TEI files comments on IAS 12: July 27, 2004.

On July 27, 2004, Tax Executives Institute sent the following letter on IAS 12, Deferred Tax Accounting for Intercompany Profits in Inventory, to Sir David Tweedie, Chairman of the Inaternational Accounting Standards Board. The comments were prepared uner the auspices of TEI's Federal Tax and International Tax Committees, whose chairs are Neil D. Traubenberg of Storage Technology Corporation and Bruce R. Maggin of IBM Corporation. Contributing materially to the development of the comments were Janice L. Lucchesi of Akzo Noble Inc., Jeffrey J. Lonsdale of Lamar Hunt Family Companies, Anthony J. Maggiore of Richemont International SA, Alan B. Richer of General Electric Company, and James P. Silvestri of Cognizant Technology Solutions.

On behalf of the Tax Executives Institute, I am pleased to submit the following comments regarding deferred tax accounting for intercompany profits in inventory. Although the International Accounting Standards Board (IASB) has addressed this aspect of deferred tax accounting in the past and confirmed its adherence to International Accounting Standard (IAS) 12, Income Taxes, we understand that a review of the standard is underway. TEI is concerned about the financial statement distortions that in some instances may be caused by IAS 12.

To improve the comparability and transparency of financial reporting, TEI recommends the IASB consider converging IAS 12 with Financial Accounting Standard (FAS) Statement 109, Accounting for Income Tax, of the U.S. Generally Accepted Accounting Principles (GAAP). Such an approach would be consistent with the October 2002 memorandum of understanding issued by the IASB and FASB committing to moving toward convergence. Until that convergence is accomplished, the IASB should consider modifying IAS 12 to compute deferred tax for intercompany profits in inventory using the tax rate applicable in the jurisdiction of the seller. Our concerns are illustrated with an example based upon the experience of multinational companies that manufacture and sell products in multiple jurisdictions having different tax rates.

I. Background

Founded in 1944 as a non-profit organization in the United States to serve the professional needs of business tax professionals, TEI now has an international scope with 53 chapters spread throughout North America and Europe. Our 5,400 members represent 2,800 of the largest companies in the United States, Canada, and Europe. The majority of TEI members work for multinational companies with substantial international operations and sales.

TEI represents a cross-section of the business community; it is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and governments alike. As a professional association, TEI is firmly committed to maintaining tax systems that are administrable and with which taxpayers can comply.

TEI members often have direct or indirect responsibility for the tax accounting presented in their companies' financial statements, and for the tax footnotes contained in their companies' external reporting. As such, they must interpret not only the myriad tax laws affecting their companies, but also the applicable accounting standards. When accounting standards change or are unclear, or when there are different standards applicable in different jurisdictions, transparency and investor confidence suffer.

The IASB and FASB have established different accounting standards for deferred taxes on intercompany profits in inventory. As a result, companies' financial statements may materially differ depending upon which standard is applied. While total convergence of global accounting standards would be the optimal (and long-term) solution, in the interim, corporations and investors alike will be better served if there were one standard for deferred taxes on intercompany profits in inventory.

II. Deferred Tax on Intercompany Profits in Inventory

Deferred tax accounting originated to ensure a proper matching of accounting profits and losses and the related tax effects. Although the original reason for deferred tax accounting may have been to reflect the effects of accelerated depreciation, other book/tax differences are possible. An example is the tax asset associated with the intercompany profit on inventory that is eliminated on consolidation.

TEI's comments are focused on the appropriate tax rate applicable to the recognition of intercompany profit from the sale of inventory. IAS 12 recognises the deferred tax effect is at the buyer's tax rate, while under FAS 109, the deferred tax effect is booked at the seller's tax rate. The FASB and IASB are addressing the applicable rate issue differences in their respective short-term convergence projects (relating to IAS 12 and FAS 109). TEI believes that the standard should be to recognise the deferred tax effect at the seller's tax rate.

As the IASB has recognized, an intercompany transfer of assets (such as the sale of inventory or depreciable assets) between tax jurisdictions is a taxable event that establishes a new tax basis for those assets in the buyer's tax jurisdiction. The new tax basis of those assets is deductible on the buyer's tax return when the assets, the cost of which are reported in the consolidated financial statements, are sold to an ultimate third party. FAS 109 requires taxes paid by the seller on intercompany profits to be deferred. IAS 12 does not provide a similar exception.

