Fair Value and Corporate Taxation: Out through the Door, Back through the Window?

2.1 Some Accounting Issues Related to Fair Value

The IASB and the FASB have been promoting an international trend in accounting harmonization where FVA is increasingly used in the preparation of financial statements. The IASB has been extending FVA to financial instruments and issued IFRS 13 to clarify its use. The historical cost paradigm, traditionally dominant in financial accounting, especially in countries with a continental approach of accounting, is being relatively sidelined by the extended use of fair value (Cairns, 2006; Cairns et al., 2011). Both supporters and critics of FVA can be found in the accounting literature (Adwan et al., 2020; Biondi, 2011; Yuan & Liu, 2011).

According to Biondi (2011) the debate between historical cost paradigm and FVA lays in understanding the fundamental principles of financial accounting, including their implications for relevance and reliability. Accounting standards provide the grounds for managerial decision-making, cost setting, profit determination and many other important matters for business. From this perspective, accounting numbers are not straightforward “natural” measurements, but “artificial” social-economic constructions, which are framed and shaped by standards and conventions underpinned by fundamental accounting principles of reference.

Even before the financial crisis of 2007–08, critics argued that FVA may be pro-cyclical and may impair financial stability (Dietrich et al., 2000). Particularly after the financial crisis, the relationship between accounting and financial market stability has been an issue of interest in the academic community with fair value charged of being a risk for financial market stability (Biondi, 2015). Biondi and Giannoccolo (2015) developed a theoretical framework of analysis for comparatively assessing alternative accounting regimes in terms of systemic risk and financial stability. Their results show higher market volatility under FVA regime, making the financial system more unstable.

One alleged advantage of FVA is that it generates more up-to-date balance sheet figures that reflect market consensus on the financial market value of assets and liabilities (Hung & Subramanyam, 2007; Tsalavoutas et al., 2012). The supporters of fair value consider accounting as “part of the information required by capital market participants to predict current values based on the future, which is supposed to be the proper basis for financial decision-making” (Biondi, 2011:11). On the other hand, income volatility can increase, and the firm becomes less attractive for financial investment purpose (Hung & Subramanyam, 2007; Tsalavoutas et al., 2012). Some empirical research (Landsman, 2007; Siciliano, 2019) highlights the usefulness of fair value to investors and cast doubts about its negative impact on financial stability, while other studies stress its shortcomings concerning the contracting and stewardship role of accounting. Mirza et al. (2011) point out that the inconsistencies in the assessment of investment properties could influence the information available for investors and then their financial decisions.

FVA does not appear suitable for assessing assets traded in illiquid markets or valuing specific business assets. Additionally, historical cost-based accounting is seen as more reliable (Fukui & Saito, 2020; Ramanna, 2021), since past acquisition expenditures and realized revenues from customers are easily proven. Under historical cost accounting, unrealized gains are usually not recognized, given the conservatism applied to the preparation of financial information.

While, on the accounting side, fair value is at the center of an ongoing debate, the tax consequences of its adoption are also a major issue for legislators, companies, and tax practitioners. With the widespread acceptance of FVA, tax legislators around the world have struggled to find how to accommodate FVA in corporate tax codes, since the determination of the corporate income tax basis depends and draws upon financial statements.

2.2 An Overview of Tax Issues Related to Fair Value Taxation

Financial accounting standards aim at establishing a set of rules which provide a true and fair view of a reporting entity’s performance and financial position. Designing a tax system has also some overarching goals: It must raise revenue to support public spending; it should strike a balance between fairness, efficiency and simplicity (Slemrod & Bakija, 2017); it is expected that accounting and taxable income are impacted by different policy goals (Blaufus & Jacob, 2017).

In a significant number of countries, tax rules are based on lower-of-cost-or-market and historical cost systems instead of references to current market prices. In the last years the standardization of the taxable income and accounting income has been under discussion. The European Commission considered the IFRS framework as a starting point for the implementation of CCCTB^[4] (Becker & Steinhoff, 2014). According to Desai (2005:172) the existing differences between book and taxable income led to a deterioration of financial results and “greater conformity in the measurement of book and tax profits could provide firms with some automatic incentives to reduce tax avoidance and to be less aggressive in reporting profits to capital markets”. Sunder (2011) highlights the advantages of combining tax and financial reporting, such as the end of dual auditing (tax auditors and statutory auditors).

Different solutions are potentially available when fair value-based taxation is discussed. To relegate fair value to the accounting side, while basing taxation on the realization principle, would imply a complete disconnection between book and taxable income. The realization principle protects taxable income from the assets’ value oscillations. On the other hand, the full acceptance of the tax consequences of fair value could be adopted. That is, fair value gains and losses recognized by the accounting rules would be included in the determination of the tax base, achieving greater convergence.

