Accounting for Income Taxes According to International Financial Reporting Standards

Transcription

1 4 Accounting for Income Taxes According to International Financial Reporting Standards Dave Santerre* Abstract The adoption of international financial reporting standards (IFRS) in Canada noticeably modifies accounting for income taxes. The purpose of this chapter is to inform the reader about accounting for income taxes in financial statements prepared according to IFRS. The chapter begins with a brief history of accounting for income taxes under Canadian generally accepted accounting principles (GAAP) up to the adoption of IFRS on January 1, It then outlines the changes that affect accounting for income taxes according to IFRS, as prescribed under IAS 12. While the basics of accounting for income taxes will be looked at, the chapter focuses primarily on the difference in accounting treatment between the current IAS 12 standard and the current practices under Canadian GAAP. Introduction The adoption of international financial reporting standards (IFRS) is the topic of the day in the finance function of companies. The changeover from Canadian generally accepted accounting principles (GAAP) to IFRS took place on January 1, 2011 for all Canadian publicly accountable enterprises. 1 IFRS will apply to annual and interim financial statements for years beginning on or after that date. * Of PricewaterhouseCoopers LLP, Montreal. 1 Other companies will be able to select which accounting principles they apply, but Canadian GAAP as we know them today will no longer be applied. See chapter 2 in this volume for other possible options for non-publicly accountable enterprises (small and medium-sized businesses). 93

2 94 / IFRS: Adoption in Canada The adoption of IFRS in Canada noticeably modifies accounting for income taxes. The purpose of this chapter is to inform the reader about accounting for income taxes in financial statements prepared according to IFRS. 2 It begins with a brief history of accounting for income taxes under Canadian GAAP. Then it examines recent and anticipated changes to IAS 12 3 that affect accounting for income taxes according to IFRS. Lastly, a more detailed analysis of the current IAS 12 standard is presented, comparing the accounting treatments with current practices under Canadian GAAP. Although the framework for the two standards is similar, we will see that there are significant differences in the way they are applied. History of Accounting for Income Taxes According to Canadian GAAP Fixed Deferral Method: Income-Based Approach Before 1968, two methods for accounting for income taxes were permitted when there were temporary differences between accounting income and taxable income: the tax deferral method, based on accounting income; and the current tax method, based on taxable income. In practically all companies, there is a difference between accounting income and taxable income. This is primarily due to differences in timing between the fiscal year in which certain revenues and expenses are included in accounting income and the taxation year when they are included in the taxable income calculation. Depending on the method used, net income after taxes for the same company could often be very different. In light of this situation and the importance of taxes in determining income, it made more sense to use a standard method. As a result, the Canadian Institute for Chartered Accountants (CICA), which established financial reporting standards in Canada, adopted section 3470 ( Corporate Income Taxes ) in Section 3470 recommended use of the 2 See the chapter by Jason Doucet in this volume for an analysis of the impacts on tax compliance with the changeover to IFRS in Canada. 3 International Accounting Standards Board, International Accounting Standard IAS 12, Income Taxes, October 1996, as amended. 4 See the 1968 version of Canadian Institute of Chartered Accountants, CICA Handbook (Toronto: CICA) (looseleaf ).

3 Accounting for Income Taxes According to IFRS / 95 deferral method when accounting for income taxes. This method ties the income tax expense or income tax recovery to the accounting income for the year, whether the taxes were paid in a previous year or will become payable in a future year. Thus, the tax effect of transactions is accounted for in the same year as the underlying transactions using a tax deferral in the income statement. Under this method, the tax deferral calculation is based on the effective rate upon initial recognition, without being subsequently restated to take into account changes in tax rates. This approach is based on an income statement analysis, as opposed to the balance-sheet-based approach that is currently used (and described below). In 1973, following the adoption of the new Income Tax Act 5 (reflecting proposals for tax reform in the Report of the Royal Commission on Taxation 6 and the 1969 white paper 7 ), section 3471 ( Corporate Income Taxes Additional Areas ) was added to the CICA Handbook to specify the accounting treatment resulting from certain new tax provisions, such as those dealing with refundable taxes or a change in a company s tax status. Liability Method: Balance-Sheet-Based Approach In 1997, the CICA approved section 3465 ( Income Taxes ) to supersede sections 3470 and The introduction of this new section was the result of several years work. In 1988, the first exposure draft proposed to modify the accounting for income taxes as it had been practised since The exposure draft was abandoned in 1989 owing to a lack of consensus on the amendments to be made. The plan to amend existing standards was only relaunched in At that time, the US Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) had published new standards for accounting for income taxes. In 1992, the FASB published FAS 109, 8 which replaced previous interpretations of accounting for income taxes. In 1994, the IASB published exposure draft E49, 9 significantly modifying IAS 12 ( Accounting 5 SC , c. 63; effective January 1, Canada, Report of the Royal Commission on Taxation (Ottawa: Queen s Printer, 1966) (commonly known as the Carter report). 7 Canada, Department of Finance, Proposals for Tax Reform (Ottawa: Queen s Printer, 1969). 8 Financial Accounting Standards Board, Statement of Financial Accounting Standards no. 109, Accounting for Income Taxes, February International Accounting Standards Board, Exposure Draft E49, Income Taxes, October 1994.

