UNDERSTANDING DEFERRED TAXES: PART I
Excerpt
Deferred tax arises when there are timing differences between how income and expenses are recognised for accounting purposes and for tax purposes. Under IFRS (IAS 12), these differences create deferred tax assets or liabilities that reflect future tax benefits or obligations. This article explain...
1. What are deferred taxes and why do they arise?
Deferred taxes are an accounting concept that reflects timing differences between the tax base of assets / liabilities and their carrying (book) amounts. In simple terms, deferred taxes represent taxes that a company will pay or save in future years when those timing differences are reversed.
For example, if a company uses accelerated tax depreciation (high deduction early on) for tax but straight-line depreciation for accounting, the carrying amount of the asset (book value) will be higher than the tax base in the first few years. The difference (a taxable temporary difference) means the company will pay more tax later as the accounting depreciation catches up. IFRS calls the resulting future tax payable a deferred tax liability ("DTL").
Conversely, if a deductible temporary difference exists (e.g. an expense recognized in accounting but not yet deductible for tax, or unused tax losses), it creates a deferred tax asset ("DTA") - the company will pay less tax in the future when that difference reverses.
2. How do we define "temporary difference"?
Under IFRS (IAS 12), a temporary difference is literally the difference between the carrying amount of an asset or liability and its tax base. The tax base is "the amount attributed to that asset or liability for tax purposes".
Suppose a factory machine costs $100. The company charges straight-line depreciation of $25 per year (4-year life), so after two years its carrying amount is $50. Tax rules allow accelerated write-off, so the tax base after two years might be $30. The temporary difference in Year 2 is $50–$30 = $20. If the corporate tax rate is 20%, a DTL of $4 arises. The $4 represents tax that will be paid in future because $20 of the asset's remaining book expense will not be deductible for tax. This matches the IFRS rule to measure deferred tax at the enacted tax rate expected to apply when the difference is reversed.
3. DTA vs. DTL:
In general, IFRS instructs that all taxable temporary differences give rise to deferred tax liabilities, and all deductible temporary differences (and unused losses/credits) give rise to deferred tax assets (subject to recovery conditions).
A Deferred Tax Liability arises when future tax payments will increase because the accounting carrying amount of an asset (or liability) is higher (or lower) than its tax base. Classic examples include accelerated tax depreciation (as above) or upward revaluations of assets that are not recognized for tax.
A Deferred Tax Asset arises when future taxes will decrease because the carrying amount of an asset is lower than its tax base, or because tax losses/credits can offset future taxable income. For example, provisions for warranty or bad debts are recognized in book profit but are not deductible for tax until used, creating a deductible temporary difference. Similarly, a tax loss this year may be carried forward to reduce future tax, effectively a DTA when future profits arise.
What about items not deductible for tax (Permanent Differences)?
IFRS only recognizes deferred tax for temporary differences. Permanent differences like fines, penalties or non-deductible entertainment expenses affect book profit but will never give rise to future taxable or deductible amounts from a tax perspective. For instance, if a fine reduces accounting profit today, but tax law disallows it permanently, there is no deferred tax asset (the tax benefit is never realized). Such items are treated simply as differences between accounting and taxable profit for the current year, with no future tax effect.
4. How are deferred taxes recorded and measured?
IAS 12 requires a liability-method approach: compute deferred tax on each temporary difference at the tax rate expected to apply when the difference reverses. The rate used must be "enacted or substantively enacted" by the balance sheet date. Thus, if tax rates change, deferred tax balances must be adjusted to the new rate immediately.
Under IFRS
Recognition: A DTL is recorded for all taxable temporary differences at year-end (the “full provision method”). A DTA is recognized only to the extent that it is “probable” that future taxable profits will be available to use the deductible differences or losses. (This is a judgment call: IFRS says you should recognize DTAs to the extent recovery is probable.)
Exceptions: There are important exceptions. No deferred tax is recorded on temporary differences that arise from the initial recognition of an asset or liability in a transaction that is not a business combination and does not affect either accounting profit or taxable profit at the time of recognition (i.e. a balance sheet transaction), except where the transaction gives rise to equal taxable and deductible temporary differences (e.g. IFRS 16 leases). For example, if a company issues simple bonds or buys inventory, the initial difference between cost and tax base (if any) generally has no deferred tax if it does not affect profit. (Similarly, IAS 12 specifically prohibits recognising deferred tax liabilities on the initial recognition of goodwill.) Further, there is a temporary exception from recognising DTA’s / DTL’s arising from Pillar 2 income taxes.
