Introduction
In previous chapters, we have looked at the income tax computation, property
and investment income and employment income. We are now going to look at
the taxation of unincorporated businesses. We work out a business’s profit as
if it were a separate entity (the separate entity concept familiar to you from
basic bookkeeping) but as an unincorporated business has no legal existence
apart from its proprietor, we cannot tax it separately. We have to feed its profit
into the proprietor’s personal tax computation.
In this chapter, we look at the computation and taxation of profits. Standard
rules on the computation of profits are used instead of individual traders’
accounting policies, so as to ensure fairness. We also need special rules, the
basis period rules, to link the profits of periods of account to the personal
computations of tax years.
Finally, we see how national insurance contributions apply to the selfemployed.
In the next chapters, we study the allowances available for capital expenditure
and then we look at losses and partnerships.
Study guide
| Intellectual level | ||
| 1 | Income and income tax liabilities in situations involving further overseas aspects and in relation to trusts, and the application of exemptions and reliefs | |
| (a) | The contents of the Paper F6 study guide for income tax and national insurance, under heading: | 2 |
| | B3 Income from self employment | |
| | B6 National insurance contributions for employed and self-employed persons | |
| (d) | Income from self employment | 3 |
| (i) | Advise on a change of accounting date |
Exam guide
Rather than being asked to calculate taxable trade profits you are more likely to be asked about the effect on after tax income of a business action such as taking on an additional contract. This will involve calculating the incremental profits, deducting tax payable, and taking any other costs (and their possible tax savings) into account. This will normally include VAT considerations. To be able to do this you need a full understanding of the rules for calculating taxable trade profits and allocating them to tax years.
Most of this chapter is revision from Paper F6. The examination team has identified essential underpinning knowledge from the F6 syllabus which is particularly important that you revise as part of your P6 studies. In this chapter, the relevant topic is:
| Intellectual level | ||
| B3 | Income from self-employment | |
| (f) | Compute the assessable profits on commencement and on cessation | 2 |
Change of accounting date is a new topic at P6 level. The only change in 2015/16 from 2014/15 in the material covered at F6 level concerns Class 2 NICs which are now collected through the self-assessment system.
| 1 The badges of trade | 6/15 |
FAST FORWARD
The badges of trade can be used to decide whether or not a trade exists.
1.1 Introduction
Before a tax charge can be imposed it is necessary to establish the existence of a trade.
Key terms A trade is defined in the legislation only in an unhelpful manner as including any venture in the nature of
trade. It has therefore been left to the courts to provide guidance. This guidance is often summarised in a collection of principles known as the ‘badges of trade’. These are set out below. Profits from professions and vocations are taxed in the same way as profits from a trade.
1.2 The subject matter
Whether a person is trading or not may sometimes be decided by examining the subject matter of the transaction. Some assets are commonly held as investments for their intrinsic value: an individual buying some shares or a painting may do so in order to enjoy the income from the shares or to enjoy the work of art. A subsequent disposal may produce a gain of a capital nature rather than a trade profit. But where the subject matter of a transaction is such as would not be held as an investment (for example, 34,000,000 yards of aircraft linen (Martin v Lowry 1927) or 1,000,000 rolls of toilet paper (Rutledge v CIR 1929)), it is presumed that any profit on resale is a trade profit.
1.3 The frequency of transactions
Transactions which may, in isolation, be of a capital nature will be interpreted as trading transactions where their frequency indicates the carrying on of a trade. It was decided that whereas normally the purchase of a mill-owning company and the subsequent stripping of its assets might be a capital transaction, where the taxpayer was embarking on the same exercise for the fourth time they must be carrying on a trade (Pickford v Quirke 1927).
1.4 Existence of similar trading transactions or interests
If there is an existing trade, then a similarity to the transaction which is being considered may point to that transaction having a trading character. For example, a builder who builds and sells a number of houses may be held to be trading even if they retain one or more houses for longer than usual and claims that they were held as an investment (Harvey v Caulcott 1952).
1.5 The length of ownership
The courts may infer adventures in the nature of trade where items purchased are sold soon afterwards.
1.6 The organisation of the activity as a trade
The courts may infer that a trade is being carried on if the transactions are carried out in the same manner as someone who is unquestionably trading. For example, an individual who bought a consignment of whiskey and then sold it through an agent, in the same way as others who were carrying on a trade, was also held to be trading (CIR v Fraser 1942). On the other hand, if an asset has to be sold in order to raise funds in an emergency, this is less likely to be treated as trading.
1.7 Supplementary work and marketing
When work is done to make an asset more marketable, or steps are taken to find purchasers, the courts will be more ready to ascribe a trading motive. When a group of accountants bought, blended and recasked a quantity of brandy they were held to be taxable on a trade profit when the brandy was later sold (Cape Brandy Syndicate v CIR 1921).
1.8 A profit motive
The absence of a profit motive will not necessarily preclude a tax charge as trading income, but its presence is a strong indication that a person is trading. The purchase and resale of £20,000 worth of silver bullion by the comedian Norman Wisdom, as a hedge against devaluation, was held to be a trading transaction (Wisdom v Chamberlain 1969).
1.9 The way in which the asset sold was acquired
If goods are acquired deliberately, trading may be indicated. If goods are acquired unintentionally, for example by gift or inheritance, their later sale is unlikely to be trading.
1.10 Method of finance
If the purchaser has to borrow money to buy an asset such that they have to sell that asset quickly to repay the loan, it may be inferred that trading was taking place. This was a factor in the Wisdom v Chamberlain case as Mr Wisdom financed his purchases by loans at a high rate of interest. It was clear that he had to sell the silver bullion quickly in order to repay the loan and prevent the interest charges becoming too onerous. On the other hand, taking out a long term loan to buy an asset (such as a mortgage on a house) would not usually indicate that trading is being carried on.
1.11 The taxpayer’s intentions
Where a transaction is clearly trading on objective criteria, the taxpayer’s intentions are irrelevant. If, however, a transaction has (objectively) a dual purpose, the taxpayer’s intentions may be taken into account. An example of a transaction with a dual purpose is the acquisition of a site partly as premises from which to conduct another trade, and partly with a view to the possible development and resale of the site. This test is not one of the traditional badges of trade, but it may be just as important.
| If on applying the badges of trade HMRC do not conclude that income is ‘trade income’ then they can potentially treat it as other income or a capital gain. Remember that capital gains are taxable at a maximum rate of 28% whereas income is taxed at a maximum rate of 45%. HMRC will therefore be looking very carefully to see if a transaction really results in a capital gain or whether it is really a trade receipt. |
Exam focus point
2 The computation of trade profits
|
||
|
2.1 The adjustment of profits
The net profit shown in the statement of profit or loss is the starting point in computing the taxable trade profits. Many adjustments may be required to calculate the taxable amount.
| Only International Accounting Standard terminology is used when presenting accounting information contained within an examination question. This applies for companies, sole traders and partnerships. |
Exam focus point
Here is an illustrative adjustment of a statement of profit or loss:
£ £
Net profit 140,000
Add: expenditure charged in the accounts which is not deductible from 50,000 trading profits income taxable as trading profits which has not been included in the accounts 30,000
80,000 220,000
Less: profits included in the accounts but which are not taxable trading profits 40,000 expenditure which is deductible from trading profits but has not been charged in the accounts 20,000
)
Adjusted taxable trading profit
You may refer to deductible and non-deductible expenditure as allowable and disallowable expenditure respectively. The two sets of terms are interchangeable.
