Recognition of Current Tax

The primary goal of the liability method is to present the estimated actual taxes to be payable in current and future periods as the income tax liability on the statement of financial position. Based on this goal, current tax for the current and prior periods is recognised as a liability to the extent it is unpaid at the end of the reporting period. If the amount paid exceeds the respective current tax recorded, an asset is recognised. The benefit of a tax loss that can be carried back to recover current tax of previous periods must also be recognised as an asset as the benefit is both probable and reliably measurable.

Measurement of Current Tax

Current tax liabilities are measured at the amount expected to be paid to the taxation authorities, using the tax rates (and tax laws) that have been enacted or substantially enacted by the end of the reporting period. Current tax assets are similarly measured at the amount expected to be recovered from the taxation authorities.

Recognition of Deferred Tax

The recognition of deferred tax is based on a statement of financial position orientation. Based on this orientation, deferred tax liabilities are recognised for taxable temporary differences and deferred tax assets are recognised for deductible temporary differences, the carryforward of unused tax losses and the carryforward of unused tax credits.

The general principle is that a deferred tax liability is recognised for all taxable temporary differences. Two exceptions are, however, applicable. The first is temporary differences arising from the initial recognition of goodwill and the second is temporary differences arising from the initial recognition of an asset or liability in a transaction which is not a business combination and at the time of the transaction affects neither accounting profit nor taxable profit (tax loss).

Deferred tax assets recognised for deductible temporary difference, the carryforward of unused tax losses and the carryforward of unused tax credits are subject to a probability limitation. Deferred tax is only recognised to the extent that it is probable that taxable profits are available against which the deductible temporary difference could be utilised. An exception, similar to a deferred tax liability, is also applicable to deductible temporary differences arising from the initial recognition of an asset or liability in a transaction which is not a business combination and at the time of the transaction affects neither accounting profit nor taxable profit (tax loss).

Special principles are applicable to the recognition of temporary differences associated with investments in subsidiaries, branches and interest in joint ventures, which is discussed under Specific Transactions.

Measurement of Deferred Tax Assets

Deferred tax assets and deferred tax liabilities are measured at the tax rates that are expected to apply to the period when the assets are realised or the liabilities are settled. The applicable tax rate is based on the tax rate (and tax laws) that have been enacted or substantively enacted by the end of the reporting period.

The computation of the amount of deferred taxes is based on the rate expected to be in effect when the temporary differences reverse. The annual computation is considered a tentative estimate of the liability (or asset) that is subject to change as the statutory tax rate changes or as the taxpayer moves into other tax rate brackets. The measurement of deferred tax liabilities and deferred tax assets reflects the tax consequences that would follow the manner in which management expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities.

The issue is that both the tax rate and the tax base of an asset or liability can be dependent on the manner in which the entity recovers or settles the asset or liability. An asset can either be recovered through usage or sale, or a combination. IAS 12 clarifies that the tax rate and tax base consistent with the expected manner of recovery or settlement must be used.

Special guidance is applicable to non-depreciable assets measured under the revaluation model and investment properties measured under the fair value model:

• Revalued non-depreciable assets are regarded to be recovered only through sale, since these assets are not depreciated. The tax rate and tax base that should be used is the one that would be applicable if the asset were sold at the end of the reporting period.
• A rebuttable presumption exists that investment properties carried at fair value will be recovered through sale. Deferred tax is thus created as if the entire investment property is recovered through sale at the end of the reporting period.

The presumption regarding investment properties is rebutted if the investment property is depreciated (for example, buildings and leasehold land) and held within a business model whose objective is to consume substantially all the economic benefits embodied in the investment property over time, rather than through sale. The presumption cannot be rebutted for freehold land, which is not depreciable. The rebuttable presumption is also applicable to investment properties measured at fair value in a business combination.

Identification of Temporary Differences

The preponderance of the typical reporting entity's revenue and expense transactions are treated identically for tax and financial reporting purposes. Some transactions and events, however, will have different tax and accounting implications. In many of these cases, the difference relates to the period in which the income or expense will be recognised. Under earlier iterations of IAS 12, the latter differences were referred to as timing differences and were said to originate in one period and to reverse in a later period.

The current IAS 12 introduced the concept of temporary differences, which is a somewhat more comprehensive concept than that of timing differences. Temporary differences include all the categories of items defined under the earlier concept and add a number of additional items as well. Temporary differences are defined to include all differences between the carrying amount and the tax base of assets and liabilities.

The tax base of an asset or liability is defined as the amount attributable to that asset or liability for tax purposes. The following principles are included in IAS 12 to determine the tax base of assets and liabilities:

The tax base can also be determined for transactions not recognised in the statement of financial position. For example, if an amount is expensed, but the amount is only deductible for tax purposes in the future, the tax base will be equal to the amount deductible in the future. When the tax base of an item is not immediately apparent, the following general principle of IAS 12 must be followed to determine the tax base:

1. Recognise a deferred tax asset when recovery or settlement of the carrying amount will reduce future taxable income; and
2. A deferred tax liability when the recovery or settlement of the carrying amount will increase future taxable income.

