Habel Inc. owns equipment with a tax base of $400,000 and a carrying value of $600,000. Habel also has a tax loss carryforward of $200,000 that is expected to be utilized in the foreseeable future. Deferred tax items on the balance sheet are valued based on a tax rate of 30%. If the tax rate is expected to increase to 35%, the adjustments to the value of deferred tax items will most likely cause Habel’s total liabilities-to-equity ratio to:
A) decrease. B) increase. C) remain unchanged. View Answer and Explanation
The $200,000 difference between the tax base and the carrying value of the equipment gives rise to a taxable temporary difference that leads to a deferred tax liability of $60,000 ($200,000 × 30%). The tax loss carryforward of $200,000 leads to a deferred tax asset of $60,000 ($200,000 × 30%).
The increase in the tax rate from 30% to 35% will increase both the DTL and the DTA by $10,000 ($200,000 × 5%). Equity is unchanged. Therefore, the total liabilities-to-equity ratio will increase because of the increase in the deferred tax liability.
So the answer is B, increase. I am confused as to why this is not remain unchanged. If both the DTA and DTL are $60,000 before the tax change, and they both increase by $10,000 each due to the tax change, won’t they offset each other, leaving deferred taxes unchanged?