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IAS 12 — Deferred tax – tax base

Date recorded:

IAS 12 Income Taxes Deferred tax – tax base of assets and liabilities (Agenda Paper 4)

Background

The Committee received a request to interpret how IAS 12 should be applied when a lessee recognises an asset and liability at commencement of a lease (applying either IFRS 16 Leases or IAS 17 Insurance Contracts). A similar question has also arisen on initial recognition of decommissioning assets and liabilities applying IAS 16 Property, Plant and Equipment and IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

IFRS 16 requires that a lessee recognises a right-of-use asset and a lease liability. In many jurisdictions, lease payments are tax-deductible on a cash basis. As a result, the tax bases of the right-of-use asset and lease liability are zero. The result is a taxable temporary difference in relation to the right-of-use asset and a deductible temporary difference in relation to the lease liability. This is also relevant to the initial recognition of a finance lease asset and finance lease liability when IAS 17 is applied.

IAS 12 states that an entity does not recognise a deferred tax asset or a deferred tax liability to the extent that it arises from the initial recognition of an asset or liability in a transaction that is not a business combination and at the time of the transaction, affects neither accounting profit nor taxable profit. The submitter says there are at least three approaches being followed in applying the exemption (in IAS 12.15 and IAS 12.24) and that this diversity will become more extensive with the introduction of IFRS 16.

One approach is to apply the initial recognition exemption separately to the lease asset and the lease liability. Because, on initial recognition, the lease transaction affects neither accounting nor taxable profit, there is no deferred tax accounting throughout the entire lease term. Instead, the temporary differences related to the lease asset and the lease liability affect the effective tax rate and are disclosed as reconciling items when explaining the relationship between tax expense and accounting profit.

Another approach is to assess the lease asset and the lease liability together for the purpose of recognising deferred tax as a single transaction. Thus, there is no temporary difference on initial recognition. Temporary differences that arise subsequently as the lease asset is depreciated and the lease liability is reduced do not qualify for the exemption. As a result, the tax impact of the lease transaction is reflected in the primary financial statements and the effective tax rate more closely reflects the economics of the lease.

A third approach is to conclude that the initial recognition exemption does not apply to the gross temporary differences because an asset and a liability are recognised at the same time. The accounting outcome of this approach is similar to that of the second approach described above. 

Staff analysis

Whether temporary differences arise on initial recognition of the lease asset and lease liability requires an assessment of the relevant tax law to determine the amount attributable to the lease asset and lease liability for tax purposes. Depending on the provisions of the applicable tax law, the entity might determine that the tax deductions are attributable to either the lease asset, because the deductions relate to the expenses arising from the lease (depreciation and interest expense) or to the repayment of the lease liability.

In the fact pattern in the submission, tax deductions are available for the payments made under the lease contract. The staff state that this does not necessarily mean that the tax authority regards the deductions as relating to the repayment of a liability (as assumed in the submission). The tax authority is allowing specified cash outflows to be deducted for taxation purposes. It is a matter of judgement as to whether the applicable tax law regards the tax deductions as relating to depreciation (and thus partly attributed to the lease asset) and interest expense or to the repayment of the principal amount of the lease liability (and thus partly attributed to the lease liability) and interest expense. 

The staff would expect an entity in these circumstances to attribute the tax deductions it claims for lease payments to the lease asset (for deductions relating to depreciation) and to the future interest accrual (for deductions relating to the future interest expense) when repayments of the principal amount of borrowings are not deductible for tax purposes but tax deductions for the use of an asset (ie depreciation) and for interest payments on a loan are allowed.  In contrast, the staff would expect an entity to attribute the tax deductions to the repayment of the lease liability (for deductions relating to the repayment of the principal) and to the future interest accrual (for deductions relating to the future interest expense) when repayments of the principal amount of borrowings are deductible for tax purposes. How the tax deductions are attributed is not an accounting policy choice, but reflects consideration and analysis of the applicable tax laws. The staff would expect entities in the same tax jurisdiction to apply the same judgement for similar transactions.

The staff also conclude that an entity must consider the lease asset and lease liability independently of each other for the purposes of recognising deferred tax. The initial recognition exemption would apply separately to the lease asset and lease liability that an entity recognises in its statement of financial position at lease commencement. Because the entity recognises a lease asset and lease liability at lease commencement, the transaction affects neither accounting profit nor taxable profit (tax loss). The staff conclude that if an entity determines that temporary differences arise on initial recognition of the lease asset and lease liability, the initial recognition exemption applies and the entity would not recognise deferred tax. This reflects the first approach described in the submission.

Staff recommendation

The staff are recommending that the Committee not add the item to its agenda, on the grounds that the requirements in IAS 12 provide an adequate basis for an entity to determine whether to recognise a deferred tax asset or deferred tax liability in the fact pattern described in the request.

Discussion

Most of the discussion centred on the difficulty of determining whether allowable tax deductions relate to an asset or liability. It is clear that IAS 12 requires that assessment but it is also clear that IAS 12 does not address how to make the attribution. Some members said that tax deductibility is a fact in law rather than a matter of judgement. Looking at the tax law in this way is artificial and it is unlikely that there would be consistency in thinking and this should be unsurprising.

Tax generally focuses on inflows as assessable income and outflows as deductible expenses. Much tax legislation will never have reflected any thinking about assets or liabilities. Nevertheless, this is what IAS 12 says you must assess. Members noted that you can get diversity because the tax laws are different or because the application is different. 

There seems to be diversity between and within jurisdictions. If there is anything the Committee can do to reduce that diversity then that would be a step in the right direction. One member reminded the Committee that this issue was looked at in 2005, but was not pursued because the IASB and FASB were working on a series of improvements, that were not finalised. The problem could be worse from next year when IFRS 16 comes into effect and some entities elect not to separate services from leased assets, but the tax is separated. 

Several members noted that the analysis did not consider the Day 2 accounting. This could be demonstrated with an example.

A staff member noted that a single tax deduction could have more than one accounting asset or liability and that IAS 12 does not cope with this.

Several members questioned exactly what needed to be clarified. If you start changing the way you look at tax bases there could be unintended consequences.  Many members thought this was more than an agenda decision.

No vote called. The staff will bring back a paper to look at a possible interpretation. In that vein, a member suggested that the staff try to group different types of transaction to see if the type of transaction lends itself to particular thinking. One member said that it needs to work both ways, when the book basis is zero but there is a tax asset or liability.

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