Important Keyword: Income Tax Paid or Provisioned, Temporary Differences, Deferred Tax Asset.
Table of Contents
Introduction
In the world of corporate accounting, companies maintain two sets of financial records: one as per the Companies Act and the other under the Income Tax Act. The difference in the way profits are calculated in these two systems gives rise to timing differences, leading to the creation of deferred tax assets or liabilities. These adjustments are critical for businesses, as they influence the tax liabilities in both current and future financial years.
This article simplifies the concept of deferred tax, explaining what deferred tax liability is, how it arises, and why it matters for companies and other businesses.
What is Deferred Tax Liability?
Deferred tax liability (DTL) arises when the book profit (profits reported in the company’s financial statements) exceeds the taxable profit (profits calculated for tax purposes). Essentially, Deferred Tax Liability represents taxes that a company owes but has postponed to future periods due to differences in accounting methods.
For example, depreciation is calculated differently under the Companies Act and the Income Tax Act. These differences create a gap in tax calculations, leading to deferred tax.
The tax impact of this difference is known as deferred tax, and it reflects the future tax payments a company is liable to make once the timing differences reverse.
Temporary vs Permanent Differences
Timing differences that lead to deferred tax are categorized into temporary and permanent differences:
- Temporary Differences: These differences between book profit and taxable profit are reversible in future years. For instance, depreciation under the Income Tax Act may differ from the depreciation charged under the Companies Act, but the overall depreciation will balance out over time.
- Permanent Differences: These differences arise from items that are treated differently in the tax books and the financial books and cannot be reversed in future periods. Examples include expenses that are fully disallowed under tax laws but allowed in financial accounting.
How Deferred Tax is Reflected in Financial Statements
The balance sheet of a company shows deferred tax as either an asset or a liability:
- Deferred Tax Liability (DTL): This appears on the liability side when book profits exceed taxable profits, meaning the company will pay more tax in the future due to temporary differences.
- Deferred Tax Asset (DTA): This appears on the asset side when taxable profits exceed book profits. In this case, the company pays more tax now but will benefit from lower tax payments in future years when the temporary differences reverse.
Each year, the company records either a deferred tax asset or liability, which is adjusted annually until the timing differences are fully accounted for.
When Does Deferred Tax Liability Arise?
A deferred tax liability typically arises when:
- The company’s book profits are higher than taxable profits.
- This difference in profits results from temporary differences, such as higher depreciation allowed for tax purposes compared to depreciation recorded in financial statements.
- The company enjoys lower tax payments now, but it will have to pay higher taxes in future years when the timing differences reverse.
When Does Deferred Tax Asset Arise?
Conversely, a deferred tax asset arises when:
- The company’s taxable profits exceed book profits.
- The company pays more tax in the current year due to certain timing differences, such as revenue recognition differences or higher provisions for employee benefits in tax filings.
- In future years, the company benefits from lower taxes as the timing differences even out.
Who Needs to Deal with Deferred Tax?
While the concept of deferred tax is most commonly associated with corporate entities, it also applies to other businesses that maintain books of accounts differing from what is prescribed under the Income Tax Act. For example:
- Companies accounting for employee benefits or leave encashments differently in financial books versus tax returns.
- Entities making provisions for liabilities or recognizing income that differs between tax filings and financial reports.
Steps for Filing Deferred Tax in the Income Tax Return
Before filing their income tax returns, companies must compute their book profits and make specific adjustments. These adjustments help reconcile the difference between the profits in financial statements and taxable profits under the Income Tax Act.
Here’s a breakdown of the adjustments to calculate book profit for tax purposes:
Adjustments to Increase Net Profit:
- Income Tax Paid or Provisioned: Any provision made for income tax in financial statements needs to be added back to profits.
- Reserves: Any amount carried to a reserve fund needs to be added back.
- Unascertained Liabilities: Provisions made for liabilities that are unascertained at the time of filing need to be added back to the net profit.
- Deferred Tax Provision: Any deferred tax provision recorded in the profit and loss account needs to be added back to calculate the book profit for tax purposes.
Adjustments to Decrease Net Profit:
- Withdrawal from Reserves: If the company withdraws amounts from previously set reserves, it is deducted from the net profit.
- Depreciation: Depreciation charged in the profit and loss account, except for depreciation on revalued assets, is deducted.
- Losses or Unabsorbed Depreciation: The lower of the losses carried forward or unabsorbed depreciation from previous years can be deducted from the net profit.
- Deferred Tax Credited: If deferred tax has been credited to the profit and loss account, this amount is deducted from the book profits.
Once these adjustments are made, the company compares its book profit to taxable profit, and any resulting deferred tax asset or liability is recognized in the financial statements.
Example of Deferred Tax Calculation
Consider a company that records a book profit of ₹10 lakh in its financial statements but calculates taxable profit of ₹8 lakh under the Income Tax Act. This ₹2 lakh difference arises from a temporary difference in depreciation calculations.
- The company will pay less tax in the current year because its taxable income is lower than its book income.
- However, in future years, when this temporary difference reverses, the company will need to pay higher taxes.
- Hence, the company will recognize a deferred tax liability on the ₹2 lakh difference.
Conclusion
Deferred tax liabilities and assets are essential for businesses to understand, as they represent future tax obligations or benefits arising from temporary differences in the way profits are calculated. By correctly recognizing deferred tax in financial statements, businesses can ensure they remain compliant with tax regulations and maintain accurate records of their future tax liabilities or assets.
Download Pdf: https://taxinformation.cbic.gov.in/view-pdf/1001006/ENG/Notifications
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