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Taxable Income versus Accounting Profit, and a Legal Obligation Trap

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Taxable Income versus Accounting Profit, and a Legal Obligation Trap

Mānuka Wellness Ltd is a New Zealand company with accounting profit before tax of $860,000 for the year. The following items are included in that figure:

  • Fines for a health-and-safety breach: $22,000
  • Entertainment of clients: $18,000
  • Depreciation expense: $140,000; tax depreciation allowed: $195,000
  • Doubtful debts expense: $30,000 (tax deduction allowed only when debts are written off)
  • A $50,000 government grant received in cash this year, treated as deferred income and amortised over four years, with $12,500 recognised in accounting profit
  • Legal fees of $35,000 incurred to defend a patent, which was successfully defended

The CFO says: 'Just add back the fines and entertainment and use the accounting profit - the rest is timing.' The company tax rate is 28%.

1. Calculate taxable income and tax payable, and evaluate the CFO's statement.

Read the worked answer

The CFO is only partly right. Fines and entertainment are permanent differences, but the remaining items are temporary differences that must still be adjusted to arrive at taxable income - they reverse over time, but they change this year's tax. Treating them as 'just timing' and ignoring them would misstate the current tax liability.

Taxable income calculation:

Item $
Accounting profit before tax 860,000
Add: fines (non-deductible) +22,000
Add: client entertainment (non-deductible) +18,000
Add: accounting depreciation +140,000
Less: tax depreciation −195,000
Add: doubtful debts expense (not yet written off) +30,000
Less: grant received in cash not yet taxable (50,000 − 12,500) −37,500
Add: legal fees to defend patent (capital, not deductible) +35,000
Taxable income 872,500

Tax payable = 872,500 × 28% = $244,300.

Judgement points:

  • The grant is taxed when received (cash) but recognised over four years for accounting. Only $12,500 is in accounting profit, so $37,500 must be deducted to avoid double counting.
  • The patent defence costs are treated as capital - they protect a capital asset - and are therefore not deductible. This is the item most likely to be missed.
  • The doubtful debts add-back reverses when debts are written off.

2. Explain how the temporary differences would be reflected in deferred tax, and identify which differences do not create deferred tax.

Read the worked answer

Deferred tax arises on temporary differences - differences between the carrying amount of an asset or liability and its tax base that will reverse in future periods.

Differences that create deferred tax:

  1. Depreciation. Accounting carrying amount of PPE exceeds its tax base (because tax depreciation ran ahead), giving a taxable temporary difference → deferred tax liability. The difference this year is $55,000; the cumulative difference drives the balance.
  2. Doubtful debts. The accounting provision is a liability with a tax base of nil (deductible only on write-off), giving a deductible temporary difference → deferred tax asset, recognised only to the extent future taxable profit is probable.
  3. Government grant. Deferred income of $37,500 carried as a liability has a tax base of nil (already taxed), giving a deductible temporary difference → deferred tax asset.

Differences that do NOT create deferred tax:

  • Fines - non-deductible permanently; the difference never reverses.
  • Client entertainment - 50% or fully non-deductible depending on the rule; the permanent portion never reverses.
  • Patent defence costs - capital, non-deductible; no temporary difference arises.

These permanent differences affect the effective tax rate but not deferred tax. The effective rate here is 244,300 / 860,000 = 28.4%, above the statutory 28% precisely because of the permanent add-backs. Explaining that gap is exactly the kind of analysis the examiner rewards.