Understanding the impact of COVID-19 on your 2020 deferred tax provision

Spotlight on Financial Reporting

COVID-19 has had a tremendous impact on Canada’s business landscape. The federal government announced a number of measures to help Canadian businesses alleviate cash flow and defer tax payments, while companies are mobilizing to rationalize costs, monetize assets and utilize cash surpluses to bridge their cash flow needs. Globally, governments have taken similar measures, most notably in the US, with Congress passing an historic $2 trillion-dollar stimulus, inclusive of numerous corporate tax measures. The speed of change has not given finance teams opportunity to determine the resulting financial reporting and compliance implications.

This article outlines key areas of your tax provision that could be affected by the impacts of COVID-19 and related tax stimulus and should be considered when preparing your 2020 tax provision for financial reporting purposes under IAS 12 Income Taxes (IAS 12). These issues may be applicable as early as Q1 for December 31 fiscal year ends.

Recognition of deferred tax assets

For established business with a long history of profitability, deferred tax assets are often recognized without debate for deductible temporary differences. For many companies, however, deferred tax assets are recognized for non-capital losses, but only when supported by convincing evidence of future taxable profit as outlined in IAS 12.35.  When it is no longer probable that future taxable profit will be available, the corresponding deferred tax asset can no longer be recognized under IAS 12. 

With the Canadian unemployment rate expected to hit 10% as quickly as Q2 2020^[1], some entities will be significantly challenged to support their profitability assumptions.  Further complications can also exist for companies with limited working capital reserves that may now be facing going concern challenges. While Canadian corporate taxpayers can carry net operating losses forward 20 years, companies may be challenged by regulators, auditors and others when projections of profitability exceed five years.     

Deferred tax liabilities associated with investment in subsidiaries

For many companies with foreign subsidiaries, accumulated foreign profit is reinvested in overseas operations or used to finance further global expansion. All the while, deferring withholding tax on distribution, should these earnings be repatriated to Canada through a dividend. When dividends are eventually paid, they are often received by the Canadian taxpayer with a full dividend deduction provided they are paid out of active business earnings of the foreign subsidiary. There are certain instances when these dividends are subject to corporate level tax in Canada. IAS 12.39 does not require the recognition of deferred tax liabilities associated with these “outside basis differences” so long as management has control over the disbursement of funds, and it is probable that these funds will not be repaid within the foreseeable future. With the COVID-19 pandemic, many reporting issuers are modelling possible contingency plans that may require funding future deficits associated with the resulting economic downturn. These plans may incorporate cash repatriation to Canada that could result in a corresponding tax liability. Depending on the implications of COVID-19 to your business, management should be assessing whether the deferred tax liability associated with these “outside basis differences” should now be recognized in the company’s financial statements.

Expected manner of reversal

Under IAS 12.51, taxable and deductible temporary differences are required to be measured using the rates at which these differences are expected to reverse. Often, the relevant rate is the general corporate income tax rate applicable to the profit of the entity. In some jurisdictions including Canada, however, the tax rates which apply to gains and losses on the disposition of property are different from these general rates. Business rationalization may be an inevitable fallout of COVID-19, which could alter the composition of existing temporary differences as well as the way those temporary differences reverse. This could result in a change in the appropriate tax rate used to measure certain components of deferred tax.

Interim reporting- effective tax rate

IAS 34 Interim Financial Reporting, paragraph 30(c), requires the use of the so called “effective tax rate method” or “ETR method” as the most appropriate depiction of a reporting issuer’s tax provision on a quarterly basis. The ETR method uses the weighted average annual expected income tax rate (ETR) and applies this to the pre-tax income of the interim period. The logic being that in the normal course, companies are taxed based on their annual income, which encompasses the activity of an annual fiscal period (all quarters of a year) and not the activity of one specific quarter. Absent significant uncertainty, a projected effective tax rate should be a reasonable approximation of an annual tax rate.   

With COVID-19 and the existing uncertainty as to when global economies will begin to recover, coupled with various government support and incentives that are being announced daily with the administration of the programs not yet finalized, it may be difficult to demonstrate that a reliable estimate of the annual tax rate can be made using the ETR. Furthermore, the composition of taxable income could be highly uncertain as a result of the government programs.

As reporting issuers look to record their income tax accrual for their quarters during fiscal 2020, consideration should be given to whether the continued use of the ETR method is a reasonable approach to reporting income taxes on an interim basis. If a reasonable estimate of the ETR cannot be made, reporting issuers may wish to consider a year-to-date actual tax calculation as the best estimate of the ETR. IAS 34 in general, requires anticipated tax credits and benefits, related to a one-off event are recognized in the interim period in which they are anticipated to be received. This requirement may further complicate the ability to derive a reasonable ETR.  

Additional Considerations

Some additional areas that companies should consider are:

• Receipt of Government Assistance: whether any government assistance received is within the scope of IAS 12 or IAS 20 Accounting for government grants and disclosure of government assistance
• Changes to tax law: certain governments have adopted tax reforms as a means of supporting business in 2020 potentially affecting substantially enacted tax rates and/or realization of deductible temporary differences
• Global tax planning arrangements: companies may be engaging in global tax planning arrangements to take advantage of the various government tax reforms and incentives related to COVID-19. Those tax planning strategies may need to be considered when preparing the 2020 quarterly tax provisions.

The items covered in this article are potential impacts that that the COVID-19 crisis might have on your income tax provision. This list is not exhaustive. The situation is fluid and government response around the globe is continuously changing.    

_{[1] https://business.financialpost.com/news/economy/it-will-no-doubt-get-worse-canadian-unemployment-rate-may-already-top-10-per-cent-as-global-jobless-claims-surge}