4 96 / IFRS: Adoption in Canada for Taxes on Income ). 10 The revised version of IAS 12 ( Income Taxes ), 11 taking the exposure draft into account, was adopted in At that time, both standards recommended an approach based on a company s balance sheet. Under the balance-sheet-based approach, future income tax cash flows resulting from the realization of assets and the settlement of liabilities for their carrying amounts are recorded as future income tax assets and liabilities. 12 The calculation of future income tax assets and liabilities is based on temporary differences between the carrying amount and the tax base of an asset or liability on a company s balance sheet. The tax base is the amount that could be deducted in establishing the taxable profit when recovering an asset or settling a liability. If there is no tax effect when recovering the carrying amount of an asset or settling a liability, the tax basis is equal to the carrying amount. Future income taxes are calculated by multiplying temporary differences by the expected income tax rate at the time the difference is going to reverse. The rate used should be enacted or substantively enacted at the balance sheet date. Although the CICA used the FASB and IASB working documents when drafting the new version of section 3465, the final version of the standard was different from FAS 109 and IAS 12. The general principles of the US standards and IFRS were ultimately adopted. However, depending on the standard, there are exceptions to accounting for income taxes that are not the same. Furthermore, depending on the situation, the CICA would follow either the US standard or IFRS. As a result, there were three standards founded on the balance-sheet-based approach, but with different results. Recent IAS 12 Developments and Expected Changes Over the past few years, the FASB and the IASB have worked on a convergence project to align US GAAP and IFRS. One aspect of the project covers accounting for income taxes. In September 2008, the FASB announced a change in its strategy regarding its short-term convergence projects, given the possibility that 10 International Accounting Standards Board, International Accounting Standard IAS 12, Accounting for Taxes on Income, July Supra note In this chapter, the terms future income taxes and deferred income taxes have the same meaning.

5 Accounting for Income Taxes According to IFRS / 97 US listed companies may be allowed to adopt IFRS in the foreseeable future. The IASB was pursuing its intention to amend IAS 12 in order to reduce the differences between IFRS and US GAAP, and remove nearly all exceptions to the recognition of deferred taxes under IAS 12. In March 2009, an exposure draft aimed at substantially amending the current IAS 12 was published. 13 As a result of some rather negative comments from practitioners in response to the exposure draft, the IASB withdrew it in October The IASB decided to opt for the publication of another exposure draft with a more limited scope than the version submitted in March In September 2010, a limited-scope exposure draft was published with the objective of prescribing the measurement of deferred taxes on assets revalued to fair market value. 14 It is expected that, later in 2011, another limited-scope exposure draft will be published with the objectives of aligning the recognition and measurement of uncertain tax positions with the principles described in IAS 37 ( Provisions, Contingent Liabilities and Contingent Assets ), 15 and making various changes included in the March 2009 exposure draft that were supported by professionals. These amendments become generally effective 12 to 18 months after the exposure draft is adopted. Scope of the Standard on Accounting for Income Taxes IAS 12 deals with accounting for income taxes. In this context, income taxes means taxes based on taxable income. This definition does not only apply to 13 International Accounting Standards Board, Exposure Draft ED/2009/2, Income Tax, March For more information on the amendments proposed in the exposure draft, see Dave Santerre, «Faits saillants des modifications proposées à la norme IAS 12» (2009) 14:3 Stratège International Accounting Standards Board, Exposure Draft ED/2010/11, Deferred Tax: Recovery of Underlying Assets, September International Accounting Standards Board, International Accounting Standard IAS 37, Provisions, Contingent Liabilities and Contingent Assets, September 1998, as amended.

6 98 / IFRS: Adoption in Canada income tax under part I of the Income Tax Act (Canada), 16 its provincial equivalent, or that of another country; taxable income can also be a gross or net profit margin. What counts is that revenues are reduced by certain expenses. This explains why taxes based on sales or gross revenue are not considered to be income taxes. Moreover, a company can be subject to two or more income taxes. For example, companies with mining operations in Quebec are subject to provincial mining duties and are also taxable under the federal and Quebec income tax acts. 17 Income taxes also include taxes, such as withholding taxes, that are payable by a subsidiary, associate, or joint venture on distributions to the entity presenting its financial statements. 18 However, IAS 12 does not deal with methods of accounting for government grants or investment tax credits. 19 As we will see, IAS 20 ( Accounting for Government Grants and Disclosure of Government Assistance ) 20 addresses accounting for government assistance. Accounting for Income Taxes: Similarities and Differences Between IAS 12 and Canadian GAAP As mentioned above, the framework of IAS 12 is similar to the prevailing framework under Canadian GAAP. This chapter covers certain important aspects that are similar in both standards; however, emphasis is placed on the main differences between the standards and, more specifically, those of interest to Canadian companies. To that end, the discussion that follows includes illustrative examples, where necessary. Unless otherwise specified, the examples provided are in the context of Canadian tax legislation. Measurement and Valuation DETERMINING THE TAX BASE OF AN ASSET Under IFRS, the tax base of an asset is defined as 16 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as ITA ). 17 Mining Duties Act, RSQ, c. D-15; Quebec Taxation Act, RSQ, c. I IAS 12, supra note 3, at paragraph Ibid., at paragraph International Accounting Standards Board, International Accounting Standard IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, April 1983, as amended.

