Donal O'Sullivan Partner Corporate Tax Services

Earlier this year, the Revenue Commissioners produced guidance notes on the International Financial Reporting Standards (IFRS) measures contained in Section 48 of the 2005 Finance Act. The guidance was issued as part of a complete set of notes covering the entire 2005 Finance Act. However, the Revenue Commissioners have been working for some time on more detailed notes that will contain additional material on foot of representations from several parties, including Ernst & Young. It is expected that a revised set of guidance notes on Section 48 will issue in the near future once the Revenue Commissioners have evaluated recent correspondence received as part of that consultation process.

General points
Section 76A of the Taxes Consolidation Act, 1997 (TCA 97) provides that a company’s trading profits should normally be computed in accordance with generally accepted accounting practice (GAAP). The Revenue Commissioners are expected to confirm that ‘profits’ in this context mean, where Irish GAAP is used, those reflected in the profit and loss account, and where IFRS is used, amounts reflected in the income statement. It is also expected that the Revenue Commissioners will outline the treatment of any gains and losses reflected in the Statement of Changes in Equity (i.e. reserves) that are subsequently recycled through the income statement.

The Revenue Commissioners have already clarified that statements of practice are not regarded as ‘law’ for the purposes of ascertaining what adjustments may be ‘required or authorised by law’. However, it would be preferable if confirmation was also given that all existing practices will continue to apply, even where the tax treatment may differ from the accounting treatment.

Leasing
The interaction of the new rules with the existing tax treatment of finance leases will be clarified in the new guidance notes. The tax deduction for lease payments incurred by a lessee is generally determined based on the legal form of the transaction rather than the accounting treatment. In arriving at a taxable profit figure, the lessee would typically disallow the depreciation and finance lease charges, and claim a deduction instead for the gross rental payments. Certain additional guidance regarding abnormal upfront payments is contained in Statement of Practice IT52.

Concerns had been raised that because the precise statutory basis for continuing to follow this treatment (as distinct from simply following the accounting treatment) is unclear, it is necessary for the Revenue Commissioners in their upcoming guidance notes to confirm that the tax treatment of finance leases remains unchanged. It is expected that the existing tax treatment of leases will be maintained.

Case III/IV income
Section 48 only applies ‘for the purposes of Case I or Case II’. However, there appears to be no reason why the requirement to compute income in accordance with GAAP and the transitional arrangements should not also apply to trading income chargeable under Case III and also to Section 110 TCA 97 securitisation vehicles (if these are no longer subject to ‘old GAAP’ as permitted by Section 48). This aspect is likely to be referred to in the new guidance.

Deferred consideration
Income recognition rules under IFRS may require a company to account for income on the basis of the fair value of any consideration receivable. If the income is received over a period of time, this may require a company to reflect only the net present value of the consideration at the outset, with a discount factor being reflected in ‘other operating income’ or as interest receivable. The expectation is that the Revenue Commissioners will confirm that if the consideration is a trading receipt, any difference between the nominal value of the consideration and the deferred consideration will also be regarded as trading income, as and when it is reflected in the income statement.

Similarly, where a company acquires a fixed asset on deferred payment terms, the cost of the asset may be reflected in the accounts at a net present value of the consideration to be provided. In this instance, the discount will likely be reflected as a finance cost rather than as part of fixed assets. It is understood that the Revenue Commissioners' preference is to treat the actual expenditure on the asset as the amount qualifying for capital allowances. The reluctance to allow a deduction for the discount might not be unrelated to the fact that not all fixed assets qualify for capital allowances.

If that view is reflected in the new guidance notes, it will mean that companies will need to carefully consider the various components of the finance cost recorded in the income statement. Different components could have different tax treatments. This is only one instance of many where finance costs could include more than the actual payment of interest. Further examples might arise when accounting for interest free loans and convertible bonds.

Share options
The Revenue Commissioners received a number of submissions relating to the tax treatment of share-based payments as outlined in Section 48.That provision denies a tax deduction for any consideration given by a company in the form of shares for goods or services, or to its employees or directors.

