There are many reasons why the "profits" figure on which your company or personal tax bill is based may differ from the profits figure shown in the accounts. To help readers, we summarise a few of the most common reasons below.
The key thing to appreciate is that the UK tax system and UK accounting standards each tend to define profits, losses and gains in slightly differently ways. Your accountant will prepare your business's accounts in accordance with UK accounting standards; but when they prepare your tax returns, they have to convert the figures in your accounts into amounts that are recognised in UK tax law, and the two are rarely the same thing.
How does this work in practice? What usually happens is your accountant firstly prepares your business's accounts. Then they prepare your tax computation(s) and return(s). To prepare a tax computation, they will usually start with the profit (or loss) shown in the accounts but then they have to adjust it to end up with a figure that is recognised in UK tax law.
Depreciation and capital allowances
Depreciation, which is charged to the profit & loss account as an expense, is a measure of how a business "uses up" or "consumes" assets that it owns for the long term, for example plant & machinery. For tax purposes, depreciation is generally not deductible, so it has to be added back when converting accounting profits into taxable profits. Businesses can instead claim "capital allowances" which provide relief for the cost of acquiring plant & machinery, integral features forming part of a building, or (since October 2018) the cost of commercial premises.
If your business is unincorporated (i.e. if it trades as a sole trade or partnership) then the private element of any expenditure through the profit & loss account will not be deductible, so it has to be added back. Private motoring expenses and utility bills are common examples. The situation may be different if your business is a limited company, because private costs paid by the employer will generally be deductible if paid "wholly and exclusively for the purposes of the trade", although income tax and NIC may be levied under the "taxable benefits" regime.
Certain business expenses are specifically non-deductible for tax purposes, including most business entertaining costs, gifts to customers (with some exceptions for low value items), and almost all fines and penalties. Non-deductible expenses have to be added back when converting accounting profits to taxable profits.
Deductions governed by the timing of payment
Accounts prepared under UK accounting standards adopt the "accruals basis" of accounting, meaning they reflect income earned and expenses incurred in the period, rather than cash received and cash paid. Therefore some expenses shown in the accounts may not actually have been paid until after the period end. This is significant because some expenses that appear in profit & loss accounts are only deductible for tax purposes if actually paid within specific time limits.
Under UK tax rules, employer pension contributions are only deductible in the period in which they are paid. When working out taxable profits, an adjustment has to be made to the accounting profit to add back any employer pension contributions that have been incurred, but not actually paid, in the period.
As another example, employee and director remuneration that is not paid within nine months of a company's year end is only deductible for tax purposes in the period in which it is ultimately paid.
Losses brought forward
For tax purposes, trading losses may be carried forward and relieved against profits arising in future periods. Therefore whilst a business may report a profit in its accounts for a certain period, for tax purposes the profit could be much lower, or even zero, once tax losses brought forward from prior periods are taken into account.
This is just a short introduction to explain the basic approach and highlight some of the most common examples of adjustments between accounting and taxable profits. For further guidance contact our tax team today.