Accounting for Income Tax

Introduction

The report will attempt to examine the various tax values reported in the consolidated financial statements of the QBE Insurance Group. The report will begin with some basic understanding of the terms that would be used going forward in the analysis. It will then attempt to make sense of the existence of deferred tax asset and liability in the balance sheet as well as attempt to explain why there is a difference in the amount of tax liability and the tax expense recorded in the income statement. The report will further dwell on temporary and permanent differences before delving into the oddities specific to the tax structure of this particular company. The report will then finally end with a conclusion regarding the findings of the report.

Basic Terminologies

• Accounting Profit: Profit, in accounting, is the portion of the income earned in a profitable marketing/production process, which is distributable to the owners the said process. This is calculated according to the principles laid down by the International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS). As opposed to economic profit, accounting profit does not take into account implicit cost of the production process, such as opportunity cost.[1]
• Taxable Profit: While accounting profit is calculated for reporting purposes, taxable profit is calculated solely for the purpose of finding out the tax payable on income. For various reasons, referred to as temporary differences, the accounting profit and taxable profit may differ. So, for example if the company depreciates motor vehicles at 25% per annum using reducing balance method (RBM), arriving at a depreciation expense of US$ 250 but tax rules state that motor vehicles ought to be depreciated at 20% per annum using RBM, the tax depreciation would be US$ 200, instead of US$ 250. Consequently, the profit according to tax authorities would be US$ 50 higher than the accounting one.
• Temporary Differences: These differences arise due to the carrying amount of an asset/liability being different from its tax base. Tax base refers to the value of an asset/liability assessed that is subject to taxation. These differences aren’t due to actual differences in the value of the asset/liability, but rather due to a difference in timing. The differences are settled when the carrying amount of the asset or liability is recovered or settled. [2]In the above-mentioned example, the difference of US$ 50 income will result in a temporary difference in the tax amount being calculated.
• Taxable Temporary Difference: A taxable temporary difference is when there will be some taxable amount in the future. This timing difference means that the current year taxable income would be lower leading to a difference in the amount of tax assessed according to accounting profit and taxable profit. Since the temporary difference caused the current year income to go up, the temporary difference in our example was not that of a taxable temporary difference.
• Deductible Temporary Difference: A deductible temporary difference is when there might be an amount that is deductible in the future arises. This timing difference causes the taxable income and hence income tax payable in current period to be higher than the accrual income tax. [3]Hence, the excess income (and thus excess income tax) in the current year would be a deductible temporary difference, in our example.
• Deferred Tax Asset: This balance sheet item reduces future taxable income. A business may overpay tax in a certain year which would eventually be returned to them in the form of tax relief in the future. As such, that overpayment may be considered as an asset by the company. In our little example, a lower charge for depreciation in this year simply means that the charge for depreciation in the future would be higher. This means that in our example, there would be creation of a deferred tax asset in the current year for the company.
• Deferred Tax Liability: This is the portion of the tax liability payable in the current period but has not been paid. This is, once again, due to the difference in timing of when tax is accrued and when tax is paid. In our example, had the depreciation charge been higher in the current year, it would’ve led to a creation of a deferred tax liability, as the timing difference would simply have meant that there would be a lower charge in the future and hence a higher tax in the future.

Based on the general description, it may seem as if deferred tax/liability are mere tools for managing the tax burden for one period or another. However, there are strict guidelines companies must follow when recognizing either deferred tax asset of liability. These guidelines are laid down in International Accounting Standards. According to IAS 12, deferred tax assets are recognized only to the extent that recovery is probable. It further states that a deferred tax asset will be recognized for all deductible temporary differences unless it arises from initial recognition of an asset/liability in a transaction that is either not a business combination or doesn’t affect the accounting/taxable profit.[4] The same rule applies for recognition of deferred tax liability, except that in case of liability, the prohibition also applies to initial recognition of goodwill. In order to recognize (include in the statement of financial position) a deferred tax asset, there must be an expectation of sufficient future taxable profits to utilize the deductible temporary differences. There is no specific restriction on how many years the entity may look forward (‘the lookout period’), unless there is a date at which the availability of the tax losses expires. Since recognition is an internal function, management will have to exercise their own judgement to assess whether future taxable profits are probable or not. There are separate criteria for recognition in interim statements and how they’d be reconciled with the annual reports and how tax losses and tax credits affect the recognition. However, such details are practically beyond the scope of this report and would need a separate report just for it altogether.

The Analysis

Income tax expense is the accounting tax charge for the period and is calculated as the tax payable on the current period taxable income based on the applicable income tax rate. Income tax expense does not equate to the amount of tax actually paid to tax authorities around the world, as it is based upon the accrual accounting concept. Accounting income and expenses do not always have the same recognition pattern as taxable income and expenses, creating a timing difference as to when a tax expense or benefit can be recognized. These differences usually reverse over time but, until they do, a deferred tax asset or liability is recognized on the balance sheet.[5]

The income tax expense for the year 2019 for QBE Insurance is US$ 104 million. The company’s accounting profit for the year was US$ 672 million and the given tax rate for the QBE is 30%. Calculating via this we get a supposed tax liability of US$ 202 million. This is, of course, not the same as the tax expense for the year because deferred tax asset/liability and unused tax losses have to be adjusted for. Over provisioning in the prior years, untaxed dividends in the current period as well as differences in tax rates all over the globe contributed to the difference that can be seen between tax expense and tax assessed.

The annual report for QBE outlines the company’s policy on deferred taxation as deferred income tax is provided in full using the liability method on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. As stated above, deferred tax liabilities are not recognized by QBE if they arise from the initial recognition of goodwill or if they arise from the initial recognition of an asset or liability in a transaction other than a business combination that at the time of the transaction affects neither accounting nor taxable profit or loss. Deferred income tax is determined using tax rates (and laws) that have been enacted by the end of the reporting period and are expected to apply when the related deferred income tax asset is realized, or the deferred income tax liability is settled. Deferred tax assets are recognized for deductible temporary differences and unused tax losses only if it is probable that future taxable amounts will be available to utilize those temporary differences and losses. Deferred tax assets and liabilities are not recognized for temporary differences between the carrying amount and tax bases of investments in foreign operations where the company is able to control the timing of the reversal of the temporary differences and it is probable that the differences will not reverse in the foreseeable future. Deferred tax assets and liabilities are offset in the consolidated financial statements when there is a legally enforceable right to offset current tax assets and liabilities and when the deferred tax balances relate to the same taxation authority.[6]

The consolidated statement of financial position of the company shows the company’s deferred tax assets to be US$ 479 million, while its deferred tax liabilities are US$ 15 million, for the year 2019. Deferred tax asset due to some items being in the income statement that would otherwise not be recognized as income/expense for taxation purposes. The fair value movements for non-current assets and all provisions being maintained are two such examples. The company adopted the Australian Accounting Standards Board (AASB) 16 for leases in 2019, which caused some movement in the valuation of the assets held by QBE Insurance. Based on the tax policy mentioned above, the company set off US$ 671 million worth of deferred tax liabilities against deferred tax assets, before recording the remaining US$ 479 million in the consolidated statement of financial position.

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