IASB clarifies accounting for deferred taxes relating to assets and liabilities arising from a single transaction (leases and decommissioning obligations)
To date there has been diversity in practice when it comes to accounting for deferred tax involving transactions that give rise to an asset and liability in a single transaction. The most common examples are leases in the books of a lessee (which give rise to a right-of-use asset and lease liability) and decommissioning and restoration liabilities (where the initial estimate of costs are included in the cost of property, plant and equipment).
Typically, preparers might ignore both sides completely by using the ‘initial recognition exemption’ in paragraphs 15 and 24 of IAS 12 Income Taxes, or otherwise both the deferred tax asset and liability are recognised for both sides of the transaction.
To address this diversity, the IASB recently published amendments to IAS 12 to clarify that the ‘initial recognition exemption’ cannot be used on initial recognition of leases by lessees, or on the initial recognition of asset retirement obligations which give rise to equal taxable and deductible temporary differences. Applying the ‘initial recognition exemption’ would result in no deferred tax recognised on initial recognition or subsequently over the life of the asset/liability. This would result in tax expense fluctuating based on the availability of tax deductions, rather than the recovery of the item’s carrying values over time.How does the initial recognition exemption work?
Prior to the amendments, IAS 12 required that deferred tax assets and liabilities be recognised for all taxable and deductible temporary differences, except to the extent that the deferred tax asset or liability arises from:
(a) the initial recognition of goodwill; or
(b) the initial recognition of an asset or liability in a transaction which:
(i) is not a business combination; and
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).
A common example where the ‘initial recognition exemption’ applies is for the purchase of a luxury motor vehicle costing $90,000 that is only eligible for tax deductions of $50,000. At initial recognition, there is a taxable temporary difference of $40,000 between the carrying amount of the motor vehicle ($90,000) and its tax base ($50,000). In this example, the initial recognition exemption is used, and no deferred tax liability is recognised, for this $40,000 taxable temporary difference because:
- It does not arise from the initial recognition of goodwill
- It was not acquired as part of a business combination, and
- At initial recognition, neither profit or loss or taxable profit are affected.
However, deferred tax is recognised to the extent that accounting depreciation and tax depreciation for the $50,000 tax deductible portion of the asset differ during the asset’s life as shown in the table in Example 1 below.
Example 1
Using the fact pattern for the luxury vehicle above (i.e., cost of $90,000 and tax base of $50,000), the example below assumes the following:
-
Tax rate is 20%
- The entity depreciates motor vehicles using a straight-line basis for accounting purposes of 20% (i.e., $10,000 for 5 years), and tax purposes of 25% (i.e., $12,500 for 4 years)
- Accounting profit is $70,000 in each of years 1-5 before accounting depreciation of $10,000.
|
Year |
Carrying value at end of each year |
Tax base at end of each year |
Taxable temporary difference |
Deferred tax liability @ 20% tax rate |
Accounting profit ($70,000 - $10,000) |
Taxable profit ($70,000- $12,500) |
Current tax expense (i.e. taxable profit X 20%) (A) |
Deferred tax expense (B) |
Combined tax expense (A+B) |
| $ | $ | $ | $ | $ | $ | $ | $ | $ | $ |
| 0 | 50,000 | 50,000 | - | - | - | - | - | - | - |
| 1 | 40,000 | 37,500 | 2,500 | 500 | 60,000 | 57,500 | 11,500 | 500 | 12,000 |
| 2 | 30,000 | 25,000 | 5,000 | 1,000 | 60,000 | 57,500 | 11,500 | 500 | 12,000 |
| 3 | 20,000 | 12,500 | 7,500 | 1,000 | 60,000 | 57,500 | 11,500 | 500 | 12,000 |
| 4 | 10,000 | - | 10,000 | 2,000 | 60,000 | 57,500 | 11,500 | 500 | 12,000 |
| 5 | - | - | - | - | 60,000 | 70,000 | 14,000 | (2000) | 12,000 |
Recognising a deferred tax liability during the life of the luxury motor vehicle results in a tax charge in profit or loss that corresponds to the period when accounting depreciation is recognised (or carrying value of asset is recovered), rather than when the vehicle is deductible for tax purposes. This is evident by the consistent $12,000 tax charge recognised each year as shown in the table above. However, the $40,000 non-deductible portion of the vehicle will result in a ‘permanent difference’ because it results in an accounting deduction in profit or loss but there will never be a corresponding tax deduction for this amount.
