Deferred Tax Asset Recognition - a familiar path, but with pitfalls along the way

Deferred Tax Asset Recognition - a familiar path, but with pitfalls along the way

The principle of deferred tax asset recognition, namely that assets should be recognised to the extent there are probable future taxable profits, seems simple enough, if a little subjective.  However, we continue to encounter ‘hard’ errors in this area, most often in consolidated financial statements. This article examines a few of the common missteps we see and punctures associated myths.

The basic principle of deferred tax asset (DTA) recognition, that DTAs should be recognised to the extent that future taxable profits are probable, is well known and accepted. Sources of future taxable profits include the ability to carry back the asset, the existence of suitable deferred tax liabilities (DTLs), other future taxable profits and tax planning opportunities. In this article we are going to concentrate on the need to consider whether suitable DTLs exist – as this seems to be at the root of the most common misunderstandings we see in practice.

(i)    ‘Losses are forecast for the foreseeable future so no DTAs can be recognised.’

It is not uncommon for groups to leap to unfavourable future profit forecasts as a reason to limit, in part or in full, the recognition of DTAs. This misses out a crucial step in the consideration of whether future taxable profits exist. IAS 12 is prescriptive in stating that groups should first look to whether there are probable future taxable profits in the form of DTLs before going on to consider whether other future taxable profits exist. This means that even if a group is forecasting only losses in future periods, if it has DTLs that on reversal would result in taxable profit against which the DTAs can be utilised, then these DTAs should be recognised irrespective of the existence of those future losses.

(ii)    ‘It arises on consolidation so it can’t represent future taxable income at entity level.’

So, if we accept that we should consider whether we have suitable DTLs as an initial step in the DTA recognition process, what DTLs should be included? Most missteps happen here when looking at group positions and often result from a lack of understanding of the nature of consolidation adjustments. Each of these adjustments, whilst arising on consolidation, will, at some point in the future, impact at subsidiary level and in a future tax return.

The most ignored or misunderstood item is a DTL arising in respect of a consolidated intangible asset.   This asset represents the future value a group is expecting to recover due to its ownership of that particular asset or business. Therefore, the income arising from the DTL would be expected to occur in the company or companies that benefit from the IP or conduct the relevant business in future periods. So, whilst the intangible asset itself and its amortisation will never be seen at company level, the profits arising from its existence will be there. On this basis the existence of such DTLs will often represent suitable taxable profits against which DTAs on losses and other temporary differences can be recognised.  

One common scenario is where there are DTAs in respect of UK tax losses that arose post April 2017 in a holding company and a DTL for a consolidated intangible in respect of the business undertaken by the group’s main trading company.  Under UK tax law losses (other than capital losses) which arise post April 2017 can be group relived to profit making companies either in the year they arise or in future years. This sharing of losses in future periods is a key change and makes post 2017 tax losses a much more flexible tax asset. But it also means that potentially all or part of the DTA can be recognised at group level on the basis of the existence of the consolidated DTL. This is because, as the trading entity earns profits arising from the intangible, the holding company can surrender its brought forward losses to the trader to offset its profit.

(iii)    ‘Our DTLs are bigger than our DTAs so we can recognise in full.’

It would great if it was this easy!  In considering whether DTAs can be recognised on the basis of the existence of DTLs, the reality of tax law needs to be ever present. In essence the analysis needs to be:
‘If the only items present in future group tax returns for the relevant territory or tax group were the reversing DTLs and DTAs to what extent would the deductions arising from the DTAs reduce the income arising from the DTLs.’

Scenarios in which a £1 for £1 offset doesn’t always hold:

  • Minimum taxation. In the UK groups are only permitted to offset £5m of brought forward losses plus 50% of any excess profits annually. So, if there was a DTL on a chargeable gain which would generate £10m of profit and a DTA on £9m of losses, only £7.5m (£5m + (50% of £5m)) of the losses could be recognised, assuming the £10m of gain all arises in the same period.
  • Recognition of a DTA for interest carry forwards under the Corporate Interest Restriction rules.  Here, UK tax law requires a group to have surplus debt cap capacity in order to reactivate brought forward interest, but even then only 30% of tax EBITDA can be reactivated. So here groups must consider the implied tax EBITDA from the reversal of their DTAs and DTLs in each future period and then will only be able to recognise up to 30% of estimated positive EBITDA.

Timing is critical

The above demonstrates the importance of scheduling the timing of the reversals of the items to show how they would actually interact in a tax return. This timing point is of equal relevance when looking at forecasts of other future taxable profits when a group doesn’t have sufficient DTLs to justify full recognition of DTAs:
  • A group has concluded that it has probable future taxable profits for the next three years.  These profits total £5m over the three year period. It has a DTA on capital allowances of £3m.
  • A simplistic response would be to conclude that due to the size of the forecast profits the DTA can be recognised in full (as £5m is bigger than £3m). However, detailed scheduling reveals that due to the way a capital allowances asset reverses under tax law*, it will only reverse to £1m over the three year period.
  • On this basis only £2m of the DTA can be recognised. This is the amount that will actually reverse over the three year period that the group has asserted it will have probable taxable profits. The remaining £1m will reverse later but with no probable future taxable profits in existence there is insufficient evidence to recognise.

Hopefully the above has gone some way to demonstrating some of the more common pitfalls seen in the area of DTA recognition; to get it right it is important to keep both the principles per the accounting standards and the operation of tax law front of mind at all times.   

If you require further details or have any questions regarding DTA recognition, please get in touch with Michelle Wilson.
*Footnote – future temporary differences need to be ignored when scheduling the reversal of the differences that exist at any balance sheet date.  Therefore the £2m reversal ignores the impact of any new fixed asset additions etc.