International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 478
the net asset or liability is compared to its tax base and deferred tax is recognised accordingly. On initial
recognition of the provision and the addition to PP&E on 1 January 2019, the net carrying amount is zero so
there is no temporary difference to recognise.
This would result in the following amounts being 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 (0.78)
(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 decommissioning liability increases from nil to €1.95m, resulting in a deferred tax asset
€0.78m (€1.95m @ 40%) – similarly for 2020-2022. The charge in 2023 represents the release of the
remaining net deferred tax asset (equal to cumulative income statement credits in 2019-2022).
If the deferred tax asset and deferred tax liability are capable of being offset in the statement
of financial position (see 13.1.1 below), it would appear that Approach 2 and Approach 3
yield the same result. However, where Approach 2 is applied, the taxable temporary
difference relating to the asset and the deductible temporary difference relating to the
decommissioning liability are considered separately. Accordingly, a deferred tax asset will
only be capable of recognition if it can be shown that there are probable taxable profits in
future periods against which the entity can benefit from the tax deductions arising when the
decommissioning obligation is settled. [IAS 12.29]. This might not be the case, for example
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where the liability is settled after the entity’s revenue-generating activities have ceased and
where tax losses incurred at this time are not permitted to be carried back to earlier periods.
7.2.7.B
Leases under IFRS 16 taxed as operating leases
In a number of jurisdictions, tax deductions are given for leases on the basis of lease
payments made (i.e. regardless of whether a right-of-use asset is recognised under
relevant accounting requirements). The total cost for both accounting and tax purposes is
the same over the period of the lease, but in those cases where a right-of-use asset is
recognised for accounting purposes, the cost recognised in the income statement
comprises depreciation of the asset together with finance costs on the lease liability,
rather than the lease payments made (on which tax relief is often given). Application of
the initial recognition exception separately to the recognition of the right-of-use asset
and the lease liability would lead to a result similar to that set out in the illustration of
Approach 1 in Example 29.18 above, where the entity recognises neither a deferred tax
asset for the deductible temporary difference on the lease liability nor the corresponding
deferred tax liability for the taxable temporary difference on the right-of-use asset.
However, the accretion of interest on the lease liability does create a deductible
temporary difference, creating variability in the effective tax rate in the income statement.
As noted at 7.2.7 above, an alternative would be to disregard the initial recognition
exception and consider the asset and liability recognised at the inception of a lease as a
single transaction that gives rise to both a taxable temporary difference (on the asset) and
a deductible temporary difference (on the liability). Under the second approach noted
above, the amount of the temporary differences are equal and opposite. However, those
temporary differences will only give rise to a net deferred tax position of zero if the entity
is able to justify recognition of a separate deferred tax asset for the deductible temporary
difference and the criteria for offset in the standard are met (see 13.1.1 below). Under the
third approach noted above, the recording of a non-deductible right-of-use asset and a
tax deductible lease liability is regarded as being economically the same as the acquisition
of a tax deductible asset that is financed by a loan. Using this approach, the net temporary
difference at initial recognition is zero. In both of these alternative approaches, the fact
that the right-of-use asset is amortised at a different rate to the underlying lease liability
does not result in any variation in the effective tax rate in the income statement (as
illustrated in Approach 2 and Approach 3 in Example 29.18 above).
The Interpretations Committee considered this issue on two occasions in 2005 in
relation to arrangements accounted as finance leases under IAS 17 – Leases.
IFRIC Update for April 2005 supported Approach 1:
‘The [Interpretations Committee] noted that initial recognition exemption applies
to each separate recognised element in the [statement of financial position], and
no deferred tax asset or liability should be recognised on the temporary difference
existing on the initial recognition of assets and liabilities arising from finance leases
or subsequently.’12
However, only two months later in June 2005, the Committee added:
‘The [Interpretations Committee] considered the treatment of deferred tax
relating to assets and liabilities arising from finance leases.
