Deferred Tax Impact on Employee Benefits (Plan Assets)

- CA. Jiban Shakya, The author is Member of ICAN and currently serving as Deputy Manager at Nepal Telecom. He can be reached at: shakyajiban@gmail.com

Abstract:

Employee Benefits under defined benefits plan shall be recognized in financial statements through actuarial valuation but those expenses shall be deducted in income tax as and when the payment is made to the individual employees on retirement or termination. In initial years when the expenses are recognized, the accounting profit will be less than taxable profit. In subsequent period on employee’s retirement or termination, the reverse will happen. If income tax expense is recognized as per the prevailing tax laws in financial statements, then the future tax benefit (less tax in future) would cause distortion in performance measurement over the future accounting period(s) of an entity So, to balance those differences through tax expenses, the deferred tax principles come into existence. The creation of plan assets does not have any tax consequences.

 

Background:

In most of the jurisdiction across the globe, the Accounting profit reported in Financial Statement as per financial reporting framework and the Taxable profit reported in Income Tax Authorities differ, meaning the Current Tax payable has little relationship with the Accounting profit.

Economic transactions which are reported in a particular period may have their tax effect deferred in subsequent year(s). The tax authorities follow the taxation laws to arrive at a Taxable Profit which differed from International Financial Reporting Standards (IFRS)/Nepal Financial Reporting Standards (NFRS) provisions. Employee Benefits under defined benefits plan shall be recognized in financial statements through actuarial valuation but those expenses shall be deducted in income tax as and when the payment is made to the individual employees on retirement or termination. In initial years when the expenses are recognized, the accounting profit will be less than taxable profit. In subsequent period on employee’s retirement or termination, the reverse will happen. So, to balance those differences through tax expenses, the deferred tax principles come into existence. The difference between two sets of principles /rules will results in variations in Current Tax Expense and Tax Expense in Financial Statement. The Current Tax expense is the tax rate applied to the Taxable Profit and not the Accounting Profit. The deferred tax expenses or income balances the tax expenses recognized in the financial statement and ultimately the financial performance i.e. Net Profit of an entity over the periods.

 

Objective of Deferred Tax:

The objective of this Standard (Nepal Accounting Standard 12: Income Taxes) is to prescribe the accounting treatment for income taxes. The principal issue in accounting for income taxes is how to account for the current and future tax consequences of:

                (a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are          recognized in an entity’s statement of financial position; and

                (b) transactions and other events of the current period that are recognized in an entity’s         financial statements.

 

If income tax expense or refund calculated as per the prevailing tax laws and regulation of the particular country is taken as the basis of accounting charges as per applicable financial reporting framework, then the upfront tax benefit accrued that will reverse in the future would cause distortion in performance measurement over the future accounting period(s) of a particular entity. In initial years when tax benefit has been received, performance of entity will be better as compared to when tax benefit will reverse in subsequent years. Deferred tax accounting intends to neutralize the effect of such temporary difference.

 

The conceptual framework of financial reporting states that Accrual accounting depicts the effects of transactions on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.

 

 

Recognition of Deferred Tax Assets:

 

A deferred tax asset shall be recognized for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized. The carrying amount of a deferred tax asset shall be reviewed at the end of each reporting period. An entity shall reduce the carrying amount of a deferred tax asset to the extent that it is no longer probable that sufficient taxable profit will be available.

 

As per para 7 of IAS/NAS-12, the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the Carrying Amount of the asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount. Similarly, as per para 8 of IAS/NAS-12, the tax base of a liability is its Carrying Amount (CA), less any amount that will be deductible for tax purposes in respect of that liability in future periods.

 

As per para 55 of IAS/NAS 12- Income Taxes, Temporary differences are determined by reference to the carrying amount of an asset or liability. This applies even where that carrying amount is itself determined on a discounted basis, for example in the case of retirement benefit obligations.

 

Employee Benefits:

As per IAS/NAS-19: Employee Benefits are all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment. Post-employment benefits are employee benefits that are payable after the completion of employment. Defined benefit plans are post‑employment benefit plans other than defined contribution plans.

 

The objective of this Standard (IAS/NAS 19 – Employee Benefits) is to prescribe the accounting and disclosure for employee benefits. The Standard requires an entity to recognize:

1. a liability when an employee has provided service in exchange for employee benefits to be paid in the future; and
2. an expense when the entity consumes the economic benefit arising from service provided by an employee in exchange for employee benefits.

