Convergence with IFRS is expected to give rise to significant income-tax issues in addition to financial reporting and other business issues. Consequently, it is vital that the tax workstream of any convergence project remains integrated with the financial reporting and other workstreams. However, this is not without its challenges, and continuing uncertainty around how the tax authorities will deal with the convergence may compound this problem.
To address the issues relating to current tax, the Institute of Chartered Accountants of India (ICAI) and the Central Board of Direct Taxes (CBDT) have constituted a joint working group. Recently, the Secretary to the Ministry of Corporate Affairs (MCA) has asked this group to come out with a specific proposal that will result in a tax-neutral position. Some have speculated that this may result in Indian GAAP numbers remaining the basis for the payment of tax by companies. While there remains an uncertainty with respect to the current tax, experience indicates that conversion may also have significant deferred tax implications, with a significant impact on the financial statements and tax processes. This article provides an overview of some commonly occurring instances of key deferred tax impact.
Timing differences versus temporary differences approach
Over the last eighty years or so, two methods have evolved for the accounting for deferred taxes, commonly known as the “timing differences” and “temporary differences” approach. The timing difference approach, which is the basis of accounting for deferred tax under Indian GAAP, focuses on the differences that arise between the timing of the recognition of income and expenditure for financial reporting and tax purposes.
At a conceptual level, Ind-AS focuses on the “temporary difference” approach. This approach is also known as the “balance sheet approach” as it focuses on the differences between the carrying amounts of assets and liabilities and the amounts attributed to them for tax purposes. In broad terms, this method seeks to calculate the tax, which would be paid if the net assets of the company were realized at their book value.
In a number of areas, a timing difference approach and a temporary difference approach will not result in any arithmetical difference with respect to the deferred tax calculated under Ind-AS as opposed to Indian GAAP. However, there are a number of important instances where a temporary difference is also not a timing difference. In more complex situations such as multinational groups, the two methodologies can produce radically different results.
For example, the revaluation of fixed assets will have no deferred tax impact under the timing difference approach, as the revaluation is neither reflected in the accounting profit nor in the taxable profit. However, the temporary difference approach will result in the recognition of deferred tax due to a difference between the carrying value and tax base of fixed assets.
To correctly capture the temporary differences, it will be necessary to create a “tax balance sheet” to be compared with the Ind-AS balance sheet. A tax balance sheet typically reflects how the tax authorities view the carrying value of each item as at the balance sheet date. It is recommended that the tax balance sheet should be carefully prepared to ensure that it includes certain items, which are not recognized as assets or liabilities in the Ind-AS financial statements, but nevertheless have a tax base. For example, the company formation expenses are written off immediately for financial reporting purposes; however, they are allowed under tax over a period of five years.
The preparation of a tax balance sheet is a new exercise for most companies and new processes may well need to be developed to capture the necessary information and data for producing the tax balance sheet. However, experience of implementing deferred tax accounts in other jurisdictions has shown that preparation of a tax balance sheet is the only certain way to identify all temporary differences – companies that tried to short-cut this step sometimes had to go back and re-evaluate their deferred tax provisions at a later date.
Initial recognition exception
The tax balance sheet will help companies to identify all temporary differences in a comprehensive manner. However, they should note that ED-Ind-AS 22 Income Taxes may not allow the recognition of deferred tax on all such differences. ED-Ind¬AS 22 contains an exception with regard to the recognition of deferred tax on temporary differences that arise on the initial recognition of an asset or liability, if this asset/liability arises from a transaction, which is not a business combination, and at the time of the transaction, affects neither accounting profits nor taxable profits (tax loss).
The subsequent changes to an initially unrecognized deferred tax relating to such an asset, e.g., as a result of depreciation or impairment of the asset, are consequently not recognized even if there is a difference between the accounting charge/credit and the tax deduction/charge. This will require companies to devise systems to track such differences separately.
Deferred tax in consolidated financial statements (CFS)
Under Indian GAAP, the tax expense to be accounted for in the balance sheet is the simple aggregation of the amount appearing in the separate financial statements (SFS) of the parent and its subsidiaries. In other words, companies need not calculate the deferred tax again at the CFS level. However, this approach will not be acceptable under Ind-AS. ED-Ind-AS 22 requires deferred tax to be computed again at the CFS level. Based on our experience, some common issues that may arise have been discussed below.