Measurement: Deferred tax is measured on the cumulative difference as on the reporting date, not just the year’s difference. Practically, the deferred tax balance is tracked and updated each period.
Deferred tax = Temporary Difference Ă— Applicable Tax Rate expected to apply when the asset is recovered, or the liability is settled.
where, Temporary Difference = Carrying Amount - Tax Base
The resulting amount is recognised as a deferred tax liability or deferred tax asset depending on whether the temporary difference will give rise to taxable or deductible amounts in future periods, as outlined in the table below:
Item Type | Relationship Between Carrying Amount (CA) & Tax Base | Temporary Difference Type | Deferred Tax Result | Future Effect |
|---|---|---|---|---|
Asset | CA > Tax Base | Taxable temporary difference | Deferred Tax Liability (DTL) | Future tax payment |
Asset | CA < Tax Base | Deductible temporary difference | Deferred Tax Asset (DTA) | Future tax benefit |
Liability | CA > Tax Base | Deductible temporary difference | Deferred Tax Asset (DTA) | Future tax benefit |
Liability | CA < Tax Base | Taxable temporary difference | Deferred Tax Liability (DTL) | Future tax payment |
Continuing the machine example, if at year-end, the difference is $20 and the enacted tax rate is 20%, the DTL is $4. If next year, the remaining carrying amount equals tax base, the $20 difference has reversed and the DTL will be eliminated by charging $4 to expense. During the period the DTL exists, each year the company adds or reverses it in the income tax expense line.
What if a company has a tax loss?
Under IFRS, a tax loss carryforward is like a deductible difference that creates a DTA, but only if future profits are “probable”. For example, a start‑up with a $100 loss might not recognize a $20 DTA immediately (20% tax rate * $100) if it’s uncertain about future profits. Once profits materialize, the loss carryforward can be used to offset taxable income each year, to the extent permissible (there are caps on the extent of offset in many jurisdictions, see Jurisdictional Differences below), at which point the DTA becomes realizable.
How does a change in tax rate affect deferred tax?
When a new tax rate is enacted or substantively enacted by the end of the reporting period, the existing DTA/DTL balances must be remeasured at the new rate. For example, if the tax rate goes from 25% to 30% in the period in question, each deferred tax balance is updated.
5. Presentation
Deferred tax assets and liabilities are shown on the balance sheet (net if they relate to the same tax authority) and the change goes through profit or loss (except changes from adjustments to the balance sheet, e.g. revaluation). Under IAS 12, an entity offsets DTA and DTL only if legally allowed, and they relate to the same tax authority.
Common Examples of Deferred Tax
Depreciation/Capital allowances: The most typical example is a depreciable asset. If accounting depreciation is slower than tax depreciation, we get a DTL (we deducted for tax faster, so we will pay more tax later). Conversely, if tax depreciation is slower, a DTA arises.
Revalued assets: Revaluation of fixed assets (common under IFRS) creates a difference: the carrying amount increases, but the tax base usually stays the same. This is a taxable temporary difference, and a DTL must be recorded.
Provisions: A warranty provision or bad-debt allowance reduces accounting profit today but is not immediately tax-deductible. This creates a deductible temporary difference (lower carrying amount than tax base) and hence a DTA (to the extent future profitability is likely).
Tax loss carry-forwards: A company with a tax loss can offset future profits with that loss. The unused loss is a DTA (subject to recovery conditions).
Advanced Issues in Deferred Tax (IAS 12)
Offsetting: Deferred tax balances must be assessed separately for each tax authority. Deferred tax amounts relating to different countries cannot be offset. Even within one country, a deferred tax asset and deferred tax liability may be offset only if they relate to the same tax authority, and the entity has a legally enforceable right to offset current tax balances (i.e. tax payable or refundable today).
Specific exemptions & measurement rules: IAS 12 contains specific exemptions and special measurement rules. These include the initial recognition exemption (which does not apply where a transaction gives rise to equal taxable and deductible temporary differences), the prohibition on recognising deferred tax on the initial recognition of goodwill, guidance on outside basis differences in subsidiaries and associates (including situations where the parent can control the timing of reversal), and special measurement assumptions for investment property measured at fair value and certain non-depreciable assets. While these situations go beyond the basic mechanics of deferred tax, they become important in more complex group structures and transactions.
Tax incentives and subsidies: Government grants and tax incentives must be analysed based on how they are treated for accounting and tax purposes. If a grant is taxable or deductible at a different time from its accounting recognition, temporary differences may arise and IAS 12 applies in the usual way. However, if a grant is permanently exempt from tax, it creates a permanent difference and no deferred tax arises. The treatment therefore depends on the specific tax rules applicable to the incentive.
