Last week I published an article with summary of the standard IAS 12 on Income taxes. It’s not an easy text to read and some definitions in IAS 12 are so obscure that many people grope in the fog unsure what to do.
When it comes to setting the tax base of assets or liabilities, the issue becomes even more painful because it’s very hard to understand the definitions in IAS 12.
In this article I would like to explain a concept of a tax base and give you some useful hints how to determine it.
This Is What You Should Ask First
Before trying to set a tax base of any asset or liability, ask yourself these questions:
What happens when in the future I recover this asset or settle this liability and remove it from my balance sheet? Will this removal affect my tax payments in the period of recovery or settlement? In other words, will I have to make some adjustment to my accounting profit in order to arrive to taxable profit?
If the answer is yes, then the tax base of this asset or liability is for sure different from its carrying amount.
If not, then the tax base of this asset or liability equals to its carrying amount.
Now let’s break it down.
Setting the tax base of assets
“Tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.”
That’s the definition from IAS 12 Income Taxes.
However, I look at tax base of an asset as at something “what’s left in the tank” to deduct for tax purposes in the future.
Let me show you 2 examples. From the “tax base” point of view, there are 2 types of assets. No matter what type you’re dealing with, setting the tax base is the same.
- Assets that will be recovered through their usage
As you will recover the carrying amount of these assets by their usage in order to achieve profit, you will probably charge them to your profit or loss in the future. The examples of these assets are property, plant and equipment or prepaid expenses.
Let’s say you have a machine with a cost of 1 000 and you charged depreciation of 200. However, for tax purposes, you can deduct only 150 this year.
Clearly, carrying amount of this asset is 800 which is 1 000 less 200.
What is a tax base?What’s left in the tank for future tax deductions?
Since you have already deducted 150, you will be able to deduct 850 in the future (1000 less 150), so the machine’s tax base is 850.
Now you can work out temporary difference and deferred tax yourself.
- Assets that will be recovered through receipt of cash or other asset
In this case, you will not charge a carrying amount to profit or loss. Instead, you will credit a carrying amount against any cash or other consideration received in exchange. The examples of these assets are receivables.
Let’s say you have an interest receivable of 500. However, you did not include this receivable into taxable profit calculation because in your country interest received is taxed when cash is received.
What’s left in the tank for future tax deductions when you recover this receivable?
The answer is zero. Nil. Why?
Because when you recover the receivable in the future by receiving the cash, then you need to include it in your tax return. How much can you deduct for tax purposes in the time of taxing? Zero. You must tax it in full.
As the carrying amount of this interest receivable is 500 and tax base is 0, you can work out the temporary difference and a deferred tax.
Setting the tax base of liabilities
The definition of a tax base of a liability coming from IAS 12 Income Taxes is:
“Tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.”
However, I look at tax base of a liability as everything you are NOT going to deduct in the future for tax purposes.
From the “tax base” point of view, there are 2 types of liabilities:
- Liabilities that will be settled through profit or loss
These are the liabilities that you will derecognize by charging them to profit or loss, for example, unearned income or various revenues where the cash is received in advance.
Let’s say you received the prepayment of 200 from a client for the services you’ll provide the next year. Revenue is taxable based on the time of generating it (=provision of services) and not in the time of receiving the payment.
What is a tax base of the liability from prepayment received?
In other words – what are you NOT going to deduct in the future?
In this case, when you provide the services and thus settle the liability from prepayment by charging it as revenue to profit or loss – can you deduct something from that revenue for tax purposes in the next year?
No, you cannot. You must tax your revenue in full, there’s NO deduction and it means that the tax base of your liability is equal to its carrying amount. As there’s no temporary difference, there’s no deferred tax.
However if you need to tax your revenues at the time of cash receipt instead of time of providing the service, the situation becomes different. In such a case, you tax the revenue when you receive the prepayment and in the next period of settling the liability, you can deduct full amount from taxable profit. So the amount that you are NOT going to deduct in the future becomes zero which would be the tax base of your liability.
- Liabilities that will be settled through delivery of cash or other asset
Here, you will settle the liability by giving away some cash or other asset. The examples of these liabilities are payables or provisions.
Let’s say you recognized a provision for employee benefits of 800. According to tax rules in your country you cannot deduct costs for creating that provision for tax purposes until you actually pay these benefits.
What is a tax base of the provision?
What are you NOT going to deduct in the future?
The answer is zero. Why?
Because when you pay the benefits to the employees and thus settle the liability, you can deduct the full amount for tax purposes in that time. Therefore the amount that you are NOT going to deduct in the future becomes zero which is the tax base of your liability.
If you’d like to know how to calculate deferred tax step by step, please read my guest post here.
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