If you’re anything like me, information about tax bases feels frustratingly opaque. While it’s critical for financial analysts to understand them, we usually leave tax topics to accountants. I’ve found that the easiest way to tackle tax base is starting with the tax base of assets.
The tax base of an asset is a formal way of saying “how a tax administration such as the IRS considers your assets.” The way in which these administrations treat assets often differs from how traditional GAAP treats them. The difference between the two, therefore, needs to be treated in the company’s financial statements.
Again, when it comes to the tax base of assets, the fundamental question we’re asking is “does the accounting methodology to impact the P&L differ from the tax methodology, and if so, how do I record the difference?“
To push it one step further, the key to understanding the tax basis of assets is to think about how assets impact the P&L.
For example, if accounting depreciation is higher than tax base depreciation, and both of them decrease taxable income on the P&L, then I need to record a liability. Why?
Because if I had used the tax basis, i.e. a lower depreciation, then my taxable income would have been higher. Since I don’t record this marginally-higher tax payment under accounting standards, I need to add it.
Make sense? Let’s look at the definition, key terms, and examples to flush out any confusion.
Definition
The tax base of an asset is a tax authority’s calculation of an asset’s impact on taxable income (P&L) through asset adjustments that differ from accounting standards, such as more aggressive depreciation schedules1.
Tax Base vs Carrying Amount
The two terms we use to think about assets are tax base and carrying amount. The carrying amount is the value of an asset as treated with accounting standards. The tax base is the value of an asset as treated by tax standards.
For assets, the following are true:
- When the carrying value is higher than the tax base, we record a deferred tax liability.
- When the carrying value is lower than the tax base, we record a deferred tax asset.
Remember, you should always think of these items in terms of how they affect the P&L. Again with the example of depreciation, if we have a higher depreciation in accounting than the tax base, then we are recording a lower taxable amount than the amount tax authorities claim. We need therefore a deferred tax liability.
Moreover, the deferred tax assets and liabilities should be thought of as notional, which means they are used to keep balance in the accounts and don’t behave like traditional assets and liabilities.
Example 1: Asset Depreciation
Imagine HighTech Inc. has a steady yearly $500,000 of EBDAT, or Earnings Before Depreciation & Amortization and Tax. It purchased a big machine for $100,000. Under accounting standards, HighTech Inc. depreciates the asset by $20,000 per year over 5 years. However, tax authorities only allow 10% depreciation of big machine assets each year. Additionally, the tax rate is 30%.
We can think about the situation in the following table:
As you can see, the value of the asset in year one under accounting depreciation is $100,000 from which the normal $20,000 depreciation is deducted. This means the taxable income after accounting depreciation is $480,000, of which the 30% tax is $144,000.
Under the tax base, the asset value is the same in year one. However, tax depreciation of 10% is $10,000. This makes the tax base $490,000, of which the 30% tax is $147,000.
In other words, the difference between taxes due and accounting taxes is $3,000 ($147,000 – $144,000). But how do we treat this $3k difference? Since we are paying more taxes than we record via the accounting method, we record the difference as an asset.
As you can see in the journal entries section, we debit the tax expense, credit taxes payable, and debit the difference as a deferred tax asset.
How Are Deferred Tax Assets Used?
The obvious question now is what happens to deferred tax assets once the company records them? Quite simply, the deferred tax asset is used to reduce the taxable amount on an asset when it is recovered or sold at a later stage.
When would there be a deferred tax liability?
We’ve talked about deferred tax assets, but what about liabilities? It’s important to note in what context we would record a deferred tax liability. In short, we would have a tax liability if the accounting base had been higher than the tax base.
How Accountants Talk About Deferred Tax Assets
NOTE: in most cases, you will not see this concept as thoroughly represented as I have done in the image above. Accountants use a shortcut, and you need to understand it.
Specifically, they use the terms taxable differences and deductible differences. Let’s cover those now.
Taxable Differences vs Deductible Differences
As shown in the image above, when the carrying amount of an asset is lower than the tax base then we record a tax asset. Inversely, when the carrying amount is higher than the tax base, we record a tax liability.
When the carrying amount is lower than the tax base, thus, the difference is called a deductible difference. Inversely, when the carrying amount is higher than the tax base, we call this a taxable difference.
In short:
- Carrying amount < tax base → deductible difference → deferred tax asset
- Carrying amount > tax base → taxable difference → deferred tax liability
NOTE: this language is used only for temporary differences, not permanent differences. We’ll talk about these later, but suffice it to say for now that temporary differences account for the vast majority of cases. They’re reversed when as asset is recovered or sold, while permanent differences are never reversed.
Example 2: Dividends Receivable
Dividends are not a P&L account, and they are not taxable. Therefore, there is no tax base for dividends.
Example 3: Development Costs
Development costs usually consist of salaries that need to be capitalized. They behave exactly like a fixed asset (Example 1 above), which means deductible differences and taxable differences arise when the the carrying value is lower than the tax base or higher than the tax base, respectively.
Example 4: Research Costs
Research costs are not capitalized in most accounting standards. Under tax standards, however, they usually are. This means the carrying amount is 0 whereas the tax base is >0. In other words, the carrying amount < the tax base, and there’s a deductible difference that needs to be recorded as a deferred tax asset.
Example 5: Accounts Receivable & Bad Debt
Accounts receivable are directly connected to sales made on credit. The carrying value and tax base for these accounts are related to company income. Since income is always taxable, accounts receivable is taxable. The one exception is bad debt.
Bad debt is an amount of sales on credit that will not be recovered. Why? Simply because some customers will not hold to their promise, or will go bankrupt, or will pass away, and their debt is not recoverable.
This means that we need an account for these bad debts — they become an expense on the income statement that decreases our taxable income.
In most cases, the tax carrying amount of AR – Bad Debt will be higher than the tax base of AR – Bad Debt. This is because in most jurisdictions tax standards allow more bad debt than accounting standards.
In other words, carrying amount > tax base, which creates a taxable difference, which leads to deferred tax liability.
Example 6: Revenue Received in Advance a.k.a Deferred Revenue
The tax base of deferred revenue depends entirely on jurisdiction and its tax authorities. Some tax authorities tax income on a cash basis, meaning they tax income the moment it hits the company’s bank account. In this case, the carrying amount < the tax base, which results in a deferred tax asset (but does not touch the P&L since it’s deferred revenue).
Other tax authorities may tax income as goods are delivered, i.e in the same way accounting standards recognize revenue. In this case, carrying amount and tax base are equal, resulting in no taxable or deductible differences.
Example 7: Tax Base of Interest Receivable
The tax base of interest receivable is easy. It behaves exactly like accounts receivable, only there is rarely a bad debt associated with interest income, so the carrying amount and tax base are almost always equal. This means there are rarely deductible or taxable differences.
Temporary vs Permanent Differences
There is a distinction between deductible and taxable differences concerning the temporal nature of the difference. It can be either temporary or permanent. In most cases, we deal with temporary differences.
Temporary Differences
Temporary differences are always the result of misalignment between carrying value and tax base, and these differences are reversed when the asset is recovered or sold. Every example we’ve discussed in the article concerns temporary differences.
Permanent Differences
Permanent differences, on the other hand, are simple differences between the total value of items under accounting and tax standards. For example, some expense items are wholly non-deductible from a tax perspective. This results in a permanent difference that remains on the company’s balance sheet. Moreover, the company may have tax credits it uses to reduce tax payments. This difference is permanent and will never be reversed.
Conclusion
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- This article is intended for educational purposes only and should not be considered tax advice. [↩]
