IAS 12 Income tax definition

IAS 12 Income tax definition

IAS 12 Income tax definition is a summary of other issues which can arise in practice, namely:

• whether a particular taxation regime meets the definition of an income tax
• the tracking of temporary differences arising on initial recognition
• the accounting for changes in an asset’s tax base due to revaluation or indexation of that tax base
• the treatment of deferred tax on gains and losses relating to an available-for-sale financial asset reclassified to profit or loss
• accounting for deferred tax on compound financial instruments.

IAS 12 Income tax definition

The scope of IAS 12 is limited to income taxes.

This is defined in IAS 12.2 as follows: ‘For the purposes of this Standard, income taxes include all domestic and foreign taxes which are based on taxable profits. Income taxes also include taxes, such as withholding taxes, which are payable by a subsidiary, associate or joint arrangement on distributions to the reporting entity.’

As a result, if taxes are not based on ‘taxable profits’, they are not within the scope of IAS 12. For example, sales or payroll taxes are not income taxes. These taxes are based on the sales an entity generates or on salaries and wages it pays to its employees.

However, with some other types of tax the question of whether the definition of an income tax is met is less clear. For example, when an entity is not taxed on the basis of its accounting profit, the assessment basis of taxation may still be considered taxable profit. The IFRIC has acknowledged that whether a tax is within or outside the scope of IAS 12 is an area of interpretation and has pointed out in one of its agenda rejection decisions that ‘…the term ‘taxable profit’ implies a notion of a net rather than gross amount’.

Therefore, if a tax is based on a net income figure, (ie revenues less deductions) it will generally meet the definition of an income tax and needs to be considered in accounting for current and deferred tax under IAS 12. On the other hand, taxes levied on gross amounts (such as revenues or assets) are generally outside the scope of IAS 12.

Some taxes are assessed on different bases depending on the circumstances. For example, to secure a stable flow of tax payments to the tax authorities or for simplification, taxes may be based not only on taxable profits, but also on another amount such as sales or capital employed.

An analysis of whether the tax is an income tax might focus on the assessment basis that is most likely to apply to the entity in practice. Moreover, where a tax may be imputed on an assessment basis that is a substitute for a net income figure, it could be regarded as an income tax within the scope of IAS 12.

One tax commonly substituted for corporation tax is the tonnage tax regime, typically used in the shipping industry in many tax jurisdictions. Whether this falls within the definition of an income tax has been a matter of some debate. In its May 2009 meeting, the IFRIC concluded that tonnage tax was not within the scope of IAS 12 because it is based on gross tonnage and not on net profit.

Accounting for initial temporary differences after day one

Where initial recognition differences have been identified that are subject to the exemptions set out in IAS 12.15(b) and 24, no deferred taxes are recognised at initial recognition of the asset or liability. Further, subsequent changes in the unrecognised deferred tax assets or liabilities are also not recognised (IAS 12.22(c)). The entity therefore needs to identify exempt initial temporary differences and distinguish them from subsequent temporary differences, which are not subject to the initial recognition exemption.

Changes in temporary differences result from changes in either the carrying amount or the tax base of an asset or liability. IAS 12 does not, however, explain comprehensively how to distinguish changes in temporary differences that relate to initial recognition from subsequent temporary differences.

Subsequent to initial recognition, assets and liabilities may be measured in the financial statements at fair values. The resulting changes in the carrying amount affect the asset’s or liability’s temporary difference. The tax base of an asset or a liability may, alternatively, be subject to an indexation allowance scheme or a revaluation for tax purposes that gives rise to future tax deductions. Both situations raise the question whether the initial recognition difference has been affected or if a subsequent temporary difference has been established.

There are many reasons for subsequent changes in temporary differences. Each needs to be assessed drawing on the guidance in IAS 12. The tax base may also be changed by many different factors. This is therefore an area of interpretation.

One approach to arrive at a consistent accounting policy is to assess whether the change in the temporary difference results from (i) the ‘consumption’, or use, of the original carrying amount and/or tax base, or (ii) from the revaluation of the asset, liability or tax base. For example, the following may be regarded as a consumption of the original amounts which change pre-existing exempt initial recognition differences:

• the impairment or the reversal of a previous impairment of the original carrying amount
• the depreciation or amortisation of an asset’s or liability’s original carrying amount and/or
• the change of the tax base caused by taking tax deductions.

These changes should not affect accounting for deferred taxes. These differences relate to initial recognition and remain exempted in accordance with IAS 12.15(b) or 24.

However, when the asset or liability is revalued, any change between the previous carrying amount and the revalued carrying amount should be considered as a new temporary difference. The initial recognition exemption does not then apply. Deferred tax will or may need to be recognised.

The same principle applies to the corresponding tax base. If future tax deductions are restated or revalued, eg as a result of an indexation allowance scheme, this also establishes a subsequent temporary difference, which, therefore, should be included in accounting for deferred taxes.

