21
Taxation (SSAPs 5 and 15 and FRSs 16
and 19)
After reading this chapter you should be able to:
■ describe the requirements of SSAP 5 accounting for value added tax
■ describe the effect of the imputation tax system on accounting profits
■ describe the requirements of FRS 16
■ explain deferred tax
■ describe the arguments for and against providing for deferred tax
■ identify several possible methods of accounting for deferred tax
■ critically examine the Accounting Standards Board’s approach
■ identify and critically appraise the requirements of FRS 19 ‘Deferred Tax’.
Introduction
The amount of tax charged against profit in any period is, as we will see in Chapter 26, an
important determinate of earnings per share and thus the price earnings (PE) ratio. Unfortunately, the tax charge calculated under revenue law is not simply a matter of computing
a given rate of accounting profits, as taxable profits defined by revenue law are not the same
as accounting profits assessed in accordance with the Companies Act and SSAPs/FRSs.
We also must consider the effect of value added tax on company accounts.
Value added tax
SSAP 5 relating to accounting for value added tax (VAT) is completely uncontroversial and
is of passing interest only. The central requirements are that:
1 turnover in the P&L account should exclude VAT
2 irrecoverable VAT on fixed asset acquisition should be included with the cost of the asset;
and
3 the net debit or credit carried in the balance sheet need not be separately disclosed.
CORPORATION TAX (CT)
407
Corporation tax (CT)
The tax levied on UK corporate profits is called corporation tax and it is generally due for
payment nine months after the end of the accounting period. This rule applies unless the
company is designated as a large company which occurs when a company’s corporation
tax profits for an accounting period are more than £1.5m. Such large companies will pay
their CT in 4 quarterly instalments as follows:
6 months and 14 days after the start of the accounting period (AP)
9 months and 14 days after the start of the AP
14 days after the end of the AP
6 months and 14 days after the end of the AP
Activity 1
Company A and company B both have accounting periods ending 31 December 2000. Company
A’s taxable profits are in the region of £1m and company B’s £2m. Identify the due dates, for
each company, for payment of CT.
Activity 1 Feedback
Company B will be classed as a large company and will pay tax in 4 equal instalments
on 14 July 2000, 14 October 2000, 14 January 2001, and 14 July 2001. Company
A will not be classed as a large company and therefore will pay its CT on 14 October
2001.
The clear winner in cash flow terms is company A, the smaller company, in the above
activity. The above rules were enacted as from AP ending on or after 30 June 1999 and are
as a result of the modernisation of the tax system which reached its final stages in April
1999.
The old CT payment timing rules.
Prior to the modernisation of the CT system companies paid their CT 9 months after the
end of the AP unless they paid dividends during the year. (Note here that the revenue , by
altering the rules, have accelerated their tax cash flows from large companies). When dividends were paid during the year the revenue required advance instalments of a company’s
corporation tax. The advance instalment was calculated as the tax credit associated to a dividend payment and was due 14 days after the end of the quarter in which the dividend was
paid. These advance payments could be deducted, within limits, from the total corporation
tax bill and the remainder, known as mainstream corporation tax, was paid under the 9
month rule.
This old regime was known as the imputation tax system and, as dividends were paid by
a company out of profit after tax, the revenue took the view that tax had already been deducted from these dividends. Thus the dividend in the hands of the shareholder was assessed
as if tax had already been deducted at basic rate and a tax credit was imputed to the dividend received. The result was known as franked investment income. A simple example
explains how this used to operate for an individual.
408
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Example 1
Company S declares and pays a dividend of £80 to shareholder A. The basic rate of income
tax is 20%. If the shareholder is a basic rate taxpayer then the tax credit imputed and the
tax payable by A would be as follows:
Tax credit at 20% = 1/4 × £80 = £20
Amount received by A before tax = £80 + £20
=
£100
–––––
Tax payable by A (basic rate tax payer)
Tax deemed to have been paid
£20
£20
Tax remaining payable by A
£0
–––––
–––––
If A paid tax at 40% then:
Tax payable by A (40% tax payer)
Tax deemed to have been paid
£40
£20
Tax remaining payable by A
£20
–––––
–––––
Of course companies could themselves be shareholders and the old rules for accounting
for the imputation tax system embodied in SSAP 8 required that:
1 The total franked investment income and a tax credit based on the current income tax
rate should be disclosed in the accounts in accordance with appropriate Companies Act
presentation format
2 The tax credit thus credited to the P&L account would be debited ‘lower down’ being
included within the total tax charge for the year.
The following example demonstrates how this used to operate.
Example 2
Company A receives a dividend of £20 000 from company B. Basic rate of income tax is
20%. This would be reflected in company A’s books as follows:
Dividend received account
P&L
25 000
–––––––––
25 000
–––––––––
Cash
20 000
Taxation
charge P&L 5 000
–––––––––
25 000
–––––––––
P &L account
Tax charge
5 000
Profit after tax 20 000
–––––––––
25 000
–––––––––
Investment
Income
25 000
–––––––––
25 000
–––––––––
The above treatment was required by SSAP 8 so as to provide consistency with other
elements of profit appearing above the taxation charge line in the P&L account as these
were also shown gross.
Activity 2
Beta plc, accounting year end 31 March 1995, paid a dividend of £80 000 on 19 February 1995.
The corporation tax assessment for the company was £158 000, and was due nine months after
the accounting year end. Show the liabilities for tax that would have existed in the year end
CORPORATION TAX (CT)
409
accounts and the relevant ledger accounts (income tax rate 20%) under the old imputation tax
system rules and SSAP 8.
Activity 2 feedback
(ACT is advance corporation tax.)
Corporation tax
31.3.95 ACT recoverable
31.3.95 Bal c/d
20 000
138 000
––––––––––
158 000
––––––––––
31.3.95 P&L
1.4.95 Bal b/d
(due 31.12.95)
158 000
––––––––––
158 000
––––––––––
138 000
Dividends paid
19.2.95 cash
80 000
––––––––––
31.3.95 P&L
80 000
––––––––––
ACT payable
31.3.95 ACT rec
(due 14.4.95)
20 000
ACT recoverable
31.3.95 ACT payable
20 000
31.3.95 CT
––––––––––
(Note the use of an ACT recoverable account.)
20 000
––––––––––
Limit on offset of ACT
Offset of ACT against corporation tax was limited to an amount equal to the current basic
rate of income tax applied to taxable profits for the year. In Activity 2 if taxable profits
were £330 000 then the limit of offset would be £66 000. Excess ACT could be recovered
against the previous six years’ tax bills, always remembering the offset rules, or carried
forward for offset against future tax bills. This introduced the accounting problem of whether
or not this unrecovered ACT would be recovered in the future. Note what prudence should
have dictated here and then read on!
ACT and proposed dividends
ACT was also due on proposed dividends and was therefore shown as a liability at the yearend, but this ACT could not be offset against current year’s tax only future year’s tax. We
therefore had a debit balance appearing on the ACT recoverable account at the year-end.
The question we needed to answer in respect of this debit balance was, is it an asset? What
would prudence have dictated?
SSAP 8 which was issued in 1974, ‘The treatment of taxation, under the imputation
system in the accounts of companies’ gave us an answer to the above problem as
follows:
410
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
6 For accounting purposes it is necessary to decide whether recovery of the ACT
is reasonably certain and foreseeable or whether it should be written off in the
profit and loss account. If the taxable income of the year under review and the
amounts available from the preceding year or years are insufficient to cover
the ACT, then recoverability of ACT will depend on the extent to which income
is earned in future periods in excess of dividends paid or on the existence of
a deferred taxation account of adequate size. Although the relief remains available indefinitely it will be prudent to have regard only to the immediate and
foreseeable future; how long this future period should be will depend upon
the circumstances of each case, but it is suggested that where there is no
deferred taxation account it should normally not extend beyond the next
accounting period.
