Deferred Income Taxes: the controversy

regarding discounting.

Ainhoa Lavín (Anr. 332060)

Supervisor:

Mr. Micha Keyzer

2017

Deferred Income Taxes: the controversy

regarding discounting.

Master thesis International Business Taxation/ track: International Business Tax

Law

Tilburg School of Law

Tilburg University

Name: Ainhoa Lavín

ANR: 332060

Supervisor: Mr. Micha Keyzer

Second reader: Prof. Dr. R. Russo

Date: 19 June 2017

PREFACE

This Master’s thesis has been presented for the attainment of the International Business Tax Law

& Business Organizations and Strategies LLM in Tilburg University. The research has been conducted

under the supervision of Mr. Micha Keyzer in the Fiscal Institute Tilburg between January and June 2017.

The dissertation herein submitted is a result of the knowledge acquired during a year of analysing

and comprehending the relation between the intricate and complex features and institutions shaping the

international tax environment. Specifically, the topic of the thesis was selected after the study of deferred

tax assets and liabilities in the course International Taxation given by Prof. Dr. R. Russo with the

collaboration of Prof. Dr. P. H. J. Essers. The course provided a comprehensive view of the relation

between financial accountings and tax accountings awakening the interest of the author in this field,

which lead to the selection of the subject of this paper in order to deepen and enhance the knowledge of

the author in the convoluted domain of deferred income taxes.

I gratefully acknowledge my debt to my brilliant friends Mr. Thijs Maas and Mr. Niccolò S. Piga

for their collaboration and support on the drafting of this thesis. I would also like to take that chance to

give my heartfelt thanks to my friends and colleagues Mr. Andzej Trusevic and Mr. Mikola Vanik for

their constant support and patience during this year. I also thank my loving parents and relatives, whose

support has been vital during my studies.

LIST OF ABBREVIATIONS: 3

1

1. INTRODUCTION 4 DEFERRED INCOME TAX UNDER ASC 740 9 DEFERRED INCOME TAX UNDER IAS 12 12 IAS 12 V. ASC 740 15

3. DIFFERENCES BETWEEN DISCOUNTING AND NOT DISCOUNTING 18 DEFERRED TAXES WITHOUT DISCOUNT 18 DISCOUNTING DEFERRED TAXES 18

4. POLEMIC OF APPLYING A DISCOUNT RATE TO DEFERRED INCOME TAXES 22 ARGUMENTS IN FAVOUR OF DISCOUNTING 23

The “Asset/Liability or Balance Sheet” Argument 23 The “Income Statement” Argument 25 The “Compromise” Argument 26

ARGUMENTS AGAINST DISCOUNTING 27 The “Non Conventional Liabilities” Argument 27 The “No Incurred Cost” Argument 28 The “Zero Interest Rate” Argument 28 The “Complexity (Cost/Benefit)” Argument 30 The “No Future Cash Flow” Argument 31 The “Explicit Interest Cost” Argument 31

THE POSITION OF THE IASB 32

5. MEASUREMENT OF DEFERRED INCOME TAXES 34 The United States of America 35 Spain 39 Germany 42 The United Kingdom 46 The Netherlands 49

ANNEX I 56

ANNEX II 57

ANNEX III 58

ANNEX IV 60

REFERENCES AND SELECTED BIBLIOGRAPHY 62

LIST OF ABBREVIATIONS:

AICPA ---- American Institute of Certified Public Accountants

2

APB ----- Accounting Principles Board ASC ------ Accounting Standards Codification CITA ------ Corporate Income Tax Act DTA ------ Deferred Tax Asset DTL ------ Deferred Tax Liability EU ------ European Union FASB ----- Financial Accounting Standards Board GAAP ---- Generally Accepted Accounting Principles GASB ---- Governmental Accounting Standards Board HMRC --- Her Majesty’s Revenue & Customs IAS ------ International Accounting Standards IASB ------ International Accounting Standards Board IASC ------ International Accounting Standards Committee IFRS ------ International Financial Reporting Standards OECD ---- Organization for the Economic Cooperation and Development SEC ----- Securities and Exchange Commission SFAS ----- Statement of Financial Accounting Standards UK ------ United Kingdom UN ------ United Nations US ------ United States (of America) USC ----- United States Code VAT ------ Value Added Tax WTO ------ World Trade Organization

1. INTRODUCTION

Accounting for income taxes is an area of great relevance in the context of financial reporting for

companies, as well as a topic of great complexity which in many cases requires the collaboration of tax

accounting professionals in order to manage them correctly. Deferred tax assets and liabilities represent in

the financial statement a tax credit or a tax claim existing between taxpayers and tax authorities. They are

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caused because certain items receive a different treatment in tax law and in the legislation governing

financial reporting. As a result, there is often a divergence between the tax due according to the financial

statement and the one stated in the tax return. These differences might be created for several reasons.

However, they all have in common that they are only temporary differences. It means that companies will

not pay more or less taxes, but that the payment is allocated in time in a different way.

Nevertheless, not every temporary difference between financial and tax books gives rise to the

creation of a deferred income tax. In order to recognise a deferred tax asset, most countries require that

the company will be able to offset that credit in the future. This might depend either on the expected

development of the transaction or accounting item that caused the creation of the deferred tax asset, or on

the overall expected performance of the company. It is very challenging to assess these expectations,

which makes the process of accounting for deferred income taxes a very complicated one. Moreover, the

measurement of the recognised deferred tax assets and liabilities may change if the circumstances that

were considered in order to recognise them vary, which makes this accounting practice even more

arduous.

The importance of this topic can be explained by the huge impact deferred income taxes can have

on the financial statements of a company. The most important sources of money for companies are net

income and depreciation. The third most important would be by deferred taxes. A lot of companies

manage to postpone the payment of the tax bill for a long time, specially companies which carry out

heavy investments. These companies have more money than the amount reflected in the profit and loss

account, as they pay a lower tax, making the company look sound and steady in the eyes of shareholders

and other stakeholders. The same effect is produced when a company suffers losses. The accountants

might expect to offset those losses against future profit and recognise a tax credit for those losses,

creating a deferred tax asset. This results on the financial statement understating the loss. 1

In this context, it might be obvious that the rules of recognition and measurement of deferred

taxes have to be in accordance with economic reality, giving a fair and true image of the company’s

situation. Nevertheless, the reader might find it surprising that the main financial reporting standard

boards in the international arena, the International Accounting Standards Board (IASB) in Europe and the

Financial Accounting Standards Board (FASB) in the United States of America, prohibit the application

of a discount rate to deferred tax assets and liabilities. The rest of the assets and liabilities that might be

1Dan Duane, 'Deferred Taxes (II): How They’Re Important' (PRACTICAL STOCK INVESTING, 2013) <https://practicalstockinvesting.com/2013/02/21/deferred-taxes-ii-how-theyre-important/> accessed 12 June 2017.

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found in the balance sheet are measured by taking into consideration the time value of money. However,

is not the case with deferred income taxes.

This thesis will therefore focus on analysing the reasons that might lead the IASB to establish the

non discounting policy, and to assess its adequateness. Thus, the research question of this master thesis

will be the following: Should the IASB maintain the prohibition of discounting deferred income

taxes?

In order to address the point in question, it is indispensable to first answer the following research

sub-questions:

● What is the nature and function of deferred income taxes?

● What is the underlying reasoning brought forward in doctrine for and against discounting

deferred tax assets and liabilities?

Analysing these topics will be relevant in order to understand, firstly, the essence of deferred tax

assets and liabilities, what they represent, how they are recognised and measured, and what is their main

role in financial reporting. Secondly, through the examination of different reasonings to defend

discounting or to criticize it, it will be simpler to understand the stance of the IASB in this matter.

The methodology used by the author to address the research question is mainly based on the

analysis of literature published about deferred tax assets and liabilities - in particular the information

released by the IASB itself. ohn N. Kissinger’s paper, ‘On Discounting Deferred Tax Income’, has been

of paramount importance to the drafting of this thesis, in which the author examines the different

argumentation put forth by scholars in regards to the subject of discounting. The final part of the thesis

has been conducted by studying tax guides by country, published yearly by Deloitte, as well as directly

reviewing the tax legislation and financial legislation of different states.

The thesis analyses the subject of deferred income taxes from an international perspective.

Nevertheless, the main focus lies on the European Union and the stance of the IASB on the issue of

discounting. However, the position the FASB and its regulation on deferred income taxes is also studied.

The starting point is the current situation, with the IASB strictly prohibiting to measure deferred tax assets

and liabilities on their present value, and most of the countries applying these financial reporting

standards complying with this prohibition. Building on this base, the author of this thesis compares the

IFRS rules for deferred income tax with the rules applied in the United States of America. It also analyses

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different approaches that might have been taken regarding discounting. Finally a comparative analysis of

different countries and their regulation of deferred income tax is conducted, highlighting their main

divergences from the International Financial Reporting Standards (IFRS) issued by the IASB.

The first chapter introduces the concept of deferred income tax, from the perspective of the

standards issued by the IASB - International Accounting Standards 12 (IAS 12), as well as the ones issued

by the FASB - Accounting Standards Codification 740 (ASC 740). Even if they have similar governing

rules, there are differences between both standards that will be explained at the end of the chapter.

Chapter 2 illustrates and explains the difference between the same financial statement applying a

discount rate to deferred income tax and without applying the discount rate.

Chapter 3 starts by explaining the concept of the time value of money and why it might be

relevant to consider the option of applying it to these type of assets and liabilities. It continues reviewing

the most relevant arguments used by scholars to advocate for discounting, to proceed examining the

arguments against it.

Chapter 4 makes a comparative analysis of 5 different countries with different relations between

their financial accountings and tax accountings, and explains the manner in which they recognise and

measure deferred income taxes. These countries are the United States of America, Spain, Germany, the

United Kingdom and the Netherlands, the last one being the only country that allows the application of a

discount rate.

Finally, in the last chapter the main conclusions will be presented along with the opinion of the

author in regard of the research question.

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2. THE ESSENTIALS OF DEFERRED INCOME TAXES

Deferred income taxes arise when there is a difference between the income tax payable on the tax

return and the income tax expenses recorded on the financial statement. These differences occur because

the financial statement and the tax return do not have the same objectives, are not addressed to the same

entity and are not regulated under the same legislation. On the one hand, the financial statement has the

purpose of giving the shareholders and other stakeholders of a company information about its financial

state, and it is usually ruled by the national Generally Accepted Accounting Principles (GAAP). On the

other hand, the tax return is intended to raise the revenues of national coffers. Consequently, the addressee

is the national tax authority, and the regulation is national tax law.

It may happen that the income tax expenses on the financial statement are greater than the income

tax payable recognized in the tax return, giving rise to the creation of a deferred tax liability (DTL). It is

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a liability because the company pays less taxes than it should have according to the income calculated

using the GAAP rules, making it necessary to report the company’s obligation to pay those taxes in the

future. On the contrary, when the company is required to pay an excessive tax due to the differences

arising between financial and tax accountings, a deferred tax asset (DTA) is created, representing the

economic benefit the company expects to receive because of the excessive charge.

It is important to note that DTLs only arise from deductible temporary differences as opposed to

DTAs which arise from taxable temporary differences, tax credits and loss carryforwards. Temporary

differences are defined in IAS 12, the accounting standard issued by the IASB governing “Income Taxes”,

as “Differences between the carrying amount of an asset or liability in the statement of financial position

and its tax base.” Not every difference between the information shown in financial and tax reports will 2

give rise to a DTA or DTL, but only those which qualify as temporary differences.

Permanent differences, which are not expected to reverse in the future, do not lead to the creation

of deferred income taxes. Among the events or transactions which produce DTAs an example may be

made of those caused by expense items, such as allowances for bad debts, compensation accruals or

contingency reserve accruals; or revenue items such as an advanced receipt for goods. They might also be

produced, unlike DTLs, by carryforward items such as tax credits granted by the Member States as a part

of their corporate income tax structure; or net operating losses from previous years waiting to be offset

against future income.

In order to better understand how deferred income taxes are created, a common example of an

economic transaction provoking the creation of a DTL will be analyzed in a simple manner in Example A

in ANNEX I.

● DEFERRED INCOME TAX UNDER ASC 740

The financial treatment received by income taxes has been a controversial issue since its

inception. Originally, the debate was focused on whether the income taxes paid by businesses should be

considered as an operational expense or as a distribution of income to the government. Both options have

different consequences regarding the financial statement and consequently, the amount recollected by tax

authorities, hence its importance for both businesses and governments.

2 ' IAS 12 — Income Taxes' (Iasplus.com, 2017) <https://www.iasplus.com/en/standards/ias/ias12> accessed 5 April 2017.

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If viewed as expenses, the impact of temporary differences should be reflected in the financial

statements by virtue of the principle of accrual. This principle entails that accounting transactions should

be recorded when they occur, rather than in the moment when the cash flows originated from them

occurs. In this way, deferred income taxes would be considered as expenses derived from a transaction

that should appear reflected in the financial statements.

If considered as income distribution, the taxes paid in each period could be designated as the

portion of financial income not available to business owners. This way, temporary differences in tax

liabilities would bear no consequence in the financial statement.

From the end of the 40s on, the difference between the pre-tax base in financial statements and

the base used for tax purposes started to increase considerably and, consequently, so did the debate over

the financial treatment of income taxes. In 1953, the American Institute of Certified Public Accountants

(AICPA) released the Accounting Research Bulletin nº 43, which states the following:“Financial

statements are based on allocations of receipts, payments, accruals, and various other items. Many of the

allocations are necessarily based on assumptions, but no one suggests that allocations based on imperfect

criteria should be abandoned in respect of expenses other than income taxes, or even that the method of

allocation should always be indicated. Income taxes are an expense that should be allocated, when

necessary and practicable, to income and other accounts, as other expenses are allocated. What the

income statement should reflect under this head, as under any other head, is the expense properly

allocable to the income included in the income statement for the year.” 3

Having settled this dispute, the debate shifted to how to measure income tax expense of each

concrete period, and how to report in the financial statement the difference between the amount of tax that

should be paid according to the financial statement, and the amount of tax that was actually paid based on

taxable income. The discussion continued over the next years, and in 1967 the Accounting Principles

Board (APB) (former authoritative body of the AICPA which would later be replaced with the FASB),

published the Opinion nº11 establishing the deferred method as the allocation method for income tax. 4

The FASB changed this criterion in 1987 issuing the Statement of Financial Accounting

Standards (SFAS) nº 96 , which adopted the asset and liability method instead of the deferred method. 5

3 Accounting Research Bulletin nº 43, “Income Taxes”, New York: AICPA, 1953, Ch.10, p.88 4 Opinions of the Accounting Principles Board nº11, “Accounting for Income Taxes”, New York: APB, 1967 5 Statement of Financial Accounting Standards nº 96, “Accounting for Income Taxes”, Stamford, Connecticut: FASB, 1987

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This change resulted in DTAs and DTLs now being affected by the changes in interest rates over the next

years, unlike what happened with the deferred method, which implied that deferred income tax would

only be affected by the interest rate of the year in which differences reversed. This Statement was

amended in 1992 with the SFAS 109 which would be later replaced by the current ASC 740 . 6 7

ASC 740-10-10-1 enunciates the objectives in accounting for income taxes as follows:

“There are two primary objectives related to accounting for income taxes:

○ To recognize the amount of taxes payable or refundable for the current year.

