Numerous items create differences between accounting profit and taxable income. These differences can be divided into two types.

Permanent differences do not cause deferred tax liabilities or assets. These occur if a revenue or expense item:

• is recognized for tax reporting but never for financial reporting, or
• is recognized for financial reporting but never for tax reporting.

Therefore, permanent differences result from revenues and expenses that are reportable on either tax returns or in financial statements but not both. Permanent differences arise because the tax code excludes certain revenues from taxation and limits the deductibility of certain expenses.

• In the U.S., for example, interest income on tax-exempt bonds, premiums paid on officer's life insurance, and amortization of goodwill (in some cases) are included in financial statements but are never reported on tax returns.
• Similarly, certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the financial statements.
• Tax credits are another type of permanent difference. Such credits directly reduce taxes payable and are different from tax deductions that reduce taxable income.

These differences are permanent because they will not reverse in future periods.

No deferred tax consequences are recognized for permanent differences; however, they result in a difference between the effective tax rate and the statutory tax rate that should be considered in the analysis of effective tax rates.

Example

A company owns a $50,000 municipal bond with a 4% coupon and has an effective tax rate of 50% and a statutory tax rate of 40%. Calculate the deferred tax created by this bond.

Solution

The bond does not result in deferred tax, as the difference it causes is a permanent difference that will not reverse. As a result, no deferred tax is recognized.

Temporary differences result in deferred tax liabilities or assets. Different depreciation methods or estimates used in tax reporting and financial reporting are a common cause of temporary differences.

There are two categories of temporary differences.

Taxable Temporary Differences (TTD)

• These will result in taxable amounts when an asset is recovered or a liability is settled.
• Hence, these result in deferred tax liabilities. This means the company will pay more tax in the future.

Items that give rise to taxable temporary differences are:

• Receivables resulting from sales.
• Prepaid expenses.
• Tax depreciation rates > accounting rates.
• Development costs capitalized and amortized.

Deductible Temporary Differences (DTD)

• These will result in deductible amounts when an asset is recovered or a liability is settled.
• Hence, these result in deferred tax assets. This means the company will pay less tax in the future.

Items that give rise to deductible temporary differences are:

• Accrued expenses.
• Unearned revenue.
• Tax depreciation rates < accounting rates.
• Tax losses.