2.2 Accounting policies
The fundamental concept is that the profits of the business must be calculated in accordance with generally accepted accounting principles. These profits are subject to any adjustment specifically required for income tax purposes. The accounting method usually applies the accruals concept of accounting for income and expenditure as it accrues or is incurred, but some small unincorporated businesses can use a cash basis of accounting instead. The adjustment rules described below relate to the accruals method. The cash basis of accounting mainly uses the same rules of adjustment but has some differences, particularly in relation to capital expenditure .We will look at the cash basis in detail later in this chapter.
2.3 Capital allowances
Under the Capital Allowances Act 2001 (CAA 2001) capital allowances are treated as trade expenses and balancing charges are treated as trade receipts (see later in this Text).
2.4 Non-deductible expenditure
Certain expenses are specifically disallowed by the legislation. These are covered in paragraphs 2.4.12.4.10. If however a deduction is specifically permitted this overrides the disallowance.
2.4.1 Capital expenditure
Income tax is a tax solely on income so capital expenditure is not deductible. This denies a deduction for depreciation or amortisation (although there are special rules for companies in relation to intangible assets – see later in this Text). The most contentious items of expenditure will often be repairs (revenue expenditure) and improvements (capital expenditure).
- The cost of restoration of an asset by, for instance, replacing a subsidiary part of the asset is revenue expenditure. Expenditure on a new factory chimney replacement was allowable since the chimney was a subsidiary part of the factory (Samuel Jones & Co (Devondale) Ltd v CIR 1951).
However, in another case a football club demolished a spectators’ stand and replaced it with a modern equivalent. This was held not to be repair, since repair is the restoration by renewal or replacement of subsidiary parts of a larger entity, and the stand formed a distinct and separate part of the club (Brown v Burnley Football and Athletic Co Ltd 1980).
- The cost of initial repairs to improve an asset recently acquired to make it fit to earn profits is disallowable capital expenditure. In Law Shipping Co Ltd v CIR 1923 the taxpayer failed to obtain relief for expenditure on making a newly bought ship seaworthy prior to using it.
- The cost of initial repairs to remedy normal wear and tear of recently acquired assets is allowable. Odeon Associated Theatres Ltd v Jones 1971 can be contrasted with the Law Shipping Odeon were allowed to charge expenditure incurred on improving the state of recently acquired cinemas.
Other examples to note include:
- A one-off payment made by a hotel owner to terminate an agreement for the management of a hotel was held to be revenue rather than capital expenditure in Croydon Hotel & Leisure Co v Bowen 1996. The payment did not affect the whole structure of the taxpayer’s business; it merely enabled it to be run more efficiently.
- A one-off payment to remove a threat to the taxpayer’s business was also held to be revenue rather than capital expenditure in Lawson v Johnson Matthey plc 1992.
- An initial payment for a franchise (as opposed to regular fees) is capital and not deductible.
2.4.2 Expenditure not wholly and exclusively for the purposes of the trade
Expenditure is not deductible if it is not for trade purposes (the remoteness test), or if it reflects more than one purpose (the duality test). The private proportion of payments for motoring expenses, rent, heat and light and telephone expenses of a proprietor is not deductible. If an exact apportionment is possible relief is given on the business element. Fixed rate expenses, as prescribed in the legislation, can also be claimed in certain cases where there is a private element of expenditure (see later in this chapter). Where the payments are to or on behalf of employees, the full amounts are deductible but the employees are taxed under the benefits code (see earlier in this Text).
The remoteness test is illustrated by the following cases:
- Strong & Co of Romsey Ltd v Woodifield 1906
- customer injured by a falling chimney when sleeping in an inn owned by a brewery claimed compensation from the company. The compensation was not deductible: ‘the loss sustained by the appellant was not really incidental to their trade as innkeepers and fell upon them in their character not of innkeepers but of householders’.
- Bamford v ATA Advertising Ltd 1972
- director misappropriated £15,000. The loss was not allowable: ‘the loss is not, as in the case of a dishonest shop assistant, an incident of the company’s trading activities. It arises altogether outside such activities’.
- Expenditure which is wholly and exclusively to benefit the trades of several companies (for example, in a group) but is not wholly and exclusively to benefit the trade of one specific company is not deductible (Vodafone Cellular Ltd and others v Shaw 1995).
- McKnight (HMIT) v Sheppard (1999) concerned expenses incurred by a stockbroker in defending allegations of infringements of Stock Exchange regulations. It was found that the expenditure was incurred to prevent the destruction of the taxpayer’s business and that as the expenditure was incurred for business purposes it was deductible. It was also found that although the expenditure had the effect of preserving the taxpayer’s reputation, that was not its purpose, so there was no duality of purpose.
The duality test is illustrated by the following cases:
- Caillebotte v Quinn 1975
- self-employed carpenter spent an average of 40p per day when obliged to buy lunch away from home but just 10p when he lunched at home. He claimed the excess 30p. It was decided that the payment had a dual purpose and was not deductible: a taxpayer ‘must eat to live not eat to work’.
- Mallalieu v Drummond 1983
Expenditure by a lady barrister on black clothing to be worn in court (and on its cleaning and repair) was not deductible. The expenditure was for the dual purpose of enabling the barrister to be warmly and properly clad as well as meeting her professional requirements.
- McLaren v Mumford 1996
- publican traded from a public house which had residential accommodation above it. He was obliged to live at the public house but he also had another house which he visited regularly. It was held that the private element of the expenditure incurred at the public house on electricity, rent, gas, etc was not incurred for the purpose of earning profits, but for serving the non-business purpose of satisfying the publican’s ordinary human needs. The expenditure, therefore had a dual purpose and was disallowed.
However, the cost of overnight accommodation when on a business trip may be deductible and reasonable expenditure on an evening meal and breakfast in conjunction with such accommodation is then also deductible.
2.4.3 Impairment losses (bad debts)
Only impairment losses where the liability was incurred wholly and exclusively for the purposes of the trade are deductible for taxation purposes. For example, loans to employees written off are not deductible unless the business is that of making loans, or it can be shown that the writing-off of the loan was earnings paid out for the benefit of the trade.
Under generally accepted accounting principles, a review of all trade receivables should be carried out to assess their fair value at the balance sheet date and any impairment losses written off. The tax treatment follows the accounting treatment so no adjustment is required for tax purposes. General provisions (ie those calculated as a percentage of total trade receivables, without reference to specific receivables) will now rarely be seen. In the event that they do arise, increases or decreases in a general provision are not allowable /taxable and an adjustment will need to be made.
If an impairment loss which has been deducted for tax purposes is later recovered, the recovery is taxable so no adjustment is required to the amount of the recovery shown in the statement of profit or loss.
2.4.4 Unpaid remuneration
If earnings for employees are charged in the accounts but are not paid within nine months of the end of the period of account, the cost is only deductible for the period of account in which the earnings are paid. When a tax computation is made within the nine month period, it is initially assumed that unpaid earnings will not be paid within that period. The computation is adjusted if they are so paid.
Earnings are treated as paid at the same time as they are treated as received for employment income purposes.
2.4.5 Entertaining and gifts
The general rule is that expenditure on entertaining and gifts is non-deductible. This applies to amounts reimbursed to employees for specific entertaining expenses and gifts, and to round sum allowances which are exclusively for meeting such expenses. There is no distinction between UK and overseas customer entertaining for income tax and corporation tax purposes (a different rule applies for value added tax).
