Deferred tax analysis

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The concept of Deferred Tax is not a simple to understand and many get confused
while applying it in the books. So, we shall try to go through simple and lucid manner to
understand the whole concept and its application in the books through entries.

The word Deferred is derived from the word “Deferments” which means arranging for
something to happen at a later date. Thus, 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.

“As per AS 22,

Current tax is the amount of income tax determined to be payable (recoverable) in respect
of the taxable income (tax loss) for a period.

Deferred tax is the tax effect of timing differences.

Timing differences are the differences between taxable income and accounting income for
a period that originate in one period and are capable of reversal in one or more subsequent
periods.

Permanent differences are the differences between taxable income and accounting income
for a period that originate in one period and do not reverse subsequently.”

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.

Expenses amortized in the books over a period of years but are allowed for tax purposes
wholly in the first year. (e.g. substantial advertisement expenses to introduce a product, etc.
treated as deferred revenue expenditure in the books). Expenses paid without deducting
TDS will not be allowed for tax purpose and will be allowed after deducting TDS on that.
Expenditure of the nature mentioned in section 43B (e.g. taxes, duty, cess, fees, etc.)
accrued in the statement of profit and loss on mercantile basis but allowed for tax purposes
in subsequent years on payment basis. If we make provision of bonus payable, provident
fund contribution, Provision for staff leave encashment, etc. but do not pay before filing of
return they are disallowed in that year but will be allowed in the year of payment. If we
make part payment out of this before filing of return that amount actually paid will be
allowed for tax purpose and the remaining amount will be allowed in the year of payment.
This is called temporary timing difference. But if we pay cash above Rs.20000/- this
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expense will not be allowed for tax purpose any time. So this is permanent difference.

We should keep in mind that Deferred Tax Liability or Deferred Tax Assets are created only
for temporary timing difference. For permanent difference it is not created as they are not
going to be reversed.

The book entries of deferred tax is very simple. We have to create Deferred Tax liability
A/c or Deferred Tax Asset A/c by debiting or crediting Profit & Loss A/c respectively.

The Deferred Tax is created at normal tax rate.

[1] Profit & Loss A/c Dr

To Deferred Tax Liability A/c

[2] Deferred Tax Asset A/c

To Profit & Loss A/c

Please, note that both the entries are not passed but only liability or asset is created for net
amount of deferred tax.

If book profit is greater than taxable profit, create deferred tax liability.

If book profit is less than taxable profit, create deferred tax asset.

If there is loss in the books of accounts but profit as per income tax and the difference (e.g.
disallowance of exp.) subject to adjustments in future, create deferred tax asset.

If there is profit in the books of accounts but loss as per income tax and carry forward of
loss is allowed, (we have to pay MAT), create deferred tax liability.

Thus it is understood that, Deferred Tax Asset and Liability arising on account of timing
differences and which are capable of reversal in subsequent periods are recognized using
the tax rates and laws that have been enacted or substantively enacted as of Balance sheet
date. Deferred Tax Asset is not recognized unless there is virtual certainty that sufficient
future taxable income will be available which such deferred tax asset will be realized.

In other words, DTL is recognized for temporary differences that will result in taxable
amount in future years, Whereas DTA is recognized for temporary differences that will
result in deductible amounts in future years and for carry forwards. It is to be noted that
DTA is created in case of certainty only.

Example to understand Deferred Tax concept.

But the calculation is more important. Let us take one simple example of Depreciation
difference in books of accounts and taxable income.

Suppose, one company purchases a machine costing Rs. 300000/- on 1ST April. The
salvage value is assumed at zero. The working life is assumed at 3 years. The company
uses straight line method for depreciation in books of accounts but this machine is of that

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type which can be depreciated fully in the first year for tax purpose. Suppose tax rate is
30% for 3 years. For simplification profit before depreciation and tax is assumed
Rs.500000/-.

