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October 14, 2020

Know all about Deferred Tax Asset and Deferred Tax Liability

by CA Shivam Jaiswal in Income Tax

Know all about Deferred Tax Asset and Deferred Tax Liability

Company computes its book profits from the financial statements prepared in accordance with the provisions of the Companies Act and calculates its taxable profit based on provision of the Income Tax Act. Due to applicability of 2 distinct Acts, there may arise a difference between the profits or losses computed as per the Income Tax Law and profits or losses computed according the Company Law. A deferred tax liability or asset is created when there are temporary differences between book tax and actual income tax. Let us learn the taxability of a deferred tax liability and a deferred tax asset in this article.

What do you mean by temporary differences?

Differences between book income and tax income which are capable of being reversed in subsequent period are known as temporary differences. While, differences between book income and tax income which are not capable of being reversed in subsequent period are known as permanent differences. Temporary differences give rise to deferred tax liabilities and a deferred tax asset.

Some examples of temporary differences are:

  • Interest revenue received in arrears, included in the accounting profit on a time apportionment basis but taxable on a cash basis.
  • Development costs have been capitalized and will be amortised to the income statement but were deducted for tax purposes as incurred
  • Prepaid expenses have already been deducted on a cash basis for tax purposes but are to be charged in the income statement in a later period
  • Current investments are carried at fair value which exceeds cost but remain at cost for tax purposes.
  • Non-current assets are revalued upwards for accounting purposes with no adjustment for tax purposes
  • Accumulated depreciation of an asset in the financial statements is greater than the cumulative depreciation allowed up to the balance sheet date for tax purposes
  • The net realizable value of an item of inventory, or the recoverable amount of an item of property, plant or equipment, is less than the previous carrying amount and an enterprise therefore reduces the carrying amount of the asset, but that reduction is ignored for tax purposes until the asset is sold
  • Research costs are recognised as an expense in determining accounting profit but are not permitted as a deduction in determining taxable profit until a later period

Permanent differences in accounting arise when the rules for financial accounting permit a transaction not allowed in tax accounting or vice versa. Some examples of permanent difference are:

  • Interest income received on tax-exempt securities, life insurance premiums paid for key officers or employees, fines and expenses for violating the law, and book depreciation in excess of the amount allowed by tax law. These items are recorded in a business’s books but never on a tax return.
  • Dividends-received deduction and the deduction for percentage depletion of natural resources in excess of their cost are part of a tax return but never recorded in a business’s books.

What do you mean by a deferred tax asset (DTA)?

Deferred tax asset (DTA) refers to the asset that arises when profit as per books of account is less than taxable profit due to temporary differences. Creation of deferred tax asset is subject to the principles of prudence.

DTA = Tax on Taxable Profit – Tax on Accounting Profit

When the books of accounts reflect loss for the period under consideration but there is profit as per the provisions of tax laws due to temporary differences, then, in that case also, the deferred tax asset is required to be recognized and carried forward to subsequent years.

For instance, as per the Income-tax Act, 1961 provision for bonus is allowed in the year in which it is paid. On the other hand, in the accounting books it is recorded as an expenditure in the year in which it is created. Accordingly, deferred tax asset is created on provision for bonus.

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How is a Deferred tax asset (DTA) accounted?

DTA is shown under the head of Non- Current Assets in the balance sheet. Entry for DTA is:

Deferred Tax Asset A/C Dr To Profit & Loss A/C

For instance, book profit of an entity before taxes is Rs 1,000 and this includes provision for bad debts of Rs.200. For the purpose of tax profit, bad debts will be allowed in future when it is actually written off. Hence taxable income after this disallowance will be Rs 1200. Assuming income tax rate is 30% then the entity will pay taxes on Rs. 1200 i.e (1200*30%) Rs. 360.

