The term "deferred tax" refers to a tax which shall either be paid in future or has already been settled in advance. In this article, we will see why a company may differ its tax to a subsequent fiscal year or why a company may choose to pay the tax in advance.
Most companies normally prepare an "income statement" and a "tax statement" every fiscal year because the guidelines that govern the recording of income and taxation are slightly different. It is this slight disparity between the guidelines that creates the scope for deferred tax.
There are two types of deferred tax −
Deferred tax asset
Deferred tax liability.
A deferred tax is recorded in the balance sheet of a company if there are chances of a reduced or increased tax liability in the future.
It is important to recognize deferred tax liabilities because it helps the company be prepared for future expenses and plan its business operations accordingly. Similarly, it is prudent to recognize deferred tax assets because it can help reduce tax liabilities in the future.
When a company pays its tax liability in advance, or reduces its tax liability, for a subsequent year, then it is known as a Deferred Tax Asset. A deferred tax asset is a balance sheet component that reduces the taxable income of a company in the subsequent years. Since the taxes are overpaid in advance, it becomes an asset in the future.
Now, why would a company prefer to pay taxes in advance? Let's find out.
In case of a gross loss - If a company makes a gross loss in a particular fiscal, then it can carry it forward to offset the profits that may be generated in the next year. In that way, it will reduce the taxable income of the company in the future.
Accounting rules mismatch with tax rules - When there is a disparity between accounting rules and tax rules, it creates an opportunity to have deferred tax asset. For example, suppose there are expenses which a company has recorded in its books, but these expenses have not been considered for tax calculations. In such a situation, the company ends up paying an advance tax for the current year, which becomes a deferred tax asset in the subsequent year.
When a company opts to accumulate its tax for a particular fiscal year and settle it in the subsequent year, then it is known as "deferred tax liability". It indicates a future financial obligation. Let's take an example to understand why and when such a situation may arise.
Suppose a company uses "straight-line method" to calculate its depreciation costs, whereas the Income Tax Department uses "accelerated depreciation method", then there will be an inconsistency in the income statement and the tax statement. In this case, the depreciation considered by the IT department will be higher than what was reported by the company, hence the company will have a reduced tax liability. However, this disparity in tax is only temporary and the company has to clear it by paying a higher tax in the subsequent year.
Hence, it is a future financial obligation that is recorded as deferred tax liability.
As per the taxation rules in India, there is no separate tax rate for deferred taxes. The general corporate tax rate is applicable in the calculation of deferred tax.