brought a firm assertion from the Ministry of Corporate Affairs (MCA) indicating
International Financial Reporting Standards (IFRS) is the only way forward — but
companies may reach the destination in a phased manner starting 2011. One year
hence, news is in the air that based on several representations from India Inc,
the Ministry is likely to postpone the convergence. On the other hand, India
will have to rethink whether it wants to go back on its word given to the G20.
Hence, to balance the mounting global pressure and India Inc’s demands, the
Ministry is said to be contemplating making it optional.
In the meantime,
the Institute of Chartered Accountants of India (ICAI) has already issued
nearfinal IFRS-equivalent Indian Accounting Standards (Ind-AS), pending approval
of the Ministry.
Now, for India
Inc, the most vital step is to be ready for Ind-AS as is, and wait and watch for
any further bumps (amendments) on this rollercoaster ride.
One of the
standards that will make your ride bumpier is Ind-AS 12 Income Taxes. For
almost every adjustment that it is made to comply with IFRS, there will be a
deferred tax impact staring right back at you.
Bridging the gap
between the income statement approach under Indian GAAP and the balance sheet
approach under IFRS itself is intimidating to many. This article makes an
attempt at simplifying the new concepts IAS 12 brings.
To understand the
impact of deferred taxes, it is imperative to understand why deferred tax is
required in the first place. The example below explains why deferred taxes are
purchases a machine costing Rs.100 million having a useful life of two years. As
per the tax laws, 100% depreciation is allowed in the first year itself. Profit
before depreciation and tax was Rs.200 million. The profits of the Company X,
without considering the deferred tax impact is as shown in Table I.
depreciation and tax
Profit as per
expense (30% of tax profits)
Effective tax rate
effective tax rate is different from the actual tax rate in both the years.
the profits and the tax rate for both the years remain unchanged, the tax
expense is different and consequently the profit after tax is different.
accounting in line with our basic concepts ?
As per the
accrual concept, tax should be accounted for in the books of accounts as and
when it accrues. However, current tax is provided based on taxation laws.
Taxes should be
accounted for in the same period as the related incomes and expenses are
Hence, to prepare
the books of accounts in line with the above-mentioned concepts, we account for
What is deferred
Deferred tax is
the tax on:
income earned/accrued but not taxed as per the
taxation laws of the country, or
income not earned/accrued but taxed as per the
taxation laws of the country.
In simple terms,
deferred tax is a tax (book entry) on the gap between the books of account and
the tax books.
Standard (AS) 22
Taxes on Income advocates income statement
approach. Under this approach, profit as per books is compared with profit as
per tax. Then, deferred tax is created on all timing differences. Timing
differences are the differences between taxable income and accounting income for
a period that originate in one period and are capable of reversal in one or more
subsequent periods. No deferred tax is created on permanent differences.
approach, deferred tax is created on only those items that have an impact on the
income statement. In other words, ‘income statement approach’ assumes that all
the incomes are accrued in the income statement. However, items like gain on
revaluation of fixed assets (i.e.,
revaluation reserve) are not considered for deferred tax purposes. Also, in
insurance companies and banks, investments are marked to market and the gain
thereon is parked in a reserve till it is realised. Although the income is
earned in the above cases deferred tax on the same is not recognised as the
transactions don’t impact the income statement directly.
Hence, IASB, in
1996, came up with the concept of temporary differences/balance sheet approach.
difference’ is wider in scope as compared to ‘timing difference’. It also covers
those differences that originate in the books of accounts in one period and are
capable of reversal in the same books, of accounts in one or more subsequent
periods. For example, gain on revaluation arises in books of accounts and
reverses in the same books by way of higher depreciation charge. Now, many argue
that the revaluation gain is a notional gain and does not give rise to any tax
in future periods. To understand the logic behind the balance sheet approach, it
is important to go back to the definition of an asset. An asset is a resource
controlled by the entity as a result of past events and from which
benefits are expected to flow to the entity.
For example, when an asset costing Rs.100 is valued at Rs.120, it means that the
asset owner will receive future economic benefit of Rs.120. Since the asset
owner has paid just Rs.100 to get a benefit of Rs.120, the upfront benefit of
Rs.20 (120-100) is considered for deferred tax. In short, it is based on an
assumption that the recovery of all assets and settlement of all liabilities
have tax consequences and these consequences can be estimated reliably and
cannot be avoided.