An intermediate solution could be adopted, according to which limited and clearly stated changes in fair value would produce tax effects. Solutions adopted by many jurisdictions show that this is not an easy regulatory decision. As stated by Cavana et al. (2013:52) for the Italian case: “(…) the wide use of fair value in the measurement of financial assets required by IAS 39 is one of the most controversial issues in the debate about the suitability of IFRS for tax purposes because, as a general tax principle, capital gains or losses should assume relevance only at realization”.

After the introduction of the IFRS standards, countries tend to move toward a greater disconnection between corporate book and tax income (Gee et al., 2010; Wahaba & Holland, 2015). FVA is a key reason for this disconnection, given the lower reliability of accounting values, especially when levels 2 and 3 of FVA are used for assessment. At the same time, several countries provide exceptions from the general realization principle that usually underpins taxation (Blaufus & Jacob, 2017). Such exceptions typically concern financial assets and liabilities held for trading. These authors point out that in the Czech Republic, Denmark, Finland, France, Hungary, Italy, Portugal, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom financial assets and liabilities held for trading, measured at fair value, produce, in certain circumstances, unrealized (fair value) profits and losses subject to corporate tax. Thus, some tax base items for which fair value accounting is accepted are found in some jurisdictions around the world.

Given that traded financial instruments are accounted for at FVA level 1 basis, this subset of FVA values is considered for tax purposes. This is a usual area where accounting values have tax consequences.

Following the fair value hierarchy, when quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) are not available, several tax systems, including the Portuguese CITC, introduce several limitations on the use of FVA. Unobservable inputs (Level 3 inputs), usually described as mark to model valuation, bring undesirable subjectivism of economic and financial assumptions into the tax base definition. In particular, as mentioned above, Level 3 inputs often rely on DCF models, reflecting current market expectations on discount rate or cost of capital. Paragraph B13 of IFRS 13 establishes that present value determination includes several elements such as: (i) estimates of future cash flows for the asset or liability under measurement, (ii) expectations about variations in the amount and timing of the cash flows representing riskiness, (iii) the time value of money, represented by the rate on risk-free monetary assets, (iv) the price, or compensation, for bearing the uncertainty inherent in the cash flows (i.e., a designated “risk premium”), and (v) other factors that market participants would consider.

At level 3 of FVA measurement hierarchy, the absence of a comparable market requires the use of a model to calculate hypothetical market prices. Tax legislators choose to keep FVA at the margin because of its volatility and lack of reliability when there are no organized markets to trade assets (Martins, 2015; Tavares, 2011). To prevent managerial opportunism and potential abuse, the role of FVA is explicitly restricted in corporate taxation in Portugal, as analysed in next Section 3.

However, the DCF method, which is prominent in Level 3 FVA, permeates the tax base through goodwill expensing, transfer pricing, impairment charges, exit tax issues and in the measurement of other assets and liabilities, bringing - through the window - precisely the volatility and subjectivism inherent to FVA that legislators explicitly tried to avoid. These issues are addressed in detail in Section 4.

4.1 Goodwill

Goodwill is defined by the Accounting and Financial Reporting Standard n. 6 (based on International Accounting Standard n. 38 as adopted by the EU) as an intangible asset with an indefinite useful life. Considering that a business combination gives the acquirer control of other businesses, the identifiable and separate assets and liabilities transferred to the acquirer are revalued at fair value at the time of the acquisition. It must be noted that in a business combination, the net assets acquired (if an acquisition of net assets) or the entity over which control is obtained (if an acquisition of equity interests) must constitute a business (Accounting and Financial Reporting Standards n. 14). Goodwill, as a kind of residual asset, is also recognized at the date of the acquisition as the difference between the consideration paid to perform the operation and the revaluated value of acquired net assets.

The reliability of this measurement is based on an effective transaction that occurred between participants to the business combination transaction. However, it is, by nature, a forward-looking value that depends on several unobservable variables and forecasts (Neves, 2004). Baker et al. (2008) describe several problems arising from the measurement of that consideration paid to achieve a business combination.

In Portugal, since 2016, the Accounting and Financial Reporting Standard n. 14 ^[6] states that goodwill must be amortized according to its useful life, or if the latter is indefinite, for ten years. This diverges from international accounting standard as adopted by the EU, which excludes goodwill amortization. Moreover, following the recommendation of the Commission for the Reform of Corporate Income Tax in 2013,^[7] the legislator granted a specific tax treatment to intangible assets without a defined useful life. For these “perpetual” assets, the CITC established (in article 45-A) the deduction of their acquisition cost, in equal parts, over twenty tax periods.

