Reinstatement of tax depreciation on buildings – impact on deferred tax
Due to the financial impacts of COVID-19, on 17 March 2020, the Government announced a package of measures in support of businesses via the COVID-19 Response (Taxation and Social Assistance Urgent Measures) Act 2020, which received Royal Assent on 25 March 2020.
One such measure is the reintroduction of tax depreciation on (non-residential) commercial and industrial buildings and the allowance for tax depreciation on newly acquired buildings and capital improvements made to existing buildings from the 2020/21 tax year. The tax depreciation rate will be 1.5% straight line or 2% diminishing value.
Tax depreciation of buildings was originally removed in May 2010 with effect for the 2012 income tax year. The removal of the tax depreciation on buildings at that time resulted in a significant increase in the deferred tax liability of certain existing buildings where deferred tax was recognised on a recovery through use basis (i.e. these buildings are held for use in the business). For new buildings (where recovery is through use) acquired after May 2010, entities were able to apply the initial recognition exemption available under NZ IAS 12 Income Taxes (NZ IAS 12) and no deferred tax was required to be accounted for.
With tax depreciation on (non-residential) buildings now being reintroduced, there is likely to be a significant impact on the recognition of deferred tax in relation to those buildings (where recovery is through use) as the associated tax base will increase to reflect the future tax deductions that are now available.
The extent of the impact (recognition of a deferred tax asset/liability or the reduction of an existing deferred tax liability, and the corresponding adjustment to tax expense in profit or loss) will depend on the deferred tax treatment previously applied and the calculation of the adjusted tax base.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 assets. NZ IAS 12.7
It should be noted that the calculation of the adjusted tax base of a non-residential building may not be straight forward and will depend on a number of factors, for example care will need be taken when there have been additions to the building in later years. Expert assistance may be required. Determining the tax base will need to be done on a building-by-building basis.
For buildings on a recovery through use basis acquired before the May 2010 tax change
As mentioned above, for buildings acquired before the May 2010 tax change, the removal of the tax depreciation on buildings resulted in an increase in the deferred tax liability for those buildings, as most impacted buildings had a tax base of $nil.
The amount of the tax base going forward should reflect the tax depreciation deductions available over the remaining accounting economic useful life of the building and will be impacted by the tax depreciation rate and method expected to be applied to the building.
With the reinstatement of tax depreciation on these buildings the tax base will likely increase to reflect the future tax deductions that are now available, which will result in a reduction of the associated deferred tax liability. To the extent the new tax base exceeds the carrying value of the buildings, a deferred tax asset may arise.
The recognition of any deferred tax asset resulting from these changes would need to be carefully assessed, as NZ IAS 12 only permits a deferred tax asset to be recognised to the extent it is probable that taxable profits will be available to offset the tax deductions giving rise to the deductible temporary difference.
Given the impact that COVID-19 has had on the economy, greater scrutiny will likely be placed on the assessment of whether it is probable that there will be sufficient taxable profits to offset the tax deductions, especially if a deferred tax asset already exists in relation to unused tax losses or other temporary differences.
For buildings on a recovery through use basis acquired after the May 2010 tax change
As mentioned above, for buildings acquired after the May 2010 tax change (including any subsequent additions to those buildings), it is likely that entities applied the initial recognition exception available under NZ IAS 12 and that no deferred tax was recognised on these buildings.
With the reinstatement of tax depreciation on the buildings, there is an associated reinstatement of a tax base on these buildings. Consideration needs to be given as to whether this would result in a deferred tax asset or liability depending on the tax and accounting depreciation profile of the building and any subsequent additions. (It should be noted that there is a degree of uncertainty on the application of IAS 12 for the tax change in these instances and we note that guidance may continue to evolve in this area in the coming months.)
As above, the tax base of these buildings would need to be calculated by reference to the future tax depreciation deductions available over the remaining accounting economic useful life of the buildings.
For buildings on a recovery through sale basis
For buildings where deferred tax is recognised on a recovery through sale basis, as opposed to a recovery through use basis, there is likely to be no change to deferred tax as a result of the reinstatement of tax depreciation on non-residential buildings.
Deferred tax is recognised on these buildings based on the tax consequences of sale. Provided the building is held on capital account, this means that deferred tax is only recognised based on any tax depreciation that would be “clawed back” on sale.
The reintroduction of tax depreciation on non-residential buildings will likely result in the deferred tax liability increasing each year by the tax effect of the tax depreciation claimed on that building going forward.
This would include buildings held-for-sale and investment property where the sale presumption is not rebutted.
Revaluations on building held for use
It is not anticipated the reintroduction of tax depreciation on non-residential buildings will have an impact on the deferred tax liabilities arising from the revaluation element of the carrying value of the building under NZ IAS 16 Property, Plant and Equipment.
For non-residential building acquisitions, if the accounting carrying value and tax base are not equal on acquisition then the initial recognition exception available under NZ IAS 12 should be considered.
For residential building acquisitions, deferred tax would continue to be applied as it was prior to the reintroduction of tax depreciation on non-residential buildings.
When to apply these changes from?
NZ IAS 12 requires deferred tax to be accounted for based on tax legislation that has been substantively enacted by the end of the relevant financial reporting period.
As the COVID-19 Response (Taxation and Social Assistance Urgent Measures) Act 2020 received Royal Assent on 25 March 2020, entities with a 31 March 2020 financial year end and later will need to reflect these changes when calculating deferred tax on buildings.
For entities with an earlier financial year end, e.g. 31 December 2019, note disclosure could be made outlining the nature of the change and the estimated impact, if that impact is considered material, as a non-adjusting post-reporting date event.
For 31 March 2020 and later financial reporting periods, the impact of the change should be reflected through tax expense, rather than as an adjustment to opening retained earnings.
For more on the above, please contact your local BDO representative.