‘Deferred tax’ is a term you may have come across in your company’s accounts when filing tax returns. But what is it, how does it work and what impact does it have on tax payments? To help you understand, let’s talk about what this term means and look at an example of how it can benefit a company.
What Is Deferred Tax and How Does It Work?
When a company calculates its taxes, they usually have depreciation charges on purchases such as office supplies and equipment. But with purchases expected to last more than one year (known as fixed assets), the company can instead claim capital allowance. This means the company can claim tax deductions. Thanks to Annual Investment Allowance, these deductions tend to be more than the depreciation charges. This means that when corporation tax on profits is calculated, it will be higher during the first year but lower in the years that follow.
A deferred tax is, then, a way to spread tax payments on fixed assets more evenly. While it is possible for companies to accelerate taxes, meaning they pay more in a shorter timeframe, it’s more common for payments to be deferred.
Alternatively, capital allowance may be used to pay a lower amount of tax in year one and more in years two and three. Let’s say your company’s annual profits are £6,000, and you buy desks for the office. It should be several years before they need to be replaced, so they are fixed assets. The desks are purchased for £1,200 and are written off with a depreciation charge. Over three years, this is an annual charge of £400, so in the first year, the company’s profits are £5,600 after depreciation charges have been applied.
Assuming the profits before depreciation stayed the same, this should mean that profits after depreciation remain at £5,600 over the next two years. This is, however, affected by capital allowance, which means the cost of the desks would be completely covered in the first year, with no allowance for the second and third. So, the company will pay a lower amount of tax in year one, but a higher amount in the subsequent two.
The tax expense total is then calculated by adding the deferred tax charges to corporation tax.
Benefits of Deferred Tax
Evening out payments with deferred tax can be useful to a company in a number of ways. It could mean, for example, that a company’s estimation of its annual profits is more accurate – they’re less likely to overestimate. This is important for the company as not only will they have a realistic prediction of their profits for the year, but they will also be able to use this estimate to help ensure that their tax expenses are calculated and paid correctly.
After reading this, you may have further questions about deferred tax and how to make it work for your business. At AccountantFor, we can help you with all your accountancy needs, including deferred tax. Get in touch with us today and find out how we can make things simpler for you.
Last Updated on August 15, 2022 by Michael Bush
Michael is the owner of AccountantFor, which is part of the Bula Media group. As an experienced business owner and investor, Michael wanted to build AccountantFor through his personal experience of his frustration in finding the most suitable accountant for his requirements. In addition to this, we bring a number of expert views from accountancy and financial experts to help small businesses and sole traders.