Question

A firm uses straight line depreciation for fixed assets with an estimated useful life of 12 years for its financial statements and 8 years for taxable income.

●    Equipment is bought for 500 on December 31, 20X0.
●    The firm’s corporate income tax payments are 65 in 20X1, 69 in 20X2, and 57 in 20X3.

●    In 20X1 and 20X2, the corporate tax rate is expected to be 19% for all years.
●    On January 1, 20X3, legislation is enacted that reduces the tax rate to 10% for 20X4 and later years.

2. For the year 20X2

a. What is the tax basis of the equipment on December 31, 20X2?

b. What is the deferred tax asset (liability) at December 31, 20X2?

Answer 1

If the life is 8 years as per tax laws, and 12 years as per accounting practice, it will result in lower tax paid because the depreciation allowed per year will be higher in years 1-8 and lower in years 9-12

According to Tax law depreciation will be calculated as follows:

500 Depreciation = 8 = 62.50

While according to the accounting rules depreciation will be:

500 Depreciation = = 41.67 12

This will result in tax authorities considering lower profit and therefore lower taxes in the profit as compared to that calculated as per accounting rules. Therefore the actual tax paid will be lower and result in deferred tax liability.

According to the tax accounting, in year 20x2 if the tax paid is 57 @ 19% so the tax basis will be:

Tar basis x tax rate = tar paid

Tax basis x 0.19 = 57

Tar basis = 300

Deferred tax liability is the difference in tax caused due to difference in depreciation and is calculated as follows:

Tax Rate x (Depreciation difference) = Deferred tax liability

0.19 x (62.5 – 41.67) = $3.96

So the tax deferred to later period due to higher depreciation is $3.96