Measurement of deferred taxes that arise from investment in associate accounted for using the equity method

At the 7th meeting of the IASB Emerging Economies Group, held in Moscow on May 28-29, 2014, Danil Prokopovich, chairman of IFRS committee at the Institute of Professional Accountants and Auditors of Russia, member of National Accounting Standards Board (Russia), have raised a question on measurement of deferred taxes by investor when using an equity method. This question has been developed and discussed in further consultations with experts of the IFRS Foundation. Below is the content of the discussion and proposed solutions.

Background

According to the paragraph 51 of IAS 12, the measurement of deferred tax liabilities and deferred tax assets shall reflect the tax consequences that would follow from the manner in which the entity expects to recover or settle the carrying amount of its assets and liabilities.

According to the paragraph 51A of IAS 12, in some jurisdictions, the manner in which an entity recovers (settles) the carrying amount of an asset (liability) may affect either or both of: (a) the tax rate applicable when the entity recovers (settles) the carrying amount of the asset (liability); and (b) the tax base of the asset (liability). In such cases, an entity measures deferred tax liabilities and deferred tax assets using the tax rate and the tax base that are consistent with the expected manner of recovery or settlement.

The paragraphs 51A-51D of IAS 12 also provide corresponding examples and guidance in relation to property, plant and equipment, non-depreciable asset measured using the revaluation model, and investment property.

But no specific guidance on the applicable tax rate is provided in relation to the investments in associates that are accounted for using the equity method.

The paragraph 38 of IAS 12 gives only the statement and reasons when the carrying amount of investment in associates becomes different from the tax base and temporary differences arise.

Issue

Nevertheless, the measurement of deferred tax liability or asset that arises from investment in associate that is accounted for using equity method could be even more difficult and could create unnecessary divergence in practice.

Normally the carrying amount of an investment in associate could be recovered by (a) receiving of dividends (or other distribution of profit), (b) sell to third party, (c) receiving of residual assets upon liquidation of the associate. And normally the investor considers all of these variants of recovery. One part of capitalized profit will be received as dividends during the holding period. Another part will be recovered upon sell or liquidation. At the same such investor usually does not have enough power to control the proportion of profit that will be distributed (as dividends) or retained (capitalized).

If local tax legislation prescribes application of different tax rates for different manners of recovery (dividends, sell, liquidation), what tax rate should be used?

Example

Russian tax legislation prescribes application of different tax rates of profit tax: (a) 9% for profit received in form of dividends and (b) 20% for profit received in all other forms (with certain exceptions that are not relevant to this question).

As of the reporting date (say 31.12.2013) an investor accounts its share in associate using the equity method to the carrying amount of 1 500 CU (that includes cost – 500 CU and share in undistributed profit – 1 000 CU). The tax base of the investment is equal to its cost (500 CU).

The investor expects to receive dividends from the associate during an indefinite holding period. The investor also considers this investment as available for sale (it could be sold in some future periods; there is no plan to sell it immediately).

What tax rate (9% or 20%) should be used in order to calculate the deferred tax liability related to this investment?

Inside/outside perspective

To avoid misunderstanding we should note that the above-mentioned issue does not relate to discussion on inside/outside temporary differences held in context of the Project of Annual Improvements – 2011-2013 cycle.

The above-mentioned issue considers the measurement of deferred tax assets or liabilities only from the investor’s point of view (only “outside” perspective).

Discussible solution

By result of preliminary consultations the experts consider possible to recommend the following solution.

Situation “A” – if there is an agreement among investors that the associate will not pay dividends – the deferred tax liability should be measured using the tax rate applicable on disposal of the investment (20%).

Situation “B” – if there is a management decision to sell an investment in associate – the deferred tax liability should be measured using the mixed approach: in part of dividends that are expected to be received before sell – should be used the rate applicable for dividends (9%), to the rest part – the rate applicable on disposal (20%).

Situation “C” – if there is no agreement among investors that the associate will not pay dividends, neither a management decision to sell an investment – the deferred tax liability should be measured using the rate applicable for dividends (9%). Upon the decision to sell – the liability should be restated according to situation “B”.

Official position

The final official position on this matter will be reflected in the documents of the IFRS Foundation after an extensive due process and deliberation.

As expected, this issue will not be considered as a separate project for Interpretations Committee (IFRIC), instead, the appropriate changes will be made within subsequent cycles of the Project of Annual Improvements.

© Danil Prokopovich
FCCA, CGA, CIPA, Ph.D, auditor
chairman of IFRS committee at the Institute of Professional Accountants and Auditors of Russia, member of National Accounting Standards Board (Russia), partner of National Audit Corporation