Deferred tax

Deferred tax arises when the actual tax consequence of a particular transaction (tax payable or recoverable) arises in a different period from the period in which the transaction itself is included in the financial statements. Examples include (but are not restricted to):

• Fixed asset costs that have a different pattern of tax deductions to the write off of the asset in the financial statements.
• Pension liabilities that are accrued in the financial statements but are allowed for tax only when the contributions are made to the pension fund at a later date.
• Inter-group profits in stock that are unrealised for consolidation purposes, yet taxable in the computation of the group company that made the unrealised profit.
• Losses reported in the financial statements where the related tax relief is only available to carry forward against future taxable profits.

These differences are referred to in FRS 19, ‘Deferred Tax’ as timing differences.

Since taxation is payable on profits (or gains) less losses, FRS 19 adopts the approach that classifies differences between the gains and losses that are recognised in the financial statements and the gains and losses that are recognised for tax purposes into two types:

1. Permanent differences - one-off differences between results for accounting purposes and taxable income, caused by certain items not being taxable / allowable. Such differences only impact on the taxation computation of one period (e.g. in England, entertaining other than staff entertaining is never allowable for tax purposes and certain types of grant are never taxable).
2. Timing differences - defined above.

Alternative approaches to accounting for deferred tax
The nil provision, or flow through basis ignores the taxation effects of timing differences completely. Tax is accounted for as it is assessed on the basis that taxation is an appropriation of profits by the government, and so is not relevant as a performance indicator. A theoretical justification for this argument is that the only tax liability that satisfies the statement of principles’ definition of a liability (an obligation to transfer economic benefits out of past transactions and events) is current taxation.

The full provision is based on the view that every transaction has a tax consequence and it is possible to make a reasonable estimate of the future tax consequences of transactions that have occurred by the balance sheet date. If this basis of deferred tax accounting is adopted, the computation of the deferred taxation figures is a relatively straightforward arithmetical exercise.

The position taken by SSAP 15 (the previous UK standard on deferred tax) was known as the partial provision basis. Like the full provision basis the partial provision basis is based on the premise that the future reversal of a timing difference gives rise to a tax liability (or asset). However, instead of focusing on the individual components of the tax computation the partial provision basis analyses the components as a whole in a single net assessment. To the extent that timing differences are expected to continue in future (by the existing timing differences being replaced by future timing differences as they reverse) the tax is viewed as being deferred permanently. The computation of deferred tax balances under the partial provision basis is rather more complicated than under the full provision basis because of the need to use forecasts of future transactions to estimate the incidence of future timing differences.

The FRS 19 approach to accounting for deferred tax
The general principle underpinning FRS 19 is that deferred tax should be provided in full on all timing differences – in other words the full provision basis.

The partial provision basis underpinning SSAP 15 was rejected for the following reasons:

• it is inconsistent with international practice;
• the financial statements reflect the tax consequences of transactions that have not yet occurred;
• reliance on future forecasts is subjective;
• the basis had already been regarded as inappropriate for dealing with certain categories of timing differences – for example on post-retirement benefits.

The full provision basis of accounting for deferred taxation was regarded as preferable to the flow-through basis because:

• the flow-through basis is not used internationally and the ASB is committed to convergence of UK and international practice where appropriate;
• the full provision basis recognises the future taxation consequences of transactions that have already occurred and from which entities clearly cannot withdraw. Therefore it is appropriate to recognise such future consequences as assets or liabilities.

The approach taken in FRS 19 to deferred tax accounting under the full provision basis is the incremental liability approach. This approach recognises deferred tax only when it could be regarded as meeting the definition of an asset or a liability in its own right.

An alternative approach to deferred tax accounting under the full provision approach is the valuation adjustment approach. This is the approach taken in the international accounting standard on deferred tax – IAS 12, ‘Income Taxes’. This approach recognises deferred tax on all differences between the carrying values of assets and liabilities in the financial statements and their values for tax purposes (the value for tax purposes is referred to in IAS 12 as the tax base of the assets or liabilities).

Three examples will illustrate the different approaches to full provision deferred tax accounting between FRS 19 and IAS 12. In all examples we will assume the tax rate is 30%.

Example 1
A fixed asset cost £100,000 when purchased and depreciation totalling £40,000 has been charged up to the balance sheet date – 31 March 2002. The company has claimed total tax allowances on the asset of £50,000. On 31 March 2002 the asset is revalued to £90,000.

Solution - incremental liability approach (FRS 19)
The timing difference on the asset prior to revaluation is £10,000 (£50,000 - £40,000. The tax payable on this timing difference (30% x £10,000 = £3,000) is an unavoidable liability of the entity. If the asset is retained then future tax allowances will be £50,000 and future depreciation charges £60,000 (£100,000 - £40,000).

The tax payable on the net reversing timing difference is £3,000. If the asset is sold then the written down value for tax purposes (£100,000 - £50,000 = £50,000) is £10,000 larger than the written down value for accounts purposes (£100,000 - £40,000 = £60,000). Once again, an unavoidable liability to tax on the reversing timing difference arises of £3,000.

