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The AccountingWEB guide to deferred tax considerations

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25th Nov 2009
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Steve Collings offers a refresher guide to deferred tax rules and considerations for those preparing financial statements.

A UK resident company is chargeable for corporate tax on its profits wherever they arise, other than dividends received from other UK companies, and this liability is accounted for as a current liability – it’s all very straight forward.

The complexities seem to arise when deferred tax appears on the scene. With more and more companies taking advantage of HMRC’s £50,000 Annual Investment Allowance, deferred tax issues may become a material component of a company’s financial statements.

This article looks at the concept of deferred tax and the inherent complexities, as well as addressing some of the more common concerns practitioners often have with deferred tax.

Some view deferred tax as a meaningless accounting exercise and in some cases preparers of financial statements often ignore the concept completely. However, by ignoring the effects of deferred tax, preparers may be in breach of FRS 19 ‘Deferred Tax’ and the recognition of deferred tax assets and/or deferred tax liabilities.

Timing differences

FRS 19 defines timing differences as:

‘Differences between an entity’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 financial statements. Timing differences originate in one period and are capable of reversal in one or more subsequent periods.’

An example of the above could be where a company accrues income in 2008 which is subsequently taxable in 2009 on receipt. Conversely, a company could make a provision for restructuring costs in 2009 which will attract tax relief when the expenditure has been incurred in 2010.

It therefore follows that a timing difference originates when a transaction is accounting for in the financial statements of an entity, but has not yet been accounted for in the tax computation. Timing differences reverse when the transaction is accounted for in the tax computation or financial statements, whichever the case may be.

There are instances where timing differences arise and then reverse but are never reflected in the tax computation. Such an example could be a provision for bad debts done in 2008 and written back in 2009, as the provision has been deemed unnecessary. Admittedly, these cases (especially for clients in the SME sector) are quite rare. To illustrate the concept, other examples of timing differences could be:

  • Accelerated capital allowances in respect of fixed assets.
  • Accrued pension liabilities in the financial statements which are subsequently granted tax relief when they are paid at a later date.
  • Assets subject to revaluation, where the revaluation gain only crystallises for tax purposes when the asset is sold.
  • Intra-group profits in stock which are unrealised at group level, but are reversed on consolidation.

Deferred tax assets
In practice, the most common transactions giving rise to a deferred tax asset are unutilised tax losses. In today’s climate these are particularly common. A deferred tax asset is recognised in respect of unutilised tax losses because less tax will be payable in the future, as the losses can be offset against future profits.

Care must be taken in recognising a deferred tax asset. A deferred tax asset should only be recognised when it is expected to be recoverable. Therefore, it can be only be recognised as a deferred tax asset where it is more likely than not that there will be sufficient taxable profits generated by the entity in future periods from which the future reversal of the underlying timing differences can be deducted.

The term ‘more likely than not’ is not defined in FRS 19, but FRS 12 at paragraph 23 suggests that it should be taken to mean that ‘the probability that the event will occur is greater than the probability that it will no’”. US GAAP at SFAS 109 ‘Income Taxes’ suggests that something is ‘more likely than not’ if its likelihood of occurring is more than 50%.

For example, if a company has tax losses in 2008, but the directors consider that 2009 will yield profits because they have won a lucrative contract, then the directors can recognise a deferred tax asset.

Conversely, if a company is producing losses year on year then not only will doubt be cast on the company’s going concern, but the chances are that there will not be suitable taxable profits generated in the future. As a consequence, a deferred tax asset should not be recognised. However, the mere existence of unrelieved tax losses should be taken as evidence that there will not be suitable future profits generated to offset the deferred tax asset and evidence to the contrary would normally be identifying the cause of the unrelieved tax losses and the fact that the company has previously been profitable and past losses have also been able to be utilised against future profits.

Deferred tax liabilities
The most frequent transactions giving rise to a deferred tax liability in the financial statements (especially those of SMEs) is accelerated capital allowances.

Figure 1
Company A purchases an item of plant for £45,000. The company’s year-end is 31 July 2009 and it has been trading for a full 12 months. The company’s accounting policy in respect of plant and machinery is to write the cost of the asset off over the useful economic life of the plant using depreciated historic cost with a full year’s depreciation charge in the year of acquisition and no depreciation in the year of disposal. In respect of the new item purchased, this machine is deemed to have a useful economic life of five years with no residual value. The company has also taken advantage of HMRC ‘Annual Investment Allowance’ and pays tax at 21%.

In Company A’s financial statements, the new item of plant will have a carrying value of (£45,000 – (£45,000 / 5) £9,000) = £36,000. The company has taken advantage of HMRC’s AIA and has chosen to write off the whole of this cost off in the 2009 tax computation. This results in the item of plant having a value of £nil for tax purposes.

