U.K. ‘Super’ Tax Deduction—Tax & Accounting Impact—Part 2

Accounting for income tax is overly complex due to deferred income taxes. Years ago, the Financial Accounting Standards Board (FASB) concluded that deferred income taxes are functionally “assets” and “liabilities” and so we must contend with this consequential accounting (at least until FASB produces a better and simpler model).

In plain English, deferred income taxes are future receipts and payments of income tax from the future usage of productive and investment assets and future payments of non-tax liabilities. Think about it as “payback” of tax decisions and elections made today for assets and liabilities expected to affect current and future income. Accelerating tax depreciation to Year-1 due to a “Super” deduction means the payback is going to be in Year-2 through Year-6, because there would be no cost offset against the taxable profits of those years. A deferred tax liability would arise in Year-1 for the forgone future tax amortization savings in Year-2 through Year-6.

The real secret is this: Without deferred income taxes, the effective tax rate would be “all over the map,” because tax laws rarely follow financial accounting. It is a tax rate “normalization” procedure to ensure the effective tax rate is as close as possible to the statutory tax rate, which is what corporate decision makers monitor.

To illustrate how deferred income tax accounting should work, we use the example from Part I replicated below.

An asset costing £1 million and written off using the annual investment allowance (AIA), the current tax benefit in 2021 would be £190,000 (19% times £1,000,000) and the deferred tax expense would be £191,500 (sum of forgone tax amortization benefits in 2022 to 2026). The resulting net tax expense of £1,500 is due to the tax rate increase recognized in income tax expense in calendar 2021 (yielding a “negative” effective tax rate). In plain English, the tax rate increase would cost a company more tax dollars than the tax saving received from the annual recovery allowance in 2021, ignoring time value of money or cost of capital. The table below summarizes the tax accounting.

Obviously, the “Super” deduction is a better option than the AIA, because it increases the current tax rate of 19% by a 1.3 multiplier to offset or blunt the tax rate increase. The current tax benefit of £247,000 received in calendar 2021 less a deferred tax expense of £191,500 (sum of forgone tax amortization benefits in 2022 to 2026), netting an income tax accounting benefit of £55,500. The table below summarizes the tax accounting.

A brief precursor of accounting thought before we explain the “emerging” income tax accounting for the “Super” deduction and whether recording a net tax benefit (as described above) is acceptable.

U.S. accounting standards historically incorporated “conservatism,” “matching income and expense,” “off balance sheet,” “voting-power control,” “no immediate income recognition from acquisitions,” “historical cost bases,” and more. However, in less than 20 years, accounting thought has radically changed, in large part due to accounting scandals such as the Enron, Lehman Brothers, and the like.

Fair value accounting and its “forward looking” attendance, putting “everything” on the balance sheet, and accelerated income and expense recognition have all become recurring themes in every accounting standard FASB has manufactured in the last two decades. A prime example is the newest standard on credit loss, which requires estimation of potential credit losses into the “infinite” future.

The accounting standard for business combinations is an example of the shift in accounting thought. Introduced in 2007, the revised business combination rule did a 180-degree shift in accounting for deals. First, it mandated that we recognize all acquired assets and liabilities at their fair values including goodwill. Second, it required immediate income recognition of a bargain purchase gain instead of reducing the fair value basis of other acquired assets until the “bargain” gain disappears (distorting the opening balance sheet to avoid immediate income recognition).

On the tax front, the revised rules barred recognition of changes in acquired deferred income taxes through goodwill adjustment to preserve the acquisition-date fair value of goodwill for future impairment testing (and more recently, limited amortization for non-public businesses).

The income tax accounting standard issued in 1992 and now under FASB’s Accounting Standards Codification ASC 740 (previously known as “FAS 109”) has stayed the same for 30 years with limited improvements. Making changes and simplifications has proven difficult. The income tax disclosures project is languishing over five years, diluted so many times that it has lost its relevance (a global push for a minimum tax and greater transparency of income tax paid by multinational corporations may resuscitate it).