Inter-company transactions and balances
In general, the profit that the seller realizes on the sale is taxed by the seller’s local tax authorities. For the buyer, the tax basis of the asset is typically the amount the buyer paid. In the CFS, the profit on the intercompany sale is eliminated and the asset is carried at the value it originally had, before the intercompany sale. In this situation, a temporary difference is created because the tax basis of the asset in the buyer’s jurisdiction is higher than the carrying amount in the CFS. This difference results in the recognition of deferred tax in the CFS, which was not there in SFS.
Furthermore, under Ind-AS, all consolidation adjustments recorded in the preparation of the CFS will need to be reviewed to evaluate whether they give rise to deferred tax consequences.
Undistributed profits/ (losses) of subsidiaries, associates and joint ventures
Under Ind-AS, “temporary differences” also arise if the carrying amounts of the investments in subsidiaries, associates or interests in joint ventures undergo a change for reasons such as (i) recognition of undistributed profits of these subsidiaries, associates and joint ventures, (ii) changes in foreign exchange rates, and (iii) recognition of impairment losses, in the CFS. These differences are also sometimes referred to as the “outside differences,” and do not result in the recognition of deferred tax under Indian GAAP. However, ED-Ind-AS 22 requires deferred tax to be recognized for all taxable temporary differences associated with investments in subsidiaries and associates or interest in joint ventures differences unless both these clauses hold correct:
We believe that in the case of a subsidiary, the parent is able to control when and whether the retained earnings are distributed. Therefore, no deferred tax liability will be recognized for the distribution of profits, which the parent has determined will not occur in the near future.
In the case of an associate, the investor does not generally control the distribution policy. Therefore, in the absence of an agreement requiring that the profits of the associate will not be distributed in the foreseeable future, an investor will recognize a deferred tax liability arising from all taxable temporary differences associated with its investment in the associate, even if it is clear that the associate will not distribute its entire reserve in the near future. As a result, this may result in a significant additional deferred tax liability being recognized under Ind-AS, which does not exist under Indian GAAP.
Recognition of deferred tax assets
Under Indian GAAP, if a company has unabsorbed depreciation or the carry forward of losses under tax laws, deferred tax assets are recognized only to the extent that there is a virtual certainty supported by the convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realized.
Under Ind-AS, deferred tax assets are recognized only to the extent that it is probable that taxable profits be available against which the temporary differences can be adjusted. The same principle will apply even if a company has unabsorbed depreciation or the carry forward of losses under tax laws. This seems to indicate that Ind-AS has laid down a lower threshold for the recognition of deferred tax asset in such cases. However, there is clearly a word of caution on recognizing deferred tax assets in a loss scenario because the existence of unused tax losses is strong evidence that future taxable profit may not be available. This effectively means that significant additional judgment will be exercised in recognizing such deferred tax assets. It will be important to prepare robust taxable income forecasts in order to recognize deferred tax assets and support the assertion that it is “probable” that they will be realized. Such forecasts may not have been required under Indian GAAP where virtual certainty almost prohibits recognition. Any reversal of deferred tax asset in a subsequent period will lead to a direct hit on EPS and it may lead to other business implications.
In addition, the application of Ind-AS may have many other deferred tax implications, e.g., relating to the recognition of deferred tax in case of business combinations, share-based payments, change in tax base of an asset/liability due to the indexation of tax costs, finance leases and the presentation of minimum alternative tax (MAT). Ind-AS also requires significant additional disclosures, some of which may be very challenging.
Wide-ranging and significant impact on businesses
The implementation of the temporary difference approach will require significant changes to be made to the tax processes and tax and financial accounting personnel will need to work more closely than ever before.
Tax professionals will require an increased amount of data in order to prepare the tax balance sheet and calculate the temporary differences. In particular, for groups and multi-nationals with decentralized accounting functions, the data capture for the purposes of deferred tax may not be straightforward as the information required may be available only at the subsidiary level. This may require updates to be made to group reporting forms and templates to ensure that subsidiaries provide all the required information. This will require planning and adequate training of subsidiary teams.
The involvement of tax professionals in the financial close process will increase. Not only will they be required to support the finance team in computing the deferred tax for separate financial statements, but also to compute the impact of the consolidation adjustments on the consolidated financial statements.
The recognition of deferred tax will require much greater judgment to be exercised whether it is in relation to deferred tax assets on the carried forward losses or a group’s intentions with respect to remitting the distributable reserves of subsidiaries and jointly controlled entities.
Tax does not have to be taxing, but proper planning and execution is important to achieve a smooth and well managed transition