Concept of Deferred Tax
The most significant question in terms of accountancy which arises in relation to taxation is how to allocate the income tax expense between accounting periods. IFRS governs the way that transactions in a particular accounting period are recognised in the financial statements, but the timing of these transaction for the purposes of measuring taxable profit is governed by tax legislation. It is therefore widely known that sometimes IFRS will prescribe one accounting treatment for a transaction(s), whereas tax legislation may dictate something else. The generally accepted view is that it is necessary to seek some sort of reconciliation between these two different treatments and this reconciliation is known as ‘deferred taxation’. The main thrust of deferred tax is therefore to recognise the tax effects of transactions in the financial statements in the same period as the transactions themselves.
Understanding Permanent Difference
If an item in the profit and loss account is never chargeable or allowable for tax or is chargeable or allowable for tax purposes but never appears in the profit and loss account then this is a permanent difference. A permanent difference does not give rise to deferred tax.
Example: Lets say a financial transaction involving an entertainment expense is incurred. The nature of expense is such that it is disallowed for tax deduction. Then the amount of entertainment expense in financial statement is Rs. X but the amount of entertainment expense in income return is Rs. 0. This difference is called permanent difference which will not be adjusted/reconciled any time in the future for tax purposes.
Understanding Temporary Difference
If items are chargeable or allowable for tax purposes but in different periods to when the income or expense is recognised then this gives rise to temporary differences. Temporary difference do give rise to potential deferred tax, but the rules on whether the deferred asset or liability is actually recognised can vary.
Example: Lets say a financial transaction involving an interest expense is incurred. The nature of expense is such that it is allowed for tax deduction but subject to a fixed limit in an income year, the excess would be carried forward into next year. Then the amount of interest expense in financial statement is Rs. X but the amount of entertainment expense in income return is Rs. Y. This difference is called temporary difference which will be adjusted/reconciled in the future for tax purposes.
Components of a Financial Transaction
Any financial transaction can be reflected in double entry system through the broad headings: Income, Expense, Asset and Liability.
The component of Financial Amount can be divided into Permanent Difference, Temporary Difference and Taxable Amount.
Over time, the Temporary Difference will be reversed and all the Temporary Difference will be nullified. Eventually, Financial Amount and Tax Amount will be equal. The Taxable Amount and Financial Amount may not be equal over time due to the Permanent Difference.
Component of Income Tax
The term Income Tax included Current Tax and Deferred Tax. They are calculated as follows:
1. Current Tax: Taxable Amount × Tax Rate
2. Deferred Tax: Temporary Difference × Tax Rate
Computation of Deferred Taxes (In No-Tax-Holiday Period)
Like discussed above deferred taxes are accounted only for the temporary differences. Permanent differences do not give rise to deferred taxes.
In the example below, a company derives a constant income of 400,000 over the period of 10 years. However, due the difference in tax regulations and management policy for expense recognition, total expense of 2,000,000 over the period of 10 years is booked differently in accounts and claimed for deduction for tax purpose differently. Despite this difference, the total expense claimed for financial purpose and tax purpose eventually equals over the period of 10 years i.e. 2,000,000. This is known as temporary difference and deferred tax expense/income is recognized against this as depicted in C5 assuming a tax rate of 25%.
Yr | Income | Fin. Expense | Tax. Expense | Tax Paid | Difference | Reversal | DT Expense/(Income) | Fin. Reserve | Tax. Reserve |
C1 | C2 | C3 | C4 | C5 | C6 | C7 | C8 | C9 | |
Mgmt. Policy | Tax Regulations | (C1-C3)×25% | (C3-C2) | (C5+C6)×25% | C1-C2-C4-C7 | C1-C3-C4-C7 | |||
1 | 400,000 | 200,000 | 333,333 | 16,667 | 133,333 | – | 33,333 | 150,000 | 16,667 |
2 | 400,000 | 200,000 | 333,333 | 16,667 | 133,333 | – | 33,333 | 150,000 | 16,667 |
3 | 400,000 | 200,000 | 333,333 | 16,667 | 133,333 | – | 33,333 | 150,000 | 16,667 |
4 | 400,000 | 200,000 | 333,333 | 16,667 | 133,333 | – | 33,333 | 150,000 | 16,667 |
5 | 400,000 | 200,000 | 333,333 | 16,667 | 133,333 | – | 33,333 | 150,000 | 16,667 |
6 | 400,000 | 200,000 | 333,333 | 16,667 | 133,333 | – | 33,333 | 150,000 | 16,667 |
7 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
8 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
9 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
10 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
4,000,000 | 2,000,000 | 2,000,000 | 500,000 | (0) | – | (0) | 1,500,000 | 1,500,000 |
Computation of Deferred Taxes (In Tax-Holiday Period)
Same as above but in this example below, the company has a tax holiday period from Year 1 to Year 7, where it is taxed at 0% on its profits.
Yr | Income | Fin. Expense | Tax. Expense | Tax Paid | Difference | Reversal | DT Expense/ (Income) | Fin. Reserve | Tax. Reserve |
C1 | C2 | C3 | C4 | C5 | C6 | C7 | C8 | C9 | |
Based on Mgmt. Policy | Based on Tax Regulations | (C1-C3)×Rate | (C3-C2) | (C5+C6)×25% | C1-C2-C4-C7 | C1-C3-C4-C7 | |||
1 | 400,000 | 200,000 | 333,333 | – | 133,333 | (133,333) | – | 200,000 | 66,667 |
2 | 400,000 | 200,000 | 333,333 | – | 133,333 | (66,667) | 16,667 | 183,333 | 50,000 |
3 | 400,000 | 200,000 | 333,333 | – | 133,333 | – | 33,333 | 166,667 | 33,333 |
4 | 400,000 | 200,000 | 333,333 | – | 133,333 | – | 33,333 | 166,667 | 33,333 |
5 | 400,000 | 200,000 | 333,333 | – | 133,333 | – | 33,333 | 166,667 | 33,333 |
6 | 400,000 | 200,000 | 333,333 | – | 133,333 | – | 33,333 | 166,667 | 33,333 |
7 | 400,000 | 200,000 | – | – | (200,000) | 200,000 | – | 200,000 | 400,000 |
8 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
9 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
10 | 400,000 | 200,000 | – | 100,000 | (200,000) | – | (50,000) | 150,000 | 350,000 |
4,000,000 | 2,000,000 | 2,000,000 | 300,000 | (0) | – | – | 1,700,000 | 1,700,000 |