Deferred income tax is recognised under IAS 12 to account for differences between tax base of an asset or a liability and its carrying amount. Deferred income tax and current income tax comprise total tax expense in the income statement.
Definition of temporary differences
The notion of temporary differences is fundamental to understanding deferred tax. Temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position and its tax base (IAS 12.5). In other words, temporary differences are timing differences with respect to recognition of transactions in IFRS financial statements and for tax purposes. Temporary differences may be either taxable or deductible.
The tax base is the amount attributed to an asset or a liability for tax purposes. Specific calculation formula for assets and liabilities is given below:
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 an entity when it recovers the carrying amount of the asset. If these profits will not be taxable, the tax base of the asset is equal to its carrying amount (IAS 12.7). See examples given in paragraph IAS 12.7.
The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods (IAS 12.8). See examples given in paragraph IAS 12.8.
Taxable temporary differences – deferred tax liabilities
A deferred tax liability is recognised (except for initial recognition exemption) for all taxable temporary differences that arise when:
- The carrying amount of an asset is higher than its tax base or
- The carrying amount of a liability is lower than its tax base.
See a simple example below.
In 20X1, Entity A purchases a fixed asset that costs $1,000. Its useful life is determined to be 5 years, therefore the depreciation charge amounts to $200 per year. However, when calculating income tax payable to the tax authorities, Entity A is able to include a depreciation charge of $500 for the next 2 years. Entity A generates $800 of revenue each year (taxable at the same time as recognised under IFRS). Tax rate is 20%. All calculations presented in this example are available for download in this excel file.
Entity A calculated income tax that is payable to tax authorities as follows (you can scroll these tables horizontally if they don’t fit your screen):
(under tax law)
|Tax at 20%||60||60||160||160||160|
And here is deferred tax calculation at the end of each year:
of fixed asset
|Deferred tax liability||60||120||80||40||-|
Here is how the IFRS financial statements look like when deferred tax is recognised:
under IAS 16
|Profit before tax||600||600||600||600||600|
|Effective tax rate*||20%||20%||20%||20%||20%|
|Effective tax rate|
without deferred tax
* Effective tax rate is calculated by dividing total income tax charge by profit before tax.
As we can see, recognition of deferred tax enables entities to ‘accrue’ income tax when the tax depreciation is inflated, and then utilise this ‘accrual’ when the tax depreciation is nil.
Examples of situations when taxable temporary differences arise, and deferred tax liability is recognised, are as follows:
- entity accrues revenue which will be taxable when the cash is collected,
- a fixed asset is depreciated faster for tax purposes than for accounting purposes,
- an expenditure is capitalised for accounting purposes but treated as a one-off expense for tax purposes,
- assets are revalued upwards and this revaluation is ignored for taxation purposes (see also paragraph IAS 12.20),
- unrealised losses resulting from intragroup transactions are eliminated on consolidation.
Deductible temporary differences – deferred tax assets
General criteria for recognition of deferred tax assets
A deferred tax asset is recognised (subject to initial recognition exemption) for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. This is a significant difference compared to deferred tax liabilities whose recognition does not depend on estimates of future taxable profits.
Taxable temporary differences arise when:
- The carrying amount of an asset is lower than its tax base or
- The carrying amount of a liability is higher than its tax base.
Examples of situations when deductible temporary differences arise, and deferred tax asset is recognised, are as follows:
- a provision is recognised under IAS 37 which will be deducted from taxable income in the future on a cash basis,
- liabilities for long-term employee benefits are recognised under IAS 19 which will be deducted from taxable income in the future on a cash basis,
- impairment loss is recognised for assets other than goodwill, and it does not impact tax base of related assets,
- unrealised gains resulting from intragroup transactions are eliminated on consolidation.
Availability of taxable profit in the future
As noted earlier, deferred tax assets are recognised only to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised (IAS 12.27). ‘Probable’ is not defined is IAS 12 but it is widely accepted that it is used in the same meaning as in IAS 37 and as is given in the IFRS glossary of terms, i.e. more likely than not (>50%).
