Part 1 looked at . Is Tax a Distribution of Earnings or a Business Expense? . Accounting Profit versus Taxable Profit, Tax Paid versus Tax Expense and . What is Deferred Tax?
. Deferred Tax Under International Accounting Standards (IAS) 12
Before the Malaysian Accounting Standards Board (MASB) was created, the International Accounting Standards was used as a guiding rule in the local accounting industry. The International Accounting Standards is a dominant standard considering it inspired the financial reporting framework in most parts of the world. The International Accounting Standard that touches on income taxes is IAS 12. The original IAS 12 was issued in 1979, named IAS 12 : Accounting for Taxes on Income. It was later replaced by IAS 12 (reformatted 1994), IAS 12 (revised 1996) and the latest being IAS 12 (revised 2000). IAS 12 (revised 2000) is known as “Income Taxes”. The original IAS 12 issued in 1979 uses the concept of timing difference in determining deferred tax.
. IAS 12 (1979): Timing Difference Method
Based on the original IAS 12 issued in 1979, the items that caused accounting profits to defer from taxable profits can be categorised as those that are permanent (known as permanent differences) and those that are temporary (known as temporary differences).
[a]. Permanent differences
Permanent differences arise in two instances: . When an income item in the P&L is not tax chargeable, such as tax-free interest, proceeds from life insurance policies and capital gain, and . When an expense item in the P&L is not tax deductible, such as unapproved donations, fines for violations of law and disallowed entertainment expenses.
For an income that is not tax chargeable, it will only be included in computing accounting profit and will be deducted when calculating taxable profit, thus making accounting profit higher than taxable profit. On the other hand, non-tax deductible expenses are deducted when calculating accounting profit but added back when calculating taxable profit, thus making taxable profit higher than accounting profit. As an example showing the difference in accounting profit and taxable profit due to permanent differences, assume Company ABC (ABC) has an accounting profit calculated based on Table 1.
Table 1 : ABC's summarized P&L and taxable profit computation
As seen from the table above, tax-free interest and gain on disposal of investment (capital gain) are non-taxable items whereas unapproved donations are non-tax deductible items under the tax rules. Therefore, to derive taxable profit, tax-free interest and gain on disposal of investment have to be deducted from accounting profit whereas donations to unapproved organisations have to be added back to accounting profit. Based on the current tax rate of 28%, the amount of tax that Company ABC is liable for is RM14,000 (RM50,000 X 28%). Table 2 shows the simplified income statement for ABC.
Table 2 : Summarized P&L for ABC (RM)
Permanent differences only create a difference between accounting profit and taxable profit in the year these items arose, and do not cause the differences to be carried to the following period/s because they are either wholly included or excluded when calculating one of the profits. Therefore, as can be seen from Table 2, although the effective tax rate differs from the actual tax rate, this difference is only caused by items attributable to that particular period and has no tax effect on subsequent periods. Thus, it can be concluded that permanent differences do not give rise to deferred tax.
[b]. Timing differences
As explicitly stated in its name, timing differences are caused by items that are included in calculating both accounting profit and taxable profit, but differ in the periods that the items are being recognised. For example, Company ABC (ABC) receives an income of RM1,200. Assume that the RM1,200 interest has different recognition periods for accounting and tax rules, as shown in Table 3 below.
Table 3: Calculation of timing differences (RM)
Based on the example above, the whole RM1,200 income is recognised by both accounting profit and taxable profit. The only difference lies with the period the income is recognized. The difference between the amounts being recognised based on tax rule and amount being recognized based on accounting rule is known as timing difference. From the table above, it can also be seen that there is a trend where for the first two periods, the timing difference are caused by tax profit recognition being more than accounting profit recognition and the timing difference for the subsequent periods (period 3 to 5) are the result of accounting profit recognition being more than tax profit recognition. Such a reversal of trend is one of the characteristic of timing differences: whatever timing differences that initially arise (known as timing difference originating) will be reversed out in the subsequent period/s by timing differences that is known as ‘timing difference reversing’.
In short, since timing difference causes accounting profit and taxable profit to differ for more than a period before finally reversing out, it creates the need to allocate the tax expense to the respective periods. Thus, the deferred taxation that is based on the original IAS 12 (1979) is actually to take into account the tax effect of these timing differences.