Allocating deferred tax charge

Allocating deferred tax charge or credit

This narrative summarises the approach to allocating the deferred tax charge or credit for the year to the various components of the financial statements. Similar principles apply to the allocation of current tax.

IAS 12 requires that the deferred tax effects of a transaction or other event are consistent with the accounting for the transaction or event itself (IAS 12.57). The deferred tax charge or credit for the year can arise from a number of sources and therefore may need to be allocated to:

• continuing operations within profit or loss
• discontinued operations within profit or loss
• other comprehensive income (OCI) or equity
• goodwill

in order to comply with this basic principle.

Flowchart for allocating the deferred tax charge or credit

IAS 12.58 requires that deferred tax should be recognised as income or an expense and included in profit or loss for the period, except to the extent that the tax arises from:

• a transaction or event which is recognised, in the same or a different period, outside profit or loss, either in other comprehensive income (OCI) or directly in equity or
• a business combination.

The flowchart below summarises this requirement diagrammatically. It shows the steps needed to allocate the deferred tax charge or credit to the various components of the financial statements.

Step 1 – Recognition of deferred tax in OCI or equity

The first step in the flowchart above considers the allocation of deferred tax for items that have been recognised directly in other comprehensive income (OCI) or directly in equity.

IAS 12.61A requires that, where deferred tax arises on items that are recognised outside profit or loss, either in current or prior periods, the related deferred tax should be recognised outside of profit or loss. IAS 12.61A then expands on this by specifying that:

• deferred tax relating to items recognised in OCI shall be recognised in OCI and
• deferred tax relating to items recognised directly in equity shall be recognised directly in equity.

These requirements are consistent with IAS 12’s principle that the deferred tax effects of a transaction or other event is consistent with the accounting for the transaction or event itself.

Examples of items recognised in OCI

Examples of items which are recognised in OCI include:

• re-measurements of the net defined benefit liability, or asset, for defined benefit pension schemes where recognised in OCI
• fair value adjustments on available-for-sale financial assets
• movements on hedging relationships recognised in OCI
• revaluations of property, plant and equipment.

Case – Purchase of an equity investment

On 1 January 20X1 Company A purchases an equity investment for CU6,000. This financial asset is classified, in accordance with IAS 39 ‘Financial Instruments: Recognition and Measurement’ (IAS 39), as an available-for-sale financial asset. At 31 December 20X1, this financial asset has a fair value of CU8,500. The gain on revaluation of this financial asset is taken to OCI in accordance with IAS 39. The financial asset has a tax base equal to its original cost. The taxable temporary difference of CU2,500 that arises due to the revaluation gives rise to a deferred tax charge in the year of CU575, at a tax rate of 23% (assumed tax rate). The resulting deferred tax charge should be recognised in OCI to match the recognition of the gain that gave rise to this deferred tax charge.

Examples of items recognised directly in equity

Examples of items that are recognised directly in equity include:

• an adjustment to the opening balance of retained earnings resulting from either a change in accounting policy that is applied retrospectively or the correction of an error
• amounts arising on initial recognition of the equity component of a compound financial instrument
• deferred tax on equity-settled share-based payments where the expected future tax deduction is greater than the cumulative share-based payment expense recognised.

Deferred tax on equity-settled share-based payments

IAS 12 contains specific rules on the deferred tax that can arise on equity-settled share-based payments accounted for under IFRS 2 ‘Share-based Payment’ (IFRS 2). In certain tax jurisdictions, a tax deduction is available when share options are exercised. The tax deduction is based on the intrinsic value of those options at the date of exercise (in other jurisdictions, tax deductions may be determined in another way specified by tax law).

The rules in IAS 12.68A-68C cover two main complications that arise with such tax deductions: how the tax deduction should be measured at the end of the period and where the resulting deferred tax should be recognised.

Measurement of deferred tax

IAS 12.68B requires that if the tax deduction is dependent upon the entity’s share price at a future date, the measurement of the deductible temporary difference should be based on the entity’s share price at the end of the reporting period.

