This is the first in a series of articles which will examine some of the more technical aspects of the new UK GAAP which came into force for accounting periods starting on or after 1 January 2015 for companies which are not part of the small companies’ regime.
Companies which are eligible to apply the small companies’ and micro-entities’ regime will report under new UK GAAP mandatorily for accounting periods starting on or after 1 January 2016 (although earlier adoption is permissible). This article explores the concept of deferred tax and how FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with the issue.
It is worth noting at the outset that micro-entities applying the provisions of FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime are prohibited from accounting for deferred tax. This is because the rigidity of the financial statements and the lack of disclosures means that it would not be possible to distinguish deferred tax and current tax and hence the Financial Reporting Council have prohibited micro-entities from providing for deferred tax under FRS 105. On transition to FRS 105, deferred tax balances will be reversed with the corresponding entry going to retained earnings (profit and loss reserves).
The concept of deferred tax
The vast majority of transactions which are recorded in the financial statements of a reporting entity will have some form of tax consequence, whether in the current accounting period or in succeeding accounting periods. Future tax consequences cannot be avoided and will mean that the company will pay more or less tax in future periods. The most common example which illustrates this well is when a company purchases a fixed asset; a lot of fixed assets purchased by companies can be deductible for tax purposes in both the current and subsequent accounting periods. In some situations, HM Revenue and Customs (HMRC) may grant up to 100% capital allowances in the year of acquisition as can be seen in the following example:
Example – 100% capital allowances
A company purchases a fixed asset for £50,000 which is eligible to 100% capital allowances from HMRC in the year of acquisition. The company’s depreciation policy for this fixed asset is to depreciate it over its useful economic life of five years with a full year’s depreciation charge in the year of acquisition and none in the year of disposal. At the end of the asset’s useful economic life, the residual value of the asset is expected to be nil. The finance director has claimed 100% capital allowances in the tax computation when calculating the company’s liability to tax at the year-end.
In this example the financial statements will show a carrying amount of £40,000 (£50,000 less £10,000 depreciation). For tax purposes the machine will have a tax written down value of £nil as the company has claimed 100% capital allowances in the year of acquisition. This gives rise to a timing difference of £40,000 between the financial statements and the capital allowances computation and a deferred tax liability arises. If we assume the company will pay tax at 17% when they eventually dispose of the machine the deferred tax liability is £6,800 (£40,000 x 17%) and the entries in the books will be:
|Dr tax expense (profit and loss)||£6, 800|
|Cr deferred tax provision (balance sheet)||£6, 800|
A deferred tax liability has arisen in the example above because the company has made a cash flow saving in the year that it acquired the fixed asset by taking advantage of enhanced capital allowances. This allowance will not be available in the next accounting period and therefore the tax liability will be higher. Recognising a deferred tax liability will mean the financial statements recognises this additional tax as the timing difference begins to unwind in years two to five.
Deferred tax has long since been a topical issue and it is worth examining the objectives of deferred tax, which are two-fold:
1. To ensure that the future tax consequences of past transactions and events are recognised as assets or liabilities within a reporting entity’s financial statements.
2. To disclose any additional special circumstances which may have an effect on future tax charges.
Timing difference ‘plus’ approach
In the UK and Republic of Ireland, companies have always calculated deferred tax based on the timing difference approach. This is markedly different than what happens under IFRS because IAS 12 Income Taxes requires deferred tax to be calculated using the temporary difference approach and there are significant differences between the two approaches.
Timing differences are differences between a company’s taxable profit and its results as stated in the financial statements which arise from the inclusion of gains and losses in tax assessments in periods different from those in which they are recognised in the accounts. Therefore the timing difference approach focuses on the profit and loss account. The temporary difference approach focuses on the balance sheet and hence a deferred tax liability would arise if the carrying value of an asset is greater than its tax base, or if the carrying value of a liability is less than its tax base.
FRS 102 is based on the principles found in IFRS (specifically IFRS for SMEs) and it follows that the calculation of deferred tax under FRS 102 should not be too disparate from that which would be calculated under IFRS principles. Therefore, FRS 102 uses a timing difference ‘plus’ approach to the calculation of deferred tax. The plus part brings in three additional situations which will give rise to deferred tax under FRS 102 as follows:
1. revaluation of non-monetary assets;
2. fair values in business combinations; and
3. unremitted earnings in overseas subsidiaries and associates.
Revaluation of non-monetary assets
There was a specific exemption contained in previous UK GAAP from recognising deferred tax on non-monetary assets subject to revaluation, unless at the balance sheet date:
1. there was a binding agreement to sell the asset; and
2. the gain or loss expected to arise on the sale had been recognised.
This exemption is no longer available and therefore where a company subjects non-monetary assets (such as an investment property) to revaluation then it must also recognise the associated deferred tax, which is calculated using the rate of tax expected to apply on the sale of the asset (in many cases this will be the latest rate of tax known (currently 17% for small companies)).
