What is Deferred Tax Liability?

Companies have to maintain a profit and loss statement, balance sheet and other important records for the benefit of shareholders and company auditors. And since these are maintained according to the financial year, there are certain instances where purchases and sales might be spread over more than one financial year.

This can affect a company’s tax obligations. And cause a deferred tax liability in particular. And if you’re wondering what this is, you’re in the right place.

Here, we discuss deferred tax liability, its meaning, examples, how you can calculate it and more.

What is deferred tax liability?

A deferred tax liability meaning a record on a company’s balance sheet, is one that specifies taxes that the company must pay in the following tax payment cycle and not the current one.

In other words, a deferred tax liability takes place when an obligation to pay tax arises in a financial year but is due for payment in the subsequent year. This obligation is initially recorded in the profit and loss statement before getting recorded in the balance sheet under ‘non-current liabilities’.

Additionally, it’s important to note that a deferred tax liability is based on a subsequent event the company is sure will occur. It cannot be added to the balance sheet if there is reason to question its certainty.

Deferred tax liability examples

Here are some examples of how deferred tax liability can arise for a company. 

#1. Asset depreciation

The most common example of deferred tax liability arises due to a difference in depreciation rates. The depreciation rate defined by the income tax department could be higher than the one specified by the company.

This usually happens in the early years of an asset’s life. In such situations, the company’s profit will be higher in its own books as compared to tax reports. And this, in turn, will give rise to deferred tax liability.

#2. Instalment sale

The next example of deferred tax liability is an instalment sale. This is when companies recognise a sale in its entire value, even though they will receive the payment in future instalments. In other words, the income a company is to receive from a sale will be recorded as complete even though it is yet to receive the income from the sale.

This creates a positive difference between accounting earnings and taxable income temporarily, leading to deferred tax liability.

How to calculate deferred tax liability?

Deferred tax is calculated in accordance with the Ind AS12 (India Accounting Standard 12). This was previously known as Accounting Standard 22. To demonstrate how to calculate deferred tax liability, here we’re taking a case of asset depreciation.

Suppose a company purchased machinery for Rs 80 lakhs on April 1, 2022. This machinery is the only asset on the company’s books. According to the accounting rules, the machinery has a useful life of five years and is depreciated using the straight-line method (SLM).

For tax purposes, the machinery is depreciated at a rate of 30% per year. The effective tax rate applicable for the company is 32.5% (Base rate 30% + surcharge 2.5%).

Now, the deferred tax for the financial year 2022-2023 will read as follows.

Since the depreciation charged as per accounting books is lower than the depreciation as per the Income tax rules, the profit calculated as per accounting books is higher. This difference creates a deferred tax liability. To put it simply,

Deferred tax = amount of depreciation as per income tax book - the amount of depreciation as per accounting book

Rs. 8,00,000 (deferred tax) = Rs. 24,00,000 - Rs. 16,00,000

Since deferred tax liability = deferred tax x effective tax rate, the final calculation will be,

Rs 8,00,000 x 32.5% = Rs. 2,60,000

So, the deferred tax liability for the year 2022-23 is Rs. 2,60,000.

Difference between deferred tax liability and deferred tax asset

To better understand what a deferred tax liability is, let’s compare it to a deferred tax asset. Both are a result of variances in tax guidelines and accounting methods. Here’s how these two differ.

Final takeaway

A deferred tax liability is recorded in a company’s books to inform shareholders of outstanding liabilities as well as for clarity on the company’s operations during company audits. While it can be beneficial for companies that need to postpone tax payments, a deferred tax liability must be managed in a timely manner. This is because it can turn hostile if the company experiences losses. The money saved while putting off tax payments to the following year can help companies gain flexibility with their cash flows but, ultimately, must be paid on time to ensure the company’s smooth functioning.

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