Once the tax base is determined the related temporary difference is calculated as the difference between carrying value and the tax base. Temporary differences are divided into taxable and deductible temporary differences. Taxable temporary differences represent a liability and are defined as temporary differences that will result in taxable amounts in determining taxable profits of future periods when the carrying amount of the asset or liability is recovered or settled. Deductible temporary differences represent an asset and are defined as temporary differences that will result in amounts that will be deductible in determining the taxable profits of future periods when the carrying amount of the asset or liability is recovered or settled.

Deductible and taxable temporary differences are thus based on the future taxable effect explained in the following examples:

1. Revenue recognised for financial reporting purposes before being recognised for tax purposes. Examples include revenue accounted for by the instalment method for tax purposes but reflected in income currently; certain construction-related revenue recognised on a completed-contract method for tax purposes, but on a percentage-of-completion basis for financial reporting; earnings from investees recognised by the equity method for accounting purposes but taxed only when later distributed as dividends to the investor. These are taxable temporary differences because the amounts are taxable in future periods, which give rise to deferred tax liabilities.
2. Revenue recognised for tax purposes prior to recognition in the financial statements. These include certain types of revenue received in advance, such as prepaid rental income and service contract revenue that is taxable when received. Referred to as deductible temporary differences, these items give rise to deferred tax assets.
3. Expenses that are deductible for tax purposes prior to recognition in the financial statements. This results when accelerated depreciation methods or shorter useful lives are used for tax purposes, while straight-line depreciation or longer useful economic lives are used for financial reporting; and when there are certain pre-operating costs and certain capitalised interest costs that are deductible currently for tax purposes. These items are taxable temporary differences and give rise to deferred tax liabilities.
4. Expenses that are reported in the financial statements prior to becoming deductible for tax purposes. Certain estimated expenses, such as warranty costs, as well as such contingent losses as accruals of litigation expenses, are not tax deductible until the obligation becomes fixed. These are deductible temporary differences, and accordingly give rise to deferred tax assets.

Other examples of temporary differences include:

1. Reductions in tax-deductible asset bases arising in connection with tax credits. Under tax provisions in certain jurisdictions, credits are available for certain qualifying investments in plant assets. In some cases, taxpayers are permitted a choice of either full accelerated depreciation coupled with a reduced investment tax credit, or a full investment tax credit coupled with reduced depreciation allowances. If the taxpayer chose the latter option, the asset basis is reduced for tax depreciation, but would still be fully depreciable for financial reporting purposes. Accordingly, this election would be accounted for as a taxable timing difference and give rise to a deferred tax liability.
2. Increases in the tax bases of assets resulting from the indexing of asset costs for the effects of inflation. Occasionally, proposed and sometimes enacted by taxing jurisdictions, such a tax law provision allows taxpaying entities to finance the replacement of depreciable assets through depreciation based on current costs, as computed by the application of indices to the historical costs of the assets being remeasured. This re-evaluation of asset costs gives rise to deductible temporary differences that would be associated with deferred tax benefits.
3. Certain business combinations accounted for by the acquisition method. Under certain circumstances, the costs assignable to assets or liabilities acquired in purchase business combinations will differ from their tax bases. The usual scenario under which this arises is when the acquirer must continue to report the predecessor's tax bases for tax purposes, although the price paid was more or less than book value. Such differences may be either taxable or deductible and, accordingly, may give rise to deferred tax liabilities or assets. These are recognised as temporary differences by IAS 12.
4. Assets that are revalued for financial reporting purposes although the tax bases are not affected. This is analogous to the matter discussed in point 2. Under certain IFRS (such as IAS 16 and IAS 40), assets may be upwardly adjusted to current fair values (revaluation amounts), although for tax purposes these adjustments are ignored until and unless the assets are disposed of. The discrepancies between the adjusted book carrying values and the tax bases are temporary differences under IAS 12, and deferred taxes are to be provided on these variations. This is required even if there is no intention to dispose of the assets in question, or if, under the salient tax laws, exchanges for other similar assets (or reinvestment of proceeds of sales in similar assets) would effect a postponement of the tax obligation.

Identification of Exemptions

Two exemptions are applicable to the recognition of deferred tax, namely goodwill and initial recognition exception.

Identification of Unused Tax Losses or Tax Credits

Unused tax losses or unused tax credits must be identified to determine whether deferred tax assets should be recognised in such transactions. Deferred tax assets are recognised for these amounts if they are regarded to be probable.

