QUESTION 46

The directors of Panel, a public limited company, are

reviewing the procedures for the calculation of the
deferred tax liability for the year ended 31 October
20X5. The directors are unsure how the deferred tax
provision will be calculated and have asked for some
general advice relating to IAS 12 Income Taxes. The
directors wish to know how the provision for deferred
taxation would be calculated in the following situations
under IAS 12:
a) Explain:
(i) How IAS 12 Income Taxes defines the tax base of
assets and liabilities. (3 marks)
Tax base
The tax base of an asset is the tax deduction which will be
available in future when the asset generates taxable
economic benefits, which will flow to the entity when the
asset is recovered. If the future economic benefits will not
be taxable, the tax base of an asset is its carrying amount.

The tax base of a liability is its carrying amount, less the

tax deduction which will be available when the liability is
settled in future periods. For revenue received in advance
(or deferred income), the tax base is its carrying amount,
less any amount of the revenue which will not be taxable
in future periods.

(ii) How temporary differences are identified as taxable

or deductible temporary differences. (3 marks)
Temporary differences
Temporary differences occur when items of revenue or
expense are included in both accounting profits and taxable
profits, but not for the same accounting period.

A taxable temporary difference arises when the carrying

amount of an asset exceeds its tax base or the carrying
amount of a liability is less than its tax base. All taxable
temporary differences give rise to a deferred tax liability.

A deductible temporary difference arises in the reverse

circumstance (when the carrying amount of an asset is less
than its tax base or the carrying amount of a liability is
greater than its tax base). All deductible temporary
differences give rise to a deferred tax asset.

(iii) The general criteria prescribed by IAS 12 for the

recognition of deferred tax assets and liabilities. You do
not need to identify any specific exceptions to these
general criteria. (3 marks)
Recognition of deferred tax assets and liabilities
The general requirements of IAS 12 are that deferred tax
liabilities should be recognised on all taxable temporary
differences (with specific exceptions). IAS 12 states that a
deferred tax asset should be recognised for deductible
temporary differences if it is probable that a taxable profit,
or sufficient taxable temporary differences will arise in
future against which the deductible temporary
difference can be utilized.

b) Discuss, with suitable computations, how the

situations (i) to (iv) above will impact on the accounting
for deferred tax under IAS 12 in the consolidated
financial statements of Panel.

(i) On 1 November 20X3, the company had granted ten

million share options worth $40 million subject to a
two-year vesting period. Local tax law allows a tax
deduction at the exercise date of the intrinsic value of
the options. The intrinsic value of the ten million share
options at 31 October 20X4 was $16 million and at 31
October 20X5 was $46 million. The increase in the share
price in the year to 31 October 20X5 could not be
foreseen at 31 October 20X4. The options were
exercised at 31 October 20X5. The directors are unsure
how to account for deferred taxation on this transaction
for the years ended 31 October 20X4 and 31 October
20X5.
Under IFRS 2 Share-based Payment the company
recognises an expense for the employee services received
in return for the share options granted over the vesting
period. The related tax deduction does not arise until the
share options are exercised. Therefore, a deferred tax
asset arises, based on the difference between the intrinsic
value of the options and their carrying amount (normally
zero).

At 31 October 20X4 the tax benefit is as follows: $m

Carrying amount of share based payment –

Less tax base of share based payment (16/2) (8)
Temporary difference (8)

The deferred tax asset is $2.4 million (30% x 8). This is

recognised at 31 October 20X4 provided that taxable profit
is available against which it can be utilized. Because the tax
effect of the remuneration expense is greater than the tax
benefit, the tax benefit is recognised in profit or loss. (The
tax effect of the remuneration expense is 30% x $40 million
÷ 2 = $6 million.)

At 31 October 20X5 there is no longer a deferred tax

asset because the options have been exercised. The tax
benefit receivable is $13.8 million (30% x $46 million).
Therefore, the deferred tax asset of $2.4 million is no
longer required.

