Deferred tax assets Future tax profits

Deferred tax assets Future tax profits

The availability of future taxable profits – a problem in four parts Deferred tax assets Future tax profits

The best starting point for determining the availability of future taxable profits is a company’s own business planning cycle and resulting forecasts. Using the company’s forecasts to assess the value of assets with potentially significant impact is not a unique exercise for most telecom operators. Given the significant balances of goodwill, other intangible and tangible assets, impairment testing is an important element of their financial reporting process. Deferred tax assets Future tax profits

Impairment tests generally are based on approved budgets, which result from a robust budgeting process, and often external experts are involved throughout the impairment process. Often, the analyses used in impairment testing are in some way adjusted, for example to eliminate deliberate ‘challenges’ inserted in the budget for internal management purposes, or to adjust for market perception of risk levels. 

Given the fact that these robust forecasts already are available, they are also used as a basis for the deferred tax asset analysis. If the analyses are robust enough to maintain significant amounts of goodwill and other assets on the balance sheet, using other assumptions when assessing the valuation of deferred tax assets is hard to justify. Assessing the value of deferred tax assets, therefore, should be broadly consistent with the assumptions used for impairment testing.

Nevertheless, the four common differences that exist in forecasting future taxable profits must be considered, as follows.

1. Determining cash flows on the basis of an entity’s business, not its disposal value Deferred tax assets Future tax profits

In an impairment test performed in accordance with IAS 36 Impairment of Assets, the recoverable amount of a cash generating unit is determined. The recoverable amount is the higher of the value in use and the fair value less the cost to sell. Deferred tax assets Future tax profits

The fair value less cost to sell may be based on the net proceeds that are expected to be generated by the sale of one or more subsidiaries that together form the relevant cash generating unit. When considering the valuation of the deferred tax assets of these subsidiaries, however, the value in use assumptions are the only relevant basis for evaluating the forecasts of their future taxable income. Deferred tax assets Future tax profits

On the other hand, the forecast for deferred tax purposes may include elements such as the impact of future restructuring activities or from improving or enhancing the asset’s performance, which would be restricted or prohibited under IAS 36. All this may mean that although a company expects its goodwill and other assets to be fully recoverable in the event of external sale, insufficient future taxable profits may exist to justify recognising a deferred tax asset.

Cash flow forecasts should be translated to taxable profits under applicable tax laws and regulations. Depreciation and interest expenses that are not included in a value in use calculation should be taken into account in the taxable profit analysis if they are tax deductible. At the same time, forecasted taxable profits should exclude non-taxable or non-deductible items that are included in the value in use calculation.

Example Deferred tax assets Future tax profits

Telecom operator X has significant carryforward losses as a result of licence and network impairments recognised in the past. The carrying amount of the licence and network assets is EUR 4.5 million.

The expected remaining useful life is five years. Based on the 2009 impairment test, the operator concludes that no additional impairment should be recognised, nor is there a basis for an impairment reversal, i.e. the recoverable amount at the end of 2009 approximates the carrying amount of the cash generating unit, which includes the licence and network assets: Deferred tax assets – Future tax profits

Deferred tax assets Future tax profits

The operator has incurred significant debt in the past, and annual interest charges amount to EUR 500,000. Assuming that the company’s net cash flow before interest and taxes is equal to its EBITDA (earnings before interest, taxes, depreciation and amortisation), and that depreciation equals the deductible amount for tax purposes, the forecasted results are as follows:

Deferred tax assets Future tax profitsAlthough positive cash flows before interest and taxes are expected and operator X did not recognise an impairment charge in 2009, there is insufficient basis to recognise a deferred tax asset for the carryforward losses available at the end of 2009, since the company does not expect taxable profits in the near future. Deferred tax assets – Future tax profits

Often, the timing and amount of tax deductions for depreciation and interest can differ from their equivalent accounting expenses. For example, an asset may be depreciated (or impaired) for accounting purposes over a shorter period than that over which tax relief is obtained, resulting in a deductible temporary difference.

