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Deferred Taxation 3
CHAPTER THREE
DEFERRED TAXATION - WHAT IS IT?
Executive Summary
A
The aim of deferred taxation is to ensure a consistent rate of tax on the profits of an
entity, regardless of the timing of various tax adjustments. The deferred tax provision
was called, very many years ago, the tax equalisation account, and this provides an
insight into its function.
B
Deferred tax accounting involved some very subjective judgements for a period up to
2000. For this reason it has been viewed with some considerable suspicion by those
without an intimate knowledge of its inner workings. Since 2000 Financial Reporting
Standard 19 (“FRS 19”) (the relevant standard under UK GAAP) has required a far
less subjective approach.
C
The relevant standard under international financial reporting standards or IFRS is
IAS 12. This has a slightly different approach to deferred tax accounting but the
fundamentals are the same in the two systems: neither involve subjectivity in any
material way.
D
As subjectivity has now been largely stripped from accounting for deferred tax it is a
subject that can be embraced by the non-Accountant with rather greater confidence
than previously.
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1
Introduction
1.1
One of the themes of this book is to reach for an example when trying to explain a
relevant concept. This is what we are doing in order to explain the reason for
deferred tax. In chapter 2 we gave the simple example of Rickinghall Printers Limited
which bought a piece of equipment for £10,000 and depreciated it over ten years.
The depreciation charge was therefore £1,000 a year. The capital allowances in the
first four years were £2,000, £1,600, £1,280 and £1,024 respectively. In year 8 the
capital allowances were £419. If the Company made a steady profit of £2,000 a year,
assuming a constant corporation tax rate of 20%, we can see the differences in the
tax charges over the first 4 years. This is on the assumption that the depreciation
and capital allowances on this equipment were the only adjusting items on the tax
computations. We are also showing the result for year 8 in order to illustrate the
trend:
Year
1
2
3
4
8
£
£
£
£
£
2,000
2,000
2,000
2,000
2,000
Add: Depreciation
Less: Capital allowances
Taxable profits
1,000
(2,000)
1,000
1,000
(1,600)
1,400
1,000
(1,280)
1,720
1,000
(1,024)
1,976
1,000
__(419)
2,581
Tax payable at 20%
Profit after tax
__200
1,800
__280
1,720
__344
1,656
__395
1,605
__516
1,484
Effective rate of tax
10.0%
14.0%
17.2%
19.75%
25.8%
Profits
1.2
In this example it can be seen that the tax charged on the same level of profits
virtually doubles between years 1 and 4, as the capital allowances reduce. This trend
then continues as is shown in year 8. The fact that the capital allowances are
available rather more quickly than the equipment is depreciated has the effect of
moving the tax payments towards the final five years, rather than the first five years
of the life of the equipment.
1.3
Deferred taxation works in such a way that the tax benefit which has been gained in
the first 4 years is deferred (for accounting purposes only), and is then used to
reduce the higher tax charge that arises in the later years. It has no impact on cash
flows.
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1.4
If a charge for deferred taxation is included in the accounts, the profit and loss
accounts appear as follows:
Year
Profit per accounts
Corporate tax charge
Deferred tax charge/(credit)
Total tax charge
Profit after tax
Effective rate of tax
1
2
3
4
8
£
£
£
£
£
2,000
2,000
2,000
2,000
2,000
200
200
400
280
120
400
344
_56
400
395
__5
400
1,600
1,600
1,600
1,600
1,600
20%
20%
20%
20%
20%
516
(116)
400
1.5
There are a range of timing adjustments apart from the differences between
depreciation and capital allowances. It is the province of deferred tax to deal with
such timing differences.
1.6
In Chapter 2, dealing with corporation tax, we used the example of Hauleigh
Horsegear Limited: you will recall that we separated the adjustments in the tax
computations between those which were absolute, as they increased the effective
overall rate of tax, and those which were timing, as they had the effect of moving the
profits into different periods for tax purposes.
