When filling in a tax return and calculating allowances, expenses and liabilities, there are several terms company owners may come across. One key concept to grasp when looking at the books is that of 'deferred tax'. 

What exactly is deferred tax? 

'Deferred tax' can often be seen as a heading in a company’s accounts, but what does it mean and how does deferred tax affect a company's tax payments? 
 
When calculating corporation tax, limited companies are able to make a series of adjustments, including depreciation charges on assets such as machinery and office equipment. In some cases, rather than applying depreciation allowances, the company will claim capital allowances. Capital allowances often offer more scope for limited companies to save due to the Annual Investment Allowance. By taking this route, companies use a deduction, rather than a depreciation charge, and this means that the tax on profits would be higher in the first year but lower in subsequent years. 
 
Essentially, using deferred tax is a means of evening out payments, which can help to lower the risk of a company overestimating annual profits. 
 
Deferred tax charges also provide a way to account for timing differences. With the Annual Investment Allowance, companies may receive more benefits early on and pay less tax, and this means that the business will either accelerate or defer the tax expenses. In the majority of cases, the payment is deferred. The result is that the figure for total tax expenses, which is calculated by adding corporation tax to deferred tax charges, works out at a similar amount to the profit before tax and tax rate calculation. 

An example of how deferred tax works 

There are two key stages involved in working out the value of deferred tax charges. 
 
The first step to take is to figure out how much tax will be deferred. In many cases, this valuation relates to fixed assets - for example a new computer - and it can be calculated by comparing the net value of any fixed assets and the net value used for corporation tax purposes. This means that if you have assets worth £10,000 and the net value is £3,000 after depreciation charges have been taken into account, you would compare this figure to the written value for corporation tax, which includes capital allowances. 
 
On a sum of £10,000, for example, a sum of £8,500 is claimed in capital allowances and the net written down value is £1,500. 
The second step involves working out the amount of deferred tax using the average corporation tax rate. In a situation where the difference is £1,500 and the corporation tax rate is 19%, the deferred tax total would be £285. 
 
Another example highlights the impact of capital allowances. If a company purchases a printer for £1,500, this can be written off in the next three years using a depreciation charge of £500. If the company's profits are £5,000, this means that profits are worth £4,500 after depreciation. The tax payment for the next two years would be the same based on the depreciation charge of £500. 
 
In reality, the calculation is different for the limited company’s tax because of capital allowances. In year one, 100% of the total cost of the printer would be covered, and this means that there are no allowances for years two and three. Consequently, the tax payment is lower in year one and higher in years two and three. 

What are the benefits of deferred tax for company owners? 

Balancing the books is one of the most critical concerns for business owners. 
 
When it comes to calculating tax liability and working out profits and losses, limited company directors need to be aware of how much tax they’re paying and to be able to plan in advance. Deferred tax charges enable company owners to accelerate access to tax benefits and to delay payments for future periods. The aim is to try and balance payments so that the timing of tax charges fits in with the company’s profit records. 
 
Deferred tax can contribute to a reduction in the amount of profit available to distribute to shareholders and this creates a pot to use for future tax payments, which coincide with lower capital allowances. The outcome is a more balanced approach, which prevents the company from overestimating profit predictions. 
 
Overall, deferred tax is basically a means of evening out tax payments when you buy a fixed asset for your company. 
 
Capital allowances enable access to deductions in the first year, which lowers payments for the tax year, but increases charges for subsequent years. The alternative is to pay the same amount each year. 
 
Essentially, deferred tax can help businesses to calculate profits more accurately. 

Next steps 

Deferred tax is one of those complex subjects that we can handle for you. Feel free to get in touch with us today to see how we can ease your tax and accounting headaches. Feel free to give us a call or drop us an email. We’ll be more than happy to help advise you, taking your individual circumstances into consideration. 
 
 
 
 
Written by 
 
Nicola J Sorrell - 
Effective Accounting 
 
Founder | Xero Champion | IR35 Expert 
Tagged as: Company Tax, Tax Rates
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