Under the asset-liability method, the tax rates used for future income tax calculations are those enacted

Under the asset-liability method, the tax rates used for future income tax calculations are those enacted at the balance sheet date, based on how the reversal will be treated for tax purposes.

Instructions

For each of the following situations, discuss the impact on future income tax balances.

(a) At December 31, 2010, Golden Corporation has one temporary difference that will reverse and cause taxable amounts in 2011. In 2010, new tax legislation sets tax rates equal to 45% for 2010, 40% for 2011, and 34% for 2012 and the years thereafter.

Explain what circumstances would require Golden to calculate its future tax liability at the end of 2010 by multiplying the temporary difference by:

1. …………….    45%.

2. …………….    40%.

3. …………….    34%.

(b) Record Inc. uses the fair value method for reporting its investment properties. The company has an investment property with an original cost of $5 million and a tax carrying amount of $3.5 million due to cumulative capital cost allowance claimed to date of $1.5 million. This asset is increased to its fair value of $8 million for accounting purposes. No equivalent adjustment is made for tax purposes. The tax rate is 30% for normal business purposes. If the asset is sold for more than cost, the cumulative capital cost allowance of $1.5 million will be included in taxable income as recaptured depreciation, but sale proceeds in excess of cost will be taxable at 15%. Calculate the related future income balance assuming:

1. the value of the asset will be recovered through its use

2. the value of the asset will be recovered by selling the asset  (c) Assume the same above for (a) and (b), but the company is now revaluing a tract of land and a building that are included in property, plant, and equipment. The change in revaluation has been reported in other comprehensive income. All numbers remain the same as discussed in (a) and (b) above. What differences in the tax impact, if any, would be required?

(a)

(1) The 45% tax rate would be used in calculating the future income tax liability at December 31, 2010, if a net operating loss expected in 2011 is to be carried back to 2010 (the enacted tax rate is 45% in 2010). (See discussion below.)

(2) The 40% tax rate would be used in calculating the future income tax liability at December 31, 2010, if taxable income is expected in 2011 (the tax rate enacted for 2011 is 40% and 2011 is the year in which the future taxable amount is expected to occur). (See discussion below.)

(3) The 34% tax rate would be used in calculating the future income tax liability at December 31, 2010, if a net operating loss expected in 2011 is to be carried forward to 2012 (the tax rate enacted for 2012 is 34%). (See discussion below.)

Discussion:

In determining the future tax consequences of temporary differences, it is helpful to prepare a schedule that shows in which future years existing temporary differences will result in taxable or deductible amounts. The appropriate enacted tax rate is applied to these future taxable and deductible amounts. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the reversal of existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods.

For future taxable amounts:

1.  If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related future income tax liability.

2.  If an operating loss is expected in the year that a future taxable amount is scheduled, use the enacted rate of what would be the prior year that the operating loss would be carried back to (or the enacted rate of the future year to which the carry forward would apply, whichever is appropriate), to calculate the related future income tax liability.

For future deductible amounts:

1.  If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related future income tax asset.

2.  If an operating loss is expected in the year that a future deductible amount is scheduled, use the enacted rate of what would be the prior year that the operating loss would be carried back to (or the enacted rate of the future year to which the carry forward would apply, whichever is appropriate), to calculate the related future income tax asset.

(b)

(1) Assuming that the company will recover the asset value through use, the company will generate taxable income of $ 8 million, but only be able to deduct CCA of $3,500,000.  Consequently, a temporary taxable difference between the current carrying value and the tax value is $8,000,000 minus $3,500,000 which is $4,500,000.   At a tax rate of 30%, a future income tax liability of $1,350,000 will be reported.  As the gain on this fair value adjustment is reported in net income, any change in the future income tax liability account required to report a total amount of $1,350,000 would also be reported in net income.

(2) If the company expects to recover the value of the asset through a sale in the next year, the proceeds on this sale will attract different income tax rates.  The future income tax liability should be calculated based on the applicable tax rates to be paid.  Given the above information, the future income tax liability is calculated as follows:

$1,500,000 will be recaptured and taxed at 30% = $450,000

$3,000,000 will be taxed as capital gains and attract a tax rate of 15% (as given in the question) = $450,000

Total future tax liability will be $900,000 (= $450,000 + $450,000).

Any change required to adjust the future tax liability will be reported in net income, as the fair value adjustment was reported in net income.

(c) If this property was measured using the revaluation method, the same numbers would apply as calculated above.  However, changes required to adjust the future tax liability account will be reflected in other comprehensive income, since the revaluation adjustment was reported to the other comprehensive income account.