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The tax computation is given below:
Tax
Computation
£
Profit per accounts
1,500,000
Absolute adjustments
Add:
Disallowed legal costs
Disallowed entertaining expenditure
Profit plus absolute adjustments
42,000
___58,000
1,600,000
Timing adjustments
Add:
Depreciation on plant, furniture and equipment
Closing general bad debt provision
Closing unpaid pension contribution
Timing
adjustments
£
392,000
270,000
110,000
(392,000)
(270,000)
(110,000)
Less:
Capital allowances
Opening general bad debt provision
Opening unpaid pension contribution
Adjusted profit for the year
(362,000)
(350,000)
__(80,000)
1,580,000
362,000
350,000
80,000
Less: Losses brought forward
Taxable profits
_(580,000)
1,000,000
580,000
_______
600,000
Total timing differences
Corporation Tax payable: £1,000,000 at 24%
Deferred Tax charge: £600,000 at 24%
Total tax charge
240,000
144,000
384,000
168,000
1.7
The deferred tax charge is £600,000 at 24%, which is £144,000. In order to
understand this charge against profits, we need to understand its constituent parts:
1.7.1
the depreciation is £392,000 and the capital allowances are £362,000. The capital
allowances and depreciation on plant, equipment vehicles, furniture, etc., are equal
over the life of the asset: however, the charges in the accounts for this capital
expenditure is at a different rate from that at which capital allowances are available.
There is therefore a mismatch between the accounts and the tax treatment.
1.7.2
In earlier years the capital allowances will have exceeded the depreciation charge.
So that these years did not gain the benefit of a lower tax charge, and knowing that
the reverse would apply in the future, the reduced tax charge of that earlier year was
increased by a deferred tax charge. The opposite now applies and there is a
deferred tax credit of £30,000 (£392,000 - £362,000) at 24% which is £7,200.
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1.7.3
The closing bad debt provision is £270,000 but the opening bad debt provision was
£350,000. The difference between the two is £80,000. As this provision was not
treated as deductible for tax purposes when it was created, its release is similarly
non taxable. A general bad debt provision should always reverse at some stage: it is
either released to the profit and loss account, giving a tax-free boost, or it is
allocated against specific debts, at which point it becomes a deductible provision.
1.7.4
When the general bad debt provision was created there was a charge in the profit
and loss account but no tax relief granted. Therefore this triggered a deferred tax
credit, in recognition that this credit would reverse when the general bad debt
provision was released. There is a partial release in the current year and this
therefore leads to a deferred tax charge of £80,000 at 24% which is £19,200.
1.7.5
The unpaid pension contribution works in a similar way: this is £110,000 at the year
end and was £80,000 at the prior year end. By adding back the closing unpaid
contribution and deducting the opening unpaid contribution the charge in the
accounts is effectively switched from a matching or accruals basis onto a cash basis.
Therefore the pension contributions which are deductible are those paid in the year
which are £30,000 (£110,000 less £80,000) lower than those which were charged in
the year. This therefore leads to a deferred tax credit of £30,000 at 24% which is
£7,200.
1.7.6
The final adjustment for the year is in respect of the tax losses brought forward:
these were £580,000 at the last year end. The Company had made losses in the two
earlier years: the directors therefore recognised a tax credit in the accounts of the
two years in which these losses had arisen. If they had not done this, the Company
would have made a loss before taxation, with no tax credit in respect of those losses.
Now that the losses are being utilised there is a deferred tax charge, which is
computed as £580,000 at 24% which is £139,200.
1.8
We can therefore summarise the ingredients of the deferred tax charge in the year:
Gross
£
Depreciation in excess of capital allowances
Decrease in general bad debt provision
Increase in unpaid pension contribution
Use of tax losses brought forward
Total charge for year and increase in provision
(30,000)
80,000
(30,000)
580,000
600,000
Net at 24%
£
(7,200)
19,200
(7,200)
139,200
144,000
1.9
It is therefore the objective of deferred taxation to ensure that tax charges which are
included in the accounts of various years are not distorted by the timing of reliefs
which are given by the tax system.
1.10
Deferred taxation is never payable: the concept is that charges or credits appear in
the profit and loss account as originating entries and they then reverse at a later
date.
