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Deferred Tax Liability (DTL) or Deferred Tax Asset (DTA) item forms an important part of your Financial Statements. This adjustment made at year-end closing of Books of Accounts affects the Income-tax outgo of your Business for that year as well as the years ahead.

Timing Difference

Company derives its book profits from the financial statements prepared in accordance with the rules of companies act and it calculates its taxable profit based on provision of the Income-tax Act.

There is a difference between the book profit and taxable profit because of certain items which are specifically allowed and disallowed for tax purpose. This difference between the book and the taxable income or expense is known as timing difference and it can be either:

1. Temporary Difference – Differences between book income and tax income which are capable of reversing in subsequent period

2. Permanent Difference – Differences between book income and tax income which are not capable of reversing in subsequent period

Timing Difference

 

Deferred Tax (DT)

The tax effect on the timing differences is termed as deferred tax which literally means taxes which are deferred. Deferred tax is recognised on all timing difference – Temporary and Permanent.

These deferred taxes are given effect to in the financial statements through Deferred Tax Asset and Liability as under:

Sl.No Entity Profit Status Entity – Current Entity – Future Effect
1 Book profit higher than the Taxable profit Pay less tax now Pay more tax in future Creates Deferred Tax Liability (DTL)
2 Book profit is less than the Taxable profit Pay more tax now Pay less tax in future Creates Deferred Tax Asset (DTA)


With respect to timing differences related to unabsorbed depreciation or carry forward losses, DTA is recognised only if there is future virtual certainty. It means DTA can be realized only when the company reliably estimates sufficient future taxable income. This test for virtual certainty has to be done every year on balance sheet date and if the condition is not fulfilled, such DTA/DTL should be written off.

While computing future taxable income, only profits pertaining Business and Professional should be considered and not the income from other sources.

Example for Virtual Certainty

Future profits projection prepared by an entity based on the future restructuring, sales estimation, future capital expenditure past experience etc which are submitted to banks for loan is a concrete evidence for virtual certainty. But virtual certainty cannot be convincing if it’s only based on some say binding export order which has the risk of cancellation anytime.

Example of Deferred Tax Asset and Liability

DTA – Say Book profit of an entity before taxes is Rs. 1000 and this includes provision for bad debts of Rs.200. For the purpose of tax profit, bad debts will be allowed in future when it’s actually written off. Hence taxable income after this disallowance will be Rs. 1200 and let’s say income tax rate is 20% then the entity will pay taxes on Rs. 1200 i.e (1200*20%) Rs. 240.

If bad debts were not disallowed, entity would have paid tax on Rs. 1000 i.e (1000*20%) Rs 200. For the additional Rs. 40 which is already paid now, we have to create DTA. Entry for recording DTA is as under:

  • Deferred Tax Asset Dr                    40
  • To Deferred Tax Expense Cr        40

(Being DTA of Rs. 40 accounted in the books)

DTL – Common example of DTL would be depreciation. When the depreciation rate per Income tax act is higher than the depreciation rate per companies act (generally in the initial years), entity will end up paying less tax for the current period. This will create deferred tax liability in the books:DTL/DTA

There is no DTA or DTL provisions made for permanent differences. Eg. Fines and Penalties which are part of book profits but never allowed for tax purpose. Hence this difference created will be a permanent difference.

DTA is presented under Non-Current Asset and DTL under the head Non-Current Liability. Both DTA and DTL can be adjusted with each other provided if they are legally enforceable by law and there is an intention to settle the asset and liability on a net basis.

