Tax & Admin

Deferred tax and what it means for your business: The ultimate guide

Business Advice | 7 September 2021 | 3 years ago

Deferred tax and what it means for business

Deferred tax is the accumulation of taxes that are not paid or deducted during a current tax period but are instead deferred to future periods. It is calculated on business profits and arises when your company has made an accounting loss for the current year, but expects to make profit in the future. It can be difficult to understand how deferred tax works if you have never experienced it before, because there are different types of deferred taxes depending on whether they’re asset- or liability-based.

In this article, we’ll discuss what deferred taxes are in more detail so that you can decide whether they are something that could benefit your business.

What is deferred tax?

Deferred tax is the difference between what a business has earned and what it actually owes. It arises when there is a difference between your company’s accounting profit and its taxable profits due to timing. There are various reasons why this may occur such as capital allowances, depreciation, and timing differences between the times you buy an asset and sell it.

Deferred tax means that some of your business’s income has been taxed in one year, but not all of it. The UK government allows businesses following certain accounting rules to set aside this excess amount for later payment of current taxes without incurring penalties or interest charges.

How does deferred tax affect your business?

Deferring your company’s taxes can have several benefits, including reducing uncertainty about what money it should set aside each year for its future taxes so you don’t end up overestimating or underestimating how much is needed, avoiding incurring penalties and interest charges, and distributing your business profits over a longer time period.

Deferring your business’s taxes will have no effects on profits today but can reduce taxable profit tomorrow or many years from now when it is finally paid. Being able to spend your business’s profits over a longer time period means that you are able to use the capital you have generated for other purposes such as investment or paying dividends.

It also means that you can is to avoid paying high rates of current income tax and any penalties or interest charges associated with late payment if the deferred taxes are not deducted beforehand.

How do you calculate deferred tax?

The process of calculating deferred tax is quite complicated but it actually boils down to three basic steps:

  • First, your business calculates the tax it should owe based on its taxable profits.
  • Next, your business applies any deferred tax liability or reliefs that apply to those profits.
  • Finally, your company deducts all payments and credits made in the current year before calculating how much future tax is due.

What are deferred tax liabilities?

A deferred tax liability is the amount of money that your company will have to pay in taxes at some point. This balance arises when there are profits and losses on which no taxes were paid. It also arises when your company has tax losses that it can’t use up or carry forward to future years.

When profits are high, the deferred tax liability may be low because there is no difference between what you earned and what you will have to be paid in taxes. However, if your business incurs losses during the year, then those can offset some of your other income so that less income becomes taxable for that current year’s expected liability.

Deferred Tax Liabilities affect companies’ cash flow positively or negatively depending on whether the liabilities exceed assets and how long until they are expected to be paid.

When do you pay the deferred tax liability?

The deferred tax liability is your business’ accounting of the difference between your current liabilities and assets. If your company has made a profit in any year for which taxes have not been paid, due to years being carried forward from previous losses, an allowable deduction like depreciation expense reducing net income taxable at full rate, or simply because no money was owed yet, you will carry over some portion of these unpaid taxes as deferred tax. This debt must be accounted for on your balance sheet under long-term liabilities. This means that what you owe today may not be due until tomorrow or even many years later depending on how long certain items like depreciation take to offset taxable income.

The liability becomes payable when you have available assets to pay it off with, which may be in the form of accumulated profits or from future earnings. This may be more or less than what you would have paid if you hadn’t deferred depending on whether your company has been profitable or not.

Strategies for minimising or avoiding deferred tax liability

Your company may be able to minimise or avoid a deferred tax liability and thereby reduce the amount of current taxes that it has to pay in future years. There are various different ways businesses usually do this:

  • Investingmore money into certain assets such as inventory or property – This will increase their tax deductions in the future when they sell these assets and will reduce their deferred tax liability.
  • Accelerating income to be able to use more of these deductible expenses today – This can work if your company still has unused business expense deductions available for this year that are greater than the amount of its taxable profits (the deduction limit).
  • Taking advantage of losses that have already been incurred – This can work if your company has made certain types of deductible expenses this year greater than its taxable profits.
  • Instituting an accounting technique called “accelerated depreciation” – This increases the annualdeduction for a given asset which can will reduce its deferred tax liability for future years.
  • Investing in employee retirement plans – This will allow you to deduct the contributions made as business expenses and then defer taxation. This can be effective if your company has a high proportion of its profits in the form of employee wages or benefits.
  • Purchasing other insurance policies that have guaranteed cash values – This means your business will be able to make deductions for premiums and claim any losses as tax-deductible expenses, thereby reducing yourdeferred tax liability.