This tax treatment was not placed in the CITC’s section dealing with “Depreciation and amortization”. It was set up in “Other tax deductions”.^[8]

When asset control is transferred, goodwill represents “the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized” (IFRS 3, Appendix A). The consideration paid to achieve the business combination is then split between goodwill and the acquired identifiable assets and liabilities on the basis of their revaluated values. The rest of the consideration after having deducted the revalued net assets is allocated to goodwill in the financial statements of the acquiring entity. Thus, not only the fair values of the assets transferred have tax effects, but also the amount corresponding to goodwill is deductible over a twenty-year period (Article 45-A of CITC).

Supposing that, for an amount of 100, Company A acquires assets and assumes liabilities from Company B. The latter set of accounting elements is supposed to constitute a business. The allocation of B’s identifiable net assets on the basis of their fair values amounts to 80. The excess (20) of the consideration paid to acquire those net assets over the amounts assigned to the identifiable accounting elements would be recognized as goodwill.

In this case, the identifiable assets will be depreciated over their useful lives, and, as a rule, these expenses are tax deductible. The amount related to goodwill will be amortized for ten years, assuming that its useful life is not indefinite. But, as said, the Portuguese CITC should not allow in principle the inclusion in the taxable base of goodwill amortization, since depreciation of assets with indefinite useful lifetimes is not deductible. Nevertheless, it accepts the deduction of goodwill over twenty years.

To sum up, and considering the example given above, the expensing of goodwill through an annual tax deduction of 5% (implying twenty years for completing amortization), is based on its initial recognized value (20 = 100–80). Not only the acquisition value, but the specific allocation and valuation of B’s identifiable assets are based on fair values. This accounting evaluation procedure may include FVA level 1 (e.g., listed financial instruments held by B), level 2 (e.g., investment properties valued on the basis of comparable transactions) and level 3 (e.g., a patent). Thus, FVA may have considerable impact in the amount of goodwill (20) that is expensed for tax purposes, as well as on the remaining assessed values (80).

4.2 Impairments

The second example refers to impairment loss for non-current assets, which can be deducted from the tax base. According to Accounting and Financial Reporting Standard n. 12, following a conservative approach, an impairment loss should be recognized if the recoverable amount of a tangible asset is lower than its book value. The recoverable amount is the highest between a fair value less costs (market value) and the value in use (DCF value). This complies with international accounting standard n. 36. When the value in use of the asset exceeds the former, it becomes the reference value in the impairment test. In other words, if the present value of estimated cash flows related to the asset is lower than its net book value, a write-off ensures that the asset is not overvalued on the balance sheet. This occurs after identifying factors underpinning the asset’s impairment, such as accidents, natural disasters, significant technology changes or new regulatory enforcements influencing the ability to generate future cash flows (Elliott & Elliott, 2009; Martins et al., 2020a; Rodrigues, 2021).

When a company records an impairment loss, it should be recognized as a reduction of net income. However, this expense is not automatically accepted for tax purposes. An ex-ante authorization from the Portuguese Tax Administration prior to its deduction from the taxable income must be obtained. This authorization introduces a further restriction beyond the requirements of the accounting standard of reference. As stated in Article 31-B of the CITC, an impairment loss on non-current assets from proved abnormal causes, such as disasters, natural phenomena, exceptionally rapid technical innovations, or significant changes with adverse effect in the legal context, may be accepted as tax expenditure. In the request, the cash flow that the asset was expected to generate, either through its best use, or by selling it to a third party, should be determined. Once again, financial valuation techniques (Level 3 FVA) are based on hypotheses and assumptions. Clearly, if the non-current asset refers to goodwill, the degree of complexity increases, as previously explained. In the impairment domain, DCF is key for accounting valuation and may have tax relevance.

4.3 In-Kind Assets

Portuguese commercial law allows equity holders to contribute in kind in the form of assets (e.g., land, buildings, inventory) in view to achieve an increase of the company’s share capital.

When establishing a company, or increasing its equity capital, shareholders may contribute in-kind assets and not in-cash. This option involves legal procedures, such as an independent report by an independent statutory auditor, ensuring a fair and proportional distribution of the capital to shareholders. Additionally, since share capital is expected to work as a protective buffer for company creditors, in-kind contributions should be carefully measured. The professional rules followed by statutory auditors require a market approach when determining the value of contributions made in kind. Consequently, those assets transferred by shareholders to the company’s capital are measured at fair value. The initial recognition of a building as part of capital paid up in kind may imply the use of DCF, if no market prices for similar assets are available. Thus, an additional avenue for the tax relevance of FVA is observed.

Additionally, further deductible amortizations, depreciations, or impairments factored into the calculation of taxable income have their base on a valuation of these in-kind assets (Article 31(1)(c) of the CITC). When these assets are not actively traded in markets, level 3 FVA is the last (and tax relevant) resort for valuing capital contributions in kind.

