What it means
For a business, income tax starts with the profit shown in the accounts and then adjusts it to reach taxable profit. Some costs that are perfectly legitimate for accounting, such as client entertainment or a regulatory fine, are not deductible for tax.
Other items, such as equipment, are written off for tax on a schedule set by legislation rather than by the company's own depreciation policy. Because of those adjustments, most companies report two related numbers.
Current tax is the amount owed on this year's taxable profit, while deferred tax records the future consequence of timing differences, such as claiming faster tax relief on equipment now and less later. Deferred tax is an accounting entry rather than a cash payment, which is a distinction worth holding on to.
The headline rate is not the whole story either, and the number that matters commercially is the effective tax rate. That is total tax expense divided by accounting profit before tax, and it can sit above or below the statutory rate depending on reliefs, disallowed costs and losses brought forward.
Analysts watch it because an unusually low effective rate often reverses in later years. Income tax matters to managers mainly as a cash planning problem.
Tax is normally paid in instalments based on estimated profits, so a business that grows quickly can face a much larger bill than the previous year while also funding stock and receivables. Setting money aside monthly is the standard defence against that squeeze.
The last nuance is that tax planning and tax evasion are different things. Claiming reliefs the law provides, timing capital purchases sensibly and choosing an appropriate legal structure are ordinary commercial decisions.
Deliberately concealing income or inventing costs is a criminal matter and carries penalties well beyond the tax itself.
In practice
Real-world examples.
Example
A sole trader makes $95,000 of profit from a landscaping business. After personal allowances and bands, her average tax rate works out at 24%, giving a bill of $95,000 x 0.24 = $22,800. She pays it in two instalments and keeps a separate account funded at 25% of every invoice.
Example
A trading group makes $400,000 of profit but has $250,000 of losses carried forward from an earlier downturn. Taxable income is $400,000 - $250,000 = $150,000, so tax at 20% is $30,000. The finance director makes sure the loss position is documented properly, because losses are only usable if claimed correctly.
Example
A marketing agency forecasts annual income tax of $180,000 and budgets quarterly instalments of $180,000 / 4 = $45,000. When a large client cancels mid-year, the agency applies to reduce the remaining instalments rather than overpaying and waiting for a refund. Cash stays in the business where it is needed.
Formula
Calculation
Income tax = Taxable income x Applicable tax rate, where taxable income is accounting profit adjusted for disallowed costs and different tax timing.
A company reports accounting profit before tax of $600,000. It adds back $20,000 of client entertainment and $10,000 of regulatory fines, neither of which is deductible, and deducts an extra $60,000 because tax law allows faster write-off on new machinery than the company's own depreciation policy. Taxable income is $600,000 + $20,000 + $10,000 - $60,000 = $570,000. At a corporate rate of 25%, current income tax is $570,000 x 0.25 = $142,500. The effective tax rate on accounting profit is $142,500 / $600,000 = 23.75%, below the headline 25% because the machinery relief outweighs the disallowed costs. The $60,000 timing difference also creates a deferred tax liability of $60,000 x 0.25 = $15,000, because that relief will not be available in future years.Case study
Seen in the real world.
Bluewater Joinery is a fictional cabinet maker used here purely as an illustrative example. Its owner saw profit before tax of $480,000 in the accounts and assumed a bill of 25% of that, or $120,000. The accountant's computation looked different: $70,000 of the profit was a tax-exempt regional grant and came out of the calculation, while $25,000 of disallowed costs, mostly entertainment and a late-filing penalty, went back in. Taxable profit was $480,000 - $70,000 + $25,000 = $435,000 and the tax due was $435,000 x 0.25 = $108,750.
The surprise was welcome but the cash timing was not. The company had reserved $90,000 across the year, leaving $108,750 - $90,000 = $18,750 to find within six weeks of the filing deadline. From the next year onward the owner moved a fixed 22% of every monthly gross profit figure into a separate tax account, and the business never had to draw on its overdraft for tax again.
Watch out
Common mistakes.
- Assuming the tax bill is simply accounting profit multiplied by the headline rate, and then being caught out by disallowed costs.
- Spending the cash that belongs to a future tax bill because it is sitting in the current account and looks available.
- Confusing deferred tax, which is an accounting adjustment for timing differences, with tax that is actually about to be paid.
Questions
People also ask.
Why is my effective tax rate different from the statutory rate?
Because reliefs, exempt income, disallowed expenses and brought-forward losses all shift the taxable base away from accounting profit.
Can I deduct the cost of new equipment from my taxable profit?
Usually yes, but on the timetable tax law sets through capital allowances or depreciation rules, not necessarily in the year you bought it.
What happens if I pay income tax late?
Interest normally accrues from the due date and penalties can be charged on top, so filing on time and agreeing a payment plan is far cheaper than simply paying late.
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