In simple terms, deferred tax is a tax (book entry) on the
gap between the books of account and the tax books.
Income statement approach :
Accounting Standard (AS) 22 Taxes on Income advocates
income statement approach. Under this approach, profit as per books is compared
with profit as per tax. Then, deferred tax is created on all timing differences.
Timing differences are the differences between taxable income and
accounting income for a period that originate in one period and are capable of
reversal in one or more subsequent periods. No deferred tax is created on
permanent differences.
Under this approach, deferred tax is created on only those
items that have an impact on the income statement. In other words, ‘income
statement approach’ assumes that all the incomes are accrued in the income
statement. However, items like gain on revaluation of fixed assets (i.e.,
revaluation reserve) are not considered for deferred tax purposes. Also, in
insurance companies and banks, investments are marked to market and the gain
thereon is parked in a reserve till it is realised. Although the income is
earned in the above cases deferred tax on the same is not recognised as the
transactions don’t impact the income statement directly.
Hence, IASB, in 1996, came up with the concept of temporary
differences/balance sheet approach.
Balance sheet approach :
‘Temporary difference’ is wider in scope as compared to
‘timing difference’. It also covers those differences that originate in the
books of accounts in one period and are capable of reversal in the same books,
of accounts in one or more subsequent periods. For example, gain on revaluation
arises in books of accounts and reverses in the same books by way of higher
depreciation charge. Now, many argue that the revaluation gain is a notional
gain and does not give rise to any tax in future periods. To understand the
logic behind the balance sheet approach, it is important to go back to the
definition of an asset. An asset is a resource controlled by the entity as a
result of past events and from which future economic benefits are expected to
flow to the entity. For example, when an asset costing Rs.100 is valued at
Rs.120, it means that the asset owner will receive future economic benefit of
Rs.120. Since the asset owner has paid just Rs.100 to get a benefit of Rs.120,
the upfront benefit of Rs.20 (120-100) is considered for deferred tax. In short,
it is based on an assumption that the recovery of all assets and settlement of
all liabilities have tax consequences and these consequences can be estimated
reliably and cannot be avoided.
Temporary Difference is defined as a difference
between the carrying amount of an asset or liability and its tax base, where
tax base is the amount that will be deductible for tax purposes.
Where the economic benefits are not taxable or expense not deductible, the tax
base of the asset is equal to its carrying amount.
In simple terms, an entity will have to draw a tax balance sheet. The numbers appearing in the tax balance sheet is termed as ‘tax base’. This tax base will be compared with the carrying amount of assets and liabilities in the books of accounts. Deferred tax will be calculated on the difference so calculated. For example — if interest expense is allowed on cash basis under tax laws, no expense would have been booked. Hence, no corresponding liability would exist as per tax books i.e., tax base is nil. On the other hand, a liability for the interest will be recorded in the books of accounts. The difference in carrying the amount of the liability is regarded as a temporary difference under the balance sheet approach.
To better understand the concept of ‘tax base’, a few examples have been given below:
1)A machine costs Rs.100. For tax purposes, depreciation of Rs.30 has already been deducted in the current and prior periods and the remaining cost will be deductible in future periods, either as depreciation or through a deduction on disposal. The tax base of the machine is Rs.70.
2)Dividends receivable from a subsidiary of Rs.100. The dividends are not taxable. Thus, the tax base of the dividends receivable is 100. (Note: If the economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount.)
3) Similarly, a loan receivable has a carrying amount of Rs.100. The repayment of the loan will have no tax consequences. The tax base of the loan is Rs.100.
4) Current liabilities include interest revenue received in advance of Rs.100. The related interest revenue was taxed on a cash basis. The tax base of the interest received in advance is nil.
Temporary differences are of two types:
1) Taxable temporary differences (Deferred tax liability):
Taxable temporary differences are temporary differences that will result in taxable amounts in determining taxable profit/loss of future periods when the carrying amount of the asset or liability is recovered or settled. For example — incomes accrued as per books of accounts (fair value of financial instruments) but taxable on receipt basis and lower depreciation charge in books of accounts.
In simple words, where the carrying value of assets is more as per books of accounts or carrying value of liability is less as per books of accounts when compared to tax base, it results in taxable temporary differences.
2)Deductible temporary differences (Deferred tax assets):
Deductible temporary differences are temporary differences that will result in amounts that are deductible in determining taxable profit/loss of future periods when the carrying amount of the asset or liability is recovered or settled. For ex-ample — higher depreciation charge in books of accounts. In simple words, where the carrying value of assets is less as per books of accounts or carrying value of liability is more as per books of accounts when compared to tax base, it results in deductible temporary differences.
Deferred tax on items recognised outside profit or loss:
Current tax and deferred tax shall be recognised outside profit or loss if the tax relates to items that are recognised, in the same or a different period, outside profit or loss. Therefore, current tax and deferred tax that relate to items that are recognised, in the same or a different period:
a) in other comprehensive income, shall be recognised in other comprehensive income (OCI)
b) directly in equity, shall be recognised directly in equity i.e., in the Statement of Changes in Equity (SOCIE).
