What is a tax provision? A tax provision is the estimated amount of income tax a business is legally expected to pay to the IRS for the current year. It’s just a type of provision that corporate finance departments set aside to cover probable future expense. Other types of provisions that a business typically records include bad debts, depreciation, product warranties, pensions, and sales allowances.
Tax provisions are considered current tax liabilities for accounting purposes as they are amounts subject to taxes to be paid in the current year. While the basic definition sounds simple, what is not always simple is how to prepare for the best business tax provision calculation while being fast, accurate and defensible. Estimating each year’s tax provision is no small task and can require a significant amount of time and effort for corporate tax departments.
How to calculate the provision for income tax
The tax provision of a company consists of two parts: current expense for income tax and deferred income tax expense. To further complicate matters, most accounting departments use Generally Accepted Accounting Principles (GAAP) to calculate their financial position. GAAP procedures differ in important ways from income tax accounting rules. These differences play an important role in calculating the current and deferred income tax expense.
Current tax expense
The current tax expense is the amount of income tax that a company will pay in the current year. It is calculated from current earnings and current year permanent and temporary differences between GAAP and income tax rules. The following steps describe how to calculate the current income tax provision:
- Start with your company’s net income. This is your GAAP income before income taxes.
- Calculate the permanent differences of the current year. These are items of income or expense that are not allowed for income tax purposes but are allowed by GAAP. Because these expense or income items are disregarded or unrecognized for income tax purposes, they are considered permanent. Examples of permanent differences include fines and penalties, entertainment expenses, municipal bond interest, and life insurance proceeds.
- Calculate temporary differences for the current year. These are items of expense or income that are allowed for GAAP or income tax purposes in one year, but not under the other accounting system until a later year. Determine your company’s temporary differences by reviewing the current year’s balance sheet and identifying the differences between your GAAP calculations and your income tax calculations. Common temporary differences include expenses incurred but not yet paid and depreciation.
- Apply credits and net operating losses (NOL). After you have accounted for these differences, you arrive at your taxable income for the current year. Now you can apply credits and NOL.
- Apply the current tax rate. Multiply the current year’s taxable income by your current statutory federal tax rate. The result is your company’s current year tax expense for the income tax provision.
Deferred income tax expense
Deferred income tax is a liability that the company has on its balance sheet but is not yet due. This more complicated part of the income tax provision calculates a cumulative total of the temporary differences and applies the appropriate tax rate to that total. It focuses on the deferred effects of income, expenses, NOL and tax credits. After this calculation, you will record your tax-deferred expense on your company’s GAAP balance sheet as an asset or a liability depending on whether you will owe taxes or receive a tax benefit in the future.
Challenges in calculating the income tax provision
Calculating the tax provision is complex and challenging. Corporate tax teams face the following common tax provision calculation issues.
- Unsynchronized income reports. Getting the calculation right requires starting with the correct number for your net income. Most businesses report annual or quarterly revenue, so the amount of the tax provision can only be estimated.
- Difficulty collecting and integrating the correct data. Gathering data for your calculation from the finance and tax departments, as well as integrating and structuring it properly, is complicated.
- Handling a large volume of data. Even the simplest calculation can require a team of tax experts to examine things like annual reports, financial statements, tax payments, and net income.
- Keep up with changes in tax law. Changes in tax legislation affect its calculation formulas. Your tax department should be aware of these new regulatory requirements.
- Trust in manual calculation processes. Calculating the corporate tax provision using spreadsheets and manual processes can slow down your ability to obtain accurate and compliant data in a timely manner.
4 steps to improve the process and results of calculating tax provisions
With the right approach, your tax department can achieve faster and better tax provisioning results, reduce your tax provisioning obligations, and reduce tax provisioning errors and risks. These are the steps to consider:
- Leverage and analyze your data. Collecting and consolidating the correct data makes tax provision calculations much more accurate.
- Consult checklists of tax provisions. Use tools like the industry-leading Thomson Reuters Corporate Income Tax Provisions Checklists to assess your income tax measurement processes, disclosure requirements, and risk management controls.
- Check your compliance. Take a close look at your tax provision calculation process to verify that you are using the correct criteria to calculate the tax provision.
- Opt for automation. Processes that are time-consuming or error-prone can be improved with a tax provisioning solution that offers faster and more accurate data collection, consolidation, and analysis.
How Tax Provision Software Can Help
Corporate tax provision software incorporates automation and other technologies that can speed up your tax provision calculation in a number of ways. The right tax filing software helps eliminate errors and simplifies your tax calculation processes so you can easily complete filing obligations. Tax provision software offers the tools to help you respond to regulatory changes around the world in almost any jurisdiction. Tax departments report up to 50% faster processing with some tax reporting software, along with other improved results.
Tax provision software like Thomson Reuters ONESOURCE™ Tax Provision gives your organization the ability to balance compliance needs with accurate tax provision while ensuring a defensible process.