Component in which to recognise deferred tax

IAS 12.68C requires the deferred tax credit that arises to be recognised in profit or loss unless the expected future tax deduction exceeds the cumulative remuneration charge recognised to date in accordance with IFRS 2. Where the expected future tax deduction is greater than the cumulative share-based payment expense, the deferred tax credit relating to that excess is recognised directly in equity.

Case – Employee share option plan

On 1 January 20X1, Company A issued share options to its employees with a one year vesting period. At 31 December 20X1, an IFRS 2 charge of CU15,000 had been recognised. At 31 December 20X1, the share options expected to be exercised had a total intrinsic value of CU25,000. In the year, a deferred tax credit of CU5,750 should be recognised, based on a tax rate of 23% (assumed tax rate) (CU25,000 × 23%). At 31 December 20X1, the expected tax deduction of CU25,000 exceeds the cumulative IFRS 2 charge recognised to date of CU15,000 by CU10,000. Therefore, of the tax credit of CU5,750, CU3,450 should be recognised in profit or loss (CU15,000 × 23%) and CU2,300 should be recognised directly in equity (CU10,000 × 23%). A more extensive example of the deferred tax associated with equity-settled share-based payments is considered in Deferred tax and share-based payments.

Step 2 – Deferred tax allocated to business combinations

Where a deferred tax asset or liability arises on a business combination, a calculation of that deferred tax asset or liability is required at the date of acquisition. This deferred tax asset or liability affects goodwill or bargain purchase gain at the date of the acquisition, in accordance with IAS 12.66.

In summary, the calculation of goodwill in a business combination in accordance with IFRS 3 ‘Business Combinations’ (IFRS 3 (Revised 2008)) requires a comparison of the fair value of the net assets acquired with the fair value of the consideration transferred.

Any difference is either recognised as goodwill, to the extent the consideration transferred exceeds the fair value of the net assets acquired, or is recognised immediately in profit or loss, to the extent the fair value of the net assets acquired exceeds the consideration transferred.

The deferred tax asset or liability associated with the net assets acquired is calculated in the same way as other deferred tax assets and liabilities. The deferred tax is not therefore ‘fair valued’ at the acquisition date. Therefore, if the fair value of the acquired assets and liabilities is different from their tax base, deferred tax will need to be provided on those temporary differences. The resulting deferred tax assets and liabilities will affect the value of the net assets acquired and hence will impact the calculation of any goodwill, or bargain purchase gain.

Case – Temporary differences arising on acquisition

On 6 June 20X1, Company A acquired Company B for CU50,000. At the date of acquisition, the fair value of the identifiable assets and liabilities of Company B was CU25,000. This included an intangible asset that was not recognised in the individual financial statements of Company B, of CU5,000. The tax base of the assets and liabilities acquired, other than the intangible asset, was equal to their accounting base. The tax base of the intangible asset was nil. Therefore, a taxable temporary difference of CU5,000 exists at the date of acquisition, and a deferred tax liability of CU1,150 is recognised (CU5,000 × 23% (assumed tax rate)). The net assets at the date of acquisition are therefore CU23,850 (CU25,000 – CU1,150) and goodwill of CU26,150 (CU50,000 – CU23,850) is recognised.

Case – Movements in temporary differences associated with business combinations

In the previous example a deferred tax liability of CU1,150 was recognised at the date of acquisition of Company B. The recognition of this deferred tax liability caused the carrying value of goodwill to increase by an equivalent amount at the date of acquisition. At 31 December 20X1, the intangible asset has been amortised and is now carried in the consolidated statement of financial position at CU4,200. Hence, the deferred tax liability associated with this intangible asset is CU966 (CU4,200 × 23%). Assuming the amortisation of this intangible asset is recognised in profit or loss, so the movement in the deferred tax liability of CU184 (CU1,150 – CU966) is also recognised in profit or loss.