7 Accounting for Income Taxes According to IFRS / 99 the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount. 21 For example, the tax base of property, plant, and equipment is the unamortized capital cost. For an investment, the tax base is its adjusted cost base that is used to calculate the capital gain on disposal. Additional examples of tax base can be found in appendix A of IAS 12. In some situations, the tax base of an asset is different depending on whether the asset is utilized or sold. In this case, Canadian GAAP state that the tax base of the asset to be used is the greater of those amounts. 22 This method leads to the recognition of the minimum tax effect that could result from the realization of the asset for its carrying amount. Yet under IFRS, the asset s tax base must be determined according to management s expected manner of recovery. 23 The same treatment applies to liabilities. Thus, when the tax base associated with management s expected manner of recovery is not the highest amount, there will be a difference between IFRS and Canadian GAAP. This difference arises, for example, in the accounting treatment of eligible capital property (ECP). 24 Eligible capital expenses are deductible for tax purposes up to a maximum of 75 percent of costs incurred. In addition, 75 percent of the amount received when the property is sold is included as proceeds of disposition. The portion of the amount received that exceeds the total cost of the company s cumulative eligible capital (CEC) is ultimately taxable at a 50 percent inclusion rate. For the purposes of calculating the tax base of an asset that qualifies as ECP used in the company, the deductible amount is equal to 75 percent of costs incurred. However, if an asset that qualifies as ECP is sold, the cumulative eligible capital expenditure amount will be reduced only by 75 percent of the amount received, 25 thus resulting in a tax base equivalent to 100 percent of costs incurred, less tax deductions claimed in the past. 21 IAS 12, supra note 3, at paragraph See the current version of Canadian Institute of Chartered Accountants, CICA Handbook Accounting (Toronto: CICA) (online, DVD, and print), at section (d). 23 IAS 12, supra note 3, at paragraph Defined in ITA subsection 248(1). 25 ITA subsection 14(5).

8 100 / IFRS: Adoption in Canada Take the example of an asset that qualifies as ECP with a historic cost of $100,000, which will be recovered when sold. For tax purposes, $75,000 is added to the CEC, which is deductible at an annual rate of 7 percent. However, if the asset is sold immediately for $100,000, 25 percent of the proceeds of disposition will not be taxable. The sale will have no tax consequence for the entity. 26 Under IFRS, in the event of a sale, the tax base is therefore equal to the carrying amount of $100,000 that is, the amount included in the CEC of $75,000 plus the non-taxable portion of the proceeds of disposition ($25,000). However, if the expected manner of recovery is through use, the tax base will be $75,000. Under Canadian GAAP, regardless of the expected manner of recovery, the tax base will always be the higher of the two amounts $100,000 in this case. TAX RATE TO BE USED Under IFRS, deferred tax assets and liabilities must be measured at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled, based on tax rates and tax laws that have been enacted or substantively enacted by the end of the reporting period. 27 This is also the case under Canadian GAAP. 28 In some jurisdictions, announcements of tax rates and tax laws have the substantive effect of actual enactment, which may occur several months after the announcement. In these circumstances, deferred tax assets and liabilities are measured using the announced tax rates and tax laws. 29 During a meeting held in February 2005, the IASB specified at what point during the legislative process a tax law could be deemed substantively enacted. 30 With reference to Canada, the IASB referred to the guidelines in Abstract EIC-111 of the CICA s Emerging Issues Committee. 31 The guidelines basically state that, under a majority government, a law is substantively enacted when a bill receives first reading in the House of Commons. In the case of a minority government, 26 This example is based on the assumption that no property was previously included in the entity s ECE. 27 IAS 12, supra note 3, at paragraph CICA Handbook, supra note 22, at section IAS 12, supra note 3, at paragraph PricewaterhouseCoopers, Manual of Accounting IFRS 2011 (Toronto: CCH Canadian, 2010), at chapter 13, section Canadian Institute of Chartered Accountants, Emerging Issues Committee, Abstract EIC-111, Determination of Substantively Enacted Tax Rates Under CICA 3465.

