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Deferred Tax in Simple Words - PART II

Vignesh Killur 
on 02 May 2012

LinkedIn


The Day is 1st of April 2001; the Indian Accounting Fraternity is introduced to the concept of Deferred Tax.

Accounting for Taxes on Income (AS – 22) is applicable to different categories of enterprises from different dates.

TABLE 1:

Levels of Enterprises

Applicable with effect from

All Types of Companies

As per Companies (AS) Rules 2006

Level I

01-04-2001

Level 2

01-04-2002

Level 3

01-04-2006

Before we proceed any further, it is very essential to know the meaning of Level 1,2,3 Enterprises.

LEVEL 1 ENTERPRISES:

Enterprises, which fall in any one or more of the following categories, at any time during the accounting period, are classified as Level I enterprises:

i) Enterprises whose equity or debt securities are listed whether in India or outside India.

ii) Enterprises, which are in the process of listing their equity or debt securities as evidenced by the board of directors’ resolution in this regard.

iii) Banks including co-operative banks.

iv) Financial Institutions

v) Enterprises carrying on insurance business.

vi) All commercial, industrial and business reporting enterprises, whose turnover for the immediately preceding accounting period on the basis of audited financial statements exceeds Rs. 500 million. Turnover does not include ‘other income’.

vii) All commercial, industrial and business reporting enterprises having borrowings, including public deposits, in excess of Rs. 100 million at any time during the accounting period.

viii) Holding and subsidiary enterprises of any one of the above at any time during the accounting period.

LEVEL2 ENTERPRISES:

Enterprises, which are, not Level I enterprises but fall in any one or more of the following categories are classified as Level II enterprises;

i) All commercial, industrial and business reporting enterprises, whose turnover for the immediately preceding accounting period on the basis of audited financial statements exceeds Rs. 4 million, but does not exceed Rs. 500 million. Turnover does not include ‘other income’.

ii) All commercial, industrial and business reporting enterprises having borrowing, including public deposits, in excess of Rs. 10 million but not in excess of Rs. 100 million at any time during the accounting period.

iii) Holding and subsidiary enterprises of any one of the above at any time during the accounting period.

LEVEL 3 ENTERPRISES:

Enterprises, which are not covered under Level I and Level II are considered as Level III enterprises.

CASE STUDY:

Mr. V runs a small scale business unit by the name of V Company LTD. It is an existing business. His business is in the development stage.  But Since 2006, AS 22 is applicable to him, he has to ascertain his accumulated balance of Deferred tax liability/Asset as on 1st of April 2006.

 He is advised by Mr. P, his CA as follows:

“Deferred Tax was introduced in accordance with the matching concept which states that the income of the year should be matched with the expenses incurred during the year. Since Income tax forms a significant portion of the expenses, it became very essential to match the current year taxes against current year Income.”

Since the concept is new to this Enterprise, you have to first ascertain the Opening balance of Deferred Tax Liability or Asset”

Naturally the question Mr. V had was how to ascertain the Opening balance of Deferred Tax Asset/ Liability.

Mr. P replies as follows- “It is the Difference between the Value of Assets as per Books of Accounts and the Value of Assets as per Income Tax Act.

To Illustrate, let me give an example. Think that you have Fixed Assets worth Rs. 10 Crore as of today, i.e the Book Value of Assets as on 1st April 2006 is Rs. 10 Crore. And the written down value as per Income Tax Act is Rs. 7 Crore. Then the Opening Balance of Deferred Tax Liability is 0.927 Crores i.e  (10-7)*30.9%. Deferred Tax Liability is created at the highest marginal Rate of Tax.

The meaning of creating this deferred tax liability is that the Company will have a tax liability of 0.927 Crores in the future because the Depreciation as per Income Tax Act will be less in the future years, thus profit as per IT Act will be higher leading to a higher taxation. (WDV remaining to be written off as per IT Act only 7 crores as compared to 10 Crore as per Books of Account)

The above Computation is true only if Depreciation is the only timing Difference.

