8 Business tax

Need to know

This chapter provides a high-level overview of key business taxes. Professional advice is always required for tax matters. Taxation is a large and complex discipline; it is unique to each company and depends upon business structure. There are also differences between and within countries.

Why is this important?

Tax is a significant business cost both in terms of monetary cost and the time involved in compliance and administration.

It is a legal requirement to pay tax and keep detailed tax records. There are penalties for making mistakes or deliberate misstatements.

The major taxes that a company is obliged to pay are as follows:

• 1Tax on profits
• 2Tax on capital gains
• 3Employment taxes
• 4Value added tax (VAT).

1. Tax on profits

Although the profit and loss account is the official record of a company’s profit, the reported profit will often be different from the profit used to calculate tax. This is because certain expenses are not allowable deductions for tax purposes. Examples include:

• ■depreciation (see the Nice to know section below and Chapter 9 Tangible fixed assets and depreciation)
• ■formation and acquisition costs
• ■donations to political parties
• ■entertaining clients.

Accounting profit is also adjusted for:

• ■non-taxable income, for example government grants
• ■tax allowances on certain asset purchases (see the Nice to know section below).

Returns from investments, such as bank interest and dividends from other companies in which the business holds shares (see Chapter 16 Group accounts), are also included in taxable profit.

On an annual basis, the adjusted profit figure is multiplied by the ‘tax rate’ (19% in the UK at the time of publication) to arrive at the ‘tax charge’.

In the UK, tax on a company’s profits is known as corporation tax (CT).

Losses are covered in the Nice to know section below.

2. Tax on capital gains

If a company sells an asset or investment for more than its original cost, it is subject to tax on the capital gain which arises.

In the UK, the capital gain is calculated as the disposal proceeds less the following:

• ■the original cost
• ■initial purchase-related costs
• ■improvements and enhancement costs (but not repairs and maintenance)
• ■selling costs.

The UK also allows the original cost to be adjusted for the effect of inflation. This is known as ‘indexation allowance’. However, this allowance cannot create or increase a capital loss. It can only reduce a gain.

In the UK, capital gains for companies are taxed at the same tax rate as other profits.

If a company replaces an asset, the capital gain on disposal of the original asset can be deferred until the replacement asset is disposed. This is known as ‘rollover relief’ in the UK.

If a company makes a capital loss, it can only usually be set against gains of the current and future years. The relief available is therefore far more limited than for trading losses (covered in the Nice to know section below).

3. Employment taxes

Employers act as tax collectors and deduct employees’ income tax and other contributions directly from their pay. This is subsequently paid across to tax authorities. In the UK, this system is known as PAYE (Pay As You Earn).

The costs of administering the system are borne by employers.

PAYE includes:

• ■income tax on cash payments such as basic pay, overtime, bonuses and commissions
• ■income tax on non-cash items (benefits in kind) such as company cars and private health insurance
• ■social security contributions towards state benefits such as public health services, pensions and welfare benefits. These are known as National Insurance Contributions (NIC) in the UK and are paid by both employees and employers.

4. Value added tax (VAT)

Value added tax (VAT) or sales tax is an indirect tax levied on the final consumer of certain goods and services.

In the UK and most other OECD (Organisation for Economic Co-operation and Development) countries, VAT is applied at multiple stages in the supply chain. In this system, every time a sale is made, VAT is charged (output VAT). However, a business can also claim back the VAT it has paid on purchases to make or sell the product (input VAT). The business pays back the difference to the tax authorities on a regular basis.

VAT example

ABC Ltd sells furniture and buys its raw materials (such as wood, glue and nails) from XYZ Ltd. In a typical month, ABC purchases £50,000 of raw materials and sells £100,000 of furniture. This example uses a VAT rate of 20% (which is the standard rate of VAT in the UK at the time of publication).

In this example, XYZ and ABC have both ‘collected’ and paid £10,000 of VAT. Both companies have added £50,000 of value. The difference is that ABC has deducted £10,000 of input VAT on its purchases to calculate the net £10,000.

The end ‘retail’ consumers of the furniture have paid the full VAT burden of £20,000. The £20,000 has been collected at two stages in the supply chain, when value has been added to the furniture.

Therefore, in summary, VAT is not technically a cost to a business, as it can reclaim input VAT on its purchases. The business is merely a collecting agent on behalf of the tax authorities and suffers the costs of administering the system.

VAT exceptions

• 1Certain items (for example children’s clothing and books in the UK) are zero rated for VAT. This means that no output VAT is charged on sales, although input VAT can be reclaimed on purchases made to make those items.
• 2Certain items (for example domestic fuel and mobility aids for the elderly in the UK) are taxable at different rates (e.g. 5%) from standard goods and services.
• 3Certain activities (for example charitable fundraising events and lottery ticket sales in the UK) are exempt from VAT. No output VAT is charged on sales and no related input VAT can be reclaimed on those activities.

When are taxes important?

There are multiple deadlines for both reporting and paying tax. Penalties and interest may be charged for being late or reporting incorrect amounts.

The UK has the following deadlines:

In addition, UK businesses are required to keep tax records for a minimum of six years for most taxes.

In practice

HMRC collected £584 billion in the tax year 2020–2021 (2019–2020: £633 billion). Total receipts are split as follows (10-year average):¹

Tax evasion and avoidance

An example of tax evasion is where a business deliberately misrepresents its profits and as a result does not pay the rightfully payable tax. Tax evasion is subject to substantial penalties.

‘Tax avoidance’ is the use of legal methods to reduce the amount of tax payable. This is usually achieved by claiming permissible tax deductions and tax credits. Tax authorities can introduce anti-avoidance legislation if they become aware of many businesses using perceived legal loopholes.