Calculation and Measurement of Deferred Tax Assets and Liabilities

The procedure to compute the gross deferred tax provision (i.e., before addressing whether the deferred tax asset is likely to be realised and therefore should be recognised) after exempt temporary differences and unused tax losses and tax credits are identified is as follows:

1. Segregate the temporary differences into those that are taxable and those that are deductible. This step is necessary because under IAS 12 only those deferred tax assets that are likely to be realised are recognised, whereas all deferred tax liabilities are recognised in full.
2. Accumulate information about the deductible temporary differences, particularly the net operating loss and credit carryforwards that have expiration dates or other types of limitations.
3. Measure the tax effect of aggregate taxable temporary differences by applying the appropriate expected tax rates (federal plus any state, local and foreign rates that are applicable under the circumstances).
4. Similarly, measure the tax effects of deductible temporary differences, including net operating loss carryforwards.

It should be emphasised that separate computations should be made for each tax jurisdiction, since in assessing the propriety of recording the tax effects of deductible temporary differences it is necessary to consider the entity's ability to absorb deferred tax assets against tax liabilities. Inasmuch as assets receivable from one tax jurisdiction will not reduce taxes payable to another jurisdiction, separate calculations will be needed. Also, for purposes of statement of financial position presentation (discussed below in detail), the offsetting of deferred tax assets and liabilities may be permissible only within jurisdictions, since there may not be a legal right to offset obligations due to and from different taxing authorities. Similarly, separate computations should be made for each taxpaying component of the business. Thus, if a parent company and its subsidiaries are consolidated for financial reporting purposes but file separate tax returns, the reporting entity comprises a number of components, and the tax benefits of any one will be unavailable to reduce the tax obligations of the others.

The principles set forth above are illustrated by the following examples.

Limitation on the Recognition of Deferred Tax Assets

Although the case for presentation in the financial statements of any amount computed for deferred tax liabilities is clear, it can be argued that deferred tax assets should be included in the statement of financial position only if they are, in fact, very likely to be recovered in future periods. Since recoverability will almost certainly be dependent on the future profitability of the reporting entity, it may become necessary to ascertain the likelihood that the enterprise will be profitable.

Under IAS 12, deferred tax assets resulting from temporary differences, tax loss carryforwards and tax credits carryforwards are to be given recognition only if realisation is deemed to be probable. The standard establishes that:

1. It is probable that future taxable profit will be available against which a deferred tax asset arising from a deductible temporary difference can be utilised when there are sufficient taxable temporary differences relating to the same taxation authority which will reverse either:
   1. In the same period as the reversal of the deductible temporary difference; or
   2. In periods into which the deferred tax asset can be carried back or forward; or
2. If there are insufficient taxable temporary differences relating to the same taxation authority, it is probable that the enterprise will have taxable profits in the same period as the reversal of the deductible temporary difference or in periods to which the deferred tax can be carried back or forward, or there are tax-planning opportunities available to the enterprise that will create taxable profit in appropriate periods.

When an entity assesses whether taxable profits are probable, it must consider the effect of any tax law restrictions on the sources of taxable profits. A deferred tax asset is then assessed in combination only with other deferred tax assets that are also restricted.

There necessarily will be an element of judgement in making an assessment about how probable the realisation of the deferred tax asset is, for those circumstances in which there is not an existing balance of deferred tax liability equal to or greater than the amount of the deferred tax asset. If it cannot be concluded that realisation is probable, the deferred tax asset is not recognised.

As a practical matter, there are a number of positive and negative factors which may be evaluated in reaching a conclusion as to amount of the deferred tax asset to be recognised. Positive factors (those suggesting that the full amount of the deferred tax asset associated with the gross temporary difference should be recorded) might include:

1. Evidence of sufficient future taxable income, exclusive of reversing temporary differences and carryforwards, to realise the benefit of the deferred tax asset.
2. Evidence of sufficient future taxable income arising from the reversals of existing taxable temporary differences (deferred tax liabilities) to realise the benefit of the tax asset.
3. Evidence of sufficient taxable income in prior year(s) available for realisation of an operating loss carryback under existing statutory limitations.
4. Evidence of the existence of prudent, feasible tax planning strategies under management control that, if implemented, would permit the realisation of the tax asset. These are discussed in greater detail below.
5. An excess of appreciated asset values over their tax bases, in an amount sufficient to realise the deferred tax asset. This can be thought of as a subset of the tax strategies idea, since a sale or sale/leaseback of appreciated property is one rather obvious tax-planning strategy to salvage a deferred tax benefit that might otherwise expire unused.
6. A strong earnings history exclusive of the loss that created the deferred tax asset. This would, under many circumstances, suggest that future profitability is likely and therefore that realisation of deferred tax assets is probable.

Although the foregoing may suggest that the reporting entity will be able to realise the benefits of the deductible temporary differences outstanding as of the date of the statement of financial position, certain negative factors should also be considered in determining whether realisation of the full amount of the deferred tax benefit is probable under the circumstances. These factors could include:

1. A cumulative recent history of accounting losses. Depending on extent and length of time over which losses were experienced, this could reduce the assessment of likelihood of realisation below the important “probable” threshold.
2. A history of operating losses or of tax operating loss or credit carryforwards that have expired unused.
3. Losses that are anticipated in the near future years, despite a history of profitable operations.

