The telecommunications industry is very dynamic, driven by technological developments and changes in the competitive and regulatory environment. Due to the significant capital expenditure involved in building infrastructure, investment recovery periods tend to be longer than in many other industries. In the past, a number of telecom operators have recorded significant start-up trading losses and losses due to impairment charges on licences or goodwill and other assets resulting from business combinations. Depending on local tax legislation, operators can use these losses to offset future taxable income.
Companies are required to assess the accumulated losses and the recoverability of any related deferred tax assets (DTA) each year. The amounts involved are often material. The table below shows the DTAs recognised in the 2008/09 financial statements of a selection of major European telecom operators.
The unrecognised (potential) deferred tax assets for some of these operators are even larger. For example, Vodafone reported total available (unrecognised) tax losses carried forward amounting to GBP 83 billion; BT, GBP 24 billion; KPN, EUR 22 billion; and France Télécom and Telecom Italia, EUR 5 billion each.
Which rules apply?
The relevant international accounting standard is IAS 12 Income Taxes. The standard provides that a DTA should be recognised for all deductible temporary differences, to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. Similarly, a DTA should be recognised for the carryforward of unused tax losses and unused tax credits, to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised.
Unlike many of the more recent International Financial Reporting Standards, the asset is determined not on the basis of its fair value or discounted values, but rather at its nominal amount. This is a particular concern due to the generally long periods required to recover the net operating losses. The farther a company needs to look into the future to estimate taxable profits, the harder it will be to make a reliable estimate. As discounting cannot be applied to reduce the relative impact on the value of later years, companies need to find ways to deal with the inherent uncertainties in their forecasts.
An analysis of the recoverability of deferred tax assets considers:
- The availability of sufficient taxable temporary differences
- The probability that the entity will have sufficient taxable profits in the future, in the same period as the reversal of the deductible temporary difference or in the periods into which a tax loss can be carried back or forward
- The availability of tax planning opportunities that allow the recovery of DTAs
The first and last of those factors generally are a matter of applying relevant fiscal laws and regulations. For available temporary differences, there may be judgment resulting from uncertain tax positions to the extent that tax assessments are not final. Tax planning opportunities have an inherent uncertainty insofar as they have not yet been confirmed by the tax authorities.
The remainder of this paper focuses primarily on the analysis that should be made in order to assess the probability that future taxable profits will be available to recover the DTAs. To begin with, however, a few comments on the need for a thorough analysis.
The thoroughness of the analysis should reflect the materiality and level of judgment
By its nature, a deferred tax asset is evidenced solely by the underlying analysis. As can be seen in Figure 1, for many telecommunications companies, the potential DTA is material, or even fundamental, to the financial statements as a whole. In addition, determining probabilities in the assessment of a DTA is highly judgmental. The level of judgment will depend also on an entity’s track record with regard to the predictability of its core earnings. When tax losses are caused by a non-recurring event for an otherwise profitable company, the nature of the judgment is different than that for an entity that has had more loss-making years in recent history. The thoroughness of the analysis should reflect both the materiality of the (potential) DTA and the level of judgment involved.
The key judgment in the analysis relates to probability. The term probable is not defined in IAS 12; but with reference to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, it is generally defined as ‘more likely than not’. In other words, if it is more likely than not that all or any portion of the deferred tax asset will be recovered, that part of the asset should be recognised.
A factor that may drive behaviour is the probability of challenge by regulators and the company’s stakeholders, or even the tax authorities. We commonly hear that management believes the risk of challenge is higher for recognising an unduly high DTA than for an unduly low DTA.
That does not mean companies should be excessively conservative in assessing the valuation of DTAs. According to the IFRS framework, the information contained in financial statements must be neutral, that is, free from bias. The exercise of prudence in preparing the financial statements does not justify deliberately understating assets, because the financial statements would not be neutral and, therefore, would not have the quality of reliability.
Both favourable and unfavourable evidence should be considered in the analysis. Objectively verifiable evidence generally will be given greater weight than less objectively verifiable evidence. A strong earnings history or existing long-term contracts that generate stable future profits will provide the most objective evidence in assuming future profitability when assessing the extent to which a DTA can be recognised.
