FRS 102: Tax implications

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland has come into mandatory effect for accounting periods commencing on or after 1 January 2015. The impact of this new regime cannot be under-estimated and the standard will also affect many small companies in the UK and Republic of Ireland for accounting periods commencing on or after 1 January 2016 (earlier adoption will be permissible) once the statutory instrument has gone through parliamentary process (which is expected to be on 6 April 2015).

The rules in FRS 102 are retrospective; in other words they have to be applied as far back as the date of transition. The ‘date of transition’ is the start date of the earliest period reported in the financial statements. Applying the rules as far back as the date of transition has the effect that the financial statements will be presented as if FRS 102 has always been the financial reporting framework adopted by the entity. In some cases there may only be a couple of adjustments due to accounting policy alignments, but in others it may be that there are several adjustments to be made. These adjustments may well have associated tax implications and this article considers some of the tax issues which need consideration.

Accounts for tax purposes

HM Revenue and Customs (HMRC) require financial statements for tax purposes to be prepared under Generally Accepted Accounting Practice (GAAP). Section 1127 of the Corporation Tax Act 2010 says that GAAP for corporation tax purposes is UK GAAP and in relation to the affairs of a company or other entity that prepares IAS accounts, in the Corporation Tax Acts ‘generally accepted accounting practice’ means generally accepted accounting practice in relation to IAS accounts (s1127(4) CTA 2010).

Consolidated financial statements will have no influence on the entities individual tax position.

The financial statements of a company reporting under FRS 102 are going to be affected in two main areas:

• the way that corporation tax liabilities for the current year are calculated; and
• the way that deferred tax assets/liabilities are calculated.

The following sections deals with these areas.

Accounting policy changes

As mentioned at the start of this article, an entity affected by FRS 102 is required to consider its accounting policies to assess whether they are compliant with FRS 102. For example, if an entity has an accounting policy which states that the method of stock valuation is the last-in first-out method, then this policy will not be compliant with FRS 102 as paragraph 13.18 specifically prohibits this method of stock valuation and hence the entity will have to change its policy to either first-in first-out, average cost or another acceptable method (e.g. the retail method).

The transitional adjustments will effectively be the same as a prior period adjustment and may give rise to either a positive adjustment (one which increases profit or reduces a loss) or a negative adjustment. Positive adjustments are taxed as receipts, whereas negative adjustments are allowed as expenses. Chapter 14 Part 3 of CTA 2009 says that where there is a change from one valid basis to another valid basis, then any adjustments are calculated to ensure that business receipts are taxed once and once only and deductions for tax purposes are given once and once only.

Deferred tax impacts

The accounting for deferred tax is more onerous under the provisions of FRS 102 and Section 29 Income Tax deals with the issue concerning deferred tax. The UK and Republic of Ireland have always calculated deferred tax using the ‘timing difference’ approach and this approach is carried over into FRS 102, albeit with fewer exemptions. The timing difference approach focuses on the differences inherent between accounting profit (loss) and taxable profit (loss). For the purposes of Section 29, a timing difference arises in one accounting period and is capable of reversal (or partial reversal) in another accounting period.

FRS 102 uses the timing difference ‘plus’ approach to the calculation of deferred tax. The ‘plus’ part builds on existing FRS 19 Deferred tax requirements and the FRSSE (effective April 2008) and (effective January 2015) by requiring deferred tax to be calculated for three additional types of transaction as follows:

• Non-monetary assets subject to revaluation.
• Fair values in business combinations.
• Unremitted earnings in overseas subsidiaries or associates.

As a result, FRS 102 is more onerous where deferred tax calculations are concerned and the reason for this is because deferred tax calculated under the provisions of Section 29 should not be too far disparate from the same calculation that would be achieved under IFRS for SMEs (which uses the ‘temporary difference’ approach to the calculation of deferred tax).

Another change inherent with the way that deferred tax is calculated under FRS 102 (although will largely go unnoticed) is the fact that deferred tax balances cannot be discounted to present day values under Section 29.

Current tax impacts

Under tax legislation, a company must calculate profits of a trade in accordance with GAAP, subject to any adjustment which is required by law in calculating profits for tax purposes. A typical adjustment that would be made would be to add-back depreciation to accounting profit as depreciation is disallowable for the purposes of tax and then bring into the tax computation any capital allowances which the entity might be able to claim.