The tax gap is a measure of the difference between the amount of tax collected by a country’s tax authorities and the amount that should be collected. For the tax year ending April 2020, the HMRC estimated that the tax gap was £35 billion, which is 5.3% of the total tax owed.²

The HMRC also measures the additional amount it generates by tackling tax avoidance, evasion and non-compliance, known as the compliance yield. Closing the tax gap and increasing the compliance yield is a continual goal for the HMRC.

Nice to know

Capital allowances

In the UK, businesses deduct capital allowances instead of depreciation (see Chapter 9 Tangible fixed assets and depreciation) to calculate taxable profit. Capital allowances are similar in principle to depreciation, in that they apportion the cost of an asset over its life. Whereas depreciation policy is chosen by a company, there is no discretion over capital allowances, which use specific tax rules.

Capital allowances are typically permitted on assets such as machinery, computer equipment and certain items in buildings or costs related to buildings, although not usually on land or the buildings themselves.

To encourage investment, accelerated capital allowances (for example a 100% first-year allowance) are allowed on certain assets such as environmentally friendly vehicles.

Tax relief for losses

If a company makes a loss instead of a taxable profit, no tax is payable for that particular year and a tax relief is created. The UK offers the following reliefs for trading losses:

• ■carry the loss forward against future trading profits of the same trade
• ■offset the loss against other income or capital gains of the same period
• ■carry the loss back against profits of previous periods
• ■offset the loss against the profits of another group company (‘group loss relief’) (see Chapter 16 Group accounts).

Optional detail

International taxation

Residence

Globalisation and the growth in multinational corporations, with operations in multiple countries, have increased the relevance of international taxation.

Companies pay tax on their worldwide income to the country in which they are ‘resident’ for tax purposes. Residence is determined by a company’s:

• ■Place of incorporation (domicile)
• ■Place of effective management and control
• ■Place of permanent establishment.

To be resident a company must demonstrate that a degree of trade is undertaken or decisions are made in a particular country. A warehouse on its own, for example, is simply a storage area. A registered office does not mean that actual office work takes place.

Double taxation

Where a company is resident in two (or more) countries, it is potentially subject to tax in both those countries and could theoretically suffer double taxation.

The OECD suggests that a company can only have one place of effective management, which is where it should be deemed resident and pay tax. The place of effective management is:

• ■The place where key management and commercial decisions are made
• ■The place where the board or senior management meets.

Most countries have established double tax treaties with their international trading partners. These treaties determine which country will tax profits and the methods of double tax relief for companies which trade in both countries.

For example, dividends are paid from post-tax profits, i.e. they will have already ‘suffered’ tax in the paying country. When a parent company receives a dividend from a foreign subsidiary, the dividend must be included in the parent company’s income and once again be taxed, this time in the receiving parent company’s country of residence (see Chapter 16 Group accounts). Depending on the country and treaty, double tax relief is often available for the overseas tax paid.

The decision to establish an overseas subsidiary (a separate legal entity) or simply a branch, may be influenced by the ‘local’ tax rate and the respective double tax treaty.

Deferred tax

Deferred tax is an accounting adjustment which arises because the accounting treatment of a transaction is different from the tax treatment. It is essentially a temporary timing difference. See the extract from Greggs plc 2020 annual report and accounts for an example.

Effective tax rate

The effective tax rate is the rate of tax paid based on accounting profits, as opposed to taxable profits. This gives a more accurate picture of a company’s tax liability than a country’s headline tax rate. See the extract from Greggs plc 2020 annual report and accounts for an example.

Reflect and embed your understanding

• 1Is it reasonable for a business to pursue tax avoidance?
• 2Should governments offer accelerated capital allowances? If so, why?
• 3The UK offers various reliefs for tax losses. What is the goal of this policy and is it an appropriate tax relief?
• 4What is the fairest and most appropriate way to tax multinational corporations?
• 5Keep up with changes in tax announced annually by the Chancellor in the budget statement (typically around March every year).

For the authors’ reflections on these questions please go to financebook.co.uk

Where to spot in company accounts

Tax can be found in both the profit and loss account (the current year’s tax charge) and balance sheet (the amount of tax owed to tax authorities). This will usually be supported by detailed notes to explain any adjustments made in calculating the tax charge and liability.

Employers’ contributions to NI (or equivalent) are usually detailed in the note under employment costs.

Extract from Greggs plc 2020 annual report and accounts

In Greggs plc’s annual report, the supporting tax notes calculate an effective tax rate. Greggs plc’s effective tax rate for 2020 was 5.2% (2019: 19.7%). The 2020 rate was lower due to Greggs plc making a loss. In the associated ‘financial review’ the effective rate was forecast to be 1.5% above the headline rate of 19% in future years, mainly due to non-deductible expenses.

Greggs plc’s 2020 annual report shows a net ‘deferred tax’ liability. For Greggs plc this is mainly due to capital expenditure and employee benefits.

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 387.

Watch out for in practice

• →The effective rate of tax paid and how it compares to the headline tax rate.
• →The nature of adjustments to the taxable profit.
• →The nature of any non-deductible expenses.
• →The reason for any deferred tax assets or liabilities.
• →Tax losses carried forward, as these give an indication of historic trading activity.
• →Tax in relation to capital gains. This indicates a disposal of assets. It is useful to know why a company is disposing of assets and if they are being replaced.

1gov.uk/government/collections/hm-revenue-customs-receipts

2gov.uk/government/statistics/measuring-tax-gaps