Estimates of taxable profits in the future are similar in nature to estimating future cash flows for impairment tests purposes. Obviously, they need to be adjusted for the provisions of tax law and tax planning opportunities (IAS 12.29-31). The assessment of future taxable profit should in particular:
- be made at the level of a taxable entity and taxation authority,
- exclude the effect of reversal of deductible temporary differences,
- exclude the effect of future temporary differences,
- take into account tax planning opportunities (see IAS 12.30).
As deferred tax assets are not discounted (IAS 12.53), entities often recognise them even if they are expected to be utilised e.g. in 30 years.
There is no time limit set by IAS 12 with respect to utilisation of deferred tax assets. When combined with the fact that deferred tax is not discounted, entities sometimes recognise deferred tax assets that will be utilised many years (e.g. 50) in the future.
It is assumed that it is probable that taxable profit will be available when there are sufficient taxable temporary differences (i.e. deferred tax liabilities) relating to the same taxation authority and the same taxable entity. Such taxable temporary differences should be expected to reverse in the same period as the expected reversal of the deductible temporary difference or in periods into which a tax loss arising from the deferred tax asset can be carried back or forward (IAS 12.28).
Unused tax losses and unused tax credits
Deferred tax asset is recognised also for the carryforward of unused tax losses and unused tax credits (IAS 12.34). As with other deferred tax assets, availability of future taxable profit criterion applies. Paragraph IAS 12.35 specifically emphasises that the existence of unused tax losses is strong evidence that future taxable profit may not be available and that an entity with a history of recent losses recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit will be available (see also IAS 12.36).
Paragraph IAS 12.82 imposes additional disclosure requirements for entities that recognised deferred tax assets for unused tax losses and which had a tax loss in the current or preceding period in the same tax jurisdiction.
Initial recognition exemption
Deferred tax is not recognised if it arises on initial recognition of assets/liabilities in a transaction which is not a business combination and, at the time of the transaction, affects neither accounting profit nor taxable profit (IAS 12.15/24). It is important to note that this exemption relates to impacts resulting from initial recognition only. Consider the following example and compare it to previous example where all temporary differences resulted from subsequent accounting.
Example: Exemption for initial recognition of assets/liabilities
Entity A acquires an asset for $10 million that is not tax deductible for tax purposes. Therefore, its tax base equals 0 and there is a temporary difference. However, based on initial recognition exemption from IAS 12.15, deferred tax is not recognised. As a result, subsequent depreciation of the initial carrying value will also not trigger any deferred tax recognition as it will relate to the carrying amount covered by the initial recognition exemption.
When this asset would be revalued to fair value, say $12 million, the revaluation gain would result from subsequent accounting and would therefore not be covered by the initial recognition exemption. As a result, deferred tax liability should be recognised for the part of carrying amount representing the revaluation gain (i.e. $2 million). Subsequent depreciation of the part representing the revaluation gain would ‘utilise’ this deferred tax liability.
Initial recognition exemption related to assets and liabilities arising from a single transaction
It gets more complicated when it comes to recognition of assets and liabilities arising from a single transaction. For example, this happens when a lease liability and right-of-use assets are recognised under IFRS 16 and the tax law treats it as an operating lease deductible when lease payments are made. There are 2 distinct approaches to the initial recognition exemption:
- Approach #1: The initial recognition exemption is applied separately to right-of-use asset and lease liability. As the recognition affects neither accounting profit nor taxable profit and there is no deferred tax accounting throughout the entire lease term. This causes a distortion of an effective tax rate as shown below.
- Approach #2: The right-of-use asset and lease liability are assessed on a net basis for the purpose of application of the initial recognition exemption. This means that deferred tax is not recognised at initial recognition of the lease, but is recognised at subsequent accounting for the lease when the net asset/liability changes, i.e. when the right-of-use asset is amortised and lease liability is reduced.
Similar issue arises when decommissioning provision is recognised as an addition to the depreciable amount of a fixed asset, whereas the tax expense arises only when the provision is utilised, i.e. actual payment is made.
Consider the following example relating to IFRS 16:
Entity A enters into a lease of an asset on 1 January 20X1. The treatment of the lease under the tax law is different than under IFRS 16. Namely, the tax expense arises on a cash basis, i.e. when lease payments are made. In this example, the discount rate is 5% and tax rate is 20%. All calculations presented in this example are available for download in this excel file. You may need to familiarise yourself with accounting for leases under IFRS 16 before digesting this example.
