Tax Accounting Implications on Conversion to IFRS

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Tax Accounting Implications on Conversion to IFRS Carolyn Engel, CA Deloitte & Touche LLP Canadian Tax Foundation Calgary Young Practitioners March 9, 2010

1 Tax Accounting Implications on Conversion to IFRS Carolyn Engel, CA Deloitte & Touche LLP Canadian Tax Foundation Calgary Young Practitioners March 9, 2010 Presentation Overview Adoption and Framework of IFRS CRA Response IAS 12: Key Canadian GAAP vs IFRS Differences Selected Oil & Gas Issues Recent Developments Questions & Answers 1

2 Adoption of IFRS January 1st, 2010 : Transition Date Opening balance sheet date if PAE does not early adopt IFRS before the final deadline (Jan 1, 2011). First date of converted comparative f/s (assuming only one year of comparative statements presented) January 1st, 2011 : Conversion Adoption is required for fiscal years beginning on or after January 1, 2011 Jan Jan Dec Year Ended December 31, 2010 : Quantitative disclosure, if available, of impact of conversion to IFRS in MD&A (assuming no early adoption) December 31, 2011: First audited financial statements in compliance with IFRS 2 Authoritative References International Accounting Standards IAS 12 Income Taxes The International Accounts Standards Board (IASB) is an independent body that issues International Financial Reporting Standards (IFRS) Formed in 2001; adopted all of the International Accounting Standards (IAS) issued by its predecessor body, the International Accounting Standards Committee (IASC) The International Financial Reporting Interpretations Committee (IFRIC) is a committee that assists the IASB. Replaced the Standing Interpretations Committee (SIC) Analogous with the Emerging Issues Committee (EIC) The IAS 12 Exposure Draft ( ED ) released in March 2009 was widely criticized and therefore, the IASB voted in late 2009 to defer work on the ED. 3

3 Framework Common conceptual foundation (IAS 12 and CICA Section 3465) Both standards are based on the balance sheet approach. Recognition of deferred tax assets and liabilities for temporary differences, for operating loss and tax credit carryforwards Differences mostly in the details. 4 First -Time Adoption of IFRS IAS 12 must be applied retroactively No special exemptions available under IFRS 1 for income taxes General principles of IFRS 1 should be applied on first-time adoption: Recognize all deferred tax assets and liabilities that should be recognized in accordance with IAS 12; Do not recognize deferred tax assets and liabilities for which IAS 12 does not permit recognition; 5

First -Time Adoption of IFRS New temporary differences may arise as a result of changes in accounting standards Measurement of deferred taxes on transition follows the

Effect of changes generally recorded to opening retained earnings 6 CRA Response CRA website dedicated to the impact of IFRS: http://www.cra-arc.gc.

4 First -Time Adoption of IFRS New temporary differences may arise as a result of changes in accounting standards Measurement of deferred taxes on transition follows the measurement of other assets and liabilities. Therefore, the various other adjustments made under IFRS 1 affect the measurement of deferred tax on transition. Effect of changes generally recorded to opening retained earnings 6 CRA Response CRA website dedicated to the impact of IFRS: Content: IFRS Advisory Committee on Tax Administration Publicly accountable enterprises Impact on taxable income Transfer pricing and conversion Books and records guidance 7

accordance to IFRS be acceptable with regards to a 5907(2.1) ITR election?

5 Tax Authorities vs. IFRS Recent Developments: 2010 Table Ronde APFF : Question 49: For an affiliate of a Canadian public corporation, will F/S prepared in accordance to IFRS be acceptable with regards to a 5907(2.1) ITR election? Response: With respect to the surplus accounts of foreign affiliates, the CRA would allow the F/S to be prepared in accordance to IFRS only if, by doing so, the F/S are prepared in accordance with the laws of the country where the foreign affiliate resides. 8 IAS 12: Key Canadian GAAP vs. IFRS Differences 9

6 The Initial Recognition Exception ( IRE ) IAS 12 CICA Section 3465 Deferred tax liability/asset is recognized, unless deferred tax liability/asset arises from: The initial recognition of goodwill, or The initial recognition of an asset or liability in a transaction that is not a business combination, and at the time of the transaction, affects neither accounting profit nor taxable profit. Future tax liability/asset is recognized for temporary differences on the acquisition of assets in a transaction other than a business combination. Future tax liability is recognized, unless future tax liability arises from: The initial recognition of goodwill that is not deductible for income tax purposes. Reversal of the asset or liability will create a permanent difference that will impact the effective rate. 10 Initial Recognition Exception ( IRE ) 1. Non business combination acquisition AcquisitionCo TargetCo Undeveloped Oil & Gas Assets Under IAS you do not record deferred taxes on any differences between book and tax basis. 11

