Should I prepare my group subsidiaries' accounts under IFRS or UK GAAP?

One thing that crops up regularly in client meetings is the approach being taken to subsidiary company accounts.  Listed companies are, of course, compelled to prepare their consolidated accounts using EU-endorsed IFRS.  However, there is no such compulsion regarding the solus accounts of the parent company or the accounts of its subsidiaries.

I find that most groups chose to also use IFRS for the solus accounts of the parent company, to remain consistent with the consolidated accounts.  However, there is much more variation in the approach adopted for subsidiary company accounts.

Some groups have decided to also use IFRS for all their subsidiary companies.  This has the merit of simplicity, since IFRS accounting data has to be produced anyway for group consolidation purposes. Others take the approach that producing IFRS consolidated accounts is “hassle enough”, and they will stick with UK GAAP accounts for their subsidiaries to minimise the amount of change at any one time.

As a tax advisor, I always remind clients not to forget about the tax implications when deciding which course of action to follow.  Very briefly, changing from UK GAAP to IFRS will have three possible implications for the computation of profits for accounting and tax purposes.

1. Profits may be accelerated. In certain cases, IFRS requires faster revenue recognition than does UK GAAP.  Under UK GAAP, certain types of receipt may have been spread forward for accounting purposes, while IFRS may require them to be recognised immediately upon receipt as income.
2. Profits may be decelerated. IFRS may require a higher level of provisioning for certain types of risk, or otherwise defer the recognition of income.
3. There may be little change.

There is of course no substitute for considering your group’s position company by company.  Quite often one finds that some subsidiaries in the group will suffer the acceleration of income from using IFRS while for others the effect is the other way round.  What one would really like to do is to prepare UK GAAP accounts for those subsidiaries where IFRS causes acceleration in income, and switch to IFRS where this would decelerate income or cause no material change.  Obviously, this would have no impact upon the group accounts, since they would be prepared from consolidation packs prepared consistently under IFRS.

Is this approach possible?  One needs to look in the Companies Act 1985 (International Accounting Standards and Other Accounting Amendments) Regulations 2004 (the Regulations) which clarify the use of IFRS for individual UK companies.  The Regulations confirm that parent company directors should secure the consistent application of the appropriate GAAP in the individual accounts of the parent company and the individual accounts of each of its UK subsidiaries of a group, unless there is a good reason not to do so.

The DTI guidance notes supporting the Regulations do not make any specific mention of tax as a “good reason” for adopting a different framework for one UK subsidiary within a group.  However, they do emphasise that the key point is that the directors of the parent company must be able to justify any inconsistency, to shareholders, regulators or other interested parties (see the appendix for the relevant extracts from the Regulations and DTI guidance notes).   

It should be noted that there are tax anti-avoidance rules designed to prevent companies seeking to achieve a tax advantage through arbitrage between EU-adopted IFRS and UK GAAP on intra-group transactions.  Where one party to the transaction uses EU-adopted IFRS and the other does not, if the result is a tax advantage both companies are treated for tax purposes as if they had followed UK GAAP.

In commercial terms tax is a business cost like any other, and hence it might seem reasonable to take the view that if a group’s existing tax position would be significantly adversely affected by a company in the group using EU-endorsed IFRS, that this might be a “good reason” for the parent company’s directors to decide that that particular UK subsidiary should continue to use UK law and accounting standards.

Whether tax issues are a “good reason” will depend on the individual facts and circumstances and doubtless the interpretation of what constitutes a “good reason” will evolve over time, particularly as UK GAAP converges with IFRS.  Informal discussion with the Inland Revenue at a senior level has established that they acknowledge that some companies may wish to choose to remain on UK GAAP because using IFRS would cause additional tax costs or accelerate tax cash payments. Furthermore, we understand that the Inland Revenue is encouraging groups to actively discuss with them their reasoning for maintaining UK GAAP for particular subsidiaries in advance. 

The following scenarios provide some additional guidance. In all cases it is assumed that the rest of the group’s UK subsidiaries will be adopting EU-adopted IFRS, and that the proposed accounting of the company that would not use EU-adopted IFRS will be fully in accordance with UK GAAP.

