Asset tax base is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized.
|Item||Carrying Amount||Tax Base||Temporary Difference|
|An asset is purchased for 50; for year 1 depreciation = 25 on income statement and 40 for tax purposes.||25||10||15|
|Capitalized development cost = 100 at the start of the year. During the year 30 was amortized.
For tax purposes only 25% amortization is allowed.
|Research cost for the year = 100; entire cost was expensed.
Tax rules require cost to be spread over 4 years.
|Gross accounts receivable = 100
Provision for doubtful debt = 10%.
Tax authorities allow 20%.
The tax base of a liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes in the future.
|Item||Carrying Amount||Tax Base||Temporary Difference|
|Customer payments received in advance = 50
Amount is taxable.
Since the customer pays 50 in advance. A liability called unearned revenue is created on the accounting side making the carrying amount of the liability to 50. On the tax side, 50 is shown as revenue and taxes are paid for the same. So tax base is 0 and carrying amount is 50.
The measurement of deferred tax assets/liabilities is based on current tax law. But, if there is any subsequent change in tax laws or new income tax rates, then existing deferred tax assets and liabilities must be adjusted to reflect those changes. When income tax rate changes, deferred tax assets and liabilities are calculated based on the new tax rate.
Let us take an example to see what happens to DTL. Assume the carrying amount of an asset is 25 and its tax base is 10. When the tax rate is decreased from 40% to 30%, the effect on DTL is:
DTL changes from 6 to 4.5.
Relationship between tax rate, DTL, and DTA
Firm A has a net deferred tax liability. The government announces a decrease in the statutory tax rate. Will this change benefit the income statement and balance sheet?
If the government announces a decrease in the statutory tax rate, it will cause the net DTL to decrease. A lower tax rate causes the tax expense to decrease, and consequently the net income and equity to increase.
Permanent differences are differences between tax and financial reporting of revenue (expenses) that will not be reversed at some future date. These differences do not give rise to DTLs and DTAs. Examples include:
As no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s effective tax rate and statutory tax rate.
In 2012, Acme’s provision for income tax was 20 against an EBT of 100. In the same year, the tax payable was 25 and the taxable income was 110. What was Acme’s effective tax rate for 2012?
Effective tax rate = 20/100 = 20%
Temporary differences between taxable and accounting profit arise from a difference between the tax base and the carrying amount of assets and liabilities. DTLs and DTAs are only created if there is temporary difference which is expected to reverse in the future.
Some examples of situations that lead to temporary differences in carrying amount and tax base are listed below:
|Temporary differences between carrying amount and tax base|
|Balance Sheet Item||Carrying amount vs. Tax Base||DTL or DTA||Example|
|Asset||Carrying amount > Tax Base||DTL||Straight-line depreciation for accounting profit. Accelerated depreciation for taxable profit.|
|Asset||Carrying amount < Tax Base||DTA||Research cost expensed for accounting profit.
Amortized for tax.
|Liability||Carrying amount > Tax Base||DTA||Cash from customers before revenue recognition.
Cash from customers is taxed.
|Liability||Carrying amount < Tax Base||DTL|
Remember the first relation for how a DTL is created for an asset. Everything else follows.
Tax loss carry forward occurs when a company experiences a loss in the current period that may be used to reduce future taxable income. Tax loss carry forward reduces the taxes paid in future.
Let us take an example. Assume, in 2011 Acme Inc. records revenue of $500,000 and operating expenses of $750,000. It pays taxes at the rate of 25%. The company’s net operating income for 2011 was -$250,000. Since the net operating income was negative, Acme would not pay any taxes for 2011. Now, assume in 2012, the company turns profitable and records $500,000 of taxable income. Instead of paying a tax of 0.25 * 500,000 = $125,000, the company may choose to use the tax loss carry forward of -250,000 this year. This reduces the taxable income to 250,000 * 0.25 = $62,500.
Tax credit is the amount that a taxpayer can deduct from the tax owed. Governments may grant a tax credit to promote a specific behavior. For example, to promote growth in the rural areas the government may give tax credits encouraging companies to set up factories. Deferred tax assets may arise from unused tax losses and tax credits.
Often, the tax loss carry forward and tax credits can be used only up to a certain time period in the future. If the company expects to be profitable in the future periods like we saw for Acme Inc. in 2012, it would be prudent to recognize tax loss carry forward. Instead, if it anticipates losses in the future periods, recognizing tax loss carry forward would be rendered useless.
IFRS allows recognition of unused tax losses and tax credits only to the extent that it is probable that in the future there will be taxable income against which unused tax losses and credits can be applied. Under US GAAP, a deferred tax asset is recognized in full but is reduced by a valuation allowance if it is unlikely that the benefit will be realized.
A few guidelines to assess the probability a firm will be sufficiently profitable in the future are listed below:
If a tax credit directly reduces taxes, a permanent difference is created between tax expense and tax payable. A permanent difference does not lead to a deferred tax asset or liability. If a tax credit reduces taxes presumably in future periods, then a deferred tax asset would have been created. This is again assuming there is a probability for the company to be profitable in the future.