Accounting BDO Kendalls News A National Audit & Assurance Publication Demystifying Deferred Tax Even though AASB 112 Income Taxes has been effective for a while (from financial years ending 31 December 2005), many preparers of financial statements under Australian Equivalents to International Financial Reporting Standards () are confused because the basis of calculating deferred tax has changed from the income statement approach to the balance sheet approach. The perception is that AASB 112 is vastly different from the requirements of old Australian GAAP (). This newsletter seeks to demystify the requirements of AASB 112 by illustrating some of the more unusual requirements and consequences of the standard. These include: Asset revaluations Black hole expenditure Business acquisitions Initial recognition exemptions luxury motor vehicles Foreign exchange translation reserves Leases Equity accounted investments eating a profit from revaluing plant and equipment No more virtual certainty test. Background Under, deferred tax was computed using the income statement approach. Future income tax benefits (deferred tax assets) and deferred tax liabilities were recognised for all timing differences, i.e. for all items that were recognised in the books of an entity in periods different to those in which they were taken into account for determining taxable income/tax losses. AASB 112 Income Taxes requires that we use the balance sheet approach to compute deferred tax. This means that, subject to certain limited exceptions, deferred tax assets/liabilities are recognised for all temporary differences, i.e. the difference between the carrying values of assets, liabilities and reserves in the books of the entity, and their respective tax bases. For standalone entities that have not acquired any businesses/entities, do not revalue their assets, have no foreign exchange reserves and no compound financial instruments (e.g. convertible notes), the ultimate deferred tax assets and liabilities calculated are quite likely to be exactly the same as those Continued page 2... 1
...continued from previous page computed under. In fact, if one performed a deferred tax proof under using balance sheet amounts, this would follow a similar process to the balance sheet approach. This is best illustrated by Example 1 below. Example 1 BC Pty Limited purchased 1 motor vehicle on 1 July 2005 for 10,000. The vehicle is depreciated at 25% p.a. straight line for accounting purposes and at 20% p.a straight line for tax purposes. The workings below illustrate how the deferred tax asset balance would be the same under as under (AASB 112). (after depreciation) is 10,000 for the year ended 30 June 2006. Tax rate is 30%. Asset revaluations Under, a deferred tax liability was never recognised for the potential gain to be recognised on a revalued asset and the non allowable depreciation on the revalued amount of the asset would be a permanent difference. AASB 112 requires that the deferred tax liability be recognised on all revalued assets, irrespective of whether the asset is expected to be realised through sale or through use over its expected useful life. Add: Depreciation Deduct: Tax Depreciation Deferred tax assets (500 @ 30%) Carrying value Tax base Deferred tax assets (500 @ 30%) 10,000 2,500 (2,000) 10,500 150 7,500 8,000 500 150 Knowing that your temporary differences under will essentially result in the same amounts for deferred tax assets and liabilities as you would have calculated for timing differences under, let s move on and explore some of the more complex areas of deferred tax, i.e. the additional amounts you will be required to compute under AASB 112. Tax reconciliation notes The tax reconciliation note included in the financial statements serves as a useful check to determine whether deferred tax has been calculated correctly. As a rule of thumb, if deferred tax has been calculated correctly and completely, (i.e. no exceptions made for deferred tax assets not recognised), the only reconciling items should be for genuine nondeductible expenses such as fines, penalties and non-deductible entertainment. In other words, there are no more permanent differences. The examples that follow illustrate this point. This means that you would recognise a deferred tax liability on revalued buildings, irrespective of whether you intended to sell them immediately or to use the buildings over their remaining life, the only difference being that the tax base for the buildings that you intend to sell would be your CGT cost base whereas the tax base for the buildings you intend to use would be the written down tax value. The tax base on non-depreciable assets such as land or certain categories of intangible assets is always the CGT cost base because these assets can never be recovered through use and have no written down tax value. Each year the reduction in the revalued amount through depreciation results in the carrying value becoming closer to the tax base, hence the deferred tax liability reduces and there is a deferred tax credit recorded in the income statement. (Refer Example 2 next page) 2
