When calculating the corporation tax charge for a limited company a number of adjustments are made. The most significant of these is that any depreciation charge on fixed assets (assets which will last more than one year eg computers, plant & machinery etc) will be disallowed and instead the company will be allowed to claim capital allowances.
The capital allowances which a company can claim as a deduction are often far more generous (because of the Annual Investment Allowance) than the depreciation charge. This means that if we calculated corporation tax on the accounting profit it would be higher than the corporation tax charge on the taxable profit in the first year but vice versa in the following years.
Putting through a deferred tax charge is a way of 'evening' out these differences so that the company doesn't overestimate its profit. A provision is created when deferred tax is charged to the profit and loss account and this provision is reduced as the timing difference reduces.
Let's look at an example.
A business has profits each year of £5,000 before any depreciation charge. In year 1 they buy a computer for £1,800 and this is written off in the accounts by way of a depreciation charge over 3 years. So each year there's a depreciation charge of £600 - meaning their accounting profit after depreciation is £4,400. If corporation tax was charged on accounting profit then they would have tax charge of £880 (£4,400 * 20% as at June 2016). And assuming the company's profits stayed consistent for the next two years, year 2 and year 3 would have the same accounting profit after depreciation and the same taxation charge.
However the tax computation is different. Rather than a £600 charge for depreciation each year, 100% of the cost of the computer is allowed in year 1 and then there is no allowance in years 2 and 3. So the tax payable is higher in years 2 and 3 than in year 1.
Let's see how this looks in a table:​
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| Year 1 | Year 2 | Year 3 | Total |
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Accounting profit before tax | £4,400 | £4,400 | £4,400 | £13,200 |
Add: Depreciation | £600 | £600 | £600 | £1,800 |
Less: Capital allowances (currently 100% first year) | £(1,800) | £0 | £0 | £(1,800) |
Taxable profit | £3,200 | £5,000 | £5,000 | £13,200 |
Corporation tax on taxable profit at 20% | £640 | £1,000 | £1,000 | £2,640 |
Corporation tax on accounting profit |
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Difference - put through the accounts as a deferred tax charge/(release) |
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Deferred tax provision on balance sheet | £240 | £120 | £0 | |
Total tax charge per accounts - corporation tax and deferred tax |
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So the deferred tax charge is just a way of accounting for the timing differences due to the different corporation tax rules - and over time the corporation tax charged will be the same whether it's calculated on the accounting profit (£4,400 per year) or on the taxable profit (£3,200 in year 1 and £5,000 in years 2 and 3).
And the deferred tax provision on the balance sheet is £240 in year 1 but reduces by £120 in year 2 and £120 in year 3 - so at the end of the 3 years there is no provision left.