9 Accounting for Income Taxes According to IFRS / 101 a law is deemed substantively enacted when the bill passes third reading in the House of Commons. There are certain differences between Canadian GAAP and IFRS in terms of the income tax rates to be used in order to establish the amount of deferred tax assets or liabilities. In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the profits are paid out to holders of the entity. In these circumstances, under IFRS, deferred tax assets and liabilities are measured at the tax rate applicable to undistributed profits. 32 If income taxes can be recovered or paid when profits are distributed to holders of the entity, the tax effect is recognized when the distribution is recorded in the financial statements. 33 Under Canadian GAAP, future income tax assets resulting from a tax recovery are recognized at the same time as the transaction that gives rise to the recovered tax, or subsequently, when it is more likely than not that the taxes will be recovered in the foreseeable future, 34 whether or not the distribution was recorded in the financial statements. Furthermore, certain rules under Canadian GAAP apply to determine the tax rate to be used for entities that can deduct the amounts that they distribute to unitholders, such as income trusts and real estate investment trusts. If such an entity plans to distribute to its unitholders all or virtually all of its income that would otherwise have been taxable, or if it is contractually committed to do so, the entity does not account for any current or deferred tax. 35 IFRS do not contain any guidelines for these entities. Thus, the general principle described above regarding the rate applicable to distributions applies; entities must account for income taxes without considering the tax benefit of the subsequent distributions, and record such benefit only upon distribution. The absence of clear guidelines can create unusual situations for certain entities. To that end, the IASB stated in March 2010 that the topic will be addressed in the course of the work on the limited-scope exposure draft, which, as noted above, should be published later in IAS 12, supra note 3, at paragraph 52A. 33 Ibid., at paragraph 52B. 34 CICA Handbook, supra note 22, at section Additional conditions must also be met to ensure that these entities do not have to account for current and deferred tax. For more information, see Canadian Institute of Chartered Accountants, Emerging Issues Committee, Abstract EIC-107, Application of CICA 3465 to Mutual Fund Trusts, Real Estate Investment Trusts, Royalty Trusts and Income Trusts. 36 IASB meeting, March 15-19, 2010.

10 102 / IFRS: Adoption in Canada UNCERTAIN TAX POSITIONS Uncertainties about income taxes are not directly addressed in IAS 12. IAS 37 ( Provisions, Contingent Liabilities and Contingent Assets ) 37 does not cover income taxes in its scope. The general measurement criteria in IAS 12 should be applied instead: current or deferred tax liabilities or assets must be measured at the amount expected to be paid to the taxation authorities or to be recovered from them. 38 No measurement method is indicated in IAS 12. As a result, various practices are accepted in authoritative accounting literature. 39 A liability should be recognized for each item that is not more likely than not to be sustained on the basis of technical merits. Acceptable practices for quantifying the liability are as follows: 1) The liability is measured using a weighted average of probabilities for each of the possible scenarios. 2) An estimate is made, based on the outcome most likely to occur among the possible scenarios. Example 1 An entity deducts $100,000 for current expenses incurred as part of a business combination. Tax authorities may be of the opinion that the expenses are capital in nature and should be capitalized to the cost of the shares acquired. The probabilities that the position can be sustained are as follows: Likelihood Weighted average Possible outcomes of occurring of possible outcomes percent dollars Deduction disallowed Deduction granted ,000 Total ,000 Using an approach based on the weighted average of outcomes to measure the uncertain tax provision, a liability of $40,000 (the $100,000 deduction taken less the $60,000 deduction that can be recognized in the financial statements) should be recorded. 37 Supra note IAS 12, supra note 3, at paragraph PricewaterhouseCoopers, supra note 30, at chapter 13, section 76.

11 Accounting for Income Taxes According to IFRS / 103 If the entity chooses the estimate based on the outcome more likely to occur, no provision is needed since the most likely scenario is that the full deduction of the expenses will be granted. The rationale is similar under Canadian GAAP, since uncertain tax positions are not directly addressed in section However, contrary to IAS 37, its equivalent, section 3290 ( Contingencies ) of the CICA Handbook, does not exclude income taxes from its scope. In practice, the guidelines in section 3290 are used to recognize and measure uncertain tax positions. The measurement of a liability is similar to the second of the acceptable practices under IFRS stated above. Under Canadian GAAP, a contingent liability should be recognized for each of the tax positions that will likely not be sustained. The degree of likelihood derived from the word likely (defined in practice as a 70 to 80 percent chance that something will occur) is stronger than the expression more likely than not or probable under IFRS (more than 50 percent). Since there is no clear guideline on this topic under IFRS, a company may establish its own accounting policy and continue to use Canadian guidelines to recognize and measure its uncertain tax positions, as long as the method is similar to either of the acceptable practices described above. This choice of accounting method under IFRS should be applied consistently from one year to the next, unless IAS 12 is amended and the accounting treatment to be used is specified. IAS 12 does not have any specific guideline on the classification of uncertain tax positions. The presentation must be consistent with the general principles above. With respect to current taxes, we are of the opinion that uncertain tax positions from current and prior periods should be included in current tax liabilities, since the entity does not have the unconditional right to defer the settlement of the liability by more than 12 months after the reporting period, 40 even if it does not expect to pay the amount within 12 months of the end of the reporting period. With respect to deferred taxes, we are of the opinion that the entity should determine the tax base in its deferred tax calculation on the basis of the amount determined according to the prior analysis. For example, if a loss carried forward is going to be denied by the tax authorities, no deferred tax assets should be recorded. 40 International Accounting Standards Board, International Accounting Standard IAS 1, Presentation of Financial Statements, December 2003, as amended, at paragraph 69(d).