One simplification success story is the 2016 change to stock option accounting fought against strong opposition from powerful constituents (I would not call their names here, and leave it to your imagination).

Since the time stock options got expensed (around 2006), the income tax benefit of stock options deduction was “buried” (yes) in equity, never hitting the income tax expense, which was inflated due to the stock option tax benefit plugged into equity. Income tax expense was “grossed up” by the actual income tax benefit from stock option deductions, thereby shifting the actual cash tax savings to equity. This convoluted accounting finally ended in 2016. FASB deserves credits when credit is due. It did the right thing with the stock options tax accounting, as it also did with the accounting for uncertain tax benefits years earlier.

With this background in mind, we can finally discuss the accounting options for the U.K. “super” deduction income tax law.

In my view, most accounting professionals and corporate accounting decision makers would call the net income tax effect by its name: “A current income tax benefit and a deferred tax expense” that belong in the income tax line of the income statement (simple but logical as illustrated in the previous table). The latter years’ whipsaw effect due to the higher deferred tax rate of 25% does not change this conclusion.

If you thought this is a logical accounting for an income tax effect, the accounting profession’s thought leadership “gatekeepers” have a different view. The correct accounting, according to the “gatekeepers,” lies in an old FASB’s Emerging Issues Task Force (EITF) interpretation from 1998. Like many other interpretative “pronouncements,” this one was also codified into the ASC 740 verbatim. The EITF is the equivalent of the “elite” accountants making interpretative recommendations and rules, which FASB adopts (or sometimes rejects).

So, what is the accounting treatment according to them?

The answer is we are not allowed to record the income tax benefit of the “Super’’ deduction effect in income tax expense and instead we must defer recognition (put the excess tax benefit on the balance sheet) and overtime shift the income tax benefit to pretax income. You might ask why and how (very reasonable questions). They point to this 1998 interpretive pronouncement, which now resides in three paragraphs in ASC 740 (if you are curious, the exact paragraphs are 740-10-25-51 and 740-10-55-171).

What does EITF 98-11/ASC 740 require?

Remember that this interpretation was issued when FASB believed you should not record income or gain from acquisitions of businesses or assets and that income and expense should be “matched.” Consistently, the EITF 98-11 concluded that when a business acquires an asset (or a group of assets that do not qualify as “business” and thus precluding business combination accounting), and the asset’s tax basis is higher than the cash paid for the asset, the tax effect (from excess tax basis over amount paid) must be deferred on the balance sheet and released to pretax income throughout the asset’s recovery life. The way to accomplish this shift from income tax to pretax is by using what mathematicians (yes) call “simultaneous equations.”

But before we solve a mathematical challenge, let us understand the accounting in simple words.

When we defer accounting recognition of income tax benefit, we fudge the balance sheet to shift the accounting impact from income tax expense to pretax income. There is no other way to accommodate this income statement “manipulation.”

Mechanically, we force the carrying value of the acquired asset downward to accommodate the tax benefit effect that we seek to defer (really, “hide”) on the balance sheet. Using the “simultaneous equations” (look it up), we create a deferred tax asset by forcing a lower carrying value than the cash value. To be fair, this is not the only place in ASC 740 we fudge the balance sheet. There is a similar “preferred” accounting for investment tax credits (a separate topic for another blog) and excess tax goodwill over book goodwill.

So back in 1998 it was okay to fudge the carrying value of an acquired asset (or a group of assets), as in business combination with a bargain gain, to shift an income tax effect to pretax income. In both instances, the gains were deferred on the balance sheet and manifested in later years through lower book depreciation of the affected asset(s) (higher pretax income or lower pretax loss).

With this understanding, let us turn back to the U.K.’s “Super” deduction law using the above example to illustrate this convoluted accounting.