8 Any irrecoverable ACT (i.e. ACT the recoverability of which is not reasonably certain and foreseeable) should be written off in the profit and loss account
in which the related dividend is shown.
Accounting treatment of irrecoverable ACT
SSAP 8 states:
9 There are two differing views on the presentation in the profit and loss account
of irrecoverable ACT written off. One view is that irrecoverable ACT should
be treated as part of the tax charge upon the company to be deducted in arriving at profits after tax: the other that the irrecoverable ACT, being a cost stemming from the payment of a dividend, should be treated as an appropriation
like the dividend itself. Of the two methods the first is supported as the appropriate accounting treatment because unrelieved ACT constitutes tax upon the
company or group, as opposed to tax on the shareholders, and is not an appropriation of profits. It is appreciated however that some readers or analysts of
accounts may wish for their purposes to regard irrecoverable ACT in some
other manner. The amount of irrecoverable ACT should therefore be separately
disclosed if material.
Thus, the irrecoverable ACT affected the profit after tax figure and therefore earnings
per share (eps).
Another twist
The imputation tax system allowed companies to reduce the ACT payable by the amount
of tax credit on franked investment income (FII) received by the company if it was received
in the same quarter as the dividend was paid. Note that this allowance did not reduce the
amount of the tax bill in any way just the timing of payments. However, consider the following activity.
ACCOUNTING TREATMENT OF IRRECOVERABLE ACT
411
Activity 3
A company proposes a dividend of £28 000 at the accounting year-end, 31 March 1996, when
the income tax rate is 20%. The company expects to receive dividends of £8000 from one of
its investments on 2 May 1996. Which liability should the company have shown in its year-end
accounts – £7000 or £5000?
Activity 3 feedback
ACT payable is 1/4 × £28 000 = £7000 which is due in less than one year and would therefore appear as a liability on the balance sheet.
However, if investment dividend is received on 2 May 1996 then a tax credit of £2000
would have occurred and the company paid ACT of £5000. The liability eventually paid
was thus £5000, but the liability which prudence and SSAPs (particularly SSAP 17) dictates we should declare was £7000. Strange how some companies actually reported only
the £5000 as a liability!
We make no apology for working through the old regime of corporation tax and ACT as
you will need to understand this when we come to the issue of transitional arrangements
under the new regime.
The new tax credit rules
Although ACT has now been abolished shareholders will still receive a tax credit on their
dividend income. From the 6 April 1999 the tax credit is 10% of the gross dividend and
dividends will only be taxable for companies who hold investments as trading assets and
for individuals paying high rate tax.
Activity 4
Alpine plc has taxable profits for the year ended 31.12.X1 of £3 000 000. Corporation tax rate
is 30%. Alpine paid a dividend of £500 000 on 31.5.X1.
Calculate the tax payable and the tax payments under the previous regime, assuming ACT is
1/4 for the year in question, and under the new regime.
Activity 4 Feedback
Previous regime;
Total tax payable is £3 000 000 × 30% = £900 000. ACT on dividend is £500 000 × 25%
= £125 000. Payments are £125 000 July X1 and £775 000 September X2.
New regime;
Total tax payable is still £900 000 but payments are now £225 000 July X1, £225 000
October X1, £225 000 January X2 and £225 000 April X2. Note Alpine is classed as a large
company.
412
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
FRS 16 current tax
In December 1999 the ASB finally withdrew SSAP 8, which was based upon the old tax
system, by the issue of FRS 16. This deals with accounting for tax under the new tax
regime with the exception of deferred tax which we will deal with later in this chapter.
The new tax regime, by abolishing ACT, made accounting for tax much simpler but
transitional arrangements were required for the move from one tax regime to the other
and the problem of how to deal with tax credits on dividends received still needed
resolving.
Transitional arrangements
These are identified in an appendix to FRS 16 and are essentially a shadow ACT system.
The shadow system is designed to ensure that ACT c/f after April 1999 is recovered only
if it would have been recovered had the ACT system still existed. It was estimated that there
was approximately £7bn surplus ACT still awaiting recovery when the legislation was
changed. All of this £7bn will now be subject to the shadow arrangements which will allow
offset against future tax bills (and actually reduce the tax bill) but only up to the amount
that could have been offset if ACT had continued.
Activity 5
Apex plc has surplus ACT of £100 000 and taxable profits for the year ended 31.3.2000
of £250 000. It pays a dividend at the year end of £60 000 and received at that time a
dividend of £16 000. Corporation tax rate is 30% and income tax rate 20%, implying
an ACT rate of 25%. Identify the ACT set-off possible under the transitional arrangements of
FRS 16.
Activity 5 Feedback
If ACT still applied Apex plc would be liable to pay in ACT
25% × £60 000 – tax credit on dividends received of 25% × £16 000 = £11 000
Maximum offset of ACT would have been
20% × £250 000 = £50 000
New regulations CT liability of Apex plc year ended 31.3.2000 is
30% × 250 000 = £75 000
ACT set off possible
Maximum offset available
Shadow ACT
Therefore surplus to be set off is
Actual MCT payable for the year is
£50 000
11 000
–––––––––
39 000
–––––––––
(of £100 000 total surplus)
75 000 − 39 000 = £36 000
–––––––––––––––––
Surplus ACT c/f is £61 000 (100 000 − 39 000) and this can be offset in future years.
FRS 16 CURRENT TAX
413
The treatment of tax credits
Under SSAP 8 dividends received were grossed up by their tax credit and shown as income
in the P&L account and the tax credit was shown as a deduction from the P&L account
under the tax charge element. We saw this at example 2 earlier. The change in the tax regulation now requires that this method of accounting be reviewed as the majority of companies will no longer be able to recover the tax credit.
FRS 16 provides us with the following definitions:
Tax credit ‘The tax credit given under UK tax legislation to the recipient of a dividend from a UK company. The credit is given to acknowledge that the income
out of which the dividend has been paid has already been charged to tax, rather
than because any withholding tax has been deducted at source. The tax credit may
discharge or reduce the recipient’s liability to tax on the dividend. Non-taxpayers may or may not be able to recover the tax credit.’
Withholding tax ‘Tax on dividends or other income that is deducted by
the payer of the income and paid to the tax authorities wholly on behalf on the
recipient.’
There are three essential differences between tax credits and withholding tax:
■
■
■
Withholding (WH) tax is a tax that has actually been paid by the recipient (or at least
paid on his behalf).
Income on which withholding tax has been suffered is treated as taxable and subject to
further tax unless the amount of withholding tax is sufficient to discharge the liability;
whereas in many circumstances no further tax is payable on dividends received with a
tax credit. This dividend is treated as non-taxable income.
The amount at which the dividend is measured, if it is subject to further tax, is the
amount of the cash dividend received i.e. without the tax credit whereas income (dividend) subject to withholding tax is taxed on the amount received plus the withholding
tax.