Case – Non-deductible cost of a building

On 31 December 20X1, entity A acquires a building for CU1 million. The cost of the building will never be deductible for tax purposes in the country where entity A is domiciled, even upon its eventual disposal. Therefore, the tax base is nil and a taxable temporary difference of CU1 million arises, for which the initial recognition exemption applies. Hence, no deferred tax liability is recognised in accordance with IAS 12.15(b). The building is subsequently measured using IAS 16’s revaluation model. It is recorded at its fair value at the date of the revaluation less any subsequent accumulated depreciation and impairment losses in accordance with IAS 16.31. In the years to 31 December 20X2 and 31 December 20X3, the entity depreciates the building over its useful life, considered to be 20 years, so that at the end of the periods, the carrying amount of the building is CU950,000 and CU900,000, respectively. In addition, the building is revalued to its current fair value of CU1.2 million at 31 December 20X3, with a corresponding pre-tax gain of CU300,000 (CU1.2 million – CU900,000) recorded in other comprehensive income. The subsequent depreciation of the asset in the years to 31 December 20X2 and 31 December 20X3 could be considered to be a change of the original carrying amount of the building and thus should be considered to be a consumption of the initial temporary difference. The depreciation-related change of the initial temporary difference of CU1 million should therefore not be included in accounting for deferred taxes. The revaluation of the asset, however, does not relate to the initial temporary difference at all and therefore gives rise to a subsequent temporary difference of CU300,000, in respect of which deferred tax is recognised. The deferred tax should be recognised in other comprehensive income as this is where the revaluation gain has been recognised. In the year to 31 December 20X4 the building is not revalued. The revalued carrying amount of CU1.2 million will be depreciated over its remaining useful life of 18 years. The carrying value of the building is therefore CU1.13 million (CU1.2 million – (CU1.2 million/18 years)). The tax base is still nil and therefore the temporary difference is CU1.13 million. However, the initial temporary difference of CU1 million, on which no deferred tax is calculated, is now “amortised” to CU850,000 (CU1 million x 17/20years). Therefore deferred tax is provided on CU280,000 (CU1.13 million – CU850,000).

Changes in an asset’s tax base due to a revaluation or indexation

IAS 12.65 explains that an entity must look at the way an asset is measured subsequently when it determines whether the deferred tax effect of a revaluation of the asset for tax purposes should be recognised in other comprehensive income or profit or loss.

The deferred tax effect of a revaluation of an asset for tax purposes should only be recognised in other comprehensive income if the revaluation for tax purposes relates to a recent or future revaluation of the asset under IFRSs, which will be or has been recognised in other comprehensive income.

Hence, where an asset is not revalued under IFRSs, and so there are no adjustments to its carrying amount charged or credited in other comprehensive income , any resulting deferred tax asset or liability from a tax revaluation will give rise to a corresponding income or expense to be included in profit or loss.

IAS 12 does not take into consideration other changes in an asset’s tax base. In fact, the standard does not even define what constitutes a revaluation for tax purposes. Arguably, IAS 12.65 should also be applied to circumstances where the tax base of an asset is subject to an indexation allowance.

The principle again is that the deferred tax effect is charged to other comprehensive income if and only if the indexation is ‘related’ to an accounting revaluation. In most cases, they will be based on different valuation metrics and hence this will not be so.

Gains and losses relating to an available-for-sale financial asset reclassified to profit or loss

When an available-for-sale financial asset is derecognised, the corresponding cumulative gain or loss previously recognised in other comprehensive income needs to be reclassified to profit or loss (IAS 39.55(b)). IAS 12 is silent on the allocation of deferred tax income or expenses that previously have been charged or credited directly to other comprehensive income.

As the financial asset is derecognised, the corresponding temporary difference ceases to exist. The associated deferred tax asset or liability therefore has to be eliminated. The release of the deferred tax asset or liability should be recognised through other comprehensive income. This is because the deferred tax effect of the cumulative gain or loss was previously recognised in other comprehensive income.

Deferred tax on compound financial instruments

IAS 12 takes the view that a temporary difference arising from separation of a compound financial instrument into its liability and equity component does not relate to initial recognition (IAS 12.23).

Consequently, any temporary difference arising is not excluded by the initial recognition exemption and deferred tax must be recognised where applicable.

IAS 12.23 also specifies that: the initial deferred tax on a taxable temporary difference resulting from separation of a compound instrument is charged to equity, following the principle in IAS 12.61A that deferred tax is recorded in equity if it relates to an item charged or credited directly to equity in the same or a different period, and subsequent changes to this deferred tax liability are recorded in profit or loss, in accordance with IAS 12.58.

The temporary difference is the difference between the carrying amount of the liability component and its tax base. The liability component is determined in accordance with IAS 32 ‘Financial Instruments: Presentation’.

