Deferred Tax
Introduction
Deferred tax could be deferred tax asset or deferred tax liability, in which it will be deductible or taxable in the future. Deferred tax is the tax effect that occurs due to the temporary differences, either taxable temporary difference or deductible temporary difference.
The company usually either has deferred tax liability or deferred tax asset as the deferred tax would be net off between deferred tax liability and deferred asset.
Temporary Difference
Temporary difference is the difference between the carrying value of an asset or liability in the accounting base and tax base.
Taxable temporary difference:
- when carrying value of asset in accounting base is bigger than those in tax base, or
- when carrying value of liability in accounting base is smaller than those in tax base
Deductible temporary difference:
- when carrying value of asset in accounting base is smaller than those in tax base, or
- when carrying value of liability in accounting base is bigger than those in tax base
Taxable temporary difference creates deferred tax liability while deductible temporary difference creates deferred tax asset.
Temporary difference is the timing difference which if it is recognized as the asset or liability in this year, it will be reversed back in the future years in the balance sheet. Or in the income statement, if it is recognized as income or expense in this year in the accounting base but not in the tax base, it will be recognized in the tax base in the futures year and vice versa. And the total in accounting base and tax base is the same.
Example of Temporary Difference
In 2017, XY Internet Co. received $20,000 from its clients in advance for 2 years’ internet service in 2018 and 2019; hence the company recognized it as unearned revenues in 2017 and as revenues equally in 2018 and 2019 in the accounting base. However, all $20,000 is recognized as revenues in 2017 in the tax base.
This will create the temporary difference as below:
| Balance Sheet | Unearned Revenues | |
|---|---|---|
| Year | Accounting base | Tax base |
| 2017 | 20,000 | 0 |
| 2018 | (10,000) | 0 |
| 2019 | (10,000) | 0 |
| Total | 0 | 0 |
| Income Statement | Revenues | |
|---|---|---|
| Year | Accounting base | Tax base |
| 2017 | 0 | 20,000 |
| 2018 | 10,000 | 0 |
| 2019 | 10,000 | 0 |
| Total | 20,000 | 20,00 |
Deferred Tax Liability
Deferred tax liability is the tax liability that is payable in the future which results from the taxable temporary differences that exist in the current accounting period.
Accounting entry
Deferred tax liability is a liability that will credit when it increases.
| Account | Debit | Credit |
|---|---|---|
| Income tax expense | 000 | |
| Deferred tax liability | 000 | |
| Income tax payable | 000 |
Example of Deferred Tax Liability:
On 31 Dec 2017, ABC Co. depreciated its $40,000 truck (bought at the beginning of the year) with a useful life of 5 years on the straight-line method in accounting base. However, in tax base, the depreciation on vehicles must be calculated using the declining balance with the rate of 35% per annum. Tax is charged at the rate of 25%.
Assume ABC Co. does not have other differences between accounting base and tax base and its total profit before tax is $50,000.
What are the temporary difference and deferred tax in 2017?
What is the accounting entry for deferred tax on 31 Dec 2017?
Solution:
On 31 Dec 2017, the difference of depreciation and carrying value of truck between accounting base and tax base are as follow:
Accounting base:
- Depreciation = 40,000 / 5 = 8,000
- Carrying value of truck (NBV) = 40,000 – 8,000 = 32,000
Tax base:
- Depreciation = 40,000 *35% = 14,000
- Carrying value of truck (NBV) = 40,000 – 14,000 = 26,000
Hence, the temporary difference = 32,000 – 26,000 = 6,000
The carrying value of truck of asset, truck, in the accounting base is bigger than in the tax base;
hence it is the taxable temporary difference.
So it results in the deferred tax liability.
Deferred tax liability (6,000 * 25%) = 1,500
Deferred tax liability at beginning = 0
Deferred tax expense for current year = 1,500 (1,500-0)
The company profit before tax is 50,000; however, it is the profit in accounting base so we have to make adjustment to determine taxable income by adding back the accounting depreciation and deducting the tax depreciation.
Taxable income (50,000 + 8,000 – 14,000) = 44,000
Current income tax payable (44,000 * 25%) = 11,000
Income tax expense for the year (1,500+11,000) = 12,500
Accounting entry:
| Account | Debit | Credit |
|---|---|---|
| Income tax expense | 12,500 | |
| Deferred tax liability | 1,500 | |
| Income tax payable | 11,000 |
Deferred Tax Asset
Deferred tax asset is the tax asset that is refundable (or deductible) in the future which result from the deductible temporary differences that exist in the current accounting period.
Accounting entry
Deferred tax asset is an asset which will debit when it increases.
| Account | Debit | Credit |
|---|---|---|
| Income tax expense | 000 | |
| Deferred tax asset | 000 | |
| Income tax payable | 000 |
Example of Deferred Tax Asset:
In 2017, XY Internet Co. received $20,000 from its clients for internet service in advance. The internet service of $20,000 is for 2 years in 2018 and 2029, hence the company recognized it as revenues equally in 2018 and 2019 in the accounting base. However, all $20,000 is recognized as revenues in 2017 in the tax base.
Assume XY Internet Co. does not have other differences between accounting base and tax base and its total profit before tax is $80,000. The tax is charged at the rate of 25%.
What are the temporary difference and deferred tax in 2017?
What is the accounting entry for deferred tax on 31 Dec 2017?
Solution:
The $20,000 received from its clients for the internet service in advance is an unearned revenue which is liability and recorded as such in the accounting base.
The difference of carrying value of unearned revenue between accounting base and tax base are as follow:
| Accounting base | Tax base | |
|---|---|---|
| Unearned revenue | 20,000 | 0 |
Temporary difference = 20,000 – 0 = 20,000
The carrying value of the liability (unearned revenue) in the accounting base is bigger than in the tax base; hence it is the deductible temporary difference.
So it results in the deferred tax asset.
Deferred tax asset (20,000 * 25%) = 5,000
Deferred tax asset at beginning = 0
Deferred tax income for current year = 5,000 (5,000-0)
The company profit before tax is 80,000; however, it is the profit in accounting base so we have to make adjustment to determine taxable income by adding $20,000 as revenues in 2017
Taxable income (80,000 + 20,000) = 100,000
Current income tax payable (100,000 * 25%) = 25,000
Income tax expense for the year (25,000-5,000) = 20,000
Accounting entry:
| Account | Debit | Credit |
|---|---|---|
| Income tax expense | 20,000 | |
| Deferred tax asset | 5,000 | |
| Income tax payable | 25,000 |
Difference Between Accounting and Tax Base
The main reasons that create the differences between accounting base and tax base are the accrual basis and the matching principle which the company follow in the accounting base while the tax rule usually ignore these two points by either providing capital allow (depreciation rate) to encourage the business in the early state or following cash basis such as on cash receipt.
The commonly seen transactions that create temporary differences are:
- Provision on doubtful accounts (or debt) or warranty
- Depreciation on fixed assets
- Revenues recognition policy especially on unearned revenue
Permanent Difference
Permanent difference is the difference resulting from the different treatment of income or expense items in the accounting base and tax base and never reverse back in the future. The permanent difference is not the timing difference hence it does not create a deferred tax.
Permanent differences result from non-taxable incomes and non-deductible expenses. The non-taxable income is the income that exempts from tax and non-deductible expense is the expense that cannot deduct from taxable income.
The commonly seen non-deductible income is government bond which the company invests in. The interest income from the government bond is the non-taxable income.
The commonly seen non-deductible expenses are:
- Meal or entertainment expenses
- Fine and expenses resulting from a violation of the law
- Expenses which has no proper invoices for filing tax declaration