The final version of the Accounting Standards for Private Enterprises (ASPE) was released in December 2009. Private enterprises have a choice — to adopt ASPE or International Financial Reporting Standards (IFRS). In either case, ASPE or IFRS are effective for annual financial statements relating to fiscal years beginning on or after January 1, 2011. Note that early adoption of ASPE is allowed. For entities adopting ASPE, changes may already be implemented or at least underway.
Accounting choices have an impact on tax. Private enterprises that choose to adopt ASPE need to consider the impact of any reporting changes from a tax perspective. Since net income for accounting purposes is the starting point for determining net income for tax purposes, it is critical to understand how accounting net income has changed as a result of ASPE in order to determine what accounting to tax adjustments are required. When converting to ASPE, there may be measurement changes due to mandatory ASPE policies, as well as optional elections that can be made. The resulting adjustments can impact retained earnings on transition and reported net income for accounting purposes from the date of transition onwards. The purpose of this article is to highlight the significant changes resulting from the conversion to ASPE that will impact tax.
ASPE changes to consider
Financial instruments
The following changes to the standards for financial instruments need to be considered as they will impact the computation of net income for tax purposes.
Valuation: Under the new financial instrument section in ASPE (Section 3856), certain financial instruments must be accounted for at fair value, which will result in adjustments when determining net income for tax purposes.
All financial instruments must be measured at fair value initially — when originated, acquired, issued or assumed in an arm’s length transaction. Generally, there are three methods of measurement after initial recognition: fair value, cost less impairment or amortized cost less impairment.
Investments in equity instruments quoted in an active market such as shares of a public company and derivative contracts such as forward contracts, foreign exchange contracts and interest rate swaps (other than derivatives designated to be accounted for using hedge accounting) will be measured at fair value. Other equity investments, such as minor investments held in private company shares are measured at cost less any reduction for impairment. All other financial assets and liabilities are measured at amortized cost. Note that entities can elect to account for any financial asset and financial liability at its fair value with subsequent changes going through net income. The designation is generally made at initial recognition and it is irrevocable.
For financial instruments recorded at fair value, the adjustments to fair value are not subject to tax. For tax purposes, gains and losses are recognized on actual dispositions based on original cost. Therefore, accounting to tax adjustments will be required to reverse fair value adjustments, thereby not recognizing unrealized gains and losses, and to report capital gains and losses on actual dispositions for tax purposes.
Keep in mind that where financial instruments are recognized at trade date for accounting purposes (at initial measurement and on disposition), there may be a timing difference for tax purposes as the settlement date is generally the relevant date for tax reporting and transactions normally settle three days after trade.
Impairments: The accounting standards with respect to impairments of financial assets have changed. Under ASPE, financial assets measured at cost or amortized cost must be assessed for impairment based on the rules set out in ASPE Section 3856, and impairment losses are booked to net income. Impairments can be reversed in a subsequent period if the situation changes, but the reversal cannot exceed the amount of the loss that was originally recognized. Note that the new impairment standards also apply to investments in subsidiaries and interests in joint ventures (ASPE sections 1590 – Subsidiaries, 3051 - Investments and 3055 – Interests in Joint Ventures). These types of investments and interests are also considered financial instruments, but are dealt with in separate sections of the CICA Handbook.
For tax purposes, any recorded impairment or subsequent reversal is not recognized and will not change the cost of the asset. Therefore, accounting to tax adjustments will be required in the period that the impairment (or reversal) is recorded and possibly in the period of disposition to ensure the proper gain or loss is ultimately recorded for tax purposes.
Transaction costs: The reporting of transaction costs under ASPE will depend on how the financial instrument is measured. For financial instruments measured at fair value, directly attributable costs such as legal fees, reimbursement of the lender’s administrative costs and appraisal costs associated with the financial instrument are expensed. For financial instruments carried at cost or amortized cost, the transaction costs that are directly attributable to their origination, acquisition, issuance or assumption are included in the carrying amount at initial recognition.
It will be necessary to keep track of transaction costs as accounting to tax adjustments may be required to ensure such costs are treated appropriately for tax purposes.