Fair value gains and losses on investment property are taken to profit or loss rather than a revaluation reserve under FRS 102 and associated deferred tax must be provided for on the gain or loss arising. As the gain or loss is taken to profit or loss, it follows that the deferred tax implications must also be taken to profit or loss.
On the other hand, if an item of property, plant and equipment (not investment property) increases in value then the gain will be taken to the revaluation reserve. The associated deferred tax implications will also be taken to the revaluation reserve because that is where the underlying transaction has been posted; hence the concept of ‘tax treatment follows accounting treatment’ applies in this respect.
Fair values in business combinations
Paragraph 29.11 says that when the tax base of an asset acquired in a business combination (not goodwill) is less than the value at which it is recognised in the acquirer’s financial statements, a deferred tax liability is recognised which represents the additional tax that will be paid in the future. Conversely, when the tax base of an asset is more than the amount recognised for the asset in the financial statements, a deferred tax asset is recognised to represent the additional tax that will be avoided in respect of that difference. A deferred tax asset or liability is recognised for the additional tax that the company will either avoid or pay due to the difference in value at which a liability is recognised and the amount that is assessed to be owed to HMRC. Amounts attributed to goodwill are adjusted by the amount of deferred tax.
Example – Deferred tax in a business combination
Company A acquires 100% of the net assets of Company B for £1.1 million. Company B has a valuable customer list which was not recognised on Company B’s balance sheet because it failed to meet the recognition criteria as it was internally generated. Tax relief has been obtained by Company B for the expenditure it incurred in creating the customer list.
At the date of acquisition, the customer list was fair valued at £150,000 and the fair value of the other assets in the acquisition amount to £600,000. Company A pays tax at 20%.
The difference between the tax base of the asset (which is £nil because tax relief has already been granted by HMRC in respect of the expenditure) and the fair value of the intangible asset of £150,000 gives rise to a deferred tax liability of £30,000 (£150,000 x 20%). The amount attributed to goodwill is adjusted by this deferred tax balance which is calculated as follows:
|Cost of business combination||£1,100,000|
|Fair value of customer list||(£150, 000)|
|Fair value of other net assets||(£600,000)|
|Deferred tax||£30, 000|
Unremitted earnings in overseas subsidiaries and associates
The parent’s/investor’s financial statements will recognise its share of profits or losses from the overseas subsidiary or associate. Ordinarily when an overseas subsidiary or associate remits a dividend to its parent or investor it will suffer withholding tax. Deferred tax is recognised on unremitted earnings in overseas subsidiaries and associates to represent the additional withholding taxes payable in the future.
Deferred tax assets
Care must be taken where deferred tax assets are concerned because Section 29 of FRS 102 takes a pessimistic approach to deferred tax assets (as did FRS 19 Deferred tax and the FRSSE). In practice, the most common event that will (potentially) give rise to a deferred tax asset is when a company has a taxable loss to carry forward which may be offset against future profits that the company generates. Paragraph 29.7 of FRS 102 says:
‘Unrelieved tax losses and other deferred tax assets shall be recognised only to the extent that it is probable that they will be recovered against the reversal of deferred tax liabilities or other future taxable profits (the very existence of unrelieved tax losses is strong evidence that there may not be other future taxable profits against which the losses will be relieved).’
When a company makes a loss which turns into a taxable loss, the default presumption under FRS 102 is that the company will never return to profit and evidence to the contrary must be obtained before recognising any deferred tax assets. This underlying concept in Section 29 is because assets cannot be stated in the balance sheet in excess of recoverable amount and so the pessimistic approach is adopted so as to reduce the scope for reporting entities from inappropriately recognising deferred tax assets that may never be used.
Example – Recognition of a deferred tax asset
A company has been established for many years but during the last couple of years has seen a decline in turnover and profit. The financial statements for the year-ended 31 December 2015 have reported a significant loss (for both accounting purposes and tax purposes) of £100,000. This loss has arisen as a result of reduced gross profit margins due to supplier price rises which have not been passed on to customers and redundancy costs which have occurred during the year. The financial statements have been completed to draft stage but have not yet been approved. Company A pays corporation tax at a rate of 20%.
On 2 January 2016 it was confirmed that the company was awarded a five-year contract for goods and services to a major blue-chip listed company. This contract was awarded following a rigorous tendering process because the contract will involve supplying goods and services on a ‘just-in-time’ basis. The contract will become operational in 2016.
The awarding of the contract is evidence that the company will generate suitable taxable profits in the year for which a deferred tax asset can be utilised. On this basis, the company can recognise a deferred tax asset of £20,000 (£100,000 x 20%).
Deferred tax has become more onerous for small companies and other unlisted entities reporting under FRS 102 due to the additional circumstances which now bring deferred tax into account. In addition, it is important to ensure that deferred tax is correctly posted into the financial statements (keeping in mind the concept of ‘tax treatment follows accounting treatment’), especially in light of the new accounting methodologies inherent in FRS 102.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.