“Avoid surprises on deferred income taxes” by Lucy L. Chan and Armin F. Tulio (October 24, 2011)

SUITS THE C-SUITE By Lucy L. Chan and Armin F. Tulio
Business World (10/24/2011)

Given that current income tax has an immediate impact on an entity’s cash flows, companies have traditionally focused their resources on the computation of current income tax, compliance with income tax rules and regulations, tax planning and strategizing, among others.

The other aspect of income tax, specifically accounting for deferred income tax, is usually given less priority.

And yet, this is one area where finance, accounting or tax professionals generally find difficulty in applying appropriate concepts and principles.

As a result, companies which fail to consider deferred tax items in their interim management reports are often caught by surprise once these items are taken into account at yearend.

Accounting for deferred income tax has been around since the mid-1990s. Prior to 2005, it was relatively simple to apply because accounting used to be based on a profit-and-loss approach. Under that approach, deferred tax was to be recognized whenever a transaction affected accounting income but not taxable income or vice-versa (referred to as timing difference).

Transactions which did not affect the taxable income were automatically ignored for deferred tax purposes (referred to as permanent difference).

In 2005, the transition to Philippine Financial Reporting Standards (PFRS) brought about concurrent adoption of Philippine Accounting Standard (PAS) 12, Income Taxes.

PAS 12 advocated a balance sheet approach, the objective of which was to recognize the future tax consequences of events already recognized in financial statements or tax returns through the setup of deferred tax asset or liability.

Deferred tax asset or liability is calculated as the tax rate multiplied by the temporary difference — i.e., the difference between the accounting base of an asset or liability (amount reflected in the accounting balance sheet) and the tax base (amount reflected in a notional tax balance sheet).

But deferred tax involves more than just a mathematical calculation. Rather, it is an area where significant judgment is required.

Several questions need to be answered: (a) How do we determine the tax base of an asset or a liability? (b) How do we know if the difference between the book base and the tax base is a temporary difference? (c) When do we set up a deferred tax asset or liability on a temporary difference and at what tax rate?

There are assets or liabilities which, by their nature, make it relatively easy for companies to determine whether there are temporary differences that would result in deferred tax assets or liabilities. Examples include:

• possible deferred tax assets resulting from a receivable’s allowance for doubtful accounts where the provision for impairment losses has been reflected in the income statement but bad debts are still to be claimed for future tax purposes; and

• deferred tax liabilities arising from capitalization of borrowing costs as part of a fixed asset’s cost for financial reporting purposes. For tax purposes, borrowing costs have been claimed outright as deductible expense.

There are also assets or liabilities where transactions seem to have no tax consequences and, therefore, companies run the risk of not setting up the proper deferred tax for these temporary differences.

A common example would be the so-called “day one gains or losses” on non-interest bearing receivables or payables.

Under PAS 39, Financial Instruments: Recognition and Measurement, financial assets or liabilities should be recognized at inception at their fair values. Accordingly, for receivables or payables which do not bear interest or with off-market interest rates, their fair values are lower than their face amounts (due to the time value of money), giving rise to “day one gains or losses.”

Since “day one” gains on non-interest bearing payables are not taxable, interest expense accreting on the payable would also be non-deductible for income tax purposes.

Consequently, companies have a tendency to treat these as permanent differences and no deferred tax is set up.

When principles of PAS 12 are applied, however, deferred tax liability should be recognized on the “day one” gain on the payable, with the deferred tax liability reduced as the liability increases over the years, making tax expense closer to the statutory tax rate.

Another example would be in situations where functional currency used for financial accounting is different from currency used for tax purposes.

Under PFRS, a company is required to measure transactions in its functional currency. And a functional currency can be different from the currency used where the company is located.

For example, a company that sells its services and incurs costs in US dollars may have as functional currency the US dollars.

This means that while the functional currency of a company operating in the Philippines is in US dollars, its tax currency is the Philippine peso as, in fact, existing tax rules mandate that this be the case.

Due to changes in the foreign exchange rates between the functional currency and the tax currency, the book base and the tax base of non-monetary items (e.g., property, plant and equipment) will have differences that are considered temporary differences for which deferred tax should be recognized.

This is an area which can be easily overlooked by companies since temporary differences are not obvious.

Accounting for deferred tax forces companies to monitor their temporary differences.

This has two main advantages. First, it enables a company to consider appropriate reconciling items when preparing its income tax return and reconciles its accounting income to taxable income. Second, monitoring temporary differences helps minimize the risk of overlooking tax benefits, such as benefits from net operating loss carry-over or minimum corporate income tax.

Accounting for deferred tax has never been easy.

As transactions and accounting standards become more complex and tax rules evolve, so do the questions related to deferred tax become more difficult to answer.

Since PAS 12 is very much principles based, careful analysis and significant judgment in preparing financial statements are required to ensure that deferred tax is appropriately recognized.

(Lucy L. Chan is a Partner of SGV & Co.; Armin F. Tulio is a Senior Director of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.