Normally, in determining the sufficiency of taxable profits under IAS 12, taxable amounts arising from future deductible temporary differences are ignored. Therefore, for simplicity, forecasts include accounting rather than tax amounts. However, careful analysis will be necessary when losses cannot be carried forward indefinitely. Deferred tax assets Future tax profits

Particular issues exist when forecasts include the amounts relevant for tax purposes (rather than the accounting deductions) and losses are recoverable only against taxable profits arising as a result of future deductible temporary differences. In that case, those taxable profits can be taken into account only if the deferred tax assets relating to the future deductible temporary differences also can be recovered subsequently.Deferred tax assets Future tax profits

Example Deferred tax assets Future tax profits

A start-up telecom operator has incurred tax losses of EUR 100 million. The IFRS results of the entity, approximately EUR 5 million annually, are still negative and are expected to be negative in the near term. For tax purposes, however, decommissioning expenses are recognised as incurred and thus no decommissioning liabilities are recognised.

As a result, tax profits are slightly positive in the early years of operation, as the operator’s depreciation and interest expenses are lower for tax purposes than for IFRS purposes. The actual decommissioning expenditures are expected to be incurred starting in 2012.

Although the operator is profitable for tax purposes, no deferred tax asset is recognised since taxable IFRS profits are negative. The fact that some expenses are deferred for tax purposes gives rise to a deductible temporary difference.

Because recovery of the deductible temporary differences that replace the carryforward losses still depends on the entity generating IFRS taxable profits, which currently is not the case, the recoverability of the deferred tax asset is assessed based on taxable IFRS profits.

2. Translating a cash generating unit into taxable entities Deferred tax assets Future tax profits

IAS 12 indicates that the recoverability of deferred tax assets should be assessed with reference to the same taxation authority and the same ‘taxable entity’. Sufficient future taxable profit must be available to the taxable entity where those deductible temporary differences or unused tax losses originated, in order for an asset to be recognised by that entity.

To the extent that a tax group can recover tax losses or any deductible temporary differences generated, in consolidated financial statements, taking into account the taxable profits of all entities in the wider tax group would be appropriate.

This tax group, however, may not equal the cash generating unit that is the basis for business planning or impairment testing. A tax group may very well consist of multiple cash generating units, or a cash generating unit may consist of more than one taxable entity or tax group.

For example, in the past many telecom operators have included licences or intellectual property in separate taxable entities that generate revenues by licensing out these assets at a predetermined (royalty) fee. Although these assets generate separate profits for tax purposes, the assets generally would not constitute a separate cash generating unit for impairment testing purposes. Deferred tax assets Future tax profits

Example Deferred tax assets Future tax profits

In the past, operator A acquired a telecom licence at a significant cost. Under the terms of the licence, operator A provides telecom services over its network and could not operate without the licence. For tax purposes, the licence and the network are included in separate taxable entities.

The licence is held by entity B and the network by C. A is the owner of the group’s customers and generates revenues from the services provided to these customers. The entities that hold the licence and the network each charge A with a fee for the use of these assets. In the past, an impairment was recognised, which was allocated pro rata to the licence and the network assets.

For impairment testing purposes, operator A classifies its own assets combined with the licence and underlying network assets held by B and C as a single cash generating unit, as this is deemed the smallest unit to generate independent cash flows.

For deferred tax asset valuation purposes, however, the future taxable profits of B and C should be assessed separately because they are the entities that incurred the losses in the past and should generate future taxable profits to recover the respective deferred tax assets.

As a result of differences between taxable entities and cash generating units, the forecasts that were the basis for impairment testing may have to be broken into smaller elements to assess the valuation of carryforward losses. This may result in deferred tax assets being recognised in a loss-making cash generating unit or in no asset being recognised even though the cash generating unit is profitable.

3. Assessing legal or contractual limits to the recovery period Deferred tax assets Future tax profits

In many jurisdictions, limits exist on the recovery of tax assets. Typically, a limit is implemented as a maximum recovery period. This presents a cut-off for the cash flow projection period in determining the deferred tax asset.

Contractual limits to the recovery period may also exist. The operator may have special purpose entities to hold, for example, a telecommunications licence or a patent. These entities typically acquire the intangible asset and licence it to a service entity of the operator, against a contractually pre-established fixed or variable royalty.

The life of such entities is de facto limited to the contractual life of the underlying asset, which in turn presents a cut-off for the cash flow projection period in determining the deferred tax asset. Tax planning opportunities may exist to recover any remaining temporary differences or unused losses at the expiration of the contract, but these opportunities should be sufficiently probable and evidenced to be usable in supporting further deferred tax assets.

4. Weighing the uncertainties in future profits and cash flows Deferred tax assets Future tax profits

Where there is a balance of favourable and unfavourable evidence, careful consideration is given to an entity’s projections for taxable profits for each year from the balance sheet date until the expiry date of the carryforward losses. As indicated before, the projections that are the basis for the assessments must be broadly consistent with the assumptions made about the future in relation to other aspects of financial accounting (for example, impairment testing).