Income
taxes
2399
While noting that there is diversity in practice in applying the requirements of IAS 12
to assets and liabilities arising from finance leases, the [Interpretations Committee]
agreed not to develop any guidance because the issue falls directly within the scope
of the Board’s short-term convergence project on income taxes with the FASB.’13
At that meeting, the Committee had acknowledged that other approaches were applied
in practice. However, it chose not to discuss the merits or problems relating to those
approaches, because at that time the IASB had a project to replace IAS 12. This project
resulted in the issue of the exposure draft (ED/2009/2 – Income Tax) noted at 1.1 above
and was eventually abandoned.
In light of the impending implementation of IFRS 16 – Leases (see Chapter 24), the
Committee was asked in 2018 to consider the recognition of deferred tax when a lessee
(entity) recognises an asset and a liability at the commencement date of a lease applying
the new Standard. It was also noted that a similar question arises when an entity recognises
a liability and includes in the cost of an item of property, plant and equipment the costs of
; decommissioning that asset. The request described a fact pattern in which the lease
payments and decommissioning costs are deductible for tax purposes when paid.
The Committee acknowledged the three approaches currently applied in these
circumstances as noted above. It 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.14 Notwithstanding
that this recommendation would result in the treatment described as Approach 2 in
Example 29.18 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.
7.2.8
Initial recognition of compound financial instruments by the issuer
IAS 32 requires ‘compound’ financial instruments (those with both a liability feature and
an equity feature, such as convertible bonds) to be accounted for by the issuer using so-
called split accounting. This is discussed in more detail in Chapter 43 at 6, but in essence
an entity is required to split the proceeds of issue of such an instrument (say €1 million)
into a liability component, measured at its fair value based on real market rates for non-
convertible debt rather than the nominal rate on the bond (say €750,000), with the
balance being treated as an equity component (in this case €250,000).
Over the life of the instrument, the €750,000 carrying value of the liability element will
be accreted back up to €1,000,000 (or such lower or higher sum as might be potentially
repayable), so that the cumulative income statement interest charge will comprise:
(a) any actual cash interest payments made (which are tax-deductible in most
jurisdictions); and
(b) the €250,000 accretion of the liability from €750,000 to €1,000,000 (which is not
tax-deductible in most jurisdictions).
Where such an instrument is issued, IAS 12 requires the treatment in Example 29.19 to
be adopted. [IAS 12 IE Example 4].
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Example 29.19: Compound financial instrument
An entity issues a zero-coupon convertible loan of €1,000,000 on 1 January 2019 repayable at par on
1 January 2022. In accordance with IAS 32, the entity classifies the instrument’s liability component as a
liability and the equity component as equity. The entity assigns an initial carrying amount of €750,000 to the
liability component of the convertible loan and €250,000 to the equity component. Subsequently, the entity
recognises the imputed discount of €250,000 as interest expense at the effective annual rate of 10% on the
carrying amount of the liability component at the beginning of the year. The tax authorities do not allow the
entity to claim any deduction for the imputed discount on the liability component of the convertible loan.
The tax rate is 40%.
Temporary differences arise on the liability element as follows (all figures in € thousands).
1.1.19 31.12.19 31.12.20 31.12.21
Carrying value of liability
750
825
908
1,000
component1
Tax base
1,000
1,000
1,000
1,000
Taxable temporary difference
250
175
92
–
Deferred tax liability @ 40%
100
70
37
–
1
Balance carried forward at end of previous period plus 10% accretion of notional interest less repayments.
The deferred tax arising at 1 January 2019 is deducted from equity. Subsequent reductions in the deferred
tax balance are recognised in the income statement, resulting in an effective tax rate of 40%. For example,
in 2019, the entity will accrete notional interest of €75,000 (closing loan liability €825,000 less opening
balance €750,000) with deferred tax income of €30,000 (closing deferred tax liability €70,000 less opening
liability €100,000).
