Deferred Tax Liability - Meaning, Calculation & Example

Written by : Knowledge Centre Team

2024-08-02

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Deferred Tax Liability (DTL) is one of the important factors in a company's financial statement. It is a form of adjustment made at the end of the year and affects the income tax calculation of the business for the current year and the coming years.

The company's financial statement has a section on book profits. The section details are calculated as per the rules of the Companies Act. The taxable profit is calculated based on the provision of the IT Act. Certain items are allowed or disallowed each year for tax purposes. As a result, there is a difference between the book profit and taxable profit. This difference is known as timing difference, and it is of two types:

a) Permanent Difference:

If the difference between tax income and book income cannot be reversed in subsequent years.

b) Temporary Difference:

If the difference between tax income and book income can be reversed in upcoming years.

This difference results in the creation of a deferred tax liability or asset.

What is Deferred Tax Liability?

Deferred tax liability is created when a tax obligation is accumulated in one financial year but is due in the subsequent years. A deferred tax liability arises due to the difference in timing between when the tax was accrued and when it is due to be paid. When a company depreciates its asset differently than the IT department, the variance from the tax laws creates a temporary discrepancy in the company's financial statements and corresponding tax reports.

Another example of deferred tax liability is instalment sales. The company is allowed to recognize full income from the instalment sale, while tax laws require companies to recognize the income when instalment payments are made. This creates a temporary positive difference and is referred to as deferred tax liability.

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What is a Deferred Tax Asset?

Deferred tax assets are items that reduce a company's taxable income in the future. Such an entry may be created on the company's balance sheet when a business overpays its taxes.

The additional money the company paid gets returned as tax relief. Hence, the overpayment becomes an asset for the company.

For example, a Television manufacturer estimates that 2% of the total TV sold will come back to them for warranty repair. The company's total revenue for the year is Rs 30 lakh, and warranty expense is Rs 60,000. Hence total taxable income is Rs 29.4 lakh.

However, the deduction is not considered by the IT department and hence the company will pay tax on Rs 30 lakh at a 30% interest rate. However, the difference between the tax payable and the actual taxes paid is a deferred tax asset. In this example, DTA will be (30% of Rs 60000) Rs 18000.

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Deferred Tax Liability vs Deferred Tax Asset

Deferred tax liability or asset arises due to the difference in accounting principles and tax guidelines. Below is a detailed comparison between the two:

Parameters	Deferred Tax Liability	Deferred Tax Asset
What is it?	When the tax is accrued by the company in the current year but is paid in the coming years, it comes under differed tax liability.	When the company pays advance in the current period, but it will be accrued in the later period, it comes under deferred tax asset.
When an entry is made	When profits in a company's income statement are higher than what is mentioned in its income tax reports.	When profits in a company's income statement are lower than what is mentioned in the income tax reports.
How is it treated?	Businesses record deferred tax liabilities in the balance sheet under non-current liabilities.	Businesses record deferred tax assets in the balance sheet under non-current assets.

Role of Virtual Certainty in DTA

Deferred Tax Asset is only recognized if there is a future virtual certainty. DTA is realized only when the company reliably estimates sufficient future taxable income. A virtual certainty test has to be done every year by the company. If the conditions are not met, such DTA has to be written off.

For example, a company has projected future profits based on the sales estimates and future restructuring and submits it to the bank for a loan. In such cases, it is considered convincing evidence for virtual certainty. On the other hand, virtual certainty will not be concrete if only a binding export order is provided that may get cancelled anytime. Virtual certainty is based on projects that are likely to happen in the future.

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DTA/DTL vs Tax Holiday & MAT

Tax Holiday is a benefit provided to a new organization established in 100% export-oriented undertaking, free trade zones, etc under Section 10A and 10B of the Income Tax Act. The government exempts certain taxes for a temporary period subject to a specific condition to encourage the production and consumption of certain items.

For the timing difference, the deferred tax reverses during the period of a tax holiday. It should not be considered during the company's tax holiday period. Deferred tax related to the timing difference that reverses after the tax holiday must be recognized in the origination year.

Minimum Alternate Tax or MAT is a tax that an organization has to pay if it's tax payable as per the normal provision of the IT Act and is less than the tax computed at 18.5% of the book profit. It comes under Section 115JB of the IT Act. MAT does not give rise to any difference between taxable income and book income. In accordance with AS22, it is not right to consider MAT credit as a deferred tax asset.

Deferred tax liability and assets must be recorded in the company's book so that its shareholders are aware of all the underlying liabilities (and assets) the company has at the end of a financial year. These are also useful for auditing purposes.

Disclaimer: This article is issued in the general public interest and meant for general information purposes only. Readers are advised to exercise their caution and not to rely on the contents of the article as conclusive in nature. Readers should research further or consult an expert in this regard.

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