If bad debts were not disallowed, entity would have paid tax on Rs. 1000 amounting Rs 300 i.e 1000*30%. For the additional Rs. 60 which is already paid now, entity will have to create DTA. Entry for recording the DTA is as under:

Deferred Tax Asset Dr                    60

To Deferred Tax Expense Cr        60

(Being DTA of Rs. 60 accounted in the books)

What are the conditions to be fulfilled to record DTA?

  • The concept of prudence cannot be ignored while recognizing the tax effect of temporary differences.
  • Deferred tax asset is recognized and carried forward to subsequent periods only to the extent that there is a reasonable certainty of their realization.
  • If there is a virtual certainty that sufficient taxable income will be available in subsequent period against which such deferred tax asset can be realized, only then such deferred tax is recognized in the books.
  • Further, the amount of deferred tax asset that is being carried forward should be appraised at each balance sheet date and should be increased/ decreased to the extent that makes the realization of such deferred tax asset reasonably certain in future period.   

What do you mean by a deferred tax liability (DTL)?

Deferred tax liability refers to the liability that arises when profit as per books of account is more than taxable profit due to timing differences. Creation of deferred tax liability is subject to payment of Minimum Alternative Tax (MAT)

DTL = Tax on Accounting Profit – Tax on Taxable Profit

When the books of accounts reflect profit for the period under consideration but there is loss as per the provisions of tax laws due to timing difference, then in that case also, the deferred tax liability is required to be recognized and carried forward to subsequent years.

For instance, in case of advertisement expenses, the benefit of expenses incurred on the advertisement of products/services extents to subsequent years also. Since, their benefit extends to subsequent years, they are amortized accordingly in the books of account. However, while computing taxable income as per tax laws, the amount of expenses incurred are allowed wholly for deduction. Such expenses are known as Deferred Revenue Expenditure that are accountable for time differences.

How is a Deferred tax liability (DTL) accounted?

DTL is shown under the head of Non- Current Liability in the balance sheet. Entry for DTL is:

Profit & Loss A/C Dr To Deferred Tax Liability A/C

Let us refer to the example given below to under DTL better:

Income as per the books of accounts of a company

Revenue50,00,000
(-) Expenses as per books(8,00,000)
Taxable Income42,00,000
Tax @ 30%12,60,000

Income as per the income tax provisions

Revenue50,00,000
(-) Deductions as per IT Act(10,00,000)
Taxable Income40,00,000
Tax @ 30%12,00,000

DTL = 12,60,000 – 12,00,000 = 60,000

Can DTA and DTL be netted off in the Financial Statements?

  • Balance of DTA and DTL should be netted off i.e. either DTA or DTL should be disclosed in the balance sheet and both should not be disclosed simultaneously for the same period.
  • Enterprise should offset DTA and DTL if:
    1. The enterprise has a legally enforceable right to set off
    2. The enterprise intends to settle the asset and liability on a net basis.
  • DTA, DTL should be disclosed under a separate heading in the balance sheet separately from current assets and current liabilities.
  • The DTA/DTL should be reviewed as at each of the Balance Sheet Date and written up/down to reflect the amount that is reasonably /virtually certain to be realised.

How is DTA/DTL accounted in the situations of tax holiday?

A tax holiday is a government incentive program that offers a tax reduction or elimination to businesses. Tax holidays are often used to reduce sales taxes by local governments, but they are also commonly used by governments in developing countries to help stimulate foreign investment.

Timing differences which reverse during the tax holiday period (whether originated in the tax holiday period or before that) – Do not recognise deferred tax

Timing differences which reverse after the tax holiday period (whether originated in the tax holiday period or before that) – Recognise deferred tax in the year in which the timing differences originate (subject to the consideration of prudence)

Can MAT (Minimum Alternate Tax) be considered as Deferred Tax Asset?

MAT is income tax paid on book profit (a type of taxable income) payable by a company. MAT is required to be paid if tax payable as per normal provision of the income tax act is less than the tax computed @ 18.5% of the book profit. MAT does not create any difference between accounting income and taxable income since it is computed after computation of accounting income & taxable income. Therefore, it is not prudent to consider MAT credit as a deferred tax asset.

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