Greater care is needed, however, if prior years’ losses are very significant relative to expected annual profits. In that case, positive evidence of future taxable profits may be less objectively verifiable. Therefore, evidence of future taxable profits may be assigned lesser weight in assessing the appropriateness of recording a DTA when other evidence is unfavourable. Specifically, in the case of a history of losses that did not result from identifiable causes that are unlikely to recur, it is unlikely that a DTA can be recognised. IAS 12 explains that when an entity has a history of recent losses, convincing evidence of sufficient future taxable profits is required before a DTA can be recognised.
The entity should have regard to any time limit on the carryforward of tax losses. However, whilst it may be that the longer into the future an assessment is required the less probable any particular level of taxable profit becomes, there should be no arbitrary cut-off in the time horizon over which such an assessment is made. This point is considered further in the duration of this paper.
The availability of future taxable profits – a problem in four parts
The best starting point for determining the availability of future taxable profits is a company’s own business planning cycle and resulting forecasts.
Using the company’s forecasts to assess the value of assets with potentially significant impact is not a unique exercise for most telecom operators. Given the significant balances of goodwill, other intangible and tangible assets, impairment testing is an important element of their financial reporting process. Impairment tests generally are based on approved budgets, which result from a robust budgeting process, and often external experts are involved throughout the impairment process. Often, the analyses used in impairment testing are in some way adjusted, for example to eliminate deliberate ‘challenges’ inserted in the budget for internal management purposes, or to adjust for market perception of risk levels.
Given the fact that these robust forecasts already are available, we see that generally they are also used as a basis for the DTA analysis. Indeed, we would argue that if the analyses are robust enough to maintain significant amounts of goodwill and other assets on the balance sheet, using other assumptions when assessing the valuation of DTAs is hard to justify. Assessing the value of DTAs, therefore, should be broadly consistent with the assumptions used for impairment testing.
Nevertheless, the four common differences that exist in forecasting future taxable profits must be considered, and we discuss them below.
1. Determining cash flows on the basis of an entity’s business, not its disposal value
In an impairment test performed in accordance with IAS 36 Impairment of Assets, the recoverable amount of a cash generating unit is determined. The recoverable amount is the higher of the value in use and the fair value less the cost to sell.
The fair value less cost to sell may be based on the net proceeds that are expected to be generated by the sale of one or more subsidiaries that together form the relevant cash generating unit. When considering the valuation of the DTAs of these subsidiaries, however, the value in use assumptions are the only relevant basis for evaluating the forecasts of their future taxable income. On the other hand, the forecast for deferred tax purposes may include elements such as the impact of future restructuring activities or from improving or enhancing the asset’s performance, which would be restricted or prohibited under IAS 36.
All this may mean that although a company expects its goodwill and other assets to be fully recoverable in the event of external sale, insufficient future taxable profits may exist to justify recognising a DTA.
Cash flow forecasts should be translated to taxable profits under applicable tax laws and regulations. Depreciation and interest expenses that are not included in a value in use calculation should be taken into account in the taxable profit analysis if they are tax deductible. At the same time, forecasted taxable profits should exclude non-taxable or non-deductible items that are included in the value in use calculation.
Often, the timing and amount of tax deductions for depreciation and interest can differ from their equivalent accounting expenses. For example, an asset may be depreciated (or impaired) for accounting purposes over a shorter period than that over which tax relief is obtained, resulting in a deductible temporary difference. Normally, in determining the sufficiency of taxable profits under IAS 12, taxable amounts arising from future deductible temporary differences are ignored. Therefore, for simplicity, forecasts include accounting rather than tax amounts. However, careful analysis will be necessary when losses cannot be carried forward indefinitely.
Particular issues exist when forecasts include the amounts relevant for tax purposes (rather than the accounting deductions) and losses are recoverable only against taxable profits arising as a result of future deductible temporary differences. In that case, those taxable profits can be taken into account only if the DTAs relating to the future deductible temporary differences also can be recovered subsequently.
2. Translating a cash generating unit into taxable entities
IAS 12 indicates that the recoverability of DTAs should be assessed with reference to the same taxation authority and the same ‘taxable entity’. Sufficient future taxable profit must be available to the taxable entity where those deductible temporary differences or unused tax losses originated, in order for an asset to be recognised by that entity. To the extent that a tax group can recover tax losses or any deductible temporary differences generated, in consolidated financial statements, taking into account the taxable profits of all entities in the wider tax group would be appropriate.