FRS 16 requires that ‘Outgoing dividends paid and proposed, interest and other amounts
payable should be recognized at an amount that:
(a) includes any withholding taxes; but
(b) excludes any other taxes, such as attributable tax credits, not payable wholly on behalf
of the recipient. (para. 8 FRS 16) and
Incoming dividends, interest or other income receivable should be recognized at an
amount that:
(a) includes any withholding taxes; but
(b) excludes any other taxes, such as attributable tax credits, not payable wholly on behalf
of the recipient. (para. 9 FRS 16).
In addition the FRS also ensures that tax is correctly attributed between the P&L account
and the STRGL as follows:
Current tax should be recognized in the profit and loss account for the period,
except to the extent that it is attributable to a gain or loss that is or has been
recognized directly in the STRGL. (para. 5 FRS 16)
414
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Where a gain or loss is or has been recognized directly in the statement of total recognized gains and losses, the tax attributable to that gain or loss should also be recognized
directly in that statement.’ (para. 6 FRS 16)
Measurement of tax
FRS 16 requires that current tax should be measured at the amounts expected to be paid
(or recovered) using the tax rates and laws that have been enacted or substantially enacted
by the balance sheet date (para 14 FRS 16). Substantially enacted is where a Bill has been
passed through the House of Commons and is awaiting House of Lords approval etc. at the
balance sheet date or a resolution having statutory effect that has been passed under the
Provisional Collection of Taxes Act 1968. This brings FRS 16 in line with IAS 12 Income
Taxes.
Activity 6
The following information is available for Beta plc for the year ended 30.9 2000.
Accounting profit before taking account of dividends received or paid/proposed is £1 500 000.
Corporation tax due for the year ended 30.9.2000 is £520 000 (before taking effect of any
tax paid on the company’s behalf) which includes tax of £35 000 attributable to a gain recognized in the STRGL.
Dividends paid (cash) and proposed (cash) amount to £54 000 and £27 000 respectively and
both were subject to withholding tax of 10%. They also have attributable tax credits of £15 000
and £7500 respectively.
The company received dividends (cash) of £72 000. These had been subject to withholding
tax of 10% and have an attributable tax credit of £20 000.
The company is aware that the corporation tax rate may change from that used in the calculations above and before the due date of payment of the tax and asks for advice on how to
deal with this.
Show the profit and loss account for the period ended 30.9.2000 as far as the above information permits and advise the company in respect of the change in tax rate.
Activity 6 Feedback
Abridged profit and loss account for the period ended 30.9.2000 for Beta plc
£000
Accounting profit before dividends
Dividends received (gross up for WH tax but not tax credit)
£000
1500
80
––––––
1580
475
Corporation tax (520 − 35 − 10 see note 1)
––––––
1103
Dividends paid
(grossed up for WH tax)
Dividends proposed (but not tax credit)
60
30
90
––––––
1013
––––––
DEFERRED TAXATION
415
Note 1:
The £35 000 tax due on the gain recognized in the STRGL will also be recognized in the
STRGL. The £8000 withholding tax has been paid on behalf of the recipient company and
will be deducted from the CT due as given as the figure was calculated before taking account
of this.
The possibility of the change in tax rate will not be actioned by the company as FRS 16
requires that current tax should be measured at the amounts expected to be paid using the
tax rates and laws that have been enacted or substantively enacted by the balance sheet date.
Neither enaction or substantive enaction by the balance sheet date of 30.9.2000 is suggested
by the information given above.
Disclosure requirements of FRS 16
These are quite straightforward and require a company to disclose UK or Republic of Ireland
tax and foreign tax separately both for the P&L account and the STRGL.
Deferred taxation
Introduction
In the UK the amount of tax payable by a business for a particular period often bears little relationship to profit as reported by the accountants in the P&L account. The tax authorities (the Inland Revenue) take the accountant’s reported profit figure as their starting point,
but they make all sorts of adjustments to it. These adjustments are presented by Parliament
in the Finance Acts. There is at least one Finance Act each year, sometimes two. This
process enables Parliament to make fairly rapid changes (and often extremely frequent
changes). The separation of taxable profit from accounting profit also means that Parliament
can pursue its objectives (whatever they are!) without treading on the accountants’ toes,
and similarly the accountants can pursue their true and fair view unhindered by tax legislation. This separation, although common in the English-speaking world, is by no means
universal. Much of mainland Europe, for example, requires tax adjustments to be incorporated in the published accounts.
The most important difference between the accountant’s profit and the taxable profit concerns the treatment of depreciation. As we have seen (Chapter 16) the ‘appropriate’ charge
for depreciation is a highly uncertain, subjective, amount. This would be unacceptable to
the Revenue, who requires certainty and precision. Additionally governments have frequently felt that by varying the tax allowances, they can provide incentives to businesses
to invest more, or to invest in some particular way. So the first thing that the Revenue does
to the accountant’s profit figure, as calculated and published, is to remove all the depreciation entries put in by the accountant. In other words the depreciation figure, which will
have been deducted in arriving at the accountant’s profit figure, is simply added back again
(a profit on disposal that will have been added by the accountant will of course need to be
removed by deduction). From the resulting figure the Revenue now deducts whatever the
appropriate Finance Act tells them to, under the heading of ‘capital allowances’. The implications arising from this have led to a long, complicated and sometimes badly argued debate
over the last three decades.
416
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
What is deferred tax?
First let us look at the difference between taxable profits and accounting profits.
Activity 7
An asset attracting 25% capital allowances per annum costs Deftax Ltd £100. It has an expected life of five years at the end of which it is estimated it can be sold for £25. Taxation is payable
at the rate of 33%. Complete the following table (note that capital allowances apply to the
reducing balance of the asset).
accounting profit (after
depreciation charge)
depreciation
capital allowance
taxable profit
profit before tax
taxation 33% taxable profit
profit after tax
profit before tax
taxation charge calculated
on accounting profits
profit after accounting tax
1
£
2
£
100
100
1
£
2
£
100
15
25
100
15
18
90
Year
3
£
4
£
5
£
100
100
4
£
5
£
100
15
14
100
15
11
100
15
8
97
101
104
107
100
30
100
32
100
33
100
34
100
36
70
68
67
66
64
100
100
100
100
100
33
33
33
33
33
67
67
67
67
67
100
Activity 7 feedback
accounting profit (after
depreciation charge)
depreciation
capital allowance
taxable profit
profit before tax
taxation 33% taxable profit
profit after tax
profit before tax
taxation charge if calculated on
accounting profit
profit after accounting tax
Year
3
£
WHAT IS DEFERRED TAX?
417
The profit after tax figures, which are used for the eps and PE ratio (see Chapter 26) would
indicate that in year 2 the performance of the company decreased and continued to do so
for the next three years. But has the firm and the management been less successful?
Arguably not! Over the five-year period the company has made the same accounting profit with the same resources each year (excluding the problems of historical cost here). Thus,
the profit after accounting tax figures provides a better guide to performance of the
company.
If we look carefully at the above table we note that the total tax charge is £165 over the
five-year period using either method. Thus the use of capital allowances does not alter the
total tax due, only the timing of those tax payments. The capital allowance has the effect
of deferring tax payments in year 1, £3 and year 2, £1, and then collecting these in year 4
and 5.
So we have an eventual payment that relates to year 1 and 2 and arises as a result of the
transactions and results of years 1 and 2 and it is therefore arguable that there is a liability created at year 1 and increased at year 2. We are in effect suggesting that:
1 The tax charge for year 1 and year 2 should really be £33, as this is the amount that
must eventually be paid as a result of the year 1 and 2 activities.
2 There is a liability of £3 at the end of year 1, in respect of tax related to year 1 but payable
in later years which increases to £4 by the end of year 2.
