INCOME TAXES MFRS 112

Introduction Accounting profit is calculated on earned income for the year and based on accounting principles. Tax, on the other hand, is calculated based on the Income Tax Act 1967 and Rules.

Pretax Financial Income Accounting for Income Taxes Financial Statements Tax Return vs.  Pretax Financial Income Taxable Income MFRS Tax Code  Income Tax Expense Income Taxes Payable LO 1

Book vs. Tax Differences Illustration 19-2 MFRS Reporting 2014 2015 2016 Total Revenues $130,000 $130,000 $130,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Pretax financial income $70,000 $70,000 $70,000 $210,000 Income tax expense (40%) $28,000 $28,000 $28,000 $84,000 Illustration 19-3 Tax Reporting 2014 2015 2016 Total Revenues $100,000 $150,000 $140,000 $390,000 Expenses 60,000 60,000 60,000 180,000 Taxable income $40,000 $90,000 $80,000 $210,000 Income tax payable (40%) $16,000 $36,000 $32,000 $84,000 LO 1

Revenues or gains are taxable after they are recognized in Temporary Differences Illustration 19-22 Examples of Temporary Differences Revenues or gains are taxable after they are recognized in financial income. An asset (e.g., accounts receivable or investment) may be recognized for revenues or gains that will result in taxable amounts in future years when the asset is recovered. Examples: Income accounted for on the accrual basis for financial reporting purposes v. cash basis for tax purposes. Contracts accounted for under the percentage-of-completion method for financial reporting purposes and a portion of related gross profit deferred for tax purposes. LO 6

Expenses or losses are deductible after they are recognized Temporary Differences Illustration 19-22 Examples of Temporary Differences Expenses or losses are deductible after they are recognized in financial income. A liability (or contra asset) may be recognized for expenses or losses that will result in deductible amounts in future years when the liability is settled. Examples: Interest expense accrued on time basis but only tax-deductible when paid. Product warranty liabilities. Bad debt expense recognized using the allowance method for financial reporting purposes; direct write-off method used for tax purposes. LO 6

Revenues or gains are taxable before they are recognized in Temporary Differences Illustration 19-22 Examples of Temporary Differences Revenues or gains are taxable before they are recognized in financial income. A liability may be recognized for an advance payment for goods or services to be provided in future years. For tax purposes, the advance payment is included in taxable income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to those who cancel their orders) that settle the liability will result in deductible amounts in future years. Examples: Subscriptions received in advance. Advance rental receipts. Prepaid contracts and royalties received in advance. LO 6

Expenses or losses are deductible before they are recognized in Temporary Differences Illustration 19-22 Examples of Temporary Differences Expenses or losses are deductible before they are recognized in financial income. The cost of an asset may have been deducted for tax purposes faster than it was expensed for financial reporting purposes. Amounts received upon future recovery of the amount of the asset for financial reporting (through use or sale) will exceed the remaining tax basis of the asset and thereby result in taxable amounts in future years. Examples: Depreciable property, depletable resources, and intangibles. Prepaid expenses that are deducted on the tax return in the period paid. LO 6

Specific Differences Originating and Reversing Aspects of Temporary Differences. Originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. Reversing difference occurs when eliminating a temporary difference that originated in prior periods and then removing the related tax effect from the deferred tax account. LO 6

Specific Differences Permanent differences result from items that (1) enter into pretax financial income but never into taxable income or (2) enter into taxable income but never into pretax financial income. Permanent differences affect only the period in which they occur. They do not give rise to future taxable or deductible amounts. There are no deferred tax consequences to be recognized. LO 6

Permanent Differences Illustration 19-24 Examples of Permanent Differences Items are recognized for financial reporting purposes but not allowable for tax purposes. Examples: Donations to unapproved charities. Entertainment expenses. Fines and penalties resulting from a violation of law. Dismantling & decommissioning expenses. LO 6

Taxable temporary differences They are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Deductible temporary differences They are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Tax base The tax base of an asset or liability is the amount attributed to that asset or liability for tax purpose. (*See Example 7 of Lazar & Huang 4th Ed, pg 396 - 398)

Deferred tax computation Only items that cause temporary differences are taken into consideration. i.e. If an item is not allowed for deduction in computing taxable profit it will be allowed in the next or later period. Temporary differences are also known as timing differences.

Illustration 1 A company acquired a plant costing RM400,000 which is depreciated at 10% per annum on cost. The initial allowances and capital allowances is 20%. Profit before tax was RM800,000. Income tax rate is 30%.

