Navigating the Tax Treatment under IFRS and Income Tax Ordinance, 2001: Prevailing Frameworks for Current, Prior, and Deferred Tax

In Pakistan, companies face the unique challenge of balancing compliance with the locally enforced Income Tax Ordinance, 2001 (ITO 2001) and the globally accepted International Financial Reporting Standards (IFRS). While ITO 2001 dictates the actual tax liabilities and cash outflows for tax compliance, IFRS guides financial reporting practices, providing transparency for stakeholders and investors. This article explores the distinct tax treatments under these frameworks, analyzing what prevails in cases of conflict and discussing relevant case laws to illustrate these differences.

1. Recognition and Accounting Standards

IFRS and ITO 2001 have fundamental differences in the recognition of tax expenses:

• IFRS Compliance: IFRS requires that tax expenses (current and deferred) be recognized based on the nature of the related income or expense. This means tax expenses should be matched with revenue and included in the profit and loss statement, or in other comprehensive income or directly in equity, depending on the item. This approach aligns with IFRS’s matching principle, ensuring accurate financial reporting.
• ITO 2001 Compliance: In contrast, ITO 2001 is legally binding and enforces a cash-based approach to tax computation for compliance. It focuses solely on tax collection and compliance with the tax law, without aligning with IFRS’s accounting principles. For companies operating in Pakistan, ITO 2001 ultimately dictates tax liabilities.

Prevailing Framework: In matters of tax payments and legal compliance, ITO 2001 prevails. IFRS only influences the presentation of tax expenses in financial reports, while ITO 2001 determines actual tax payments.

Relevant Case Law:

• Rehmat Fabrics Ltd. vs. Commissioner Inland Revenue (2012): The court upheld the precedence of ITO 2001 over IFRS, reinforcing that tax provisions must strictly comply with ITO requirements, irrespective of the company’s accounting standards.

2. Current Tax

Under IFRS, the current tax is computed using the tax rates that are enacted or substantively enacted as of the reporting date. IFRS also requires companies to account for uncertain tax positions by recognizing provisions if it’s probable that tax authorities might dispute them. This allows some flexibility for management judgment in estimating tax liabilities.

While ITO 2001 specifies that current tax liabilities must follow the set tax rates, allowances, and exemptions, with limited leeway for management judgment. Tax reassessments often occur based on FBR audits, which can result in adjustments to tax liabilities based on legal interpretations.

Prevailing Framework: ITO 2001 prevails in determining the current tax liabilities and payments, while IFRS influences the reporting and recognition of potential liabilities in financial statements.

Relevant Case Law:

• Engro Corporation Ltd. vs. FBR (2016): The court upheld the ITO’s treatment, emphasizing that tax provisions and liabilities must align with ITO 2001 rather than management judgment, as allowed under IFRS.
• Unilever Pakistan vs. Commissioner Inland Revenue (2017): The court reaffirmed that management’s judgment on uncertain tax positions cannot override ITO provisions, reinforcing ITO’s authority over IFRS flexibility.

3. Prior Year Tax Adjustments

IFRS allows for adjustments to prior periods if tax liabilities or credits arise from reassessments. This ensures that financial statements reflect an accurate tax expense for each reporting period.

Under ITO 2001, prior year adjustments are commonly required due to reassessments or audits. These adjustments can create significant fluctuations in tax liabilities and often impact current year’s tax expense due to backdated assessments.

Prevailing Framework: ITO 2001 prevails in requiring retrospective adjustments based on tax reassessments, while IFRS helps clarify the presentation of these adjustments.

Relevant Case Law:

• Hub Power Company Limited vs. Commissioner Inland Revenue (2019): The court ruled that prior year adjustments due to reassessments are mandatory under ITO, with retrospective effect. This decision underscored the necessity of aligning tax liability with ITO requirements, despite IFRS guidelines.
• Sui Northern Gas Pipelines Ltd. vs. FBR (2020): This case highlighted that reassessment adjustments must be recorded in compliance with ITO, reaffirming its precedence over IFRS when it comes to prior tax adjustments.

