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Deferred tax

Understanding accounts series

Introduction to deferred tax

This is probably the most abstract topic you will find in any of our factsheets. Most people will see the heading in their accounts and, when reassured by their accountant that they won’t have to pay it – ever – they relax and instantly forget it was ever mentioned.What this factsheet aims to do is to at least explain a bit about why it is there, how its value is determined and consider if it is in anyway useful to the business owner.

Why do we have deferred tax in limited company accounts?

Tax is generally treated as an expense in a company’s accounts and this treatment – as an expense – means that we must treat it like all other expenses.From an accounting point of view that requires us to consider what tax is due based on the income and expenses that were received or incurred during the year and compare that with the tax that is actually going to be paid by the company on the profits shown in the accounts.The differences this kind of analysis might throw up could be permanent – eg you will never be able to get a tax deduction for entertainment expenses. These kinds of differences are ignored. The other kinds of differences are timing differences – in other words you may not get a deduction this year but you could get a deduction for that same expense next year. In times when there are beneficial tax allowances, as there are now with the annual investment allowance (please see the jargon-buster on capital investment), this situation is reversed and you receive more allowances early on and pay less taxation.The result is that the tax expense in the accounts is either accelerated (you pay sooner) or it is deferred (it is paid later). As it is usually the latter, the entry in the accounts is called deferred tax whether or not it actually is! The overall effect of this deferred tax process is that the total tax expense (corporation tax plus deferred tax) shown in the accounts should come fairly close to the result of the calculation profit before tax x tax rate. It will seldom work out exactly – because of the permanent differences – but it will be close.

How do we decide on the value of deferred tax in the accounts?

There are two stages in calculating the value for deferred tax.Firstly, how much tax is to be deferred.Broadly speaking – and there are some exceptions – the amount on which the deferred tax is calculated is usually based on (but not exclusively so) the difference between the net value of fixed assets and the net written down value for corporation tax purposes.

So the net value of relevant assets in the accounts:
Cost10,000
Aggregate Depreciation7,000
Net Value3,000
The net written down value for tax purposes:
Cost10,000
Capital Allowances8,500
Net Written Down Value1,500
So the difference is1,500

The second stage is to calculate how much the deferred tax amount is. This is based on the average rate of corporation tax the company will pay on that year’s profit. Normally this will be the corporation tax rate but it can be different in particular situations.Corporation tax rate = 21%. Amount of difference £1500.So deferred tax amount is £315.This amount is the total shown in the notes to the accounts and in the balance sheet in the section, provisions and other liabilities.The amount shown in the profit and loss account is different, however. The amount shown in that statement is only the increase or decrease in the balance sheet value since the previous year.

Is there any value in deferred tax for the business owner?

I believe the answer is yes.Accounting standards make published accounts comparable, between one company and another, so that everyone knows what eg profit after tax means. The premise behind deferred tax is sound enough and allows informed users of the accounts to do their own calculations.Deferred tax generally reduces the amount of profit available for distribution to shareholders and so sets aside a sum of money for future tax liabilities when the impact of accelerated capital allowances reduces, so it encourages a more prudent approach to dividend policy.

Disclaimer

The information contained within this factsheet is factual but may contain opinion and express different ways of considering the topic.No responsibility is accepted by NGM Accountants for any losses or profits foregone by acting on or refraining from acting on any information contained within this factsheet or any factsheets to which this refers.Before making any decisions concerning the accounts of your business or enterprise, you should consult a professionally qualified accountant.Return to Advice page.

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