Corporation tax - Calculation of taxable profits

Learning Outcomes

This article explains the calculation of taxable profits for corporation tax, including:

• identifying the different income sources within corporation tax (trading, non-trading, property business income and chargeable gains) and distinguishing them from exempt income such as most dividends
• applying the wholly and exclusively rule to classify allowable and disallowable expenses, with emphasis on common examination items such as client entertainment, provisions, fines and depreciation
• distinguishing capital from revenue expenditure and understanding how capital allowances replace depreciation in the tax computation
• computing capital allowances using AIA, WDA, special rate pools, SBA, first-year allowances and full expensing, and recognising when each relief is available or restricted
• reconciling accounting profit to taxable total profits through systematic add-backs, deductions, inclusion of chargeable gains, exclusion of exempt income and relief for qualifying losses
• determining corporation tax liabilities using the small profits rate, main rate and marginal relief, including adjustments for associated companies, short accounting periods and changes in financial year rates
• applying these rules in SQE1-style questions to construct clear, step-by-step computations, spot typical traps and avoid frequent calculation and presentation errors.

SQE1 Syllabus

For SQE1, you are required to understand the calculation of taxable profits for corporation tax, with a focus on the following syllabus points:

• 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.

Tax computations begin with the company’s accounting profit (profit before tax) and adjust it for tax purposes. Adjustments remove disallowable items (such as depreciation) and include tax reliefs (such as capital allowances) to arrive at taxable total profits. It is important to identify the company’s accounting period (normally 12 months) and the financial year rate that applies to profits arising in that period. Where an accounting period straddles financial years, profits are apportioned to each financial year to apply the correct rate.

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. Stock and work-in-progress must be properly valued at the end of the period to reflect true trading profit (closing stock reduces cost of sales in the period).

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

Common inclusions within trading income include sales of goods and services, recoveries and rebates, and certain trading-related compensation receipts. Where a company also has a property rental business, those profits are brought into the computation separately as property business income rather than as trading income.

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. Interest and similar amounts fall within the loan relationships regime and are often analysed separately as non-trading loan relationship profits; interest payable can be deductible, subject to the usual wholly and exclusively rule and wider interest restriction rules (complex anti-avoidance and debt cap rules exist but are outside core SQE scope).

Property rental profits for companies are included within taxable profits, calculated after deducting property-related expenses (such as agents’ fees, repairs of a revenue nature, and allowable finance costs). Where a company carries on an investment business, it may have “management expenses” that are deductible against its total profits.

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.

Chargeable gains are computed by deducting allowable acquisition and disposal costs and enhancement expenditure from the proceeds. Indexation allowance for companies was removed for disposals on or after 1 January 2018 (with a final indexation factor allowed up to December 2017 only), so for current periods indexation will not usually feature. Capital losses can be set against chargeable gains of the same period or carried forward to offset future gains; they cannot be used against income profits.

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. Most dividends (both UK and many overseas dividends) are exempt under the distribution exemption regime and are excluded from taxable total profits. It remains essential to confirm the exemption applies; certain distributions may fall outside the exemption in specific circumstances.

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. The test is purpose-based: the fact that an expense has an incidental non-business benefit does not necessarily disallow it, provided the business purpose is the sole purpose.

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.

In practice:

• where expenditure has mixed business and private elements, apportionment may be possible if distinct parts can be identified; if not, the whole may be disallowed.
• the capital/revenue distinction remains critical: capital costs are not deductible as revenue expenses and instead may attract capital allowances or other reliefs.

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 (subject to rules on interest restrictions)
• Bad debts written off after reasonable recovery efforts
• Employer pension contributions to registered schemes
• Business insurance, advertising, and training directly related to the trade
• Irrecoverable VAT where input tax cannot be reclaimed

Expenses must be supported by records and incurred in the accounting period on an accruals basis (accruals and prepayments are recognised for tax in line with accounting standards, subject to tax-specific adjustments).

Disallowable Expenses

Certain expenses are never deductible for corporation tax:

• Client or business entertainment costs (including most gifts unless they carry a conspicuous advert and are of small value)
• Fines and penalties
• Depreciation of fixed assets (replaced by capital allowances)
• Capital expenditure (e.g., purchase of fixed assets)
• Dividends and distributions
• General provisions not based on specific, quantifiable liabilities
• Political donations

Intangible fixed assets (such as purchased goodwill, patents, and software) are normally outside capital allowances and within the separate intangible assets regime. Depending on the date and nature of the asset, amortisation or impairment under that regime is often deductible for corporation tax. Depreciation on tangible assets is disallowed and replaced by capital allowances or first-year allowances where applicable.

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.

Qualifying assets include plant and machinery used in the business. Assets acquired for resale, land (except built-in features within buildings), and most assets not used in the trade do not qualify. Cars qualify but are subject to specific rules based on CO₂ emissions and do not generally benefit from AIA.

