IAS 12 Initial recognition exemption – What is the purpose?
No one enjoys accounting for deferred tax. It can be confusing and, more often than not, a frustrating process. So, when there is an exemption to recognising deferred tax, reporting entities usually jump at the chance. Exemptions can, however, cause their own problems, especially when they are not applied properly.
For example, there is the well-known exemption under IAS 12 Income Tax (IAS 12) commonly referred to as the ‘initial recognition’ exemption. An exemption that is regularly used but often misinterpreted. Why does the exemption exist?
IAS 12 requires the deferred tax movement to follow the transaction that created the related temporary difference. For example, when investment property is measured at fair value at each reporting date, the movement is recognised in profit or loss, the resulting deferred tax movement must then be recognised as part of tax expense in the profit or loss. Another example is property, plant and equipment that is measured using the revaluation model. Any movements in fair value are recognised through other comprehensive income to a reserve (generally referred to as the revaluation reserve). The resulting deferred tax on this movement must also be recognised through other comprehensive to the revaluation reserve.
If the transaction or event causing the temporary difference doesn’t impact profit or loss, other comprehensive income or even equity, where should the deferred tax then be recognised? There is nowhere to record the deferred tax, other than to the carrying amount of the related asset. This is not appropriate because the journal entry can’t be processed as it would an in and out to the same account.
These situations are the reason for the ‘initial recognition’ exemption. When these types of transactions or events occur, this exemption allows preparers to “ignore” the temporary difference and not raise any deferred tax.
A common example includes the purchase of administration buildings where the South African Revenue Service (SARS) does not allow any deductions on the purchase. The carrying amount will equal the cost of the buildings while the tax base will equal zero because there are no future deductions available to the reporting entity for the acquisition.
Unfortunately, over the years, some individuals have interpreted the exemption to apply when any tax base is equal to zero on initial recognition. This is not the case. Take the example of an internally generated intangible asset capitalised during the development phase where the costs meet the requirements of IAS 38 Intangible Assets (IAS 38). In some of these cases, based on current legislation, SARS will allow a 150% deduction on all the costs incurred. This deduction is allowed upfront on the recognition of the intangible asset. This means that the carrying amount will equal the development costs and the tax base will be zero because all the deductions have already been claimed. In this case a deferred tax liability is recognised to represent that the economic benefits recovered will be taxable with no more deductions allowed i.e. the deferred tax is recognised on the difference between the carrying and the tax base, which is reduced as the carrying amount decreases. Another example is an intangible asset purchased as part of a business combination. The carrying amount is greater than the tax base of zero; causing a temporary difference that is does not meet the exemption criteria.
Could it be that referring to it as the ‘Initial recognition’ exemption is misleading? Most transactions and events lead to assets and liabilities where the carrying amounts and tax bases are equal with no temporary differences to either account for or to exempt from deferred tax.
This exemption applies even if there is change in use for an asset far after initial recognition. A classic example is on a building that is classified by the reporting entity as an investment property under IAS 40 Investment Property; later the entity decides to move into the building itself using it for an administrative purpose. The reclassifying journal entry moving the building from investment property to property, plant and equipment creates a temporary difference because the tax base becomes zero with no change to the carrying amount of the asset. This temporary difference is exempt from deferred tax.
There are situations where the initial recognition exemption does not apply where it seems it should. For example, lease liabilities, decommissioning and restoration liabilities, and other similar liabilities where the corresponding amount is recognised as part of the cost of the related asset (e.g. lease liabilities equal right of use assets). There were divergent accounting treatments in the past for such transactions. Some reporting entities recognised deferred tax on the future tax consequences and others applied the ‘initial recognition’ exemption. The standard has been amended to remove any such conflicts. The amendment, Deferred Tax related to Assets and Liabilities arising from a Single Transaction clarifies that where there are equal taxable and deductible temporary differences such as those in lease transactions, the ‘initial recognition’ exemption may not be applied. The deferred tax must instead be recognised in profit or loss initially and during subsequent measurement.
Maybe this exemption should be rebranded the ‘tax movement’ exemption to better represent its purpose, which is to avoid incomplete journal entries for temporary differences where there is nowhere appropriate to recognise the tax movement.
Authors:
Miguel de Sousa, Manager
13 September 2023
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