Calculating Profits & Paying VAT Flashcards
what tax do businesses pay?
- sole traders and partners -: income tax and capital gains tax
- companies -: corporation tax
- businesses -: VAT
types of profits businesses can make
businesses can make two kinds of profit -: income and capital
income profits are generally those profits which are recurring in nature, such as rent or trading profit
capital profits are one-off items, such as an office building increasing in value
calculating trading income
default method: ‘cash basis’
- this effectively taxes the difference between money received and money paid during the accounting period and is therefore a simpler way of calculating trading income
larger/more complex businesses are likely to opt out of this method. this is because…
- if the business wants to obtain finance, the lender is likely to want to see accounts drawn up in the traditional way before deciding to offer finance
- certain reliefs cannot be claimed if the business uses the cash basis
- the cash basis does not apply to companies or LLPs
the accounting period of a business
a business must prepare accounts for an accounting period, usually of 12 months, to show the profit or loss made by its trade during those 12 months
trading profits or losses are calculated by subtracting deductible expenditure and capital allowances from chargeable receipts:
- chargeable receipts MINUS deductible expenditure MINUS capita allowances = trading profit/loss
what are chargeable receipts?
means money received for the sale of goods and services
receipts must derive from the business’s trade and be income (ie recurring) rather than capital in nature
- it is generally accepted that if a business buys something to sell on at a profit, the proceeds of sale will be income
- if, however, the business sells something which it has used in its trade – for example, its office premises – and makes a profit, this will instead be classed as a capital profit
what is deductible expenditure?
deductible expenditure must be of an income nature, and incurred ‘wholly and exclusively’ for the trade
deduction must not be prohibited by statute, for example, client entertainment and leasing cars with emissions over a certain level
what is income in nature?
if the reason for incurring the expenditure is so that the business can sell the item at a profit (eg, stock) - then it is income in nature
if the expenditure has the quality of recurrence (for example, utility bills) - it will be income in nature
expenditure on items to help the business to trade, for example, the office building, will be capital in nature and therefore not deductible
what does ‘wholly and exclusively for the purposes of trade’ mean?
means thatexpenditure is only deductible in calculating business profits if it is incurred only for business purposes
Examples of items that are commonly deductible -:
- salaries (as long as they are not excessive given the services that the person carries out)
- rent on commercial premises
- utility bills
- stock
- contributions to an approved pension scheme for directors/employees
- interest payments on borrowings
capital allowances
capital items cannot be deducted from chargeable receipts when calculating trading profits, because they are not income in nature
such items are expensive and a business which needs to heavily invest in such items could have severe cash flow problems
such assets almost always decrease in value over time, so businesses are faced with a situation where they have spent a great deal of money on an item which is necessary for the business but which may be valueless several years later
to encourage businesses to invest in essential machinery to help them to grow, they are entitled to a capital allowance, which allows them to deduct a proportion of the cost of most capital items from chargeable receipts
this will ultimately result in the business paying less tax overall
the main types of capital asset for which a capital allowance is permitted are plant and machinery
what is plant and machinery?
plant includes whatever apparatus business people use to carry out their business
- includes all goods and chattels which they keep for permanent use in their business, but not stock in trade
- eg: manufacturing equipment, tools, computers, office equipment
each financial year, the business is entitled to a writing down allowance:
- the WDA is 18% of the value of the business’s plant and machinery, valued at the start of the financial year
- each financial year, the plant and machinery the business owns will be valued, and 18% of its total value will be deducted from chargeable receipts when calculating trading profits for that accounting period.
- the reduced value of the plant and machinery is known as the written down value of the asset
pooling
usually, businesses own more than one item of plant and machinery
for this reason, all plant and machinery is generally pooled, and the WDA is calculated each year on the basis of the value of the whole pool
if an asset is sold, the proceeds of sale are deducted from the value of the whole pool, not the individual item
annual investment allowance
businesses are entitled to an annual investment allowance
the AIA allows businesses to deduct the whole cost of new or used plant and machinery purchased in that particular accounting period from chargeable receipts (not just 18% of the value of those assets, as with capital allowances)
amount of the AIA = £1 million
- this means that the first £1 million of fresh qualifying expenditure on plant and machinery incurred in an accounting period will be wholly deductible
- a group of companies will receive only one AIA for the group in each accounting period
full expensing - for companies only
allows companies to deduct 100% of the cost of only brand new plant and machinery purchased in that particular accounting period from chargeable receipts
amount deductible is uncapped
on disposal of the asset, a balancing charge is applied equal to 100% of the disposal value where full expensing has been claimed
full expensing is set to end on 31 March 2026
the normal AIA of 100% of the cost of the asset, capped at £1 million, is in force in addition to full expensing, and for companies the AIA will be relevant for assets which are second-hand or refurbished rather than brand new
trading profit calculation
chargeable receipts (sales)
MINUS
deductible expenses (income nature, wholly and exclusively for the purpose of trade, not barred by statute)
MINUS
capital allowances on plant and machinery (existing plant and machinery = WDA 18% and new plant and machinery = AIA 100%, of up to £1m)
= TRADING PROFIT
relief for trading loss: unincorporated businesses
for sole traders or general partnerships
trading income calculations may reveal a loss
the taxpayer may be able to claim relief for such trading losses
- the reliefs effectively allow the taxpayer to deduct a trading loss from other income, resulting in them paying less tax overall
- where the taxpayer is eligible for more than one relief, they may choose which relief to claim
if, after claiming as much relief as is available under one provision, there are still some unabsorbed losses, the taxpayer can claim relief for the balance of the loss under another provision if they are eligible
sometimes the loss is set against total income, and sometimes it is set against a particular component of income
some of the reliefs are also subject to a cap for any one tax year
partners will decide individually which relief/reliefs they wish to claim in relation to their share of the partnership’s losses -: partners may all make different decisions, depending on their personal circumstances
the taxpayer must apply for the relief - it is not automatically applied by HMRC
what are the reliefs for trading loss?
