Financial reporting challenges for corporate taxation

Financial Reporting Brief October 2019

This article, 'Taxation – A Financial Reporting Challenge', takes a look at some developments and considerations in relation to accounting and financial reporting for corporate taxation.

Our Quarterly Financial Reporting Brief comments on a wide range of topics including accounting developments, both internationally and in Ireland/UK, in relation to financial instruments, taxation and others. Sustainability reporting and related matters continue to the fore. IAASA published its annual Observations Paper.

Corporate taxation consistently gives rise to considerable public interest, and many column inches and professional articles are written about tax management and planning. While not often written about in the context of accounting and reporting, accounting for taxation does put forward many issues and complexities, and gives rise to questions where a high level of judgement is required.

The objective of IAS 12 is to prescribe the accounting treatment for income taxes. The questions of recognition of tax bases of assets and liabilities, recoverable losses and temporary differences are fundamental elements of the basis of IAS 12. Since the International Standard, IAS 12 Income Taxes, was first published in July 1979 it has been the subject of regular review and comment, and amendment in some instances.

In the current year, accounting periods beginning on or after 1 January 2019, we again see significant developments with the requirements of ‘Uncertainty Over Income Tax Treatments’, issued by the International Financial Reporting Interpretations Committee , introduced. In addition, in 2019 the International Accounting Standards Board has published an exposure draft – ‘Deferred Tax related to Assets and Liabilities arising from a Single Transaction’.

Perhaps of even greater significance for many is the Public Statement published by the European Securities and Markets Authority (ESMA) – ‘Considerations on Recognition of Deferred Tax Assets Arising from the Carry Forward of Unused Tax Losses’. ESMA is concerned with promoting the consistent application of the requirements set out in IAS 12.

Uncertain Tax Positions

The International Accounting Standards Board sister organisation, the International Financial Reporting Interpretations Committee, sets out in IFRIC 23 how to determine the accounting tax position when there is uncertainty that could be significant to a company’s financial position, and/or in some instances the profitability of certain activities.

Much concern has arisen in practice as to how uncertainty should be reflected in the financial statements, where it is unclear how a tax authority will consider a particular tax treatment used by an entity in its income tax filings.

Where it is considered not probable that the tax authority will accept the tax treatment used or planned to be used by an entity in its income tax filings, the effect of uncertainty should be estimated using either the most likely amount or the expected value method, depending on which method better predicts the resolution of the uncertainty.

IFRIC 23 does not provide any further guidance on assessing whether it is probable that the tax authority will accept the entity’s tax treatment. IFRIC 23 requires consistent judgements and estimates to be applied to current and deferred taxes, and relevant information should be disclosed in accordance with IAS 1 ‘Presentation of Financial Statements’. Clarity about significant risk of short-term adjustment to uncertain tax provisions is valuable to the users of accounts, with focus on cases where there is non-quantification of the position. In similar context, the existence of tax related contingent liabilities should be disclosed where they are potentially material.

Deloitte IFRS in Focus provides a brief summary of requirements with some observations on practical application.

Initial Recognition

Amendments are proposed to IAS 12 to address circumstances where an asset with a matching liability arising from the same transaction are recognised. Prime examples of this are Leases under IFRS 16 and Decommissioning Obligations.

Of pressing interest for many entities is IFRS 16 which is effective for accounting periods beginning on or after 1 January 2019 and which requires an entity to recognise a right of use asset and an equivalent lease obligation.

The main change in the amendments proposed is that the initial recognition exemption would not apply to transactions in which both deductible and taxable temporary differences arise on initial recognition that result in the recognition of deferred tax assets and liabilities of the same amount. The proposed change is to address the uncertainty in practice whereby in some cases the initial recognition exemption is applied while in others it is not.

Simplification is provided for the assessment of the probability that a taxable profit will be available against which the deductible temporary differences can be utilised. There are certain reliefs available on transition and first-time adoption.

Deloitte IFRS in Focus provides a brief summary of the proposals in the ED and certain observations.

Consistent Application

The European Securities and Markets Authority (ESMA) has published a Public Statement arising from the findings and discussions of the European Economic
Coordination Sessions (EECS). Several cases have highlighted that significant divergence exists in the application and enforcement of the requirements on deferred tax assets arising from unused tax losses carried forward. These requirements are set out in IAS 12 and relate to the recognition, measurement and disclosure of such assets.

ESMA highlights the need for issuers to assess thoroughly the nature and extent of evidence which supports the conclusion that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised and, wherever relevant, the need to provide high-quality disclosures.

Several cases related to the recognition of deferred tax assets have arisen at EECS in recent years arising from the carry forward of unused tax losses, and identified significant shortcomings in the evidence issuers provided to support their recognition. Enforcers have even come across situations where despite having a history of recent losses, issuers have recognised material assets without having sufficient evidence supporting their expectation that sufficient taxable profits will be available in future years.

When evaluation of whether it is probable that sufficient future taxable profits will be available, the nature, origin and timing of such profit should be considered. Issuers should assess whether the evidence that supports the expectation of future taxable profits is convincing, and ESMA expects that convincing evidence should be objectively verifiable to support the recognition of deferred tax assets. Disclosure should be issuer-specific and tailored to the facts and circumstances. Critical judgements, uncertainties and sensitivity analysis on assumptions used are key to the quality and transparency of disclosure.

The ESMA Public Statement is an important document for those engaged with entities that have significant deferred tax assets arising from losses forward or other such sources, the recovery of which is dependent on future taxable profits.

Conclusion

Preparing financial statements is a demanding responsibility for all involved. Growing complexity of business transactions and greater investor, regulatory and public scrutiny has substantially increased the demands.

IFRIC 23 is increasing the requirements on issuers in relation to tax uncertainties and clearly there is scope for companies to better explain the bases for recognition and measurement.

The ESMA Public Statement will further highlight accounting for deferred tax assets, and how their inclusion in financial statements is supported by reliable evidence.

Investors and other stakeholders will always feel more secure where there is a high level of quality and transparency in financial reporting. Developments on accounting for taxation will contribute to this.