Tax Provision

A tax provision is the amount of income tax that a company recognises as an expense in its financial statements for a reporting period. It is an estimate, prepared before the tax return is filed, of the tax that the period's profits will eventually cost. The figure appears in the income statement as income tax expense and is one of the larger judgement-based numbers in most company accounts.

The term is used loosely. In everyday finance work, "the tax provision" usually means the whole income tax calculation done at each period end, covering both current and deferred tax. More narrowly, it can mean a specific amount set aside for a tax position that an authority may challenge. Under International Financial Reporting Standards (IFRS), income taxes are governed by IAS 12; in the United States the equivalent guidance sits in the accounting codification topic on income taxes, often referred to as ASC 740.

The provision combines two elements that answer different questions:

• Current tax. This is the tax payable, or recoverable, on the taxable profit of the period, calculated under the tax law and rates in force. Unpaid current tax is shown on the balance sheet as income taxes payable.
• Deferred tax. This reflects the future tax effects of differences between the carrying amounts of assets and liabilities in the accounts and their values for tax purposes. A difference that will raise future tax creates a deferred tax liability; one that will lower it, including unused tax losses, creates a deferred tax asset.

The total provision for the period is current tax plus the movement in deferred tax balances, apart from items that the standards require to be recorded outside profit or loss, such as tax on gains taken directly to equity.

The calculation starts from accounting profit before tax. Permanent differences are adjusted first: income that is never taxed and expenses that are never deductible. Temporary differences are then identified, for example where tax depreciation runs faster than accounting depreciation, or where a loan loss provision is deductible only when the loss is realised. The result is taxable profit, to which the statutory rate is applied to give current tax. Deferred tax is measured on the temporary differences at the rates expected to apply when they reverse, using laws enacted or substantively enacted at the reporting date.

A simple check on the outcome is the effective tax rate:

A company with profit before tax of 10 million, current tax of 2.2 million and an increase in deferred tax liabilities of 0.3 million records a provision of 2.5 million, an effective rate of 25%. If the statutory rate is 23%, the gap must be explained in the notes through a tax reconciliation.

Several areas depend on estimates. A deferred tax asset may be recognised only to the extent that future taxable profit is probable, so loss-making groups must forecast their recovery. Groups operating in many countries must decide whether tax will arise when subsidiaries distribute their profits. Where it is unclear whether an authority will accept a tax treatment, for instance on transfer pricing, the IFRS interpretation on uncertain tax treatments requires the company to assume that the authority will examine the position with full knowledge and to reflect the likely outcome in the provision.

The international minimum tax has added a further layer. Groups within the scope of the Pillar Two global minimum tax may owe top-up tax where their effective rate in a jurisdiction is below 15%. Amendments to IAS 12 issued in 2023 introduced a mandatory temporary exception from recognising deferred tax arising from these rules, together with disclosure of the exposure, so top-up tax is treated as current tax when it arises.

Preparing the provision is part of the period-end close. Tax teams collect trial balances from each entity, compute local provisions, consolidate them and reconcile the tax accounts in the general ledger. After the return is filed, usually many months later, the provision is compared with the return and the difference, often called a true-up, is booked in the following period. Because errors in the tax line have been a frequent cause of restatements, auditors treat the provision as a significant risk area and test both the calculations and the controls around them.

The provision is not the same as the cash tax a company pays in the year: payments on account, refunds and deferred tax all create timing gaps, which is why analysts also look at the cash flow statement. Effective tax rates can swing because of one-off items, changes in tax law or the reassessment of deferred tax assets, making comparisons between companies and years less reliable than the single percentage suggests.

• IFRS Foundation: IAS 12 Income Taxes