How is corporation tax calculated? Corporation tax for small business explained!

When you trade as a limited company, your company will pay corporation tax based on the level of profits it makes. In this guide we explain the basics of corporation tax including how it is calculated and when to pay your corporation tax.

We also include some simple corporation tax calculation examples.

This UK guide has been written with a particular focus on modern small service business, freelancers and contractors as they are the main types of clients we work with at JF Financial.

 

How is corporation tax calculated

 

What is corporation tax?

Corporation tax is the tax that UK companies pay on their taxable profits.

The current corporation tax rate for 2019/20 is 19%.

In very simple terms, if a companies taxable profit is £20,000, the corporation tax would be £3,800 based on a 19% tax rate.

If a company makes a taxable loss but had made a profit in the previous year, it may be able to carry back that loss to the previous year and get some tax refunded.

 

How does corporation tax get reported and when is it due?

Every year a company has to file a corporation tax return with HMRC along with a detailed set of company accounts. The deadline for paying the corporation tax to HMRC is usually 9 months and 1 day after the financial year end.

There is no set financial year end for all companies – the companies year end will depend on the date the company was formed and can actually be changed subject to certain conditions.

 

Corporation tax reference – UTR

Shortly after you setup the company with Companies House, HMRC should post the companies 10 digit unique tax reference (UTR) to the registered office address.

You will need your UTR when it comes to preparing your company tax returns.

This is a separate UTR to the one you may have personally for your self assessment personal tax returns.

If you don’t have a UTR for your company you will need to speak with HMRC on the corporation tax helpline.

 

Accounting profit vs taxable profit

Before explaining how to calculate corporation tax, we’re going to take one step back and explain what a profit and loss account is.

A profit and loss account will show a businesses performance over a period of time, usually one year.

A businesses profit (or loss) is calculated as the income the company has earned during a period, less any business costs.

Below is a typical example of a profit and loss account for a very simple service business:

 

example of a profit and loss account

 

The profit and loss account is not simply based on cash receipts and payments during the period, it will also include timing adjustments.

In the above example, the profit is shown as £55,420, however you cannot simply take this profit figure and apply the current corporation tax rate to this, as there may be some tax adjustments to make.

The main tax adjustments that will be made for simple services businesses will be:

  • Business entertaining
  • Capital expenditure & depreciation

 

Business entertaining corporation tax adjustments

If costs are incurred when entertaining business contacts or clients, these are referred to as business / client entertaining.

As long as they are for genuine business purposes they can usually be put through the company as a business expense but they are treated as disallowable for corporation tax purposes.

This means the cost has to get added back when doing the corporation tax calculation.

Although business entertaining is not an allowable expense for corporation tax, it is still a real cost for the company so it is beneficial to claim this back from your company (if you have paid for it personally) – for example if you have paid £50 out of your own pocket on entertaining a client, it is usually better to claim this back from your company than to have to extract a further £50 in dividends to cover it.

As with any business costs, they must be wholly and exclusively incurred for the purposes of your business.

HMRC may challenge a cost if it considers that the primary motive for incurring it is to obtain a private benefit for a director or employee.

In order to claim Business Entertaining make sure you keep the receipts and note the below:

  • Who were you entertaining?
  • For what business purpose?
  • Where was it?
  • When did it take place?

 

Capital expenditure & depreciation corporation tax adjustments

When you purchase equipment & assets for your business that will be used in the business for multiple years, the purchase will be treated as a capital asset.

The cost will be recorded in the balance sheet section of your accounts and each year you’ll move part of this cost to your profit and loss account as a “depreciation” charge.

The simplest way of working out how long to depreciate items for is to estimate the number of years you’ll use the equipment in your business, and spread the cost over this number of years.

See below for some typical periods of depreciation for some common business assets:

  • Computer 3 – 4 years
  • Smartphone 2 – 3 years
  • Office desk / chairs 4 – 5 years

However when it comes to corporation tax, the purchase is treated quite differently – the tax relief is actually pretty generous and will allow you to deduct the full cost of your equipment from your profit in the year you make the purchase due to something called the Annual Investment Allowance which is a type of Capital Allowance.

If your business purchases a company vehicle the tax and accounting treatment can be much more complicated so we have ignored that scenario completely in this article.

The government introduced the Capital Allowance tax relief known as the Annual Investment Allowance in 2008 – the size of the allowance has changed over the years but currently it is £1 million for the period between 1 January 2019 and 31 December 2020.

This is an annual allowance, so covers up to £1 million of relevant purchases each year.

Computer equipment for use in your business is a relevant purchase, HMRC will categorise it as “plant and machinery”.

There are some items of plant and machinery for use in business that you can’t claim capital allowances on. These include:

  • Items you lease – you must own them
  • Buildings, including doors, gates and shutters
  • Items used only for business entertainment (HMRC includes as examples a yacht or karaoke machine!)

It’s worth mentioning that the Annual Investment Allowance cannot be claimed for company cars. These get tax relief via the part of the capital allowance system know as “writing down allowances”. Company vans do qualify for the Annual Investment Allowance, as they are considered to be “plant and machinery” for this purpose – however as mentioned earlier in this article we are ignoring company vehicles in this article as it is a very complicated area and we want to keep things as simple as possible here.

There are a few other details and criteria to be able to claim the Annual Investment Allowance – for more info see the HMRC guidelines.

Once you start buying equipment, your profit recorded in your accounts will no longer be the same as the profit on which you pay corporation tax.

This is because your accounts will have a depreciation charge, and your corporation tax computation will have capital allowances instead.

It sounds complicated, but should become clearer if we look at some examples below which will also include an adjustment for business entertainment which we discussed earlier.

You don’t always have to treat the purchase of equipment as being capital expenditure – if the purchase value is small (say less than £500) or the assets useful life is no more than one year, you could simply allocate the purchase directly to the profit and loss account to keep things simple.

 

Corporation tax computation – example 1

Below is an example of a one person limited company running a simple service business (e.g. a management consultant)

To keep things straightforward let’s also assume the business is not VAT registered.

The below example has no necessary adjustments for corporation tax, so the corporation tax is simply calculated as 19% of the profit.

Corporation tax computation - example 1

 

 

Corporation tax computation – example 2

Next let’s look at another example – exactly the same as above but this time there is £500 of business entertaining that is not allowable for corporation tax:

Corporation tax computation - example 2

 

 

Corporation tax computation – example 3

Now let’s look at exactly the same example as above but with a further tax adjustment – this time let’s assume the business purchased a computer during the year costing £3,000 which has been capitalised and will be depreciated over 3 years.

Corporation tax computation - example 3b

 

Dividends and corporation tax

It’s really important that you factor in your companies running corporation tax position when it comes to working out the available retained profits in your company available for dividends.

We’d always advise leaning on the side of caution when it comes to assessing how much dividend headroom your company has.

You don’t want to be in a position further down the line where you find you paid out too much dividends – if there were not sufficient post tax retained profits to support the dividends at the point of payment, the dividends would be deemed to be illegal, which has potentially serious tax issues.

 

Corporation tax computations – summary

Hopefully this article has helped you understand how corporation tax is calculated – the adjustments we have covered are the typical ones encountered by small simple service businesses, however there are many more corporation tax computation adjustments that could affect your business so if you have any questions about how to calculate corporation tax we would recommend that you discuss this with your accountant.