IAS 12 Income Taxes

Country-by-Country tax reporting IAS 12 Risk or Profit

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Country-by-Country tax reporting

Country-by-Country tax reporting has become a fact of life for multinational enterprises (MNEs) with worldwide revenue above EUR 750 million.

While most MNEs have developed processes to gather and report the required information, how well are they managing the risk associated with the Report?

Have they integrated the reporting process into their ongoing transfer pricing management and documentation?

Is the information generated by the reporting process consistent with the intent of their global transfer pricing policy?

Action 13 of the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan introduced a CbC reporting template which certain multinational enterprises (MNE) are required to complete and submit (usually) to the tax authority in their home country.

Following a consultation process, the template was published in September 2014 and was finalised on October 5, 2015 when the OECD also published final implementation guidance.

The final OECD report recommended that CbC reporting commence for periods starting on or after January 1, 2016. In general, multinationals with consolidated group revenue of less than EUR 750 million (or equivalent in local currency) in the prior financial year are exempted from filing the CbC Report.

However, for those not exempt, filing with the parent country tax authority is typically due within 12 months of the group’s financial year-end. If the country of the MNE parent does not require reporting, it is the responsibility of the MNE to designate a surrogate parent in a country where the CbC Report can be filed.

One of the main reasons that tax authorities implemented the CbC reporting requirement was to gain a better understanding of a multinational group’s activities, value drivers, profit creation, and taxes paid in each of the jurisdictions in which it operates.

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Uncertain tax treatments in IAS 12 and IFRIC 23

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Uncertain tax treatments

Uncertain tax treatments – In short

Neither IAS 12 Income Taxes nor IFRIC 23 Uncertainty over Income Tax Treatments (the Interpretation) contain explicit requirements on the presentation of uncertain tax liabilities or assets in the statement of financial position.

This has led to diversity in practice. Some entities present uncertain tax liabilities as current (or deferred) tax liabilities and others include these balances within another line item such as provisions.

In September 2019, in response to a request for clarification on this matter, the IFRS Interpretations Committee (the IFRS IC or the Committee) published an agenda decision. The Committee concluded that an entity is required to present uncertain tax liabilities as current tax liabilities or deferred tax liabilities; and uncertain tax assets as current tax assets or deferred tax assets.

Based on an earlier agenda decision, the impact of uncertain tax treatments that meet the definition of income taxes should be presented in the statement of profit or loss in the line item ‘tax expense’.

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Deferred tax and business combinations in IAS 12

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Deferred tax and business combinations

Deferred tax and consolidated accounts

Business combinations offer an added level of complexity to the reporting of deferred taxes. This section considers a number of practical issues that can arise, specifically:

Intangible assets arising on a business combination

IFRS 3 (Revised 2008) requires intangible assets acquired in a business combination to be recognised at their fair Deferred tax and business combinationsvalue in the consolidated statement of financial position. Tax rules on intangible assets vary from jurisdiction to jurisdiction.

Understanding these rules is necessary to identify the tax bases of intangible assets and, accordingly, any temporary difference that may arise. For example, in certain jurisdictions tax is calculated using the separate financial statements of the members of the group, and not the consolidated accounts.

Hence, if an asset arises only on consolidation, its tax base will be nil. This is because, the income earned whilst the asset is used will be taxable and there will be no tax deductions available against that income from the use of the asset. Equally, if such an asset were sold, there would be usually no tax deduction on disposal.

This results in a temporary difference equal to the carrying value of the asset on initial recognition in the consolidated accounts. As the intangible asset and the related deferred tax arise on a business combination, the other side of the entry is to goodwill under IAS 12.66, see Deferred tax allocated to business combinations in Allocating the deferred tax charge or credit.

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Allocating deferred tax charge or credit in IAS 12

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Allocating deferred tax charge or credit

This narrative summarises the approach to allocating the deferred tax charge or credit for the year to the various components of the financial statements. Similar principles apply to the allocation of current tax.

IAS 12 requires that the deferred tax effects of a transaction or other event are consistent with the accounting for the transaction or event itself (IAS 12.57). The deferred tax charge or credit for the year can arise from a number of sources and therefore may need to be allocated to:

in order to comply with this basic principle.

