Deferred tax - Partial arts

One of the big issues of the year is whether the basis of UK accounting for tax should be changed. Since 1978 SSAP 15 has required UK companies to provide for deferred tax on timing differences, but on the basis of ‘partial provision’. This means providing for that part of the deferred tax liability that seemed likely to arise in the short to medium term, but not for deferred tax which, though a theoretical liability, would not arise at all or for a very long time.

Adopting the partial provision basis was an attempt to be realistic in accounting for deferred tax. For example, if a capital-intensive company has a big and predictable programme of capital expenditure of a type that attracts capital allowances, then an effect of this would be that new capital allowances on capital expenditure would indefinitely defer the payment of tax.

So, provided companies continued to invest, that tax would never, in fact, arise. Realistic accounting would not show it as a liability, but would instead footnote it as a kind of contingent liability.

So far, so pragmatic.

But internationally, and increasingly in this country, partial provision is being criticised. The principal arguments include:

– If deferred tax is a liability, all of it should be provided for, not just part of it.

– Providing part on the grounds that new deferred tax liabilities will replace old ones and there will be a core that is never paid is not a good argument. The same line can be taken with regard to trade creditors, but no one suggests providing only part of them.

– Relying on future capital expenditure to support (non)accounting for deferred tax on current items is suspect.

– If the delay in payment is a concern, the way to deal with that is by discounting, not by ignoring part of it.

Despite these arguments, many people in the UK believe that partial provision works rather way in a pragmatic way. Indeed, there is a strong feeling that a policy of fully providing for tax which is likely to be indefinitely delayed fails to report the actual and intentional effects of government fiscal policies.

In short, if governments give tax allowances that have the effect of deferring tax liabilities, why should accountants account for them as if they are payable tomorrow?

Despite all this, there is a serious possibility – at least – that UK accounting rules will change to require full provision to be used. This is largely because of international practice. Most other countries in which deferred tax is an issue use the full provision basis. Specifically, the international accounting standards committee (IASC) has recently published IAS 12 ( revised): Income taxes.

This not only requires companies that follow IAS to use full provision but also requires a version of full provision that, from a UK perspective, seems like over-full provision. It not only involves providing tax on all timing differences (those that originate in the profit and loss account, such as the difference between book depreciation and capital allowances), but also providing on other so-called ‘temporary differences’, ie other differences between the book value and the tax value of items, even if they originate in the balance sheet – for example, the revaluation of a fixed asset.

Many questions arise from this development: (1) In a world that now places considerable emphasis on harmonisation, is partial provision sustainable any longer? (2) If not, should the UK move to full provision? (3) If so, should the UK move to the IAS 12 version or should it stop at, say, full provision for all timing differences? (4) What effect might a change to full provision have on UK companies?

These are all big questions and here we concentrate on the last one.

(The brief answers to the others are: (1) Probably not; (2) Reluctantly, yes; (3) If we are going to full provision we may as well harmonise.)

To examine the likely effect on UK companies we surveyed 90 of the largest listed companies across a variety of sectors for the Coopers & Lybrand Manual of Accounting. We could not assess the impact of IAS 12. Instead we based our figures on seeing what would the effect be on gearing if the ‘unprovided’ deferred tax (that under SSAP 15 has to be disclosed in the notes to the accounts) was treated as a liability.

Bringing the unprovided deferred tax on balance sheet in fact has three immediate effects: (1) It increases reported liabilities; (2) It reduces shareholders’ funds – specifically, it reduces distributable profits (a very serious practical issue for some companies); (3) It increases the gearing ratio. And, going forward, it increases the tax rate in the profit and loss account.

The results are shown in the table above. What is clear is that the effect varies considerably from sector to sector. The average is that gearing would be pushed up from 40% to 50% and many companies in the services and general industrial sectors are not far from those figures. Banks, though, provide most of their deferred tax already and so a change to full provision would have relatively little impact.

At the other extreme, utilities are a dramatic case. Because they have heavy and predictable programmes of capital expenditure, they find that their taxes are indefinitely deferred. Hence, and again quite correctly under partial provision, they provide little or no deferred tax. Under full provision, they would have to bring in a provision for something that they are unlikely to have to pay, at least not for a very long time.

One of the possibilities is to bring in deferred tax on a full provision basis but with discounting of the provision to allow for the delay in payment. This would introduce more complexity into the process. However, utilities and other companies with similar characteristics would probably find it worth the effort in order to introduce some sense and meaning into the figures.

Peter Holgate is accounting technical partner and Orla Horgan is a technical manager with Coopers & Lybrand.

They are contributing authors to the Coopers & Lybrand Manual of Accounting, published by Accountancy Books and available to readers of Accountancy Age at #160 post free (normal price #180) by calling 01908 248000 (ref PG6A).