Finance Act 2021 impacts deferred tax in company accounts: IFRS and US GAAP treatment
Changes in the UK corporation tax rates and major tax amendments included in Finance Act 2021 will have a direct impact on the recognition of current and deferred tax in company accounts.
Among other changes, Finance Act 2021 increases the UK corporation tax rate from 19% to 25% effective 1 April 2023 for companies with profits in excess of GBP 250,000. It also introduces a small profits rate of corporation tax of 19% for companies with profits of GBP 50,000 or less and “marginal relief” to provide a gradual increase in the rate for companies with profits between GBP 50,000 and GBP 250,000. Further, the Finance Act introduces a temporary super deduction of 130% for purchases of qualifying new plant and machinery before 31 March 2023.
Rules regarding tax rates in company accounts
For accounts prepared under International Financial Reporting Standards (IFRS) and Financial Reporting Standard (FRS) 101, both current and deferred taxes are dealt with under International Accounting Standard (IAS) 12. For accounts prepared under FRS 102, current and deferred taxes are addressed in section 29.
Under section 29 and IAS 12, current tax is the amount of income tax expected to be paid to (or recovered from) the tax authorities in relation to that period (and prior periods where there is a prior year adjustment). Tax is calculated based on the tax rules and laws that have been enacted or substantively enacted at the reporting date. Any change in the tax rate will have no effect on current tax liabilities arising before the effective date of change.
Under section 29, deferred tax should be measured using the tax rates that are expected to apply when the reversal of the timing differences takes place. Under IAS 12, deferred tax assets and liabilities should be measured at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled.
For UK companies, the tax rates and tax laws to be used are those that have been enacted or substantively enacted by the balance sheet date. For UK tax rates, “substantively enacted” means that the act or other measure legislating the rate has passed through all stages of reading by the House of Commons. Finance No. 2 Bill 2021 became substantively enacted on 24 May 2021. As a result,
- For accounting periods ending on or after 24 May 2021, deferred tax for temporary/timing differences that are forecast to unwind in the UK on or after 1 April 2023 will need to be re-measured and recognised at 25% if company profits are expected to be in excess of GBP 250,000 (at the marginal rate if profits are expected to be between GBP 50,000 and GBP 250,000).
- For accounting periods ended before 24 May 2021 (but approved on or after 3 March 2021), deferred tax for temporary/timing differences that are forecast to unwind on or after 1 April 2023 continue to be recognised at 19% (i.e., the rate that is substantively enacted at the balance sheet date), but a transitional disclosure may be required.
U.S. groups with UK corporation tax liabilities
U.S. GAAP requires the new tax rates to become law (i.e., be enacted) before they are used for deferred tax calculations. Therefore, U.S. groups must use the new UK rates from the date of Royal Assent to the Finance Act which was given on 10 June 2021.
A company would need to re-measure its deferred tax balances in the period that the rate change was enacted, which would be the annual or interim period that includes 10 June 2021. The process of remeasurement for U.S. GAAP would be identical to the process described above. The impact of the change in deferred tax would be reported in continuing operations regardless of whether it relates to any other component of comprehensive income.
Both IAS and UK GAAP impose a disclosure requirement where the effect of applying changes that have been announced, but not yet substantively enacted/enacted, is expected to be significant. Both the nature of the event (i.e., the change in the tax rate) and an estimate of its financial effect must be disclosed. If it is not possible to estimate the financial effect, this fact must be disclosed.
As the rate reductions were announced in the UK Budget on 3 March 2021, where any UK accounts were approved on or after 3 March 2021 with a balance sheet date before 24 May 2021, companies should consider whether there was a potential significant effect and, if so, make a disclosure.
A similar disclosure would be required under US GAAP where the accounts have not been issued or been made available for issuance for balance sheet dates before 10 June 2021.
Super deduction for plant and machinery
The Finance Act 2021 introduces a super deduction for asset purchases made in the period 1 April 2021 to 31 March 2023, allowing companies to benefit from a 130% first-year allowance for capital expenditure on qualifying new plant and machinery assets. This deduction will allow companies to potentially reduce tax payable by 25p for every GBP 1 invested in eligible plant and machinery.
It is expected that the deduction will be considered to consist of two parts for UK accounting purposes: (i) a 100% allowance for the cost of the asset and (ii) an additional 30% super deduction that we consider to be an investment tax credit given that there are no substantive additional requirements to be met not related to the investment. If the qualifying asset is sold before 1 April 2023, a special balancing charge calculation is needed for assets on which the super deduction was previously claimed: in simple terms, the disposal value for the year of sale is 1.3 times the sale proceeds of the asset.