Lease payments and calculation of initial recognition of right-of-use asset and lease liability are shown in the table below (you can scroll these tables horizontally if they don’t fit your screen).
|payment||date of payment||discount factor||discounted amount|
The accounting schedule for right-of-use asset is as follows:
And the accounting schedule for lease liability:
Now we move on to two approaches for deferred tax accounting throughout the lease term. They are described in the section immediately preceding this example.
Under Approach #1, there is no deferred tax accounting throughout the entire lease term. Statement of financial position (SoFP) and profit or loss (P/L) under this approach are presented below. As a reminder, all calculations are available in this excel file.
|20X1 YE||20X2 YE||20X3 YE||20X4 YE||20X5 YE||20X6 YE|
|Deferred tax asset||-||-||-||-||-||-|
|Current income tax charge||(20,000)||(10,000)||(10,000)||(10,000)||(10,000)||(10,000)|
|Deferred income tax|
|Effective tax rate||44%||21%||20%||19%||18%||10%|
Under Approach #2, deferred tax accounting is effected for the net asset/liability throughout the entire lease term:
|20X1 YE||20X2 YE||20X3 YE||20X4 YE||20X5 YE||20X6 YE|
|Deferred tax asset||10,824||11,256||11,276||10,865||10,000||-|
|Current income tax charge||(20,000)||(10,000)||(10,000)||(10,000)||(10,000)||(10,000)|
|Deferred income tax|
|Effective tax rate||20%||20%||20%||20%||20%||20%|
As we can see, Approach #1 distorts the effective tax rate, while Approach #2 better presents tax impact of the lease. This matter was considered by IASB which proposed a narrow scope amendment to IAS 12, under which the initial recognition exemption in IAS 12.15/24 would not apply to transactions that, at the time of the transaction, give rise to equal amounts of taxable and deductible temporary differences (i.e. Approach #2). See the current stage of this project on a dedicated project page on IFRS.org.
Investments in subsidiaries, branches and associates and interests in joint arrangements
IAS 12 contains specific provisions concerning recognition of deferred tax with respect to investments in subsidiaries, branches and associates and interests in joint arrangements (IAS 12.38-45). These criteria relate to so-called ‘outside’ temporary differences, i.e. differences between carrying amount of an investment (or net assets in consolidated financial statements) and its tax base. In contrast, ‘inside’ temporary differences are differences relating to individual assets or liabilities held by investees (e.g. PP&E, provisions).
Deferred tax liabilities are recognised for the ‘outside’ temporary differences arising on the above investments unless (IAS 12.39):
- the investor is able to control the timing of the reversal of the temporary difference and
- it is probable that the temporary difference will not reverse in the foreseeable future.
See paragraphs IAS 12.40-43 for more discussion on the criteria above.
Deferred tax assets are recognised for the ‘outside’ temporary differences arising on the above investments only to the extent that it is probable that (IAS 12.44):
- the temporary difference will reverse in the foreseeable future and
- taxable profit will be available against which the temporary difference can be utilised.
In practice, the above criteria allow entities not to recognise deferred tax for the ‘outside’ temporary differences arising on most of its investments. However, the deferred tax is usually recognised when:
- the distribution of retained profits is probable and has tax effects,
- a sale of an investment becomes probable.
Example: ‘Outside’ temporary differences arising on an investment in a subsidiary
On 1 January 20X1, Entity A acquires Entity B for EUR 100m. Entity A operates in Germany and EUR is its functional currency, whereas Entity B operates in Australia with AUD as its functional currency. Assume that tax rate in Germany is 20% and 30% in Australia. The table below shows assets and liabilities of Entity B translated to EUR:
|Fair value||Tax base||Temporary
|Total Assets||230||180||50 (taxable)|
|Total liabilities||140||120||20 (deductible)|
In order to arrive at net assets of Entity B in the consolidated financial statements of Entity A we need to calculate deferred tax on temporary differences and recognise goodwill:
A: Net assets of B excluding deferred tax and goodwill: EUR 90m
B: Deferred tax liability at tax rate of B [(50-20)]*30%: EUR 9m
C: Net assets of B including deferred tax, excluding goodwill (A-B): EUR 81m
D: Goodwill (consideration of EUR 100m less net assets acquired of EUR 81m): EUR 19m
E: Net assets of B in consolidated financial statement of A (C+D): EUR 100m
As we can see, net assets of Entity B in the consolidated financial statements of Entity A amount to EUR 100 million. The tax base of investment in B from the perspective of A is also EUR 100 million, i.e. the cost. Therefore, there is no ‘outside’ temporary difference in separate or consolidated financial statements at the date of acquisition.
