Calculating Deferred Tax & Online Accounting Services

Deferred tax is an accrual (deferred tax liability) or a prepayment (deferred tax asset) of income tax payable or receivable in future periods caused by temporary differences. These temporary differences are differences in the carrying amount of an asset or liability (accounting base) and its tax base.

Let see an example of how Online Accounting Services help you calculate deferred tax:

Suppose there is an asset that was bought for £10,000 and depreciated over 5 years, its yearly depreciation charge is £2,000. But if the tax law of a country says that capital allowances for that asset are given 50% first year and 50% second year. Then, the entity needs to make an accrual to pay the tax that has not being paid now due to higher capital allowances which reduce taxable profits more than the accounting depreciation.

In the financial accounts using Accounting Standards, the profit has been reduced by £2,000, whilst in the tax return, it has been reduced by £5,000 due to capital allowances, hence there is a £3,000 (temporary) difference of tax that has NOT being paid in the fist year which will need to be paid in the future.

If the corporation tax rate is 20%, this means that £600 (£3000 x 20%) will be a deferred tax to pay later.

The second year, the capital allowances to claim on the tax return are another 50%, so £5,000. But in the financial accounts using Accounting Standards, the depreciation charge is £2000, hence the difference of £3000 times the tax rate of 20% (£600) is a tax charge that will need to be paid in the future (deferred tax).

Year 1 and year 2 has accumulated £1200 deferred tax to pay in future period (deferred tax liability).

In year 3, there is no capital allowances as all have been given, hence the entity in year 3 is paying more tax that it should as per its accounts. It will pay £2000 times 20% = £400 more of tax in year 3 given that it will not have any capital allowances to claim. Part of this payment is to settle previous tax not paid in year 1 and year 2 (the accumulated £1200 deferred tax)

The deferred tax liability is reduced from £1200 to £800 in year 3

In year 4 as there are no capital allowances for tax, the entity will pay £400 more in tax (£2000 x 20%). Part of this payment is to settle previous tax not paid in year 1, year 2 and year 3 (the accumulated £800 deferred tax)

In year 4, the deferred tax liability is reduced from £800 to £400

In year 5, the entity will pay another £400 more of tax and the asset is now fully depreciated. The deferred tax liability is reduced from £400 to cero and hence the temporary differences between the tax return and the financial statements is closed/settled.