What is Deferred Tax? How is it Calculated?
For accounting purposes, a company prepares two financial reports or statements for every financial year – an income statement and a tax statement. The guidelines for preparing such reports differ from each other. Additionally, the timing for filing income tax statements is dependent on the beginning and end of a fiscal year.
In such a scenario, the tax payment gets deferred to be paid at a later date. The deferred tax listed on a company’s balance sheet provides a clear picture of the company’s current and future tax.
Read on to know the types of tax-deferred accounts and their benefits.
What Is Tax-Deferred?
Deferred tax is the temporary difference between income tax payable and income tax recorded for a company at the end of a fiscal year. These gaps might occur due to a number of reasons:
- Expenses are taken into account by the taxing authority in advance.
- Revenue earned is taxed before time.
- The tax regulations for the assets and liabilities are different.
If a company or individual incurs a loss during a particular financial year, it can use it to lower its taxable income in the current year. However, if we defer some amount of the tax payable in the current year, we still have to pay it in the future.
When Is an Account not Tax-Deferred?
Any investment made has the potential to gain value or generate income over time. Income from such investments comes in two primary forms – interest and dividends. If the investment comes under the heading of a taxable account, the income earned is calculated under taxable income for that financial year. Any sale of an asset under a taxable account that is sold for more value than what was invested will earn the owner more income and increased tax liability. Such income has to be taxed in that same financial year and hence, cannot be included under a deferred account.
Also Read: Regressive Tax – Types and Working with Examples
What Are the Types of Tax-Deferred?
There can be two types of differences between the two reports – overly paid taxes or deferred tax assets and due taxes or deferred tax liabilities. This can be due to a company’s unrealised revenues and unpaid taxes.
- Deferred Tax Asset
Overly paid taxes have either been paid or taken into account early or have been carried forward. However, it has not been reflected in the income statement yet. The value of this deferred tax asset is analysed based on the difference between booked income and taxable income of a company.
- Deferred Tax Liability
Deferred tax liability is the opposite of deferred tax assets. It takes into consideration the taxes due or unpaid, which will be paid off over time eventually. By taxes due, it is not meant that the taxes are not paid in time. These taxes just have to be paid at a later date in the future.
Examples of Tax-Deferred Accounts
Let’s understand tax-deferred accounts with the help of an example:
A good example of tax-deferred accounts can be the IRA or individual retirement accounts that are sponsored by employers. These plans enable the employees to invest a portion of their pre-tax salary into one or more investment instruments. The taxes on the income are deferred to be paid at a later date.
A traditional life insurance policy is also a good example of a tax-deferred vehicle. The annuity received from such a policy is also tax-deferred, which can also be referred to as a deferred annuity.
Occasions where Deferred Tax Is Recorded
As stated before, there can be scenarios when the tax gets deferred. A few of those scenarios have been discussed below:
- Gross Loss
Deferred tax can be found if the company experiences a huge loss in one financial year. The company can decide to carry it forward to the next year to adjust it with the upcoming profits. This reduces the tax liability of the company during that particular fiscal year.
- Depreciation Calculation Method
Another possible scenario can be if a company calculates its depreciation on assets by using a different method from the one that has been recommended by the Income Tax department. However, the company adjusts such differences in the following years to omit such disparity.
- Depreciation Percentage
The last possible scenario is where there is a difference in depreciation in the calculation done by the Income Tax Department with the one presented by the company. This gap is considered deferred tax as well.
How Is Deferred Tax Calculated?
There is no hard and fast rule for calculating deferred tax. It is simply the difference between the total profits in two financial reports – the income statement and tax statement.
Have a look at the illustration below to get a better understanding:
| Attributes | Income Report (Rs.) | Tax Statement (Rs.) |
| Total Income | 20,00,000 | 20,00,000 |
| Expenses | 13,00,000 | 13,00,000 |
| Gross profit before depreciation and taxation | 7,00,000 | 7,00,000 |
| Depreciation | 90,000 | 80,000 |
| Gross profit after depreciation | 6,10,000 | 6,20,000 |
As you can see, the taxable income here varies by Rs.10,000, and so does the depreciation. Hence, the tax liability should be 30% on Rs 6,20,000, which is Rs.1,86,000 (as per Income Tax slab, new regime). But according to the income statement, the tax liability should have been Rs.1,83,000. An additional Rs.3,000 is an advance expense, which creates the deferred tax asset.
What Are the Benefits of Tax Deferral?
Deferred tax is calculated as per accounting standards. Hence, if done rightly, you can find the following benefits of tax deferral:
- According to the accrual accounting standard, the deferred tax must be identified in the same financial period they are accounted for. This will help in understanding the company’s financial situation and its gross profit after taxation.
- If the deferred tax asset or liability is not recognised for the same FY, it can lead to an overstatement of profit or extra disbursement of dividends.
- The process of tax-deferred, if done rightly, can help an organisation to adjust its loss with its profit next year and limit the tax liability during an FY.
Tax-Deferred Account vs Tax-Exempt Account
A tax-deferred account and a tax-exempt account both offer tax benefits on your investments. But these vary fundamentally. Here are the differences between a tax-deferred and a tax-exempt accounts:
- A tax-deferred account reduces the tax liability on the current year’s income. You do not have to pay the tax upfront, but you will pay it later on the withdrawals. Your investment will grow without taxation.
- For a tax-exempt account, you make investments with the money you have already paid your tax contributions for, and your investment and withdrawal amount are exempted from taxation.
Tax Deductions on Tax-Deferred Accounts
Tax deduction on tax deferred accounts is available in a few accounts, such as retirement plans and life insurance policies. One can claim a tax deduction in such accounts for the contribution he/she makes in a year. This might not be available for all types of accounts, but you will have the facility of tax deferral for each succeeding year.
Also Read: What is Tax Evasion and What are the Penalties?
Final Word
The term “defer” means “delay” or “postpone,” which should throw some light on what is meant by “deferred tax” and how this account works. In this article, you will find the relevant information which will hopefully satiate your curiosity or doubt in simple terms.
Frequently Asked Questions
Ans. Oftentimes, companies make and keep two copies of the financial statements. One is for their personal use, and one is to present to the tax authorities. This is referred to as dual accounting.
Ans. IRA or individual retirement accounts are tax-deferred accounts. These accounts are ideal for investment plans for retirement as it allows you to delay paying taxes until withdrawal on maturity.
Ans. Deferred income tax, as the name suggests, is when an organisation postpones or delays paying income taxes for a particular period. There can be more than one reason behind such a delay.
Ans. A tax-deferred exchange is where someone is allowed to sell an appreciated asset and can delay paying taxes on the capital gain. Instead, that individual has to purchase another property with that capital gain.
Ans. Deferred tax liabilities appear as non-current assets on the balance sheet of a company. This is not a current liability as the company does not need to pay it immediately but at a later date in the future.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.Disclaimer
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