Thus, the process of determining how much of the computed gross deferred tax benefit should be recognised involves the weighing of both positive and negative factors to determine whether, based on the preponderance of available evidence, it is probable that the deferred tax asset will be realised. IAS 12 notes that a history of unused tax losses should be considered “strong evidence” that future taxable profits might prove elusive. In such cases, it would be expected that primary reliance would be placed on the existence of taxable temporary differences that, upon reversal, would provide taxable income to absorb the deferred tax benefits that are candidates for recognition in the financial statements. In the absence of those taxable temporary differences, recognition would be much more difficult.

The estimation of probable future taxable profit may include the recovery of some of an entity's assets for more than their carrying amount if there is sufficient evidence that it is probable that the entity will achieve this. For example, when an asset is measured at fair value, the entity shall consider whether there is sufficient evidence to conclude that it is probable that the entity will recover the asset for more than its carrying amount.

Uncertainties over Income Tax Treatments

IFRIC 23, Uncertainty over Income Tax Treatments, was issued June 2017 to clarify how to apply the recognition and measurement requirements in IAS 12 when there is uncertainty over the income tax treatment. The IFRIC is effective for annual reporting periods beginning on or after January 1, 2019, and earlier application is permitted. The current or deferred tax asset or liability shall still be recognised and measured applying the requirements of IAS 12 regarding, for instance, taxable profit (tax loss), tax bases, unused tax losses, unused tax credits and tax rates.

Effect of Tax Law Changes on Previously Recorded Deferred Tax Assets and Liabilities

The statement of financial position-oriented measurement approach of IAS 12 necessitates the revaluation of the deferred tax asset and liability balances at each year-end. Although IAS 12 does not directly address the question of changes to tax rates or other provisions of the tax law (e.g., deductibility of items), which may be enacted that will affect the recoverability of future deferred tax assets or liabilities, the effect of these changes should be reflected in the year-end deferred tax accounts in the period the changes are enacted. The offsetting adjustments should be made through the current period tax provision.

When revised tax rates are enacted, they may affect not only the unreversed effects of items which were originally reported in the continuing operations section of the statement of income (under revised IAS 1, the income statement section of a combined statement of profit or loss and other comprehensive income), but also the unreversed effects of items first presented as other comprehensive income. Although it might be conceptually superior to report the effects of tax law changes on such unreversed temporary differences in these same statements of profit or loss and other comprehensive income captions, as a practical matter the complexities of identifying the diverse treatments of these originating transactions or events would make such an approach unworkable. Accordingly, remeasurements of the effects of tax law changes should generally be reported in the tax provision associated with continuing operations.

Changes in tax law may affect rates and may also affect the taxability or deductibility of income or expense items. While the latter type of change occurs infrequently, the impact is similar to the more common tax rate changes.

Reporting the Effect of Tax Status Changes

Changes in the tax status of the reporting entity should be reported in a manner that is entirely analogous to the reporting of enacted tax law changes. When the tax status change becomes effective, the consequent adjustments to deferred tax assets and liabilities are reported in current tax expense as part of the tax provision relating to continuing operations.

The most commonly encountered changes in status are those attendant to an election, where permitted, to be taxed as a partnership or other flow-through enterprise. (This means that the corporation will not be treated as a taxable entity but rather as an enterprise that “flows through” its taxable income to the owners on a current basis. This favourable tax treatment is available to encourage small businesses, and often will be limited to entities having sales revenue under a particular threshold level, or to entities having no more than a maximum number of shareholders.) Enterprises subject to such optional tax treatment may also request that a previous election be terminated. When a previously taxable corporation becomes a non-taxed corporation, the stockholders become personally liable for taxes on the company's earnings, whether the earnings are distributed to them or not (similar to the relationship among a partnership and its partners).

As issued, IAS 12 did not explicitly address the matter of reporting the effects of a change in tax status, although the appropriate treatment was quite obvious given the underlying concepts of that standard. This ambiguity was subsequently resolved by the issuance of SIC 25, which stipulates that in most cases the current and deferred tax consequences of the change in tax status should be included in net profit or loss for the period in which the change in status occurs. The tax effects of a change in status are included in results of operations because a change in a reporting entity's tax status (or that of its shareholders) does not give rise to increases or decreases in the pre-tax amounts recognised directly in equity.

The exception to the foregoing general rule arises in connection with those tax consequences which relate to transactions and events that result, in the same or a different period, in a direct credit or charge to the recognised amount of equity. For example, an event that is recognised directly in equity is a change in the carrying amount of property, plant or equipment revalued under IAS 16. Those tax consequences that relate to change in the recognised amount of equity, in the same or a different period (not included in net profit or loss), should be charged or credited directly to equity.

