Benjamin Franklin once wrote: “In this world nothing can be said to be certain, except death and taxes“. Income tax is something that can hardly be avoided by a profit-making company.
You might find filling-in the tax return a demanding task because everything must be correct – otherwise you are asking for penalties from your tax office.
On top of that, you still need to calculate deferred tax!
Deferred income tax belongs to top 10 reasons of accountants’ headaches because its concept and application is not easy to understand. When it comes to IFRS financial statements, a lot of them contain errors exactly in a deferred taxation.
The standard IAS 12 guides us in the area of income taxes and really, it is not an interesting easy-to-read novel.
So let’s see what’s inside.
What is the objective of IAS 12?
The objective of IAS 12 is to prescribe the accounting treatment for income taxes.
The main issue here is how to account for the current and future consequences of
- The future recovery (settlement) of the carrying amount of assets (liabilities) recognized in the entity’s financial statements.
Here, if the future recovery or settlement will make future tax payments larger or smaller than they would be if such recovery or settlement were to have no tax consequences, then an entity must recognize deferred tax liability or asset.
- Transactions and other events of the current period recognized in the entity’s financial statements.
IAS 12 requires accounting for current and deferred income tax from certain transaction or event exactly in the same way as the transaction or event itself.
Understand the differences
Almost in every country the accounting rules differ from the tax laws and regulations. Sometimes, these differences are really significant and accountants must make lots of adjustments to their accounting profit in order to arrive to the basis for calculation of income tax.
In order to understand the meaning and the rules of IAS 12 fully, you need to understand the meaning of and differences between
- Accounting profit and taxable profit, and
- Current income tax and deferred income tax.
I. Accounting versus taxable profit
Accounting profit is profit or loss for a period before deducting tax expense. Please note that IAS 12 defines accounting profit as a before-tax figure (not after tax as we normally do) in order to be consistent with the definition of a taxable profit.
Taxable profit (tax loss) is the profit (loss) for a period determined in accordance with the rules established by the taxation authorities upon which income taxes are payable (recoverable).
You can clearly see here that these 2 numbers can differ significantly because accounting and tax rules are not the same. A number of differences can pop out between accounting profit and taxable profit you have to make the following adjustments to your accounting profit:
- Add back the expenses recognized but non-deductible for tax purposes
- Add income not recognized but included under tax regulations
- Deduct expenses not recognized but deductible for tax purposes
- Deduct income recognized but not taxable under tax regulations.
II. Current tax versus deferred tax
Current income tax is the amount of income tax that you actually need to pay to your tax office.
Deferred income tax is an accounting measure used to match the tax effect of transactions with their accounting impact and thereby produce less distorted results.
I have outlined the other differences between current and deferred income tax in the following scheme:
Current income tax
Current tax is the amount of income tax payable (recoverable) in respect of the taxable profit (loss) for a period.
Measurement of current tax liabilities (assets) is very straightforward. We need to use the tax rates that have been enacted or substantively enacted by the end of the reporting period and apply these rates to the taxable profit (loss).
Current income tax expense shall be recognized directly to profit or loss in most cases. However, If the current tax arises from a transaction or event recognized outside profit or loss, either in other comprehensive income or directly in equity, then current income tax shall be recognized in the same way.
Deferred income tax
Deferred income tax is the income tax payable (recoverable) in future periods in respect of the temporary differences, unused tax losses and unused tax credits.
Deferred tax liabilities result from taxable temporary differences and deferred tax assets result from deductible temporary differences, unused tax losses and unused tax credits.
We can calculate deferred tax as temporary difference multiplied with the applicable tax rate.
Before you dig deeper in the concept of temporary differences, you need to understand the tax base first.
What is a tax base
Tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. In my opinion, this definition does not say that much, so let’s explain it in a greater detail:
Tax base of an asset
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.
For example, when you have an interest receivable and interest revenue is taxed on a cash basis, then the tax base of interest receivable is 0. Why? Because when you actually receive the cash and remove the interest receivable from your books, you will need to include full amount of cash received into your tax return. At the same time you cannot deduct anything from this amount for tax purposes.
Tax base of a liability
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.
For example, when you accrue some expenses that will be deductible when paid, then the tax base of a liability from accrued expenses is 0.
Careful about items not shown in your balance sheet!
If you review all your assets and liabilities calculating their tax bases, be careful! There could be some items not recognized in your balance sheet that still do have a tax base.
For example, you might have incurred some research costs included in the profit or loss in the past that you could not deduct for tax purposes until later periods. In such a case, the research costs are not shown in your statement of financial position but they do have a tax base.
If you are still unsure about the tax base, then my next article will be for you. I will describe how to determine a tax base of your assets or liabilities in a very simple way.
Temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position and its tax base.
When the carrying amount of an asset or a liability is greater than its tax base, then there is a taxable temporary difference and it gives rise to deferred tax liability.
In the opaque situation, when the carrying amount of an asset or a liability is lower than its tax base, then there is a deductible temporary difference and it gives rise to deferred tax asset.
Deferred tax liability
You need to recognize deferred tax liability for all taxable temporary differences you discovered, except for the following situations:
- No deferred tax liability shall be recognized from initial recognition of goodwill
- No deferred tax liability shall be recognized from initial recognition of asset or liability in a transaction that is not a business combination and at the time of the transaction it affects neither accounting nor taxable profit (loss).
The most common examples of taxable temporary differences giving rise to deferred tax liabilities are:
- Timing differences
Timing difference arises when the recognition of certain item in the financial statements occurs in a different time than its recognition in tax return, for example, interest received is taxed deductible only when cash is received.
