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Old Friday, March 24, 2006
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Default Defered Tax & Current Tax

Hi All,

Can please any one explain explain what is current Tax & Deffered Tax.
and what is there treatment.

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Old Friday, March 24, 2006
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Thumbs up Deferred Tax & Current Tax n their treatment

HI, free thinker,
here's a brief overview of yur query..................

Deferred Tax
FRS 19 defines deferred tax as:
‘The estimated future tax consequences of transactions and events recognised in the financial statements of the current and previous periods’.
Deferred tax arises when the actual tax consequence of a particular transaction (tax payable or recoverable) arises in a different period from the period in which the transaction itself is included in the financial statements. Examples include (but are not restricted to):
  • Fixed asset costs that have a different pattern of tax deductions to the write off of the asset in the financial statements.
  • Pension liabilities that are accrued in the financial statements but are allowed for tax only when the contributions are made to the pension fund at a later date.
  • Inter-group profits in stock that are unrealised for consolidation purposes, yet taxable in the computation of the group company that made the unrealised profit.
  • Losses reported in the financial statements where the related tax relief is only available to carry forward against future taxable profits.
These differences are referred to in FRS 19, ‘Deferred Tax’ as timing differences.
Since taxation is payable on profits (or gains) less losses, FRS 19 adopts the approach that classifies differences between the gains and losses that are recognised in the financial statements and the gains and losses that are recognised for tax purposes into two types:
  1. Permanent differences - one-off differences between results for accounting purposes and taxable income, caused by certain items not being taxable / allowable. Such differences only impact on the taxation computation of one period (e.g. in England, entertaining other than staff entertaining is never allowable for tax purposes and certain types of grant are never taxable).
  2. Timing differences - defined above.
Alternative approaches to accounting for deferred tax
The nil provision, or flow through basis ignores the taxation effects of timing differences completely. Tax is accounted for as it is assessed on the basis that taxation is an appropriation of profits by the government, and so is not relevant as a performance indicator. A theoretical justification for this argument is that the only tax liability that satisfies the statement of principles’ definition of a liability (an obligation to transfer economic benefits out of past transactions and events) is current taxation.
The full provision is based on the view that every transaction has a tax consequence and it is possible to make a reasonable estimate of the future tax consequences of transactions that have occurred by the balance sheet date. If this basis of deferred tax accounting is adopted, the computation of the deferred taxation figures is a relatively straightforward arithmetical exercise.
The position taken by SSAP 15 (the previous UK standard on deferred tax) was known as the partial provision basis. Like the full provision basis the partial provision basis is based on the premise that the future reversal of a timing difference gives rise to a tax liability (or asset). However, instead of focusing on the individual components of the tax computation the partial provision basis analyses the components as a whole in a single net assessment. To the extent that timing differences are expected to continue in future (by the existing timing differences being replaced by future timing differences as they reverse) the tax is viewed as being deferred permanently. The computation of deferred tax balances under the partial provision basis is rather more complicated than under the full provision basis because of the need to use forecasts of future transactions to estimate the incidence of future timing differences.
The FRS 19 approach to accounting for deferred tax
The general principle underpinning FRS 19 is that deferred tax should be provided in full on all timing differences – in other words the full provision basis.
The partial provision basis underpinning SSAP 15 was rejected for the following reasons:
  • it is inconsistent with international practice;
  • the financial statements reflect the tax consequences of transactions that have not yet occurred;
  • reliance on future forecasts is subjective;
  • the basis had already been regarded as inappropriate for dealing with certain categories of timing differences – for example on post-retirement benefits.
The full provision basis of accounting for deferred taxation was regarded as preferable to the flow-through basis because:
  • the flow-through basis is not used internationally and the ASB is committed to convergence of UK and international practice where appropriate;
  • the full provision basis recognises the future taxation consequences of transactions that have already occurred and from which entities clearly cannot withdraw. Therefore it is appropriate to recognise such future consequences as assets or liabilities.
The approach taken in FRS 19 to deferred tax accounting under the full provision basis is the incremental liability approach. This approach recognises deferred tax only when it could be regarded as meeting the definition of an asset or a liability in its own right.
An alternative approach to deferred tax accounting under the full provision approach is the valuation adjustment approach. This is the approach taken in the international accounting standard on deferred tax – IAS 12, ‘Income Taxes’. This approach recognises deferred tax on all differences between the carrying values of assets and liabilities in the financial statements and their values for tax purposes (the value for tax purposes is referred to in IAS 12 as the tax base of the assets or liabilities).
Three examples will illustrate the different approaches to full provision deferred tax accounting between FRS 19 and IAS 12. In all examples we will assume the tax rate is 30%.
Example 1
A fixed asset cost £100,000 when purchased and depreciation totalling £40,000 has been charged up to the balance sheet date – 31 March 2002. The company has claimed total tax allowances on the asset of £50,000. On 31 March 2002 the asset is revalued to £90,000.
Solution - incremental liability approach (FRS 19)
The timing difference on the asset prior to revaluation is £10,000 (£50,000 - £40,000. The tax payable on this timing difference (30% x £10,000 = £3,000) is an unavoidable liability of the entity. If the asset is retained then future tax allowances will be £50,000 and future depreciation charges £60,000 (£100,000 - £40,000).
The tax payable on the net reversing timing difference is £3,000. If the asset is sold then the written down value for tax purposes (£100,000 - £50,000 = £50,000) is £10,000 larger than the written down value for accounts purposes (£100,000 - £40,000 = £60,000). Once again, an unavoidable liability to tax on the reversing timing difference arises of £3,000.
Revaluing the fixed asset to £90,000 does not create an unavoidable incremental tax liability. The revaluation of a fixed asset is not a taxable event and a tax liability does not crystallise until the asset is sold. Therefore, unless the company has made a binding commitment to sell the asset by the balance sheet date no additional liability for deferred tax is recognised.
Solution - valuation adjustment approach (IAS 12)
The deferred tax liability prior to the revaluation is the same as for the incremental liability approach – although reached by a different method. The carrying value of the asset is £60,000 (£100,000 - £40,000) and its tax base is £50,000 (£100,000 - £50,000). The difference between the carrying value of an asset and its tax base is £10,000 (referred to in IAS 12 as a temporary difference). Under IAS 12 deferred tax is recognised on most temporary differences so the liability will be £3,000 (£10,000 x 30%).
Revaluing the asset increases its carrying value without altering its tax base (since revaluations have no immediate tax consequences). Therefore the revaluation creates an additional temporary difference of £30,000 (£90,000 - £60,000) and so additional deferred tax of £9,000 (£30,000 x 30%) would be recognised.
Example 2
On 30 June 2001, a group acquires a new subsidiary. At the date of acquisition the subsidiary had stock that was shown in its financial statements at a carrying value of £50,000. The group assessed the fair value of the stock to be £55,000.
Solution - incremental liability approach (FRS 19)
There are no deferred tax implications in the consolidated accounts because a fair value adjustment has no effect on the tax payable on the eventual sale of the stock. The tax payable is based on the profit made by the new subsidiary in the tax jurisdiction in which it operates. This is not changed by its incorporation into the consolidated financial statements.
Solution - valuation adjustment approach (IAS 12)
The carrying value of the stock in the consolidated accounts is £55,000 whilst its tax base is £50,000. Deferred tax is recognised on the temporary difference of £5,000. Since the tax rate is 30% then the deferred tax asset is £1,500.
Example 3
A UK company has an associate located overseas in Taxland. The UK company’s share of the retained profits of the associate is £40,000. If these profits were remitted to the UK company as a dividend then under tax legislation in Taxland the associate would need to deduct withholding tax equivalent to £4,000 from the payment. It is unclear whether any double tax relief would be available.
Solution - incremental liability approach (FRS 19)
Unless the overseas associate has entered into a binding obligation to pay a dividend there are no deferred tax consequences. No further tax will be payable until the earnings are remitted.
Solution - valuation adjustment approach (IAS 12)
The existence of a potential tax charge on the payment of a dividend affects the tax base of the net assets of the associate in the consolidated accounts. Provision is made for deferred tax on the £4,000 potentially payable.