We can easily allow for both these considerations by creating a liability account, known
as a deferred tax account. This is shown in the table below. The amount to be transferred
to the credit of the deferred tax account can be formally calculated as follows.
Amount equals:
Tax rate × (capital allowances given – depreciation disallowed)
Thus for year 1:
33% × (25 − 15) = 3
and year 2:
33% × (18 − 15) = 1
Year
Profit before tax
Taxation: payable for year
Additional charge (credit) to
deferred tax account
Total tax charge
Profit after tax
1
£
100
30
2
£
100
32
3
£
100
33
4
£
100)
34)
5
£
100)
36)
Total
£
500
165
3
33
1
33
0
33
(1)
33)
(3)
33)
0
165
–––––
67
–––––
–––––
67
–––––
–––––
67
–––––
–––––
67)
–––––
–––––
67)
–––––
–––––
–––––
335
418
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Deferred tax account
Balance c/d 31.12.01
£
3
––
3
––
Balance c/d 31.12.02
4
––
4
£
Appropriation account
31.12.01
Balance b/d 1.1.02
Approp. Acc. 31.12.02
––
Balance c/d 31.12.03
Approp. Acc 31.12.05
Balance b/d 1.1.03
1
3
––
4
––
3
Balance b/d 1.1.04
––
For year 4
33% × (11 − 15) = −1
3
1
––
4
––
4
––
4
––
Approp. Acc. 31.12.04
Balance c/d 31.12.04
3
––
3
––
Balance b/d 1.1.05
4
––
4
––
4
––
4
––
3
––
and year 5
33% × (8 − 15) = −3
So the transfer for year 4 is a debit to deferred tax account of £1 (or in effect, a credit of −
£1, if you find that easier to see), and a credit of £1 to the appropriation account. For year
5 we have a debit to deferred tax account of £3 and a credit of £3 to the appropriation
account.
Arguments for deferred tax
From the above discussion we can note that:
1 The tax charge by including deferred tax is £67 for years 1–5, which provides a profit
after tax figure which reflects the performance of the company.
2 There is a liability balance remaining at the end of each year in respect of tax related to
the current or earlier years but not yet paid or due for payment. This, we also suggested, was a desirable outcome.
3 The total position viewed over the five years as a whole remains unaltered. This is to be
expected as nothing we are doing, and also nothing that Parliament is doing, through
capital allowances, alters the total tax eventually payable as a result of a year’s profits.
All the above appears totally logical and in accord with accounting principles. So where
is the problem?
Arguments against deferred tax
A problem occurs with the previous logic if a company buys assets regularly, which is a
realistic assumption as companies tend to become more capital intensive. Let us demonstrate the problem with an activity.
ARGUMENTS AGAINST DEFERRED TAX
419
Activity 8
In addition to the information given in Activity 7 Deftax Ltd buys an asset in year 2 for £100, one
in year 3 for £120 and one in year 4 for £220 and two in year 5 for £250 and £300, respectively.
All these assets also have an expected life of five years, but unlike the first asset, all these later
ones have an expected scrap value of zero. Complete the table in Activity 7 using the new information and show the deferred tax account over the five-year period. Comment upon the results.
Activity 8 feedback
Year
1
£
100
15
25
2
£
100
35
43
3
£
100
59
62
4
£
100
103
103
5
£
100
213
215
Taxable profit
90
92
97
100
98
Tax charge
Deferred tax charge
30
3
30
3
32
1
33
0
32
1
Accounting profit
Depreciation
Capital allowance
Total tax
33
33
33
33
33
Profit after tax
67
67
67
67
67
To help you with the above activity we provide the workings for years 2 and 3 for the calculation of depreciation and capital allowances. Years 4 and 5 follow the same pattern.
Workings:
Year 2:
Asset 1 depreciation 75/5 =
Asset 2 depreciation 100/5 =
15
20
––––
35
––––
Asset 1 capital allowance 25% × 75
Asset 2 capital allowance 25% × 100
Year 3:
Asset 1 depreciation
=
Asset 2 depreciation
=
Asset 3 depreciation 120/5 =
= 18
= 25
––––
43
––––
15
20
24
––––
59
––––
Asset 1 capital allowance 25% × (75 − 18)
Asset 2 capital allowance 25% × (100 − 25)
Asset 3 capital allowance 25% × 120
= 14
= 18
= 30
––––
62
––––
420
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Deferred tax account
Balance c/d 31.12.01
Balance c/d 3 1.12.02
Bal. c/d 31.12.03
Bal. c/d 31.12.04
Bal. c/d 31.12.05
3
––
3
––
6
––
6
––
7
––
7
––
7
––
7
––
8
––
8
––
3
Appropriation a/c
3
Bal. b/d 1.1.02
3
Appropriation a/c
6
Bal. b/d/ 1.1.03
1
Appropriation a/c
7
Bal. b/d 1.1.04
0
Appropriation a/c
7
Bal. b/d 1.1.05
1
Appropriation a/c
8
Bal. b/d 1.1.06
––
3
––
––
6
––
––
7
––
––
7
––
––
8
––
31.12.01
31.12.02
31.12.03
31.12.04
31.12.05
Comparing the tables from Activities 7 and 8 we see that the total position over the five
years is no longer the same. The total tax charge is increased by £8. This is not surprising,
as it equals the liability provided for at the end of year 5 on the deferred tax account. The
transfer to the deferred tax account can be seen to be the result of an amalgam of positive
originating timing differences relating to depreciation. The resultant figure of profit after
tax, £67 per annum, reflects the underlying profitability of the company. It does not give
an impression of improved profitability because of the effect of tax allowances related to
asset acquisitions. Everything appears fine so where is the problem? The problem is the £8
remaining on the deferred tax account. Does this liability actually exist?
In the long term we can suggest that:
1 If the company reaches the state where it has a constant volume of fixed assets, merely
replacing its existing assets as they wear out, and also the price it has to pay for replacement fixed assets does not rise over time, then the balance of liability on the deferred
tax account will remain a more or less constant figure.
2 If the company finds that it is effectively in the position of paying gradually more and
more money for fixed assets each year, then the balance of liability on the deferred tax
account will gradually rise, apparently without limit.
3 Only if the monetary amount of reinvestment in fixed assets actually falls will the balance of liability on the deferred tax account start to fall.
How likely is each of these three outcomes? In general 2 will tend to be the most frequent for three reasons:
1 firms have a tendency to expand
2 firms have a tendency to become more capital intensive
THE ACCOUNTANTS’ RESPONSE
421
3 inflationary pressures tend to cause the amount of money paid for assets to increase over
time.
So the most likely outcome, if full provision is to be made for deferred tax in this way,
is of a liability figure on the balance sheet that is apparently ever-increasing. But what is a
liability? Informally, we can say that it is an amount to be paid out in the future. We have
an account representing a liability to the Inland Revenue. The balance on this account is
gradually getting bigger and bigger and, as far as can reasonably be foreseen, this process
is going to continue. Therefore the liability balance does not seem to be getting paid, nor,
in the foreseeable future is it likely to be paid. Therefore it appears that it is not a liability
at all within the meaning of the word liability! If the liability account seems all set to keep
on growing, is there a probable future sacrifice?
It should be observed that one way of summarizing the two arguments as regards the liability aspect is that we can consider the position for each individual asset, or we can consider the position for all assets in the aggregate. In the former case the tax ‘deferred’ will
all have become payable by the end of the asset’s life, so deferred tax provision would seem
to be necessary. In the latter case the aggregate liability is likely to go on increasing so
deferred tax provision would seem to be unnecessary.