Adjustments to accounting policies as a result of the transition to FRS 102 would be classed as arising due to the move from one valid basis to another and hence would be allowable (or taxable) under the provisions outlined in HMRC’s BIM34070.

The corporation tax treatment for companies relies heavily on the accounting treatment and therefore on transition there will be adjustments which will have a direct tax consequence. The following outlines the view by HMRC as to whether certain transactions will, or will not, be allowable or taxable for the purposes of tax:

Errors

Under old UK GAAP at FRS 3 Reporting financial performance, an entity would correct an error by way of a prior period adjustment if that error was ‘fundamental’. The term ‘fundamental’ was defined as essentially destroying the truth and fairness of the financial statements and the validity of those financial statements.

Under FRS 102 at Section 10 Accounting Policies, Estimates and Errors, an entity corrects an error by way of a prior period adjustment if that error is ‘material’ and hence it is more likely that more errors will be corrected by way of a prior period adjustment under the new regime.

HMRC say that a material error would be a change from an invalid basis to a valid basis and therefore UK tax law requires the invalid basis to be corrected in the year it first occurred and subsequent periods are then restated. It would all depend on the time limits for making or amending self-assessments as to whether the consequential tax impact can be collected or repaid.

Financial instruments

Financial instruments are dealt with in Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues in FRS 102. Accounting for certain types of financial instruments (for example derivatives) is a complex area and the provisions in FRS 102 allow for three types of accounting policy choices as follows:

• FRS 102, Section 11 or Section 12;
• IAS 39 Financial Instruments: Recognition and Measurement; and
• IFRS 9 Financial Instruments.

For tax purposes, the general principle is that the tax treatment follows the accounting treatment because for most companies, most financial instruments will fall to be classed as loan relationships (under Part 5 CTA 2009), non-lending money debts (treated as loan relationships under Chapter 2 of Part 6 CTA 2009) or derivative contracts (under Part 7 CTA 2009). In addition, tax legislation also ensures that most items which are taken to reserves are brought into account and a further rule exists within tax legislation which says that if a profit or loss from a loan relationship or derivative contract is recognised directly within equity, this is to be brought into account in the same way as if it was recognised in profit or loss through reserves (this would be the case for a financial instrument measured at fair value through other comprehensive income).

Derivative instruments

Under FRS 102, derivative financial instruments have to be recognised on the balance sheet with fair value fluctuations going through profit or loss. Subject to limited exceptions, gains and losses which have been recognised in profit or loss on derivatives (and foreign exchange transactions) will form part of taxable income.

Hedge accounting

FRS 102 contains special rules which allow an entity to use hedge accounting so as to reduce the volatility of derivatives valued at fair value passing through profit or loss. For tax purposes, these adjustments will not apply although there are special tax rules which may well be relevant in some circumstances.

Investment property

The accounting for fair value changes in investment property is markedly different under the principles of FRS 102 than was the case under old UK GAAP. Under previous UK GAAP, fair value gains and losses were taken to the revaluation reserve (to the extent that there was a balance on the revaluation reserve). Under FRS 102 principles, fair value gains and losses are instead to take profit or loss. In addition, there is no exemption for property let to and occupied by group entities to be excluded from investment property classification as there was in SSAP 19 Accounting for investment properties. There is also an option in FRS 102 not to fair value investment properties on the grounds of ‘undue cost or effort’.

HMRC say that the accounting treatment of investment properties does not determine, for tax purposes, whether the property is an investment property or whether a disposal of a property is a capital or a revenue disposal. Investment property income for tax purposes is brought into tax as it is recognised in the accounts (for example rental income). Movements on the fair value of investment property passing through profit or loss are not taxable. On disposal, investment properties will be subject to capital gains.

Finally, there are some situations where a company holding investment property as a lessee under an operating lease may account for the property as an investment property. Where this happens, the investment property is recognised in the account at the lower of its fair value and the present value of the minimum lease payments with the associated creditor being recognised as a finance lease. In such cases, the tax rules which apply to a finance lease will apply.

