The Short Answer
Deferred tax is tax that a company will pay, or save, in a later year because of something that has already happened in its accounts. It exists because the profit in your accounts and the profit HMRC taxes are worked out using different rules, and some of those differences only last a few years before they swing back.
The classic example is equipment. Your accounts spread the cost of a machine over its useful life through depreciation. HMRC ignores depreciation and gives you capital allowances instead, often 100% in year one. So in year one your tax bill is lower than your accounting profit suggests, and in later years it is higher. Deferred tax is the accounts recognising that the tax you saved this year is really tax put off, not tax avoided.
Two things worth saying up front, because they are the questions we get most:
- Deferred tax is not a bill. It never appears on a CT600 and HMRC never asks for it. The only tax you actually pay is the corporation tax on your tax computation.
- It still matters. It changes the profit after tax in your accounts, the reserves you can pay dividends from, and the way a lender or buyer reads your balance sheet.
Why It Exists: Two Sets of Rules
Every UK company effectively produces two profit figures each year.
- Accounting profit, under accounting standards such as FRS 102. This is what goes in the profit and loss account and onto Companies House.
- Taxable profit, under tax law. Your accountant gets there by starting with accounting profit and adjusting it in the corporation tax computation.
Some of those adjustments are permanent. Some are just timing. That distinction is the whole of deferred tax.
Permanent differences never reverse, so there is no deferred tax on them. Client entertaining is the obvious one. It reduces your accounting profit, HMRC never allows it, and that is the end of the story. Fines and penalties work the same way.
Timing differences reverse. The item hits accounting profit in one year and taxable profit in another, but over the whole life of the transaction the totals match. Deferred tax is only ever recognised on timing differences.
FRS 102, which most UK small and medium companies use, builds its deferred tax rules in Section 29 around these timing differences. If you have read about "temporary differences" elsewhere, that is the language of IAS 12, the international standard used by listed groups. The answer is usually the same for a small company, but the logic is different, and most of the top results for "deferred tax" are written for ACCA students sitting the international paper, not for a director looking at their own accounts.
The Timing Differences Small Companies Actually Have
In the accounts we prepare for owner-managed companies, nearly all deferred tax comes from a short list:
| Source | What happens | Usually creates |
|---|---|---|
| Capital allowances faster than depreciation | AIA or full expensing gives relief upfront, depreciation trickles through for years | Liability |
| Trading losses carried forward | A loss now reduces tax on future profits | Asset |
| Pension contributions accrued but unpaid | Expensed in the accounts, deductible for tax only when paid | Asset |
| Directors' bonuses unpaid nine months after the year end | Expensed in the accounts, deductible only when paid | Asset |
| Investment property revalued upwards | Gain in the accounts, taxed only when the property is sold | Liability |
The first one dwarfs the rest. Since the Annual Investment Allowance was set permanently at £1 million, almost every small company buying vans, machinery or IT gets full relief in year one while depreciating over three to ten years. That gap is the deferred tax liability you see on most small company balance sheets.
Liability or Asset?
A deferred tax liability means more tax is coming later. You have had the relief early, the accounts have not caught up yet, and when they do your tax bill will be higher than your accounting profit suggests. Under the Companies Act formats it sits under "Provisions for liabilities" on the balance sheet.
A deferred tax asset means less tax is coming later. You have had the expense in the accounts but not yet the tax relief, or you have losses waiting to be used. It sits in debtors.
A quick sense check: if your tax computation has been generous to you so far, you probably have a liability. If it has been mean, you probably have an asset.
A Worked Example: Five Years of One Machine
Hadley Fabrications Ltd is a metalwork business in New Barnet with a 31 March year end. Its profit before tax is a steady £320,000 a year, so it pays the 25% main rate of corporation tax. On 1 April 2026 it buys a CNC machine for £60,000.
- Accounts: depreciated straight line over five years, so £12,000 a year.
- Tax: the full £60,000 qualifies for the Annual Investment Allowance in the year to 31 March 2027.
Year one. The tax computation adds back the £12,000 depreciation and deducts the £60,000 AIA:
Taxable profit = £320,000 + £12,000 − £60,000 = £272,000
Current tax at 25% = £68,000
At the year end, the machine is in the accounts at £48,000 (cost less one year's depreciation). For tax, it has been written off completely, so its tax value is nil. The timing difference is £48,000, and the deferred tax liability is £48,000 × 25% = £12,000.
