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by Danny Leiwy 28 Mar 2006 Diploma in Financial Management Relevant to All papers

Corporation tax is payable by all companies, and certain clubs and associations, resident in the UK on their 'profits' - both income and capital gains - arising worldwide. Non-resident companies are liable on income and capital gains in the UK only.

Corporation tax is payable for each 'accounting period', normally the company's accounting year. The rate of corporation tax is fixed in the Finance Act for each 'financial year'. In the financial year 2005, which is the year from 1 April 2005 until 31 March 2006, the rate of corporation tax is 30%. Special rates apply to small companies. A company's liability must be discharged within nine months of the end of its accounting period or, in certain circumstances, in quarterly instalments.

One might naturally assume that if a company makes a profit before tax of £100m, its corporation tax charge at the rate of 30% would be £30m, but this is not, in fact, so. The rules for determining a company's accounting profit and its taxable profit are different, and are designed with different considerations.

Computation of profit

A company's profit before tax is determined by rules and conventions, many of which are set out in the Companies Acts, 1985 and 1989, in International Financial Reporting Standards (IFRSs), Financial Reporting Standards (FRSs) and Statements of Standard Accounting Practice (SSAPs), and in Stock Exchange regulations. These rules and conventions, on the whole, are designed to result in the profit and loss account showing a 'true and fair view', and since this is such an imprecise concept, allows considerable choice in accounting policies. The rules for determining taxable profit set out in tax law, such as the Income and Corporation Taxes Act, 1988 and the Finance Acts, as well as case law are far more specific. Since the tax regulations are different to the accounting rules, a different profit figure results.

It is not, however, necessary to produce two different sets of accounts for these two purposes. The approach is to start the corporation tax computation with the profit before tax shown in the annual accounts and then to make adjustments as necessary.

'Non-allowable' expenses

Some expenses are legally deductible in the profit and loss account under the accounting rules and conventions but are 'not deductible', or are 'not allowable' for tax purposes, while some items shown in accounting profit are not taxable and must therefore be deducted in computing taxable profit.

Expenses considered 'not allowable' include the following:

• depreciation on tangible fixed assets
• amortisation of goodwill on consolidation
• losses on sale of fixed assets
• entertainment expenses
• general provisions (eg for bad debts)
• legal and other professional fees on acquisitions of a capital nature, eg a new factory
• political and most charitable donations unless made under Gift Aid
• fines, generally, eg for contravention of Factories Acts.

There a several reasons that these items are not allowable for tax purposes. In the case of depreciation, for example, FRS 15 gives an accountant considerable latitude as to the method and rate adopted. The consideration in the annual accounts is to select the method which shows a true and fair view and since depreciation is added back in the tax computation, the wish to reduce the tax liability will not enter into the selection of the accounting policy. Moreover, tax legislation, where possible, lays down specific rules, unlike the more subjective rules of accounting. In place of depreciation, tax legislation permits a deduction for the costs of specific capital expenditure, at specified rates. Such deductions are known as capital allowances and will be discussed later.

Most company expenses are allowable. If a company incurs salary costs of £1m, this will reduce profit accordingly and since this is an allowable expense and will not be added back in the tax computation, the corporation tax charge will be reduced by £300,000 (£1m x 30%). The net cost to the company is, therefore £700,000. In the case of entertainment, however, while this is a perfectly legitimate expense, the UK Government is unwilling to pick up 30% of the bill and thus entertainment is 'not allowable'.

Non-taxable profits

Among those items of accounting income which must be deducted in the tax computation are:

• profits on the sale of fixed assets which may be taxed as chargeable gains
• dividends received from UK companies.

Additionally, items such as interest paid and received are treated for tax purposes on a cash basis and not on the accruals basis applying in the profit and loss account. Adjustment may therefore be necessary for the difference between interest payable for the year and interest actually paid in the year. A similar adjustment would apply to interest receivable/received.

Capital allowances

A company can deduct expenditure on specified fixed assets. In the case of 'plant and machinery', which includes furniture and fittings, office equipment such as computers and motor vehicles, a writing down allowance (WDA) at the rate of 25% pa on a reducing balance basis is available. In the case of motor cars, the maximum WDA is £3,000 pa for each car. Thus a Rolls-Royce will attract the same deduction in year 1 as a Ford Fiesta costing £12,000. Small and medium-sized companies, as defined by the Companies Act 1985, are entitled to first-year allowances of 40% of the cost of plant and machinery and 25% WDA in subsequent years.

In the case of 'industrial buildings' such as factories and warehouses and hotels, WDAs of 4% pa on a straight line basis apply.

Allowances are given for certain other capital expenditure such as agricultural buildings and for industrial and commercial buildings in 'enterprise zones'.