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1.11
The components of the deferred tax provision can be identified in any company, in a
similar manner to that shown above. If we continue the above theme, and make an
assumption as to the levels of the fixed assets and the capital allowance pools, the
balance sheet representation of the above deferred tax charge is:
This Year
Gross
Net
£
£
Book amount of plant
Less: Capital allowance pools
2,981,000
1,970,000
1,011,000
242,640
Next Year
Gross
Net
£
£
2,890,000
1,849,000
1,041,000
249,840
General bad debt provision
(270,000)
(64,800)
(350,000)
(84,000)
Unpaid pension contributions
(110,000)
(26,400)
(80,000)
(19,200)
__ 631,000
__ 151,440
(580,000)
_31,000
(139,200)
__7,440
Tax losses carried forward
Total per balance sheet
1.12
The gross value of the balances in the deferred taxation account have increased by
£600,000, from £31,000 to £631,000. The net balances have increased by £144,000,
that is from £7,440 to £151,440. It may seem mysterious that these figures are
identical to the figures in the tax computations. This is not a coincidence: it is an
aspect of accounting that things balance. It is an aspect of deferred tax accounting
that it works in this way.
1.13
You should be able to identify the rationale for the equilibrium in respect of the tax
losses, the general bad debt provision and the pension liability. The transactions
within the fixed assets and capital allowances are rather more opaque. However, we
can confirm that the movements in respect of both the net book amount of the fixed
assets and the capital allowance pools, will be consistent between the profit and loss
account and the balance sheet. Such is the apparent alchemy of deferred tax
accounting.
1.14
Happily there is no need for this to remain as alchemy: this occurs as the same
figures are added to the capital allowance pool as are added to the net book amount
of fixed assets in respect of additions. Regardless of rates of writing down allowance,
the existence of long-life assets or short-life assets, the capital allowance pools will
be increased in aggregate by the increase in the eligible fixed assets. In the same
way, the disposal proceeds will be deducted from the capital allowance pools. The
net book amount of the fixed assets will be reduced on the disposal of assets: the
net book amount disposed of and the profit or loss on disposal will aggregate to the
same as the proceeds.
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2
The Accounting Standards
2.1
It is very understandable that the legal profession has viewed deferred tax with a
mixture of suspicion and hostility: deferred tax has been in existence for a
considerable period, but there have been different accounting standards which have
governed its use.
2.2
Much of the suspicion of deferred taxation, and the belief that it is entirely subjective
in its application, and should therefore play no part in legal documents, is based on
Statement of Standard Accounting Practice 15. This standard was wrestling with the
problems arising from deferred tax accounting in times of high inflation. In the
crucible of the 1970’s there were very high rates of inflation and also a front-end
loading of capital allowances: 100% allowances were given in the year of acquisition
of plant and equipment. In addition to this, for a period there was a tax
allowance given for increases in the levels of closing stocks. These heady
ingredients mixed to give a potent brew: the financial statements of companies
trading in such times were showing ever-increasing deferred taxation provisions, with
no apparent prospect of reversal.
2.3
The response to these challenges was SSAP 15: this enabled companies to follow a
policy of partial provisioning. Provided that forecasts were produced which showed
ever-increasing capital expenditure, no provision was needed for the tax arising in
respect of the accelerated capital allowances. This then enabled the tax charge in
the accounts to be lower than the headline rate: provided that there was a
combination of relatively high levels of inflation and high levels of first year
allowances, this gave a better reflection of the effective rate of tax being paid by
capital-intensive companies.
2.4
The subjectivity inherent within SSAP 15 inevitably meant that it was viewed with
some considerable caution: different assumptions in budgets could have a material
impact on the amounts of deferred tax that were provided in the financial statements.
It was therefore perhaps no surprise that the deferred tax provision was given a wide
berth by those dealing with Tax Covenants.
2.5
By the late 1990’s the climate had altered markedly: inflation had reduced very
considerably and the regime of greatly accelerated capital allowances had been
largely dismantled. The front-end loading of the tax allowances was therefore far less
prevalent than previously. These conditions provided the backdrop for Financial
Reporting Standard 19 which was introduced in December 2000. This standard
requires full provisions to be made for deferred tax. It also introduced the facility for
deferred tax balances to be both net liabilities and net assets.
