Deferred Tax Explained: A Complete Guide to IAS 12 (With Examples)

What Is Deferred Tax?

Deferred tax is income tax that will be paid or recovered in a future period because the financial statements and the tax return recognise the same income or expense in different years. IAS 12 Income Taxes requires it so that the tax effect of a transaction is recognised in the same period, and in the same statement, as the transaction itself.

Tax law often follows its own timing. A machine may be depreciated over four years in the financial statements while the tax authority allows most of its cost as a deduction in the first year. Tax payable would then be low in the first year and higher afterwards, although the business and its profit had not changed.

A deferred tax liability is tax postponed to a later year; a deferred tax asset is tax paid ahead of time, or a tax saving still to come. The result is a tax charge in the income statement that reflects the profit actually reported, rather than the timing of the tax return. The effective tax rate therefore equals the statutory rate, except for permanent differences such as non-deductible expenses and exempt income.

Accounting Profit vs Taxable Profit

The income tax expense in profit or loss has two components:

• Current tax: the tax payable for the year, calculated on taxable profit in the tax return.
• Deferred tax: the movement in deferred tax balances during the year. An increase in a deferred tax liability, or a decrease in a deferred tax asset, is a deferred tax expense. The reverse is deferred tax income, which reduces the total tax expense.

Taxable profit starts with accounting profit and applies the tax law's own rules. The adjustments fall into two groups.

Permanent differences never reverse. A fine that tax law never allows as a deduction, or a dividend that is exempt from tax, never impacts taxable profit, but affects accounting profit in at least one year.

Temporary differences reverse. The item is recognised in full by both systems, only in different periods. Depreciation against tax allowances, provisions deducted only when paid and income taxed when received rather than when earned are the most common examples.

A company reports profit before tax of 1,000,000. Included in that figure are a non-deductible fine of 20,000, exempt dividend income of 50,000, and depreciation of 25,000 on a machine for which tax allows 40,000 this year.

Deferred tax is calculated on temporary differences only. Permanent differences are excluded from the calculation entirely; they remain as the difference between the tax expense and tax at the statutory rate, explained in the tax rate reconciliation covered later in this guide.

The same applies where only part of an asset is deductible. A building costs 1,000,000, of which only 600,000 qualifies for tax allowances. Only the carrying amount of the 600,000 portion is compared with its tax base, and depreciation on the remaining 400,000 is a permanent difference. In IAS 12 terms, the non-deductible portion falls under the initial recognition exemption, covered under exceptions below.

The Tax Base

Although the idea starts with profit, IAS 12 measures deferred tax from the statement of financial position. Every asset and liability is compared with its tax base, the amount attributed to it for tax purposes. This balance sheet approach captures every timing difference, including those that bypass profit or loss entirely.

Tax base of an asset: the amount that will be deductible for tax against the taxable economic benefits the asset generates when its carrying amount is recovered. Where those benefits will not be taxable, the tax base equals the carrying amount.

For a depreciable asset, the tax base is cost less the tax allowances claimed to date. As depreciation reduces the carrying amount over the asset's life, allowances reduce the tax base in the same way. The temporary difference is the difference between the two, and it falls to nil once both are fully written off.

Tax base of a liability: its carrying amount, less any amount that will be deductible for tax in future periods. For income received in advance, it is the carrying amount less any amount that will not be taxable in future.

Common Temporary Differences

• Property, plant and equipment, where depreciation differs from tax allowances
• Revaluations and investment property at fair value, where the tax base stays at cost
• Provisions deductible only when paid, such as leave pay, bonuses and warranties
• Income received in advance and taxed on receipt
• Allowances for credit losses, where only part is deductible
• Right-of-use assets and lease liabilities
• Fair value adjustments on financial instruments
• Cash-settled share-based payments
• Fair value adjustments on assets and liabilities acquired in a business combination

Items With a Tax Base but No Carrying Amount

Some costs are expensed immediately in the financial statements, while tax law allows the deduction only in later periods. Nothing is recognised in the statement of financial position, but the amount still deductible in future is the tax base. The result is a deductible temporary difference and a deferred tax asset, subject to the recoverability test covered below. Examples include:

• Research costs expensed under IAS 38, where tax law spreads the deduction over later years.
• Pre-trade expenditure incurred before a business starts trading, which in South Africa (section 11A) becomes deductible only once trade commences.
• Unused tax losses. IAS 12 does not call these temporary differences, but they work the same way: no carrying amount, a future deduction, and a deferred tax asset to the extent that it is recoverable.

