Proposed new tax accounting standard — a missed opportunity?

Earlier this year, the International Accounting Standards Board (IASB) issued an Exposure Draft (ED) of a new accounting standard to replace IAS 12 Income Taxes which, if adopted, would dramatically impact the way current and deferred taxes and tax uncertainties are defined, measured, presented and disclosed in the financial statements (refer to Box 1 for a listing of proposed changes).

The IASB received over 160 comment letters on the ED, which have been posted on the IASB’s website and are now under review. This volume of responses is indicative of a high level of interest in this subject amongst many constituents. The IASB has stated that it would like to issue a new standard on income taxes in the second half of 2010. The IASB’s income taxes project was originally a joint project with the US Financial Accounting Standards Board (FASB), undertaken as part of both Boards’ short-term convergence project aimed at eliminating differences between US GAAP and IFRS. However, last year, the FASB suspended its deliberations on the income taxes project. In this article, we highlight some of the key concerns we expressed in our comment  letter to the IASB about the ED.

The two main objectives of the IASB’s income taxes project are to clarify and improve IAS 12 and to eliminate differences between US GAAP and IFRS. While we strongly support these objectives, we believe that the ED does not meet them. Furthermore, some areas of the ED are more ambiguous and difficult to interpret, and others less easy to understand conceptually, than the current provisions of IAS 12. We do not think it is reasonable for existing IFRS users to shoulder the burden of implementing a new, and in many respects more complex, standard that does not, in our view, achieve its stated goals.

Summary of proposed changes

The ED proposes additions or changes to IAS 12 in the following areas:

Ø       Definitions of ‘tax basis’ and ‘temporary difference’

Ø       Exceptions to the temporary difference approach

Ø       (elimination of the initial recognition exception)

Ø       Measurement of deferred tax liabilities

Ø       Recognition of deferred tax assets

Ø       Allocation of tax to components of comprehensive income or

Ø       equity

Ø       Balance sheet classification

Ø       Uncertain tax positions

Ø       Definitions of tax credit and investment tax credit

Ø       Other miscellaneous changes

Ø       Disclosures

Areas for improvement to IAS 12

We acknowledge that accounting for income taxes is a challenging subject and that there is room for improving IAS 12. In fact, in the IASB’s press release issued on publication of the ED, the IASB acknowledged a fundamental review of income tax accounting is being undertaken by a number of national standard-setters working with the IASB. If there is a possibility that the deliberations of those national standard-setters will lead to a major new standard on income taxes being issued in the medium term, we do not believe

that it is appropriate to proceed with the issuance of a revised standard on income taxes at this time.

In our experience, several areas of IAS 12 give rise to practical difficulties, in particular:

Ø       Determining the manner of recovery of assets

Ø       Some aspects of the initial recognition exception

Ø       The recognition and measurement of uncertain tax positions

Ø       The allocation of income taxes within a tax group

Ø       The treatment of deferred tax assets

We feel that the IASB should retain IAS 12 and focus on complementing it with new or additional guidance in these key areas. In our opinion, that would be more beneficial to IFRS users than completely replacing IAS 12 with the proposals in the ED, with the potential of further changes to income tax accounting after the

fundamental review by standard-setters is completed. We highlight our thoughts on two of the more significant and controversial proposed changes below – those covering uncertain tax positions and definitions of tax base and temporary difference.

Uncertain tax positions

Uncertain tax positions arise where there is an uncertainty as to the meaning of the law, the applicability of the law to a particular transaction, or both. IAS 12 does not explicitly address the recognition and measurement of uncertain tax positions, although it notes that the principles of IAS 37 Provisions, Contingent Assets and Contingent Liabilities may be relevant to the disclosure of tax-related contingent assets and contingent liabilities. As a result, practice in this area has been varied. The ED proposes that entities measure uncertain tax positions on an expected outcome basis (i.e., at the probability weighted average of expected outcomes). The ED also proposes that entities should disclose information about the major sources of estimation uncertainties relating to tax effects to enable users to assess the possible financial effects of the estimation uncertainties and their timing (for example, the effects of unresolved disputes with the tax authorities), including:

Ø       A description of the uncertainty

Ø       An indication of its possible financial effects on amounts recognised for taxes and the timing of those effects

These proposals, which greatly increase the disclosures required for what are typically sensitive issues, may prove one of the most contentious aspects of the ED. While we support some aspects of the IASB’s proposals, we have a number of reservations. We support the proposed ‘probability-weighted average’ approach, but only to the extent that it is consistent with the IASB’s standard on liabilities expected to be issued later this year. We do not consider that uncertain tax positions should be accounted for differently from other liabilities. In principle, however, we remain unconvinced by the ‘probabilityweighted average’ approach. Our comment letter in response to the ED of proposed changes to IAS 37 and IAS 19 Employee Benefits expressed our view that this approach would not provide relevant information for users, since the measurement of the liability would not be reflective of future cash outflows, as the weighted-average probability on which it is based is merely a subjective estimation.

