LEARNING OBJECTIVES

1.         Define current tax and the recognition of current tax liabilities and assets under IAS 12.
2.         Describe the concept of tax base, temporary differences and permanent differences.
3.         Understand the purpose of providing for deferred tax.
4.         Make the provision for deferred tax on the full provision basis.
5.         Explain the requirements of IAS 12 in respect of accounting for deferred tax.

1.5

Example 1

In 2012, ABC Co had taxable profits of $120,000. In previous year income tax on 2011 profits had been estimated as $30,000.

Required:

Calcualte tax payable and the charge for 2012 if the tax due on 2011 profits was subsequently agreed with the tax authorities as:

(a)       $35,000
(b)       $25,000

Any under or over payments are not settled until the following year’s tax payment is due. Tax rate is 30%.

Solution:
(a)

(b)

1.7

Example 2

In 2011 ABC Co paid $50,000 in tax on its profits. In 2012 the company made tax losses at $24,000. The local tax authority rules allow losses to be carried back to offset against current tax of prior years. Tax rate is 30%.

Required:

Show the tax charge and tax liability for 2012.

Solution:

Tax repayment due on tax losses = 24,000 × 30% = $7,200.

The journal entry is as follows:

2.2.1

Definitions

(a)        Permanent differences are items included in the accounting profit that will never be taxed or allowed as reductions, for example, dividends, non-business entertainment (disallowable) and traffic fines (disallowable). Permanent differences will not reverse in future periods and thus give rise to no tax effects in other periods.
(b)       Temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position and its tax base. Deferred tax assets and liabilities are calculated using the following formula:

(c)       The tax base (計稅基礎) of an asset or liability is the amount attributed to that asset or liability for tax purposes. The tax base can be nil, the same as the carrying amount of the asset or liability for accounting purposes, or different from the carrying amount.
(d)        Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences.
(e)        Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
(a)        Deductible temporary differences
(b)        The carry forward of unused tax losses
(c)        The carry forward of unused tax credits (稅款抵減)

2.2.2

Two types of temporary differences

(a)        A taxable temporary difference (應稅暫時性差異) will result in an increase in income tax payable in future reporting periods, and gives rise to a deferred tax liability.
(b)        A deductible temporary difference (可抵扣暫時性差異) will result in a decrease in income tax payable in future reporting periods, and gives rise to a deferred tax asset.

2.3.1

Two basic principles

(a)        The first principle relates to the issue of whether or not a deferred tax liability/asset exists. This principle states that if it is probable that recovery or settlement of the carrying amount of an asset or liability will make future tax payments larger or smaller than they would be if such recovery or settlement were to have no tax consequences, then a deferred tax liability or asset should be recognized, with certain limited exceptions. Thus:
(i)         if an item is accounted for in year one, but will be taxed (or tax deductible) in year two (or in any subsequent years), then, a deferred tax liability/asset must be accounted for in year one;
(ii)        if an item is accounted for in year one, and will be taxed (or tax deductible) in year one, then, a tax payable or tax receivable should be accounted for in year one; and
(iii)       if an item is accounted for in year one, and will not be taxed (or tax deductible), then, there is no tax effect to be accounted for.
(b)        The second principle relates to the issue of how the effect of deferred tax should be accounted for. This principle states that an entity should account for the effect of the deferred tax liability/asset in the same way that it accounts for the underlying transaction or event. Thus, the deferred tax effect will be:
(i)         recognized as income or expense and included in profit or loss for the period, if the underlying transaction or event is recognized in profit or loss for the period;
(ii)        recognized outside profit or loss (either in other comprehensive income or directly in equity), if the underlying transaction or event is recognized in the same or a different period, outside profit or loss; and
(iii)       recognized as an adjustment to goodwill if the underlying transaction or event arises from a business combination.

2.4.2

Example 3

Profits before taxation of ABC Ltd for each of the years 2011 and 2012 were $320,000. The profits tax rate was 20% in both years. In 2011, plant purchases amounted to $200,000. The rate of depreciation was 25% per annum on cost. For tax purposes an initial allowance of 100% of cost is given in the year of purchase.

Scenario 1: ABC Ltd accounts for current taxes only (i.e. nil provision or flow through method)

Assuming that there are no other differences, taxable profits will be calculated as follows:

It may be noticed that though the company’s profit before tax was exactly the same in the two years, the difference in the profit after tax is significant.

