UK EXPERIENCE OF INTRODUCING INTERNATIONAL FINANCIAL REPORTING STANDARDS FOR TAX PURPOSES .

1. UK EXPERIENCE OF INTRODUCING INTERNATIONAL FINANCIAL REPORTING STANDARDS FOR TAX PURPOSES. August 2006 John Cullinane

2. UK EXPERIENCE OF INTRODUCING INTERNATIONAL FINANCIAL REPORTING STANDARDS FOR TAX PURPOSES • Background • Increasing accounting/tax alignment in the UK • Codification and capital markets focus of accounting standards • Requirements to adopt IFRS • Approach taken by UK tax authorities • Areas of modest or manageable impact • Intangible assets/goodwill • Employee shares/share options • Pensions • Debt & derivatives (the major problem area in the UK) • Deferred tax • Policy implications

3. INCREASING ACCOUNTING/TAX ALIGNMENT IN THE UK • “Judge-made rules” based on “ordinary principles of commercial accountancy” prior to codification of accounting standards. • Trend of legislation and case law in 1990s toward complete alignment with GAAP unless there is a “rule of law” to the contrary. • In the debt/derivatives/intellectual property areas, this trend (for companies) even overrrides the capital/revenue distinction • Originally seen as business friendly, more recently as anti-avoidance and tax base broadening. • So-called principle of “true representation” taxes/relieves profits/losses on debt and derivatives even where taken to reserves/equity in commercial accounts. • Some aspects of this virtually unique to UK.

4. CODIFICATION AND CAPITAL MARKETS FOCUS OF ACCOUNTING STANDARDS • UK GAAP: Statements of Standard Accounting Practice (1970s onward) followed by Financial Reporting Standards. • UK Accounting Standards Board (“ASB”) established after accounting scandals of 1980s. • ASB (and, even more so, the International Accounting Standards Board (“IASB”)) prioritise the needs of capital markets investors. • Post-Enron professional standards severely restrict the availability of accounting opinions. • These developments problematic for other uses of the accounts for which companies have a legitimate need for certainty – distributable reserves, regulation, banking covenants, tax.

5. REQUIREMENTS TO ADOPT IFRS • European Union (“EU”) legislation requires consolidated accounts of entities with listed shares or securities issued in EU to conform to IFRS w.e.f 1 January 2005. • UK follows option to allow solo companies to use either IFRS or UK GAAP accounts (subject to certain consistency requirements). • ASB is pursuing policy of aligning UK GAAP with IFRS and, in particular, FRS 26 imposes (broadly speaking) IAS 39 debt/derivatives treatment on solo companies with listed shares or securities issued in the EU. • De facto 3 GAAPs in UK currently: IFRS, “new UK GAAP” followed by “FRS 26 companies” and “old UK GAAP” followed by others.

6. SUMMARY OF TAX IMPACT OF IFRS BY JURISDICTION* * 28 EU/EEA countries plus Russia, South Africa and Switzerland

7. APPROACH TAKEN BY UK TAX AUTHORITIES(FINANCE ACT 2004 (“FA 2004”) PROVISIONS AND RELATED ANNOUNCEMENTS) • Maintain policy of “qualified” accounting/tax alignment. • “Legitimise” IFRS for tax purposes. • Maintain value of research and development deductions and tax credits by reversing IFRS-induced capitalisation of development expenditure for tax purposes. • Anti-avoidance legislation against “GAAP shopping”. • Vague promise to preserve “hedge accounting” for tax. • Open to lobbying over problems if evidence produced (problematic, given uncertainty of new accounting). Outcome – very consultative process, complex (often retrospective) legislation. • UK tax authority website on IFRS: http://www.hmrc.gov.uk/practitioners/int_accounting.htm

8. INTANGIBLE ASSETS AND GOODWILL • New “intellectual property” rules in 2002 had put IP and goodwill on “accounts basis” but with exclusion of pre-2002 IP assets and election to deduct “new” goodwill at 4% p.a. • IFRS “unbundles” much goodwill into specific IP assets: FA 2005 introduced computational rules to cope with this. • Goodwill not regularly amortised under IFRS: but no extension of deadline for “4% election”. • FA 2004 had overridden capitalisation of development expenditure under IFRS.

9. AREAS OF MODEST IMPACT • Special tax regime in UK for stock option deductions based on different principles from accounting treatment (and aligned with taxation treatment of employees). • Similarly pension deductions very largely based on payments of contributions rather than accounting treatment. • Consequently, relatively little impact of IFRS in these areas (other than through deferred taxation).

10. DEBT AND DERIVATVES • IAS 39 follows a “mixed valuation model”: some items are “fair valued” and others accounted for at “amortised cost”, sometimes broadly matching items are treated differently. • The result is considerable profit volatility (and even more, balance sheet volatility, as some items taken to equity/reserves). • Policy climate in UK Treasury of favouring cash tax volatility as an economic “stabiliser” and of taxing fair value movements as being a broader “tax base”. However accounting volatility can be independent of real economic variables. • UK tax principle of “true representation” increases volatility issue. • This lies behind most of the specific problems that have arisen.

