SISTEMAS CERRADOS

I’ve already explained that in many countries taxable profits aren’t the same as the reported profit before tax. So you can’t take the pre tax profits, mul-tiply them by the tax rate and arrive at the tax charge. Some things that are charged to the published income statement (in the UK a good example is entertaining clients) aren’t allowed for tax purposes. Other things have dif-ferent values in the tax accounts and the published accounts.

These differences between the two sets of accounts are called timing dif-ferences. They can either be permanent, where they appear in one set of accounts but not the other. Or, they could show in the published accounts in a different year than they show in the tax accounts. Accountants talk about these differences being either ‘permanent’ or ‘timing’. Perhaps the best example of a timing difference is the different property, plant and equipment values that are found in the two sets of accounts. Each company determines its depreciation charge, and the depreciation charged on the same asset is often different in one company to another. The tax authorities in the UK ignore the depreciation charge, as it varies from one company to another, and gives companies a standard tax allowance. This is called a capital allow-ance. (Company tax allowances work essentially the same way as personal tax allowances, reducing the taxable profit.) Because the depreciation charge is different from the tax allowance, the asset’s value is not the same in the tax accounts as the published accounts. There’s usually a temporary difference between an asset’s book value, shown at cost or valuation less depreciation to date, and its tax value. These differences could either be taxable (the book value is higher than the tax value) or deductible (the book value is lower than the tax value). If the asset’s book value is higher than its tax value, and the asset is sold at its book value, the company will have a taxable profit.

I’ll explain this in the next example.

Firstly let’s look at the published accounts.

A company buys a machine for £5,000 and plans to keep it for five years. At the end of the five years it believes that the machine will be worth nothing.

To the company, depreciation is a matter of simple arithmetic – it has £5,000 to write off over five years – £1,000 a year. (Most companies make an equal charge over the life of the asset, using a method of depreciation called the straight line method, and I’ll discuss the different depreciation methods later in this chapter.) The depreciation charge is part of the operating costs in the income statement.

Now let’s consider the tax accounts. I’ll assume that the machine qualifies for a 25% tax allowance. Most UK companies use the straight line method to calculate their depreciation charge, but tax allowances in the UK are calcu-lated using a different method. In the first year the allowance would be 25%

of £5,000 = £1,250, giving an asset value of £3,750. In the second it would be 25% of £3,750 (£5,000 – £1,250) = £938. The tax allowance is given on a reducing balance basis. (Some companies, largely overseas and small UK com-panies, use this method to calculate their depreciation charge.)

You can see that that the tax value of the asset is very different from the book value of the asset when assets are depreciated on a straight line basis and tax allowances are given on a reducing balance basis. I’ve graphed the different values in the figure below:

0 Year 1 500

3,500

2,500

1,000 2,000 3,000 4,000 4,500

Year 2 Year 3

Comparison of an asset’s book value and its tax value

Year 4 Year 5 Book value Tax value

You can see that the machine’s value is different in the two sets of accounts.

In the early years it is worth more in the published accounts, but from the third year onwards it is worth more in the tax accounts. At the end of the fifth year the asset has a zero book value, but is still worth over £1,186 in the tax accounts. In the first two years there would be a deferred tax liability (a future tax payment) and from year three onwards there would be a deduct-ible difference, a deferred tax asset (a future tax repayment or credit note).

You’ll see these deferred tax assets and liabilities shown on the balance sheet.

Deferred tax assets may be small, unless the company has a large pension deficit and, or, has made large acquisitions, as they can only be shown if they are recoverable.

I’ll use my previous example to illustrate the deferred tax charge and the resulting deferred tax liability. In the first year the machine was worth

£4,000 in the company’s published accounts and £3,750 in its tax accounts.

Assuming a tax rate of 28% there is a deferred tax charge of £70 (£250 x 28%), which would show as a deferred tax liability on the company’s bal-ance sheet. Deferred tax has the effect of aligning the tax charge with the country’s tax rate, and I’ll show you what I mean by continuing my previous example and assuming that the company makes £11,000 profit before the depreciation charge of £1,000, so its reported profit before tax is £10,000.

Tax accounts: £ Published accounts: £

Reported profit 10,000 Profit before tax 10,000

Depreciation 1,000 Tax charge:

Profit for tax purposes 11,000 Current tax (2,730)

Less capital allowance 1,250 Deferred tax (70)

Taxable profit 9,750 Profit after tax 7,200

Tax @ 28% (2,730)

The total tax charge is £2,800, 28% of the profit before tax. If only the cur-rent tax had been charged the effective tax rate would have been 27.3%, lower than the country’s corporation tax rate.

Deferred tax just follows normal accounting practice – a deferred tax liability is effectively an accrual for tax, and a deferred tax asset is a tax prepayment.

Deferred tax brings the tax accounts and the published accounts into line. It adjusts the tax charge to reflect the tax that would be payable if the asset’s book value was the same as its tax value. This means that the tax charge now

reflects the total possible tax charge, including tax that might never have to be paid.

Deferred tax must be provided for in full for all temporary differences between the tax value of the assets and liabilities and their book value in the financial statements unless the temporary difference arises from:

O

O the initial recognition of goodwill (this only applies to a potential deferred tax liability);

O

O the initial recognition of an asset or a liability in a transaction that is not a business combination and that affects neither accounting profit nor taxable profit;

O

O investments in subsidiaries, branches, associates and joint ventures but only where certain criteria apply.

Reconciling the tax charge to the profit before tax in the