The P&L tax charge is current tax plus the movement in deferred tax: £68,000 + £12,000 = £80,000. That is exactly 25% of £320,000. This is the point of deferred tax. Without it, the accounts would show a 21.25% effective tax rate in year one and something above 25% for the next four years, and anyone comparing years would draw the wrong conclusions.
Years two to five. There are no more allowances, but the £12,000 depreciation is still added back each year, so taxable profit is £332,000 and current tax is £83,000. The deferred tax liability unwinds by £3,000 a year.
| Year to 31 March | Accounts value | Tax value | Timing difference | Deferred tax liability | Deferred tax charge / (credit) | Current tax | Total tax charge |
|---|---|---|---|---|---|---|---|
| 2027 | £48,000 | £0 | £48,000 | £12,000 | £12,000 | £68,000 | £80,000 |
| 2028 | £36,000 | £0 | £36,000 | £9,000 | (£3,000) | £83,000 | £80,000 |
| 2029 | £24,000 | £0 | £24,000 | £6,000 | (£3,000) | £83,000 | £80,000 |
| 2030 | £12,000 | £0 | £12,000 | £3,000 | (£3,000) | £83,000 | £80,000 |
| 2031 | £0 | £0 | £0 | £0 | (£3,000) | £83,000 | £80,000 |
Over five years the company pays £400,000 of corporation tax on £1.6 million of profit. Exactly 25%. The AIA did not reduce the total. It moved £12,000 of tax from year one into years two to five. That is a real cash benefit, but it is a loan from HMRC, not a gift, and the deferred tax line is the accounts telling you so.
When the Deferred Tax Becomes Real
Suppose Hadley sells the machine at the end of year two for £40,000. Its accounts value is £36,000, so the accounts show a £4,000 profit on disposal.
For tax, the £40,000 proceeds come off the capital allowance pool. If the machine was the only thing in the pool, that creates a balancing charge of £40,000, taxed at 25%, which is £10,000. More often there are other assets in the pool, and the proceeds simply reduce future allowances, so the tax arrives more slowly. Either way it arrives.
Now look at what the accounts had already provided: £9,000 of deferred tax on the machine, plus £1,000 on the £4,000 accounting profit. £10,000 in total. The deferred tax liability was a reasonably honest forecast of the tax that would fall due when the asset left the business.
This is the bit we spend most time explaining to clients selling vans and equipment. They remember the big AIA claim. They do not remember that it comes back when the asset is sold for more than nothing.
Which Rate? The Marginal Relief Problem
Since April 2023, UK corporation tax has had more than one rate:
- 19% on profits up to £50,000
- 25% on profits over £250,000
- Marginal relief in between, which works out at an effective 26.5% on each pound of profit inside the band
Deferred tax is measured at the rate expected to apply when the timing differences reverse, using rates already enacted at the balance sheet date. For a company comfortably above £250,000 or below £50,000, that is easy: 25% or 19%.
For the large number of owner-managed companies that sit in the £50,000 to £250,000 band, FRS 102 points you to the average rate expected to apply to taxable profits in the years of reversal. A company expecting profits of around £150,000 pays £36,000 of tax at that level, an average rate of 24%, so it would provide deferred tax at 24%.
Here is our view, and it is a slightly awkward one. The average rate understates the real cost. When a £12,000 slice of depreciation reverses inside the marginal band, it adds £12,000 to taxable profit at the 26.5% marginal rate, not 24%. On Hadley's £48,000 timing difference, that is a gap of £1,200. For most small companies that is too small to matter, and we follow the standard. But if you are using the balance sheet to work out what you can afford to take out of the company, remember the deferred tax figure is a slight underestimate for a business in the band.
The other trap is using last year's rate out of habit. We still see accounts carrying deferred tax at 19% for companies whose profits have grown well past £50,000. Fixing that adds to the liability and reduces reserves in one go.
Deferred Tax Assets and Losses
Losses work in the opposite direction. Brunswick Studio Ltd, a design agency in its first year, makes a trading loss of £70,000. It expects profits of around £40,000 a year from year two, all at 19%. In principle that loss is worth £13,300 of future tax savings, and the accounts could show a deferred tax asset of that amount.