There are specific exceptions to the general rule:
- Entertaining for and gifts to employees are normally deductible although where gifts are made, or the entertainment is excessive, a charge to tax may arise on the employee under the benefits legislation.
- Gifts to customers not costing more than £50 per donee per year are allowed if they carry a conspicuous advertisement for the business and are not food, drink, tobacco or vouchers exchangeable for goods.
- Gifts to charities may also be allowed although many will fall foul of the ‘wholly and exclusively’ rule above. If a gift aid declaration is made by an individual in respect of a gift, tax relief will be given under the gift aid scheme, not as a trading expense. If a qualifying charitable donation is made by a company, it will be given tax relief by deduction from total profits (see later in this Text).
2.4.6 Lease charges for cars with CO2 emissions exceeding 130g/km
There is a restriction on the leasing costs of a car with CO2 emissions exceeding 130 g/km. 15% of the leasing costs will be disallowed in the calculation of taxable profits.
2.4.7 Interest payments
Interest which is allowed as deductible interest (see earlier in this Text) is not also allowed as a trading expense.
2.4.8 National Insurance contributions
No deduction is allowed for any National Insurance contributions except for employer’s contributions. For the purpose of your exam, these are Class 1 secondary contributions and Class 1A contributions (Class 1B contributions are not examinable). National Insurance contributions for self employed individuals are dealt with later in this chapter.
2.4.9 Penalties and interest on tax
Penalties and interest on late paid tax are not allowed as a trading expense. Tax includes income tax, capital gains tax, VAT and stamp duty land tax.
2.4.10 Crime related payments
A payment is not deductible if making it constitutes an offence by the payer. This covers protection money paid to terrorists, bribes and similar payments made overseas which would be criminal payments if they were made in the UK. Statute also prevents any deduction for payments made in response to blackmail or extortion.
2.5 Deductible expenditure
Most expenses will be deductible under the general rule that expenses incurred wholly and exclusively for the purpose of the trade are not disallowed. Some expenses which might otherwise be disallowed under the ‘wholly or exclusively’ rule, or under one or other of the specific rules discussed above are, however, specifically allowed by the legislation. These are covered in paragraphs 2.5.1 to 2.5.11.
2.5.1 Pre-trading expenditure
Expenditure incurred before the commencement of trade is deductible, if it is incurred within seven years of the start of trade and it is of a type that would have been deductible had the trade already started. It is treated as a trading expense incurred on the first day of trading.
2.5.2 Incidental costs of obtaining finance
Incidental costs of obtaining loan finance, or of attempting to obtain or redeeming it, are deductible other than a discount on issue or a premium on redemption (which are really alternatives to paying interest). This deduction for incidental costs does not apply to companies because they obtain a deduction for the costs of borrowing in a different way. We will look at companies later in this Text.
2.5.3 Short leases
A trader may deduct an annual sum in respect of the amount liable to income tax on a lease premium which they paid to their landlord (see earlier in this Text). Normally, the amortisation of the lease will have been deducted in the accounts (and must be added back as capital expenditure).
2.5.4 Renewals
Where a tool is replaced or altered then the cost of the renewal or alteration may be deducted as an expense in certain instances. These are that:
- A deduction would only be prohibited because the expenditure is capital expenditure, and
- No deduction can be given under any other provisions, such as under the capital allowances legislation.
2.5.5 Restrictive covenants
When an employee leaves their employment they may accept a limitation on their future activities in return for a payment. Provided the employee is taxed on the payment as employment income (see earlier in this Text) the payment is a deductible trading expense.
2.5.6 Secondments
The costs of seconding employees to charities or educational establishments are deductible.
2.5.7 Contributions to agent’s expenses
Many employers run payroll giving schemes for their employees. Any payments made to the agent who administers the scheme towards running expenses are deductible.
2.5.8 Counselling and retraining expenses
Expenditure on providing counselling and retraining for leaving employees is allowable.
2.5.9 Redundancy
Redundancy payments made when a trade ends are deductible on the earlier of the day of payment and the last day of trading. If the trade does not end, they can be deducted as soon as they are provided for, so long as the redundancy was decided on within the period of account, the provision is accurately calculated and the payments are made within nine months of the end of the period of account. The deduction extends to additional payments of up to three times the amount of the redundancy pay on cessation of trade.
2.5.10 Personal security expenses
If there is a particular security threat to the trader because of the nature of the trade, expenditure on their personal security is allowable.
2.5.11 Patents, trade marks and copyrights
The costs of registering patents and trade marks are deductible for trades only (not professions or vocations). Copyright arises automatically and so does not have to be registered. Patent royalties and copyright royalties paid in connection with a trade are deductible as trading expenses.
2.6 Trade income
There are also statutory rules governing whether certain receipts are taxable or not. These are discussed in 2.6.1 to 2.6.5.
2.6.1 Capital receipts
As may be expected, capital receipts are not included in trade income. They may, of course, be taken into account in the capital allowances computation, or as a capital gain.
However, compensation received in one lump sum for the loss of income is likely to be treated as income (Donald Fisher (Ealing) Ltd v Spencer 1989).
In some trades, (eg petrol stations and public houses), a wholesaler may pay a lump sum to a retailer in return for the retailer only supplying that wholesaler’s products for several years (an exclusivity agreement). If the payment must be used for a specific capital purpose, it is a capital receipt. If that is not the case, it is an income receipt. If the sum is repayable to the wholesaler but the requirement to repay is waived in tranches over the term of the agreement, each tranche is a separate income receipt when the requirement is waived.
2.6.2 Debts released
If the trader incurs a deductible expense but does not settle the amount due to the supplier, then if the creditor releases the debt other than under a statutory arrangement, the amount released must be brought into account as trade income.
2.6.3 Takeover of trade
If a trader takes over a trade from a previous owner, then if they receive any amounts from that trade which related to a period before the takeover they must be brought into account unless the previous owner has already done so.
2.6.4 Insurance receipts
Insurance receipts which are revenue in nature, such as for loss of profits, are trading receipts. Otherwise the receipt must be brought in as trade income if, and to the extent that, any deduction has been claimed for the expense that the receipt is intended to cover.
2.6.5 Gifts of trading stock to educational establishments or schools
When a business makes a gift of equipment manufactured, sold or used in the course of its trade to an educational establishment or for a charitable purpose, nothing need be brought into account as a trading receipt or (if capital allowances had been obtained on the asset) as disposal proceeds, so full relief is obtained for the cost.
2.7 Excluded income
Although the accounts may include other income, such as interest, such income is not trade income. It will instead be taxed under the specific rules for that type of income, such as the rules for savings income. It is therefore excluded from trade profits.
Certain types of income are specifically exempt from tax, and should be excluded from trade profits.
2.8 Application of general rules
These general rules can be applied to particular types of expenditure and income that you are likely to come across.
2.8.1 Appropriations
Salary or interest on capital paid to the trader are not deductible.
2.8.2 Subscriptions and donations
The general ‘wholly and exclusively’ rule determines the deductibility of expenses. Subscriptions and donations are not deductible unless the expenditure is for the benefit of the trade. The following are the main types of subscriptions and donations you may meet and their correct treatments:
- Trade subscriptions (such as to a professional or trade association) are generally deductible.
- Charitable donations are deductible only if they are small and to local charities. Tax relief may be available for donations under the gift aid scheme. In the latter case they are not a deductible trading expense.
