IAS 12, Income Tax

By Graham Holt

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IAS 12 uses a liability method and adopts a balance sheet approach to accounting for taxation. It
accounts for the temporary differences between the accounting and tax bases of assets and
liabilities rather than accounting for the timing differences between the accounting and tax
consequences of revenue and expenses. IAS 12 adopts a full provision balance sheet approach to
accounting for tax. It is assumed that the recovery of all assets and the settlement of all liabilities
have tax consequences and that these consequences can be estimated reliably and cannot be
avoided. As the IFRS recognition criteria are different from those which are normally set out in
tax law, certain income and expenditure in financial statements will not be allowed for taxation
purposes, thus causing 'temporary differences'.

A deferred tax liability or asset is recognised for the future tax consequences of past transactions
with certain exemptions. The standard assumes that each asset and liability has a value for tax
purposes and this is called a tax base. Differences between the carrying amount of an asset and
liability and its tax base are called temporary differences. The principle utilised in IAS 12 is that
an entity will settle its liabilities and recover its assets eventually over time and, at that point, the
tax consequences will crystallise. There are two kinds of temporary differences: a taxable
temporary difference and a deductible temporary difference. A taxable temporary difference
results in the payment of tax when the carrying amount of the asset or liability is settled.This
means that a deferred tax liability will arise when the carrying value of the asset is greater than
its tax base, or the carrying value of the liability is less than its tax base. Deductible temporary
differences are differences that result in amounts being deductible in determining taxable profit
or loss in future periods when the carrying value of the asset or liability is recovered or settled.
When the carrying value of the liability is greater than its tax base or the carrying value of the
asset is less than its tax base, then a deferred tax asset may arise.

Example 1

An entity has the following assets and liabilities recorded in its balance sheet at 31 December
20X8:

Tax base
Carrying value
(value for tax purposes)
$m
$m
Property 20 14
Plant and equipment 10 8
Inventory 8 12
Trade receivables 6 8
Trade payables 12 12
Cash 4 4

The entity had made a provision for inventory obsolescence of $4m that is not allowable for tax
purposes until the inventory is sold and an impairment charge against trade receivables of $2m
that will not be allowed in the current year for tax purposes but will be in the future. Income tax
paid is at 30%.

Required:
Calculate the deferred tax provision at 31 December 20X8.

Solution:

Tax base (value for

Carrying value Temporary difference
tax purposes)
$m $m
$m
Property 20 14 6
Plant and equipment 10 8 2
Inventory 8 12 (4)
Trade receivables 6 8 (2)
Trade payables 12 12 -
Cash 4 4 -
2

The deferred tax provision will be $2m x 30%, i.e. $600,000.

The provision against inventory and the impairment charge for trade receivables will cause the
tax base to be higher than the carrying value by the respective amounts.

Every asset or liability is assumed to have a tax base. Normally this will be the amount that is
allowed for tax purposes. However, some items of income and expenditure may not be taxable or
tax deductible and they will never enter into the computation of taxable profit. These have
sometimes been called permanent differences. Generally speaking, these items will have the
same tax base as their carrying amount and no temporary difference will arise. For example, if an
entity has in its balance sheet interest receivable of $2m, which is not taxable then its tax base
will be the same as its carrying value, i.e. $2m. There is no temporary difference in this case and,
therefore, no deferred taxation will arise.

There are some temporary differences that are not recognised for deferred tax purposes. These
arise:
 • from goodwill
• from the initial recognition of certain assets and liabilities, and
• from investments when certain conditions apply.

IAS 12 does not allow a deferred tax liability for goodwill on initial recognition or where any
reduction in the value of goodwill is not allowed for tax purposes. Because goodwill is the
residual amount after recognising assets and liabilities at fair value, recognising a deferred tax
liability in respect of goodwill would simply increase the value of goodwill and, therefore, the
recognition of a deferred tax liability in this regard is not allowed.