IAS 12 is based on the idea that the $30,000 ($74,000 – $34,000) reduction in tax in 2011 is only a temporary gain – a liability for it does arise in 2011 but it is deferred until the three later years in which the tax charge is increased.

Scenario 1: ABC Ltd provides for deferred tax

In this example, let us assume that ABC Ltd does not plan to buy any plant in 2013 and 2014 and that the profit before tax and taxation rates are the same in those years.

Giving effect to the requirements of IAS 12, the profit after tax will be calculated as follows:

Calculation of deferred tax based on temporary differences:

At the end of year 2011 the tax value is $150,000 less than the accounting value, and the taxable profit will also be $150,000 less than the accounting profit. As a result the tax payable will be $30,000 ($150,000 × 20%) less.

It may be noticed that although the performance of ABC Ltd was the same in both years, the profit after tax for the two years differs in Case 1 but not in Case 2. As a result of providing for deferred tax, the fluctuations in after-tax profits are evened out and the after-tax profit reflects the performance of the enterprise more realistically.

In 2012 and 2013, there will be reversing temporary differences of $50,000 each year. As a result, the profit after tax in each of those years will be $256,000.

The method of providing for deferred tax is:

(a)       to provide for extra taxation by debiting the profit and loss account in years when the effect of temporary differences is to reduce the tax charge, and
(b)       to release the credit so produced in years when the reverse effect arises.

The entries made in the four years with respect to deferred tax would be:

It may be noticed that at the end of 2014, the balance on the deferred tax account is reduced to nil.

3.1.1

Recognition principle of deferred tax

(a)        a deferred tax liability shall be recognized for all taxable temporary differences;
(b)        a deferred tax asset shall be recognized for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized.

3.2.3

Example 4 – Non-current assets

A Ltd (with 31 December accounting year-end) bought a machinery at a cost of $300,000 on 1 January 2011.

For accounting purposes, the cost of the machinery is to be depreciated using the straight-line method over five years.

Assume that tax rules allow the cost of the machinery to be claimed over three years commencing 2011 on straight-line method.

In the above case, the carrying amount of the machinery will be as follows:

At 31 December 2011: $240,000
At 31 December 2012: $180,000
At 31 December 2013: $120,000
At 31 December 2014: $60,000
At 31 December 2015: $nil

However, the tax base of the machinery will be as follows:

At 31 December 2011: $200,000
At 31 December 2012: $100,000
At 31 December 2013: $nil

Comparing the carrying amount and the tax base of the machinery will yield the following taxable temporary differences and deferred tax liabilities, assumes that the tax rate is 25%:

3.2.4

Example 5 – Interest income

B Ltd (with 31 December accounting year-end) recognizes interest income on accrual basis.

On 31 December 2012, B Ltd accrues for an interest income receivable of $100,000.

For tax purposes, the interest is taxable on a cash basis.

In the above case, the tax base of the interest receivable account is $nil. (This is because for tax purposes the interest receivable account does not exist, since the interest is taxed when received.)

Comparing the carrying amount and the tax base of the interest receivable account will yield a taxable temporary difference of $100,000 ($100,000 – nil) as at 31 December 2012.

Assuming a tax rate of 25%, the above temporary difference will give rise to a deferred tax liability of $25,000 ($100,000 × 25%) as at 31 December 2012.

3.2.5

Example 6 – Trade receivable

C Ltd has recorded a trade receivable account of $200,000 in its statement of financial position as at 31 December 2012 arising from sales for the year.

For tax purposes, the sales has been included in the computation of taxable profit for the year.

In this case, the tax base of the trade receivable account is $200,000.

Since the carrying amount of the trade receivable account equals its tax base, there is nil temporary differences. Accordingly, there will be no deferred tax liability/asset as at 31 December 2012.

3.2.6

Example 7 – Loan receivable

D Ltd as a loan receivable account of $500,000 in its statement of financial position as at 31 December 2012.

Under the tax rules, the granting and subsequent repayment of the loan has no tax consequences.

In this case, since the loan is not taxable, the tax base of the loan receivable amount is deemed to be equal to its carrying amount of $500,000.