The fact that HMRC has granted AIA against the full cost of the asset in 2009 has resulted in a disparity between the value of the asset for tax purposes and the book value of the same asset. As a result, the company will pay more tax in future periods, representing an obligation for the entity to refund a temporary cash flow advantage obtained by claiming the AIA. The deferred tax liability is calculated as follows:

Net book value of plant and machinery £36,000
Tax written down value £ nil
Difference £36,000
Deferred tax liability = £36,000 x 21% = £7,560

Industrial buildings allowance
Prior to the chancellor’s announcement to change the IBA regime, the original rules on factories, warehouses, hotels and commercial buildings in enterprise zones meant that IBA’s did not need to be repaid if they were retained in the business for a qualifying holding period of 25 years following the date of purchase. After the 25 year period had elapsed, no balancing charge arose even if an industrial building was subsequently sold for more than its tax written down value.

Under the old rules, deferred tax which was attributable to capital allowances of this type would be recognised until the conditions for retaining IBAs had been met. Once the conditions were met and there was no possibility that HMRC could claw back the allowances, the differences became permanent and any deferred tax liability previously recognised was reversed – usually at the end of year 25.

In the chancellor’s 2007 Budget, he announced two fundamental changes:

  • Balancing adjustment provisions and those that recalculate writing-down allowances for purchasers were withdrawn for balancing events occurring on or after 21 March 2007.
  • IBAs were to be phased out gradually from 2008/9 onwards by reducing the allowances from 4% to 3% to 2% to 1% with allowances being eliminated thereafter.

The measures introduced in the 2007 Budget meant that balancing adjustments would no longer arise and as a result, any deferred tax liability would never be reclaimed by HMRC. The removal of the balancing adjustment (and the qualifying period for retaining allowances) means that allowances received prior to the removal will become a permanent difference. As a consequence, no deferred tax liability should be made and any such deferred tax should be released. During the phasing out of IBAs, the allowance should be treated as a permanent difference as it arises.

Government grants

Accounting for government grants is dealt with under the provisions laid down in SSAP 4 ‘Accounting for government grants’.

Non-taxable revenue-based grants do not have any deferred tax issues attached to them because the amortised credit to the profit and loss account is a permanent difference. This also applies to non-taxable capital based grants, except to the extent that accelerated capital allowances apply.

Taxable revenue-based grants that are taxed when the company receives the grant (but recognised in the profit and loss account over a period of time for financial reporting purposes) will give rise to a timing difference on which a deferred tax asset may be required to be recognised on the unamortised balance carried forward to future periods. This is because the deferred tax asset will be recoverable in future accounting periods when the deferred credit unwinds.

Where the grant is received in respect of a fixed asset, the nature of the deferred tax will depend on both the accounting treatment and tax treatment of the grant. SSAP 4 allows the grant to be deducted from the cost of fixed assets.

It is worth mentioning at this point that companies are prohibited from deducting government grants from the purchase/production price of assets under the Companies Act 2006 (paragraphs 17 and 27 Schedule 1 (SI 2008/410) and FRSSE (April 2008) at paragraph 6.54) despite SSAP 4 deeming this treatment acceptable. The standard refers only to companies that are governed by the accounting and financial reporting requirements of UK companies’ legislation. However, this suggests that an unincorporated business can deduct the grant from the cost of the asset (IAS 20 – the international equivalent of SSAP 4 – also permits this treatment).

If the grant is deducted from the cost of the asset, the deferred tax implications are simply accelerated capital allowances. If the grant is treated as deferred income for financial reporting purposes but deducted from the cost of the asset for tax calculation purposes, then a deferred tax asset will arise on the unamortised grant which will then be offset against the deferred tax liability arising on the accelerated capital allowances.

Discounting deferred tax
Undoubtedly, the discounting of deferred tax assets and liabilities is quite rare in the UK, particularly among those who prepare financial statements for SME clients. However, FRS 19 does allow deferred tax assets and liabilities to be discounted to present day monetary values and this is where there are notable differences between FRS 19 and its international equivalent, IAS 12, which specifically prohibits the discounting of deferred tax assets and liabilities.

Steve Collings FMAAT ACCA DipIFRS is audit and technical manager at Leavitt Walmsley Associates Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’ and lectures on financial reporting and auditing issues.

 

Replies (10)

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Rebecca Benneyworth profile image
By Rebecca Benneyworth
25th Nov 2009 13:17

And another thing!

Looking at the example in relation to capital allowances, it is very common to simply compare the accounts written down value with the tax written down value to arrive at the timing difference for deferred tax purposes, and as this article highlights, with the return of AIA, we are back into deferred tax provisions.