- Political subscriptions and donations are generally not deductible.
- Where a donation represents the most effective commercial way of disposing of stock (for example, where it would not be commercially effective to sell surplus perishable food), the donation can be treated as for the benefit of the trade and the disposal proceeds taken as £Nil. In other cases, the amount credited to the accounts in respect of a donation of stock should be its market value.
2.8.3 Legal and professional charges
Legal and professional charges relating to capital or non-trade items are not deductible. These include charges incurred in acquiring new capital assets or legal rights, issuing shares, drawing up partnership agreements and litigating disputes over the terms of a partnership agreement.
Charges are deductible if they relate directly to trading. Deductible items include:
- Legal and professional charges incurred defending the taxpayer’s title to fixed assets
- Charges connected with an action for breach of contract
- Expenses of the renewal (not the original grant) of a lease for less than 50 years
- Charges for trade debt collection
- Normal charges for preparing accounts/assisting with the self assessment of tax liabilities
Accountancy expenses arising out of an enquiry into the accounts information in a particular year’s return are not allowed where the enquiry reveals discrepancies and additional liabilities for the year of enquiry, or any earlier year, which arise as a result of negligent or fraudulent conduct.
Where, however, the enquiry results in no addition to profits, or an adjustment to the profits for the year of enquiry only and that assessment does not arise as a result of negligent or fraudulent conduct, the additional accountancy expenses are allowable.
2.8.4 Goods for own use
The usual example is when a trader takes goods for their own use. In such circumstances the selling price of the goods if sold in open market is added to the accounting profit. If the trader pays anything for the goods, this is left out of account. In other words, the trader is treated for tax purposes as having made a sale to themselves. This rule does not apply to supplies of services, which are treated as sold for the amount (if any) actually paid (but the cost of services to the trader or their household is not deductible).
2.8.5 Other items
Here is a list of various other items that you may meet.
| Item | Treatment | Comment |
| Educational courses for staff | Allow | |
| Educational courses for trader | Allow | If to update existing knowledge or skills, not if to acquire new knowledge or skills |
| Item | Treatment | Comment |
| Removal expenses (to new business premises) | Allow | Only if not an expansionary move |
| Travelling expenses to the trader’s place of business | Disallow | Ricketts v Colquhoun 1925: unless an itinerant trader (Horton v Young 1971) |
| Compensation for loss of office and ex gratia payments | Allow | If for benefit of trade: Mitchell v B W Noble Ltd 1927 |
| Pension contributions (to schemes for employees and company directors ) | Allow | Special contributions may be spread over the year of payment and future years |
| Parking fines | Allow
Disallow |
For employees using their employer’s cars on business.
For proprietors/directors |
| Damages paid | Allow | If not too remote from trade: Strong and Co v Woodifield 1906 |
| Preparation and restoration of waste disposal sites | Allow | Spread preparation expenditure over period of use of site. Pre-trading expenditure is treated as incurred on the first day of trading. Allow restoration expenditure in period of expenditure |
| Rental income from letting part of premises | Deduct | Taxed as income of a UK property business
unless it is the letting of surplus business accommodation |
2.9 Rounding
Where an individual, a partnership or a single company (not a group of companies) has an annual turnover of at least £5,000,000, and prepares its accounts with figures rounded to at least the nearest £1,000, figures in computations of adjusted profits (including, for companies, non-trade profits but excluding capital gains) may generally be rounded to the nearest £1,000.
2.10 Cash basis of accounting for small businesses 2.10.1 Introduction
FAST FORWARD
An individual who is carrying on a trade may elect for the profits of the trade to be calculated on the cash basis (instead of in accordance with generally accepted accounting principles) in certain circumstances.
Usually, businesses prepare accounts using generally accepted accounting principles for tax purposes. In particular, this means that income and expenses are dealt with on an accruals basis. This is referred to as ‘accruals accounting’ in this section.
Certain small unincorporated businesses may elect to use cash accounting (known as ‘the cash basis’) rather than accruals accounting for the purposes of calculating their taxable trading income.
Exam focus
The detailed cash basis rules are quite complex. These more complex aspects are not examinable at point
Paper P6(UK). In any examination question involving an unincorporated business, it should be assumed that the cash basis is not relevant unless it is specifically mentioned.
2.10.2 Which businesses can use the cash basis?
Unincorporated businesses (sole traders and partnerships) can make an election to use the cash basis if their receipts for the tax year do not exceed the value added tax (VAT) registration threshold (currently £82,000 – this figure is given in the Tax rates and Allowances available in the exam).
The election is generally effective for the tax year for which it is made and all subsequent tax years.
However, a business must cease to use the cash basis if:
- (i) Receipts in the previous tax year exceeded twice the VAT registration threshold for that year (the limit in 2014/15 was £81,000), and
(ii) Receipts for the current year exceed the VAT registration for that year; or
- Its ‘commercial circumstances’ change such that the cash basis is no longer appropriate and an election is made to use accruals accounting.
2.10.3 Calculation of taxable profits under the cash basis
The taxable trading profits under the cash basis are calculated as:
- Cash receipts; less
- Deductible business expenses actually paid in the period.
Cash receipts include all amounts received relating to the business including cash and card receipts. They include amounts received from the sale of plant and machinery, other than on the sale of motor cars. We look at the definition of plant and machinery when we look at capital allowances later in this Text.
Receipts from the sale of motor cars and capital assets which are not classed as plant and machinery (eg land) are not taxable receipts.
Under the cash basis, business expenses are deductible when they are paid. Business expenses for the cash basis of accounting include capital expenditure on plant and machinery (except motor cars). Other capital expenses are not business expenses eg purchase of land, motor cars, and legal fees on such purchases.
The majority of the specific tax rules covered earlier in this chapter concerning the deductibility of business expenses also apply when the cash basis is used. It should be remembered, in particular, that only business expenses are tax deductible so that any private element must be disallowed. Fixed rate expenses for private use of motor cars and business premises used for private purposes may be used instead (see further below).
2.10.4 Basis of assessment
A trader using the cash basis can, like any other trader, prepare his accounts to any date in the year. The basis of assessment rules, which determine in which tax year the profits of an accounting period are taxed, apply in the same way for accruals accounting and cash basis traders (see later in this chapter).
2.10.5 Losses
A net cash deficit (ie a loss) can normally only be relieved against future cash surpluses (ie future trading profits). Cash basis traders cannot offset a loss against other income or gains. Trading losses for the accruals accounting traders are dealt with in detail later in this Text.
2.10.6 Fixed rate expenses
FAST FORWARD
Fixed rate expenses can be used in relation to expenditure on motor cars and business premises partly used as the trader’s home.
Exam focus Although the use of fixed rate expenses is optional, in any examination question involving the cash point basis, it should be assumed that, where relevant, expenses are claimed on this basis.
The option of claiming expenses on a flat rate basis is also available to unincorporated businesses generally, but it will only be examined in P6(UK) within the context of the cash basis.
Where a business elects to use the cash basis, for Paper P6(UK) purposes, it will be assumed to use fixed rate expenses rather than make deductions on the usual basis of actual expenditure incurred.
For Paper P6(UK) purposes, fixed rate expenses relate to:
- Expenditure on motor cars; and
- Business premises partly used as the trader’s home.
The fixed rate mileage (FRM) expense can be claimed in respect of motor cars which are owned or leased by the business and which are used for business purposes by the sole trader/partner or an employee of the business.