○ To recognize deferred tax liabilities and assets for the future tax consequences of events that have

been recognized in an entity’s financial statements or tax returns”. 8

Under the previous guidance, the objective was different, as it disregarded temporary differences

when calculating the total tax expenses. The balance sheet approach was used, which focused on

measuring taxes payable/refundable based on the difference between book basis and tax basis of assets

and liabilities. However, with ASC 740 a “one event” approach was incorporated, modifying the previous

guidance. Under this new ruling the focus shifts to the event that gives rise to the creation of the

deductible temporary difference, or the tax credit, or the net operating loss carryforward when

recognizing a DTA. The measurement and recognition of this asset will be subject to a realizability

assessment.

Under the previous method, the tax consequence of earning income in the future was not

anticipated. With ASC 740, the likelihood of the existence of future cash flows gains importance when

assessing the measurement of the asset, as the assets will be recognized inasmuch as they are “more likely

than not” to be realized in future returns.

The main features of the regulation of deferred income tax accounting under ASC 740 can be

summarized as follows:

○ “DTLs are recognized for future taxable amounts.

6 Statement of Financial Accounting Standards nº 109, “Accounting for Income Taxes”, Stamford, Connecticut: FASB, 1992 7ASC 740 — Income Taxes' (Iasplus.com, 2017) <https://www.iasplus.com/en-us/standards/fasb/expenses/asc740> accessed 6 Abril 2017 8 Idem

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○ DTAs are recognized for future deductions and operating loss and tax credit carryforwards.

○ The marginal tax rate is used to measure DTAs and DTLs.

○ A valuation allowance is recognized to reduce DTAs to the amounts that are more likely than not

to be realized.

○ The amount of the valuation allowance is based on all available positive and negative evidence

about the future.

○ Deferred tax expense or benefit is computed as the difference between the beginning and ending

balance of the net DTA or DTL for the period.

○ The effects of changes in rates or laws are recognized on the date of enactment”. 9

● DEFERRED INCOME TAX UNDER IAS 12

The origin of IAS 12 can be found in the Exposure Draft E13 “Accounting for Taxes on Income”

issued on April 1978 by the International Accounting Standards Committee (IASC), which would later be

replaced by IAS 12 “Accounting for Taxes on Income”. Another Exposure Draft was released in 1989 and

IAS 12 was reformatted in 1994. In October of that same year, the IASC published the “Modified and

Re-exposed Exposure Draft E49 «Income Taxes»”. IAS 12 would be amended and modified in the years

to come, until the last draft was published in January 2016, amending it by “Recognition of Deferred Tax

Assets for Unrealised Losses.” 10

IAS 12 “Income Taxes” implements a so-called comprehensive balance sheet method of

accounting for income taxes, “which recognises both the current tax consequences of transactions and

events and the future tax consequences of the future recovery or settlement of the carrying amount of an

entity’s assets and liabilities. Differences between the carrying amount and tax base of assets and

liabilities, and carried forward tax losses and credits, are recognised, with limited exceptions, as deferred

tax liabilities or deferred tax assets, with the latter also being subject to a ‘probable profits’ test.” 11

9A Roadmap To Accounting For Income Taxes (2016) <https://www2.deloitte.com/content/dam/Deloitte/us/Documents/audit/ASC/Roadmaps/us-aers-a-roadmap-to-accounting-for-income-taxes-2016.pdf> accessed 7 April 2017. 10'IAS 12 — Recognition Of Deferred Tax Assets For Unrealised Losses' (Iasplus.com, 2017) <https://www.iasplus.com/en/projects/completed/tax/ias-12-dtas> accessed 10 April 2017. 11 ' IAS 12 — Income Taxes' Op. cit.

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Contrary to the United States model, the IASC adopted from its inception the assets and liabilities

approach over the deferred method.

The IASB established the purpose of IAS 12, saying that “The objective of this Standard is to

prescribe the accounting treatment for income taxes. The principal issue in accounting for income taxes is

how to account for the current and future tax consequences of:

(a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are

recognised in an entity’s statement of financial position; and

(b) transactions and other events of the current period that are recognised in an entity’s

financial statements.” 12

It is also established the matching principle, requiring companies to recognise and account the tax

consequences of transactions or other events in the same manner as the transactions and events

themselves are accounted. This implies that when a DTA or DTL arises from a transaction which has an

impact on the profit and loss account, the tax consequences should have an impact on that account too.

When the deferred income tax is a product of an event which is recognised outside of profit and loss, the

DTA and DTL should be recognised outside of it, in other comprehensive income or directly on equity.

The aforementioned example (Example A) illustrates the tax consequences of the difference

between the depreciation charged for financial reasons and the capital allowance given for tax purposes to

an asset. This event impacts profit and loss account, as the depreciation is considered to be an expense 13

paid by the company for the cost of the asset over its useful life.

In order to exemplify an event which has an impact outside of the profit and loss account, a

revaluation of a non-current asset will is illustrated in Example B in ANNEX II. At the end of year 2, the

DTL will be of €270. This includes the DTL recognised the previous year, so the actual increase of year 2

amounts to €234, composed of €36 rising from the depreciation and €198 produced by the revaluation of

the asset. The €36 DTL will be recognised through profit and loss account, in the same way as the event

giving rise to its creation does, as explained above. However, the revaluation of the asset does not appear

in the profit and loss account.

12Idem 13 It is a special expense, as it does not provoke a cash-outflow, unlike most of the other expenses.

12

The revaluation will be recognised directly in the equity, specifically in a revaluation reserve, and

the profit related to it will be reported as other comprehensive income in the financial statement. To

comply with the matching principle, the tax charge on the surplus has to be charged to equity, just like the

surplus itself. 14

It has been stated above that DTAs and DTLs are created when temporary differences arise. IAS

12 establishes that those differences are calculated using the following formula:

TEMPORARY DIFFERENCE = Carrying amount - Tax base

The temporary difference is multiplied by the tax rate in order to calculate the deferred tax asset

or liability originated from the transaction or event.

DEFERRED TAX ASSETS AND LIABILITIES = Temporary difference * Tax rate

Analysing these formulae, it is important to note the significance of the assessment of the tax base

in the calculation of the deferred taxes. IAS 12 provides guidance in this respect, establishing a set of

rules in order to asses the tax base of assets (IAS 12.7), liabilities (IAS 12.8), revenue received in advance

(IAS 12.8), unrecognised items (IAS 12.9), tax bases not immediately apparent (IAS 12.10), consolidated

financial statement (IAS 12.11).

IAS 12.15 regulates the recognition of DTLs, prescribing that:

“A deferred tax liability shall be recognised for all taxable temporary differences, except to the extent

that the deferred tax liability arises from:

(a) the initial recognition of goodwill; or

(b) the initial recognition of an asset or liability in a transaction which:

14CCA http://www.accaglobal.com, 'Deferred Tax | F7 Financial Reporting | ACCA Qualification | Students | ACCA Global' (Accaglobal.com, 2017) <http://www.accaglobal.com/my/en/student/exam-support-resources/fundamentals-exams-study-resources/f7/technical-articles/deferred-tax.html> accessed 7 April 2017.

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(i) is not a business combination; and

(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).”

In the same manner, IAS 12.24 establishes the recognition of DTAs:

“A deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is

probable that taxable profit will be available against which the deductible temporary difference can be

utilised, unless the deferred tax asset arises from the initial recognition of an asset or liability in a

transaction that:

(a) is not a business combination;

and (b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).”

The recognition of DTAs not caused by temporary differences is regulated in IAS 12.34 as

follows:

“A deferred tax asset shall be recognised for the carryforward of unused tax losses and unused tax

credits to the extent that it is probable that future taxable profit will be available against which the

unused tax losses and unused tax credits can be utilised.”

IAS 12 makes a drastic distinction between the creation of a deferred tax asset or liability, as only

in the creation of assets is considered the “probable that future taxable profit will be available against

which the unused tax losses and unused tax credits can be utilised.”

● IAS 12 V. ASC 740

In general, the income tax accounting regulation shares the same principles under US GAAP with

ASC 740 and the IFRS with IAS 12. Both are based on the principle that DTAs and DTLs should be

recognised when temporary differences arise from the disparity between the carrying amount and the tax

base of an asset. Both use the balance sheet approach too. However, there are some important differences

that need to be noted.

Regarding classification, the IFRS does not make any distinction and all DTAs and DTLs are

classified as noncurrent. On the contrary, US GAAP distinguishes between current and noncurrent DTAs

or DTLs according to the classification of the asset or liability to which the underlying temporary

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differences relate. However, on November 2015, the FASB issued “Accounting Standards Update

2015-2017. Balance Sheet Classification of Deferred Taxes”, modifying this requirement. From

December 2017 on, entities will be required to classify all DTAs and DTLs as noncurrent on the balance

sheet.

With respect to recognition, the use of valuation allowances differ. The IFRS does not use them

at all, recognising the DTA if it is probable, i.e. there is more than 50% probability, that the asset will be

realised. US GAAP accepts the full recognition of DTAs in the beginning, and then requires to reduce the

recorded asset by a valuation allowance to the extent of the realisation of the asset is “more likely than

not”. 15

Another difference lays on the tax rate used by each system. The IFRS allows the use of the

enacted tax rate (the tax rate in effect at the moment) or a substantively enacted tax rate (a tax rate that is

not in effect but it is rational to expect that it will be in the future). US GAAP only admits the use of

enacted tax rates.

There is a big difference in the way uncertain tax positions are regulated. ASC 740 establishes a

two-step recognition and measurement approach, first in order to asses if it should be recognised the

“more-likely-than-not” criteria is applied; then, to measure the amount that should be recorded, the largest

amount of benefit that is greater than 50% likely to be realized upon settlement is considered. The IFRS

provides no specific guidance on this matter, a mere reference to regulation of contingent liabilities in IAS

37 can be found in IAS 12. Nevertheless, the IFRS Interpretation Committee published on the 7th of June

the IFRIC 23 “Accounting for Uncertainties in Income Taxes” in order to provide further guidance on this

matter. 16

Another significant contrast between the two accounting standards is their position about

backward tracing. IAS 12 requires, as mentioned above , that current and deferred tax are recognised in 17

profit and loss when the tax relates to an item that is recognised there, and when it relates to an event or

transaction recognised outside profit and loss, in other comprehensive income or equity, it should be

15Richard Stuart, 'U.S. GAAP VS. IFRS: INCOME TAXES AT-A-GLANCE' (2015) <http://rsmus.com/pdf/ifrs_income_taxes.pdf> accessed 10 April 2017. 16IFRS Interpretation Committee, 'IAS 12 Income Taxes Measurement Of Current Income Tax On Uncertain Tax Position' (2014) <http://archive.ifrs.org/Meetings/MeetingDocs/Interpretations%20Committee/2014/September/AP04%20IAS%2012%20Measurement%20of%20UTP.pdf> accessed 6 April 2017. 17 See Example A and Example B

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recognised there. Meanwhile, ASC 740 prohibits backward tracing in general, compelling companies to

locate the changes on deferred taxes always in continuing operations. 18

Notwithstanding the fact that these and other differences existing between the regulations

established by the IASB and the FASB are numerous, there exists an international harmonization process

that cannot be ignored. It is aimed at reducing the differences between the IFRS and the SFAS. The

existence of a single set of global standards would be very beneficial, as it would facilitate

capital cross-border information and investors would moreover be more able to effectively

compare information from companies all over the world.

Both parts have made efforts to reduce the gap. In September 2002, the IASB officially

added to its active agenda the necessity to “Income Taxes - Comprehensive Project” as a result

of an IASB-FASB convergence project which was being discussed at the moment. In March

2009 the Exposure Draft ED/2009/2 “Income Tax” was published. However, in October the 19

IASB decide to finalise the ED because of the IASB-FASB joint discussions which were taking

place. Instead, IASB opted for limited scope amendments to IAS 12 in regarding the recovery of

underlying assets. 20

18ASB, US GAAP, Local Country GAAP: Upcoming Changes and Differences(2016). 19'Income Taxes — Comprehensive Project' (Iasplus.com, 2017) <https://www.iasplus.com/en-gb/projects/iasb-and-ifrs-projects/research/long-term/income-taxes> accessed 9 April 2017. 20'IAS 12 — Recovery Of Underlying Assets' (Iasplus.com, 2017) <https://www.iasplus.com/en-gb/projects/iasb-and-ifrs-projects/completed/tax/ias-12-limited-scope-amendments> accessed 12 April 2017.

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3. DIFFERENCES BETWEEN DISCOUNTING AND NOT DISCOUNTING

A simple example of the effect of discounting is presented below. Company A purchases a 21

machine for €350.000. This asset is depreciated for book purposes over 7 years with the straight-line

method. For tax purposes, the 5 years accelerated depreciation is applied. The EBITDA is €100.000 and

the effective tax rate applicable is 55%.

● DEFERRED TAXES WITHOUT DISCOUNT

ANNEX III illustrates the treatment of the DTL when there is no discounting considering that the

depreciation of this asset is the only item causing differences between the taxable income and the

financial reporting income. It illustrates both the financial statement and the tax return, and the deferred

tax account originated because of the differences between them.

21 Sudro Brown and Jeffrey Lippitt, 'Are Deferred Taxes Discountable?' (1987) 14 Journal of Business Finance & Accounting.

17

According to the income statement, the tax expense should be of €27,.500. However, for tax

purposes, the use of the accelerated tax depreciation allows the company to have a bigger depreciation

expense , and consequently, a smaller taxable base. This way, the taxes payable are €26.125. 22

The difference between both amounts - €1.375 - is the credit of the deferred tax account. It

illustrates the deferral on the payment of the taxes by the company, which has to recognize a liability, an

obligation to pay those taxes later.

By deferring the payment of the taxes, the company enjoys an economic benefit, as they can use

the cash required to pay those taxes for other purposes, they have more liquidity.

● DISCOUNTING DEFERRED TAXES

As analysed previously, many scholars argue that the economic benefit received by the company

thanks to the deferral of the taxes should be calculated at its present value, applying a discount rate. In this

manner, companies would recognize in their books the current economic equivalent of cash payments that

have to be made in the future, in line with the time value of money theory.

ANNEX IV shows the same example as ANNEX III, but this time a 14% discount rate is applied.

The discount rate for the example has been randomly chosen, as the actual rate used is not so important in

order to understand the different effects of discounting and no discounting that are being analysed.