FRS 19 - a summary of the requirements of the standard
Subject to the specific exceptions noted below deferred tax is recognised on all timing differences that have originated but not reversed by the balance sheet date. However, deferred tax is not recognised on permanent differences.
Deferred tax is not recognised on revaluations of fixed assets unless:
  • The fixed assets are continually revalued to fair value with changes recognised in the profit and loss account (e.g. investments that are ‘marked to market’).
  • The company has entered into a binding commitment to dispose of the asset by the balance sheet date and expects to pay tax on the sale.
Deferred tax is not recognised on fair value adjustments made when a subsidiary, associate or joint venture is consolidated for the first time. The only (very rare) exception to this general rule is where the consolidated entity has (at the date of acquisition) entered into a binding agreement to dispose of an asset that attracts a fair value adjustment.
Deferred tax is not recognised on potential tax payable on the unremitted earnings of subsidiaries, associates and joint ventures unless the subsidiary, associate or joint venture is demonstrably committed to distribute those earnings at the balance sheet date.
In principle, deferred tax assets should be recognised in just the same ways as deferred tax liabilities. However as with all assets the question of recoverability arises. Deferred tax assets are regarded as recoverable if, on the basis of all the available evidence, it can be regarded as more likely than not that there will be suitable taxable profit from which the future reversal of the underlying timing differences can be deducted. The criteria often need to be applied in practice if the potential deferred tax asset is caused by a trading loss that can only be relieved by carry forward against future taxable profits. The reason for the existence of past trading losses needs to be established. If they are caused by a non-recurring event or series of events (such as the disposal of a loss-making business segment) then it might be reasonable to assume that future trading profits will be available to offset the losses. However, if the reasons for the trading loss relate to ongoing conditions then it may well be inappropriate to regard the potential deferred tax asset as recoverable.
Deferred tax should be recognised in the profit and loss account for the period, unless the gain or loss in respect of which the deferred tax arises is recognised in the statement of total recognised gains and losses. An example of such a gain or loss would be the gain or loss on revaluation of the net pension asset or liability that is required under FRS 17, ‘Retirement Benefits’.
Deferred tax should be measured at the average tax rates that are expected to apply in the periods in which the timing differences are expected to reverse, based on tax rates that have been enacted or substantively enacted by the balance sheet date.
Reporting entities are permitted but not required to discount deferred tax assets and liabilities to reflect the time value of money. The reasons for allowing, rather than requiring, discounting appear to be two-fold:
  • Whilst the majority of the ASB appear to be in favour of the conceptual validity of discounting (it is used in other standards such as FRS 12, ‘Provisions and Contingencies’ and FRED 17, ‘Retirement Benefits’ it is not permitted in IAS 12 and so discounting could be said to inhibit international harmonisation of deferred tax accounting.
  • There is a balance to be drawn between the additional costs of discounting and the potential benefits that the approach could bring. There is currently a reasonably widely held view that disclosure of the expected periods of reversal of long-term timing differences would be an acceptable (and less costly) alternative. Therefore the case for discounting is not sufficiently strong to make it compulsory at this time.
If discounting is adopted then:
  • Certain timing differences, that are already based on discounted cash-flows (such as provisions for future pension liabilities) should not be discounted further.
  • The discount rates used should be the post-tax yields to maturity that could be obtained on government bonds with maturity dates, and in currencies similar to those of the deferred tax assets or liabilities.
  • The ‘full reversal’ approach should be adopted, taking to account the incidence of potential future timing differences that will replace those reversing.
Current Tax

