Taxation
Taxation tests the computation of taxable income, deferred tax, indirect taxes, and compliance. Jurisdictional rates and rules vary, so apply the framework and rates given in the question rather than memorized rates.
Taxable income and deferred tax
- Accounting profit is adjusted for permanent and temporary differences to reach taxable income.
- Permanent differences never reverse: examples are non-deductible penalties or exempt income. They affect the current tax charge only.
- Temporary differences reverse over time. A taxable temporary difference creates a deferred tax liability because future taxable profit will be higher; a deductible temporary difference creates a deferred tax asset if recovery is probable.
- Current tax = taxable income × enacted tax rate. Deferred tax = temporary difference × enacted rate expected to apply on reversal.
- VAT or GST is collected as output tax and offset by input tax; the net amount is remitted. It is not revenue or an expense when recoverable.
Worked example
Accounting profit is 200,000. Tax depreciation exceeds accounting depreciation by 30,000, and there are no other differences. Taxable income is 200,000 − 30,000 = 170,000. At a 25 percent rate, current tax is 42,500. The 30,000 difference is taxable and temporary, so deferred tax liability is 30,000 × 25% = 7,500. Total tax expense is 42,500 + 7,500 = 50,000, equal to accounting profit × 25%. The entry is debit income tax expense 50,000; credit current tax payable 42,500; credit deferred tax liability 7,500. The liability reverses when book depreciation exceeds tax depreciation in later years.
Traps
Treating a permanent difference as deferred overstates the deferred tax balance. Using an expected future rate instead of the enacted rate is wrong. A deferred tax asset is not recognized without assessing probable recovery; a valuation allowance may be needed. Recoverable VAT is not an expense. Fines and penalties are commonly non-deductible, so do not assume every accounting expense is tax-deductible.