The manner of tax recovery properly using IAS 12

The manner of tax recovery and the blended tax rate

Some assets or liabilities can have different tax effects if they are recovered or settled in different ways. For example, in certain jurisdictions the sale of an asset gives rise to a tax deduction whereas the use of that asset might not give rise to a tax deduction.

The calculation of the deferred tax balance should take into account the manner in which management expects to recover or settle an asset or liability. In many cases this may be obvious, in others it may not. In some cases the expected manner of recovery will be a mix of both use and sale. This section looks at the practical problems associated with calculating the impact on the deferred tax balance based on the expected manner of recovery of an asset.

Method of recovery of an asset

Many assets are recovered partly through use and partly by sale. For example, it is common for an investor to hold an investment property to earn rentals for a period and then sell it. Other assets, such as property, plant and equipment and intangible assets are also frequently used in a business for part of their economic life and then sold. When such assets are depreciated, the residual value ascribed to them indicates an estimate of the amount expected to be recovered through sale.

Under IAS 12, the measurement of deferred taxes related to an asset should reflect the tax consequences of the manner in which an entity expects to recover the carrying amount of the asset (IAS 12.51-51A).

When the tax rate and the tax base are the same for both use and sale of the asset, the deferred tax does not depend on the manner of recovery and hence no complications arise. In some jurisdictions the tax rate applicable to benefits generated from using a specific asset, the ‘use rate’, differs from the rate applicable to benefits from selling the asset, the ‘sale rate’.

Further in certain jurisdictions, tax bases may vary depending on how an entity benefits from a specific asset. In these circumstances, the measurement of deferred taxes should be consistent with the expected manner of recovery of the asset. This principle requires measurement of deferred taxes by reference to:

• the use tax rate and the tax base applicable for the use of the asset to the extent that the entity expects to recover the carrying amount of the asset through use and
• the sale tax rate and the tax base applicable for the sale of the asset to the extent that the entity expects to recover the carrying amount through sale.

Amendments to IAS 12

In December 2010, the IASB published amendments to IAS 12 to provide further guidance on the above principle for revalued non-depreciable assets under IAS 16 ‘Property, Plant and Equipment’ and for investment property that is measured using the fair value model under IAS 40 ‘Investment Property’.

IAS 12.51B states that deferred tax arising from the revaluation of non-depreciable assets under IAS 16 should be measured on the basis of the tax consequences that would follow from the recovery of the carrying amount through sale. This incorporated the consensus reached in SIC-21 into the standard.

For investment property, an entity may expect to rent out the property to earn rental income and then sell it to gain from capital appreciation at some point in the future. Without specific plans for disposal of the investment property, it is difficult and subjective to estimate how much of the carrying amount of the investment property will be recovered through cash flows from rental income and how much of it will be recovered through cash flows from selling the asset.

This is particularly so when the carrying amount is measured using the fair value model in IAS 40. To provide a practical approach in such cases, the amendment introduces a presumption that an investment property is recovered entirely through sale (IAS 12.51C).

However in the case of a building the presumption may be rebutted if the building is held in a business model whose objectives is to consume substantially all of the economic benefits embodied in the building over time, rather than through sale. For land that meets the definition of investment property, the presumption of recovery through sale may not be rebutted, as the land is a non-depreciable asset.

Dual intention assets

The application of IAS 12.51 is straightforward in situations where an asset will be recovered in its entirety through either use or sale. The measurement of deferred taxes is, however, more complex when an entity has ‘dual intentions’, ie if it intends to first use and then sell the asset. In this case, a measurement approach needs to be adopted that reflects the tax consequences of this dual intention.

IAS 12 does not set out specific guidance on how to determine deferred taxes for ‘dual intention assets’ when different tax rates and/or tax bases apply. One approach used in practice is to calculate temporary differences and measure the resulting deferred taxes using a blended measurement approach.

Methodology for calculating deferred tax on dual intention assets

The procedure for the blended measurement approach can be illustrated as follows:

Step 1

Determine the element of the carrying value of the asset that will be recovered through use and through sale, respectively. For an asset held at depreciated cost, the amount to be recovered on sale should equal the residual value assumed for depreciation purposes, although it should not exceed the carrying value of the asset. The balance, ie the expected future depreciation charges, is the amount expected to be recovered through use.

Step 2

Identify the tax deductions expected to be available in accordance with the expected manner of recovery of the asset to determine the asset’s tax base for use and for sale. In some jurisdictions this may result in a ‘negative’ tax base for a recovery of previous tax allowances, only effective when the asset is sold.

In other tax jurisdictions, tax bases may be based on original cost with some tax deductions during the use period and the remaining balance, if any, deductible on sale. The entity then has to split the overall tax base into the parts that are expected to apply for the sale and use of the asset, respectively.

Step 3

Calculate the temporary differences of the asset applicable to its use and the sale elements by subtracting the tax bases from their respective proportions of the asset’s carrying amount.

Step 4

Determine the tax rate(s) applicable to the use and sale of the asset and multiply them by the relevant temporary differences to calculate deferred tax assets and/or deferred tax liabilities for the use and sale element of the asset.

Integrating initial recognition exemptions into the calculation

In implementing dual intentions into the calculation of deferred taxes, initial recognition exemptions need to be taken into consideration. As set out in IAS 12.15(b) and IAS 12.24 respectively, temporary differences arising upon initial recognition of an asset or a liability outside a business combination are not recognised when accounting for deferred taxes.

