Tax Accounting — Tax Adjustments for Depreciation: Depreciation Limit, Disallowed Excess and Shortfall

Accounting depreciates in line with the pattern in which economic benefits are consumed (Principles of Accounting chapter 9). For fairness in taxation, tax law sets a depreciation limit and allows as a deduction only the amount the company records in its books up to that limit. Depreciation is a book-based adjustment item, so it cannot be deducted if it is not recorded in the books (chapter 1).

1. Factors that set the depreciation limit

• Acquisition cost: purchase price and incidental costs, plus any capital expenditure.
• Method: straight-line for buildings; for other property, plant and equipment, the declared choice of straight-line or declining-balance (declining-balance if nothing is declared); straight-line for most intangible assets.
• Useful life: the declared life within 25% either side of the asset’s standard useful life (the standard life if nothing is declared).
• Residual value: treated as zero. The declining-balance rate reflects a 5% residual value, and when depreciation ends, the lesser of 5% of cost and ₩1,000 is kept as a memorandum value.

2. Disallowed excess and shortfall

A shortfall means the company depreciated less than the limit. Because depreciation is a book-based item, an amount not in the books cannot be deducted, so the shortfall simply lapses. But if earlier amounts disallowed above the limit remain, they are revived as deductions up to the shortfall (reversal).

3. Worked example

TK bought a machine for ₩100 million at the start of 20X1. With straight-line depreciation and a declared useful life of five years, the limit is ₩20 million a year.

In 20X3 the shortfall is ₩2 million, but only ₩1 million of disallowed amounts remain, so only ₩1 million is deducted and the other ₩1 million lapses.

4. Deemed immediate depreciation

If the company expenses as repairs a capital expenditure that increases an asset’s value or extends its useful life, tax law deems the amount to have been recorded as depreciation. It is added to the amount recorded and also to the acquisition cost, and the limit is recalculated.

Separately from the table above, if in 20X2 TK had expensed as repairs ₩10 million spent on upgrading the machine’s performance, the depreciation it recorded would be $1{,}600 + 1{,}000 = 2{,}600$ (₩26 million). Under straight-line, the limit is based on cost, so it is $(10{,}000 + 1{,}000) \times 0.2 = 2{,}200$ (₩22 million). The ₩4 million excess is disallowed (retained).

The following, however, are deductible immediately (immediate depreciation exceptions): small assets costing ₩1 million or less per transaction, repairs of an individual asset under ₩6 million or under 5% of its previous carrying amount, and periodic repairs recurring at intervals of less than three years.

Check your understanding

TL bought fixtures for ₩40 million at the start of 20X1. It declared the declining-balance method, with a rate of 0.451. In 20X1 the company recorded ₩20 million of depreciation, and in 20X2 ₩10 million. What are the tax adjustments for the two years?

The 20X1 limit is $4{,}000 \times 0.451 = 1{,}804$ (₩18.04 million), so the ₩1.96 million excess is disallowed (retained). In 20X2 the tax undepreciated balance is the book carrying amount of ₩20 million plus the ₩1.96 million retained, ₩21.96 million, and the limit is $2{,}196 \times 0.451 ≈ 990$ (about ₩9.9 million). The ₩10 million recorded is about ₩100,000 more, so about ₩100,000 is disallowed (retained), bringing the retained balance to about ₩2.06 million.

References

• Corporate Tax Act, Article 23 (disallowance of depreciation) — Korea Law Information Center
• Enforcement Decree of the Corporate Tax Act, Article 26 (calculation of the depreciation limit) and Article 31 (deemed immediate depreciation)
• Enforcement Rules of the Corporate Tax Act, Appended Tables 5 and 6 (standard useful lives)