The most common situation giving rise to a change in tax status would be the election by a corporation, in those jurisdictions where it is permitted to do so, to be taxed as a partnership, trust or other flow-through entity. If a corporation having a net deferred tax liability elects non-taxed status, the deferred taxes will be eliminated through a credit to current period earnings. That is because what had been an obligation of the corporation has been eliminated (by being accepted directly by the shareholders, typically); a debt thus removed constitutes earnings for the formerly obligated party.

Similarly, if a previously non-taxed corporation becomes a taxable entity, the effect is to assume a net tax benefit or obligation for unreversed temporary differences existing at the date the change becomes effective. Accordingly, the financial statements for the period of such a change will report the effects of the event in the current tax provision. If the entity had at that date many taxable temporary differences as yet unreversed, it would report a large tax expense in that period. Conversely, if it had a large quantity of unreversed deductible temporary differences, a substantial deferred tax benefit (if recoverable) would need to be recorded, with a concomitant credit to the current period's tax provision in the statement of comprehensive income. Whether eliminating an existing deferred tax balance or recording an initial deferred tax asset or liability, the income tax note to the financial statements will need to fully explain the nature of the events that transpired.

In some jurisdictions, non-taxed corporation elections are automatically effective when filed. In such a case, if a reporting entity makes an election before the end of the current fiscal year, it is logical that the effects be reported in current year income to become effective at the start of the following period. For example, an election filed in December 202X-1 would be reported in the 202X-1 financial statements to become effective at the beginning of the company's next fiscal year, January 1, 202X. No deferred tax assets or liabilities would appear on the December 31, 202X-1 statement of financial position, and the tax provision for the year then ended would include the effects of any reversals that had previously been recorded. Practice varies, however, and in some instances the effect of the elimination of the deferred tax assets and liabilities would be reported in the year the election actually becomes effective.

Implications of Changes in Tax Rates and Status Made in Interim Periods

Tax rate changes may occur during an interim reporting period, either because a tax law change mandated a midyear effective date, or because tax law changes were effective at year end, but the reporting entity has adopted a fiscal year end other than the natural year (December 31).

The fact that income taxes are assessed annually is the primary reason for concluding that taxes are to be accrued based on an entity's estimated average annual effective tax rate for the full fiscal year. If rate changes have been enacted to take effect later in the fiscal year, the expected effective rate should take into account the rate changes as well as the anticipated pattern of earnings to be experienced over the course of the year. Thus, the rate to be applied to interim period earnings (or losses, as discussed further below) will take into account the expected level of earnings for the entire forthcoming year, as well as the effect of enacted (or substantially enacted) changes in the tax rates to become operative later in the fiscal year. In other words, and as expressed by IAS 34, the estimated average annual rate would “reflect a blend of the progressive tax rate structure expected to be applicable to the full year's earnings enacted or substantially enacted changes in the income tax rates scheduled to take effect later in the financial year.”

While the principle espoused by IAS 34 is both clear and logical, a number of practical issues can arise. The standard does address in detail the various computational aspects of an effective interim period tax rate, some of which are summarised in the following paragraphs.

Many modern business entities operate in numerous nations or states and therefore are subject to a multiplicity of taxing jurisdictions. In some instances, the amount of income subject to tax will vary from one jurisdiction to the next, since the tax laws in different jurisdictions will include and exclude disparate items of income or expense from the tax base. For example, interest earned on government-issued bonds may be exempted from tax by the jurisdiction that issued them but be defined as fully taxable by other tax jurisdictions the entity is subject to. To the extent feasible, the appropriate estimated average annual effective tax rate should be separately ascertained for each taxing jurisdiction and applied individually to the interim period pre-tax income of each jurisdiction, so that the most accurate estimate of income taxes can be developed at each interim reporting date. In general, an overall estimated effective tax rate will not be as satisfactory for this purpose as would a more carefully constructed set of estimated rates, since the pattern of taxable and deductible items will fluctuate from one period to the next.

Similarly, if the tax law prescribes different income tax rates for different categories of income, then to the extent practicable, a separate effective tax rate should be applied to each category of interim period pre-tax income. IAS 34, while mandating such detailed rules of computing and applying tax rates across jurisdictions or across categories of income, nonetheless recognised that such a degree of precision may not be achievable in all cases. Thus, IAS 34 allows usage of a weighted-average of rates across jurisdictions or across categories of income provided it is a reasonable approximation of the effect of using more specific rates.