For this purpose, it is also important to know what Permanent Difference and temporary difference (timing difference) means:

From the above, it is clear that Deferred Tax Liability arises due to some items which cause a difference between the profits as per P&L A/c (Net profit) and profit as per Income tax act (taxable Income)

Permanent Differences

1. One Classic example of permanent difference is Cash Payment in Excess of Rs. 20,000. The item is debited to P&L A/c. But for Income Tax purposes it is disallowed as an expense under section 40(A)(3). In this case there is no chance of Reversal in the Subsequent years, Hence this item is a permanent Difference.

2. Another Example of Permanent Difference is Exemption is claimed for a particular Income U/s 80-IA of the IT Act. This profit will not be taxed in the future years. Hence it is a permanent Difference.

Temporary Differences

Bonus Payable of Rs. 50,000/- to employees is debited to P&L A/c but the Bonus is not disbursed to employees before the due date of filing the return. This expense will be disallowed as per IT Act U/s 43B. Hence it won’t be allowed as a deduction under the IT Act thus increasing the Taxable income as per IT Act. But this item is capable of Reversal in the future years. The Bonus will be allowed as expense under the IT Act in the year in which it is paid, thus resulting the Tax Profits to go down during that year.

Important: Please note that only temporary differences result in Deferred Tax Asset/Liability.

Now consider this situation: The Opening position of Mr. V’s business as on 1st April ’06 is as follows.

TABLE 2:

Value of Assets as per Books of Account

10 Crores

WDV of Assets as per Income Tax Act

7 Crores

 Unabsorbed Depreciation as per IT Act

2 Crores

 Unpaid Bonus of FY 2005-06 (Paid on 31st December 2006)

0.5 Crores

Now the Deferred Tax Liability has to be carefully ascertained after considering the Tax Assets of the Company.

TABLE 3:

Computation of Opening Balance of Deferred Tax Liability:

In Crores

In Crores

Value of assets as per Books

10

WDV as per IT Act

7

Deferred Tax Liability to be created on:

3

Less : Deferred Tax Assets on Account of :

           a) Unabsorbed Depreciation

2

           b) Unpaid Bonus

0.5

2.5

Deferred Tax Liability created @ 30.9% on 0.5 Crores (0.5*30.9%)

0.1545

1. Deferred Tax Asset (i.e a tax asset or something which reduces taxes in future years) on account of Unabsorbed Depreciation and bonus arises since if the company is called to pay tax on 3 Crores (WDV Difference) it can always set off the Unabsorbed Depreciation and claim the Bonus as expenses under Income from Business, thus reducing current year taxes. Hence it is an tax asset.

2. In theory, if there are no timing differences on any given date, then the Deferred Tax Balance should be ZERO.

We will test this theory.

FINANCIAL YEAR 2006-07

Consider the following events in the F.Y 2006-07

1. The Depreciation as per Books is 3 Crore. The Depreciation as per IT Act is NIL. (Assumed). Thus as on 31st of March 2007, there is no timing difference

2. The unpaid bonus is entirely paid

3. Unabsorbed Depreciation is fully set off against Income from Business.

The Deferred Tax Computation will be as follows:

TABLE 4:

Disallowed Under Income tax Act:

In Crores

In Crores

Depreciation as per Books of Accounts

3

Total

3

Less: Deductible Under the IT Act

i) Depreciation as per IT Act

0

ii) Unabsorbed Depreciation

2

iii) Unpaid Bonus of F.Y 2005-06 paid during F.Y 2006-07

0.5

2.5

Difference

0.5

Deferred Tax Liability Reversed (0.5*30.9%)

0.1545

Less: Opening balance of Deferred Tax Liability

0.1545

Balance as on 31st March 2007

0.00

1. This technique can be followed for Calculating Deferred Tax: First write all expenses which are Disallowed for Income Tax purposes. Then write down all expenses which are allowed for IT purposes. If the difference is positive, then create Deferred Tax Asset/Liability Reversal. If the amount is negative, the create deferred tax liability.