The ED does not specify the ‘unit of account’ for uncertain tax positions. In practice, this might be an entire tax computation, individual uncertain positions, or a group of related uncertain positions (e.g., all positions in a particular tax jurisdiction, or all positions of a similar nature or relating to the same interpretation of tax legislation). In our view, the lack of a definition of unit of account creates a number of challenges in the analysis,measurement and disclosure of uncertain tax positions. We are also concerned that the additional disclosures of uncertain tax positions proposed in the ED could result in excessive and prejudicial disclosure. For this reason, we believe that there should be an exemption equivalent to that already in IAS 37 from disclosure of seriously prejudicial information. It would be anomalous for this exemption to be available only for provisions for liabilities other than income taxes.

Definitions of tax basis and temporary difference

IAS 12 currently requires the tax base of an asset or liability to reflect the manner in which the entity expects to recover the asset (or settle the liability). This effectively makes deferred tax a function of management intent. The IASB is eliminating intent from other areas of financial reporting and therefore proposes to eliminate this concept in IAS 12. The ED proposes replacing the term ‘tax base’ with ‘tax basis’, defined in the ED as ‘the measurement, under applicable substantively enacted tax law, of an asset, liability or other item’. The tax basis of an asset (or liability) is determined by the tax consequences of selling (or settling) it for its carrying amount at the reporting date.  At present, a temporary difference is simply the difference between the carrying amount of an item and its tax base. The ED redefines a ‘temporary difference’ as the difference between the carrying amount of an item and its tax basis that the entity expects will affect taxable profit when the carrying amount of the related asset or liability is recovered or settled (or, in the case of items other than assets or liabilities, will affect taxable profit in the future). In effect, this means that in some cases, the entity’s expectations determine the measurement of deferred tax, so the IASB has not been able to remove management intent from the picture entirely.

We do not support the definitions proposed in the ED. Those definitions may result in an entity recording deferred taxes, and an effective tax rate in the income statement, that do not reflect its actual tax position. Under the proposals, the tax basis of an asset or liability is determined on the assumption that the asset or liability is sold or settled at the balance sheet date. However, whether that tax

basis gives rise to a temporary difference is to be determined by reference to the actual expected manner of realisation or settlement.

A further source of confusion is whether deferred tax that is required to be calculated on a ‘sale’ basis is to be strictly regarded as being the tax payable on a sale. This may be relevant to assessing the recoverability of deferred tax assets in jurisdictions where capital and revenue transactions are distinguished for tax

purposes. An entity in such a jurisdiction may have brought forward tax losses which can be offset against future revenue profits, but not future capital profits. If a deferred tax liability recognised in the balance sheet is taken to represent the tax payable on a sale (i.e., capital gains tax), it cannot be used as the basis for recognising the deferred tax asset for revenue losses. Considerations such as these suggest to us that the ‘sale basis’ approach is neither a holistic model nor appropriate for jurisdictions where assets may (as a matter of tax law, not ‘management intent’) have more than one tax basis or where there is a distinction between revenue and capital gains for tax purposes. Therefore, we  do not support in principle a presumption that, where there is more than one tax basis, a particular tax basis should always be taken as the starting point for calculating deferred tax. If, however, such a principle is to be adopted, it is surely inappropriate to give preference to the ‘sale basis’, when in reality nearly all the tax deductible assets of most entities will be consumed or realised in the course of business rather than sold. Our overall recommendation is for the approach of IAS 12 to be retained. We agree that there have been differences of view in practice as to how to interpret the phrase ‘manner in which the entity expects to recover … the carrying amount of assets’ in IAS 12. However, we believe that these differences would be better addressed by new application or implementation guidance. Such guidance should clarify whether the determination of the manner of recovery must (as we believe) be consistent with assumptions made for the purposes of other IFRS, in particular IAS 16 Property, Plant and Equipment, IAS 38 Intangible Assets and IAS 36 Impairment of Assets, or whether such determination can — or must be a separate exercise for the purposes of IAS 12.

Conclusion

The ED proposed to replace IAS 12 has been a long-awaited document after several years of analysis by the IASB. We applaud the IASB for taking on the challenge of developing an improved standard for accounting for income taxes. However, we do not feel that the ED issued meets the IASB’s objectives to clarify and improve IAS 12 and to eliminate differences between US GAAP and IFRS. We believe that any difficulties in applying the current standard would be better addressed by providing application and /or implementation guidance to the current requirements, rather than by the complete replacement of those requirements by the alternatives proposed in the exposure draft. We will continue to monitor how the IASB responds to the comment letters it received and the next steps in the journey of trying to improve this challenging subject. Given the volume of comment letters, that journey will be closely watched by many.

Article was earlier published in one of the reputed IFRS website.