Property, plant and equipment

There are relatively few changes brought about in FRS 102 as to how property, plant and equipment (tangible fixed assets) are accounted for and FRS 102 is broadly consistent with old UK GAAP, except:

• FRS 102 requires that major spare parts are capitalised as part of property, plant and equipment (PPE);
• for assets acquired under terms beyond normal credit terms, cost is measured by reference to the present value of all future payments;
• the concept of ‘renewals accounting’ is not permitted under FRS 102; and
• residual values are to be based on current, as opposed to historic, prices.

Under UK tax law, depreciation and revaluations in respect of capital assets are disallowed and instead HMRC grants capital allowances on some assets and thus the above accounting changes are not expected to have a significant tax impact.

There are some occasions when revenue expenditure is included in the cost of an asset and where this is the case the tax treatment follows the accounting treatment by recognising amounts reflected in profit and loss by way of depreciation charges to the extent that they are a write-off of revenue expenditure. Hence where depreciation charges under FRS 102 differ from that under previous FRS 15 Tangible fixed assets (for example due to revaluation of residual values), tax will follow the amount under FRS 102 at Section 17 Property, Plant and Equipment.

As renewals accounting is not permitted under Section 17, there may be an adjustment for tax purposes made under the change of basis legislation.

Intangible assets (including goodwill)

The definition of intangible assets under FRS 102 is wider and hence under the principles of FRS 102, an entity may have to deal with more intangible assets than under previous GAAP.

Sections 871-879 of Part 8 CTA 2009 provides a comprehensive set of rules for changes in accounting for intangible assets and especially for cases where what is included entirety as goodwill under old UK GAAP is disaggregated into different types of intangible assets, with different amortisation rates or impairment factors, under FRS 102 principles.

FRS 102 also restricts the amortisation of intangible assets where a reliable estimate of the intangible asset’s useful economic life cannot be made by management (under August 2014 FRS 102 the cap is five years, but this is due to be increased to 10 years under the next version of FRS 102 due to a change in the legislation for small companies). In addition, under FRS 102 a company cannot have intangible assets with indefinite useful economic lives – all intangible assets will therefore be amortised over the estimated useful economic lives under the new regime.

Tax relief is granted on either the amortisation/impairment of goodwill and intangible assets recognised in the accounts. Sections 871 to 873 of CTA 2009 ensures that any write-up on transition to FRS 102 is a taxable credit for Part 8, and section 872 ensures that any such credit is limited to the net amount of relief already given. Any impairment from written-up cost will be deductible.

Furthermore, tax relief is unlikely to be affected if an entity has elected for a fixed rate of 4%.

Software costs

The accounting treatment under FRS 102 means that software used in the business is to be treated as an intangible asset as opposed to part of fixed assets. For tax purposes, tax relief is obtained through the amortisation charge in the financial statements rather than through capital allowances.

Leases

The provisions in FRS 102 where leases are concerned are notably different than under old SSAP 21 Accounting for leases and hire purchase contracts. The 90% ‘bright line test’ that was contained in SSAP 21 (and in the Glossary to the FRSSE (effective April 2008) and (effective January 2015)) does not appear in FRS 102 and hence more judgement is needed on the part of the preparer of the financial statements to determine whether a lease is a finance or an operating lease. There are eight indicators contained in FRS 102 that a lease is a finance lease rather than an operating lease.

Where a lessee receives a lease incentive, the treatment under FRS 102 is different than under SSAP 21 in that the lease incentive is recognised over the period of the lease in FRS 102 whereas UITF 28 Operating lease incentives required that operating lease incentives in the lessee are spread over the period ending on the date from which it is expected that the prevailing market rent will be payable.

For lease incentives, the tax treatment will follow the accounting treatment provided that the incentives are not of a capital nature.

Revenue recognition

The wording in Section 23 Revenue in FRS 102 is notably more relaxed than the wording contained in Application Note G to FRS 5 Reporting the substance of transactions and the wording in FRS 102 is not as specific as the wording in Application Note G.

It is to be expected that revenue will continue to be recognised in the same way under FRS 102 as it was under old UK GAAP and hence HMRC have taken the view that there will be no accounting or tax impact. It is also worth noting that the Financial Reporting Council have intimated that if there is ‘abuse’ of the relaxed wording in FRS 102, they will issue an Abstract to clarify the position (which would essentially confirm the same treatment under old UK GAAP is relevant under FRS 102).