2.6
There are still three areas of choice or subjectivity that exist within FRS 19, but their
impact is now very much reduced, as they do not affect the core of the Standard:
2.6.1
there is a choice as to whether or not to discount the components of the deferred tax
account for the time value of money This may be appropriate when dealing with very
long-life assets. Apart from this, discounting is unlikely to be material;
2.6.2
the second area of subjectivity is in respect of tax which may be deferred by rollover
relief, depending on future plans. Provision should not be made for deferred tax
which is to be deferred by rollover relief;
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2.6.3
if there is a deferred tax asset it should be recognised if it is more likely than not that
there will be taxable profits in the future against which the deferred tax asset can be
offset.
2.7
Evidence of the lack of subjectivity is given by the opening paragraph of FRS 19
which states: “Financial Reporting Standard 19 “Deferred Tax” requires full provision
to be made for deferred tax assets and liabilities arising from timing differences
between the recognition of gains and losses in the financial statements and their
recognition in a tax computation.”
2.8
In the examples given above of Rickinghall Printers Limited and Hauleigh Horsegear
Limited there are no subjectivities involved: the composition of the deferred tax
account is determined by the underlying facts; it is not coloured by any judgements.
2.9
IAS 12 has a very similar structure to FRS 19. There is one main area of difference
and that is that IAS 12 gives itself a wider scope. IAS 12 requires that tax is provided
on the uplift in value of fixed assets which have been revalued, whereas this is not
permitted under FRS 19. There is also a slight difference in the terminology which
reflects this different approach: FRS 19 refers to “timing differences”, whereas IAS
12 uses the phrase “temporary differences” as it seeks to embrace all differences
between the carrying amount of assets and liabilities and their tax base.
2.10
Under IAS 12 the viewpoint from which deferred tax is surveyed is the balance sheet:
if a property is revalued this creates a temporary difference: a temporary difference
is a difference between the carrying amount of an asset or liability and its respective
tax base. Under IAS 12 there is a requirement that a provision for deferred tax is
made in respect of that valuation difference.
2.11
The conceptual basis of FRS 19 is that of recognising a liability when it arises: no
liability arises when a property is revalued as this does not trigger a tax charge. Such
a charge only arises on sale. With IAS 12 the central concept is that of ultimate
realisation: every asset will be realised over time, either by consumption as its value
is gradually used up, or by disposal. The recognition of temporary differences under
IAS 12 is based on this theme of ultimate realisation.
2.12
It can therefore be seen that IAS 12 has a broader compass: it picks up many of the
liabilities which are the concern of tax warranties, such as tax base costs of assets
which are lower than the book amounts.
2.13
The discounting of deferred tax liabilities is not permitted under IAS 12.
3
Timing Differences
3.1
We have already introduced some of the more common timing differences, namely:
3.1.1
the difference between depreciation of fixed assets and the tax allowances given;
3.1.2
taxed provisions, that is provisions in the accounts which are not deductible for tax
purposes;
3.1.3
tax losses carried forward to a later period.
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3.2
There are several other types of timing difference and we will examine some of these
below.
3.3
If interest is capitalised as part of the cost of a fixed asset, or as part of the cost of
stock, such as on a large building project, it is still deductible for tax purposes as if it
had been charged directly to the profit and loss account. Such interest is therefore a
timing difference: the tax benefit arising from the interest expense has to be deferred
in the same way that the cost of the interest has been deferred. As the fixed asset is
then depreciated, this timing difference effectively reverses, as the interest is then
effectively charged to the profit and loss account by means of an increased
depreciation charge. A similar concept applies to the stock: at the point when the
cost of the stock, including the interest component, is recognised in the profit and
loss account as a component of cost of sales, then the timing difference reverses.
3.4
It is very possible that smaller items of capital expenditure may be written off to
repairs. If this happens it is necessary for the repair cost to be disallowed, and for
capital allowances to be claimed instead. This is therefore another type of timing
difference affecting fixed assets.