In computing an expected effective tax rate given for a tax jurisdiction, all relevant features of the tax regulations should be taken into account. Jurisdictions may provide for tax credits based on new investment in plant and machinery, relocation of facilities to backward or underdeveloped areas, research and development expenditures, levels of export sales, and so forth, and the expected credits against the tax for the full year should be given consideration in the determination of an expected effective tax rate. Thus, the tax effect of new investment in plant and machinery, when the local taxing body offers an investment credit for qualifying investment in tangible productive assets, will be reflected in those interim periods of the fiscal year in which the new investment occurs (assuming it can be forecast to occur later in a given fiscal year), and not merely in the period in which the new investment occurs. This is consistent with the underlying concept that taxes are strictly an annual phenomenon, but it is at variance with the purely discrete view of interim financial reporting.

IAS 34 notes that, although tax credits and similar modifying elements are to be taken into account in developing the expected effective tax rate to apply to interim earnings, tax benefits that will relate to onetime events are to be reflected from the interim period when those events take place. This is perhaps most likely to be encountered in the context of capital gains taxes incurred in connection with occasional disposals of investments and other capital assets; since it is not feasible to project the timing of such transactions over the course of a year, the tax effects should be recognised only as the underlying events actually do transpire.

While in most cases tax credits are to be handled as suggested in the foregoing paragraphs, in some jurisdictions tax credits, particularly those that relate to export revenue or capital expenditures, are in effect government grants. Accounting for government grants is set forth in IAS 20; in brief, grants are recognised in income over the period necessary to properly match them to the costs which the grants are intended to offset or defray. Thus, compliance with both IAS 20 and IAS 34 would require that tax credits be carefully analysed to identify those which are in substance grants, and that credits are accounted for consistent with their true natures.

When an interim period loss gives rise to a tax loss carryback, it should be fully reflected in that interim period. Similarly, if a loss in an interim period produces a tax loss carryforward, it should be recognised immediately, but only if the criteria set forth in IAS 12 are met. Specifically, it must be deemed probable that the benefits will be realisable before the loss benefits can be given formal recognition in the financial statements. In the case of interim period losses, it may be necessary to assess not only whether the enterprise will be profitable enough in future fiscal years to utilise the tax benefits associated with the loss, but furthermore, whether interim periods later in the same year will provide earnings of sufficient magnitude to absorb the losses of the current period.

IAS 12 provides that changes in expectations regarding the recoverability of benefits related to net operating loss carryforwards should be reflected currently in tax expense. Similarly, if a net operating loss carryforward benefit is not deemed probable of being realised until the interim (or annual) period when it in fact becomes realised, the tax effect will be included in tax expense of that period. Appropriate explanatory material must be included in the notes to the financial statements, even on an interim basis, to provide users with an understanding of the unusual relationship reported between pre-tax accounting income and the provision for income taxes.

Income Tax Consequences of Dividends Paid

Dividends are defined in IFRS 9 as “distributions of profits to holders of equity instruments in proportion to their holdings of a particular class of capital.” IAS 12 clarifies that the income tax consequences of dividends are recognised when the corresponding liability to pay a dividend is recognised. Therefore, if dividends are declared before the end of the year, but are payable after year end, the dividends become a legal liability of the reporting entity and taxes should be computed at the appropriate rate on the amount thus declared. If the dividend is declared after year end but before the financial statements are issued, a liability cannot be recognised on the statement of financial position at year end, and thus the tax effect related thereto also cannot be recognised. Disclosure would be made, however, of this event after the reporting date.

An entity shall recognise the income tax consequences of dividends in profit or loss, other comprehensive income or equity according to where the entity originally recognised those past transactions or events that create the dividend. The reason is that the income tax consequences of dividends are linked more directly to past transactions or events that generated distributable profits than to distributions to owners.

To illustrate the foregoing, consider the following example:

The only exception to the foregoing accounting for tax effects of dividends that are subject to differential tax rates arises in the situation of a dividend-paying corporation which is required to withhold taxes on the distribution and remit these to the taxing authorities. In general, withholding tax is offset against the amounts distributed to shareholders, and is later forwarded to the taxing bodies rather than to the shareholders, so that the total amount of the dividend declaration is not altered. However, if the corporation pays the tax in addition to the full amount of the dividend payments to shareholders, some might view this as a tax falling on the corporation and, accordingly, add this to the tax provision reported on the statement of comprehensive income. IAS 12, however, makes it clear that such an amount, if paid or payable to the taxing authorities, is to be charged to equity as part of the dividend declaration if it does not affect income taxes payable or recoverable by the enterprise in the same or a different period.

Finally, IAS 12 provides that disclosure will be required of the potential income tax consequences of dividends. The reporting enterprise should disclose the amounts of the potential income tax consequences that are practically determinable, and whether there are any potential income tax consequences not practically determinable.

Accounting for Business Combinations at the Acquisition Date

When assets and liabilities are valued at fair value, as required under IFRS 3, but the tax base is not adjusted (i.e., there is a carryforward basis for tax purposes), there will be differences between the tax and financial reporting bases of these assets and liabilities, which will constitute temporary differences. Deferred tax assets and liabilities need to be recognised for these differences as an adjustment to goodwill or the bargain purchase gain. The most common example of this is where taxes are calculated at a subsidiary level in a group, and when these items are consolidated into the group accounts, there are consolidation adjustments to the carrying amounts of the assets which result in additional temporary differences at group level.