7 Initial Recognition Exception ( IRE ) 2. Asset Retirement Obligations Dr. Asset $100 $150 Cr. Liability $ Initial Recognition Exception ( IRE ) 3. Capitalized Stock Based Compensation Under IFRS the stock based compensation should follow the employee and can therefore be recorded as an expense or capital. For Canadian tax purposes stock based compensation is normally not deductible. Amounts capitalized to PP&E will result in a book difference that can not be recorded pursuant to IAS

8 Initial Recognition Exception ( IRE ) 4. Discount on Certain Obligations - Initial recognition exemption should apply where an instrument is issued at a discount, and only ½ of the discount may be deducted pursuant to ITA 20(1)(f). 14 Compound Financial Instruments IAS 12 CICA Section 3465 Per IAS 32, the issuer of a compound financial instrument (i.e., convertible debenture) classifies the liability component as a liability an the equity component as equity. Where the tax base of the liability component on initial recognition is equal to the sum of the components, a taxable temporary difference should arise. The deferred tax is charged directly to the carrying amount of the equity component. Subsequent changes in the deferred tax liability are recognized in profits or loss as deferred tax expense (income). Prohibits recognition of future income taxes where the enterprise is able to settle the instrument in accordance with its terms, either through settlement on maturity or conversion, without the incidence of tax. The tax basis of the liability component is considered to be the same as its carrying amount and there is no temporary difference. The IRE should not apply to certain compound financial instruments. 15

9 Transfer of Assets in the Consolidated Group IAS 12 CICA Section 3465 Deferred taxes are recognized in the consolidated financial statements for temporary differences resulting from unrealized profits from intergroup transactions. Prohibits recognition of future income taxes in the consolidated financial statements for any temporary differences arising from the transfer of the assets within the consolidated group. The taxes paid/payable by the seller are recognized as prepaid taxes. 16 Inter-Company Sales - Example UK Parent Company CanCo USCo Hong Kong Co. China Suppliers Sales price - $15 Product Cost - $10 Assume no transfer pricing issues Canco s deferred tax asset: $5 x 30% = $1.50 Hong Kong Co s current tax expense - $5 x 16.5% = $0.83 Accounting issues revolve around whether one is dealing with non-consolidated financial statements of Canco (including accounting policies on related party transactions) VS. consolidated financial statements of the UK Parent Company 17

10 Recognition of Deferred Tax Asset IAS 12 CICA Section 3465 A deferred tax asset is recognized only to the extent that it is probable that taxable profits will be available against which the deductible temporary differences can be utilized. The term probable is not defined in the standard. In practice, the IAS definition of probable as being more likely than not is used. A future income tax asset is recognized to the extent that it is more likely than not to be realized. A valuation allowance may be used to reduce the future tax assets to the extent they are more likely than not to be realized. The concept of valuation allowance is not used in IAS Investment Tax Credits ( ITCs ) IAS IFRS treatment of ITCs is uncertain. ITCs are not specifically defined d in IAS 12; no specific guidance provided under IFRS. Treatment of ITCs under IAS 20 (i.e. Accounting for Government Grants and Disclosure of Government Assistance) also possible alternative. CICA Under CGAAP, accounted for under s of the CICA HB. Treated using cost reduction approach and recognized when company incurs qualifying expenditures and when there is reasonable assurance that the credits will be realized. 19

11 Acquisition of Tax Benefits (Loss Co.) IAS 12 CICA Section 3465 This area is not addressed in IAS 12. Current view is that the deferred credit is not recorded under IAS. Instead the credit is recorded to the income statement. EIC 110 Accounting for Acquired Future Tax Benefits in Certain Purchase Transactions that are not Business Combinations provides guidance: acquired future tax benefits should be recorded as future tax assets Dr. FITA Cr. Deferred credit Cr. Cash 20 Uncertain Tax Positions IAS Uncertain tax positions ( UTPs ) are not specifically addressed in IAS 12 View A: UTPs are within the scope of IAS 12: Current tax assets and liabilities are measured based on the expected amount paid to (or recovered from) the tax authorities CICA Uncertain tax positions generally accounted for as contingencies under CICA 3290 Contingencies, though some variety in practice exists. View B: IAS 37 is relevant because provision is recorded for a UTP that gives rise to a liability of uncertain timing or amount 21

