In this blog, we will explore the top 10 deferred taxes in India, highlighting common situations that give rise to deferred tax implications and their impact on financial reporting. In this blog, we will explore the top 10 deferred taxes in India, highlighting common situations that give rise to deferred tax implications and their impact on financial reporting.
What is the Deferred Tax?
Deferred tax refers to the difference between the amount of tax calculated on accounting standards and the amount of tax calculated as per tax laws. It arises due to short-term timing differences between the recognition of income or expense in financial statements (prepared under accounting standards) and tax returns (prepared under tax laws).
1. Timing Differences:
Deferred tax is caused by the timing difference between accounting profit and taxable profit. These differences are short-term so they will reverse in future periods.
2. Types of Deferred Tax:
Deferred Tax Asset (DTA): It is created when the tax paid in advance (or due) exceeds the tax expense recorded in the financial statements.
Examples: carry forward of losses, disallowances under tax laws, or differences in depreciation methods.
Deferred Tax Liability (DTL): It arises when the tax expense as per accounting records is less than the tax liability as per tax laws.
Example: Accelerated depreciation under tax laws, where the tax benefit is claimed even before it is recorded in the books.
What are the Top 10 Deferred Taxes in India?
1. Depreciation Differences
2. Provision for Bad Debts
3. Carry Forward of Losses
4. Employee Benefits (Gratuity/Leave Encashment)
5. Revenue Recognition Timing
6. Warranty Expenses
7. Fair Value Gains on Investments
8. Lease Accounting (Ind AS 116)
9. Share-Based Payments (ESOPs)
10. R&D Expenses
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1. Depreciation Differences
Depreciation differences are one of the most common causes of deferred tax in India. They arise due to the different methods and rates of depreciation used in computation (as per Indian Accounting Standards) and assessment (as per Income Tax Act, 1961).
Higher Depreciation in Tax Books:
When tax depreciation exceeds book depreciation, taxable income is reduced, leading to a deferred tax liability (DTL).
Higher Depreciation in Financial Books:
When book depreciation exceeds tax depreciation, taxable income is higher, resulting in a deferred tax asset (DTA).
2. Provision for Bad Debts
Provision for bad debts is an accounting entry made to estimate the potential loss from receivables that cannot be collected. This ensures that financial statements reflect a more realistic value of accounts receivable and adhere to the dictates of prudence.
1. What is Provision for Bad Debts: It is an estimated amount that is set aside for debts that are likely to not be paid.
2. Accounting Treatment: It reduces the profit in the financial statements to reflect the expected loss.
3. Tax Implication:
Under Indian tax laws, provisions are not a deduction for tax purposes. Only bad debts written off are allowed as a deduction.
This creates a deferred tax asset (DTA), so the tax benefits will accrue in the future when the bad debts are written off.
3. Carry Forward of Losses
Loss carry forward is a rule under Indian tax laws that allows businesses to carry forward certain unused losses to offset future taxable profits. This ensures that businesses can use past losses to reduce their tax liability in profitable years, thereby promoting fairness and financial stability.
1. Business losses: Set off against business income, carried forward for 8 years.
2. Unabsorbed depreciation: No time limit; can be offset against any income (except salary).
3. Speculative losses: Only offset against speculative income, carried forward for 4 years.
4. Capital Losses:
STCL: Offset against any capital gains.
LTCL: Offset only against long-term capital gains.
Both carried forward for 8 years.
5. Loss of house property: Carried forward for 8 years.
6. Loss of racehorse: carried forward for 4 years.
4. Employee Benefits (Gratuity/Leave Encashment)
Employee benefits (gratuity/leave encashment) refer to post-employment or post-termination benefits granted gracefully to employees. These benefits may give rise to deferred tax implications due to timing differences between accounting recognition and tax treatment.
Both gratuity and leave encashment create deferred tax assets (DTA) due to the timing difference in calculating these expenses (accrual basis vs. cash basis in the books for tax purposes).
5. Revenue Recognition Timing
Revenue recognition timing is defined as the difference between the timing of the recognition of revenue in the financial statements and the timing of its recognition for tax purposes. These timing differences can lead to the creation of deferred tax assets (DTA) or deferred tax liabilities (DTL).
Accounting: Revenue is recognized when received, for example, when goods/services are delivered.
Taxation: Revenue is taxed when it is received or when specific conditions are met.
6. Warranty Expenses
Warranty expense refers to the costs a company expects to incur in the future to repair or replace products under warranty. These are recognized as liabilities in the financial statements when a product is sold, even if the actual expense is not incurred until a later period.
The provision for warranty costs is a best estimate based on historical data, product type, and expected failure rates.
Timing differences between accounting and tax recognition of these costs result in tax deferrals.
A deferred tax asset is created when an expense is recognized in the books but is not yet deductible for tax purposes.
