Prestwick: an uncertain R&D deduction, an enacted rate change and a loss carryforward
Prestwick Industries has an accounting profit before tax of 12,000,000 for the year ended 31 December FY13. Its tax rate is 30%. Permanent items are a non-deductible regulatory fine of 200,000 and exempt dividend income of 300,000. Prestwick's return claims an incremental R&D super-deduction of 1,500,000. Counsel advises that there is a 65% likelihood the full deduction will be sustained on review, a 20% likelihood only half will be sustained, and a 15% likelihood none will be sustained. At year-end Prestwick has a tax loss carryforward of 4,000,000 expiring in five years. It also has taxable temporary differences of 1,200,000 that will reverse in FY15. Forecast taxable profits, before use of the loss, are 900,000 in FY14 and 1,100,000 in FY15; no reliable forecast exists beyond FY15. Prestwick has a history of losses and only recently returned to profit. In December FY13 legislation was enacted reducing the tax rate to 25% with effect from FY15.
1. Compute current tax expense for FY13, including the measurement of the uncertain R&D position, and justify the measurement method.
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Current tax per the return.
- Accounting profit: 12,000,000
- Add back non-deductible fine: +200,000
- Deduct exempt dividend: -300,000
- Deduct the super-deduction claimed: -1,500,000
- Taxable income per return: 10,400,000
- Tax at 30%: 3,120,000
Uncertain tax position. Because there is a range of outcomes, measure the deduction using expected value: (65% x 1,500,000) + (20% x 750,000) + (15% x 0) = 975,000 + 150,000 = 1,125,000. That is the amount of benefit that is probable of being sustained.
Consequence. The 375,000 excess deduction (1,500,000 - 1,125,000) is not recognized, so an uncertain tax liability of 375,000 x 30% = 112,500 is recorded. Total current tax expense = 3,120,000 + 112,500 = 3,232,500.
Justification. Expected value is appropriate because there is a population of similar exposures and a probability distribution over three discrete outcomes; it is the method that best predicts the resolution. Under a most-likely-amount approach the full deduction would be sustained because 65% exceeds any other single outcome, giving no liability at all - the two methods give different answers, so the choice must be reasoned and disclosed. Note the asymmetry: the 200,000 fine and the 300,000 dividend are permanent differences and create no deferred tax.
2. Compute the deferred tax balance at 31 December FY13, including the valuation allowance on the loss carryforward, and explain the judgement applied.
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Rate selection. All items are expected to reverse in FY15 or later, when the enacted rate is 25%, so 25% is applied to each. A trap here is using 30% because it is the current-year rate; the rate used is the one expected to apply on reversal.
Gross balances.
- Deferred tax asset on the loss: 4,000,000 x 25% = 1,000,000
- Deferred tax liability on taxable temporary differences: 1,200,000 x 25% = 300,000
Recoverability of the asset. Sources of future taxable profit available to utilise the loss:
- Reversal of the taxable temporary difference: 1,200,000
- Forecast FY14 profit: 900,000
- Forecast FY15 profit: 1,100,000
- Total: 3,200,000
Only 3,200,000 of the 4,000,000 loss can be supported, leaving 800,000 unsupported. Valuation allowance = 800,000 x 25% = 200,000. Net deferred tax asset = 1,000,000 - 300,000 - 200,000 = 500,000.
Judgement. Three points must be documented. First, the 1,200,000 reversal is a genuine source of taxable income even though it is a liability, because it will be taxed; excluding it is a common error. Second, the five-year expiry matters: the forecast is only reliable for two years, and if later-year profits are not expected, the allowance stands regardless of the expiry window. Third, the recent loss history means the 900,000 and 1,100,000 forecasts require corroboration - board-approved budgets, order books and covenant headroom - before they can be used as a source. If the FY14 forecast is revised down, extend the allowance rather than keep the asset.
3. Explain how the enacted rate reduction should be reflected, including where the effect is recognized, and whether the uncertain tax position affects the deferred tax computation.
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Measurement. Deferred tax is measured at the rates expected to apply when the temporary differences reverse, based on rates enacted or substantively enacted by the reporting date. The 25% rate was enacted in December FY13 with effect from FY15, and every relevant reversal is expected in FY15 or later, so 25% applies to the whole of the deferred tax computation for FY13.
Where the effect goes. The remeasurement of the opening deferred tax balances at the new rate is recognized in profit or loss in FY13, not retrospectively. The exception is an item that was originally recognized in other comprehensive income or directly in equity, where the related remeasurement follows the same route. There is no restatement of prior-year comparatives.
Disclosure. Disclose the nature of the rate change and the amount of deferred tax income or expense arising from it, so that the reader can separate the rate effect from current-year trading. Presenting the 25% rate without the quantified effect is a common filing weakness.
Interaction with the uncertain position. The 375,000 of unrecognized deduction is a current tax exposure, not a temporary difference: it is a liability for tax on income already reported, so it is classified as current tax payable. It does not create a deferred tax balance, because the uncertain amount is not an asset that will be recovered in a later period. Separately, the exposure is a contingent liability and needs disclosure of its nature and an indication of the uncertainty, unless the possibility of outflow is remote - which a 15% likelihood of complete disallowance is not.