There is thus no temporary difference, and consequently, no deferred tax liability/asset.

3.2.7

Example 8 – Dividend receivable

E Ltd has a dividend receivable account of $100,000 in its statement of financial position as at 31 December 2012.

Assuming the dividend is paid out of the exempt profit of the investee, the dividend will not be taxable at the hand of E Ltd under the relevant tax rules.

In this case, since the dividend income is not taxable, the tax base of the dividend receivable account is deemed to be equal to its carrying amount of $100,000.

There is thus no temporary difference, and consequently, no deferred tax liability.

3.2.9

Example 9 – Accruals on cash basis

ABC Ltd has an accrued expense payable account of $10,000 in its statement of financial position as at 31 December 2012.

For tax purposes, the related expense will be deductible on cash basis.

In this case, the tax base of the accrued expense payable account is $nil (carrying amount of $10,000 less deductible amount of $10,000).

Comparing the carrying amount and the tax base of the accrued expense payable account will yield a deductible temporary difference of $10,000 ($10,000 – $nil) as at 31 December 2012.

Assuming a tax rate of 25%, the above temporary difference will give rise to a deferred tax asset of $2,500 ($10,000 × 25%) in the statement of financial position as at 31 December 2012.

3.2.10

Example 10 – Accruals already deducted for tax purposes

ABC Ltd has an accrued expense payable account of $10,000 in its statement of financial position as at 31 December 2012.

For tax purposes, the related expense has already been deducted.

In this case, the tax base of the accrued expense payable account is $10,000 (carrying amount of $10,000 less deductible amount of $nil).

Since the carrying amount of the accrued expense payable account equals its tax base, there is nil temporary difference. Accordingly, there will be no deferred tax liability/asset as at 31 December 2012.

3.2.12

Example 11 – Revenue in advance

GHI Ltd has a rent received in advance account of $10,000 in its statement of financial position as at 31 December 2012.

For tax purposes, the rental income was taxed on cash basis.

In this case, the tax base of the rent received in advance account is $nil (carrying amount of $10,000 less amount not taxable in the future of $10,000).

Comparing the carrying amount and the tax base of the rent received in advance account will yield a deductible temporary difference of $10,000 ($10,000 – $nil) as at 31 December 2012.

Assuming a tax rate of 25%, the above temporary difference will give rise to a deferred tax asset of $2,500 ($10,000 × 25%) in the statement of financial position as at 31 December 2012.

3.2.14

Example 12 – Accrual for penalty

MNO Ltd has accrued for a penalty imposed by the government of $10,000 in its statement of financial position as at 31 December 2012.

For tax purposes, the penalty is not deductible (permanent difference). In this case, since the penalty is not deductible, the tax base of the penalty payable account is deemed to be equal to its carrying amount of $10,000.

There is thus no temporary difference, and consequently, no deferred tax liability/asset.

3.2.15

Example 13 – Repayment of loan

PQR Ltd has a loan payable account of $10,000 in its statement of financial position as at 31 December 2012.

For tax purposes, the raising repayment of the loan have no tax consequences.
In this case, since the loan has no tax consequences, the tax base of the loan payable account is deemed to be equal to its carrying amount of $10,000.

There is thus no temporary difference, and consequently, no deferred tax liability/asset.

3.2.17

Example 14 – Research expense

AB Ltd has commenced a new research project in the year 2012, and has recognized the research cost of $10,000 incurred during the year as an expense for the year ended 31 December 2012.

For tax purposes, research costs are deductible only in later period when the research project is abandoned or when the new products are sold.

In this case, the tax base of research costs is $10,000, being the amount the tax authority will permit as a deduction in the future periods.

Comparing the carrying amount of $nil and the tax base of $10,000 will yield a deductible temporary difference of $10,000 as at 31 December 2012.

Assuming a tax rate of 25%, the above temporary difference will give rise to a deferred tax asset of $2,500 ($10,000 × 25%) in the statement of financial position as at 31 December 2012.

3.2.18

Fundamental principle

IAS 12 is based that an entity shall:
(a)        recognize a deferred tax liability whenever recovery or settlement of the carrying amount of an asset or a liability would make the future tax payments larger than they would be if such recovery or settlement were to have no tax consequences.
(b)        recognize a deferred tax asset whenever recovery or settlement of the carrying amount of an asset or a liability would make the future tax payments smaller than they would be if such recovery or settlement were to have no tax consequences.

