Deferred tax assets are one of those accounting concepts that matter more in practice than they appear to on a balance sheet. A WFOE in China that builds up a deferred tax asset position — typically from tax losses carried forward, from timing differences between book and tax depreciation, or from provisions that are deductible for tax purposes only when paid — needs to understand how the Chinese tax authorities view deferred tax assets and what happens to them when the business changes.
A deferred tax asset that the company expects to recover through future taxable profits may not be recoverable in the way the company expects, and a deferred tax asset that disappears on a restructuring is a real economic loss that someone bears.
Where Deferred Tax Assets Come From
The most common source of deferred tax assets in China is tax losses carried forward. A company that incurs a tax loss in a given year can carry the loss forward and deduct it from taxable income in future years. The carryforward period is five years for ordinary losses and ten years for losses incurred by high and new technology enterprises and small and medium-sized technology enterprises.
The tax loss creates a deferred tax asset on the balance sheet — a future tax benefit that the company expects to realize when it generates taxable profits against which to offset the loss. The accounting for the deferred tax asset requires an assessment of whether it’s probable that the company will have sufficient taxable profits in the future to utilize the loss. If it’s not probable, the deferred tax asset must be written down through a valuation allowance.
Timing differences between book depreciation and tax depreciation are another common source. If the company depreciates an asset over ten years for book purposes but the tax rules allow accelerated depreciation over five years, the company records higher depreciation for tax purposes in the early years and lower depreciation in the later years, creating a temporary difference that reverses over the asset’s life.
Provisions and accruals that are expensed for book purposes but are only deductible for tax purposes when paid — warranty provisions, bonus accruals, litigation provisions — create temporary differences that give rise to deferred tax assets.
The Recovery Assessment
The accounting standards require the company to assess at each reporting date whether it’s probable that sufficient taxable profits will be available to allow the deferred tax asset to be recovered. The assessment must consider the company’s business plan, its historical profitability, and any specific factors that affect its ability to generate taxable profits.
A company that has been loss-making for several years and has a balance sheet with a large deferred tax asset supported by a forecast of future profitability that hasn’t materialized is at risk of a valuation allowance write-down. The auditor will challenge the assumptions underlying the forecast, and the tax bureau may challenge the company’s characterization of its tax position if the deferred tax asset is presented as an asset supporting the company’s financial position.
The recovery assessment for a WFOE in China should consider the specific characteristics of the China operation. A WFOE that’s a contract manufacturer for a related party — the parent company places orders, and the WFOE fulfills them on a cost-plus basis — has limited ability to generate significant taxable profits independently because its transfer pricing arrangement limits its profit to a markup on costs. A deferred tax asset that requires significant taxable profits to recover may not be recoverable if the WFOE’s transfer pricing doesn’t allow for significant profits.
Tax Losses on a Restructuring
Tax losses are generally not transferable in China. If a company with accumulated tax losses is merged into another company, the tax losses of the absorbed company generally cannot be carried forward by the surviving company unless the merger qualifies as a special tax-free reorganization and the tax authorities approve the carryforward.
The rules for special tax-free reorganizations require that the business of the absorbed company is continued by the surviving company, that the shareholders of the absorbed company receive shares in the surviving company as consideration, and that the transaction is not undertaken primarily for tax avoidance purposes. A merger that meets these conditions may allow the surviving company to carry forward the tax losses of the absorbed company, subject to an annual limitation based on the value of the transferred assets.
A simple share transfer does not affect the target company’s tax losses. The target company continues as the same legal entity, and its tax losses remain available to be carried forward against its own future taxable profits. A foreign company that acquires a Chinese company with accumulated tax losses can benefit from those losses if the target company generates taxable profits in the future.
The tax authorities scrutinize acquisitions of loss-making companies where the primary motivation appears to be the acquisition of the tax losses. An acquisition that is structured to bring the target company’s tax losses within a profitable group may be challenged if the commercial rationale for the acquisition is not substantive.
The Impact of a Change of Business
A company that changes its business — for example, a WFOE that was a trading company and becomes a services company — can generally continue to carry forward its tax losses from the earlier business against profits from the new business, because the legal entity hasn’t changed and the tax losses belong to the legal entity, not the business.
But the tax authorities may question whether the new business is a genuine continuation of the old business or a new business that is using the old company’s tax losses to shelter income that would otherwise be taxed. A company that ceased trading operations, dismissed all its trading staff, and started providing services with new staff and new assets is arguably a different business in the same legal entity, and the tax authorities may challenge the use of the old trading losses against the new services income.
The company should document the commercial rationale for the business change and the continuity between the old and new businesses. A trading company that transitions to providing supply chain management services to the same customers is evolving its existing business, not starting a new one. The continuity of customer relationships, staff, and business assets supports the argument that the company is the same business and the tax losses are validly carried forward.
Impairment and Write-Off
A deferred tax asset that is not expected to be recovered must be written down through a valuation allowance. The write-down is an expense on the income statement and reduces the company’s net assets. A write-down that’s recognized late — after the company has been carrying an unrecoverable deferred tax asset on its balance sheet for several periods — may indicate a failure of management’s financial reporting controls.
The decision to write down a deferred tax asset is a judgment that depends on management’s assessment of future profitability. The judgment is subject to audit scrutiny and, in a regulated environment, to regulatory scrutiny. A company that resists writing down a deferred tax asset because the write-down would trigger a breach of a loan covenant or a regulatory capital requirement is making a fraudulent representation about its financial position and may expose its directors and officers to personal liability.
The practical approach is to prepare a detailed forecast of taxable profits for the period over which the deferred tax asset is expected to be recovered, to document the assumptions underlying the forecast, to update the forecast at each reporting date, and to write down the deferred tax asset promptly when the forecast no longer supports recovery. A write-down that’s recognized early is a disappointment. A write-down that’s recognized late is a problem.