12 Uncertain Tax Positions (cont d) Presume 100% likelihood of detection by the tax authorities Presume that the tax authorities have all the relevant information Under either view you still need to determine the quantum of the reserve various possible methods to determine Need to consider binary versus non-binary issues. 22 Uncertain tax positions - Example Possible Outcome ($) Probability (%) Probability Weighted $100 5% $5 $80 30% $24 $60 20% $12 $40 15% $6 $20 20% $4 $0 10% $0 $51 is the probability weighted outcome (reserve of $49) $80 is the most probable outcome (reserve of $20) FIN 48 - $60 has a cumulative probability > 50% (reserve of $40) 100% $51 23

13 Outside basis differences on subsidiaries and joint ventures IAS 12 CICA Section 3465 Taxable temporary differences relating to investments in subsidiaries, branches, associates* and interests in JV s is not recognized if: Investor able to control timing of reversal of temporary difference; and, It is probable that temporary difference will not reverse in foreseeable future. Deductible temporary differences recognized only to extent it is probable that: Temporary differences will reverse in foreseeable future; and Taxable profit will be available against which temporary difference can be utilized. Essentially the same exception exists under Canadian GAAP, but not for equity accounted investees. EIC 106 addresses measurement of deferred taxes related to investments in equity accounted investees. * i.e., equity accounted investees 24 Disclosure Requirements IAS 12.7: The 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. If those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount. IAS 12.81(f): The aggregate amount of temporary differences associated with investments in subsidiaries, branches and associates and interest in joint ventures, for which deferred tax liability have not been recognized shall be disclosed separately. 25

14 Reversal of Outside Basis Differences Et External Lenders Canadian Parent Corporation Can Holdco 1 Dividend Deductible per ITA 113? Withholding tax? Can Holdco 2 Can Opco US Holdco UK Opco US Opco 26 Foreign Currency vs. Tax Currency IAS 12 CICA Section 3465 IAS 12 requires recognition of a deferred tax asset/liability for temporary differences that arise on translation of non-monetary assets that are remeasured from the local currency to the functional currency using historical rates and results from changes in exchange rates and indexing for income tax purposes. A future tax asset or liability should not be recognized for a temporary difference arising on translating nonmonetary assets or liabilities of integrated foreign operations. Is the tax currency different than the functional currency? 27

15 Foreign Currency Transition Example A Canadian parent s US subsidiary has been determined to have a functional currency that is Canadian dollars. However, it is required to file its US tax returns in US dollar terms. A taxable temporary difference may emerge due solely to foreign exchange movements on the tax pools May impact the effective tax rate. Under Canadian GAAP, no future tax would be recoded for this temporary difference. 28 Substantively Enacted Tax Rates IAS 12 CICA Section 3465 IAS 12 requires assets/liabilities to be measured based on rates/laws that have been enacted or substantively enacted by the balance sheet date. The extent to which the remaining procedures or processes are perfunctory is viewed as a the point substantive bt ti enactment toccurs EIC 111 Determination of Substantively Enacted Tax Rates provides guidance on conditions evidencing the substantive enactment in Canadian specific context. 29

16 Substantively Enacted Tax Rates Factors to consider The legal system and related procedures or processes necessary for enactment t of the tax law change; The nature and extent of the remaining procedures or processes; The extent to which the remaining procedures or processes are perfunctory; and The timing of the remaining procedures and processes 30 Distributed versus Undistributed Rate of Income Tax IAS 12.52A CICA Section 3465 In some jurisdictions, income taxes are payable at a high or lower rate if part or all of the net profit or retained earnings is paid out as a dividend. In these situations, current and deferred tax assets and liabilities are measured at the tax rate applicable to the undistributed profits. No concept of dual rates 31

17 Distributed versus Undistributed Tax Rate MFT Example: Mutual Fund Trust 39% vs. 25% GP CanOpco Operating LP 32 Distributed versus Undistributed Tax Rate (cont d) Is a REIT also subject to this dual rate concept or does a REIT only have one rate (ie. 39%) and can eliminate this if they pay distributions. 33

18 Backwards Tracing IAS 12 CICA Section 3465 IAS 12 allocates to equity any current-year deferred taxes on items that are related to an item charged to equity in a prior year (backwards tracing). When income taxes are being recognized (or de-recognized) in a subsequent period, they are charged to the income statement and not to equity. (e.g., share issue costs) 34 Interest and Penalties IAS 12 CICA Section 3465 IAS 12 restricts what is included in tax expense. Interest and penalties are not included in this definition and should be included either in interest expense or operating expenses. Repealed exposure draft contemplated given companies the option to record above or below the line. Does not address interest and penalties. 35

issuance proceeds must be bifurcated between the liability (i.e., premium) and equity components.

