What is Deferred Tax Liability

The objective of this article is to familiarize the reader with deferred tax liability and how to compute the same. But before moving to deferred tax liability, one must know about deferred tax and how it is classified into deferred tax assets and deferred tax liability. 

What is Deferred Tax?

Deferred tax is the notional tax that the company computes and discloses in its financial statements. It signifies that the tax is either paid in advance or has been carried forward but has still not been recognized in Company’s Profit and loss account.

Why deferred tax?

• One of the key purposes of deferred taxes is that the company prepares its books of accounts according to IGAAPs/Ind AS and based on the provisions of the Income-tax Act, various adjustments are made to the profit and loss account to arrive at the taxable income under the I-T Act.

• These differences in income tax provisions and the GAAP result in some differences between the income as per accounting books and as a tax return, which results in the creation of a deferred tax liability or an asset.

• Deferred tax is meant to meet the concept of the matching principle. It basically means allowing accounting for the taxes in the same financial year to which the profit or loss account pertains.

• If the deferred tax asset or liability is not recognized for the same financial year, it can lead to an overstatement or understatement of profits.

Permanent and Temporary Differences

The company’s financial statement has a section on book profits calculated as per the provisions of the Companies Act, 2013, and applicable Generally Accepted Accounting Principles (GAAPs).

Certain adjustments in income and expenses appearing in the P&L Account are made for tax purposes. As a result, there is a difference between the book profit and taxable profits. This difference can be a permanent difference or a temporary timing difference.

1) Permanent Difference:

It is the difference between tax income and book income that cannot be reversed in subsequent years. The cases where an item in the profit and loss account is never chargeable or allowable for tax purposes or is chargeable or allowable for tax purposes but never appears in the profit and loss account are called permanent differences. A permanent difference does not give rise to deferred tax.

2) Temporary Difference:

It is the difference between tax income and book income that is reversed in subsequent years. In other words, If an item of income/ expense is chargeable or allowable for tax purposes but in a different period than the one for which the accounts have been prepared, (i.e. when the income or expense is recognized in the books), then it gives rise to temporary differences. Temporary differences do give rise to potential deferred tax.  

Classification of Deferred Tax:

Deferred tax can be classified in two buckets:

1.       Deferred Tax asset:

It means paying more tax now and less tax in the future.

Deferred tax assets are the assets created in the books of accounts which denote that with reference to the book income the income tax is paid in advance as the taxable income is higher than the book income. This tax is then recoverable in future periods by way of (a) deductible temporary differences; (b) the carry forward of unused tax losses; which are only recorded as an asset if it is deemed to be used in a future financial year.

It arises when the profit as per accounting books is less than the profit as per tax books

It is an asset on a company’s balance sheet that may be used to reduce any subsequent period’s income tax expense. So, when the Company’s balance sheet has a deferred tax asset, it signifies the overpayment of taxes which becomes an asset for the company whose benefit it will receive in the future in the form of tax relief.

2. Deferred Tax Liability.

Deferred tax liability is the opposite of deferred tax assets. In simple terms, it is a tax that is payable in the future period owing to different treatment in accounts and tax laws on the items of income/ expense. The liability arises when the temporary timing difference leads to higher profit as per accounting books than taxable profit as per Income-tax Act.

One of the common and important instances wherein deferred tax liability may arise is as below

Method of Depreciation as per books v/s I-T return. 

• When a company depreciates its assets differently than the Income-tax Act, of 1961, it leads to a temporary timing difference. This difference creates a temporary discrepancy between depreciation figures mentioned in a company’s financial statements and the corresponding tax returns.
• When a company depreciates its assets at a lower rate in the books of accounts than in the tax return, its gross profit for that particular year as per books tends to be higher than taxable profits as per tax return.
• However, as the asset has the end life defined in both the books and is assumed to be used till the end of its useful life by fully depreciating it, then at the end of its useful life the difference between net book value as per both the books would eventually become Nil or reach its scrap value.

Calculation of deferred tax liability

Deferred tax is calculated as per India Accounting Standard 12 (Ind AS 12) (previously referred to as Accounting Standard 22).

The tax is calculated on the difference between the balances as per books and balances as per tax return.

Let’s understand it with an example:

ABC limited purchased Computers costing Rs 50 lakhs on 1^st April 2021. Let us assume this asset is the only asset forming part of ABC Ltd.’s books of accounts. The company follows the straight-line method (SLM) of depreciation and follows the useful life prescribed as per schedule II of the Company’s act 2013 which is 3 years.

For treatment in tax books, the company depreciates this asset at the rate of 40% p.a. as specified in the Income-tax Act, 1961. 

Assume that the effective tax rate applicable for the company is 34.94% (Base rate 30% + surcharge 4% + cess 1%).

The computation of deferred tax for FY 21-22 is as below:

As the depreciation charged as per accounting books is lower than depreciation as per Income tax, the profit as per accounting books is higher, thereby giving rise to deferred tax liability.

Temporary timing difference = Depreciation as per Tax books – Depreciation as per Accounting Books

i.e., Rs 20,00,000 – Rs 16,66,667 = Rs 3,33,333

Deferred Tax Liability = Rs 3,33,333 x 34.94% = Rs 1,16,467.

Final note: Deferred tax liability is recorded in the books of a company to comply with the applicable accounting standards and to facilitate a better picture for the shareholders about the underlying tax liability which may not arise today due to timing differences, but will arise in the future.

Frequently Asked Questions