Deferred Tax Assets

Deferred Tax Assets Stem from Deductible Differences

In our previous article, we discussed that the difference between accounting and taxable profits can be either permanent or temporary. Furthermore, we delved into the classification of temporary differences into taxable temporary differences and deductible temporary differences. Our discussion ultimately revealed that deductible temporary differences give rise to deferred tax assets.

A deferred tax asset, found on a company's balance sheet, symbolizes the excess taxes paid by the company or the tax deductions that can be utilized to reduce future tax obligations. This asset arises from various factors, such as cases where taxable revenue exceeds accounting revenue due to deductible temporary differences, instances where taxable expenses are lower than accounting expenses because of deductible temporary differences, and situations where the company has tax losses or tax credits to be carried forward.

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Tax authorities may require businesses to pay tax on a greater amount of income compared to what is reported in the statement of comprehensive income, resulting in higher taxable profits. For example, if a business receives three years' rent amounting to Dh 300,000 as advance. In the accounting records, this amount would typically be spread out and amortized over three years at Dh 100,000 per year. However, tax authorities may operate on a cash basis and could mandate that the entire Dh 300,000 rental receipt be treated as taxable revenue in the initial year. It is important to note that in the UAE, advances such as mentioned above are not subject to corporate tax, therefore deferred revenue from advances will not create any deductible temporary differences.

In scenarios where taxable expenses fall below accounting expenses, common examples include provisions for warranties, bad debts, research and development costs, legal costs, and more. Companies often record expenses based on estimates or provisional figures, whereas tax authorities may recognize expenses on a cash basis. For example, let's take a company such as X Ltd. They project, using historical data, that 5% of their total sales, equivalent to Dh 1,000,000, should be set aside for repairs in the next years to cover potential warranty claims. As a result, X Ltd creates a provision of Dh 50,000 [1,000,000 * 5%] which may not be accepted by tax authorities and can lead to deferred tax assets.

?Another factor contributing to deferred tax assets, leading to reduced future tax payments, is the utilization of carried forward losses and tax credits. These losses and/or credits will be offset against upcoming taxable profits, thereby reducing taxable income, and consequently lowering the tax burden. The duration for which losses can be carried forward differs across jurisdictions, and the specific timeframe for carrying forward these losses is contingent upon the prevailing laws that govern each jurisdiction. In the UAE corporate tax law (the law), the tax losses can be carried forward for unlimited period.

International Financial Reporting Standards [‘IFRS’) states that the deductible temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.

Referring to the definition of IFRS provided above, the instances of Dh 200,000 [carrying amount Dh 100,000 less tax base Dh 300,000] in rent and Dh 50,000 [carrying amount Dh 50,000 less tax base Dh 0] in warranty costs represent deductible temporary differences. As a result of these factors, the company will pay higher taxes in the present period. Nevertheless, these amounts will be deductible in the future when calculating the taxable profits for the respective period.

IFRS with the few exceptions further states that a deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized.

As the total deductible temporary differences amount to Dh 250,000 [200,000 + 50,000], the company will recognize a deferred tax asset of Dh 22,500 [250,000 * 9% (the applicable corporate tax rate)], assuming that there will be future tax liability against which this deferred tax asset will be adjusted.

Along with the requirement of IFRS, in the law we need to carefully examine the provisions that result in deductible temporary differences, leading to the recognition of deferred tax assets.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not his official but personal opinion. For any clarification, please feel free to contact him at?[email protected]