Accounting alert 2011/04 - Financial reporting impacts of recent and proposed tax changes
Considerations for financial reporting at 30 June 2011
This Accounting alert sets out some general financial reporting considerations in relation to recent and proposed tax law changes.
Taxation of financial arrangements (TOFA)
New laws relating to the taxation of ‘financial arrangements’ (TOFA) were enacted on 26 March 2009. The measures mandatorily apply to tax accounting years commencing on or after 1 July 2010, but may have been elected to be adopted in the year that commenced on/after 1 July 2009. Accordingly, for many June balancing entities, the first year in which the new rules apply will be for financial years ending 30 June 2011. Individuals and small businesses are generally not required to apply the new rules but may elect to do so.
The TOFA rules apply a number of methods (some of which are default methods and others can be applied by irrevocable election). All methods require a number of conditions to be satisfied.
If an entity elects to bring financial arrangements it holds as at 1 July 2010 into TOFA, the difference between the tax value as at that date under the previous tax rules and the tax value as at that date if TOFA had always applied to each financial arrangement, creates a balancing adjustment for tax purposes. This balancing adjustment is aggregated for all financial arrangements transitioned into TOFA and is then spread equally over a four year period for tax purposes (either as a net gain or as a net loss).
The balancing adjustment is ‘detached’ from the underlying financial arrangement, such that the balancing adjustment is spread over the four year period regardless of what happens to the financial arrangement itself (e.g. the balancing adjustment is not impacted by the sale or realisation of the underlying financial arrangement). Similarly, in tax-consolidated groups, the balancing adjustment is attributed to the head entity for tax purposes, even though the underlying financial arrangement may be legally held in a subsidiary, and so is also unaffected by a subsidiary leaving a tax-consolidated group.
Impact on financial reporting
Once TOFA is applied by the entity, the accounting and tax treatments may be aligned for the financial arrangement, particularly where: (a) the effective interest method applies for accounting and the accruals method applies for TOFA, or (b) relevant elections have been made to apply the fair value, foreign exchange retranslation or financial reports methods under TOFA.
Accordingly, for financial arrangements that are transitioned into TOFA and for which the treatment under TOFA aligns to the accounting treatment, previously recognised deferred taxes will effectively ‘reverse’ and be replaced by the balancing adjustment which is spread over a four year period for tax purposes.
A question for transitional financial arrangements under TOFA therefore is how the ‘balancing adjustment’ should be accounted for when applying AASB 112 Income Taxes.
In general terms, if the hedging election is not made, the balancing adjustment for transitional financial arrangements, together with the ongoing application of the TOFA rules to transitional and new financial arrangements, effectively changes the timing of when tax consequences arise, rather than the amount of the tax ultimately paid in respect of the gain/loss on the financial arrangement. If a hedging election is made, the amount of tax ultimately paid in respect of the gain/loss on a financial arrangement may change (to match the taxation of the hedged item). Accordingly, the general principle to be applied when accounting for deferred taxes should reflect this perspective. Note; if a transitioned hedge is brought within the tax hedging election, only tax timing is aligned with the hedged item, not the tax character of the hedged item.
The application of the general principles above mean:
- The reversal of any deferred taxes associated with financial arrangements should comply with the so-called ‘backwards tracing’ concept under AASB 112, e.g. if deferred taxes associated with a cash flow hedge were originally recognised in other comprehensive income (OCI, e.g. hedge reserve), then the reversal of the deferred taxes should also be recognised in OCI
- The ‘balancing adjustment’ arising from transition to TOFA should be recognised and initially be ‘linked’ to the underlying financial arrangement giving rise to it*. Consistent with the reversal of any deferred taxes previously recognised, this may mean amounts are recognised in OCI if the gains, losses or other amounts giving rise to the balancing adjustment were themselves recognised in OCI when accounting for the financial arrangement itself
- After initial recognition, the balancing adjustment is accounted for separately, both for current and deferred tax calculation purposes. Accordingly, in the majority of cases, the current tax (amortisation of the balancing adjustment) and the deferred tax impact (reduction in the unclaimed or unreturned balancing adjustment) will offset each other and no profit and loss impacts will result
- The creation of the balancing adjustment within a tax-consolidated group should be treated in a manner consistent with tax losses and tax credits, i.e. the amount is initially recognised by the subsidiary and then accounted for as immediately assumed by the head entity. This may give rise to equity contributions or distributions where the relevant tax funding arrangement does not provide for payment for such transfers.
|*||This general principle is subject to the application of the recognition exceptions and other requirements of AASB 112. For example, the recognition of any deferred tax assets arising would need to consider the ‘probable’ recognition threshold and the ‘investment recognition exceptions’ may possibly apply if the underlying instrument relates to an investment in a subsidiary, joint venture, associate or branch. However, the ‘initial recognition exception’ should not be applied to prevent the recognition of deferred taxes in respect of the balancing adjustment itself|
Other taxation changes
The only certainty in taxation law is change. Numerous changes have occurred during the past 12-18 months which may impact financial reporting at June 2011, including for example:
- The final run-off of the Federal Government’s ‘Small Business and General Business Tax Break’, which provided a temporary investment allowance for entities undertaking certain types of capital expenditure. The allowance was permitted as an additional deduction at various rates depending upon the size of the entity. The allowance did not impact the ability to claim depreciation in the future
- A raft of amendments to the tax-consolidation provisions of the Australian tax acts. Many of the changes are retrospectively applicable, in some cases as far back as the commencement of the tax consolidation regime in 2002. The changes have various impacts on how an entity treats items under tax consolidation and in some cases may change the tax treatment of items, e.g. the ‘rights to future income’ deductions
- There is currently a Australian Taxation Office proposal to require larger taxpayers to lodge a ‘reportable tax position’ (RTP) schedule with their tax returns. The RTP schedule would include details of certain positions taken by the entity in preparing the tax return where they have not been otherwise adequately disclosed to the Commissioner.
