Taxation in any economy is a complex process that contains several micro units which make up the entire tax regime of any country. Taxes from various individuals as well as enterprises comprise the whole income tax accountable to the government. Deferred tax is a form of tax levied on companies, that has either been deducted in advance and is eligible for carry over to the subsequent financial years or it can be tax that has been exempted on account of advance of an accounting expense. Hence, these two forms of deferred tax are knows as Deferred Tax Liabilities and Deferred Tax Assets.
Forms of Deferred Tax:
Deferred tax can arise as a result of timing difference or temporary differences in accounting. Given below are the two most generic forms in which deferred tax may arise for any enterprise.
- Deferred Tax Asset:
Deferred tax assets arise when the tax amount has been paid or has been carried forward but has still not been recognized in the income statement. The value of deferred tax asset is created by taking the difference between the book income and the taxable income. For example, a case of deferred tax may arise if the tax authority recognizes revenue or expenses at different points of time than that set by an accounting standard. Any deferred tax asset is useful in plummeting the company’s future tax liability.Situations when Deferred Tax assets may arise:
Following are the reasons which give rise to deferred tax assets.
- Expenses are taken into account by the taxing authority even before they are required to be recognized
- Revenue earned is taxed even before the time when it should be recognized
- The tax rules or base for assets and liabilities are different
Let us take an example of company XYZ which produces mobile phones. The company XYZ assumes that the probability of a mobile phone being sent for warranty repairs is 2%. If XYZ’s revenue for financial year 2015 is Rs.10,00,000, then the following discrepancy arises in the income statement and the tax authority statement.Income Statement of Company:
Revenue 10,00,000 Warranty Expense 20,000 Taxable Income 9,80,000 Taxes Payable (at 30%) 2,94,000 Revenue 10,00,000 Warranty Expense 0 Taxable Income 10,00,000 Taxes Payable (at 30%) 3,00,000
In the example above, the difference obtained between the two taxes payable is the deferred tax asset. The deferred tax asset in this case is (Rs.3,00,000 – Rs.2,94,000) = Rs.6,000.
- Deferred Tax Liability:
Deferred tax liability arises when there is a difference between what a company can deduct as tax and the tax that is there for accounting purposes. A deferred tax liability signifies that a company may in future pay more income tax because of a transaction in the present.Reasons for deferred tax liability to arise:
Listed below are a few reasons which result into deferred tax liability arising for a company.
- Dual accounting of figures. For example, most corporates keep multiple copies of financial statements for their personal use as well as those that are furnished to the public and to the tax authorities. This is also because standard accounting rules and tax code differs heavily in key areas like revenue, expense and depreciation of asset.
- Companies generally aim to push their profits in order to show maximum profits to their shareholders.
- Companies generally tend to push current profits also into future so as to reduce the tax burden. This allows more money for investment purposes rather than paying it off as tax to the government.
Let us take an example of the same company XYZ which produces mobile phones. The company XYZ assumes that a manufacturing machine that costs Rs.60,000 will last for 3 years and it pays a 30% tax on profits. However, regular financial accounting will take into account the Rs.20,000 depreciation per year for the next 3 years. Hence, each year income is reduced by Rs.20,000 and Rs.6,000 reduction in tax.
However, suppose the tax accounting allows depreciation in such a way that Rs.30,000 is the depreciation in the first year, Rs.20,000 in the next and Rs.10,000 in the third year. So for the first year, company can claim Rs.30,000 as depreciation and it gets a tax benefit of Rs.9000.
Although in doing so it creates a tax liability of:
Rs.9,000 – Rs.6,000 which is,
(tax that the company should have paid on the basis of accounting) – (the tax that it actually paid). Here, in this example a deferred tax liability of Rs.3,000 has been created. This liability, the company will have to make up for in its future transactions pertaining to taxes.