Provision for Tax, Sections, Features, Advantages, Disadvantages
Provision for Tax refers to the estimated amount of income tax a company expects to pay on its profits for a given accounting period. Since the exact tax liability is determined after the finalization of accounts and assessment by tax authorities, companies create a provision to account for this future obligation.
It is a liability and shown under “Current Liabilities” in the balance sheet. This provision ensures that profits are not overstated and aligns with the matching principle of accounting, which requires expenses to be recognized in the same period as the related revenues.
The provision is made based on prevailing tax rates and estimated taxable income. Later, when the actual tax is paid, any difference between the provision and actual tax is adjusted.
Creating a provision for tax helps maintain transparency, ensures compliance with laws, and provides a realistic picture of the company’s financial position.
Sections of Provision for Tax in India:
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Section 139 – Filing of Return
Under Section 139 of the Income Tax Act, 1961, every company is required to file an income tax return for each assessment year, irrespective of whether it has earned income or not. In order to compute accurate taxable income, companies must estimate and account for tax liabilities at the end of the financial year. This estimation is recorded in the books of accounts as a provision for tax. Although the final tax liability is determined after assessment by the tax department, making a provision ensures that financial statements reflect a realistic liability for the period.
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Section 115JB – Minimum Alternate Tax (MAT)
Section 115JB deals with the concept of Minimum Alternate Tax (MAT). It is applicable to companies whose income tax liability under normal provisions is less than 15% of their “book profit.” In such cases, they are required to pay tax at 15% (plus surcharge and cess) on the book profit. This MAT is also included in the provision for tax if applicable. MAT ensures that companies showing high profits in books but paying little or no tax under the normal provisions contribute a minimum amount to the government.
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Section 209 – Advance Tax Computation
Section 209 specifies the computation of advance tax for assessees whose total estimated tax liability is ₹10,000 or more in a financial year. Companies are required to pay advance tax in four installments during the year. Provision for tax also includes the estimation and recording of advance tax liabilities. These advance tax payments are adjusted against the total tax liability at the end of the year. Failure to pay advance tax results in interest penalties under Sections 234B and 234C.
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Section 145 – Method of Accounting
Section 145 of the Income Tax Act mandates that income must be computed in accordance with the mercantile system or the cash system of accounting, as regularly followed by the assessee. Most companies follow the mercantile system, where income and expenses are recognized on an accrual basis. Therefore, the provision for tax is recorded even though the actual tax payment is made at a later date. This ensures that the expenses match the revenues earned during the accounting period in line with the matching principle of accounting.
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Section 37(1) – General Deduction
As per Section 37(1), expenses that are not specifically covered under any other section and are incurred wholly and exclusively for business or profession are allowed as deductions. However, it is important to note that income tax paid is not allowed as a business expenditure. Although actual tax payments are not deductible, the provision for tax is made in books for accounting purposes only and does not affect taxable profits. This distinction is important for both tax computation and financial reporting.
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ICDS IX – Provisions, Contingent Liabilities
The Income Computation and Disclosure Standards (ICDS) are a set of standards notified by the Income Tax Department to ensure uniformity in income computation. ICDS IX specifically deals with provisions and contingent liabilities. It outlines how provisions (including provision for tax) should be recognized and disclosed for tax purposes. According to ICDS IX, a provision is recognized only when there is a present obligation resulting from a past event, and the amount can be reliably estimated. This helps in maintaining consistency and compliance in recognizing tax provisions.
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Section 123 of the Companies Act, 2013
According to Section 123 of the Companies Act, 2013, a company must provide for depreciation and tax before declaring any dividend. This means that the provision for tax must be created and adjusted in the profit and loss account prior to the appropriation of profits for dividend payments. This ensures that dividends are paid only from the net profits of the company, maintaining the integrity of the company’s financial position and protecting shareholder interests.
Features of Provision for Taxation:
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Estimation of Future Tax Liability
Provision for taxation represents the estimated amount of income tax a company expects to pay for the current accounting year. It is not the exact tax payable but a fair approximation based on taxable income and prevailing tax rates. This provision is made before the final assessment by the tax authorities. Estimating tax in advance ensures that the financial statements show a more realistic picture of the company’s financial obligations, helping in the application of the matching principle in accounting—where expenses are matched with revenues of the same period.
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Non-Cash, Adjusting Entry
The provision for tax is a non-cash, adjusting journal entry made at the end of the accounting year. Although the actual payment of tax occurs later, the entry ensures that tax expenses are recognized in the financial statements of the relevant period. It does not involve an immediate cash outflow but prepares the business for a future liability. This entry affects the Profit and Loss Account by reducing net profit and is shown as a current liability on the balance sheet, maintaining the accuracy of financial reports.
