Deferred tax when different tax rates apply
“I work in a country with more than one tax rates and I have issues with the correct calculation of our deferred taxes. It relates to our buildings.
In a country where I work there are two different rates related to buildings. When we sell the building on profit, we have to pay capital gain tax on property of 30%. But when we do not sell it, but use it, we charge depreciation and pay tax on profit of roughly 25%.
I understand that when I only buy asset for sale, I make deferred tax at 30% and when we plan to use the asset without selling it, we calculate deferred tax at 25%.
What about the situation when we use the asset for some time, charge depreciation and then we sell it on profit? Thus we apply two different rates.
How to calculate deferred tax in this case?”
Answer: IAS 12 guidance
Let’s take a look at IAS 12 Income taxes for some guidance.
IAS 12 Income tax says in the article 51 that the deferred tax should be measured by the reference to the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of the asset or a liability to which it relates.
In other words, when you operate in a country that charges different tax rates on capital gains and on profit, then you really need to examine what you are going to do with your asset.
How are you going to recover that asset?
Illustration: Different expected recovery of an asset
Let’s say you bought a building with cost of 100 000 CU.
Then you charged depreciation and at the end of the year its carrying amount is 95 000 CU.
Then you charged tax depreciation of 10 000 CU – or in other words, you deducted 10 000 CU to arrive at taxable profit.
So, your tax base is basically the cost of 100 000 less tax allowance or tax depreciation of 10 000 – which is 90 000 CU.
Your carrying amount is 95 000 CU.
There is a difference of 5 000 CU.
But what is the deferred tax? Let’s say that the tax on profit is 25% and capital gain tax is 30%.
If you are going to sell the asset the next year, then you need to apply the rate applicable for capital gains, that is 30% and your deferred tax liability is 1 500 CU, which is the difference of 5 000 multiplied with 30%.
It’s the deferred tax liability, because the carrying amount is higher than the tax base.
But if you plan to use the asset until the end of its useful life, fully depreciate it and then demolish the building, then you need to apply the tax rate on profits which is 25% and your deferred tax would be the difference of 5 000 multiplied with 25% which is 1 250.
I made this short illustration simple on purpose and it applies if the building is sold the next year – so if the full carrying amount as at the end of the year is used to sell an asset and not for other purpose.
Not sure how exactly an asset will be recovered?
What happens if you know that one day in a future you are going to sell the building, just you do not know when?
And, at the same time you know that the part of that building will be recovered via using it and another part will be recovered via selling.
How to calculate deferred tax in this case?
OK, so it requires a little work and believe me, there is no precise guidance in IAS 12.
Thus we need to employ the logic, search in other rules and do some work.
So, as for buildings – if they are classified as property, plant and equipment under IAS 16 and not as investment property under IAS 40, you should calculate the depreciation of these buildings as a depreciable amount divided by the useful life.
What is depreciable amount?
It is in fact the cost of an asset less its residual value.
And, the residual value is the estimated amount that an entity would currently obtain from disposal of the asset after deducting estimated cost of disposal if the asset were already of the age and condition expected at the end of its useful life.
What does that all imply?
If you plan to sell the building after some time, then it has some residual value and you have to determine it.
You are effectively assuming, that you expect:
- To recover the depreciable amount of your building through its use and
- To recover the residual value through its sale.
Therefore, you need to split the asset’s carrying amount and the tax base in two parts and calculate the deferred tax separately on each part.
Illustration: “Dual-based” asset
Let’s say that the building from our first example has residual value of 10 000 and in the case of sale, you have the right to deduct the same tax allowances as in the case of using the asset and then demolishing it. Just to make the things simple.
You plan to use the building for 20 years and then sell it. The annual tax allowance is 10 000 CU for the next 10 years.
At the end of year 1:
- Your carrying amount is CU 95 500, thereof:
- CU 10 000 is residual value to be recovered via sale after 20 years,
- CU 85 500 is depreciable amount less 1-year of depreciation charge.
- Your tax base is CU 90 000, thereof:
- CU 90 000 are future tax allowances within the next 9 years that will be recovered via building’s use,
- CU 0 are future tax allowances that will be recovered via building’s sale. It is logical because if you use all allowances in the first 10 years, there’s nothing left for sale. Of course, check up your own tax rules – this is just an example I made up.
In this case, the deferred tax is:
- Related to the recovery via building’s use: CU (85 500 – 90 000)*25% which is tax on profits = CU 1 125. This is a deferred tax asset because your carrying amount is lower than the tax base.
- Related to the recovery via building’s sale: CU (10 000 – 0)*30% = CU 3 000. This is a deferred tax liability since the carrying amount is higher than the tax base.
Net is off and you get the net deferred tax liability of CU 1 875.
That’s approximately how you should analyze the expected manner of recovery of your assets.
Always think, especially when different tax rates apply, if you are going to use, or sell, what tax allowances you can get in both cases etc.
Any questions or comments?
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wheather deffered tax asset of previous year would be adjusted against defferd tax liability of current year
will you plz explain the para 64 of IAS 12 with example?
Hello Silwia, if we divide 1875 by 5500 we get an implied tax rate of 34%. I can’t wrap my head aroud this. How this is an higher rate than both tax rates used (25% and 30%)? Would you know why?
Hi Marc, hmhm, it’s not OK to calculate effective tax rate purely with deferred tax on separate isolated items. You calculate the effective tax rate by comparing total tax expense (current tax and deferred tax) with the accounting profit. The logic is as follows:
– total current tax “income” is tax depreciation of 10 000 multilpied with 25% = + 2 500 – that’s the amount that actually decreased your current income tax expense because of tax allowance.
– actual tax that you should have paid based on accounting depreciation is 4 500 x 25% = – 1 125.
Thus you overpaid by 1 375 and you will have to pay this in the future – if the tax rates are the same.
BUT – you will tax a big portion at higher tax – that’s why your future (deferred) tax liability is higher than 1 375 – it is 1 875 reflecting future higher tax rate.
So, calculating “implied tax rate” makes no practical sense. And, it’s OK that is does not fall within 25 and 30%, because one is asset and the other one is much bigger liability 🙂
Thank you for your explanation, you’re right, we need to take the total tax impact and not just the deferred tax figure.
Out of curiosity I checked (with Excel) the tax impact on the P&L for every year of use of this asset.
The first year, the tax decrease that the asset is 2500 (25% of 10 000) -1875 [the deferred tax liability increase] = -625
The second year is 2500-( (80000-81000) ∗25% – 1875)) = -1125
It’s the same amount for every year: -1125
Even for year 20: we have a decrease in deferred tax liability of 4125 and we must pay 10000 ∗30% 3000-4125=1125
But I think it’s normal that we take the impact of the higher tax rate the first year: the higher tax rate because of final disposal is already known from the beginning.