3.5
With defined benefit pension schemes (more commonly known as final salary
schemes) there is a requirement under FRS 17 to include on the balance sheet the
amount of the surplus or deficit in the pension scheme. The profit and loss account
should include the cost relating to providing the benefits relating to that period. This
amount is determined by the actuary and may be far removed from the contributions
actually paid to the scheme in the year. For various reasons the deferred tax effects
from this treatment are shown as part of the FRS 17 provision on the balance sheet.
3.6
The accounts of each company in a group will record its stocks of goods for resale at
the lower of cost or net realisable value. These measures will be applied to each
company as a separate entity. If chemicals are manufactured or bought by Stanton
Chemicals Limited for £8 per litre and then sold to its wholly owned subsidiary,
Ixworth Cleaning Limited for £10 per litre, the individual accounts will record the cost
of the chemicals at £8 and £10 respectively. If Ixworth Cleaning Limited has 60,000
litres in stock at the year end, it will therefore record these in its accounts at a cost of
£600,000. However, if consolidated accounts are produced, the profits of £120,000
made by Stanton Chemicals Limited are unrealised as the stocks have not yet left
the group - they remain on the balance sheet of Ixworth Cleaning Limited at a value
which includes a profit of £120,000. For the consolidated accounts these stocks are
therefore reduced in value from £600,000 to £480,000. Tax has however crystallised
in Stanton Chemicals Limited in respect of the profits made on these sales. This tax
has crystallised before the profit is realised in group terms, and therefore the charge
is deferred to the next period (for accounting purposes only), when the stocks will be
sold.
3.7
It should be noted that, under UK GAAP, the revaluation of a fixed asset does not
result in the recognition of a deferred tax liability, representing the tax on the uplift in
value. The reason for this is that this is not consistent with the conceptual framework
on which UK GAAP is built. The act of revaluation has no discernible effect on the
tax liabilities of the company. There is deferred tax under IFRS on such a
revaluation.
3.8
If however a company follows a policy of continuous revaluation of assets, such as
the use of a mark to market approach, then the tax timing differences should be
recognised.
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3.9
Tax that could be payable on any future remittance of the past earnings of an
overseas subsidiary or joint venture should be provided for only to the extent that
dividends have been treated as receivable in the UK.
4
The Discounting of Deferred Tax Liabilities
4.1
Liabilities are normally recorded in financial statements at the amount at which they
are to be settled. They are not usually discounted to reflect any delay in their
settlement. This makes eminent sense as most liabilities are either to be settled
within a relatively short period of the year end or they are entitled to interest to reflect
the delay in their settlement. There are one or two exceptions to this basic rule: one
of these is in respect of pension fund liabilities. These are normally long-term
liabilities and they may have an average payment date of 16 or more years. When
accounting for pension fund obligations the future liabilities are discounted by the
actuary to reflect the time period until settlement.
4.2
A second example where discounting may be applied is in respect of deferred tax
liabilities: this is permitted but is not obligatory under FRS 19. Discounting is normally
only appropriate when it makes a material difference. This will normally arise when
the timing differences may not reverse for some considerable period such as with
very long life assets.
4.3
We are not exploring the mechanics of the discounting of deferred tax liabilities.
However, it is important to understand whether or not the Company has discounted
the deferred tax provision for the time value of money. This should be evident from
the accounting policies or the other notes to the financial statements.
5
Deferred Tax Relief - One of the Buyer’s Reliefs
5.1
The classic Tax Covenant generally steers well clear of deferred taxation balances.
One of the exceptions is that the asset components of the deferred tax account are
recognised by the Buyer as being of value: therefore the protection of the Tax
Covenant is extended to embrace them. This is done by including such assets within
the definition of a Buyer’s Relief. There are four components to the classic definition
of Buyer’s Relief, and the first one is:
(a)
any Relief to the extent that such Relief has been taken into account in
computing and so reducing or eliminating any provision for deferred Tax
which appears in the Completion Accounts, or which but for such Relief
would have appeared in the Completion Accounts or was taken into account
in computing any deferred Tax asset which appears in the Completion
Accounts (“Deferred Tax Relief”).
