Deferred tax and Zakat on construction contract timing differences · IAS 12

In plain words

Accounting recognises contract revenue as work progresses, while for Zakat or tax purposes the same revenue may follow billings or completion. How is this gap handled? For income tax, the contractor compares the carrying amount of each contract balance with its tax base; the difference is a temporary difference that may create a deferred tax liability or asset. Zakat is different: it is calculated on a Zakat base, not on taxable profit, so it generally falls outside the deferred tax standard (IAS 12). An entity that pays only Zakat therefore usually records no deferred tax, and an entity with mixed Saudi and foreign ownership applies deferred tax to the income-tax portion only. The entity's actual Zakat and tax position should be confirmed first.

Why it matters

Over-time revenue recognition for accounting often diverges from the timing used for tax purposes on long-duration contracts. For the income-tax-paying portion of an entity, treating this as immaterial or ignoring deferred tax misstates both the income tax expense and the deferred tax position, an error that compounds year after year on a multi-year project and can produce a large, unexpected catch-up at contract completion. The opposite error is equally common: applying deferred tax to the Zakat portion, which generally falls outside IAS 12 because Zakat is calculated on a Zakat base rather than taxable profit.

Diagnostic questions

Is the entity a Zakat payer, an income-tax payer, or a mixed Saudi/foreign-owned entity, and what share of its ownership is subject to income tax? For the income-tax-paying portion, does the tax base recognize contract profit on a different basis or timing than the over-time accounting method, such as a completed-contract or billings/certification basis? Have temporary differences been computed for every contract-related balance, including contract assets, contract liabilities, onerous contract provisions, and warranty provisions? Are onerous contract provisions and ECL allowances deductible for tax on the same timing as they are recognized for accounting purposes? Is there a sufficient history or forecast of taxable profits to support recognizing a deferred tax asset on contract-related losses?

Recognition

Determine the entity's Zakat and income tax profile first: Zakat payer, income-tax payer, or mixed Saudi/foreign ownership. Deferred tax under IAS 12 applies to income taxes, meaning taxes based on taxable profit. Zakat is calculated on a Zakat base rather than taxable profit, so it generally falls outside IAS 12 and entities generally do not recognise deferred tax for the Zakat portion; confirm any established entity policy before concluding.
For the income-tax-paying portion, identify the tax base of each contract-related asset and liability (contract assets, contract liabilities, onerous contract provisions, warranty provisions) by determining how each item is treated for tax purposes, which may follow a different revenue recognition pattern (e.g. completed-contract or billings-based) than IFRS.
Compute the temporary difference as the difference between the accounting carrying amount and the tax base for each item.
Recognize a deferred tax liability for taxable temporary differences (typically arising where accounting revenue/margin is recognized ahead of the tax base) and a deferred tax asset for deductible temporary differences, subject to the recoverability test (probable future taxable profit), applied only to the income-tax-paying portion at the income tax rate for that portion.
Reassess deferred tax assets for recoverability at each reporting date, particularly where a contract's profitability outlook has deteriorated, and revisit the income-tax portion when ownership changes.

Measurement

Measure deferred tax using the income tax rates expected to apply in the period the temporary difference is expected to reverse, based on rates enacted or substantively enacted at the reporting date; do not discount deferred tax balances. For mixed Saudi/foreign-owned entities, recognise deferred tax only on the income-tax-paying portion, at the income tax rate applied to that portion, consistent with the entity's actual shareholder composition and the way the tax authority requires the split to be computed; revisit the portion if ownership changes. Do not apply a blended Zakat and income tax rate to the whole temporary difference: the Zakat portion is measured as a current Zakat charge on the Zakat base and generally carries no deferred component, unless the entity has an established, disclosed policy to the contrary.

Presentation & disclosure

Disclose: (1) the components of deferred tax assets and liabilities by major category of temporary difference (contract assets/liabilities, provisions, PP&E); (2) a reconciliation of the deferred tax movement for the period; (3) unrecognized deferred tax assets and the reason for non-recognition; (4) the split between Zakat and income tax where a mixed-ownership regime applies; (5) significant judgments in assessing the recoverability of deferred tax assets on long-duration, potentially loss-making contracts.

Common mistakes

Applying a single blended Zakat and income tax rate to the whole temporary difference, which creates deferred tax on the Zakat portion even though Zakat is calculated on a Zakat base and generally falls outside IAS 12
the opposite error of ignoring deferred tax on the income-tax-paying portion because the entity is '
mostly a Zakat payer'
assuming the tax base always follows a completed-contract method without confirming the actual basis used in filings
failing to reassess deferred tax asset recoverability when a previously profitable contract turns onerous
not adjusting the deferred tax computation when the entity'
s Zakat/tax ownership mix changes (e.g. after a share transfer)
using the current-year tax rate for reversal periods many years in the future without checking for substantively enacted rate changes.

Simple example

A contractor that is 70% Saudi-owned (subject to Zakat) and 30% foreign-owned (subject to income tax at an assumed 20% rate) recognizes SAR 18,750,000 of accounting revenue on a contract under the over-time cost-to-cost method, while the tax base for the same contract (using a billings/certification basis assumed to be permitted under the applicable tax treatment) recognizes only SAR 16,000,000. The temporary difference is SAR 2,750,000 (matching the contract asset recognized). Deferred tax is recognized only on the 30% income-tax-paying portion: 2,750,000 x 30% = 825,000; 825,000 x 20% = SAR 165,000. No deferred tax is recognized for the 70% Zakat portion; its Zakat is charged as current Zakat expense on the Zakat base.
Journal entry to recognize the deferred tax liability:
Dr Deferred income tax expense (P&L) 165,000
Cr Deferred tax liability 165,000
In a later period, if the contract turns onerous and a provision for future losses is deductible for tax only on cash settlement (creating a deductible temporary difference of, say, SAR 1,000,000), and recovery is probable: 1,000,000 x 30% x 20% = SAR 60,000.
Dr Deferred tax asset 60,000
Cr Deferred income tax expense (P&L) 60,000

Professional judgment

Confirming the entity's Zakat and tax profile, and any established policy on deferred Zakat, is a scoping judgment that should be documented: the generally followed position is that Zakat on a Zakat base is outside IAS 12, but some entities have adopted a different policy, and the choice must be applied consistently and disclosed. Determining the tax base of contract balances for the income-tax-paying portion requires understanding how the tax authority actually assesses long-duration contracts in practice (which can differ from a literal reading of the rules), often clarified only through assessment history or specific tax advice. Assessing recoverability of deferred tax assets arising from onerous contract provisions or accumulated losses on long-duration projects requires a credible forecast of future taxable profits, which is inherently uncertain for cyclical, project-based businesses and should not be assumed merely because the entity has been profitable historically.

Source basis

IAS 12 · Income Taxes

Paragraph references

IAS 12.5IAS 12.15IAS 12.24

Verified against the official standard texts used in the IFRS Expert skill.

IAS 12 Income Taxes

Issued: 1996 (revised) · Effective: 1 January 1998

Related issues

Educational and navigation content only. Not professional advice. Does not reproduce official IFRS/IAS text. Consult the authoritative standards and qualified professionals; professional judgment may still be required.