Example 2 DEF Pty Limited owns buildings (written down carrying amount ) that it revalues on 1 July 2005 to 750,000. The remaining useful life of these buildings are 10 years. Assume buildings are being depreciated at 5% p.a. for both book and tax purposes. The workings below illustrate how the deferred tax liability would be calculated under (AASB 112) and the resulting tax reconciliation note. (after depreciation) is. Tax rate is 30%. Book Value Tax Base Difference Deferred Tax 1 July 2005 Revaluation Depreciation 30 June 2006 250,000 (75,000) 675,000 (50,000) 450,000 250,000 (25,000) 225,000 75,000 (7,500) 67,500 This means that a deferred tax liability is recognised on 1 July 2005 for 75,000 and 7,500 is reversed during the 30 June 2006 year because of the unwinding of the additional depreciation that is not allowed as a deduction for tax purposes. The tax reconciliation under and is as follows: Prima facie tax on net profit (@30%) Add back disallowable depreciation on revaluation Tax expense 7,500 Tax expense comprises: current tax payable reversal of deferred tax liability (7,500) Following on from the point made in Tax reconciliation notes above, this example illustrates the point that one can generally tell if a deferred tax calculation is correct under AASB 112 by the absence of reconciling items. Black hole expenditure Black hole expenditure comprises costs directly associated with raising equity funding which in certain situations can be deducted for tax purposes over a 5 year period. Under AASB 132, such equity raising costs are offset against the proceeds of the equity raised. Again, we can check that our deferred tax calculations are correct by observing no reconciling items in the tax note. (Refer Example 3 next page) 3
Example 3 GHI Limited raised 10 million during the period. Costs of raising equity were. All costs are deductible over a 5 year period for tax purposes. The journal entries are as follows: Bank Equity Being proceeds of equity raising Equity Bank Being payment for equity raising costs On the date that equity raising costs are paid: Deferred tax asset Equity Being 30% of 30,000 30,000 At the end of each of the following 5 years: Income tax expense Deferred tax asset 6,000 6,000 Even though this deferred tax asset is initially recognised in equity, it is unwound through the income statement, resulting in no tax reconciling item. Prima facie tax on net profit (@30%) Deduct: Black hole expenditure Tax expense Tax expense comprises: current tax payable reversal of deferred tax asset (6,000) 6,000 Business Acquisitions Remember that under the balance sheet approach, deferred tax is recognised on temporary differences between the carrying values recorded in the financial statements and the relevant tax bases. This means that when fair value adjustments are made to an acquiree s assets in a business combination, deferred tax must be recognised on consolidation for these temporary differences. However, no deferred tax is provided on temporary differences associated with goodwill because it results in a circular calculation and is specifically exempt under AASB 112. Initial recognition exemptions luxury motor vehicles One of the areas where AASB 112 provides an exemption from recognising deferred tax is where on initial recognition of an asset or a liability, the temporary difference is not part of a business combination and does not impact either accounting or taxable profit or loss. A good example of this is luxury motor vehicles. Say for example, MNO Pty Limited purchases a luxury motor vehicle for and only 60,000 of the cost will be deductible for tax purposes. On initial recognition, i.e. date of acquisition, the purchase price does not impact accounting or taxable profit/loss, nor is it part of a business combination. As such, the 40,000 temporary difference ( carrying value v. 60,000 tax base) is not tax effected. This means that any depreciation for accounting purposes on this additional 40,000 non-deductible portion will be treated as an add-back in the tax reconciliation note. 4