The exception occurs when relevant standards require a different treatment (for example, impairment testing generally cannot take account of future investment).

IAS 36 requires that, in an impairment test, the projections be made on the basis of reasonable and supportable assumptions that represent management’s best estimate of future profits. However, no matter how robust the forecasting process has been, there is always a risk that actual future outcomes will differ from these estimates.

In the traditional impairment testing approach, such risks are generally incorporated in a single discount rate. The higher the risks in the estimated future cash flows, the higher the element that is included in the discount rate to reflect the risk that the future cash flows will differ from the estimates in amount or timing.


Telecom operator X operates in its home country, where it holds the number 1 position. The market is mature and predictable. Management predicts an annual net cash flow of EUR 1 million. Given the low risk involved in this estimate, a discount rate of 8% is applied to these forecasts.

Recently, operator X also entered a new country, where it currently holds the number 4 position and expects significant growth opportunities. As a result of expected market growth and growth of its market share, operator X expects to double in size during the next three years, after which it plans to maintain a stable cash flow.

Given the risk involved in this business plan, a 20% discount rate is applied to the forecasts. The table below illustrates how the risk involved in management’s forecasts affects the weight that is assigned to these forecasts in the impairment test:

Deferred tax assets Future tax profits

As the example indicates, in an impairment test the further the expected cash flows lie into the future, the lower the weight assigned to the cash flows. One reason is the time value of money (‘it is better to receive one euro today than in a year’).

A significant factor, though, is the risk involved, as the table illustrates by the differences in weights assigned to the low-risk and to the high-risk forecasts. Irrespective of the risk involved, beyond a certain point in time virtually no value is assigned to the forecasted cash flows.

For the high-risk cash flows, the cash flows expected in year 10 add only 16% of their nominal amount to the value of the asset, and the cash flows projected after 30 years receive no weight at all.

IAS 12, however, does not permit the discounting of deferred tax assets (or liabilities), based on the argument that detailed scheduling of the timing of the reversal of temporary differences is impracticable or highly complex.

As a result, companies need to consider other methods that appropriately reflect risk in their forecasts of future taxable profits. This issue particularly affects telecommunications companies, because their large capital intensity dictates longer periods to recoup net operating losses.

Companies in this industry seek methods that will allow them to take into account increasing uncertainty as time progresses. Three possible methods applied in practice are considered below.

(i) Lookout-period approach Deferred tax assets Future tax profits

The further into the future it is necessary to look for sufficient taxable profits (the ‘lookout’ period), the more subjective the projections become. It may be argued that the probability of taxable profits decreases over time such that there could be a point beyond which no reliable earnings projections can be made, and thus that taxable profits are no longer probable.

However, we believe that generally there should be no arbitrary cut-off in the time horizon over which an assessment of expected taxable profits is made.

Without specific circumstances, we consider it inappropriate to assume that no taxable profits are probable after a specified time period. The expiration date of a significant licence, for example, and uncertainty about the company’s ability to extend the licence to stay in business beyond the expiration date could be such a specific circumstance a telecom operator would take into consideration.


Three years ago, telecom operator X acquired a 10-year mobile telecom licence in country Y, which has a fast-growing mobile telephony market. In the first two years, operator X incurred start-up losses, but the company is now moving into a profitable position.

The government of country Y does not have a policy of renewing licences after the initial term. As a result, operator X expects that after the initial 10-year period it will have to compete for a new licence in an auction with existing operators and potential new entrants.

It is uncertain whether, and at what price, operator X will be able to acquire a new licence. Therefore, operator X concludes that it is not appropriate to include future taxable profits beyond the 7-year horizon until the next auction.

Given the increased uncertainty beyond a specific point in the future, using a restricted lookout period is not necessarily inconsistent with the assumptions used in the company’s impairment test. The first reason is that, in a high-risk scenario, the discount rate used in the impairment test should reflect this risk appropriately. In the previous example above, the weight assigned to an expected cash flow of 100 in year 7 is only 28 in the high-risk scenario.

The second reason is that the business case for the price paid in a new auction will be based on future cash flow projections, whereas taxable profits may deviate from these cash flows as a result of tax deductible depreciation or interest charges.