Group financial statements

Temporary differences can also arise from adjustments on consolidation. The tax base of an item
is often determined by the value in the entity accounts - that is, for example, the financial
statements of a subsidiary. Deferred tax is determined on the basis of the consolidated financial
statements and not the individual entity accounts.Therefore, the carrying value of an item in the
consolidated accounts can be different from that in the individual entity accounts, thus giving
rise to a temporary difference. An example of this is the consolidation adjustment that is required
to eliminate unrealised profits and losses on the inter group transfer of inventory. Such an
adjustment will give rise to a temporary difference which will reverse when the inventory is sold
outside the group.

IAS 12 does not specifically address how inter-group profits and losses should be measured for
tax purposes. It says that the expected manner of recovery or settlement of tax should be taken
into account. This would generally mean that the receiving company's tax rate should be used
when calculating the provision for deferred tax as the receiving company would be taxed when
the asset or liability is realised.

Example 2

A wholly subsidiary sold goods costing $30m to its holding company for $33m and all of these
goods are still held in inventory at the year end.
The unrealised profit of $3m will have to be eliminated from the consolidated income statement
and from the consolidated balance sheet in group inventory. The sale of the inventory is a taxable
event and it causes a change in the tax base of the inventory. The carrying amount in the
consolidated financial statements of the inventory will be $30m but the tax base is $33m. This
gives rise to a deferred tax asset of $3m at the tax rate of 30%, which is $900,000 (this is
assuming that both the holding company and subsidiary are resident in the same tax jurisdiction).

Summary of accounting for deferred tax

In summary, the process of accounting for deferred tax is as follows:

• determine the tax base of the assets and liabilities in the balance sheet
• compare the carrying amounts in the balance sheet with the tax base. Any differences will
normally affect the deferred taxation calculation
 • identify the temporary differences that have not been recognised due to exceptions in IAS
12
• apply the tax rates to the temporary differences
• determine the movement between opening and closing deferred tax balances
• decide whether the offset of deferred tax assets and liabilities between different
companies is acceptable in the consolidated financial statements
• recognise the net change in deferred taxation.

Deferred tax assets

Deductible temporary differences give rise to deferred tax assets. Examples include tax losses
carried forward or temporary differences arising on provisions that are not allowable for taxation
until the future. These deferred tax assets can be recognised if it is probable that the deferred tax
asset will be realised. Its realisation will depend on whether or not there are sufficient taxable
profits available in future.

Sufficient taxable profits can arise from three different sources:

• existing taxable temporary differences. In principle these differences should reverse in

the same accounting period as the reversal of the deductible temporary difference, or in
the period in which a tax loss is expected to be used
• if there are insufficient taxable temporary differences, the entity may recognise the
deferred tax asset where it feels that there will be future taxable profits, other than that
arising from taxable temporary differences. These profits should relate to the same
taxable authority and entity
• the entity may be able to prove that it can create tax planning opportunities whereby the
deductible temporary differences can be utilised. Wherever tax planning opportunities are
considered, management must have the capability and ability to implement them.

Similarly, an entity can recognise a deferred tax asset arising from unused tax losses or credits
when it is probable that future taxable profits will be available against which these can be offset.
However, the existence of current tax losses is probably evidence that future taxable profit will
not be available.

Sundry points

The tax rates that should be used to calculate deferred tax are the ones that are expected to apply
in the period when the asset is realised or the liability settled. The best estimate of this tax rate is
the rate which has been enacted or substantially enacted.

Deferred tax assets and liabilities should not be discounted because it is difficult to accurately
predict the timing of the reversal of each temporary difference.

The standard also deals with current tax liabilities and current tax assets. An entity should
recognise a liability in the balance sheet in respect of its current tax expense, both for the current
and prior years to the extent that it is not yet paid. Current and deferred tax should both be
recognised as income or expense and included in the net profit or loss for the period.

To the extent that the tax arises from a transaction or event that is recognised directly in equity,
then the tax that relates to these items that are credited or charged to equity should also be
charged or credited directly to equity. Any tax arising from a business combination should be
recognised as an identifiable asset or liability at the date of acquisition.