However, it is important to note that, along with the discussion about the adequateness of applying or not

a discount rate to deferred taxes, it has been widely discussed by scholars which discount rate should be

applicable if chosen to discount. Nevertheless, for the time being, it is sufficient to know that a 14%

discount rate is introduced.

Focusing first on the tax return, it can be appreciated that it is exactly the same in ANNEX III and

ANNEX IV. This can be explained because it derives from the taxable income, which is not affected by

the discount rate applied to the deferred tax. The discount rate applicable to deferred taxes only affects the

income statement, as that is the place where DTAs and DTLs are recognized.

In the income statement, the process starts with EBITD , and then depreciation expenses and 23

interest expenses are deducted, leaving the income before tax. However, in the tax return, the taxable

22 Note that depreciation expenses are special kind of expenses as there is not cash flow associated with it. 23 For simplicity, amortization expenses are overlooked in the examples.

18

income is only affected by depreciation before getting to the moment when the 55% tax rate is applied

and the payable taxes are calculated.

It should be noted that in the second example, the tax expense - €26.751- is considerably smaller

than the one the company had without the discount rate - €27.500-. This occurs because income

statement, and consequently the tax expense, is affected by the discount rate.

By comparing the income statement of Company A in both examples, the impact of the discount

rate can be appreciated.

No discounting Year 1 Discounting Year 1

Income Statement Income Statement

Earnings Before Taxes & Depreciation

100.000 Earnings Before Interest, Taxes & Depreciation

100.000

Depreciation Expense 50.000 Depreciation Expense 50.000

Earnings Before Interest & Tax

50.000

Interest on Deferred Tax

0

Earnings Before Tax 50.000 Earnings Before Tax 50.000

19

Tax Expense 27.500 Tax Expense 26.751

The company has an EBIT of €50.000 in both cases, however, the tax expense varies even if the

interest on the deferred tax is 0. Out of those €50.000, only €47.500 are taxable in year 1, and the €2.500

difference is taxed in year 7 when the reversal of the deferred tax occurs, and €1.375 (€2.500*0’55) are

paid on taxes. The present value of the deferred payment is €626 [1.375 / (1’14)6].

At the end of year 1, there is a credit in the deferred tax account of €626, which is the difference

between the tax expense and the payable taxes (€26.751 - €26.125). This €626 represent the present value

of the deferred payment and is the measure of the current value of the liability that must be included on

the year 1 balance sheet. Deferring the payment of the tax for 6 years with a discount rate, the company

enjoys a benefit of €749 (€1.375 - €626). This benefit reduces the current tax expense. This way, the

difference between the tax expense in both examples is explained (€27.500 - €26.751 = €749).

The first year the difference is not so noticeable, however, the difference between financial and

tax depreciation increases considerably in the next years, and therefore, so does the credit of the deferred

tax account.

Comparing both tax returns, it can be easily appreciated that the application of a discount rate

entails certain differences. The ending balance of the DTL is substantially smaller when the discount rate

is applied. However, the application of the discount rate implies the creation of an account on the balance

sheet reflecting the liability of the company to pay interests.

The interest expense is calculated by applying the discount rate to the beginning balance of the

deferred tax account. In the example, year 1 would have €0 interest, but year 2 would recognise an

interest expense of €88 (€626 *14%). It is added to the beginning balance of the deferred tax account and

it is also reflected in the Income Statement as an interest expense.

The tax expense when a discount rate is applied is also smaller the first 5 years. However, the

accounting of the payable interest should be considered once again. Net income is bigger the first four

years if the discount rate is applied, but smaller the last 3 years.

It is important to note that the total cumulative income over the period is the same in both

examples.

20

Deferred Tax Account (NO discounting)

Year 1 2 3 4 5 6 7

Ending Balance 1.375 16.225 29.150 42.075 55.000 27.500 0

Deferred Tax Account (Discounting)

Year 1 2 3 4 5 6 7

Ending Balance 626 8.427 17.396 29.777 45.283 24.123 0

4. POLEMIC OF APPLYING A DISCOUNT RATE TO DEFERRED INCOME

TAXES

The word “discounting” in the field of accountings refers to “the use of a measurement technique

which takes into account the value of money over time. It recognizes that the timing of a cash flow

affects its value” . According to the time value of money theory, an amount of money received today is 24

more valuable than the same amount received in the future. This is so because if received today, the

money can be immediately invested and start increasing its value. If a company receives €1000 today, it

might choose to put them in a savings account at an annual rate of 0.5 %. At the end of the year, the

savings account would show a balance of €1.050. Two key conclusions can be drawn from this theory:

firstly, the perfectly rational and informed individual will always choose to receive money in the present

rather than receiving the same quantity on a later date; secondly, for that same individual it will be the

same to receive €1.000 today as to receive €1.050 in 365 days.

Applying this principle to the field of accounting, and more precisely to the accounting of DTAs

and DTLs, discrepancies arise. DTLs represent the obligation of a company to pay taxes in the future. It is

money the company owes the tax authorities. Logic would suggest that a discount rate should be applied

24 Roman L. Weil. ‘Role of the Time Value of Money in Financial Reporting’ (1990) The Accounting Review.

21

to DTLs, otherwise it would be like receiving an interest free loan from the State. However, this is not the

case.

Applying a discount rate to deferred income taxes is currently prohibited by ASC 740 and IAS

12. The former specifically precludes companies from applying a discount rate in ASC 740-10-05-07 and

ASC 740-10-30-8. For its part, IAS 12.53 strictly forbids the application of a discount rate stating that:

“Deferred tax assets and liabilities shall not be discounted”. Sections 54 and 55 add further comments on

the topic.

Both accounting standards set the prohibition firmly. However, this is a decision that has not been

unanimously endorsed. Moreover, the controversy about applying a discount rate to DTAs and DTLs has

been going on for many decades, and even if the most important bodies responsible for establishing

international accounting standards agree on the prohibition, this decision has been and still is criticised by

scholars all over the world.

This topic has been a subject of controversy for a long time. However, it has gained more

importance from the beginning of the 80’s on, due to the increasing significance of DTAs and DTLs in

accountings, which was a direct outcome of the capital allowance granted through accelerated

depreciation rules for companies. Many arguments can be found both for and against discounting. 25

KISSINGER identifies and categorizes the most relevant ones as follows. 26

● ARGUMENTS IN FAVOUR OF DISCOUNTING

○ The “Asset/Liability or Balance Sheet” Argument

One of the main topics which has been discussed in order to consider the possible use of a

discount rate has been to establish whether DTAs and DTLs meet the definition that the IASB or the

FASB give for the terms “assets” and “liabilities”.

25 Sudro Brown and Jeffrey Lippitt, 'Are Deferred Taxes Discountable? Op. cit. 26John N. Kissinger, 'On Discounting Deferred Income Taxes' (2006) 10 Academy of Accounting and Financial Studies Journal.

22

The IASB defines assets as “a resource controlled by the entity as a result of past events and

from which future economic benefits are expected to flow to the entity.” It also establishes that “an asset 27

will be recognised when:

○ it is probable that any future economic benefit associated with the item will flow to the entity; and

○ the item has a cost or value that can be measured with reliability.” 28

In order to be recognised as an asset in the financial statement, apart from meeting this definition,

the asset has to meet the recognition criteria established by the IASB. This means the inflow of economic

benefits to the entity must be probable and it has to be possible to measure the cost or value of the asset

reliably.

The IASB has established that liabilities are “present obligations of the entity arising from past

events, the settlement of which is expected to result in an outflow from the entity of resources embodying

economic benefits.” As a recognition criterion, it is prescribed that the liability should be: 29

○ “The outflow of resources embodying economic benefits (such as cash) from the entity is

probable.

○ The cost/value of the obligation can be measured reliably.” 30

The FASB defines them in a similar manner, establishing that assets are “probable future

economic benefits obtained or controlled by a particular entity as a result of past transactions or events”

, and establishes that “An asset has three essential characteristics: 31

(a) it embodies a probable future benefit that involves a capacity, singly or in combination with

other assets, to contribute directly or indirectly to future net cash inflows,

(b) a particular entity can obtain the benefit and control others' access to it, and

27'Conceptual Framework - Definition Of Elements (IASB)' ( Iasplus.com, 2017) <https://www.iasplus.com/en/meeting-notes/iasb/2013/february/cf-elements> accessed 10 May 2017. 28 Idem 29 Idem 30 Idem 31Statement of Financial Accounting Concepts nº 6, “Elements of Financial Statements”, Stamford, Connecticut: FASB, 1985

23

(c) the transaction or other event giving rise to the entity's right to or control of the benefit has

already occurred.” 32

Regarding liabilities, the FASB describes them as “Liabilities are probable future sacrifices of

economic benefits arising from present obligations of a particular entity to transfer assets or provide

services to other entities in the future as a result of past transactions or events.” It also includes some 33

general characteristics essential to liabilities:

○ “it embodies a present duty or responsibility to one or more other entities that entails settlement

by probable future transfer or use of assets at a specified or determinable date, on occurrence of

a specified event, or on demand,

○ the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid

the future sacrifice, and

○ the transaction or other event obligating the entity has already happened.” 34

Considering these definitions it can be concluded that DTAs and DTLs do fit in the

interpretations provided by the accounting standards as they represent long-term probable future

cash-flows (either inflow or outflow) which derive from the existence of a present credit or obligation,

which in turn is the consequence of a past event.

Accepting these conclusion would imply that the time value of money theory is being ignored by

the accounting standard institutions. In this sense, “failure to consider the time value of money:

(1) is inconsistent with the current accounting model's treatment of long-term assets and liabilities such as

long-term notes, capital leases and pensions,

(2) implies an unrealistic zero discount rate, or

(3) results in an overstatement of the asset/liability.” 35

32 Idem 33 Idem 34 Idem 35 John N. Kissinger, 'On Discounting Deferred Income Taxes' Op.cit.

24

A variation of this argument has also been applied in the discussion on long-term DTLs that result

from non recurring timing differences. They contend that reporting such tax effects at their discounted

amounts is relevant "if the objective is to provide information useful in predicting cash flows." 36

○ The “Income Statement” Argument

This argument is based on the fact that “accounting for deferred tax liabilities on a discounted

basis is more informative, as long as the interest expense recognized thereon is disclosed separately” as

“interest expense on deferred tax liabilities represents an additional permanent difference between taxable

income and pretax accounting income; its separate disclosure is essential to the analysis of permanent and

timing differences, which in turn is essential to the application of interperiod tax allocation in the

accounts.

Alternatively, interest expense on deferred tax liabilities may be viewed as an allocation of

income tax expense, whereby pretax accounting income is replaced by the quantum accounting income

before taxes and implicit interest.” 37

The idea underlying this argument is based on the fact that the income statement is used to

evaluate the performance of the corporate management. The only way to adequately disclose the interest

savings inherent to deferred taxes is by discounting them. Otherwise, the periodic after-tax accounting

incomes of two otherwise identical corporations would be the same, ceteris paribus, although one

allocated taxes because it recognized a revenue later (or the expense earlier) for tax purposes than for

financial accounting purposes, whereas the other recognize the revenue (or the expense) concurrently for

both financial accounting and tax purposes, hence did not allocate taxes. 38

NURNBERG’s argument is based on the fact that discounting enhances the informativeness of

the financial statement. As will be explained later, this argument has been criticised by scholars who

claimed that the average investor is not able to understand the implications of the discount.

36 Debra Jeter and Paul Chaney, 'A Financial Statement Approach To Deferred Taxes' (1988) 2 Accounting Horizons. 37 Hugo Nurnberg, 'Discounting Deferred Tax Liabilities' (1972) 47 The Accounting Review. 38 James M. Fremgen, ‘Interperiod Income Tax Allocation and Income Determination’ (1963) N.A.A. Bulletin.

25

○ The “Compromise” Argument

As it has been mentioned earlier, the recognition and measurement of deferred income taxes have

always been a polemic issue. One of the debates has been revolving around two conflicting positions:

those in favor of comprehensive allocation of DTLs and those who defend partial allocation.

Discounting could be seen as a middle ground between both positions, as it reduces the effect of

the total allocation and the amounts provided would be closer to the ones recognized using partial

allocation. 39

● ARGUMENTS AGAINST DISCOUNTING

○ The “Non Conventional Liabilities” Argument

Some authors have claimed the similarities between DTLs and regular liabilities in order to

defend the application of a discount rate. Opposingly, other scholars have based their arguments on the

differences existing between them.

In this manner, STEPP noted several distinctions between some characteristics of DTLs and

common liabilities according to their definitions in the APB Opinion No. 21 of the FASB . First, deferred 40

tax liabilities are not fixed sums payable at fixed dates. The carrying amount of the DTA or DTL may

vary along its life. These variations may obey predictable rules, such as the temporary differences caused

by the depreciation of a fixed asset (ANNEX I); or be subject to arbitrary events, e.g. allowances for bad

debts. In STEPP’s words, “the reversals of certain timing differences may depend on future events and,

for certain timing differences, the occurrence of the reversals can be determined only by arbitrary

ordering. The amount and timing of the tax payable on reversal of timing differences will depend on the

tax rates enacted for the future periods and the taxpayer’s tax position, including taxable income or loss,

carryback availability, and available credits and carry-forward.” 41

Another difference highlighted by the author relays on the fact that, while common liabilities are

usually originated by a transaction involving two contracting parties which negotiate the characteristics of

39 Bruce Bublitz and Gilroy Zuckerman, 'Discounting Deferred Taxes: A New Approach' (1988) 6 Advances in Accounting. 40 Accounting Principles Board Opinion nº 21, ‘Interest on Receivables and Payables’ Stamford, Connecticut: FASB 1971. 41 James O. Stepp, ‘Deferred Taxes: The Discounting Controversy’ (1985) Journal of Accountancy.

26

the transaction (including the applicable interest rate), the creation of DTLs is regulated in the applicable

national tax legislation and there is no negotiation involved in its creation. These provisions contained in

the national tax law are not affected by changes in the market interest rate, and all taxpayers can enjoy

this incentive, regardless of their creditworthiness. According to the author, “the most important timing

differences represent economic incentives - the temporary deferral of tax payments - that the government

provides for specific transactions. The ‘discount’ on the deferred taxes arguably measures the amount of

the economic incentives”.

○ The “No Incurred Cost” Argument

This argument is based on the concept of opportunity cost. It’s been argued that there is an implicit

interest in DTLs, as the company enjoys the benefits of the present availability of cash, which allows it to

invest it. However, many scholars have argued at this implicit interest should not be displayed in the

financial reports, as it is not an incurred expense, but an opportunity cost. Along these lines,

NURNBERG states that “unlike other liabilities, interest expense on deferred tax liabilities is an

opportunity cost, hence represents a departure from generally accepted accounting principles. But

although not generally used in financial reports for external parties, the value of including opportunity

costs in reports for management has long been recognized. Accordingly, the evaluation of the desirability

of discounting deferred tax liabilities is tenuous, for it depends on assertions concerning whether the

inclusion of opportunity cost in financial reports for external parties is good or bad, and in particular,

whether discounting deferred tax liabilities is consistent or inconsistent with more basic accounting

concepts”. However, the usefulness of the information provided to external parties by disclosing the 42

interest expense of DTLs in the financial report has been a polemic issue.