Impact on financial reporting
With tax laws constantly undergoing change, it is important that entities carefully monitor these changes and ensure the financial reporting aspects are adequately considered. Where impacts are material or accounting approaches are varied, consideration of the need for additional disclosure is also warranted.
Accounting for the investment allowance is unclear under IFRS. As an ‘investment tax credit’ is excluded from the scope of AASB 112 Income Taxes, there are differing views on how to account for the impacts of the benefit. The two main approaches are to treat it as a tax benefit in income tax expense, or to treat it as a form of government grant that is matched against the amortisation of the underlying asset.
The impacts of the tax-consolidation amendments is recognised once from the time the amending legislation is enacted or substantively enacted.
The partially retrospective nature of the tax-consolidation changes also presents difficulties in accounting. Some entities may have already applied principles consistent with certain aspects of the new legislation in the past. Others may have followed other interpretations, potentially leading to ‘prior period adjustments’ in the income tax reconciliation as the effects may generally be reflected in income tax expense once the legislation is enacted or substantively enacted.
The ‘rights to future income’ proposals, also have retrospective application. The linkage between book and tax treatment of items and the past treatment for accounting purposes will be important considerations in reflecting the impact of any changes in this area. This is particularly important since some tax changes maybe retrospectively applied in accounting periods before Australia’s adoption of IFRS, or under various standards and amendments affecting accounting for business combinations since IFRS was adopted.
The proposed disclosure of ‘reportable tax positions’ by larger entities when preparing their tax returns may also have financial reporting considerations. For instance, AASB 112 requires the disclosure of tax-related contingent liabilities and contingent assets in accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets.
Federal Government taxation reform proposals
At the time of preparing this publication, the Federal Government continued to pursue the possible introduction of the proposed Mineral Resource Rent Tax (MRRT), together with changes to superannuation and the general corporate tax rate (proposed to be lowered from 30% to 29%). Legislation is not expected until later in 2011.
Impact on financial reporting
Care needs to be taken to ensure the accounting implications of these proposed tax changes are appropriately anticipated to and addressed in financial reporting. Direct and indirect accounting consequences may include, for example:
- Accounting for tax rate changes - the enactment or substantive enactment of legislation to implement the proposed corporate tax rate change from 30% to 29% would trigger changes to deferred taxes in the financial reporting period in which the enabling legislation is substantively enacted. This may require the ‘scheduling’ of the reversal of temporary differences, tax losses and other tax credits to determine the appropriate rate(s) to apply to each item. In other words, temporary differences expected to reverse when the 29% rate would be measured at this rate, as would tax losses that are expected to be utilised after the tax rate change takes effect. There can be numerous practical issues in determining this ‘scheduling’ and policies
- Deferred tax accounting for MRRT – based on the details available to date, it appears likely the proposed MRRT will be considered an ‘income tax’ under Australian Accounting Standards, impacting effective tax rates reported in financial statements and requiring deferred tax accounting. However, the proposed crediting of State royalties may introduce questions of how the interaction of royalties and MRRT should be presented in the statement of comprehensive income. The proposed transitional provisions allowing the use of market-based values for MRRT tax purposes may result in potential deferred tax assets that need to be carefully considered and accounted for in accordance with the recognition requirements of AASB 112. It should be noted the final accounting approach for the proposed MRRT can only be determined once enabling legislation is finalised
- Enactment or substantive enactment of Bills – direct tax accounting consequences of the enabling legislation would only be recognised once it is enacted or substantively enacted. Given the composition of the current Federal Parliament, substantive enactment may not occur until the legislation has been passed by both Houses of Parliament, even if early indications are for support from particular parties or members of Parliament. Additionally, as the changes are presented as a ‘package’, care needs to be taken when assessing substantive enactment to ensure the enactment of one Bill is not dependent upon another
- Impact on impairment calculations – the quite of changes may have impacts on recoverable amount calculations. The lower tax corporate tax rate, and the MRRT itself, may require adjustments to forecast cash, directly or through determining the pre-tax discount rate. The rebate of State royalties may impact cash flows. Risk premiums, fair values and other market-based factors may also be impacted as more certainty about the proposed changes in known and is priced into market variables
- Fair values – the impacts of major tax changes can result in realignment of fair values to take into account the new regime. As the proposed changes have both positive and negative impacts, this factor may evolve over time as the legislation is fine tuned and debated in Parliament
- Disclosure – there are a number of disclosures that may be triggered by the proposals, including accounting policies (how aspects of the proposals are accounted for), uncertainties (particularly in enactment of the proposals and the impacts on recoverable amount models), significant items (for any amounts recognised), impairment (impact on recoverable amount models, assumptions and sensitivity analyses)