• at the time of the transaction, affects neither accounting profit nor taxable
profit (tax loss).
These exceptions to the recognition principles do not apply to taxable temporary
differences associated with investments in subsidiaries, branches and associates, and
interests in joint arrangements, which are subject to further detailed provisions of
IAS 12 (see 7.5 below). [IAS 12.15].
Examples of taxable temporary differences are given in 6.2.1 above.
7.1.2
Deductible temporary differences (deferred tax assets)
IAS 12 requires a deferred tax asset to be recognised in respect of all deductible
temporary differences to the extent that it is probable that taxable profit will be
available against which the deductible temporary difference will be utilised except
those arising from the initial recognition of an asset or liability in a transaction that:
• is not a business combination; and
• at the time of the transaction, affects neither accounting profit nor taxable profit
(tax loss). [IAS 12.24].
IAS 12 does not define ‘probable’ in this context. However, it is generally understood
that, as in other IFRSs, it should be taken to mean ‘more likely than not’. The exposure
draft ED/2009/2 (see 1.3 above) effectively clarified that this is the intended meaning.10
These exceptions to the recognition principles do not apply to deductible temporary
differences associated with investments in subsidiaries, branches and associates, and
interests in joint arrangements, which are subject to further detailed provisions of
IAS 12 (see 7.5 below).
Examples of deductible temporary differences are given in 6.2.2 above.
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7.1.3 Interpretation
issues
7.1.3.A Accounting
profit
The provisions of IAS 12 summarised above refer to a transaction that affects
‘accounting profit’. In this context ‘accounting profit’ clearly means any item recognised
in total comprehensive income, whether recognised in profit or loss or in other
comprehensive income.
7.1.3.B
Taxable profit ‘at the time of the transaction’
The provisions of IAS 12 summarised above also refer to a transaction which affects
taxable profit ‘at the time of the transaction’. Strictly speaking, no transaction affects
taxable profit ‘at the time of the transaction’, since the taxable profit is affected only
when the relevant item is included (some time later) in the tax return for the period. It
is clear, however, that the intended meaning is that the transaction that gives rise to the
initial recognition of the relevant asset or liability affects the current tax liability for the
accounting period in which the initial recognition occurs.
Suppose that, in the year ended 31 December 2018, an entity received €2 million, being
5 years’ prepaid rent of an investment property. In the statement of financial position
as at 31 December, €1,800,000 is carried forward as deferred income. The whole
€2 million is taxed on receipt and will therefore be included in the tax return for the
period, which is not filed until 2019.
It could be argued that, in a literal legal sense, the transaction ‘affects taxable profit’ only
in 2019. For the purposes of IAS 12, however, the transaction is regarded as affecting
taxable profit during 2018 (since it affects the current tax for that period). This gives rise
to the recognition, subject to the restrictions discussed at 7.4 below, of a deferred tax
asset based on a deductible temporary difference of €1,800,000 (see 6.2.2.A above).
7.2
The initial recognition exception
The exceptions (summarised at 7.1 above) from recognising the deferred tax effects of
certain temporary differences arising on the initial recognition of some assets and
liabilities are generally referred to as the ‘initial recognition exception’ or ‘initial
recognition exemption’, sometimes abbreviated to ‘IRE’. ‘Exception’ is the more
accurate description, since a reporting entity is required to apply it, rather than having
the option to do so implicit in the term ‘exemption’.
The initial recognition exception has its origins in the now superseded ‘income
statement’ approaches to accounting for deferred tax. Under these approaches,
deferred tax was not recognised on so-called ‘permanent differences’ – items of income
or expense that appeared in either the financial statements or the tax return, but not in
both. The majority of transactions to which the initial recognition exception applies
would have been regarded as permanent differences under income statement
approaches of accounting for deferred tax. For entities applying the temporary
difference approach of IAS 12, the IRE avoids the need for entities to recognise an initial
deferred tax liability or asset and adjust the carrying amount of the asset or liability by
the same amount. The Standard argues that such adjustments would make the financial
statements less transparent. Therefore, IAS 12 does not allow an entity to recognise the
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resulting deferred tax liability or asset, either on initial recognition or subsequently.
[IAS 12.22(c)]. It would also be inappropriate to recognise any adjustment as a gain or loss
in profit or loss, given that the transaction itself has no effect on profit or loss.
The purpose of the initial recognition exception is most easily understood by
considering the accounting consequences that would follow if it did not exist, as
illustrated in Example 29.2 below.
Example 29.2: Rationale for initial recognition exception
An entity acquires an asset for €1,000 which it intends to use for five years and then scrap (i.e. the residual
value is nil). The tax rate is 40%. Depreciation of the asset is not deductible for tax purposes. On disposal,
any capital gain would not be taxable and any capital loss would not be deductible.