Accounting vs. Tax Differences MFRS Reporting Yr 1 Yr 2 Yr 3 Yr 4 Profit before tax $800,000 $800,000 $800,000 $800,000 Tax 30% 240,000 240,000 240,000 240,000 Tax Reporting Yr 1 Yr 2 Yr 3 Yr 4 Profit before tax $800,000 $800,000 $800,000 $800,000 Add: depreciation 40,000 40,000 40,000 40,000 Less: Initial allowance (20%) (80,000) Less: Capital allowances (20%) (80,000) (80,000) (80,000) (80,000) Taxable profit $680,000 $760,000 $760,000 $760,000 Income tax payable (30%) $204,000 $228,000 $228,000 $228,000 Difference $36,000 $12,000 $12,000 $12,000

Illustration 1 (continued) The difference of RM36,000 in the 1st year and RM12,000 in the next 3 years will become payable (will reverse) from year 5 onwards.

Accounting for Deferred Tax Underlying Principles MFRS 112 Income Taxes requires an enterprise to recognise and account for any deferred liability or asset. Deferred tax liability will arise if the recovery of the carrying amount of underlying assets or the settlement of liability gives rise to a higher tax payment in the future. Deferred tax asset will arise if the recovery give rise to lesser tax payable in the future.

Accounting for Deferred Tax Temporary Differences & Tax Effects Carrying Amount (CA) > Tax Base (TB) Carrying Amount (CA) < Assets items Taxable Temp. Diff (TTD)  Deferred Tax Liability (DTL) Deductible Temp. Diff (DTD)  Deferred Tax Asset (DTA) Liability items

Recognition of Deferred Tax Liabilities Paragraph 15 A DTL shall be recognised for all TTD except to the extent that DTL arises from: INITIAL recognition of goodwill; or The INITIAL recognition of an asset or liability in a transaction which; (i) is not a business combination; and (ii) at the time of the transaction, affect neither ACCOUNTING PROFIT nor TAXABLE PROFIT (tax loss)

Recognition of Current & Deferred Tax Tax expense for the year = current year’s tax + deferred tax affecting income statement Illustration 3 At the end of the FY, entity had a property whose CA was RM12m and tax base was RM9.5m. At the same time it had accrued interest payable of RM200,000. Tax rules will only recognise the expense when it is paid. Tax rate is 25%.

Recognition of Current & Deferred Tax For property CAA (RM12m) > TBA (RM9.5m) DTL = (RM12m – RM9.5m) x 25% = 625,000 For interest CAL (200,000) > TBL (Nil) DTA = (RM200,000 – 0) x 25% = 50,000 Journal entries Dr Tax expense 575,000 Cr Deferred tax liability 575,000

Accounting for Deferred Tax Liabilities CAA, TBA, TTD, DTL & reversal of DTL Illustration 4 A newly incorporated company bought a machine for RM500,000 and depreciates it over 10 years an straight line basis. Capital allowance on such a machine is 50% in 1st year and 25% in the following 2 years. Assume tax rate is 30%. 31.12.X1 CAA = 500,000 – 1/10 (500,000) = RM450,000 TBA = 500,000 – (50% x 500,000) = RM250,000 DTL = (450,000 – 250,000) x 30% = 60,000 Dr Tax expense 60,000 Cr Deferred tax liability 60,000

Accounting for Deferred Tax CAA, TBA, TTD, DTL & reversal of DTL Illustration 4 (Contd.) 31.12.X2 CAA = 450,000 – depn 50,000 = RM400,000 TBA = 250,000 – (25% x 500,000) = RM125,000 DTL = (400,000 – 125,000) x 30% = RM82,500 DTL per 31.12.X1 = RM60,000 Current year component of DTL = 82,500 – 60,000 = 22,500 Dr Tax expense 22,500 Cr Deferred tax liability 22,500

Accounting for Deferred Tax CAA, TBA, TTD, DTL & reversal of DTL Illustration 4 (Contd.) 31.12.X3 CAA = 400,000 – depn 50,000 = RM350,000 TBA = 125,000 – (25% x 500,000) = 0 DTL = (350,000 – 0) x 30% = RM105,000 DTL per 31.12.X2 = RM82,500 Current year component of DTL = 105,000 - 82,500 = 22,500 Dr Tax expense 22,500 Cr Deferred tax liability 22,500

Accounting for Deferred Tax CAA, TBA, TTD, DTL & reversal of DTL Illustration 4 (Contd.) 31.12.X4 CAA = 350,000 – depn 50,000 = RM300,000 TBA = 0 DTL = (300,000 – 0) x 30% = RM90,000 DTL per 31.12.X3 = RM105,000 There is a reversal of deferred tax liability of: 105,000 – 90,000 = 15,000 Dr Deferred tax liability 15,000 Cr Tax expense 15,000

Assets Carried at Fair Value Depreciable assets Under MFRS 116, Property, Plant & Equipment, the surplus on revaluation is not subjected to tax and tax base is not adjusted. Further temporary differences give rise to deferred tax liability. Revalued amount will be recovered through use (depreciation) and will generate taxable income.