Difference is defined as a difference between the carrying amount of an
asset or liability and its tax base, where
tax base is the amount that will be
deductible for tax purposes. Where the economic benefits are not taxable or
expense not deductible, the tax base of the asset is equal to its carrying
In simple terms,
an entity will have to draw a tax balance sheet. The numbers appearing in the
tax balance sheet is termed as ‘tax base’. This tax base will be compared with
the carrying amount of assets and liabilities in the books of accounts. Deferred
tax will be calculated on the difference so calculated. For example — if
interest expense is allowed on cash basis under tax laws, no expense would have
been booked. Hence, no corresponding liability would exist as per tax books
i.e., tax base is nil. On the other hand, a liability for the interest will
be recorded in the books of accounts. The difference in carrying the amount of
the liability is regarded as a temporary difference under the balance sheet
understand the concept of ‘tax base’, a few examples have been given below :
(1) A machine
costs Rs.100. For tax purposes, depreciation of Rs.30 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.
The tax base of the machine is Rs.70.
receivable from a subsidiary of Rs.100. The dividends are not taxable. Thus,
base of the dividends receivable is 100.
(Note : If the economic benefits will not be taxable, the tax base of the
asset is equal to its carrying amount.)
(3) Similarly, a
loan receivable has a carrying amount of Rs.100. The repayment of the loan will
have no tax consequences.
The tax base of the loan is Rs.100.
liabilities include interest revenue received in advance of Rs.100. The related
interest revenue was taxed on a cash basis.
The tax base of
the interest received in advance is nil.
Temporary differences are of two types :
temporary differences (Deferred tax liability) :
differences are temporary differences that will result in taxable amounts in
determining taxable profit/loss of future periods when the carrying amount of
the asset or liability is recovered or settled. For example — incomes accrued as
per books of accounts (fair value of financial instruments) but taxable on
receipt basis and lower depreciation charge in books of accounts.
In simple words,
where the carrying value of assets is more as per books of accounts or carrying
value of liability is less as per books of accounts when compared to tax base,
it results in taxable temporary differences.
temporary differences (Deferred tax assets) :
temporary differences are temporary differences that will result in amounts that
are deductible in determining taxable profit/loss of future periods when the
carrying amount of the asset or liability is recovered or settled. For example —
higher depreciation charge in books of accounts. In simple words, where the
carrying value of assets is less as per books of accounts or carrying value of
liability is more as per books of accounts when compared to tax base, it results
in deductible temporary differences.
Deferred tax on
items recognised outside profit or loss :
Current tax and
deferred tax shall be recognised outside profit or loss if the tax relates to
items that are recognised, in the same or a different period, outside profit or
loss. Therefore, current tax and deferred tax that relate to items that are
recognised, in the same or a different period :
(a) in other
comprehensive income, shall be recognised in other comprehensive income (OCI)
(b) directly in
equity, shall be recognised directly in equity
i.e., in the Statement of Changes in Equity
deferred tax on revaluation of assets should be recognised in revaluation
reserve in OCI. Hence, there will not be any charge to profit or loss.
Deferred tax on
revaluation of assets :
IFRSs permit or
require certain assets to be carried at fair value or to be revalued (for
example, IAS 16 Property, Plant and Equipment, IAS 38 Intangible Assets, IAS 39
Financial Instruments: Recognition and Measurement and IAS 40 Investment
Property). However, as per the tax laws, revaluation of assets is not considered
while computing the taxable income. Consequently, the tax base of the asset is
not adjusted. Nevertheless, the future recovery of the carrying amount (on sale
or otherwise) will result in a taxable flow of economic benefits to the entity
and the amount that will be deductible for tax purposes will differ from the
amount of those economic benefits. The difference between the carrying amount of
a revalued asset and its tax base is a temporary difference and gives rise to a
deferred tax liability or asset. This is true even if :
(a) the entity
does not intend to dispose of the asset. In such cases, the revalued carrying
amount of the asset will be recovered through use and this will generate taxable
income which exceeds the depreciation that will be allowable for tax purposes in
future periods; or
(b) tax on
capital gains is deferred if the proceeds of the disposal of the asset are
invested in similar assets. In such cases, the tax will ultimately become
payable on sale or use of the similar assets.
Company A buys an asset worth Rs.100 on 1st April, 2010. The useful life of the
asset is five years and the tax laws allow it to be depreciated over four years.
One year later, on 31st March, 2011, the Company revalues the asset to Rs.120.