19 Selected Oil & Gas Issues Flow Through Shares Petroleum Revenue Tax 36 Flow Through Shares ( FTS ) There is no specific guidance under IFRS regarding FTS EIC 146 is no longer a source of GAAP Under IFRS, the share issuance proceeds must be bifurcated between the liability (i.e., premium) and equity components. In practice, two views are being taken: A. No deferred taxes should be recognized B. UGAAP policy should be employed 37

20 View A: No Deferred Tax Recognized Pursuant to ITA 66(12.61), the qualifying expenditures are deemed never to have been incurred, hence creating a temporary difference. The IRE is applicable and no deferred tax liability should be recognized. The premium is released to income at the time the qualifying expenditures are incurred. 38 View A: Example Share Issuance Proceeds: $1,000,000 Premium Liability: $150,000 On Issuance: Dr. Cash $1,000,000 Cr. Premium Liability $150,000 Cr. Share Capital $850,000 As Qualifying Expenditures are Incurred: Dr. PPE $1,000,000 Dr. Premium Liability $150,000 Cr. Cash $1,000,000 Cr. Other Income $150,000 39

21 View B: UGAAP Policy The incurrence of the expenditures and subsequent renouncement is analogous to a debit and subsequent credit to the tax pool. The IRE should not apply. ppy This view is consistent with the FASB/SEC position articulated by the FASB staff in Appendix A of the November 2004 US SEC publication International Financial Reporting and Disclosure Issues in the Division of Corporate Finance. When is renouncement? 40 View B: Example On Issuance: Dr. Cash $1,000,000 Cr. Premium Liability $150,000 Cr. Share Capital $850, On Renouncement: Dr. Premium Liability $150,000 Dr. DIT Expense $100,000 Cr. Deferred Tax Liability $250,000 As Expenditures Incurred: Dr. PPE $1,000,000 Cr. Cash $1,000,000 41

22 Petroleum Revenue Tax ( PRT ) In some jurisdictions (i.e., UK and Aus) PRT is charged on companies involved in the extraction of oil and gas. PRT is determined on the basis of revenue from extraction activities, less certain deductions of allowable expenditure. In arriving at corporate taxable income, any PRT paid is considered a deduction for purposes of the corporate income tax regime. Is PRT an income tax to be accounted for in accordance with IAS 12? 42 Recent Developments In the March 2010 Board meeting, the Board decided that the scope of the project should be to consider the following practice issues: 1. Uncertain tax positions, but only after the revision of IAS 37 is finalized 2. Deferred tax on property remeasured at fair value The Board also decided to introduce the following proposals that were generally supported by respondents to the exposure draft issued in March 2009: 1. The introduction of an initial step to consider whether the recovery of an asset or settlement of liability will affect taxable profit 2. The recognition of a deferred tax asset in full and an offsetting valuation allowance to the extent necessary 3. Guidance on assessing the need for a valuation allowance 4. Guidance on substantive enactment 5. The allocation of current and deferred taxes within a group that files a consolidated tax return In addition, the Board suggested adding to the project the issue of what tax rate should be applied (distributed vs. undistributed rate) for entities such as real estate investment trusts. 43

Recent Developments (Cont d) Exposure Draft (September 2010)- Deferred Tax: Recovery of Underlying Assets The proposals would introduce a presumption that, for the assets noted below, an asset is

Investment properties (when an entity applies the fair value model in IAS 40), PP&E or intangible assets (when an entity applies the revaluation model in IAS 16 or IAS 38) The ED was open for comment

23 Recent Developments (Cont d) Exposure Draft (September 2010)- Deferred Tax: Recovery of Underlying Assets The proposals would introduce a presumption that, for the assets noted below, an asset is recovered entirely through sale unless the entity has clear evidence that recovery will occur in another manner. Investment properties (when an entity applies the fair value model in IAS 40), PP&E or intangible assets (when an entity applies the revaluation model in IAS 16 or IAS 38) The ED was open for comment until November 9, 2010 On December 3 rd, 2010 The Board voted almost unanimously (all but 1 member) to adopt a narrow scope exception limited only to investment property measured using IAS 40. This amendment to IAS 12 would be effective January 1, 2012 with early adoption permitted and applied retrospectively. 44 Questions & Answers 45

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