YEAR I II III

PROFIT BEFORE DEPRECIATION AND TAXES 500000.00 500000.00 500000.00

DEPRECIATION IN BOOKS OF ACCOUNTS 100000.00 100000.00 100000.00

PROFIT BEFORE TAXES 400000.00 400000.00 400000.00

TAXABLE INCOME 200000.00 500000.00 500000.00

=PROFIT - ALLOWABLE DEPRECIATION
(500000-300000, 500000-0, 500000-0)

CURRENT TAX @ 30 % ON TAXABLE INCOME 60000.00 150000.00 150000.00

DEFERRED TAX LIABILITY 60000.00 0.00 0.00

DEFERRED TAX ASSETS 0.00 30000.00 30000.00

(BEING REVERSAL OF LIABILITY)

TAX EXPENSE 120000.00 120000.00 120000.00

= 30% OF PROFIT BEFORE TAXES
OR CURRENT TAX+DTL-DTA

NET TIMING DIFFERENCE 200000.00 100000.00 0.00

BALANCE OF DEFERRED TAX LIABILITY 60000.00 30000.00 0.00

ENTRIES FOR THIS EXAMPLE :

In year I

Profit & Loss A/C DR 60000/-

To Provision for Income Tax A/C 60000/-
(Being provision made for tax payable for current year)

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Profit & Loss A/C DR 60000/-
To Deferred Tax liability A/C 60000/-
(Being Deferred Tax liability created on account of timing difference)

In Balance sheet Deferred Tax liability will be reflected by Rs.60000/-

In year II

Profit & Loss A/C DR 150000/-

To Provision for Income Tax A/C 150000/-
(Being provision made for tax payable for current year)

Deferred Tax Asset A/C DR 30000/-

To Profit & Loss A/C 30000/-
(Being deferred tax liability reduced on reversing timing difference)

In Balance sheet Deferred Tax liability will be reflected by Rs.30000/-

In year III

Profit & Loss A/C DR 150000/-

To Provision for Income Tax A/C 150000/-
(Being provision made for tax payable for current year)

Deferred Tax Asset A/C DR 30000/-

To Profit & Loss A/C 30000/-
(Being deferred tax liability reduced on reversing timing difference)

Deferred Tax liability is zero so there is no question to reflect it in Balance sheet.

Please note that net of deferred tax liability and asset will be reflected in Balance Sheet.

There are so many reasons for which allowable depreciation for tax purpose and
depreciation booked in accounts differs. The rate of depreciation may differ in law and in
books. The method of depreciation may differ in law and in books. The method of
calculation may differ as in books we may depreciate the assets individually account wise
whereas for tax purpose depreciation may be calculated block wise.

First time introduction of Deferred Tax in Books of accounts.

(Transitional Provisions)

As per AS 22 “On the first occasion that the taxes on income are accounted for in
accordance with this Standard, the enterprise should recognise, in the financial statements,
the deferred tax balance that has accumulated prior to the adoption of this Standard as
deferred tax asset/liability with a corresponding credit/charge to the revenue reserves,
subject to the consideration of prudence in case of deferred tax assets (see paragraphs 15-
18). The amount so credited/charged to the revenue reserves should be the same as that
which would have resulted if this Standard had been in effect from the beginning.”

To introduce deferred tax first time in the books, we have to find Difference between the
Value of Assets as per Books of Accounts and the Value of Assets as per Income
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Tax Act. To simplify if we have fixed assets in the books as gross block Rs.250 lacs
and accumulated depreciation Rs.150 lacs, the net value in the books is Rs.100 lacs.
Suppose, the net block value as per Income Tax calculation (as per tax audit) Rs.80
lacs. It means that in future we shall calculate depreciation on Rs.100 lacs whereas
as per Income Tax Act, the depreciation will be calculated on Rs.80 lacs. This will
result in less allowable depreciation creating more tax liability in future. Therefore,
we have to create Deferred Tax liability for this future Tax liability. The timing
difference is Rs.20 lacs on which we have to create Deferred Tax Liability of Rs.6
lacs at the assumed I.tax rate of 30%. In the same way we have to introduce for all
differeciating assets and liabilities.