Keeping records: Financial statement records may not be sufficient to track the tax cost of investments. With adjustments for fair value and impairments in subsequent periods, and due to the differing treatment of transaction costs for accounting and tax purposes, the carrying value of investments for accounting purposes will often differ from the tax cost. As a result, the tax cost may not be easily obtained each year from accounting records. Therefore, it will be important to track tax costs separately to ensure the necessary information is available when investments are disposed of.
Retained earnings adjustments
On first-time adoption of ASPE, there will be adjustments to retained earnings due to mandatory policy changes and optional elections. Certain adjustments will be related to revenue and expense recognition changes, resulting in certain revenue and expense items possibly being reported twice in the income statement or not reported at all. Adjustments will also result if the optional election to measure property, plant and equipment at fair value is made. At the date of transition to ASPE, a corporation may elect to measure any individual item of property, plant and equipment at fair value, and use the fair value as the deemed cost at that date. The corresponding adjustment will be recorded in retained earnings.
From a tax perspective, accounting to tax adjustments may be necessary to ensure income and expenses are reported only once and in the proper period. Further to this, adjustments to retained earnings impact taxable capital. The largest tax impact may arise from the election to record property, plant and equipment at fair value as this will increase an entity’s taxable capital.
From a tax perspective, adjustments to retained earnings could impact an entity’s:
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Capital tax liability (in provinces where such tax applies);
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Corporate small business deduction due to the grind down of the deduction where taxable capital exceeds $10 million;
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Scientific research and experimental development incentives which are reduced at higher levels of taxable capital; and
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Interest deductibility under the thin capitalization rules.
Note also that if the election to measure property, plant and equipment at fair value is made, evidence of fair value must be provided and valuation related costs may need to be incurred. It will be necessary to consider how these costs are treated for tax purposes.
Since retained earnings adjustments impact taxable capital, consideration should be given to the impact an accounting policy choice has from a tax perspective when determining whether or not to adopt certain accounting policies under ASPE.
Income tax reporting
ASPE allows a free choice between using the future taxes payable method or the taxes payable method when accounting for income taxes in the financial statements. Previously, under Canadian GAAP, differential reporting allowed non-publicly accountable enterprises to use the taxes payable method only where owners unanimously consented to the use of the taxes payable method in writing. This consent is no longer required to choose the taxes payable method.
Where the future taxes payable method is chosen for reporting income taxes, consideration should be given to the impact of all the accounting policy choices under ASPE on future tax balances. Where changes to the accounting standards result in different carrying values of assets and liabilities in the financial statements, there may well be an impact on the balance of future taxes. As previously mentioned, fair value and impairment adjustments, as well as transaction costs impact the carrying value of financial instruments. In addition, the fair value election for property, plant and equipment will impact the carrying value of these assets. ASPE also allows entities the option to adopt a simplified method for accounting for defined benefit pension plans. All of these changes in measurement for accounting purposes will impact the calculated temporary differences and will therefore impact the balance of future taxes.
Where the taxes payable method is chosen, entities will report only the cost or benefit of current income taxes for the period. Under this method there will be no future tax recorded and therefore temporary differences will not be tracked. However, consideration should be given to maintaining a tax continuity schedule that tracks these differences to ensure that tax adjustments are not missed in the future.
Summary
The following are a few key points to keep in mind when considering the ASPE changes from a tax perspective:
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When determining the amount of income subject to tax, it is important to watch for accounting policy changes and optional elections under ASPE that require new accounting to tax adjustments for the first taxation year and on a go forward basis. Some adjustments will not be subject to tax at all, while others may need to be adjusted as temporary differences
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Process changes may be required to track cost information for tax purposes, where accounting records may not specifically track this information. This will be particularly useful for equities accounted for at fair value and for property, plant and equipment that has been written up to fair value
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It is important to consider the impact of optional elections on taxable capital, as well as on future tax balances (where this method of reporting is chosen)
ASPE requires changes to the financial statements of private enterprises and it is important to consider these changes from a tax perspective. For more information about the impact of ASPE on tax calculations and reporting, contact your BDO advisor.
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