When is deferred tax an asset?

When a company has incurred costs that are deductible for tax purposes in future periods, the UK deferred tax is an asset if it meets one of two conditions:

  • The taxable profit would have been higher had these provisions not been made. The difference between this and what was recorded represents the amount by which assets were increased to give rise to a liability.
  • It can be clearly demonstrated from reliable evidence (e.g., contracts) that there will be sufficient taxable profits against which to set off the cost.
If you cannot demonstrate both conditions then your deferred tax may be classified as an expense rather than an asset.

What are the consequences of not paying deferred taxes on time?

The consequences of not paying a deferred tax liability can vary depending upon how long it takes before the payment is made and whether there is an interest charge levied against late payments. The longer it takes to pay, the more interest is added. For example, if your business has not paid an amount of deferred tax for two years then there may be penalties in addition to accrued interest charges as well as late payment fines and fees.

If your company is experiencing cash flow issues or have difficulty paying your deferred taxes, you may be able to negotiate a payment plan with the authorities so that you can pay your deferred taxes over time. You will need to make sure that what you owe is not in excess of your company’s assets though, or else it could becomes an unsecured debt on your balance sheet which could lead to insolvency if there are any more liabilities added.

Make sure you contact the relevant tax authorities as soon as possible to ask about the terms for a payment plan. This way you can get it set up before your business’s financial situation spirals out of control. It also means you cannot be accused of deliberately avoiding your tax obligations because you will have made the authorities aware of your payment difficulties straight away.

Common mistakes when calculating deferred taxes

There are a few common mistakes when calculating deferred taxes, one of the main ones being not understanding the difference between deductible and taxable expenses in deferred tax calculations.

For example, it’s important to know that some types of startup expenditures may not be deducted from your business earnings as they would on a personal income statement since you don’t yet have any earnings for them to offset against (e.g., equipment purchases).

However, these same expenditures might still be considered “deferred costs” if they’ll produce future benefits over several years or more, in which case they could negatively impact your company’s current profit margin but will provide lasting savings later down the road. Examples may include:

  • Research and development expenses.
  • Certain marketing expenditures.
  • Legal fees pertaining to intellectual property protection.
  • Interest on borrowed money used to fund the Startup Phase when revenue streams aren’t sufficient to cover expenses.
  • Costs incurred in the acquisition of an intangible asset that will benefit future periods.
It’s also important not to overlook any “deferred revenue” when calculating deferred taxes. This may include refunds or rebates from vendors, deposits on orders, trade discounts, and accrued payments. Even if these aren’t deductible for your business at this time due to cash flow restrictions, they will still need accounting treatment so you can prepare for them down the line.

What is the difference between deferred and current tax?

The difference between deferred and current tax is that deferred taxes are calculated on the profit of a business. This means they only arise when your profits go above zero, which in turn creates an opportunity to offset them with future losses if you make any. Current tax, meanwhile, happens every time revenue goes into your business’s account because it will be immediately deducted from this amount. It can also come out of any money you try to withdraw before paying yourself as an owner-manager or it might even require withholding payments for other entities such as shareholders who have not been paid dividends yet.

When should you talk to an expert to help with your deferred tax situation?

Mismanagement of deferred taxes can lead to various issues. Hiring an accountant will help you to understand exactly what needs to happen next. This could include things like reviewing projected cash flow statements, determining available funds for reducing liquidity risk, and ensuring you don’t accrue any late fees or penalties.

The following are situations in which an expert should be consulted:

  • If your company has not been paying its taxes from profit for three consecutive years.
  • If there is no foreseeable end of the nonpayment of taxes and interest due on any future payment dates.
  • If it becomes clear that the assets can’t provide enough money to pay all current and past liabilities within 12 months.
  • If you don’t know how to estimate future tax liabilities or when a rise in interest rates might affect your deferred-tax situation.
  • You are planning to sell your business and need to get your taxes in order first.

Final thoughts

Deferred taxes can be very useful and can really help your business to excel. They provide you with the extra capital you need for investment, enables you to make more reliable financial plans, and helps you to avoid fees and penalties. In order to make the most of these benefits, it is very important that you calculate your deferred taxes correctly to ensure that you don’t miss payments. Deferring your taxes does not mean just ignoring them at a later date, and you should always be aware of how much money you owe, and when it will need paying. If you are any having any problems paying your deferred taxes, make sure you notify the relevant tax authorities immediately and that you speak to an accountant or tax expert who will be able to help you get your business’s financial situation in order.

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