Suppose, a firm has the following positions as on 31st March,

Asset / Liability as per as per difference DTL

books I.tax. (+)
DTA
(-)
@
30%

Assets :

Net fixed assets-written down value. 100.00 80.00 20.00 6.00

( In future more tax has to be paid on less allowable

depreciation as per tax law)

Liabilities:

Provision for gratuity 40.00 0.00 -40.00 -

12.00
(when paid in future it will reduce tax at that time)

Provision for staff leave encashment 30.00 0.00 -30.00 -9.00

(when paid in future it will reduce tax at that time)

Total -50.00 -
15.00

The entry to be passed in books for Rs. 15.00 lacs DTA newly introduced.

Deferred Tax Asset A/C DR 1500000/-

To Revenue Reserve A/C 1500000/-

ANNUAL CALCULATION

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It may be noted that we don’t have to calculate deferred tax on each and every transactions
related to it. The Deferred Tax is calculated annually from comparison of book profit and
taxable profit. The Deferred Tax Liability or Deferred Tax Asset is derived from the
comparison of Profit & Loss A/c of Balance sheet and Computation of Total Income for
Income Tax purpose. If any amount is expensed out in Profit & Loss A/c but not deducted
for Income tax purpose, it will create Deferred Tax Asset. If any amount claimed in Income
Tax is more than expensed out in Profit & Loss A/c, it will create Deferred Tax Liability.

The net difference of DTA / DTL is computed and transferred to Profit & Loss A/c. The
Balance of Deferred Tax Liability / Asset is reflected in Balance sheet. For that the following
simple statement may be used.

For the above example, Suppose in next year, the firm makes payments
from provision and makes new provisions from P/L A/c.

Details P/L Computation of difference DTL(+)

A/c Income /
DTA(-)
@
30%

Opening balance of -15.00

DTL(+) / DTA (-)

Comparison of P/L A/c and Computation of

Income

payment of staff leave encashment from 10.00 10.00 3.00

provision

payment of gratuity from provision 15.00 15.00 4.50

new provision for staff leave made from P/L 5.00 -5.00 -1.50
A/c

new provision for gratuity made from P/L A/c 5.00 -5.00 -1.50

depreciation as per books and tax audit 20.00 16.00 -4.00 -1.20

Total of comparison 3.30

Closing Balance of DTL(+) / DTA (-) -11.70

Or using Balance sheet approach also we can derive same figure as under :

The closing balance of assets assuming depreciation rate of 20% will be Rs.80 & 64 lacs
respectively. The closing balance of Gratuity provision will be 40-15+5=30 lacs and for
Provision of Leave Encashment will be 30-10+5=25 lacs. The calculation will be as under.
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 Asset / Liability as per books as per I.tax. difference DTL (+)
DTA (-)
@ 30%

Assets :

Net fixed assets 80.00 64.00 16.00 4.80

Liabilities:

Provision for gratuity 30.00 0.00 -30.00 -9.00

Provision for staff leave encashment 25.00 0.00 -25.00 -7.50

total -39.00 -11.70

Last year Deferred Tax Assets were of Rs. 15 lacs which arrived at 11.70 lacs current
year. So there is a deferred tax liability of Rs. 3.30 lacs for current year.

The only one entry will be passed in books for Rs. 3.30 lacs DTL newly calculated.

Profit & Loss A/C DR 330000/-

To Deferred Tax Liability A/C 330000/-

The balance of RS 11.70 lacs DTA will be reflected at asset side in Balance sheet.

As per revised schedule VI, DTL/DTA will be shown under “ Non Current Liabilities / Non
Current Asset ”.

For Financial Institutions, the application of deferred tax on Special Reserve created
under section 36(1)(viii) of the Income Tax Act, 1961

As per section 36(1)(viii) of Income Tax Act 1961

in respect of any special reserve created and maintained by a specified entity, an amount
not exceeding twenty per cent of the profits derived from eligible business computed under
the head "Profits and gains of business or profession" (before making any deduction under
this clause) carried to such reserve account:

Provided that where the aggregate of the amounts carried to such reserve account from
time to time exceeds twice the amount of the paid up share capital and of the general
reserves of the specified entity, no allowance under this clause shall be made in respect of
such excess.

