Sources of difference

Suresh Krishnamurthy

The major factor that creates a difference between accounting profits and profits offered for taxation is depreciation. The rates of depreciation allowed under tax laws is higher than what is required to be charged under the Companies Act. For instance, according to the Companies Act, the rate of depreciation for most plant and machinery is 15 per cent. Under the I-T Act, the rate allowed is 25 per cent normally, but increases to 100 per cent in some cases.

In the case of a company that invests heavily in fixed assets, profits offered for taxation will always be lower than what is reported in the annual accounts in the initial years. This is because of the impact of depreciation. For instance, consider a company starting out on a business. Assume that the company invests in plant and machinery in the first year and does not make any investments in later years. In such a case, the deferred tax liability will be created in the initial years.

The question whether this tax liability will reverse depends on the difference in the rate of depreciation between company accounts and the rate allowed under I-T purposes. If the difference is higher, then the tax liability will materialise at an early date, because the initial deferred tax liability created will be higher. If the difference is not large then the liability will materialise later but the initial liability created will also be smaller.

If the company continues to make investments, then the year in which the tax liabilities materialises will get pushed further down. However, if instead of making investments, the company reduces its assets because of impairment - which, in effect, means an increase in the rate of depreciation in company accounts - then the deferred tax liability will reduce faster. Another factor complicates the issue - if the company follows the straight-line depreciation method in its books of accounts, then the deferred tax liability will reduce faster than in the written-down-value method.

While depreciation is a major source of the difference, it is not the only source. Expenses and provisions charged in accounts, but disallowed by tax laws, will create a deferred tax asset. Losses incurred by a company in earlier years will also create deferred tax assets.