The original cost of an asset is $600,000. The asset has a 3-year life and no salvage value expected. For tax purposes, the asset is depreciated using an accelerated depreciation method with tax return depreciation of $300,000 in year 1, $200,000 in year 2, and $100,000 in year 3. The firm adopts straight-line method of depreciation in its income statements. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is $500,000 each year. The firm’s tax rate is 40%. Calculate the firm’s income tax expense, and deferred tax liability for each year of the asset’s life.
What do you understand by the term ‘Deferred Tax’? Gerald Ltd. revalued a property from a carrying value of $4 Million to its fair value of $6.2 million during the reporting period. The property cost $6.5 Million, and its tax base is $3.5 Million. The tax rate is 30%. Explain the deferred tax implications.
The correct answer and explanation is :
1. Deferred Tax:
Deferred tax refers to the difference between the income tax expense reported on a company’s income statement and the actual taxes paid or payable in the current period. These differences arise due to the different ways that financial accounting and tax regulations treat certain transactions or assets. A deferred tax liability arises when a company pays less tax now but expects to pay more in the future, while a deferred tax asset arises when the company pays more tax now, but will be able to reduce future taxes.
2. Income Tax Expense and Deferred Tax Liability Calculation:
Step-by-Step Calculation:
Depreciation Differences:
The company uses two different methods for depreciation:
- Tax depreciation (accelerated):
- Year 1: \$300,000
- Year 2: \$200,000
- Year 3: \$100,000
- Book depreciation (straight-line):
- Since the total depreciation over 3 years is \$600,000, the straight-line depreciation per year is: $$
\text{Annual depreciation (book)} = \frac{600,000}{3} = 200,000 \text{ each year}
$$
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
EBITDA is given as \$500,000 each year.
Step 1: Calculate Pre-tax Income (EBIT):
To calculate the pre-tax income (EBIT) for each year:
$$
\text{EBIT} = \text{EBITDA} – \text{Book depreciation}
$$
So, for each year:
$$
\text{EBIT for Year 1} = 500,000 – 200,000 = 300,000
$$
$$
\text{EBIT for Year 2} = 500,000 – 200,000 = 300,000
$$
$$
\text{EBIT for Year 3} = 500,000 – 200,000 = 300,000
$$
Step 2: Calculate Income Tax Expense:
Income tax expense is calculated as:
$$
\text{Income tax expense} = \text{EBIT} \times \text{Tax rate}
$$
Thus, for each year:
$$
\text{Income tax expense for Year 1} = 300,000 \times 0.40 = 120,000
$$
$$
\text{Income tax expense for Year 2} = 300,000 \times 0.40 = 120,000
$$
$$
\text{Income tax expense for Year 3} = 300,000 \times 0.40 = 120,000
$$
Step 3: Calculate Taxable Income:
Taxable income is calculated as:
$$
\text{Taxable income} = \text{EBITDA} – \text{Tax depreciation}
$$
So, for each year:
$$
\text{Taxable income for Year 1} = 500,000 – 300,000 = 200,000
$$
$$
\text{Taxable income for Year 2} = 500,000 – 200,000 = 300,000
$$
$$
\text{Taxable income for Year 3} = 500,000 – 100,000 = 400,000
$$
Step 4: Calculate Taxes Payable:
The taxes payable are calculated as:
$$
\text{Taxes payable} = \text{Taxable income} \times \text{Tax rate}
$$
Thus, for each year:
$$
\text{Taxes payable for Year 1} = 200,000 \times 0.40 = 80,000
$$
$$
\text{Taxes payable for Year 2} = 300,000 \times 0.40 = 120,000
$$
$$
\text{Taxes payable for Year 3} = 400,000 \times 0.40 = 160,000
$$
Step 5: Calculate Deferred Tax Liability:
The deferred tax liability (DTL) arises because the tax depreciation is higher than book depreciation in the first two years, resulting in less taxes paid now. This will reverse in later years when the depreciation difference decreases.
$$
\text{DTL for Year 1} = (\text{Tax depreciation} – \text{Book depreciation}) \times \text{Tax rate} = (300,000 – 200,000) \times 0.40 = 40,000
$$
$$
\text{DTL for Year 2} = (200,000 – 200,000) \times 0.40 = 0
$$
$$
\text{DTL for Year 3} = (100,000 – 200,000) \times 0.40 = -40,000 \text{ (deferred tax liability decreases)}
$$
Summary Table:
| Year | Income Tax Expense | Deferred Tax Liability | Taxes Payable |
|---|---|---|---|
| Year 1 | \$120,000 | \$40,000 | \$80,000 |
| Year 2 | \$120,000 | \$0 | \$120,000 |
| Year 3 | \$120,000 | -\$40,000 | \$160,000 |
3. Deferred Tax Implications for Gerald Ltd.:
When Gerald Ltd. revalued its property, the carrying value increased from \$4 million to \$6.2 million, and the tax base is \$3.5 million.
- Carrying Value: \$6.2 million (fair value)
- Tax Base: \$3.5 million
The difference between the carrying value and the tax base creates a temporary difference of \$2.7 million (\$6.2M – \$3.5M).
Since the carrying value is greater than the tax base, this will create a deferred tax liability because the firm will eventually pay taxes on the revaluation surplus when the property is sold or otherwise disposed of. The tax rate is 30%, so the deferred tax liability will be:
$$
\text{Deferred tax liability} = 2.7 \, \text{million} \times 0.30 = 810,000
$$
This means the company will recognize a liability of \$810,000 in the current period, which will be reversed in the future when the tax base catches up with the carrying value.