For example, deferred tax on revaluation of as-sets should be recognised in revaluation reserve in OCI. Hence, there will not be any charge to profit or loss.
Deferred tax on revaluation of assets:
IFRSs permit or require certain assets to be carried at fair value or to be revalued (for example, IAS 16 Property, Plant and Equipment, IAS 38 Intangible Assets, IAS 39 Financial Instruments: Recognition and Measurement and IAS 40 Investment Property). However, as per the tax laws, revaluation of assets is not considered while computing the taxable income. Consequently, the tax base of the asset is not adjusted. Nevertheless, the future recovery of the carrying amount (on sale or otherwise) will result in a taxable flow of economic benefits to the entity and the amount that will be deductible for tax purposes will differ from the amount of those economic benefits. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset. This is true even if:
a) the entity does not intend to dispose of the asset. In such cases, the revalued carrying amount of the asset will be recovered through use and this will generate taxable income which exceeds the depreciation that will be allowable for tax purposes in future periods; or
b) tax on capital gains is deferred if the proceeds of the disposal of the asset are invested in similar assets. In such cases, the tax will ultimately become payable on sale or use of the similar assets.
For example, Company A buys an asset worth Rs.100 on 1st April, 2010. The useful life of the asset is five years and the tax laws allow it to be depreciated over four years. One year later, on 31st March, 2011, the Company revalues the asset to Rs.120. In such a case the temproary difference will be as shown in Table 2.
In the above case, the deferred tax liability created on revaluation on 31st March, 2011, of Rs.45 reverses in the subsequent periods. The accounting entry for the year 2011 would be:
Revaluation reserve A/c Dr. 45
To Deferred tax liability A/c 45
Suppose on 31st March, 2013, the Company decides to sell the asset at Rs.70. In this case, there would be a gain of Rs.10 as per the books of accounts. However, the tax books will show a gain of Rs.45, thus offsetting the temporary difference of Rs.35.
Indian GAAP:
Accounting Standard (AS) 22 Taxes on income does not permit creation of deferred tax on the excess depreciation charged on the revalued portion. It is not considered as a timing difference, but a permanent one. The underlying reason is that, under the income statement approach, a deferred tax liability is not created on the date of revaluation (since it does not have an effect on the income statement). Thus, deferred tax assets (reversal of deferred tax liability) cannot be recorded on the excess depreciation charged.
Deferred tax on business combination:
IFRS 3 Business Combinations require the identifiable assets acquired and liabilities assumed in a business combination to be recognised at their fair values at the acquisition date. Temporary differences arise when the tax bases of the identifiable assets acquired and liabilities assumed are not affected by the business combination or are affected differently. For example, when the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises which results in a deferred tax liability. The resulting deferred tax liability affects goodwill.
For example, Company A merges Company B with itself. In the process it acquires net assets of Rs.1,000 crore (fair value Rs.1,200 crore) for Rs.1,500 crore. Goodwill being the difference between the consideration paid and fair value was Rs.300 crore (1,500 — 1,200 crore). Now, Company A will have to calculate the deferred tax on the fair valued por-tion of Rs.200 crore (1,200 — 1,000 crore), the tax base being the cost to previous owner of Rs.1,000 crore as compared to the revised carrying amount of Rs.1,200 crore. The deferred tax would hence be 100 crore (assuming tax rate of 50%). These Rs. 100 crore will be added to goodwill and the total goodwill will be Rs.400 crore (300 + 100 crore). The accounting entry would be:
Goodwill A/c Dr. 100
To Deferred tax liability A/c 100
Indian GAAP:
As per Accounting Standard Interpretation (ASI) 11* Accounting for Taxes on Income in case of an Amalgamation, deferred tax on such differences should not be recognised as this constitutes a permanent difference. The consequent differences between the amounts of depreciation for accounting purposes and tax purposes in respect of such assets in subsequent years would also be permanent differences.
It may be noted that ASI 11 has been issued by the ICAI but has not been incorporated in the standards notified under the Companies (Accounting Standards) Rules, 2006. Hence, ASI 11 is not applicable to companies. However, it is generally noted that companies treat such difference as permanent difference and do not create any deferred tax on the same.
Deferred tax on consolidation:
IAS 12 requires re- calculation of deferred tax at consolidated level. In effect, an entity will have to calculate deferred tax impact on inter-company transactions.
For example — Company H, the holding company, sells goods costing Rs.1,000 to Company S, the subsidiary company, for Rs.1,200. The goods are lying in the closing stock of Company S. Assume tax rate 0f 50%. Then entry in the consolidated
books is as follows:
Deferred tax asset A/c Dr. 60
To Deferred tax expense A/c 60
[(1,200-1,000)*50%]
Here, the deferred tax asset is created because the profit element of Rs.200 (1,200 — 1,000) is not eliminated in the tax books i.e., the consolidated books has an inventory of Rs.1,000 but the tax books of Company S has an inventory of Rs.1,200.
