Deferred Tax: Determine the Tax rate(law), Measurement, Recognition and Accounting of deferred tax, Practical Application Deferred tax arising from a business combination

Determining the tax rate for calculating deferred tax according to Ind AS 12, “Income Taxes,” is a critical step in the measurement of deferred tax liabilities or assets. Deferred tax accounts for the future tax effects of current transactions and events, and its calculation is based on the difference between the carrying amount of assets and liabilities in the financial statements and their tax base. The tax rate used should reflect the rates that are expected to apply in the period when the asset is realized or the liability is settled.

1. Enacted or Substantively Enacted Tax Rates

Deferred tax assets and liabilities should be measured at the tax rates that have been enacted or substantively enacted by the reporting date. An enacted tax rate is one that has been formally passed into law. A substantively enacted rate is one that has advanced to the point where further progression is virtually certain, even if it has not been formally enacted by the reporting date.

2. Expected Tax Rates

The measurement should be based on the tax rates (and tax laws) that are expected to apply in the period when the deferred tax liability is settled or the deferred tax asset is realized. This expectation should be based on the tax rates (and laws) that have been enacted or substantively enacted by the end of the reporting period.

3. Consideration of Future Changes

If specific changes in the tax rates or tax laws are announced, substantively enacted, or enacted by the reporting date, these should be considered in the measurement of deferred tax. This includes understanding when these changes are expected to take effect and applying them to the periods in which temporary differences are expected to reverse.

4. Different Tax Rates

If different tax rates apply to different levels of taxable income or to different categories of taxpayers, the rate to be applied is the rate expected to apply to the taxable income of the periods in which the deferred tax asset or liability is expected to be settled or realized. This requires an estimation of the taxable income in future periods.

5. Tax Rate Variability

For entities operating in multiple jurisdictions, the tax rate used for calculating deferred tax should reflect the tax rate of the jurisdiction in which the entity operates and generates taxable income. If there are different rates for different types of income or transactions, the appropriate rate is the one that applies to the temporary differences that are being reversed.

6. Measurement Reflection

The measurement of deferred tax liabilities and assets must reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities. This includes considering the tax consequences of the way assets are expected to be realized or liabilities to be settled, such as through use or sale.

Measurement of Deferred Tax:

The measurement of deferred tax involves calculating the tax effect of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their tax bases. Ind AS 12, “Income Taxes,” provides the framework for this calculation, focusing on the deferred tax liabilities and assets that result from those temporary differences.

Temporary Differences

First, identify the temporary differences. These differences may arise due to the different treatment of items for accounting and tax purposes. Temporary differences can be:

• Taxable temporary differences: Differences that will result in taxable amounts in future periods when the carrying amount of the asset or liability is recovered or settled.
• Deductible temporary differences: Differences that will result in amounts that are deductible in future periods when the carrying amount of the asset or liability is recovered or settled.

Tax Rates for Measurement

Deferred tax assets and liabilities should be measured using the tax rates that are expected to apply in the period when the asset is realized or the liability is settled. The rates used must be those that have been enacted or substantively enacted by the reporting date.

Recognition of Deferred Tax Assets

Deferred tax assets should be recognized for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized. The future realization of the deferred tax asset depends on whether there is sufficient taxable profit expected in the future.

Measurement Techniques

The measurement of deferred tax liabilities and assets should reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities. This involves:

• Using appropriate tax rates: As mentioned, the rates should be those enacted or substantively enacted by the reporting date.
• Tax base determination: The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
• Valuation allowances: If it is not probable that some or all of a deferred tax asset will be realized, a valuation allowance is recognized to reduce the deferred tax asset to the amount that is probable to be realized.

Reassessment

Entities must reassess at each reporting date the likelihood of realizing the deferred tax asset. Changes in circumstances that affect the entity’s ability to generate sufficient taxable profits in the future could lead to adjustments in the recognition of deferred tax assets.

Presentation

Deferred tax liabilities and assets are presented in the statement of financial position as non-current. However, the classification of deferred tax assets and liabilities into current and non-current is not required under Ind AS.

Disclosures

Ind AS 12 requires disclosures that enable users of financial statements to understand the relationship between the tax expense (income) and accounting profit, and the nature and amounts of deferred tax liabilities and assets.

Recognition and Accounting of Deferred Tax:

The recognition and accounting of deferred tax involve principles established under Ind AS 12, “Income Taxes.” This standard addresses how to account for the current and future tax consequences of:

• The future recovery (realization) of the carrying amount of assets or liabilities that are recognized in an entity’s balance sheet, and
• Transactions and other events of the current period that are recognized in an entity’s financial statements or tax returns.

Recognition of Deferred Tax Liabilities

Deferred tax liabilities are recognized for all taxable temporary differences, with certain exceptions. A taxable temporary difference is the amount by which the carrying amount of an asset or liability in the balance sheet exceeds its tax base. The recognition of deferred tax liabilities reflects the fact that the entity will pay more tax in the future as a result of these differences.