The accountants’ response
Formally, three approaches have been distinguished:
1 The flow-through approach, which accounts only for that tax payable in respect of the
period in question, i.e. timing differences are ignored.
2 Full deferral, which accounts for the full tax effects of timing differences, i.e. tax is
shown in the published accounts based on the full accounting profit, and the element
not immediately payable is recorded as a liability until reversal.
3 Partial deferral, which accounts only for those timing differences where reversal is likely to occur in aggregate terms (because, for example, replacement of assets and expansion is expected to exceed depreciation).
These alternatives are discussed and explained in the following activities.
Activity 9
Should the flow through approach be identified as the method to be used for accounting for
tax?
Activity 9 feedback
Arguments in favour:
■
■
Tax is assessed on taxable profits not accounting profits. The only liability for tax for
the period therefore is that accordingly assessed.
Future years’ tax depends on future events and is therefore not a present liability (see
definition of liability from the Statement of Principles)
422
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
■
Even if current events were giving rise to future tax liabilities then, as the tax charge
will be based on a complex set of future transactions, it cannot be measured with reliability and therefore should not be recognized.
Arguments against:
■
■
As tax charges can be traced to individual transactions and events then any future tax
consequences arising from these should be provided for at the outset
Flow through method can understate an entity’s liability to tax.
SSAP 11 Accounting for deferred tax issued 1975 rejected flow through as did its successor SSAP 15 issued 1978 and the revised version 1985. The latest statement from the
ASB on the issue, FRS 19 Deferred Tax, still rejects the flow through approach.
The ASB also provides another reason for rejecting the flow through approach, ‘flow
through accounting would not have moved the UK accounting more into line with international practice’ (FRS 19 Appendix V para 21).
Activity 10
Should the full deferral method be adopted as the method to be used for accounting for
tax?
Activity 10 feedback
This was the approach recommended by the ASC in their first standard in 1975, as outlined in paragraph 9 of SSAP 11:
The view is taken that the amount of the tax saving should not appear as a benefit
of the year for which it was granted, but should be carried forward and re-credited to the profit and loss account (by way of reduction of the tax charged therein) in the year or years in which there are reversing time differences. The account
in which these deferred tax savings are held, has, by custom, become known as
the ‘deferred taxation account’.
In effect, therefore, the full unreversed element is shown as a liability.
Applying this to the circumstances of Deftax Ltd, we arrive at the position in Activity
7. Thus we could well be showing a liability that will never crystallize.
Activity 11
Should partial deferral be the method adopted for accounting for tax?
Activity 11 feedback
As we have seen, the one major problem with full deferral is that the balance on the deferred
tax account is likely to increase continuously where there is expansion and replacement at
increased prices. If, however, timing differences are regarded in aggregate terms rather than
THE ACCOUNTANTS’ RESPONSE
423
as relating to individual assets, then this could be taken as evidence that the differences were
not reversing. In short, is a liability that is never likely to become payable, a liability
at all?
The ASC’s second standard on deferred tax, SSAP 15 (1978), followed this approach,
as explained below:
In many businesses timing differences arising from accelerated capital
allowances are of a recurring nature, and reversing differences are themselves offset, wholly or partially, or are exceeded, by new originating differences thereby
giving rise to continuing tax reductions or the indefinite postponement of any
liability attributable to the tax benefits received. It is therefore appropriate that
in the case of accelerated capital allowances, provision be made for deferred taxation except in so far as the tax benefit can be expected with reasonable probability to be retained in the future in consequence of recurring timing differences
of the same type.
However the successor to SSAP 15, FRS 19, rejects the partial provision method for the
following reasons:
■ the recognition rules and anticipation of future events are subjective and inconsistent with
the principles underlying other aspects of accounting, particularly the principle that
liabilities should be determined on the basis of obligations rather than management
decisions or intentions
■ SSAP 15 was already inconsistent at it had been amended in 1992 to account for longterm deferred tax assets associated with post-retirement benefits on a full provision basis
■ comparability between companies in the deferred tax area was reduced as similar companies with similar circumstances were making different judgements on the amount of
deferred tax to be provided
■ by adopting partial provision the UK was out of step with standard setters in other countries who were rejecting it, particularly the US FASB and the IASB.
Activity 12
On the assumption that the directors of Deftax Ltd foresee no reversal of timing differences for
some considerable time, and using the information from Activity 7, show the taxation effect
using the partial deferral method.
Activity 12 feedback
Profit before tax
Taxation
Deferred tax charge
1
£
100
30
0
––––––
70
––––––
2
£
100
30
0
––––––
70
––––––
Year
3
£
100
32
0
––––––
68
––––––
4
£
100
33
0
––––––
67
––––––
5
£
100
32
0
––––––
68
––––––
424
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Deferred tax calculation
Year
Originating (O) timing
Difference
1
10 (25 capital allowance
−15 depreciation)
2
18 (43 − 35)
3
6 (30 − 24)
4
11 (55 − 44)
5
28 (138 − 110)
6 onwards no net reversals.
Reversing (R) timing
Difference
–
Net timing
Difference
10 (0)
–
3
11
26
8 (0)
3 (0)
(0)
2 (0)
The liability for tax will never crystallize therefore no provision for deferred tax. No net
reversal appears ever to be expected.
Activity 13
A company Partax Ltd acquires a fixed asset for £100 in year 1 with residual value at end of
useful life £20 and another for £200 with nil residual value in year 5. Assuming, assets are depreciated using straight line and a life of five years, that profits before tax are £250 per annum,
that corporation tax is 33%, assets receive a 25% capital allowance, and that after year 5 new
assets will be acquired annually, show the taxation charges using partial deferral method of
provision for the first four years.
Activity 13 feedback
Profit before tax
Depreciation
1
£
250
16
–––––––
266
Capital allowance
Taxable profit
Tax 33%
Deferred tax
Total tax
Deferred tax calculation
Originating
1
9
2
3
3
–
4
–
5
10
25
–––––––
266
19
–––––––
247
–––––––
–––––––
82.3
–––––––
–––––––
82
–––––––
Reversing
–
–
3
5
8
–––––––
266
–––––––
241
–––––––
80
2.3
Year
3
£
250
16
2
£
250
16
14
–––––––
252
–––––––
82
–
4
£
250
16
–––––––
266
11
58
–––––––
–––––––
–––––––
82
–––––––
82.3
82.4
Thereafter should be originating as assets are bought annually.
306
–––––––
248
–––––––
84
(1.6)
Net
9O
3O
2R
5R
2O
–––––––
–––––––
255
–––––––
83
(0.7)
–––––––
–––––––
5
£
250
56
82
–
FRS 19 REQUIREMENTS
425
Reversals of 7 need to be provided for in total, thus a deferred tax provision of £2.3 is
required at year 1 (7 × 33%). This very clearly illustrates that the deferred tax is only being
‘partially’ provided for.
FRS 19 ‘Deferred tax’
In December 2000 the ASB issued its new standard on deferred tax which was based on
FRED 19 and the preceeding discussion paper of 1995. The discussion paper explored again
the three methods of providing for deferred tax: flow through, full provision and partial provision. It argued the case for full provision in that:
■
■
It is consistent with international and USA standards
It is based on the position of the entity at the balance sheet date, not on an assessment
of future transactions, but acknowledges that it can give rise to a deferred tax liability
that may not become payable.
