Revenue Guidance on FA2005 Section 48 - IFRS measures
Author:
David Fennell
On 22 December 2005, the Revenue Commissioners finalised their guidance note on the International Financial Reporting Standards (IFRS) measures contained in Section 48 of the 2005 Finance Act. Guidance had previously been issued as part of the complete set of notes covering the entire 2005 Finance Act. However, the latest guidance contains additional material.
General points
Section 76A of the Taxes Consolidation Act, 1997 (TCA 97) provides that a company’s trading profits should normally be computed in accordance with generally accepted accounting practice (GAAP). The Revenue Commissioners have confirmed that ‘profits’ in this context mean, where Irish GAAP is used, those reflected in the profit and loss account, and where IFRS is used, amounts reflected in the income statement.
The guidance note reiterates that statements of practice are not regarded as ‘law’ for the purposes of ascertaining what adjustments may be ‘required or authorised by law’, a fact recently emphasised by Clarke J in his High Court decision in Brendan Crawford (Inspector of Taxes) v Centime Ltd [2005] IEHC 328.
Leasing
The interaction of the new rules with the existing tax treatment of finance leases has been clarified in the new guidance note. The tax deduction for lease payments incurred by a lessee is generally determined based on the legal form of the transaction rather than the accounting treatment. In arriving at a taxable profit figure, the lessee would typically disallow the depreciation and finance lease charges, and claim a deduction instead for the gross rental payments.
Concerns had been raised that the precise statutory basis for continuing to follow this treatment (as distinct from simply following the accounting treatment) was unclear. However, the Revenue Commissioners have confirmed that the tax treatment of finance leases remains unchanged.
Case III/IV income
Section 48 only applies ‘for the purposes of Case I or Case II’. However, the guidance confirms that there is no reason why the requirement to compute income in accordance with GAAP and the transitional arrangements should not also apply to trading income chargeable under Case III and also to Section 110 TCA 97 securitisation vehicles.
Deferred consideration
Income recognition rules under IFRS may require a company to account for income on the basis of the fair value of any consideration receivable. If the income is received over a period of time, this may require a company to reflect only the net present value of the consideration at the outset, with a discount factor being reflected in ‘other operating income’ or as interest receivable. The Revenue Commissioners have confirmed that if the consideration is a trading receipt, any difference between the nominal value of the consideration and the deferred consideration will also be regarded as trading income, as and when it is reflected in the income statement.
Where a company acquires a fixed asset on deferred payment terms, the cost of the asset may be reflected in the accounts at a net present value of the consideration to be provided. In this instance, the discount will likely be reflected as a finance cost rather than as part of fixed assets. The Revenue Commissioners have indicated that the actual expenditure on the asset will be regarded as the amount qualifying for capital allowances.
The guidance note contains an example to illustrate the tax treatment described above.
The introduction of IFRS means that companies will need to carefully consider the various components of the finance cost recorded in the income statement. Different components could have different tax treatments. Examples might arise when accounting for interest free loans or convertible bonds.
Decommissioning costs
Under IFRS, the net present value of decommissioning/restoration costs associated with an asset may, in certain instances, be included as part of the cost of the asset. The Revenue Commissioners have indicated that it is the actual expenditure on the asset that will qualify for capital allowances. Any amounts for expected decommissioning/restoration costs must be ignored, as should any subsequent unwind of the value of these costs.
Share options
The Revenue Commissioners received a number of submissions relating to the tax treatment of share-based payments as outlined in Section 48.That provision denies a tax deduction for any consideration given by a company in the form of shares for goods or services, or to its employees or directors.
Section 48 (1)(c)(i) was introduced to preserve the denial of a tax deduction for the cost of providing shares or share options to employees. IFRS 2/Financial Reporting Standard (FRS) 20 would require companies to expense such costs. While the decision in Lowry v Consolidated African Selection Trust Ltd [1940], 23 TC 259, might suggest that such an expense is not deductible, there was a possibility that this 65-year-old decision might not find current favour with any court considering the new accounting rules. However, the amendment went much further than what was actually required to counteract the effect of IFRS 2/FRS 20. Section 81(2)(n) TCA 97 now denies a tax deduction for ‘any consideration given for goods or services, or to an employee or director of a company, which consists directly or indirectly, of shares in the company, or a connected company (within the meaning of Section 10) or a right to receive such shares …’
The widely drafted restriction applies not only to shares issued to employees, but also to any goods (e.g. stock) acquired or services received in return for the issue of shares. The practical effect of the legislation comes into sharpest focus in the case where a company acquires a business and pays for the net assets by issuing shares. If the company acquires inventory for €150 and subsequently sells this for €200, a profit of €50 will be reflected in the company’s accounts. If the Finance Act 2005 was to be applied literally, the company would be taxed on the entire €200. This would be highly inequitable and represent a departure from the pre-Finance Act position.
The Revenue Commissioners have adopted a common-sense approach to the above difficulty and have stated that where a company acquires a business in return for shares, it will be entitled to a tax deduction for any trading stock acquired.
The guidance note also advises that in a case involving the transfer of goods that constitute trading stock of both the transferor and the transferee, in return for shares in the transferee company, a deduction for the value of the stock transferred will not be denied if it can be shown that the value of the stock is taken into account in computing trading income of the transferor. The practical difficulty of proving that the value of the goods has in fact been taken into account in computing trading income should not be underestimated.
There are a number of exceptions that continue to allow a tax deduction for payments that are indirectly connected with shares, such as for payments to group companies. In a welcome move, the guidance note contains several examples illustrating the tax treatment under certain scenarios. Example 4 outlines the tax treatment of a parent company in receipt of a payment from its subsidiary in return for the issue of shares to employees of that subsidiary, noting that ‘there would be no tax implications for the parent company as the issue of the shares would simply add to its share capital’.
