Impact of IFRS on the Canadian Tax Practitioner (Oct. 2009)

The Canadian Accounting Standards Board January 2006 announcement to transition to International Financial Reporting Standards (“IFRS”) for annual periods beginning on or after January 1, 2011impacts all publically accountable enterprises meaning all publically listed companies or those who are responsible to a diverse number of stakeholders. Companies are now in the midst of preparing for this transition by assessing the impact of convergence with IFRS and options available under IFRS 1 while keeping an eye on those standards which may change between now and January 2011.

For those responsible for tax compliance internally or working on client engagements – a similar assessment process should be underway. The Canada Revenue Agency (“CRA”) has stated

“Once adopted for accounting purposes, financial statements prepared under IFRSs will be considered an acceptable starting point for computing taxable income. As well, all references to GAAP in CRA documents or tax legislation can be interpreted as IFRSs for those entities that report under IFRSs. After initial adoption, we expect taxpayers to apply IFRSs on a consistent basis to all income tax filing and all years. ”

The CRA’s requirement for financial information to be calculated in accordance with Canadian Generally Accepted Accounting Principles (“GAAP”), being IFRS as of January 2011, will still be met. What will change however are the measurement, recognition and timing of certain financial items and their corresponding impact on the calculation of taxable income.

In this article I discuss the most common convergence differences and how they may impact compliance. 

It should be comforting to know that IFRS and the current Canadian GAAP are conceptually similar in that they are both principles based and tend to reach the same conclusion on many issues.  Unfortunately, the application of IFRS can be quite different for particular issues and it is essential to review the details of each standard. In addition, companies will need to evaluate the options under IFRS 1 which is a one-time event and available only on convergence. When addressing tax compliance, the most important application difference relates to the measurement of specific financial items and whether the measurement methodology used is acceptable for calculating taxable income in Canada.   

The convergence to IFRS will require tax practitioners to perform additional work primarily in the identification of those financial items for which IFRS changes the measurement and the IFRS methodology either:

• deviates from the measurement specifically required by the Income Tax Act (“ITA”) or
• aligns itself to the measurement specifically required by the ITA.

There some financial items, such as inventory, where convergence with IFRS may result in adjustments to taxable income and other tax schedules in very specific circumstances.  The article discusses only broader changes which will affect the majority of companies.

Although this article deals with the impact of IFRS on income taxes, it is worth a quick comment on capital taxes.   In jurisdictions and for those companies where capital tax remains, generally the calculation of the capital tax base has been harmonized  with few adjustments from the balance sheet figures required; to the extent the measurement of the items on the balance sheet change, companies may see an increase (or decrease) in capital tax expense relative to pre-convergence years.

Property, Plant and Equipment

The majority of capital expenditures are not deductible for tax purposes in the year they are acquired. Rather the initial cost of an individual asset is added to a specific class of assets which is then depreciated into taxable income as a deduction at a prescribed rate.  This discretionary deduction (otherwise known as Capital Cost Allowance or CCA) may be taken at the earlier of when the asset is “available for use)” or the second taxation year after it is acquired. A public company however may begin deducting CCA (other than buildings) in the year it begins deducting accounting depreciation. 

For tax purposes the “capital cost” is the purchase price plus other costs incurred to prepare the asset for use.  Although both current Canadian GAAP and IFRS require companies to measure an asset at its initial cost – what constitutes initial cost under each differs.  Tax compliance staffs need to be aware of these differences to ensure that appropriate adjustments are made not only to the capital cost for tax purposes (Schedule 8) but in some circumstances to the calculation of taxable income (Schedule 1).

• Under Canadian GAAP, the initial cost would include legal obligations only in respect of asset retirement obligations such as decommissioning and restoration costs.  IFRS also requires constructive obligations to be included in initial cost.
• IFRS provide more details in respect of what may not be included in the initial costs such as the cost related to opening a new facility, introducing a new product or service (including advertising and promotion), and conducting business in a new location or with a new type of customer (including training costs).
• Canadian GAAP permits companies to capitalise interest costs attributable directly to the acquisition, construction or development of the asset.  Under IFRS, interest costs must be capitalised for certain qualifying assets.
• Currently net revenue/expenses derived from the asset prior to its readiness is included in the cost whereby IFRS requires these amounts to be recognized in the income statement as they do not relate to bringing the asset into operation.

After recording the initial cost, IFRS requires companies to choose from one of two options for measuring each class of assets: continued historical cost or (fair value) revaluation.  If a company selects the revaluation method, the resulting surplus or deficit is treated differently.  To complicate matters more, the treatment of the surplus or deficit is in respect of a specific asset and not an entire class of assets.

• A surplus is recorded in equity unless it is reversing a previous deficit which was recognized in the income statement in a prior year for the same asset.  This surplus may also be reduced by increases in liabilities relating to asset retirement (decommissioning) obligations.
• A deficit is charged first against any surplus for the asset and any excess to the income statement. 

The revaluation surpluses and deficits charged to the income statement would not relate to an asset disposition and would be an adjustment to the calculation of taxable income (Schedule 1).

Although component accounting is required by Canadian GAAP, IFRS is more explicit and can result in a component being physical (engine) or non-physical (overhaul).   There is potential for existing assets, when broken out into sub-classes for purposes of component accounting to have components that do not qualify as assets for tax purposes.  Moreover, these new components may require adjustments to, or reclassification of, assets in the existing CCA classes and possibly additions to other tax asset classes. .

Another potential change under IFRS will be the reclassification of assets as “investment properties” held to earn rental income or for capital appreciation (or both).  In some situations, tax staff may not be aware that existing properties have a rental component and, as such may not have been reflecting the corresponding income as investment income for tax purposes.  Furthermore, existing buildings may be broken out into separate classes for accounting if a portion is used for rental purposes.  Tax staff may need to spend additional time reconciling accounting classes to ensure all assets have been recorded for tax purposes.

IFRS explicitly requires a company to report its financial statements in its “functional currency” which is the currency of its primary economy where it operates and is determined using a number of factors. 

• Which currency is the main influence on its sales price (goods or services) and is typically the currency in which the sales are denominated and settled?
• Which currency represents the main regulatory and competition forces to determine the sales prices and the costs of those goods (inputs including labour)? 
• Other factors such as the currency of financing and receipts may also be considered.

It is conceivable that some Canadian companies may have to report in a foreign currency requiring separate financials to be prepared for tax compliance purposes.

Currently, foreign exchange gains or losses on translation or settlement of non-monetary items carried at fair value are recognized in the income statement for the period.  IFRS requires that foreign exchange gains or losses on non-monetary items be linked to the specific item itself so that if the non-monetary item gain is recorded directly into equity; the related foreign exchange gain or loss is also recorded in equity   Tax staff will need to ensure that all unrealised foreign exchange charged to the income statement is identified and excluded for in the calculation of taxable income (Schedule 1). Moreover, realised foreign exchange included in balance sheet items will need to be identified and included in taxable income for the year. 

The ITA has limited deductions for specific reserves and contingent liabilities but generally relies on case law and GAAP to define the terms.  IFRS will change these terms slightly as well as introduce new terms “constructive obligation” and “provision”. 

• A constructive obligation may be created by a public statement, pattern of past actions, or an indication to third parties – all of which establish an expectation that the obligation will be fulfilled.
• IFRS defines provisions as liabilities whose timing and amounts are not certain but is probable to occur.  Probable is defined as “more likely than not’ indicating a likelihood of the outcome of 50-95% (Canadian GAAP range is 70-95% for this term).

Additional steps may be required to assess whether all reserves, contingent liabilities and provisions in the financial statements also meet the criteria for deduction in the ITA or result in an adjustment to the calculation of taxable income (Schedule 1).   

It is not possible to cover all the changes that may be required on the convergence to IFRS as they will be specific to an acquisition.  IFRS 1 recognizes that compliance with this standard may be problematic and permits companies to choose between three alternatives being retroactive from the beginning of the company, retroactive from a specific date or prospective application from the convergence date.  Tax staff involved in compliance should be aware of the following possible changes on convergence.

• IFRS will result in a number of asset acquisitions being treated as business combinations.  IFRS defines a business as an operation which is acquired with the view to having an economic benefit (dividends, increased profits, etc).
• The cost of the acquisition includes contingent consideration which may not meet the criteria of “capital cost” or “adjusted cost base” for tax purposes.
• Canadian GAAP accounts for a “stage or step acquisition” using the cost of each individual purchase.  IFRS requires a company that acquires controls of an investment and had a pre-existing ownership, to revalue all of its interest at the most recent acquisition date with the corresponding gain or loss recorded in the income statement.  These gains or losses should not be recognized when calculating taxable income, or form part of the adjusted cost base.

One last notable differences tax staff involved in compliance should be aware of when calculation taxable income is IFRS permits a company to recognise actuarial gains or losses arising from assets in a defined benefit plan in any one of three manners with the difference from Canadian GAAP being that they may also be recognized in other comprehensive income.

Although none of the differences discussed above are complex from a tax perspective they do require forethought.  How accounting information required for tax compliance is measured, tracked and manipulated for use will change and could become more cumbersome and time consuming.  The tax department should be involved in the IFRS convergence project as early as possible to assess the impact on the information required and discuss with accounting how to begin streamlining the gathering process.

The Claret Partners Limited is a consulting firm dedicated to providing the best in regulatory compliance, tax, risk and governance services as consultants and project managers creating workable and practical solutions.  For more information please contact us at contact@theclaretpartners.com. 

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