MTT27150 - Calculating the effective tax rate: Covered tax balance: Deferred tax: Amounts relating to tax credits

A tax credit is an amount which can be directly credited against an amount of tax which would otherwise be payable. This is in contrast to a tax loss, deduction, or allowances, which can only be set against taxable income.

A deferred tax asset may be recognised in the accounts in a period where:

  • a tax credit is available,
  • it cannot be fully utilised, and
  • the unused part of that tax credit can be carried forward.

In the accounts, under IFRS, a deferred tax asset will only be recognised if it is probable that there will be future taxable profits against which the tax credits can be utilised.

Any amount of deferred tax expense relating to such a deferred tax asset is to be excluded when calculating the total deferred tax adjustment amount. It is to be excluded both when the deferred tax asset is created and when it reverses. This results in the same outcome as if the deferred tax asset for the tax credit was not recorded at all. Because deferred tax assets from the generation and use of tax credits are excluded from the total deferred tax adjustment amount and will not reduce the covered taxes balance (when created), the generation of tax credits should not give rise to a top-up tax under section 203.

This is set out in section 182(2)(e) of Finance (No.2) Act 2023.

Foreign tax credits

This exclusion applies to all tax credits, including foreign tax credits, which are granted by one territory in respect of a tax imposed by another territory. Additional rules apply to certain foreign tax credits.

See MTT27160 for guidance on qualifying foreign tax credits and MTT27165 for guidance on qualifying foreign tax credits where carry forward of credits are not permitted. 

Qualifying refundable tax credits

The exclusion applies to all tax credits, including qualifying refundable tax credits. See MTT21410 for guidance on the additional rules which apply to qualifying refundable tax credits.

However, see below for the difference in treatment for Domestic Top-up Tax purposes.

Domestic Top-up Tax

For the purposes of Domestic Top-up Tax, the exclusion will not apply to qualifying refundable tax credits. No adjustment needs to be made to exclude an amount of deferred tax expense relating to a qualifying refundable tax credit.

Example

J Ltd is tax resident in a territory with a 30% tax rate. In Year 1, J Ltd invests 2m in qualifying expenditure which generates a tax credit of 1m. The tax credit is subject to a limitation under which the maximum amount of credit which may be used in any period is limited to 0.5m, with any balance to be carried forward.

In Year 1, profits of 5m are earned resulting in a potential pre-tax credit tax liability of (30% * 5m) = 1.5m.  The actual tax liability is 1m after the set-off of the maximum 0.5m per annum tax credit. A deferred tax asset of 0.5m arises in respect of the amount of carried-forward tax credit. This produces a deferred tax credit of 0.5m.

This deferred tax credit is excluded when determining the total deferred tax adjustment amount, so the covered tax balance for Year 1 will reflect the full 1m of current tax expense.

If there were no exclusion, the covered tax balance would be 0.5m (1m current tax less 0.5m deferred tax credit).

In Year 2, profits of 2m are earned resulting in a potential pre-tax credit tax liability of 0.6m. The actual tax payment is 0.1m after being offset by the 0.5m carried-forward tax credit. The reversal of the deferred tax asset produces a deferred expense of 0.5m in the Year 2 accounts.

This deferred tax expense is excluded when determining the total deferred tax adjustment amount, so the covered tax balance for year is limited to the 0.1m of current tax expense.

If there were no exclusion, the deferred tax expense would be taken into account in Year 2 and would result in a covered tax balance of 0.6m (0.1m current tax + 0.5m deferred tax expense).