Deferred tax

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Deferred tax is an accounting term, meaning future tax liability or asset, resulting from temporary differences between book (accounting) value of assets and liabilities, and their tax value. This arises due to differences between accounting for shareholders and tax accounting.

Tax deferral may also refer to incentives provided that allow a taxpayer (an individual or a company) to defer or delay payment of taxes to future years.

Tax Deferral

Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. In practice, due to the time value of money, paying taxes in future is usually preferable to paying them now. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes. It is a general fact of taxation that when taxpayers can choose when to pay taxes, the total amount paid in tax will likely be lower.

Corporate tax deferral

Corporations (or other enterprises) may often be allowed to defer taxes, for example, by using accelerated depreciation. Profit taxes (or other taxes) are reduced in the current period by either lowering declared revenue now, or by increasing expenses. In principle, taxes in future periods should be higher.

Income tax deferral

In many jurisdictions, income taxes may be deferred to future periods by a number of means. For example, income may be recognized in future years by using income tax deductions, or certain expenses may be provided as deductions in current rather than future periods. In jurisdictions where tax rates are progressive - meaning that income taxes as a percentage of income are higher for higher incomes or tax brackets, resulting in a higher marginal tax rate - this often results in lower taxes paid, regardless of the time value of money.

Tax deferred retirement accounts exist in many jurisdictions, and allow individuals to declare income later in life; if the individuals also have lower income in retirement, taxes paid may be considerably lower. In Canada, contributions to registered retirement savings plans or RRSPs are deducted from income, and earnings (interest, dividends and capital gains) in these accounts are not taxed; only withdrawals from the retirement account are taxed as income.

Other types of retirement accounts will defer taxes only on income earned in the account. In the United States, a number of different forms of retirement savings accounts exist with different characteristics and limits, including 401ks, IRAs, and more.

As long as the individual withdraws tax only when he or she is in a lower tax bracket (that is, has a lower marginal tax rate), total taxes payable will be lower.

What are deferred taxes?

The need for deferred tax accounting arises because companies often postpone or pre-pay taxes on profits pertaining to a particular period.

When a company arrives at its profits or losses for a period, it does so after deducting all the expenses, including the tax for the period, from the revenues earned. But a company's profits/losses reported to investors often differ, sometimes substantially, from the profits the taxman lays claim to - the taxable profit.

What are the situations in which there is a deferred tax liability?

There may be a difference in the way certain items of expense are allowed to be treated for tax purposes and how a company actually treats them.

Tax laws allow a 100% depreciation in the first year after a company acquires certain assets, a form of accelerated depreciation. But a company may actually write off the depreciation over a larger number of years in its financials. The company may charge depreciation at lower rates than allowed under tax laws. Or it may use a different method of charging depreciation.

Tax laws may allow a company to deduct certain expenses in full in a single year, but it may charge the expenses against profits for the purposes of reporting to its shareholders.

How should companies account for this?

Under the old system of accounting only for current taxes, the company's profits would be artificially high in the first year (due to the tax savings).

The profits would, however, be lower in the subsequent years, as the tax laws in subsequent years would not recognise the depreciation charge or the amortised expense, as the case may be. In order to improve reporting to shareholders and respect the principle of matching revenues with expenses, accounting standards were modified.

More recent accounting standards require that a company carve out a part of its current year's profits (equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's higher tax liability in those years.

Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes.

When does a company create a deferred tax asset?

The tax laws may not recognise some of the expenses that a company has charged off in its accounts. For instance, provisions made at the discretion of management, such as those for bad debts, may not be fully recognised by tax authorities.

In some tax systems, companies may be able to "carry forward" losses to future years, which may be referred to as tax write-offs. In such cases, the company may have a tax asset representing the amount that future taxes payable may be reduced due to tax losses in previous years.

Expenses which are accounted for on an accrual basis (that is, when they become due and not when they are actually paid) may not be applicable to tax accounting and therefore to taxable profit. Companies may charge off duty, cess and tax dues against profits when they become due, but they would be recognised for tax computation only when actually paid.

In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the profits that are taxable would be higher than those computed in the company's books of accounts; there is a timing difference in the recognition of the taxable profit compared to the accounting profit.

So, while the company shells out a disproportionately high tax in the current year, it would save on tax in the years when the expenses or provisions actually materialise.

Tax assets and liabilities: management judgment and estimations

Management has an obligation to accurately report the true state of the company, and to make judgments and estimations where necessary. In the context of tax assets and liabilities, there must be a reasonable likelihood that the tax difference may be realised in future years.

For example, a tax asset may appear on the company's accounts due to losses in previous years (if carry-forward of tax losses is allowed). If it becomes clear that the company does not expect to make profits in future years, the value of the tax asset has been impaired: in the estimation of management, the likelihood that this profit tax shield can be utilised in the future has significantly fallen.

In cases where the carrying value of tax assets or liabilities has changed, the company may need to do a write down, and in some cases, a restatement of its financial results from previous years.

Why account for deferred taxes?

By recognizing deferred tax liabilities in its books, a company makes sure that the tax liability for any particular year is reflected in that year's financials and does not carry over to future profits.

It brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations (rather than from fiscal savings).

External links

• Summary of International Accounting Standard 12: Income Taxes - by the International Accounting Standards Board
• Summary of Financial Accounting Standard 109: Income Taxes - US Financial Accounting Standard
• Financial Reporting Standard 19: Deferred Tax - UK Financial Reporting Standard