Business Taxes

Chapter 11Accounting for Tax Charges and Provisions

LEARNING OUTCOMES

Prior to covering the material in this chapter you should review the chapter 9 in your Financial Reporting & Tax Accounting Fundamentals manual.

11.1 Calculate the deferred tax expense (or income) for the Statement of Comprehensive Income 310
11.2 Calculate the deferred tax provision for the Statement of Financial Position 315

11.1.Calculate the deferred tax expense (or income) for the Statement of Comprehensive Income

Example 11.1

If a company purchases a machine for €10,000 and depreciates it over 5 years at 20% there will be a depreciation charge of €2,000 per annum. At the end of the 5 years the machine will be fully written-off in the company’s books.

From the tax perspective, the cost of the machine will be written-off over 8 years (s. 284(2) TCA 1997).

Therefore for the first 7 years there will be a difference (called a “temporary difference”) between the carrying value of the machine for accounting purposes and its tax written down value (its “tax base”). This temporary difference gives rise to a deferred tax asset or liability.

By the end of the eighth year, the asset will have a nil value for both accountancy and tax purposes and therefore the deferred tax asset/liability will have ceased to exist.

So, a temporary difference is the difference between the carrying amount of an asset or liability in the Statement of Financial Position and its tax base.

11.1.1.Deferred tax expense or deferred tax income?

The deferred tax entry in the Statement of Comprehensive Income can be a deferred tax expense (i.e. a corporation tax liability that has been deferred to a future accounting period) or deferred tax income (i.e. a corporation tax refund that has been deferred to a future accounting period).

The entry is a deferred tax expense if:

the deferred tax asset in the Statement of Financial Position has decreased year on year, or

the deferred tax liability in the Statement of Financial Position has increased year on year.

The entry is deferred tax income if:

the deferred tax asset in the Statement of Financial Position has increased year on year, or

the deferred tax liability in the Statement of Financial Position has decreased year on year.

11.1.2.Step by step guide

You should follow these steps to calculate the deferred tax entry for the Statement of Comprehensive Income (and, in doing so, you also calculate the deferred tax provision for the Statement of Financial Position):

Step 1: Calculate the carrying value of the asset or liability in the accounts as at the Statement of Financial Position reporting date.
Step 2: Calculate the tax base of the asset or liability as at the Statement of Financial Position reporting date.
Step 3: Calculate the temporary difference (= carrying amount of the asset or liability in the accounts minus its tax base).
Step 4: Calculate the deferred tax asset or liability (= temporary difference multiplied by the appropriate tax rate). The resulting figure is the liability/asset for the Statement of Financial Position.
Step 5: Calculate the deferred tax entry for the Statement of Comprehensive Income for the accounting period (= deferred tax asset or liability at the end of the accounting period minus deferred tax asset or liability at the beginning of the accounting period). This figure appears in the Statement of Comprehensive Income.

The following example sets out the calculation of the deferred tax entry for the Statement of Comprehensive Income (and, by extension, the deferred tax provision for the Statement of Financial Position).

Example 11.2

F Ltd purchases a machine for €20,000 in May 2014. It has a depreciation policy of 20% per annum straight line and charges a full year’s depreciation in the year of acquisition and none in the year of disposal. F Ltd has a December year end.

Year 1

The calculation of the deferred tax expense (or income) for inclusion in the Statement of Comprehensive Income of F Ltd for the year ended 31 December 2014 would be as follows:

Step 1: Calculate the carrying value of the asset or liability in the accounts as at the Statement of Financial Position reporting date

Step 2: Calculate the tax base of the asset or liability as at the Statement of Financial Position reporting date.

Accounting calculation Tax calculation
Cost 20,000 Cost 20,000
Depreciation charge 20% (4,000) Capital allowances 12.5% (2,500)
Net Book Value 16,000 Tax written down value 17,500

Step 3: Calculate the temporary difference (= carrying amount of the asset or liability in the accounts minus its tax base)

Tax written down value 17,500
less: Net Book Value (16,000)
1,500

Step 4: Calculate the deferred tax asset or liability (= temporary difference multiplied by the appropriate tax rate)

€1,500 × 12.50% = Deferred tax asset €187.50

Step 5: Calculate the deferred tax entry for the Statement of Comprehensive Income for the accounting period

(= deferred tax asset or liability at the end of the accounting period minus deferred tax asset or liability at the beginning of the accounting period)

€187.50 - Nil = €187.50

Because the deferred tax asset has increased over the course of the accounting period, this €187.50 is deferred tax income.

In this example, F Ltd will add back the annual depreciation of €4,000 for the five years of its useful life while the company will claim a wear and tear allowance of €2,500 annually.

