Deferred tax - What is deferred tax?
Deferred tax refers to either a positive (asset) or negative (liability) entry on a company’s balance sheet regarding tax owed or overpaid due to temporary differences
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Deferred tax can fall into one of two categories. Deferred tax liabilities, and deferred tax assets. Both will appear as entries on a balance sheet and represent the negative and positive amounts of tax owed. Note that there can be one without the other - a company can have only deferred tax liability or deferred tax assets.
Depending on whether the tax is owed or paid will determine whether it is considered an asset or liability.
Deferred tax and taxable temporary differences
An important concept to explain in relation to deferred tax is that of taxable temporary differences. This occurs when a business has an asset with a liability value that does not match with the current taxable value of the asset. This can happen when the accounting approach and tax laws differ in how the depreciation of an asset is handled.
These temporary differences can impact on a financial account because they mean that income and expenses appear within one accounting period, but the tax is payable in a different accounting period. A taxable difference can be either taxable or deductible.
Deferred tax liability
A deferred tax liability occurs when a business has a certain amount of income for an accounting period and that amount is different from the taxable amount on their tax return. When the amount is less than the estimated tax, an entry is placed on the balance sheet in the form of a liability.
Deferred tax typically refers to liabilities, wherein the amount entered on the balance sheet is payable at a future time. However, deferred tax can also apply in the opposite sense.
Example of a deferred tax liability
Company XYZ owns machinery that is classified as an asset. They choose to use a certain depreciation method - in this case, an accelerated method that allows higher deductions earlier in ownership of the asset and lower deductions further on
This differs from the slower, straight-line depreciation that is used by tax authorities, which means the the depreciation is spread evenly over the useful life of the asset.
The depreciation method affects how much the charges will be for each accounting period. These charges can be claimed for capital allowance
Because the depreciation method chosen by Company XYZ would result in at first a larger deduction than the method used by tax authorities, their income would be higher than what would be considered the taxable income. In this case, the temporary difference would be added as a liability to the balance sheet.
Deferred tax asset
When a company overpays for a particular tax period, this can be marked as a deferred tax asset on the balance sheet. If taxes are overpaid or paid in advance, then the amount of overpayment can be considered an asset and illustrates that the business should receive some tax break in the next filing.
Paying in advance to create deferred tax assets can aid a business looking to decrease their tax liability in a future period.
A deferred tax asset can also occur due to losses that are carried over to a new accounting period from a previous accounting period and can then be claimed in the new period as an asset.