Functional Currency's consequential Impact on Deferred Tax

In continuation of my previous article, this article highlights the consequential impact of having two sets of functional currency (one for GAAP reporting and other Tax submissions) on deferred tax computation under Ind AS 12, which again is based on a new approach i.e. ‘Temporary difference’ as against ‘Timing difference’ under existing AS 22.

Temporary difference is essentially arrived at by comparing the balance sheet under tax books with financial books. This approach is also known as ‘Balance Sheet approach’ and the approach in AS 22 is termed as “P&L approach”.

The consequential impact of Functional Currency on Deferred taxes, is not part of the carve outs and hence would need due care while the standard is practically implemented in India.

Ind AS 12: Income Taxes

A deferred tax asset or liability shall be recognised for all taxable temporary differences.

‘Temporary differences’ are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. The ‘tax base’ of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The primary approach of accounting of deferred tax under Ind AS is using the balance sheet approach. For example, revaluation of fixed assets under Indian GAAP with no corresponding revaluation in Tax books ie Tax base nil, has no impact on deferred tax computation under AS 22 since the revaluation impact is only a balance sheet adjustment with corresponding impact directly in reserves.

Under Ind AS 12, even though the revaluation does not impact income statement, there is a need to adjust the deferred tax and post the net impact in revaluation reserve. This is because this originates a temporary difference on comparison between the balance sheet value of asset and tax base for that particular asset. This is true for all such differences between the balance sheet value and tax base, that have a potential of reversal either in Tax books such as 43B items or financial books itself such as Revaluation adjustments.

While comparing the balance sheet values and tax base, the following paragraph brings out the impact of functional currency on deferred tax computation.

“The non-monetary assets and liabilities of an entity are measured in its functional currency (see Ind AS 21 The Effects of Changes in Foreign Exchange Rates). If the entity’s taxable profit or tax loss (and, hence, the tax base of its non-monetary assets and liabilities) is determined in a different currency, changes in the exchange rate give rise to temporary differences that result in a recognized deferred tax liability or (subject to paragraph 24) asset. The resulting deferred tax is charged or credited to profit or loss.” (Para 41)

The application of this paragraph will not trigger if the currency in which the company maintains its books of accounts i.e. functional currency and the ones used for calculating taxable profit under tax laws is the same ie INR for India. It is pertinent to note that choosing a different currency for presentation of financial statements to stock market, lender, investors, etc, will not attract application of paragraph 41 of Ind AS 12.

However, with the change in accounting standard wherein the accounting records may have to be made under say US$ (considering primary economic environment criteria under Ind AS 21) and taxable profit or loss is to be calculated under INR, this may cause the temporary difference if the USD: INR exchange rates changes at every balance sheet date.

We will take an example to understand the implications of functional currency on deferred tax.

Closing deferred tax status of deferred tax liability as on March 31, XXXX of Entity A is as follows:

As can be seen from the above calculation, the translation of tax base using closing rate has lead to a difference of $14.73. It is pertinent to note that this difference is only for deferred tax computation and not for accounting in financial books.

The notional comparison has reduced the tax base in US$ by 14.73 and thus leads to creation of a deferred tax liability with a corresponding deferred tax expense in income statement. The impact of $ 5.01 over net assets of $ 63 will be a material impact on the profits of the company. It will vary depending upon the value of non monetary assets as on reporting date and movement of exchange rates during the period.

There would not have been any temporary difference in the above example if the functional   currency was INR since tax base and book base would have been same.

Since the functional currency is US$ and the carrying value in functional currency is at the historic rate, to compare with the tax base it is converted at the current rate exchange closing. This will give rise to a temporary difference even though notional.

Impact of accounting Deferred Tax such functional currency difference

1. The accounting for deferred tax on account of such notional differences creates high volatility in the income statement.

2. The gain/loss on account of such treatment has no corresponding charge/income in the income statement. It is accounted based on pure out of books comparison of exchange rates on non monetary items.  ($14.05 is notional only for comparison but tax of $ 5.01 is real for accounting)

3. This item has no bearing to operations or profit; instead it pulls down/up financial results from operations due to tax provision and thus calls for suitable disclosures in financial statements to explain the earnings per share to investors, analysts, etc .

It is pertinent to note that ‘US Generally Accepted Accounting Principles’ i.e. US GAAP, Financial Accounting Standard (FAS) 109 prohibits recognition of a deferred tax liability or asset for differences related to assets and liabilities that, under FASB Statement No. 52, Foreign Currency Translation, are re-measured from the local currency into the functional currency using historical exchange rates and that result from (a) changes in exchange rates or (b) indexing for tax purposes.

On one hand Ind AS 21 aims to reduce the volatility in results on account of currency exposure and on the other hand Ind AS 12 brings in volatility in income taxes on account of notional difference created on account on comparing the balance sheet value and tax base in functional currency at the closing date.

Thus, choice of functional currency other than that used for Tax reporting will lead to such temporary differences and will continue to exist until book currency and tax currency are aligned.

International Precedence

In order to related to deferred tax implications under IFRS, we can be refer Tenaris S.A.’s annual financial statements, which carries a note in its financial statements under ‘Tax reconciliation note’ to explain the investors and readers on the volatility caused due to tax accounting.

Tax note from Tenaris S.A 2008 financial statements–

“Tenaris applies the liability method to recognize deferred income tax expense on temporary differences between the tax bases of assets and their carrying amounts in the financial statements. By application of this method, Tenaris recognizes gains and losses on deferred income tax due to the effect of the change in the value of the Argentine peso on the tax bases of the fixed assets of its Argentine subsidiaries, which have the U.S. dollar as their functional currency. These gains and losses are required by IFRS even though the devalued tax basis of the relevant assets will result in a reduced dollar value of amortization deductions for tax purposes in future periods throughout the useful life of those assets. As a result, the resulting deferred income tax charge does not represent a separate obligation of Tenaris that is due and payable in any of the relevant periods.”

With respect to deferred taxes, we can see that it was not welcomed by few of them on account of notional volatility and thus gave an exclusive note in financial statements to guide the analysts and readers of financial statements, which can be followed by Indian implementers.

Forward Path

It will be a challenging journey for Indian corporates who will adopt Converged IFRS ie “Ind AS” and will have to definitely consider the implications of these standards on its accounting and reporting requirements.

Especially from stability of profitability and ultimately EPS perspective, the companies may avoid the volatility of currency exposure but may not escape the volatility created by foreign exchange rates in computing deferred taxes.

In order to explain the volatility on deferred tax front, companies may prefer to give note disclosures as given by international peers.

Alternative approach: Ind AS 12 ‘Income Taxes’

Considering the amount of volatility of foreign exchange rates with INR and its notional impact on financial statements, Institute of Chartered Accounts of India can look forward for a “Carve-out” while converging to IAS 12 or represent to International Accounting Standards Board for granting an exemption under IAS 12 which will flow in Ind AS 12. This is keeping in mind the deferment of Ind AS implementation in India and practical hardships that will be faced by Indian Multinational Congloromates. Currently the carve outs are proposed for (a) Accounting of FCCBs (b) Accounting for revenues in real estate from based % completion to actual sale of property (c) Option to defer exchange fluctuation on long term foreign currency liabilities. 

Sanjay Chauhan