Example. A company spends 90,000 on research and expenses it in full. Tax law allows the deduction in three equal instalments, starting in the current year. At year-end, 60,000 is still deductible, so the tax base is 60,000 against a carrying amount of nil. At 25%, a deferred tax asset of 15,000 is recognised.

In a business combination the position is often reversed. The acquirer recognises in-process research and development as an intangible asset at fair value, even though the acquiree expensed the costs. The asset has a carrying amount but usually no tax base, which gives rise to a deferred tax liability that increases goodwill.

Items With No Temporary Difference

No temporary difference arises where tax law recognises an item in the same period as the financial statements, because the tax base then equals the carrying amount. Common examples are:

• Accrued expenses deductible when incurred, such as an electricity accrual. The deduction has already been claimed, so nothing remains deductible in future.
• Trade payables for goods and services already deducted.
• Trade receivables for revenue already included in taxable income.
• Loans and cash, whose repayment or recovery has no tax effect.
• Inventory, where its value for tax purposes follows the accounting measurement.

Deferred Tax Assets and Liabilities

A taxable temporary difference will increase taxable profit when it reverses and gives rise to a deferred tax liability. A deductible temporary difference will reduce taxable profit when it reverses and gives rise to a deferred tax asset.

Applied to the earlier table at a tax rate of 25%, the machine (15,000) and the prepaid insurance (12,000) give a deferred tax liability of 6,750. The leave pay accrual (30,000) and the income received in advance (20,000) give a deferred tax asset of 12,500.

Deferred tax is simply the temporary difference multiplied by the applicable rate. The judgement lies in the tax base, the rate and whether an asset may be recognised.

Practical Example: Accelerated Tax Allowances

A company buys a machine for 100,000 and depreciates it over four years. Tax law allows 40% of the cost in the first year and 20% in each of the following three. Profit before tax is 200,000 every year after depreciation, and the tax rate is 25%.

Now compare the tax expense with and without deferred tax.

Current tax alone would show an effective rate of 23.1% in year 1 and 25.6% thereafter, although nothing about the business changed. With deferred tax, the tax expense is 25% of reported profit in every year. The year 1 journal is:

In years 2 to 4 the entry reverses, 1,250 at a time, as the liability unwinds to nil.

Where Deferred Tax Is Recognised

Deferred tax follows the item that created it (IAS 12.58 to .68):

• Profit or loss where the underlying item was recognised in profit or loss, as with the machine.
• Other comprehensive income where the item was recognised in OCI, such as a revaluation surplus.
• Equity where the item was recognised directly in equity, such as the equity component of a convertible bond.
• Goodwill where the temporary difference arises in a business combination.

Example. Land bought for 500,000 is revalued to 700,000. Its tax base remains 500,000, giving a taxable temporary difference of 200,000. At an effective capital gains rate of 20%, a deferred tax liability of 40,000 is recognised against OCI, and the revaluation surplus is presented net at 160,000.

In a business combination, assets and liabilities are measured at fair value while their tax bases usually stay unchanged, and the resulting deferred tax adjusts goodwill. Our guide to leases in a business combination shows this for acquired leases.

Measuring Deferred Tax

Tax Rate

Deferred tax is measured at the tax rates expected to apply when the temporary difference reverses, based on laws enacted or substantively enacted by the reporting date. A rate announced after year-end is not used, but it is disclosed where material. Deferred tax is never discounted, however distant the reversal.

Manner of Recovery

The measurement reflects how the entity expects to recover the asset. A building recovered through use attracts the normal income tax rate, while the same building expected to be sold may attract capital gains tax on the portion of the gain above cost. IAS 12 presumes that revalued land, and investment property at fair value, are recovered through sale. The presumption for investment property can be rebutted.

In South Africa, for example, only 80% of a company's capital gain is included in taxable income, so the portion of a revaluation above cost carries an effective rate below the normal rate.

Changes in the Tax Rate

When the rate changes, the whole opening balance is remeasured. In the machine example, suppose the rate falls from 25% to 24% during year 3. The opening liability of 2,500 (10,000 at 25%) is remeasured to 2,400. The decrease of 100 is credited to profit or loss, because the original deferred tax was recognised there. Had it been recognised in OCI, the effect would go to OCI.