2. When there is no timing difference i.e Dep. as per IT and Books are equal, No Unabsorbed Dep, No Bonus remaining to be paid, there will be NIL DTA/DTL.

Accordingly Mr. V passes the entries in his Books of Account.

1. Deferred Tax Liability should be debited to the P&L account as a provision and should be shown as a separate item after Unsecured Loan in Balance Sheet.

2. Deferred Tax Asset should be credited to P&L Account and shown in the Asset side below Investments.

3. Please Refer the Revised Schedule VI for latest classification

FINANCIAL YEAR 2007-08

Now in the F.Y 2007-08, the following events occur:

1. Mr. V buys a Machine used for Scientific Research Rs. 2 Crores related to his business which qualifies for Deduction under Section 35 at the rate of 100% in the first year. However the Useful life of the Machine is 5 years.

2. As on 31st March 2008, a Bonus Payable to workers entry is passed at 20% of Wages for each worker aggregating to the tune of Rs. 75,00,000/-. This amount is unpaid till the date of filing the Return of Income.

3. Consultancy Fees is paid to a Non Resident in connection with his business to the tune of Rs. 20,00,000/-. But TDS has not been made on the above till the due date of filing the Return of Income.

4. Cash Expenses of Rs. 50,000 has been paid on a single transaction.

5. Provision for Retirement Benefit (Gratuity and Leave Encashment) of Staff has been passed to the tune of Rs. 1,50,00,000/-. This liability may arise in the future.

6. A Term Loan has been borrowed from a Bank. But the repayment starts 3 years later. In other words there is a moratorium on the Repayment. But V has made a Provision for accrued interest on term loan of Rs. 80,00,000/-.

7. Depreciation (excluding Scientific Research Equipment) as per Books of Accounts comes to Rs. 2 Crores

8. Depreciation as per Income tax Act (Excluding Scientific Research Equipment) comes to Rs. 4 Crore.

9. The Net Profit as per P&L A/c of the Company comes to Rs. 95,00,000/-

TABLE 5:

COMPUTATION OF DEFERRED TAX AND TAXABLE INCOME

DEFERRED TAX

TAXABLE INCOME

Net Profit as per P&L Account

95,00,000

ADD:

Expenses Disallowed as per IT Act (Only Timing          Differences)

  1. Depreciation as per Books

2,00,00,000

  1. Depreciation in Books for Scientific Equipments - 20%

40,00,000

  1. Interest on Term Loan - Provision for Accrued Interest

80,00,000

  1. Provision for Retirement Benefit of Staff

1,50,00,000

  1. Consultancy Fees (TDS not deducted)

20,00,000

  1. Unpaid Bonus of the F.Y 2007-08

75,00,000

TOTAL

5,65,00,000

LESS: Expenses Deductible under the Income Tax Act

  1. Depreciation as per Income tax act

4,00,00,000

  1. Depreciation on Scientific Equipment - 100%

2,00,00,000

TOTAL

6,00,00,000

Difference

-35,00,000

-35,00,000

Deferred Tax Liability @ 30.9%

-10,81,500

ADD: Permanent Differences:  Cash Payments exceeding Rs. 20,000/-

50,000

TAXABLE INCOME AS PER IT ACT

60,50,000

NOTES:

1. Depreciation on Scientific Research Equipment is a temporary difference as in the subsequent years the Depreciation on Scientific research equipment as per IT Act will be NIL, but the Depreciation as per Books will continue till the day the equipment is fully depreciated. Hence any difference in the value of asset for Tax and Accounting purpose is purely temporary.

