Demystifying deferred taxation

Last week, banks published their financial statements for the third quarter ending September 30. Many reported profits before or after tax, while for some it was the opposite.
Women sort red and green pepper at NAEB's Pack House. Companies need to know taxes they are expected to pay, when and how to pay them. / File
Women sort red and green pepper at NAEB's Pack House. Companies need to know taxes they are expected to pay, when and how to pay them. / File

Last week, banks published their financial statements for the third quarter ending September 30. Many reported profits before or after tax, while for some it was the opposite. Generally, any entity that generates revenue also incurs some expenses to make more money. That’s an arguable fact. Some of these expenses are in form of salaries or wages paid to employees, rental fees, and borrowing costs commonly known as interest expenses, among others.

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When firms deduct expenses from their revenues, what remains is either a profit or loss before tax. The profit is subject to 30 per cent tax rate paid to government to run its operations and provide citizens services, infrastructure and other facilities that create a conducive environment. Companies use what remains after tax to support future business activities or pay shareholders in form of dividend, which may also be subject to withholding tax.

In Rwanda, there are various types of taxes, such as corporate income tax, withholding taxes, value added tax (VAT), and consumption tax, among others. These taxes are computed by applying a specific tax rate on profit or transaction amount. Losses are not taxed.

Understanding deferred tax

We need to understand that there are two kinds of profits or losses; profit or loss in accordance with the accounting standards and profit or loss in accordance with tax legislation body like Rwanda Revenue Authority. The accounting profit or loss is arrived after deducting business expenses as determined by the accounting policies, whereas the tax profit or loss is arrived after deducting or adding back income or expenses as required by the tax laws.

Therefore, not all business expenses as determined based on accounting rules will qualify as allowable expenses for tax purposes of determining the taxable profit. The difference in the treatment of some of the business expenses is what leads to either more tax to be paid, or recovered in the current period of income or in the future.

It requires proper understanding of the tax laws and accounting policies to determine whether business expense qualifies as tax allowable expenses as it is not straight forward. This calls for tax consultancy services.

In a nutshell, deferred tax concept lies on the timing differences. We refer to deferred taxation when a transaction done today is subject to tax but the actual cash is to be paid in future. Therefore, when we recognise an asset or liability, we need to ask ourselves about the tax effects of these future benefits or future outflows.

It is important to note that the principle behind deferred tax is the “matching of the relevant tax expense to income in the relevant period in accounting”. The accrual basis principle states that expenses should be recognised in the period in which they are incurred and matched back to the related incomes.

With this principle, it is therefore clear that a tax expense should be recognised in accordance with the accrual basis principle but not necessarily when tax is paid. Therefore such tax effects need to be recognised immediately even when actual payment will happen in future. This is called deferred tax; a levy to be paid in future.

Deferred tax, therefore, ensures that the total tax expense recognised relates to the period in which the accounting profit/loss is made.

For instance, the useful life of computers may be estimated at two years by tax authorities but in actual sense computers may be used for even above three years. Therefore, the depreciation for the computer as determined based on tax useful life of two years will be different from the depreciation determined for accounting purposes using three or four years. This difference will either lead to more tax to be paid or recovered in future. The accountants call such differences in years, timing differences. These differences will either lead you to paying more taxes in future (this is called deferred tax liability) or to recover the over paid taxes (this is called deferred tax asset).

Based on accounting standard, the deferred tax liability is simply the amount of income tax payable in future periods in respect of taxable temporary differences. Assuming a company X expects to receive interest of 100, which will be taxed only when the company receives the cash payment. The statement of financial position includes an asset (receivable) of 100. However, the tax base of the asset is equal to zero since the interest will be taxed in the future. This difference is a taxable temporary difference because the amount will be taxed in a future period, when cash is received.

On the other hand, deferred tax asset is the amount of income tax recoverable in future periods in respect of deductible temporary differences, the carry forward of unused tax losses, and the carry forward of unused tax credits.

Circumstances that give rise to deductible temporary differences include those with transactions that affect the statement of profit or loss such as accumulated depreciation when the accounting depreciation is greater than tax depreciation.

The responsibility of preparing fair financial statements is that of management and directors. They should ensure that their staff acquire enough accounting skills by attending accounting profession courses available at the Institute of Certified Public Accountants of Rwanda (ICPAR) and other professional firms or by a continuous reading of relevant accounting standards in order to accurately present the income tax expense in the financial statements.

The writer is a senior audit associate with KPMG Rwanda

The views expressed in this articles are those of the author’s and do not necessarily represent those of KPMG or Business Times.

 

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