Business Taxation Flashcards
What is Business Taxation
It’s taxes that businesses need to pay on their earnings
Who is subject to business taxation under UK Income Tax rules
Sole traders (self-employed individuals) and partnerships.
Not limited companies (they pay Corporation Tax).
Around 10% of the UK workforce falls under these rules.
Taxable profit = Net profit (accounts) + Disallowed expenses – Capital allowances.
What is changing about the basis period for business taxation in 2024-25
Current rule: Businesses can use any accounting period (e.g., 31 December).
New rule (2024-25): Must align with the tax year (6 April – 5 April).
Part of Making Tax Digital (MTD) to simplify reporting.
Example: A business with a 31 December year-end must report profits from 1 Jan 2024 – 5 Apr 2025 for the 2024-25 tax year.
How does HMRC distinguish between a trade and a hobby for tax purposes
They use the Badge if Trade to identify what classes as a trade.
Trade: Profits taxed as Income Tax (20%-45% + National Insurance).
Hobby: Gains may be Capital Gains Tax (CGT) (10%-28%, with £3,000 annual exemption in 2024-25).
Key question: Is the activity systematic, frequent, and profit-driven?
What are the 6 Badges of Trade (SFLMPC)
Subject Matter
Frequency of Transaction
Length of Ownership
Supplementary Work & Marketing
Profit Motive
Circumstances of Sale
Badge of Trade - Subject Matter
Trading likely: Goods typically bought/sold for profit (e.g., toilet rolls, branded items).
Case: Rutledge v IRC (1929) – Buying 1 million toilet rolls was trading.
Not trading: Investments (stocks, property held long-term) or personal-use items (e.g., a painting hung at home).
Badge of Trade - Frequency of Transactions
High frequency (e.g., selling 100 cars/year) = Strong indicator of trade.
One-off sales (e.g., selling an inherited watch) = Likely not trading.
Example: A car dealer selling 50 vehicles a year is clearly trading.
Badge of Trade - Length of Ownership
Short-term (quick resale) → Suggests trading (e.g., property flipping).
Long-term (years) → Suggests investment (e.g., holding stocks for dividends).
Badge of Trade - Supplementary Work and Marketing
Adding value (e.g., repairing cars, blending products) indicates trade.
Case: Cape Brandy Syndicate (1927) – Blending and marketing brandy = trading.
Passive ownership (e.g., holding stocks) = Not trading.
Badge of Trade - Profit Motive
Key factor but not definitive (hobbyists may also seek profit).
Trade likely: Systematic purchases aimed at resale (e.g., bulk-buying phones to sell online).
Hobby likely: Occasional sales (e.g., selling homemade crafts).
Badge of Trade - Circumstances of Sale
Acquired accidentally (inheritance) or sold in emergency → Not trading.
Planned purchases for resale (e.g., auction buys to flip) → Trading.
Is selling items on eBay considered trading?
Depends on frequency, profit motive, and effort.
Trading: Regular sales, bulk purchases, marketing (e.g., reselling sneakers).
Hobby: Occasional sales of personal items (e.g., old clothes).
How does HMRC decide borderline cases?
No strict formula – examines all badges collectively.
Self-assessment: Taxpayer must justify their position.
Disclose if unsure to avoid penalties.
What steps can taxpayers take to justify hobby vs trade status?
Document intent (e.g., notes on purchases).
Limit frequency if claiming hobby status.
Seek professional advice for ambiguous cases (e.g., Airbnb rentals).
What is Taxable Income
Income that HMRC taxes after deducting your personal allowances and other relief
What is the starting point for calculating taxable trading profits
Net profit per accounts (prepared under accounting rules).
For 2023/24, accounts can be drawn up for any period (not necessarily aligned with the tax year).
From 2024/25, all taxpayers must use a 5 April year-end (basis period reform).
What are the two key questions when determining taxable profits
What income/expenses are relevant? (Adjustments needed).
Which accounts to use for the tax year? (Called the basis period for assessment).
2024/25 change: All taxpayers must use a 5 April year-end (no more misaligned accounting periods).
Why must accounting profits be adjusted for tax purposes
Accounting rules ≠ Tax rules.
Adjustments ensure only taxable income and allowable expenses are included.
Examples:
Add back disallowed expenses (e.g., client entertainment).