In such a case the temproary difference will be as shown in Table 2.
Year ending March 31,
Net book value
In the above
case, the deferred tax liability created on revaluation on 31st March, 2011, of
Rs.45 reverses in the subsequent periods. The accounting entry for the year 2011
would be :
reserve A/c Dr.
To Deferred tax
Suppose on 31st
March, 2013, the Company decides to sell the asset at Rs.70. In this case, there
would be a gain of Rs.10 as per the books of accounts. However, the tax books
will show a gain of Rs.45, thus offsetting the temporary difference of Rs.35.
Indian GAAP :
Standard (AS) 22
Taxes on income does not permit creation of
deferred tax on the excess depreciation charged on the revalued portion. It is
not considered as a timing difference, but a permanent one. The underlying
reason is that, under the income statement approach, a deferred tax liability is
not created on the date of revaluation (since it does not have an effect on the
income statement). Thus, deferred tax assets (reversal of deferred tax
liability) cannot be recorded on the excess depreciation charged.
Deferred tax on
business combination :
Business Combinations require the identifiable assets acquired and
liabilities assumed in a business combination to be recognised at their fair
values at the acquisition date. Temporary differences arise when the tax bases
of the identifiable assets acquired and liabilities assumed are not affected by
the business combination or are affected differently. For example, when the
carrying amount of an asset is increased to fair value but the tax base of the
asset remains at cost to the previous owner, a taxable temporary difference
arises which results in a deferred tax liability. The resulting deferred tax
liability affects goodwill.
For example, Company A merges Company B with
itself. In the process it acquires net assets of Rs.1,000 crore (fair value
Rs.1,200 crore) for Rs.1,500 crore. Goodwill being the difference between the
consideration paid and fair value was Rs.300 crore (1,500 — 1,200 crore). Now,
Company A will have to calculate the deferred tax on the fair valued portion of
Rs.200 crore (1,200 — 1,000 crore), the tax base being the cost to previous
owner of Rs.1,000 crore as compared to the revised carrying amount of Rs.1,200
crore. The deferred tax would hence be 100 crore (assuming tax rate of 50%).
These Rs. 100 crore will be added to goodwill and the total goodwill will be
Rs.400 crore (300 + 100 crore). The accounting entry would be :
Goodwill A/c Dr.
To Deferred tax
Indian GAAP :
As per Accounting
Standard Interpretation (ASI) 11*
Accounting for Taxes on Income in case of an
Amalgamation, deferred tax on such
differences should not be recognised as this constitutes a permanent difference.
The consequent differences between the amounts of depreciation for accounting
purposes and tax purposes in respect of such assets in subsequent years would
also be permanent differences.
It may be noted
that ASI 11 has been issued by the ICAI but has not been incorporated in the
standards notified under the Companies (Accounting Standards) Rules, 2006.
Hence, ASI 11 is not applicable to companies. However, it is generally noted
that companies treat such difference as permanent difference and do not create
any deferred tax on the same.
Deferred tax on
IAS 12 requires
re-calculation of deferred tax at consolidated level. In effect, an entity will
have to calculate deferred tax impact on inter-company transactions.
For example —
Company H, the holding company, sells goods costing Rs.1,000 to Company S, the
subsidiary company, for Rs.1,200. The goods are lying in the closing stock of
Company S. Assume tax rate 0f 50%. Then entry in the consolidated books is as
asset A/c Dr.
To Deferred tax
deferred tax asset is created because the profit element of Rs.200 (1,200 —
1,000) is not eliminated in the tax books
i.e., the consolidated books has an
inventory of Rs.1,000 but the tax books of Company S has an inventory of
Please note :
the tax rate used in this case would be the rate applicable to the Company S,
since the deduction will be available to Company S.
Indian GAAP :
Under Indian GAAP,
the practice followed is to consolidate the books by adding line-by-line items.