Section 48 1(c)(i) was introduced to preserve the denial of a tax deduction for the cost of providing shares or share options to employees. IFRS 2/Financial Reporting Standard (FRS) 20 would require companies to expense such costs. While the decision in Lowry v Consolidated African Selection Trust Ltd [1940], 23 TC 259, might suggest that such an expense is not deductible, there was a possibility that this 65-year-old decision might not find current favour with any court considering the new accounting rules. However, the amendment went much further than what was actually required to counteract the effect of IFRS 2/FRS 20. Section 81(2)(n) TCA 97 now denies a tax deduction for ‘any consideration given for goods or services, or to an employee or director of a company, which consists directly or indirectly, of shares in the company, or a connected company (within the meaning of Section 10) or a right to receive such shares …’

This prohibition is very widely drafted. The restriction will apply not only to shares issued to employees, but also to any goods (e.g. stock) acquired or services received in return for the issue of shares. The practical effect of the legislation comes into sharpest focus in the case where a company acquires a business and pays for the net assets by issuing shares. If the company acquires inventory for €150 and subsequently sells this for €200, a profit of €50 will be reflected in the company’s accounts. If the Finance Act 2005 was to be applied literally, the company would be taxed on the entire €200.

This is highly inequitable and represents a departure from the pre-Finance Act position. In Osborne (HMIOT) v Steel Barrel Co. Ltd, 24 TC 293, a deduction for stock was upheld by the UK Court of Appeal despite the fact that the stock, along with other assets, had been purchased partly in return for the issue of fully paid up shares to the vendor. Lord Greene observed, ‘When fully paid shares are properly issued for a consideration other than cash the consideration moving from the company must be at least equal in value to the par value of the shares and must be based on an honest estimate by the directors of the value of the assets acquired’.

It is expected that the Revenue Commissioners will take a common-sense approach to the above difficulty and that where a company acquires a business in return for shares, it will be entitled to a tax deduction for any trading stock acquired. However, it has also been pointed out to the Revenue Commissioners that trading stock might be acquired in return for shares without necessarily acquiring a business. Further clarification on when this provision is applicable may be required.

There are a number of exceptions that continue to allow a tax deduction for payments that are indirectly connected with shares, such as for payments to group companies. In a welcome move, the Revenue Commissioners have advised that the new guidance notes will contain several examples illustrating the tax treatment under certain scenarios.

Where a trust is used to hold shares for subsequent transmission to employees, any deductibility will, of course, be subject to Section 81A TCA 97.

Capitalised ‘revenue’ expenditure
The 2005 Finance Act maintains the status quo in relation to the tax treatment of interest and expenditure on research and development (R&D). The legislation states that a deduction shall not be denied simply because, under IFRS, it is included for accounting purposes in the cost of an asset. It is unclear if this means that ‘capitalised’ R&D costs are deductible on an amortisation basis rather than on a payments basis. Clarification on this point has been requested.

Transitional measures
The 2005 Finance Act contains transitional arrangements providing for the spreading, over 5 accounting periods, of certain specified adjustments arising on the transition to IFRS. Representations have been made that it may be more appropriate that the ‘spreading’ take place by reference to the continuation of the specific trade for 5 successive accounting periods rather than simply by reference to the existence of any trade. Problems may arise where a cessation of one trade occurs while the company continues to carry on a second trade.

The guidance notes on the 2005 Finance Act contain an example of the treatment of bad debts. However, it would appear that technically a legislative adjustment may be required to Section 81(2)(i) TCA 97 to allow bad debt provisions to be computed on the basis of the FRS 26/IAS 39 rules. The Finance Act itself does not contain any specific measure confirming that a tax deduction will be available for bad debts computed in accordance with IFRS/FRS 26. Such a statement is contained in the explanatory memorandum to the Finance Act. However, Section 81(2)(i) TCA 97 still prohibits a tax deduction for ‘any debts, except bad debts proved to be such to the satisfaction of the inspector and doubtful debts to the extent that they are respectively estimated to be bad …’ This apparent anomaly is all the more relevant where a debt becomes impaired, not because it will never be paid, but because it will be paid at some predicted future point in time (thus requiring the debt to be written down to its net present value).

Transitional measures apply to gains and losses on financial instruments. The legislation identifies the amounts of gains or losses which could be either double counted, or fall out of account, for tax purposes. Once these are calculated, the net amount is taken into account for tax purposes over a period of 5 years. The measures are most likely to apply where a company moves from a realisation basis of taxation to taxation based on fair value movements. However, they can apply to companies already operating on a mark to market basis.

