Chapter 5.7® - Reconciliation of Effective Tax Rates & Differential Reporting & Accounting Treatment of the Investment Tax Credit

• Part 5.1 - Accounting for Corporate Income Taxes & Intra-period Tax Allocations
• Part 5.2 - Income Tax Provision or Expense? Differences between Taxable & Accounting Income (Permanent & Temporary Differences)
• Part 5.3 - Conceptual Issues in Interperiod Tax Allocation - Comprehensive & Partial Tax Allocation Methods (theory only)
• Part 5.4 - Future Tax Calculations using the Deferral or Liability (Accrual) Methods, Basic Illustration of Interperiod tax Allocation
• Part 5.5 - Changes in Income Tax Rate, Recording Future Tax Liability
• Part 5.6 - Difference between Carrying Value and Tax Basis
• Part 5.7 - Reconciliation of Effective Tax Rates & Differential Reporting & Accounting Treatment of the Investment Tax Credit

The tax status of the corporation may not be obvious to the financial statement users. The reason is that the income tax expense (including both current and future taxes) reported by the company on its financial statements may appear to bear little resemblance to the expected level of taxes under the prevailing statutory tax rate.

For private companies, the difference between the actual tax expense and the statutory tax rate can readily be explained to the small number of stakeholders if they need to know. In a public company, there is no way for an individual investor or creditor to know what factors caused the variation in the tax rate.

Differential Reporting:

A corporation is not publicly accountable if none of its securities is traded in the public securities markets – that is, it is a private corporation. But certain types of enterprises are publicly accountable even of their securities are publicly traded.

For the application of the differential reporting, all of the corporation’s shareholders must agree unanimously, in writing. The consent requirement applies to the holders of non-voting share as well as to voting shares.

Accounting Method:

Qualifying corporations may elect to use the taxes payable method of accounting for income taxes instead of comprehensive allocation. Under this method,

“….an enterprise reports as an expense of the period only the cost (benefit) of current income taxes for that period, determined in accordance with the rules established by taxation authorities.”

Cash Flow Statement:

The impact of income tax accounting on the cash flow statement is clear: all tax allocation amounts must be reversed out of transactions reported on the cash flow statement. The cash flow statement must include only the actual taxes paid.

When the indirect method of presentation is used for operating cash flow, future tax assets and liabilities that have been credited (or charged) to income must be subtracted from (or added back to) net income. The reversals include both (1) allocations relating to temporary differences and (2) benefits recognized for the future benefits of tax loss carryforwards. When the direct method of presentation is used, the cash used for (or provided by) income taxes must include only the taxes actually paid (or payable) to the government and tax refunds actually received (or receivable) from the government.

The Investment Tax Credit:

General Nature:

The Income Tax Act provides for investment tax credits for specified types of expenditures for capital investment and for qualifying research and experimental development expenditures. The expenditures that qualify for the investment tax credit is a matter of government policy and change from time to time. The idea is that, by giving a tax credit, the government can influence companies to increase investments in certain types of facilities and in selected geographic areas by effectively reducing their cost. The expenditures that qualify vary on three dimensions:

A tax credit is a direct, dollar-for-dollar offset against income taxes that otherwise are payable. The advantage of a tax credit (instead of a tax deduction for the expenditures) is that the amount of the tax credit is not affected by the tax rate being paid by the corporation.

Accounting Treatment:

There are two possible approaches to accounting for the investment tax credit:

1. the flow-through approach, whereby the ITC for which the corporation qualifies is reported as a direct reduction in the income tax expense for the year; or
2. the cost-reduction approach, in which the ITC is deducted from the expenditures that give rise to the ITC; the benefit of the ITC is thereby allocated to the years in which the expenditures are recognized as expenses.

Expenditures Reported as Current Expenses:

The government often grants ITC for research and development expenditures. Some of those expenditures will not qualify for the defer-and-amortize approach for development costs and will be charged to expense in the period in which they are incurred.

Investment tax credits that relate to expenditures that are reported as expenses in the income statement are permitted to flow through to the income statement.

The ITC on current expenses may be recognized in either of two ways:

The second method may seem more consistent with the cost-reduction approach, but it is contrary to the general principle that revenues and expenses should not be shown net of taxes.

Expenditures Capitalized or Deferred:

If the ITC qualifying expenditures are for a capital asset or are for development costs that can be deferred and amortized, then the ITC itself is deferred and amortized on the same basis as the asset. This can be accomplished either by reducing the capitalized cost of the asset or by separately deferring and amortizing the ITC:

Investment tax credits related to the acquisition of assets would be either: