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 :
Deferred Tax Explanation:
Deferred tax refers to taxes that are owed or will be owed in future periods due to temporary differences between accounting income (as per financial statements) and taxable income (as per tax returns). It arises when there are discrepancies in how assets or liabilities are valued for tax purposes compared to financial reporting purposes. Deferred tax liabilities occur when a company has underpaid taxes in the current period (i.e., the tax expense reported in the income statement is less than the actual tax paid due to temporary differences). Conversely, deferred tax assets are recognized when taxes are overpaid relative to accounting income, with the expectation of recovery in future periods.
Question 1: Depreciation Calculation
Given Information:
- Asset cost = \$600,000
- Depreciation (tax return): \$300,000 (Year 1), \$200,000 (Year 2), \$100,000 (Year 3)
- Depreciation (straight-line): \$600,000 / 3 years = \$200,000 per year
- Earnings before interest, taxes, depreciation, and amortization (EBITDA) = \$500,000 per year
- Tax rate = 40%
Year 1:
- Taxable Income (Tax Depreciation):
Tax Depreciation = \$300,000
Taxable Income = EBITDA – Tax Depreciation = \$500,000 – \$300,000 = \$200,000
Tax Expense = \$200,000 × 40% = \$80,000
Deferred Tax Liability (DTL) = (Tax Depreciation – Straight-line Depreciation) × Tax Rate
DTL = (\$300,000 – \$200,000) × 40% = \$40,000
Year 2:
- Taxable Income (Tax Depreciation):
Tax Depreciation = \$200,000
Taxable Income = EBITDA – Tax Depreciation = \$500,000 – \$200,000 = \$300,000
Tax Expense = \$300,000 × 40% = \$120,000
DTL = (\$200,000 – \$200,000) × 40% = \$0
Year 3:
- Taxable Income (Tax Depreciation):
Tax Depreciation = \$100,000
Taxable Income = EBITDA – Tax Depreciation = \$500,000 – \$100,000 = \$400,000
Tax Expense = \$400,000 × 40% = \$160,000
DTL = (\$100,000 – \$200,000) × 40% = -\$40,000 (reduction in DTL, i.e., DTL is now reduced by \$40,000)
Summary of Results:
- Year 1:
- Tax Expense: \$80,000
- DTL: \$40,000
- Year 2:
- Tax Expense: \$120,000
- DTL: \$0
- Year 3:
- Tax Expense: \$160,000
- DTL: -\$40,000 (a reduction in DTL)
Question 2: Deferred Tax Implications of Property Revaluation
Given Information:
- Property cost = \$6.5 million
- Carrying value = \$4 million
- Fair value = \$6.2 million
- Tax base = \$3.5 million
- Tax rate = 30%
Revaluation Impact:
- The carrying value is revalued to \$6.2 million, which exceeds the previous carrying value of \$4 million, creating a temporary difference.
- The tax base remains \$3.5 million, and now the carrying value exceeds the tax base.
Deferred Tax Implications:
- The temporary difference arises between the carrying value (\$6.2 million) and the tax base (\$3.5 million), amounting to \$6.2 million – \$3.5 million = \$2.7 million.
- A deferred tax liability (DTL) is created because the company will owe more taxes in the future as the revaluation creates a higher carrying value for the asset, meaning less depreciation will be allowed for tax purposes.
- DTL = \$2.7 million × 30% = \$810,000.
Summary of Deferred Tax Implications:
- The company will recognize a deferred tax liability (DTL) of \$810,000 due to the difference between the carrying value and tax base of the revalued property.
- This deferred tax liability will be settled in the future as the property depreciates, and the tax deductions become smaller compared to the depreciation expense recognized in the financial statements.