(ii) Panel is leasing plant over a five year period. A

right-of-use asset was recorded at the present value of
the lease payments of $12 million at the inception of the
lease which was 1 November 20X4. The right-of-use
asset is depreciated on a straight-line basis over the five
years. The annual lease payments are $3 million
payable in arrears on 31 October and the effective
interest rate is 8% per annum. The directors have not
leased an asset before and are unsure as to its treatment
for deferred taxation. The company can claim a tax
deduction for the annual rental payment as the lease
does not qualify for tax relief.

Leased plant
Under IFRS 16 Leases, a right-of-use asset and a lease
obligation are recognised.

The lease liability is measured at the present value of the

lease payments discounted using, if available, the interest
rate implicit in the least.

The right-of-use asset is measured at the amount of the

initial measurement of the lease liability, plus certain other
direct costs not incurred in this case, such as legal fees. It is
depreciated on a straight-line basis over the five years.

The obligation to pay lease rentals is recognised as a

liability. Each installment payable is treated partly as
interest and partly as repayment of the liability. The
carrying amount of the plant for accounting purposes is
the net present value of the lease payments less
depreciation.

A temporary difference effectively arises between the

value of the plant for accounting purposes and the
equivalent of the outstanding obligations, as the annual
rental payments quality for the relief. The tax base of the
asset is the amount deductable for tax in future, which is
zero. The tax base of the liability is the carrying amount
less any future tax deductible amounts, which will give a
tax base of zero.

Therefore at 31 October 20X5 a net temporary difference

will be as follows:

Carrying amount in financial statements:

Asset:
Net present value of future lease payments at inception of lease 12.00
Less depreciation (12/5) (2.40)
9.60
Less lease liability
Liability at inception of lease 12.00
Interest (8% x 12) 0.96
Lease rental (3.00
(9.96)
0.36
Less tax base (0.00)
Temporary difference
0.36

A deferred tax asset of $108,000 (30% x 360,000) arises.

(iii) A wholly owned overseas subsidiary, Pins, a limited

liability company, sold goods costing $7 million to Panel
on 1 September 20X5, and these goods had not been
sold by Panel before the year end. Panel had paid $9
million for these goods. The directors do not understand
how this transaction should be dealt with in the
financial statements of the subsidiary and the group for
taxation purposes. Pins pays tax locally at 30%.

Intra-group sale Pins has made a profit of $2 million on

its sale to Panel. Tax is payable on the profits of
individual companies. Pins is liable for tax on this profit
in the current year and will have provided for the related
tax in its individual financial statements.

However, from the viewpoint of the group the profit will

not be realized until the following year, when the goods
are sold to a third party and must be eliminated from the
consolidated financial statements. Because the group pays
tax before the profit is realized there is a temporary
difference of $2 million and a deferred tax asset of
$600,000 (30% $2 million).

(iv) Nails, a limited liability company, is a wholly owned

subsidiary of Panel, and is a cash generating unit in its
own right. The value of the property, plant and
equipment of Nails at 31 October 20X5 was $6 million
and purchased goodwill was $1 million before any
impairment loss. The company had no other assets or
liabilities. An impairment loss of $1.8 million had
occurred at 31 October 20X5. The tax base of the
property, plant and equipment of Nails was $4 million
as at 31 October 20X5. The directors wish to know how
the impairment loss will affect the deferred tax liability
for the year. Impairment losses are not an allowable
expense for taxation purposes. Assume a tax rate of
30%.

Impairment loss
The impairment loss in the financial statements of Nails
reduces the carrying amount of property, plant and
equipment, but is not allowable for tax. Therefore, the tax
base of the property, plant and equipment is different from
its carrying amount and there is a temporary difference.

Under IAS 36 Impairment of Assets the impairment loss is

allocated first to goodwill and then to other assets:
Goodwill PPE Total
Carrying amount at 31 October $ $ $
20X5 1.00 6.00 7.00
$ $ $
Impairment loss (1.00) (0.80) (1.80)
$ $
$ - 5.20 5.20

IAS 12 states that no deferred tax should be recognised

on goodwill and therefore only the impairment loss
relating to the property, plant and equipment affects
the deferred tax position.
The effect of the impairment loss is as follows

Before After
Impairment Impairment Difference
Carrying $ $ $
amount 6.00 5.20 0.80
$ $
Tax Base (4.00) (4.00) $ -
Temporary $ $ $
Difference 2.00 1.20 0.80
Tax Liability
(30%) 0.60 0.36 0.24

Therefore the impairment loss reduces deferred the tax

liability by $240,000.

