Deferred Tax on Buildings

Deferred Tax on Buildings

In last month’s unpublished articleI made a plea to define fair presentation as the prime objective to be achieved when solving GAAP problems. Fair presentation in accordance with the framework is first prize. The standards should then be interpreted to support fair presentation. I gave various examples to illustrate this approach. However, what does one do when the standard is clearly wrong as in the case of owner occupied and investment buildings? Does one publish financial statements that do not fairly reflect the financial position and performance of the entity? Paragraph 13 of IAS1 states that in such a situation, fair presentation overrides the standards. However, this only applies in “extremely rare circumstances”.

I find it incredible that the problem with deferred tax on buildings has not been solved after all these years. When I was on the APC we pointed out that the standard was wrong. We approached the international standard setters and their comment was that they knew it was wrong but did not want too many exemptions in the standard as it would undermine its integrity. Surely by leaving known flaws in standardsundermines their integrity? Every year valuable resources are expended by companies having to debate this issue with their auditors. Some companies apply the strict wording of the standard and produce results that are meaningless and others contravene the standard. As a profession, we need to address this issue NOW.

The following building is given for illustrative purposes. To simplify the problem, assume that the lessee pays rental to the owner of the land for the use of the land. Assume that the building will be given to the owner of the land at the end of ten years for no compensation.

Previous year’s rent / 10 000
Previous year’s expenses / 2 000
Annual rent escalation / 8,0%
Annual expense escalation / 6,0%
Tax on taxable income / 29,0%
Capital gains tax rate / 14,5%
Required yield on investment / 15,0%

The value of the building (arrived at by discounting after tax net rentals at 15% p.a., being an after tax yield) is R41 764. (If you would like a copy of the calculation, email and I will send it to you.)

Now let’s assume that the building is recognised at a cost of R60000 less accumulated depreciation of R30000. The fair value of the building is R41 764. This value represents the AFTER TAX future net rents we would receive by owning the building. If we revalued the building to R41 764 it would NOT be necessary to provide for ANY deferred tax on this revaluation as, on a going concern basis, this value takes into account all taxes payable in the future. But on a careful reading of SIC21 one will conclude that the full tax on the revaluation will have to be provided. The journal entry would be:

Building at value / Dr. / R41 764
Accumulated depreciation / Dr. / 30 000
Building at cost / Cr. / 60 000
Deferred tax / Cr. / 3 412
Revaluation surplus / Cr. / 8 352

If the value of the building is R41 764 on a going concern basis then the increase in the wealth of the equity holder is R11 764 and not R8352. Last year the IASB tentatively passed a resolution to solve the problem by dividing the revaluation of R11 764 by 0,71, revaluing the building by R16 569 and providing for deferred tax of 29% of this figure, i.e. R4 805. This would then give the correct revaluation surplus but the building would now be measured partly at a pre-tax value and partly at a post-tax value. Clearly this is not an acceptable approach. The only logical solution is for the standard to state that if the asset represents the after tax future economic benefits no liability for deferred tax should be recognised.

Some would argue that CGT should be provided on the revaluation of the building. This is also incorrect as the R41764 takes all taxes payable on a going concern basis. As there is no intention to sell the building, CGT is not payable. One only provides for secondary tax on companies when the dividend is declared. Therefore, one should only provide for CGT when the decision to sell the building has been made. If you do not agree with this (and I don’t), then we should accrue for STC and possible CGT.

I have heard the argument that buildings are valued by discounting pre-tax net rental income. Why would any sane honest person buy an asset based on pre-tax rentals and then hand over 29% of the net rentals to SARS when received? It is traditional to value buildings by capitalising pre-tax net rentals at a pre-tax yield. This does not mean that one is valuing the pre-tax net rentals. Some people value supermarkets by applying a factor to sales. This does not mean that they are valuing the sales. For example, if one capitalises pre-tax net rental by 10% and growth in rental is expected to be 8% p.a. in the long term, the after tax return earned on this building would be approximately 15% p.a. calculated as follows:

Pre-tax yield / 10%
Tax thereon 29% / 3%
Net after tax return / 7%
Growth in rental / 8%
Return on investment / 15%

I recently asked a property investment manager (not a CA): “How much would you pay for a rental “stream” consisting of R10 000 receivable tomorrow?” He said: “R10 000”. I said: “And when you earn it you are going to hand over R2 900 to SARS and be left with R7 100?” He said: “No, we will find a tax scheme to avoid paying the tax!” This manager was of the opinion that it is traditional in the market to buy buildings on a pre-tax basis. If this is the case, then on day one we should provide for a 29% upfront loss on the full cost of the building as SARS is clamping down on tax schemes! This manager thinks that because one values buildings by dividing pre-tax profits by pre-tax rent, one is paying for the pre-tax rent. Try this exercise: Value of land and buildings: R100 000 divided by 10% = R1 million. Now reduce the R100 000 by 29% and the yield by 29% and see what answer you get. Still think you are buying pre-tax rent?

Dear Uncle Charlie,

SARS has indicated to me that if I accrue rent that I have not received in cash, they will tax me on it. Is this true and if it is, where will I find the cash to pay the tax?

Dear If This is True,

Gross income is defined as the amount received or accrued so I would suggest that if you admit to rear end loading rental income by passing a journal entry debiting receivables and crediting rent, you have opened yourself up to attack by SARS. As to where to get the cash to pay the tax, bond the building!

Dear Uncle Charlie,

I raised the asset for accrued rental for a client and then my client and the tenant agreed to cancel the lease agreement as it was in both their interests to do so. What do I do with this so-called asset?

Dear So Called Asset,

The accrued rental was fictitious in the first place so the loss is also fictitious. I will be educating users of financial statements to ignore both the gain and the loss.

Dear Uncle Charlie,

What do we do in Zimbabwe about accruing rental expenses? My client was rendered technically insolvent the year he entered into a rental agreement!

Dear Zim,

Did you not know that GAAP now dictates how we now have to do business (the tail wagging the dog)? It’s a zoo out there so play duck and dove: Tell your client to take over the company that is leasing the building. That way the massive gain made on their side will make your client solvent again!

Charles Hattingh CA(SA), Chartered Financial Analyst and Honorary Professor at the University of the Free State