The potential benefit of the acquiree’s income tax losses carried forward or other deferred tax assets might not satisfy the criteria for separate recognition when a business combination is initially accounted for but might be realised subsequently. An acquirer is required to recognise acquired deferred tax benefits that it realises after the business combination as follows:

• acquired deferred tax benefits recognised within the measurement period that result from new information about facts and circumstances that existed at the acquisition date shall be applied to reduce the carrying amount of any goodwill related to that acquisition. If the carrying amount of that goodwill is nil, any remaining deferred tax benefits shall be recognised in profit or loss
• all other acquired deferred tax benefits realised shall be recognised in profit or loss (or, if IAS 12 so requires, outside profit or loss).

Entities might have business combinations in which the acquisition date preceded the application of IFRS 3 (Revised 2008). However, where an acquiree’s deferred tax asset acquired in a business combination to which IFRS 3 (Revised 2008) was not applied is subsequently recognised in a period in which IFRS 3 (Revised 2008) is applied, the adjustment to deferred tax is recognised in profit or loss with no adjustment to the amount of goodwill originally recognised.

Case – Trading losses at acquisition

On 31 July 20X1, Company A acquired Company C. Company C had trading losses available for deduction against future trading profits of CU50,000 at the date of acquisition. These losses did not qualify for recognition in accordance with IAS 12 at the date of acquisition. At the date of combination, goodwill of CU100,000 was recognised. On 31 December 20X2, management still did not consider it probable that future taxable profits would be recognised by Company C sufficient to justify recognition of this deferred tax asset. IFRS 3 (Revised 2008) was applied by Company A for the financial year beginning 1 January 20X3. On 31 December 20X3 management considered it probable that future taxable profits will be recognised by Company C sufficient to justify recognition of this deferred tax asset. Therefore, a deferred tax asset of CU11,500 was recognised (CU50,000 × 23% (assumed tax rate)) with an equivalent credit recognised in tax allocated to profit or loss. In accordance with the revised provisions of IAS 12 introduced by IFRS 3 (Revised 2008), no adjustment should be made to goodwill.

Deferred tax assets of the acquirer

As a result of a business combination, the probability of realising a pre-acquisition deferred tax asset of the acquirer may change. An acquirer may consider it probable that it will recover its own deferred tax asset that was not recognised before the business combination. For example, the acquirer may be able to utilise the benefit of its unused tax losses against the future taxable profit of the acquiree.

Alternatively, as a result of the business combination it might no longer be probable that future taxable profit will allow the deferred tax asset to be recovered. In such cases, the acquirer recognises a change in the deferred tax asset in the period of the business combination, but does not include it as part of the accounting for the business combination. Therefore, the acquirer does not take it into account in measuring the goodwill or bargain purchase gain it recognises in the business combination accounting.

Step 3 – Deferred tax allocated to discontinued operations

If there are no discontinued operations then this step can be ignored.

There are no explicit requirements for allocating deferred tax charges or credits between continuing and discontinued operations. However IFRS 5 ‘Non-current Assets Held for Sale and Discontinued Operations’ (IFRS 5) requires a single amount to be shown on the face of the statement of comprehensive income comprising the total of:

• the post-tax profit or loss of discontinued operations and
• the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation.

IFRS 5 also requires this single amount to be disaggregated into the following:

• the revenue, expenses and pre-tax profit or loss of discontinued operations
• the related income tax expense as required by IAS 12.81(h)
• the gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation.

As there is no explicit guidance in IAS 12 on allocating the deferred tax charge or credit between continuing and discontinued operations, management should use their judgement to determine an accounting policy. If material, this judgement will need to be disclosed in accordance with IAS 1 ‘Presentation of Financial Statements’ (IAS 1.122).

Deferred tax recognised in profit or loss

Having identified the amount of the movement in deferred tax attributable to business combinations, other comprehensive income, and other elements of equity and discontinued operations, any remaining movement in the net deferred tax asset or liability should be recognised in profit or loss.

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