However, this non-payment will be due to future transactions not past. This is consistent
with the ASB’s definition of a liability in its Statement of Principles – an obligation to transfer economic benefits as a result of past transactions or events.
We can also argue the case for partial provision. As partial provision provides for the
probable obligation to transfer economic benefits then this is the liability that should be
shown. Any other probable, possible or remote deferred tax provision should then be dealt
with using FRS 12 Provisions, contingent liabilities and contingent assets.
The discussion paper suggested that the apparent overstatement of the deferred taxation
liability could be dealt with by using discounting – a further major complication for consideration.
FRS 19 supersedes SSAP 15 for those accounting periods ending on or after 23 January
2002 but earlier adoption, as usual, was encouraged.
FRS 19 requirements
Method of provision
The standard requires full provision to be made for deferred tax assets and liabilities arismg from timing differences between the recognition of gains and losses in the financial statements and their recognition in a tax computation. It clearly states in the FRS that transactions
or events that give the entity an obligation to pay more or less tax in the future must have
occurred by the balance sheet date and this is in accordance with the ASB’s definition of
an asset or liability.
The FRS requires deferred tax to be recognized on timing differences attributable to:
■
■
■
■
■
accelerated capital allowances
accruals for pension costs and other post-retirement benefits that will be deductible for
tax purposes only when paid
elimination of unrealised intragroup profits on consolidation
unrelieved tax losses
other sources of short-term timing differences
and prohibits the recognition of deferred tax on timing differences arising when:
■
■
a fixed asset is revalued without there being any commitment to sell the asset
the gain on sale of an asset is rolled over into replacement assets
426
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
■
the remittance of a subsidiary, associate or joint venture’s eamings would cause tax to
be payable, but no commitment has been made to the remittance of the earnings. (FRS
19 Summary para. (b)(a and b)).
There is one interesting exception to the above requirements and that is:
As an exception to the general requirement not to recognise deferred tax on revaluation gains and losses, the FRS requires deferred tax to be recognised when
assets are continuously revalued to fair value, with changes in fair value being
recognised in the profit and loss account. (FRS 19 Summary para.(c))
The assets to which this paragraph applies are those that are ‘marked to market’. Thus we
would include investments and current assets here where fluctuations in value are recognised in the profit and loss account.
Discounting
The FRS permits but does not require entities to adopt a policy of discounting deferred tax
assets and liabilities. This is a change from FRED 19 which proposed discounting should
be mandatory. This optional approach to discounting could lead to a loss of comparability
between companies but the ASB argued that this would not be the case as:
providing discounting was applied consistently from one period to the next, and
the impact of discounting on the financial statements was highlighted clearly there
would not be a serious loss of comparability if not all entities discounted deferred
tax. (FRS 19 appendix V para 10 1(c))
We could question whether the user of the financial statements would actually understand
the discounting impact. It is also worth noting that although the ASB adopted a full provision approach to deferred tax on the grounds of international harmonisation, they were
less concerned with it as far as discounting was concerned. With reference to discounting
the ASB state at appendix V para 101(b) ‘A methodology was being introduced in the UK
before an international concensus had been reached.’ However the IASB is as part of its
project on discounting considering whether deferred tax should be discounted.
Where a reporting entity opts for discounting of deferred tax assets and liabilities to reflect the time value of money then all deferred tax balances that have
been measured by reference to undiscounted cash flows and for which the impact
of discounting is material should be discounted. (FRS 19 para 44)
FRS 19 also determines the discount rate to be used:
post tax yields to maturity that could be obtained at the balance sheet date on government bonds with maturity dates and in currencies similar to those of the
deferred tax assets and liabilities. (FRS 19 para 52)
Example 1 (adapted from appendix 1 FRS 19)
Given that the original cost of fixed assets of an entity is £3300, depreciation to date £1000
and capital allowances to date on fixed assets £2186, calculate the deferred tax provision
required under FRS 19.
DISCOUNTING
427
Answer 1
Full provision for deferred tax is required which is calculated as
30% × (2186 − 1000) = £356.
Example 2
Further to the information given in Example 1 the following is available. It is assumed that
the reversal of timing differences will occur as follows and that government bond post tax
rates are as per column 4.
Year
col. 1
1
2
3
4
5
6
7
8
9
10
Reversal of
timing difference
col. 2
22
91
143
207
131
148
186
89
117
52
–––––––
1186
–––––––
Deferred tax
liability (at 30%)
col. 3
7
27
43
62
39
44
56
27
35
16
––––––
356
––––––
Gov. bond
post tax rate (%)
col. 4
4.7
4.4
4.2
4.0
3.9
3.8
3.8
3.7
3.7
3.7
Calculate the discounted deferred tax provision required under FRS 19.
Answer 2
FRS 19 requires us to discount at a rate equivalent to the post tax yields to maturity that
could be obtained at the balance sheet date on government bonds with maturity dates, and
in currencies similar to those of deferred tax assets and liabilities. These we will assume
are those given in column 4 above. When discounted the deferred tax liability becomes £290
(i.e. 7/(1.047)1 + 27/(1.044)2 + 43/(1.042)3 + 62/(1.04)4, etc.) The liability has in fact been
discounted by £66.
Unwinding of the discounting
The FRS requires us to show, ‘changes in the amount of discount deducted in arriving at
the deferred tax balance’ (para. 60(a)(ii)) and in the balance sheet ‘the impact of discounting
on and discounted amount of the deferred tax balance’ (para. 61(b)). Thus we need to be
able to calculate the unwinding of the discounting. Using the example above and discounting
the deferred tax liabilities from the end of year 1 onwards gives a discounted deferred tax
figure of £295 compared to an undiscounted figure of £349, a discounting effect of £54.
Comparing this with the discounting effect at year 0 of £66 identifies an unwinding of £12.
Another way to calculate this unwinding is to multiply the discounted deferred tax liabilities by the bond rate again.
428
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Year
col. 1
1
2
3
4
5
6
7
8
9
10
Discounted deferred tax
col. 2
7
25
38
53
33
35
43
20
25
11
–––––
290
–––––
Bond rate %
unwinding
col. 3
4.7
4.4
4.2
4.0
3.9
3.8
3.8
3.7
3.7
3.7
col. 3 × co. 2
0.3
1.1
1.6
2.2
1.3
1.3
1.6
0.8
0.9
0.4
––––––
11.5
––––––
This £12 will be shown as an increase to the deferred tax provision due to the unwinding
of the discounting.
Deferred tax assets
Para 23
Deferred tax assets should be recognised to the extent that they are regarded as
recoverable. They should be regarded as recoverable to the extent that, on the basis
of all available evidence, it can be regarded as more likely than not that there will
be suitable taxable profits from which the future reversal of the underlying timing
differences can be deducted.
Para 24
Suitable taxable profits from which the future reversal of timing differences could
be deducted are those that are:
(a) Generated in the same taxable entity (or in an entity whose profits would be available via group relief) and assessed by the same taxation authority as the income
or expenditure giving rise to the deferred tax asset;
(b) Generated in the same period as that in which the deferred tax asset is expected
to reverse, or in a period to which a tax loss arising from the reversal of the deferred
tax asset may be carried back or forward; and
(c) Of a type (such as capital or trading) from which the taxation authority allows the
reversal of the timing differences to be deducted.
Recognition of deferred tax in Statements of Performance
Para 34
Deferred tax should be recognised in the profit and loss account for the period,
except to the extent that it is attributable to a gain or loss that is or has been recognised directly in the statement of total recognised gains and losses.
