Why it’s hard to measure deferred tax on investments in subsidiaries

IAS 12 Income Taxes prohibits recognition of most of those deferred tax liabilities (and deferred tax assets) resulting from investments in subsidiaries. This post examines why that prohibition exists.

In summary, when that prohibition applies, the parent has a deferred tax liability (or deferred tax asset). The parent must disclose the underlying ‘temporary difference’. But the parent does not recognise the deferred tax because it is highly uncertain which tax rate would apply to the temporary difference.

The post discusses the following:

  • requirements in IAS 12
  • why did IASC create this exception?
  • thoughts for the future

To keep the discussion simple, this post focuses on investments in subsidiaries. IAS 12 sets largely similar requirements for ‘temporary differences’ associated with investments in branches or associates and with interests in joint ventures.

Requirements in IAS 12

IAS 12 requires entities to recognise a deferred tax liability for most ‘taxable temporary differences’ and a deferred tax asset for most ‘deductible temporary differences’. Those differences result in deferred tax liabilities (or deferred tax assets), regardless of whether they are recognised.

Parents often have taxable (or deductible) temporary differences associated with an investment in a subsidiary. For taxable temporary differences associated with an investment in a subsidiary IAS 12 (in paragraph 39), prohibits a parent from recognising a deferred tax liability to the extent that the following conditions are both met:

  • the parent can control the timing of the reversal of the temporary difference; and
  • it is probable that the temporary difference will not reverse in the foreseeable future.

Similarly, for a deductible temporary difference associated with such an investment, paragraph 44 of IAS 12 prohibits a parent from recognising a deferred tax asset to the extent that it is not probable that the deductible temporary difference will reverse in the foreseeable future.

IAS 12 also prohibits recognition of such a deferred tax asset to the extent that it is not probable that taxable profit will be available against which the deductible temporary difference can be utilised. IAS 12 applies this recoverability test to all deferred tax assets, but applies no test of this kind to any deferred tax liabilities.

Without the exception contained in paragraphs 39 and 44, IAS 12 would require a parent to recognise all deferred tax liabilities and all deferred tax assets associated with investments in subsidiaries.

Why did IASC create this exception?

The IASB’s predecessor, IASC, created this exception in 1996 when it issued IAS 12. IASC did not provide an accompanying Basis for Conclusions. Indeed, IASC did not issue its first Basis for Conclusions until it issued IAS 19 Employee Benefits in 1998.

Nevertheless, IAS 12 does explain briefly the reasoning behind some of the decisions implemented in IAS 12. That was partly because IAS 12’s balance sheet temporary difference approach was very different from approaches in the previous version of IAS 12 and in almost all national accounting standards existing at the time. So IASC felt a need to explain the approach. In fact, when IASC published in 1994 the Exposure Draft (E49) of what became the new IAS 12, it published at the same time a separate background paper. That paper explained the approach in more detail.      

Explanation in IAS 12

Paragraph 40 of IAS 12 explains the reason for not recognising a deferred tax liability for temporary differences associated with such investments:

  • as the parent controls its subsidiary’s dividend policy, it can control the timing of the reversal of the temporary difference.
  • it would often be impracticable to determine the amount of income taxes that would be payable when the temporary difference reverses.

No more partial recognition

Like many previous national accounting standards for income taxes, the previous version of IAS 12 permitted a ‘partial recognition’ (or ‘partial allocation’) approach for deferred tax. Such approaches did not require an entity to recognise deferred tax if the entity did not expect temporary differences (or timing differences) to reverse in the future.

Some people favouring ‘partial recognition’ approaches might misunderstand paragraph 40. They might read it as saying that a deferred tax liability does not even exist if the parent can control reversal of the temporary differences associated with its investment in a subsidiary and if it is probable that the temporary difference will not reverse.

I believe that would be a mis-reading, for 3 reasons:

  • in issuing the revised IAS 12 in 1996, IASC consciously moved away from partial provision approaches. No hint of a partial provision approach remains in any part of IAS 12.
  • the drafting of the disclosure requirements reflects the conclusion that a deferred tax liability does exist in such cases.
  • in moving towards finalising IAS 12, IASC benefited from a persuasive explanation of why the [US] Financial Accounting Standards Board (FASB) had recently included a similar exemption in its own standard on this topic.

