Are deferred tax assets capable of recovery?by
While deferred tax assets arising from unutilised tax losses can be contentious, it is crucial to consider whether the asset is actually capable of recovery.
Deferred tax issues are dealt with in FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland in Section 29 Income Tax. Micro entities preparing their financial statements under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime are prohibited from recognising deferred tax in their financial statements.
It is fair to say that deferred tax has been a contentious issue for many years and there are still a number of challenges where the concept is concerned.
In September 2022, the Financial Reporting Council (FRC) published Thematic Review: Deferred tax assets. The FRC was prompted to revisit the topic of deferred tax asset accounting following the Covid-19 pandemic on the basis that the pandemic caused many companies to report losses or reduced profits. While the FRC’s focus of the Thematic Review is that of companies reporting under International Financial Reporting Standards (IFRS) accounting standards, the FRC’s Thematic Review is somewhat relevant to UK and Ireland generally accepted accounting principles (GAAP) reporters, particularly where deferred tax assets have arisen from unutilised tax losses.
FRS 102 requirements
FRS 102 is brief where the issue of deferred tax assets is concerned and paragraph 29.7 states: “Unrelieved tax losses and other deferred tax assets shall be recognised only to the extent that it is probable that they will be recovered against the reversal of deferred tax liabilities or other future taxable profits (the very existence of unrelieved tax losses is strong evidence that there may not be other future taxable profits against which the losses will be relieved).”
The stance taken by FRS 102 where deferred tax assets are concerned is that they can only be recognised where recovery is probable (in other words, more likely than not). This is notably different than the requirements of FRS 102, Section 21 Provisions and Contingencies in that recognition of a deferred tax asset is not dependent on recovery being “virtually certain” (which is the threshold for a reimbursement asset under FRS 102, Section 21).
Paragraph 29.7 also takes a somewhat pessimistic approach to the recognition of a deferred tax asset. It suggests that the very existence of unrelieved tax losses is strong evidence that there may not be other future taxable profits against which the losses will be relieved. In other words, just because an entity may have unutilised tax losses, it does not necessarily mean that a deferred tax asset is recognised on the balance sheet. There must be corroboratory evidence that future taxable profits will arise against which the unutilised tax losses can be relieved, hence meaning the deferred tax asset is capable of recovery. For example, a change in circumstance, such as a new order or product, may have occurred that makes the turnaround probable. This pessimism is there to stop reporting entities from recognising deferred tax assets that will not be recoverable.
If a deferred tax asset arises because of unutilised tax losses and there is no available evidence that the entity will generate other future taxable profits against which the deferred tax asset can be utilised, no deferred tax asset should be recognised.
The need to consider whether the entity will generate “future taxable profits” is critical where deferred tax assets are concerned. Indicators that an entity will generate future taxable profits to utilise a deferred tax asset include:
- the awarding of a contract to the entity in the next financial year which is likely to prove profitable
- evidence that the taxable loss incurred is an isolated occurrence (for example due to a large bad debt or a large restructuring) and the company’s budgets and forecasts indicate the company will return to profit in the next financial year
- the entity is a member of a group and group relief is available where a loss in one group member can be offset against another group member’s profit.
Positive and negative evidence
The FRC’s Thematic Review clarifies that in assessing the availability of future taxable profits, companies should consider all available evidence (both negative and positive). Appendix A to the Thematic Review sets out a table of positive and negative evidence.
|Positive evidence||Negative evidence|
|Losses occurred due to identifiable one-time/non-recurring event||A recent history of operating losses for tax purposes|
|A strong earnings history exclusive of a non-recurring loss||Start-up business|
|New business opportunities, such as new patents||History of significant variances of actual outcomes against business plans|
|Restructuring or disposal which clearly eliminates the loss sources||Losses of major customers and/or significant contracts|
|Convincing tax planning strategies||Uncertainty regarding going concern|
|Firm sales backlog or new contracts||History of restructuring without returning to profitability, or emerging from bankruptcy|
|Business acquisitions generating sustainable profit margins in the relevant taxable entity sufficient to enable the utilisation of tax losses||Losses expected in early future years|
|History of unused tax losses and/or credits expiring|
|The losses relate to core activities and thus may recur|
The Thematic Review clarifies that it is not sufficient to simply discontinue making losses. Profit forecasts used in assessing whether a deferred tax asset is recognised should be used with caution if these require significant judgments to be made concerning the future. In particular, start-up companies, or companies with a volatile profit or loss history may need more extensive convincing evidence than other companies with a history of reliable and stable profit forecasts.
Example: losses arising due to the pandemic
In the past two years, an entity in the hospitality sector has sustained material losses which started during the Covid-19 pandemic. The draft accounts for the year ended 31 October 2022 show a return to profitability (albeit at a low level) and a deferred tax asset has been recognised in the previous two years as the directors considered the event giving rise to the loss (the pandemic) will not recur.
The Thematic Review clarifies that where material losses have occurred as a result of a specific event that is not expected to recur, companies will need to consider whether, and how, their business will recover and adapt.
Relevance to UK and Ireland GAAP reporters
The focus of the FRC’s Thematic Review is on public interest entities reporting under International Accounting Standards (IAS) 12 Income Taxes. Deferred tax under IAS 12 is notably different than deferred tax under FRS 102, Section 29 as IAS 12 calculates deferred tax using a “temporary difference” approach, whose focus is on the balance sheet differences between assets and liabilities and their associated tax written down values. FRS 102 calculates deferred tax on a “timing difference plus” approach, whose focus is on the differences inherent between accounting profit and taxable profit – that is, the profit and loss account.
The content of the Thematic Review is, to a certain extent, relevant to UK and Ireland GAAP reporters, notably:
- to ensure that deferred tax assets are only recognised when they are capable of recovery
- to ensure that there is corroboratory evidence that the entity will generate future taxable profit enabling the deferred tax asset to be utilised
- ensuring that profit forecasts used when determining whether a deferred tax asset should be recognised are reliable
- disclosing information as key sources of estimation uncertainty or judgments (for non-small entities).
Periodic review of UK and Ireland GAAP
At the time of writing, the FRC was in the process of analysing responses to FRED 82 Draft amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and other FRSs – Periodic Review. FRED 82 proposes little in the way of change to FRS 102, Section 29 but does propose to include new paragraphs 29.17A to 29.17c on uncertain tax treatments.
For small entities applying the presentation and disclosure requirements of FRS 102, Section 1A Small Entities, FRED 82 proposes to require additional disclosures in respect of deferred tax as follows:
- the amount of the net reversal of deferred tax assets and deferred tax liabilities expected to occur during the year beginning after the reporting period together with a brief explanation for the expected reversal
- the amount of deferred tax liabilities and deferred tax assets at the end of the reporting period for each type of timing difference and the amount of unused tax losses and tax credits
- the expiry date, if any, of timing differences, unused tax losses and unused tax credits.
The above additional disclosures are expected to become mandatory for accounting periods commencing on or after 1 January 2025 (although this date is tentative).
Deferred tax assets arising from unutilised tax losses have often proven to be contentious in the past, usually because entities recognise them without any due consideration of whether they are capable of recovery. The important issue to consider is whether the deferred tax asset is capable of recovery because if it is not (or it is doubtful that it is capable of recovery) it should not be recognised.