DISCOUNTING
429
Para 35
Where a gain or loss is or has been recognised directly in the statement of total
recognised gains and losses, deferred tax attributable to that gain or loss should
also be recognised directly in that statement.
Measurement of deferred tax
Para 37
Deferred tax should be measured at the average tax rates that are expected to apply
in the period in which the timing differences are expected to reverse, based on
tax rates and laws that have been enacted or substantially enacted by the balance
sheet date. This follows FRS 16 and the liability method of providing for deferred
tax as discussed below.
The deferred tax amount is dependent on the tax rate used. When calculating the amount
we could either use:
the tax rate applying when the timing difference originated – deferral method
or the tax rate (or the best estimate of it) ruling when the tax will become payable – liability method.
A simple example is used to illustrate the difference.
■
■
Example 3
An enterprise purchases a non-current asset for £5 000 000 on 1.1.20X0. It is depreciated
on a straight line basis over five years. It attracts tax allowances of £200 000 in 20X0 and
£150 000 in 20X1. The tax rate in 20X0 is 30% and in 20X1 25%.
Depreciation charge
Tax allowance
Timing difference
20X0
100 000
200 000
100 000
20X1
100 000
150 000
50 000
Deferred tax provided
Deferred tax charge
Adjustment to carry forward
Deferred tax balance
Deferral method
20X0
20X1
30%
25%
30000
12500
30000
42500
Liability method
20X0
20X1
30%
25%
30000
12500
(5000)
30000
37500
The (5000) in 20X1 under the liability method adjusts the carry forward of 30 000 to 25 000
which is the timing difference of 100 000 at 25% tax rate. The 37 500 is now the best estimate of the tax payable if the timing differences reversed, whereas the 42 500 does not
represent the best estimate of the likely liability.
One further problem with paragraph 37 of the standard is that we are required to use the
average tax rates that are expected to apply. The average calculation will become necessary when different tax rates apply to different levels of taxable income. It will thus be necessary in these circumstances to make a judgement on the levels of profits expected in the
periods in which the timing differences are expected to reverse. This judgement of profits
could be made we presume by reference to the past.
430
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Activity 14
An enterprise operates in an environment where different tax rates apply to different levels of
taxable income as follows:
Profits
<300 000
Next 700 000
Next 500 000
Next 1m
Over 2.5m
Tax rate %
19
25
27.5
30
33
The enterprise’s taxable profits in recent years have been approximately £5m and there is no
reason to assume that this level of profits will not be achieved in the future. Calculate the average rate of tax to be used in calculating the deferred tax balances if any of the enterprise.
Activity 14 feedback
Profits (£)
300 000
700 000
500 000
1 000 000
2 500 000
Tax rate (%)
19
25
27.5
30
33
Tax (£)
57 000
175 000
137 500
300 000
525 000
5 000 000
1 494 500
Average tax rate is:
1 494 500
= 29.89%
5 000 000
Note that the average rate is highly dependent on the estimate of future profits. If in the
example above estimated future profits were only £4m then the average tax rate would
change to 29.11%.
Deferred tax presentation and disclosure
Deferred tax liabilities are required to be shown as provisions for liabilities and charges
and deferred tax assets as debtors. The exact requirements in respect of disclosure are quoted below and we also show the disclosure illustration included in Appendix 11 to the FRS.
60 The notes to the financial statements should disclose the amount of deferred
tax charged or credited within:
(a) tax on ordinary activities in the profit and loss account, separately disclosing material components, including those attributable to:
(i) changes in deferred tax balances (before discounting, where applicable) arising from:
■ the origination and reversal of timing differences;
■ changes in tax rates and laws; and
■ adjustments to the estimated recoverable amount of deferred tax
assets arising in previous periods.
DISCOUNTING
431
(ii) where applicable, changes in the amounts of discount deducted in
arriving at the deferred tax balance.
(b) tax charged or credited directly in the statement of total recognised gains
and losses for the period, separately disclosing material components,
including those listed in (a) above.
61 The financial statements should disclose:
(a) the total deferred tax balance (before discounting, where applicable),
showing the amount recognised for each significant type of timing difference separately;
(b) the impact of discounting on, and the discounted amount of, the deferred
tax balance; and
(c) the movement between the opening and closing net deferred tax balance,
analysing separately:
(i) the amount charged or credited in the profit and loss account for the
period;
(ii) the amount charged or credited directly in the statement of total
recognised gains and losses for the period; and
(iii) movements arising from the acquisition or disposal of businesses.
61 The financial statements should disclose the amount of a deferred tax asset
and the nature of the evidence supporting its recognition if:
(a) the recoverability of the deferred tax asset is dependent on future taxable
profits in excess of those arising from the reversal of deferred tax liabilities; and
(a) the reporting entity has suffered a loss in either the current or preceding
period in the tax jurisdiction to which the deferred tax asset relates.
1 Tax on profit on ordinary activities
(a) Analysis of charge in period
200Y
£m
Current tax:
UK corporation tax on profits of the period
Adjustments in respect of previous periods
40
4
––––––
Foreign tax
Total deferred tax (note 2)
Tax on profit on ordinary activities
£m
200X
£m
26
(6)
44
12
––––––
––––––
Total current tax (note 1(b))
Deferred tax:
Origination and reversal of timing differences
Effect of increased tax rate on opening liability
Increase in discount
£m
––––––
56
67
12
(14)
20
16
36
60
–
(33)
––––––
––––––
65
––––––
121
––––––
27
––––––
63
––––––
(b) Factors affecting tax charge for period
The tax assessed for the period is lower than the standard rate of corporation tax in the UK
(31 per cent). The differences are explained below:
200Y 200X
432
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
£m
361
Profit on ordinary activities before tax
Profit on ordinary activities multiplied by standard rate of
corporation tax in the UK of 31% (200X: 30%)
Effects of:
Expenses not deductible for tax purposes
(primarily goodwill amortisation)
Capital allowances for period in excess of depreciation
Utilisation of tax losses
Rollover relief on profit on disposal of property
Higher tax rates on overseas earnings
Adjustments to tax charge in respect of previous periods
–––––
–––––
112
98
22
(58)
(17)
(10)
3
4
10
(54)
(18)
–
6
(6)
––––––
Current tax charge for period (note 1(a))
£m
327
56
–––––
––––––
36
–––––
2 Provision for deferred tax
Accelerated capital allowances
Tax losses carried forward
Undiscounted provision for deferred tax
Discount
Discounted provision for deferred tax
Provision at start of period
Deferred tax charge in profit and loss
account for period (note 1)
Provision at end of period
31.12.200Y
£m
426
–
21.12.200X
£m
356
(9)
426
(80)
347
(66)
–––––
–––––
346
–––––
–––––
–––––
281
–––––
281
65
–––––
346
–––––
International aspects
IAS 12 ‘Income Taxes’ deals with deferred tax and like FRS 19 it requires deferred tax to
be recognised on a full provision basis. However IAS 12 requires recognition of deferred
tax on the basis of temporary differences rather than on the basis of obligations arising from
timing differences. Thus the IAS view focuses on a balance sheet approach to deferred tax
whereas the UK, even under FRS 19, still uses an income statement approach.
Example 4
An enterprise buys an asset for £100 depreciated over five years on a straight line basis.
