This article was first published in the June 2011 China edition of Accounting and Business magazine.
Is IAS 12, Income Taxes, flawed? Well, no one standard is perfect, let alone the evolving accounting standards. Nonetheless, it’s a fact that deferred tax accounting has received a lot of criticism. Whether you agree with the saying that deferred tax is one of the least understood items on balance sheets, there is a consensus that there needs to be a comprehensive review of the fundamentals for income tax accounting.
But before that happens, the International Accounting Standards Board (IASB) has decided to make certain smaller changes. One recent change is the amendment to IAS 12, Deferred Tax: Recovery of Underlying Assets.
In Asia Pacific, many companies carry investment properties at fair value, particularly in places where the property market is sky-rocketing, such as Hong Kong and Singapore. The increase in fair value of the property is a future income to the company, either in the form of rental income if the property is held to be leased out, gain on sale of the property, or a combination of both.
Typically, the increase in fair value of the property is not tax-affected until either the rental income is earned or the property is disposed of. If either is taxable, then a deferred tax liability should be recorded in the financial statements at the same time the fair value increase is recorded. This is the spirit of deferred tax under IAS 12: when the recovery of an asset (or settlement of a liability) at its carrying amount as reflected in the financial statements will have tax consequences in the future, the related deferred tax effects should be recognised.
Depending on the tax rules in a given jurisdiction, different ways of recovering an asset may attract different taxes at different amounts. IAS 12 sets out the principle that companies should measure the deferred tax based on the way management expects to recover the asset.
Take an investment property in Hong Kong as an example. If management expects the property is held to generate rental income which will be taxable at an income tax rate of 16.5%, then a deferred tax liability relating to the increase in fair value should be recognised at 16.5% at the same time that the fair value increase is recognised.
If, however, management expects the property to be sold soon and if the gain is deemed to be capital in nature by the tax authority (which is non-taxable in Hong Kong), then no deferred tax liability is necessary for the increase in the value of the property.
However, the way an investment property is expected to be recovered is not always as clear-cut. Because a property lasts for a long time, particularly on land that is freehold or on a long lease, it can be difficult for companies to have a clear plan as to what portion of the property’s value will be recovered through use (rental income) and what portion will be recovered through sale.
In the absence of a specific expected time to sell, given these companies have been and continue to be holding at the time of reporting the properties to earn rental income, it is common for companies to deem the properties to be recovered through use entirely until there is a specific plan or actual sale.
As such, prior to the amendment, these companies would have to provide for the deferred tax liability based on the tax rate levied on rental income (the use rate). Where sales of these properties are tax-free, companies are troubled with this accounting because this accumulated deferred tax liability will continue to be recorded but may never have to be paid if one day the property is sold.
They complain that such accounting does not reflect the economics. For a number of years, some jurisdictions, including Hong Kong, Singapore and New Zealand, have been lobbying the IASB for a change to the requirement. The IASB eventually issued the amendment in December 2010 as a quick fix.
What is the change?
Essentially, the amendment creates a rule-based exception for investment properties that are measured at fair value. Instead of the normal rule of following management’s expected manner of recovery as required by IAS 12, the amendment pre-empts the management’s expectation and mandates the sales recovery. That is, on the reporting date, the company presumes that its property will be sold at its fair value on that date (the presumption) and recognises any tax effects on such sale as deferred tax.
This is so regardless of whether the management intends to hold it for a longer period of time without a specific disposal plan, or if it does have a specific plan to sell, say in three years’ time, the property is presumed to be recovered through sale on the reporting date. The IASB believes this presumption would remove the subjectivity and difficulty of pinning down a specific disposal plan some companies found in following IAS 12.
That said, the presumption is not invincible. It is rebuttable if (here we go, an exception to an exception) the company’s business model is to hold its properties for rental income for a long, long time – so long that the value of the property is substantially recovered through use, rather than through sale. That could mean that even if a very good price is offered, the company might not be convinced to sell and would rather continue to hold the property.
One may see the hurdle to rebut: in a market where the property values continue to increase, it may be difficult to achieve the ‘substantial value’ of the property.
On the other hand, rebuttal is possible where the property’s life is finite (eg land that is held through an operating lease), or where the property is held by a shell company that has nothing else (corporate wrapper) and whose sole purpose is to hold the property forever for some reason.
One of these reasons could be the high capital gains tax levied on direct sales of property in some jurisdictions, making it uneconomical for companies to buy and sell a property directly.
To buy and sell the property, these companies buy and sell the corporate wrapper’s shares instead. If the presumption is rebutted, then the company falls back to the normal rule in IAS 12 to follow management’s expected recovery – that is, substantially through use in this case – and hence the use rate is applied in determining the deferred tax liability.
The presumption cannot be rebutted for an investment property, or portion of an investment property, that is non-depreciable. Therefore, if the land element of an investment property is freehold – such as some land in Malaysia – even though a company is able to rebut the presumption, the recovery of the freehold land must still be through sale, while the building element of the same property is recovered through use.
This presumption applies equally to investment properties that are bought as part of an acquisition of another company or a business (business combination), but only if they are measured at fair value subsequently by the buyer. Someone may spot the anomaly that the exception requires different deferred tax accounting for similar investment properties and tax rates, but different accounting policies for the properties.
For an investment property measured at cost (as allowed by IAS 40), be it acquired directly or as part of a business combination, this presumption is not available. To illustrate, let’s look at two similar properties in the same area where there is income tax but no capital gains tax.
Property A is measured at fair value, hence recovery is through sale based on the presumption resulting in no deferred tax liability. Meanwhile, property B next door is measured at cost, so recovery can be through use (if that’s the management’s expectation), resulting in deferred tax liability at income tax rate.
This amendment is mandatory for companies reporting under the International Financial Reporting Standards (IFRS) for annual periods beginning on or after 1 January 2012 and full retrospective application is required. The IASB worked very hard to publish the amendment on 20 December 2010, so that companies that are eager to adopt early can do so in their 2010 financial statements.
Solving or creating problems?
In principle, the IASB and the constituents at large have been working diligently to strive for a set of principle-based accounting standards, with as few exceptions as possible. So it is understandable that many respondents were strongly against this amendment when it was first proposed.
While this amendment is certainly welcomed by some jurisdictions that have been advocating the change (typically where there is no capital gains tax, or capital gains tax is lower than the income tax rate, as companies affected can reduce the deferred tax liability significantly), the effect of the exception is yet to be fully known. Some heated debates have been going on since its issuance:
- For companies in jurisdictions where the capital gains tax rate is higher than the income tax rate, would this amendment create a burden to them to rebut the presumption in order to use the lower income tax rate?
- How will the deferred tax for properties transferred from/to investment properties be accounted for?
- Should a scope extension be given to include assets measured at cost as the ‘principle’ of the exception is equally applicable?
As the IASB is busy meeting the deadline for its new wave of many other accounting standards (revenue, leases, financial instruments, etc), many IFRS users and preparers are looking forward to a better tax accounting standard – a more robust, principle-based and conceptually sound standard that reflects the economics of transactions and events.
Dorothy Leung is director of accounting consulting services at PwC Hong Kong