The FRM expense is calculated as the business mileage times the appropriate rate per mile. The appropriate mileage rates for motor cars are 45p per mile for the first 10,000 miles, then 25p per mile thereafter.
Exam focus
point These rates are the same as the authorised mileage rates for employment income given in the Tax rates and Allowances available in the exam.
A fixed rate monthly adjustment can be made where a sole trader/partner uses part of the business premises as his home eg where a sole trader runs a small hotel or guesthouse and also lives in it. The adjustment is deducted from the actual allowable business premises costs to reflect the private portion of household costs, including food, and utilities (eg heat and light). It does not include mortgage interest, rent, council tax or rates: apportionment of these expenses must be made based on the extent of the private occupation of the premises.
The deductible fixed rate amount depends on how many people use the business premises each month as a private home:
| Number relevant occupants | Non-business use amount |
| 1 | £350 |
| 2 | £500 |
| 3 or more | £650 |
Exam focus These rates will be given in the examination question, if relevant.
point
Be careful when using these amounts – they are not the deductible expense but the disallowable amount.
2.11 Example
Larry started trading as an interior designer on 6 April 2015. The following information is relevant for the year to 5 April 2016.
- Revenue was £65,000 of which £8,000 was owed as receivables at 5 April 2016.
- A motor car was acquired on 6 April 2015 for £15,000. Larry drove 10,000 miles in the car during the year to 5 April 2016 of which 3,000 miles were for private journeys. The car qualifies for a capital allowance of £1,890, after taking account of private use.
- Machinery was acquired on 1 May 2015 for £4,000. The machinery qualifies for a capital allowance of £4,000.
- Other allowable expenses were £12,000 of which £1,000 was owed as payables at 5 April 2016.
If Larry uses the accruals accounting basis and does not use fixed rate expenses, his trading profit will be calculated as follows:
| £ | £ | |
| Revenue (accruals) | 65,000 | |
| Less: capital allowance on motor car | 1,890 | |
| business motoring expenses £2,000 × 7/10 | 1,400 | |
| capital allowance on machinery | 4,000 | |
| other allowable expenses (accruals) | 12,000 | |
| (19,290) | ||
| Taxable trading profit | 45,710 |
If Larry uses the cash basis of accounting and fixed rate expenses, his trading profit will be calculated as follows:
| £ | £ | |
| Revenue (cash received £65,000 – £8,000) | 57,000 | |
| Less: FRM on car 7,000 × 45p | 3,150 | |
| cost of machinery | 4,000 | |
| other allowable expenses (cash paid £12,000 – £1,000) | 11,000 | |
| (18,150) | ||
| Taxable trading profit
2.12 The cessation of trades 2.12.1 Post cessation receipts and expenses |
38,850 |
Post-cessation receipts (including any releases of debts incurred by the trader) are chargeable to income tax as miscellaneous income.
If they are received in the tax year of cessation or the next six tax years, the trader can elect that they be treated as received on the day of cessation. The time limit for electing is the 31 January which is 22 months after the end of the tax year of receipt.
Certain post cessation expenses paid within seven years of discontinuance may be relieved against other income. The expenses must relate to costs of remedying defective work or goods, or legal expenses of or insurance against defective work claims. Relief is also available for trade receivable that subsequently prove to be impaired.
2.12.2 Valuing trading stock on cessation
When a trade ceases, the closing stock must be valued. The higher the value, the higher the profit for the final period of trading.
If the stock is sold to a UK trader who will deduct its cost in computing their taxable profits, it is valued under the following rules.
- If the seller and the buyer are unconnected, take the actual price.
- If the seller and the buyer are connected (see below), take what would have been the price in an arm’s length sale.
- However, if the seller and the buyer are connected, the arm’s length price exceeds both the original cost of the stock and the actual transfer price, and both the seller and the buyer make an election, then take the greater of the original cost of the stock and the transfer price. The time limit for election for unincorporated business is the 31 January which is 22 months after the end of the tax year of cessation (for companies, it is two years after the end of the accounting period of cessation).
In all cases covered above, the value used for the seller’s computation of profit is also used as the buyer’s cost.
Key term An individual is connected (connected person) with their spouse (or civil partner), with the relatives
(brothers, sisters, ancestors and lineal descendants) of themselves and their spouse (or civil partner), and with the spouses (or civil partners) of those relatives. In-laws and step family are included; uncles, aunts, nephews, nieces and cousins are not. He is also connected with their business partners (except in relation to bona fide commercial arrangements for the disposal of partnership assets), and with their spouses (or civil partners) and relatives (see diagram below). An individual is also connected with a company if he has control of that company (or if he and persons connected with him together have control of it). An individual is also connected with the trustees of a trust of which that individual is the settlor.
|
If the stock is not transferred to a UK trader who will be able to deduct its cost in computing their profits, then it is valued at its open market value as at the cessation of trade. 3 Basis periods 12/11, 6/12, 12/12, 6/14, 9/15 |
FAST FORWARD
Basis periods are used to link periods of account to tax years.
3.1 Introduction
A tax year runs from 6 April to 5 April, but most businesses do not have periods of account ending on 5 April. Thus there must be a link between a period of account of a business and a tax year. The procedure is to find a period to act as the basis period for a tax year. The profits for a basis period are taxed in the corresponding tax year. If a basis period is not identical to a period of account, the profits of periods of account are time-apportioned as required on the assumption that profits accrue evenly over a period of account. We will apportion to the nearest month for exam purposes.
We will now look at the basis period rules that apply in the opening, continuing and closing years of a business when there is no change of accounting date. Special rules are needed when the trader changes their accounting date. We will look at these rules in the next section.
The first tax year is the year during which the trade commences. For example, if a trade commences on 1 June 2015 the first tax year is 2015/16.
3.2 The first tax year
FAST FORWARD
In opening and closing years, special rules are applied so that a new trader can start to be taxed quickly, and a retiring trader need not be taxed long after their retirement.
The basis period for the first tax year runs from the date the trade starts to the next 5 April (or to the date of cessation if the trade does not last until the end of the tax year).
So continuing the above example a trader commencing in business on 1 June 2015 will be taxed on profits arising from 1 June 2015 to 5 April 2016 in 2015/16, the first tax year.
3.3 The second tax year
- If the accounting date falling in the second tax year is at least 12 months after the start of trading, the basis period is the 12 months to that accounting date.
- If the accounting date falling in the second tax year is less than 12 months after the start of trading, the basis period is the first 12 months of trading.
- If there is no accounting date falling in the second tax year, because the first period of account is a very long one which does not end until a date in the third tax year, the basis period for the second tax year is the year itself (from 6 April to 5 April).
The following flowchart may help you determine the basis period for the second tax year.
3.4 Examples: the first and second tax year
- John starts to trade on 1 January 2016 making up accounts to 31 December 2016.
1st tax year: 2015/16 – tax profits 1.1.16 – 5.4.16
2nd tax year: 2016/17
- Is there a period of account ending in 2016/17?
- How long is the period of account?
12 months or more ie 12 months (exactly) to 31.12.16.
- So in 2016/17 tax profits of 12 months to 31.12.16.
- Janet starts to trade on 1 January 2016 making up accounts as follows:
Six months to 30 June 2016
12 months to 30 June 2017
1st tax year: 2015/16 – tax profits 1.1.16 – 5.4.16
2nd tax year: 2016/17
- Is there a period of account ending in 2016/17?
