Revaluation gain on investments to be booked as profit, resulting in tax liability
The way in which companies have to account for revaluation gains on their investment properties - broadly defined as properties held to earn rent or capital appreciation or both - has changed this year, thanks to the introduction of a new accounting standard.
But what some may not have realised is that the new standard could also introduce a tax element into the equation - which will hit bottomlines, in a significant way, from this financial year.
In a nutshell, it could mean that companies would have to account for revaluation gains and losses on their investment properties through the income statement, together with the related deferred tax provisions.
And with property prices soaring as much as they have this year, it will mean substantial revaluation gains for most - and also substantial deferred tax provisions.
Property companies are expected to be the most affected, because they have extensive portfolios of investment property.
Some have played down the move as no more than an accounting adjustment. But others have expressed their displeasure with the need to provide for deferred tax on revaluation gains.
From Jan 1, 2007, companies will have to adopt Financial Reporting Standard (FRS) 40 - which prescribes accounting and disclosure treatments for investment properties.
Under FRS 40, any changes in the fair value of an investment property held have to be taken to the profit and loss account - instead of to a revaluation reserve in the balance sheet, as previously allowed. In other words, an upward revaluation of investment property will add to the bottomline, while a downward revaluation will eat into earnings.
Then, there’s the tax effect of that.
Under another standard already in place - FRS 12, on income taxes - companies should have to account for the future tax related to this increase in property value. In accounting-speak, it’s to ensure that there is proper matching of the timing of the recognition of an event and its tax effect.
Looking at future rental stream
It would mean that an upward revaluation of any investment property would indicate an increase in the amount of future rental income or proceeds from disposal of the property. This increase is recognised in the income statement and, hence, there would need to be a corresponding recognition of the deferred income tax expense in the income statement.
PricewaterhouseCoopers (PwC) partner and assurance leader, Yeoh Oon Jin, who supports this position, explains: ‘It’s essentially a deferred tax position that’s been created in conjunction with the revaluation of the property. But it’s important to note that it’s a deferred tax provision which companies will have to reflect in their books - there is no actual tax paid in the year when the provision is made.’
In addition, some companies won’t actually have to physically hand over this amount in tax, for example in the case when they sell their properties and recognise a capital gain. Still, they will have to recognise these deferred taxes as an expense in their income statement as long as there is no plan to sell the properties - hurting their bottomlines.
And the impact could be significant.
Before FRS 40, Singapore companies didn’t account for deferred taxes on revaluation gains of investment properties because the effect to the financial statements could be immaterial.
Mr Yeoh explains: ‘As the revaluation gain of an investment property is accounted for in the revaluation reserve, under FRS 12, the related deferred tax would be accounted for against the revaluation reserve. Therefore, the amount of deferred tax vis-a-vis the net asset value of companies would generally be less significant and may be immaterial.’
‘However, under FRS 40, the changes in fair value have to be included in the profit and loss account - and generally, the amount of profit and loss for the year is only a fraction of the net asset value of many companies, especially the property-owning companies. Therefore, the deferred tax expense on fair value gains would be more material on adoption of FRS 40.’
Tham Sai Choy, incoming regional Asia Pacific head of audit at KPMG, emphasises that there has been no change in the accounting standard for deferred tax. ‘What has changed is that the new FRS 40 will see revaluation gains on investment properties being taken up as profit. This has focused the spotlight on the tax effect arising from that profit,’ he said.
It’s not a change that’s sitting too well with property companies here. It’s not just the potential negative impact to their bottomlines that they’re concerned about - it’s also what appears to be a departure from the current treatment that bothers them.
Currently, companies don’t pay tax on the gain from the sale of any property - as there is no capital gains tax in Singapore. And some property companies feel that revaluation gains in investment property should be treated as a capital gain, and not subject to tax.
Under FRS 12, deferred income tax is recognised in the books - but companies are only taxed when the profit is realised. But since gains from the sale of properties are not taxed even when the property is sold - because there is no capital gains tax - some feel that the deferred tax shouldn’t even be reflected in the accounts.
CapitaLand’s group CFO, Olivier Lim, comments: ‘Accounting standards require deferred tax to be provided for even when the tax liabilities are not immediately payable. That is entirely correct. However, where there is no expectation of a tax liability payable now or in future, it would be inappropriate to book a liability.’
But as PwC’s Mr Yeoh sees it: ‘One cannot dismiss that an increase in the fair value of the property is a representation of an expected increase in the future rental stream and/or proceeds from the ultimate disposal of the property.’
KPMG’s Mr Tham, however, is concerned that this complex issue may be over-simplified. ‘As with any complex accounting standard, it is tempting to over-simplify its interpretation. The accounting standard on deferred tax is one of the more complex standards, dealing with an area that is difficult for accountants as well as the companies that issue the accounts,’ he says.
He told BT that KPMG has had some ‘very involved discussions’ with property companies here - and is aware that there is a wide range of issues that will crop up from this.
One property company that foresees an issue with the new standard is City Developments Ltd (CDL). A CDL spokesman told BT: ‘Some accountants have interpreted the standard to mean that a deferred tax liability should be recorded immediately for the tax payable on future rental income. Yet, when the rental income is received, a further tax liability is set aside again. The tax is payable just once, but the liability would be set up twice. This distorts the accounts. When the asset is sold and assuming this is a non-taxable capital gain, it becomes clear that there is no tax liability to pay from the disposal. A gain gets recorded as a result of the reversal of the deferred tax liability previously recorded.’
Hidden gains and losses
Mr Tham believes the tax gain arising on disposal is an unintended effect of the accounting standards, and goes against the point of fair value accounting.
Other anomalies could also arise from careless interpretations of the standard, such as a company recording a loss immediately when it buys a property because of the deferred tax liability that will be recorded. And a property that requires no deferred tax provision might require one when the business decides it is no longer held for sale but is to be rented out instead.
Mr Tham also worries that the issue could be blind-sided by the current buoyant property market in Singapore.
‘Booking a deferred tax liability which is not payable means that the liability is reversed when the property is sold, creating an artificial gain. If property prices are falling, the reverse could happen, so that a ‘hidden’ loss arises when a property is sold,’ he said.
Mr Tham concludes: ‘We do not think the accounting standard, as with any standard, was meant to create accounts that are far removed from business realities. It falls on everyone concerned to apply business sense and professional judgement so that this accounting standard is applied correctly, ultimately so that the accounts make sense when they are issued.’
Source : Business Times - 2 Aug 2007