- Business combinations
In a business combination identifiable assets and liabilities can be revalued upwards to fair value at the acquisition date, but no adjustment is made for tax purposes. As a result, taxable temporary difference arises.
- Assets carried at fair value
When a company applies policy of revaluation (for example, revaluation model for property, plant and equipment in line with IAS 16) and some assets are revalued upwards to their fair value, taxable temporary difference arises.
- Initial recognition of an asset / liability
When an asset or liability are initially recognized in the financial statements, part or all of it could be tax-non-deductible or not taxable. In this case, deferred tax liability is recognized based on the specific situation.
Deferred tax asset
While you need to recognize deferred tax liability for all taxable temporary differences, here the situation is different.
A deferred tax asset shall be recognized for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized.
No deferred tax asset shall be recognized from initial recognition of asset or liability in a transaction that is not a business combination and at the time of the transaction it affects neither accounting nor taxable profit (loss).
The most common examples of deductible temporary differences giving rise to deferred tax assets are:
- Timing differences
Timing difference arises when the recognition of certain item in the financial statements occurs in a different time than its recognition in tax return, for example, accrued expenses are tax deductible only when paid.
- Business combinations
In a business combination identifiable assets and liabilities can be revalued downwards to fair value at the acquisition date, but no adjustment is made for tax purposes. As a result, deductible temporary difference arises.
- Assets carried at fair value
When a company applies policy of revaluation (for example, revaluation model for property, plant and equipment in line with IAS 16) and some assets are revalued downwards to their fair value, deductible temporary difference arises.
- Initial recognition of an asset / liability
When an asset or liability are initially recognized in the financial statements, part or all of it could be tax-non-deductible or not taxable. In this case, deferred tax asset is recognized based on the specific situation.
Unused tax losses and tax credits
A deferred tax asset shall be recognized for the unused tax losses carried forward and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilized.
Investments in subsidiaries, branches and associates and interests in joint ventures
Except for various kinds of temporary differences mentioned above, a number of them can arise at business combinations. This issue is even more complicated that it looks because temporary difference may be different in the consolidated financial statements from temporary difference in the individual parent’s financial statements.
Such differences arise in number of circumstances:
- Undistributed profits of subsidiaries, branches, associates and joint arrangements
- Changes in foreign exchange rates when a parent and its subsidiary are based in different countries
- Reduction in the carrying amount of an investment in an associate to its recoverable amount.
Here, 2 essential rules for recognition of deferred tax apply:
- An entity shall recognize a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint arrangements, except to the extent that both of the following conditions are satisfied:
- the parent, investor, joint venturer or joint operator is able to control the timing of the reversal of the temporary difference; and
- it is probable that the temporary difference will not reverse in the foreseeable future.
- An entity shall recognize a deferred tax asset for all deductible temporary differences arising from investments in subsidiaries, branches and associates, and interests in joint arrangements, to the extent that it is probable that:
- the temporary difference will reverse in the foreseeable future; and
- taxable profit will be available against which the temporary difference can be utilized.
Measurement of deferred tax
In measuring deferred tax assets / liabilities you need to apply the tax rates that are expected to apply to the period when the asset is realized or the liability is settled. However, these expected rates need to be based on tax rates or tax laws that have been enacted or substantively enacted by the end of the reporting period.
So please, don’t use some estimates of the future tax rates, as this is not allowed.
Let me also point out that the measurement of deferred tax should reflect the tax consequences that would follow from the manner of expected recovery or settlement.
So for example, if in your country, sales of property are taxed at 35% and other income at 30%, then for calculation of deferred tax on your property you need to apply the tax rate based on your expected way of property’s recovery – if you plan to sell it, then measure your deferred tax at 35% and if you plan to use it and then remove it, then measure your deferred tax at 30%.
How to recognize deferred taxes
In almost all situations you would recognize deferred tax as an income or an expense in profit or loss for the period. There are just 2 exceptions of this rule:
- if a deferred tax arose from a transaction or even recognized outside profit or loss, then you need to recognize deferred tax in the same way (in other comprehensive income or directly in equity)
- if a deferred tax arose in a business combination, deferred tax affects goodwill or bargain purchase gain.
How to present income taxes
The principal issue in presenting income taxes is offsetting. Can you present current or deferred income tax assets and liabilities as one net amount? Or do you need to show them separately?
Offsetting the current income tax
You can offset current income tax assets and liabilities if 2 conditions are fulfilled:
- You have a legally enforceable right to set off the recognized amounts; and
- You intend either to settle on a net basis or to realize the asset and settle the liability simultaneously.
Offsetting the deferred income tax
You can offset deferred income tax assets and liabilities if 2 conditions are fulfilled:
- You have a legally enforceable right to set off the current income tax assets against current income tax liabilities (see above when it happens); and
- The deferred tax assets and the deferred tax liabilities relate to income taxed levied by the same taxation authority on either
- the same taxable entity; or
- different taxable entities which intend to settle current tax liabilities and assets on a net basis or realize the assets and settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled or recovered.
Just be careful when making consolidated financial statements because often you just cannot simply combine deferred tax assets of a parent with deferred tax liabilities of a subsidiary and present them as 1 net amount.
Want to dive deeper into IFRS? I’ve created the free report “Top 7 IFRS mistakes that you should avoid”. Sign up for email updates, right here, and you’ll get this report as well as 3 free important chapters from my course IFRS In 1 Day.
Please, watch the following video with the summary of IAS 12 Income Taxes: