What is a Deferred Income Tax Liability?

A deferred income tax liability arises when book income exceeds taxable income. It represents the amount of the tax obligation in the reporting period for which payment is not yet due. When this happens, a business recognizes a deferred income tax liability, which is based on the anticipated tax rate multiplied by the difference between these two types of income. It may be some time before this tax liability is actually paid, depending on the extent to which the taxpaying entity has deferred the liability. In the meantime, the liability appears on the organization's balance sheet.

Example of a Deferred Income Tax Liability

Calcification Corporation purchases a piece of machinery for $100,000 with a useful life of 5 years. For tax purposes, the company uses an accelerated depreciation method, allowing it to depreciate $40,000 in the first year. For accounting purposes, the company uses the straight-line depreciation method, resulting in a depreciation expense of $20,000 per year. Therefore, the tax depreciation is $40,000, while the book depreciation is only $20,000.

Assuming that Calcification Corporation has a pre-depreciation income of $200,000 for both accounting and tax purposes, its taxable income is now $160,000, while its accounting income is $180,000. Assuming a tax rate of 30%, the tax expense on accounting income would be $180,000 x 30% = $54,000. The actual tax payable would be based on taxable income, or $160,000 x 30% = $48,000. Since the tax expense recognized in the financial statements ($54,000) is higher than the actual tax payable ($48,000), the difference of $6,000 ($54,000 - $48,000) will be recorded as a deferred tax liability. This amount reflects future taxes the company will eventually pay as the depreciation differences reverse over time.

What Causes a Deferred Income Tax Liability?

The reason why a deferred liability arises is that the tax laws differ in some respects from the applicable accounting framework (such as GAAP or IFRS). For example, the tax laws might allow for the more rapid recognition of depreciation expense, while GAAP might allow for a more delayed recognition period. This means that an entity may recognize a higher income on its financial statements than on its tax return. An income tax liability should be recognized on the differential. As the business gradually recognizes depreciation on its financial statements, the liability is reduced in size, and eventually vanishes when all of the depreciation has been recognized.