The tax base of the liability should be determined based on the general definition in IAS 12.8. This can be expressed as the following formula:

Tax base (of a liability) = carrying amount – future deductible amounts + future taxable amounts

In many jurisdictions, the initial tax base of a compound instrument is equal to the total proceeds of the instrument, ie the instrument is treated as ‘straight’ debt for tax purposes with no separation into debt and equity.

For example, consider an entity that issues a convertible bond for total proceeds of CU1 million , of which CU900,000 is determined to be a liability component and CU100,000 the equity component. The entity will record a liability of CU900,000 on the issue date. Assume that if the issuer settled the instrument on the same day for CU900,000, a taxable gain of CU100,000 would arise under the relevant tax laws. In that scenario the tax base is CU1 million.

This is confirmed by applying the following formula for determination of tax bases:

Tax base (of a liability) = carrying amount – future deductible amounts + future taxable amounts Tax base = CU900,000 – nil + CU100,000 = CU1 million

Tax treatment affected by manner of settlement

In some jurisdictions, the tax treatment of a compound instrument might depend on whether it is converted or redeemed. For example, notional interest expense included in the liability component, as a result of measurement at amortised cost using the effective interest method, might be deductible for tax purposes only if the bond is redeemed. In accordance with IAS 12.51-51E, measurement of deferred tax should reflect the expected manner of settlement. The manner of settlement might affect the tax base, the tax rate, both or neither.

When a deductible temporary difference arises if the bond is settled in the expected manner, additional analysis is required to determine whether the resulting deferred tax asset qualifies for recognition. A deferred tax asset should be recorded only when it is probable that the entity will have sufficient taxable profits against which the deductible temporary difference may be utilised.

Case – Convertible bond with tax base not affected by manner of settlement

Company A issues a convertible bond for CU800 on 1 January 20X1. No interest will be paid. The bondholders can convert each bond into a fixed number of equity shares of Company A on 31 December 20X5. The bond must be redeemed, if not converted, for CU800 on 31 December 20X5. On 1 January 20X1, Company A determines that the market interest rate for a similar bond with no conversion option is 2.71%. On this basis, the liability component of the bond is determined to be CU700. The liability is to be measured at amortised cost using the effective interest rate. Under the relevant jurisdictional tax laws, the bond is regarded as a loan of CU800. The imputed interest charges are not tax deductible. Conversion of the bond has no additional tax consequences. The applicable tax rate is 23%. The tax base of the bond is CU800. A taxable temporary difference of CU100 therefore arises on initial recognition. A deferred tax liability of CU23 (CU100 × 23%) is recorded on 1 January 20X1. In accordance with IAS 12.23, the corresponding charge is recorded in equity. The respective entries on 1 January 20X1 are as follows: Amounts in CU Debit Credit Cash 800 Equity – conversion option 100 Financial liability 700 Deferred tax liability 23 Equity – deferred tax 23 The subsequent accounting entries for 20X1 to 20X5 are summarised below: Amounts in CU 20X1 20X2 20X3 20X4 20X5 Carrying amount of liability – opening 700 719 738 758 779 Imputed interest expense 19 19 20 21 21 Carrying amount of liability – closing 719 738 758 779 800 Tax base 800 800 800 800 800 Taxable temporary difference – opening 100 81 62 42 21 Taxable temporary difference – closing 81 62 42 21 Deferred tax liability at 23% – opening 23.0 18.6 14.2 9.6 4.8 Credited to profit or loss -4.4 -4.4 -4.6 -4.8 -4.8 Deferred tax liability at 23% – closing 18.6 14.2 9.6 4.8 0.0

Case – Convertible bond with tax base dependent on manner of settlement

Company A issues a bond on 1 January 20X1 on exactly the same terms as the previous example. The market interest rate is also the same. However, in this case the relevant tax laws differ such that: the tax treatment of the bond follows the accounting. Accordingly the tax authorities treat the bond as a debt issuance of CU700 and a written warrant of CU100 and the interest accrued will be deductible if the bond is redeemed but not if converted. In this case, there is no temporary difference on initial recognition. Consequently, no deferred tax is recorded on 1 January 20X1. Subsequently, Company A records interest on the liability component. The accrued interest creates a deductible temporary difference because it represents a future deduction that would arise if the liability were settled for its carrying amount. For example, at 31 December 20X4 the carrying amount of the liability is CU779, see table above. The tax base is CU700 on redemption, but CU779 on conversion. The tax base formula confirms this as follows: Tax base (of a liability) = carrying amount – future deductible amounts + future taxable amounts Tax base (redemption) = CU779 – CU79 + nil Tax base (conversion) = CU779 – nil + nil Accordingly a deductible temporary difference of CU79 exists at this date if Company A expects to settle the bond by redemption. A deferred tax asset of CU18 (CU79 × 23%) is recorded, to the extent that it is probable that Company A will have sufficient taxable profits against which this deductible temporary difference may be utilised. However, if Company A expects the bond to be settled by conversion into shares there is no temporary difference so no deferred tax is recognised.

IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition

IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition IAS 12 Income tax definition