12 104 / IFRS: Adoption in Canada Canadian GAAP and IFRS do not address the presentation of interest and penalties on uncertain tax positions in the income statement. Practices tend to vary. Under Canadian legislation, interest and penalties on income taxes are not deductible. Thus, some companies recognize and classify interest and penalties as income tax expense in the income statement. Others are of the opinion that interest and penalties are not based on the taxable income calculation and must be recognized and classified as financing costs (interest) and operating costs (penalties). In the March 2009 exposure draft, the IASB indicated that companies should disclose where in the income statement interest and penalties are classified either as an income tax expense or under operating costs. The exposure draft acknowledged that various practices may be acceptable. Finally, a company needs to consider whether disclosure of uncertainties about income taxes is required in the main sources of uncertainties with respect to the estimates that are included in the notes to financial statements. Recognition of Deferred Taxes RECOGNITION AND PRESENTATION OF DEFERRED TAX ASSETS Unless otherwise specified, a deferred tax asset must be recognized for all deductible temporary differences to the extent that it is probable that a taxable profit will be available against which the deductible temporary differences can be utilized. 41 Even if the term more likely than not is used in Canadian GAAP, IFRS also provides a definition of the term probable, which means more likely than not, 42 making the two standards similar in this regard. The two standards are also similar in terms of the criteria and guidelines used in assessing the recognition of a deferred tax asset, which include the following: 43 the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which deductible temporary differences, unused tax losses, and unused tax credits can be charged before they expire; 41 IAS 12, supra note 3, at paragraph International Accounting Standards Board, International Financial Reporting Standard IFRS 5, Non-Current Assets Held for Sale and Discontinued Operations, March 2004, as amended, at appendix A. 43 IAS 12, supra note 3, at paragraph 36; and CICA Handbook, supra note 22, at section

13 Accounting for Income Taxes According to IFRS / 105 it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire; taxable profits from prior years would entitle the entity to a tax refund, to the extent that tax laws allow carrybacks; unused tax losses result from identifiable causes, which are unlikely to recur; or tax-planning opportunities are available to the entity that will create taxable profit in the period in which the unused tax losses or unused tax credits can be charged. Under IFRS, if an entity is unlikely to have a taxable profit that can be offset against deductible temporary differences, unused tax losses, or unused tax credits, the deferred tax asset is not recognized. The amount and the expiry date, if any, of these deductible temporary differences, unused tax losses, and unused tax credits must be disclosed in the notes to financial statements. 44 In terms of presentation, Canadian GAAP offer an alternative that is not available under IFRS: all future income tax assets can be recognized less an amount of valuation allowance that is sufficient to reduce deferred tax assets to an amount that will more likely than not be realized. 45 The difference between the standards, if the choice has been made, can be significant for the disclosure in the notes to financial statements, but should have no impact on the amount of deferred tax asset or liability recognized on the balance sheet. DEFERRED TAXES IN A BUSINESS COMBINATION In a business combination, the acquiree may have deferred tax assets. In certain situations, the deferred tax assets cannot be recognized, because it is not probable that they will be realized. Canadian GAAP formerly required that if the assets were recognized in a period subsequent to the acquisition, the resulting deferred tax recovery reduced the goodwill and the intangible assets related to the acquisition to zero before being recognized in the income statement IAS 12, supra note 3, at paragraph 81(e). 45 CICA Handbook, supra note 22, at section CICA Handbook, supra note 22, at section The adoption of new section 1582 of the CICA Handbook eliminates the difference in accounting treatment at this level, since Canadian GAAP adopt the accounting treatment applicable under IFRS. Since section 1582 will be applied only in 2011, the analysis addresses the prevailing accounting treatment under the current section 1581 for business combinations.

14 106 / IFRS: Adoption in Canada Under IFRS, the subsequent recognition of the acquired entity s deferred tax assets will be accounted for in the income statement, unless the recognition takes place during the measurement period and results from new information about facts and circumstances that existed at the acquisition date. In this case, the resulting deferred tax recovery reduces goodwill to zero before being recognized in the income statement. 47 The measurement period is the period that follows the acquisition date during which the acquiror can adjust amounts temporarily recognized for the business combination. The measurement period may not, however, exceed one year from the acquisition date. Following a business combination, the acquiror may recognize its own deferred tax asset, which was not recognized before the business combination. For example, the acquiror may be able to utilize its unused tax losses against the future taxable profit of the acquiree. In these cases, under IFRS, the acquiror recognizes a deferred tax asset but does not include it as part of the accounting for the business combination. Consequently, the acquiror does not take the deferred tax asset into account in measuring goodwill, 48 and the asset will be accounted for in the income statement. Under Canadian GAAP, recognition of the asset is included in the allocation of the acquiree s purchase price. 49 DEFERRED TAXES ON GOODWILL IN A BUSINESS COMBINATION Goodwill generated by a business combination is measured as the excess of the consideration paid over the fair value of identifiable assets and liabilities of the acquiree. Under Canadian GAAP, any difference between the carrying amount of goodwill and its tax base is a taxable temporary difference that normally generates a deferred tax liability. Canadian GAAP preclude the recognition of future income tax liability in respect of goodwill, 50 because goodwill itself is a residual and the recognition of the future income tax liability would merely increase the carrying amount of that residual. 51 The same exception to the recognition of a deferred tax liability exists under IFRS. 52 In addition, IAS 12 states that if the carrying amount of the goodwill is 47 IAS 12, supra note 3, at paragraph Ibid., at paragraph CICA Handbook, supra note 22, at section Ibid., at section Ibid., at section IAS 12, supra note 3, at paragraph 21.

