Question

Why are tax effect entries sometimes necessary in making consolidation worksheet adjustments? Explain this in detail for the year ending 30 June 2017 using the following example:

Apple Ltd owns all the share capital of Pear Ltd. The income tax rate is 30%.

On 30 June 2017, Apple Ltd sold a motor vehicle to Pear Ltd for $15 000. The motor vehicle had a carrying amount to Apple Ltd of $12 000.

Answer 1

Tax entries are necessary in the consolidation worksheet because the sum of profits of all entities being consolidated need not necessaily be the profits of the Group, i.e. as a Group, there may be inter company transactions, wherein, the individual entities will be liable to pay tax, but in the Group level, the impact of profits and expenses is eliminated, and therefore, the associated tax impact also needs to be eliminated.

In the above example, Apple will book a profit of 3,000 in the standalone accounts and pay tax on the same. Pear Ltd will record the asset at 15,000 and accordingly, claim depreciation on 15,000. However, from the perspective of consolidated financial statements, for the Group, cost of the asset remains 12,000. Therefore, in consolidated accounts, the profit of 3,000 will be eliminated against the fixed asset and incremental depreciation charged by Pear. Before these adjustments impact the consolidated profit (i.e. sum of both entity profits will not be equal to consolidated profit), a corresponding tax impact for these adjustments is also required.

From the balance sheet perspective, the tax base of an asset/liability of a subsidiary, from a standalone subsidiary perspective, which is also generally used for tax purpose, will be different from the value of the asset in consolidated financial statements, where the parent will record the asset/liability at fair value on acquisition date. Therefore, these differences in tax base of asset and liability need to be appropriately reflected in the consolidated financial statements.

In the above example, Apple would have paid tax on profit of USD 3,000, i.e. USD 900 as tax, an amount which will not be reflected as a profit in the consolidated financial statements. This will therefore, require creation of a deferred tax asset. On the other hand, Pear has recorded the asset at USD 15,000 and accordingly booked higher depreciation. The excess depreciation will be eliminated as a part of consolidation adjustment. This will warrant creation of deferred tax liability. This deferred tax liability will keep accumulaating till the time a deferred tax liability is creted on the entire incremental depreciation of 3,000. Once the incremental amount of 3,000 is amortised, the deferred tax asset and liability (both on USD 3,000) wiill be eliminated as the book base and tax base of the asset will both be 0.