QUESTION 47

The following information is relevant to the above

statement of financial position:

(i) The financial assets are classified as 'investments in

equity instruments' but are shown in the above statement of
financial position at their cost on 1 July 20X5. The market
value of the assets is $10.5 million on 30 June 20X6.
Taxation is payable on the sale of the assets. As allowed by
IFRS 9, an irrevocable election was made for changes in
fair value to go through other comprehensive income (not
reclassified to profit or loss).

(ii) The stated interest rate for the long-term borrowing is

8%. The loan of $10 million represents a convertible bond
which has a liability component of $9.6 million and an
equity component of $0.4 million. The bond was issued on
30 June 20X6.

(iii) The defined benefit plan had a rule change on 30 June

20X6, giving rise to past service costs of $520,000. The
past service costs have not been accounted for.
(iv) The tax bases of the assets and liabilities are the same
as their carrying amounts in the draft statement of financial
position above as at 30 June 20X6 except for the following:

(1)

$'000
Property, plant and equipment
2,400
Trade receivables 7,500
Other receivables 5,000
Employee benefits 5,000

(2) Other intangible assets were development costs

which were all allowed for tax purposes when the cost
was incurred in 20X5.

(3) Trade and other payables includes an accrual for

compensation to be paid to employees. This amounts
to $1 million and is allowed for taxation when paid.

v) Goodwill is not allowable for tax purposes in this

jurisdiction.

(vi) Assume taxation is payable at 30%.

PART A
Discuss the conceptual basis for the recognition of
deferred taxation using the temporary difference
approach to deferred taxation.

Answer to Part A

(a) IAS 12 Income Taxes is based on the idea that all

changes in assets and liabilities have unavoidable tax
consequences. Where the recognition criteria in IFRS are
different from those in tax law, the carrying amount of an
asset or liability in the financial statements is different
from its tax base (the amount at which it is stated for tax
purposes). These differences are known as temporary
differences. The practical effect of these differences is that
a transaction or event occurs in a different accounting
period from its tax consequences. For example,
depreciation is recognised in the financial statements in
different accounting periods from capital allowances.

IAS 12 requires a company to make full provision for the

tax effects of temporary differences. Both deferred tax
assets, and deferred tax liabilities can arise in this way.

It may be argued that deferred tax assets and liabilities do

not meet the definition of assets and liabilities in the
IASB Conceptual Framework for Financial Reporting.
Under the Conceptual Framework an asset is the right to
receive economic benefits as a result of past events, and a
liability is an obligation to transfer economic benefits,
again as a result of past events.

Under IAS 12, the tax effect of transactions are recognised

in the same period as the transactions themselves, but in
practice, tax is paid in accordance with tax legislation when
it becomes a legal liability. There is a conceptual
weakness or inconsistency, in that only one liability, that is
tax, is being provided for, and not other costs, such as
overhead costs.

PART B

Calculate the deferred tax liability at 30 June 20X6

after any necessary adjustments to the financial
statements showing how the deferred tax liability would
be dealt with in the financial statements. (Assume that
any adjustments do not affect current tax. Candidates
should briefly discuss the adjustments required to
calculate deferred tax liability.)

Answer to Part B

Notes on adjustments

1 The investments in equity instruments are shown at cost.

However, per IFRS 9, they should instead be valued at fair
value, with the increase ($10,500 – $9,000 = $1,500) going
to other comprehensive income (items that will not be
reclassified to profit or loss) as per the irrevocable election.

2 IAS 32 states that convertible bonds must be split into

debt and equity components. This involves reducing debt
and increasing equity by $400.

3 The defined benefit plan needs to be adjusted to reflect

the change. The liability must be increased by $520,000.
The same amount is charged to retained earnings.
4 The development costs have already been allowed for tax,
so the tax base is nil. No deferred tax is recognised on
goodwill.

5 The accrual for compensation is to be allowed when paid,

i.e. in a later period. The tax base relating to trade and other
payables should be reduced by $1 million.