Revaluing the fixed asset to £90,000 does not create an unavoidable incremental tax liability. The revaluation of a fixed asset is not a taxable event and a tax liability does not crystallise until the asset is sold. Therefore, unless the company has made a binding commitment to sell the asset by the balance sheet date no additional liability for deferred tax is recognised.

Solution - valuation adjustment approach (IAS 12)
The deferred tax liability prior to the revaluation is the same as for the incremental liability approach – although reached by a different method. The carrying value of the asset is £60,000 (£100,000 - £40,000) and its tax base is £50,000 (£100,000 - £50,000). The difference between the carrying value of an asset and its tax base is £10,000 (referred to in IAS 12 as a temporary difference). Under IAS 12 deferred tax is recognised on most temporary differences so the liability will be £3,000 (£10,000 x 30%).

Revaluing the asset increases its carrying value without altering its tax base (since revaluations have no immediate tax consequences). Therefore the revaluation creates an additional temporary difference of £30,000 (£90,000 - £60,000) and so additional deferred tax of £9,000 (£30,000 x 30%) would be recognised.

Example 2
On 30 June 2001, a group acquires a new subsidiary. At the date of acquisition the subsidiary had stock that was shown in its financial statements at a carrying value of £50,000. The group assessed the fair value of the stock to be £55,000.

Solution - incremental liability approach (FRS 19)
There are no deferred tax implications in the consolidated accounts because a fair value adjustment has no effect on the tax payable on the eventual sale of the stock. The tax payable is based on the profit made by the new subsidiary in the tax jurisdiction in which it operates. This is not changed by its incorporation into the consolidated financial statements.

Solution - valuation adjustment approach (IAS 12)
The carrying value of the stock in the consolidated accounts is £55,000 whilst its tax base is £50,000. Deferred tax is recognised on the temporary difference of £5,000. Since the tax rate is 30% then the deferred tax asset is £1,500.

Example 3
A UK company has an associate located overseas in Taxland. The UK company’s share of the retained profits of the associate is £40,000. If these profits were remitted to the UK company as a dividend then under tax legislation in Taxland the associate would need to deduct withholding tax equivalent to £4,000 from the payment. It is unclear whether any double tax relief would be available.

Solution - incremental liability approach (FRS 19)
Unless the overseas associate has entered into a binding obligation to pay a dividend there are no deferred tax consequences. No further tax will be payable until the earnings are remitted.

Solution - valuation adjustment approach (IAS 12)
The existence of a potential tax charge on the payment of a dividend affects the tax base of the net assets of the associate in the consolidated accounts. Provision is made for deferred tax on the £4,000 potentially payable.

FRS 19 - a summary of the requirements of the standard
Subject to the specific exceptions noted below deferred tax is recognised on all timing differences that have originated but not reversed by the balance sheet date. However, deferred tax is not recognised on permanent differences.

Deferred tax is not recognised on revaluations of fixed assets unless:

• The fixed assets are continually revalued to fair value with changes recognised in the profit and loss account (e.g. investments that are ‘marked to market’).
• The company has entered into a binding commitment to dispose of the asset by the balance sheet date and expects to pay tax on the sale.

Deferred tax is not recognised on fair value adjustments made when a subsidiary, associate or joint venture is consolidated for the first time. The only (very rare) exception to this general rule is where the consolidated entity has (at the date of acquisition) entered into a binding agreement to dispose of an asset that attracts a fair value adjustment.

Deferred tax is not recognised on potential tax payable on the unremitted earnings of subsidiaries, associates and joint ventures unless the subsidiary, associate or joint venture is demonstrably committed to distribute those earnings at the balance sheet date.

In principle, deferred tax assets should be recognised in just the same ways as deferred tax liabilities. However as with all assets the question of recoverability arises. Deferred tax assets are regarded as recoverable if, on the basis of all the available evidence, it can be regarded as more likely than not that there will be suitable taxable profit from which the future reversal of the underlying timing differences can be deducted. The criteria often need to be applied in practice if the potential deferred tax asset is caused by a trading loss that can only be relieved by carry forward against future taxable profits. The reason for the existence of past trading losses needs to be established. If they are caused by a non-recurring event or series of events (such as the disposal of a loss-making business segment) then it might be reasonable to assume that future trading profits will be available to offset the losses. However, if the reasons for the trading loss relate to ongoing conditions then it may well be inappropriate to regard the potential deferred tax asset as recoverable.

Deferred tax should be recognised in the profit and loss account for the period, unless the gain or loss in respect of which the deferred tax arises is recognised in the statement of total recognised gains and losses. An example of such a gain or loss would be the gain or loss on revaluation of the net pension asset or liability that is required under FRS 17, ‘Retirement Benefits’.

Deferred tax should be measured at the average tax rates that are expected to apply in the periods in which the timing differences are expected to reverse, based on tax rates that have been enacted or substantively enacted by the balance sheet date.

