International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 477
$
Depreciation of asset (100,000)
Current tax income1 72,000
Deferred tax charge2 (30,000)
Net tax credit 42,000
Profit after tax
(58,000)
1
$1,200,000 [deemed tax cost of asset] × 20% [tax depreciation rate] × 30% [tax rate]
2
$100,000 [temporary difference] × 30% [tax rate] – brought forward balance [nil]
If this calculation is repeated for all 10 years, the following would be recognised in the financial statements.
Deferred tax
Current
(charge)/
Total tax
Effective tax
Year Depreciation
tax credit
credit
credit
rate
a
b
c
d (=b+c)
e (=d/a)
1 (100,000) 72,000
(30,000)
42,000
42%
2 (100,000) 72,000
(30,000)
42,000
42%
3 (100,000) 72,000
(30,000)
42,000
42%
4 (100,000) 72,000
(30,000)
42,000
42%
5 (100,000) 72,000
(30,000)
42,000
42%
6 (100,000)
–
30,000
30,000
30%
7 (100,000)
–
30,000
30,000
30%
8 (100,000)
–
30,000
30,000
30%
9 (100,000)
–
30,000
30,000
30%
10 (100,000)
–
30,000
30,000
30%
This accounting results in an effective 42% tax rate for this transaction being reported in years 1 to 5, and a rate
of 30% in years 6 to 10, in contrast to the true effective rate of 36% for the transaction as a whole – i.e. cost of
$1,000,000 attracting total tax deductions of $360,000 ($1,200,000 at 30%). This is because, whilst in the case
of a partially deductible asset as in Example 29.16 above there is an accounting mechanism (i.e. depreciation)
for allocating the non-deductible cost on a straight-line basis, in the present case of a super deductible asset there
is no ready mechanism for spreading the additional $60,000 tax deductions on a straight-line basis.
In individual cases it might be possible to argue that the additional tax deductions had
sufficient of the characteristics of a government grant (e.g. if it were subject to conditions
2394 Chapter 29
more onerous that those normally associated with tax deductions in the jurisdiction
concerned) to allow application of the principles of IAS 20 so as to allocate the additional tax
deductions over the life of the asset (see 4.3 above). However, such circumstances are rare.
Again, as in Example 29.16 above, no single approach can be said to be required by
IAS 12 and other methodologies could well be appropriate, provided that they are
applied consistently in similar circumstances.
7.2.7
Transactions involving the initial recognition of an asset and liability
As noted at 7.2 above, the initial recognition exception is essentially a pragmatic remedy
to avoid accounting problems that would arise without it, particularly in transactions
where one asset is exchanged for another (such as the acquisition of PP&E for cash).
However, experience has shown that the exception creates new difficulties of its own.
In particular, it does not deal adequately with transactions involving the initial
recognition of an equal and opposite asset and liability which subsequently unwind on
different bases. Examples of such transactions include:
• recording a liability for decommissioning costs, for which the corresponding debit
entry is an increase in PP&E (see 7.2.7.A below); and
• the commencement of a finance lease by a lessee, which involves the recording of
an asset and a corresponding financial liability (see 7.2.7.B below).
In these circumstances there are three alternative approaches seen in practice:
(i)
apply the initial recognition exception. Recognise nothing in respect of temporary
differences arising at the time the asset and liability are first recognised. No
deferred tax arises for any changes in those initial temporary differences;
(ii) consider the asset and the liability separately. Recognise a deferred tax liability in
respect of any taxable temporary differences related to the asset component and
a deferred tax asset in relation to any deductible temporary differences related to
the liability component. On initial recognition, the taxable temporary difference
and the deductible temporary differences are equal and offset to zero. Deferred
tax is recognised on subsequent changes to the taxable and deductible temporary
differences; or
(iii) regard the asset and the liability as in-substance linked to each other. Consider any
temporary differences on a net basis and recognise deferred tax on that net amount.
In this approach, the non-deductible asset and the tax deductible liability are regarded
as being economically the same as a tax deductible asset that is acquired on deferred
terms (where the repayment of the loan does not normally give rise to tax). On this
basis, the net carrying value of the asset and liability is zero on initial recognition, as is
the tax base. There is therefore no temporary difference and the initial recognition
exception does not apply. Deferred tax is recognised on subsequent temporary
differences that arise when the net asset or liability changes from zero.