Although the asset is non-deductible, its recovery has tax consequences, since it will be recovered out of
taxable income of €1,000 on which tax of €400 will be paid. The tax base of the asset is therefore zero, and
a temporary difference of €1,000 arises on initial recognition of the asset.
Absent the initial recognition exception, the entity would recognise a deferred tax
liability of €400 on initial recognition of the asset, being the taxable temporary
difference of €1,000 multiplied by the tax rate of 40%. A debit entry would then be
required to balance the credit for the liability.
One possibility might be to recognise tax expense of €400 in the statement of total
comprehensive income. This would be meaningless, since the entity has clearly not
suffered a loss simply by purchasing a non-deductible asset in an arm’s length
transaction for a price that (economically) must reflect the asset’s non-deductibility.
A second possibility would be to gross up the asset by €400 to €1,400. However, IAS 12
states that to make such adjustments to the carrying value of the asset would make the
financial statements ‘less transparent’. [IAS 12.22(c)].
A third possibility (broadly the guidance provided under US GAAP) would be to gross
&
nbsp; up the asset to the amount that would rationally have been paid for it, had it been fully
tax-deductible, and recognise a corresponding amount of deferred tax. As the asset is
non-deductible, the €1,000 cost must theoretically represent the anticipated minimum
post-tax return from the asset. In order to achieve a post-tax return of €1,000, an entity
paying tax at 40% needs to earn pre-tax profits of €1,667 (€1,000/[1 – 0.4]). Therefore,
the cost of an equivalent fully-deductible asset would, all else being equal, be €1,667.
On this analysis, the entity would gross up the asset to €1,667 and recognise deferred
tax of €667 (€1,667 @ 40%).
The fourth possibility, which is what is actually required by IAS 12, is not to provide for
deferred tax at all, where to do so would lead to one of the three outcomes above.
However, in cases where provision for the deferred tax on a temporary difference arising
on initial recognition of an asset or liability would not lead to one of the outcomes above,
the initial recognition exception does not apply. This is the case in a business combination
or a transaction affecting taxable profit or accounting profit (or both).
• Business combination
In a business combination, the corresponding accounting entry for a deferred tax
asset or liability forms part of the goodwill arising or the bargain purchase gain
recognised. No deferred tax income or expense is recorded.
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• Transaction affecting taxable profit or accounting profit
In a transaction affecting taxable profit or accounting profit (or both), the
corresponding accounting entry for a deferred tax asset or liability is recorded as
deferred tax income or expense.
This ensures that the entity recognises all future tax consequences of recovering the
assets, or settling the liabilities, recognised in the transaction. The effect of this on the
statement of total comprehensive income is broadly to recognise the tax effects of the
various components of income and expenditure in the same period(s) in which those
items are recognised for financial reporting purposes (as illustrated at 1.2.2 above).
In short, the initial recognition exception may simply be seen as the least bad of the
four theoretically possible options for dealing with ‘day one’ temporary differences.
7.2.1
Acquisition of tax losses
The initial recognition exception applies only to deferred tax relating to temporary
differences. It does not apply to tax assets, such as purchased tax losses, that do not arise
from deductible temporary differences. The definition of ‘deferred tax assets’ (see 3 above)
explicitly distinguishes between deductible temporary differences and unused losses and
tax credits. [IAS 12.5]. There is therefore no restriction on the recognition of acquired tax
losses other than the general criteria of IAS 12 for recognition of tax assets (see 7.4 below).
Under the general principles of IAS 12, acquired tax losses are initially recognised at the
amount paid, subsequently re-assessed for recoverability (see 7.4.6 below) and re-measured
accordingly (see 8 below). Changes in the recognised amount of acquired tax losses are
generally recognised in profit or loss, on the basis that, as acquired losses, they do not relate
to any pre-tax transaction previously accounted for by the entity (see 10 below). However,
in some limited circumstances, changes to tax losses acquired as part of a business
combination are required to be treated as an adjustment to goodwill (see 12.1.2 below).
7.2.2
Initial recognition of goodwill
7.2.2.A Taxable
temporary
differences
In many jurisdictions goodwill is not tax-deductible either as it is impaired or on
ultimate disposal, such that it gives rise to a temporary difference equal to its carrying
amount (representing its carrying amount less its tax base of zero).
It may well be that the shares in the acquired entity have a tax base equal to their cost
so that, economically, an amount equal to the goodwill is deductible on disposal of those
shares. However, accounting for the tax effects of the shares in an acquired subsidiary
(or other significant group investment) is subject to separate provisions of IAS 12, which
are discussed at 7.5 below.
