Taxation
Taxation tests the computation of taxable profit and tax balances from accounting data, plus indirect taxes and cross-border issues. The core skill is reconciling accounting profit to taxable profit and separating permanent from temporary differences.
The reconciliation
Start with accounting profit before tax. Add back expenses that are not deductible (fines, certain entertainment, political donations where disallowed) and accounting charges replaced by tax allowances, such as accounting depreciation. Deduct tax allowances and exempt income. Apply the tax rate to taxable profit to get current tax payable. Permanent differences affect the effective tax rate; temporary differences reverse over time and create deferred tax.
Deferred tax
A temporary difference is the difference between the carrying amount of an asset or liability and its tax base. Taxable temporary differences create deferred tax liabilities; deductible temporary differences create deferred tax assets, recognised only to the extent future taxable profit is probable. Deferred tax is measured at rates expected to apply when the difference reverses, based on enacted or substantively enacted law.
Worked example
Accounting profit is 500,000. A fine of 20,000 is non-deductible. Accounting depreciation is 80,000; tax allowances are 120,000. Taxable profit = 500,000 + 20,000 + 80,000 − 120,000 = 480,000. At 25%, current tax is 120,000. The depreciation difference of 40,000 is a taxable temporary difference, giving a deferred tax liability of 10,000 if the rate stays at 25%. The fine is permanent and creates no deferred tax.
Indirect taxes
For VAT-type taxes, output tax on sales less input tax on purchases gives the amount payable, provided the business is registered and the purchases are for taxable business use. Irrecoverable VAT becomes part of the cost of the asset or expense. Exempt supplies typically break the chain and restrict input recovery.
Traps
Deducting fines and penalties. Treating a temporary difference as permanent. Computing deferred tax on the full asset cost instead of the temporary difference. Using either the carrying amount or the tax base alone. Netting output and input tax when the question asks for gross amounts. Ignoring the probability test on deferred tax assets.