I discuss those 3 reasons below.

No more ‘partial provision’

The discussion in paragraph 40 of IAS 12 is not to be read in isolation. It needs to be seen in the context of the whole standard. The 2nd of the unnumbered paragraphs in the Objective section at the beginning of IAS 12 explains the underlying reason for recognising deferred tax liabilities and deferred tax assets resulting from the existence of an asset:

  • it is inherent in the recognition of an asset that the reporting entity expects to recover the carrying amount of the asset. (paragraphs 16 and 25 of IAS 12 convey a similar message, and go on to explain that a deferred tax liability or deferred tax asset exists in such cases)
  • if it is probable that recovery of that carrying amount would make future income tax payments larger than they would be if such recovery were to have no tax consequences, IAS 12 requires the entity to recognise the resulting deferred tax liability.

An investment in a subsidiary is an asset—although consolidated financial statements depict that investment on a gross basis by recognising the subsidiary’s underlying assets and liabilities, rather than on a net basis by recognising the investment as a single (net) asset. Applying the principle described above, it is inherent in the recognition of that investment (whether gross, as in consolidated financial statements, or net, as in unconsolidated financial statements) that the parent expects to recover the carrying amount of the investment.

Subsidiaries: inside and outside bases

In discussing deferred tax associated with investments in subsidiaries, it is important to remember that there are 2 separate effects, in 2 different tax jurisdictions:

(1) Some tax effects relate to temporary differences between the carrying amount (in the consolidated financial statements) of the subsidiary’s assets and liabilities and their tax base (in the subsidiary’s tax jurisdiction). People often call these differences inside basis differences (ie inside the subsidiary).

(2) Some tax effects relate to temporary differences between the aggregate carrying amount (in the consolidated financial statements) of all the subsidiary’s assets less liabilities and the tax base (in the parent’s tax jurisdiction) of the parent’s investment in the subsidiary. People often call these differences outside basis differences (ie outside the subsidiary).

The exception in paragraphs 39 and 44 of IAS 12 applies only to the outside basis differences. It does not affect inside basis differences.

Without the exception in paragraph 39, IAS 12 would require an entity to recognise a deferred tax liability if (and only if) recovering the carrying amount of the investment in the subsidiary would make future income tax payments larger than they would be if such recovery were to have no tax consequences.

In this particular case, IASC concluded that the deferred tax liability exists—but prohibited recognition because measuring the liability would often be too difficult.  

Disclosure

Paragraph 81(f) of IAS 12 requires entities to disclose the aggregate amount of temporary differences associated with investments in subsidiaries, branches, associates and interests in joint ventures, for which deferred tax liabilities have not been recognised.

The wording of that requirement:

  • acknowledges that a deferred tax liability exists, even though it is not recognised.
  • requires disclosure of the temporary difference but not of the resulting deferred tax liability. The temporary difference can be measured readily. But the resulting deferred tax liability is difficult to measure: far in advance, it is often not clear how the parent will decide to recover the carrying amount of the investment; so it is often not clear which types of tax rate(s) will apply to the recovery, and in which tax jurisdiction(s).

For deferred tax assets, the corresponding disclosure requirement sits in paragraph 81(e), but within a broader requirement to disclose unrecognised deferred tax assets of all kinds. That requirement, too, is to disclose the amount of the related deductible temporary difference, not the amount of the resulting deferred tax asset.

FASB experience

Both in developing Exposure Draft E49 and finalising the new IAS 12 in 1996, IASC benefited from the experience of the FASB. FASB issued its own standard (FAS 109 Accounting for Income Taxes) on this topic in 1992. That standard adopted a broadly similar approach to deferred tax.

At a IASC Board meeting which was discussing the exception for investment in subsidiaries, a FASB Board member was attending as an observer and gave a very illuminating explanation. He summarised the FASB’s thinking in deciding to include an exception for investments in subsidiaries:

  • a taxable temporary difference definitely exists, and results in a deferred tax liability (unless the rate applying to the difference will ultimately be zero).
  • parents generally have many ways to extract part of their investment from a subsidiary. Tax rates often depend greatly on which way a parent chooses to withdraw their investment. Many parents will not decide in detail which route they are likely to use until they conclude that they might want to extract something in the next few years. So, for parts of the investment that the parent expects to retain for many years, any estimate of the tax rate that will ultimately apply—and, hence, any measurement of the deferred tax liability—would be just a guess. [1]

As the project manager responsible for taking the project to revise IAS 12 from the Exposure Draft to the final standard, I found that explanation very persuasive. From discussion afterwards with several Board Representatives, I know that they, too, found it persuasive.