However, you will need to be very careful about cars purchased after 1 April 2009. When the car is sold for considerably less than the tax written down value there is no longer a balancing allowance, so the remaining cost stays in the pool to be given by way of WDA - potentially at only 10% reducing balance. As I have shown in this article, this leaves an increasing "rump" of expenditure in the pool, which will essentially continue to increase, representing future capital allowances or a deferred tax asset. But the tax effect of this will only really unwind when trade ceases and it is given as a balancing allowance, so I would further propose that this should therefore not be recognised, as it does not meet the conditions.

So the technique of providing on the difference means that a deferred tax asset which should not be recognised is effectively set off against the liability. What companies will need to do in future is to segregate the accounts and tax WDV's of their cars (ugh) to avoid this leading to an understatement of the deferred tax liability.

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By carnmores
26th Nov 2009 13:00

bah humbug

i would like to find somewhe a deferred tax calculator and reconciliation - that can be done manually or on excel - any pointers

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By User deleted
30th Nov 2009 13:03

Will it add value for small clients?

My clients are all very small; all of them being private companies paying the small companies rate of CT and mostly living off cash flow. What value will it add if I calculate their deferred tax and put it in the accounts, bearing in mind the cost of this to the client?

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By raybackler
30th Nov 2009 13:43

FRSSE and Deferred Tax

The FRSSE (April 2008) says that:

"As stated in the Foreward to Accounting Standards, accounting standards, including the FRSSE, need not be applied to immaterial items."

I only use the FRSSE, as being a CIMA Member in Practice I don't have any clients that require an audit or are above the FRSSE thresholds, but this quote appears to apply to all accounting standards.

It follows that if Deferred Tax for a business entity is small under any accounting standard it can be ignored.  Under the FRSSE, if the business enity has less than £6.5m turnover etc and adopts the FRSSE, then it too can ignore Deferred Tax.

So the only thing to worry about is whether the amount is material or not.  I certainly think Deferred Tax of less than £100 can be ignored on these grounds for all business entities and for larger businesses this materiality will depend on the size of the organisation.

What do others think?

Ray

 

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By User deleted
30th Nov 2009 13:59

Deliberate ommision

We have the deliberate policy of ignoring DT for small incorporated bodies unless the result is significant as we found that no stakeholder (ie CH, HMRC or the client) (a) cared, much least (b) understood what it was, and we spent an awfully long time computing it, explaining it and generally being precise anoroak accountants, but to no absolutely no value to the client. I should point out computing it takes only a few minutes,  its the time spent explaining it that is the real issue. All clients, no matter how non-accounts literate will read at least three lines - turnover, profit and tax.  If the tax line is not the same as the tax return questions will be raised by most clients - and quite rightly too.

We have been considering it in more detail in the past 18 months, but have only really put it in where its clearly material, that is to say there are profit distribution issues or the figures are significant, depsite the fact the FRSEE gives no exemption on this area for materiality.

For very small clients AIA actually removes the DT issue for the simple reason that we are expensing a lot more PC equipment (which has also fallen in price to low levels for most clients) straight through to the P&L account as there is no longer any tax risk in doing so. Small clients seem to like this approach as it matches closer to their often cash based understanding of the business. Obviously easier for us too.

 

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By carnmores
30th Nov 2009 18:24

£100 you must be joking

materiality is usually a derivative of turnover or net assets if i remember correctly - but anything under  a £1000 should not trouble the scorers - client doesnt usually get it anyway and as you only have to show a balance sheet under abbreviated accounts who knows and can tell about it anyway - bloody useless large tinctures all round

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By bhafan
30th Nov 2009 19:00

Note to the accounts

I totally agree that immaterial amounts of deferred tax should be ignored as its inclusion adds no benefit or relevance to the accounts. However, does anyone know if it is necessary to add a note to the accounts disclosing that deferred tax has been ignored because of its immateriality?

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collings
By Steven Collings
30th Nov 2009 19:18

Materiality

Hi,

The second paragraph of the article says "....may become a material component of a company's financial statements".  Clearly if deferred tax is immaterial and wouldn't result in the financial statements being misleading then there's no point providing for it.  In some cases however, deferred tax may become material and this article aims to highlight that practitioners need to be considering the impact of deferred tax given HMRC's AIA.  Just because an item of capital expenditure may be written off in full under HMRC's AIA, there is still a requirement to recognise an asset in the balance sheet.

Kind regards

Steve

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By twickers
02nd Mar 2014 13:01

deferred tax

one of the best articles I have read on the site/ and wonderfully honest comment....

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By JimH
07th Jul 2015 09:56

Deferred tax
very helpful article and discussion

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