○ The “Zero Interest Rate” Argument

The supporters of this argument claim that even if from a formal point of view it could be

adequate to apply a discount rate to DTAs and DTLs, the correct interest rate that companies should use is

0%, so it would make no difference to apply the discount rate or not. There are different rationales authors

use in order to justify the adequateness of the 0% interest rate.

For example, the reason given by KELLER is that “the implicit interest charge is generally

thought to be that amount which is added to the price of the good or service for the privilege of delaying

42 Hugo Nurnberg, 'Discounting Deferred Tax Liabilities' Op. cit.

27

payment. It is no the value of the deferral to the entity, which has delayed the payment (…). The value of

the deferral to the company permitted to defer its taxes will be reflected in higher earnings to the

stockholders, which in turn will call for a revaluation of the stock equity (…). The tax deferral does not

provide for the payment of interest to the government. It is an interest-free loan by the government to the

business in an attempt to encourage increased spending on plant assets (…). In the case of the tax liability,

the applied rate should be 0 %. The present value of an amount due in n periods at 0% interest is the same

as the maturity amount.” It can be appreciated that the author understands the deferral as a resource of 43

the government to promote a series of behavior paths. Being so, the “loan” given by the government

would not be comparable to regular loans, so it would be understandable not to apply the theory of the

time value of money in this case, as doing so would frustrate the object and purpose of these measures

taken by the government.

On a slightly different line of argument, STEPP, who believes that timing differences originate

economic incentives, states that deferred taxes measure the subsidy provided by the government, and that

subsidy should not be anticipated by discounting. Talking concretely about the timing differences caused

by accelerated depreciation for tax purposes, he argues that it is not necessary to recognize the benefit

provided by the government’s economic incentive immediately on the income, as it would be more

adequate to spread that benefit over the life of the asset or it should be recognised as a cost reduction

when considering the book value of the book when calculating the base of the asset for financial

depreciation, as happens with regular subsidies. 44

WHEELER and GALLIART also advocate for the application of a 0% discount rate, however,

their argument is based on a different claim. In the words of the authors, “The purpose of discounting is to

state the liability at an amount which represents the cash required to liquidate the obligation at the balance

sheet date. From an income statement perspective, it also values services received in exchange for a

liability at the cash equivalent price. However, tax produces no services proportionate to its cost. Thus, a

cash equivalent price for the income tax cannot be ascertained. Discounting should not reflect current

values of services to be lower than future values if the dollar cost of the services would be the same

regardless of when the payment for them was made. This suggests that the appropriate discount rate for

deferred tax is zero. This conclusion does not mean that deferred tax is an interest free loan, but only that

43Thomas F. Keller, ‘Accounting for Corporate Income Taxes”’(1961) Michigan Business Studies, University of Michigan. 44 James O. Stepp, ‘Deferred Taxes: The Discounting Controversy’ Op. cit.

28

the cost of governmental operations is unaffected, from a micro view, by the timing of the payment.” In 45

other words, the authors claim that the discount rate is trying to represent at the balance sheet date, the

day that the financial statement is reported, the value of the asset or liability on their realization date. In

the case of DTAs and DTLs, in the opinion of the authors, they are a consequence of the payment of a tax

in advance or in delay. This service offered by the government to the company, or viceversa, cannot be

given a concrete value, so there is no point of applying a discount rate which represents precisely this

value.

○ The “Complexity (Cost/Benefit)” Argument

Many scholars have affirmed that the costs of applying a discount rate would far exceed its

benefits. They rightly state that the correct assessment of the measurement of both the deferred tax and

the interest associated with it would entail the creation of highly complex accounting procedures.

It has been mentioned above that STEPP considers deferred taxes as the measurement of the 46

economic incentive provided by the government, which should be treated in a similar manner as

subsidies, and consequently, it should be amortized over the life of the asset. In order to do this, “deferred

taxes would be reduced by the “discount”, and the “discount”, representing the subsidy, would also be

reflected separately as a deferred credit. The aggregate “discount” would be accreted by charge to income

on an interest method over the period to payment of the deferred taxes and would be credited to income

over the life of the fixed asset as an adjustment of depreciation. This approach would complicate

accounting…”. It is evident that the accounting techniques necessary to do his would be extremely

complicated, and would go against the current trend which pursues simpler accounting standards. 47

BROWN & LIPPITT proposed that the correct approach to effectively incorporate a discount rate

to DTLs and DTAs would be by using a reversal pattern, which implies “the need to associate each

originating difference with a particular future reversing difference so that a time period can be determined

for application of the present value function.” Keeping track of the reversal of each deferred tax would be

extremely burdensome, especially considering those reversals which depend on future events. 48

45 James E. Wheeler & Willard H. Gallart, ‘An Appraisal of Interperiod Income Tax Allocation’ (1974) Financial Executive Research Foundation. 46 Stepp focuses on temporary differences caused by accelerated tax depreciation of fixed assets. 47 James O. Stepp, ‘Deferred Taxes: The Discounting Controversy’ Op. cit. 48 Sudro Brown and Jeffrey Lippitt, 'Are Deferred Taxes Discountable?' Op.cit.

29

As a critic to the arguments defending discounting for its informativeness, WHEELER &

GALLIART highlighted that in this scenario, it is necessary to consider the ability of readers to

understand the relevance of discounted deferred tax in the financial statement. The complexity of adding a

discount rate to the already over-complicated process of tax allocation currently in place might make the

financial statement more obscure and, consequently, less valuable. 49

Even RAYBURN, who defended discounting based on the asset and liability argument,

recognizes that “the present value concept inherent in discounting taxes is relatively simple, but the

implementation issues may be somewhat more burdensome. The basic implementation issues are

predicting timing difference reversals, selecting an appropriate discount rate, and selecting a method to

schedule timing difference reversals.” 50

○ The “No Future Cash Flow” Argument

Temporary differences can be distinguished according to where do they appear reflected first,

either in the financial reporting income or in the taxable income. According to STEPP, in the former case,

for example, when a DTL is created because of the recognition of gross profit on installment sales for

financial reporting purposes, there is an expectable future cash flow. This will appear with the reversal of

the DTL, when the timing difference is reflected in taxable income.

However, when timing differences appear first reflected in taxable income, the cash flow has

already occurred with the recognition of the DTL, and the future reversal of the timing difference finds its

accomplishment by its reflection in the financial reporting income. In STEPP’s words, “the tax effects of

such timing differences need no discounting to be measured at their present value.” In this cases, the 51

deferred tax provision represents a cash inflow that has already been received, therefore, it is already

stated at its present value.

○ The “Explicit Interest Cost” Argument

LEMKE and GRAUL do not advocate against discounting per se, but they do propose the use of a

discount rate which has the same effects as not discounting. They defend the use of an explicit interest

cost instead of the opportunity cost to discount deferred taxes. They argue that other scholars failed to

49 James E. Wheeler & Willard H. Gallart, ‘An Appraisal of Interperiod Income Tax Allocation’ Op. cit. 50 Frank R. Rayburn, ‘Discounting of Deferred Income Taxes: An Argument for Reconsideration’ (1987) Accounting Horizons. 51 James O. Stepp, ‘Deferred Taxes: The Discounting Controversy’ Op. cit.

30

acknowledge the existence of “an explicit future return to the government on deferred taxes, and,

obversely, an explicit future cost of deferred taxes to the firm. That return/cost consists of the future tax

payments on any incremental taxable income that the firm may derive from investment of the funds made

available to it by way of tax deferrals.” In other words, the future tax payments of the income that 52

originates from the investments the company makes using the deferred taxes as a source of funding. The

authors provide a numerical example in their paper to illustrate how the use of the explicit interest cost as

a discount rate results on the discounted present value of the deferred taxes being the same, “no matter

what amount or patterns of contribution to future taxable income is derived from investment of the funds

made available by the tax deferral.” Their approach is not the same as the one used in the argument 53

defending a zero interest rate, but it has the same results.

● THE POSITION OF THE IASB

As stated at the beginning of the chapter, applying a discount rate to deferred income taxes is

currently prohibited by ASC 740 and IAS 12. IAS 12.53 prohibits this practice in a very clear manner

leaving no room for misinterpretation. The reason to adopt this approach is the complexity it implies,

which makes it impractical, because the informational value added with discounting is not enough to

compensate for the work and effort it requires. This conclusion can be extracted from the reading of IAS

12.54.

IAS 12.54 “The reliable determination of deferred tax assets and liabilities on a discounted basis

requires detailed scheduling of the timing of the reversal of each temporary difference. In many cases,

such scheduling is impracticable or highly complex. Therefore, it is inappropriate to require discounting

of deferred tax assets and liabilities. To permit, but not to require, discounting would result in deferred

tax assets and liabilities which would not be comparable between entities. Therefore, this Standard does

not require or permit the discounting of deferred tax assets and liabilities”.

Particular attention should be paid to the fact that, even if it does not appear expressly mentioned

the IASB, as well as the FASB, are using the cost/benefit principle to substantiate their decision. This

principle entails that the cost of providing financial information in the financial statement must not

outweigh the benefit of providing that information to the users of the financial statements, In order to

asses if a reporting technique or standard is in line with this principle, two different perspectives need to

52 Kenneth W. Lemke & Paul R. Graul, ‘Deferred Taxes - an Explicit Cost Solution to the Discounting Problem’ (1981) Accounting and Business Research. 53 Idem

31

be considered: the level of detail provided and the types of information required. The former implies that

companies should not waste money and energy on disclosing details which do not contribute to a better

understanding of the financial situation of the company and only serves to make the financial statement

more extensive. The latter affects the reporting institutions, which should avoid imposing an excessive

burden to companies. This principle is important to keep a balance, as the costs involved with reporting

the financial information are borne by the companies, while the benefits are enjoyed by the users of the

financial statement. This principle is a constraint for the issuers of financial reporting standards, who

always need to bear it in mind when asking companies to report information.

The stance of the IASB has both been criticized and appraised by scholars often. The fact that the

prohibition has been established since the inception of the IAS 12 does not mean that the criticism of this

practice is an old argument. A clear example of this can be found in the Discussion Paper published by

the European Financial Reporting Advisory Group on December, 2011. The title of the paper was

“Improving the Financial Reporting of Income Tax” and intended to encourage the debate regarding the 54

future of IAS 12, which was perceived as unsatisfactory regarding certain aspects. One of the topics

discussed was the possibility of allowing for the discount of deferred income taxes.

In this matter, the Discussion Paper introduces the issue of the “Discounting of Deferred Tax” in

its Part 2 Paragraph 44 “Perhaps one of the more substantive changes that might be made to the approach

under IAS 12 is to reflect the time value of money for deferred income tax amounts on the balance sheet.

To meet the needs of users, financial statements need to report faithfully the economic burden of tax. That

economic burden is reduced where a charge to tax is postponed. Under IAS 12 discounting of deferred

tax assets and liabilities is prohibited. The result is that the reported tax charge for the period is the same

irrespective of whether or not an entity takes advantage of an opportunity to defer tax expense”. After

pointing out the relevance of discounting with respect to the informational value of financial statements,

some arguments for discounting are presented. It is also explained that the fundament of the prohibition

lays on the complexity of the practice. 55

54 European Financial Reporting Advisory Group Discussion Paper ‘Improving the Financial Reporting of Income Tax’ (2011) EFRAG. 55 Idem

32

5. MEASUREMENT OF DEFERRED INCOME TAXES

The internationalization of economic activity, which has been produced by a variety of factors

such as the increase of the number of MNEs and the growth of foreign investments, has caused the need

for the harmonization of international financial reporting. In this matter, the EU and the IASB have

invested a great deal of effort in achieving this goal.

The International Accounting Standards Committee, the predecessor of the IASB, developed the

International Accounting Standards in 1973 in order to facilitate the comparison of companies from

different countries among other reasons. In 2001, it was replaced by the IASB, which adopted the rules

set up in the IAS, and based on them issued the IFRS. Since then the IASB has continued trying to

harmonize international financial accounting. The slow progress of the harmonization process increased

the awareness of the EU in this matter and resulted in the issuance of the Regulation 1606/2002 EU , 56

which established the obligation to follow the IFRS for consolidated companies listed in European stock

markets from January 2005 on.

Below there are presented 5 examples of how different states deal with deferred income taxes. 4

of them follow the IFRS, namely the Netherlands, Germany, Spain and the United Kingdom, and the

other one, the United States of America, has its own standards. It will be analysed the general structure of

the country, the relationship between financial and tax accounting, and the treatment they provide to

deferred taxes, specifically regarding the recognition and measurement rules.

● The United States of America

The United States of America is a federal republic composed of 50 largely self-governing and

semi-sovereign states. The Constitution, drafted in 1787, establishes the separation of power between the

Congress, which has the legislative power; the President as the head of the executive power; and the

Supreme Court as the head of the judicial power. Legislative authority is divided into three tiers of

national, state and local government and all of the three levels have some degree of authority to tax,

56 Regulation (EC) No 166/2002 of the European Parliament and of the Council, of 19 July 2002, on the application of international accounting standards. Official Journal L 243, 11/09/2002 P. 0001 - 0004.

33

legislate and regulate. It has the world’s largest economy in the world, mainly based in the service sector.

It is a member of a number of international organizations, including the WTO, the UN and the OECD.

As mentioned, taxes are levied on three different levels and there are several different tax types,

including taxes on income, taxes on property and taxes on goods and services. This 3 level taxation makes

the systems very complex, as companies have to take into consideration a number of different taxes which

affect their decision making process.

The US income tax law, mainly the Internal Revenue Code, is very straightforward when

identifying who are subject to US income tax. “Taxpayers” logically have the obligation to pay taxes, and

the term taxpayer is identified with the term “person” which includes “individual, trusts, estates,

partnerships, associations, companies or corporations”, according to IRC (US) s. 7701 . Corporations 57

are taxed differently depending on their residence. Resident corporations are taxed in their worldwide

income, whereas non-resident ones are taxed in their source income. To determine if a corporation is

resident or not, attention must be paid once again to IRC (US) s. 7701, where “domestic corporation” is

defined as the corporation “...created or organized in the United States or under the law of the United

States…”.

In respect of the accounting practices in the US, in principle it has practically material

independent tax accounting. Separate tax accounting exists in practice, although they use financial

accountings as a starting point. This is what is prescribed under IRC (US) s. 446.a, “taxable income shall

be computed under the method of accounting on the basis of which the taxpayer regularly computes his

income in keeping his books.” It should be noted that this provision does not make reference to 58

generally accepted accounting principles.