3.2.19

Example 15

Assume that XYZ Ltd commenced operation in January 2011. Its statement of financial positions as at 31 December 2011 showed the following relevant items:

(a)        carrying amount of machinery of $40,000,000;
(b)        provision for doubtful debt of $2,000,000; and
(c)        provision for warranty of $1,000,000

For tax purposes:
(a)        the tax written down value of the machinery is $35,000,000;
(b)        the provision for doubtful debt is deemed to be a general provision and is not allowed deduction until it becomes a specific provision; and
(c)        the warranty is deductible only when incurred.

In this case, the temporary differences of XYZ Ltd as at 31 December 2011 may be computed as follows:

Assuming a tax rate of 25%, the deferred tax liability for XYZ Ltd as at 31 December 2011 is $500,000 ($2,000,000 x 25%). The journal entry (ignoring tax payable account) to recognize the deferred tax liability will be as follows:

During the year 2012, the following were charged to income statement:

(a)        depreciation expenses of $10,000,000;
(b)        provision for doubtful debt of $500,000; and
(c)        provision for warranty of $600,000.

However, for tax purposes, the following items were deductible:

(a)        capital allowances of $13,000,000;
(b)        actual bad debt of $600,000;
(c)        actual warranty expenses of $400,000.

There was no other movement for the relevant accounts and their respective balances as at 31 December 2012 will be as follows:
(a)        carrying amount of machinery of $30,000,000 (tax written down value of $22,000,000);
(b)        provision for doubtful debt of $1,900,000; and
(c)        provision for warranty of $1,200,000.

In this case, the temporary differences of XYZ Ltd as at 31 December 2012 may be computed as follows:

Assuming a tax rate of 25%, the deferred tax liability for XYZ Ltd as at 31 December 2012 is $1,225,000 ($4,900,000 × 25%).

Given that the deferred tax liability as at 31 December 2011 was $500,000, it shall be increased (credited) by $725,000 to arrive at the balance of $1,225,000 to be shown in the balance sheet as at 31 December 2012. The journal entry (ignore tax payable account) will be as follows:

3.3.2

Example 16 – Revaluation of assets

AB Ltd acquires a piece of land as an investment property in 2011 at a cost of $10,000,000. On 31 December 2012, the land is revalued to $12,000,000. Assume that when the investment property is sold, the profit thereof will attract tax at a rate of 25%.

In this case, when the land is revalued, it gives rise to a temporary difference of $2,000,000, being the difference between the carrying amount of $12,000,000 and the tax base of $10,000,000. (Alternatively, under the first principle, when the land is revalued and subsequently recovered at $12,000,000, it will give rise to a taxable profit of $2,000,000 and an additional tax to be paid, and therefore a deferred tax liability should be recognized at the date of revaluation.) Thus, a deferred tax liability of $500,000 ($2,000,000 × 25%) should be recognized.

Applying the second principle, since the revaluation surplus is recorded directly in revaluation reserve, the deferred tax liability should similarly be taken directly to revaluation reserve.

Consequently, the revaluation in 2012 will be recorded as follows:

Subsequently, how the deferred tax liability is accounted for depends on whether or not the gain on sale of land is taxable.

Scenario I
Assume that the land is sold in 2013 for $13,000,000, and the profit thereof attracts tax at the rate of 25%.

In this case, the taxable profit will be $3,000,000 ($13,000,000 – $10,000,000), and the tax payable will be $750,000 ($3,000,000 × 25%). However, the accounting profit will only be $1,000,000 ($13,000,000 – $12,000,000), and the tax expense thereof shall be $250,000 ($1,000,000 × 25%).

The journal entries to record the sale of land and the tax effect thereof will be as follows:

Scenario II
Assume that the land is sold in 2013 for $13,000,000, and the profit thereof is not taxable. The deferred tax liability previously provided for should be reversed.

In this case, the journal entries related to the sale of land and the tax effect thereof will be as follows:

3.4.5

Example 17 – Fair value adjustments

A Ltd acquires the business of B Ltd in 2012 for a cash consideration of $1,500,000.

