Deferred tax
This article is about deferred tax as an accounting concept. For deferral of tax liabilities in cash-flow terms, see tax deferral (below).
Deferred tax is an accounting concept (also known as future income taxes), meaning a future tax liability or asset, resulting from temporary differences or timing differences between the accounting value of assets and liabilities and their value for tax purposes.
Temporary Differences
Temporary differences may be either:
- taxable temporary differences,
- deductible temporary differences,
Tax base
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes:- the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.
- the tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.
Illustrated example
The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common example in which a company has fixed assets which qualify for tax depreciation.The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years. The company claims tax depreciation of 25% per year. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value.
| Purchase | Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|---|
| Accounting value | $1,000 | $800 | $600 | $400 | $200 |
| Tax value | $1,000 | $750 | $563 | $422 | $316 |
| Taxable/(deductible) temporary difference | $0 | $50 | $37 | $(22) | $(116) |
| Deferred tax liability/(asset) at 35% | $0 | $18 | $13 | $(8) | $(41) |
In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.
Timing differences
Whereas International Financial Reporting Standards and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAPs such as UK GAAP require deferred tax to be instead recognised in respect of timing differences.A timing difference arises when an item of income or expense is recognised for tax purposes but not accounting purposes, or vice versa, and is therefore consistent with a profit and loss approach to deferred tax.
In many cases the deferred tax outcome will be similar for a temporary difference or timing difference approach. However, differences can arise such as in relation to revaluation of fixed assets qualifying for tax depreciation, which gives rise to a deferred tax asset under a balance sheet approach, but in general should have no impact under a timing difference approach.lll
[edit] Justification for deferred tax accounting
Deferred tax is irrelevant to matching principle.[edit] Examples
[edit] Deferred tax liabilities
Deferred tax liabilities generally arise where tax relief is provided in advance of an accounting expense, or income is accrued but not taxed until received. Examples of such situations include:- a company claims tax depreciation at an accelerated rate relative to accounting depreciation
- a company makes pension contributions for which tax relief is provided on a paid basis, whereas accounting entries are determined in accordance with actuarial valuations
[edit] Deferred tax Assets
Deferred tax assets generally arise where tax relief is provided after an expense is deducted for accounting purposes.Examples of such situations include:- a company may accrue an accounting expense in relation to a provision such as bad debts, but tax relief may not be obtained until the provision is utilised
- a company may incur tax losses and be able to "carry forward" losses to reduce taxable income in future years
[edit] Deferred tax in modern accounting standards
Modern accounting standards typically require that a company provides for deferred tax in accordance with either the temporary difference or timing difference approach. Where a deferred tax liability or asset is recognised, the liability or asset should reduce over time (subject to new differences arising) as the temporary or timing difference reverses.Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes, which is similar (but not identical) to SFAS 109 under US GAAP. Both these accounting standards require a temporary difference approach.
Other accounting standards which deal with deferred tax include:
- UK GAAP - Financial Reporting Standard 19: Deferred Tax (timing difference approach)
- Mexican GAAP or PCGA - BoletÃn D-4, el impuesto sobre la renta diferido
- Canadian GAAP - CICA Section 3465
- Russian PBU 18 (2002) Accounting for profit tax (timing difference approach)
[edit] Derecognition of deferred tax assets and liabilities
Management has an obligation to accurately report the true state of the company, and to make judgements and estimations where necessary. In the context of tax assets and liabilities, there must be a reasonable likelihood that the tax difference may be realised in future years.For example, a tax asset may appear on the company's accounts due to losses in previous years (if carry-forward of tax losses is allowed). In this case a deferred tax asset should be recognised if and only if the management considered that there will be sufficient future taxable profit to utilise the tax loss.[2] If it becomes clear that the company does not expect to make profits in future years, the value of the tax asset has been impaired: in the estimation of management, the likelihood that this tax loss can be utilised in the future has significantly fallen.
In cases where the carrying value of tax assets or liabilities has changed, the company may need to do a write down, and in certain cases involving in particular a fundamental error, a restatement of its financial results from previous years. Such write-downs may involve either significant income or expenditure being recorded in the company's profit and loss for the financial year in which the write-down takes place.
Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes. It is a general fact of taxation that when taxpayers can choose when to pay taxes, the total amount paid in tax will likely be lower.[citation needed]
[edit] Corporate tax deferral
Corporations (or other enterprises) may often be allowed to defer taxes, for example, by using accelerated depreciation. Profit taxes (or other taxes) are reduced in the current period by either lowering declared revenue now, or by increasing expenses. In principle, taxes in future periods should be higher.[edit] Income tax deferral
In many jurisdictions, income taxes may be deferred to future periods by a number of means. For example, income may be recognized in future years by using income tax deductions, or certain expenses may be provided as deductions in current rather than future periods. A 2010 study documents the large extent to which U.S. taxpayers accelerate their deductible state tax income taxes by prepaying them in December, instead of their normally due January of the following year. (Shon & Veliotis "December Effect: Strategic Prepayments of Deductible State Tax Payments,” Journal of the American Taxation Association, Fall 2010, Vol. 32, No. 2, 53-71). In jurisdictions where tax rates are progressive - meaning that income taxes as a percentage of income are higher for higher incomes or tax brackets, resulting in a higher marginal tax rate - this often results in lower taxes paid, regardless of the time value of money.Tax deferred retirement accounts exist in many jurisdictions, and allow individuals to declare income later in life; if the individuals also have lower income in retirement, taxes paid may be considerably lower. In Canada, contributions to registered retirement savings plans or RRSPs are deducted from income, and earnings (interest, dividends and capital gains) in these accounts are not taxed; only withdrawals from the retirement account are taxed as income.
Other types of retirement accounts will defer taxes only on income earned in the account. In the United States, a number of different forms of retirement savings accounts exist with different characteristics and limits, including 401ks, IRAs, and more.
As long as the individual makes withdrawals when he or she is in a lower tax bracket (that is, has a lower marginal tax rate), total taxes payable will be lower.
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