To understand deferred tax, it shall be noted at the outset that as per the accounting standards followed by companies, there are two different financial reports which an organisation prepares every fiscal year – an income statement and a tax statement.

The primary motive behind the creation of two different financial reports is varying guiding principles which govern the recording of companies’ income and their taxation.

In other words, the guidelines behind the preparation of a company’s income statement and tax statement are slightly different. Hence, sometimes the numbers mentioned in both these reports might vary.

It is this disparity that creates the scope for deferred tax. The term deferred tax, in essence, refers to the tax which shall either be paid or has already been settled due to transient inconsistency between an organisation’s income statement and tax statement.

As per this definition, there are two types of deferred tax-deferred tax asset and deferred tax liability.

A deferred tax of any type is recorded in the balance sheet of an organisation; however, their point of generation is typically in the income statement. It is crucial to note that deferred tax is only recorded in the books of an organisation if chances of a reduced or increased tax liability in the future are more likely to occur than not.

Types of Deferred Tax

There are two types of deferred tax as discussed below –

  • Deferred tax asset

When an inconsistency between the income statement of an organisation and its corresponding tax statement provides that the company pays its tax liability for another period in advance or is able to reduce its tax liability for a subsequent period in a particular, fiscal year, then that is recorded as deferred tax asset.

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In other words, if a company clears its tax liability for a subsequent year in advance or reduces the same in advance, then that shall be considered as a deferred tax asset.

There are several instances which can prompt the generation of a deferred tax asset like a gross loss wherein such organisation carries it forward to the next year for adjustment against that year’s gross profit. In doing so, a company reduces the gross profit for the next year, which leads to reduced tax liability. It shall be noted that, as the gross loss was generated in a particular year, any future reduction in tax liability due to it shall be recorded in that year itself, thus qualifying it as deferred tax asset.

  • Deferred tax liability

In case the disparity in numbers between an organisation’s income statement and tax statement provides that tax be accumulated in a particular year, but such company is liable to settle it in a subsequent fiscal year, then it shall be considered as a deferred tax liability.

In other words, a deferred tax liability is created when there is a timing difference between when a tax liability accrues and when a company is liable to pay it. As it is a future financial obligation, an organisation accounts for it in the year it accrues as per accounting guidelines.

Akin to deferred tax assets, there are multiple events which precipitate the creation of a deferred income tax liability. For instance, the depreciation method followed by companies and the Income Tax Department is different. Hence, a natural inconsistency appears between depreciation numbers in the income statement and tax statement.

If depreciation is higher in a company’s tax statement than its income statement, then such organisation’s tax liability is reduced. Nevertheless, as this disparity in depreciation numbers is only temporary, companies have to pay taxes against it in the future and hence that obligation is recorded as deferred tax liability.

It shall also be noted that there is no separate deferred tax rate followed in taxation practices in India. Therefore, the general corporate tax rate is applicable in the calculation of deferred tax.

Scenarios in which Deferred Tax is Recorded?

As mentioned previously, there are multiple occasions or financial events on account of which deferred tax asset or liability is created. A few of these events are mentioned below –

  • Difference in the depreciation calculation method

A deferred tax can be created when there is a difference between the approach in which a company calculates depreciation on its assets and the method of depreciation calculation as prescribed by the Income Tax Department.

Suppose that Company A calculates depreciation in the straight-line method; whereas the Income Tax Department follows accelerated depreciation method. This company has machinery worth Rs. 1,00,000 with an estimated lifetime of 5 years and it expects no salvage value for the same. Hence, depreciation as per their calculation shall be Rs. 20,000. Now, as the Income Tax Department follows accelerated depreciation method, their calculation shows a depreciation of Rs. 25,000. As seen, depreciation considered by the IT department is higher, which implies a lower tax liability for the company for that particular fiscal year. However, company A will adjust depreciation in the subsequent years so that it eliminates such inconsistency between the two depreciation figures by the end of machinery’s lifetime. Hence, it poses a future financial obligation accruing in that particular year, thus creating a deferred tax liability.

  • Difference in Depreciation Percentage

If there is a difference in the percentage of depreciation calculated by an organisation on its assets and considered by the IT department, then a deferred tax can be created.

For instance, company B has assets worth Rs. 60,000 on which it calculates 10% depreciation whereas as per the IT department, depreciation shall be calculated at the rate of 15%. As per the supposition, depreciation recorded in the company’s income statement is Rs. 9,000, while in its tax statement it is mentioned as Rs. 6,000. This temporary difference of Rs. 3,000 will create a deferred tax asset as the company is paying an additional tax of Rs. 750 (25% x 3000) in its current fiscal year.

  • Gross loss

Deferred tax asset is created when a company realises gross loss in a particular year. It creates an opportunity for a company to carry forward it to the next year to be adjusted with subsequent profits, thus reducing that year’s tax liability. Deferred tax asset or DTA is recorded in the year when such loss is realised.

Unrealised revenues and expenses

As per taxation policies, tax cannot be levied on revenues which have yet not been realised by companies. For instance, if there are unrealised receivables from debtors, then although as per accounting laws it shall be recorded in the income statement; it is not considered for taxation. This disparity in treatment of revenues creates a deferred tax liability because companies are required to pay tax on a later date when they realise such receivables.

At the same time, when there are expenses which a company has recorded in its books but has not yet incurred is not considered for tax calculations. Thereby, such company’s gross profit in its books is lower than what is shown in its tax statement. Consequently, an organisation ends up paying advance tax for a higher profit in tax statements. Hence, that creates a deferred tax asset.

Suppose, company D has created a provision for bad debts of Rs. 10,000, which brings down its gross profit to Rs. 1,05,000. However, in its tax statements, it has not mentioned that provision, due to which their gross profit is Rs. 1,15,000. Therefore, it is creating a deferred tax asset of Rs. (25% x 10,000) or Rs. 2,500.

There is no separate deferred tax rate followed in taxation practices in India; therefore, the general corporate tax rate is applicable in the calculation of deferred tax.

Calculation of Deferred Tax

There are no strict rules for deferred tax calculation as it is merely the difference between gross profit in a Profit & Loss Account and a tax statement.

For easier understanding, a deferred tax example is mentioned below –

Particulars As per Income Statement (Rs.) As per Tax Statement (Rs.)
Total income 1800000 1800000
Expenses 1200000 1200000
Gross profit before depreciation and tax 600000 600000
Depreciation 120000 100000
Gross Profit after depreciation 480000 500000

Here, as the depreciation computed varies by Rs. 20,000, the taxable incomes in both cases also vary by the same amount. Hence, its tax liability shall be 25% on Rs. 5,00,000, i.e. Rs. 1,25,000. However, as per its books, its tax liability should have been Rs. 1,20,000. As an additional Rs. 5,000 is being paid as tax in the current year, and it creates a deferred tax asset.

Benefits of Deferred Tax

As the temporary difference in two statements creates the scope for deferred tax, there is no pronounced benefit to it per se. However, recognising such liabilities allows an organisation to be financially prepared for future expenses. On the other hand, recognition of deferred tax assets can significantly reduce tax liabilities for the future.