Taxation consists of two components:
Current tax
Deferred tax
Current tax is ordinarily straightforward. Complexities arise, however, when we consider the future tax consequences of what is going on in the accounts now. This is an aspect of tax called deferred tax, which we will look at in the next section. IAS 12 Income taxes covers both current and deferred tax. The parts relating to current tax are fairly brief, because this is the simple and uncontroversial area of tax.
1.1 Definitions
These are some of the definitions given in IAS 12. We will look at the rest later.
Accounting profit. Net profit or loss for a period before deducting tax expense.
Taxable profit (tax loss). The profit (loss) for a period, determined in accordance with the rules
established by the taxation authorities, upon which income taxes are payable (recoverable).
Tax expense (tax income). The aggregate amount included in the determination of net profit or loss for
the period in respect of current tax and deferred tax.
Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss)
for a period. (IAS 12)
Remember the difference between current and deferred tax.
(a) Current tax is the amount actually payable to the tax authorities in relation to the trading activities
of the entity during the period.
(b) Deferred tax is an accounting measure, used to match the tax effects of transactions with their
accounting impact and thereby produce less distorted results.
1.2 Recognition of current tax liabilities and assets
Current tax is the amount payable to the tax authorities in relation to the trading activities during the
period. It is generally straightforward.
Key terms
FAST FORWARD
IAS 12 requires any unpaid tax in respect of the current or prior periods to be recognised as a liability.
Conversely, any excess tax paid in respect of current or prior periods over what is due should be
recognised as an asset.
Question
Current tax
In 20X8 Darton Co had taxable profits of $120,000. In the previous year (20X7) income tax on 20X7 profits had been estimated as $30,000. The tax rate is 33%.
Required
Calculate tax payable and the charge for 20X8 if the tax due on 20X7 profits was subsequently agreed with the tax authorities as:
(a) $35,000 (b) $25,000
Any under- or over-payments are not settled until the following year's tax payment is due.
Answer
(a)
$
Tax due on 20X8 profits ($120,000 33%) 40,000
Underpayment for 20X7 5,000
Tax charge and liability 45,000
(b)
$
Tax due on 20X8 profits (as above) 40,000
Overpayment for 20X7 (5,000)
Tax charge and liability 35,000
Alternatively, the rebate due could be shown separately as income in the statement of profit or loss and other comprehensive income and as an asset in the statement of financial position. An offset approach like this is, however, most likely.
Taking this a stage further, IAS 12 also requires recognition as an asset of the benefit relating to any tax loss that can be carried back to recover current tax of a previous period. This is acceptable because it is
probable that the benefit will flow to the entity and it can be reliably measured.
1.3 Example: Tax losses carried back
In 20X7 Eramu Co paid $50,000 in tax on its profits. In 20X8 the company made tax losses of $24,000. The local tax authority rules allow losses to be carried back to offset against current tax of prior years.
Required
Show the tax charge and tax liability for 20X8.
Solution
Tax repayment due on tax losses = 30% $24,000 = $7,200. The double entry will be:
DEBIT Tax receivable (statement of financial position ) $7,200 CREDIT Tax repayment (statement of profit or loss and other
comprehensive income)
$7,200 The tax receivable will be shown as an asset until the repayment is received from the tax authorities.
1.4 Measurement
Measurement of current tax liabilities (assets) for the current and prior periods is very simple. They are measured at the amount expected to be paid to (recovered from) the tax authorities. The tax rates (and
tax laws) used should be those enacted (or substantively enacted) by the year end.
1.5 Recognition of current tax
Normally, current tax is recognised as income or expense and included in the net profit or loss for the period, except in two cases.
(a) Tax arising from a business combination which is an acquisition is treated differently (see
Section 6 of this chapter).
(b) Tax arising from a transaction or event which is recognised directly in equity (in the same or a
different period).
The rule in (b) is logical. If a transaction or event is charged or credited directly to equity, rather than to profit or loss, then the related tax should be also. An example of such a situation is where, under IAS 8, an adjustment is made to the opening balance of retained earnings due to either a change in accounting
policy that is applied retrospectively, or to the correction of a fundamental error.
1.6 Presentation
In the statement of financial position, tax assets and liabilities should be shown separately from other
assets and liabilities.
Current tax assets and liabilities can be offset, but this should happen only when certain conditions apply.
(a) The entity has a legally enforceable right to set off the recognised amounts.
(b) The entity intends to settle the amounts on a net basis, or to realise the asset and settle the liability
at the same time.
The tax expense (income) related to the profit or loss for the year should be shown in the profit or loss
section of the statement of profit or loss and other comprehensive income.
2 Deferred tax
12/07, 6/10, 6/12, 12/12
Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting
impact. It is quite complex.
Students invariably find deferred tax very confusing. It is an inherently difficult topic and as such it likely to appear frequently in its most complicated forms in Paper P2. You must understand the contents of the rest of this chapter.
2.1 What is deferred tax?
When a company recognises an asset or liability, it expects to recover or settle the carrying amount of
that asset or liability. In other words, it expects to sell or use up assets, and to pay off liabilities. What happens if that recovery or settlement is likely to make future tax payments larger (or smaller) than they would otherwise have been if the recovery or settlement had no tax consequences? In these
circumstances, IAS 12 requires companies to recognise a deferred tax liability (or deferred tax asset).
Exam focus
point
2.2 Definitions
Here are the definitions relating to deferred tax given in IAS 12.
Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable
temporary differences.
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
Deductible temporary differences The carryforward of unused tax losses The carryforward of unused tax credits
Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base. Temporary differences may be either:
Taxable temporary differences, which are temporary differences that will result in taxable amounts
in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.