Why has the IASB amended the ‘initial recognition exemption’ in IAS 12?
On initial recognition of a right-of-use (ROU) asset and lease liability by a lessee, or when an entity recognises the asset and liability for restoration obligations, both the asset and liability side have a carrying amount, but a zero tax base.
Example 2
If a lessee recognises a ROU asset and lease liability at initial recognition of $50,000, the temporary differences are as follows:
|
Item |
Carrying amount at initial recognition |
Tax base at initial recognition |
Deductible /(taxable) temporary difference |
| $ | $ | $ | |
| ROU asset | 50,000 | - Note 1 | (10,000) |
| Lease liability | 50,000 | - Note 2 | 10,000 |
Note 1: The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset (IAS 12.7). As the ROU asset is not tax deductible, its tax base at initial recognition is NIL.
Note 2: The tax base of a liability is its carrying amount, less any amounts that will be deductible for tax purposes in respect of that liability in future periods (IAS 12.8). Lease payments are deductible for tax purposes, and these include a capital and interest portion. The capital portion represents future tax deductions against the lease liability. Therefore the tax base at initial recognition is the carrying amount of the lease liability of $50,000 less $50,000 future tax deductions, which equals NIL.
If the entity applies the ‘initial recognition exemption’ to the above deductible and taxable temporary differences, no deferred tax asset or liability is recognised for the above deductible and temporary difference when the lease is first recognised on balance sheet, and also during the life of the lease.
This results in the annual tax charge fluctuating year on year based on tax deductions (usually lease payments, representing capital and interest payments on the lease liability), rather than how the carrying values of the ROU asset is recovered over time.If the entity did recognise both the deferred tax asset and deferred tax liability of $10,000 on initial recognition, both balances would reduce over the life of the lease as the ROU asset is depreciated, and the lease liability is settled.
What’s changed?
The IASB has amended the ‘initial recognition exemption’ so that it cannot be applied to transactions such as leases and restoration obligations which give rise to equal taxable and deductible temporary differences at initial recognition.
In Example 2 above, the initial recognition exemption therefore cannot be applied, and both the deferred tax asset and deferred tax liability of $10,000 each must be recognised at initial recognition, and unwound over the life of the lease. The two balances can be presented ‘net’ if the offset criteria in IAS 12, paragraph 74 are met.
An entity shall offset deferred tax assets and deferred tax liabilities if, and only if: a. the entity has a legally enforceable right to set off current tax assets against current tax liabilities; andb. the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same taxation authority on either:
(i) the same taxable entity; or
(ii) different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realise the assets and
settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected
to be settled or recovered. IAS 12, paragraph 74
Example 2 (continued)
To illustrate how the deferred tax liability on the ROU asset and the deferred tax asset on the lease liability unwind over the life of the lease, we will assume:
-
Tax rate is 20%
-
The entity depreciates the ROU asset using a straight-line basis for accounting purposes of 20% (i.e. $10,000 for 5 years)
- Accounting profit is $70,000 in each of years 1-5 before accounting depreciation and interest on the lease liability.
