Tax Risk Markers Along the IFRS Roadmap

Deloitte shines a light on potential tax risks tied to IFRS adoption.

If you’ve ever complained about the complexity of corporate tax rules – wait – things are about to get more complicated. As part of a worldwide movement to standardize accounting rules, the U.S. Securities and Exchange Commission announced on Wednesday that it would be testing the waters with regard to moving U.S. companies to international financial reporting standards.

More than 100 countries have already signed on to do the same, most methodically abandoning local generally accepted accounting principles in favor of the still evolving IFRS. With the transition comes thorny accounting questions and still more complicated tax issues to untangle.

With that in mind, Deloitte has issued a three-page report on what its tax specialists view as the potential major tax risks inherent in a switch to IFRS. The key points are summarized below:

Local interest deductibility. A switch to IFRS could result in a change to retained earnings, which may have either a positive or negative effect on a subsidiary’s ability to deduct interest expense for tax purposes. Basically, highly leveraged subsidiaries may be denied interest deductions in jurisdictions that base their debt and equity limitations on data from the tax accounts. Further, standard setters are working on new rules that may reclassify some financial instruments that were once classified as equity, as debt. This reclassification could retrigger the same interest expense limitation rule.

Hybrid instruments. A change in the definition of equity under IFRS could eliminate the tax benefits of hybrid instruments because income may be treated as interest rather than a dividend.

Foreign currency gains and losses. With respect to recording transactions such as hedges and currency translation gains and losses, companies will have to determine whether the currency fluctuations are recorded as income or equity.

Amortization and other deductions. In the case of goodwill and other intangible assets, the tax basis often drives the calculation of the deduction for tax purposes. Some countries allow the use of either local GAAP or IFRS, so it makes sense compare the tax liability recorded under both methods.

Transfer pricing. Substantiating that intercompany pricing is done at arms length may become easier under an IFRS regime. Indeed, documentation to prove a company’s case is often based on financial data from comparable companies. As more companies adopt IFRS, finding supporting evidence may require fewer steps and less time.

Share-based compensation. Share-based compensation rules vary greatly. At the most basic level, a company should determine what deductions are possible under the local rules, versus IFRS. Tax managers should also take into consideration the interplay between local tax rules and corporate recharge, reimbursement, and transfer pricing arrangement for share-based compensation.

Repatriation strategies. Moving to IFRS likely will give companies the chance to revise cash repatriation strategies. That will play out in two way: Through the earnings available to be repatriated under local rules versus IFRS; and via the characterization of distributions held by the parent corporation (dividends versus return of capital).

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