1. In the case of existing arrangements or structures, where a transition to EU adopted IFRS would result in a significant increase or potential volatility in taxable profits, or a significant acceleration of tax cash outflows, or introduce a significant new tax exposure, compared with the company continuing to use UK law and accounting standards, then the tax consequences may well be a “good reason” to keep one subsidiary on UK GAAP. The argument is particularly compelling over the transition period to IFRS, given the uncertainties and lack of time to assess and act on the impact of IFRS and implications of the final tax legislation. In this context “significant” might be in absolute terms or relative to the size of the company affected.  However a trivial tax effect should not be used as an excuse to keep a company on UK GAAP.
2. The conclusion above regarding pre-existing arrangements or structures should not be altered by the fact that they represented a tax planning strategy based on a proper interpretation of tax  law, even if the Inland Revenue or Customs & Excise may be expected to challenge it and try to defeat it through litigation or through a change of law. If, as a result of a company using EU-adopted IFRS, the group could no longer claim the benefits of existing tax planning (or the benefits would be significantly reduced or new tax risks would arise under EU-adopted IFRS such that the planning would not have been entered into with companies using EU-adopted IFRS) the tax effect of using EU-adopted IFRS may be a good reason to remain on UK GAAP.
3. If a company has not changed to EU-adopted IFRS because it would adversely affect a tax planning strategy and that strategy has come to an end, it should change to EU-adopted IFRS from the start of the accounting period following that in which the tax planning strategy had ended, unless there was another “good reason” not to do so.

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Mohammed Amin

Comments

[Stephen Payne 23 Feb 2006 16:06:59]

It would be useful to have a summary by country which confirms whether local accounts are required to be under IFRS or local GAAP or a choice between the two (as in the UK)

Does anyone know if such a comparison table exists - if so where?

Thanks

[15 Mar 2006 14:57:35]

Stephen

A year or so ago the EU published a matrix of IFRS requirements by Member State. Here is a link... http://europa.eu.int/comm/internal_market/accounting/docs/ias/ias-use-of-options_en.pdf

Unfortunately it's a bit cumbersome and difficult to use, but it's a start.

[Fredrick 1 May 2006 03:01:49]

Im after information regarding the contrasts between IRFS and UK GAAP with regards to terminologies. Can you help me or point me to any online source regarding this?

[Bob 2 May 2006 20:50:59]

Mr. Amin,

I am interested in understanding the cash tax impact of adopting IRFS accounting vs. a country's existing statutory accounting. My understanding is that a particulat country's company income taxation calculation starts with it's local statutory accounting pretax profit plus/minus certain permanent and temporary differences to arrive at currently taxable profit. Will each country automatically adopt IFRS as their new "statutory accounting" for purposes of calculating their cash taxes due for the period?

[Danny Chee 28 Mar 2007 17:24:06]

Mr Amin,

I am interested in understanding how to compute effective interest rate for multi tier interest rate type of lending/borrowing, i.e 1st year rate - 5%, 2nd year rate -7% and subsequent year - Prime rate + spread

[Mohammed Amin 3 Apr 2007 11:28:23]

Danny,

The question is how one computes an effective interest rate when the interest rate will vary in future years.

If the future interest rates are fixed, then there is a relatively straightforward mathematical relationship. For example, if the rate of interest is specified for just two future periods, with year one being 5% and year two being 7%, then an annual equivalent rate can be computed as follows, assuming that the interest for each period is paid at the end of each year.

(1) Compute the cash flows in the base case, which are as follows

Time zero: outflow £100
End of year one: inflow £5
End of year two: inflow £107, being the interest and loan repayment

(2) Calculate the discount rate that makes the net present value of the inflows equal to the outflow. ie solve the equation below:

100 = 5/(1+r) + 107/(1+r)^2

(3) The solution, r, is the effective rate of interest, which can be expressed as a percentage 100*r%.

A spreadsheet program such as Excel makes the calculations relatively straightforward.

In my view the problem is not meaningfully specified where the interest rate in a future year will be a floating rate, such as the suggestion in the comment of Prime Rate + a margin for year three and future years.