The limitation on the recognition of deferred tax assets is also applicable to business combinations.

Accounting for Business Combinations after the Acquisition

Under the provisions of IAS 12, net deferred tax benefits are not to be carried forward as assets unless the deferred tax assets are deemed probable of being recovered. The assessment of this probability was discussed earlier in the chapter.

In the above example (Windlass Corp.), it was specified that all deductible temporary differences were fully recoverable, and therefore the deferred tax benefits associated with those temporary differences were recorded as of the acquisition date. In other situations, there may be substantial doubt concerning recoverability; that is, it may not be probable that the benefits will be realised. Accordingly, under IAS 12, the deferred tax asset would not be recognised at the date of the business acquisition. If so, the allocation of the purchase price would have to reflect that fact, and more of the purchase cost would be allocated to goodwill than would otherwise be the case.

If, at a later date, it is determined that some of or the entire deferred tax asset that was not recognised at the date of the acquisition is, in fact, probable of being ultimately realised, the effect of that re-evaluation will reduce the carrying amount of goodwill. If the carrying amount of goodwill is reduced to nil, any remaining deferred tax asset will be recognised in the tax expense in profit or loss. If a bargain purchase price gain was recognised initially, the deferred tax asset adjustment must be recorded in profit or loss.

A related issue is that the probability of recoverability of a pre-acquisition deferred tax asset of the acquirer could change due to the business combination. For instance, the acquirer has an unrecognised deferred tax loss that would in the future be recoverable from income receivable from the acquired subsidiary. The acquirer recognises the change in the deferred tax asset in the period of the acquisition but cannot include it in the accounting of the business combination, and therefore in the determining of the goodwill or bargain purchase gain of the business combination. This is because the unrecognised deferred tax is not a transaction of the acquiree.

Temporary Differences in Consolidated Financial Statements

Temporary differences in consolidated financial statements are determined by comparing the consolidated carrying values of assets and liabilities with the relevant tax base. The tax base is determined by reference to the applicable tax regime. If the entity is taxed on a group base, the tax base is the group tax base. However, if each entity in the group is taxed separately, the tax base is determined with reference to each individual entity. In the latter case, additional deferred tax can arise that is only recognised in the consolidated financial statements.

Assets Carried at Fair Value

IFRS allows certain assets to be recognised at fair value or at revalued amounts. If the revaluation or adjustment to the fair value affects the taxable profit immediately, the tax base is also adjusted and no deferred tax would be recognised. Examples include derivatives recognised at fair value for both accounting and tax purposes. However, if the revaluation or restatement to fair value does not affect the taxable profit immediately, deferred tax must be created on the revaluation. The tax base of the asset is not adjusted.

The difference between the adjusted carrying value and the tax base is a temporary difference. The normal principles regarding the recovery of the assets through use or sale will be applicable to determine the amount of the related deferred tax. It should be noted that IAS 12 has specific provisions relating to the recognition of deferred tax on revalued assets (under IAS 16) and investment properties at fair value (under IAS 40). For these assets, IAS 12 has a presumption that the assets will be recovered through sale. As a result, any deferred tax raised on the revalued or fair valued assets is done so at the rate applicable on sale. This presumption can be rebutted should the entity be able to prove that it consumes substantially all the asset through use, and that the asset is a depreciable asset, in which case it may use the use rate to calculate the deferred tax.

What this means in practice is that should an entity rebut the presumption, it would need to split the deferred tax into that relating to the land and that relating to the building. The deferred tax on the land will always be raised at the sale rate as it is not a depreciable asset, whereas the deferred tax relating to the building would be raised at the use rate. This split can prove difficult in practice, which is why most entities elect to use the sale rate for all temporary differences arising on revalued and fair valued buildings.

The example below adjusted from IAS 12 illustrates that a temporary difference should be recognised even if the fair value reduces below the carrying value.

Tax on Investments in Subsidiaries, Associates and Joint Ventures

In terms of the general rule, deferred tax should also be recognised on investments in subsidiaries, associates and joint ventures similar to other assets. In an important exception to the general rule, IAS 12 provides that when the parent, investor or joint-venturer can prevent the taxable event from occurring, deferred taxes are not recognised. Specifically, under IAS 12, two conditions must both be satisfied to justify not reflecting deferred taxes in connection with the earnings of a subsidiary (a control situation), branches and associates (significant influence) and joint ventures. These are: (1) that the parent, investor or venturer is able to control the timing of the reversal of the temporary difference: and, (2) it is probable that the difference will not reverse in the foreseeable future. Unless both conditions are met, the tax effects of these temporary differences must be given recognition.

