1 Introduction
1.1 One of the themes of this book is to reach for an example when trying to explain a relevant concept. This is what we are doing in order to explain the reason for deferred tax. In chapter 2 we gave the simple example of Rickinghall Printers Limited which bought a piece of equipment for £10,000 and depreciated it over ten years. The depreciation charge was therefore £1,000 a year. The capital allowances in the first four years were £2,000, £1,600, £1,280 and £1,024 respectively. In year 8 the capital allowances were £419. If the Company made a steady profit of £2,000 a year, assuming a constant corporation tax rate of 21%, we can see the differences in the tax charges over the first 4 years. This is on the assumption that the depreciation and capital allowances on this equipment were the only adjusting items on the tax computations. We are also showing the result for year 8 in order to illustrate the trend:
Year
1
2
3
4
8
Profits
2,000
2,000
2,000
2,000
2,000
Add: Deprecation
1,000
1,000
1,000
1,000
1,000
Less: Capital allowances
(2,000) _____
(1,600) _____
(1,280) _____
(1,024) _____
(419)
_____ 2,581
Taxable profits
1,000
1,400
1,720
1,976
Tax payable at 21%
210
294
361
415
542
_____ 1,790
_____ 1,706
_____ 1,639
_____ 1,585
_____ 1,458
Profit after tax
Effective rate of tax
10.5%
14.7%
18.05%
20.75%
27.1%
1.2 In this example it can be seen that the tax charged on the same level of profits virtually doubles between years 1 and 4, as the capital allowances reduce. This trend then continues as is shown in year 8. The fact that the capital allowances are available rather more quickly than the equipment is depreciated has the effect of moving the tax payments towards the final five years, rather than the first five years of the life of the equipment. 1.3 Deferred taxation works in such a way that the tax benefit which has been gained in the first 4 years is deferred (for accounting purposes only), and is then used to reduce the higher tax charge that arises in the later years.
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