11. HEDGING: “DISREGARD REGULATIONS” Example: Accounting: Cashflow hedge is fair valued (to B/S, maybe to P/L). Economics: No change in market value of UK company from FX fluctuations. Tax: 10% FX change could generate cash tax charge in excess of market capitalisation. UK Company $ export sales(expected, 5 years) £/$ hedge Solution: ‘Disregard’ Regulations aim to preserve (but had to codify) old-style UK GAAP hedging for tax purposes. Approach applied to broad range of hedging arrangements. Ability to ‘elect out’ of Regulations within tightly prescribed terms if prefer cash tax volatility to “tax GAAP”.

12. EMBEDDED DERIVATIVES – CONVERTIBLE LOANS Example: Accounting: Loan disaggregated and treated as “vanilla loan” (“host contract”) and either “equity instrument” (possibly for issuer) or “derivative” to be fair valued (for investor and possibly issuer). Economics: In line with accounting? Tax: Very complex! Convertible Loan UK investingcompany UK issuingcompany Solution: Complex provisions based on accounts but with ongoing changes - preserving, for example, capital gains treatment for investors in certain instruments but on a fair value and deemed annual disposal basis.

13. DERIVATIVES EMBEDDED IN TRADING CONTRACTS Example: Accounting: May disaggregate into sterling contract and £/$ derivative. Economics: In line with accounting? Tax: Likely unacceptable volatility. UK company $ receipts underlong-term tradingcontract Solution: As with ‘Disregard Regulations’, go back to ‘old’ UK GAAP for tax, with ability to elect out into IFRS account basis. Same choice between compliance and cash volatility. Ongoing changes to regulations.

14. SECURITISATION COMPANIES Example: Accounting: FRS 26/IFRS applies to all securitisation issuing companies. Even if all on “amortised cost” basis differential EIRs will produce profit volatility and unfunded tax liabilities. Economics: Profit illusory and reversing. Tax: Anomalous. 4% EIR UK securitisationcompany 5% EIR Return from singlebasket of securitised assets (effective interestrate (“EIR”) say 7%). 10% EIR Different levels ofsubordination ofdebt or deferredconsideration Solution: “Old UK GAAP” preserved for tax purposes while permanent solution found. Likely to entail taxing the profit per UK payments waterfall in deal documentation (i.e. ignoring accounting altogether).

15. FUNCTIONAL CURRENCY Example: £ group Accounting: Under IFRS $ SPV may have to use £ as functional currency. Economics: Depends on circumstances/perspective. Tax: Follows accounts if IFRS reported. £ parentcompany other groupcompanies $ SPV $ loan Solutions: - Follow UK GAAP at solo company level in SPV? - Restructure? - Possible law change?

16. MATCHING Example: £ group Accounting: Under IFRS, €/$ asset can only be “matched” with liabilities at consolidated level. Economics: Matching is meaningful at solo company level. Tax: Previously followed “solo company matching” accounting rules so needed to be rebased. £ parentcompany External €/$ debt liability at which level? other groupcompanies UK subholdingcompany - €/$ asset recognised €/$ subgroup Solution: Introduce tax solo company matching for consolidated matching situations. Problems of recreating old accounting and avoiding “involuntary matching”. Work in progress.

17. TRANSITIONALS • Normal rule would have implied taking full adjustment in 2005 (for most companies). This is normal rule and still generally applies other than to debt/derivatives. • For debt/derivatives, large “winners and losers” and revenue effects issues: single most dominant issue was potential windfall for banks as “general bad debt provisions” gave way to specific “impairment reviews”. • Initially deferred till 2006 pending a costing exercise (and subject to anti-avoidance to counter “forestalling” disposals). • For many transitional adjustments there will be 10 year spreading – determined retrospectively and after much discussion (lobbying banks’ deferred tax and regulatory position was important to the outcome).

18. DEFERRED TAX • Changes affect ‘new’ IFRS-reporting groups irrespective of approach taken to tax in different jurisdictions in which they operate. • IFRS approach based on differences between tax and accounting “carrying values” of assets and liabilities, not confined to differences arising from past profits, for example • Revaluation gains, irrespective of intentions re disposal (leading to unutilisable capital losses potentially having accounting value) • Tax timing differences inherited or generated on acquisition of a busines. • More difference between cash tax and earnings tax line (reported tax rate) effects of transactions.

19. POLICY IMPLICATIONS • Full accounting/tax alignment (even in a defined area) means accounting changes generate tax law changes without any policy decision. • But partial/vague accounting/tax alignment leads to uncertainty of treatment. • Going into IFRS before addressing the complex issues arising was a mistake, not fully compensated for by the open and thorough consultative approach in dealing with the problems arising. • Consider “freezing” GAAP for tax purposes for a period, e.g. GAAP changes ineffective for tax for, say, 2 years? • Be prepared for future changes – e.g. IAS 39 revision, revenue recognition standard, UK GAAP alignment and impact on SMEs.

20. Member of Deloitte Touche Tohmatsu Deloitte & Touche LLP is authorised and regulated by the Financial Services Authority.