Flowchart for allocating the deferred tax charge or credit

IAS 12.58 requires that deferred tax should be recognised as income or an expense and included in profit or loss for the period, except to the extent that the tax arises from:

The flowchart below summarises this requirement diagrammatically. It shows the steps needed to allocate the deferred tax charge or credit to the various components of the financial statements.

Allocating deferred tax charge

Step 1 – Recognition of deferred tax in OCI or equity

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Deferred taxes and Share-based payments IAS 12 accurate accounted for

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Deferred taxes and Share-based payments

This narrative looks at two particular issues that arise in accounting for deferred tax arising on share-based payments, specifically:

Calculating the credit to equity

IAS 12 requires a deferred tax asset to be recognised for deductible temporary differences associated with equity-settled share-based payments. In certain jurisdictions, tax law provides for a deduction against corporation tax when share options are exercised. The deduction can be equal to the intrinsic value (market price less exercise price) of the share options at the date they are exercised or computed on another basis specified by the tax law.

IAS 12.68C requires any deferred tax credit arising on equity-settled share-based payments to be allocated between profit or loss and equity.

What amount should be credited in profit or loss?

Simple case – Tax credit in profit or loss

On 1 January 20X1, Company A issued share options to its employees with a one year vesting period. At 31 December 20X1, an IFRS 2 charge of CU15,000 had been recognised. At 31 December 20X1, the share options expected to be exercised had a total intrinsic value of CU25,000. In the year, a deferred tax credit of CU5,750 should be recognised, based on a tax rate of 23% (assumed tax rate) (CU25,000 × 23%).

At 31 December 20X1, the expected tax deduction of CU25,000 exceeds the cumulative IFRS 2 charge recognised to date of CU15,000 by CU10,000. Therefore, of the tax credit of CU5,750, CU3,450 should be recognised in profit or loss (CU15,000 × 23%) and CU2,300 should be recognised directly in equity (CU10,000 × 23%).

In the above simple case, the amount of the deferred tax credit to be taken to profit or loss was simply the current year’s share-based payment charge multiplied by the effective tax rate. However, this will not always be the case. Whether any amount should be taken to equity in a given year depends on whether or not there is an ‘excess tax deduction’.

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The manner of tax recovery properly using IAS 12

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The manner of tax recovery and the blended tax rate

Some assets or liabilities can have different tax effects if they are recovered or settled in different ways. For example, in certain jurisdictions the sale of an asset gives rise to a tax deduction whereas the use of that asset might not give rise to a tax deduction.

The calculation of the deferred tax balance should take into account the manner in which management expects to recover or settle an asset or liability. In many cases this may be obvious, in others it may not. In some cases the expected manner of recovery will be a mix of both use and sale. This section looks at the practical problems associated with calculating the impact on the deferred tax balance based on the expected manner of recovery of an asset.

Method of recovery of an asset

Many assets are recovered partly through use and partly by sale. For example, it is common for an investor to hold an investment property to earn rentals for a period and then sell it. Other assets, such as property, plant and equipment and intangible assets are also frequently used in a business for part of their economic life and then sold. When such assets are depreciated, the residual value ascribed to them indicates an estimate of the amount expected to be recovered through sale.

Under IAS 12, the measurement of deferred taxes related to an asset should reflect the tax consequences of the manner in which an entity expects to recover the carrying amount of the asset (IAS 12.51-51A).

When the tax rate and the tax base are the same for both use and sale of the asset, the deferred tax does not depend on the manner of recovery and hence no complications arise. In some jurisdictions the tax rate applicable to benefits generated from using a specific asset, the ‘use rate’, differs from the rate applicable to benefits from selling the asset, the ‘sale rate’.

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IAS 12 Income tax definition

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IAS 12 Income tax definition

IAS 12 Income tax definition is a summary of other issues which can arise in practice, namely:

  • whether a particular taxation regime meets the definition of an income tax
  • the tracking of temporary differences arising on initial recognition
  • the accounting for changes in an asset’s tax base due to revaluation or indexation of that tax base
  • the treatment of deferred tax on gains and losses relating to an available-for-sale financial asset reclassified to profit or lossIAS 12 Income tax definition
  • accounting for deferred tax on compound financial instruments.

IAS 12 Income tax definition

The scope of IAS 12 is limited to income taxes.

This is defined in IAS 12.2 as follows:

‘For the purposes of this Standard, income taxes include all domestic and foreign taxes which are based on taxable profits. Income taxes also include taxes, such as withholding taxes, which are payable by a subsidiary, associate or joint arrangement on distributions to the reporting entity.’