Consolidations and foreign subsidiaries: In a consolidated group, each subsidiary measures deferred tax using the tax laws and rates of the jurisdiction in which it operates. For example, a German subsidiary recognises deferred tax using German tax rates, even if the parent prepares IFRS financial statements in another country. Additional deferred tax may arise at the group level from temporary differences between the carrying amount of investments in foreign subsidiaries and their tax bases, for example where accumulated profits may give rise to tax on distribution or sale.
Other aspects to note
How do deferred taxes work in low /no tax jurisdictions? If a country has no income tax, no current tax is due and IFRS normally implies no deferred tax balance related to that jurisdiction (temporary differences don’t matter if the tax rate is 0%). For example, before 2023, the UAE had essentially no corporate tax, so most UAE companies had no deferred tax. Once UAE introduced a 9% corporate tax (0% on profits up to AED 375,000), entities were required to recognise deferred tax on existing and future temporary differences expected to reverse after the effective date of the tax law.
In the case of a tax exemption wherein there is a tax holiday for a specific period, the key question would be whether the reversal would be in the tax holiday period or after. If the reversal is expected to happen after the end of the tax holiday period, then deferred tax would have to recognised.
Can deferred tax ever affect equity directly? Generally, changes in deferred tax go through profit or loss. However, some tax effects (like deferred tax on an asset revaluation or available-for-sale securities) adjust other comprehensive income and equity. For example, deferred tax on a revaluation surplus of land would be charged to equity (as a direct adjustment to revaluation reserve). IFRS requires reflecting tax effects consistently with where the underlying item is recognized.
Why do we talk about deferred tax if the tax money isn’t paid yet? Because accounting matches expenses with revenues. Even if the cash tax payment is delayed, accounting rules require reflecting the obligation in the period the income/expense arises. Deferred tax ensures the income tax expense in each year reflects the true economic profit, not just the taxes paid that year.
Are there any special GCC tax items? Yes. For instance, Saudi companies (with Saudi owners) pay Zakat instead of tax. In practice, Saudi entities account for Zakat under IAS 12 principles, although it is calculated differently from corporate income tax. Kuwait has special levies (Zakat, NLST, etc.) that affect tax base; an accountant should consider these in calculating tax base.
Jurisdictional differences (GCC countries)
Deferred tax principles are the same under IFRS in all countries, but local tax rules (tax rates, allowances, loss carry-forwards, etc.) differ. The table below summarizes key points for Gulf Cooperation Council ("GCC") countries. Each country generally follows IFRS (or IFRS-like) accounting, but tax rates and rules vary:
Particulars | Saudi Arabia (KSA) | UAE | Qatar | Oman | Bahrain | Kuwait |
|---|---|---|---|---|---|---|
Corporate tax (CT) regime | 20% on non-Saudi share. Saudis/GCC nationals subject to 2.5% Zakat. Oil/gas businesses taxed 50-85% in practice. | 9% standard rate (0% on first AED 375k). CT effective from FY starting Jun 2023.
DMTT top-up tax applies (min. 15% ETR) for large groups from January 2025 onward. | 10% CT on foreign-owned companies. 100% Qatari/GCC-owned companies are tax-exempt.
Oil and gas special agreements are subject to a higher rate (minimum of 35%), as stipulated in the agreement.
DMTT top-up tax applies (min. 15% ETR) for large groups from January 2025 onward. | 15% standard CIT. 3% for qualifying SMEs. Petroleum companies taxed at 55% (under PSA terms). | No general CIT on ordinary businesses. Only oil/gas extractors pay 46%.
DMTT top-up tax applies (min. 15% ETR) for large groups from January 2025 onward. | Foreign companies: 15% CIT.