B Ltd’s statement of financial position at the date of above acquisition comprises share capital and reserve of $1,200,000; trade receivable of $500,000 and inventories of $700,000. It was mutually agreed that B Ltd’s inventories have a market value of $900,000. Assume the tax rules requires the inventories to be valued at $700,000.

In this case, there is a temporary difference of $200,000 due to fair value adjustment for the inventories. Assuming a tax rate of 25%, a deferred tax liability of $50,000 will have to be accounted for, and the goodwill account will correspondingly be adjusted. Consequently, the acquisition transaction will be recorded as follows:

(As required by IAS 12, the tax effect of fair value adjustments affects the computation of goodwill. Note that without accounting for the tax effect of fair value adjustments, the goodwill would have been just $100,000 (purchase consideration of $1,500,000 less fair value of identifiable net assets acquired of $1,400,000)).

3.6.5

Example 18

A Ltd bought a building at a cost of $10,000,000 on 1 January 2011. The building is to be depreciated over its useful life of 25 years, using the straight-line method.

For tax purposes, the building does not qualify as an “industrial building”, and consequently, no capital allowances may be claimed on the building, and on disposal, any capital gain/loss will have no tax consequences.

In this case, even though there is a temporary difference of $9,600,000 (carrying amount of $9,600,000 and tax base of $nil) on 31 December 2011, no deferred tax liability is recognized.

Similarly, on 31 December 2012, no deferred tax liability is recognized for the temporary difference of $9,200,000 on the building, because it results from initial recognition of an asset.

The same applies to all subsequent periods.

3.6.6

Example 19

B Ltd bought a piece of machinery for $10,000,000. It received a non-taxable government grant of $4,000,000 related to the machinery.

Scenario A
For accounting purposes, the government grant of $4,000,000 is offset against the cost of the machinery to arrive at the carrying amount of the machinery. However, the government grant is not deductible for purposes of computing the capital allowances relating to the machinery.

In this case, the tax base of the machinery is $10,000,000, while its carrying amount is only $6,000,000, thereby giving rise to a deductible temporary difference of $4,000,000.

However, in accordance with the requirement of IAS 12, no deferred tax asset is recognized.

Scenario B
For accounting purposes, the government grant of $4,000,000 is recorded as a deferred income. However, for tax purposes, the government grant is not taxable.

In this case, the tax base of deferred income is $nil, while its carrying amount is $4,000,000, thereby giving rise to a deductible temporary difference of $4,000,000.

However, in accordance with the requirement of IAS 12, no deferred tax asset is recognized.

4.4

Example 20

A Ltd suffered a loss of $100,000 in 2011, and made a profit of $300,000 in 2012 (assuming no temporary differences and therefore the accounting profit or loss is equal to tax profit or loss)

For 2011, A Ltd would have no tax payable because there was no taxable profit.

For 2012, A Ltd would have a taxable profit of $200,000, after offsetting the tax loss of $100,000 carried forward from 2011 against the profit of $300,000 in 2012. Assuming a tax rate of 25%, A Ltd would have a tax payable of $50,000.

It may be noted that, without the loss in 2011, A Ltd would have a tax payable of $75,000 ($300,000 × 25%) instead of $50,000 in 2012. The tax loss of $100,000 in 2011 gives rise to a tax saving of $25,000 in 2012.

It may be appreciated, however, that if A Ltd does not make any profit in all the years subsequent to 2011 before it is wound up, then the benefit relating to the tax loss of $100,000 in 2011 will never be realized.

Thus, there is a benefit relating to the tax loss but the realization of the benefit is contingent upon sufficient income being made in subsequent periods.

4.8

Example 21

A Ltd commenced operation in 2007 and has been operating profitably. It suffered loss of $100,000 in 2011 due to labour disputes. Assume there were no temporary differences such that the accounting loss is equal to tax loss, and a tax rate of 25%. The labour dispute has been settled towards the end of 2011, and the company expected to operate profitably again in year 2012 and beyond.

In this case, it may be argued it is probable that future taxable profit will be available against which the loss forward can be utilized. A deferred tax asset in relation to the loss and the related tax benefit is recognized in 2011.

Assume that A Ltd made a profit of $300,000 for the year ended 31 December 2012 (Assume further there were no temporary differences such that the accounting loss is equal to tax loss, and a tax rate of 25%).