Explanation.—In this clause,—

(a) "specified entity" means,—

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(i) a financial corporation specified in section 4A of the Companies Act, 1956 (1 of 1956)

(ii) a financial corporation which is a public sector company;

(iii) a banking company;

(iv) a co-operative bank other than a primary agricultural credit society or a primary co-
operative agricultural and rural development bank;

(v) a housing finance company; and

(vi) any other financial corporation including a public company;

(b) "eligible business" means,—

[(i) in respect of the specified entity referred to in sub-clause (i) or sub-clause (ii) or sub-
clause (iii) or sub-clause (iv) of clause (a), the business of providing long-term finance for -

(A) industrial or agricultural development;

(B) development of infrastructure facility in India; or
(C) development of housing in India;]

(ii) in respect of the specified entity referred to in sub-clause (v) of clause (a), the business
of providing long-term finance for the construction or purchase of houses in India for
residential purposes; and

(iii) in respect of the specified entity referred to in sub-clause (vi) of clause (a), the business
of providing long-term finance for development of infrastructure facility in India;

(c) "banking company" means a company to which the Banking Regulation Act, 1949 (10 of
1949) applies and includes any bank or banking institution referred to in section 51 of that
Act;

(d) "co-operative bank", "primary agricultural credit society" and "primary co-operative
agricultural and rural development bank" shall have the meanings respectively assigned to
them in the Explanation to sub-section (4) of

(e) "housing finance company" means a public company formed or registered in India with
the main object of carrying on the business of providing long-term finance for construction
or purchase of houses in India for residential purposes;

(f) "public company" shall have the meaning assigned to it in section 3 of the Companies
Act, 1956 (1 of 1956);

(g) "infrastructure facility" means—

(i) an infrastructure facility as defined in the Explanation to clause (i) of sub-section (4) of
(ii) an undertaking referred to in clause (ii) or clause (iii) or clause (iv) or clause (vi) of sub-
section (4) of
(iii) an undertaking referred to in sub-section (10) of

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(h) "long-term finance" means any loan or advance where the terms under which moneys
are loaned or advanced provide for repayment along with interest thereof during a period of
not less than five years;]

The eligible entities are getting deduction on Special Reserve created under this section by
resulting into reduction of tax liability.

As we know that authorities like RBI & NHB have asked to create Deferred Tax Liability of
Special Reserve Created u/s 36(1)(viii) of Income Tax Act,1961.

In this connection, I would like to invite some logical representations on some queries
related it.

As per AS 22,

Deferred Tax is the tax effect of timing differences.

Timing differences are the differences between taxable income and accounting income for
a period that originate in one period and are capable of reversal in one or more subsequent
periods.

Taxable income (tax loss) is the amount of the income (loss) for a period, determined in
accordance with the tax laws, based upon which Income tax payable (recoverable) is
determined.

Accounting income (loss) is the net profit or loss for a period, as reported in the statement
of profit and loss, before deducting income tax expense or adding income tax saving.

It is clearly written that accounting income / loss is the net profit / loss before tax effect.
There is no differentiation of above line or below line entries. Profit before tax is to be
considered as accounting income. And one more important view should be taken into
account that Deferred Tax is to be calculated on the items which are the main cause for
difference between accounting and taxable income. If a particular item reflects the same
numerical value in both workings then that item cannot be treated as item creating
difference between both income. We have to consider two main parts of Timing difference.
First is that there should be difference between both calculation and that difference can be
reversal in future at any point of time. If there is no difference between both calculation why
should we create deferred tax on such item ?

Now take an example for this.