Foreign exchange translation reserves Another area where preparers of financial statements tend to overlook the provision of deferred tax is for foreign currency translation reserves. These reserves arise when a foreign subsidiary is translated from its functional currency into the presentation currency of the reporting entity. Year end exchange rates are generally used for translating assets and liabilities, which means that if the entity has exactly the same asset and liability base in its functional currency from one year end to another, except that the exchange rate between the functional currency of the foreign subsidiary and the presentation currency has changed, recorded amounts for these assets and liabilities change in the accounts, and the difference is recorded in a Foreign Currency Translation Reserve. Any deferred tax on temporary differences between assets and liabilities in the foreign subsidiary have already been recognised in the functional currency accounts of the foreign subsidiary. However, if the entire subsidiary were sold, or a dividend declared from the subsidiary to the holding company of all its reserves at the year-end exchange rate, a tax liability may eventuate if the foreign currency translation reserve is in credit. AASB 112 requires that deferred tax be recognised for all temporary differences of subsidiaries unless: the parent is able to control the timing of the reversal of the temporary difference; and it is probable that the temporary difference will not reverse in the foreseeable future. It is quite difficult to establish a tax base for the foreign currency translation reserve unless the entity has a clear intention to either sell or wind up the foreign subsidiary and pay a dividend. The tax consequences could be quite different, depending on whether the subsidiary is sold or wound up. Using the exemption noted above, one could argue that if the parent has no intention to sell/wind up the subsidiary in the foreseeable future that it is not probable that the temporary difference will reverse in the foreseeable future. Hence no deferred tax need be provided in such cases. Leases Finance leases can cause some confusion when calculating deferred tax using the balance sheet approach. Whether we use the income statement approach under or the balance sheet approach under, we should arrive at the same answer. Remember that for finance leases, the expense recorded in the financial statements comprises depreciation of the asset and interest expense. For tax purposes, the entire finance lease expense is deductible. Effectively, the interest portion for accounting and tax purposes is the same. This means that the temporary difference comprises essentially the difference between accounting depreciation and the capital payment made on the finance lease liability. The following example illustrates an easy method to calculate the temporary differences associated with a finance lease. Example 4 WWW Pty Limited entered into a finance lease on 1 July 2005 for a motor vehicle. The cost of the motor vehicle was 40,000, to be depreciated over 4 years for accounting purposes. Lease payments are 15,000 for 4 years as follows: End of Year 1 Motor vehicle Lease liability Year Capital () Interest () 1 2 3 4 Book Value 30,000 32,000 8,000 8,000 10,000 14,000 Tax Base 32,000 32,000 Difference (2,000) 7,000 7,000 5,000 1,000 This means that in Year 1, accounting depreciation is 10,000 and the capital repayment on the liability is 8,000. For accounting and tax purposes interest is 7,000. Deferred Tax 600 DTA The rule of thumb under AASB 112 is that the tax base of liabilities is generally = to their carrying values. As such, the lease liability has a tax base = to its carrying value of 32,000. The temporary difference is then calculated on the motor vehicle, being the difference between accounting depreciation and future deductible capital repayments. The deferred tax asset is the same as would have been calculated under. 5
Equity accounted investments Under, equity accounted profits of associates/ joint venture entities would typically be treated as permanent differences on the tax reconciliation note. This is because no deferred tax was provided on the temporary difference, being the equity accounted carrying value v. initial cost. AASB 112 requires that a deferred tax liability or asset is recognised for temporary differences between the carrying value and tax base of an associate unless it is not probable that the temporary difference will reverse in the foreseeable future. This means that if a potential dividend payment of the undistributed profits of the associate would be franked, this would not be taxable and therefore the temporary differences would not reverse. As such, deferred tax is only recognised where such a future dividend would attract tax. Example 5 illustrates the difference between the tax reconciliations for and where dividends