Question 48 (c)

In the consolidated financial statements for 20X4,

Chemclean recognised a net deferred tax asset of $16
million, which represented 18% of its total equity. This
asset was made up of $3 million taxable temporary
differences and $19 million relating to the carry-
forward of unused tax losses. The local tax regulation
allows unused tax losses to be carried forward
indefinitely. Chemclean expects that within five years,
future taxable profits before tax would be available
against which the unused tax losses could be offset. This
view was based on the budgets for the years 20X4–
20X9. The budgets were primarily based on general
assumptions about the development of key products and
economic improvement indicators. Additionally, the
entity expected a substantial reduction in the future
impairment of trade receivables and property which the
entity had recently suffered and this would result in a
substantial increase in future taxable profit. Chemclean
had recognised material losses during the previous five
years, with an average annual loss of $19 million. A
comparison of Chemclean's budgeted results for the
previous two years to its actual results indicated
material differences relating principally to impairment
losses. In the interim financial statements for the first
half of the year to 30 June 20X4, Chemclean recognised
impairment losses equal to budgeted impairment losses
for the whole year. In its financial statements for the
year ended 30 June 20X4, Chemclean disclosed a
material uncertainty about its ability to continue as a
going concern. The current tax rate in the jurisdiction is
30%.

(c) Deferred tax

(i) Chemclean should not have fully recognised the
deferred tax asset arising from the carry forward of unused
tax losses. It is recognizable only to the extent of its taxable
temporary differences. IAS 12 Income Taxes states that a
deferred tax asset shall be recognised for the carry-forward
of unused tax losses to the extent that it is probable that
future taxable profit will be available against which unused
tax losses can be utilised. IAS 12 explains that the
existence of unused tax losses is strong evidence that future
taxable profit may not be available. Therefore, when an
entity has a history of recent losses, the entity recognises a
deferred tax asset arising from unused tax losses only to the
extent that the entity has sufficient taxable temporary
differences or when there is convincing other evidence that
sufficient taxable profit will be available against which the
unused tax losses can be utilized by the entity.
Chemclean recognised losses during the previous five
years. In order to use the deferred tax asset of $16m,
Chemclean would have to recognise a profit of $53.3m at
the existing tax rate of 30%. In comparison, the entity
recognised an average loss of $19m per year during the five
previous years. There should be convincing evidence
showing that there would be taxable profits available in the
future in order to recognise a deferred tax asset. A
comparison of the budgeted results to its actual results for
the previous two years indicated material differences
relating to impairment losses. In the interim financial
statements for the first half of the financial year to 30 June
20X4, Chemclean recognised impairment losses equal to
budgeted impairment losses for the whole year. The unused
tax losses appear to result from identifiable causes, which
are likely to recur.

IAS 12 states that in assessing the probability that taxable

profit will be available against which the unused tax losses
or unused tax credits can be utilised, a consideration is
whether the unused tax losses result from identifiable
causes which are unlikely to recur. Chemclean's budgets
and assumptions are not convincing other evidence because
the entity does not appear to have been capable of making
accurate forecasts in the past and there were material
differences between the amounts budgeted and realized for
the previous two years. Chemclean had presented future
budgets primarily based on general assumptions about the
development of key products and economic improvement
indicators, rather than what was expected to influence the
future income and therefore enable the use of the deferred
tax asset. Finally, in its financial statements, Chemclean
disclosed a material uncertainty about its ability to continue
as a going concern. This would be a key factor when
considering the recognition of a deferred tax asset.

Therefore no deferred tax asset or liability should be

recognised. The liability of $3m relating to temporary
differences can be offset against $3m of unused tax losses.
No further tax losses should be recognised.

Deferred tax assets on losses

In theory, unused tax losses give rise to a deferred tax asset.