Please note: the tax rate used in this case would be the rate applicable to the Company S, since the deduction will be available to Company S.
Indian GAAP:
Under Indian GAAP, the practice followed is to consolidate the books by adding line-by-line items. Deferred tax is also calculated in the consolidated books as a summation of deferred tax appearing in the individual books of accounts.
Deferred tax on undistributed profits:
As per IAS 28 Investments in Associates, an entity is required to account for its investment in associates as per equity method in the consolidated financial statements. Under the equity method, the investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition, reduced by distributions received. On the other hand, its tax base will remain the cost of investment. The difference between the books of accounts and tax base is investor’s share of undistributed reserves of the investee entity. In simple terms, an entity will have to provide for deferred tax on its share of undistributed reserves of the investee company in its consolidated books.
Similar is the treatment under IAS 31 Interests in Joint Ventures where an entity elects equity method of accounting.
Nevertheless, an entity is exempted from the above requirement if the following conditions are satisfied:
a) the investor/venturer is able to control the timing of the reversal of the temporary difference; and
b) it is probable that the temporary difference will not reverse in the foreseeable future.
However, an investor in an associate/a venturer in a joint venture, generally, does not control that entity and is usually not in a position to determine its dividend policy. Therefore, in the absence of an agreement requiring that the profits of the associate/venturer will not be distributed in the foreseeable future, an investor/venturer recognises a deferred tax liability arising from taxable temporary differences associated with its investment in the associate/joint venture.
Deferred tax on land:
The Income-tax Act, 1961 provides for indexation of cost of non-depreciable assets like land, when computing the capital gain/loss on sale. This indexed cost of land (i.e., its tax base) will exceed the book value of land by the indexation benefit provided. Hence, a deferred tax asset will have to be created on this difference.
Indian GAAP:
Since the indexation benefit neither affects the current year’s tax profit, nor the profit as per books, deferred tax is not provided as per Indian GAAP.
Carried forward business losses and unabsorbed depreciation:
A deferred tax asset shall be recognised for the carried forward business losses and unabsorbed depreciation to the extent that it is probable that future taxable profit will be available against which such losses and depreciation can be utilised.
Although the term ‘probable’ is not defined by the standard, probable in general terms is ‘more likely than not’.
Indian GAAP:
AS 22 mandates virtual certainty for recognition of deferred tax assets in case of carried forward business losses and unabsorbed depreciation.
As per ASI 9 Virtual certainty supported by convincing evidence, virtual certainty is not a matter of perception. It should be supported by convincing evidence. Evidence is matter of fact. Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Keeping in view ‘virtual certainty’ as against ‘probable certainty’ it seems that Indian GAAP is more conservative on the matter of recognition of deferred tax asset.
Exceptions:
There continues to remain certain items over which the standard does not permit creation of deferred taxes, as below:
1) Initial recognition of goodwill:
Para 21 of IAS 12 Income Taxes prohibits recognition of deferred tax liability on initial recognition of goodwill, because goodwill is measured as a residual and the recognition of the deferred tax liability would increase the carrying amount of goodwill.
2) Initial recognition of an asset or liability in a transaction which:
i) is not a business combination, and
ii) at the time of transaction, affects neither accounting profit nor taxable profit/loss.
For example, a penalty was paid in the process of bringing an asset to its working condition as intended by the management and hence, it was capitalised. As per taxation laws, penalty is not allowed as an expense. Now, this penalty affects neither accounting profit nor taxable profits. Hence, as per the above said exception, no deferred tax shall be created on this difference.
Re-assessment:
At the end of each reporting period, an entity reassesses unrecognised deferred tax assets. The entity recognises a previously unrecognised deferred tax asset to the extent that it has become probable that future taxable profit will allow the deferred tax asset to be recovered. For example, an improvement in trading conditions may make it more probable that the entity will be able to generate sufficient taxable profit in the future for the deferred tax
asset to meet the recognition criteria.
Discounting:
The principles of IFRS require long-term assets and liabilities to be discounted to the present value. In most cases detailed scheduling of the timing of the reversal of each temporary difference is impracticable and highly complex for the purpose of reliable determination of deferred tax assets and liabilities on a discounted basis. Therefore, the deferred tax assets and liabilities shall not be discounted.
Current/Non-current:
IAS 1 Presentation of financial statements requires an entity to present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position. However, an entity shall not classify deferred tax assets/liabilities as current assets/ liabilities, i.e., deferred taxes shall always be clas-sified as non-current.
Takeaways:
As mentioned above, deferred taxes will impact almost all IFRS adjustments. One will have to consider all IFRS adjustments like fair valuation, use of effective interest rates, derivative and hedge accounting to calculate accurate deferred taxes.
To conclude, there are three important takeaways:
1) An entity will have to calculate the tax base for each asset and liability and compare the same with the financial statements,
2) Items that were earlier considered as permanent difference as per Indian GAAP may have to be considered as temporary difference as per IFRS, and
3) Deferred taxes, for certain items, will be rec-ognised outside profit or loss i.e., in OCI or SOCIE.