Deductible temporary differences, which are temporary differences that will result in amounts that
are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
(IAS 12)
2.3 Tax base
We can expand on the definition given above by stating that the tax base of an asset is the amount that
will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying value of the asset. Where those economic benefits are not taxable, the tax base of the asset is the same as its carrying amount.
Question
Tax base 1State the tax base of each of the following assets:
(a) A machine cost $10,000. For tax purposes, depreciation of $3,000 has already been deducted in the current and prior periods and the remaining cost will be deductible in future periods, either as depreciation or through a deduction on disposal. Revenue generated by using the machine is taxable, any gain on disposal of the machine will be taxable and any loss on disposal will be deductible for tax purposes.
(b) Interest receivable has a carrying amount of $1,000. The related interest revenue will be taxed on a cash basis.
(c) Trade receivables have a carrying amount of $10,000. The related revenue has already been included in taxable profit (tax loss).
(d) A loan receivable has a carrying amount of $1m. The repayment of the loan will have no tax consequences.
(e) Dividends receivable from a subsidiary have a carrying amount of $5,000. The dividends are not taxable.
Answer
(a) The tax base of the machine is $7,000. (b) The tax base of the interest receivable is nil. (c) The tax base of the trade receivables is $10,000. (d) The tax base of the loan is $1m.
(e) The tax base of the dividend is $5,000.
In the case of (e), in substance the entire carrying amount of the asset is deductible against the economic benefits. There is no taxable temporary difference. An alternative analysis is that the accrued dividends receivable have a tax base of nil and a tax rate of nil is applied to the resulting taxable temporary difference ($5,000). Under both analyses, there is no deferred tax liability.
In the case of a liability, the tax base will be its carrying amount, less any amount that will be deducted for
tax purposes in relation to the liability in future periods. For revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in
future periods.
Question
Tax base 2State the tax base of each of the following liabilities.
(a) Current liabilities include accrued expenses with a carrying amount of $1,000. The related expense will be deducted for tax purposes on a cash basis.
(b) Current liabilities include interest revenue received in advance, with a carrying amount of $10,000. The related interest revenue was taxed on a cash basis.
(c) Current assets include prepaid expenses with a carrying amount of $2,000. The related expense has already been deducted for tax purposes.
(d) Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines and penalties are not deductible for tax purposes.
(e) A loan payable has a carrying amount of $1m. The repayment of the loan will have no tax consequences.
Answer
(a) The tax base of the accrued expenses is nil.
(b) The tax base of the interest received in advance is nil. (c) The tax base of the accrued expenses is $2,000. (d) The tax base of the accrued fines and penalties is $100. (e) The tax base of the loan is $1m.
IAS 12 gives the following examples of circumstances in which the carrying amount of an asset or liability will be equal to its tax base.
Pre-paid expenses have already been deducted in determining an entity's current tax liability for
the current or earlier periods.
A loan payable is measured at the amount originally received and this amount is the same as the
amount repayable on final maturity of the loan.
Accrued expenses will never be deductible for tax purposes.
Accrued income will never be taxable.
2.4 Temporary differences
You may have found the definition of temporary differences somewhat confusing. Remember that accounting profits form the basis for computing taxable profits, on which the tax liability for the year is
calculated. However, accounting profits and taxable profits are different. There are two reasons for the differences.
(a) Permanent differences. These occur when certain items of revenue or expense are excluded from
the computation of taxable profits (for example, entertainment expenses may not be allowable for tax purposes).
(b) Temporary differences. These occur when items of revenue or expense are included in both
accounting profits and taxable profits, but not for the same accounting period. For example, an expense which is allowable as a deduction in arriving at taxable profits for 20X7 might not be included in the financial accounts until 20X8 or later. In the long run, the total taxable profits and total accounting profits will be the same (except for permanent differences) so that timing differences originate in one period and are capable of reversal in one or more subsequent periods. Deferred tax is the tax attributable to temporary differences.
The distinction made in the definition between taxable temporary differences and deductible temporary differences can be made clearer by looking at the explanations and examples given in the standard and its
appendices.
2.5 Section summary
Deferred tax is an accounting device. It does not represent tax payable to the tax authorities.
The tax base of an asset or liability is the value of that asset or liability for tax purposes.
You should understand the difference between permanent and temporary differences.
Deferred tax is the tax attributable to temporary differences.
3 Taxable temporary differences
Deferred tax assets and liabilities arise from taxable and deductible temporary differences.
The rule to remember here is that:
'All taxable temporary differences give rise to a deferred tax liability.'
The following are examples of circumstances that give rise to taxable temporary differences.
3.1 Transactions that affect the statement of profit or loss and other
comprehensive income
Interest revenue received in arrears and included in accounting profit on the basis of time
apportionment. It is included in taxable profit, however, on a cash basis.
Sale of goods revenue is included in accounting profit when the goods are delivered, but only
included in taxable profit when cash is received.
Depreciation of an asset may be accelerated for tax purposes. When new assets are purchased,
allowances may be available against taxable profits which exceed the amount of depreciation chargeable on the assets in the financial accounts for the year of purchase.
Development costs which have been capitalised will be amortised in profit or loss, but they were
deducted in full from taxable profit in the period in which they were incurred.
Prepaid expenses have already been deducted on a cash basis in determining the taxable profit of
the current or previous periods.
3.2 Transactions that affect the statement of financial position
Depreciation of an asset is not deductible for tax purposes. No deduction will be available for tax
purposes when the asset is sold/scrapped.