Response to Exposure Draft Recognition of Deferred Tax Assets for Unrealised Losses

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1 Kim Chiu Chua Singapore 18 December 2014 International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom Submitted electronically through IFRS wedsite Dear Sirs Response to Exposure Draft Recognition of Deferred Tax Assets for Unrealised Losses I am providing, in a personal capacity, my comments on the above Exposure Draft (ED) issued by the International Accounting Standards Board (IASB) in August The views expressed in this letter are mine and do not necessarily reflect those held by the firm in which I am a partner, the national accounting standard setting body of which I am a council member or the professional body for which I chair a committee on financial reporting standards. I wish to commend IASB for taking the step to clarify the recognition of a deferred tax asset that is related to a debt instrument measured at fair value in circumstances where its cost remains the tax base. Instead of providing my specific response to each of the questions in the ED, I wish to provide some general comments focusing on the principles. Recovering a deferred tax asset arising from fair value accounting in two ways I agree that there are divergent practices relating to the recognition of a deferred tax asset arising from applying fair value accounting for a debt instrument held. While it is a fact that IAS 12 does not address certain issues directly, I do not believe that the best way to rectify this is to expand the IAS 12 to address these specific issues oneby-one on an ad hoc basis. In my view, a better approach is to focus on the principle for deferred tax asset recognition and make it more comprehensive. I will explain my proposition starting from the case of a fixed-rate debt instrument held as a financial asset measured at fair value and then test the generality of my proposition against another classic example. 1

2 When the fair value of a fixed-rate debt instrument declines due to a rise in market interest rates but not to its impairment, the expected cash flows from the instrument remain the same as the contractual cash flows coming in periodically as interest income and finally as principal repayment. The new fair value is merely the result of discounting the same set of cash flows at a higher discount rate, such that after the carrying amount is adjusted to the fair value, the instrument s new effective interest rate, which is the same as the new discount rate, will reflect a higher yield to maturity. This fair value loss creates, for income tax purposes, a deductible temporary difference. This difference creates a deferred tax asset because the entity is able to recover its value in one of the following ways: First scenario Deductible expense offset against taxable income Second scenario Non-taxable income The first scenario is where the entity sells the debt instrument at its fair value before its maturity and realises a loss that becomes a tax deductible expense available for offset against taxable profit. As only taxable income, not necessarily profit, is needed for the utilisation of the deductible expense, I would suggest using taxable income as a more general term in this context. The second scenario is where the entity holds the debt instrument to maturity. As the debt instrument reverses the earlier fair value loss over time towards its maturity, the resulting fair value gain is a non-taxable income. The deferred tax asset is recovered through the tax saving effect of a non-taxable income. It is important to note that the recovery of the deferred tax asset in this manner is not dependent on the entity s ability to generate an overall taxable profit or any other source of taxable income to utilise the tax-deductible expense. Proposed amendments to IAS 12 2

3 IAS 12 and the current proposed amendments continue to focus largely on the first scenario. For example: Para 24: to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised ; Para 27: reductions in tax payments will flow to the entity only if it earns sufficient taxable profits against which the deductions can be offset ; Para 27A: whether taxable profits will be available against which it can utilise a deductible temporary difference ; Para 29(a)(i) the extent to which the future taxable profit is sufficient for the entity to deduct the amounts resulting from the reversal of those deductible temporary differences; Para 29A Estimating taxable profit in future periods. recovery of an asset for more than its carrying amount is likely to be probable, if, for example, it is measured at cost and used in a profitable operation It is clear that para 24 is too narrowly worded as it requires probable that taxable profit will be available. It does not directly accommodate the second scenario mentioned above which is a common phenomenon. While the proposed amendments and the new example will help to clarify the issues around one type of transaction brought up by the IFRS Interpretations Committee, they may not be capable of addressing other similar issues with different fact patterns. Readers who interpret the accounting standards literally may continue to regard future taxable profit as a pre-condition for deferred tax asset recognition. A more generalised principle for deferred tax recognition I propose that the Board consider amending the general principle in para 24 as follows: A deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is probable that taxable income will be available against which the deductible temporary difference can be utilised, or that the deductible temporary difference will itself reverse over time as non-taxable income, unless.. Consequential amendments can then be made to other parts of IAS 12. Recovery of a deferred tax asset by an unprofitable business I would like to use another classic example to test the generality of the proposed para 24 above. 3

4 This occurred in a real life situation where a literal interpretation of IAS 12 some years ago led to a questionable accounting treatment for a listed company. It highlighted another important characteristic of a deferred tax asset. The entity was in the hotel business. It was unprofitable due to its heavy initial investment in property, plant and equipment (PPE) and low occupancy rate for its rooms. The entity claimed tax depreciation on its PPE over a number of years based on the tax rules, which was much shorter than the estimated useful life used for accounting depreciation, resulting in a taxable temporary difference. Correspondingly, this accelerated tax depreciation gave rise to a deductible temporary difference in the form of unutilised tax loss. On a strict interpretation of IAS 12 at that time, a deferred tax liability was provided on the taxable temporary difference under IAS while a deferred tax asset could not be recognised under IAS as it was not considered probable that taxable profit would be available in the foreseeable future. As a result, the entity provided for deferred tax liability without recognising a deferred tax asset, resulting in recording a tax expense for an unprofitable business in the initial years. In later years, it recorded a tax credit (with no correlation to the pre-tax profit or loss for each of the years) as the accumulated tax depreciation and accumulated accounting depreciation (another way of saying the tax base of the PPE and the carrying amount of the PPE) converged over time. The above example clearly illustrates two important points: (a) Intuitively, an entity incurring a loss over several years should not have a tax expense in the initial years, only to reverse the prior-year deferred tax expense (provided as a liability) as a tax credit in later years. (b) A deferred tax asset should be recognised where the deductible temporary difference (unutilised tax loss) will reverse over time while the taxable temporary difference reverses itself over the life of the PPE. This shows that there is a third scenario that enables a deferred tax to be recovered regardless of the existence of future taxable profit. Third scenario Deductible expense offset against reversing taxable difference It is my proposal that to accommodate this common phenomenon, the Board consider expanding para 24 as follows: 4

5 A deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is probable that taxable income will be available against which the deductible temporary difference can be utilised, or that the deductible temporary difference will itself reverse over time as non-taxable income or that the deductible temporary difference will itself reverse while the corresponding taxable temporary difference reverses over time, unless.. I am of the view that instead of working with an incomplete principle in para 24 and then expanding the Standard with more guidance and examples to address specific situations, the focus should be to amend the general principle to cater to a wider range of situations. I hope my comments are useful. If you require any clarification, please do not hesitate to contact me. Yours faithfully, Kim C Chua. 5