Suppose that during the year 20X1 the following happens:
- Entity B makes a net loss of EUR 10 million,
- Entity A records in consolidated OCI EUR 5 million of translation differences (gain) relating to Entity B,
- EUR 15 million of goodwill impairment is recognised by Entity A in consolidated financial statements and EUR 15 million of impairment of investment in B carried at cost in separate financial statements.
As a result, at the end of 20X1, net assets of Entity B amount to EUR 80 million in the consolidated financial statements of A:
|100||opening balance of net assets|
|80||net assets at 31 Dec 20X1|
The tax base remains unchanged at EUR 100 million, therefore a deductible ‘outside’ temporary difference of EUR 20 million arises in the consolidated financial statements of A. In the separate financial statements of A, the investment in B amounts to EUR 85 million (i.e. original cost minus impairment), therefore the deductible ‘outside’ difference amounts to EUR 15 million. If there were no separate provisions for recognition of deferred tax arising on investments in subsidiaries as discussed above, Entity A would have to recognise deferred tax on ‘outside’ temporary differences arising on its investment in Entity B.
Applicable tax rate
It is often the case that different tax rates apply to dividends received from an investment and to gains on disposal of an investment. The measurement principle states that the measurement of deferred tax assets/liabilities should reflect the tax consequences that would follow from the manner in which the entity expects to recover the carrying amount of its assets. Therefore, if an entity determines it necessary to recognise a deferred tax, it should determine which part of the investment will be recovered through dividends or other forms of capital distributions, and which part will be recovered through disposal. This view was confirmed by the IFRIC in their March 2015 IFRIC update.
Single asset entities
Some assets, usually properties, are held by a single asset entity. It is usually done due to legal and/or tax reasons. IFRIC July 2014 update considers the issue whether deferred tax relating to such entities should be assessed with reference to both ‘outside’ and ‘inside’ temporary differences, i.e. differences relating to the investment in the entity and the asset held by the entity. The conclusion is that, based on paragraphs IAS 12.11,38, deferred tax should be assessed with respect to both ‘outside’ and ‘inside’ temporary differences as currently IAS 12 does not give any exceptions that would specifically apply to single asset entities.
Measurement of deferred tax
General requirements for measurement of deferred tax
Deferred tax assets and liabilities are measured at the tax rates that are expected to apply in the period when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting period (IAS 12.47).
The measurement of deferred tax is based on the carrying amount of the assets and liabilities of an entity (IAS 12.55). Therefore, it cannot be based on a fair value of an asset that is measured at cost in the statement of financial position.
Deferred tax assets and liabilities are not discounted (IAS 12.53-54).
Tax laws enacted or substantively enacted
IAS 12 does not give any specific guidance on when a tax law is enacted or substantively enacted as it depends on local legislation process. Usually there is a consensus among accounting professionals what it means in each tax jurisdiction.
Note that a law that is enacted or substantively enacted after the end of the reporting period is a non-adjusting event (IAS 10.22(h)).
Uncertain tax treatments
There is a separate interpretation issued by the IASB that deals with uncertain tax treatments: IFRIC 23 Uncertainty over Income Tax Treatments. An uncertain tax treatment is defined there as a tax treatment for which there is uncertainty over whether the relevant taxation authority will accept the tax treatment under tax law (IFRIC 23.3). Under IFRIC 23 an entity:
- considers uncertain tax treatments separately or jointly based on which approach better predicts the resolution of the uncertainty (IFRIC 23.6-7),
- assumes that a taxation authority will examine amounts it has a right to examine and have full knowledge of all related information when making those examinations, so called ‘full detection risk’ (IFRIC 23.8),
- considers whether it is probable (i.e. >50%) that a taxation authority will accept an uncertain tax treatment, if so – the measurement is based on the tax treatment used or planned to be used in its income tax filings (IFRIC 23.9-10),
- if it is not probable that a taxation authority will accept an uncertain tax treatment, the uncertainty in measurement is reflected using the most likely amount or the expected value (see Examples 1 and 2 accompanying IFRIC 23) depending on which method the entity expects to better predict the resolution of the uncertainty (IFRIC 23.11-12),
- reassesses a judgement or estimate made if the facts and circumstances change (IFRIC 23.13-14, A1-A3).