would be unfranked. Example 5 ZZZ Limited acquired a 25% investment in Associate ABC Pty Limited on 1 July 2005 for. During the financial year ended 30 June 2006, ABC Pty Limited made a profit after tax of 50,000. The following analysis of the tax reconciliation note illustrates how we no longer show a reconciling item for the associate s share of profits if the dividend payable by the associate out of these accumulated profits were unfranked or was from a foreign associate with no dual tax agreements in place. Book Value Tax Base Difference Deferred Tax Associate ABC - 1 July 2005 Share of profits - year ending 30 June 2006 (25% of 50,000) 12,500 12,500 3,750 DTL This means that a deferred tax liability is recognised by debiting income tax expense and crediting deferred tax liabilities, hence no tax reconciling items below. Prima facie tax on net profit (@30%) Deduct: Associate ABC share of profits (12,500 @ 30%) Tax expense Tax expense comprises: current tax payable creation of deferred tax liability (3,750) 3,750 Note that if the associate had incurred losses and we had not recognised the deferred tax asset on the basis that recovery was not probable the tax reconciliation note above would be the same under and under.further, if a future dividend receivable from the undistributed profits of the associates would be franked, the above tax reconciliation note would also be the same under and under. eating a profit from revaluing plant and equipment An unusual consequence of strictly applying AASB 112 is that the revaluation of land can in certain cases give rise to a credit to the income statement where the entity has unrecognised capital losses. 6
Example 6 BBB Limited has unrecognised capital losses of 400,000 arising from past disposals of capital assets. These were not recognised as deferred tax assets because it was not probable that these losses would be utilised. In the current year BBB Limited revalued land by. The entries in respect of this revaluation are as follows: Land Asset revaluation reserve Being revaluation entry Asset revaluation reserve Deferred tax liabiliy Being deferred tax entry on revaluation 150,000 150,000 Deferred tax asset Income tax expense Being 30% of 400,000 capital loss whose utilisation is now probable when land is sold. 120,000 120,000 It may be arguable that the revaluation entry is not required in order for the capital loss to be recognised as a deferred tax asset, provided that it is known that the land is valued above cost. No more virtual certainty test Lastly, it is important to remember that required virtual certainty when determining whether tax losses should be recognised as deferred tax assets. Generally the 95% certainty test was applied, with the Australian Securities and Investments Commission issuing guidance expecting that the tax losses would only be recognised if very strict criteria were met. AASB 112 introduces the more likely that not test which means that we should expect to see more deferred tax assets being recognised for tax losses. If preparers are still using the old virtual certainty test then this could contradict with assumptions used in impairment testing and going concern assessments. Summary In this newsletter, we have considered many new areas where deferred tax needs to be considered. Whilst it all may seem a bit daunting at first, remember the golden rule: No reconciling items on tax reconciliation note unless there is an exemption for recognising deferred tax or relates to nondeductible entertaining or fines. For more information Phone 1300 138 991 or visit www.bdo.com.au NSW/ACT* Sean Osborn Telephone 02 9286 5455 sean.osborn@bdo.com.au Northern Territory Casmel Taziwa Telephone 08 8981 7066 casmel.taziwa@bdo.com.au North Queensland Katrina Faulkner Telephone 07 4046 0020 katrina.faulkner@bdo.com.au South Australia Greg Wiese Telephone 08 8223 1066 gregory.wiese@bdo.com.au Tasmania aig Stephens Telephone 03 6324 2499 craig.stephens@bdo.com.au Western Australia Glyn O Brien Telephone 08 9380 8405 glyn.obrien@bdo.com.au Queensland Tim Kendall Telephone 07 3237 5948 tim.kendall@bdo.com.au Victoria Nick Burne Telephone 03 8320 2165 nick.burne@bdo.com.au BDO Kendalls is a national association of separate partnerships and entities. Disclaimer: This publication is issued exclusively for the general information of clients and staff of BDO Kendalls. The contents are not a substitute for specific advice and should not be relied upon as such Accordingly, whilst every care has been taken in the presentation of the publication, no responsibility is accepted for persons acting on this information. *Liability limited by a scheme approved under Professional Standards Legislation.