Deduct capital allowances (tax-approved depreciation).
Are all accounting policies acceptable for tax purposes
Most are OK, but some are disallowed:
Anticipated losses (e.g., losses on long-term contracts cannot be deducted in advance).
Provisions not meeting tax rules (e.g., doubtful debts must be specific, not general).
What income adjustments are needed for taxable profits
Goods taken for own use: Add selling price to profit (treated as if sold to the taxpayer).
Exclude non-trading income:
Income taxed elsewhere (e.g., rent = property income).
Capital receipts (e.g., proceeds from selling a business asset).
What are Deductible (Allowable) Expenses?
Expenses allowed for both accounting and tax purposes.
No adjustment needed (already reduce taxable profit).
Examples:
Wages, rent, utilities, stock purchases.
Capital allowances (replacing accounting depreciation).
What are Non-Deductible (Disallowable) Expenses
Expenses allowed in accounts but not for tax.
Added back to accounting profit to calculate taxable profit.
Examples:
Client entertainment.
Depreciation (replaced by capital allowances).
Fines/penalties (e.g., HMRC penalties).
How are Goods taken for personal use treated in tax calculations?
Added to profit at selling price (as if sold to the owner).
Example: A baker takes bread home worth £100 → add £100 to taxable profit.
Capital vs Revenue Income
How are capital receipts (e.g. selling a business van) treated?
Excluded from trading profits.
Taxed under Capital Gains Tax (CGT) if a gain arises.
Example: Selling a delivery van for £10,000 (original cost £8,000) → £2,000 gain reported under CGT.
What are the steps to Adjusting Accounting Profit for Tax
Start with net profit per accounts.
Add back disallowed expenses (e.g., depreciation, entertaining).
Deduct non-trading income (e.g., rent, capital receipts).
Add omitted trading income (e.g., goods for own use).
Apply capital allowances (tax-approved depreciation).
What are the 3 Main Criteria for Deductible Expenses
MUST BE:
Wholly and exclusively for trade (no private purpose)
Revenue (not capital) nature
Not specifically disallowed by statute
What’s the ‘Wholly and Exclusive’ test, how does it affect duality
Expense must have no private purpose (e.g., business-only mobile phone = allowable).
Duality test: If mixed use (e.g., car for business & private trips), either:
Apportion (business % allowed), or
Fully disallowed if private use is significant.
Example: 70% business mileage → 70% of costs deductible.
How does the ‘fruit and trees’ test distinguish Revenue vs Capital Expenses?
Revenue (fruit): Day-to-day running costs (e.g., repairs, wages) → deductible.
Capital (trees): Long-term assets/improvements (e.g., buying machinery) → not deductible (may qualify for capital allowances).
Example: Replacing a broken window = repair (revenue). Installing new windows = improvement (capital).
5 Specifically Disallowed Expenses by Statute
Depreciation (use capital allowances instead).
Client entertaining (staff entertaining = allowable).
Fines/penalties (e.g., parking fines, except employee fines).
Proprietor’s salary (treated as profit appropriation).
Gifts to customers (>£50/year or no business branding).
Why is Depreciation added back, how is it replaced?
Depreciation (accounting) ≠ Capital allowances (tax).
Add back £7,400 depreciation → Deduct £8,000 capital allowances (example).
Key point: Only HMRC-approved capital allowances reduce taxable profit.
Repairs vs Improvement
When is a repair deductible, when is it a disallowed improvement
Repair: Restores asset to original condition (e.g., fixing a leak) → deductible.
Improvement: Enhances asset (e.g., upgrading to energy-efficient windows) → capital.
Case law:
Law Shipping: Initial repairs to make asset usable = capital.
Odeon Theatres: Repairs after usable = revenue.
When are Legal Fees Deductible
Allowable: Debt collection, trade disputes, accounting fees.
Disallowed: Capital items (e.g., drafting lease agreements).
Example: Legal fees for new lease → added back (capital).
How are car leasing costs treated for high emission vehicles
CO2 emissions > 50g/km: 15% of leasing cost disallowed.
Example: £10,000 lease → £1,500 added back to profit.
Is Staff Training always Deductible
Allowed: Update courses, skill maintenance.
Disallowed: Proprietor’s new skill development (e.g., accountant taking a coding course).
