Last week I published an article with summary of the standardIAS 12 on Income taxes. It’s not an easy text to read and some definitions in IAS 12 are so obscure that many people grope in the fog unsure what to do.
When it comes to setting the tax base of assets or liabilities, the issue becomes even more painful because it’s very hard to understand the definitions in IAS 12.
In this article I would like to explain a concept of a tax base and give you some useful hints how to determine it.
This Is What You Should Ask First
Before trying to set a tax base of any asset or liability, ask yourself these questions:
What happens when in the future I recover this asset or settle this liability and remove it from my balance sheet? Will this removal affect my tax payments in the period of recovery or settlement? In other words, will I have to make some adjustment to my accounting profit in order to arrive to taxable profit?
If the answer is yes, then the tax base of this asset or liability is for sure different from its carrying amount.
If not, then the tax base of this asset or liability equals to its carrying amount.
Now let’s break it down.
Setting the tax base of assets
“Tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.”
That’s the definition from IAS 12 Income Taxes.
However, I look at tax base of an asset as at something “what’s left in the tank” to deduct for tax purposes in the future.
Let me show you 2 examples. From the “tax base” point of view, there are 2 types of assets. No matter what type you’re dealing with, setting the tax base is the same.
- Assets that will be recovered through their usage
- Assets that will be recovered through receipt of cash or other asset
As you will recover the carrying amount of these assets by their usage in order to achieve profit, you will probably charge them to your profit or loss in the future. The examples of these assets areproperty, plant and equipment or prepaid expenses.
Let’s say you have a machine with a cost of 1 000 and you charged depreciation of 200. However, for tax purposes, you can deduct only 150 this year.
Clearly, carrying amount of this asset is 800 which is 1 000 less 200.
What is a tax base?
What is a tax base?
What’s left in the tank for future tax deductions?
Since you have already deducted 150, you will be able to deduct 850 in the future (1000 less 150), so the machine’s tax base is 850.
Now you can work out temporary difference and deferred tax yourself.
In this case, you will not charge a carrying amount to profit or loss. Instead, you will credit a carrying amount against any cash or other consideration received in exchange. The examples of these assets are receivables.
Let’s say you have an interest receivable of 500. However, you did not include this receivable into taxable profit calculation because in your country interest received is taxed when cash is received.
What’s left in the tank for future tax deductions when you recover this receivable?
The answer is zero. Nil. Why?
Because when you recover the receivable in the future by receiving the cash, then you need to include it in your tax return. How much can you deduct for tax purposes in the time of taxing? Zero. You must tax it in full.
As the carrying amount of this interest receivable is 500 and tax base is 0, you can work out the temporary difference and a deferred tax.
Setting the tax base of liabilities
The definition of a tax base of a liability coming from IAS 12 Income Taxes is:
“Tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.”
However, I look at tax base of a liability as everything you are NOT going to deduct in the future for tax purposes.
From the “tax base” point of view, there are 2 types of liabilities:
Be careful about items not shown in your balance sheet!
If you review all your assets and liabilities calculating their tax bases, be careful! There could be some items not recognized in your balance sheet that still do have a tax base.
For example, you might have incurred some research costs included in the profit or loss in the past that you could not deduct for tax purposes until later periods. In such a case, the research costs are not shown in your statement of financial position but they do have a tax base.
If you are still unsure about the tax base, then my next article will be for you. I will describe how to determine a tax base of your assets or liabilities in a very simple way.
Investments in subsidiaries, branches and associates and interests in joint ventures
Except for various kinds of temporary differences mentioned above, a number of them can arise at business combinations. This issue is even more complicated that it looks because temporary difference may be different in the consolidated financial statements from temporary difference in the individual parent’s financial statements.
Such differences arise in number of circumstances:
- Undistributed profits of subsidiaries, branches, associates and joint arrangements
- Changes in foreign exchange rates when a parent and its subsidiary are based in different countries
- Reduction in the carrying amount of an investment in an associate to its recoverable amount.
Here, 2 essential rules for recognition of deferred tax apply:
- An entity shall recognize a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint arrangements,except to the extent that both of the following conditions are satisfied:
- the parent, investor, joint venturer or joint operator is able to control the timing of the reversal of the temporary difference; and
- it is probable that the temporary difference will not reverse in the foreseeable future.
- An entity shall recognize a deferred tax asset for all deductible temporary differences arising from investments in subsidiaries, branches and associates, and interests in joint arrangements, to the extent that it is probable that:
- the temporary difference will reverse in the foreseeable future; and
- taxable profit will be available against which the temporary difference can be utilized.
How to recognize deferred taxes
In almost all situations you would recognize deferred tax as an income or an expense in profit or lossfor the period. There are just 2 exceptions of this rule:
- if a deferred tax arose from a transaction or even recognized outside profit or loss, then you need to recognize deferred tax in the same way (in other comprehensive income or directly in equity)
- if a deferred tax arose in a business combination, deferred tax affects goodwill or bargain purchase gain.
If you’d like to know how to calculate deferred tax step by step, please read my guest post here.
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