- How long is the period of account?
Less than 12 months ie six months long.
- So in 2016/17 tax profits of first 12 months of trade ie 1.1.16 – 31.12.16, ie p.e. 30.6.16 profits plus
6/12 of y.e 30.6.17 profits
- Jodie starts to trade on 1 March 2016 making up a 14 month set of accounts to 30 April 2017.
1st tax year: 2015/16 – tax profits 1.3.16 – 5.4.16
2nd tax year: 2016/17
- Is there a period of account ending in 2016/17?
No (p.e. 30.4.17 ends in 2017/18)
- So in 2016/17 tax profits of 6.4.16 – 5.4.17.
3.5 The third tax year
- If there is an accounting date falling in the second tax year, the basis period for the third tax year is the period of account ending in the third tax year.
- If there is no accounting date falling in the second tax year, the basis period for the third tax year is the 12 months to the accounting date falling in the third tax year.
3.6 Later tax years
For later tax years, except the year in which the trade ceases, the basis period is the period of account ending in the tax year. This is known as the current year basis of assessment.
3.7 The final year
- If a trade starts and ceases in the same tax year, the basis period for that year is the whole lifespan of the trade.
- If the final year is the second year, the basis period runs from 6 April at the start of the second year to the date of cessation. This rule overrides the rules that normally apply for the second year.
- If the final year is the third year or a later year, the basis period runs from the end of the basis period for the previous year to the date of cessation. This rule overrides the rules that normally apply in the third and later years.
3.8 Overlap profits
| Profits which have been taxed more than once are called overlap profits. |
Key term
When a business starts, some profits may be taxed twice because the basis period for the second year includes some or all of the period of trading in the first year or because the basis period for the third year overlaps with that for the second year.
Overlap profits may be deducted on a change of accounting date (see below). Any overlap profits unrelieved when the trade ceases are deducted from the final year’s taxable profits. Any deduction of overlap profits may create or increase a loss. The usual loss reliefs (covered later in this Text) are then available.
3.9 Example: accounting date in 2nd year at least 12 months
Jenny trades from 1 July 2010 to 31 December 2015, with the following results.
Period Profit
£
1.7.10 – 31.8.11 7,000
1.9.11 – 31.8.12 12,000 1.9.12 – 31.8.13 15,000 1.9.13 – 31.8.14 21,000 1.9.14 – 31.8.15 18,000 1.9.15 – 31.12.15 5,600
78,600
The profits to be taxed in each tax year from 2010/11 to 2015/16, and the total of these taxable profits are calculated as follows.
| Year | Basis period | Working | Taxable profit |
| £ | |||
| 2010/11 | 1.7.10 – 5.4.11 | £7,000 9/14 | 4,500 |
| 2011/12 | 1.9.10 – 31.8.11 | £7,000 12/14 | 6,000 |
| 2012/13 | 1.9.11 – 31.8.12 | 12,000 | |
| 2013/14 | 1.9.12 – 31.8.13 | 15,000 | |
| 2014/15 | 1.9.13 – 31.8.14 | 21,000 |
2015/16 1.9.14 – 31.12.15 £(18,000 + 5,600 3,500)
The overlap profits are those in the period 1 September 2010 to 5 April 2011, a period of seven months. They are £7,000 7/14 = £3,500. Overlap profits are either relieved on a change of accounting date (see below) or are deducted from the final year’s taxable profit when the business ceases. In this case the overlap profits are deducted when the business ceases. Over the life of the business, the total taxable profits equal the total actual profits.
Peter trades from 1 September 2010 to 30 June 2015, with the following results.
Period Profit
£
1.9.10 – 30.4.11 8,000
1.5.11 – 30.4.12 15,000
1.5.12 – 30.4.13 9,000
1.5.13 – 30.4.14 10,500
1.5.14 – 30.4.15 16,000 1.5.15 – 30.6.15 950
59,450
Show the profits to be taxed in each year from 2010/11 to 2015/16, the total of these taxable profits and the overlap profits.
| Taxable | |||
| Year | Basis period | Working | profits |
| £ | |||
| 2010/11 | 1.9.10 – 5.4.11 | £8,000 7/8 | 7,000 |
| 2011/12 | 1.9.10 – 31.8.11 | £8,000 + (£15,000 4/12) | 13,000 |
| 2012/13 | 1.5.11 – 30.4.12 | 15,000 | |
| 2013/14 | 1.5.12 – 30.4.13 | 9,000 | |
| 2014/15 | 1.5.13 – 30.4.14 | 10,500 | |
| 2015/16 | 1.5.14 – 30.6.15 | £(16,000 + 950 – 12,000) | 4,950 |
| 59,450 |
The overlap profits are the profits from 1 September 2010 to 5 April 2011 (taxed in 2010/11 and in
2011/12) and those from 1 May 2011 to 31 August 2011 (taxed in 2011/12 and 2012/13).
£
1.9.10 – 5.4.11 £8,000 7/8 7,000 1.5.11 – 31.8.11 £15,000 4/12 5,000
Total overlap profits 12,000
3.10 Example: no accounting date in the second year
Thelma starts to trade on 1 March 2014. Her first accounts, covering the 16 months to 30 June 2015, show a profit of £36,000. The taxable profits for the first three tax years and the overlap profits are as follows.
| Taxable | |||
| Year | Basis period | Working | profits |
| £ | |||
| 2013/14 | 1.3.14 – 5.4.14 | £36,000 1/16 | 2,250 |
| 2014/15 | 6.4.14 – 5.4.15 | £36,000 12/16 | 27,000 |
| 2015/16 | 1.7.14 – 30.6.15 | £36,000 12/16 | 27,000 |
The overlap profits are the profits from 1 July 2014 to 5 April 2015: £36,000 9/16 = £20,250.
3.11 The choice of an accounting date 12/14
A new trader should consider which accounting date would be best. There are a number of factors to consider from the point of view of taxation.
- If profits are expected to rise, a date early in the tax year (such as 30 April) will delay the time when rising accounts profits feed through into rising taxable profits, whereas a date late in the tax year (such as 31 March) will accelerate the taxation of rising profits. This is because with an accounting date of 30 April, the taxable profits for each tax year are mainly the profits earned in the previous tax year. With an accounting date of 31 March the taxable profits are almost entirely profits earned in the current year.
- If the accounting date in the second tax year is less than 12 months after the start of trading, the taxable profits for that year will be the profits earned in the first 12 months. If the accounting date is at least 12 months from the start of trading, they will be the profits earned in the 12 months to that date. Different profits may thus be taxed twice, and if profits are fluctuating this can make a considerable difference to the taxable profits in the first few years.
- The choice of an accounting date affects the profits shown in each set of accounts, and this may affect the taxable profits.
- An accounting date of 30 April gives the maximum interval between earning profits and paying the related tax liability. For example if a trader makes up accounts to 30 April 2016, this falls into the tax year 2016/17 with payments on account being due on 31 January 2017 and 31 July 2017, and a balancing payment due on 31 January 2018 (details of payment of income tax are dealt with later in this Text). If the trader makes up accounts to 31 March 2016, this falls in the tax year 2015/16 and the payments will be due one year earlier (ie on 31 January 2016, 31 July 2016 and 31 January 2017).
