IAS 12 Income Taxes: Complete Guide to Deferred Tax Assets & Liabilities

IAS 12 Scope and Deferred Tax Concept

IAS 12 applies to all entities and requires recognition of deferred tax assets/liabilities for temporary differences between book values (IFRS) and tax bases (local tax rules).

Why deferred tax exists: Tax authorities use different rules than IFRS. A transaction might be a £10m asset on the balance sheet but have a £0 tax base, creating a temporary difference. When the asset is eventually used/disposed, the difference reverses and affects future tax cash flows.

Temporary Differences: Book vs Tax

Example 1: Depreciation Timing

Example 2: Warranty Provisions

• Book (IFRS 37): Recognize £50,000 warranty provision (expected future claims)
• Tax: No deduction until claim is paid (future year)
• Temporary difference: £50,000 (deductible when paid →’ DTA)

Deferred Tax Assets vs Liabilities

Deferred Tax Liability (DTL)

When book value > tax base. Tax will increase when the difference reverses.

• Accelerated tax depreciation (tax deducted faster than book)
• Fair value revaluation (book increase not deductible)
• Goodwill (tax non-deductible, book carries forward)

Deferred Tax Asset (DTA)

When book value < tax base. Tax will decrease (or loss is deducted) when the difference reverses.

• Provisions recognized (book) but deducted at payment (tax)
• Unused tax losses (deductible in future years)
• Deductible temporary differences

Deferred Tax Calculation Step-by-Step

Step 1: Identify All Temporary Differences

Compare book values to tax bases across the balance sheet.

Step 2: Calculate Net Deferred Tax Position

Step 3: Assess DTA Realizability

Will the company generate sufficient future taxable income to utilize DTA? If not, record a valuation allowance.

Step 4: Measure at Expected Tax Rate

Use the tax rate expected to apply when the difference reverses (often the current enacted rate for near-term reversals).

Recognition and Valuation Allowances

When to Recognize a DTA

Recognize a DTA for deductible temporary differences and unused tax losses if it is probable that taxable income will be available to utilize the DTA.

"Probable" test: Is there convincing evidence the company will have taxable profit to use the losses? If loss-making for multiple years with no recovery plan, DTA recognition is uncertain.

Valuation Allowance (Contra-Asset)

If recognition is uncertain, offset the DTA with a valuation allowance:

Example: Loss-Making Subsidiary

• Unused tax losses: £10m (potentially deductible in future years)
• Gross DTA: £10m × 20% tax rate = £2m
• Assessment: Subsidiary has been loss-making for 5 years; no turnaround plan visible
• Valuation allowance: 100% of DTA = £2m (fully reserved against)
• Reported DTA on balance sheet: £0

Tax Rate Changes

When the government changes the tax rate, remeasure all deferred tax balances at the new rate and recognize the adjustment in P&L or OCI (depending on whether the item was a P&L or OCI transaction).

Worked Example: Rate Increase

• Existing DTL (at 19%): £10m
• Tax rate enacted to change to 25%: New rate applies to future reversals
• Remeasured DTL (at 25%): £10m / 19% × 25% = £13.16m
• P&L adjustment: £3.16m (tax expense increase, hit P&L as "Impact of tax rate change")

Worked Example: Manufacturing Company Deferred Tax

Balance Sheet as at 31 Dec 2025

Deferred Tax Calculation (Tax Rate 19%)

• Gross DTL: £30m × 19% = £5.7m
• Gross DTA (warranty + loss): £35m × 19% = £6.65m
• Net DTA before valuation: £6.65m −’ £5.7m = £0.95m

Valuation Assessment

Company is profitable and profitable in future is likely (5-year plan shows profit). Valuation allowance not needed.

Balance Sheet Presentation

• Deferred tax asset (non-current): £0.95m
• Deferred tax liability (non-current): £0 (netted)

Real Company Example: Rolls-Royce Deferred Tax

Rolls-Royce plc (aerospace & defense), 2023 Annual Report, reported:

• Deferred tax assets: £800m (mostly from UK losses carried forward)
• Deferred tax liabilities: £350m (revaluation of aircraft engines, goodwill)
• Valuation allowance on DTA: £200m (recognition uncertainty on some losses)
• Net deferred tax asset: ~£250m

The £200m valuation allowance reflects auditor and management scrutiny: Rolls-Royce has a complex cash-flow situation and loss carry-forwards that may not be utilized within the statutory period.

Audit Red Flags and Common Errors

Red Flag 1: Unrecognized DTA

Finding: Company has £20m in unused tax losses, all fully valuation-allowed, but 5-year plan shows clear path to profitability.

Auditor action: Challenge valuation allowance; likely partial or full reversal required, increasing reported DTA and reducing tax expense.

Red Flag 2: DTL Not Remeasured After Tax Rate Change

Finding: Tax rate increases from 19% to 25% effective next year; DTL not remeasured.

Auditor action: Require remeasurement; P&L impact of 6%+ rate increase is significant.

Red Flag 3: Tax Loss Carryforward Not Assessed

Finding: £50m tax loss carryforward not evaluated for DTA recognition due to ownership change restrictions (Section 382 in the US, or similar rules in other jurisdictions).

Auditor action: Assess whether loss is available; if restricted, no DTA (or partial).

Red Flag 4: SORIE (Statement of Other Comprehensive Income) Not Tracked

Finding: Revaluation of PP&E increases equity via OCI, but deferred tax on revaluation goes to P&L (incorrect).

Auditor action: Deferred tax on OCI items must go to OCI (matching principle). Reclassify from P&L to OCI.

Red Flag 5: Acquisition Not Deferred Taxed

Finding: Acquisition creates £50m of identifiable intangibles (non-deductible for tax). No DTL recognized on the fair value step-up.

Auditor action: Recognize DTL on intangible fair value adjustments; affects goodwill calculation and future tax expense.

Real-Life Case Study: Deferred Tax From Accelerated Capital Allowances