A Footnotes Analyst guide for investors
One of the complexities in deferred tax accounting is the treatment of temporary differences at the time a transaction is initially recognised. The accounting differs depending on whether initial recognition is part of a business combination or not, and also differs for IFRS and US GAAP.
We think investors should be familiar with this issue to understand effective tax rates and whether they are predictive of future cash taxes.
Note: If you are unfamiliar with deferred tax and the concept of temporary differences first read ‘The Footnotes Analyst guide to deferred tax and temporary differences’ before continuing.
In most transactions the temporary difference when an asset or liability is first recognised is zero. In the case of an asset the tax base – the amount deductible for tax purposes – is the same as the accounting carrying value. Subsequently, if the tax and accounting treatment of the transaction differs, a temporary difference (and hence a deferred tax asset or liability) accumulates, and is fully reversed when the asset or liability is derecognised.
There can be situations where a temporary difference arises at initial recognition. This is not a problem where the transaction affects profit at the point of recognition (as in the environmental provision example we include in our guide to deferred tax and temporary differences). However, where the transaction does not affect profit and loss immediately, deferred tax becomes more complicated.
An example is where a depreciating asset is purchased for which no tax allowance is given. In this case the tax base is zero and the accounting carrying value is the purchase price. Under the temporary difference approach to deferred tax this difference would result in a deferred tax liability. Normally an increase in deferred tax liabilities results in a tax expense; however, it would not be logical to report an expense when, at that time, the transaction itself has no effect on profit and loss.
Unfortunately, from a global comparability perspective, IFRS and US GAAP deal with this situation differently.
IFRS initial recognition exemption: Under IFRS there is an exemption from recognising deferred tax (the so-called ‘initial recognition exemption’) in situations where a temporary difference arises on initial recognition and the transaction does not affect profit and loss, unless the temporary difference arises as a result of a business combination. This means that no deferred tax is recognised initially or subsequently. The lack of a tax deduction is gradually reflected in profit and loss, which results in a higher effective tax rate. Because no deferred tax is initially recognised there is no reversal and hence no deferred tax credit to offset the higher tax payable due to the lack of the tax allowance.
US GAAP gross-up approach: Under US GAAP a different approach is applied. In this case a deferred tax liability is recognised; however, the corresponding entry is to increase the fixed asset carrying value and not report an expense, as would normally be the case. This results in a higher depreciation charge and a deferred tax credit in future periods, which offsets the higher cash taxes payable. The problem is that the adjustment is a somewhat complicated calculation which necessitates solving simultaneous equations (one of the reasons IFRS does not apply this method is the computational complexity).
The advantage of the US GAAP approach is that the effective tax rate is unaffected by the lack of tax deduction. However, the deferred tax balance is difficult to rationalise, and the fixed asset ends up being measured at an amount higher than the actual purchase price. In addition, the US GAAP tax charge is, in aggregate, lower than the actual cash taxes paid. The overall impact on profit and loss is the same, but the US GAAP approach produces a lower operating profit, due to the increased depreciation, offset by a lower tax charge.
Here is a simple example to illustrate the IFRS and US GAAP calculations.
Illustrative example – Deferred tax on initial recognition
An asset is purchased for 100 which has a useful life of 5 years with a zero residual value and is depreciated on a straight-line basis. For tax purposes the depreciation is not tax deductible.
The accounting carrying value of this asset on initial recognition is 100 but the tax base is zero.1The tax base of an asset depends on the method of ‘recovery’ – whether the asset will be used in the business or sold. We assume that this asset is recovered through use. This results in a taxable temporary difference which, ordinarily, would result in a deferred tax liability. However, under IFRS, the transaction qualifies for the initial recognition exemption and no deferred tax is recognised.
Under US GAAP a deferred tax liability is recognised which is added to the asset carrying value. A higher asset value itself results in a higher initial temporary difference and therefore a higher amount of deferred tax. This circularity must be resolved mathematically, which in this case produces a revised asset carrying value of 125 and a deferred tax liability of 25.
Here is the resulting tax calculations and profit:
Notice that under IFRS the effective tax rate is higher than the statutory rate. This a reflection of the lack of tax deduction for the depreciation of the asset combined with not recognising deferred tax. Under US GAAP the same overall post-tax result is obtained by a different route. A deferred tax liability is recognised but on initial recognition this is used to increase the fixed asset carrying value. The resulting higher depreciation reduces operating profit but is offset by a deferred tax credit as the deferred tax liability unwinds.
We think that, of the above two approaches, IFRS is preferable. The problem with US GAAP is that the resulting financial statement amounts differ from the related cash flows. The total tax charge over the life of a transaction does not equal the actual cash paid, the fixed asset balance and capital expenditure is not the cash paid, and operating profit is lower than the cash generated from operations.
Initial recognition, deferred tax and business combinations
Temporary differences also arise on the initial recognition of assets and liabilities acquired in a business combination. In this case, IFRS and US GAAP apply the same approach – a deferred tax asset or liability is recognised but the corresponding entry is to adjust goodwill. This also has implications for equity analysis but is not something we consider further here.
In IFRS, the business combination treatment of a temporary difference arising on initial recognition is, in effect, an exception to the initial recognition exemption. A further exemption has recently been added in respect of certain other transactions, including capitalised leases.