When are Customer Gifts Deductible
Allowed if:
Cost < £50/year per customer, and
Clearly advertises business (e.g., branded pens).
Disallowed: Luxury gifts (e.g., £100 gift cards).
Are Patent Royalties Deductible as Trading Expenses?
No → Treated as “charges on income” (deducted after profit calculation).
What is the Cash Basis, and why might a small business choose it
Definition: Recognizes income/expenses only when cash changes hands (no receivables/payables).
Eligibility: Turnover < £150,000 (designed for micro-businesses and sole traders).
Pros:
Simpler for businesses with minimal inventory or credit transactions (e.g., freelancers, small retailers).
Avoids complex accounting for unpaid invoices.
Cons:
£500 cap on loan interest deductions (e.g., a business loan’s interest beyond £500 is disallowed).
Distorts profitability for businesses with significant credit sales/purchases.
Example: A plumber invoices £5,000 in March but receives payment in April. Under cash basis, this is 2024/25 income.
How does the accruals basis reflect economic reality, and when is it required?
It records income when earned (invoice issued) and expenses when incurred (bill received), regardless of cash flow.
Required for:
Businesses exceeding £150,000 turnover.
Limited companies (must use accruals under Companies Act).
Advantages:
Matches income to related expenses (e.g., sales revenue vs. cost of goods sold).
Complies with GAAP (Generally Accepted Accounting Principles).
Tax Impact:
Anticipated losses (e.g., a contract penalty expected next year) are disallowed – only actual losses count.
Example: A bakery buys flour on credit in December 2023 (used for orders delivered that month). Under accruals, the expense is 2023/24, even if paid in 2024.
How does Current Year Basis determine tax years, and what are common pitfalls
Rule: Profits are taxed in the tax year (6 April – 5 April) where the accounting period ends.
Key Scenarios:
Year-end 31 December 2023: Falls in 2023/24 tax year (since 31 Dec 2023 is between 6 Apr 2023 and 5 Apr 2024).
Year-end 30 April 2024: Falls in 2024/25 tax year.
Pitfalls:
Misalignment can cause overlap profits (taxed twice in early years) or gaps (e.g., when closing a business).
Example: A consultancy with a 30 June year-end reports profits for:
1 July 2022 – 30 June 2023 → 2023/24 tax year.
What’s changing in 2024/25, and how will it affect businesses?
New Rule: All businesses must report profits aligned with the tax year (5 April year-end).
Transition Year (2023/24):
Businesses with non-5 April year-ends will report >12 months of profits (e.g., 1 Jan 2023 – 5 Apr 2024 for a 31 Dec year-end).
Spread excess profits over 5 years to ease tax burden.
Impact:
Simplifies MTD compliance but may cause cash flow issues (higher taxable profits in transition year).
Example: A café with a 31 March year-end:
2023/24: Profits from 1 Apr 2023 – 5 Apr 2024 (12 months + 5 days).
2024/25 onward: 6 Apr – 5 Apr reporting.
Cash vs Accrual - Tax Timing Differences
How does the choice of basis affect tax payments?
Cash Basis:
Delays tax on unpaid invoices (e.g., £10,000 billed but not yet received = no tax until payment).
Risk: Large cash receipts in one year can spike tax liability.
Accruals Basis:
Tax due on invoices issued, even if unpaid (e.g., bad debts require manual adjustment).
Benefit: Smoother profit reporting for growing businesses.
Example: A graphic designer:
Cash basis: £8,000 project (completed Dec 2023, paid Jan 2024) = 2024/25 income.
Accruals basis: Same project = 2023/24 income.
Exceptions to Current Year Balance
How are the first and last years of trading taxed differently
Opening Years:
Year 1: Taxed on profits from start date to following 5 April.
Year 2: Often creates “overlap profits” (some profits taxed twice).
Closing Year:
Taxed on profits from last 6 April to cessation date.
Example: A business starts 1 Oct 2023 and ends 30 Sep 2025:
2023/24: 1 Oct 2023 – 5 Apr 2024 (6 months).
2025/26: 6 Apr 2025 – 30 Sep 2025 (final 6 months).
Why is loan interest restricted under cash basis, how does it work?
£500 Annual Cap: Aimed at preventing manipulation (e.g., loading expenses into cash basis periods).
Accruals Basis: No cap if interest is wholly and exclusively for trade.
