Deferred Tax Complete Beginner's Guide

Call me a vigilante or a super-villain disguised as a hero, I'm all set to simplify Deferred Taxation in this article.?

I can feel you. The word?"simple" doesn't fit well with "deferred tax". So let's devise the simplest example the eyes have witnessed.

Simplest Example:

You own a company. "Campany A" it is.

The company owns only one asset (costing $240,000), the asset has a useful life of 3 years and the only use of that asset is to rent it to other entities. Each year the asset would be rented to a different entity for 12 months and all three contracts are already signed. Repairs and maintenance of the asset are the responsibility of the tenants.

As a result of these activities, the only revenue the company has is $100,000 each year and the only expense the company has is a depreciation expense of $80,000 on straight-line basis.

This is your PnL for the next 3 years.

But taxation authorities love us so much that they want to allow us accelerated depreciation of 37.5% in the first year for tax purposes.?

This simply means that the depreciation expenses for "tax purposes" would be $90,000 in the first year and $75,000 in the next 2 years. Consequently, here is the profit computed for tax purposes for each of the next 3 years:

Tell me, which of the profits should be used to compute tax.

a) Accounting Profit b)Tax Profit

Before you Choose...

Assuming a tax rate of 20%, if I use accounting profits, the tax would be $4,000 every year.?If I use tax profits, the tax would be $2000 in year 1 but $5000 in year 2 and year 3.?

Also, note that the total profit for all three years is $ 60,000 under both tax and accounting assumptions. Similarly, the total tax to be paid during the next 3 years is also same under both income statements at $ 12,000.

Irrespective of whether we use the tax assumption or accounting assumption we would end up paying the same amount of tax.?In our example, the only difference is in the timing of recognition.

Lets be more specific.

Focus on the first year.

Recognizing $4000 as tax expense in our "Accounting PnL" makes more sense because while we have recognized $20,000 profit before tax in our "accounting" PnL. We should recognize the MATCHING tax expense in the same year. The expenses should match with corresponding revenues in any given period.

This means that $ 2,000 is CURRENTLY due to tax authorities. However, a total of $4,000 is?eventually payable against the CURRENT year's profits. We actually have two kinds of "tax payables" arising from current year's profit:

1- The one which is immediatly due to the tax aurhorities.

2- The portion which will eventually be payable to the tax athourities, as a result of current years profits.

Accounting Entry for recognizing Deferred Tax

The following accounting entry is made to recognize tax expense and the corresponding split of payables.

Income Tax Expense??$4,000

Current Tax Liability??$ 2,000

Deferred tax liability?$ 2,000

Also note that this 2000 is an increase in deferred tax liability. There might be outstanding deferred tax liability balance outstanding from previous years. Whenever we go through "PnL" approach we can only compute "increase" or "decrease" in the balance which needs to be added to the opening balance in the balance sheet.

More on this in the "Balance sheet approach section below"

Balance sheet Approach

The pattern in which depreciation is released in profit or loss in accounting and tax PnL will determine the asset's NBV in the accounting and tax balance sheet.

Here is how the accounting balance sheets look at the end of each period:

However, on the tax Balance Sheet, the pattern of depreciation was different. Have a look

Terminology Alert: Tax NBV is called "Tax base" while the Accounting NBV is called "Carrying amount"

Note that in year one Tax depreciation was HIGHER than accounting depreciation by $10,000, and as a result tax NBV (tax base) was LOWER by $10000 at the end of?year 1.?

However, also note that in year 2 the tax depreciation was LOWER than?accounting depreciation by $ 5000 yet the tax NBV (tax base) was NOT $5000 higher at the end of year 2 BUT $5000 LOWER.

I understand that it takes some brain cells to track these higher and lowers when studying deferred taxation. Let's try to reduce the number of brain cells required.

Have a look at what exactly is going on behind the scenes.

We have already discussed the differences in profit (column 2 and column 4 above) and tax expenses (column 3 and column 5) for accounting and tax purposes in each of the 3 years.

But if you look at the column "Deferred tax arising during the year", it would show you the differences arising from the current year's profits only.?For example in year 2, there was a $1000 reduction in deferred tax because the tax profits were higher than accounting profits.

However, the final balance in the deferred tax account shall be $1,000 as shown in the last column. This is because the deferred tax liability of $2,000 which arose in the first year was reduced by $1,000 during the second year. And in the final years, it was completely reversed.

The same deferred tax "balances" can be computed directly using the balance sheet approach by comparing the net book value and the tax bases.

All we have to do is compare accounting carrying values with their respective tax bases.

But don't get me wrong!

Although our example only contains a tax base for fixed assets, it's not just about fixed assets. Any difference that is temporary will result in a difference in the accounting balance sheet and Tax balance sheet.?

Show me how!

Think about income received in advance this year which is tax authorities tax on cash basis. The tax balance sheet will have no unearned income (because the same is released to tax PnL) while the accounting balance sheet will have a liability of unearned income (because the amount of cash received in advance has not been recorded in Accounting PnL). Read this para again!

Okay, but where's the catch?

Let me ask you first. Should "accounting" tax expenses be computed in the folowing manner??

Accounting profits * Tax rate

No.

Yes, we do apply the tax rate on accounting profits but only on THOSE accounting profits which we expect to be ACTUALLY TAXED.

Example:

Imagine your "Company A" in addition to the 100,000 in revenue, also received a grant of 5,000 from the government and such grants are exempt for the purpose of tax. The tax would not be applied to the new computed profit of 25000.?Rather the exempt income shall be deducted as follows:

These are usually called permanent differences. Think about it for a moment. The exempt income of $5,000 will never be taxed. So extra $1000 ($5000 * 20%) should never be recorded as tax expense. NOT EVEN IN THE ACCOUNTING INCOME STATEMENT.

Here's a quick question for you. To compute "tax expense" to be recognized in "accounting PnL" we multiply "tax rate" with:

a) Accounting profit

b) Tax profit

c) Taxable ACCOUNTING PROFIT

Are there permanent differences in IAS 12?

No. In IFRS all the differences between the Carrying Amount and the Tax base are TEMPORARY DIFFERENCES.

What makes them "permanent" is how the "tax base" is computed under IAS 12.

If you don't like getting into terminologies, here is a shortcut for you suggested by the standard itself. Treat all the differences as temporary differences and multiply exempt (portion of) items by 0% tax rate to come up with the deferred tax liability.

But for the experts, there are 3 different formulas for tax bases. No, I am not making them up. These are defined so in the standard.

1 - Tax base of an asset

Tax base = The amount that will be deductible for tax purposes against any taxable economic benefits

2 - Tax base of liability (other than unearned income)

Tax base = Carrying amount - any amount that will be deductible for tax purposes in respect of that liability in future periods

3 - Tax base of unearned income

Tax base = Carrying amount - any amount of the revenue that will not be taxable in future periods

Let us have a look at each of these with a PERMANENT DIFFERENCE in the next article. Till then, have fun!