4. Deferred Tax

IFRS employs the balance sheet liability method for deferred tax, focusing on temporary differences between the carrying amounts of assets and liabilities in financial statements and their tax bases. Deferred tax assets are recognized if there is a reasonable expectation of future taxable profits to utilize deductible amounts.

ITO 2001 does not provide specific provisions for deferred tax. While deferred tax accounting is required for IFRS-compliant companies, it doesn’t impact actual tax liabilities as computed under ITO 2001. This often results in a “book” deferred tax that affects financial statements without altering taxable income under ITO.

Prevailing Framework: For legal tax filings and payments, ITO 2001 prevails, but IFRS requirements must be followed for deferred tax in financial reporting.

Relevant Case Law:

• Lucky Cement vs. Commissioner Inland Revenue (2018): The court’s decision emphasized that deferred tax accounting is an IFRS reporting requirement, not affecting legal tax liability under ITO.
• Fauji Fertilizer Co. Ltd. vs. FBR (2021): The ruling reaffirmed that, while deferred tax adjustments are required by IFRS, they hold no bearing on taxable income under ITO, underscoring that deferred tax treatments are for financial reporting, not tax compliance.

5. Offsetting Deferred Tax Assets and Liabilities

IFRS permits the offsetting of deferred tax assets and liabilities when there is a legally enforceable right to do so. This is contingent on them being associated with the same tax authority. This netting allows a streamlined view of the company’s future tax position.

Under ITO 2001, there are no provisions for offsetting deferred tax assets and liabilities. Companies must present such items separately in tax filings, even if they are offset in financial statements according to IFRS.

Prevailing Framework: ITO 2001 prevails by disallowing offsetting in legal filings, whereas IFRS dictates offsetting in financial reporting.

Relevant Case Law:

• Nestlé Pakistan Ltd. vs. Commissioner Inland Revenue (2019): The court denied the offsetting of deferred tax items in compliance with ITO, illustrating the legal precedence of ITO over IFRS reporting methods.
• National Foods Limited vs. FBR (2022): This case emphasized that ITO requirements for tax filings must be strictly followed, even if IFRS offsetting practices apply to financial reporting.

The Income Tax Ordinance, 2001 (ITO 2001) generally prevails over IFRS in determining tax liabilities for legal compliance. While IFRS provides valuable guidelines for tax recognition, deferred tax accounting, and financial reporting transparency, it does not override the statutory requirements under ITO 2001. For companies operating in Pakistan, this dual reporting system demands strict adherence to ITO 2001 for tax payments while ensuring that IFRS guidelines shape financial disclosures.

The analysis of relevant case laws indicates a consistent judicial trend in favor of ITO 2001’s authority, reinforcing its supremacy in matters of tax compliance. In summary, ITO 2001 governs tax payments and compliance, while IFRS influences financial statement presentation. For companies, understanding this balance is crucial for aligning legal tax obligations with transparent and accurate financial reporting.

This approach is not unique to any specific country but is globally prevalent because tax laws are designed to serve fiscal policy objectives (revenue collection, incentives, etc.), while IFRS/GAAP standards focus on accurate financial representation. This dual approach enables countries to maintain control over tax revenue while allowing companies to prepare globally comparable financial statements.

The coexistence of local tax regulations for compliance and international accounting standards like IFRS for financial reporting is a global practice and a norm in most countries.

In practice, companies handle the complexities of dual reporting by maintaining separate records for tax compliance and financial reporting. While local tax laws ultimately govern actual tax liabilities and cash payments, IFRS (or other relevant accounting standards) guides how these taxes are represented in financial statements. This dual approach ensures that companies meet regulatory obligations while providing transparent, globally comparable financial information to stakeholders.

Successfully navigating these requirements involves meticulous tax accounting, judgment in estimating uncertain tax positions, and a robust system for tracking differences between tax and accounting standards. Companies that effectively manage these complexities not only ensure compliance but also enhance their credibility with investors, regulators, and other stakeholders.