Deferred Tax - Explained from the basics in detail

The concept of deferred tax is unknown to many and misunderstood by the rest. To understand deferred taxes, it is first important to gain conceptual clarity on certain ancillary legal terms. Depreciation: When you buy machinery or equipment and put it to use, over time and with use, the machines capacity to perform reduces. This natural wear and tear is called depreciation. Mathematically, there are two prominent schools of thought when it comes to how depreciation must be calculated. Straight Line Method of Depreciation (SLM): Here, the life of the machine is estimated in years (standardized as per usage in various industries), and then the value of the machinery is written off equally over this estimated life. For example, if a machine is bought for Rs.10000 and its estimated life as per industry standards is 5 years, Rs. 2,000 must be written off every year. Written-Down Value method of depreciation (WDV): Here, an estimate of the percentage of wear and tear that is expected to occur on the machine is made. Every year, that percentage is reduced from the value of the machinery as at the end of the year. Taking the same example of a machine costing Rs.10000, if the industry standard estimate is that 20% of the value of the machine gets depleted every year, at the end of the first year, Rs. 2,000 will be written off (20% of Rs.1000def0). During the next year, the depreciation will be Rs. 1600, being 20% of Rs. 8000 (as Rs. 2,000 has been written off in the previous year), and so on. Temporary Difference concept: As can be seen above, under SLM, the depreciation for the five years will be Rs. 2000 every year for 5 years, at the end of which the value of the asset will be nil. However, under WDV, the depreciation @ 20% per year will be different amounts for the 5 years at the end of which the value of the asset will be 3,276.8 (depreciation @ 20% for 5 years will be Rs.2,000, Rs.1,600, Rs.1,280, Rs.1,024, Rs. 819.20 respectively.) This difference between the first method and the second method is called temporary difference. It is temporary because even under WDV, the value of the asset is going to come down to nil at some point of time. Contrary provisions of the Income Tax Act and Companies Act, 1956 While the Companies Act, 1956 recommends that companies follow SLM for depreciation, the Income Tax Act, 1961 has provided that while deducting depreciation from total income for income tax calculation, the depreciation must be calculated as per WDV. Hence this causes a temporary difference as per the books

of the company and the Income tax calculation. This causes the creation of deferred tax asset/ liability. Deferred tax asset - When the depreciation for the Books (SLM) is higher than the depreciation for Income Tax (WDV), then the companys taxable income is higher than its actual income, as lesser depreciation is deducted from the total income than the actual depreciation. Consequently the company pays more income tax than it rightfully should, on account of the temporary difference. This temporary difference is called a deferred tax asset and can be carried forward by the company in its balance sheet and used to set-off future taxes. Deferred tax liability - On the other hand, the depreciation for books (SLM) can be lower than the depreciation for taxation (WDV), or the asset may be written off in the books (making the depreciation nil) but has some depreciable value for income tax. In this case, the taxable income of the company will be lower than the actual income, as more depreciation has been deducted from the total income than the actual depreciation. Hence, the company ends up paying lesser tax than it actually should be paying, again on account of the temporary difference. This time, the temporary difference is a deferred tax liability and has to be carried forward in the books in the balance sheet. Criticisms Having fixed methods to calculate depreciation itself has been criticized as unrealistic. The depreciation of machinery is dependent on the usage and the efficiency of the user. Giving a standard rate of depreciation has encouraged companies to write off large amounts as depreciation to reduce profits and hence their tax liabilities. So while the books would show that the machine is written of and obsolete, in actuality, the machine would be fully operational and productive. Secondly, the whole complex concept of deferred tax came into existence because the two Acts, the Companies Act and the Income Tax Act, failed to reconcile their stand on which method of depreciation to follow. What has resulted is another avenue of unnecessary taxation involving complex calculations and lengthy disclosures.
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