The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
The Tax Base of an Asset
An asset's tax base is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the asset's carrying amount. It is the amount that would be tax deductible if the asset was sold on the balance sheet date.
For example, a firm has total accounts receivable of $100,000. At the end of the year, management recognized a specific doubtful debt division of $3,000 for financial reporting. However, provisions for doubtful debts are not allowed for tax purposes in the firm's tax jurisdiction. A tax deduction is received when the receivable is written off as bad debt.
The carrying amount of the accounts receivable becomes $97,000. The tax base of the asset still remains $100,000. The firm has a deductible temporary difference of $3,000. Management should recognize a deferred tax asset in respect to the deductible temporary difference.
If the economic benefit will not be taxable, the tax base of the asset will be equal to the carrying amount of the asset. An example is dividends receivable from a subsidiary. If it is not taxable, the tax base and the carrying amount of the dividends receivable are equal.
The Tax Base of a Liability
The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes with respect to that liability in future periods.
- An unearned revenue item is treated as a liability for financial reporting but tax authorities often recognize it as taxable income. The tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in the future. Examples are prepaid rent, prepaid subscriptions, etc.
- If an item has already been expensed, then its tax base and carrying amount are both zero. One example is interest paid on long-term loans.
At the beginning of the year a firm received a lump sum of $5 million for rent from a lessee. The rent was for the use of an office building for the next 5 years. Local tax authorities require 70% of rent received in advance to be taxable income.
At the end of the year, $4 million should be treated as a liability for financial reporting purposes. That's the carrying amount. The tax base of the liability is $1.2 million (30% of $4 million) and $2.8 million should be treated as taxable income.
Changes in Income Tax Rates
When tax rates change, the deferred tax liability or asset has to be adjusted immediately to the new amount that is now expected, based upon the new expected tax consequences. The effect of this change in estimate will be included in the income from continuing operations.
The effect of an income tax rate increase:
- It raises deferred tax liabilities and thus increases tax expense.
- It raises deferred tax assets and thus decreases tax expense.
- If deferred tax liabilities exceed deferred tax assets, the net effect is to increase tax expense, and vice versa.