FRS 16, Current tax, was issued in December 1999. It applies to all accounting periods ending on or after 23 March 2000. For examination purposes, it is examinable from the December 2000 diet. The system of UK corporate taxation changed fairly radically in April 1999 with the abolition of Advance Corporation Tax (ACT), and consequently of the imputation system of taxation. Prior to 6 April 1999 UK companies were normally required to make a payment of Corporation Tax whenever they paid a dividend to their shareholders. This payment of corporation tax acted as a payment on account of the total corporation tax liability for the period in which the dividend was paid and effectively discharged the basic rate income tax liability of the recipient. Where a recipient was not a taxpayer it had been possible for the recipient to reclaim the tax that had effectively been deducted at source by the payer of the dividend.
Therefore, SSAP 8 — the predecessor standard to FRS 16 — required UK companies to show dividends as the cash amount receivable plus the associated tax credit. From 1997 the ability of non-taxpaying recipients to reclaim the tax credit was curtailed so the ASB was examining the issue of the treatment of dividend income in any event. The abolition of ACT was one of the factors that led to a root and branch review of SSAP 8 and the issue of FRS 16. Recognition of current tax

Current tax is defined in the standard as the amount of tax estimated to be payable or recoverable on the taxable profit or loss for the period, along with adjustments to estimates in respect of previous periods. FRS 16 requires that current tax should be recognised in the profit and loss account for the period, unless the related gain or loss is recognised directly in the statement of total recognised gains and losses (STRGL). An example of a gain or loss that might go directly to the STRGL, yet have current tax implications, would be the prior year effect of a change in accounting policy.
Treatment of outgoing and incoming dividends