2. Interest on term loan in debited as an expense in the P&L A/c but for tax purposes the Interest will be allowed as deduction only on actual payment under section 43B. Thus it is only a matter of time before it is allowed as an expense. Hence it is currently a tax asset. Because it will yield future tax benefits.

3. Like all Provisions, Provision for Retirement Benefits to staff will be disallowed as an expense for tax purpose since it is merely a provision, The expense will be allowed as deduction when the Gratuity or Leave Encashment is actually paid. Hence this is also a timing difference and will lead to the creation of tax asset to that extent.

4. TDS is required to be deducted on Payment of Consultancy Fees to Non Residents. If no TDS is deducted, then that particular expense will not be allowed as deduction. But this is temporary as the expense will be allowed when the TDS is deducted and remitted to the tax authorities.

5. Similarly Unpaid Bonus is not allowed as deduction Under Section 43B. It will be allowed only if the payment takes place before the due date of filing the returns or in the financial year in which the payment takes place.

6. As stated earlier only temporary differences give rise to deferred tax asset or Liability. Since Cash payment in excess of Rs. 20,000 is a permanent difference (there is no chance of reversal) it does not lead to the creation of DTA/DTL.

FINANCIAL YEAR 2008-09

EFFECT OF CHANGES IN TAX RATES:

On 12-02-2009, the Finance Minister announces that the Corporate tax rate is to be increased to 33.99% (tax=30%, Surcharge=10% on tax, EC @3% on tax +surcharge) w.e.f. A.Y 2009-10 i.e the F.Y 2008-09.

The introduction of surcharge is set to hit the corporate sector very hard which is already suffering from high tax rates.

How will this change affect the Deferred Tax which has been created when the tax rates were 30.9%. (30% tax, 3% EC on tax)

In the above case:

For the F.Y 2008-09

TABLE 6:

Opening Balance of Deferred Tax Liability as on 1-4-2008

10,81,500

Change on Account of Changes in Tax Rate : 10,81,500 X 33.99/30.9

11,89,650

Difference Deferred Tax Liability to be recognized on Account of Change in Tax Rates

- 1,08,150

Closing Balance of Deferred Tax Liability as on 31-03-2009

11,89,650

In addition to the above, if there are any DTA/DTL during the year, it should be accounted for at 33.99% (For Convenience Assume no Depreciation is charged this year)

FINANCIAL YEAR 2009-10

Now Mr. V decides to convert his company into a 100% Export Oriented Unit (EOU). For this purpose it is necessary to dispose of all the Assets of the Company and start fresh with newly purchased Machinery. He has to completely liquidate the company and start a new one. He has two main items of Machinery:

TABLE 7:

Manufacturing Machinery

Scientific Research Machinery

WDV as per IT Act on 1st April 2009

3 Crores

0

Value as per Books of Accounts

5 Crores

1.6 Crore

Sold on

16-02-2010

12-05-2010

Sale Value

1.5 Crores

1 Crore

Since he intends to convert his company into an 100% EOU to claim deduction under section 10B, it is very necessary to close down his existing business, sell all the plant and machinery and buy new ones (One of the Conditions of Sec 10B is that it should not be constituted by the transfer of old plant and machinery and also by splitting or Reconstruction of the business.

As can be seen from the above, first Manufacturing Machinery is sold for Rs. 1.5 Crores, then later Research Machinery is sold for 1 Crore.

How does it affect DTA/DTL?

AS – 22 says that Deferred Tax Asset should be recognized in relation to Loss under the head Capital gain to the extent that such losses can be set off in the subsequent periods from Income arising under the same heads. i.e Capital Gains

There should be reasonable certainty that such Loss can be set off. In this case lets assume that the Sale deed for Sale of Research Machine has been drafted for Rs. 1 Crore. The Capital Gains are Computed as follows

TABLE 8:

Manufacturing Machinery

(in Crores)

Research Machinery

(In Crores)

Sale Consideration

1.5

1

Less: WDV as per IT on the date of Sale

3

0

Short Term Capital Gains/ (Loss)

(1.5)

1

This short term Loss of 1.5 Crores can be set off against gains of Rs. 1 Crore. Hence Deferred Tax Asset is to be recognized only to the extent of Rs. 1 Crore.