The initial recognition exception for taxable temporary differences on goodwill prevents
the grossing-up of goodwill that would otherwise occur. Goodwill is a function of all the
net assets of the acquired business, including deferred tax. If deferred tax is provided for
on goodwill, the goodwill itself is increased, which means that the deferred tax on the
goodwill is increased further, which means that the goodwill increases again, and so on.
Equilibrium is reached when the amount of goodwill originally recorded is grossed up by
the fraction 1/(1 – t), where t is the entity’s tax rate, expressed as a decimal fraction.
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For example, an entity that pays tax at 30% and recognises CU1,400 of goodwill before
recognising deferred tax would (absent the initial recognition exception) increase the
goodwill to CU2,000 and recognise a deferred tax liability of CU600 (which is 30% of
the restated goodwill of CU2,000).
IAS 12 takes the view that this would not be appropriate, since goodwill is intended to
be a residual arising after fair values have been determined for the assets and liabilities
acquired in a business combination, and recognition of deferred tax would increase that
goodwill. [IAS 12.21].
7.2.2.B
Deductible temporary differences
Where the carrying amount of goodwill arising in a business combination is less than its
tax base, a deductible temporary difference arises. IAS 12 requires a deferred tax asset
to be recognised in respect of any deductible temporary difference, to the extent that
it is probable that taxable profit will be available against which the temporary difference
could be utilised. [IAS 12.32A]. This contrasts with the prohibition against recognising a
deferred tax liability on any taxable temporary difference on initial recognition of
goodwill (see 7.2.2.A above). A more general discussion of the criteria in IAS 12 for
assessing the recoverability of deferred tax assets may be found at 7.4 below.
IAS 12 gives no guidance on the method to be used in calculating the resulting deferred
tax asset, which is not entirely straightforward, as illustrated by the following example.
Example 29.3: Deferred tax asset on initial recognition of goodwill
An entity that pays tax at 40% recognises, in the initial accounting for a business combination, goodwill of
€1,000. Tax deductions of €1,250 are given for the goodwill over a 5 year period.
One approach would be to adopt an iterative method similar to that described
at 7.2.2.A above, whereby recognition of a deferred tax asset on goodwill leads to a
reduction of the goodwill, which in turn will lead to a further increase in the deferred
tax asset, and so on. Equilibrium is reached when the goodwill is adjusted to an
amount equal to ( g – bt )/( 1 – t ), where:
• g is the amount of goodwill originally recorded (before recognising a deferred tax asset);
• b is the tax
base of the goodwill; and
• t is the tax rate, expressed as a decimal fraction.
Under this method, the entity would record goodwill of €833 (being [€1,000 –
0.4 × €1,250] ÷ 0.6) and a deferred tax asset of €167. This represents a deductible
temporary difference of €417 (comprising the tax base of €1,250 less the adjusted
carrying amount of €833), multiplied by the tax rate of 40%. On any subsequent
impairment or disposal of the goodwill, the entity would report an effective tax rate of
40% (the statutory rate), comprised of pre-tax expense of €833 and tax income of €333
(the real tax deduction of €500 (€1,250 @ 40%), less the write-off of the deferred tax
asset of €167).
An alternative approach might be to record a deferred tax asset based on the carrying
amount of goodwill before calculating the deferred tax asset, and adjust the goodwill
only once, rather than undertaking the iterative reduction in the goodwill described
in the previous paragraph. In the example above this would lead to the entity
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recording a deferred tax asset of €100 (representing 40% of the deductible temporary
difference of €250 between the tax base of the goodwill of €1,250 and its original
carrying amount of €1,000) and goodwill of €900. On any subsequent impairment or
disposal of the goodwill the entity would report an effective tax rate of 44% (higher
than the statutory rate), comprised of pre-tax expense of €900 and tax income of
€400 (the real tax deduction of €500 (€1,250 @ 40%), less the write-off of the deferred
tax asset of €100).
7.2.2.C
Tax deductible goodwill
Where goodwill is tax-deductible, new temporary differences will arise after its initial
recognition as a result of the interaction between tax deductions claimed and
impairments (if any) of the goodwill in the financial statements. These temporary
differences do not relate to the initial recognition of goodwill, and therefore deferred
tax should be recognised on them, as illustrated by Example 29.14 at 7.2.4.C below.
[IAS 12.21B].
7.2.3
Initial recognition of other assets and liabilities
Where a temporary difference arises on initial recognition of an asset or liability, its treatment
depends on the circumstances which give rise to the recognition of the asset or liability.
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 474