 

Key Terminologies:

 

Term	Definition
Post-employment benefit plans	are formal or informal arrangements under which an entity provides post-employment benefits for one or more employees.
Defined contribution plans	are post-employment benefit plans under which an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods.
Net defined benefit liability/ (asset)	is the deficit or surplus, adjusted for any effect of limiting a net defined benefit asset to the asset ceiling. The deficit or surplus is: (a) the present value of the defined benefit obligation less (b) the fair value of plan assets (if any).
Present value of a defined benefit obligation	is the present value, without deducting any plan assets, of expected future payments required to settle the obligation resulting from employee service in the current and prior periods.
Plan assets	It comprises: (a) assets held by a long-term employee benefit fund; and (b) qualifying insurance policies.

 

Provisions of Tax Laws in Nepal:

 

Accounting of transactions as per IFRS/NFRS and as per Tax laws are different. The Current Tax expense is based on profit calculated as per Tax laws. for example, Section 24 of the Income Tax Act, 2058 (updated by prevailing Finance Act) prescribes accrual basis of accounting for the entity wherein for retirement benefit costs payable to employees shall be deemed to have been incurred at the time of payment only.

 

As per the prevailing income tax laws, regulations and directives in Nepal, the contribution made to the retirement fund shall not be deducted in determining taxable profit and the same is deducted as and when the retirement benefits are paid by the entity to the individual employees. The investment risk and the actuarial risks vest with the employer and the provision of plan assets (contribution paid to the fund or earmarking of Assets) is merely a funding arrangement for the security of retirement benefits. This kind of arrangement guarantees the retirement benefits to employees, if the entity is unable to make payment from its regular cash flows or on liquidation of the entity.

 

Impact of Deferred tax on Employee Benefits and Plan assets: 

 

Employee Benefits under defined benefits plan shall be recognized in financial statements through actuarial valuation but those expenses shall be deducted in income tax as and when the payment is made to the individual employees on retirement or termination.

 

As per para 26 of the IAS/NAS 12- Income Taxes, the following are examples of deductible temporary differences that result in deferred tax assets:

(a) retirement benefit costs may be deducted in determining accounting profit as service is provided by the employee, but deducted in determining taxable profit either when contributions are paid to a fund by the entity or when retirement benefits are paid by the entity.

Temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position and its tax base. Deductible temporary differences 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.

 

So deferred tax assets shall be created when the Employee Benefits under defined benefits plan are charged to statement of Profit or loss but only allowable as deduction in income tax when retirement benefits are paid by the entity. At the time of payment, the deferred tax assets shall be reversed.

 

The creation of plan assets does not have any tax consequences. The Net defined benefit liability/ (asset) is presented the statement of financial position after netting the present value of the defined benefit obligation and the fair value of plan assets. If the present value of the defined benefit obligation is more than the plan assets, there will be net defined benefit liability and vice versa. 

 

The standard setters have very wise and foresightedly defines the tax base of liability by which the deferred tax shall be created only of amount that will be deductible for tax purposes in respect of the settlement of that liability in future periods.

 

For better understanding of the issues based on above provisions, let us take the following example so that it would be crystal clear about the impact of Deferred Tax on Employee Benefits (Plan Assets).

 

Example 1:

A Telecommunication Company in Nepal is providing telecommunication services with consistent business operation and earning profits. As per prevailing income tax legislation, the company will get income tax deduction of those retirement benefits when it is actually paid to its employees. The company has movement in plan assets and retirement benefit liability as below.

1. In Year 20X2 ,the company earmarked its Fixed Deposit of Rs. 500 crores and contribute Rs. 500 crores in  Nagarik Lagani Kosh for retirement benefits.
2. In Year 20X3, the company introduced Voluntary Retirement Scheme (VRS) through which Rs 1,000 crores has been paid to employees from the Plan assets.

 

The corporate tax rate is 30%.