Deferred tax is also calculated in the consolidated books as a summation of
deferred tax appearing in the individual books of accounts.
on undistributed profits :
As per IAS 28
in Associates, an entity is required to account for its investment in
associates as per equity method in the consolidated financial statements. Under
the equity method, the investment in an associate is initially recognised at
cost and the carrying amount is increased or decreased to recognise the
investor’s share of the profit or loss of the investee after the date of
acquisition, reduced by distributions received. On the other hand, its tax base
will remain the cost of investment. The difference between the books of accounts
and tax base is investor’s share of undistributed reserves of the investee
entity. In simple terms, an entity will have to provide for deferred tax on its
share of undistributed reserves of the investee company in its consolidated
Similar is the
treatment under IAS 31
Interests in Joint Ventures
where an entity elects equity method of accounting.
entity is exempted from the above requirement if the following conditions are
investor/venturer is able to control the timing of the reversal of the
(b) it is
probable that the temporary difference will not reverse in the foreseeable
investor in an associate/a venturer in a joint venture, generally, does not
control that entity and is usually not in a position to determine its dividend
policy. Therefore, in the absence of an agreement requiring that the profits of
the associate/venturer will not be distributed in the foreseeable future, an
investor/venturer recognises a deferred tax liability arising from taxable
temporary differences associated with its investment in the associate/joint
Deferred tax on
Act, 1961 provides for indexation of cost of non-depreciable assets like land,
when computing the capital gain/loss on sale. This indexed cost of land (i.e.,
its tax base) will exceed the book value of land by the indexation benefit
provided. Hence, a deferred tax asset will have to be created on this
Indian GAAP :
indexation benefit neither affects the current year’s tax profit, nor the profit
as per books, deferred tax is not provided as per Indian GAAP.
business losses and unabsorbed depreciation :
A deferred tax
asset shall be recognised for the carried forward business losses and unabsorbed
depreciation to the extent that it is probable that future taxable profit will
be available against which such losses and depreciation can be utilised.
Although the term ‘probable’ is not defined by the standard, probable in general
terms is ‘more likely than not’.
Indian GAAP :
AS 22 mandates
virtual certainty for recognition of deferred tax assets in case of carried
forward business losses and unabsorbed depreciation.
As per ASI 9
certainty supported by convincing evidence,
virtual certainty is not a matter of perception. It should be supported by
convincing evidence. Evidence
is matter of fact. Virtual certainty refers
to the extent of certainty, which, for all practical purposes, can be considered
certain. Keeping in view ‘virtual certainty’ as against ‘probable certainty’ it
seems that Indian GAAP is more conservative on the matter of recognition of
deferred tax asset.
to remain certain items over which the standard does not permit creation of
deferred taxes, as below :
recognition of goodwill :
Para 21 of IAS 12
Taxes prohibits recognition of deferred tax liability on initial recognition
of goodwill, because goodwill is measured as a residual and the recognition of
the deferred tax liability would increase the carrying amount of goodwill.
recognition of an asset or liability in a transaction which :
(a) is not a
business combination, and
(b) at the time
of transaction, affects neither accounting profit nor taxable profit/loss.
For example, a
penalty was paid in the process of bringing an asset to its working condition as
intended by the management and hence, it was capitalised. As per taxation laws,
penalty is not allowed as an expense. Now, this penalty affects neither
accounting profit nor taxable profits. Hence, as per the above said exception,
no deferred tax shall be created on this difference.
At the end of
each reporting period, an entity reassesses unrecognised deferred tax assets.
The entity recognises a previously unrecognised deferred tax asset to the extent
that it has become probable that future taxable profit will allow the deferred
tax asset to be recovered. For example, an improvement in trading conditions may
make it more probable that the entity will be able to generate sufficient
taxable profit in the future for the deferred tax asset to meet the recognition
The principles of
IFRS require long-term assets and liabilities to be discounted to the present
value. In most cases detailed scheduling of the timing of the reversal of each
temporary difference is impracticable and highly complex for the purpose of
reliable determination of deferred tax assets and liabilities on a discounted
basis. Therefore, the deferred tax assets and liabilities shall not be
Presentation of financial statements requires an entity to present current
and non-current assets, and current and non-current liabilities, as separate
classifications in its statement of financial position. However, an entity shall
not classify deferred tax assets/liabilities as current assets/liabilities,
i.e., deferred taxes shall always be classified as non-current.
above, deferred taxes will impact almost all IFRS adjustments. One will have to
consider all IFRS adjustments like fair valuation, use of effective interest
rates, derivative and hedge accounting to calculate accurate deferred taxes. To
conclude, there are three important takeaways :
(1) An entity
will have to calculate the tax base for each asset and liability and compare
the same with the financial statements,
(2) Items that
were earlier considered as permanent difference as per Indian GAAP may have to
be considered as temporary difference as per IFRS, and
taxes, for certain items, will be recognised outside profit or loss i.e.,
in OCI or SOCIE.