As we are rushing towards the Tax audit due date, I thought its worthy to attempt a write-up on a concept that holds significant place in accounting of taxes of a business(i.e) Deferred Tax.
What is deferred tax?
Before we go through the definition of Deferred tax, lets have a simple understanding of the term Deferment. The Cambridge Dictionary defines the term “Deferment” as an action to delay/postpone until a later time. Hence basically, Deferred Tax means, the tax-effect which has been deferred to a later period or postponed to a future period. Now the obvious question is WHY?? Why any tax-effect needs to be postponed to a future period? What causes this deferment?
The major contributor for this deferment is Matching Concept. This concept insists the business to recognize the revenues with their related expenses in an accounting period giving no scope for misstatement of earnings in any accounting years. The best example is depreciation of a fixed asset. Even though a huge sum has been invested on a capital asset, only a portion of the value of the capital assets would be written off in the books of accounts. Thus,
Profit= Income earned (-) expenses incurred to earn the stated revenue
The matching concept matches best with the Accrual accounting than its counterpart, cash based accounting. As all the related expenses of a business are debited to P&L account in an accounting period, its fair to give the same treatment for the tax-expense as well. Isnt it? But how to recognize the tax-effect in the CY and in the subsequent years? Thus, the concept of timing difference comes into the limelight.
Every business has to calculate their income as per tax laws and pay the taxes on their profits so determined. But this Taxable income might differ with the Accounting income for various reasons in a same accounting period. The contribution being from,
1. Different depreciation methods and rates
2. Expenses disallowed as per tax laws but considered in the books
3. Expenses amortized in the books of accounts but, are fully allowed in the first year as per tax laws
4. C/F of Unabsorbed depreciation and losses
5. Provisions allowed in the books but are disallowed as per tax laws being contingent etc.,
Due to many factors including the above stated reasons the taxable income of a business might differ from accounting income leading to a timing difference. This difference can be of two types, one where the difference originates in one period and gets reversed in the next period. For example, Expense disallowed under sec 43B is allowed in the next period after the payment. These are (temporary) timing differences. Secondly where, the difference that originates in one accounting period but does not gets reversed in the later years. Example being, the fine/penalty paid by the business for non-compliance of laws. These are permanent differences. Permanent differences do not affect deferred tax where as the temporary timing difference plays a major role in determining the Deferred Tax of a business.
Lets consider an example where a business has an earnings (after all expenses except the interest) of Rs.100 and has a liability to pay an interest of Rs.20 (all amounts in lakhs) to a Public Financial institution. If this interest gets disallowed as per income tax law due to non-payment under sec 43B, the taxable income of the business would be Rs.100/- where as the income as per books will be Rs.80/-(i.e) (100-20) Rs.20 is disallowed only in the computation of taxable income and not in accounting income. Considering 40% corporate tax rate for example, the business Is liable to pay Rs.40/-(100*40%) as Income tax. But, taking Rs. 80/- as its income in its books of accounts, it recognizes Rs.32/-(net)as its tax liability in the books. It simply means that the difference of Rs.8/- (40-32) or (20*40%) can be treated as an asset which will be reversed against the future income. Hence, we can term this treatment to be Deferred Tax Asset(DTA) where the tax-effect to the extent of Rs.8 is deferred to the next year.
AS-22 states that the “Tax expense for the period, comprising current tax and deferred tax, should be included in the determination of the net profit or loss for the period.” Hence mathematically,
Total earnings Rs.100
Less: Current tax Rs.40
Add: DTA Rs.08
Total tax-effect in the CY Rs.32
In Accounting terms,
P&L Account Dr. Rs.40
To Current tax Rs.40
Deferred Tax Dr. Rs. 8
To P&L Account Rs.8
In the subsequent year, If the disallowed expense under sec 43B gets allowed, the accounting income is going to be Rs.100/-(As the interest had already been deducted in the previous year itself) and the taxable income will be Rs.80/-(after the deduction of Rs.20 disallowed in the previous year due to non-payment under sec 43B and allowed in the CY after payment). Now the timing difference of Rs.20/- has to be accounted in the books of accounts. Thus mathematically,
Total earnings Rs.100
Less: Current tax Rs.-32
Less: DTL Rs.-08
Total tax-effect in the CY Rs.40
In the accounting terms,
P&L Account Dr. Rs.32
To Current tax Rs.32
P&L Account Dr. Rs.8
To Deferred Tax Rs.8
The deferred tax asset recognized in the previous FY has been reversed in the CY by debiting the P&L account with the same amount. Thus, the concept of deferred tax helps in recording the tax expense of a CY considering the timing difference and the difference it causes to the income.
Further , AS-22 specifies that the Deferred Tax has to be recognized for all the temporary timing differences in the CY subject to the consideration of prudence(i.e) the DT can be carried forward to the next year only to the extent to which the business has a reasonable certainty that the carried forward DT can be realized against the sufficient future taxable income where as in the case of business having unabsorbed depreciation and carry forward of losses, the deferred tax should be recognized only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax is realized.
When a business pays the tax under sec 115JB of the Income tax act, the deferred tax which arises due to the timing differences in the CY, has to be recognized using the regular rate of taxes and not the tax rate specified by the sec 115JB and also when the deferred tax recognized during the year and the same gets reversed in the subsequent years where the business expects to pay tax under sec 115JB, the actual rates of taxes have to be considered.