It should be noted that these assets come from the shareholders’ personal sphere, as an alternative to cash contributions. Therefore, they are often in second-hand condition, bringing complexity and subjectivity to fair-value evaluation. For instance, one of the challenges faced by the statutory auditor consists of appreciating the usefulness of the assets for the firm. Their usefulness results either from the specific use of the asset at a business level, or its market liquidity. The admissibility of this procedure under tax law contrasts with the frequent legal restrictions designed to protect tax income. For example, as mentioned above, the increase in depreciation expenses resulting from a revalued fixed asset is not tax deductible.

4.4 Transfer Pricing

As known, transfer pricing deals with intra-group transactions, using the arm’s length principle to derive prices for these transactions deemed similar to transactions concluded between unrelated entities, in comparable circumstances (OECD, 2017; 2022). The implementation of this principle requires alternative measures (Avi-Yonah, 2017), and it plays a central role in international tax avoidance. The right to minimize tax burden and the duty to pay a fair amount of tax often frame the debate on related issues (Biondi, 2017).

The legal framework of the transfer pricing regime in Portugal is provided by Article 63 of the CITC and Regulation 268/2021, 26th November. Two cases suffice to illustrate the role of Level 3 FVA in tax relevant transfer pricing computation. In the first case, it is assumed that a company and its shareholders exchange non-traded equity instruments. Provided that no level 2 FVA can be used, then a DCF valuation must be performed to estimate the market value of those financial instruments. Tax authorities may accept or challenge the assessment. If it is challenged, the DCF is generally calculated again based on alternative assumptions. Significant amounts of taxable income may be at stake, depending on fair value inputs which do not come from regulated exchanges (Martins et al., 2020b). In Case No. 205/2020-T, 24/4/2021, a Portuguese tax Court analyzed the suitability of the method applied by the tax authorities to assure comparability between operations. The final decision concluded, in line with the OECD guidelines and with financial literature, that companies’ share valuation must be based on available information, including data (cash flows and discount rates) that can be known, or estimated, at the time of the valuation.

In a hypothetical second case, it is conceivable that real estate transactions may happen between firms and related parties. If an appraiser is appointed by both parties to produce a technical report, the capitalization of future income generated by the assets (Level 3 FVA) may produce material values relevant for tax purposes.^[9]

In both examples, we highlight that the valuation of transacted assets is not based on historical cost, book value or any other non-fair-value measurement technique. On the contrary, an assessment method anchored in Level 3 FVA is used and, if tax authorities do not challenge it, it has immediate tax consequences. Even if challenged in a tax audit, the adjustments made are, at their root, dependent on FVA inputs.

4.5 Exit Tax

Exit tax is regulated in Article 83 of the CITC, transposing the rules prescribed in EU ATAD Directive. This directive establishes that assets transferred between jurisdictions must be assessed at market value. This valuation implies the computation of potential capital gains (Zernova, 2011). Benefiting from a country’s environment during a period of residence supports the option to locally tax the gains which arise during this period.

We point out two issues emerging from the EU Directive’s application. One of a general nature, the other related to the Portuguese version of the exit tax.

The first one stems from the fact that most assets are not traded in active markets, comparable transactions are rarely available, and the typical valuation done in such circumstances is based on a DCF model (level 3 FVA).

In such an assessment, both the forecasted cash flows and the applied discount rate (cost of capital) are of paramount importance. In the computation of a proper discount rate, when an asset is less tradable or non-tradable, financial theory and practice recommend increasing the discount rate (and the corresponding decrease in fair values) by the so-called discount for “lack of tradability or liquidity” (Brealey et al., 2014; Hitchner, 2011).

Applying DCF methods in the context of exit taxes to non-traded cash-flow-generating assets may become a complex topic, prone to litigation between companies and tax authorities, because small variations in discount rates (and other critical assumptions) may induce significant changes in computed valuations and the exit tax’s quantitative base.

The second issue is related to the Portuguese version of the exit tax. Under this rule, the taxable income base of the period in which a Portuguese company transfers its residence to another jurisdiction, must contain the positive or negative differences of market values and the tax-relevant values of the assets “even if not expressed in the accounts” (Article 83(1) of the CITC). Here we enter into a very problematic issue: how to value some internally generated assets that cannot be recognized in financial statements? How to value, for instance, often non-recognized assets such as a customer list, the skills of the workforce, brand recognition, or R&D in progress?

In case of a business combination, the entire value of these assets can be recognized, as explained above. However, since an effective transaction does not occur in a business dislocation, their values must be estimated. This is usually based on DCF methods, aiming to assess current values to determine the taxable income. In this sense, the impact of level 3 FVA is also introduced in the corporate tax domain.