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Based on Accounting Profit, Not Taxable Profit
Provision for tax is generally created on the basis of accounting profit and not the actual taxable profit as per the Income Tax Act. Accounting profit is computed according to financial reporting standards (such as Companies Act provisions or accounting standards), whereas taxable profit includes adjustments and disallowances under income tax laws. Therefore, the provision may differ from the final tax liability. Any differences between provision and actual tax are adjusted in subsequent periods, either by creating a tax payable or excess provision account.
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Helps Comply with Matching Concept
One of the main purposes of creating a provision for tax is to comply with the matching concept of accounting. This principle states that expenses should be recognized in the same period as the revenues they help generate. Since taxes are a result of profits earned during the year, the tax expense (even if unpaid) should be accounted for in the same financial year. Creating the provision ensures that the profit reported is net of estimated tax, giving a more accurate picture of the company’s performance.
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Shown as Current Liability
Provision for taxation is shown on the liabilities side of the balance sheet under the heading current liabilities and provisions. It represents a legal obligation of the company to pay income tax in the near future. The amount remains as a liability until the tax is paid or assessed. It alerts stakeholders and auditors about the company’s obligations and ensures that the financial position is not overstated. This treatment enhances transparency and reflects the company’s commitment to meeting its statutory obligations.
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Subject to Adjustments
The provision for tax is not a final amount—it is subject to changes and adjustments once the actual tax liability is computed and paid. If the provision is higher than the actual tax, the excess is written back to profit in the next year. If the provision is lower, the shortfall is recorded as an additional tax expense. These adjustments ensure accuracy in the company’s books and help reconcile the differences between book profit and taxable income over time, aligning with financial and statutory requirements.
Advantages of Provision for Taxation:
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Ensures Accurate Financial Reporting
Provision for taxation helps in presenting a true and fair view of the company’s financial statements. By recognizing expected tax liabilities in the current period, it prevents overstatement of profits. This aligns with the matching principle and ensures that the expenses related to the current year’s income are accounted for properly. It improves the reliability of financial statements and helps stakeholders make informed decisions based on realistic profit figures after considering expected tax obligations.
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Facilitates Better Financial Planning
Creating a provision for taxation allows a company to set aside funds in anticipation of future tax payments. This helps avoid sudden cash flow pressure when tax becomes payable. With better foresight into upcoming tax liabilities, the company can plan investments, dividends, and working capital more efficiently. It enables businesses to manage liquidity better and avoid financial disruptions, ensuring that adequate resources are available when the actual tax dues are settled with the tax authorities.
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Helps in Legal and Regulatory Compliance
Maintaining a provision for taxation ensures that a company complies with statutory requirements, such as the Companies Act and accounting standards. It signals that the company is responsibly planning to meet its tax obligations. Auditors and regulatory authorities often look for such provisions as a sign of good governance. Additionally, accurate provisioning helps in smooth tax assessments and audits, reducing the risk of penalties and interest due to underreporting or delayed recognition of tax liabilities.
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Enhances Credibility Among Stakeholders
When a company maintains proper provisions for taxation, it boosts the confidence of investors, lenders, and other stakeholders. It demonstrates sound financial management and responsible behavior in anticipating and preparing for tax liabilities. Credit rating agencies and financial institutions often view accurate provisioning as a positive indicator of a company’s discipline and foresight. This can enhance the company’s reputation in the market and improve its ability to attract capital or secure loans at better terms.
Disadvantages of Provision for Taxation:
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Risk of Over or Under Provisioning
One major disadvantage of provision for taxation is the risk of overestimating or underestimating the actual tax liability. If over-provided, it unnecessarily reduces reported profits, affecting dividend declarations and investor perception. If under-provided, it can lead to future cash flow strain and accounting adjustments. In both cases, the accuracy of financial statements is compromised, which may mislead stakeholders and require restatement of profits in subsequent periods, reducing financial statement reliability.
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No Tax Deduction for Provision
Although a company creates a provision for taxation in its books, the Income Tax Act does not allow deduction for provisions—only actual tax payments are deductible. This leads to a situation where the expense is recorded in accounting books but not recognized for tax purposes, resulting in deferred tax differences. This creates complexity in tax calculations and reconciliation, and requires maintenance of deferred tax asset/liability accounts, which adds to the administrative and accounting workload.
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Reduces Available Profits for Distribution
Creating a provision for taxation reduces the net profit of the company for the period, thereby decreasing the profits available for distribution as dividends. This may disappoint shareholders who expect regular or higher dividend payouts. For small companies or those with tight margins, this reduction can significantly impact their ability to reinvest in the business or maintain dividend consistency. It also may affect market perception, as lower profits could be seen as a sign of reduced performance.
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Complexity in Estimation and Compliance
Accurately estimating the provision for taxation involves a deep understanding of current tax laws, deductions, allowances, and company-specific tax planning strategies. Any error in interpretation or calculation can result in incorrect provisioning. Moreover, changing tax rates, amendments in laws, or new tax regimes add to the complexity. Companies need skilled professionals to ensure compliance and avoid penalties or misstatements. This increases administrative burden and the cost of maintaining proper tax accounting systems.