Example: A cash basis business pays £1,200 loan interest in 2024/25:
£500 deductible → £700 disallowed.
Why has the cash basis not been widely adopted?
Complexity in tracking cash flows vs. invoices.
Restrictions (e.g., loan interest cap, turnover limit).
Accruals better reflects true profitability.
Why does HMRC prefer Accruals for large business over £150K turnover
Prevents manipulation: Cash basis could defer income (e.g., delaying invoices to reduce tax).
GAAP Compliance: Required for audited accounts.
Matching Principle: Ensures revenue and costs are recorded in the same period (e.g., sales and inventory costs).
How does cash basis treat a £2K roof repair paid in instalments
Cash Basis: Deducts only the amount paid in the tax year (e.g., £500 paid in 2023/24 = £500 deduction).
Accruals Basis: Deducts full £2,000 when work is completed (if incurred in the period).
What constitutes UK Property Income, how is it taxed?
Rents, lease premiums (<50 years), rights of way, sporting rights, caravan/houseboat lettings.
Tax Treatment:
All properties pooled into a single “Property Income Business” (one profit/loss calculation).
Unearned income: Not pensionable, taxed separately from trading income.
Basis: Accruals (default) or cash basis (if small income).
Adjustments: Similar to trading income (e.g., “wholly & exclusively” rule), but:
No capital allowances – use renewals basis for capital items (e.g., replacing furniture).
Example: Rental income of £8,000 is excluded from trading profits and taxed separately.
Deductible Expenses for Property Income
What Expenses can Landlords Deduct from Rental Income?
Allowed:
Mortgage interest (restricted to basic-rate tax relief).
Repairs (but not improvements).
Letting agent fees, insurance, ground rent.
Renewals basis: Cost of replacing furnishings (e.g., new sofa).
Disallowed:
Capital expenditures (e.g., property extensions).
Personal use portions (e.g., if you live in the property part-time).
Key Rule: Expenses must be “wholly and exclusively” for the property business.
Furnished Holiday Lettings (FHL)
Why are they treated differently from other properties
Treated as trading income (not property income), so eligible for:
Capital allowances (on furniture, equipment).
Pension contributions (tax relief).
CGT reliefs: Entrepreneurs’ Relief, Rollover Relief.
Loss Relief: FHL losses can offset future FHL profits (unlike other property losses).
EEA Properties: Treated as separate; losses can’t offset UK FHL profits.
What are the 4 conditions a property must meet to qualify as FHL
Commercial intent: Must aim to make a profit.
Availability: Let for >210 days/year.
Occupancy: Actually let for >105 days/year.
No long-term tenants: No single let >31 days (unless exceptional circumstances).
Example: A seaside cottage rented weekly in summer = likely FHL. A 6-month lease to a student = not FHL.
How does the Rent a Room Scheme work, who benefits
Tax-Free Allowance: £7,500/year (per property, not per tenant).
Applies to: Furnished rooms in your main home.
Taxable Excess: If rent > £7,500, choose:
Method A: Pay tax on profit (rent – allowable expenses).
Method B: Pay tax on rent above £7,500 (no expenses deducted).
Planning Tip: Parents renting to university students often use this.
Example: Rent £10,000, expenses £2,000:
Method A: Tax on £10,000 – £2,000 = £8,000 (only £500 taxed after allowance).
Method B: Tax on £10,000 – £7,500 = £2,500.
When should a landlord choose Method A or B for Rent a Room
Method A (profit – expenses): Better if expenses > £7,500.
Method B (rent – £7,500): Simpler if expenses are minimal.
Example: Rent £9,000, expenses £500:
Method A: Tax on £9,000 – £500 = £8,500 (£1,000 taxable).
Method B: Tax on £9,000 – £7,500 = £1,500 (worse here).
How are EEA (European Economic Area) FHLs treated?
Separate Property Business: UK and EEA FHLs can’t pool profits/losses.
Same Criteria: Must meet UK FHL availability/occupancy tests.
Example: A French holiday let’s losses can’t offset UK FHL profits.
What adjustment are made to property income for tax
Add: Disallowed expenses (e.g., personal use).
Deduct: Allowable expenses (e.g., repairs, agent fees).
Exclude: Capital receipts (e.g., selling a property).
Note: Mortgage principal repayments are not deductible (only interest).
