FRS 102: Deferred tax issues explained
In the current version of UK GAAP taxation is dealt with in two accounting standards: FRS 16 Current Tax and FRS 19 Deferred Tax, explains Steve Collings.
Aspects concerning taxation are also found in FRS 17 Retirement Benefits (specifically paragraphs 71 and 72) which deal with tax relief on a company’s pension contributions and the attribution of the tax effects to the profit and loss account and statement of total recognised gains and losses.
FRS 102 deals with taxation in Section 29 Income Tax. The scope paragraph of Section 29 confirms that income tax (for the purposes of FRS 102) includes all domestic and foreign taxes which are based on taxable profit. It then goes on to include taxes such as withholding taxes payable by a subsidiary, associate or joint venture within its scope.
Unlike FRS 16 and FRS 19 currently, Section 29 combines the requirements of both current and deferred taxes and the standard recognises that current tax is payable or refundable in respect of the taxable profit or taxable loss in respect of the current reporting period or past reporting periods. The scope section of Section 29 takes the same stance as FRS 19 in respect of deferred tax in that it acknowledges that deferred tax represents the future tax consequences of transactions and events recognised in the entity’s financial statements of both the current and previous accounting periods. When a business combination takes place (business combinations are dealt with in Section 19 Business Combinations and Goodwill) the section also requires deferred tax to be recognised in respect of assets and liabilities recognised as a result of the business combination. In respect of assets, it is all assets other than goodwill.
This is the simplest part of Section 29 and relates to the CT charge or credit and the associated liability or asset depending on whether the company has a liability to CT, or is due a refund from HMRC in respect of taxable losses that have, perhaps, been carried back and offset against the previous year’s taxable profit.
Paragraph 29.3 requires a reporting entity to recognise a current tax liability in respect of CT payable for the current and past periods. This will, in almost all cases, be based on the company’s taxable profit for the financial year. On the flip side if a company is due a refund of CT, then the company is required to recognise a current tax asset in respect of such. All tax amounts are required to be measured using the tax rates and laws that have been enacted or substantively enacted by the balance sheet date.
Here cometh the problem child! At the outset I think it is important to acknowledge that the accounting for deferred tax could have been a whole lot worse in the previous exposure drafts. In the previous exposures which were based on IFRS for SMEs, the section that dealt with deferred tax looked at deferred tax from a temporary difference approach. In the UK, accountants have been used to dealing with deferred tax from a timing difference approach. The differences between the two are fairly significant. The temporary difference approach focuses on the balance sheet so, for example, a deferred tax liability would arise if the carrying value of an asset was greater than its tax base or if the carrying value of a liability is less than its tax base.
Timing differences, on the other hand, focus on the P&L account and are differences between a company’s taxable profits and its results as stated in the financial statements that arise from the inclusion of gains and losses in tax assessments in periods different from those in which they are recognised in the financial statements. A typical scenario of a timing difference in the UK would be where an asset qualifies for 100% Annual Investment Allowance (AIA) in the year of acquisition, but is being depreciated over three years using the straight-line method of depreciation. In this scenario, a deferred tax liability would be recognised.
None of these concepts are new to accountants and paragraph 29.6 to Section 29 does require deferred tax to be recognised in respect of all timing differences at the balance sheet date. Paragraph 29.6 goes on to define a timing difference slightly differently than FRS 19 does as follows:
‘Timing differences are differences between taxable profits and total comprehensive income as stated in the financial statements that arise from the inclusion of income and expenses in tax assessments in periods different from those in which they are recognised in the financial statements.’
So, in a nutshell, what this definition is saying is that a timing difference will arise when an item is included in the tax computation in the current period but the same transaction has been recognised in the financial statements in a different period.
In respect of deferred tax recognition, there are some points that practitioners will need to note in Section 29:
- Tax losses that are carried forward to the next accounting period that essentially give rise to a deferred tax asset must only be recognised to the extent that it is probable that they will be recovered against the reversal of deferred tax liabilities. Like its outgoing predecessor, FRS 19, the default presumption is that the mere existence of tax losses is taken as strong evidence that there may not be other future taxable profits against which the unutilised tax losses can be relieved. There should be evidence to the contrary that the company will be able to utilise deferred tax assets (such as the awarding of a lucrative contract in the next financial year)
- Paragraph 29.8 says that deferred tax will be recognised in an entity’s financial statements in respect of tax allowances for the cost of a fixed asset when these are received before or after the depreciation of the fixed asset is recognised in profit or loss. If, and when, the client has met all the conditions imposed by HMRC for retaining the relevant capital allowances, deferred tax is then reversed
- When a client has a subsidiary, associate, branch or an interest in a joint venture, it must recognise deferred tax when income or expenses from these sources have been recognised in the financial statements but will subsequently be included in the tax computation in a future period. There are two exceptions to this rule:
o Where the reporting entity has control over the reversal of the timing difference
o There is probability that reversal of the timing difference will not take place in the foreseeable future
Paragraph 29.9 gives an example of a situation where there are undistributed profits in a subsidiary, associate, branch or interest in a joint venture.
Timing difference ‘plus’
As mentioned earlier in the article, the previous FRED 44 required deferred tax to be computed using a temporary difference approach. There was an outcry about this approach and so the (now defunct) Accounting Standards Board (ASB) required this particular area to be redrafted, but to be as near to the international equivalent (IAS 12 Income Taxes) as possible. This resulted in the concept of the ‘timing difference PLUS’ approach being borne.