IAS 12 can create distortions when it is applied to the intercompany profit on inventory that is eliminated in consolidation, particularly when there is a significant difference between the tax rate of the related company selling the inventory and that of the controlled company holding the inventory. The current standard applies the same logic to that item that it applies to liabilities, i.e., the difference is valued using the local tax rate that is expected to apply when (and in the entity in which) the difference reverses. In practice, this means that the tax is computed by multiplying the eliminated intercompany profit by the tax rate of the jurisdiction in which the inventory is located. This is often the jurisdiction of the distributing subsidiary of a multinational company (and, hence, not the jurisdiction of the subsidiary that either manufactured or acquired the inventory for resale to the distribution subsidiary).

In contrast, under the FAS standard, the tax charge that is deferred is the one that has actually been borne in the jurisdiction of the subsidiary that either manufactured or acquired the inventory for resale to the distribution subsidiary. FASB's approach focuses on the need for consistency with the treatment of the intercompany profits on which the deferred tax arises. Otherwise, users would recognise income taxes on unrecognised intercompany gains, and a tax benefit or expense would be recognised before the transferred inventory was sold to a third party.

The FASB and IAS approaches can lead to very different results, as illustrated by the following example:</p> <pre> Year 2001: Multinational company manufactures in country A at a cost of 30, ships to country B at a cost of 90, and pays country A tax of 10 percent on (90-30) = 6. Year 2002: Multinational company sells in country B to a third party at 100 and pays country B tax of 50 percent on (100-90) = 5. </pre> <p>Although the mechanics in the above example are the same, the results are dramatically different because of the different tax rates used to accrue the deferred tax on unrealized intercompany profit in inventory.

At first glance, the liability approach appears conceptually sound and relatively simple to apply because the inventory need not be traced to its source to identify the originating tax rate; rather, the rate of tax in the jurisdiction where the inventory is located is applied. As the example illustrates, however, this approach is counterintuitive and leads to extreme results. The tax that has to be eliminated under IAS is not the tax borne on the eliminated profit, but the tax hypothetically "saved" in the new jurisdiction. More troublesome, a profit on the tax line will arise on a transaction for which the profit before tax has been eliminated. TEI urges the IASB to address this issue by converging the two standards.

III. Summary

The disadvantages of the IAS 12 method for computing a deferred tax asset on eliminated intercompany profit in inventory include:

* The recognition of a profit on the tax line in an intercompany transaction;

* The inconsistency between eliminating the profit in inventory and creating a profit in tax; and

* The risk of abuse in creating accounting tax assets by moving ownership of inventory around the group - physical movement is not required.

Its advantages are:

* Consistency in using the "liability" method for all tax assets and liabilities; and

* Ease of ascertaining the tax rates to be used in computing the tax assets.

On balance, the disadvantages considerably outweigh the advantages. TEI believes that IAS 12 should be conformed to FAS 109. In particular, taxes paid by the seller on intercompany profits should be deferred using the tax rate in the seller's country. We believe that a new conformed statement should prohibit the recognition of a deferred tax asset for the difference between the tax basis of the assets in the buyer's tax jurisdiction and their cost as reported in the consolidated financial statements. IAS 12 should be amended to converge with FAS 109 in this regard. The conformed standards would better match the components' pretax accounting income to the taxes actually imposed by the respective taxing jurisdictions. Therefore, adopting such conformity will create more understandable financial statements that more accurately apply the matching principle of accounting.

IV. Conclusion

Tax Executives Institute appreciates this opportunity to present our views on IAS 12. These comments were prepared under the guidance of TEI's Federal Tax and International Tax Committees. If you have any questions about the Institute's views, please contact Neil D. Traubenberg, chair of TEI's Federal Tax Committee, at 1.303.673.3904, or [e-mail], or Mary L. Fahey of the Institute's legal staff at 1.202.638.5601, or [e-mail].

                             Current     Deferred     Total
                   Profit      tax         tax         tax
                   before     charge/     charge/     charge/
           Year     tax      (credit)    (credit)    (credit)

FAS 109

           2001       0         6           -6           0
           2002      70         5            6          11

IAS 12

           2001       0         6          -30         -24
           2002      70         5            0          35