Finance & Accounting Income Tax

A detailed guide on IAS 12 on Income Taxes

Because its concept and application are difficult to understand, deferred income tax is one of the top ten causes of accountants’ challenges. When it comes to IFRS^[1] financial statements, many of them have problems in the deferred taxes section. In the domain of income taxes, the standard IAS 12 serves as a reference, although it is not a particularly simple or easy-to-read standard.

Objectives of IAS 12

The basic purpose of this Accounting Standard is to specify how income taxes should be accounted for. Income taxes are defined as all domestic and foreign taxes based on taxable profits for the purposes of this Standard. Income taxes also include taxes paid by a subsidiary entity, associate, or joint venture on distributions to the reporting business, such as withholding taxes.

Accounting for income taxes is primarily concerned with how to account for the current and future tax effects of:

• the recovery and/or settlement to be made in the future of the carrying values of assets & liabilities that are recognized in the balance sheet of an enterprise
• the transactions and events pertaining to the present period that are recognized in the financial statements of an enterprise

Differences in taxes

Accounting principles differ from tax laws and regulations in almost every jurisdiction. These variations can be large, requiring accountants to make numerous changes to their accounting profit in order to arrive at the foundation for income tax calculation. To properly comprehend the meaning and rules of IAS 12, one must first comprehend the meaning and distinctions between accounting profit and taxable profit, as well as current and deferred income taxes.

Accounting profit signifies the profit or loss during a period before taxes are deducted. One should note that, in order to be commensurate with the definition of a taxable profit, IAS 12 describes accounting profit as a figure before tax (rather than after-tax, as we usually do). A profit (loss) for a period determined in compliance with the provisions established by the taxation authorities on which income taxes are payable or recoverable is known as taxable profit (taxable loss).

Because accounting and tax regulations are not the same, one can see how these two amounts can change dramatically. Because there are several discrepancies between accounting profit and taxable profit, you must modify your accounting profit as follows:

• Adjust the expenses that were recognized but aren’t tax-deductible.
• Add unrecognized income that is subject to taxation.
• Deduct expenses that you didn’t realize were deductible for tax purposes.
• Deduct money that has been earned but is not taxable under the tax laws.

Additionally, current income tax is the amount of income tax that you must pay to your tax department straight away. Deferred income tax, on the other hand, is an accounting method used to align the tax effect of transactions with their accounting effect, resulting in less distorted results.

The amount of income tax due (recoverable) in respect of taxable profit (or loss) for a certain time is known as current tax. It’s simple to calculate current tax liabilities (assets). We must apply the legislated or substantially enacted tax rates to the taxable earnings (or loss) by the end of the reporting period.

The income tax payable (or recoverable) in future periods on temporary differences, unused tax losses, and unused tax credits is referred to as deferred income tax. Taxable temporary differences give rise to deferred tax liabilities, while deductible temporary differences, unused tax losses, and unused tax credits give rise to deferred tax assets. Deferred tax can be calculated by multiplying the temporary difference by the tax rate in effect.

Discrepancies between the carrying amount of an asset or liability in the statement of financial position and its tax base are known as temporary differences. There is a taxable temporary difference when the carrying value of an asset or liability exceeds its tax base, thereby resulting in a deferred tax liability. When the carrying amount of an asset or liability is less than its tax base in an ambiguous situation, there is a deductible temporary difference, which results in a deferred tax asset.

Deferred tax liability and deferred tax asset

Except in a few cases, one must recognize deferred tax liability for all taxable temporary differences discovered. Firstly, from the initial recognition of goodwill, no deferred tax liability will be recognized. Secondly, a deferred tax liability will not be recognized from the initial recognition of an asset or liability in a business transaction that is not a business combination and affects neither accounting nor taxable profit/earnings at the time of the transaction.

Below are some of the most typical taxable temporary differences that result in deferred tax liabilities:

• When an item gets recognized in the financial statements at a different time than it is recognized in the tax return, a timing difference occurs. For example, interest is taxed only when cash is received.
• Identifiable assets and liabilities can be upward revalued to their fair value at the purchase date in a business combination, but no tax adjustment is made. As a result, there is a taxable temporary difference.
• When a corporation uses a revaluation policy (for instance, the IAS 16 revaluation model for property or equipment) and some of its assets are revalued upwards to their respective fair value, a taxable temporary difference occurs.
• Part or all of an asset or liability may be non-tax-deductible or non-taxable when it is first recognized in the financial statements. Deferred tax liability is recognized in this case owing to the peculiar circumstances.

Contrary to deferred tax liability, to the point that it is likely that taxable profit would be available to the entity against which the deductible temporary difference could be used, a deferred tax asset will be established for all deductible temporary differences. A deferred tax asset may not be recognized from the initial recognition of an entity’s asset or liability in a business transaction that is not a business combination and does not alter accounting or taxable profit (or losses) at the time of the transaction.

Below are some of the most typical deductible temporary differences that result in deferred tax assets:

• When an item gets recognized in the financial statements at a different time than it is recognized in the tax return, a timing difference occurs. For example, accrued expenditures are tax-deductible only when they are paid.
• Identifiable assets and liabilities can be revalued (downward) to their fair value at the purchase date in a business combination, but no tax adjustments are made. As a result, a temporary difference that is deductible emerges.
• When a corporation uses a revaluation policy (for instance, the IAS 16 revaluation model for property or equipment) and some of its assets are downward revalued to their respective fair value, a deductible temporary difference occurs.
• Part or all of an asset or liability may be non-tax-deductible or non-taxable when it is first recognized in the financial statements. A deferred tax asset could be recognized in this case owing to the peculiar circumstances.

Recognition and measurement in IAS 12

To the degree that it has not been paid, current tax for current and past periods will be recognized as a liability. If the amount already paid for current as well as preceding periods exceeds the amount due for such periods, the difference is to be recorded as an asset. To determine the current tax assets/liabilities, the amount estimated to be paid to (recovered from) the taxation authorities for the current and prior periods shall be measured using tax rates (and tax regulations) that have been established or substantially enacted by the end of the reporting period.

The expectation that the reporting organization will recover or settle the carrying value of an asset or liability is built into the process of asset or liability recognition. With certain limited exceptions, this Standard necessitates an entity to recognize a deferred tax liability (deferred tax asset) if it is likely that recovery or settlement of such carrying value of the asset/liability shall make the future tax payments greater (or lower) as compared to what they ought to have been if such recovery or settlement had no tax consequences.

In addition, wherever it is likely that future taxable earnings of the company shall be available with it against which any unused tax losses, as well as any unused tax credits, can be applied, a deferred tax asset will be recognized.

Deferred tax assets and liabilities are valued at the tax rates that are projected to apply when the concerned asset is realized or the liability is paid, depending on tax rates (and tax regulations) that have been adopted or substantially enacted by the end of the reporting period.

Conclusion

According to IAS 12, the tax effects of the way in which the entity expects to collect or settle the carrying amount of its assets and liabilities at the balance sheet date are reflected in the measurement and calculation of deferred tax liabilities and assets.

Read our Article:Section 269SU of the Income Tax Act