The journal entries for 2012 will be as follows:

The above entries could, in fact, be combined as follows:

The relevant accounts will be shown in the 2011 and 2012 financial statements of A Ltd as follows:
Income statements

Statement of financial position

(Note that, in financial accounting, the term “tax credit” is simply the opposite of “tax expense”; it does not carry the same meaning as the term “tax credit” under the IRO.)

4.10

Example 22

B Ltd commenced operation in January 2011, and suffered a loss of $100,000 for the year ended 31 December 2011.

No deferred tax asset (and related tax benefit) is recognized in 2011. The tax saving relating to the $100,000 loss in 2011 is accounted for only in the years in which it is realized.

Assume that B Ltd made a profit of $300,000 for the year ended 31 December 2012. In this case, the tax saving relating to the $100,000 loss in 2011 will be recognized in 2012.

The journal entries for the two years will be as follows:

2011
No entry is required.

2012

The above entries could, in fact, be combined as follows:

The relevant accounts will be shown in the 2011 and 2012 financial statements of B Ltd as follows:

Income statements

Statements of financial position

4.14

Example 23

C Ltd commenced operation in 2008, and has been incurred losses. The cumulative loss as at 31 December 2012 is $100,000. In 2012, the company bought a computer, and as at 31 December 2012, there is a taxable temporary difference of $120,000 in relation to the computer. The relevant tax rate is 25%.

In this case, the company will have to first recognize a deferred tax liability in relation to the taxable temporary difference, as follows:

The company shall also recognize a deferred tax asset in relation to the loss carried forward, given that there is sufficient taxable temporary difference against which the loss can be utilized, as follows:

The above journal entries could be combined as follows.

It may be noted that, in this case, where the amount of temporary difference is larger than that of tax loss, all the tax benefit of the tax loss is recognized in the year of loss.

5.3

Example 24

In November 2011, the government announced that the tax rate which has been 28%, will be lowered to 25% effective from 1 January 2012.

A Ltd has to a taxable profit of $100,000 for the year ended 31 December 2011. Its taxable temporary differences have increased from $50,000 as at 31 December 2010 to $60,000 as at 31 December 2011.

In this case, the current tax payable will be $28,000, measured based on 28%. The deferred tax liability as at 31 December 2011 will be $15,000, measured based on 25%. (The deferred tax liability as at 31 December 2010 was $14,000 ($50,000 × 28%)).

The journal entry to record the tax expense will be as follows:

The tax expense charged to the income statement for the year ended 31 December 2011 will therefore be $29,000.

In the statement of financial position as at 31 December 2011, the current tax payable will be carried at $28,000, and the deferred tax liability will be carried at $15,000.

5.6

Example 25

Richard Co has an asset with a carrying amount of $10,000 and a tax base of $6,000. If the asset were sold, a tax rate of 20% would apply. A tax rate of 30% would apply to other income.

Required:

State the deferred tax consequences if the entity:
(a)        sells the asset without further use.
(b)        expects to return the asset and recover its carrying amount through use.

Solution:

(a)        A deferred tax liability is recognized of $(10,000 – 6,000) × 20% = $800.
(b)        A deferred tax liability is recognized of $(10,000 – 6,000) × 30% = $1,200.

$

Carrying amount of share-based payment expense

X

Less: Tax base of share-based payment expense (estimated amount tax authorities will permit as a deduction in future periods, based on year end information

(X)

Temporary difference

X

Deferred tax asset at X%

X

7.6

Example 27

An investment property has a cost of $10 million and fair value of $15 million. It is measured using the fair value model in IAS 40. It comprises land with a cost of $4 million and fair value of $6 million, and a building with a cost of $6 million and fair value of $9 million. The land has an unlimited useful life.

Cumulative depreciation of the building for tax purposes is $3 million. Unrealised changes in fair value of the investment property do not affect taxable profit. If the investment property is sold for more than cost, the reversal of the cumulative tax depreciation of $3 million will be included in the taxable profit and taxed at an ordinary tax rate of 30%. For sale proceeds in excess of cost, tax law specifies rates of 25% for assets held for less than two years and 20% for assets held for two years or more.