Where a trust is used to hold shares for subsequent transmission to employees, any deductibility will, of course, be subject to Section 81A TCA 97.
Capitalised ‘revenue’ expenditure
The 2005 Finance Act maintains the status quo in relation to the tax treatment of interest and expenditure on research and development (R&D). The legislation states that a deduction shall not be denied simply because, under IFRS, it is included for accounting purposes in the cost of an asset. The guidance note confirms that ‘capitalised’ research and development costs are deductible on an amortisation basis rather than on a payments basis.
Transitional measures
The 2005 Finance Act contains transitional arrangements providing for the spreading, over 5 accounting periods, of certain specified adjustments arising on the transition to IFRS. Nevertheless, complications may arise where a cessation of one trade occurs while the company continues to carry on a second trade.
The guidance note contains an example of the treatment of bad debts. However, it would appear that technically a legislative adjustment may be required to Section 81(2)(i) TCA 97 to allow bad debt provisions to be computed on the basis of the FRS 26/IAS 39 rules. The Finance Act itself does not contain any specific measure confirming that a tax deduction will be available for bad debts computed in accordance with IFRS/FRS 26. Such a statement is contained in the explanatory memorandum to the Finance Act. However, Section 81(2)(i) TCA 97 still prohibits a tax deduction for ‘any debts, except bad debts proved to be such to the satisfaction of the inspector and doubtful debts to the extent that they are respectively estimated to be bad …’ This apparent anomaly is all the more relevant where a debt becomes impaired, not because it will never be paid, but because it will be paid at some predicted future point in time (thus requiring the debt to be written down to its net present value).
Transitional measures apply to gains and losses on financial instruments. The legislation identifies the amounts of gains or losses which could be either double counted, or fall out of account, for tax purposes. Once these are calculated, the net amount is taken into account for tax purposes over a period of 5 years. The measures are most likely to apply where a company moves from a realisation basis of taxation to taxation based on fair value movements.
The above transitional measures apply upon the application of ‘relevant accounting standards’ for the first time. ‘Relevant accounting standards’ will include Irish standards that are stated to embody international accounting standards. At present, the Irish standards that embody IFRS are FRS 20 to FRS 26 inclusive and FRS29.
In view of the fact that Irish standards will converge with international accounting standards over a period of time, Schedule 17A can apply on a piecemeal basis (i.e. as both sets of standards converge).
‘Bed and breakfast’ provisions
The Revenue Commissioners have stated that the anti-avoidance rules that apply where group companies use different accounting frameworks do not require a tax avoidance motive as a prerequisite to their application.
Similarly, the 2005 Finance Act contains measures designed to prevent companies from ‘bed and breakfasting’ financial assets or liabilities on which they have incurred an unrealised loss, i.e. by crystallising that loss for tax purposes prior to the transition to IFRS/FRS 26, while at the same time not crystallising any real economic loss. The Revenue Commissioners have indicated that the measure is also not conditional on there being a tax avoidance motive.
The ‘bed and breakfast’ anti-avoidance provision applies where there is a disposal of a financial asset or a financial liability at a loss in the 6-month period prior to the ‘changeover day’ (e.g. from 1 July 2005 to 31 December 2005, where IFRS/FRS 26 accounts are to be prepared for the first time for the year ended 31 December 2006). Where a loss on a disposal arises in this 6-month period, and within an 8-week period around that disposal (4 weeks before and 4 weeks after) the company acquired an economically substantially identical asset, the tax effect will be that the loss will only be allowed over 5 successive accounting periods, starting with the accounting period in which the disposal took place.
The legislation is primarily aimed at preventing companies taxed on a realisation basis from crystallising losses prior to the transition (at a time when such companies could delay the realisation of gains). The Revenue Commissioners have accepted representations that a company should not be required to apply the measure to financial instruments if the taxable profits on such financial instruments were calculated on a mark to market basis prior to the move to IFRS. There is unlikely to be a significant advantage in such circumstances.
The ‘bed and breakfast’ anti-avoidance provision appears is likely to create practical difficulties for affected companies because accounting systems will likely need to be adapted to ensure that the relevant information can be captured. The 6-month period seems excessive and means that for companies moving to IFRS/FRS 26 with effect from 1 January 2006, this may require the monitoring of the acquisition of financial assets and liabilities from as early as 3 June 2005 onwards. Furthermore, there is no guidance as to what is meant by assets or liabilities ‘providing substantially the same access to economic benefits and exposure to risk’, although it is appreciated that in most cases this will be readily apparent.
Preliminary tax
The Finance Act 2005 also contains specific rules concerning the preliminary tax payment requirements of companies moving to relevant accounting standards. However, the relaxation of the preliminary tax requirements is still tainted by the administrative burden required of companies to avail of the measure. It remains to be seen if the provision can be of any practical benefit. The fundamental problem is that many companies in all industry sectors already find it difficult to predict what their first instalments of preliminary corporation tax should be. It will be extremely difficult for companies to ensure that income volatility in areas other than unrealised gains and losses on financial instruments do not result in underpayments of the first instalment of preliminary tax.
Future developments
While the new guidance note is likely to be very helpful, there are some further areas requiring attention. In this regard the Revenue Commissioners have signalled their intention to now examine the issues facing specific sectors such as insurance companies. Further consultation and guidance is expected throughout 2006.
David Fennell, FCA, is a Tax Director in Ernst & Young.