So that’s what Deferred Tax is!
Well, That Figures; smoothing the tax charge makes sense at last, having had a chat with Jonathan about the delights of the Deferred Tax charge that appears in accounts.
I was so delighted that I finally understood Deferred Tax that I could not resist helping myself to a chunk of Jonathan’s fruit cake; little knowing that this would result in me being taken ASAP to the vets for treatment. Jonathan was not impressed with the resulting vet’s bill so I have been trying to smooth his irritation by showing him extra love and affection now, to avoid his long term disappointment later; which strikes me as being a little like Deferred Tax!
Read on if you do not believe me…
My understanding of Deferred Tax
“OK Lyra, first of all you have to understand that if you buy a piece of machinery, for example a milky bone maker at a cost of 100 milky bones,” (at this point I was all ears) “then in the accounts we will depreciate the asset over the life of the machine, which is say four years.”
Well, that to me seems entirely reasonable, as I know the machine is going to be working overtime producing milky bones for me and my friends (AKA customers!) to eat.
“Next,” said Jonathan, “your friends at HMRC will allow you to claim all the cost of the machine against your taxable profits in year 1. This means that if your profits (before we depreciate the machine) are 100 milky bones then, in year 1, there will be no tax to pay, so you get to keep more milky bones.”
I liked the sound of this so far although, while I know that eating all the profits of my business is not necessarily a good idea (see the blog, WTF! Overdrawn director’s loan account puts Lyra on a diet), I still think I can find room for a few more milky bones.
And then the bad news that I knew was coming.
“But you need to understand that in years 2 to 4 your taxable profits will be significantly higher than your accounting profits (as the machine will still being depreciated in your accounts), which means you will be paying a lot more milky bones to HMRC than you might think.”
Jonathan could see I was starting to look a little sad at the prospect of fewer milky bones for me to eat in the future which might mean another stringent diet for me! So, at this point Jonathan produced his promised spreadsheet to show me how many milky bones I would have to pay HMRC each year. He explained this was a simple model and did not deal with the super deduction for capital allowances that would add 30 milky bones to the tax deduction on the purchase of the machine.
So, here it is:
It is obvious to me (and should be to even the dumbest of cats, who after all are not known for their intelligence) that if I ate all 75 milky bones in year one then I would be faced with fewer bones to eat in the next 3 years. Surely there must be something that can be done here to avoid the diet?!
“Yes, there is,” said Jonathan getting quite excited (which is saying a lot for an accountant), “And this is where Deferred Tax comes in. Effectively we create a “Deferred Tax provision” in the accounts that reduces the retained profits after tax in year one (so less milky bones for you to eat) to reflect the tax break given to you by HMRC and then we reduce the provision (increasing the after tax profits; so more milky bones to eat) in years 2 to 4.
This would result in this situation:
While I am always up for eating more than I should, I can see the merits in having a Deferred Tax charge in the accounts, so the tax charge is smooth like a Labrador’s coat and no enforced diet is required in later years (although how I eat 0.75 of a milky bone is beyond me).
For those few of you who have not read my Dictionary of business terms (see Business Directory of Terms - Part 1) the good news is that the Deferred Tax charge does not involve any extra cash going out of the door to HMRC in year one, it is effectively an enforced savings scheme, reducing the retained profits that can be paid as dividends in year one and increasing them in subsequent years.
Being a clever Labrador, I noticed Jonathan had deliberately ignored the impact that the Capital Allowance Super Deduction would have on the tax charge in the accounts.
“This is because” said Jonathan, “that is another can of worms that is going to get bigger once the Corporation Tax rate increases to 25% (or higher for a number of small businesses). I wanted to give a simple example first, so that the readers of your blog get to understand the concept of Deferred Tax, before taking them into the minefield that “Dishi Rishi” has laid out for companies next year.
At this point my bed called out to me and off I went to dream about buying not 1 but 20 machines to make my milky bones.