In this case, because the investment property is measured using the fair value model in IAS 40, there is a rebuttable presumption that the entity will recover the carrying amount of the investment property entirely through sale. If that presumption is not rebutted, the deferred tax reflects the tax consequences of recovering the carrying amount entirely through sale, even if the entity expects to earn rental income from the property before sale.

The tax base of the land if it is sold is $4 million and there is a taxable temporary difference of $2 million ($6m – $4m). The tax base of the building if it is sold is $3 million ($6m – $3m) and there is a taxable temporary difference of $6 million ($9m – $3m). As a result, the total taxable temporary difference relating to the investment property is $8 million ($2m + $6m).

The tax rate is the rate expected to apply to the period when the investment property is realized. Thus, the resulting deferred tax liability is computed as follows, if the entity expects to sell the property after holding it for more than two years:

If the entity expects to sell the property after holding it for less than 2 years, the above computation would be amended to apply a tax rate of 25%, rather than 20%, to the proceeds in excess of cost.

If, instead, the entity holds the building rather than through sale, this presumption would be rebuttable for the building. However, the land is not depreciable. Therefore, the presumption of recovery through sale would not be rebutted for the land. It follows that the deferred tax liability would reflect the tax consequences of recovering the carrying amount of the building through use and the carrying amount of the land through sale.

The tax base of the building if it is used is $3 million ($6m – $3m) and there is a taxable temporary difference of $6 million ($9m – $3m), resulting in a deferred tax liability of $1.8 million ($6m × 30%).

The tax base of the land if it is used is $4 million and there is a taxable temporary difference of $2 million ($6m – $4m), resulting in a deferred tax liability of $0.4 million ($2m × 30%).

As a result, if the presumption of recovery through sale is rebutted for the building, the deferred tax liability relating to the investment property is $2.2 million ($1.8m + $0.4m).

Question 1
Nette purchased a building on 1 June 2003 for $10 million. The building qualified for a grant of $2 million which has been treated as a deferred credit in the financial statements. The tax allowances are reduced by the amount of the grant. There are additional temporary differences of $40 million in respect of deferred tax liabilities at the year end. Also the company has sold extraction equipment which carries a five year warranty. The directors have made a provision for the warranty of $4 million at 31 May 2004 which is deductible for tax when costs are incurred under the warranty. In addition to the warranty provision the company has unused tax losses of $70 million. The directors of the company are unsure as to whether a provision for deferred taxation is required.

(Assume that the depreciation of the building is straight line over ten years, and tax allowances of 25% on the reducing balance basis can be claimed on the building. Tax is payable at 30%.)

Required:

Explain with reasons and suitable extracts/computations the accounting treatment of the above situation in the financial statements for the year ended 31 May 2004.                      (14 marks)
(ACCA 3.6 Advanced Corporate Reporting June 2004 Q3)

6.6

Example 26

Lamar Co has the following share option scheme at 31 December 2011:

The price of the company’s shares at 31 December 2011 is $7 per share and at 31 December 2010 was $7.50 per share.

The directors must be working for Lamar on the vesting date in order for the options to vest.

No directors have left the company since the issue of the share options and none are expected to leave before December 2013. The shares can be exercised on the first day of the month in which they vest.

In accordance with IFRS 2 an expense of $25,000 has been charged to profits in the year ended 31 December 2010 in respect of the share option scheme. The cumulative expense for the two years ended 31 December 2011 is $125,000.

Tax allowances arise when the options are exercised and the tax allowance is based on the option’s intrinsic value at the exercise date.

Assume a notional tax rate of 16 per cent.

Required:

What are the deferred tax implications of the share option scheme?

Solution:

Year to 31 December 2010

The cumulative remuneration expense is $25,000, which is less than the estimated tax deduction of $37,500. Therefore:

• A deferred tax asset of $6,000 is recognised in the statement of financial position
• There is deferred tax income of $4,000 (25,000 × 16%)
• The excess of $2,000 goes to equity

Year to 31 December 2011

The cumulative remuneration expense is $125,000, which is less than the estimated tax deduction of $150,000. Therefore:

• A deferred tax asset of $24,000 is recognised in the statement of financial position at 31 December 2011.
• There is potential deferred tax income of $18,000 for the year ended 31 December 2011.
• Of this, $16,000 [16% × ($125,000 – $25,000)] is recognised in the income statement.
• The remainder ($2,000) is recognised in equity.