Assets Carried at Fair Value Non-depreciable asset accounted for using fair value model (freehold land & investment property) 2 treatments: If intend to sell, deferred tax liability use Real Property Gains Tax rate. If not intend to sell, use minimum rate 5% because no recovery through use.

Assets Carried at Fair Value Depreciable asset which do not enjoy capital allowance Tax base on initial recognition is nil. If subsequently revalued, surplus give rise to taxable temporary difference and recovered through use or sale. If not intend to sell, use income tax rate for calculation of deferred tax liability. If intend to sell, use sum of income tax rate and RPGT payable on disposal.

Illustration 5 XYZ has the following assets on 31.12.X1: CA Tax base RM RM Plant & equipment 25,000 15,000 Freehold land 300,000 300,000 Office building 300,000 300,000 The office building does not enjoy capital allowances. Tax rate is 30%. Assume there is no deferred tax provision b/f.

Illustration 5 (Contd.) TTD: CA Tax base TTD RM RM RM Plant & equipment 25,000 15,000 10,000 Freehold land 300,000 300,000 - Office building 300,000 300,000 - X1: DTL = RM10,000 x 30% = RM3,000

Illustration 5 (Contd.) X2: Freehold land is revalued to RM350,000 & there is no commitment to dispose of it in near future. Office building has a FV of RM390,000 & carrying amount is RM290,000. There is no intention to sell the building. TTD: CA Tax base TTD RM RM RM Plant & equipment 28,000 14,000 14,000 Freehold land (300+50) 350,000 300,000 50,000 Office building (300+90) 390,000 290,000 100,000

Illustration 5 (Contd.) X2: TTD (RM) DTL (RM) Plant & equipment 14,000 4,200 (30%) Office building (reval surplus) 100,000 30,000 (30%) 114,000 Freehold land (reval surplus) 50,000 2,500 (5%) 36,700 Less: DTL of X1 (Plant & machinery) 3,000 33,700 DR Tax expense 1,200 DR Revaluation reserves of freehold land & office building (2,500 + 30,000) 32,500 CR Deferred tax liability 33,700

Illustration 5 (Contd.) If there is intention to sell the office building, additional DTL based on RPGT will be calculated: RM100,000 x 5% = RM5,000 Additional journal entry: Dr Revaluation reserve 5,000 Cr Deferred tax liability 5,000

Recognition of Deferred Tax Assets Paragraph 24 A DTA shall be recognised for all DTD (to the extent that it is probable that taxable profit will be available against which the DTD can be utilised) unless the DTA arises from: The INITIAL recognition of an asset or liability in a transaction which; (i) is not a business combination; and (ii) at the time of the transaction, affect neither ACCOUNTING PROFIT nor TAXABLE PROFIT (tax loss)

Recognition of Deferred Tax Assets Arises from deductible temporary differences. Deferred tax asset is recognised only when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised. Deferred tax asset arising on carry forward losses and tax credits can be recognised only if it is probable that future taxable profit will be available for which these items can be utilised. If subsequent review show insufficient future taxable profit, it should be reduced. If then sufficient, reverse previous reduction.

Recognition of Deferred Tax Assets Examples of deductible temporary differences: Provision for doubtful debts (accounting rule) vs. actual bad debts (tax rule) Accrues interest expense (accounting rule) vs. deduction when paid (tax rule) Provide retirement benefits when services provided by employees (accounting rule) vs. deduction when paid (tax rule)

Recognition of Deferred Tax Assets Illustration 5 As at 31 Dec 20x8, an entity has: (i) TTD 400 x 20% = 80 DTL (ii) DTD 300 x 20% = 60 DTA (iii)Unused losses c/f 200 x 20% = 40 DTA Required: Estimate DTA if: Expect more future taxable losses; DTL 80 – DTA 60 = Net DTL 20 Do not recognise DTA of 40 as will not be able to utilise DTD in near future due to future taxable losses

Recognition of Deferred Tax Assets Illustration 5 As at 31 Dec 20x8, an entity has: (i) TTD 400 x 20% = 80 DTL (ii)DTD 300 x 20% = 60 DTA (iii)Unused losses c/f 200 x 20% = 40 DTA Required: Estimate DTA if: (b) Expect future taxable profit of 500 in 20x9; Can recognise DTA of 40 as can utilise DTD in near future due to future taxable profit (giving rise to tax benefit of 500 x 20% = 100)