- start-up loss relief (early trade losses relief)
- carry-across/one year carry-back relief
- set-off against capital gains
- carry-forward relief
- carry-back of terminal trading loss
- carry-forward relief on incorporation of business
- cap on reliefs
start-up loss relief (early trade losses relief)
available when the taxpayer suffers a loss in any of the first four tax years of the new business
the loss can be carried back and set against the taxpayers total income in the three tax years immediately prior to the tax year of the loss
particularly useful for anyone who starts a new business, but before that, had an income from a former business or from their employment
enables the taxpayer to claim back from HMRC some of the income tax they paid in their previous business or employment in the three tax years prior to the tax year of the loss
carry-across/one year carry-back relief for trading losses generally
four options for this relief. the losses can be…
- set against total income from the same tax year
- set against total income from the tax year preceding the tax year of the loss
- set against total income from the same tax year until that income is reduced to zero, with the balance of the loss being set against total income from the tax year preceding the tax year of the loss
- set against total income from the tax year preceding the tax year of the loss until that income is reduced to zero, with the balance of the loss being set against total income from the tax year of the loss
when the taxpayer claims this relief, they must set their loss against total income, often reducing it to zero (meaning the lose the benefit of their personal allowance)
he claim for this relief must be made on or before the first anniversary of 31 January following the end of the tax year in which the loss is assessed
set-off against capital gains
allows the taxpayer to set trading losses against chargeable gains in the same tax year, and applies when a taxpayer has claimed carry-across relief but not all of the loss has been absorbed
must claim this relief on or before the first anniversary of 31 January following the end of the tax year in which the loss is assessed
this relief allows loss relief against chargeable capital gains as well as against income
carry-forward relief
taxpayer may carry forward their trading loss for a tax year and set it against subsequent profit which the trade produces in subsequent year - taking earlier years first
losses can be carried forward indefinitely until the loss is exhausted, so if several years go by before the trade makes a profit against which to set the losses, this is no bar to claiming the relief
taxpayer must notify HMRC of its intention to claim the relief no more than four years after the end of the tax year in which the loss was incurred
taxpayer can use all of carry-forward, cary-across and carry-back reliefs in relation to the same loss, until the loss is wiped out
carry-back of terminal trading loss
applies when a taxpayer incurs a loss in the final 12 months of trading
any loss incurred by a taxpayer in the final 12 months of trading can be carried across and set against trading profits in the final tax year, and then carried back and set against trading profit in the three years preceding the year of the loss, starting with the year preceding the year of the loss and moving back year by year until the loss is fully absorbed or the three-year limit is reached, whichever is first
there is no cap on the amount which can be relieved
rules allow other sources of income which are connected to the trade but not actually profits of the trade to be treated as trading profits for the purposes of this relief - this makes it possible for a loss to be set against a profit from the same trade from the same year
this relief may result in the taxpayer receiving a tax rebate, because their trading profits from previous years will be reduced and it is likely that their tax liability will reduce as a consequence
this relief can only be applied to trading income, not to non-trading income or capital gains
must be made no more than four years after the end of the tax year to which the claim relates
carry-forward relief on incorporation of business
this relief kicks in when someone turns their sole trader business into a company (this is called incorporation), and they made a trading loss before doing that
if a taxpayer incorporates their business by transferring it to a company wholly or mainly in return for shares, any trading losses which have not been relieved can be carried forward and set against any income they receive from the company, such as their salary or dividends
‘wholly or mainly in return for shares’ = 80% or more of the consideration for the business transferred must be shares in the company
no cap on the amount that can be relieved under this provision
taxpayer must notify HMRC of its intention to claim the relief no more than four years after the end of the tax year in which the loss was incurred
cap on reliefs
start-up relief and carry-across/carry-back relief are all subject to a cap of no greater than £50,000 or 25% of the taxpayer’s income in the tax year in relation to which the relief is claimed
the cap does not usually have a significant impact because the cap only applies to income from sources other than the trade which produced the loss
VAT
VAT is charged every time a business supplies goods or services
current rate of VAT is a flat rate of 20%
business charges the customer VAT at 20% on the value of the goods or services - output tax
business deducts from the amount it collects in output tax any VAT it has itself paid on goods or services - input tax
pays the difference to HMRC