Tax allowances on capital assets are 50% in the first year and tax rate is 30%. Under the
income statement approach, known as limiting difference, the deferred tax provided for at
the end of the first year is:
Tax allowance
50
Depreciation
20
Timing differences
30
DISCOUNTING
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Table 21.1
Circumstances giving rise
to deferred tax
Deferred tax required to be recognised by
FRS 19
IAS 12
1. Revaluation of
non-monetary assets
Provision is required only if either: (a) the asset
is revalued to fair value each period with
changes in fair value being recognised in the
profit and loss account; or (b) the entity has
entered into a binding agreement to sell the
revalued asset, has revalued the asset to its
selling price and does not expect to obtain
rollover relief
Provision is required whether or not it is
intended that the asset will be sold and
whether or not rollover relief could be claimed
2. Sale of assets, where gain
has been or might be
rolled over into
replacement assets
Provision is required only if rollover relief has
not been obtained and it is not expected to be
obtained
Provision is required. The deferred tax is
measured on the difference between the
replacement asset’s cost and its tax base
(i.e. cost less taxable gain rolled over)
3. Adjustments to recognise
assets and liabilities at
their fair values on the
acquisition of a business
The amendment to FRS 7 ‘Fair values in
acquisition accounting’ introduced by FRS 19
requires deferred tax to be provided for as if
the adjustments had been gains or losses
recognised before the acquisition. Deferred tax
would not normally be recognised on
adjusting non-monetary assets to market
values. No provision is recognised in respect of
acquired goodwill
Provision is made for all differences between
the fair values recognised for assets and
liabilities and their tax base. The only exception
is that no provision is required in respect of
the temporary difference arising on the
recognition of non-deductible goodwill
4. Unremitted earnings of
subsidiaries, associates
and joint ventures
Provision is required only to the extent that
dividends payable by a subsidiary, associate or
joint venture have been accrued at the balance
sheet date or a binding agreement to
distribute the past earnings in future has been
made
Provision is required on the unremitted earnings
of associates in all circumstances. Provision is
required on the unremitted profits of
subsidiaries, branches and joint ventures if either
the parent/investor is unable to control the
timing of the remittance of the earnings or it is
probable that remittance will take place in the
foreseeable future
5. Exchange differences arising
on consolidation of nonmonetary assets of an entity
accounted for under the
temporal method
No provision is required because there is no
timing difference
Provision is required on the temporary
difference between the carrying amount (at
historical exchange rate) and the tax base (at
balance sheet date exchange rates)
6. Unrealised intergroup
profits (for example, in
stock) are eliminated on
consolidation
Provision is required on the timing difference,
i.e. the profit that has been taxed but not
recognised in the consolidated accounts. It is
therefore measured using the supplying
company’s rate of tax
Provision is required on the temporary
difference. IAS 12 states that this is the
difference between the (reduced) carrying
amount of the stock in the balance sheet and
its higher tax base (the amount paid by the
receiving company). The provision is measured
using the receiving company’s rate of tax
Note well that IAS 12 does not permit deferred tax balances to be discounted even as an option.
434
TAXATION (SSAPS 5 AND 15 AND FRSS 16 AND 19)
Deferred tax
The balance sheet approach, temporary difference, is
Net book value of asset at end year 1
Tax base (tax written down value)
9
80
50
30
9
Deferred tax
In this example there is no difference between the two methods.
If the asset had been revalued to £200 at the end of year 1 then only the balance sheet
calculation would change:
NBV
Tax base
Temporary difference
Deferred tax
200
50
150
45
The argument for providing deferred tax on the temporary difference (note there is no timing difference) is that it is presumed the revalued carrying amount of the asset will be recovered through use and will generate taxable income that will be taxable in the future and
therefore there is a deferred tax liability. There is a problem with this logic, though, given
the definition of a liability as ‘a present obligation arising out of a past event’. The future
taxable income referred to here is not a past event.
IAS 12 also requires provisions to be made for deferred tax when the critical event causing the deferred tax to become payable in future has not occurred by the balance sheet date.
The main differences between the recognition requirements of IAS 12 and those of FRS
19 are detailed in Table 21.1 extracted from Appendix IV of FRS 19.
Summary
Within this chapter we have considered some problem areas of accounting for taxation,
particularly those relating to deferred tax. We have noted the various solutions the ASC/B
have produced for deferred tax:
Prior to SSAP 11 flow through approach
SSAP 11 full deferral approach
■ SSAP 15 1978 and 1985 partial approach
■ FRS 19 full provision with a discounting option
and demonstrated the differences between these approaches.
■
■
We have also noted that even though the ASB is concerned to harmonise UK standards with
those of the IASB there are at least two major differences between FRS 19 and
IAS 12:
■
■
IAS 12 does not permit discounting
IAS 12 takes a balance sheet approach to provision of deferred tax whereas FRS 19 still
focuses on the income statement.
It is anticipated that when the UK listed companies report under IASs as from 2005 several
of them with large investment property portfolios will have to recognise several million more
in deferred tax on revaluations of these properties, which will have an impact on net asset
values.
EXERCISES
435
Exercises
1 Outline the major arguments in favour of always providing for deferred tax where the
amounts would be material.
2 Explain and distinguish between:
(a) the flow-through approach
(b) full deferral
(c) partial deferral.
3 Explain and distinguish between:
(a) the deferral method
(b) the liability method.
Do you agree with the choice made by the ASB?
4 ‘Comparability requires that either all companies provide in full for deferred tax, or that it
is always ignored. Therefore the concept of partial deferral must be unacceptable.’ Consider.
5 Draft a memorandum to your client, a non-accountant, outlining what deferred tax is and
why there are problems in suggesting the appropriate treatment.
6 Does the required accounting treatment of taxation in published financial statements lead
to a true and fair view?
7 Does the ASB’s decision to permit optional discounting lead to a lack of comparability
between companies?
8 (a) FRS 19 ‘Deferred Tax’ was issued in December 2000. It details the requirements relating to the accounting treatment of deferred tax.
Required:
Explain why it is considered necessary to provide for deferred tax and briefly
outline the principles of accounting for deferred tax contained in FRS 19
‘Deferred Tax’.
(b) Bowtock purchased a fixed asset for £2 000 000 on 1 October 2000. It had an estimated life of eight years and an estimated residual value of £400 000. The plant is
depreciated on a straight-line basis. The Inland Revenue allow 40% of the cost of this
type of asset to be claimed against corporation tax in the year of purchase and 20%
per annum (on a reducing balance basis) of its tax written down value thereafter. The
rate of corporation tax can be taken as 25%.
Required:
In respect of the above item of plant, calculate the deferred tax charge/credit
in Bowtock’s profit and loss account for the year to 30 September 2003 and the
deferred tax balance in the balance sheet at that date.
(ACCA FR Dec. 2003)
9 Spencer plc has produced draft consolidated financial statements for the year ended 30
June 2003. These financial statements include deferred tax liability of £8 million. However,
no account has been taken of the potential deferred tax implications of the following:
(a) On 30 June 2003, the group revalued all its properties and a surplus of £7 million
was taken to the statement of total recognised gains and losses. The group has no
intention of disposing of any of these properties in the foreseeable future.
(b) One of the subsidiaries of Spencer plc made a loss adjusted for tax purposes of £2
million in the year ended 30 June 2003. This loss can only be relieved against future
trading profits made by the subsidiary. The directors of Spencer plc believe the loss
made by the subsidiary to be attributable to nonrecurring factors.
Required:
What is the deferred tax liability of Spencer plc at 30 June 2003 under the provisions of FRS 19 after taking account of both the events above?
(CIMA FR
Nov. 2003)