These three approaches are illustrated in Example 29.18 below.
As can be seen below, applying the initial recognition exception results in significant
fluctuations in effective tax rates reported in the periods over which the related asset is
depreciated and the finance cost on the liability is recognised. Whilst this is the accounting
Income
taxes
2395
treatment required by IAS 12, it fails to reflect the economic reality that all expenditure is
ultimately expected to be eligible for tax deductions at the standard tax rate. Indeed, it
could be argued that the result of applying the initial recognition exception in these
circumstances makes the financial statements less transparent, contrary to the stated
reason in IAS 12 for requiring the exception to be applied. [IAS 12.22(c)].
Arguably a more informative result is achieved when the initial recognition exception is
disregarded, as in the second and third approaches set out above. Both of these approaches
eliminate the volatility in the reported effective tax rate, as demonstrated by Approach 2
and Approach 3 in Example 29.18 below. All three approaches give a result that is
consistent with the implied intention of the initial recognition exception (that the reporting
entity should provide for deferred tax on initial recognition unless to do so would create
an immediate net tax expense or credit in the statement of comprehensive income).
As noted at 7.2.7.B below, in June 2018 the Interpretations Committee ac
knowledged the
three approaches currently applied in the circumstances noted above and decided to
recommend that the Board should develop a narrow-scope amendment to IAS 12. That
narrow-scope amendment would propose that the initial recognition exception in
paragraphs 15 and 24 of IAS 12 does not apply to transactions that give rise to both
deductible and taxable temporary differences to the extent that an entity would otherwise
recognise a deferred tax asset and deferred tax liability of the same amount in respect of
those temporary differences.11 Notwithstanding that this recommendation would result in
the second treatment above being required, we believe that any of the approaches
described above continue to be acceptable until such an amendment is issued by the Board.
7.2.7.A Decommissioning
costs
When an entity recognises a liability for decommissioning costs and the related asset is
measured using the cost model, it adds to the carrying amount of the related item of
PP&E an amount equal to the liability recognised. [IAS 16.16(c), IFRIC 1.5]. In many
jurisdictions, no tax deduction is given in respect of this decommissioning component
of the carrying value of the PP&E asset. However, payments made for decommissioning
expenses are deductible for tax purposes. The effects of applying the three approaches
in this situation are illustrated in Example 29.18 below.
Example 29.18: Asset and liability giving rise to equal temporary differences on
initial recognition
On 1 January 2019 an entity paying tax at 40% recognises a provision for the clean-up costs of a mine that
will require expenditure of €10 million at the end of 2023. A tax deduction for the expenditure will be given
when it is incurred (i.e. as a reduction in the current tax liability for 2023).
In accordance with IAS 37, this provision is discounted (at a rate of 6%) to €7.5m, giving rise to the following
accounting entry (see Chapter 27 at 6.3):
€m
€m
PP&E 7.5
Provision for clean-up costs
7.5
Under local tax legislation, no deductions are available for depreciation of the decommissioning component
of the PP&E asset. However, payments made for decommissioning expenses are deductible for tax and
capable of being carried forward or carried back against taxable profits.
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On initial recognition, the tax base of the decommissioning component added to the carrying value of PP&E is nil,
since no deductions are available and the €7.5 million carrying value of the asset is recovered through future taxable
profits. The tax base of the provision is also nil (carrying amount of €7.5 million, less the amount deductible in
future periods, also €7.5 million). Although deductions of €10 million are expected to be received in 2023 when
the decommissioning costs are incurred, the tax base is determined by reference to the consequences of the liability
being settled at its carrying amount of €7.5 million, which would result in a tax deduction of only €7.5 million.
There is therefore a taxable temporary difference of €7.5 million associated with the decommissioning component
of the PP&E asset and a deductible temporary difference of the same amount associated with the provision.
Over the next five years, an expense of €10 million (equivalent to the ultimate cash spend) will be recognised
in profit or loss, comprising depreciation of the €7.5 million decommissioning component of PP&E and
accretion of €2.5 million finance costs on the provision. Given that this €10 million is fully tax-deductible,
the entity expects to be entitled to a €4 million reduction in its current tax liability when the obligation for
decommissioning costs is settled.