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5.2
If we return to the example of Hauleigh Horsegear Limited, the gross and net values
of the asset components of the deferred tax account in the previous year are:
Capital allowance pools
General bad debt provision
Unpaid pension contributions
Tax losses carried forward
Total
Gross
£
Net at 24%
£
1,849,000
350,000
80,000
__580,000
2,859,000
443,760
84,000
19,200
_139,200
686,160
5.3
Therefore if the shares in Hauleigh Horsegear Limited had been sold sometime after
the date of the accounts of the previous year, then the above balances would have
represented the Deferred Tax Relief component of Buyer’s Relief. This is on the
assumption that the transaction did not involve completion accounts.
5.4
It is understandable that the Buyer wants the protection of the Tax Covenant
extended to cover these amounts: the level of the tax losses carried forward may
well have featured in his assessment of value when negotiating the price for the
shares.
5.5
The impact of the loss of a Deferred Tax Relief is dealt with in the definition of Tax
Liability, which is stated to include:
i)
the loss, utilisation or reduction of any Deferred Tax Relief which would
(were it not for the said loss, utilisation or reduction) have been available to
the Company in which case the amount of the Tax Liability will be the amount
of Tax which would have been saved if the Deferred Tax Relief had been
available;
5.6
We can therefore explore some of the possible events which may result in a loss of a
Deferred Tax Relief.
5.7
If it is identified after Completion that there had been a casting error in the capital
allowance pool calculations, with the effect that the pool balances were overstated by
£100,000, then this would enable a claim to be made under the Tax Covenant: if the
pool had been at the level anticipated the extra capital allowances in the first 4 years
would have been £20,000, £16,000, £12,800 and £10,240 respectively. The taxable
profits would therefore have been reduced by these amounts and the corporation tax
that would have been saved, at a rate of 24%, would have been £4,800, £3,840,
£3,072, and £2,458 respectively. The overall value of this loss of a Deferred Tax
Relief at a corporation tax rate of 24% is clearly £24,000, yet recovery of only
£14,170 has been made in the four years after Completion. As the pool balance
halves in value every 3.12 years at an allowance rate of 20%, it takes 6.2 years to
recover three-quarters of the pool and 9.4 years to recover seven-eighths, that is
87.5%.
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5.8
There is nothing particularly unjust in the above approach: this is the way that the tax
would have worked in practice, if the capital allowance pool had been greater to the
extent of £100,000. It does, however, place quite a record-keeping burden on the
Company: there is a need to maintain a record of the actual capital allowance pool
as part of the tax computations. There is then also a need to maintain a shadow
pool, so as to track the use of the Buyer’s Relief.
5.9
There are occasions when the Tax Covenant is worded in such a way that the loss of
a Deferred Tax Relief is measured on the assumption that there were sufficient
profits to allow the whole of the Relief to be used in the first accounting period after
Completion. This is not an acceptable clause as it means that the Buyer gains a
benefit which may be greatly accelerated: it is likely to put him in a better position
than he would have been in any event.
5.10
Such wording as described above may not enable the whole of the benefit to be
accelerated in any event: in the above example it is not a dearth of profits which
delays the recovery of the Deferred Tax Relief - it is the operation of the taxing
statutes. The above wording therefore creates difficulties in interpretation unless it is
also stated that it should be assumed that the lost Reliefs are immediately available,
rather than being available in accordance with the tax legislation.
5.11
If the tax computations are reviewed and amended after Completion, with £50,000 of
the general bad debt provision being allocated to specific doubtful balances, then the
effect will be that there will be a reduction of one Deferred Tax Relief (as the general
bad debt provision will now be £300,000, rather than £350,000) but there will be an
increase in another, namely the tax losses carried forward, which will have increased
by £50,000, from £580,000 to £630,000.
5.12
There has been a reduction of a Deferred Tax Relief, so the Buyer is able to recover
under the Tax Covenant. If the timing of recovery is on the assumption that profits
are sufficient to enable full utilisation of the Deferred Tax Relief, then there is an
immediate claim possible for £50,000 at 24%.
5.13
In this circumstance a Corresponding Saving would then also arise, as the increase
in the tax losses is a direct result of the decrease in the general bad debt provision.
The same would prevail if the loss only resulted in a payment at the time when the
additional tax was payable. There will always be some uncertainty as to when
general bad debt provisions should be considered to be used, as this is largely at the
behest of the Buyer.