There are certain tax consequences of dividends. In some countries income taxes are payable at
different rates if part of the net profit is paid out as dividend. Possible dividend distributions or
tax refunds have got to be taken into account in measuring deferred tax assets and liabilities. IAS
12, however, requires disclosure of the tax consequences of dividends proposed or declared at
the balance sheet date, as well as disclosure of the nature and amounts of potential tax
consequences.

Graham Holt is principal lecturer in accounting and finance at the Manchester Metropolitan
University Business School, and an ACCA examiner.

Accounting for Business Combinations – Deferred Tax Aspects

IAS 12 requires the tax effects of the tax-book basis differences of all assets and liabilities
generally be presented as deferred tax assets and liabilities as at the date of acquisition.

Illustration

Colerob Corporation Inc is involved in the acquisition of a business. Relevant data is as follows:

1. The income tax rate of Colerob Corporation is 40%

2. The cost of the acquisition was $500,000
3. The fair value of the net assets acquired are $750,000
4. The tax bases of the assets acquired are $600,000
5. The tax bases of the liabilities acquired are $250,000
6. The difference between the tax and fair values of the assets acquired are $150,000 which
consists of taxable temporary differences of $200,000 and deductible temporary differences of
$50,000
7. The directors are confident about the recoverability of the deductible temporary differences.

Required

Show how the purchase price will be allocated in the above acquisition.

Solution
Goodwill may be tax deductible depending on the tax jurisdictions or it may be non-deductible.
If it is deductible, the amortisation period will cause the carrying amount for tax purposes to
differ from that of the financial statements. Under IFRS goodwill is not amortised over its
expected useful life and as a result a temporary difference will develop with book values being
greater than tax written down values. If impairment charges are taken into account then carrying
amounts may be lower than the corresponding tax basis.

Where you encounter negative goodwill then IAS 12 states that the acquirer should reassess the
values placed on the net assets and liabilities. If this does not lead to the elimination of the
negative goodwill that amount is to be reported in income in the current period. This will likely
result in a difference between tax and carrying values for the negative goodwill and this also is a
timing difference to be considered in computing the deferred tax balance for the reporting entity.

In our above illustration the directors were confident that deferred tax assets were deemed
probable of being realised. However, there are circumstances where there is substantial doubt
about the ability to realise deferred tax assets. In other words, it is not probable that the asset
will be realised. Under IAS 12, the deferred tax asset would not be recognised at the acquisition
date. If this applied to our illustration above, the allocation of the purchase price would have to
reflect that fact and more of the purchase cost would be allocated to goodwill than would have
otherwise been the case.

Illustration

Let us assume that Colerob Corporation were involved in a business acquisition on 1 January
2005. At the date of acquisition the deferred tax assets were calculated at $100,000. On 1
January 2005, the directors considered that realisation of the deferred tax assets were NOT
probable.

The unrecognised deferred tax asset is allocated to goodwill during the purchase price
assignment process.

However, on 1 January 2009 the likelihood of realising the deferred tax assets is reassessed as
being probable in future years. On 1 January 2009 the entries are:

DR deferred tax asset $100,000

CR goodwill $100,000
Disclosures Required

IFRS requires the following to be disclosed separately in an entity’s financial statements:

• The major components of tax expense, including:

• current tax expense
• adjustments relating to previous periods
• deferred tax expense/income
• deferred tax expense/income arising because of changes to tax rates
• deferred tax implications of a change in accounting policy or correction of an error
• The aggregate current and deferred tax relating to items that are charged or credited directly to
equity and the amount charged/credited to other comprehensive income
• A reconciliation between the income tax expense and the accounting profit multiplied by the
applicable tax rate(s) disclosing also the basis on which the applicable tax rate(s) have been
computed
• A reconciliation between the average effective tax rate and the applicable tax rate together with
the basis on which the applicable tax rate has been computed.