Approach 1: Apply the initial recognition exception
The initial recognition exception in IAS 12 would prohibit recognition of deferred tax on both the taxable temporary
difference related to the decommissioning component of the asset and the deductible temporary difference on the
decommissioning liability. Under the general approach of IAS 12 summarised at 7.2.4 above, the depreciation of the
decommissioning component of PP&E is regarded as reducing the temporary difference that arose on initial
recognition of the asset, and therefore gives rise to no tax effect. However, the accretion of €2.5 million finance costs on the provision gives rise to an additional deductible temporary difference arising after initial recognition of the
liability, requiring recognition of a deferred tax asset (assuming that the general recognition criteria for assets are met
– see 7.4 below). This gives rise to the following overall accounting entries for the year ended 31 December 2019.
€m
€m
2019
Depreciation (€7.5m ÷ 5)
1.50
PP&E – decommissioning asset 1.50
Finance cost (€7.5m × 6%)
0.45
Provision for clean-up costs
0.45
Deferred tax (statement of financial position)
0.18
Deferred tax (profit or loss) (40% × €0.45m)
0.18
If equivalent entries are made for the following periods, the following amounts will be included in subsequent income
statements (all figures in € millions):
2019
2020
2021
2022
2023
Total
Depreciation 1.50
1.50
1.50
1.50
1.50 7.50
Finance costs
0.45
0.47
0.50
0.53
0.55
2.50
Cost before tax
1.95
1.97
2.00
2.03
2.05
10.00
Current tax (income)
(4.00)
(4.00)
Deferred tax (income)/charge1 (0.18)
(0.19)
(0.20)
(0.21)
0.78 –
Cost after tax
1.77
1.78
1.80
1.82
(1.17)
6.00
Effective tax rate
9.2%
9.6%
10.0%
10.3%
(157.1)% 40.0%
1
In years 2019-2022 40% × finance cost for period. In 2023, reversal of cumulative deferred tax asset
recognised in previous periods.
Approach 2: Recognise deferred tax on initial recognition – consider asset and liability separately
Under this approach, the entity would, on initial recognition of the provision and the addition to PP&E, establish
a deferred tax asset of €3 million in respect of the provision (€7.5m @ 40%) and an equal liability in respect of
the decommissioning component of PP&E. This would result in the following amounts being included in
subsequent income statements (all figures in € millions):
Income
taxes
2397
2019
2020
2021
2022
2023
Total
Depreciation 1.50
1.50
1.50
1.50
1.50 7.50
Finance costs
0.45
0.47
0.50
0.53
0.55
; 2.50
Cost before tax
1.95
1.97
2.00
2.03
2.05
10.00
Current tax (income)
(4.00)
(4.00)
Deferred tax (income)/charge1 (0.78)
(0.79)
(0.80)
(0.81)
3.18
–
Cost after tax
1.17
1.18
1.20
1.22
1.23
6.00
Effective tax rate
40.0%
40.0%
40.0%
40.0%
40.0% 40.0%
1
In 2019, the net of the reduction in deferred tax liability in respect of the decommissioning component
of PP&E €0.6m (€1.5m @ 40%) and increase in deferred tax asset in respect of provision €0.18m
(€0.45m @ 40%) – similarly for 2020-2022. The charge in 2022 represents the release of the remaining
net deferred tax asset (equal to cumulative income statement credits in 2019-2022).
In the Statement of Financial Position, the related assets and liabilities would be recognised as follows:
2019
2020
2021
2022
2023
PP&E – decommissioning asset 6.00
4.50
3.00
1.50
–
Decommissioning liability
(7.95)
(8.42)
(8.92)
(9.45)
–
Net decommissioning liability
(1.95)
(3.92)
(5.92)
(7.95)
–
Deferred tax asset
3.18
3.37
3.57
3.78
–
Deferred tax liability
(2.40)
(1.80)
(1.20)
(0.60)
–
Current tax recoverable
4.00
Approach 3: Recognise deferred tax – consider asset and liability as linked
Under this approach, the entity regards the decommissioning asset and liability as a single item. On this basis,