This tax group, however, may not equal the cash generating unit that is the basis for business planning or impairment testing. A tax group may very well consist of multiple cash generating units, or a cash generating unit may consist of more than one taxable entity or tax group. For example, in the past many telecom operators have included licences or intellectual property in separate taxable entities that generate revenues by licensing out these assets at a predetermined (royalty) fee. Although these assets generate separate profits for tax purposes, the assets generally would not constitute a separate cash generating unit for impairment testing purposes.
As a result of differences between taxable entities and cash generating units, the forecasts that were the basis for impairment testing may have to be broken into smaller elements to assess the valuation of carryforward losses. This may result in DTAs being recognised in a loss-making cash generating unit or in no asset being recognised even though the cash generating unit is profitable.
3. Assessing legal or contractual limits to the recovery period
In many jurisdictions, limits exist on the recovery of tax assets. Typically, a limit is implemented as a maximum recovery period. This presents a cut-off for the cash flow projection period in determining the DTA.
Contractual limits to the recovery period may also exist. The operator may have special purpose entities to hold, for example, a telecommunications licence or a patent. These entities typically acquire the intangible asset and licence it to a service entity of the operator, against a contractually pre-established fixed or variable royalty. The life of such entities is de facto limited to the contractual life of the underlying asset, which in turn presents a cut-off for the cash flow projection period in determining the DTA. Tax planning opportunities may exist to recover any remaining temporary differences or unused losses at the expiration of the contract, but these opportunities should be sufficiently probable and evidenced to be usable in supporting further DTAs.
4. Weighing the uncertainties in future profits and cash flows
Where there is a balance of favourable and unfavourable evidence, careful consideration is given to an entity’s projections for taxable profits for each year from the balance sheet date until the expiry date of the carryforward losses. As indicated before, the projections that are the basis for the assessments must be broadly consistent with the assumptions made about the future in relation to other aspects of financial accounting (for example, impairment testing).
The exception occurs when relevant standards require a different treatment (for example, impairment testing generally cannot take account of future investment).
IAS 36 requires that, in an impairment test, the projections be made on the basis of reasonable and supportable assumptions that represent management’s best estimate of future profits. However, no matter how robust the forecasting process has been, there is always a risk that actual future outcomes will differ from these estimates. In the traditional impairment testing approach, such risks are generally incorporated in a single discount rate. The higher the risks in the estimated future cash flows, the higher the element that is included in the discount rate to reflect the risk that the future cash flows will differ from the estimates in amount or timing.
As the example indicates, in an impairment test the further the expected cash flows lie into the future, the lower the weight assigned to the cash flows. One reason is the time value of money (‘it is better to receive one euro today than in a year’). A significant factor, though, is the risk involved, as the table illustrates by the differences in weights assigned to the low-risk and to the high-risk forecasts. Irrespective of the risk involved, beyond a certain point in time virtually no value is assigned to the forecasted cash flows. For the high-risk cash flows, the cash flows expected in year 10 add only 16% of their nominal amount to the value of the asset, and the cash flows projected after 30 years receive no weight at all.
IAS 12, however, does not permit the discounting of DTAs (or liabilities), based on the argument that detailed scheduling of the timing of the reversal of temporary differences is impracticable or highly complex. As a result, companies need to consider other methods that appropriately reflect risk in their forecasts of future taxable profits. This issue particularly affects telecommunications companies, because their large capital intensity dictates longer periods to recoup net operating losses.
In our experience, companies in this industry seek methods that will allow them to take into account increasing uncertainty as time progresses. Three possible methods that we see in practice are considered below.
(i) Lookout-period approach
The further into the future it is necessary to look for sufficient taxable profits (the ‘lookout’ period), the more subjective the projections become. It may be argued that the probability of taxable profits decreases over time such that there could be a point beyond which no reliable earnings projections can be made, and thus that taxable profits are no longer probable. However, we believe that generally there should be no arbitrary cut-off in the time horizon over which an assessment of expected taxable profits is made.