- Knowing profits well in advance of the end of the tax year makes tax planning much easier. For example, if a trader wants to make personal pension contributions and makes up accounts to 30 April 2016 (2016/17), he can make contributions up to 5 April 2017 based on those relevant earnings. If he makes up accounts to 31 March 2016, he will probably not know the amount of his relevant earnings until after the end of the tax year 2015/16, too late to adjust his pension contributions for 2015/16.
- However, a 31 March or 5 April accounting date means that the application of the basis period rules is more straightforward and there will be no overlap profits. This may be appropriate for small traders.
- With an accounting date of 30 April, the assessment for the year of cessation could be based on up to 23 months of profits. For example, if a trader who has made up accounts to 30 April ceases trading on 31 March 2016 (2015/16), the basis period for 2015/16 will run from 1 May 2014 to 31 March 2016. This could lead to larger than normal trading profits being assessable in the year of cessation.
However, this could be avoided by carrying on the trade for another month so that a cessation arises on 30 April 2016 so that the profits from 1 May 2014 to 30 April 2015 are taxable in 2015/16 and those from 1 May 2015 to 30 April 2016 are taxable in 2016/17. Each case must be looked at in relation to all relevant factors, such as other income which the taxpayer may have and loss relief – there is no one rule which applies in all cases.
Christine starts to trade on 1 December 2013. Her monthly profits are £1,000 for the first seven months, and £2,000 thereafter. Show the taxable profits for the first three tax years with each of the following accounting dates (in all cases starting with a period of account of less than 12 months).
- 31 March
- 30 April
- 31 December
| (a) | 31 March | ||
| Period of account | Working | Profits | |
| £ | |||
| 1.12.13 – 31.3.14 | £1,000 4 | 4,000 | |
| 1.4.14 – 31.3.15 | £1,000 3 + £2,000 9 | 21,000 | |
| 1.4.15 – 31.3.16 | £2,000 12 | 24,000 | |
| Year | Basis period | Taxable profits | |
| £ | |||
| 2013/14 | 1.12.13 – 5.4.14 | 4,000 | |
| 2014/15 | 1.4.14 – 31.3.15 | 21,000 | |
| 2015/16 | 1.4.15 – 31.3.16 | 24,000 |
- 30 April
Period of account Working Profits
£
1.12.13 – 30.4.14 £1,000 5 5,000
1.5.14 – 30.4.15 £1,000 2 + £2,000 10 22,000
Year Basis period Working Taxable profits
£
2013/14 1.12.13 – 5.4.14 £5,000 4/5 4,000
2014/15 1.12.13 – 30.11.14 £5,000 + £22,000 7/12 17,833
2015/16 1.5.14 – 30.4.15 22,000
- 31 December
Period of account Working Profits
£
1.12.13 – 31.12.13 £1,000 1 1,000
- – 31.12.14 £1,000 6 + £2,000 6 18,000
- – 31.12.15 £2,000 12 24,000
Year Basis period Working Taxable profits
£
2013/14 1.12.13 – 5.4.14 £1,000 + £18,000 3/12 5,500
2014/15 1.1.14 – 31.12.14 18,000
2015/16 1.1.15 – 31.12.15 24,000
Exam focus December 2014 Qu 2(a) part (iii) Piquet required candidates to identify two advantages of using a 30 April point year end as opposed to a year end of 28 February. The examiner commented that ‘Many candidates were able to identify one advantage but few were able to come up with two. This was disappointing as the choice of year end is a basic aspect of tax planning for the unincorporated trader and one that candidates should be confident of.’
| 4 Change of accounting date | 12/14 |
FAST FORWARD
On a change of accounting date, special rules apply for fixing basis periods.
4.1 Introduction
A trader may change the date to which they prepare their annual accounts for a variety of reasons. For example, they may wish to move to a calendar year end or to fit in with seasonal variations of their trade. Special rules normally apply for fixing basis periods when a trader changes their accounting date.
On a change of accounting date there may be
- One set of accounts covering a period of less than twelve months, or
- One set of accounts covering a period of more than twelve months, or
- No accounts, or
- Two sets of accounts
ending in a tax year. In each case, the basis period for the year relates to the new accounting date. We will look at each of the cases in turn.
4.2 One short period of account
When a change of accounting date results in one short period of account ending in a tax year, the basis period for that year is always the 12 months to the new accounting date.
4.3 Example: change of accounting date (1)
Sue prepares accounts to 31 December each year until she changes her accounting date to 30 June by preparing accounts for the six months to 30 June 2015.
There is one short period of account ending during 2015/16. This means the basis period for 2015/16 is the twelve months to 30 June 2015.
Sue’s basis period for 2014/15 was the twelve months to 31 December 2014. This means the profits of the six months to 31 December 2014 are overlap profits that have been taxed twice. These overlap profits must be added to any overlap profits that arose when the business began. The total is either relieved when the business ceases or it is relieved on a subsequent change of accounting date.
4.4 One long period of account
When a change of accounting date results in one long period of account ending in a tax year, the basis period for that year ends on the new accounting date. It begins immediately after the basis period for the previous year ends. This means the basis period will exceed 12 months.
No overlap profits arise in this situation. However, more than twelve months worth of profits are taxed in one income tax year and to compensate for this, relief is available for brought forward overlap profits. The overlap relief must reduce the number of months’ worth of profits taxed in the year to no more than twelve. So, if you have a fourteen month basis period you can give relief for up to two months worth of overlap profits.
4.5 Example: change of accounting date (2)
Zoe started trading on 1 October 2012 and prepared accounts to 30 September until she changed her accounting date by preparing accounts for the fifteen months to 31 December 2015. Her results were as follows.
| Year to 30 September 2013 | £24,000 |
| Year to 30 September 2014 | £48,000 |
| Fifteen months to 31 December 2015
Profits for the first three tax years of the business are: 2012/13 (1.10.12 – 5.4.13) |
£75,000 |
| 6/12 £24,000 | £12,000 |
| 2013/14 (1.10.12 – 30.9.13) | £24,000 |
| 2014/15 (1.10.13 – 30.9.14) | £48,000 |
Overlap profits are £12,000. These arose in the six months to 5.4.13.
The change in accounting date results in one long period of account ending during 2015/16 which means the basis period for 2015/16 is the fifteen months to 31 December 2015. Three months’ worth of the brought forward overlap profits can be relieved.
£
2015/16 (1.10.14 – 31.12.15) 75,000
Less overlap profits 3/6 £12,000 (6,000) 69,000
The unrelieved overlap profits of £6,000 (£12,000 – £6,000) are carried forward for relief either when the business ceases or on a further change of accounting date.
4.6 No accounting date ending in the year
If a change of accounting date results in there being no period of account ending in a tax year there is a potential problem because basis periods usually end on an accounting date. To get round this problem you must manufacture a basis period by taking the new accounting date and deducting one year. The basis period is then the twelve months to this date.
4.7 Example: change of accounting date (3)
Anne had always prepared accounts to 31 March. She then changed her accounting date by preparing accounts for the thirteen months to 30 April 2016.
There is no period of account ending during 2015/16 so the basis period for this year is the manufactured basis period of the twelve months to 30 April 2015.
You’ve probably spotted that this produces an overlap with the previous basis period. The overlap period is the eleven months from 1 May 2014 to 31 March 2015. The overlap profits arising in this period are added to any other unrelieved overlap profits and are carried forward for future relief.
