Deferred tax liabilities spring from taxable temporary differences

The temporary differences arise when income or expenses are recorded in accounting profit in one period but in taxable profit in another period, known as timing differences. These differences may result in reduced taxable profits in one tax period while higher taxable profits in the other tax period. Lower taxable profits in a tax period result in a lower tax liability for that period but higher tax liability in future period(s), prompting the taxpayer to recognise a deferred tax liability.

Taxable temporary differences occur when the taxable revenue in the current period is less than the accounting revenue. For instance, X Ltd has accrued interest of Dh50,000 on fixed-term deposits, to be received at the end of a fiveyear term. In the current period’s tax calculation, tax authorities do not acknowledge this accrued interest as income as they usually follow the cash basis of accounting. Consequently, a taxable temporary difference emerges from this accrued interest income.

When tax-deductible expenses exceed accounting expenses in the current period, a temporary difference can result in a deferred tax liability. For instance, a company pays Dh120,000 for three years’ rent in advance. The company’s accounting practice spreads this expense over three years at Dh40,000 per year. In contrast, tax authorities may require the entire Dh120,000 to be treated as a tax-deductible expense in the year of payment on a cash basis. Consequently, in the current period, taxable expenses would rise by Dh80,000 due to the prepaid rent, leading to the taxable temporary differences.

The identifiable assets acquired, and liabilities assumed in a business combination are recognised at their fair values, and it can lead to differences between the carrying amounts for accounting purposes and the tax bases of these assets and liabilities. For example, the carrying amount of an asset is increased to fair value assuming Dh1.5 million but the tax base of the asset remains at cost to the previous owner assuming Dh1.4 million, it creates a taxable temporary difference. Due to this temporary difference the company will eventually have higher taxable profits and higher tax liability in the future; for which the company needs to book the deferred tax liability today.

Based on the same principles, if the assets are being revalued without equivalent adjustment in the tax base, it can lead to temporary differences as well. For example, on December 31, 2023, if a property has been revalued from Dh23 million to Dh25 million for accounting purposes without having an impact on the tax base, it can lead to deferred tax liability.

A deferred tax liability can arise on goodwill when there is a difference between the accounting treatment and the tax treatment of goodwill in a business combination. In accounting standards, goodwill is recognised as an intangible asset on the acquirer’s balance sheet. Goodwill is not amortised but is subject to impairment tests for potential write-downs if its carrying amount exceeds its recoverable amount. Tax authorities may not allow the deduction of goodwill for tax purposes. Goodwill may not be considered a depreciable or amortisable asset for tax calculations, resulting in a difference between its accounting value and tax value. Due to this difference in treatment between accounting and tax rules regarding goodwill, a temporary difference arises. Deferred tax liabilities for taxable temporary differences relating to goodwill are recognised to the extent they do not arise from the initial recognition of goodwill. This means if such differences arise from the initial recognition of goodwill, then deferred tax liability should not be recognised.

Taxable differences can arise on the initial recognition of assets or liabilities; and the recognition of the deferred tax liability or asset depends on the nature of the transaction that led to the initial recognition of the asset or liability.

Paragraph 15 of IAS 12 requires that the deferred tax liability should be recognised for all taxable temporary differences, except for certain situations where the deferred tax liability arises from the initial recognition of goodwill or from the initial recognition of an asset or liability in a transaction that is not a business combination and meets specific criteria regarding its impact on accounting and taxable profit.

Businesses should thoroughly evaluate their temporary differences and, where applicable, recognise the appropriate deferred tax liability or asset accordingly.