However, IAS 12 Income Taxes states that deferred tax
assets should only be recognised to the extent that they
are regarded as recoverable. They should be regarded as
recoverable to the extent that on the basis of all the
evidence available it is probable that there will be
suitable taxable profits against which the losses can be
recovered. It is unlikely that future taxable profits of Ethan
will be sufficient to realize all of the tax loss because of:

(i) The announcement that a substantial loss will be

incurred this year instead of the expected profit

(ii) Considerable negative variances against budgets in the

past

Consequently, Ethan should not recognise the deferred

tax asset.
Question 64 (c)
Coate, a public limited company, is a producer of
ecologically friendly electrical power (green electricity).
In the notes to Coate's financial statements for the year
ended 30 November 20X2, the tax expense included an
amount in respect of 'Adjustments to current tax in
respect of prior years' and this expense had been
treated as a prior year adjustment. These items related
to adjustments arising from tax audits by the
authorities in relation to previous reporting periods.
The issues that resulted in the tax audit adjustment
were not a breach of tax law but related predominantly
to transfer pricing issues, for which there was a range of
possible outcomes that were negotiated during 20X2
with the taxation authorities. Further, at 30 November
20X1, Coate had accounted for all known issues arising
from the audits to that date and the tax adjustment
could not have been foreseen as at 30 November 20X1,
as the audit authorities changed the scope of the audit.
No penalties were expected to be applied by the taxation
authorities.
According to IAS 12 Income Taxes the tax expense in the
statement of profit or loss and other comprehensive income
includes the tax charge for the year, any under or
overprovision of income tax from the previous year and
any increase or decrease in the deferred tax provision:

$
Current tax expense X
Under/ (over) provisions relating to prior periods X/(X)
Increases/ (decreases) in the deferred tax balance X/(X)
X

While the correction of an over- or under-provision relates

to a prior period, this is not a prior period adjustment as
defined in IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors as assumed by Coate.
Rather, it is a change in accounting estimate.

Changes in accounting estimates result from new

information or new developments and, accordingly, are not
corrections of errors. A prior period error, which would
require a prior period adjustment, is an omission or
misstatement arising from failure to use reliable
information that was available or could have been
obtained at the time of the authorization of the financial
statements. This is not the case here. Coate had accounted
for all known issues at the previous year end (30 November
20X1), and could not have foreseen that the tax adjustment
would be required. No penalties were applied by the
taxation authorities, indicating that there were no
fundamental errors in the information provided to them.
Correction of an over- or under-provision for taxation is
routine, since taxation liabilities are difficult to estimate.

The effect of a change in accounting estimate must be

applied by the company prospectively by including it in
profit or loss in the period of change, with separate
disclosure of the adjustment in the financial statements.
QUESTION 72 (b)

Aspire has a foreign branch which has the same

functional currency as Aspire. The branch's taxable
profits are determined in dinars. On 1 May 20X3, the
branch acquired a property for 6 million dinars. The
property had an expected useful life of 12 years with a
zero residual value. The asset is written off for tax
purposes over eight years. The tax rate in Aspire's
jurisdiction is 30% and in the branch's jurisdiction is
20%. The foreign branch uses the cost model for
valuing its property and measures the tax base at the
exchange rate at the reporting date.

Aspire would like an explanation (including a

calculation) as to why a deferred tax charge relating to
the asset arises in the group financial statements for the
year ended 30 April 20X4 and the impact on the
financial statements if the tax base had been translated
at the historical rate.

Deferred tax charge

Investments in foreign branches (or subsidiaries, associates

or joint arrangements) are affected by changes in foreign
exchange rates. In this case, the branch's taxable profits
are determined in dinars, and changes in the dinar/dollar
exchange rate may give rise to temporary differences.
These differences can arise where the carrying amounts of
the nonmonetary assets are translated at historical rates and
the tax base of those assets is translated at the closing rate.
The closing rate may be used to translate the tax base
because the resulting figure is an accurate measure of the
amount that will be deductible in future periods. The
deferred tax is charged or credited to profit or loss.

The deferred tax arising will be calculated using the tax

rate in the foreign branch's jurisdiction, that is 20%.

The deferred tax charge in profit or loss will therefore

increase by $45,000.

If the tax base had been translated at the historical rate, the
tax base would have been $(5.25m ÷ 5m) = $1.05m. This
gives a temporary difference of $1.1m – $1.05m = $50,000,
and therefore a deferred tax liability of $50,000 × 20% =
$10,000. This is considerably lower than when the closing
rate is used.
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