In the absence of a specific circumstance, the use of a specific lookout period generally is not appropriate. In that situation, the lookout period is likely to be arbitrary. Thus, for every year until the expiry of tax losses, the calculation should include the taxable profits that satisfy the criterion of being more probable than not. This may result in lower estimates for years in the distant future, but it does not mean that those years should not be considered.

(ii) Risk-adjusted profits approach Deferred tax assets Future tax profits

As indicated above, the traditional impairment test approach is based on a company’s best estimate of future cash flows and uses a single discount rate to incorporate all the risks related to expectations about the future cash flows. Deferred tax assets Future tax profits

Although IAS 12 does not allow discounting of deferred tax assets, the underlying reasoning for discounting future cash flows in an impairment test may be applied also in assessing the valuation of deferred tax assets. The discount rate in an impairment test should reflect both the time value of money and the risks specific to the asset for which the future cash flow estimates have not been adjusted. The discount rate thus adjusts the value assigned to expected future cash flows to reflect the risk that actual cash flows will fall short of the expectation.

If the cash flow forecasts in the impairment model are translated into expected future taxable profits without adjusting for the inherent risk that the actual taxable profits could be lower, the deferred tax asset that is recognised will be too optimistic. Deferred tax assets Future tax profits

Adjusting the expected future taxable profits by using a risk factor, therefore, would be appropriate. This risk factor can be derived from the risk premium that is included in the discount rate used in the impairment test.

For a telecom operator, however, the risk related to future cash flows may differ from the risk related to future taxable profits. This difference results from large asset bases and the resulting depreciation charges, which may not affect future cash flows but which do affect future taxable profits. Similar to the use of a discount rate in an impairment test, the risk factor applied to taxable profits that are expected further into the future is likely to be higher than the factor applied to the taxable profits in the early years of the forecast.


Telecom operator X operates in its home country, where it holds the number 1 position. As a result of impairment charges in the past, the company has carryforward losses available. Operator X expects that it can sustain a taxable profit of EUR 1 million during the next 20 years, at which point its carryforward losses will have expired.

However, given regulatory developments and increasing competition, there is a risk that the operator will lose market share and that pricing pressure will increase. A premium of 10% to reflect these risks is considered appropriate.

The table below illustrates how the risk involved in management’s forecasts affects the level of future taxable profit that is considered probable (risk adjusted taxable profit):

Deferred tax assets Future tax profitsAs the table indicates, the operator expects future taxable profits of EUR 20 million during the 20 year period, but the risk-adjusted expected future taxable profits are much lower at EUR 8.5 million. The operator concludes that only EUR 8.5 million of the forecasted taxable profits meets the probability threshold.

(iii) Expected profits approach Deferred tax assets Future tax profits

Instead of using a single estimate of future taxable profits and reflecting all risks in a single risk factor, it is also possible to estimate a range of possible taxable profits and assign probabilities to each of the estimates. The expected profits approach breaks down the risks and uses all expectations about possible outcomes instead of the single most likely taxable profit.


Telecom operator X recently entered the market in country Y and acquired a licence that will expire in 2016. An auction will take place in 2016. Whether operator X will be able to acquire a new licence and, if so, under which conditions is uncertain.

Another auction will take place in 2020. The strategy of operator X is to gain market share quickly in 2010 and 2011 and to maintain that market share and profitability in subsequent years. The operator has prepared three scenarios for developing its future taxable profits and has assigned weights to each scenario:

Deferred tax assets Future tax profitsBased on these scenarios, the operator concludes that the following forecasted taxable profit amounts meet the probability threshold and should be taken into account in the valuation of the deferred tax asset:

Deferred tax assets Future tax profitsThe operator concludes that only EUR 7 million of the forecasted taxable profits meets the probability threshold.

In this last example, the profit level considered probable in years 2016 to 2019 is EUR 500,000 (as there is at least a 20% chance of EUR 1,000,000 profit and a 40% chance of EUR 500,000 profit, meaning that there is at least a 60% chance of EUR 500,000 profit).

The operator does not assign any weight to the chances of taxable profits of EUR 500,000 or EUR 1,000,000 in the year 2020 and beyond since this profit level is not considered probable (a 20% chance of EUR 1,000,000 profit and a 50% chance of at least EUR 500,000 profit). In an impairment analysis, it is likely that weight would be given to the chance that future cash flows are higher than nil in these years, and the associated risks would be reflected in the discount rate that is used.

Deferred tax assets Future tax profits

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