Guide to Deferred Tax
As accountants we are often asked by clients “…if the Corporation tax rate is 20%, why isn’t the amount of tax I have to pay 20% of the net profit shown in my accounts?” It’s a perfectly fair and sensible question.
Although the specifics will vary from company to company, the general answer is due to temporary timing differences occurring between accounting treatment of certain items and how the taxman treats those items.
The easiest and most common example to use is in relation to depreciation of fixed assets. Let’s say that you buy a laptop for £1,000 and expect to use it for 4 years (it's useful economic life). Therefore, in the accounts the laptop will be depreciated over 4 years. Each year there will be a depreciation cost of £250 and the value of the laptop will decrease by the same amount until it has no value. This is the correct accounting treatment.
From a tax perspective, the depreciation cost is not an allowable expense so no tax relief can be claimed on the £250. Instead, the business can claim something called capital allowances (which is the taxman’s version of depreciation) and is in fact entitled to claim the Annual Investment Allowance (AIA) on assets up to £200,000. This means that HM Revenue & Customs (HMRC) will allow full tax relief in year one on the £1,000 spent on the laptop.
If in the example the accounts show a net profit of £4,750 after depreciation, we would expect a tax charge of £950 (£4,750 x 20%). Again, this seems a reasonable assumption. However, the actual tax charge is on a taxable profit of £4,000 (£4,750 + £250 disallowed depreciation - £1,000 AIA on the laptop) resulting in tax payable of £800 (£4,000 x 20%).
The difference of £150 is only a temporary difference and this is our Deferred tax liability.
A Deferred tax liability is an amount of income tax ‘payable’ in future periods in respect of taxable temporary differences.
An adjustment will be made to the accounts to provide for deferred tax of £150 so that there will be an overall tax charge in the accounts of £950 (£850 + £150).
If we take our example into year 2, the accounts will be exactly the same, showing a net profit of £4,750 after depreciation and again we would expect a tax charge of £950 (£4,750 x 20%). From a tax perspective there is no more tax relief that can be claimed so the actual tax charge this year is on a taxable profit of £5,000 (£4,750 + £250 disallowed depreciation) resulting in tax payable of £1,000 (£5,000 x 20%).
This year the difference is £50 but is the other way which now reduces our overall difference to £100. This remaining difference will reduce to zero across years 3 and 4 when the value of the laptop will be depreciated to zero.
Deferred tax is unfamiliar for many non-accountants but if you have come across the matching concept, perhaps through accruals and prepayments or stock adjustments, the idea is the same. We are simply trying match the timing of the tax charge to the timing of the profit in the accounts.
What is changing?
In addition to the timing difference for tax relief on fixed assets, there are three additional situations when deferred tax must now be calculated and these are in respect of:
- Revaluations of non-monetary assets (including investment property)
- Fair values on business combinations i.e. acquisitions of other businesses, trades and assets
- Unremitted earnings in overseas subsidiaries and associates
What is the impact on your accounts?
Under new UK accounting standards, deferred tax is now going to be more widely applied and as a small business you may now see this appear in your accounts for the first time. The impact will vary from business to business depending on what transactions and timing differences take place.
Unfortunately, additional deferred tax provisions will reduce net assets, making the balance sheet look weaker. Some may also reduce retained profit which would have an impact on dividends that can be paid. However, for the majority of small and non-complex businesses, the implications should be minimal.
If you have not had your Pre-Year End meeting, ensure you get one booked in and get your records in as soon as possible. If you have any questions, please give your Client Manager a call or complete the Contact Form and one of us will get back to you.