Back to Tax Basics - How does Corporation Tax work?
Corporation tax is a tax that’s levied on your company’s profits.
When you operate your business through a limited company, that company is considered to be a separate entity from you as an individual. Among other things, this means you have to pay corporation tax (CT) on your company’s profits
But how does CT work? And what do you have to pay?
1. The basics of corporation tax Paying your taxes is one of your key responsibilities as a new company, but it’s important to understand what’s required and how the CT process works.
When you form a company, HM Revenue & Customs (HMRC) will issue you with a 10-digit Unique Taxpayer Reference (UTR). Within three months of you starting to trade, you’ll also need to advise HMRC that you have begun trading, the date you started and the date up to which you intend to produce your company accounts.
HMRC will send you a notice to complete a tax return. If your first accounting period is longer than 12 months, two returns will be required – no single return can cover more than 12 months. Unless you change your period end, after the first one, each accounting period is generally exactly 12 months long.
Each year, the company has to prepare a CT return, giving details of your profits and calculating the tax that’s payable.
The starting point is generally the profit shown in the company’s annual accounts. This is adjusted by adding back expenses which aren’t allowable for tax, and deducting costs which are allowable against tax but are not treated as an expense in the accounts.
Although there can be numerous adjustments between ‘accounting profit’ and ‘taxable profit’ the most common ones are to do with:
Fixed asset depreciation
Research and development (R&D) expenditure
2. Fixed assets depreciation When you buy things like plant and machinery, vehicles and computer equipment, these are shown in the company accounts as ‘fixed assets’, and the cost charged against profits over a number of years, equal to their anticipated life. The charge against profits is called depreciation.
Although depreciation appears as a line item in the company’s profit and loss account, it isn’t allowed when calculating tax, so the depreciation charge is added back. In its place, capital allowances, writing-down allowances and annual investment allowances may be claimed. The rates of these depend on the type of asset and can vary from year to year.
In many cases, this means that in the year when you purchase fixed assets, even though they may be depreciated over a number of years, the whole of the cost can be deducted from profits. Currently, there’s an additional 'super-deduction’ scheme available where 130% of actual costs are deducted, which can greatly aid cash flow.
As an example of how this works, if you buy a van costing £20,000 for work purposes that you expect to last for 5 years before being scrapped, each year you will make a depreciation provision against profits of £4,000. For tax purposes the £4,000 charges aren’t allowed but, with super-deduction, you can take £26,000 off your taxable profits in the first year instead. And you can do that even if you’re buying the van on hire purchase, where you haven’t yet paid for the van in full!
3. Business entertaining
Although, in most cases, entertaining customers or prospective customers is a perfectly reasonable business expense, for tax purposes the cost incurred is added back to your profits.
Because of this, it’s not allowed as a deduction when calculating your tax charge. It doesn’t mean you shouldn’t do it, or that it’s considered to be illegitimate in some way, it’s just not permitted as a cost when calculating corporation tax.
5. R&D allowances
When your company spends money on R&D activities, the cost that is deducted for calculating taxable profits can be up to £230 for every £100 actually spent.
To qualify for this enhanced deduction, the R&D activities have to be aimed at resolving ‘scientific or technological uncertainties’ that couldn’t be easily resolved by a professional working in the field. Even if your activity failed to resolve the issue, it still counts for the purposes of the scheme. So, if you’re in the process of carrying out R&D work, it makes great sense to claim any available R&D allowance.
To qualify, your project has to be related to an existing or proposed company trade, and can revolve around developing new or improving existing products, processes and services. The costs include staff costs, subcontractors, agency workers, utility costs, software costs and consumable materials.
R&D isn’t always the obvious things such as software development or inventions; it can be working out how to age construction materials so they can be used to repair listed buildings, or the development of eco-friendly packaging materials.
Claims can be made in respect of costs up to two accounting periods ago. So, if your company has a 31 December year-end, claims in respect of costs incurred in the year ended 31/12/2019 can still be submitted up to the end of 2021.
Unlike many tax benefits, R&D claims can be converted into cash by loss-making companies, with HMRC making payment of 14.5% of any losses surrendered.
Theoretically, making a claim for R&D relief can be made by by simply completing the appropriate boxes on the CT600 tax return and the supplementary pages. In practice, unless a report is also attached describing the projects, explaining why they fall within the scheme and breaking down the costs, it is likely to be delayed while HMRC seeks further clarification.
6. Should I try compiling my own CT return? Given the complexity of tax legislation, completing even a straightforward company tax return isn’t advisable as a ‘DIY’ job. If you want to minimise your tax bill, and maximise the available reliefs, that’s going to mean completing your CT accurately and in detail.
Talk to us about your corporation tax needs We can help you become more tax-efficient by advising you on discretionary expenditures, such as company pension contributions, fringe benefits and so on. Often, it’s necessary to include a trade off between your company’s tax position and your personal tax outcomes.
In specialist areas, like R&D allowances, we can guide you through the claim process and even highlight eligible expenditure you may not have realised you were incurring. Most R&D projects aren’t carried out by people in lab coats, so this is a relief that’s open to many businesses.
Get in touch to talk through your corporation tax.