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: Current Tax and Deferred Tax
Let’s take two transaction for an example.
Transaction 1: Income derived Rs. 200,000. Out of this, Rs. 10,000 is final withholding income so it is not included for taxation purpose. Similarly, out of this, Rs. 40,000 is not taxable in the current year but will be taxed in next income year.
Transaction 2: Expense incurred Rs. 75,000. Out of this, Rs. 5,000 is not deductible for tax purpose. Similarly, out of this, Rs. 7,000 is not deductible in the current year but will be deductible in next income year.
| # | Ledger | Type | Financial Amount | Taxable Amount | Permanent Difference | Temporary Difference |
| 1 | Bank | BS | 200,000 | 150,000 | 10,000 | 40,000 |
| Income | PL | (200,000) | (150,000) | (10,000) | (40,000) | |
| 2 | Expense | PL | 75,000 | 63,000 | 5,000 | 7,000 |
| Bank | BS | (75,000) | (63,000) | (5,000) | (7,000) | |
| 3 | Current Tax | PL | 21,750 | 21,750 | ||
| Current Tax | BS | (21,750) | (21,750) | |||
| Deferred Tax | PL | 8,250 | 8,250 | |||
| Deferred Tax | BS | (8,250) | (8,250) |
Explanation: In the above table,
Transaction 1: Income derived Rs. 200,000 (Financial Amount). Out of this, Rs. 10,000 (Permanent Difference) is final withholding income so it is not included for taxation purpose. Similarly, out of this, Rs. 40,000 (Temporary Difference) is not taxable in the current year but will be taxed in next income year.
Transaction 2: Expense incurred Rs. 75,000 (Financial Amount). Out of this, Rs. 5,000 (Permanent Difference) is not deductible for tax purpose. Similarly, out of this, Rs. 7,000 (Taxable Amount) is not deductible in the current year but will be deductible in next income year.
Transaction 3: Current Tax = Taxable Amount × Tax Rate (-150,000+63,000)×25%. Since, Current Tax is not deductible for tax purpose, the entire amount of Current Tax is Permanent Difference.
Transaction 4: Deferred Tax = Temporary Difference × Tax Rate (-40,000+7,000)×25%. Since, Deferred Tax does not have any bearing for tax purpose, the entire amount of Deferred Tax is Permanent Difference.
Computation of: General Reserve and Taxed Reserve
Lets not complicate things. We will build up on the above table for the computation of General Reserve and Taxed Reserve.
General Reserve: General Reserve is the net residual increment (both taxed and untaxed transactions) in initial capital. In above example, General Reserve is obtained from Financial Amount column.
General Reserve = (-200,000+75,000+21,750+8,250)=(-95,000)
Taxed Reserve: Taxed Reserve is the net residual increment (only taxed transactions) in initial capital. In the above example, Taxed Reserve is obtained from Tax Amount column. Tax Amount is the sum of Taxable Amount and Permanent Difference.
Taxed Reserve = (-150,000+63,000-10,000+5,000+21,750+8,250) = (-62,000)
What happens when General Reserve > Taxed Reserve?
In general cases, taxed reserve is always greater than general reserve because tax regulation generally only defer the recognition of an expense but do not defer the recognition of income.
- When the recognition of an expense is deferred, deferred tax asset arises.
- When the recognition of an income is deferred, deferred tax liability arises.
However, there may still be situations where General Reserve are greater than taxed reserve by the reason of: (a) Presence of Final Withholding Income Only, (b) Book Rate of Depreciation being greater than Tax Depreciation etc. In such cases, where deferred tax liability is arisen, general reserve is greater than taxed reserve.