IAS 12 Income Taxes requires an entity to account for the tax consequences of recovering or settling the carrying amounts of its assets and liabilities. It does so with the balance sheet liability method: deferred tax is driven by the difference between an asset or liability's carrying amount and its tax base, not by differences between accounting and taxable profit for the year.
Tax base and temporary differences
The tax base of an asset is the amount that will be deductible for tax against the taxable economic benefits when the carrying amount is recovered. The tax base of a liability is its carrying amount less any amount that will be deductible in the future. A temporary difference is the difference between the carrying amount and the tax base.
- Taxable temporary differences will result in taxable amounts in the future when the carrying amount is recovered. They give rise to deferred tax liabilities.
- Deductible temporary differences will result in deductible amounts in the future. They give rise to deferred tax assets.
A simple worked example
An asset has a carrying amount of 1,000 and a tax base of 600, because tax depreciation has been faster than accounting depreciation. The tax rate is 25%.
- Taxable temporary difference = 1,000 − 600 = 400
- Deferred tax liability = 400 × 25% = 100
As the difference reverses in future periods, the liability unwinds through deferred tax expense or income.
Recognition rules
Deferred tax liabilities
A deferred tax liability is recognised for all taxable temporary differences, with limited exceptions: the initial recognition of goodwill, and certain other differences on investments in subsidiaries, branches, associates and joint arrangements where the entity can control the timing of reversal and it is probable the difference will not reverse in the foreseeable future.
Deferred tax assets
A deferred tax asset is recognised for deductible temporary differences, unused tax losses and unused tax credits only to the extent that it is probable that future taxable profit will be available against which they can be used. Where an entity has a history of recent losses, a deferred tax asset for carried-forward losses is recognised only to the extent there are sufficient taxable temporary differences or other convincing evidence of future taxable profit. The asset is reassessed at each reporting date.
The initial recognition exception
Deferred tax is not recognised on the initial recognition of an asset or liability in a transaction that is not a business combination and affects neither accounting profit nor taxable profit at the time. Since the 2021 amendment, effective for annual periods beginning on or after 1 January 2023, this exception does not apply to transactions that give rise to equal taxable and deductible temporary differences on initial recognition, such as leases and decommissioning obligations. Deferred tax is recognised on both sides.
Measurement
- Deferred tax is measured at the tax rates enacted or substantively enacted by the reporting date that are expected to apply when the asset is realised or the liability settled.
- Deferred tax assets and liabilities are not discounted.
- The measurement reflects the manner in which the entity expects to recover or settle the underlying asset or liability.
Where the tax goes: profit or loss, OCI or equity
Current and deferred tax are recognised in profit or loss unless they relate to an item recognised outside profit or loss, in which case the tax follows the item: in other comprehensive income for items such as revaluation of property, plant and equipment, or directly in equity. Tax arising on a business combination is included in the accounting for the combination.
Offsetting and disclosure
Deferred tax assets and liabilities are offset only if there is a legally enforceable right to set off current tax assets against current tax liabilities, and they relate to income taxes levied by the same tax authority on the same taxable entity (or on different entities that intend to settle net or simultaneously). The notes must include a reconciliation between the tax expense and the product of accounting profit and the applicable tax rate, and the amount of each type of temporary difference.
Pillar Two
The IASB's May 2023 amendments introduced a temporary, mandatory exception from recognising and disclosing deferred tax assets and liabilities related to Pillar Two income taxes, together with targeted disclosure requirements about the entity's exposure.
Where this typically goes wrong
- Recognising deferred tax assets on tax losses without sufficient evidence of future taxable profit
- Using the current rate when a different rate is enacted for the period of reversal
- Forgetting deferred tax on fair value adjustments in a business combination
- Applying the old initial recognition exception to leases and decommissioning provisions
- Discounting deferred tax balances
- Offsetting balances across tax authorities or entities that don't meet the conditions