The US is a Common Law based country, and usually countries with this type of law system have

a bigger gap between the financial and fiscal accounts, as they are less likely to use financial accounts as

the starting point to calculate the tax base. 59

The Generally Accepted Accounting Principles in rule in the US, commonly called US GAAP,

are issued by the Financial Accounting Standards Board. The FASB is an independent, private-sector,

not-for-profit organization and its function is to establish financial accounting and reporting standards for

public and private companies and not-for-profit organizations. The FASB works closely to GASB, which

57 IRC s. 7701. 58 IRC s. 446.a. 59 Peter Harris, Corporate Tax Law (Cambridge University Press 2013).

34

is the Governmental Accounting Standards Board, a body which issues the GAAP that has to be followed

by the US state and local government. The Financial Accounting Trustee is in charge of overseeing and

supporting these bodies’ activities. The three entities share as a common objective to “establish and

improve financial accounting and reporting standards to provide useful information to investors and other

users of financial reports and educate stakeholders on how to most effectively understand and implement

those standards” . Another important regulatory body is the Securities and Exchange Commission (SEC), 60

which according to the Securities Exchange Act of 1934, has statutory authority to establish the

accounting principles that must be followed by publicly held companies. However, the SEC relies on the

FASB to set up those rules.

The US tax authorities, which are embodied as the Internal Revenues Service Organization, have

identified as the main tax law rules the Internal Revenue Code and the Treasury (Tax) Regulations. The

former is the most relevant one, as it is the starting point for federal tax law. It was enacted by the

Congress in Title 26 of the United States Code (26 USC). The latter complements the IRC, and provides 61

the official interpretation given to the IRC by the US Department of Treasury. 62

As regards to DTAs and DTLs, the corresponding regulation can be found in the ASC 740, which

replaced the Statement nº 109 which had regulated this topic until then. It regulates the “Accounting for

Income Taxes”, as its title states. The objective of accounting for income taxes under ASC 740 is to

reflect the after-tax financial position of the income taxes of a company, which is reflected in the balance

sheet.

Although this standard’s scope includes income taxes in general, most of the assets and liabilities

that are created as a consequence of the application of this provision are DTAs and DTLs created because

of temporary differences. ASC 740-10-20 defines this concept as “A difference between the tax basis of

an asset or liability computed pursuant to the requirements in Subtopic 740-10 for tax positions, and its

reported amount in the financial statements that will result in taxable or deductible amounts in future

years when the reported amount of the asset or liability is recovered or settled, respectively”. Analysing 63

this paragraph, some conclusions can be drawn. It is important to note that the FASB puts the emphasis

on the economic impact of recovering and settling DTAs and DTLs at their reported amount, which

60'About The FASB' (Fasb.org, 2017) <http://www.fasb.org/facts/> accessed 17 June 2017. 61 26 USC 62 'Tax Code, Regulations And Official Guidance' (Irs.gov, 2017) <https://www.irs.gov/tax-professionals/tax-code-regulations-and-official-guidance> accessed 19 June 2017. 63 ASC 740-10-20

35

implies that all the basic differences that exist in the balance sheet date have to be recognised, in order to

give a more true and fair view of the economic reality. The FASB conditions the recognition of the

temporary difference to the pursue of the requirements established in Subtopic 740-10. This has as the

effect that the tax bases of assets or liabilities that are used to calculate the temporary differences may not

coincide with the ones that appear in the as-filed tax return. It can be said that in one hand there is the tax

return submitted to the tax authorities, and in the other hand, there is an “hypothetical ASC 740 tax

return”, which are not necessarily consistent. 64

In order to achieve one of the goals of ASC 740, which is that the financial statement reflects the

current and deferred tax consequences of all events that have been recognised in the financial statement 65

or the tax return, the FASB has appointed a number of rules regarding the recognition and measurement

of DTAs and DTLs:

○ A current tax liability or asset is recognised for the estimated taxes payable or refundable

on tax returns for the current year.

○ A current tax liability or asset is recognised for the estimated future tax effects

attributable to temporary differences and carryforwards.

○ The measurement of current and deferred tax liabilities and assets is based on provisions

of the enacted tax law; the effects of future changes in tax laws or tax rates is not

anticipated.

○ The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax

benefits that, based on available evidence, are not expected to be realized.

The recognition and measurement method used under ASC 740 was pointed out in the first

Chapter of this thesis as one of the main differences between the standard used in the US and the one

adopted by the IFRS. Unlike the IAS 12, which recognizes deferred tax assets to the extent that it is

probable in the sense that it is “more likely than not” that they will be used, ASC 740 prescribes the full

64 A Roadmap To Accounting For Income Taxes (2016) Op. cit. 65 There are some exceptions which can be found in ASC 740-10-25-3.

36

recognition of the DTAs. Nevertheless, the value of the DTAs is reduced by a valuation allowance, as it

can be drawn from the last principle, which is set out in ASC 740-10-30-2. 66

In the same manner as the IASB, the FASB precludes the application of a discount rate to

deferred tax assets and liabilities. This prohibition can be found in different parts of the ASC 740. It

appears first in ASC 740-10-05-07, where the overall “Overview and Background” of Income Taxes are

set out. It states that “A temporary difference refers to a difference between the tax basis of an asset or

liability, determined based on recognition and measurement requirements for tax positions, and its

reported amount in the financial statements that will result in taxable or deductible amounts in future

years when the reported amount of the asset or liability is recovered or settled, respectively. Deferred tax

assets and liabilities represent the future effects on income taxes that result from temporary differences

and carryforwards that exist at the end of a period. Deferred tax assets and liabilities are measured using

enacted tax rates and provisions of the enacted tax law and are not discounted to reflect the time-value

of money”. Discounting is again expressly precluded in ASC 740-10-30-08, where the “Initial

Measurements” regarding DTAs and DTLs are established. The FASB adopted this stance against valuing

DTAs and DTLs at their present value because it reached the conclusion that the effort required in order

to apply a discount rate correctly was excessive compared to the benefits it produced.

In this sense, in 1966, when the APB Opinion nº 10 was published, the Board established that 67

deferred taxes should not be accounted for on a discounted basis, subject to further study of the broader

aspects of discounting. It was not until 1987, when SFAS nº 96 was issued, that this prohibition became 68

official. The Board stated that “Conceptual issues, such as whether discounting income taxes is

appropriate, and implementation issues associated with discounting income taxes are numerous and

complex… The Board decided not to consider those issues at this time. Board members who favor that

decision do so for a number of reasons. Some… oppose discounting because of the complexity…”.

On the 20th of November of 2015, the FASB issued the “Accounting Standards Update 2015-17,

Balance Sheet Classification of Deferred Taxes” , with the aim of simplifying the current accounting 69

standards. This will be effective for public entities from the annual periods beginning on December 2016,

while for the rest of the entities will be implemented for annual periods starting after the 15 of December

66 Income Taxes (2nd edn, PWC 2013) <https://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-income-taxes-second-edition-2015-2.pdf> accessed 3 June 2017. 67 Opinions of the Accounting Principles Board nº10, “Omnibus Opinion”, New York: APB, 1966 68 SFAS Nº 96 69 Asc 740

37

of 2017. One of the main changes adopted with this update affects the representation on the balance sheet

of deferred taxes. The new guidance requires that all DTAs and DTLs, along with any related valuation

allowance, to be classified as noncurrent on the balance sheet. This way, it has eliminated the need to

allocate valuation allowances on a pro rata basis between current and noncurrent. From the

implementation of this rule on, each jurisdiction will only have one net noncurrent DTA or DTL account,

as the FASB has not changed the preexisting rule that only allows offsetting within a jurisdiction. The

FASB decided to change this reporting mechanism because the classification of DTAs and DTLs into

current and noncurrent provided stakeholders with little useful information, not enough to make up for the

cost and effort that it implies. They change will put ASC 740 more in line with IAS 12 . It can be noted 70

that, once more, the FASB applies the cost/benefit principle and sacrifices the fairness and truthfulness of

the financial report for simplicity, using the same rationale they claim when precluding the reporting of

DTAs and DTLs on their present value.

● Spain

Spain has been established in its constitution, which dates from 1978, as a parliamentary

government under a constitutional monarchy. There is a bicameral parliament - Cortes Generales - with

legislative powers which is elected every 4 years. The head of the government is the president, assisted by

a council of ministers. Spain is a member of the EU, the OECD, the UN and the WTO. It has a large

economy dominated by the service sector and is a popular destination for foreign investment.

Spain is divided in 17 autonomous communities and has 2 autonomous cities in the north of

Africa. Taxes are levied in Spain both at the national and municipal levels and they may vary from one

municipality to the other. The main national taxes regarding business taxation are the Corporate Income

Tax, the Branch Profits Tax and the Value Added Tax. However, there are other taxes levied by

municipal authorities which have also an impact on business taxation, such as Capital Tax, Transfer Tax

or Real Property Tax.

According to the article 8 of the Spanish Corporate Income Tax Law - Ley del Impuesto sobre

Sociedades - a company is considered to be resident in Spain if it is incorporated in Spain, has its

70 'Heads Up | 2015 | Issue 38 | FASB Issues ASU On Balance Sheet Classification Of Deferred Taxes' (Deloitte United States, 2017) <https://www2.deloitte.com/us/en/pages/audit/articles/hu-fasb-issues-asu-on-balance-sheet-classification-of-deferred-taxes.html> accessed 19 June 2017.

38

registered office/place of business in Spain or has its effective management in Spain. Spanish resident 71

companies are subject to the corporate income tax on worldwide profits and capital gains. Non resident

companies are taxed on the profit and gains generated in Spain, according to the Spanish Non-Residents

Income Tax Law - Impuesto sobre la Renta de No Residentes -, and they are subject to the provisions set

out in the tax treaty concerned as referred to in article 4 of this law. 72

Regarding the relationship between taxation and accountancy in Spain, it is necessary to highlight

that it is a country with practically formal dependence or linkage between financial and tax accounting.

This means that there are no separate tax accounts. Differences between financial and tax accounting can

only be created with explicit tax legislation.

Spain is a country whose legal system is based on Roman Law and opposed to other countries

with a Common Law based jurisdictions, accounting rules are embodied in legislation, instead of being

oriented by accountings practice. The primary accounting legislation in Spain is the General Accounting

Plan - Plan General Contable . The Spanish GAAP currently in force was published on 2007, and it 73

establishes that consolidated companies listed in the stock market have to follow the IFRS mandatorily,

and consolidated companies that are not listed in the stock market may follow it voluntarily. The adoption

of the IFRS in Spain was implemented with the publications of the Law 62/2003 , which introduced a set 74

of social, fiscal and administrative measures. 75

Focusing on deferred taxes’ recognition and measurement, the Spanish GAAP regulates them in

different parts of the law, as they might have an impact on different parts of the financial statement. Their

value appears reflected in the balance sheet and changes in their value will affect the profit and loss

account in most of the cases. However, if the DTA or DTL is part of the equity, the change on its value

71 Article 8.1 of the Ley 27/2014, de 27 de noviembre, del Impuesto sobre Sociedades. “1. Se considerarán residentes en territorio español las entidades en las que concurra alguno de los siguientes requisitos: a) Que se hubieran constituido conforme a las leyes españolas. b) Que tengan su domicilio social en territorio español. c) Que tengan su sede de dirección efectiva en territorio español.” 72Article 4 of the Real Decreto Legislativo 5/2004, de 5 de marzo, por el que se aprueba el texto refundido de la Ley del Impuesto sobre la Renta de no Residentes. “Lo establecido en esta ley se entenderá sin perjuicio de lo dispuesto en los tratados y convenios internacionales que hayan pasado a formar parte del ordenamiento interno, de conformidad con el artículo 96 de la Constitución Española.” 73 Real Decreto 1514/2007, de 16 de noviembre, por el que se aprueba el Plan General de Contabilidad. 74Ley 62/2003, de 30 de diciembre, de medidas fiscales, administrativas y del orden social. 75 Susana Callao., ‘Adoption of IFRS in Spain: Effect on the comparability and relevance of financial reporting’(2007) Journal of International Accounting, Auditing and Taxation.

39

will not have an impact on the profit and loss account, but it will affect the statement of recognised

income and expenses.

It also embodies the rule established by IFRS according to which DTLs will be recognised when

there is a temporary difference between the tax and the financial accounting which results in the company

paying fewer taxes on the present. However, when it comes to DTAs the Spanish GAP will only accept

their recognition if it is probable that the company will have future profits to offset those taxes. It also

establishes the obligation for companies to reconsider their DTAs at the close of the financial period so

that they will proceed to derecognise those DTAs which will probably not be recovered and recognise

those which will.

Regarding the valuation rules for deferred income taxes, they shall be valued considering the

probability of getting paid or paying the authorities the amount due on taxes according to the legislation in

force at the end of the financial year. They should also be valued considering the tax rate expected for the

year of the reversion of the deferred tax. The Spanish GAAP, in line with the IFRS, also prescribes the

application of a discount rate to deferred taxes.

The DTAs appear reflected in the balance sheet as a noncurrent asset, under the account number

474. The DTLs appear reflected in the balance sheet as a noncurrent liability with the account number 479

.

As mentioned above, income or expense derived from an increase, decrease or change of the

value of the DTAs and DTLs can affect either profit and loss account, or the statement of recognised

income and expenses. In the first case, they will appear reflected with the account number 6301 and

changes will be made using account numbers 633 and 638.

When it comes to reflecting the effects in the equity, the deferred taxes will appear recognised in

the balance sheet under the account number 8301, and it will change its value using the account numbers

834, 835, 836 and 837.

DTAs and DTLs have to be disclosed in the annual report as well, where the companies have to

illustrate the rationale behind the recognition of those deferred taxes, and publish a tax planning which is

mandatory to allow the recognition of certain kind of DTAs, in order to exhibit the capacity of the

company to create a future cash flow recognize certain kind of DTAs.

40

● Germany

Germany, officially the Federal Republic of Germany, is a democratic and federal parliamentary

republic, where the legislative, executive and judicial powers are separated into different and independent

institutions. It is formed by 16 states and each state or Länder has its own constitution, government and

independent court. The formal head of state is the federal president. Nevertheless, the head of the federal

government is the federal chancellor or Bundeskazler (currently it is a Bundeskanzlerin, as for the first

time in history, there is a woman chancellor - Angela Merkel- in charge). The federal chancellor is elected

by the lower house of parliament, the Bundestag, which is directly elected. The parliament is composed

by the Bundestag and the Bundesrat, which is the upper house of the parliament and comprises 16

government delegates from each Länder. The parliament has the competence to issue major legislation on

economic policy and other relevant national matters.

Regarding the judicial power, the German system is divided in 4 types of courts: the ordinary

courts, which has competence over criminal and civil law cases; specialised courts, which deal with cases

related to labor, social, administrative, tax and patent law; and the state constitutional court, for issues

which might be against the German constitution. Hierarchically over these 3 types of courts is the federal

constitutional court, which issues decisions which are binding within the whole territory.

Germany has the largest economy in Europe and is the fourth largest economy in the world. It is

mainly based on the service sector, although it also has an strong, specialised high class industry. It is

member of the EU, the OECD, the UN and the WTO, among other international organizations.