The amortisation table for the lease liability assumes an incremental borrowing rate on the lease liability of 5%. Lease payments are made annually in arrears:
|
Year |
Opening Balance |
Interest |
Lease Payments |
Closing Balance |
| $ | $ | $ | $ | |
| 1 | 50,000 | 2,500 | 11,549 | 40,951 |
| 2 | 40,951 | 2,048 | 11,549 | 31,450 |
| 3 | 31,450 | 1,572 | 11,549 | 21,473 |
| 4 | 21,473 | 1,074 | 11,549 | 10,998 |
| 5 | 10,998 | 550 | 11,549 | - |
Table 1
The deferred tax liability (DTL) on the ROU asset unwinds from initial recognition until the end of its useful life (end of Year 5) as shown in the table below (accounting depreciation is $10,000 each year):
|
Year |
Carrying amount of ROU asset |
Tax base |
Assessable temporary difference |
DTL @ 20% |
Annual DTL reversal |
| $ | $ | $ | $ | $ | |
| 0 | 50,000 | - | 50,000 | 10,000 | - |
| 1 | 40,000 | - | 40,000 | 8,000 | (2,000) |
| 2 | 30,000 | - | 30,000 | 6,000 | (2,000) |
| 3 | 20,000 | - | 20,000 | 4,000 | (2,000) |
| 4 | 10,000 | - | 10,000 | 2,000 | (2,000) |
| 5 | - | - | - | - | (2,000) |
Table 2
The table below illustrates how the deferred tax asset (DTA) on the lease liability unwinds from initial recognition until the last lease payment is made at the end of Year 5:
|
Year |
Carrying amount of lease liability |
Tax base |
Deductible temporary difference |
DTA @ 20% |
Annual DTA reversal |
| $ | $ | $ | $ | $ | |
| 0 | 50,000 | - | 50,000 | 10,000 | - |
| 1 | 40,951 | - | 40,951 | 8,190 | (1,810) |
| 2 | 31,450 | - | 31,450 | 6,290 | (1,900) |
| 3 | 21,473 | - | 21,473 | 4,295 | (1,995) |
| 4 | 10,998 | - | 10,998 | 2,200 | (2,095) |
| 5 | - | - | - | - | (2,200) |
Table 3
Netting the DTL and DTA entries off each year (assuming the offset criteria in IAS 12 have been met), the following net deferred tax entries will be processed:
|
Year |
Opening Balance |
Interest |
Lease Payments |
Closing Balance |
| $ | $ | $ | $ | |
| 0 | - | - | - | |
| 1 | (2,000) | (1,810) | (190) |
Dr Deferred tax liability $2,000 Cr Deferred tax asset $1,810 Cr Deferred tax expense $190 |
| 2 | (2,000) | (1,900) | (100) |
Dr Deferred tax liability $2,000 Cr Deferred tax asset $1,900 Cr Deferred tax expense $100 |
| 3 | (2,000) | (1,995) | (5) |
Dr Deferred tax liability $2,000 Cr Deferred tax asset $1,995 Cr Deferred tax expense $5 |
| 4 | (2,000) | (2,095) | 95 |
Dr Deferred tax liability $2,000 Dr Deferred tax expense $95 Cr Deferred tax asset $2,095 |
| 5 | (2,000) | (2,200) | 200 |
Dr Deferred tax liability $2,000 Dr Deferred tax expense $200 Cr Deferred tax asset $2,200 |
Table 4
Recognising the assessable and deductible temporary differences over the life of the ROU asset and lease liability results in a consistent combined tax charge in profit or loss as shown below:
| (A) | (B) | (C) | (D) | (E) | |
|
Year |
Accounting profit of $70,000 less accounting depreciation and interest charge |
Taxable profit ($70,000 less lease payments of $11,549) |
Current tax expense (Taxable profit X 20%)(B) X 20% |
Deferred tax (reversal)/expense |
Combined tax expense in profit or loss |
| 1 | 57,500 | 58,451 | 11,690 | (190) | 11,500 |
| 2 | 57,952 | 58,451 | 11,690 | (100) | 11,590 |
| 3 | 58,428 | 58,451 | 11,690 | (5) | 11,685 |
| 4 | 58,926 | 58,451 | 11,690 | 95 | 11,785 |
| 5 | 59,450 | 58,451 | 11,690 | 200 | 11,890 |
Table 5
In all of the above years, the combined tax expense in Column (E) equals the prima facie tax on accounting profit or loss, i.e., Column (A) X 20%.
What about advance lease payments and initial direct costs?
Example 2 shows a simplistic fact pattern where the carrying amounts of the ROU asset and lease liability are equal when the lease is first recognised. However, in practice, these initial carrying amounts may differ due to advance lease payments and/or indirect costs. Read next month's Accounting Alert to find out how to deal with advance lease payments and initial direct costs.
More information
For a more in-depth explanation of these amendments, including detailed worked examples, please refer to BDO’s International Financial Reporting Bulletin IFRB 2021/10 IASB issues amendments to IAS 12 – Deferred tax related to assets and liabilities arising from a single transaction
For more on the above, please contact your local BDO representative.
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