ‘temporary difference’ approach. This approach is identical to the mainstream international equivalent, IAS 12 Income Taxes. The temporary difference approach is then sub-divided into:

  • a taxable temporary difference
  • a deductible temporary difference

A ‘taxable temporary difference’ results in the payment of tax when the carrying amount of the asset or liability is settled. In other words, a deferred tax liability will arise when the carrying value of an asset is greater than its tax base (its tax written down value), or when the carrying value of a liability is less than its tax base.

A deductible temporary difference is a difference that results in amounts being deductible in determining taxable profit or loss for future periods when the carrying amount of an asset or liability is recovered or settled. In other words, when the carrying value of a liability is greater than its tax base, or when the carrying amount of an asset is less than its tax base, a deferred tax asset may arise.

Under the temporary difference approach currently in FRSME, companies will see lots more deferred tax balances being provided for and it is this approach which critics want simplifying. I will illustrate the temporary difference approach using some simple numbers:

Figure 1 – Temporary Difference Approach

The Facts

The following assets and liabilities are recorded in the balance sheet of Entity A Ltd for the year ended 31 December 2010: 

Note 1

The tax written down value (tax base) of the property is £15 and the tax base of the plant and machinery is £6.

Note 2

The stock value contains a provision for obsolescence which is disallowable for tax purposes until the stock is sold amounting to £1.

Note 3

Included in the trade debtors value is a provision for bad debts amounting to £1 which is disallowable for tax purposes.

Under the temporary difference approach, the deferred tax liability will be calculated as follows:

The company pays tax at 28% in the year to 31 December 2010, but the timing differences are expected to reverse in the corporation tax year commencing 1 April 2011 so the deferred tax provision will be calculated using the 2011-2012 mainstream corporation tax rate of 27%, as this is the rate which will be in force when the timing differences reverse. FRS 19 and FRSSE requires deferred tax to be measured at the rates expected to apply when timing differences reverse, based on tax rates and laws substantially enacted by the balance sheet date. The deferred tax charge is therefore (£5,000 x 27%) £1,350.

Because of the fact that the provision for stock obsolescence and the general bad debt provision is not allowed for tax purposes, the tax base for stock and trade debtors will be higher than the book values.

Options Available

There are three commonly known methods of deferred tax provision which the ASB could consider, one of which (the ‘flow-through method’) has even been mentioned in their quest for simplification:

  • The flow-through method
  • The full-provision method
  • The partial-provision method

Flow-Through Method

Under this method, the tax liability recognised is the expected tax liability for the period (i.e. the amount of tax to be paid). No provision is made at all for deferred tax. I suspect a large majority of accountants would welcome this method with open arms because the main advantage of this method is that it is easy to apply and the tax liability recognised in the accounts is closer to users’ expectation of a ‘real’ liability.

A disadvantage, however, is that the flow-through method can lead to large fluctuations in the tax charge and it does not allow tax relief for long-term liabilities to be recognised until those liabilities are settled. IAS 12 and IFRS for SMEs do not recognise this method.

Full-Provision Method

This is the angle from which FRS 19 works. It recognises that each timing difference at the balance sheet date has an effect on future tax payments. In other words, where a company takes advantage of HMRCs ‘Annual Investment Allowance’ it recognises that future tax assessments will be larger than they would otherwise have been. 

A disadvantage inherent with the full-provision method is that under some tax jurisdictions it may give rise to large liabilities which may only fall due for payment several years in the future.

Partial-Provision Method

The old SSAP 15 took this stance and it does iron out the disadvantage I mentioned inherent in the full-provision method because this method will only provide for deferred tax only to the extent that it is expected to be paid in the foreseeable future. However, the effect of partial-provision is that deferred tax recognised at the balance sheet date includes the tax effects of future transactions which have not been recognised in the accounts. This does not accord with the ASB’s Statement of Principles which defines assets and liabilities arising because of past events.

I will illustrate the concepts of the above three methods using simple examples as follows:

Figure 2

The Facts

Company A Limited starts trading on 1 January 2010 and has a financial year-end of 31 December 2010. Its first year’s trading shows profits of £10,000, a depreciation charge amounting to £1,000 and annual investment allowances granted of £2,000. Company A Ltd pays tax on profits for the year-ended 31 December 2010 at 21%. Timing differences are expected to reverse in the corporation tax year commencing 1 April 2011.

