If you run a limited company, it’s likely that “deferred tax” will feature in the accounts. But what on earth is deferred tax?
This is one of those questions most accountants (including me) dread being asked, because the answer is a bit… complicated. I thought I’d have a go at explaining it in layman’s terms anyway. Wish me luck…
Before we get into the detail, there are some important things to appreciate:
- Limited company accounts are prepared under company law and accounting standards.
- The taxable profits of a company are calculated under UK tax law.
- Company reporting rules and UK tax rules are not the same thing (though they often overlap).
- Consequently, the profit figure on which your company’s tax charge is based, is rarely the same number as the profit figure shown in your company’s accounts.
Why have such a complicated system? Why aren’t “accounting profits” the same as “taxable profits”? The answer is simple. Governments use tax legislation to collect revenue; incentivise some behaviours; discourage other behaviours; and prevent perceived tax avoidance activity. Accounting standards are designed to make companies accurately report the economic consequences of their activities, tax rules are designed to make companies pay tax. The two systems have different objectives.
What does any of this have to do with deferred tax? Remember that accounting rules are designed to show the economic effects of a company’s activities. Tax rules are designed to collect revenue and influence taxpayer behaviour. One of the ways in which tax and accounting rules differ is that some transactions shown in a company’s accounts for one financial period are recognised for tax purposes in a different financial period. This leads to “timing differences”, situations where a transaction is recorded in the accounts in one financial period but the associated tax cost (or benefit) is suffered (or enjoyed) in another period.
In the accounts we want to recognise the economic consequences, including the economic consequences arising from taxation, of decisions made by management. And that’s where deferred tax comes in. Deferred tax is a value included within the tax charge in a company's accounts, so that shareholders (and other stakeholders) can understand the tax effects of the transactions reported therein.
The simplest and perhaps most common example of a timing difference concerns a company’s investments in plant & machinery (including things like vans, office equipment etc). Under current tax laws, small companies can generally set off as much as 100% of the cost of plant & machinery against profits, in the year of purchase. But would the cost of that plant & machinery be written off in the profit & loss account straight away? Probably not. Plant & machinery normally goes on the balance sheet, and the cost is then gradually “written off” to the profit & loss account as “depreciation” over a few years. So here we have a classic timing difference where the UK tax system gives relief for the full cost straight away, but UK accounting rules spread the cost over a number of years.
Let’s take this a step further with some numbers…
ABC Limited’s 2018 accounts show a profit before tax of £50,000. During 2018 it bought some machinery for £40,000 which it is writing off over two years, £20,000 per year, but for tax purposes it claims relief for the full cost of £40,000 straight away.
The corporation tax charge for the 2018 year (the actual tax the company will have to pay) is £5,700.
With no deferred tax provision, the 2018 accounts would show:
Profit before tax £50,000
And in 2019, assuming the same profits, the corporation tax charge would be £13,300 and the accounts would show:
Profit before tax £50,000
On the face of it, the tax figure in the 2018 accounts, £5,700, is the same as the amount of tax the company actually has to pay. Same for 2019. So what could possibly be wrong?
Well, the issue here is that the 2018 accounts show all the benefit of the tax relief, but only £20,000 of costs (being the depreciation charge for the first year). So the effective tax rate presented in the 2018 accounts is (£5,700 / £50,000 x 100) = 11.4%! Without including deferred tax, the tax charge reported in the accounts is too low, because ABC’s 2018 profit & loss account shows all the benefit of the tax relief for the cost of the machinery, but only half the cost.
The 2019 figures have the opposite problem; they show none of the benefit of the tax relief (because it was all recognised in the 2018 accounts), but they do show a further £20,000 of costs (the depreciation charge for the second year). The effective tax rate presented in the 2019 accounts is (£13,300 / £50,000 x 100) = 26.6%!! Without including deferred tax, the tax charge reported in the 2019 accounts is too high because ABC’s 2019 accounts shows £20,000 of costs, but none of the associated tax benefit.
With deferred tax included, on the other hand, the 2018 and 2019 accounts would both show:
Profit before tax £50,000
The tax charges reported in these accounts work out at 19%, which is the effective rate of tax that ABC actually pays across the two years taken together. Just as the cost of the machinery is steadily charged to the profit & loss account over the length of time the company uses it (two years in our example), so the benefit of the up-front tax relief in these accounts is now spread over the same term. ABC is now recognising both the cost (the depreciation), and the related benefit (the tax relief), pro rata over the same time periods. Once the company has included deferred tax in its accounts, there is no longer a timing difference between the recognition of the cost, and the recognition of the associated tax benefit.
Timing differences can also arise for a variety of other reasons; trading losses, unpaid pension contributions, general bad debt provisions, and unrealised gains and losses on investment properties are just a few other examples.
Ultimately, though, because deferred tax is concerned only with timing differences, it is a zero-sum game. Over the life of a company, the amounts of deferred tax recognised in the profit & loss account will eventually net down to nil. That does not mean, however, that it can be ignored, because the timing differences can have a huge impact on individual financial periods. Deferred tax must therefore usually be recognised so that the effects of timing differences such as those described above do not have a distortive effect on the reported results of any one specific financial period.