Specific tax consequences
The measurement of deferred tax assets and liabilities should reflect tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities (IAS 12.51). See paragraphs IAS 12.51A-51E for more discussion and examples.
Business combinations and goodwill
Deferred tax asset is also recognised for fair value adjustments made in accounting for business combinations, as usually such adjustments do not affect tax base of related assets and liabilities. As a rule, deferred tax arising from a business combination affects the amount of goodwill or the bargain purchase gain (IAS 12.66). If the target company has unrecognised unused tax losses carried forward, these can be recognised as deferred tax assets as a part of business combination accounting. It is always a good idea to reassess deferred tax assets of the target, as membership in the new group might bring a different perspective in terms of tax planning opportunities.
When deferred tax of the target company (acquiree) is adjusted within the measurement period and such adjustment results from new information about facts and circumstances that existed at the acquisition date, the corresponding impact is treated as an adjustment to goodwill (IAS 12.68).
A business combination may also affect pre-acquisition deferred tax of the acquiring entity, e.g. thanks to emergence of new tax planning opportunities. If this is the case, the impact of such deferred tax is not recognised as a part of business combination accounting, i.e. it usually impacts P/L for the current period (IAS 12.67). This approach is followed even if tax effects were taken into account during business combination negotiations (IFRS 3.BC286).
Goodwill is subject to an exception to general recognition criteria for deferred tax liabilities. Namely, IAS 12.15(a) specifically states that deferred tax liabilities are not recognised for taxable temporary differences arising from initial recognition of goodwill. See paragraphs IAS 12.21-21B for more discussion on why deferred tax is not recognised on initial recognition of goodwill but can be recognised when taxable temporary differences arise after the initial recognition.
Deferred tax on investments in subsidiaries etc. is covered in a separate section.
Share-based payment transactions
Accounting for current and deferred tax arising from share-based payment transactions is covered in paragraphs IAS 12.68A-68C and Example 5 accompanying IAS 12.
Reassessment and review of deferred tax
Deferred tax assets and liabilities should be reassessed and reviewed at the end of each reporting period (IAS 12.37,56). When an expected manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities changes, the tax consequences should be accounted for when the expectation changes. This may result in tax effect being accounted for in a different period than the underlying transaction itself.
General requirements for presentation of deferred tax
The general rule is that accounting for the deferred (and current) tax effects of a transaction or other event is consistent with the accounting for the transaction or event itself. This means that current and deferred tax effects are recognised in P/L, OCI, equity or affect goodwill according to the impact of the corresponding item (IAS 12.57-62A).
When an item is recycled from OCI to P/L, the tax impact is recycled as well, however this results from widely accepted practice and it is not covered in IAS 12.
Pro rata allocation
In certain circumstances, it may be very difficult to allocate the tax impact between P/L and OCI. If this is the case, IAS 12 allows a reasonable pro-rata allocation (IAS 12.63).
An example of such circumstances relates to long-term and post-employment employee benefits, where actuarial gains or losses are recognised through OCI. Tax deduction is usually available when actual payments (contributions) are made, and it is usually impossible to allocate such tax deduction between parts that previously arose through P/L (e.g. current service cost) and OCI (actuarial gains or losses).
Offsetting deferred tax assets and liabilities
Deferred tax assets and deferred tax liabilities are offset if, and only if (IAS 12.74):
- the entity has a legally enforceable right to set off current tax assets against current tax liabilities; and
- the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same taxation authority on either:
- the same taxable entity; or
- different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realise the assets and settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled or recovered.
More about IAS 12
See other pages relating to IAS 12: