Tax Treatment of a Capital Asset Revaluation and Disposal
Sylhet Ceramics Ltd revalued its factory building upward by BDT 30,000,000 on 1 July, creating a revaluation surplus in other comprehensive income. The building's tax written down value is BDT 40,000,000 and its accounting carrying amount after revaluation is BDT 90,000,000. The company's tax adviser asserts that no deferred tax arises on the revaluation because the gain is unrealised and no tax will be paid until disposal. The company also sold a machine during the year for BDT 5,000,000 against a tax written down value of BDT 3,000,000, and the accountant has recorded the entire BDT 2,000,000 difference as a capital gain exempt from tax. The finance director is unsure whether either treatment is correct and asks for a review before the return is filed.
1. Evaluate whether deferred tax should be recognised on the building revaluation, and explain the correct treatment of the machine disposal for tax purposes.
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Building revaluation. The adviser's reasoning is wrong. Deferred tax is recognised on temporary differences, which are differences between the carrying amount of an asset and its tax base. The building's carrying amount is BDT 90,000,000 and its tax base is BDT 40,000,000, giving a taxable temporary difference of BDT 50,000,000. The fact that the gain is unrealised affects the timing of the tax, not the existence of the temporary difference. Deferred tax should therefore be recognised at the applicable tax rate on the full BDT 50,000,000 difference, and the deferred tax relating to the revaluation component should be charged to other comprehensive income rather than to profit or loss, matching the gain it relates to. Recognising it in profit or loss would distort the reported profit and leave the OCI reserve overstated.
Machine disposal. The accountant's treatment is also wrong. The BDT 2,000,000 excess of sale proceeds over the tax written down value is not an exempt capital gain; it is a balancing charge. In a pooling system, sale proceeds are deducted from the pool, and if proceeds exceed the pool balance the excess is taxable income, not a capital gain. The full BDT 2,000,000 should be included in taxable income and taxed at the normal rate. Treating it as exempt understates taxable income and creates a tax exposure plus potential penalties and interest.
Summary. Both treatments are incorrect and both understate the tax charge and the deferred tax liability.
2. Explain the disclosure and compliance consequences of the errors and the steps the company should take before filing.
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Consequences.
- The deferred tax liability is understated by the tax effect of BDT 50,000,000, which is material to the balance sheet and to the OCI reserve.
- Profit or loss is overstated because the BDT 2,000,000 balancing charge has been excluded from taxable income, understating the current tax charge.
- The tax return, if filed on the current basis, would be incorrect, exposing the company to additional assessment, interest and penalties, and potentially to penalties for inaccurate returns.
- The financial statements would contain a prior-period-type error once corrected, and the auditor would be required to evaluate materiality and whether adjustments are needed.
Steps before filing.
- Recompute the deferred tax on the building at the enacted or substantively enacted rate and split the charge between OCI and profit or loss.
- Reclassify the BDT 2,000,000 as taxable balancing charge and recompute current tax.
- Reconcile the tax computation to the accounting profit, documenting every adjustment.
- Discuss the correction with the tax adviser and obtain written advice supporting the revised position.
- Consider whether the error is material enough to require disclosure of the correction and whether any voluntary disclosure to the tax authority is advisable to mitigate penalties.
- Document the review in the tax governance file, since a repeat of the same error would suggest a control deficiency.