Deferred Tax Liability

Advanced

A deferred tax liability is an amount of income tax a company expects to pay in future, because its accounts recognise profit earlier than the tax rules tax it, usually because tax deductions have been taken earlier than the related accounting expense.

Deferred tax liabilities arise from timing differences between accounting rules and tax rules. The most common cause is depreciation. Tax rules often allow faster depreciation than the straight-line method used in the accounts, so taxable profit is lower in early years and higher later.

For example, in the first year of owning a machine, a company deducts 400 of depreciation for tax but only 200 in its accounts. Its taxable profit is 200 lower than its accounting profit. At a 25% tax rate, it has paid 50 less tax than its accounts imply, and it records a deferred tax liability of 50, expecting to pay it in later years when the tax deductions are smaller.

A deferred tax liability is not a debt owed today. It reverses over time as the timing difference unwinds. For a growing company that keeps investing, new differences may continuously replace old ones, so the liability may never fully reverse in practice.

Analysts sometimes treat large, long-lasting deferred tax liabilities more like equity than debt for this reason.

For worked examples and full lessons, visit notesbysara.org.