Taxes in Germany are levied by the federal government or Bund, by the states and by the

municipalities or Städte/Gemeinden. The most relevant taxes that affect a company operating in the

country are the Corporate Income Tax, the municipal Trade Tax and the Value Added Tax. Apart from

the regular Corporate Income Tax, an additional surcharge is levied, called the Solidarity Surcharge,

which has the aim of financing Germany’s reunification.

In order to establish who is subject to German taxes, Income Tax Law in Germany refers to

“taxpayers” in the Income Tax Act - Einkommensteuergesetz - which regulates income tax for “physical

persons”. In principle, it is only addressed to individuals. However, the Corporate Income Tax Act -

Körperschaftsteuergesetz - applies many provisions of the Income Tax Act, making it possible to

indirectly relate the term “taxpayer” to non-individuals too. In order to identify which entities are subject

to CIT, German tax legislation incorporates a list of the incorporation forms that are liable to pay taxes.

41

Nevertheless, to identify which characteristics does a corporation need to fulfill in order to be considered

one of these entities, it is necessary to turn to German Commercial Law. Resident companies in Germany

are taxed on their worldwide income, and foreign-source income is usually excluded from the German

taxable base, either because the relief method is embodied in a tax treaty, or because the application of a

unilateral relief provision.

In respect of the relationship between tax law and accounting practice, Germany is a country with

practically formal dependence, same as in the Spanish case, as they both are countries where the linkage

principle between tax and financial accountings is applied. The financial statement is binding for tax

purposes, unless it is otherwise specified in tax legislation. Consequently, in most of the cases the

commercial balance sheet and the tax balance sheet are identical. If deviations were to appear, companies

have to issue a balance sheet for financial reporting - Handelsbilanz - and another one to file the tax return

- Steuerbilanz. Companies may file two completely different balance sheets or simply explain the

deviations in an Appendix attached to the CIT Return. 76

The regulation concerning the preparation of the financial statements of German companies is

contained in its commerce code, Handelsgesetzbuch - commonly known as HGB. It contains the German

GAAP, which is quite similar to the US GAAP. Since IAS 2002 was published, all listed companies in

Europe have the obligation to file their financial statements following the rules set up in the IFRS from

2005 on. In Germany, private firms were provided the chance to choose between IFRS and HGB for

consolidated accounts starting 2003. Traditionally, the German GAAP has been specially focused on

providing useful information to creditors and tax authorities, the prudence principle, more reduced

disclosure rules comparing to IFRS, and a wide range of recognition and measurement options. The

German Accounting Standards Board adopts the rules which are later included in the HGB by the Federal

Ministry of Justice. Later on, on 2009, the German legislator believed necessary to achieve a better

alignment between IFRS and HGB, and underwent an important reform of the part of the HGB which

concerns financial reporting rules. This reform was named the Accounting Law Modernisation Act,

Bilanzrechtsmodernisierungsgesetz - better known as BilMoG. This reform’s goal was to promote

transparency by providing firms with a lower-cost option than the IFRS. This lower cost incentive

resulted in more private firms adopting this new and more decision-usefulness oriented standard. The

increase in de jure comparability between both reporting standards lead to an increase in de facto

76 Peter Harris, Corporate Tax Law Op. cit.

42

comparability between companies using different standards within the country . With the implementation 77

of the BilMoG Act, there was an important change in the approach that Germany has adopted for the last

decades regarding the relationship of financial and fiscal reporting practices. After 2009, Germany

moved from having a one-book system towards a more two-book oriented system. 78

Focusing attention on DTAs and DTLs regulation in Germany, it is quite similar to the one

provided by the IFRS. Both standards follow the temporary concept for the recognition, meaning that

DTAs and DTLs only arise when differences between book value and tax value of assets and liabilities

occurs. Nevertheless, this has not always been the case, as before the publication of the BilMoG the

German system was based on timing differences. Even if the main approach is very similar, there are

some differences if compared the treatment deferred income taxes receive under the IFRS and the German

GAAP. For example, German GAAP mandates that DTAs created because of a loss carryforward and the

one created as a result of a unused tax credit should be recognised differently, as they have different

objective requirements. Another example can be found in the presentation of this accounting items. The

IFRS establishes that DTAs and DTLs should be treated as non-current items, and they should also be

presented differently depending on the expected maturity, so they will appear reflected differently if the

expected realisation date is 12 months after the balance sheet date or beyond 12 months after the balance

sheet date. However, under the German GAAP they appear under the assets side as “D. Deferred Tax

Assets” and under the liabilities side as “E. Deferred Tax Liabilities”. 79

The mandate for the recognition of deferred taxes - Latente Steuern - appears under Section 306

of the HGB , while the recognition options are regulated in Section 274 HGB which establishes that 80 81

77 Christian Gross, ‘The Effect of the German Accounting Law Modernization Act on the Comparability of Private Local GAAP and IFRS Firms’ (2016) Schmalenbach Business Review. 78Center for European Economic Research Discussion Paper nº 14-047, ‘Evidence on Book-tax Differences and Disclosure Quality Based on the Notes to the Financial Statements’(2014) Zentrum Für Europäische Wirtschaftsforschung GmbH. 79FRS Versus German GAAP (Revised)/ Summary Of Similarities And Differences. (PWC 2010) <https://www.pwc.com/gx/en/ifrs-reporting/pdf/ifrs-vs-german-gaap-similarities-and-differences_final2.pdf> accessed 5 June 2017. 80 Handelsgesetzbuch. § 306 Latente Steuern: 1 Führen Maßnahmen, die nach den Vorschriften dieses Titels durchgeführt worden sind, zu Differenzen zwischen den handelsrechtlichen Wertansätzen der Vermögensgegenstände, Schulden oder Rechnungsabgrenzungsposten und deren steuerlichen Wertansätzen und bauen sich diese Differenzen in späteren Geschäftsjahren voraussichtlich wieder ab, so ist eine sich insgesamt ergebende Steuerbelastung als passive latente Steuern und eine sich insgesamt ergebende Steuerentlastung als aktive latente Steuern in der Konzernbilanz anzusetzen. 2 Die sich ergebende Steuerbe- und die sich ergebende Steuerentlastung können auch unverrechnet angesetzt werden.3 Differenzen aus dem erstmaligen Ansatz eines nach § 301 Abs. 3 verbleibenden Unterschiedsbetrages bleiben unberücksichtigt. 4 Das Gleiche gilt für Differenzen, die sich zwischen dem steuerlichen Wertansatz einer Beteiligung an einem Tochterunternehmen, assoziierten Unternehmen oder einem Gemeinschaftsunternehmen im Sinn des § 310 Abs. 1 und dem handelsrechtlichen Wertansatz des im Konzernabschluss angesetzten Nettovermögens

43

they must be recognized for all temporary differences between the carrying amount of assets and

liabilities and their tax bases. One of the major changes implemented on the HGB with the BilMoG Act

affected Section 274, as it is the provision which settled the temporary difference approach in exchange of

the timing differences approach. Another change introduced by the reform that can be appreciated in

Section 274 is the different criteria used for the recognition of DTAs depending of their nature. This way,

DTAs arising from temporary differences or from loss-carryforwards are to be recognized if there is

sufficient evidence to believe that they will be utilised in the future. However, regarding DTAs resulting

from unused carryforwards, it is required from corporations to be conservative when measuring them, and

moreover, sets up a time limit of 5 years to offset them.

Once again, in line with the mandate of IAS 12, applying a discount rate to DTAs and DTLs is

prohibited under GAS 18 , the German Accounting Standard focused on Deferred Taxes. 82

● The United Kingdom

The United Kingdom of Great Britain and Northern Ireland, includes England, Wales, Scotland

and northern Ireland, and its capital city is London, which is the most important financial cluster in the

world. It is a constitutional monarchy and a parliamentary democracy. The monarch is Queen Elizabeth

II, who has been the head of state for more than 65 years. Executive powers lay with the Queen’s

government and the legislative power has been attributed to the Parliament which is composed by two

chambers: an non elected House of Lords and an elected House of Commons.

ergeben. 5 § 274 Abs. 2 ist entsprechend anzuwenden. 6 Die Posten dürfen mit den Posten nach § 274 zusammengefasst werden. 81 Handelsgesetzbuch. § 274 Latente Steuern: (1) Bestehen zwischen den handelsrechtlichen Wertansätzen von Vermögensgegenständen, Schulden und Rechnungsabgrenzungsposten und ihren steuerlichen Wertansätzen Differenzen, die sich in späteren Geschäftsjahren voraussichtlich abbauen, so ist eine sich daraus insgesamt ergebende Steuerbelastung als passive latente Steuern (§ 266 Abs. 3 E.) in der Bilanz anzusetzen. Eine sich daraus insgesamt ergebende Steuerentlastung kann als aktive latente Steuern (§ 266 Abs. 2 D.) in der Bilanz angesetzt werden. Die sich ergebende Steuerbe- und die sich ergebende Steuerentlastung können auch unverrechnet angesetzt werden. Steuerliche Verlustvorträge sind bei der Berechnung aktiver latenter Steuern in Höhe der innerhalb der nächsten fünf Jahre zu erwartenden Verlustverrechnung zu berücksichtigen. (2) Die Beträge der sich ergebenden Steuerbe- und -entlastung sind mit den unternehmensindividuellen Steuersätzen im Zeitpunkt des Abbaus der Differenzen zu bewerten und nicht abzuzinsen. Die ausgewiesenen Posten sind aufzulösen, sobald die Steuerbe- oder -entlastung eintritt oder mit ihr nicht mehr zu rechnen ist. Der Aufwand oder Ertrag aus der Veränderung bilanzierter latenter Steuern ist in der Gewinn- und Verlustrechnung gesondert unter dem Posten „Steuern vom Einkommen und vom Ertrag“ auszuweisen. 82 GAS 18

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The UK is part of many international organizations such as the UN, the OECD and the WTO. It

also used to be member of the European Union. However, the 23rd of June, 2016, a referendum was held

in the UK in order to decide whether the UK should leave or remain in the EU. Leave won 51.9% to

48.2% with more than 30 million people voting. The former Prime Minister, James Cameron, resigned the

same day he lost the referendum and was replaced by the actual one, Theresa May. The result of the

referendum triggered the mechanism regulated in the article 50 of the Treaty of the European Union,

which establishes the procedure to be followed in the event of a member state wanting to abandon the EU.

It consists on a process which has a duration of 2 years in which the UK has to negotiate with the other 27

member states the exiting process and its consequences, especially regarding the future relationships

between the UK and the EU. This unprecedented process, which has just begun, will be very complicated

and will be developed in an environment of great political turmoil, which makes difficult to forecast the

final outcome.

For historical reasons, the UK does not have a uniform legal system that is applicable to the

whole country. The legislation in England and Wales is pretty similar to the one in Northern Ireland,

being the legal system in Glasgow the most different one. Nevertheless, modern legislation such as the

one concerning taxes applies throughout the UK.

Companies resident in the UK and foreign corporate entities trading in the UK are liable for tax

on their income and capital gains. Companies are also affected by a number of different taxes such as

withholding taxes, VAT, National Insurance Contributions, stamp duties and other minor taxes. Her

Majesty’s Revenue & Customs, commonly referred to as HMRC, is a non-ministerial government

department which is responsible for the collection of taxes, among other duties. It is in charge of

collecting both personal and corporate income taxes, capital gain tax, inheritance tax and indirect taxes

such as VAT or excise duties. There are other taxes levied in the UK which are paid nationally and

locally, but they are usually not so relevant for corporations.

The primary term used in the UK to refer to those subjected to tax law is “person”, same as in the

US. This word appears several times in the Acts which comprise the tax legislation, but it is not defined in

any of them. Originally, it was assumed that the term only referred to individuals and corporations, but

the Interpretation Act of 1978 extended the concept, which includes any body of persons which is

corporate or unincorporate. Focusing on corporations, the UK tax system applies to “companies” which

45

appears defined in the Corporation Tax Act 2010 as “any body corporate or unincorporated association,

but does not include a partnership, a local authority or a local authority association” . 83

Resident companies are subject to tax on their worldwide income, while non resident companies

are only taxed on their source income. Traditionally, resident companies where the ones incorporated in

the UK. However, this approach was deemed to be insufficient and to give a opportunity for tax planning,

so the “central management and control” test was adopted later on. In 1988, the UK tried to go back to 84

the incorporation test through the case law, but it wasn’t until the CTA 2009 was issued that it was

actually included in tax legislation . However, due to the lack of its inapplicability to unincorporated 85

entities the “central management and control” test is still used as the main form of establishing residency.

The UK is an example of a country with material dependence between the financial and tax

accounting. This means that “in principle, financial accounting is decisive for tax accounting but it is not

necessary that the use of fiscal option rights is in accordance with the use of this rights in financial

accounting” . However, the relationship between both accounting types is very complex and fragmented. 86

The UK uses a schedular approach, as companies’ profit is composed of “income and chargeable gains”,

and while chargeable gains is regulated under the Taxation of Chargeable Gains Act of 1992, income is

calculated following rules under CTA 2009. This implies that corporations have to calculate their profit in

a different way depending on the activity which produces it. This schedular approach increases the

difference between financial and tax accounts . 87

While corporate income tax law appears is currently covered by the CTA 2010, UK GAAP is

composed of a rules and regulations issued by the UK’s Financial Reporting Council. For financial

periods starting of the 1st of January of 2015, the Financial Reporting Standards 100, 101 and 102 were

introduced, updating the old UK GAAP. However, listed companies are obliged to use the IFRS, in

accordance with the EU.

Accounting for deferred tax and income tax is covered by the Section 29 of the accounting

standards Financial Reporting Standard 102 “The Financial Reporting Standard applicable in the UK and

83 CTA 2010 (UK) Section 1121. 84 The tie-breaker rule to solve double residence situations that can be found in Double Tax Conventions is based on this test. 85 CTA 2009 (UK) Section 14.1. 86 Peter Essers, 'The Relationship Between Tax Accounting And Financial Accounting In The USA And Member States' (Tilburg University, 2016). 87 Peter Harris, Corporate Tax Law Op. cit.

46

the Republic of Ireland” , hereinafter FRS 102. FRS 102 replaced FRS 19 in 2013, introducing some 88 89

changes on the regulation of DTAs and DTLs.

Once again, we can see that the “timing difference”approach is adopted, according to Section

29.6 However, it goes further than IAS 12, as it requires recognition on asset revaluation and on DTAs 90

and DTLs arising from business combinations . The next provision, 29.7, states that DTAs shall be 91

recognised only to the extent that it is probable that they will be recovered against the reversal of deferred

tax liabilities or other future taxable profits (the very existence of unrelieved tax losses is strong evidence

that there may not be other future taxable profits against which the losses will be relieved). In this context,

the word “probable” means “more likely than not”.