This treatment causes some confusion in practice because it appears to contravene the
prohibition on recognition of deferred tax on temporary differences arising on the
initial recognition of assets and liabilities (other than in a business combination) that do
not give rise to accounting or taxable profit or loss. [IAS 12.15(b)]. IAS 12 states that this
temporary difference does not arise on initial recognition of a liability but as a result of
the initial recognition of the equity component as a result of the requirement in IAS 32
to separate the instrument between its equity and liability components. [IAS 12.23].
7.2.9 Acquisition
of
subsidiary not accounted for as a business combination
Occasionally, an entity may acquire a subsidiary which is accounted for as the
acquisition of an asset rather than as a business combination. This will most often be
the case where the subsidiary concerned is a ‘single asset entity’ holding a single item
of property, plant and equipment which is not considered to comprise a business.
Where an asset is acquired in such circumstances, the initial recognition exception
applies, as illustrated by the following example.
Example 29.20: Acquired subsidiary accounted for as asset purchase
An entity (P) acquires all the shares of a subsidiary (S), whose only asset is a property, for $10 million. The
transaction is accounted for as the acquisition of a property rather than as a business combination. The tax
base of the property is $4 million and its carrying value in the financial statements of S (under IFRS) is
$6 million. The taxable temporary difference of $2 million in the financial records of S arose after the initial
recognition by S of the property, and accordingly a deferred tax liability of $800,000 has been recognised by
S at its tax rate of 40%.
The question then arises as to whether any deferred tax should be recognised for the property in the financial
statements of P.
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Having determined that the acquisition does not constitute a business combination, the
initial recognition exception applies to the entire $6 million difference between the
carrying value of the property in the financial statements of P of $10 million and its tax
base of $4 million, in exactly the same way as if the property had been legally acquired
as a separate asset rather than through acquisition of the shares of S. [IAS 12.15(b)].
Therefore, no deferred tax is recognised by P in respect of the property at the time of
its acquisition.
This conclusion was confirmed by the Interpretations Committee in March 2017. The
Committee considered an example similar to Example 29.20 above and where the fair
value of the property had been higher than the transaction price for the shares in S
because of the associated deferred tax liability. Even in those circumstances, the
Committee concluded that in a transaction that does not mee
t the definition of a
business combination:15
(a) the entire purchase price is allocated to the investment property; [IFRS 3.2(b)] and
(b) no deferred tax liability is recognised by virtue of the initial recognition exception.
[IAS 12.15(b)].
7.3
Assets carried at fair value or revalued amount
IAS 12 notes that certain IFRSs permit or require assets to be carried at fair value or to
be revalued. These include: [IAS 12.20]
• IAS 16 – Property, Plant and Equipment;
• IAS 38 – Intangible Assets;
• IAS 40 – Investment Property;
• IFRS 9 – Financial Instruments; and
• IFRS 16 – Leases.
In most jurisdictions, the revaluation or restatement of an asset does not affect taxable
profit in the period of the revaluation or restatement. Nevertheless, the future recovery
of the carrying amount will result in a taxable flow of economic benefits to the entity
and the amount that will be deductible for tax purposes (i.e. the original tax base) will
differ from the amount of those economic benefits.
The difference between the carrying amount of a revalued asset and its tax base is a
temporary difference and gives rise to a deferred tax liability or asset. IAS 12 clarifies
that this is the case even if:
• the entity does not intend to dispose of the asset. In such cases, the revalued
carrying amount of the asset will be recovered through use and this will generate
taxable income which exceeds the depreciation that will be allowable for tax
purposes in future periods; or
• tax on capital gains is deferred if the proceeds of the disposal of the asset are
invested in similar assets. In such cases, the tax will ultimately become payable on
sale or use of the similar assets. [IAS 12.20]. A discussion of the accounting for
deferred taxable gains can be found at 7.7 below.
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In some jurisdictions, the revaluation or other restatement of an asset to fair value
affects taxable profit (tax loss) for the current period. In such cases, the tax base of the
asset may be raised by an amount equivalent to the revaluation gain, so that no
temporary difference arises.