Since the Company is in a shut down mode, it has to settle its outstanding affairs.

Also note that for convenience Depreciation has not been charged during some years.

DEFERRED TAX AS ON 31-03-2010 is calculated as follows:

TABLE 9:

Expenses Disallowed under the IT Act

Depreciation as per Books

-

Loss on Sale of Manufacturing Machine (WDV as per Books-Sale Proceeds)

3,50,00,000

Less: Permanent Difference (Loss which cannot be set off)

   50,00,000

3,00,00,000

Expenses Allowed under IT Act

Interest on Term Loan – Paid

80,00,000

Gratuity and Leave Encashment Paid out of Provision

1,50,00,000

Consultancy Fees : TDS has now been deducted

20,00,000

Unpaid Bonus of the F.Y 2007-08 Paid Now

75,00,000

3,25,00,000

Difference

-25,00,000

DTA to be created on Short Term Capital Loss

1,00,00,000

TOTAL

75,00,000

Deferred Tax Asset @ 33.99%

25,49,250

Balance DT is as follows:

TABLE 10:

Opening Balance as on 1-04-2009: DTL

11,89,650

Less: DTA During the year

25,49,250

Closing Balance of DTA as on 31-03-2010

-13,59,600

Now Lets assume the Business is wound up on 29-06-2010.

CLOSING DEFERRED TAX COMPUTATION

FINANCIAL YEAR 2010-11

TABLE 11:

Expenses Disallowed under the IT Act

Loss on Sale of Scientific Research Machinery

60,00,000

Less: Expenses allowable under the IT Act / Losses set off

Short Term Capital Loss Set off

100,00,000

Difference

-40,00,000

DTL @ 33.99%

-13,59,600

Balance DTA/DTL is closed.

TABLE 12:

Opening DTA Balance as on 1-04-2010

13,59,600

Less: DTL – Reversal during the year

13,59,600

Closing Balance

NIL

HOW TO COMPUTE DTA/DTL WHEN 10A/10B, 80IA, 80IB EXEMPTION IS CLAIMED:

Now Mr V starts a new company which is a 100% EOU availing 10B exemption, He purchases a New Machinery for manufacture costing Rs. 15,00,00,000/- (15 Crores)

DEPRECIATION SCHEDULE FOR 15 YEARS

YEAR

ACCOUNTS (SLM – 15 years

(in 000’s)

I.T

(30% WDV)

(in 000’s)

1

10,000

22,500

2

10,000

19,125

3

10,000

16,256

4

10,000

13,818

5

10,000

11,745

6

10,000

9,983

7

10,000

8,486

8

10,000

7,213

9

10,000

6,131

10

10,000

5,211

11

10,000

4,430

12

10,000

3,765

13

10,000

3,200

14

10,000

2,720

15

10,000

15,415*

TOTAL

150,000

150,000

Note: Assumed to be fully depreciated in the last year.

The Following table illustrates the company’s projected performance for a period of 15 years since its beginning.

Year

Accounting Income

In 000’s

(Before Dep)

Depreciation as Per Books

Accounting Income after Depreciation

Taxable Income

In 000’s

(Before Dep)