Illustration on DTA/DTL Calculation

Let’s understand how DTA/DTL is created in books with a simple example (amount in lacs):

Particulars For Book For Tax Difference (DTA)/DTL @30%
Income 1000 800 200
Opening Balance of (DTA)/DTL
Depreciation 100 200 100 30
Sales Tax payable 50 0 (50) (15)
Leave encashment 200 100 (100) (30)
Closing balance of (DTA)/DTL (15)

Current tax on Taxable income is 800*30% = 240

Deferred tax as per above                               = (15)

Net tax effect                                                     =225

Effect of Tax Holiday w.r.t DTA/ DTL

Tax Holiday is a benefit provided to new undertakings established in free trade zone, 100% export oriented undertakings etc under section 10A, 10B of the Income Tax Act, 1961. To encourage production, consumption of certain items, the government removes certain taxes for a temporary period subject to certain condition. DT from the timing difference that reverses during the tax holiday period should not be recognised during the enterprise’s tax holiday period. DT related to the timing difference that reverses after the tax holiday has to be recognised in the year of origination.

Illustration for Tax Holiday

A Ltd. established as a tax-free entity in 2015 u/s 10A, hence it will be exempt from tax from 2015 to 2025. It has a timing difference on account of depreciation as follows: (Assume tax rate is 30%)

Year Timing Difference – Depreciation
1 200,000
2 300,000

In the case of tax-free companies, deferred tax liability is not recognized, for the timing differences that originate and reverse in the tax holiday period. Deferred tax liability is created only when the timing differences originate in the tax holiday period and reverse after the tax holiday. Adjustments are done on the basis of FIFO method. In the above example of the 200,000, say 80,000 will reverse within the tax holiday period, so DTL is created only on the balance. DTL will be created as below:

Year Timing difference DTL @ 30%
1 120,000 (200,000-80,000) 36,000
2 300,000* 90,000

*Fully reversed after the tax holiday period.

The total DTL balance at the end of the second year will be 126,000.

 

Effect on MAT w.r.t DTA/ DTL

MAT is Minimum Alternate Tax which a company is required to pay if its tax payable as per normal provision of the income tax act is less than the tax computed @ 18.5% of the book profit. MAT is levied under section 115JB of the income tax act and it is calculated using the entity’s book profit as under:

Book profit is increased by the following:

  1. Income tax paid or provision
  2. An amount carried to any reserve
  3. Provisions made for unascertained liabilities
  4. Deferred tax provision etc

And it is decreased by the following:

  1. Amount withdrawn from any reserve or provision
  2. Depreciation debited to P&L (except revaluation depreciation)
  3. Lesser of Loss brought forward or unabsorbed depreciation  
  4. Deferred tax credited to P&L etc.

There are controversies if deferred tax liability debited to P&L should be added to the book income for the purpose of MAT calculation. Kolkata Tribunal in Balrampur Chini’s case has held that the deferred tax liability should not be added back whereas the Chennai Tribunal in Prime Textiles Ltd’s case has held otherwise.

 

“Deferred tax charge is not a provision for tax but is a provision for tax effect for difference between taxable income and accounting income and further that deferred tax charge cannot be termed as income-tax paid or payable, which has to be paid out of the profit earned. Reserves mentioned in Section 115JB is different, it can be unilaterally transferred back to P&L account or can be utilised for issuing bonus shares etc. However, amounts created towards deferred tax charge cannot be so transferred or utilized”

“The Chennai Tribunal observed that AS-22 is mandatory as per Section 211(3) of the Companies Act, however, the same is not notified by the Central Government under Section 145(2) of the IT Act. Moreover, the deferred tax liability cannot be considered as ascertained liability and therefore, assessing officer has every power to make adjustment on this account as it cannot be termed as tinkering of audited accounts prepared in accordance with the provisions of the Companies Act.”

As seen, there are conflicting judgments on this and this requires clarification from the government or decision by the high court.

Whether MAT credit can be considered as a deferred tax asset per AS 22?

As per AS 22 deferred tax asset and liability arise due to the difference between book income & taxable income and do not rise on account of tax expense itself. MAT does not give rise to any difference between book income and taxable income. It is not appropriate to consider MAT credit as a deferred tax asset in accordance with AS 22.

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