Kaplan has found that many students find deferred tax confusing. Following our successful webinar, Senior Tax Lecturer, Neil Da Costa, breaks down the tricky topic of deferred tax.
What is Deferred Tax?
Deferred tax arises because there is a difference between taxable profits and accounting profits. When computing taxable profits, companies claim tax depreciation called capital allowances while when computing accounting profits companies deduct accounting depreciation.
The value of the asset in the accounts is the carrying value which is computed as cost less depreciation, while the asset is shown in the tax computation as the tax base which is cost less capital allowances.
The difference between the carrying value and the tax base is called a ‘temporary difference’. The deferred tax liability is computed by multiplying the temporary difference by the tax rate. Once the deferred tax liability is established, it is only necessary to compute the difference.
Asset example
The cost of new computer equipment was $100,000. The company provides depreciation at a rate of 20% straight line. The capital allowances available are 50% in the first year and 25% thereafter.
If the tax rate is 20%, compute the deferred tax liability at the end of both year 1 and year 2.
Asset solution
In year 1 the depreciation is $20,000 so the carrying value is $80,000
In year 1 the capital allowances are $50,000 so the tax base is $50,000.
The deferred tax provision at the end of year 1 should be (80,000- 50,000) x 20% = $6,000.
The double entry to establish the liability is debit tax expense $6,000 and credit the deferred tax liability $6,000.
In year 2 the depreciation is $20,000 so the carrying value is $60,000
In year 2 the capital allowances are $12,500 so the tax base is $37,500.
The deferred tax provision at the end of year 1 should be (60,000- 37,500) x 20% = $4,500.
The deferred tax liability is currently $6,000 so needs to be reduced to $4,500. The double entry is debit deferred tax liability $1,500 and credit tax expense $1,500.
The important point to remember about deferred tax is that it is a notional liability which will never be actually paid. This means that once it is set up, it is only necessary to adjust for the movement from one year to the next
Other temporary differences
Financial accounts are prepared on an accruals basis while at times, taxable profits are computed, based on cash actually received or paid which creates a temporary difference.
Deferred tax assets and liabilities are not discounted and should be recognised on all assets except for goodwill.
When property, plant and equipment is revalued, it is important to recognise deferred tax on the revaluation gain as part of other comprehensive income.
Revaluation example
A building has a carrying value of $3M but a tax base of $2M. The asset was revalued to $5M and the revaluation is ignored for tax purposes until the asset is sold.
The company already has a deferred tax liability of $0.1M
If the tax rate is 20%, compute the deferred tax liability at the end of the year and the adjustment required.
Revaluation solution
The deferred tax liability on the temporary difference at the year-end which will be based on the revalued amount of $5M.
($5-$2M) x20% = $ 0.6M
The existing deferred tax liability is $ 0.1M and this needs to be increased by $0.5M
The revaluation gain is $2M which will be recorded as other comprehensive income (OCI) so the deferred tax liability on this gain $2M x 20% = $0.4M is also recorded under OCI
Step 1: Increase the deferred tax liability by $0.5M
Debit deferred tax expense $0.5M
Credit Deferred tax liability $0.5M
Step 2: Transfer part of the expense to OCI to reflect the tax on the revaluation gain.
Debit Other Comprehensive Income $0.4M
Credit Deferred Tax Expense $0.4M
This will reduce the Deferred Tax expense to just $0.1M
Unused tax losses
Companies may have unused tax losses such as capital or trading losses. Generally, trading losses can be carried forward against the company’s total income in the future while capital losses can only be carried forward against future capital gains. It is also possible for these losses to be used by group companies.
IAS12 allows companies to recognise these losses as deferred tax assets on condition that the company expects probable future gains or profits to occur.
Tax losses example
A company has $5M of unused trading losses and $5M of unused capital losses.
The company has been making trading losses for the last few years but hopes to become profitable soon.
The company owns lots of buildings which have appreciated in value and will realise substantial gains when sold. The directors already have put plans in action to sell some of the buildings to help the company’s cash flow.
Tax losses solution
The expectation of future profits is low based on the fact that the company has been making trading losses for the last few years. It should not recognise the trading losses as deferred tax assets.
However, the company is likely to realise substantial gains on the buildings and would be able to recognise the capital losses of $5M as a deferred asset.
Consolidations
When we consolidate financial statements, it is necessary to make fair value adjustments and adjust the values of assets to market values. These fair value adjustments are ignored for the tax base leading to a temporary difference and a corresponding deferred tax liability.
Another consolidation adjustment is the provision for unrealised profits on inventory sold between group companies that is still owned by the group at the end of the reporting period. These provisions are ignored for the tax base leading to a temporary difference and a corresponding deferred tax asset.
Watch our webinar on the subject
Conclusion
Deferred tax is a popular topic in many financial reporting exams and this article should make it easier for you to understand the key principles. To find out more about our tax courses please visit our tax qualification pages.
Neil Da Costa is a Senior Tax Lecturer with Kaplan in London. He is the author of Advanced Tax Condensed which summarises the entire syllabus using memory joggers.
He is also a passionate advocate for mental wellness and diversity.