FRS 102 only lets you recognise it if it is probable the company will have enough future taxable profits to use it. That is a judgement, and in our experience most young companies should not be recognising the asset. A business plan showing profits next year is not the same as evidence of them.
There is also a practical reason to be conservative. Banks and credit reference agencies often strip deferred tax assets out when they assess a balance sheet, because an asset that only turns into value if the company becomes profitable is not much comfort to a creditor. Booking it flatters net assets on paper and buys you nothing with the people reading the accounts.
Micro-Entities Do Not Show It at All
If your company files micro-entity accounts under FRS 105, there is no deferred tax in them. This is not optional. FRS 105 prohibits it.
That has two consequences people miss.
Micro accounts can overstate the real position after tax. A micro-entity that has just claimed £150,000 of AIA on vans and plant has a large deferred tax liability in economic terms, but its balance sheet will not show a penny of it. Its reserves look higher than they would under FRS 102.
Growing out of micro status brings a catch-up. The micro thresholds are now £1 million turnover, £500,000 balance sheet total and 10 employees, two out of three, for years beginning on or after 6 April 2025. When a company outgrows them and moves to FRS 102 Section 1A, the first set of FRS 102 accounts has to restate the comparatives, deferred tax included. A company with £200,000 of fully relieved vehicles and equipment could find £50,000 of deferred tax liability appearing out of nowhere, coming straight off its retained earnings.
If you have been paying dividends right up to the reserves figure on micro accounts, that is worth knowing before the switch, not after.
Where It Costs Owner-Managers Money
Deferred tax is not cash, but it touches three decisions that are.
Dividends. A company can only pay dividends out of distributable profits. A deferred tax liability reduces the profit and loss reserve, so it reduces the headroom. For a company with a big equipment base and thin reserves, the difference can decide whether a planned dividend is lawful. Our guide to the director's loan account explains what happens when money comes out without the reserves to back it.
Borrowing. Lenders look at net assets and gearing. Most treat a deferred tax liability as a long-term provision rather than debt, but it still reduces net worth. A business with low reserves and a large liability can look weaker on a credit file than its cash position suggests.
Selling the company. When someone buys your company's shares, they inherit its tax history. Assets that have already had 100% relief give the buyer no further allowances, and a sale of those assets later triggers the balancing charges. Sophisticated buyers know this, and on larger deals deferred tax is often a negotiated item in the price or the completion accounts. It is one of the reasons we tell clients thinking about an exit to look at how buyers value a business a few years ahead, not a few weeks.
Deferred Tax vs Deferred Income
The names are similar and the concepts are unrelated. Deferred income is money a customer has paid you for work you have not done yet, held on the balance sheet until you earn it. Deferred tax is about the gap between accounting and tax rules. If you see both on your balance sheet, they have nothing to do with each other.
Common Mistakes We See
- Treating the deferred tax charge as money owed to HMRC. It is not on your tax return and nobody will send you a bill for it.
- Leaving it at an old rate. A company that has moved into the marginal band or above £250,000 needs its rate updated.
- Forgetting it exists after a big AIA year, then being surprised when the tax bill rises in later years with no change in profit.
- Booking a deferred tax asset on losses with no realistic prospect of profits to use them against.
- Ignoring the catch-up when moving from FRS 105 to FRS 102, especially where dividends are planned against reserves.
- Assuming a disposal is tax-free because the asset was written off years ago. That is exactly when the balancing charge appears.
How IAK Can Help
We act for limited companies, small businesses, construction companies and landlords across North London and Hertfordshire. For most of them, deferred tax is a line we calculate at the year end and explain in two minutes. For some, it shapes real decisions: when to buy equipment, whether to sell it, how much to take out in dividends, and what a buyer will make of the balance sheet.
If your accounts show a deferred tax figure you have never had explained, or you are about to outgrow micro-entity status, see our accounting and tax planning services, try our corporation tax calculator, or get in touch.
Sources
- FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, Financial Reporting Council, Section 29 Income Tax, on timing differences, measurement and the recognition of deferred tax assets.
- FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime, Financial Reporting Council, on the prohibition of deferred tax for micro-entities.
- Corporation Tax rates and reliefs, GOV.UK, for the 19% small profits rate and 25% main rate.
- Corporation Tax marginal relief, GOV.UK, for how marginal relief works between £50,000 and £250,000.
- Claim capital allowances: Annual investment allowance, GOV.UK, for the £1 million AIA.