Flow-Through Method

Under the flow-through method, Company A Ltd has a tax liability of (£10,000 + £1,000 - £2,000) £9,000 x 21% = £1,890. No deferred tax is recognised under this method, the tax liability is simply the amount of tax due to HMRC. No judgement is required on the part of the accountant.

Full-Provision

The tax liability due to HMRC is as calculated above (£1,890), but we have to provide for deferred tax on the timing difference of (£1,000 - £2,000) £1,000 x 20% = £200. Again, no judgement is required on the part of the accountant. Note the rate at which deferred tax is calculated has dropped to 20% as this is the rate that has been enacted at the balance sheet date (small companies rate of corporation tax is 20% for the corporation tax year 2011). Tax rates are substantially enacted once a Bill has passed through the House of Commons.

Partial-Provision

This is slightly more judgemental than the other two methods. In order to determine whether a provision for deferred tax is necessary under the partial-provision method, it is necessary to look ahead at the company’s future capital expenditure plans and ask the question “will capital allowances exceed depreciation over the next few years?” If the answer to this question is “yes”, no provision for deferred tax is necessary. If the answer is “no”, then a reversal is expected (in other words, there will be a year when depreciation is in excess of annual investment (capital) allowances.  Under such provisions, the deferred tax provision is made on the maximum reversal which will be created. Any deferred tax which is not provided is disclosed in the notes to the accounts.

Assuming that the company’s future capital expenditure plans amount to £10,000 we will require a deferred tax liability of (£10,000 x 20%) £2,000. Again, note the rate of tax used to calculate the deferred tax provision has dropped to the rate expected to apply when the timing differences reverse.

Discounting

A notable difference between FRS 19 and the proposed FRSME is the prohibition in FRSME of discounting deferred tax balances. This is not a major consequence and in reality discounting would only be applied to very slow reversals of timing differences, for example with (the now revoked) industrial buildings allowances.

Conclusion

If the proposed FRSME is the way forward, the ASB do need to look into the area of deferred tax because the temporary difference approach will give rise to much more detailed deferred tax calculations based on the differences between book values and tax bases. 

It is also inherently more complicated than our current FRS 19 regime based on timing differences. More complex and larger companies will see much larger deferred tax liabilities being recognised. This article has considered the three ‘well-known’ methods of deferred tax calculations, though the ASB may have another method up their sleeves.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011). He also lectures on auditing and financial reporting issues.

Replies (4)

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By CEL
23rd May 2011 14:48

Deferred tax

What is the difference between IAS 12 and FRS 19, as far as I can see timing differences and temporary differences are the same thing.  I would have calculated the deferred tax in the IAS 12 example in exactly the same way if I was doing a FRS 19 calculation.

Please would Steve Collings clarify this.

Thanks

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collings
By Steven Collings
23rd May 2011 16:04

Temporary Differences

Hi

The illustration above was intended to show how the IFRS based method would work based on the approach our FRS 19 takes and IFRS(SME) (FRSME).  Essentially FRS 19 focuses on timing differences between taxable profit and accounting profit (i.e. a P&L approach).  IAS 12 (which is where FRSME concept for deferred tax is based) takes a balance sheet approach based on temporary differences, which are based on the differences between the tax base of an asset/liability and the carrying amount in the balance sheet. Essentially all timing differences are temporary differences, but some temporary differences will not give rise to a timing difference.  Fixed asset revaluations are the most obvious that immediately spring to mind.  Currently FRSME does prohibit revaluation of assets (though this is something else which I suspect will change) but IAS 16 does allow revaluations so if we work on the basis that revaluations will be allowed.

Under FRS 19 the revaluation of (say) a building, which the company isn't planning to sell, won't give rise to a tax liability and therefore no deferred tax is bothered with.  However, when there is a binding agreement to sell the building and the gain/loss on sale has been recognised in the accounts then you would recognise deferred tax on the timing difference. 

The difference in IAS12/IFRSSME and FRSME (in its current form) is that a temporary difference would be recognised when the building is revalued - there does not have to be a binding sale agreement, so you would recognise a taxable difference even if the company isn't planning to sell the building (or any other asset subject to the revaluation model). 

Best regards

Steve

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By Ayesha Bham
23rd May 2011 18:43

Hard work
I've heard from various sources that this proposed method will cause deferred tax nightmares if it isn't changed because of the different approach. I just hope they do simplify it as our job is hard enough but time will tell no doubt.

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By CEL
23rd May 2011 22:05

Temporary Differences

Steve,

Thanks for clarifying and taking the time to respond.

 

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