4.8 Two accounting dates ending in the year
When two periods of account end in a tax year, the basis period for the year ends on the new accounting date. It begins immediately following the previous basis period. This means that the basis period will exceed 12 months and overlap relief can be allowed to ensure that only twelve months worth of profits are assessed in the tax year.
4.9 Example: change of accounting date (4)
Elizabeth prepared accounts to 30 September until 2016 when she changed her accounting date by preparing accounts for the six months to 31 March 2016.
The new accounting date is 31 March 2016. This is the end of the basis period for 2015/16. The basis period for 2014/15 ended on 30 September 2014. The 2015/16 basis period is therefore the eighteen month period 1 October 2014 to 31 March 2016. Six months’ worth of overlap profits can be relieved in this year.
4.10 Conditions
The above changes in basis period automatically occur if the trader changes their accounting date during the first three tax years of their business.
In other cases the following conditions must be met before a change in basis periods can occur:
- The trader must notify HMRC of the change by the 31 January, following the tax year in which the change is made (by 31 January 2017 for a change made during 2015/16).
- The period of account resulting from the change must not exceed 18 months.
- In general, there must have been no previous change of accounting date in the last 5 tax years. However, a second change can be made within this period if the later change is for genuine commercial reasons. If HMRC do not respond to a notification of a change of accounting date within 60 days of receiving it, the trader can assume that they are satisfied that the reasons for making the change are genuine commercial ones.
If the above conditions are not satisfied because the first period of account ending on the new date exceeds 18 months or the change of accounting date was not notified in time, but the ‘five year gap or commercial reasons’ condition is satisfied, then the basis period for the year of change is the 12 months to the old accounting date in the year of change. The basis period for the next year is then found using rules above as if it were the year of change.
If the ‘five year gap or commercial reasons’ test is not satisfied, the old accounting date remains in force for tax purposes (with the profits of accounts made up to the new date being time-apportioned as necessary) until there have been five consecutive tax years which were not years of change. The sixth tax year is then treated as the year of change to the new accounting date, and the rules above apply.
Exam focus December 2014 Qu 2(a) parts (i) and (ii) Piquet tested change of accounting date. The examiner point commented that ‘Unfortunately, most candidates who attempted this question did not know the rules,
such that very few scored well on these parts of the question.’ The examiner added that ‘Candidates should recognise that change of accounting date is not part of the Paper F6 (UK) syllabus and must therefore be regarded as an area that will be examined regularly in future Paper P6 (UK) exams.’
5 National insurance
5.1 National insurance contributions (NICs) for the self employed
| The self employed pay Class 2 and Class 4 NICs. Class 4 NICs are based on the level of the individual’s taxable profits. Class 2 NICs are paid at a weekly flat rate. |
FAST FORWARD
The self employed (sole traders and partners) pay NICs in two ways.
Class 2 contributions are payable at a flat rate. The Class 2 rate for 2015/16 is £2.80 a week. No Class 2 contributions are payable if the individual’s taxable trading profits are less than the small profits threshold which is £5,965 (2015/16).
Class 2 NICs are payable under the self assessment system. For 2015/16, Class 2 NICs will be payable by 31 January 2017.
Additionally, the self employed pay Class 4 NICs, based on the level of the individual’s trade profits.
Main rate Class 4 NICs are calculated by applying a fixed percentage (9% for 2015/16) to the individual’s taxable trading profits between the lower limit (£8,060 for 2015/16) and the upper limit (£42,385 for 2015/16). Additional rate contributions are 2% (for 2015/16) on profits above that limit.
5.2 Example: Class 4 contributions
If a sole trader had profits of £16,725 for 2015/16 their Class 4 NIC liability would be as follows.
£
Profits 16,725
Less lower limit (8,060)
8,665
Class 4 NICs = 9% £8,665 = £780 (main only)
5.3 Example: additional Class 4 contributions
If an individual’s profits were £50,000, additional Class 4 NICs are due on the excess over the upper limit. Thus the amount payable in 2015/16 is as follows.
£
Profits (upper limit) 42,385
Less lower limit )
| Main rate Class 4 NICs 9% £34,325 | 3,089 |
| Additional rate class 4 NICs £(50,000 – 42,385) = £7,615 2% | 152 |
3,241
Class 4 NICs are collected by HMRC through the self assessment system. They are paid at the same time as the associated income tax liability. Interest is charged on overdue contributions.
5.4 Comparison of NICs for the employees and the self employed
The NIC burden on the self employed tends to be lower than that on employees, although the relative burdens vary with the level of income. The following example shows how a comparison may be made.
5.5 Example: employed and self employed NICs
Two single people, one employed and one self employed, each have annual gross income of £25,000. Show their national insurance contributions for 2015/16.
Solution
| Employed | Self-employed | |
| £ | £ | |
| NICs | ||
| Class 1: £(25,000 8,060) 12% (main only) | 2,033 | |
| Class 2: £2.80 52 | 146 | |
| Class 4: £(25,000 8,060) 9% | 1,525 | |
| 2,033 | 1,671 |
The self-employed person is better off by £(2,033 1,671) = £362 a year in NIC terms. However, that person will not be entitled to certain benefits such as job seekers allowance.
Chapter roundup
| | The badges of trade can be used to decide whether or not a trade exists. | ||
| | The accounts profits need to be adjusted in order to establish the taxable trade profits. | ||
| | An individual who is carrying on a trade may elect for the profits of the trade to be calculated on the cash basis (instead of in accordance with generally accepted accounting principles) in certain circumstances. | ||
| | Fixed rate expenses can be used in relation to expenditure on motor cars and business premises partly used as the trader’s home. | ||
| | Basis periods are used to link periods of account to tax years. | ||
| | In opening and closing years, special rules are applied so that a new trader can start to be taxed quickly, and a retiring trader need not be taxed long after their retirement. | ||
| | On a change of accounting date, special rules apply for fixing basis periods. | ||
| | The self employed pay Class 2 and Class 4 NICs. Class 4 NICs are based on the level of the individual’s taxable profits. Class 2 NICs are paid at a weekly flat rate. | ||
| Quick quiz | |||
- List the six traditional badges of trade.
- What are the remoteness test and the duality test?
- What pre-trading expenditure is deductible?
- In which period of account are earnings paid 12 months after the end of the period for which they are charged deductible?
- What is the maximum allowable amount of redundancy pay on the cessation of a trade?
- Which businesses can elect to use the cash basis of accounting?
- What is the basis period for the tax year in which a trade commenced?
- On what two occasions may overlap profits potentially be relieved?
- How are Class 4 NICs calculated?
Answers to quick quiz
- The subject matter
The frequency of transactions
The length of ownership
Supplementary work and marketing
A profit motive
The way in which goods were acquired
- Expenditure is not deductible if it is not for trade purposes (the remoteness test), or if it reflects more than one purpose (the duality test).
- Pre-trading expenditure is deductible if it is incurred within seven years of the start of the trade and is of a type that would have been deductible if the trade had already started.
- In the period in which they are paid.
- 3 statutory amount
- Unincorporated businesses (sole traders and partnerships) whose receipts for the tax year do not exceed the value added tax (VAT) registration threshold can use the cash basis of accounting.
- Date of commencement to 5 April in that year.
- On a change of accounting date where a basis period resulting from the change exceeds 12 months or on the cessation of a business.
- The main rate is a fixed percentage of an individual’s profits between the upper limit and lower limit. The additional rate applies above the upper limit.
| Number | Level | Marks | Time |
| Q7 | Introductory | 20 | 39 mins |