[1] As a reminder, IAS 12 requires entities to use tax rates that are already enacted (or substantively enacted). It does not require entities to forecast how tax rates might change in the future.
For investments in subsidiaries, the measurement uncertainty arises because the tax rate at the time of recovery may often depend on the route by which the parent chooses to withdraw (or sell) its investment.

Overall summary of paragraph 40

So, what is paragraph 40 saying? If the parent can control timing of the reversal and if reversal is not probable in the foreseeable future, then there is too much measurement uncertainty and so the deferred tax liability is not recognised.

But recognition is required if the parent does not control the timing of reversal; or if reversal is likely in the foreseeable future. In those cases:

  • it is important to give more information to users of financial statements; and
  • there is likely to be much less measurement uncertainty because management will already be considering how it would withdraw (or sell) the investment.

Thoughts for the future

A couple of things in this area may not be entirely clear:

  • the foreseeable future
  • the reporting entity concept

What is foreseeable future

I have heard different people express different views about what ‘foreseeable future’ means in paragraphs 39 and 44 of IAS 12:

  • some people think it refers only the period covered by detailed budgets and forecasts (probably not much more than 1 year) or to a period covered by outline budgets (perhaps about 3-5 years).
  • other people think it refers to the entire time horizon over which management might assess what might happen—well beyond the period covered by any kind of budget or scenario planning.

To my mind, the 1st of those views isn’t consistent with the motivation for the exception. Suppose management has detailed budgets 12 months forward and expects that it may well withdraw a large part of the investment after 13 months. There is unlikely to be much measurement uncertainty in estimating which route the parent would use in extracting (or selling) its investment—and, hence, the tax rate that would apply—in 13 months.  

Reporting entity concept

As noted in the Objective paragraphs of IAS 12, the whole standard is based on the premise that an entity expects to recover the carrying amount of all its recognised assets. A deferred tax liability (or deferred tax asset) exists if the entity expects to pay more (or less) income taxes as that recovery occurs.

The application of that premise to investments in subsidiaries presumes that the parent expects ultimately to recover the carrying amount of the investment (though maybe in many years). Is that presumption consistent with the discussion of the reporting entity concept, added to the Conceptual Framework for Financial Reporting in 2018? Among other things, that discussion states:

  • financial statements provide information from the perspective of the reporting entity as a whole (paragraph 3.8).
  • for consolidated financial statements, the reporting entity comprises both the parent and its subsidiaries. But for unconsolidated financial statements, the reporting entity is the parent alone (paragraph 3.11).
  • consolidated financial statements provide information about the assets, liabilities, equity, income and expenses of both the parent and its subsidiaries as a single reporting entity. (paragraph 3.15)

Some people may feel it is still appropriate to continue recognising deferred tax using the presumption that the parent expects ultimately to recover the carrying amount of the investments in its subsidiaries. Other people may feel that this focuses too much on the parent, and is inconsistent with treating the parent with all its subsidiaries as a single reporting entity. I haven’t looked at this question in enough depth to have an informed view one way or the other. As far as I know, the IASB has never discussed this topic.

Conclusion

IAS 12 prohibits the recognition of some deferred tax liabilities (and some deferred tax assets) resulting from investments in subsidiaries. That exception exists only because there is often significant measurement uncertainty:

  • it is not difficult to measure the related temporary difference;
  • but it is often unclear how the parent will recover the investments. Thus, there is often significant measurement uncertainty in determining what type of tax rate(s) will apply—and in which jurisdictions—when recovery occurs.  

Because of that measurement uncertainty, IAS 12:

  • prohibits recognition of those deferred tax liabilities (and deferred tax assets), even though IAS 12 acknowledges that they exist;
  • requires disclosure of the underlying temporary differences; and
  • does not require a disclosure that measures the amount of the deferred tax liabilities (and deferred tax assets). Such a measurement would require an estimate of the tax rate(s) to apply to the temporary differences.

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