Regarding measurement, DTAs and DTLs are measured using the tax rates and laws that have

been enacted or substantively enacted by the reporting date that are expected to apply to the reversal of

the timing difference. This was also established by the former rule, FRS 19. Even if the most important

rules for recognition and measurement remained the same after FRS 102 was introduced, there is a change

of great relevance regarding the previously discussed issue of discounting DTAs and DTLs. 92

In consonance with IAS 12, FRS 102 prohibits the discounting of DTAs and DTLs. Conversely,

this was allowed under FRS 19. The former regulation dedicated paragraphs 42 to 54 to the discounting of

deferred tax. Discounting was allowed but not required, however, listed companies could not use the

option as it was forbidden by IAS 12. According to paragraph 43 of FRS 19, in order to decide whether

they should discount or not, several factors should be especially relevant, namely the materiality of the

effect of discounting, whether the benefits of discounting would outweigh the costs it implies, and the

existence of an established industry practice. Small companies were not so keen on using it, as the cost

involved in collating the information required to calculate the impact was too high and the calculations

that had to be conducted were very complex. The Appendix 1 of FRS 19 included a discounting example

88FRS 102 89 FRS 19 90 FRS19 s. 29.6 “Deferred tax shall be recognised in respect of all timing differences at the reporting date, except as otherwise required by paragraphs 29.7 to 29.9 and 29.11 below. Timing differences are differences between taxable profits and total comprehensive income as stated in the financial statements that arise from the inclusion of income and expenses in tax assessments in periods different from those in which they are recognised in financial statements”. 91 Practical Guide. Issues For First-Time Adopters Of FRS 102 (PWC 2013) <https://www.pwc.com/jg/en/publications/practical-guide-for-first-time-adopters-of-frs-102.pdf> accessed 5 June 2017. 92 Tax Accounting Under FRS 102 (2nd edn, Deloitte 2013) <https://www2.deloitte.com/content/dam/Deloitte/ie/Documents/Tax/2013_tax_accounting_under_frs_102.pdf> accessed 19 June 2017.

47

which illustrates the complexity of the method and companies which decided to use a discount rate had to

use this example as a reference. According to paragraph 52, those companies that chose to discount

should use “the post-tax yields to maturity that could be obtained at the balance sheet date on government

bonds with maturity dates and in currencies similar to those of the deferred tax assets and liabilities”. 93

Currently, FRS 102 paragraph 17 establishes that “An entity shall not discount current or deferred tax

assets and liabilities”.

This approach has been adopted because the option of discounting is of very little relevance in

practice, because very few companies used it. Moreover, this approach is in line with IAS 12 and the

cost/benefit principle.

● The Netherlands

The Netherlands is a small and very densely populated country located in Western Europe which

has Amsterdam as the capital city. Politically, it is organised as a constitutional monarchy with a

bicameral parliament. Legally, it is a civil law system with the traditional separation of powers, so

legislative, executive and judicial powers are separated, governed by different institutions which are

independent from each other. The legislative power lays on the parliament -the Staaten General-, which is

composed of an upper chamber or a Senate - Eerste Kamer - and a lower chamber or House of

Representatives - Tweede Kamer. The executive power is held by the Crown and its cabinet, but they need

the support of the majority of the parliament to operate. The current king is Willem-Alexander of the

Netherlands and has been ruling for 4 years. Judicial powers are controlled by courts and tribunals. The

Netherlands is a member state of numerous international organisations including the EU, the OECD, the

WTO and the UN.

The Netherlands has a very complex tax system, where most of the taxes are levied on a national

level with just a few local government taxes for the provision of services. The government department

for the assessment and collection of taxes, the Dutch tax authorities - Belastingdienst - collect taxes

through different streams. The most relevant ones are the Income Tax - inkomstenbelasting en

vennootschapsbelasting -, the Payroll Tax - loonheffing- and the Value Added Tax - belasting

toegevoegde waarde (BTW). Companies which are considered residents of the Netherlands are affected by

93 FRS 19 ' Deferred Tax' (AccountingWEB, 2017) <http://www.accountingweb.co.uk/business/financial-reporting/frs-19-deferred-tax> accessed 4 June 2017.

48

a number of different taxes such as Corporate Income Tax, Dividend Withholding Tax, Value Added Tax,

Real Estate Transfer Tax, Social Security Taxes and a number of Environmental Taxes.

There are two different tax codes to regulate the personal and the corporate income tax. On the

one hand, the tax regime for individuals can be found in the Personal Income Tax Act 2001 - Wet

Inkomstenbelasting 2001-, and on the other hand, the taxes that need to be paid by entities operating in the

Netherlands are regulated in the Corporate Income Tax Act 1969 - Wet op de vennootschapsbelasting

1969. For this reason, the words used to identify the subjects to each tax are different, as well as the

criteria to asses the residence to be liable to pay the income tax in the Netherlands.

Article 2.1 of the Dutch Corporate Income Tax Act 1969 establishes that an entity will be 94

subject to Corporate Income Tax if it is as a resident of the Netherlands. An entity will be considered a

resident of the Netherlands if it is incorporated under Dutch law or if it has its place of effective

management in the Netherlands. Resident companies are taxed on their worldwide income while non

resident companies are taxed in specific income such as real state income located in the Netherlands or

income produced through a permanent establishment.

The Netherlands is a country with de facto or material independence between tax and financial

accountings. In principle, the financial account are used as the starting point in order to calculate the tax

base. However, in practice there are so many differences that actually two different accounts exist. A clear

example of the reasons which lead to the divergence between both accounting systems, can be found in

the dutch tax law concept of “Sound Business Practice” - Goed Koopmansgebruik. This principle is

regulated in section 3.25 of Dutch PITA and states that the annual tax profit is determined according to 95

the sound business practice. It is a very dynamic concept, which allows tax accountings to deviate from

financial accountings based on the principles of reality, prudence and simplicity. Case law is decisive in

order to establish if an accounting practice can be considered to be in line with the principle. This

provides Dutch tax law with a very dynamic and flexible concept of profit, as the courts adjust their

criteria to adapt it to new developments in business economics.

As mentioned above, Dutch Corporate Income Tax law is regulated according to the provisions of

the Corporate Income Tax Act 1969. This Act has undergone several amendments and changes over the

last decades. The last amendment proposal was publicly announced on the 20th of September 2016. If

accepted by Dutch parliament, the proposed tax package will amend several sections of the Act, so that

94CITA 1969 Article 2.1 95 PITA 2001 s. 3.2

49

the provisions contained in it are more in line with the BEPS project, in particular the section concerning

the Dutch innovation box. The legislation governing the annual accounts in the Netherlands, the NL

GAAP, is comprised of the Netherlands Civil Code and the Dutch Accounting Standards. On the one

hand, financial reporting rules are gathered in the Title 9 Book 2 of the Netherlands Civil Code -

Burgerlijk Wetboek. This Title was recently updated in order to reflect the changes introduced following

the implementation of the European Union Accounting Directive 2013/34/EU , however, these 96

amendments will only be applicable to financial years starting on or after 1 January 2016. As a

consequence of being a Member State of the EU, this Code requires listed entities to use IFRS, in line

with the Regulation issued by the EU. Nevertheless, SMEs and large entities can choose between Dutch 97

GAAP and IFRS, according to Title 2.9 of the the Dutch Civil Code. On the other hand, the Dutch

Accounting Standards Board - Raad voor de Jaarverslaggeving - issues authoritative and interpretative

accounting standards. They do not have the status of law, but their relevance has been confirmed in

several occasions by the Court of Appeal - Ondernemingskamer - and the Supreme Court - Hoge Raad. 98

Focusing on DTAs and DTLs the Dutch legislation departs the most from the IFRS compared to

the previous examples. Their regulation can be found in the Title 9 Book 2 of the Civil Code, but they are

more extensively regulated under the Dutch Accounting Standard (DAS) 272. Like the IFRS, Dutch

GAAP establishes that DTAs and DTLs are recognised for the estimated future tax effects of temporary

differences and tax loss carry-forward. The main recognition criteria and exemptions are in line with the

IFRS. Nevertheless, there are several differences between the regulation of deferred income under IAS 12

and DAS 272. While the IFRS mandates that a DTL has to be recognized on revaluation, it is optional

according to DAS 272.304. There is no initial recognition exemption for goodwill. Furthermore, if as a

result of a business combination the acquirer can offset its unrecognised unused tax losses against the

future profit of the acquiree, the acquirer should recognise a DTA. This is regulated by both standards.

However, while the IAS 12.67 mandates that the DTA should be recognised through P/L without

affecting the goodwill arising from the acquisition, according to DAS 272.505 this DTA should be

96 Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/EC of the European Parliament and of the Council and repealing Council Directives 78/660/EEC and 83/349/EEC Text with EEA relevance. Official Journal L182, 29/06/2013 P.19-76. 97 Regulation (EC) No 166/2002 of the European Parliament and of the Council, of 19 July 2002, on the application of international accounting standards. Official Journal L 243, 11/09/2002 P. 0001 - 0004. 98 Annual Accounts | Audit | Deloitte' (Deloitte Nederland, 2017) <https://www2.deloitte.com/nl/nl/pages/audit/articles/annual-accounts.html> accessed 15 June 2017.

50

deducted from the goodwill. If this DTAs is recognised at a later stage, the regulation for its recognition

also varies from one standard to the other.

There is a disparity between DAS 272 and IAS 12 in respect of the measurement of DTAs and

DTLs that is of utmost importance for this paper. DAS 272.404 stipulates that deferred tax can be

measured either on a discounted or on an undiscounted basis. If the option of discounting is the chosen

one by the company, the applied rate is based on the entity-specific post-tax interest rate for long-term

liabilities. Other differences can be found regarding presentation and disclosure which of this paper. 99

99IFRS: A Comparison With Dutch Laws And Regulations 2016 (EY 2016) <http://www.ey.com/Publication/vwLUAssets/EY-comparison-irfs-2016-brochure-2016-en/$FILE/EY-comparison-irfs-brochure-2016-en.pdf> accessed 19 June 2017.

51

6. CONCLUSION

The accounting and financial reporting techniques associated to deferred income taxes has been a

controversial issue for decades. The polemic raised by this subject can be explained by two main reasons.

On the one hand, the complexity associated to its calculation makes it difficult for scholars and

accounting experts all over the world to reach an agreement concerning the best approach to recognise

these items, and specially, to measure them. On the other hand, the importance of DTAs and DTLs have

on the balance sheet of companies, has increased tremendously over the last years. An example of this

increasing importance can be appreciated if we compare the relevance of DTAs for banks before and after

the financial crisis. Banks used to include the DTAs on their equity, and consequently, they were also

included when calculating the solvency ratio. After the crisis hit the World, the Bank for International

Settlements released the Basel Accords, and concretely in Basel III, it proscribed the inclusion of DTAs

when calculating the solvency ratios. This measure had a huge impact on the banking sector, specially in

those countries where the sector had been experiencing losses, like in the case of Spain.

Even though it has been a controversial subject for a long time, the main institutions issuing

financial reporting standards, namely the IASB and the FASB, have established a very similar regulation

for deferred taxes. Both systems are based on the same pillars: recognition of DTAs and DTLs when

temporary differences arise between financial and tax accountings, the “more likely than not” criteria

regarding the recognition of DTAs, and the balance sheet method as the allocation method for income tax.

Some differences exist between the standards promulgated by both institutions, but there has been a

movement geared towards reducing the gap between them in motion for the last years. Nevertheless, it is

not being as effective as expected.

Notwithstanding the differences between both standards, they clearly agree on one thing: the

prohibition of discounting deferred taxes. Moreover, this forbiddance has been adopted by most states.

Examining the examples presented in Chapter 3, it is clear that applying a discount rate has an

impact on the information reported by the companies, offering a view that displays the economic reality

more faithfully. It should be noted that even if the information reflected during the useful life of the asset

is different, the overall burden suffered by the company is the same. This can be explained by the fact that

it is expected to reverse during the lifetime of the asset, and after the first 5 years, the difference is

negative, reducing the deferred tax account, where both the deferred tax asset and the accrued interest are

included.

52

As for the arguments analysed in Chapter 4, some remarks have to be made. First of all, the

publications which have been used in the examination of the different arguments are rather dated. The

reason for this is that although the prohibition of discounting has been criticized for a long time, it is a

long standing provision that was steadily imposed from the beginning. Consequently, there were a large

number of the articles and publications concerning this matter when the prohibition was enforced, but the

number of new arguments decreased influenced by the fact that the issue lost relevance, and the

arguments used by later scholars were based on the same arguments proposed by the traditional ones.

Many of the authors mentioned in Chapter 4 do not only focus on the appropriateness of

discounting, but continue considering a question that is intimately related to discounting: in case of

accepting the applicability of a discount rate, which rate should be used? For reasons of space this subject

has not been developed in the present paper. However, the reader should bear in mind that it is a relevant

issue in the field of discounting.

In spite of the wide range of arguments raised by scholars, both accounting standards have based

their decision on the complexity argument. This goes in line with the duty of financial reporting

institutions to find a balance between two counterparts. On the one hand, the rights and needs of the

stakeholders to be informed and have a fair view of the financial situation of the company that will be

useful for their decision-making processes, and on the other hand, the right of the company not to be

forced to withstand an excessive burden in order to meet the reporting requirements. Through the

historical development of discounting we can see in a number of occasions how the cost/benefit principle

prevails over the true and fair view principle, always on the look for a better understanding of the

financial statement and promoting efficiency in the accounting practice. Moreover, even authors who

defended discounting, as in the case of STEPP, often highlight as a downside the complexity of applying

the discount rate in practice.

It can be inferred from the comparative analysis performed in the last Chapter that generally

deferred taxes receive a very similar treatment across different jurisdictions. The main features of the

accounting procedure, namely the the balance sheet allocation method and the recognition criteria based

on temporary differences are established in all the national regulations. Even the “more likely than not”

recognition criterion is accepted by most of the countries as prescribed by the IFRS, except of course

from the US, which has its own accounting standard which establishes another norm. Even if small

differences exist from one country to another, for some years now there has been an ongoing trend

focused on reducing these disparities. This can be appreciated in the efforts carried out by the IASB and

53

the FASB to align their reporting standards, as well as in the recent changes introduced to national tax

systems such as the BilMoG reform in Germany, the disappearance of the option to apply a discount rate

in the UK or the recently proposed amendments to the innovation box system in the Netherlands.

Considering all the information analysed along the paper and with regard to the proposed research

question the author concludes that the IASB should maintain the prohibition of discounting deferred

income taxes. Although representing the true and fair value of a company should always be the objective

of a financial statement, and its ability to faithfully reflect the economic reality of the company should be

used as a criteria to assess its value, I agree with the decision of the IASB to prohibit discounting based on

the cost/benefit principle. Apply a discount rate would imply that new accounting standards would have

to be created in order to regulate this technique and this would be very burdensome for the legislators,

both the scholars composing the Board who would have to come up with the procedure, and national

legislators who would have to adapt this novelty to their accounting system. Moreover, the technique

required in order to apply discounting satisfactorily would entail really complex accounting operations,

which would force companies to invest a lot of money and effort on implementing them correctly.

