Deferred Tax Asset and Deferred Tax Liability

Deferred Tax Liability (DTL) or Deferred Tax Asset (DTA) forms an important part of Financial Statements. This adjustment made at year-end closing of Books of Accounts affects the Income-tax outgo of the Business for that year as well as the years ahead.

Here is a write up on all about DTL/DTA, how it’s calculated and certain specific implications.

Timing Difference

Company derives its book profits from the financial statements prepared in accordance with the rules of the Companies Act and calculates its taxable profit based on provision of the Income Tax Act. There is a difference between the book profit and taxable profit because of certain items which are specifically allowed or disallowed each year for tax purposes. This difference between the book and the taxable income or expense is known as timing difference and it can be either of the following:

• Temporary Difference – Differences between book income and tax income which is capable of being reversed in subsequent period
• Permanent Difference – Differences between book income and tax income which is not capable of being reversed in subsequent period

Deferred Tax (DT)

The tax effect due to the timing differences is termed as deferred tax which literally refers to the taxes postponed. Deferred tax is recognised on all timing differences – Temporary and Permanent.

These deferred taxes are given effect to in the financial statements through Deferred Tax Asset and Liability as under:

With respect to timing differences related to unabsorbed depreciation or carry forward losses, DTA is recognised only if there is future virtual certainty. It means DTA can be realised only when the company reliably estimates sufficient future taxable income. This test for virtual certainty has to be done every year on balance sheet date and if the condition is not fulfilled, such DTA/DTL should be written off.

While computing future taxable income, only profits pertaining to business and profession should be considered and not the income from other sources.

Example for Virtual Certainty

A projection of future profits prepared by an entity based on the future restructuring, sales estimation, future capital expenditure past experience etc which are submitted to banks for loan is concrete evidence for virtual certainty. But virtual certainty cannot be convincing if it’s only based on some binding export order which has the risk of cancellation anytime. Virtual certainty must be based on projections that are more likely in future.

Example of Deferred Tax Asset and Liability

DTA – Suppose, book profit of an entity before taxes is Rs 1,000 and this includes provision for bad debts of Rs.200.

For the purpose of tax profit, bad debts will be allowed in future when it’s actually written off. Hence taxable income after this disallowance will be Rs. 1200 and let’s say income tax rate is 20% then the entity will pay taxes on Rs. 1200 i.e (1200*20%) Rs. 240.

If bad debts were not disallowed, entity would have paid tax on Rs. 1000 amounting Rs 200 i.e 1000*20%. For the additional Rs. 40 which is already paid now, we have to create DTA. Entry for recording the DTA is as under:

• Deferred Tax Asset Dr                    40
• To Deferred Tax Expense Cr        40

(Being DTA of Rs. 40 accounted in the books)

DTL – Common example of DTL would be depreciation. When the depreciation rate as per the Income tax act is higher than the depreciation rate as per the Companies act (generally in the initial years), entity will end up paying less tax for the current period. This will create deferred tax liability in the books:

There are no DTA or DTL provisions made for permanent differences. Eg. Fines and penalties which are part of book profits but are not allowed for tax purposes. Hence, this difference created will be a permanent difference. DTA is presented under non-current assets and DTL under the head non-current liability. Both DTA and DTL can be adjusted with each other provided they are legally enforceable by law and there is an intention to settle the asset and liability on a net basis.

Illustration on DTA/DTL Calculation

Let’s understand how DTA/DTL is created in books with a simple example (amount in lacs):

Current tax on Taxable income is 800*30% = 240

Deferred tax as per above = (15)

Net tax effect = 225

*The rate is applicable for companies who have not opted for Section 115BA, 115BAA and 115BAB and whose turnover exceeds Rs 400 crore.

Effect on Tax Holiday With Respect To DTA/ DTL

Tax Holiday is a benefit provided to new undertakings established in free trade zones, 100% export oriented undertakings etc under section 10A, 10B of the Income Tax Act, 1961. To encourage the production and consumption of certain items, the government exempts certain taxes for a temporary period subject to certain condition.

Deferred tax (DT) from the timing difference that reverses during the tax holiday period should not be recognised during the enterprise’s tax holiday period. DT related to the timing difference that reverses after the tax holiday has to be recognised in the year of origination.

Illustration for Tax Holiday

A Ltd. established as a tax-free entity in 2015 under section 10A, hence it will be exempt from tax from 2015 to 2025. It has a timing difference on account of depreciation as follows: (Assume tax rate is 30%)

In the case of tax-free companies, deferred tax liability is not recognised, for the timing differences that originate and reverse in the tax holiday period. Deferred tax liability is created only when the timing differences originate in the tax holiday period and reverse after the tax holiday. Adjustments are done on the basis of the FIFO method.

Suppose in the above example of the Rs 200,000, Rs 80,000 reverses within the tax holiday period, so DTL is created only on the balance. DTL will be created as given below:

*Fully reversed after the tax holiday period. The total DTL balance at the end of the second year will be 126,000.