Below is extraction of financial statement of the company (as per NFRS) before adjusting Tax expenses as on year end of 3 years:

Figure in Nrs. (crores)

Particulars	Year 20X1	Year 20X2	Year 20X3
Service Revenue	3,500	3,500	3,500
Other Income	500	500	500
Total Expenses	2,000	2,000	2,000
Defined benefit plan obligation	3,000	3,000	2,000
Fixed Deposit	2,000	1,000	1,000
Fixed Deposit (earmarked for retirement benefit)	-	500	-
Contribution in Plan Assets in Nagarik Lagani Kosh	-	500	-
# For ease of understanding the Deferred Tax effect precisely, the movement in Defined benefit plan obligation is made static.
Opening DTA in Year 20X2 is Rs.900 crores (equal to Temporary difference * Tax Rate) i.e. (Rs. 3000 crores *30% = Rs. 900 crores)

Now let’s compute deferred tax and analyze the impact on employee benefits accounting.

 

Deferred Tax Computation as per above provisions shall be as follows:

Deferred Tax Computation
	NRs in Crores
Particulars	Year 20X1	Year 20X2	Year 20X3
PV of DBO	3,000	3,000	2,000
Less: Plan Assets	-	(1,000)	-
Net Defined Benefit liability	3,000	2,000	2,000
Carrying Amount	3,000	2,000	2,000
Tax Base	=3000-3000 =0	2000-3000 =-1000	=2000-2000 =0
Timing Difference	3,000	3,000	2,000
Deferred Tax @30%	900	900	600
DTA reversal charged to Profit/Loss	-	-	300

 

The Current tax payable as per prevailing tax laws in Nepal shall be as follows:

Computation of Taxable Income
	NRs in Crores
Particulars	Year 20X1	Year 20X2	Year 20X3
Service Revenue	3,500	3,500	3,500
Other Income	500	500	500
Total Inclusions (A)	4,000	4,000	4,000
Less: Deductions
Total Expenses	2,000	2,000	2,000
Retirement Benefit payments (Given)	-	-	1,000
Total Deductions (B)	2,000	2,000	3,000
Taxable Profit (C) = A-B	2,000	2,000	1,000
Tax Rate (D)	30%	30%	30%
Current Tax (E)=C*D	600	600	300

 

The Statement of Profit or Loss is as below:

Statement of Profit or Loss
	NRs in Crores
Particulars	Year 20X1	Year 20X2	Year 20X3
Service Revenue	3,500	3,500	3,500
Other Income	500	500	500
Total Income	4,000	4,000	4,000
Total Expenses	2,000	2,000	2,000
Retirement Benefit payments (payment from liability, so no expenses in Year 20X3)	-	-	-
Profit Before Tax	2,000	2,000	2,000
Tax Expenses
Current Tax	(600)	(600)	(300)
Deferred Tax			(300)
Net Profit	1,400	1,400	1,400

 

Impact in Year 20X2

There shall be no impact regarding Deferred Tax in Year 20X2. The earmarking of Fixed Deposit and Contribution in Plan assets does not get tax deduction as per tax laws. There is no changes in amount that will be deductible for tax purposes in respect of settlement of that liability in future periods. Due to the creation of plan assets, the fixed deposit has been decreased.

 

Impact in Year 20X3

There shall be impact regarding Deferred Tax in Year 20X3. The Defined benefit plan obligation and plan assets both shall be decreased by Rs. 1,000 crores.

 

There shall be reversal of Rs. 300 crores (Rs.1,000*30%=Rs. 300 crores) out of opening DTA of Rs. 900 crores as the payment on VRS shall be deductible in income tax. There shall be equal amount of decrease in Current Tax of Rs. 300 crores as well. The remaining DTA of Rs. 600 crores will be reversed as and when the telecommunication company actually paid the amounts to its employees.

 

Conclusions:

The essence and beauty of Deferred Tax is very much clearly and precisely depicted in the above example. There is no any distortion of Net profit presented in financial statement over the period of 3 years. The Deferred Tax mechanism has effectively neutralized the effect of such temporary differences. The Deferred Tax is neither assets nor a liability. It is simply the impact of differences between the accounting treatment and tax treatment of a particular transaction/arrangement. There shall be no discounting of Deferred Tax Assets.

 

A temporary difference exists between the carrying amount of the liability (net defined benefit liability) and its tax base. Such a deductible temporary difference results in a deferred tax asset as economic benefits will flow to the entity in the form of a deduction from taxable profits when contributions or retirement benefits are paid in subsequent year(s). The creation of plan assets does not have any tax consequences. Thus, Deferred Tax shall be created on deductible temporary differences between carrying amount and its tax base and reversal happens as and when those benefits are paid by the entity.

 

References:

1. NAS-12: Income Taxes

2. NAS-19: Employee benefits

3. Income Tax Act, 2058