Without specific circumstances, we consider it inappropriate to assume that no taxable profits are probable after a specified time period. The expiration date of a significant licence, for example, and uncertainty about the company’s ability to extend the licence to stay in business beyond the expiration date could be such a specific circumstance a telecom operator would take into consideration.
Given the increased uncertainty beyond a specific point in the future, using a restricted lookout period is not necessarily inconsistent with the assumptions used in the company’s impairment test. The first reason is that, in a high-risk scenario, the discount rate used in the impairment test should reflect this risk appropriately. In example 5, the weight assigned to an expected cash flow of 100 in year 7 is only 28 in the high-risk scenario. The second reason is that the business case for the price paid in a new auction will be based on future cash flow projections, whereas taxable profits may deviate from these cash flows as a result of tax deductible depreciation or interest charges.
In the absence of a specific circumstance, the use of a specific lookout period generally is not appropriate. In that situation, the lookout period is likely to be arbitrary. Thus, for every year until the expiry of tax losses, the calculation should include the taxable profits that satisfy the criterion of being more probable than not. This may result in lower estimates for years in the distant future, but it does not mean that those years should not be considered.
(ii) Risk-adjusted profits approach
As indicated above, the traditional impairment test approach is based on a company’s best estimate of future cash flows and uses a single discount rate to incorporate all the risks related to expectations about the future cash flows. Although IAS 12 does not allow discounting of DTAs, the underlying reasoning for discounting future cash flows in an impairment test may be applied also in assessing the valuation of DTAs. The discount rate in an impairment test should reflect both the time value of money and the risks specific to the asset for which the future cash flow estimates have not been adjusted. The discount rate thus adjusts the value assigned to expected future cash flows to reflect the risk that actual cash flows will fall short of the expectation.
If the cash flow forecasts in the impairment model are translated into expected future taxable profits without adjusting for the inherent risk that the actual taxable profits could be lower, the DTA that is recognised will be too optimistic. Adjusting the expected future taxable profits by using a risk factor, therefore, would be appropriate. This risk factor can be derived from the risk premium that is included in the discount rate used in the impairment test.
For a telecom operator, however, the risk related to future cash flows may differ from the risk related to future taxable profits. This difference results from large asset bases and the resulting depreciation charges, which may not affect future cash flows but which do affect future taxable profits. Similar to the use of a discount rate in an impairment test, the risk factor applied to taxable profits that are expected further into the future is likely to be higher than the factor applied to the taxable profits in the early years of the forecast.
(iii) Expected profits approach
Instead of using a single estimate of future taxable profits and reflecting all risks in a single risk factor, it is also possible to estimate a range of possible taxable profits and assign probabilities to each of the estimates. The expected profits approach breaks down the risks and uses all expectations about possible outcomes instead of the single most likely taxable profit.
The potential tax benefit from past operating losses of telecom operators is a significant asset to these companies. The accounting for DTAs requires a high level of judgment and warrants thorough analysis and documentation.
The main judgment is the level of evidence of future taxable profits, consisting of a breakdown of projected taxable profits for each taxable entity, as well as a determination of the level of probability thereof. While in many cases an operator’s own business forecasting and impairment analyses can be a good starting point for the forecasts to be used for DTA valuation, some significant adjustments need to be made to align the analysis to the requirements for DTA valuation in IAS 12.
An important aspect is the fact that a DTA is valued on an undiscounted basis, especially as recovering some operators’ carryforward losses will take considerable time. The discount rate in an impairment model is a measure important in reflecting the uncertainties inherent in a forecast. Since in a DTA valuation these uncertainties are not reflected in a discount rate, operators need to find other ways to deal with this. This document gives some practical tools that we have seen being used in practice, and undoubtedly there are other methods as well. We recommend performing the analysis by using a combination of available methods and looking for a common ground in the outcomes.
No matter which method or methods are used, a significant element of judgment will be involved in the valuation of DTAs. A robust, well-documented analysis and decision making at the appropriate management level, therefore, will be a minimum requirement. In addition, disclosure will be required in the financial statements of the assumptions made about the future and other major sources of estimation uncertainty that have a significant risk of resulting in a material adjustment to the carrying amounts of DTAs.