15 Accounting for Income Taxes According to IFRS / 107 less than the tax base of the asset, the company must recognize the deferred tax asset in the purchase price allocation to the extent that it is probable that this deferred tax asset will be realized. 53 DEFERRED TAXES WHEN ASSETS ARE ACQUIRED OTHER THAN THROUGH A BUSINESS COMBINATION A company can acquire an asset through a transaction that is not a business combination and in which the amount paid is different from the asset s tax base. This type of transaction can be conducted through the direct purchase of one or several assets that do not constitute a company as such, or through the purchase of an interest in an entity that does not meet the definition of a business combination. The following are examples of this type of situation: Allocation of a purchase price. The allocation of a purchase price for tax purposes is different from the allocation for accounting purposes. According to tax authorities, when an asset is purchased by parties dealing at arm s length, the allocation of the purchase price stipulated in the contract is normally used. From an accounting standpoint, a more detailed valuation of the purchased asset is often performed after the transaction is completed, and the valuation is reflected in the purchaser s financial statements. The amounts allocated to the various assets purchased may then be different from the tax allocation. Purchase of an asset through the shares of a separate entity. When the shares of an entity are purchased rather than the assets, the tax base of the purchased asset is that of the acquired entity and is not the fair market value at the time of the transaction. The fair market value is usually reflected in the shares acquired for tax purposes, and not its assets. Consequently, the carrying amount of the purchased asset may be different from its tax base. Non-deductible expenses capitalized for accounting purposes, such as share-based compensation. For a capital asset that the entity has built for its own use, the cost may include materials, salaries, and wages, as well as overhead that can be allocated to the capital asset. When a non-tax-deductible expense is capitalized, the tax base and carrying amount of the asset are different. Capitalization of capital leases. When a lease is capitalized for accounting purposes, no depreciable asset is acquired for tax purposes. 54 The asset tax 53 Ibid., at paragraph 32A. 54 Unless the company makes the election allowed under ITA section 16.1.

16 108 / IFRS: Adoption in Canada base is therefore nil. Conversely, since the lease payments will be deductible in the future taxable income calculation but the notional interest expenses recognized in income will not, the liability resulting from the obligation under the capital lease also has a tax base of nil. Note that the amount of future lease payments less the amount of future notional interest expenses is equivalent to the obligation under the capital lease recognized on the balance sheet. Therefore, when an amount related to a liability is tax-deductible in future years, its tax base is nil. According to Canadian GAAP, deferred taxes resulting from the difference between the carrying amount of the acquired asset and its tax base must be recognized. The deferred income tax is then calculated using the simultaneous equations method to determine the price of the acquired assets, as well as the deferred tax assets or liabilities associated with them. 55 Example 2 The following example from the CICA Handbook 56 illustrates the simultaneous equations method: An enterprise buys an asset for $8,000 cash. The maximum tax basis of the asset on initial recognition is $2,000. The tax rate is 40 percent. In accordance with paragraph , the enterprise recognizes the asset at an initial carrying amount of $12,000 and recognizes a future income tax liability of $4,000. The initial carrying amount is determined using the formula set out below: Carrying value = Cost of the asset + That is, ([Cost tax basis] tax rate) (1 tax rate) Carrying value = $8,000 + ([$8,000 $2,000] 0.40) = $12,000 (1 0.40) The journal entry on initial recognition is: DR Asset $12,000 CR Cash $8,000 CR Future income tax liability $4,000 Under IFRS, deferred taxes resulting from such transactions are not recognized. For this exception to accounting for income taxes to apply, the transaction 55 CICA Handbook, supra note 22, at section Ibid., at section

