Prior to the amendments, IAS 12 required that deferred tax assets and liabilities be recognised for all taxable and deductible temporary differences, except to the extent that the deferred tax asset or 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).
A common example where the ‘initial recognition exemption’ applies is for the purchase of a luxury motor vehicle costing $90,000 that is only eligible for tax deductions of $50,000. At initial recognition, there is a taxable temporary difference of $40,000 between the carrying amount of the motor vehicle ($90,000) and its tax base ($50,000). In this example, the initial recognition exemption is used, and no deferred tax liability is recognised, for this $40,000 taxable temporary difference because:
- It does not arise from the initial recognition of goodwill
- It was not acquired as part of a business combination, and
- At initial recognition, neither profit or loss or taxable profit are affected.
However, deferred tax is recognised to the extent that accounting depreciation and tax depreciation for the $50,000 tax deductible portion of the asset differ during the asset’s life as shown in the table in Example 1 below.
Example 1
Using the fact pattern for the luxury vehicle above (i.e., cost of $90,000 and tax base of $50,000), the example below assumes the following:
-
Tax rate is 20%
- The entity depreciates motor vehicles using a straight-line basis for accounting purposes of 20% (i.e., $10,000 for 5 years), and tax purposes of 25% (i.e., $12,500 for 4 years)
- Accounting profit is $70,000 in each of years 1-5 before accounting depreciation of $10,000.
Year
($)
|
Carrying value at end of each year
|
Tax base at end of each year
|
Taxable temporary difference
|
Deferred tax liability @ 20% tax rate
|
Accounting profit ($70,000 - $10,000)
|
Taxable profit ($70,000- $12,500)
|
Current tax expense
(i.e. taxable profit X 20%)
(A)
|
Deferred tax expense
(B)
|
Combined tax expense (A+B)
|
$ |
$ |
$ |
$ |
$ |
$ |
$ |
$ |
$ |
$ |
0 |
50,000 |
50,000 |
- |
- |
- |
- |
- |
- |
- |
1 |
40,000 |
37,500 |
2,500 |
500 |
60,000 |
57,500 |
11,500 |
500 |
12,000 |
2 |
30,000 |
25,000 |
5,000 |
1,000 |
60,000 |
57,500 |
11,500 |
500 |
12,000 |
3 |
20,000 |
12,500 |
7,500 |
1,000 |
60,000 |
57,500 |
11,500 |
500 |
12,000 |
4 |
10,000 |
- |
10,000 |
2,000 |
60,000 |
57,500 |
11,500 |
500 |
12,000 |
5 |
- |
- |
- |
- |
60,000 |
70,000 |
14,000 |
(2000) |
12,000 |
Recognising a deferred tax liability during the life of the luxury motor vehicle results in a tax charge in profit or loss that corresponds to the period when accounting depreciation is recognised (or carrying value of asset is recovered), rather than when the vehicle is deductible for tax purposes. This is evident by the consistent $12,000 tax charge recognised each year as shown in the table above. However, the $40,000 non-deductible portion of the vehicle will result in a ‘permanent difference’ because it results in an accounting deduction in profit or loss but there will never be a corresponding tax deduction for this amount.