Profit & Loss Account :

Profit before tax and provisions 10 lacs

Less provisions :

Depreciation on fixed assets 2 lacs

Special reserve u/s 36(1)(viii) 2 lacs
Leave encashment provision 2 lacs
---------
Profit before tax 4 lacs
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Computation of Income :

Profit before tax 4 lacs

Add :
Depreciation as per books 2 lacs
Special Reserve as per books 2 lacs
Leave encashment provision 2 lacs
------- 6 lacs
--------
Total 10 lacs

Less :

Allowable deductions :

Depreciation as per I.tax Act 3 lac

Special Reserve allowable 2 lac
Leave encashment paid amount 0.5 lac
------- 5.5 lacs
-------
-
Taxable Income 4.5 lacs

In this case, deferred tax liability on depreciation and deferred tax asset on leave
encashment is to be created and because of no differentiation between special reserve
booked and special reserve allowable, there will not be any deferred tax. The detailed
calculation look like this :

Assuming tax rate of 30% Rs in lacs

Details Profit and Loss Computation of Taxable difference DTL

Account Income (+)
DTA
(-)
@
30%

Opening balance of 0.00

DTL(+) / DTA (-)

depreciation as per books and tax 2.00 3.00 1.00 0.31

audit

special reserve u/s 36(1)(viii) 2.00 2.00 0.00 0.00

staff leave encashment provision 2.00 0.50 -1.50 -

/ payment 0.46

Closing balance of -
DTL(+) / DTA (-) 0.15

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Tax on book profit will be 4 lacs * 30% = 1.20 lacs which will be divided into two parts :
Current tax on taxable income will be 4.50 lacs * 30% = 1.35 lacs
Deferred tax Assets as per above -0.15 lacs
So, net tax effect will be 1.35-0.15=1.20 lacs.

In other words Deferred tax is the bridge between tax on book profit and current tax on
taxable income. In the above example taxable income is more than book profit by 0.50 lacs
on which we have paid more tax say 0.50 * 30%= 0.15 lacs which will be reversed in future.
But if any item shows same value both in books and in taxable income , there should not be
any deferred tax. Whether it is reversible or not is the second question, first question is that
is there any difference creating item between both income.

Special reserve created under s/c 36(1)(viii) of Income Tax Act,1961 becomes taxable in
the year of reversal (withdrawn). In the year of withdrawal it will be reflected both in books
as well as in taxable income and will be taxed in that year.

Now, considering the guidelines issued by authorities if we create deferred tax liability on
the advantage taken as deduction this year, what will be the actual position . The result is
itself unremarkable !

The deferred tax liability on Special Reserve in the above example will be 2 lac * 30% =
0.60 lac. Which will increase tax liability this year. On the other hand the current tax liability
was also decreased by 0.60 lac only on account of creation of special Reserve. So, if we
create deferred tax liability on special reserve, the actual benefit of reduced current tax
creating this reserve , will be washed out by increase of deferred tax liability by the same
amount.

Now, if we assume that deferred tax liability on special reserve is created the tax effect will
be,

Tax on book profit will be 4 lacs * 30% = 1.20 lacs :

Current tax on taxable income will be 4.50 lacs * 30% = 1.35 lacs
Deferred tax liability as per above +0.45 lacs
( 0.31 on dep.+ 0.60 on spl.res. – 0.46 lv.enc )

So, net tax effect will be 1.35+0.45=1.75 lacs. Which is more by 0.60 lacs in comparison of
tax of 1.20 lacs on book profit.

This if against the main objective of creating deferred tax to bridge the book profit and
taxable income.

So, if provision created u/s 36(1)(viii) is the same as being deducted in taxable income
there is no need to create deferred tax on it.

If provision created u/s 36(1)(viii) is the more than being deducted in taxable income there
is no need to create deferred tax on it. As additional created special reserve will be added
to taxable income and will be taxed in current year which is permanent difference.

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if provision created u/s 36(1)(viii) is lower than allowable deduction in taxable income there
is no need to create deferred tax on it as actually allowed deduction will be lower amount
and surplus allowable will be ignored.

It may be noted that if Special Reserve is created through appropriation from Net Profit and
not routed through Profit & Loss A/c then Deferred tax is to be created on it. But if this
Special Reserve is routed through Profit & Loss A/c and provided before Net Profit , if we
calculate Deferred Tax on it , Effective Tax Rate will not become zero.

Views in the article:

The readers are requested to consult their Tax Consultant before implementing. The writer
does not take any responsibility for personal views reflected in the article. The remarkable
comments from consultants will be highly appreciated.

on 19 May 2016

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