7. Fair Value Gains on Investments
Fair value gains on investments refer to changes in the value of an input (such as a stock, bond, or real estate) based on market conditions, which are recorded in the financial statements. These gains represent the difference between an asset’s current market value and its carrying value (purchase price or historical cost).
Since tax laws impose taxes only when they are received, while accounting standards recognize them immediately, a deferred tax liability (DTL) arises. This is due to the timing difference between when the profit is recorded for accounting and when it is taxed.
8. Lease Accounting (Ind AS 116)
Lease accounting under Indian Accounting Standard 116 brings about significant changes in the way leases are recognized and reported in the financial statements of Indian companies. It is based on the International Financial Reporting Standard (IFRS) 16, which focuses on bringing most leases to the balance sheet to enhance transparency.
ROU asset and lease liability: Both were recorded at the inception of the lease.
Depreciation and Interest: Lease replaces rent expense.
Discounts: Short-term and low-value leases may be expensed normally.
Tax implications: There may be tax delays due to differences in accounting and tax treatment.
9. Share-Based Payments (ESOPs)
Share-based payment (ESOP) refers to compensation given to employees in the form of company shares or stock options. This allows employees to earn company stock, usually at a convenient price or as part of their remuneration package. ESOPs (employee stock ownership plans) are commonly used by companies to align employees’ interests with company performance and to attract or retain talent.
DTA (Deferred Tax Asset): This is created when the company recognizes the expense for an ESOP in the financial statements but does not receive the tax benefit until the options are exercised.
10. R&D Expenses
R&D expenses are expenses incurred by a company for activities aimed at developing new products, services, or technology or improving existing products. These costs may be eligible for tax incentives, especially in India, where they are treated separately for accounting and tax purposes.
1. Accounting: Usually expensed unless capitalized under development.
2. Tax Treatment:
100% deduction for in-house R&D.
200% deduction for scientific R&D approved by DSIR.
Depreciation is available on capital assets used for R&D.
3. Deferred Tax:
DTA can arise when R&D expenditure is capitalized in accounting but is immediately deductible for tax.
DTL occurs when tax deductions exceed accounting expenses, particularly for capitalized R&D.
Conclusion:
Deferred taxes play an important role in aligning accounting profit with taxable profit, ensuring that tax liabilities are appropriately recognized over time. By taking into account the timing differences between financial reporting and tax laws, companies can better administer their tax liabilities and assets. Understanding deferred tax assets (DTA) and liabilities (DTL) is important for businesses to accurately reflect their financial space and comply with tax regulations. In India, a variety of scenarios such as depreciation, R&D expenses, and executive benefits give rise to deferred tax implications. Proper management of these elements helps improve tax planning, and cash flow forecasting, and ensures transparent financial reporting, thereby benefiting both businesses and stakeholders.
FAQs
Q1. What is an example of a deferred income tax?
A simple example of a deferred tax asset is the carryforward of losses. When a business incurs a loss, it can use that loss to reduce taxable income in future years.
Q2. Is deferred tax a current asset?
Under US GAAP, all deferred tax assets and liabilities are classified as non-current (long-term) on the balance sheet.
Q3. What is called deferred tax?
IAS 12 defines deferred tax liability as income tax payable in future periods on account of taxable temporary differences. In simple terms, deferred tax is tax payable in the future.
Q4. What is a deferred tax journal entry?
Deferred tax liability refers to deferred tax payments due to timing differences in accounting. It is listed as a “non-current liability” on the balance sheet.
Q5. How to record deferred tax?
Journal entry: Debit the deferred tax asset account and credit the income tax expense (or deferred tax benefit) account.
Financial statements: Report the deferred tax asset as a non-current asset on the balance sheet.
Q6. Can deferred tax be negative?
Deferred tax is an entry on a company’s balance sheet that results from taxes owed or overpaid. A deferred tax asset (DTA) occurs when a company pays more taxes than it should have, thereby reducing its future tax liability.
Q7. What is deferred tax in P&L?
IAS 12 defines deferred tax liability as income tax payable in future periods on account of taxable temporary differences. In simple terms, it is a tax that will be paid in the future.
Q8. What is the difference between current tax and deferred tax?
Current tax is the income tax payable or recoverable based on the taxable profit or loss for a period. Deferred tax liabilities represent income taxes payable in the future on account of taxable temporary taxes.
Q9. Is deferred tax an asset?
Deferred tax assets arise from overpayment or advance taxes and appear on the balance sheet. This is in contrast to deferred tax liability, which represents taxes owed. Deferred tax assets generally occur due to differences between tax and accounting rules.
Q10. What is the advantage of tax-deferred?
When you sell stocks or assets that have increased in value, you get capital gains and are taxed. However, in a tax-deferred account, buying and selling assets does not incur any taxes.
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