An additional P & L hit?
As set out in our news brief in November 2019, the IASB issued an exposure draft (ED) last summer which may have a significant impact on the level of deferred tax accounted for on decommissioning assets and liabilities for certain companies.
The IASB interpretations committee recently met to discuss the feedback on this ED and they have recommended that the proposal is taken forward, but with one very important and for some unwelcome change.
It seems very likely that the proposed changes to IAS 12 will be implemented as now proposed, and with retrospective effect.
As a recap, the recommendation to now be put to the IASB is that an exception from the Initial Recognition Exemption (IRE) should be included within IAS 12 such that it would not apply to transactions that give rise to equal amounts of taxable and deductible temporary differences, such as leases, and of most significance to oil and gas companies, as arise on setting up an decommissioning provision and a corresponding decommissioning asset. This means that in the first instance full deferred tax should be set up on such balances. This will however be subject to applying the usual criteria on whether a deferred tax asset can be set up in respect of the some or all of the decommissioning provision.
Crucially the “capping rule” included in the ED, which would have only required a company to set up a deferred tax liability on the temporary difference associated with an abandonment asset to the extent that a deferred tax asset could be recognised on the corresponding temporary difference associated with the decommissioning liability, is to be removed.
The existence of such a capping rule would have minimised the impact of any changes in IAS 12 on oil companies which are not currently able to recognise a full deferred tax asset on the decommissioning liability provision because of the uncertainty as to whether the amounts are recoverable. For some companies it will therefore be the case that they will need to set up a deferred tax liability but with either no, or only a partial deferred tax asset.
We have seen a number of broad approaches for the treatment under IAS 12 for temporary differences on decommissioning assets and liabilities in recent years, but the effect of this change will be to standardise the approach going forward, and will require companies who have not been compliant with the new approach to amend their accounts with retrospective effect.
We have not, in fact, seen many companies apply the IRE in practice to decommissioning assets and liabilities in the past. The more common approach has been to treat the decommissioning asset and liability as “integrally linked” such that as no net temporary difference arises on initial set up, the IRE can have no application.
Having taken this approach however there have been two possible outcomes.
The first, which will be consistent with any amended standard, is to provide for a DTL on the asset in full, and to set up a DTA on the liability to the extent that the deductible temporary differences represented by the decommissioning liability are considered recoverable.
Alternatively, based on the integrally linked approach, some companies have “netted” the asset and liability in the calculation of their deferred tax position. Initially no amount is set up but as the asset and liability diverge (as the asset is depreciated and the liability accretes) a DTA is generally set up on the net liability number. In particular, in considering whether the deductible temporary difference in respect of the provision is recoverable some companies have taken the view that one only needs to consider this net provision position. This approach will, under the new rules in the standard in effect mean that the DTL may have been understated.
This netting approach is not new, but it increased in popularity for oil companies when the SCT rate was increased to 62% and the recoverability of tax on decommissioning was restricted to 50%. Companies were faced with the possibility of setting up an excess of 12% on the liability compared to the asset.
Although the ED addresses the narrow question of the IRE, such that we are not expecting any new wording in the standard to specifically outlaw this netting approach, the discussion papers issued as part of the IRE review make it clear that this netting approach is inconsistent with IAS 12 and should not be adopted.
Comparatives will have to be restated as a result of the retrospective application of this new rule (following IAS 8 principles).
Although retrospective application is required, the normal practice is to be modified such that an assessment of the recoverability of the DTA need only be made at the time of the first period for which comparatives are to be restated as a result of the charge, rather than the recoverability position at inception.
To the extent that the change in accounting policy leads to a reduction in deferred tax asset, or a net increase in the deferred tax liability, then this amount will be required to be taken to reserves. Going forward, in respect of new transactions the difference arising as a result of the application these rules will be required to be taken to P & L. The new proposals only have retrospective application to the accounting for leases and decommissioning assets and liabilities. For other assets the new rules, once implemented, will apply prospectively.
It is possible that the amended standard will apply to periods beginning on or after 1/1/2021.
The removal of the capping option will be a disappointment to many companies. The staff paper setting out the final recommendations indicated that it was believed it would be unusual for there to be a mismatch between recognition of assets and liabilities on decommissioning provisions. The rationale for this statement was that the amounts are likely to be large and that companies will have tax planning options available to them in order to minimise the mismatch. This comment seems naive and for many companies will not represent their reality.
We would recommend that companies review their current approach to determine whether the implementation of these proposed changes to IAS 12 could have a material impact on their position.
If a reader would like to discuss this proposed change please contact Paul Rogerson, Andrew Lister or their normal CWE contact.