21.1.06 Deferred Tax Clarification

Enquiry:

Proposition is:

“How the concept of deferred tax shall apply to tax laws in Pakistan i.e. deferred tax vis-à-vis Section 113 of Income Tax Ordinance (Minimum tax on turn over). It is assumed that company always pays tax u/s 113.”

1. The spirit of IAS-12 Deferred tax is that every year should bear the burden of tax which is fairly attributable to it.

2. Example below shows that machinery is purchased in year 1 which claims initial allowance. Accounting profits are higher and tax profits are lesser therefore year 1 pays lower tax while year 2 and subsequent years pay higher tax. There will be a deferred tax liability in year 1.

This will happen if tax is calculated as percentage of tax profit

EXAMPLE

A company (Pvt) Ltd.
Year                            1            2
Turnover              300 M     300 M
Profit before dep. 8 M        8 M
Machinery purchased 2 M     –
Initial allowance       25 %      –
Depreciation             10 % 10 %
Rate of Tax                33 % 33 %
Minimum tax (of turn over) 1 % 1 %

PROFIT & LOSS ACCOUNT

Year            1                     2
A/c Profit Tax Profit A/c. Tax

Turnover 300 M 300 M 300 M 300 M
======= ======= ======= =======
Profit 8,000,000 8,000,000 8,000,000 8,000,000
(before dep.)

Less Dep.
Initial allowance – 500,000 – –
Depreciation 200,000 150,000 180,000 135,000
200,000 650,000 180,000 135,000

Net Profit 7,800,000 7,350,000 7,820,000 7,865,000
Tax @ 33% 2,574,000 2,425,500 2,580,600 2,595,450

Deferred tax calculations:
Normal tax 2,425,500 2,595,450
Deferred tax (Liability 148,500 (14,850)

(2574000 – 2425500)
_________ _________
Total Tax 2,574,000 2,580,600

Deferred tax liability of Rs. 148,500 will be created and carried over to subsequent years and will be adjusted.

TAX LAW IN PAKISTAN

Tax liability is Rs. 2,425,500 and deferred tax Rs. 148,500 while calculating tax as percentage of tax profit.

Tax liability @ 1% of turnover is Rs. 3,000,000/- and actual payment is Rs.3,000,000/-

Company is paying higher tax.

(i) Can there be any deferred tax? (Liability or assets) If so, how much??
(ii) Is there any temporary difference?

SECOND EXAMPLE

If fixed assets are revalued, does it give rise to any deferred tax (liability or assets)? Whereas tax laws in Pakistan does not recognize any revaluation and calculates depreciation on cost (reducing balance).

Let me make the second example more explicit.

Year 3

Fixed Asset – Machinery is re-valued on 1st July to Rs. 3.000 million

Accounting Tax

Sales 300,000,000 300,000,000
========= ==========
Profit 8,000,000    8,000,000
Dep.   300,000               121,500
========= ==========
Net Profit 7,700,000 7,878,500

Income tax 33% 2,541,000 2,599,905
Sec. 113 – tax 3,000,000 3,000,000

Actual payment of tax is Rs. 3,000,000. Our tax law does not recognize the revaluation of fixed asset. Depreciation is calculated on written down value (initial allowance + dep.). What is the deferred tax?

My understanding is that deferred tax comes into play only and only if tax is calculated as percentage of income. If Sec.113 applies throughout there cannot be any deferred tax (liability or asset). We have to look at the things in the light of our income tax law.

Fixed Asset Schedule

1st Year Accounting Tax

Cost 2,000,000 2,000,000
Initial allowance 25% – 500,000
Depreciation 10% 200,000 150,000
200,000 650,000
======= =======
W.D. Value 1,800,000 1,350,000

2nd Year
Depreciation 10% 180,000 135,000
W.D. Value 1,620,000 1,215,000
======= =======
3rd Year
Machinery revalued 3,000,000 1,215,000
Depreciation 10% 300,000 121,500
2,700,000 1,093,500
======= =======

Opinion:

The Committee would like to draw your attention to the following paragraphs of IAS 12 ‘Income Taxes’ (underline is ours):

‘Current tax’ is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period.

‘Taxable profit (tax loss)’ is the profit (loss) for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable (recoverable).

15 A deferred tax liability shall be recognised for all taxable temporary differences, except to the extent that the deferred tax liability arises from:

(a) the initial recognition of goodwill; or
(b) the initial recognition of an asset or liability in a transaction which:
(i) is not a business combination; and
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

However, for taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint arrangements, a deferred tax liability shall be recognised in accordance with paragraph 39.

16 It is inherent in the recognition of an asset that its carrying amount will be recovered in the form of economic benefits that flow to the entity in future periods. When the carrying amount of the asset exceeds its tax base, the amount of taxable economic benefits will exceed the amount that will be allowed as a deduction for tax purposes. This difference is a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability. As the entity recovers the carrying amount of the asset, the taxable temporary difference will reverse and the entity will have taxable profit. This makes it probable that economic benefits will flow from the entity in the form of tax payments. Therefore, this Standard requires the recognition of all deferred tax liabilities, except in certain circumstances described in paragraphs 15 and 39 (underline is ours).

24 A deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised, unless the deferred tax asset arises from the initial recognition of an asset or liability in a transaction that:

(a) is not a business combination; and
(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

However, for deductible temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint arrangements, a deferred tax asset shall be recognised in accordance with paragraph 44.

Following paragraphs of ICAP’s Technical Release (TR – 27) ‘IAS-12, Income Taxes (Revised 2000)’ also supports this fact:

3.1 In case in a particular year, current tax liability is calculated under provisions of Section 113 due to taxable loss the effect of temporary differences should be calculated and deferred tax liability/ asset should be recognized. (underline is ours)

3.3 A deferred tax asset should be recognized for the carry forward of unused tax losses and unused tax credits (as allowed under the provisions of the Income Tax Ordinance, 2001) to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilized.

Based on above, the Committee is of the view that calculation and accounting of deferred tax is required when an entity is paying tax under Section 113 of the Income Tax Ordinance, both in the case of temporary differences arising from accelerated depreciation and revaluation of fixed assets.

However, your attention is also drawn to para 24 (reproduced above) and para 27 & 28 of IAS 12:

27 The reversal of deductible temporary differences results in deductions in determining taxable profits of future periods. However, economic benefits in the form of reductions in tax payments will flow to the entity only if it earns sufficient taxable profits against which the deductions can be offset. Therefore, an entity recognises deferred tax assets only when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised.

28 It is probable that taxable profit will be available against which a deductible temporary difference can be utilised when there are sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity which are expected to reverse:

(a) in the same period as the expected reversal of the deductible temporary difference; or
(b) in periods into which a tax loss arising from the deferred tax asset can be carried back or forward.

In such circumstances, the deferred tax asset is recognised in the period in which the deductible temporary differences arise

Keeping in view the above, the Committee is of the view that deferred tax assets will only be recognised when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised. Therefore, in Committee’s opinion deferred tax should be recognized to the extent of deferred tax liability recognized on taxable temporary differences and for any additional recognition of deferred tax asset the conditions as laid down in para 24 of IAS 12 as reproduced above should be satisfied.

The Committee would also like to refer its previous Selected Opinions No 1.13 of Volume 19 ‘Deferred Tax’ and Selected Opinion No. 1.9 of Volume 16 ‘Deferred tax – revaluation surplus on building’ for your guidance which addresses your issues.

(December 02, 2015)