6
The Deferred Tax Liabilities
6.1
It is an accident of evolution that Tax Covenants concern themselves with deferred
tax assets, but give no regard to deferred tax liabilities.
6.2
Liability balances in the deferred tax account include:
6.2.1
the book amount of those fixed assets which are eligible for capital allowances (or
the net of this figure and the capital allowance pool for those who consider that the
separation of these two components is artificial, on the basis that it is the difference
between them that is the figure in the deferred tax account);
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6.2.2
profits which have been included in the accounts but which have not yet been taxed,
such as profits recognised in consolidated financial statements in respect of
overseas operations, and which have therefore not been subject to UK tax;
6.2.3
costs which have been allowed for tax but which have not yet been recognised in the
profit and loss account, such as interest costs which have been capitalised or carried
in a work in progress balance;
6.2.4
under IFRS the deferred tax provision in respect of the revaluation of a property;
6.3
From the viewpoint of the Seller it seems inconsistent that the Seller is punished if a
deferred tax asset is overstated, but there is no mechanism for a recovery if the
deferred tax asset is understated, or a deferred tax liability overprovided.
6.4
Viewed from the perspective of the Buyer he can bring the full power of the Tax
Covenant to bear if a deferred tax asset is understated, but he has to rely on the
protection of the warranties if a deferred tax liability is underprovided.
6.5
We therefore need to consider whether Tax Covenants should address deferred
taxation in a different way: should we treat deferred tax balances, whether asset or
liability, on a consistent basis?
6.6
The answer to this question should be, in our opinion, a guarded but certain “yes”. It
is our view that the concentration on the cash flow effects of tax payments can be an
elegant means of ensuring equity between the two parties: there is an absolute
certainty to cash receipts and payments which is comforting. Having said that, it is
rather odd that claims can be made under the Tax Covenant for a loss, when there
has been no reduction in the net assets of the Company: for most purposes it is the
reduction in the value of the Company or in its level of the net assets which is the
measure of loss that might be expected. If a corporate tax provision is found to be
understated, it is very likely that the deferred tax provision will be overstated by the
same amount, if it relates to a timing adjustment.
6.7
We fully recognise that there are some capital-intensive companies where the timing
of tax payments is a matter of some importance, and where a switch from deferred
tax provisions to corporate tax liabilities is a material issue. However, there are very
many corporate transactions where this is not so: the business is not capitalintensive and the drivers of value have been the profit forecasts, with the multiplier
being coloured by the extent of the asset backing. In such cases it matters little in
terms of value what the split is on the balance sheet between the corporate tax
liability and the deferred tax provision: a transfer between the two would not have
had any appreciable impact on the price or the value received by the Buyer.
6.8
This is a matter on which this publication is engaged in missionary work: we believe
that the burden of post-completion record keeping when there are claims under the
Tax Covenant in respect of timing differences is likely to be totally disproportionate in
the majority of cases. In such cases we are of the view that there should be a
different approach to the Tax Covenant. In Chapter 19 we have included a Tax
Covenant prepared on the basis that timing differences are ignored. The Buyer does
not claim under the Tax Covenant if an increased tax liability now is effectively
matched by an identical saving some time later.
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6.9
The main effects of this change are:
6.9.1
the protection for the Buyer is now extended, so that a claim can be made if it is
found that a provision for deferred tax is insufficient in the Last Accounts or the
Completion Accounts;
6.9.2
the cost of confirming the existence of corresponding savings is now much reduced,
to the significant benefit of the Covenantors: many corresponding savings, in respect
of timing differences, will be a thing of the past;
6.9.3
the focus of the Tax Covenant will be to provide protection to the Buyer in respect of
Tax Liabilities broadly by reference to the reduction which has occurred to the net
assets arising from the additional tax in question;
6.9.4
the Buyer will not be burdened with making a series of claims in respect of a loss of
a Deferred Tax Relief if the loss relates to the reduction in the capital allowance
pools.
6.10
Due to this approach giving immediate credit for tax losses, it will not be appropriate
if the tax losses carried forward at Completion are material when compared to the
size of the transaction.
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