To comply with this exception to the underlying principle in IAS 12, an entity therefore needs to identify temporary differences that exist upon the initial recognition of an asset. This ‘exempted’ amount is carried forward and continues to affect the amount of deferred taxes recognised in later periods (IAS 12.22(c)). This is also appropriate if the entity uses a blended measurement approach and temporary differences are identified for the use and sale elements of an asset at its initial recognition.

In addition, where deductible temporary differences result from the application of the blended measurement method, the general requirements of IAS 12 apply with regard to the recoverability of deferred tax assets. Any deferred tax liability and recognised deferred tax asset may then qualify to be offset. However, this needs to be determined based on the specific circumstances in accordance with IAS 12.74.

Case – Building – Blended measurement method

On 31 December 20X1, Company A purchases a building which is considered to be an investment property to be accounted for at fair value under IAS 40 ‘Investment Property’. The initial cost of the building is CU2,000. According to A’s investment strategy, A will hold the investment property for 20 years and then sell the asset. A intends to consume substantially all of the economic benefits embodied in the building over time, rather than through sale, and therefore rebuts the presumption in IAS 12.51C. A determines: that CU1,800 is expected to be recovered through use and CU200 through sale that the Company will not be entitled to any tax deductions during the holding period, thus the use tax base is nil any profit from the sale of the asset will be taxed at a capital gains tax rate of 23%, with taxable profits equalling sale proceeds less original cost of the investment property asset and A’s regular income tax rate of 23% will apply to rental income. In accordance with the initial recognition exemptions, IAS 12.15(b) and IAS 12.24, no deferred taxes are recognised in A’s financial statements when the asset is purchased. However, this exemption does not apply if the asset is acquired in a business combination. In a business combination, the potential deferred tax asset relating to the sale element of the carrying amount would need to be tested for recoverability separately from any deferred tax liability before considering offsetting the two amounts. At 31 December 20X2 the investment property is revalued in accordance with the fair value model of IAS 40. The new carrying amount of the asset is CU2,400, of which Company A expects to recover CU2,200 through use and CU200 through sale. Using the blended measurement method as described above, but considering the initial recognition difference for the use and the sale component of the asset’s carrying amount, the computation for deferred taxes is as follows: As a result, a deferred tax liability will be recognised only for the revaluation increase of the asset. The initial recognition difference exemption applies to the remaining temporary differences identified at the reporting date. The deferred tax expense is recorded in profit or loss, as it relates to a revaluation that is recognised in profit or loss in accordance with IAS 40. If the asset in question were an item of property, plant and equipment for which a revaluation is recognised in other comprehensive income, the deferred tax consequences would also be recognised in other comprehensive income (IAS 12.61A).

Case – Asset intention changes – Blended measurement method

Company A has been operating an asset since 1 January 20X1, which it originally intended to use until the end of its useful life, initially expected to be twelve years. The asset is currently accounted for under the cost model of IAS 16 ‘Property, Plant and Equipment’, using the straight-line method of depreciation. Originally, the tax deductions available equalled the original cost of the asset at CU1,200 and no initial recognition difference was identified. The tax deductions are available at an annual allowance of 12.5% of the original cost of the asset for eight years. Any capital gains resulting from a sale of the asset will be taxable and have to be calculated at sale proceeds less any unused tax deductions at the date of sale. The use benefits of the asset will be taxed at 20% whereas the sale profit of the asset will be subject to a capital gains tax rate of 40%. On 1 January 20X4, the Company changes its intentions. As new technical alternatives to the asset become available, the Company now intends to dispose of it by sale and is looking for an adequate replacement. Nevertheless, the asset will be used for two more years, ie until 31 December 20X5, and no immediate plan to sell the asset exists. Company A expects to recover a residual value of CU550 on sale. Based on the original intentions of Company A, the carrying amount of the asset, its tax base and the resulting deferred tax liability can be projected as follows: At 31 December 20X3, the asset’s carrying amount is CU900 and the tax base is CU750, resulting in a deferred tax liability of CU30 as explained above. As the management of Company A has changed its intentions at the beginning of 20X4, the expected sale at 31 December 20X5 needs to be implemented into a new depreciation schedule as well as the residual value of CU550 that the Company expects to recover on sale. This change in accounting estimate needs to be applied prospectively in accordance with IAS 8.36, thus resulting in an increased depreciation charge of CU175 for the year ending 31 December 20X4 and a carrying amount of CU725 at the reporting date. The revised projection of the asset’s carrying amount may be summarised as follows: At 31 December 20X4, the change in Company A’s intentions regarding the asset is implemented into the deferred tax calculation using a blended measurement approach. The Company expects to recover CU550 of the total carrying amount through the sale of the asset, which therefore should be considered as the sale element of the asset’s carrying amount. The use element is the total carrying amount less the sale element CU175 (CU725 – CU550), which is equal to the expected depreciation charge for the asset in its final year of use. Applying the same methodology to the tax deductions, the tax base for the use element is equal to one year’s tax allowance at CU150. The tax base of the sale element is the remaining balance of the tax deductions, which is equal to the initial cost of the asset less tax allowances utilised until the projected date of sale, ie CU450 (CU1,200 – (5 × 150)). Company A therefore needs to recognise a deferred tax liability of CU45 at the end of 31 December 20X4: Any changes in the deferred tax liability should be recognised in profit or loss (IAS 12.58). It should also be noted that the initial recognition exemption does not affect the measurement of the deferred tax liability in this example, as the initial cost of the asset equalled available future tax deductions when the asset was recognised. In addition, the sale of the asset was not originally anticipated by the Company, but has been taken into consideration after the asset’s initial recognition. The above example is a simplification which ignores the impact of indexation. The impact of indexation on the tax base of an asset is discussed in Changes in an asset’s tax base due to a revaluation or indexation.

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