Deferred Tax- Tax Effect of Temporary Differences

Deferred tax is the tax for those items which are accounted in Profit & Loss A/c but not accounted in taxable income which may be accounted in taxable income in future & vice versa. It shall either be paid or has already been settled due to momentary inconsistency between an organization’s income statement and tax statement. The word Deferred has been derived from the word “Deferments” which means setting out for something to happen at a future date.

Deferred Tax is accounted for in accordance with Ind AS 12 “Income Taxes”. Deferred Tax can fall into one of the two categories- Deferred Tax Asset or a Deferred Tax Liability. A deferred tax of any type is recorded in the balance sheet of an organization, however their source of generation is income statement.

In earlier years, deferred tax was recognized based on the concepts of timing differences and permanent differences in accounting income and taxable income. This concept stands revised with IND AS 12 which recognizes deferred tax based on temporary differences that arise due to difference in the carrying value of an item of asset or liability as per books of accounts with the carrying value of that item as per income tax provisions. This method is known as Balance sheet approach.

Temporary Differences

Differences between the carrying value of an asset/liability in the balance sheet and its tax base are known as temporary differences. Tax Base of an asset or liability is the amount related to the asset or liability for tax purposes. A simple example to understand the tax base: A machine cost Rs 200. For tax purposes, depreciation of Rs 60 has been deducted. So the tax base of the machine is Rs 140.

 Temporary differences can be of two types:

1. Taxable Temporary Difference:

It is a temporary difference that will yield taxable amounts in the future when determining taxable profit or loss. It may arise in following cases :

     a) Depreciation on assets

     b) Interest as revenue charged in accounting profit but not added to tax profits

     c) Goodwill arise in business combination

     d) Assets revalued but no adjustment made for tax purpose

2. Deductible Temporary Difference:

It is a temporary difference that will yield amounts that can be deducted in the future when determining taxable profit or loss. It may arise in the following cases:

 a) Retirement benefits

 b) Preliminary Expenses

In both cases, the differences are settled when the carrying amount of the asset/liability is recovered or settled. Because of temporary differences, the expense that an entity incurs in a reporting period usually comprises both current tax expense or income, and deferred tax expense or income.

It should be kept in mind that Deferred Tax Liability or Deferred Tax Assets are created only for temporary timing difference. For difference other than temporary, it is not created as they are not going to be reversed.

Deferred Tax Liability (DTL)

A deferred tax liability occurs when a business has a certain amount of accounting income as per the books and that amount is different from the taxable amount on their tax return. It is the amount of income tax payable in future periods in relation to the taxable temporary differences.

             If Tax expenses                                                   If Tax income

                      >                                                                           <

   Accounting expenses = DTL                                Accounting income = DTL

Deferred Tax Asset (DTA)

When a company overpays for a particular tax period, this can be noted as a deferred tax asset on the balance sheet. If taxes are overpaid or paid in advance, then the amount of overpayment can be considered an asset and depicts that the business should receive some tax break in the next filing. A deferred tax asset can also occur due to losses that are carried over to a new accounting period from a previous accounting period and can then be claimed in the new period as an asset. A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a company.

             If Tax expenses                                                   If Tax income

                      <                                                                          >

   Accounting expenses = DTA                                Accounting income = DTA

Illustration

Let us consider a situation wherein the following details are as follows:

Income as per the books of accounts of the company

Revenue = 60, 00,000

Expenses as per books = 20, 00,000

Taxable income = 40, 00,000

Tax @ 30% = 12, 00,000

Income as per Income Tax authorities

Revenue = 50, 00,000

Expenses allowable as per IT Authorities = 8, 00,000

Taxable income = 42, 00,000

Tax @ 30% = 12, 60,000   

In the given situation, excess tax paid today due to the difference between the income computed as per books of the company and the income computed as per the income tax authorities is 12,60,000 – 12,00,000 = 60,000.

This amount i.e. 60,000 will be termed as deferred tax asset (DTA). It will be adjusted in the books of accounts during one or more subsequent year(s).