The ‘plus’ part builds on the existing ‘timing difference’ approach that many of us are already familiar with but the intention by the ASB in bringing in the ‘plus’ part was so that the calculation of deferred tax would be the same in many (but not all) cases as under IAS 12. It achieves this by extinguishing the fewer exceptions that are currently contained in FRS 19. A typical example of this is in respect of fixed assets that are subjected to the revaluation model as permitted in Section 17 Property, Plant and Equipment. Under FRS 19 at paragraph 14, no deferred tax is recognised on a revaluation gain in respect of a non-monetary asset that is subjected to the revaluation model unless the client has:
- entered into a binding agreement to sell the revalued assets
- recognised the gains and losses expected to arise on the sale
This exception contained in FRS 19 is now outlawed by paragraph 29.15 in FRS 102 which now requires deferred tax in respect of a non-depreciable property whose value is measured using the revaluation model to be measured using the tax rates and allowances that apply to the sale of the asset.
Likewise with assets carried under the revaluation model, where a client has an investment property that is measured using fair value in accordance with Section 16 Investment Property, deferred tax is recognised using the tax rates and allowances that apply to the sale of the investment property. There is an exception to this rule in paragraph 29.16 which relates to investment property that has a limited useful life and where the client is going to use the economic benefits associated with the investment property over time.
There are a couple of other additional instances (due to the ‘plus’ approach) where deferred tax concepts will be triggered and one of these is in respect of a business combination (that used to be referred to in ‘old language’ as an ‘acquisition’). Paragraph 29.11 says that when the tax base of an asset acquired in a business combination (not goodwill, however) is less than the value at which it is recognised in the acquirer’s financial statements, then a deferred tax liability is recognised to represent the additional tax that will be paid in the future. On the flip side, when the tax base of an asset is more than the amount recognised for the asset in the financial statements, a deferred tax asset is recognised to represent the additional tax that will be avoided in respect of that difference. A deferred tax asset or liability is recognised for the additional tax the client will either avoid or pay due to the difference in value at which a liability is recognised and the amount that is assessed to be owed to HMRC. Amounts attributed to goodwill will be adjusted by the amount of deferred tax recognised.
Measurement of deferred tax
The measurement of deferred tax is similar to the current FRS 19 requirements in that paragraph 29.12 requires a reporting entity to measure a deferred tax liability or asset using the tax rates and laws that have been enacted, or substantively enacted, at the balance sheet date and which are expected to apply to the reversal of the timing differences. There are some other requirements that practitioners need to consider:
- If different tax rates apply to different levels of taxable profit, deferred tax is measured using an average rate(s) that have been enacted or substantively enacted at the balance sheet date and that will apply to the taxable profit or loss of the periods in which the company expects the deferred tax asset or liability to be realised or settled
- Paragraph 29.14 recognises that in some jurisdictions, taxes are payable at higher or lower rates should all or part of the profit or profit and loss account reserves be paid out as a dividend to shareholders. Paragraph 29.14 also goes on to say that in other jurisdictions, taxes may be refundable or payable if all or part of the profit or P&L account reserves are paid out as a dividend to shareholders. This paragraph requires an entity to measure current and deferred taxes using the rates applicable to profits that are eligible to be distributed as a dividend until the entity recognises a liability to pay a dividend. When a liability to pay a dividend is recognised in the financial statements, the entity recognises a current or deferred tax liability/asset and the associated tax expense/income
- Deferred tax recognised in respect of assets carried under the revaluation model are measured using the tax rates that apply when the asset is sold
- For investment property measured at fair value, deferred tax is measured using the tax rates that apply when the asset is sold
One final point to note, which is going to go largely unnoticed (if not completely unnoticed), is that it will no longer be permissible to discount deferred tax balances to present day values. The reality is that hardly anyone discounts deferred tax balances for the time value of money so this new requirement in Section 29 is not going to be earth-shattering.
A quick point to mention where VAT is concerned is that this is dealt with in paragraph 29.20 to Section 29 and requires the turnover shown in the profit and loss account to exclude VAT. There is now reference to the flat rate scheme for VAT and any VAT imputed under the flat rate scheme is not to be included in the turnover figure.
Deferred tax liabilities will be shown within provisions for liabilities (as is the case currently) and deferred tax assets are shown within debtors. A company will not be able to offset current tax assets against current tax liabilities if there is no legally enforceable right to do so and there is the intention to settle on a net basis, or to realise the asset and then settle the deferred tax liability at the same time.
Where deferred tax is concerned and offsetting, a company can only offset deferred tax assets and liabilities in two situations:
- Where there is a legally enforceable right to set off current tax assets against current tax liabilities
- The deferred tax assets and liabilities relate to income taxes levied by the same tax authority on either the same taxable entity or different taxable entities which intend to either settle current tax assets and liabilities on a net basis, or to realise the assets and settle the liabilities at the same time in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled/recovered
FRS 102 requires disclosure of:
- The current tax expense/income
- The aggregate current and deferred tax relating to items recognised as items of other comprehensive income or equity
- A reconciliation between the tax expense/income in the P&L account and the pre-tax profit or loss on ordinary activities multiplied by the applicable tax rate
- The amount of net reversal of deferred tax assets and liabilities expected to occur during the year beginning after the reporting period together with a brief explanation for the expected reversal
- An explanation of changes in the applicable rates of tax compared with the previous period
- The amount of deferred tax liabilities/assets at the end of the reporting period for each type of timing difference and the amount of unused tax losses/tax credits
- The expiry date (if any) of timing differences, unused tax losses and credits
- An explanation of the nature of the potential tax consequences that would result from the payment of dividends to shareholders if part or all of the profit/P&L account reserves were paid out to them
While the vast majority of taxation issues contained in FRS 102 will be the same as what is currently done under FRS 16 and FRS 19, there are some additional considerations relating to deferred tax issues that practitioners need to bear in mind for their clients (particularly those concerning revaluations).
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’. He is also the author of ‘The AccountingWEB Guide to IFRS’ and ‘IFRS For Dummies’ and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.