Annual Investment Allowance (AIA)

The AIA allows 100% relief on qualifying expenditure on plant and machinery up to an annual limit. The current permanent AIA limit is £1,000,000. AIA cannot be claimed on cars, nor on expenditure incurred in relation to assets gifted to the business or acquired from connected parties in certain circumstances.

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 on a reducing balance basis:

• Main rate pool: 18%
• Special rate pool: 6%

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 in buildings such as electrical systems, lifts and escalators, thermal insulation, long-life assets, and high-emission cars) are written down at the lower special rate (currently 6%).

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. The SBA is given at a fixed rate (currently 3% per annum on a straight-line basis) over the life of the asset, and applies to construction costs rather than land. The SBA starts when the building is brought into use for the qualifying activity.

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.

First-year allowances and full expensing

In addition to AIA and WDA, certain first-year allowances may apply. From 1 April 2023, companies (not unincorporated businesses) may benefit from:

• 100% full expensing for qualifying new main-rate plant and machinery, and
• 50% first-year allowance for qualifying new special rate assets. These are subject to conditions (for example, they generally do not apply to assets for leasing). Cars are excluded from full expensing; however, new zero-emission cars can qualify for a separate 100% first-year allowance.

Balancing adjustments can arise on disposal of pool assets (balancing allowances or charges) and for single asset pools (such as short-life assets).

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.

Worked Example 1.4

A company buys a new built-in features system in a warehouse (special rate asset) for £120,000. The AIA limit is still available, but the company chooses not to use it and instead uses the pool.

Answer:
The £120,000 is added to the special rate pool. The WDA at 6% is £7,200 for the year.

Worked Example 1.5

A company purchases a new car for £30,000. The car has CO₂ emissions above the threshold for main pool treatment, so it is allocated to the special rate pool.

Answer:
The £30,000 enters the special rate pool, and the WDA at 6% gives a deduction of £1,800 for the year (subject to private use restrictions if applicable).

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. Give reliefs against total profits (e.g., certain charitable donations).
8. Deduct current-year trading losses set against profits (if claimed) and consider any brought-forward losses in line with the applicable rules.
9. The result is taxable total profits.

Remember to compute each source correctly:

• trading profits adjusted for tax rules
• non-trading loan relationship profits (interest and similar receipts)
• property business profits
• chargeable gains (net of allowable losses)

Losses are subject to specific rules. Trading losses can be relieved in various ways, including carry back (one year for most cases), carry forward, and group relief (where applicable). Capital losses may only be set against gains, not income.

Worked Example 1.6

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

Worked Example 1.7

A company’s taxable total profits are £80,000. It has no associated companies and no ring-fenced profits. What corporation tax rate applies and what is the tax liability (ignoring marginal relief apportionments)?

Answer:
The small profits rate of 19% applies (profits ≤ £50,000 are small; profits up to £250,000 may qualify for marginal relief depending on thresholds and associated companies). At £80,000, the company will normally be in the marginal relief band, not the small profits rate. Tax is calculated at the main rate of 25% and reduced by marginal relief. Illustratively, before marginal relief, the tax at 25% would be £20,000. The actual liability is decreased by marginal relief using the statutory formula, giving an effective rate between 19% and 25%. Precise marginal relief depends on the number of associated companies and the length of the accounting period.

Corporation Tax Rates and Payment

Corporation tax is charged on taxable total profits at the rate set for the financial year. From 1 April 2023, the regime is:

• Small profits rate: 19% for companies with taxable total profits not exceeding £50,000.
• Main rate: 25% for companies with taxable total profits of £250,000 or more.
• Marginal relief applies to profits between £50,000 and £250,000, tapering the effective rate between 19% and 25%.

These thresholds are adjusted if the company has associated companies (the thresholds are divided by the number of associated companies plus one) and are time-apportioned for accounting periods shorter than 12 months.

Payment deadlines:

• Companies that are not large must pay corporation tax within nine months and one day after the end of their accounting period.
• Large and very large companies pay by quarterly instalments (dates and thresholds depend on profits and the number of associated companies). Interest applies on late payment.

Filing deadlines:

• The corporation tax return is due 12 months after the end of the accounting period.
• Tax must be paid by the payment deadline even if the return is filed later; penalties can apply for late filing and late payment.

Apportionment across financial years:

• If an accounting period spans two financial years with different rates, profits are time-apportioned to apply the appropriate rate and marginal relief for each part.

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 expenditure is relieved via capital allowances rather than revenue deduction.
• Capital allowances provide tax relief for qualifying capital expenditure instead of depreciation, including AIA, WDA, special rate pool, and SBA; first-year allowances and full expensing may be available in specific cases.
• 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, excluding exempt income, and deducting capital allowances and reliefs.
• Corporation tax rates since 1 April 2023 include a 19% small profits rate, 25% main rate, and marginal relief between thresholds; payment is generally due within nine months and one day, with quarterly instalments for large companies.

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)