When a parent company that has the ability to control the dividend and other policies of its subsidiary determines that dividends will not be declared, and thus that the undistributed profit of the subsidiary will not be taxed at the parent company level, no deferred tax liability is to be recognised. If this intention is later altered, the tax effect of this change in estimate would be reflected in the current period's tax provision.

On the other hand, an investor, even one having significant influence, cannot absolutely determine the associate's dividend policy. Accordingly, it has to be presumed that earnings will eventually be distributed and that these will create taxable income at the investor company level. Therefore, deferred tax liability must be provided for the reporting entity's share of all undistributed earnings of its associates for which it is accounting by the equity method, unless there is a binding agreement for the earnings of the investee not to be distributed within the foreseeable future.

In the case of joint ventures there are a wide range of possible relationships between the venturers, and in some cases the reporting entity has the ability to control the payment of dividends. As in the foregoing, if the reporting entity has the ability to exercise this level of control and it is probable that distributions will not be made within the foreseeable future, no deferred tax liability will be reported.

In all these various circumstances, it will be necessary to assess whether distributions within the foreseeable future are probable. The standard does not define “foreseeable future” and thus this will remain a matter of subjective judgement. The criteria of IAS 12, while subjective, are less ambiguous than under the original standard, which permitted non-recognition of deferred tax liability when it was “reasonable to assume that (the associate's) profits will not be distributed.”

However, in the consolidated financial statements the investment in the subsidiary will be replaced by the assets and liabilities. Therefore, any deferred tax created on the investment in the subsidiary company in the parents' own financial statements should also be reversed.

Tax Effects of Compound Financial Instruments

IAS 32 established the important notion that when financial instruments are compound, the separately identifiable components are to be accounted for according to their distinct natures. For example, when an entity issues convertible debt instruments, those instruments may have characteristics of both debt and equity securities, and accordingly the issuance proceeds should be allocated among those components. (IAS 32 requires that the full fair value of the liability component be recognised, with only the residual allocated to equity, consistent with the concept that equity is only the residual interest in an entity.) A problem arises when the taxing authorities do not agree that a portion of the proceeds should be allocated to a secondary instrument. IAS 12 requires that deferred tax must be created on both the liability and equity component. The deferred tax on the equity component should be recognised directly in equity.

Note that the offset to deferred tax liability at inception is a charge to equity, in effect reducing the credit to the portion of the bond recognised in equity of the compound financial instrument to a net-of-tax basis, since allocating a portion of the proceeds to the equity component caused the creation of a non-deductible deferred charge, debt discount. When the deferred charge is later amortised, however, the reversing of the temporary difference leads to a reduction in tax expense to better “match” the higher interest expense reported in the financial statements than on the tax return.

Share-Based Payment Transactions

Share-based payment transactions are similar to other transactions subject to deferred tax if the carrying amount differs from the tax base. For example, the expense for the share options granted as compensations is recognised over the vesting period of the share options. For tax purposes assume the amount is only deducted when the options are granted; the tax base will be the expense recognised in equity that is only deducted for tax in future periods. A deferred tax asset is created for the amount that is deducted in the future.

Presentation

Somewhat surprisingly, IAS 12 stated that should the reporting entity classify its statement of financial position (into current and non-current assets and liabilities), deferred tax assets and liabilities should never be included in the current category. All deferred tax balances are always classified as non-current.

Current tax and deferred tax assets and liabilities may only be offset if specific criteria are met. Current tax assets and current tax liabilities may only be offset if:

1. The entity has a legally enforceable right to offset the recognised amounts; and
2. The entity intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

Current tax assets and current tax liabilities of different entities can also only be offset if the above offsetting rules apply, which would be rare, except if the group is taxed on a consolidated basis.

Deferred tax assets and deferred tax liabilities are only offset if:

1. The entity has a legal enforceable right to set off current tax assets and current tax liabilities; and
2. The deferred tax asset and deferred tax liabilities relate to income levied by the same tax authority on the same tax entity or different entities which intend either to settle current tax assets and liabilities on a net basis or simultaneously, in each future period when significant deferred tax assets or liabilities are expected to be recovered or settled.

Disclosures

Revised IAS 12 mandated a number of disclosures, including some that had not been required under earlier practice. The purpose of these disclosures is to provide the user with an understanding of the relationship between pre-tax accounting profit and the related tax effects, as well as to aid in predicting future cash inflows or outflows related to tax effects of assets and liabilities already reflected in the statement of financial position. The more recently imposed disclosures were intended to provide greater insight into the relationship between deferred tax assets and liabilities recognised, the related tax expense or benefit recognised in earnings and the underlying natures of the related temporary differences resulting in those items. There is also enhanced disclosure for discontinued operations under IAS 12. Finally, when deferred tax assets are given recognition under defined conditions, there will be disclosure of the nature of the evidence supporting recognition. The specific disclosures are presented in greater detail in the following paragraphs.