Tax Indexation of Nonmonetary Assets Part IV

Remeasurement of Tax Liabilities in Highly Inflationary Economies

Companies are required to use the U.S. dollar as if it were the functional currency if the cumulative three-year inflation rate in the foreign currency is approximately 100 percent or more. Companies in this situation often recognized dramatic deferred tax effects of exchange rate changes when applying the provisions of Statement 96. Concerns expressed by those companies were the primary catalyst behind the FASB's decision to prohibit recognition of deferred taxes for Statement 52 differences under Statement 109.

There are two major ramifications of that decision: (1) companies applying the provisions of Statement 109 will not recognize deferred tax effects of differences arising from exchange rate changes, and (2) exchange rate devaluations of currencies in highly-inflationary economies will have the effect of virtually eliminating deferred taxes otherwise recorded for differences between the foreign currency financial reporting amount and the «hypothetical» foreign currency tax bases of assets and liabilities. «Hypothetical» tax bases (original unindexed tax bases) must be used in calculating deferred taxes because the actual tax bases in countries with highly-inflationary economies often reflect indexation as permitted by the local tax law and, as explained above, Statement 109 prohibits recognizing deferred taxes for the effects of indexation when the reporting currency is used as the functional currency. The following example illustrates this second effect.

Example. Assume that a foreign operation of a U.S. parent purchased fixed assets in 1991 costing FC1,000 when the exchange rate was FC1 = $1. Beginning in 1992, the assets are amortized on a 2-year straight-line basis for tax purposes and on a 10-year straight-line basis for financial reporting purposes. The foreign tax rate is 50% and the exchange rate at December 31, 1992 is FC1 = $0.10. Indexation is also allowed for local tax purposes.

The U.S. dollar is the functional currency. For simplicity, U.S. deferred tax consequences are ignored.

In this example, it was necessary to use a hypothetical tax basis in order to ignore the effect of indexation. However, the tax depreciation life of two years was still used. The actual foreign tax basis of the fixed assets would be higher because of the indexation provision.

Assuming that the exchange rate at December 31, 1993 was FC1 = $0.01, deferred taxes at December 31, 1993 would be computed as follows.

In this example, despite the FC400 increase (FC800 – FC400) in the taxable temporary difference comparing December 31, 1993 to December 31, 1992, the deferred foreign tax liability in U.S. dollars declined $16 ($20 – $4). Assuming continued 10 to 1 devaluation, the deferred tax liability at December 31, 1994 would be less than $1 (FC700 x 50% = FC350. FC350 X 0.001 = $0.35). Thus, the rapid devaluation of the foreign currency has the effect of virtually eliminating the U.S. dollar equivalent of the deferred foreign tax liability recognized for temporary differences denominated in that foreign currency.

As discussed previously, companies are required to use the U.S. dollar as the functional currency when a foreign subsidiary«s economy is considered highly inflationary. When the U.S. dollar is the functional currency, deferred taxes are not provided for temporary differences caused by exchange rate changes or indexation. However, if the local currency is the functional currency, deferred taxes are provided for those temporary differences. EITF Issue 92-8 »Accounting for the Income Tax Effects Under Statement 109 of a Change in Functional Currency When an Economy Ceases to be Considered Highly Inflationary,« and EITF Issue 92-4 »Accounting for a Change in Functional Currency When an Economy Ceases to be Considered Highly Inflationary,« address how to account for those temporary differences when the economy is no longer highly inflationary and the subsidiary»s functional currency is the local currency. In EITF Issue 92-4 the Task Force reached a consensus that a new functional currency amount should be established at the date of the change. The reporting currency amounts at the date of the change should be translated into the local currency using current exchange rates and those amount should become the new functional currency accounting basis for the nonmonetary assets and liabilities. The difference between the new functional currency basis and the functional currency tax basis would represent a temporary difference for which deferred taxes should be provided. In EITF Issue 92-8, the Task Force reached a consensus that the deferred taxes associated with the temporary difference that arises when an economy ceases to be considered highly inflationary should be reflected as an adjustment to the cumulative translation adjustment component of equity, as opposed to income tax expense. The Task Force also concluded that if the change in functional currency is made before the initial adoption of Statement 109, any deferred tax effects of the change in functional currency would be included in the cumulative effect of adopting Statement 109.