What Is a Tax Rate Reconciliation?
A tax rate reconciliation explains why the income tax expense is not simply profit before tax multiplied by the statutory tax rate. IAS 12.81(c) requires it in the income tax note, presented as amounts, as rates, or both:
- Amounts: from tax at the applicable rate on accounting profit to the income tax expense.
- Rates: from the applicable (statutory) rate to the average effective tax rate, being the tax expense divided by profit before tax.
Users rely on it to judge whether the effective tax rate is sustainable. A rate held down by the once-off use of an old tax loss, for example, will not repeat, while exempt dividend income may recur every year.
How to Think About It
Start from one question: if every amount in profit before tax were taxed at the statutory rate, and nothing else affected the charge, what would the tax expense be? The reconciliation then lists each reason the actual expense differs from that figure.
Because of deferred tax, timing does not cause a difference. When depreciation and tax allowances differ, current tax changes but deferred tax moves by the same amount in the opposite direction. The combined expense stays at the statutory rate on the accounting amount.
Reconciling items therefore come from four sources:
- Permanent differences: income or expenses that will never be taxed or deducted in full.
- Temporary differences without deferred tax: deferred tax assets not recognised, or later utilised or recognised, and items covered by the initial recognition exemption.
- Tax relating to other periods: prior year under or over provisions and the effect of rate changes on opening deferred tax.
- Different rates: capital gains, foreign subsidiaries and other income taxed at a rate other than the applicable rate.
Each item is measured as the amount multiplied by the statutory rate, except where the item is itself a tax amount, such as a prior year adjustment.
Common Reconciling Items
| Item | Effect on tax expense |
|---|---|
| Non-deductible expenses (fines, penalties, donations above the deductible limit, expenses incurred to produce exempt income) | Increase |
| Depreciation on assets that qualify for no tax allowance, where the initial recognition exemption applies | Increase |
| Exempt income (local dividends received) | Decrease |
| Capital gains taxed at a lower effective rate | Decrease |
| Additional or special tax allowances above cost | Decrease |
| Share of profit of associates and joint ventures (already after tax) | Decrease |
| Tax losses and deductible temporary differences on which no deferred tax asset is recognised | Increase |
| Utilisation or recognition of previously unrecognised tax losses | Decrease |
| Prior year under (over) provision | Increase (decrease) |
| Rate change on opening deferred tax recognised in profit or loss | Either |
| Foreign subsidiaries taxed at different rates | Either |
Capital gains in South Africa
Companies include 80% of a net capital gain in taxable income, an effective rate of 21.6% against the 27% statutory rate. The reconciling item is the accounting gain multiplied by the 5.4% difference, assuming the accounting gain equals the capital gain.
Unrecognised Deferred Tax Assets
A tax loss or deductible temporary difference exists whether or not a deferred tax asset is recognised for it. When recovery is not probable, the tax benefit is simply not recorded, so the expense is higher than the statutory rate implies. When that unrecognised amount is later utilised against taxable profit, or recognised because recovery has become probable, the expense is lower. Over the life of the loss, the net movement in the unrecognised amount appears in the reconciliation.
What Does Not Appear
- Temporary differences on which deferred tax is recognised, such as depreciation against tax allowances, provisions deductible when paid and lease liabilities and right-of-use assets.
- Tax on items in other comprehensive income or equity, such as deferred tax on a revaluation surplus, including the effect of a rate change on those balances. The reconciliation explains tax in profit or loss only.
A timing difference that recurs in the reconciliation each year usually indicates an incorrect tax base or omitted deferred tax, not a genuine reconciling item.
Practical Example
Karoo Ltd reports profit before tax of 2,000,000. The statutory rate is 27%. Profit before tax includes:
- a non-deductible fine of 40,000;
- local dividends received of 100,000, exempt from tax;
- a profit of 300,000 on the sale of land held at cost, equal to the capital gain;
- depreciation on a machine of 200,000, against a tax allowance of 350,000.
At the previous year end, the company had an assessed loss of 100,000 on which no deferred tax asset was recognised; it is fully utilised this year. The prior year's current tax was under provided by 12,000.
Step 1: Current Tax
| Current tax computation | Amount |
|---|---|
| Profit before tax | 2,000,000 |
| Fine (non-deductible) | 40,000 |
| Exempt dividends | (100,000) |
| Accounting profit on land | (300,000) |
| Taxable capital gain (300,000 × 80%) | 240,000 |
| Depreciation | 200,000 |
| Tax allowance | (350,000) |
| Assessed loss brought forward | (100,000) |
| Taxable income | 1,630,000 |
| Current tax at 27% | 440,100 |
Step 2: Income Tax Expense
The machine's carrying amount falls by 150,000 more than its tax base, increasing the deferred tax liability by 40,500 (150,000 × 27%). The land was held at cost, so its carrying amount equalled its tax base and carried no deferred tax.
| Income tax expense | Amount |
|---|---|
| Current tax: current year | 440,100 |
| Current tax: prior year under provision | 12,000 |
| Deferred tax: machine | 40,500 |
| Income tax expense | 492,600 |
Step 3: Tax Rate Reconciliation
| Tax rate reconciliation | Amount | Rate |
|---|---|---|
| Tax at 27% on profit before tax of 2,000,000 | 540,000 | 27.00% |
| Non-deductible fine (40,000 × 27%) | 10,800 | 0.54% |
| Exempt dividends (100,000 × 27%) | (27,000) | (1.35%) |
| Capital gain at lower rate (300,000 × 5.4%) | (16,200) | (0.81%) |
| Utilisation of previously unrecognised tax loss (100,000 × 27%) | (27,000) | (1.35%) |
| Prior year under provision | 12,000 | 0.60% |
| Income tax expense / effective tax rate | 492,600 | 24.63% |
The reconciliation agrees to the expense built up in Step 2. The machine does not appear: the 150,000 difference reduced current tax by 40,500, and deferred tax added the same 40,500 back.
Of the 2.37 percentage point reduction, only the exempt dividends and possibly the capital gain are likely to recur. The tax loss benefit and prior year adjustment are once-off, so a user would expect a rate closer to 27% in the following year.
Presenting the Reconciliation
- Disclose the rate and its basis. State the applicable rate and explain any change from the prior year, as required by IAS 12.81(d).
- Groups. IAS 12.85 allows the parent's domestic rate or an aggregate of reconciliations prepared for each jurisdiction. Groups using the parent's rate show foreign rate differences as a reconciling item.
- Aggregation. Group small items into "other", but show material items separately and describe them clearly. An unlabelled "other" line that is material weakens the note.
- Verification. Prepare the reconciliation independently and agree it to the tax expense built up from current and deferred tax. A difference usually points to a temporary difference without deferred tax, a sign error, or an item from other comprehensive income included in error.
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Conclusion
The tax rate reconciliation starts with profit before tax at the statutory rate and explains every item that causes the income tax expense to differ from it: permanent differences, unrecognised deferred tax, tax relating to other periods and income taxed at other rates. Temporary differences on which deferred tax is recognised do not appear, because deferred tax offsets them.
For the underlying principles, see our complete guide to deferred tax 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.