Future taxable profits: Meaning, Criticisms & Real-World Uses

What Are Future Taxable Profits?

Future taxable profits refer to the anticipated earnings of a company or individual that will be subject to taxation in subsequent accounting periods. This concept is fundamental in Financial Accounting, particularly for entities applying either U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The assessment of future taxable profits is crucial for determining the recognition and measurement of deferred tax assets.

A deferred tax asset arises when a company has overpaid its taxes, or when it has tax benefits (like tax losses) that can be carried forward to reduce future tax obligations. For these deferred tax assets to be recognized on the balance sheet, accounting standards require that it is probable that sufficient future taxable profits will be available against which these deductible temporary differences or unused tax losses can be utilized. Without the expectation of future taxable profits, a deferred tax asset might not be recognized, or a valuation allowance might be established against it.

History and Origin

The concept of recognizing the tax effects of temporary differences between financial accounting and tax reporting gained prominence with the evolution of modern accounting standards. In the United States, Accounting Standards Codification (ASC) 740, "Income Taxes," provides the comprehensive guidance for income tax accounting under GAAP. This standard, which effectively replaced Statement of Financial Accounting Standards (SFAS) No. 109, mandates a balance sheet approach to accounting for income taxes, requiring entities to recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in financial statements or tax returns. A key component of this framework is the projection of future taxable income to assess the realizability of deferred tax assets. PwC's Viewpoint on ASC 740, specifically Section 5.8, details the necessity of considering all years that may provide a source of taxable income for the realization of deferred tax assets when scheduling future taxable income.¹⁴

Similarly, under IFRS, IAS 12, "Income Taxes," provides the framework for deferred tax accounting. This standard requires that deferred tax assets be recognized only to the extent that it is probable that future taxable profits will be available against which the deductible temporary difference can be utilized.¹³,¹² The emphasis on the "probability" of future taxable profits underscores the forward-looking nature of this accounting requirement. In 2019, the European Securities and Markets Authority (ESMA) issued clarifications and expectations regarding the recognition of deferred tax assets, particularly those arising from unused tax losses, emphasizing the need for convincing evidence to support the expectation of future taxable profits.¹¹ Such pronouncements highlight the ongoing scrutiny and importance of robust assessments of future taxable profits by regulatory bodies.

Key Takeaways

Future taxable profits are essential for a company to realize the benefits of deferred tax assets, which represent future tax deductions.
Both GAAP (ASC 740) and IFRS (IAS 12) require entities to assess the probability of sufficient future taxable profits for the recognition of deferred tax assets.
This assessment involves forecasting expected taxable income and considering sources of income that can offset deductible temporary differences and tax loss carryforwards.
The absence of convincing evidence for future taxable profits may lead to non-recognition of deferred tax assets or the establishment of a valuation allowance against them.
Economic uncertainties and changes in tax laws can significantly impact a company's projections of future taxable profits and, consequently, its deferred tax asset recognition.

Formula and Calculation

While there isn't a single universal "formula" for calculating future taxable profits, the determination primarily involves financial forecasting and detailed analysis of various components that contribute to taxable income.

The core idea is to project future accounting profit and then adjust it for permanent differences and the reversal of existing temporary differences to arrive at future taxable income.

The general approach involves:

Projecting Pre-tax Financial Income: This is the starting point, reflecting expected revenues and expenses based on business plans, market conditions, and historical performance.
Adjusting for Permanent Differences: Certain revenues and expenses recognized in financial statements may never be taxable or deductible for tax purposes. These "permanent differences" are excluded from the projection of future taxable profits.
Considering Reversals of Existing Temporary Differences: This is a critical component. Temporary differences arise when the tax base of an asset or liability differs from its carrying amount in the financial statements. When these differences reverse in future periods, they generate either taxable or deductible amounts. For example, accelerated tax depreciation creates a deferred tax liability that reverses and becomes taxable income in future periods. Conversely, a deferred tax asset from accrued expenses that are deductible only when paid will become a deduction in future periods.

The overall concept is to assess whether:

\text{Expected Future Taxable Profits} \geq \text{Amount of Deductible Temporary Differences + Unused Tax Losses}

If the expected future taxable profits are less than the sum of deductible temporary differences and unused tax losses, a valuation allowance may be required against the deferred tax asset.