Exceptions include:

• Deferred tax liabilities from the initial recognition of goodwill.
• Deferred tax liabilities from the initial recognition of an asset/liability in a transaction that:
  • Is not a business combination, and
  • At the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

Recognition of Deferred Tax Assets

Deferred tax assets are recognized for all deductible temporary differences, unused tax losses, and unused tax credits to the extent that it is probable that taxable profit will be available against which the deductible temporary differences and the carryforward of unused tax losses and unused tax credits can be utilized. The criteria for recognizing deferred tax assets include reviewing whether sufficient taxable profit will be available in the future against which the temporary differences can be utilized.

Key Considerations for Recognition:

• Assessing the probability of future taxable profits against which the deferred tax assets can be utilized.
• Considering the strategies and tax planning opportunities that could make the realization of deferred tax assets more likely.

Measurement

Deferred tax assets and liabilities are measured at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting period.

Reassessment

Entities should reassess the carrying amount of a deferred tax asset at each reporting date. The entity should reduce the carrying amount of a deferred tax asset to the extent that it is no longer probable that sufficient taxable profit will be available to allow the benefit of part or all of that deferred tax asset to be utilized.

Accounting Treatment

Deferred tax assets and liabilities should be adjusted in the period in which the change in tax rates or tax laws occurs. The effect of the change on deferred tax assets and liabilities is recognized in profit or loss for the period, except to the extent that it relates to items previously charged or credited directly to equity or other comprehensive income.

Presentation

Deferred tax assets and liabilities are presented in the statement of financial position as non-current assets and liabilities. They are not discounted to present value. The offsetting of deferred tax assets and liabilities is only permitted if the entity has a legally enforceable right to set off current tax assets against current tax liabilities and the deferred tax assets and liabilities relate to taxes levied by the same taxation authority on the same taxable entity or on different taxable entities that intend either to settle current tax liabilities and assets on a net basis, or to realize the assets and settle the liabilities simultaneously.

Disclosures

Ind AS 12 requires entities to disclose the amount of deferred tax assets and liabilities, the movements during the period, and the components of tax expense (income) in the financial statements. Additionally, entities should disclose the nature of the evidence supporting the recognition of deferred tax assets, particularly when the realization of deferred tax assets is dependent on future taxable profits in excess of the profits arising from the reversal of existing taxable temporary differences.

Practical Application Deferred Tax arising from a Business Combination:

Deferred tax considerations are critical in business combinations, as outlined in Ind AS 103, “Business Combinations,” and Ind AS 12, “Income Taxes.” The acquisition method, used in accounting for business combinations, often results in the recognition of assets and liabilities at their fair values. This revaluation can create temporary differences between the carrying amounts of assets and liabilities for accounting purposes and their tax bases. These temporary differences may lead to the recognition of deferred tax liabilities or assets.

Identifying Temporary Differences

The first step is to identify temporary differences that arise from the business combination. This involves comparing the tax bases of the acquired assets and liabilities to their recognized amounts in the financial statements post-acquisition. Common areas where temporary differences arise include:

• Intangible assets: Fair value adjustments to intangible assets, such as trademarks and customer relationships, often have no tax base or a different tax base, leading to temporary differences.
• Property, plant, and equipment (PPE): Revaluations of PPE to fair value can result in temporary differences if the tax base does not change accordingly.
• Inventories: Adjustment of inventories to fair value may also create temporary differences.

Recognition of Deferred Tax

For each identified temporary difference, the entity must recognize a deferred tax liability or asset. The recognition criteria and measurement principles follow Ind AS 12:

• Deferred tax liabilities are recognized for taxable temporary differences, except for certain exemptions such as goodwill.
• Deferred tax assets are recognized for deductible temporary differences to the extent that it is probable that future taxable profits will be available against which the deductible temporary difference can be utilized.

Measurement

Deferred tax assets and liabilities arising from a business combination are measured at the tax rates that are expected to apply in the periods when the assets will be realized or the liabilities settled. The measurement reflects the entity’s expectations, based on the tax laws that have been enacted or substantively enacted by the acquisition date.

Goodwill

One of the complexities in business combinations is the treatment of goodwill. Under Ind AS 103 and Ind AS 12, goodwill is initially measured as the excess of the consideration transferred over the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed. If a deferred tax liability is recognized for the future taxation of excess values of identifiable assets over their tax bases, this decreases the amount of goodwill recognized. Conversely, the recognition of a deferred tax asset (for example, due to the recognition of a deductible temporary difference) increases the amount of goodwill recognized, subject to the asset’s recoverability.

Practical Example

Assume Company A acquires Company B for ₹1,000,000. Among the assets acquired are patents valued at ₹200,000 for accounting purposes but with a tax base of zero. Assuming a tax rate of 30%, a deferred tax liability of ₹60,000 (₹200,000 * 30%) would be recognized. This deferred tax liability reflects the future tax consequences of recovering the patent’s carrying amount, which is higher than its tax base. The recognition of this deferred tax liability would adjust the amount of goodwill or bargain purchase gain recognized in the business combination.