17 Accounting for Income Taxes According to IFRS / 109 cannot be part of a business combination, nor can it affect the accounting profit or taxable profit of the company. Note that for capital leases, a company may in practice recognize a deferred tax liability resulting from the capital asset and a deferred tax asset resulting from the obligation, since these assets and liabilities cancel each other out on initial recognition. 57 This practice is similar to that used under Canadian GAAP. NON-MONETARY ASSETS AND LIABILITIES OF INTEGRATED FOREIGN OPERATIONS Under Canadian GAAP, no deferred tax asset or liability is recognized with regard to the temporary difference resulting from the difference between the translations to the historic exchange rate and the current exchange rate of the cost of non-monetary assets or liabilities of integrated foreign operations. 58 The concept of integrated or independent foreign operations does not exist under IFRS. Entities must determine their functional currency on the basis of the criteria established in IAS 21 ( The Effects of Changes in Foreign Exchange Rates ). 59 When the functional currency is not the same as the currency used to prepare income tax returns in the foreign jurisdiction, this results in differences that require the deferred tax to be recognized under IFRS. In a number of jurisdictions, the currency used for income tax purposes is the foreign country s currency, and the taxpayer does not have the option to use the accounting functional currency for income tax purposes. Contrary to Canadian GAAP, IAS 12 provides no exceptions relating to these temporary differences. Consequently, IAS 12 imposes the recognition of a deferred tax asset and/or liability for these translation differences. The temporary differences resulting from the effect of exchange-rate fluctuations on non-monetary assets and liabilities of integrated operations must be identified and a deferred tax recognized for them. Example 3 The CICA Handbook provides the following example: 60 On January 1, X1, Company P made an investment of $1,000,000 in Company S, an integrated foreign operation whose production facilities have a 57 PricewaterhouseCoopers, supra note 30, chapter 13, at section CICA Handbook, supra note 22, at section International Accounting Standards Board, International Accounting Standard IAS 21, The Effects of Changes in Foreign Exchange Rates, December 2003, as amended. 60 CICA Handbook, supra note 22, at section

18 110 / IFRS: Adoption in Canada fair value (and tax basis) of FC [foreign currency] 1,000,000 when the exchange rate is $1 = FC 1. At December 31, X2, the exchange rate is $1 = FC 1.5. At December 31, X2, the financial statements of Company S will reflect the production facilities at FC 1,000,000. The consolidated financial statements of Company P will reflect the production facilities at $1,000,000, based on the historic exchange rate. In order to recover the carrying value in the consolidated financial statements, Company P must realize $1,000,000 or FC 1,500,000. Realization of FC 1,500,000 would lead to a future income tax liability since the tax basis of the asset is FC 1,000,000. This future income tax liability is not recognized under Canadian GAAP. At the time of changeover to IFRS, companies may have to make significant changes to the deferred tax calculations of entities that do not have the same functional currency for accounting purposes as the one used for income tax purposes. INTERCOMPANY TRANSACTIONS A transfer of assets between companies in the same consolidated group for example, the sale of inventory or depreciable capital assets will not lead to any gain or loss for accounting purposes as long as the assets are not sold or transferred to a third party. If the transaction between related parties is made for an amount different from the accounting cost, the seller s gain or loss is eliminated in the consolidated financial statements. In this situation, under Canadian GAAP, no deferred tax asset or liability can be recognized in the consolidated financial statements for a temporary difference between the asset s tax base for the purchaser and the cost indicated in the consolidated financial statements. 61 However, all taxes paid or recovered by the vendor following the transfer must be recognized as an asset or liability in the consolidated financial statements until the gain or loss from the transaction is recognized by the consolidated entity. This exception does not exist under IFRS. Thus, income taxes paid or recovered by the vendor are recognized in income. The same applies to deferred tax assets or liabilities in the purchaser s financial statements. This results in the recognition of the tax consequences of a transaction for which no profit or loss is recognized in the consolidated financial statements. Recognition by the vendor 61 Ibid., at section

19 Accounting for Income Taxes According to IFRS / 111 of the current tax on the transaction is often offset by the recognition of the deferred tax by the purchaser. However, if the two entities have different tax rates, or if one of the two entities does not recognize its deferred tax asset, the effect of this type of transaction in the income statement can be significant. Example 4 During the year, Canadian Company A Ltd. sold assets with an accounting and tax cost of $60,000 to its American subsidiary, US Co., for proceeds of disposition of $100,000. The tax rate and tax consequences are as follows: Vendor: A Ltd. Tax cost $60,000 Proceeds of disposition $100,000 Tax rate % Current tax $12,000 Purchaser: US Co. Tax cost $100,000 Accounting cost (consolidated) $60,000 Tax rate % Under Canadian GAAP, there is no effect in the income statement, and current tax is deferred until the assets are sold to a third party. The current tax liability is therefore recognized and an asset is recognized in the financial statement until the gain is recognized by the consolidated entity. Under IFRS, the tax effects are recorded in the income statement: Current tax expense of the vendor $12,000 Deferred income tax of the purchaser (16,000) Net impact in the income statement (4,000) The current tax liability of $12,000 and the deferred tax asset of $16,000 are therefore recognized. RECOGNITION AND DISCLOSURE OF TEMPORARY DIFFERENCES RELATED TO INVESTMENTS IN SUBSIDIARIES, BRANCHES, ASSOCIATES, AND JOINT VENTURES Under Canadian GAAP, no deferred tax assets or liabilities are recognized for the difference between the carrying amount of an investment in a subsidiary or joint venture and the tax base of the investment when it is probable that the temporary difference will not reverse in the foreseeable future. 62 When deferred tax is 62 Ibid., at section