Recognition of Deferred Tax Assets Illustration 5 As at 31 Dec 20x8, an entity has: (i) TTD 400 x 20% = 80 DTL (ii)DTD 300 x 20% = 60 DTA (iii)Unused losses c/f 200 x 20% = 40 DTA Required: Estimate DTA if: Expect future taxable profit of 20 p.a. for next 10 years. - Can recognise DTA of 40 as can utilise DTD in future due to future taxable profit (giving rise to tax benefit of 20 x 10 x 20% = 40)

Measurement: Change in tax rates If rate changes, deferred tax liability b/f is adjusted because it should be measured at the tax rate that are expected to apply when asset is realised/liability settled. Example: Year 1 tax rate 40%, B/f deferred tax liability RM40,000. Year 2 tax rate is 35%. DR Deferred tax liability RM5,000 CR Tax expense (P/L) RM5,000 in Year 2. It is a change in accounting estimate (done prospectively) [RM40,000 x (40 - 35)/35 = RM5,000]

Example: a. An entity has deferred tax liability b/f of RM200 and a tax rate of 25%. The carrying value of its plant was RM10,000 but tax base was RM7,000. Trade receivable net of doubtful debts of RM500 was RM4,000. It had provided for provisions for warranty on goods sold of RM1,000. There are no other differences between the carrying value and tax base of its assets and liabilities. b. Tax rate changed to 20%

a. CA TB T T D (D T D) Plant 10,000 7,000 3,000 Receivable 4,000 4,500 (500) Provision 1,000 Nil (1,000) 1,500 DTL x 25% 750 DTA 375 DTL B/f 200 Charge in Profit or Loss 175

b. CA TB T T D (D T D) Plant 10,000 7,000 3,000 Receivable 4,000 4,500 (500) Provision 1,000 Nil (1,000) 1,500 DTLx 20% 600 DTA 300 DTL B/f 200 Charge in P/L 100 Adjustment 200 x 5/25 (40) 60

Presentation Tax assets & tax liabilities to be disclosed separately from other assets/liabilities. Deferred tax assets/liabilities to be distinguished from current tax assets/liabilities. Deferred tax assets/liabilities are NOT current assets/liabilities. Current tax assets & liabilities cannot be offset unless: there is a legally enforceable right to set off an intention to settle on a net basis, or to realise the asset & settle the liability simultaneously

Presentation Deferred tax assets & liabilities cannot be offset unless: there is a legally enforceable right to set off DTA & DTL relate to income taxes levied by the same tax authorities Tax expense for the period is disclosed on the face of the income statement

Disclosure Must disclose Current tax expense Any adjustment in the current year for prior period Deferred tax expense (originating/reversal) Change to deferred tax expense/income due to changes in tax rates Benefits arising from unrecognised tax loss, tax credit or temporary difference of prior period used to reduce tax expense/deferred tax

Disclosure Disclose separately: Aggregate of current & deferred tax relating to items charged to equity An explanation of the relationship between tax expense & accounting profit (reconciliation statement) Explanation of changes in applicable tax rates Amount of DTDs for which no DTA is recognised Amount of DTA & DTL recognised in IS & SFP

CLASS EXERCISE

Abdullah Sdn. Bhd. recognised a deferred tax liability for the year ended 30/6/2014 which is related solely to a difference between rates of capital allowance and depreciation. The carrying amount of plant and equipment was RM30 million and tax written down value was RM20 million. Tax rate is 30%. The following transactions took place during the year ended 30/6/2015: At the end of the year, the carrying amount of plant was RM42 million and tax written down value was RM25 million. The carrying value of the plant does not include the revaluation surplus of RM5 million. Development expenditure of RM12 million was capitalized in accordance with MFRS 138 but is deducted for tax purposes. There was no amortization during the year. Abdullah has recognised income receivable of RM2 million but none has been received yet. Abdullah has made provision for environment clean up of RM1 million. The expenditure will be tax deductible when paid only. The trade receivables were disclosed at RM3.5 million after providing for doubtful debts of RM250,000. The tax payable for the year was calculated at RM3.3 million. Required: Calculate, showing detailed workings, the deferred tax liability as at 30/6/2015 and the current taxation expense for the year ended 30/6/2015.

CV Tax Base TTD DTD RMm Plant 42 25 17 Revaluation reserve 5 Nil R&D 12 Income receivable 2 Provision for clean-up 1 NIL Trade receivables 3.5 3.75 0.25 36 1.25 DTL/DTA at 30% 10.8 0.375 DTA (0.375) 10.425 Net DTL B/F (30m – 20m) x 30% (3.00) Charge in IS 7.425

Profit or loss: Tax expense: RM3.3 million + RM7.425 = RM10.725 million Statement of financial position: Non-current liability: DTL RM10.425 million.