Both outgoing and incoming dividends should be recognised in the profit and loss account at an amount that:

l includes any withholding taxes; but:
l excludes any other taxes, such as tax credits, not paid wholly on behalf of the recipient.
As already stated earlier in the article, this represents a significant change in the method of accounting for incoming dividends. The change arose from reconsidering the principles underlying the standard rather than simply because of the changes to UK tax legislation. The rationale for including withholding tax (normally levied on dividends from overseas investments) but excluding tax credits (associated with dividends received from UK investments) was essentially that for companies overseas dividends represent taxable income, so the tax deducted at source is genuinely part of that income, whilst UK dividends are not taxable anyway, so any tax credit is purely notional. Most students reading this article will have studied taxation and should recall that UK companies do not pay corporation tax on dividends received from other UK companies because such dividends are paid out of the post-tax profits of the paying company, and these profits have already been subject to UK corporation tax.
A consequence of the FRS16 treatment of dividends is that the effect of withholding tax on incoming dividends should be shown as part of the tax charge as well as part of the dividend. Treatment of transactions not taxable at the standard rate

FRS16 requires that income and expenses should be included in the pre-tax results on the basis of income or expenses actually receivable or payable. The standard specifically prohibits the making of adjustments to reflect a notional amount of tax that would have been paid or relieved in respect of the transaction had it been taxable or allowable on a different basis.

This provision was considered necessary to prevent the notional grossing up of transactions with the objective of showing a consistent pre and post tax result.
A UK company purchases an asset for ?280,000. A tax-free grant of ?70,000 is available towards the cost of the purchase. The UK company leases the asset to another user for a 5 year period at an annual rental of ?40,000. UK corporation tax is levied on taxable profits at 30% and capital allowances are available in full over the asset life.
It should be clear that the company has made a pre-tax loss of ?10,000 over the 5 year period [5 x ?40,000 – {?280,000 – ?70,000}]. At first sight you might wonder why the company owning the asset would be prepared to lease it for only ?40,000 per annum. The reason is the favourable tax treatment. If the grant is tax-free then the company can receive capital allowances totalling ?280,000 to cover taxable income of only ?200,000. Therefore they have a tax loss of ?80,000 which, assuming the availability of sufficient profits on other activities, can be offset against taxable profits. Therefore, the overall position regarding this transaction would be:
?Pre-tax loss (see above)(10,000)Tax credit (30% x ?80,000)24,000 Post-tax profit14,000 Some preparers, in a desire to show a profit at both pre and post-tax level sought to apply a notional tax-rate to the tax-free grant. The result of this process was that a tax-free grant of ?70,000 was regarded as equivalent to a taxable grant of ?100,000 (?70,000 x 100/70). The pre-tax result would then be restated assuming a taxable grant of ?100,000 [making the net cost of the asset ?180,000 and the pre-tax profit ?20,000] and the tax charge increased by ?30,000 as well, to give the following result:

?Pre-tax profit20,000 Tax charge (?30,000 grant – ?24,000)(6,000)Post-tax profit 14,000
The net result is the same as before, but a profit is shown at both pre and post tax level. FRS 16 prohibits this treatment as it masks the evident fact that the profitability of the transaction is dependent on the favourable tax treatment afforded to the grant. Following the inclusion of this material in FRS 16 the ‘holding measure’ that was incorporated in UITF Abstract 16, Income and expenses subject to non-standard rates of tax, was withdrawn. This process provides students with a useful reminder of one of the functions of the UITF — to issue interim pronouncements on important issues prior to their being considered in more depth by the ASB. Rate of corporation tax used in financial statements

FRS16 requires that current tax should be measured at the amounts expected to be paid or recovered using the tax rates and laws that have been substantively enacted by the balance sheet date. A UK tax rate can be regarded as having been substantively enacted if it is included in either:

l a bill that has been passed by the House of Commons and is awaiting only passage through the House of Lords and Royal Assent; or
la resolution having statutory effect that has been passed under the Provisional Collection of Taxes Act 1968.
This provision represents a change from the previous accounting standard (SSAP 8), which required that ‘the latest known rate’ be used. The change brings UK practice more into line with that adopted internationally. Some students may be wondering why only legislation up to the date of the balance sheet can be taken into account in determining the relevant rate of tax to use. A number of commentators suggested that the date of signing the accounts should be the key date for determining the rate of tax to use. This would seem to be more consistent with SSAP 17, Accounting for post balance sheet events. However the ASB rejected this proposal on the following grounds:
lIt is desirable that a universal effect, such as a tax rate, should be applied by all reporting entities from the same date. This would not happen if the cut-off point were the date of signing the accounts.
lPractical problems could arise if a new tax rate or law was substantively enacted between the date on which a company announced its results and the date of signing the financial statements.

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Last edited by Qurratulain; Friday, March 24, 2006 at 02:40 PM.
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