Corvane Ltd: Uncertain Tax Position and Deferred Tax on Restricted Losses
Corvane Ltd has profit before tax of $4.2 million for the year ended 31 December 20X5. The draft accounts include a $900,000 deduction for management services charged by a foreign affiliate. Corvane has no contemporaneous transfer pricing documentation for the charge. Its advisers assess a 30% probability that the tax authority will disallow the deduction if challenged, and a 70% probability that it will be accepted; the authority has not opened an enquiry. Corvane also has $2.6 million of brought-forward tax losses, all in the same company. Forecast taxable profits before loss relief are $1.4 million (20X6), $1.5 million (20X7) and $1.6 million (20X8), but $0.6 million of the 20X6 figure depends on a contract not yet signed. Losses carry forward indefinitely, but relief is capped at 50% of taxable profits above $1 million each year. The enacted tax rate is 25% for 20X5 and 23% from 20X6 onwards.
1. Explain how the uncertain transfer pricing deduction should be recognised and measured, and quantify the amount.
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Framework. Uncertainty over income tax treatments is measured under the IFRIC 23 principles: assume the tax authority examines the position with full knowledge, then measure using whichever of the most likely amount or the expected value better predicts the resolution.
Measurement.
- Expected value = 30% x $900,000 x 25% = $67,500.
- Most likely amount = nil, because acceptance is 70% likely.
The outcome is binary and relates to a single item, which points to the most likely amount. But the 30% disallowance probability is not remote, the amount is large relative to profit, and the position lacks contemporaneous documentation, so the expected value better reflects the economic exposure and is the more prudent measure. Recognise a current tax liability of $67,500: Dr tax expense, Cr current tax payable.
Presentation. The $67,500 is part of current tax, not a provision under IAS 37. The $900,000 deduction remains in the tax computation unless and until it is disallowed. If the authority later accepts the charge, the liability is released through tax expense. Penalties and interest, if any, follow the applicable tax rules and may be presented separately.
2. Determine the deferred tax asset that can be recognised on the $2.6 million of losses, applying the cap and the forecast evidence.
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Step 1 - how much loss can be used each year. Relief is capped at 50% of taxable profit above $1 million, so usable loss = $1.0m + 50% x (profit - $1.0m).
Prudent view: exclude the $0.6m dependent on the unsigned contract, so 20X6 profit is $0.8m and the cap does not bite.
| Year | Profit | Loss used | Rate | DTA |
|---|---|---|---|---|
| 20X6 | 0.80 | 0.80 | 25% | 0.200 |
| 20X7 | 1.50 | 1.25 | 23% | 0.288 |
| 20X8 | 1.60 | 0.55 | 23% | 0.127 |
| Total | 2.60 | 0.615 |
Step 2 - recoverability. The losses are usable in full by 20X8 even on the prudent forecast, so the recognition threshold (probable future taxable profit) is met for the whole $2.6m. No valuation allowance is needed, but the $0.6m contract dependency should be disclosed as a judgement.
Step 3 - rate. Losses used in 20X6 are measured at the 25% rate enacted for 20X5; losses used from 20X6 onwards are measured at the 23% rate enacted for those years. Using 25% throughout would overstate the DTA by about $0.02m.
The DTA of approximately $0.615m is presented as non-current unless settlement within twelve months is expected.
3. What disclosures and audit evidence would you expect in respect of these two tax judgements?
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Disclosures
- The nature of the transfer pricing uncertainty, the possible amount of the disallowance ($900,000 deduction, $67,500 tax) and the basis of measurement, including why expected value was used.
- Key judgements and estimation uncertainty, including the sensitivity of the DTA to the $0.6m unsigned contract and to the loss-relief cap.
- A reconciliation of the tax charge showing the effect of the 23% rate change if material.
- The unrecognised losses, if any, and the expiry profile (here indefinite).
Evidence
- The affiliate agreement, invoices, service descriptions and benchmarking or transfer pricing documentation, plus the advisers' opinion and their credentials.
- Correspondence with the tax authority and confirmation that no enquiry is open.
- Board-approved profit forecasts supporting the loss utilisation, with the unsigned contract's status, probability and expected signature date.
- The enacted rate change legislation and the mechanical calculation of the cap year by year.
- Written representations from management on the completeness of uncertain positions and on the forecasts.
The auditor should also consider whether the 30% figure is management's own estimate or independent advice, and whether the expected value or most likely amount is applied consistently across all tax positions.