Deferred Income Tax is soon going to be UAE’s accountants’ headache because its concept and application is not easy to understand.
But it is so for accountants because it has been taken so at its name’s value. Only for Deferred Tax, if one may say that “What’s in a name!”, life will be easy. Here is it how!
Deferred tax is neither deferred, nor tax. It is simply an accrual for tax, an accounting measure. Also, keep away Tax Losses and Tax Credits out of the purview of Deferred Tax conceptual understanding. We will talk about them at the end and create a loop.
The accrual accounting normally differs from a presentation based on cash accounting, to reflect timing differences between cash flows and economic events. They can move profit (or loss) from period to period. Knowledge of accruals and tax are needed for timing differences (the main component). Accrual accounting is an economic presentation of financial statements.
Timing differences
Timing differences are accruals for tax. Rather, they will not have any impact on one’s payable tax liability whatsoever. They are not tax. They are accruals for tax.
If an income or expense (which creates a profit or loss) is taxed in the same period that it appears in the income statement, the tax charge for the year will reflect this and no further action is required.
If the income, or expense, is taxed wholly or partially in another period, an accrual for tax is needed in this period to reflect this.
This is a timing difference, between the economic event and the taxation.
Deferred Tax arises from the analysis of the differences between the taxable profit and the accounting profit. These differences arise from the treatment of a transaction differing within the financial and taxation accounts.
This timing difference can be categorized as permanent, or temporary timing differences.
An example of a permanent difference is the receipt of a tax-free government grant, or similar incentive. This is clearly part of the accounting profit, but it will never be part of the taxable profit. No further accounting is necessary in future periods for permanent differences.
An example of a temporary timing difference occurs when the tax and accounting depreciation of an asset differ. They can arise from differing useful lives, or differing depreciation methods, for example reducing balance and straight line. Here further accounting is required:
In order to report the earnings to the period to which it belongs, we also need to report its corresponding tax charge. This is done by adding a deferred tax charge to the current tax charge. The deferred tax charge is the value of the temporary timing differences at the current rate of tax enacted for the future periods.
The final question is whether the tax accrual (cumulative) is a deferred tax asset or a deferred tax liability.
Deferred tax liability
One need to recognize deferred tax liability for all taxable temporary differences, 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).
Deferred tax asset
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).
Tax losses and tax credits
In most countries, if one has made a loss last year, one can pay less tax this year on one’s profits. Similarly, a tax credit (to pay less tax) may be given by the government as an incentive, rather than a cash grant.
Both tax losses and tax credits are components of tax. They will reduce one’s payable tax liability. By calling them ‘deferred tax’, confusion is bound to happen to make an accountant’s life miserable.
Tax knowledge required
If there is an accrual, or revaluation, which increases (or decreases) profit, but has no impact on the current period’s payable tax liability, one need to assess whether there will be a tax charge (or credit) when the profit (or loss) is realized. If so, an accrual for tax is needed.
If one moves profit from one period to another, accrue the tax so that a movement of profit of has a net impact after the accrual for tax at a %.
Conclusion
Timing differences are the most common part of what is called ‘deferred tax’. If one can accrue for tax, in the same way that you make other accruals, the matter of deferred tax will be taken care of.
One then need not use ‘tax base’ or worry whether it is based on the ‘balance sheet’ or ‘income statement’ methods. Just make the tax accruals.
Deferred tax is neither deferred, nor tax: It is an Accrual for tax.
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