Under IFRS, for the 100% allowance, depreciation for tax and accounting purposes is the same over the asset’s life but differs from year to year, giving rise to temporary differences. In this case, the 100% allowance depreciates the asset at a faster rate for tax purposes than the rate of depreciation charged for accounting purposes. A deferred tax liability for accelerated capital allowances should therefore be recognised.
In respect of the 30% super deduction, IAS 12.51 requires the measurement of deferred tax to reflect the tax consequences that follow from the manner in which the entity expects to recover or settle the carrying amount of its assets or liabilities. Accordingly, where:
- The company does not expect to sell the plant and machinery before 1 April 2023, the super deduction will not be clawed back and so there are no additional considerations.
- The company does expect to sell the plant and machinery before 1 April 2023, the super deduction could be considered as either a tax credit or a change in the tax base. Both approaches would give rise to a deferred tax liability in respect of the temporary difference.
Under FRS 102, the 100% allowance will be accounted for as an accelerated capital allowance giving rise to a deferred tax liability. For the 30% super deduction, FRS 102 does not explicitly contain the same principles as IAS 12 in respect of measuring deferred tax in a way that reflects the manner in which the entity expects to recover the asset or settle the liability. Nevertheless, a similar approach is expected to be taken. Accordingly, where:
- The company does not expect to sell the plant and machinery before 1 April 2023, our expectation is that this would be considered a permanent difference so deferred tax would not need to be recognised.
- The company does expect to sell the plant and machinery before 1 April 2023, the super deduction would be a timing difference as the tax benefit is expected to reverse in future tax assessments so a deferred tax liability would need to be recognised for the timing difference.
As with the change in corporation tax rate, the 130% super deduction should only be accounted for from the date of substantive enactment (i.e., 24 May 2021).
Under US GAAP, the super deduction would be accounted from the date of enactment of 10 June 2021, which would include the interim and annual period including 10 June 2021. The accounting for the impact of the super deduction would be accounted for under the simultaneous equation method as outlined in ASC 740-10-25-51. The simultaneous equation method Is illustrated in Cases A-D of ASC 740-10-55-171-191.
The is easiest way to explain the workings of the simultaneous method is through the following example, which is based on Case A of ASC 740-10-55-171, which has been modified for the change in the UK tax rate.
A UK resident corporation purchases an asset for GBP 100 which, under UK tax law, the entity is allowed to deduct GBP 130 as its tax basis since it qualifies for the super deduction. The current tax rate is 19% and will be increased to 25% on 1 April 2023. It is assumed that the company can support the recognition of its deferred tax assets. The company prepares its accounts on a calendar year basis.
The differential between the book basis and tax basis would create a deferred tax asset of GBP 7 and the book basis of the asset would be written down to GBP 93. The mechanics of the calculation are as follows:
DTA = GBP 100 (book basis) - GBP 130 (tax basis) X (19% / (1-19%)) or GBP 7
The entry to record the purchase would be as follows:
Dr. Asset GBP 93
Dr. DTA GBP 7
Cr. Cash GBP 100
The entry results in no immediate income statement recognition as required pursuant to ASC 740-10-25-51.
Assuming the asset is recovered over five years for book purposes, the following would be the journal entries in the year of acquisition:
Dr. Depreciation expense GBP 18.6
Cr. Accumulated depreciation GBP 18.6
To record book depreciation expense (GBP 93/5)
Dr. Current tax payable GBP 24.7
Cr. Current tax benefit GBP 24.7
To record the tax current tax benefit of the super deduction
(GBP 130 x 19%)
Dr. Deferred tax expense GBP 24
Cr. DTA GBP 7
Cr. DTL GBP 17
DTL is measured as follows:
The application of the impact on future reversals of deferred tax due to the increase in tax rate with respect to the future rate change should not be accounted for as part of the original acquisition cost of the asset but rather measured at the time that the tax deduction is taken.
We are aware of alternative views on the US GAAP treatment of the 30% super deduction. While the accounting described above is a preferred view, it is recommended that companies confirm the US GAAP accounting treatment with their attest firm.
Such a significant change in the UK corporation tax rate will bring deferred tax calculations to the fore this year but it may not be the end of the story. Although the UK has legislated for a 25% rate from 1 April 2023, it is worth remembering that it was only in 2020 that the government overturned a legislated cut in corporation tax (from 19% to 17%) before it was ever implemented. If the post-pandemic recovery boosts UK tax revenues as fast as some commentators predict, there is an outside chance that the new rate of corporation tax will be reduced before we get to 2023.
*Tax rate for 2023 =((25%X75%) + (19%x25%))