Government grants

FRS 102 introduces a new ‘performance’ model whereby an entity recognises a grant as follows:

• A grant is recognised in income when the grant proceeds are received (or receivable) provided that the terms of the grant do not impose future performance-related conditions.
• If the terms of the grant do impose performance-related conditions on the recipient, the grant is only recognised in income when the performance-related conditions are met.
• Any grants that are received before the revenue recognition criteria are met are recognised in the entity’s financial statements as a liability.

For the purposes of tax, grants which meet revenue expenditure are normally trading receipts and this treatment will continue under FRS 102.

Share-based payments

The accounting treatment for share-based payments under FRS 102 is identical to the accounting treatment under old UK GAAP at FRS 102 Share-based payment.

There is specific tax legislation pertaining to share-based payment treatments in Part 12 CTA 2009.

Employee benefits

In respect of defined benefit pension schemes covered by Section 28 Employee Benefits, there are certain changes when compared to previous FRS 17 as follows:

• FRS 102 removes the multi-employer exemption on defined benefit schemes; and
• the calculation of net interest on defined benefit schemes comprises the expected interest income on plan assets, the interest cost on the scheme’s liabilities and the interest on the effect of the asset ceiling (if applicable).

These changes are not expected to have any impact on the entity’s tax position because tax legislation provides relief on a contributions paid basis.

Section 28 also requires a reporting entity to make an accrual for unpaid holiday entitlement accrued by the employee but not paid at the reporting date. Many entities did not make such accruals under previous UK GAAP and for the purposes of tax, this accrual would be treated in line with the treatment of unpaid remuneration which is dealt with art Part 20 Chapter 1 CTA 2009.

Transitional adjustments

On transition to FRS 102, an entity is required to apply the provisions in Section 35 Transition to this FRS. This section requires that the balance sheet presented at the date of transition:

• recognises all assets and liabilities whose recognition is required by FRS 102;
• does not recognise assets and liabilities if FRS 102 does not permit such recognition;
• reclassifies assets, liabilities and components of equity to ensure presentation is consistent with FRS 102; and
• measures all recognised assets and liabilities in accordance with FRS 102.

Mandatory and optional exemptions are contained in paragraphs 35.9 and 35.10 in an attempt to make the transition more straightforward.

For trading profit, Chapter 14 Part 3 CTA 2009 provides that where there is a change from one valid basis on which the trading profits have been calculated to another, an adjustment is calculated so as to ensure that business receipts are taxed once and once only and deductions are given once and once only.

Intangibles

It is possible that the carrying value of intangibles are adjusted in the opening FRS 102-compliant balance sheet (statement of financial position). No taxable credit or allowable debit is to be brought into account under Chapter 15 CTA 2009 at Part 8 to the extent that it is already brought into account by section 723 (revaluations), section 725 (reversal of accounting loss) or section 732 (reversal of accounting gain).

Where changes to the opening balances of intangibles takes place and no section 730 election has been made, section 872 will treat an increase as a taxable credit and a decrease as an allowable debit, arising at the start of the later accounting period.

Financial instruments

EU-adopted IFRS has been in existence in the UK for several years (applied mainly by listed companies) and the tax consequences of the transition were addressed by Change of Accounting Practice (COAP) Regulations (SI2004/3271). HMRC have confirmed that these regulations will be applicable on transition from old UK GAAP to FRS 101 Reduced Disclosure Framework and FRS 102.

Significant transitional adjustments arose in the accounting for financial instruments under EU-adopted IFRS and the effect of the regulations is to spread the transitional adjustment over 10 years, starting with the first period in which the new accounting policy applies. Other points to note are:

1. A loan relationship which comes to a natural end in the accounting period that the transition takes place because it is repaid or redeemed on the date which is the latest date on which, under its terms, it falls to be repaid or redeemed.
2. An embedded derivative that is bifurcated out of a loan asset or liability described in 1; or
3. A derivative contract which hedges a loan asset or liability described in 1.

Conclusion

This article has taken a look at some of the most notable points arising from a transition and the associated tax impacts. It is crucial that advisers fully understand the tax implications for their clients in order to correctly calculate any tax payable or refundable on transition and the tax impacts of adjustments to comparative year financial statements as a result of the accounting policy alignments needed under FRS 102.

Category: Accounting and standards, Audit