Corporation tax - Calculation of taxable profits

Learning Outcomes

After studying this article, you will be able to identify the main components of a company's taxable profits for corporation tax purposes. You will understand how to distinguish between trading and non-trading income, apply the rules for allowable deductions, and calculate capital allowances. You will also be able to apply these principles to SQE1-style questions and avoid common errors in corporation tax computations.

SQE1 Syllabus

For SQE1, you are required to understand the calculation of taxable profits for corporation tax. Focus your revision on:

• identifying the types of income included in corporation tax computations (trading, non-trading, and chargeable gains)
• distinguishing between allowable and disallowable expenses
• applying capital allowances to qualifying expenditure
• understanding the treatment of exempt income and capital profits
• calculating taxable total profits and corporation tax liability

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is an allowable deduction for corporation tax purposes?
   1. client entertainment costs
   2. staff salaries
   3. regulatory fines
   4. purchase of fixed assets

2. What is the main purpose of capital allowances in corporation tax calculations?

3. True or false? Dividends received by a UK company from another UK company are always included in taxable profits for corporation tax.

4. A company purchases new machinery for £50,000. How is this expenditure treated for corporation tax purposes?

Introduction

Corporation tax is charged on the taxable profits of companies and certain other bodies in the UK. Calculating taxable profits accurately is essential for compliance and for SQE1 assessment. This article explains the main elements of the calculation: chargeable receipts, allowable deductions, and capital allowances.

Income Included in Corporation Tax

A company's taxable profits for corporation tax include several types of income. Each must be identified and treated correctly.

Trading Income

Trading income is the profit from the company's main business activities. This is calculated on an accruals basis, matching income earned to the period in which it is earned, not when cash is received.

Key Term: trading income The profit from a company's ordinary business activities, calculated before tax and after allowable trading expenses.

Non-Trading Income

Non-trading income covers income not arising from the company's main trade. Common examples are interest received, rental income, and royalties.

Key Term: non-trading income Income received by a company that does not arise from its main trading activities, such as bank interest or property rental.

Chargeable Gains

Companies are subject to corporation tax on capital gains made from selling or disposing of assets. These are called chargeable gains.

Key Term: chargeable gain The profit made by a company on the disposal of a capital asset, after deducting allowable costs and reliefs.

Exempt Income

Some types of income are exempt from corporation tax. The most common example is dividends received from other UK companies.

Key Term: exempt income Income that is not subject to corporation tax, such as most dividends received from UK companies.

Allowable Deductions

To arrive at taxable profits, a company deducts allowable expenses from its chargeable receipts. Only certain expenses qualify.

General Rule

An expense is only allowable if it is incurred wholly and exclusively for the purposes of the company's trade.

Key Term: allowable deduction An expense that is incurred wholly and exclusively for the purposes of the company's trade and is not specifically disallowed by tax law.

Common Allowable Expenses

• Staff salaries and employer's National Insurance
• Rent, rates, and utilities for business premises
• Office supplies and professional fees
• Repairs and maintenance (not improvements)
• Interest on business loans
• Bad debts written off after reasonable recovery efforts

Disallowable Expenses

Certain expenses are never deductible for corporation tax:

• Client or business entertainment costs
• Fines and penalties
• Depreciation of fixed assets (replaced by capital allowances)
• Capital expenditure (e.g., purchase of fixed assets)

Worked Example 1.1

A company incurs the following expenses in the year: £100,000 on staff salaries, £5,000 on entertaining clients, and £10,000 on office rent. Which expenses are allowable deductions?

Answer: Only staff salaries (£100,000) and office rent (£10,000) are allowable. Client entertainment (£5,000) is disallowed.

Capital Allowances

Instead of deducting the cost of fixed assets directly, companies claim capital allowances to obtain tax relief for capital expenditure.

Key Term: capital allowance Tax relief given for certain capital expenditure, allowing companies to deduct a portion of the cost of qualifying assets from taxable profits.

Annual Investment Allowance (AIA)

The AIA allows 100% relief on qualifying expenditure on plant and machinery up to an annual limit.

Key Term: Annual Investment Allowance (AIA) A capital allowance giving 100% tax relief on qualifying plant and machinery expenditure up to a set annual limit.

Writing Down Allowance (WDA)

Expenditure not covered by the AIA is pooled and written down at a fixed percentage each year.

Key Term: Writing Down Allowance (WDA) A capital allowance giving tax relief at a fixed percentage each year on the reducing balance of qualifying expenditure.

Special Rate Pool

Certain assets (e.g., built-in features, long-life assets, high-emission cars) are written down at a lower rate.

Key Term: special rate pool A pool for capital allowance purposes for certain assets, written down at a lower rate than the main pool.

Structures and Buildings Allowance (SBA)

Relief is available for expenditure on new non-residential buildings and structures.

Key Term: Structures and Buildings Allowance (SBA) A capital allowance giving tax relief for expenditure on new non-residential buildings and structures, at a fixed annual rate.

Worked Example 1.2

A company buys machinery for £40,000 and claims the AIA (limit not exceeded). What is the capital allowance for the year?

Answer: The company can deduct the full £40,000 from taxable profits in the year of purchase.

Worked Example 1.3

A company has a main pool of plant and machinery with a written-down value of £100,000 at the start of the year. It claims a WDA at 18%. How much can it deduct?

Answer: £18,000 (18% of £100,000) can be deducted from taxable profits for the year.

Calculating Taxable Profits: Step-by-Step

The calculation of taxable profits for corporation tax follows a set sequence:

1. Start with the company's accounting profit.
2. Add back disallowable expenses (e.g., depreciation, entertainment).
3. Deduct allowable expenses not included in the accounts.
4. Deduct capital allowances for qualifying capital expenditure.
5. Add chargeable gains.
6. Exclude exempt income (e.g., most dividends).
7. The result is taxable total profits.

Worked Example 1.4

A company has the following for the year:

• Trading profit (after allowable expenses): £250,000
• Disallowed expenses added back: £10,000
• Capital allowances: £30,000
• Chargeable gain: £20,000
• Exempt dividend income: £5,000

Calculate the taxable total profits.

Answer:
Trading profit: £250,000
Add back disallowed expenses: £10,000
Deduct capital allowances: (£30,000)
Add chargeable gain: £20,000
Exclude exempt dividend: £0
Taxable total profits: £250,000 + £10,000 - £30,000 + £20,000 = £250,000

Corporation Tax Rates and Payment

Corporation tax is charged on taxable total profits at the rate set for the financial year. The main rate is 19% (as at 2023/24). Companies must pay corporation tax within nine months and one day after the end of their accounting period.

Key Point Checklist

This article has covered the following key knowledge points:

• Corporation tax is charged on a company's taxable profits, including trading income, non-trading income, and chargeable gains.
• Only expenses incurred wholly and exclusively for the trade are allowable deductions.
• Capital allowances provide tax relief for qualifying capital expenditure instead of depreciation.
• Exempt income (such as most UK dividends) is not included in taxable profits.
• Taxable total profits are calculated by adjusting accounting profit for tax rules, adding chargeable gains, and deducting capital allowances.
• The main corporation tax rate is 19% (2023/24), and payment is due within nine months and one day after the period end.

Key Terms and Concepts

• trading income
• non-trading income
• chargeable gain
• exempt income
• allowable deduction
• capital allowance
• Annual Investment Allowance (AIA)
• Writing Down Allowance (WDA)
• special rate pool
• Structures and Buildings Allowance (SBA)