Reporting entities are permitted but not required to discount deferred tax assets and liabilities to reflect the time value of money. The reasons for allowing, rather than requiring, discounting appear to be two-fold:

• Whilst the majority of the ASB appear to be in favour of the conceptual validity of discounting (it is used in other standards such as FRS 12, ‘Provisions and Contingencies’ and FRED 17, ‘Retirement Benefits’ it is not permitted in IAS 12 and so discounting could be said to inhibit international harmonisation of deferred tax accounting.
• There is a balance to be drawn between the additional costs of discounting and the potential benefits that the approach could bring. There is currently a reasonably widely held view that disclosure of the expected periods of reversal of long-term timing differences would be an acceptable (and less costly) alternative. Therefore the case for discounting is not sufficiently strong to make it compulsory at this time.

If discounting is adopted then:

• Certain timing differences, that are already based on discounted cash-flows (such as provisions for future pension liabilities) should not be discounted further.
• The discount rates used should be the post-tax yields to maturity that could be obtained on government bonds with maturity dates, and in currencies similar to those of the deferred tax assets or liabilities.
• The ‘full reversal’ approach should be adopted, taking to account the incidence of potential future timing differences that will replace those reversing.

Example 4
A company purchases an asset for £100,000 at the start of 20X0. It is estimated that the asset will have a life of 5 years and no residual value. Tax allowances of £60,000 are available in 20X0 and allowances of £10,000 are available for the following four years. The asset is depreciated on a straight-line basis and the post-tax yields to maturity on relevant government bonds is as follows:

The rate of tax that is relevant for the company is 30%.

Solution
The first step is to prepare a schedule of timing differences for each year as shown in Table 1.

It is worth noting that, without discounting, the deferred tax provision at 31.12.X0 is £12,000 (30% x £40,000). If we adopt a policy of discounting then the table shows that the timing differences at the end of 31.12.X0 are expected to reverse at £10,000 per year for the next four years (20X1-20X4 inclusive). Using the expected yields to maturity given in the question then the discounted amount of the expected future reversal is shown in Table 2.

The discounted deferred tax liability is 30% x £36,039 = £10,812. The calculation takes no account whatever of timing differences arising on future transactions that may wholly or partly offset the reversal of the timing differences. This is the basis of the full reversal approach, which is clearly in line with the principles of the standard.

FRS 19 makes the practical point that, where yields to maturity are relatively stable (they don’t change much in the example we have just worked) it may well be possible to use approximations and averages to simplify the calculations without introducing material errors.

Net deferred tax liabilities should be classified as provisions for liabilities and charges, whilst net deferred tax assets should be classified as debtors. However deferred tax relating to a net pension asset of liability should be offset against that net asset or liability as required by FRS 17, ‘Retirement Benefits’.

Deferred tax assets and deferred tax liabilities can be offset provided that:

• they relate to taxes levied by the same authority; and
• they arise in the same taxable entity or a group of taxable entities where the tax losses of one entity can reduce the taxable profits of another.

The notes to the financial statements should include a reconciliation of the current tax charge or credit reported in the profit and loss account to the current tax charge that would result from applying a standard rate of tax to the profit on ordinary activities before tax. The reconciling items will be a combination of permanent and timing differences. Only the latter will attract deferred tax.

FRS19 - an evaluation of the standard
In FRS 19 the ‘headline message’ is that the FRS requires full provision in the interests of international harmonisation. However, the reality is that its proposals achieve neither true full provision nor international harmonisation. The overall conceptual bases of IAS 12 and FRS 19 differ fundamentally; IAS 12 requires deferred tax to be provided on all revaluations and fair value adjustments; whilst FRS 19 normally does not. IAS 12 requires deferred tax to be provided on unremitted earnings unless their distribution can be prevented; FRS 19 requires deferred tax not to be provided unless there is a commitment to distribute them. IAS 12 prohibits discounting - FRS 19 allows it.

On the one hand, the ASB’s commitment to the current international harmonisation project required it to move the UK towards full provision. On the other, it had to contend not only with its own concerns as to the conceptual basis of IAS 12, but also with the practical dilemma that, whereas it may now just be possible to gain acceptance for full provision on accelerated capital allowances in the UK, any proposal to require full provision on revaluation gains would provoke outright opposition.

FRS19 has bravely tried to accommodate a number of different strands of opinion. However in practice this accommodation is difficult because of their wide diversity. However, the result is that, in the name of international harmonisation, the ASB has an FRS that still leaves accounting for tax in the UK somewhat different from the internationally accepted norm. Commentators may well question the need for change.

The ASB’s own Statement of Principles, requires every balance sheet item, other than shareholders’ equity, to be an ‘asset’ or ‘liability’ as defined in the statement. Many commentators have notes that based on the statement’s definition of ‘liability’ (i.e. a present obligation arising from past events), the only tax ‘liability’ is the amount due to the tax authorities – i.e. current tax. This implies that the appropriate accounting treatment for tax is the ‘flow through’ method, under which no provision is made for deferred tax, a treatment known to be supported by several members of the ASB.

Paul Robins BSc MBA ARCS FCA is a freelance lecturer and consultant.