It is often assumed that when a profit is shown on a set of financial statements there will be tax to pay, but that’s not always the case.
The reasons why tax may not be payable can be explained by understanding what adjustments are applied to your tax computation:
Calculating your tax
For most businesses, several adjustments have to be made to the profit from the financial statements in order to calculate the taxable profit. Depreciation and capital allowances are usually the cause of the biggest discrepancies between the two profit figures.
Depreciation – Common types of depreciable assets include vehicles, office equipment, computers, machinery, and equipment.
In the financial statements, fixed assets are depreciated by a set rate each year and spreading this cost means it can be written off against profits over several years rather than just the year of purchase. The rates for each class of asset are usually similar across industries, but there may be small discrepancies between businesses. One business may choose to depreciate their motor vehicles on a 20% “reducing balance basis” (where the accounts value of the vehicle is lowered each year by 20% of the previous year’s amount), whereas another may choose to depreciate using a 5-year “straight line” method.
Capital allowances – Effectively the tax version of depreciation. They are fixed rates and allowances issued by HMRC for certain types of assets. Some assets (plant and machinery) may qualify for Annual Investment Allowance, or the new “full expensing” announced in the 2023 Spring Budget, which is a 100% allowance in the year the asset is purchased. Others (for example cars other than those with very low emissions) may qualify for an 8% annual allowance. Capital allowances are a complex area of tax, so please contact us to discuss a purchase of an asset.
Disallowed expenses – To check whether an expense is allowable for tax purposes, the ‘wholly and exclusively’ test must be satisfied.
Most everyday business expenses will be allowable (e.g., employee salaries, purchases of raw materials) but there are a few transactions which are disallowed by HMRC. The main ones we come across when preparing the corporation tax returns for our clients are:
- Non-staff entertainment
- Depreciation (capital allowances are claimed instead)
- Fines and penalties incurred by the directors (e.g. late filing penalties, parking fines)
- Legal fees which are capital in nature (e.g. solicitor fees relating to the issue of new share capital, or relating to property transactions)
There are many grey areas around transactions which may be allowable or disallowed, which is why we ask our clients lots of questions during year end meetings.
Understanding your accounts can seem complex but it is important that you can make sense of all the elements that contribute to your financial statements, so please keep asking questions about anything in your accounts that you are uncertain about.