The above transitional measures apply upon the application of ‘relevant accounting standards’ for the first time. ‘Relevant accounting standards’ will include Irish standards that are stated to embody international accounting standards. At present, the Irish standards that embody IFRS are FRS 20 to FRS 26 inclusive, most of which have limited application to non-listed entities for the time being.

In view of the fact that Irish standards will converge with international accounting standards over a period of time, Schedule 17A can apply on a piecemeal basis (i.e. as both sets of standards converge). The Revenue Commissioners are expected to confirm this in their latest guidance notes.

‘Bed and breakfast’ provisions
It has been pointed out to the Revenue Commissioners that the anti-avoidance rules that apply where group companies use different accounting frameworks make no reference to a tax avoidance motive being a prerequisite to the application of these provisions. It is not expected that this position will change.

Similarly, the 2005 Finance Act contains measures designed to prevent companies from ‘bed and breakfasting’ financial assets or liabilities on which they have incurred an unrealised loss, i.e. by crystallising that loss for tax purposes prior to the transition to IFRS/FRS 26, while at the same time not crystallising any real economic loss. The Revenue Commissioners have indicated that the measure is not conditional on there being a tax avoidance motive.

The ‘bed and breakfast’ anti-avoidance provision applies where there is a disposal of a financial asset or a financial liability at a loss in the 6-month period prior to the ‘changeover day’ (e.g. from 1 July 2005 to 31 December 2005, where IFRS/FRS 26 accounts are to be prepared for the first time for the year ended 31 December 2006). Where a loss on a disposal arises in this 6-month period, and within an 8-week period around that disposal (4 weeks before and 4 weeks after) the company acquired an economically substantially identical asset, the tax effect will be that the loss will only be allowed over 5 successive accounting periods, starting with the accounting period in which the disposal took place.

The legislation is primarily aimed at preventing companies taxed on a realisation basis from crystallising losses prior to the transition (at a time when such companies could delay the realisation of gains). It seems inequitable that the anti-avoidance measures could also apply to companies that account for tax on a mark to market basis prior to transition. The Revenue Commissioners are considering representations that a company should not be required to apply the measure to financial instruments if the taxable profits on such financial instruments were calculated on a mark to market basis prior to the move to IFRS. There is unlikely to be a significant advantage in such circumstances.

It appears that this anti-avoidance provision is disproportionate to its objective. It is likely to create significant practical difficulties for affected companies because accounting systems will likely need to be adapted to ensure that the relevant information can be captured. The 6-month period seems excessive and means that for companies moving to IFRS/FRS 26 with effect from 1 January 2006, this may require the monitoring of the acquisition of financial assets and liabilities from as early as 3 June 2005 onwards. In this regard, companies may require guidance as to what is meant by assets or liabilities ‘providing substantially the same access to economic benefits and exposure to risk’.

Preliminary tax
The Finance Act 2005 also contains specific rules concerning the preliminary tax payment requirements of companies moving to relevant accounting standards. The practical effect for companies with a ‘31 December 2005 year end’ is that unrealised gains and losses on financial assets or financial liabilities arising in the period 1 November 2005 to 31 December 2005 may be disregarded in ascertaining if an adequate first instalment of preliminary tax was made. Any shortfall must be paid over to the Revenue Commissioners by 31 January 2006.

The relaxation of the preliminary tax requirements is tainted by the administrative burden required of companies to avail of the measure and it remains to be seen if the provision can be of any practical benefit. Companies may incur substantial costs and encounter practical difficulties in ensuring that their accounting systems are capable of producing the necessary information for the relevant 2-month period in the very short time available (1 month) to take remedial action. Even then, the fundamental problem remains that many companies in all industry sectors already find it difficult to predict what their first instalments of preliminary corporation tax should be. It will be extremely difficult for companies to ensure that income volatility in areas other than unrealised gains and losses on financial instruments do not result in underpayments of the first instalment of preliminary tax.

The Revenue Commissioners have shown little sign of providing any further concessions in this area.

While the new guidance notes are likely to be very helpful, there are some further areas that will require attention. The tax treatment of financial instruments and foreign exchange gains and losses may prove particularly complex. Up to now, the focus of attention has primarily been on the larger numbers in the consolidated financial statements of listed entities and in particular on the accounting for deferred tax. Additional tax problems will no doubt arise as companies move to adopt IFRS in their individual entity accounts and less material tax issues emerge.