The extra tax benefit in our example is worth about £55,500 after considering the tax rate increase. Without the impact of tax rate increase and under the “deferral and shifting” approach of EITF 98-11, the preliminary extra tax benefit is £57,000 (19% x [1,300,000 - 1,000,000]). Now we cannot just reduce the asset’s book carrying value by £57,000 without multiple calculations before we find a book value that would balance with the “emergent” deferred tax asset. The simultaneous equations solve this mathematical riddle. The shortcut is this: The “additional” tax basis of £300,000 divided by one, minus the applicable tax rate of 19% or 81%, for a “grossed up” basis difference of £370,000 and a “grossed up” deferred tax asset of about £70,000 (£370,000 x 19% equal £70,000 and minor change).

Now let us stop for a minute and understand what it is. Ignoring the time value of money and the tax rate increase impact, the tax benefit from this “extra” basis is only £57,000, but for accounting we are going to pretend it is £70,000 and we are going to shift an inflated number into pretax income due to the EITF 98-11 accounting.

Time to put the numbers together for those who like to see the debits and credits balance.

We already concluded that the first year (2021 in our illustration) current tax benefit is £247,000, but we are unsure about the deferred tax accounting. The initial step of fudging the balance sheet results in a deferred tax asset of £70,000 that reduces the asset’s book carrying value (£930,000 instead of £1 million purchase cost). But the tax basis fully deducted in the first year causes a reversal of this deferred tax asset to income tax expense (remember that deferred taxes are “paybacks” and this one is no different). But there is more income tax accounting.

Book carrying value remaining after 2021 is £775,000 (930,000 – 155,000) but the tax basis is zero and we need additional deferred tax liability of £182,125 (sum of forgone tax amortization benefits in 2022 to 2026 as per table below).

The net tax expense in 2021 is £5,125 (£247,000 - £70,000 – £182,125). Total accounting income tax benefit is £177,000 (net expense of £5,125 in 2021 plus £182,125 of deferred tax benefit from reversal of deferred tax liability). The effective tax rate expected over the asset’s life is 19% or a normalized tax rate (£177,000/£930,000). The table below summarizes the tax accounting.

As illustrated above, the total income tax benefit of £247,000 shows up in pretax income (£70,000) and income tax expense (£177,000). The EITF 98-11 accounting shifted an inflated tax benefit of £70,000 (instead of £57,000) from income tax to pretax income by reducing the asset’s carrying value and book deprecation. It also created a net tax expense in 2021 larger than the tax rate increase (£1,500) by “releasing” an “inflated” tax asset (£70,000 instead of £57,000). This is nonsensical accounting, despite achieving a normalized income tax rate.

Now remember the “tax rate v. tax basis” debate in Part I. While the economics are the same, the financial reporting as illustrated here is vastly different under EITF 98-11 “defer and shift” accounting than under regular income tax accounting.

In full disclosure, FASB did raise the question in 1988, albeit in a footnote, “what is a tax basis,” and provided a logical answer that it depends on the specific tax law’s wording (the footnote is in ASC 740). But what if the wording is unclear or inconclusive?

If a business decides to elect the “Super” deduction for U.K. assets acquisition, the simple, more informative (and logical) accounting is to book both the current and deferred income tax effects in income tax, period. The income tax footnote should disclose the net impact on income tax expense when the impact is material.

FASB has manufactured complex standards in recent years, while it promises simplification of existing and new standards. The recent changes to ASC 740’s intraperiod and interim reporting rules were welcomed but are not enough. FASB should continue “going down” the list of complex and often nonsensical requirements such as this EITF 98-11 rule and simply eliminate them.

There is no better (and simpler way) to improve financial reporting transparency and relevancy of income tax information by affirming that we shall recognize and present all income tax effects in income tax expense. That would be a simple and sensical principle to follow when faced with tax laws like the U.K. “Super” deduction law and a multitude of income tax credits.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Yosef Barbut is a tax accounting consultant who previously was a partner in BDO USA’s National Office, and prior to that, a income tax accounting consultant in the PwC National Accounting office.

Special acknowledgment of Ingo Harre, a German-based certified public accountant and income tax accounting specialist and former senior tax manager with BDO Germany, for his review and contribution.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.