Recognising Deferred Tax Assets and Tax Losses

A deferred tax liability is recognised in full. A deferred tax asset is recognised only to the extent that it is probable that taxable profit will be available to use it against. The sources of that profit are:

1. Taxable temporary differences with the same tax authority, reversing in the same periods.
2. Forecast taxable profit in those periods.
3. Tax planning opportunities that would create taxable profit.

Unused tax losses follow the same test, but a history of recent losses demands convincing evidence of future profit (IAS 12.35).

Example. A company has an assessed loss of 400,000 and taxable temporary differences of 120,000 on its plant. Budgets support further taxable profit of 180,000 over the period the loss can be used. At 25%:

The unrecognised 25,000 is disclosed, and it increases the tax expense relative to the statutory rate in the year the loss arises. The assessment is repeated at every reporting date: when the outlook improves, the previously unrecognised amount is recognised and reduces the tax expense, and when it deteriorates, the recognised asset is reduced.

Exceptions

IAS 12 requires deferred tax on all temporary differences, with a small number of exceptions.

Initial recognition of goodwill. No deferred tax liability is recognised on goodwill that is not deductible for tax.

Initial recognition exemption. No deferred tax is recognised on an asset or liability that arises in a transaction that is not a business combination and, at the time, affects neither accounting profit nor taxable profit. A building bought for cash on which no tax allowances are available is the usual example; the difference is never recognised, and the related depreciation becomes a permanent item in the tax rate reconciliation.

Since 2023, the exemption no longer applies where a transaction creates equal taxable and deductible temporary differences, such as a lease or a decommissioning obligation. Both sides are recognised from day one, as set out in our guide to deferred tax on leases.

Investments in subsidiaries, branches, associates and joint arrangements. A deferred tax liability is not recognised where the investor controls the timing of the reversal and it is probable the difference will not reverse in the foreseeable future, as with a parent that does not intend to distribute a subsidiary's retained profits.

Pillar Two top-up taxes. A mandatory, temporary exception prohibits recognising deferred tax related to the OECD global minimum tax rules; specific disclosures are required instead.

Presentation and the Tax Rate Reconciliation

Deferred tax assets and liabilities are always presented as non-current.

Offsetting

Each temporary difference, and each unused tax loss, gives rise to its own deferred tax asset or liability. The machine, the leave pay accrual and the assessed loss in this guide each carry a separate balance. For presentation, IAS 12.74 requires deferred tax assets and liabilities to be offset if, and only if:

• the entity has a legally enforceable right to set off current tax assets against current tax liabilities; and
• the balances relate to income taxes levied by the same tax authority on the same taxable entity, or on different entities that intend to settle current tax on a net basis.

A single company taxed in one jurisdiction usually meets both conditions, so it presents one net deferred tax asset or liability, with the gross components analysed in the notes. Balances of different group companies are offset only where they settle tax on a net basis, and balances in different countries are not offset. A group with operations in several countries therefore usually presents both a deferred tax asset and a deferred tax liability.

Tax Rate Reconciliation

The notes explain the tax charge through a tax rate reconciliation, from tax at the statutory rate on accounting profit to the actual tax expense. Continuing the example from the start of this guide, at 25%:

The depreciation and tax allowance do not appear, because deferred tax has already absorbed that timing difference. Typical reconciling items are permanent differences, unrecognised deferred tax assets, prior year adjustments, rate changes, capital gains taxed at a lower effective rate and differences in foreign tax rates. A timing difference that remains in the reconciliation year after year usually points to a tax base that has been determined incorrectly. Each item, and how to build the reconciliation, is covered in our guide to the tax rate reconciliation.

The notes also analyse the deferred tax balance by type of temporary difference (plant, provisions, leases, tax losses) and disclose unrecognised deferred tax assets and the related expiry dates.

Conclusion

Deferred tax reduces to three steps. First, determine each item's tax base and compare it with its carrying amount to find the temporary differences. Second, measure them at the rate expected to apply when they reverse, reflecting how the asset will be recovered. Third, recognise the liabilities in full and the assets only to the extent that future taxable profit makes them recoverable, subject to the exceptions in IAS 12.

For the lease-specific application, see our guides to deferred tax on leases and the tax treatment of leases in South Africa.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.