Kuwaiti/GCC-owned companies pay no corporate tax (though they may pay small taxes like Zakat or NLST on certain shareholding companies |
Tax losses for businesses (other than oil & gas) (carry-forward) | Indefinite carry-forward of losses; deductible up to 25% of annual profit. No carry-back. | Indefinite carry-forward; can offset up to 75% of taxable income per year. No carry-back. | Losses carried forward for 5 years. No carry-back. | Losses carried forward 5 years. No carry-back. | Not applicable | Foreign-company tax losses: carry-forward up to 3 years. No carry-back. |
Depreciation (tax vs IFRS) for businesses (other than oil & gas) | Tax depreciation based on prescribed rates ranging from 5% (buildings) to 25% (machinery, equipment etc.) on a declining balance method (except for zakat, where straight line depreciation is permitted). For assets depreciable at higher rates under KSA CT law, DTL's often arise. | UAE CT law generally follows IFRS depreciation (except for some elections for investment property) - so in most cases book and tax depreciation align. Timing differences may be therefore more limited than other jurisdictions, reducing deferred tax instances. | Tax depreciation based on prescribed rates ranging from 5% (buildings) to 50% (glassware, certain intangibles) on a straight-line method. For assets depreciable at higher rates under Qatar CT law, DTL's often arise. | Tax depreciation based on prescribed rates ranging from 4%(buildings) to 33.3% (computers, equipment etc.) on either a straight-line basis or a written down value basis, as specified for different classes of assets. For assets depreciable at higher rates under Oman CT law, DTL's often arise. | Not applicable | Tax depreciation based on prescribed rates ranging from 4%(buildings) to 33.3% (computers) on a straight-line basis. For assets depreciable at higher rates under Kuwait CT law, DTL's often arise. |
Goodwill amortisation for businesses (other than oil & gas) | Depreciation on goodwill is available at 10% on a written down value method under KSA CT law. Under IFRS, only impairment losses are permitted. Any difference typically yields a DTL. | UAE CT law starts with IFRS' income, and there is no explicit provision covering the deductibility of goodwill. To the extent that there is any write off of goodwill under IFRS, the deductibility will have to be tested against the general principles for deduction. | Goodwill amortisation is not deductible under Qatar CT law, generally resulting in a permanent difference. Therefore, there is no deferred tax on goodwill. | Goodwill deductible for tax over prescribed life. Under IFRS, only impairment losses are permitted. Any difference typically yields a DTL. | Not applicable | Goodwill amortisation is not deductible under Kuwait CT law, generally resulting in a permanent difference. Therefore, there is no deferred tax on goodwill. |
Small business relief | Not available. | Nil tax election if revenue does not breach the threshold of AED 3 million for the tax period in question and previous tax periods, subject to conditions. (currently up to 31 December 2026). | Not available | 3% rate if conditions met | Not applicable | Not available (in certain approved cases; a tax holiday is available). |
Deferred tax considerations for businesses (other than oil & gas) | Temporary differences commonly arise due to differences between IFRS accounting and KSA CT depreciation rates, tax amortisation of goodwill (10% annually), and timing differences on provisions etc. | Since UAE CT is based on IFRS accounting profit and depreciation on fixed assets aligns, traditional timing differences are limited. | Temporary differences commonly arise due to differences between IFRS accounting and Qatar CT depreciation rates, and timing differences on provisions etc. | Temporary differences commonly arise due to differences between IFRS accounting and Oman CT depreciation rates, tax amortisation of goodwill and timing differences on provisions etc. | Bahrain does not apply corporate income tax to most businesses, so deferred tax is generally not recognized.
However, deferred tax arises for oil and gas companies subject to the 46% income tax. It would also apply to in-scope multinational groups under the Domestic Minimum Top-up Tax (DMTT) from 2025 (while there is a temporary exception from recognising deferred tax on these taxes under IAS 12, the groups must disclose that the exception has been applied, and also separately disclose any current tax expense related to Pillar Two taxes. | Temporary differences commonly arise due to differences between IFRS accounting and Kuwait CT depreciation rates and timing differences on provisions etc. |
Summary
Deferred taxes bridge the gap between accounting profit and taxable profit. By recognizing DTAs and DTLs for timing differences, IFRS ensures the income tax expense reflects future cash taxes related to today's earnings. The concept may seem abstract, but in practice it means tracking differences like depreciation timing, loss carryforwards, and other timing items. Accountants work through deferred tax calculations step by step (often with spreadsheets) and adjust each period as tax laws or estimates change.
In the GCC, the same accounting principles apply, but local tax laws (rates, incentives, etc.) shape the numbers. For example, Saudi's 20% tax (plus Zakat) will create deferred taxes on differences, whereas in the UAE deferred tax only emerged once the 9% corporate tax was introduced. Understanding each country's tax details is key to applying the deferred tax concept correctly. (see table above)
Key points: Deferred tax is a future tax effect of today's timing differences. A DTL means future tax payable; a DTA means future tax savings. Use enacted tax rates and follow IFRS (IAS 12) rules on recognition and measurement. In doubtful cases (e.g. unrecoverable losses), recognize deferred tax only to the extent that recovery is probable. By mastering these rules and local tax nuances, you can accurately reflect a company's tax position and help ensure tax planning aligns with financial reporting.