Deferred Tax Liability (DTL): Calculation and Example

Deferred tax liability (DTL) is a fundamental concept in Indian accounting and taxation. It refers to the amount of tax that a company will be required to pay in the future because of temporary differences between the profits reported in the financial statements and the taxable profits calculated under the Income Tax Act. This article explains the deferred tax liability meaning, how it arises, the calculation of deferred tax liability, and includes a straightforward example of deferred tax liability for better understanding.

What is a Deferred Tax Liability?

To understand what is deferred tax liability, it is helpful to view it as a future tax obligation. It arises when a company reports higher profits in its accounting books compared to its tax returns, or vice versa, due to differences in accounting standards and tax regulations.

In India, financial reporting is governed by the Companies Act and Indian Accounting Standards, while taxation follows the provisions of the Income Tax Act, 1961. Due to different treatment of certain items such as depreciation, revenue recognition, and provisions, companies may defer some tax payments to a future period. The liability to pay this tax in the future is recorded as a deferred tax liability.

For example, if a company uses a straight-line depreciation method for financial reporting but a written down value method for tax reporting, its taxable income will be lower initially. This difference will reverse in future years, and the company will then pay higher taxes. The tax amount it saves today but will pay in the future becomes a deferred tax liability.

How is a Deferred Tax Liability Created?

Deferred tax liability is created because of temporary differences between accounting profit and taxable profit. These are differences that arise in one period but reverse in a later period. Here are some common causes:

• Depreciation Methods

A company may depreciate fixed assets using the straight-line method in its financial statements while using an accelerated depreciation method like the written down value for tax purposes. In the early years, the depreciation under tax rules is higher, which reduces taxable income and creates a deferred tax liability.

• Timing of Revenue Recognition

Revenue may be recognised earlier in accounting records than in tax filings. For instance, income accrued but not yet received might be included in accounting books but not taxable until received. This timing gap leads to a temporary difference.

• Provisions and Expenses

Some provisions such as those for doubtful debts, warranties, or gratuity may be allowed in accounting but not immediately allowed for tax deduction. This creates a difference between accounting and taxable profits.

• Revaluation of Assets

If an asset is revalued upwards in financial statements, but tax rules do not recognise this revaluation, a deferred tax liability can arise due to higher accounting income.

It is important to note that only temporary differences create deferred tax liabilities. Permanent differences, such as disallowed expenses (for example, fines or donations under Section 37 of the Income Tax Act), do not lead to deferred tax treatment as they do not reverse over time.

Calculation of Deferred Tax Liability (DTL)

Understanding the deferred tax liability calculation is essential for accurate financial reporting. The calculation involves identifying the temporary difference and applying the relevant tax rate. The deferred tax liability formula is:

Here are the steps involved in the calculation of deferred tax liability:

1. Identify the difference between the carrying amount of an asset or liability in the financial statements and its tax base.

2. Confirm whether the difference is temporary and will reverse in the future.

3. Apply the applicable corporate tax rate to the temporary difference.

Only those temporary differences that are expected to reverse in future periods should be considered while calculating deferred tax liability. The current tax rate in India is generally taken as 30% for domestic companies, but this may vary based on changes in law or company type.

Example of Deferred Tax Liability

Let us consider a basic example of deferred tax liability to understand the concept more clearly.

A company purchases machinery for ₹5,00,000. It depreciates the machinery as follows:

• In the books of accounts: Straight-line method over five years, which comes to ₹1,00,000 per year.

• For tax purposes: Written down value method, with ₹2,00,000 claimed as depreciation in the first year.

Profit Calculation in Accounts (Year One)

• Revenue: ₹10,00,000

• Depreciation (as per accounting): ₹1,00,000

• Profit before tax: ₹9,00,000

Profit Calculation for Tax (Year One)

• Revenue: ₹10,00,000

• Depreciation (as per tax): ₹2,00,000

• Taxable income: ₹8,00,000

Temporary Difference

The difference between the accounting profit and taxable profit is ₹1,00,000. This difference arises purely due to the different depreciation methods and is expected to reverse in future years.

Assuming the tax rate is 30%:

Deferred Tax Liability = ₹1,00,000 × 30% = ₹30,000

The company saves ₹30,000 in taxes today but will pay this amount in future years as the depreciation methods eventually align. This amount is recorded in the balance sheet as a deferred tax liability.

According to Indian GAAP (AS 22) or Ind AS 12, deferred tax liabilities are typically classified as non-current liabilities, unless there is a clear expectation that the temporary difference will reverse within twelve months.

Conclusion

The deferred tax liability meaning revolves around the future tax obligations that arise from temporary differences in how income and expenses are treated for accounting and tax purposes. While not an immediate outflow of cash, a deferred tax liability reflects the taxes that a company expects to pay in the future. Understanding what is deferred tax liability, how it is calculated, and the reasons for its creation allows businesses to prepare more accurate financial statements and better plan their tax strategies.

Accurate recognition of deferred tax liabilities underlines a company’s commitment to financial transparency. The inclusion of DTL in financial reporting ensures that stakeholders have a clearer picture of the company's future obligations, thus aiding long-term planning and compliance.