Deferred Tax Asset Meaning & Examples in Income Tax Law

Deferred Tax Asset Meaning & Examples in Income Tax Law

What is deferred tax

Deferred tax is the tax for those items which are accounted in Profit & Loss A/c but not accounted in taxable income which may be accounted in future taxable income & vice versa. The deferred tax may be a liability or assets as the case may be. Deferred tax can fall into one of two categories. Deferred tax liabilities, and deferred tax assets. Both will appear as entries on a balance sheet and represent the negative and positive amounts of tax owed.



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. 
These temporary differences can impact on a financial account because they mean that income and expenses appear within one accounting period, but the tax is payable in a different accounting period. A taxable difference can be either taxable or deductible.

Deferred tax is brought into accounts to make the clear picture of current tax and future tax. If  we take some advantage of Income Tax sections and pay less tax in current year, we may have to pay tax in future on that advantage being reverse. In the same way if we have to pay more tax by not allowing any expense in current year, it will be allowed in future and in that year tax will be reduced. So, we may get some benefit or loss on account of  difference in book profit and taxable profit.

Types of Deferred Tax

1. Deferred Tax Asset

Deferred tax assets arise when the tax amount has been paid or has been carried forward but has still not been recognized in the income statement. The value of deferred tax assets is created by taking the difference between the book income and the taxable income. For example, a case of deferred tax may arise if the tax authority recognizes revenue or expenses at different points of time than that set by an accounting standard. Any deferred tax asset is useful in plummeting the company’s future tax liability.


Situations when Deferred Tax assets may arise

Following are the reasons which give rise to deferred tax assets.

  • Expenses are taken into account by the taxing authority even before they are required to be recognized
  • Revenue earned is taxed even before the time when it should be recognized
  • The tax rules or base for assets and liabilities are different

Example of Deferred Tax Asset

Let us take an example of company XYZ which produces mobile phones. The company XYZ assumes that the probability of a mobile phone being sent for warranty repairs is 2%. If XYZ’s revenue for the financial year 2018 is Rs.10,00,000, then the following discrepancy arises in the income statement and the tax authority statement.

Income Statement of Company:
Revenue10,00,000
Warranty Expense20,000
Taxable Income9,80,000
Taxes Payable (at 30%)2,94,000
Statement of Tax Authority:
Revenue10,00,000
Warranty Expense0
Taxable Income10,00,000
Taxes Payable (at 30%)3,00,000

In the example above, the difference obtained between the two taxes payable is the deferred tax asset. The deferred tax asset in this case is (Rs.3,00,000 – Rs.2,94,000) = Rs.6,000.


2. Deferred Tax Liability

Deferred tax liability arises when there is a difference between what a company can deduct as tax and the tax that is there for accounting purposes. A deferred tax liability signifies that a company may in the future pay more income tax because of a transaction in the present.


Reasons for deferred tax liability to arise

Listed below are a few reasons which result into deferred tax liability arising for a company.

  • Dual accounting of figures. For example, most corporates keep multiple copies of financial statements for their personal use as well as those that are furnished to the public and the tax authorities. This is also because standard accounting rules and tax code differs heavily in key areas like revenue, expense, and depreciation of the asset.
  • Companies generally aim to push their profits in order to show maximum profits to their shareholders.
  • Companies generally tend to push current profits also into the future to reduce the tax burden. This allows more money for investment purposes rather than paying it off as tax to the government.

Example of Deferred Tax Liability

Let us take an example of the same company XYZ which produces mobile phones. The company XYZ assumes that a manufacturing machine that costs Rs.60,000 will last for 3 years and it pays a 30% tax on profits. However, regular financial accounting will take into account the Rs.20,000 depreciation per year for the next 3 years. Hence, each year income is reduced by Rs.20,000 and Rs.6,000 reduction in tax.

However, suppose the tax accounting allows depreciation in such a way that Rs.30,000 is the depreciation in the first year, Rs.20,000 in the next, and Rs.10,000 in the third year. So for the first year, the company can claim Rs.30,000 as depreciation and it gets a tax benefit of Rs.9000.

Although in doing so it creates a tax liability of:

Rs.9,000 – Rs.6,000 which is,

(tax that the company should have paid on the basis of accounting) – (the tax that it actually paid). Here, in this example a deferred tax liability of Rs.3,000 has been created. This liability, the company will have to make up for in its future transactions pertaining to taxes.



Effect of DTA/DTL on MAT

MAT is Minimum Alternate Tax which a company is required to pay if its tax payable as per normal provision of the income tax act is less than the tax computed at 15% of the book profit. MAT is levied under section 115JB of the income tax act and it is calculated using the entity’s book profit as under:

Book profit is increased by the following:
  • Income tax paid or provision
  • An amount carried to any reserve
  • Provisions made for unascertained liabilities
  • Deferred tax provision etc.

And it is decreased by the following:

  • Amount withdrawn from any reserve or provision
  • Depreciation debited to P&L (except revaluation depreciation)
  • Lower of Loss brought forward or unabsorbed depreciation  
  • Deferred tax credited to P&L etc.

There are controversies if deferred tax liability debited to P&L should be added to the book income for the purpose of MAT calculation. Kolkata Tribunal in Balrampur Chini’s case has held that the deferred tax liability should not be added back whereas the Chennai Tribunal in Prime Textiles Ltd case has held otherwise.  





For more info visit TAXAJ 
Posted by Ramesh Kumar Gupta


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