20 112 / IFRS: Adoption in Canada not recognized for these differences, Canadian GAAP are indicating that it is preferable that the amount of the temporary difference be disclosed as a note to the financial statements, as well as the related deferred taxes if they can be determined after a reasonable effort is made to do so. 63 In practice, very few companies disclose this information. IAS 12 is slightly different with respect to the terms used and the types of investments that benefit from the exception to recognition of a deferred tax liability. 64 In addition to covering subsidiaries and joint ventures, the exception includes branches and associates. To avoid recognizing a deferred tax liability, the investor must be able to control the timing of the reversal of the temporary difference, and that temporary difference should not reverse in the foreseeable future. The conditions are similar for the recognition of a deferred tax asset. In practice, there should not be any major difference between Canadian GAAP and IFRS in this respect. However, for disclosures made in notes to financial statements, IFRS require a company to disclose the aggregate amount of temporary differences associated with investments in subsidiaries, branches, associates, and interests in joint ventures for which deferred tax liabilities have not been recognized. 65 As mentioned above, very few companies keep the carrying amounts and tax bases of their investments up to date. The carrying amount of the investment refers to the amount determined under the equity method and not the historic accounting cost of the investment. In addition to the acquisition cost, the calculation therefore requires that the following be taken into account: distributions, profits or losses realized since the acquisition, consolidation adjustments (elimination of profit, reduction in value of assets, etc.), and the fluctuation of exchange rates if the entity has a different functional currency. As for the tax base, the adjusted cost base of investments must be updated. Furthermore, if a company decides to disclose the unrecognized deferred tax liability amount, the tax effect resulting from the reversal of temporary differences must be determined, and this may require calculation of the various surpluses under the Canadian foreign affiliate tax regime. 63 Ibid., at section IAS 12, supra note 3, at paragraph Ibid., at paragraph 81(f ).

21 Accounting for Income Taxes According to IFRS / 113 COMPOUND FINANCIAL INSTRUMENTS Under IFRS, a deferred tax liability is recognized for any temporary difference resulting from the separate initial recognition of a compound financial instrument. 66 For example, the proceeds from the issuance of a $1,000 convertible debt can be allocated between liability and equity as follows: $750 for the liability component and $250 for the equity component. Thus, the settlement of the debt for its carrying amount of $750 has tax consequences, since the principal of the debt is greater. IFRS require that a deferred tax liability be recorded on the temporary difference of $250. Subsequent changes in the deferred tax liability are recognized in income. 67 Under Canadian GAAP, when the enterprise is able to settle the financial instrument without the incidence of tax, in accordance with its terms, either through settlement on maturity or conversion, the tax basis of the liability component is considered to be the same as its carrying amount. 68 Thus, there is no temporary difference in this situation. Recognition and Measurement: Special Topics RECOGNITION OF DEDUCTIONS ON SHARE- BASED PAYMENT TRANSACTIONS In certain tax jurisdictions, share-based payment transactions are deductible. The amount of the tax deduction is not known until the stocks are issued. If a company issues stock options to its employees, it must recognize an expense corresponding to the fair value of the options in income over the lifetime of the options. Under IFRS, the company will recognize a deferred tax asset based on the allowable tax deduction. For example, if the amount permitted by the tax authorities depends on the entity s share price at a future date, the measurement of the deductible temporary difference should be based on the entity s share price at the end of the current period. 69 If the amount of the estimated tax deduction at the end of the period exceeds the amount of the related cumulative 66 Ibid., at paragraph Ibid. 68 CICA Handbook, supra note 22, at section IAS 12, supra note 3, at paragraph 68B.

22 114 / IFRS: Adoption in Canada remuneration expense, the excess current or deferred tax should be recognized in equity. 70 Canadian GAAP do not contain any guidelines on this matter. FLOWTHROUGH SHARES In Canada, tax legislation allows a company to issue shares known as flowthrough shares to its investors. 71 Such shares serve to transfer the tax benefit associated with certain eligible expenses from the company to its shareholders. When flowthrough shares are issued and expenses are capitalized as assets for accounting purposes, the carrying amount can exceed the tax base, because the company renounced its right to tax deductions in favour of its investors. Under Canadian GAAP, the deferred tax liability associated with this temporary difference is recognized in equity as a cost of issuing securities to investors when the company renounces its deductions. 72 Under IFRS, the accounting treatment for this renunciation is not specified. Presentation INTRAPERIOD ALLOCATION Under Canadian GAAP, the expense or income from current or deferred taxes is initially recognized in the income statement, unless a different allocation is indicated. 73 In general, Canadian GAAP require that tax be recognized initially in the financial statements component where the underlying revenue or expense is recorded. Financial statements component means the income statement, other comprehensive income, or equity. For example, deferred tax assets resulting from share issue expenses should be recognized in the company s equity that is, in the same item as the proceeds from the share issuance. Any change in these deferred assets that arises in a subsequent period is recognized in the income statement. Under IFRS, current and deferred taxes must be recognized in the income statement or elsewhere in the financial statements, such as in other comprehensive income or equity, on the basis of the element that triggered the tax effect in either the original period or a prior period. This intraperiod allocation method for change in subsequent periods is known as backward tracing. 70 Ibid., at paragraph 68C. 71 ITA subsection 66(12.6) and following. 72 CICA Handbook, supra note 22, at section Ibid., at section