IASB clarifies accounting for deferred taxes relating to assets and liabilities arising from a single transaction (leases and decommissioning obligations)

Prior to the amendments, IAS 12 required that deferred tax assets and liabilities be recognised for all taxable and deductible temporary differences, except to the extent that the deferred tax asset or liability arises from:

(a) the initial recognition of goodwill; or

(b) the initial recognition of an asset or liability in a transaction which:

            (i) is not a business combination; and
            (ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

A common example where the ‘initial recognition exemption’ applies is for the purchase of a luxury motor vehicle costing $90,000 that is only eligible for tax deductions of $50,000. At initial recognition, there is a taxable temporary difference of $40,000 between the carrying amount of the motor vehicle ($90,000) and its tax base ($50,000). In this example, the initial recognition exemption is used, and no deferred tax liability is recognised, for this $40,000 taxable temporary difference because:

• It does not arise from the initial recognition of goodwill
• It was not acquired as part of a business combination, and
• At initial recognition, neither profit or loss or taxable profit are affected.

However, deferred tax is recognised to the extent that accounting depreciation and tax depreciation for the $50,000 tax deductible portion of the asset differ during the asset’s life as shown in the table in Example 1 below.

Example 1

Using the fact pattern for the luxury vehicle above (i.e., cost of $90,000 and tax base of $50,000), the example below assumes the following:

• Tax rate is 20%

• The entity depreciates motor vehicles using a straight-line basis for accounting purposes of 20% (i.e., $10,000 for 5 years), and tax purposes of 25% (i.e., $12,500 for 4 years)
• Accounting profit is $70,000 in each of years 1-5 before accounting depreciation of $10,000.

Recognising a deferred tax liability during the life of the luxury motor vehicle results in a tax charge in profit or loss that corresponds to the period when accounting depreciation is recognised (or carrying value of asset is recovered), rather than when the vehicle is deductible for tax purposes. This is evident by the consistent $12,000 tax charge recognised each year as shown in the table above. However, the $40,000 non-deductible portion of the vehicle will result in a ‘permanent difference’ because it results in an accounting deduction in profit or loss but there will never be a corresponding tax deduction for this amount.

On initial recognition of a right-of-use (ROU) asset and lease liability by a lessee, or when an entity recognises the asset and liability for restoration obligations, both the asset and liability side have a carrying amount, but a zero tax base.

Example 2

If a lessee recognises a ROU asset and lease liability at initial recognition of $50,000, the temporary differences are as follows:

Note 1: The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset (IAS 12.7). As the ROU asset is not tax deductible, its tax base at initial recognition is NIL.

Note 2: The tax base of a liability is its carrying amount, less any amounts that will be deductible for tax purposes in respect of that liability in future periods (IAS 12.8). Lease payments are deductible for tax purposes, and these include a capital and interest portion. The capital portion represents future tax deductions against the lease liability. Therefore the tax base at initial recognition is the carrying amount of the lease liability of $50,000 less $50,000 future tax deductions, which equals NIL.

If the entity applies the ‘initial recognition exemption’ to the above deductible and taxable temporary differences, no deferred tax asset or liability is recognised for the above deductible and temporary difference when the lease is first recognised on balance sheet, and also during the life of the lease.

If the entity did recognise both the deferred tax asset and deferred tax liability of $10,000 on initial recognition, both balances would reduce over the life of the lease as the ROU asset is depreciated, and the lease liability is settled.

 
The IASB has amended the ‘initial recognition exemption’ so that it cannot be applied to transactions such as leases and restoration obligations which give rise to equal taxable and deductible temporary differences at initial recognition.

In Example 2 above, the initial recognition exemption therefore cannot be applied, and both the deferred tax asset and deferred tax liability of $10,000 each must be recognised at initial recognition, and unwound over the life of the lease. The two balances can be presented ‘net’ if the offset criteria in IAS 12, paragraph 74 are met.

Example 2 (continued)

To illustrate how the deferred tax liability on the ROU asset and the deferred tax asset on the lease liability unwind over the life of the lease, we will assume:

• Tax rate is 20%

• The entity depreciates the ROU asset using a straight-line basis for accounting purposes of 20% (i.e. $10,000 for 5 years)

• Accounting profit is $70,000 in each of years 1-5 before accounting depreciation and interest on the lease liability.

The amortisation table for the lease liability assumes an incremental borrowing rate on the lease liability of 5%. Lease payments are made annually in arrears:

Table 1

The deferred tax liability (DTL) on the ROU asset unwinds from initial recognition until the end of its useful life (end of Year 5) as shown in the table below (accounting depreciation is $10,000 each year):

Table 2
 

The table below illustrates how the deferred tax asset (DTA) on the lease liability unwinds from initial recognition until the last lease payment is made at the end of Year 5:

Table 3

Netting the DTL and DTA entries off each year (assuming the offset criteria in IAS 12 have been met), the following net deferred tax entries will be processed:

Table 4

Recognising the assessable and deductible temporary differences over the life of the ROU asset and lease liability results in a consistent combined tax charge in profit or loss as shown below:

Table 5

In all of the above years, the combined tax expense in Column (E) equals the prima facie tax on accounting profit or loss, i.e., Column (A) X 20%.

Example 2 shows a simplistic fact pattern where the carrying amounts of the ROU asset and lease liability are equal when the lease is first recognised. However, in practice, these initial carrying amounts may differ due to advance lease payments and/or indirect costs. Read next month's Accounting Alert to find out how to deal with advance lease payments and initial direct costs.

 
For a more in-depth explanation of these amendments, including detailed worked examples, please refer to BDO’s International Financial Reporting Bulletin IFRB 2021/10 IASB issues amendments to IAS 12 – Deferred tax related to assets and liabilities arising from a single transaction