Deferred tax arises because the profit reported in the financial statements (accounting profit) often differs from the profit on which corporation tax is calculated (taxable profit). These differences create timing differences that will reverse in future periods, and deferred tax ensures the tax charge in the accounts reflects the tax consequences of all transactions recognised in the current period.
Under FRS 102 (Section 29), deferred tax must be recognised for all timing differences at the balance sheet date, using the tax rate that is expected to apply when the timing difference reverses.
Why Deferred Tax Arises
The accounts are prepared under FRS 102 (UK GAAP), but the tax computation follows HMRC’s rules, which often differ. Common differences include:
| Item | Accounting Treatment | Tax Treatment | Effect |
|---|---|---|---|
| Depreciation vs capital allowances | Depreciation charged per company policy | Capital allowances claimed per HMRC rules | Timing difference |
| Pension contributions | Charge based on actuarial calculations | Deduction when cash contributions are paid | Timing difference |
| Accrued bonuses | Recognised when obligation arises | Deductible only when paid (within 9 months of year end) | Timing difference |
| Revaluation of assets | Gain recognised in revaluation reserve | Taxed only on disposal | Timing difference |
| Provisions | Recognised when obligation is probable | Deductible only when paid | Timing difference |
| Tax losses | No accounting entry for the loss itself | Carried forward to reduce future taxable profits | Gives rise to deferred tax asset |
Timing Differences Versus Permanent Differences
Timing differences reverse over time – the total tax paid is the same, but the timing of the charge differs between the accounts and the tax computation.
Permanent differences never reverse – certain items are allowable or disallowable for tax regardless of period. Deferred tax is not recognised for permanent differences.
| Difference Type | Example | Deferred Tax? |
|---|---|---|
| Timing | Depreciation exceeds capital allowances this year but will be less in future | Yes |
| Timing | Provision charged in accounts but not yet paid | Yes |
| Permanent | Client entertainment (never deductible) | No |
| Permanent | Fines and penalties (never deductible) | No |
| Permanent | Dividend income from UK companies (not taxable) | No |
Deferred Tax Liabilities
A deferred tax liability arises when the tax charge in the accounts is less than the tax that will ultimately be paid. This typically happens when:
- Capital allowances exceed depreciation in the early years of an asset’s life (the company pays less tax now but will pay more later)
- An asset is revalued upwards in the accounts, creating a gain that is not taxed until the asset is sold
Example: Accelerated Capital Allowances
A company purchases equipment for £100,000. The accounting depreciation is straight-line over 10 years (£10,000 per year). The company claims full expensing (100% capital allowance in year 1).
| Year | Depreciation (£) | Capital Allowance (£) | Timing Difference (£) | Cumulative Difference (£) |
|---|---|---|---|---|
| 1 | 10,000 | 100,000 | (90,000) | (90,000) |
| 2 | 10,000 | 0 | 10,000 | (80,000) |
| 3 | 10,000 | 0 | 10,000 | (70,000) |
| … | … | … | … | … |
| 10 | 10,000 | 0 | 10,000 | 0 |
At the end of year 1, the cumulative timing difference is £90,000. At a corporation tax rate of 25%, the deferred tax liability is:
£90,000 x 25% = £22,500
This liability unwinds over the remaining 9 years as depreciation exceeds capital allowances.
Deferred Tax Assets
A deferred tax asset arises when the tax charge in the accounts is more than the tax that will ultimately be paid. This typically happens when:
- The company has tax losses that can be carried forward against future profits
- Provisions or accruals have been charged in the accounts but are not yet tax-deductible
- Pension liabilities are recognised under FRS 102 but the cash contribution (which is tax-deductible) has not yet been paid
Recognition of Deferred Tax Assets
A deferred tax asset is recognised only to the extent that it is probable that taxable profits will be available in future periods against which the asset can be utilised. If a company has a history of losses and no firm prospect of returning to profitability, the deferred tax asset should not be recognised.
| Scenario | Recognise Deferred Tax Asset? |
|---|---|
| Company has tax losses but expects strong future profits | Yes – probable that the asset will be recovered |
| Company has tax losses with uncertain future profitability | Partially or not at all |
| Company has a provision that will be deductible when paid | Yes – future tax deduction is virtually certain |
Calculating Deferred Tax
Under FRS 102, deferred tax is calculated using the tax rate that has been enacted or substantively enacted by the balance sheet date and that is expected to apply when the timing difference reverses.
Formula:
Deferred tax = Cumulative timing difference x Applicable tax rate
For UK corporation tax, the main rate is currently 25% for companies with profits over £250,000, with a small profits rate of 19% for companies with profits under £50,000 and marginal relief between £50,000 and £250,000.
Journal Entries
Recognising a Deferred Tax Liability
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Tax expense (income statement) | 22,500 | |
| Deferred tax liability (balance sheet) | 22,500 |
Recognising a Deferred Tax Asset
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Deferred tax asset (balance sheet) | 5,000 | |
| Tax expense (income statement) | 5,000 |
The deferred tax charge or credit forms part of the total tax charge in the income statement, alongside the current tax charge.
Presentation in the Financial Statements
Income Statement
| Tax Charge | £ |
|---|---|
| Current tax on profits for the year | 42,000 |
| Adjustment in respect of prior years | (1,200) |
| Deferred tax charge | 6,800 |
| Total tax charge | 47,600 |
Balance Sheet
Deferred tax is presented as either:
- A provision for liabilities (if a net liability) under creditors due after more than one year
- A debtor (if a net asset) under debtors
FRS 102 requires that deferred tax assets and liabilities are not discounted.
Deferred Tax in the Notes
The notes to the accounts must disclose:
- The major components of the deferred tax balance
- The amount of deferred tax charged or credited to the income statement
- The amount charged or credited directly to equity (e.g., on revaluations)
- The tax rate used
- Any unrecognised deferred tax assets and the reasons for non-recognition
Deferred Tax and Group Accounts
In consolidated accounts, additional deferred tax considerations arise:
- Fair value adjustments on acquisition create timing differences between the consolidated carrying amount and the tax base
- Intra-group transactions may generate timing differences that require deferred tax
- Retained profits of subsidiaries may give rise to deferred tax if the parent intends to distribute them
Practical Significance
Deferred tax ensures that the total tax charge in the income statement reflects the tax consequences of all transactions recognised in the period, not just the amount currently payable to HMRC. Without deferred tax accounting, the effective tax rate would fluctuate significantly from year to year, making it difficult for users of the accounts to assess the true tax burden on the business.
For businesses making significant capital investments, deferred tax liabilities can be substantial due to the difference between generous capital allowances and the slower pace of accounting depreciation. Conversely, businesses with significant provisions or tax losses may carry deferred tax assets that reduce the overall tax charge reported in the accounts.