As a result, if taxes are not based on ‘taxable profits’, they are not within the scope of IAS 12. For example, sales or payroll taxes are not income taxes. These taxes are based on the sales an entity generates or on salaries and wages it pays to its employees.

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Determine Tax base under IAS 12

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Determine Tax base

The tax base of an asset or a liability is the amount attributed to that asset or liability for tax purposes. The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset. The tax base of a liability is its carrying amount, less anyDetermine Tax baseamount that will be deductible for tax purposes in future periods. Some items have a tax base even though they are not recognised as assets or liabilities (see below). [IAS 12.5 (see tab IFRS Definitions), IAS 12.7–9]

In determining the tax base of an asset or a liability, an entity should not carry out an assessment of how probable it is that the respective amounts will ultimately be deducted or taxed. Instead, the probability assessment is part of the analysis required for the recognition of deferred tax assets. [IAS 12.5 (see tab IFRS Definitions), IAS 12.7–8, IAS 12.24]

Case – The tax base of an asset

Company A purchased an item of property, plant and equipment for CU10,000. Over the life of the asset, deductions of CU10,000 will be available in calculating taxable profit through capital allowances. All deductions will be available against trading income and no deductions will be available on sale. Management intends to use the asset.

As deductions of CU10,000 will be available over the life of the asset, the tax base of that asset is CU10,000.

Tax base of a revalued asset that is not depreciated

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Deferred tax calculations using IAS 12

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Deferred tax calculations

IAS 12 requires a mechanistic approach to the calculation of deferred tax. This narrative looks at the definitions in the standard and explains, through the use of a flowchart, how to navigate through the requirements of IAS 12.

The following flowchart summarises the steps necessary in calculating a deferred tax balance in accordance with IAS 12.

Deferred tax calculations

Step1 The accounting base is the carrying amount in the financial statements.

The tax base has to be determined based on management intent and local tax laws and regulations.

Step 2 If there is no difference between tax and accounting base, no deferred tax is required. Otherwise, a temporary difference arises. A temporary difference can be either a taxable or deductible temporary difference.

Step 3 IAS 12 requires deferred tax assets and liabilities to be measured at the tax rates that are expected to apply in the period in which the asset is realised or the liability is settled, based on tax rates that have been enacted or substantively enacted by the end of the reporting period.

Step 4 In order to recognise (include in the statement of financial position) a deferred tax asset, there must be an expectation of sufficient future taxable profits to utilise the deductible temporary differences.

Step 5 Deferred tax assets and liabilities are required to be offset only in certain restricted scenarios.

Step 1 – Establish the accounting base and the tax base of the asset or liability

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Transfer pricing – IAS 12 Best complete read

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Transfer pricing
 for
transactions between related parties

A transfer price is the price charged between related parties (e.g., a parent company and its controlled foreign corporation) in an inter-company transaction. Although inter-company transactions are eliminated when consolidating the financial results of controlled foreign corporations and their domestic parents, for preparation of individual tax returns each entity (or a tax consolidation unit of more than one entity in the group in one and the same tax jurisdiction) prepares stand-alone (or a tax consolidation unit) tax returns.

See also:

IAS 24 Related parties narrative IFRS 15 Revenue narrative IAS 12 Income tax narrative

Transfer prices directly affect the allocation of group-wide taxable income across national tax jurisdictions. Hence, a group’s transfer-pricing policies can directly affect its after-tax income to the extent that tax rates differ across national jurisdictions.

Arm’s length transaction principle

Most OECD countries rely upon the OECD TP Guidelines for Multinational Enterprises and Tax Administrations, that were originally released in 1995 and subsequently updated in 2017 (OECD TP Guidelines). The OECD TP Guidelines reaffirmed the OECD’s commitment to the arm’s length transaction principle.

In fact, the arm’s length transaction principle is considered “the closest approximation of the workings of the open market in cases where goods and services are transferred between associated enterprises.” The arm’s length principle implies that transfer prices between related parties should be set as though the entities were operating at arm’s length (i.e. were independent enterprises).

The application of the arm’s length transaction principle is generally based on a comparison of all the relevant conditions in a controlled transaction with the conditions in an uncontrolled transaction (i.e. a transaction between independent enterprises).

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