Depreciation as per IT Act

Taxable Income after Depreciation

Section 10 B Exemption

1

30,000.00

10,000.00

20,000.00

30,000.00

22,500.00

7,500.00

7,500.00

2

30,000.00

10,000.00

20,000.00

30,000.00

19,125.00

10,875.00

10,875.00

3

30,000.00

10,000.00

20,000.00

30,000.00

16,256.25

13,743.75

13,743.75

4

30,000.00

10,000.00

20,000.00

30,000.00

13,817.81

16,182.19

16,182.19

5

30,000.00

10,000.00

20,000.00

30,000.00

11,745.14

18,254.86

18,254.86

6

30,000.00

10,000.00

20,000.00

30,000.00

9,983.37

20,016.63

20,016.63

7

30,000.00

10,000.00

20,000.00

30,000.00

8,485.86

21,514.14

21,514.14

8

30,000.00

10,000.00

20,000.00

30,000.00

7,212.98

22,787.02

22,787.02

9

30,000.00

10,000.00

20,000.00

30,000.00

6,131.04

23,868.96

23,868.96

10

30,000.00

10,000.00

20,000.00

30,000.00

5,211.38

24,788.62

24,788.62

11

30,000.00

10,000.00

20,000.00

30,000.00

4,429.67

25,570.33

0

12

30,000.00

10,000.00

20,000.00

30,000.00

3,765.22

26,234.78

0

13

30,000.00

10,000.00

20,000.00

30,000.00

3,200.44

26,799.56

0

14

30,000.00

10,000.00

20,000.00

30,000.00

2,720.37

27,279.63

0

15

30,000.00

10,000.00

20,000.00

30,000.00

15,415.45

14,584.55

0

Year

Depreciation as per Books

Depreciation as per IT Act

Difference

Deferred Tax @ 33.9%

1

10,000

22,500

-12,500.00

-4,248.75

2

10,000

19,125

-9,125.00

-3,101.59

3

10,000

16,256

-6,256.25

-2,126.50

4

10,000

13,818

-3,817.81

-1,297.67

5

10,000

11,745

-1,745.14

-593.17

6

10,000

9,983

16.63

5.65

7

10,000

8,486

1,514.14

514.65

8

10,000

7,213

2,787.02

947.31

9

10,000

6,131

3,868.96

1,315.06

10

10,000

5,211

4,788.62

1,627.65

11

10,000

4,430

5,570.33

1,893.35

12

10,000

3,765

6,234.78

2,119.20

13

10,000

3,200

6,799.56

2,311.17

14

10,000

2,720

7,279.63

2,474.35

15

10,000

15,415*

-5,415.45

-1,840.71

In Accordance with Accounting Standard 22 the timing difference which reverses itself during the tax holiday period should not be recognized. In the first five years, DTL of Rs. 11,367.68 (000’s) arises. This is reversed in the subsequent 5 years (i.e year 6 to 10) to the extent of Rs.  4,410.33 (000’s). Thus in year 1 no deferred tax liability need to be recognized. (4248.75-4410.33= -161.58 OR NIL). In year 2 DTL of only 2,940.01 needs to be recognized i.e (3101.59-161.58). The DTL to be recognized in year 1 to year 5 are given below.

YEAR

DTL AS PER TABLE

Total DTL Reversal

(DTA during the period)

(DTL)/DTA to be recognized

TAX HOLIDAY PERIOD

1

-4,248.75

0.00

2

-3,101.59

-2,940.01

3

-2,126.50

-2,126.50

4

-1,297.67

-1,297.67

5

-593.17

-11367.68

-593.17

6

5.65

0

7

514.65

0

8

947.31

0

9

1,315.06

0

10

1,627.65

+4410.33

0

AFTER TAX HOLIDAY

11

1,893.35

1,893.35

12

2,119.20

2,119.20

13

2,311.17

2,311.17

14

2,474.35

2,474.35

15

-1,840.71

-1,840.71

HOW TO COMPUTE DTA/DTL IF MAT PROVISIONS ARE APPLICABLE:

The DTA/DTL is to be computed on normal rate of tax and not at the rates prescribed under MAT.

MAT Credit can be considered as an asset only if the company expects to pay tax at the normal rates in the future years.

Thank you for Reading. I will consider my efforts amply rewarded if you find this useful.

I am an Articled Assistant from Mangalore who lives by the motto "If you make mistakes, make new ones each day so as that you learn something new everyday"




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