For these reasons, together with the fact that the supplementary information provided by

discounting would not be so significant in most cases, and considering the lack of capacity of the regular

investor to understand its implications, the author endorses the decision of the IASB.

There can be found different examples of the soundness of this position in the international arena.

The FASB precludes the use of a discount rate regarding deferred income tax for the exact same reason.

Furthermore, the UK, who admitted discounting until 2013, has joined the rest of the european countries

on their positioning against discounting, leaving the Netherlands alone.

Considering the harmonization process of financial reporting standards that is currently taking

place it is reasonable to expect that the IASB will maintain a firm stand with regards to discounting and

the few countries which allow discounting deferred income taxes will stop using it in the future.

54

ANNEX I

EXAMPLE A

Company A acquires a machine for 900 €.

For financial purposes, the machine is depreciated in 5 years.

For fiscal purposes, the tax authorities allow companies to depreciate the asset in 3 years.

The tax rate is 30%.

Financial depreciation → 180 € each year

Fiscal depreciation → 300 € years 1, 2 and 3

Year 1 2 3 4 5

Asset tax base

600 300 - - -

Asset carrying amount

720 540 360 180 -

Temporary difference

120 240 360 180 -

Deferred tax liability

36 72 108 54 -

Deferred tax expense

Deferred tax income

36 36 36

(54)

(54)

55

ANNEX II

EXAMPLE B

Consider that in the Example A the machine is revaluated to 1200€ at the end of year 2.

Opening balance

Year 2 depreciation Revaluation Closing balance

Asset tax base 600 300 - 300

Asset carrying amount

720 540 660 1.200

Temporary difference

120 240 660 900

Deferred tax liability

36 72 198 270

56

ANNEX III

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Income Statement

Earnings Before Depreciation & Taxes

100.000 100.000 100.000 100.000 100.000 100.000 100.000

Depreciation Expense

50.000 50.000 50.000 50.000 50.000 50.000 50.000

Earnings Before Tax

50.000 50.000 50.000 50.000 50.000 50.000 50.000

Tax Expense 27.500 27.500 27.500 27.500 27.500 27.500 27.500

Net Income 22.500 22.500 22.500 22.500 22.500 22.500 22.500

57

Tax Return

Taxable Income Before Depreciation

100.000 100.000 100.000 100.000 100.000 100.000 100.000

Depreciation 52.500 77.000 73.500 73.500 73.500 - -

Taxable Income

47.500 23.000 26.500 26.500 26.500 100.000 100.000

Taxes Payable

26.125 12.650 14.575 14.575 14.575 55.000 55.000

Deferred Tax Account

Beginning Balance

0 1.375 16.225 29.150 42.075 55.000 27.500

Current Timing Difference

1.375 14.850 12.925 12.925 12.925 -27.500 -27.500

Ending Balance

1.375 16.225 29.150 42.075 55.000 27.500 0

Source: BROWN, S. & LIPPIT, J., “Are Deferred Taxes Discountable?” 1987

58

ANNEX IV

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Income Statement

Earnings Before Interest, Taxes & Depreciation

100.000 100.000 100.000 100.000 100.000 100.000 100.000

Depreciation Expense

50.000 50.000 50.000 50.000 50.000 50.000 50.000

Earnings Before Interest & Taxes

50.000 50.000 50.000 50.000 50.000 50.000 50.000

Interest on Deferred Tax

0 88 1.180 2.435 4.169 6.340 3.377

Earnings Before Tax

50.000 49.912 48.820 47.565 45.831 43.660 46.623

Tax Expense 26.751 20.363 22.364 24.520 25.913 27.500 27.500

Net Income 23.249 29.550 26.456 23.044 19.919 16.160 19.123

59

Tax Return

Taxable Income Before Depreciation

100.000 100.000 100.000 100.000 100.000 100.000 100.000

Depreciation 52.500 77.000 73.500 73.500 73.500 - -

Taxable Income

47.500 23.000 26.500 26.500 26.500 100.000 100.000

Taxes Payable

26.125 12.650 14.575 14.575 14.575 55.000 55.000

Deferred Tax Account

Beginning Balance

0 626 8.427 17.396 29.777 45.283 24.123

Accrued Interest

0 88 1.180 2.435 4.169 6.340 3.377

Current Timing Difference

626 7.713 7.789 9.945 11.338 -27.500 -27.500

Ending Balance

626 8.427 17.396 29.777 45.283 24.123 0

Source: BROWN, S. & LIPPITT, J., “Are Deferred Taxes Discountable?” 1987

60

REFERENCES AND SELECTED BIBLIOGRAPHY

Legislation: EU:

● Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 on the annual

financial statements, consolidated financial statements and related reports of certain types of undertakings,

amending Directive 2006/43/EC of the European Parliament and of the Council and repealing Council

Directives 78/660/EEC and 83/349/EEC Text with EEA relevance. Official Journal L182, 29/06/2013

P.19-76

● Regulation (EC) nº 166/2002 of the European Parliament and of the Council, of 19 July 2002, on the

application of international accounting standards. Official Journal L 243, 11/09/2002 P. 0001 - 0004

● IFRS Interpretation Committee, 'IAS 12 Income Taxes Measurement Of Current Income Tax On Uncertain

Tax Position' (2014)

<http://archive.ifrs.org/Meetings/MeetingDocs/Interpretations%20Committee/2014/September/AP04%20I

AS%2012%20Measurement%20of%20UTP.pdf> accessed 6 April 2017

● 'IAS 12 — Income Taxes' (Iasplus.com, 2017) <https://www.iasplus.com/en/standards/ias/ias12> accessed

5 April 2017

● 'IAS 12 — Recognition Of Deferred Tax Assets For Unrealised Losses' (Iasplus.com, 2017)

<https://www.iasplus.com/en/projects/completed/tax/ias-12-dtas> accessed 10 April 2017

● 'IAS 12 — Recovery Of Underlying Assets' (Iasplus.com, 2017)

<https://www.iasplus.com/en-gb/projects/iasb-and-ifrs-projects/completed/tax/ias-12-limited-scope-amend

ments> accessed 12 April 2017

● 'Income Taxes — Comprehensive Project' (Iasplus.com, 2017)

<https://www.iasplus.com/en-gb/projects/iasb-and-ifrs-projects/research/long-term/income-taxes> accessed

9 April 2017

● 'Conceptual Framework - Definition Of Elements (IASB)' (Iasplus.com, 2017)

<https://www.iasplus.com/en/meeting-notes/iasb/2013/february/cf-elements> accessed 10 May 2017

● European Financial Reporting Advisory Group Discussion Paper ‘Improving the Financial Reporting of

Income Tax’ (2011) EFRAG

Germany:

● Handelsgesetzbuch

● German Accounting Standard 18 ‘Deferred Tax’ (2010)

The Netherlands:

● Corporate Income Tax Act 1969 (NL)

● Personal Income Tax Act 2001 (NL)

61

Spain:

● Ley 62/2003, de 30 de diciembre, de medidas fiscales, administrativas y del orden social.

● Ley 27/2014, de 27 de noviembre, del Impuesto sobre Sociedades

● Real Decreto Legislativo 5/2004, de 5 de marzo, por el que se aprueba el texto refundido de la Ley del

Impuesto sobre la Renta de no Residentes

● Real Decreto 1514/2007, de 16 de noviembre, por el que se aprueba el Plan General de Contabilidad

UK:

● Corporation Tax Act 2009 (UK)

● Corporation Tax Act 2010 (UK)

● The Financial Reporting Standard 102 applicable in the UK and Republic of Ireland (2015)

● The Financial Reporting Standard 19 ‘Deferred Taxes’ (2000)

US:

● Internal Revenue Code, Title 26 United States Code (1986)

● Opinions of the Accounting Principles Board nº10, “Omnibus Opinion”, New York: APB, 1966

● Opinions of the Accounting Principles Board nº11, “Accounting for Income Taxes”, New York: APB, 1967

● Accounting Principles Board Opinion nº 2, ‘Interest on Receivables and Payables’ Stamford, Connecticut:

FASB 1971

● Statement of Financial Accounting Concepts nº 6, “Elements of Financial Statements”, Stamford,

Connecticut: FASB, 1985

● Statement of Financial Accounting Standards nº 96, “Accounting for Income Taxes”, Stamford,

Connecticut: FASB, 1987

● Statement of Financial Accounting Standards nº 109, “Accounting for Income Taxes”, Stamford,

Connecticut: FASB, 1992

● ASC 740 — Income Taxes' (Iasplus.com, 2017)

<https://www.iasplus.com/en-us/standards/fasb/expenses/asc740> accessed 6 Abril 2017

Books & Articles:

● Peter Harris, Corporate Tax Law (Cambridge University Press 2013)

● Bruce Bublitz and Gilroy Zuckerman, 'Discounting Deferred Taxes: A New Approach' (1988) 6 Advances

in Accounting

● Christian Gross, ‘The Effect of the German Accounting Law Modernization Act on the Comparability of

Private Local GAAP and IFRS Firms’ (2016) Schmalenbach Business Review

● Debra Jeter and Paul Chaney, 'A Financial Statement Approach To Deferred Taxes' (1988) 2 Accounting

Horizons

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● Frank R. Rayburn, ‘Discounting of Deferred Income Taxes: An Argument for Reconsideration’ (1987)

Accounting Horizons

● Hugo Nurnberg, 'Discounting Deferred Tax Liabilities' (1972) 47 The Accounting Review

● James E. Wheeler & Willard H. Gallart, ‘An Appraisal of Interperiod Income Tax Allocation’ (1974)

Financial Executive Research Foundation

● James O. Stepp, ‘Deferred Taxes: The Discounting Controversy’ (1985) Journal of Accountancy

● John N. Kissinger, 'On Discounting Deferred Income Taxes' (2006) 10 Academy of Accounting and

Financial Studies Journal

● Kenneth W. Lemke & Paul R. Graul, ‘Deferred Taxes - an Explicit Cost Solution to the Discounting

Problem’ (1981) Accounting and Business Research

● Roman L. Weil. ‘Role of the Time Value of Money in Financial Reporting’ (1990) The Accounting

Review

● Sudro Brown and Jeffrey Lippitt, 'Are Deferred Taxes Discountable?' (1987) 14 Journal of Business

Finance & Accounting

● Susana Callao., ‘Adoption of IFRS in Spain: Effect on the comparability and relevance of financial

reporting’(2007) Journal of International Accounting, Auditing and Taxation.

● Accounting Research Bulletin nº 43, “Income Taxes”, New York: AICPA, 1953, Ch.10, p.88

● Richard Stuart, 'U.S. GAAP VS. IFRS: INCOME TAXES AT-A-GLANCE' (2015)

<http://rsmus.com/pdf/ifrs_income_taxes.pdf> accessed 10 April 2017

● Thomas F. Keller, ‘Accounting for Corporate Income Taxes”’(1961) Michigan Business Studies,

University of Michigan

Others: WEB Sites:

● Duane D, 'Deferred Taxes (II): How They’Re Important' (PRACTICAL STOCK INVESTING, 2013)

<https://practicalstockinvesting.com/2013/02/21/deferred-taxes-ii-how-theyre-important/> accessed 12

June 2017

● CCA http://www.accaglobal.com, 'Deferred Tax | F7 Financial Reporting | ACCA Qualification | Students |

ACCA Global' (Accaglobal.com, 2017)

<http://www.accaglobal.com/my/en/student/exam-support-resources/fundamentals-exams-study-resources/

f7/technical-articles/deferred-tax.html> accessed 7 April 2017

● 'About The FASB' (Fasb.org, 2017) <http://www.fasb.org/facts/> accessed 17 June 2017

● 'Tax Code, Regulations And Official Guidance' (Irs.gov, 2017)

<https://www.irs.gov/tax-professionals/tax-code-regulations-and-official-guidance> accessed 19 June 2017

63

● 'Heads Up | 2015 | Issue 38 | FASB Issues ASU On Balance Sheet Classification Of Deferred Taxes'

(Deloitte United States, 2017)

<https://www2.deloitte.com/us/en/pages/audit/articles/hu-fasb-issues-asu-on-balance-sheet-classification-of

-deferred-taxes.html> accessed 19 June 2017

● FRS 19 ' Deferred Tax' (AccountingWEB, 2017)

<http://www.accountingweb.co.uk/business/financial-reporting/frs-19-deferred-tax> accessed 4 June 2017.

Tax Guides:

● A Roadmap To Accounting For Income Taxes (2016)

<https://www2.deloitte.com/content/dam/Deloitte/us/Documents/audit/ASC/Roadmaps/us-aers-a-roadmap-

to-accounting-for-income-taxes-2016.pdf> accessed 7 April 2017

● Doing Business In The United States. A Guide To the Key Tax Issues. (PWC 2014)

<http://www.pwc.com/us/en/tax-services/publications/assets/doing-business-in-the-us-2014.pdf> accessed

2 June 2017

● Income Taxes (2nd edn, PWC 2013)

<https://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-income-taxes-second-edition-201

5-2.pdf> accessed 3 June 2017.

● FRS Versus German GAAP (Revised)/ Summary Of Similarities And Differences. (PWC 2010)

<https://www.pwc.com/gx/en/ifrs-reporting/pdf/ifrs-vs-german-gaap-similarities-and-differences_final2.pd

f> accessed 5 June 2017.

● Practical Guide. Issues For First-Time Adopters Of FRS 102 (PWC 2013)

<https://www.pwc.com/jg/en/publications/practical-guide-for-first-time-adopters-of-frs-102.pdf> accessed

5 June 2017.

● Tax Accounting Under FRS 102 (2nd edn, Deloitte 2013)

<https://www2.deloitte.com/content/dam/Deloitte/ie/Documents/Tax/2013_tax_accounting_under_frs_102.

pdf> accessed 19 June 2017.

● Annual Accounts | Audit | Deloitte' (Deloitte Nederland, 2017)

<https://www2.deloitte.com/nl/nl/pages/audit/articles/annual-accounts.html> accessed 15 June 2017.

● IFRS: A Comparison With Dutch Laws And Regulations 2016 (EY 2016)

<http://www.ey.com/Publication/vwLUAssets/EY-comparison-irfs-2016-brochure-2016-en/$FILE/EY-co

mparison-irfs-brochure-2016-en.pdf> accessed 19 June 2017.

Presentation & Lectures:

● ASB, US GAAP, Local Country GAAP: Upcoming Changes and Differences(2016)

64

● Center for European Economic Research Discussion Paper nº 14-047, ‘Evidence on Book-tax Differences

and Disclosure Quality Based on the Notes to the Financial Statements’(2014) Zentrum Für Europäische

Wirtschaftsforschung GmbH

● Peter Essers, 'The Relationship Between Tax Accounting And Financial Accounting In The USA And

Member States' (Tilburg University, 2016)

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