Rate of corporation tax

For the financial year 2005 (the year ending 31 March 2006), the rate of corporation tax is 30%. However, as the table shows, for companies with taxable profits below £1.5m, lower rates of corporation tax apply.

As you can see, companies with taxable profits below £10,000 pay no corporation tax. The effect of the marginal relief is that as taxable profits rise from £10,000 towards £50,000 so the effective rate moves from 0% to 19% and as taxable profits rise from £300,000 to £1.5m, so the effective rate moves from 19% to 30%. Special rules apply to companies with a taxable profit below £50,000 that have paid dividends to individual shareholders in the year.

Payment of corporation tax

Corporation tax is due and payable nine months after the company's year end. However, companies paying corporation tax at the full 30% rate are generally required to pay their corporation tax in four quarterly instalments, based upon their anticipated taxable profits, the first instalment becoming payable on a date six months and 14 days after the beginning of the accounting year and thereafter at three-monthly intervals.

Self assessment

In the UK, each company is required to complete a comprehensive tax return form (form CT600) for each accounting period. The return must be filed with HM Revenue & Customs, together with a copy of the accounts and the company's computation of the corporation tax liability and other supporting documentation within 12 months of the year end.

There is a regime of interest and penalties in the event of late payment of tax or overdue submission of the corporation tax return.

Deferred Tax: FRS 19

Deferred taxation is taxation attributable to 'timing differences' and can arise, for example, after the acquisition of plant and machinery. Timing differences are differences between profits for taxation and accounts profit. These result from the inclusion of items of income or expenditure in tax computations in a different period from which they are included in financial accounts.

Timing differences originate in one period and are capable of being reversed in subsequent periods and both in reality and in terms of exam questions, the most important example is in terms of the different period in which capital allowances are deducted in the corporation tax computation and depreciation is deducted in the accounts.

The provision of deferred taxation, when appropriate, results in 'true and fair view' accounts in accordance with accruals concept, the prudence concept and removes distortions in earnings per share computations. In addition to providing for the company's corporation tax liability in accordance with taxation law, as outlined above, the company provided for the corporation tax deferred for payment in subsequent years as a result of capital allowances. These arose from the acquisition of assets classified in tax law as 'plant and machinery' in an earlier period to depreciation charged under the accounting rules and conventions.

The tax deferred in the year of acquisition because capital allowances are likely to exceed the depreciation charge, is likely to be payable in subsequent years since then, depreciation is likely to exceed capital allowances. In the balance sheet, the deferred tax provision, which appears in 'Creditors: amounts falling due after more that one year' relates to the excess of the net book value of the plant and machinery over its written down value for tax purposes. The effect of deferred tax on the profit and loss account is the difference between the balance sheet value at the end of the year compared with the balance sheet value at the beginning of the year.

Past exam questions

Past questions in Module A papers have required knowledge of three areas from this article. Questions can require the description, purpose and implications of technical terms to be found in published financial statements, such as 'deferred taxation' for example. On other occasions in the past, the examiner has expected knowledge of which expenses are allowable and which aren't, together with an understanding of the effects on the corporation tax liability of both allowable and non-allowable expenses. Other questions can require an understanding of the tax implications of the acquisition of plant and machinery, eg capital allowances. Very commonly, in the Section A multiple-choice questions, and sometimes in Section B, computational questions on corporation tax and deferred taxation appear.

December 2004 Section A Question 9

At 30 November 2004 the net book value of the fixed assets of Reynard Ltd was £3,570,000 and the tax written down value was £2,450,000. The provision for deferred tax brought forward was £250,000. The tax rate is 22%.

Question
What should be reported in the profit and loss account in respect of deferred tax?
A a credit of £3,600
B a charge of £3,600
C a credit of £246,400
D a charge of £246,400

Solution
The deferred taxation provision at 30 November 2004 equals:

Therefore the answer is 'A', since the provision has reduced and so there is a credit to the profit and loss account of £3,600.

June 2005 Section B Question 1

In this question, candidates are asked to explain (i) the accounting treatment of corporation tax - an estimate of the liability based on a computation by the company at the appropriate corporation tax rate on its accounting profit, as adjusted, for example, for non-allowable expenses and capital allowances and (ii) why it is necessary to provide for deferred taxation. This estimate for corporation tax will usually be correct but sometimes computation errors or disagreements on an interpretation of the rules between the company and HM Revenue & Customs will mean that the estimated liability to higher or lower than the finally agreed tax liability. In this question, the £8,000 credit balance on the taxation account arises because the company had overestimated at 2004 corporation tax liability and so, in 2005, the corporation tax charge in the 2005 profit statement, of £62,000 will be reduced by £8,000 to £54,000. The corporation tax liability in the 2005 balance sheet is £62,000. The deferred tax liability to be shown in 'Creditors: amounts falling due after more than one year' is:

Danny Leiwy is DipFM course director at the Westminster Business School

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