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Deferred Tax: Navigating Permanent and Temporary Differences

Deferred tax is used for accounting treatment of income taxes and how to account for the effects related to current and future taxes for the same period. It is known that accounting profit is the net profit for a specific financial period derived from the income statement prepared according to accounting standards before deducting income tax, also known as profit before tax.

As for taxable profit (profit subject to tax), it is the accounting profit for a specific financial period after applying the provisions of the tax law, including adding non-deductible costs to it or deducting non-taxable revenues from it. Based on this profit, the value of payable income taxes or refundable income taxes (in case of loss) is determined. Since tax laws differ from accounting standards, taxable profit usually differs from accounting profit.

The differences between accounting profit and taxable profit can be divided into two main categories:

  • Permanent Differences
  • Temporary Differences

Permanent Differences

These are differences that arise as a result of treating certain transactions for tax purposes differently than for accounting purposes. Tax legislation includes many provisions that aim to achieve specific objectives, such as excluding certain revenues from tax or disallowing deductions for certain expenses, leading to permanent differences between accounting profit and taxable profit, resulting in a difference in the actual tax rate from the statutory tax rate.

Permanent differences are characterized by their impact being limited to the financial period in which they occur and not affecting future financial periods. This means that these differences do not have any deferred tax effects in the future, and therefore do not result in any amounts subject to tax or tax deductions in the future.

This means that the impact of permanent differences primarily affects the income statement and does not extend to the balance sheet. They can increase the tax burden on the income statement in cases resulting in additional taxes or decrease the tax burden in cases resulting in tax savings.

Permanent tax differences are continuous differences as long as the tax legislation remains unchanged and do not pose any accounting problem as their effects can be eliminated in the year they occur.

Temporary Differences

These are differences between the values of assets or liabilities in the balance sheet and their values for future tax purposes (the tax base associated with them in the future).

These differences are characterized by their impact not being limited to the financial period in which they occur but also affecting future periods. This means that there are deferred tax effects in the future resulting in amounts subject to tax or tax deductions in the future.

The impact of temporary differences is not only on the income statement but also extends to the balance sheet.

Future taxes can be defined as taxes related to the current period, including either deferred tax assets (such as carryforward losses) that are utilized over the allowable number of years according to tax laws, or when the carrying amount of a fixed asset exceeds its tax base.

Temporary tax differences concerning assets and liabilities in the balance sheet can be determined as follows:

AssetsObligations
Book Value > Tax PoolA temporary difference subject to tax creates a deferred tax liability.A temporary deductible difference arises from a deferred tax asset.
Book Value < Tax PoolA temporary difference that gives rise to a deferred tax asset is created.A temporary difference subject to tax is created, resulting in a deferred tax liability.

Conclusion

The purpose of deferred tax is to reconcile the differences between accounting profit and taxable profit due to the discrepancies in how transactions are treated for accounting versus tax purposes. Permanent differences only impact the current financial period and do not create future tax effects, whereas temporary differences impact both current and future periods, leading to deferred tax liabilities or assets on the balance sheet.

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Written By

Ismaeel Mohamed - Senior Tax

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