Interpreting the Future Taxable Profits

Interpreting future taxable profits primarily revolves around assessing the realizability of deferred tax assets. When a company recognizes a significant deferred tax asset, it signals an expectation of sufficient future taxable income to utilize that asset. The larger the deferred tax asset, the more critical the accurate estimation of future taxable profits becomes.

Management's projections of future taxable profits are subject to scrutiny by auditors and regulators. Factors such as economic downturns, industry-specific challenges, or changes in a company's business model can materially impact these projections. For instance, if a company has a history of losses, recognizing deferred tax assets for unused net operating losses becomes challenging, requiring strong, objective evidence of future profitability.¹⁰,⁹

The interpretation also involves understanding the sources of future taxable profits. These can include:

Future reversals of existing taxable temporary differences (e.g., from accelerated depreciation).
Expected future taxable income from operations, exclusive of temporary differences and carryforwards.
Taxable income in prior carryback years (if permitted by tax law).
Tax planning strategies that could create taxable income.⁸

A robust and defensible projection of future taxable profits is crucial for financial reporting transparency and for stakeholders to understand a company's true financial position and future tax obligations or benefits.

Hypothetical Example

Consider "Tech Innovations Inc." a growing software company. In 2024, due to significant research and development (R&D) investments and initial market penetration costs, Tech Innovations Inc. incurred a tax loss of $5 million. Under the tax laws, this tax loss carryforward can be used to offset future taxable income indefinitely, subject to certain limitations on annual utilization.

To determine if it can recognize a deferred tax asset for this $5 million tax loss, Tech Innovations Inc. must assess its future taxable profits. Its management team, based on detailed business plans, market analysis, and projected sales of its new software product, forecasts the following taxable profits (before considering the loss carryforward):

2025: $1 million
2026: $2 million
2027: $3 million
2028: $4 million

Based on these projections, Tech Innovations Inc. expects to generate enough future taxable profits to utilize the entire $5 million tax loss carryforward over the next few years. Specifically:

In 2025, it would use $1 million of the loss, leaving $4 million.
In 2026, it would use $2 million, leaving $2 million.
In 2027, it would use the remaining $2 million.

Since it is "probable" (meaning more likely than not) that the company will have sufficient future taxable profits, Tech Innovations Inc. can recognize a deferred tax asset related to this $5 million tax loss carryforward on its financial statements in 2024. If management did not foresee sufficient future profits, or if there was significant uncertainty, a valuation allowance would be recorded against all or a portion of this deferred tax asset.

Practical Applications

The concept of future taxable profits has several practical applications across various financial and accounting domains:

Deferred Tax Asset Recognition: The most direct application is in the recognition of deferred tax assets on a company's balance sheet. Companies with deductible temporary differences or tax loss carryforwards can only record a deferred tax asset if they can demonstrate that sufficient future taxable profits are probable. This assessment influences the reported profitability and financial position.⁷,⁶,
Financial Reporting and Disclosure: Companies are required to disclose significant judgments and estimates made in determining their tax provision, including the assumptions about future taxable profits that support the recognition of deferred tax assets. This transparency helps investors and analysts evaluate the quality of a company's earnings.
Mergers and Acquisitions (M&A): During M&A activities, the acquiring company evaluates the target's deferred tax assets and potential for future taxable profits. The ability to utilize the target's tax attributes, such as net operating losses, can significantly impact the deal's valuation.
Strategic Business Planning: Understanding potential future taxable profits allows management to engage in effective tax planning. Companies might adjust their operational strategies, capital expenditures, or financing decisions to optimize their tax position in light of anticipated taxable income.
Regulatory Scrutiny: Regulatory bodies, such as the European Securities and Markets Authority (ESMA), pay close attention to how companies assess future taxable profits to recognize deferred tax assets, particularly in times of economic uncertainty. They expect convincing evidence and clear disclosures to support these assessments.⁵,⁴ KPMG International has also highlighted that economic uncertainty may impact projections of future taxable profits used to assess the recoverability of deferred tax assets.³

Limitations and Criticisms

While the concept of future taxable profits is central to deferred tax accounting, its reliance on forecasts introduces inherent limitations and potential criticisms:

Subjectivity and Estimation: Projecting future taxable profits is inherently subjective and involves significant estimation. While companies use detailed internal forecasts and external market data, actual results can deviate significantly from projections due to unforeseen economic changes, competitive pressures, or operational issues. This subjectivity can lead to variability in financial reporting.
Economic Volatility: Periods of economic uncertainty, such as recessions or industry downturns, make the estimation of future taxable profits particularly challenging. Companies may face difficulties providing convincing evidence of profitability, potentially leading to the write-down or non-recognition of deferred tax assets, which can negatively impact reported earnings.
Aggressiveness in Projections: There can be pressure on management to be optimistic in their projections of future taxable profits to avoid recognizing a valuation allowance against deferred tax assets, which directly impacts the income statement. This can lead to inflated asset values and a less conservative financial picture if not properly scrutinized.
Complexity of Tax Laws: Tax laws are complex and vary by jurisdiction, adding another layer of complexity to projecting future taxable profits. Changes in tax rates, tax reforms (e.g., the Tax Cuts and Jobs Act in the US), or specific limitations on the utilization of tax loss carryforwards can alter future taxable profits and the value of deferred tax assets.
Lack of Realization: Even if deferred tax assets are recognized based on projected future taxable profits, there is no guarantee that these profits will materialize, or that the company will ultimately be able to realize the tax benefit. This risk is acknowledged by accounting standards, which require ongoing assessment of realizability.

Future Taxable Profits vs. Tax Loss Carryforward

While closely related, "future taxable profits" and "tax loss carryforward" are distinct concepts within tax accounting.

Feature	Future Taxable Profits	Tax Loss Carryforward
Definition	The projected income that a company expects to generate and that will be subject to taxation in future periods.	A provision that allows a company or individual to use past tax losses to offset future taxable income.
Nature	An expectation or forecast of future income.	An existing tax attribute (a past loss) that can be utilized in the future.
Purpose	Used to assess the probability of realizing tax benefits (e.g., from deferred tax assets).	Reduces future tax liability by offsetting future taxable profits.
Source	Derived from business operations, sales forecasts, and overall economic conditions.	Results from a period where deductible expenses exceeded taxable revenues.
Accounting Impact	A key assumption in recognizing deferred tax assets.	Creates a deferred tax asset that can be realized if future taxable profits are sufficient.

In essence, a tax loss carryforward creates a potential future tax benefit, represented by a deferred tax asset. However, the actual realization of this benefit is entirely dependent on the existence of sufficient future taxable profits. Without those future profits, the tax loss carryforward may not be utilized, and the corresponding deferred tax asset might be subject to a valuation allowance. The IRS Topic No. 409 explains how capital losses, a type of tax loss, can be carried forward to offset future taxable income.²

FAQs

Why are future taxable profits important for deferred tax assets?

Future taxable profits are critical for deferred tax assets because accounting standards (GAAP and IFRS) require that it must be "probable" (or "more likely than not") that a company will generate sufficient future taxable profits to utilize the tax benefits represented by these assets. If future taxable profits are not expected, the deferred tax asset may not be recognized or may require a valuation allowance.

What factors influence the estimation of future taxable profits?

The estimation of future taxable profits is influenced by a variety of factors, including economic conditions, industry trends, a company's strategic plans, sales forecasts, cost structures, and projected capital expenditures. Changes in tax laws or significant one-time events can also impact these projections.

Can a company with a history of losses recognize deferred tax assets based on future taxable profits?

Yes, a company with a history of losses can still recognize deferred tax assets, but it requires strong, objective, and convincing evidence of future taxable profits. The existence of past losses is considered negative evidence, so management must present a robust case supported by verifiable business plans and forecasts to justify the recognition.

How do tax loss carryforwards relate to future taxable profits?

Tax loss carryforwards are past tax losses that can be used to reduce taxable income in future periods. These carryforwards give rise to deferred tax assets. However, their usability is contingent on the company generating sufficient future taxable profits against which these losses can be offset, effectively reducing future tax payments.

Is the assessment of future taxable profits the same under GAAP and IFRS?

While both GAAP (ASC 740) and IFRS (IAS 12) require an assessment of future taxable profits for deferred tax asset recognition, there are some differences in the specific criteria and application. Both standards emphasize the need for probability, but the interpretation and the level of evidence required can vary. Generally, under GAAP, a valuation allowance is recognized if it's "more likely than not" (greater than 50% probability) that the deferred tax asset won't be realized, while IFRS states it should be recognized "to the extent that it is probable" that future taxable profit will be available.¹