The temporary difference is a “deductible temporary difference” (as opposed to a “taxable temporary difference”) because it will result in a tax deductible cost in future accounting periods i.e. a tax credit.

The €187.50 is treated as a deferred tax asset because, while the company is paying more tax now (because the depreciation add-back is higher than the capital allowances), it will pay less tax in future (as the annual capital allowances will eventually exceed the annual depreciation amounts).

The deferred tax income of €187.50 is credited to the Statement of Comprehensive Income to compensate for the additional tax charge of €187.50 which arises because of the difference between the depreciation charge and the capital allowances claim.

The journal entries necessary would be as follows:

DR Deferred tax - Statement of Financial Position €187.50
CR Deferred tax - Statement of Comprehensive Income €187.50

Being the movement in the deferred tax asset during the year ended 31 December 2014.

Years 2–5

In the accounts for the year ended 31 December 2015 (the second year), the deferred asset will be again be €187.50 as calculated above, given a balance of €375 (€187.50 × 2).

The deferred tax asset will increase by €187.50 for the next three years (five years in all) to €937.50.

Year 6

Remember, the asset is fully depreciated at the end of the fifth year. The deferred tax calculation in the accounts for the year ended 31 December 2019 (the sixth year) will be as follows:

Accounting calculation Tax calculation
Balance fwd - Balance fwd 7,500
Depreciation charge - Capital allowances (2,500)
Net Book Value - Tax written down value 5,000

Step 3: Calculate the temporary difference (= carrying amount of the asset or liability in the accounts minus its tax base)

Tax written down value 5,000
less: Net Book Value -
5,000

Step 4: Calculate the deferred tax asset or liability (5 temporary difference multiplied by the appropriate tax rate)

€5,000 × 12.50% = Deferred tax liability = €625

Step 5: Calculate the deferred tax entry for the Statement of Comprehensive Income for the accounting period

(= deferred tax asset or liability at the end of the accounting period minus deferred tax asset or liability at the beginning of the accounting period)

= €625 - €937.50 = (€312.50)

Because the deferred tax asset has decreased over the course of the accounting period, this €312.50 is a deferred tax expense.

The deferred tax asset has fallen from €937.50 at the end of year five to €625.00 by the end of year six. The deferred tax expense of €312.50 is charged to the Statement of Comprehensive Income.

The journal entries necessary for year six would be as follows:

DR Deferred tax charge - Statement of Comprehensive Income €312.50
CR Deferred tax asset - Statement of Financial Position €312.50

Being the movement in the deferred tax asset during the year ended 31 December 2019.

Years 1-8

The chart below shows the movement over the years of the deferred tax asset:

Year Cost Carrying accounting value at year end (NBV) Tax Base at year end (TWDV) Temporary Differences Deferred Tax Asset at 1 Jan Deferred Tax Asset at 31 Dec Movement in the Deferred Tax Asset
          Statement of Financial Position Statement of Financial Position Statement of Comprehensive Income
 
1 20,000 16,000 17,500 1,500 - 187.50 187.50
2   12,000 15,000 3,000 187.50 375.00 187.50
3   8,000 12,500 4,500 375.00 562.50 187.50
4   4,000 10,000 6,000 562.50 750.00 187.50
5   0 7,500 7,500 750.00 937.50 187.50
6     5,000 5,000 937.50 625.00 (312.50)
7     2,500 2,500 625.00 312.50 (312.50)
8       0 312.50 - (312.50)

As can be seen from the chart the Statement of Comprehensive Income will show a deferred tax credit for the first five years of €187.50 per annum.

This is the difference between annual depreciation of €4,000 and capital allowances of €2,500 multiplied by 12.5%; i.e. (€4,000 - €2,500) × 12.5%.

From the sixth year, when the asset is fully depreciated, there will be a deferred tax charge of €312.50 per annum to the income statement.

This is the difference between annual depreciation of €0 and capital allowances of €2,500 multiplied by 12.5%; i.e. (0 - 2,500) × 12.5%.

At the end of the eighth year, the cost of the asset has been fully allowed for corporation tax purposes and the deferred tax asset ceases to exist.

11.2.Calculate the deferred tax provision for the Statement of Financial Position

Remember, we calculate the deferred tax provision (be it an asset or liability) by multiplying the temporary difference for the accounting period by the appropriate tax rate.

Taking example 11.2, F Ltd’s deferred tax provision at the end of Year 5 would be €937.50. This would be a deferred tax asset.

This asset is the remaining tax written down value of the asset (i.e. the asset’s tax base: €7,500) minus the carrying value of the asset in the accounts (which has been reduced to zero), multiplied by the standard corporation tax rate (12.5%); i.e. (€7,500 - 0) × 12.5%.