Chapter 5 Adjustment of Profit: Flashcards
5.1 Introduction
Each year a trader will prepare a set of accounts in accordance to UK GAAP. In computing their profits, they will have deducted expenditure which HMRC do not allow for tax purposes. We have to add back expenditure and then we deduct receipts in the accounts which are not taxable as trading income and then we deduct capital allowances.
5.2 Disallowable Expenditure
Capital expenditure – this gives an enduring benefit to the business.
Expenditure – which has not been incurred wholly and exclusively for the purposes of the trade.
Specific disallowable – given by tax statute and case law.
5.3 Depreciation and amortisation
Depreciation and amortisation are usually not allowed for tax purposes. This is because there are many rates of depreciation and traders can choose the one to maximise tax relief. Instead businesses are able to claim capital allowances on plant and machinery used in the trade.
5.4 Capital expenditure
The purchase of capital equipment should be included on a trader’s balance sheet, these include motor vehicles, premises and other equipment. These items may be eligible for capital allowances. If the trader has included any capital additions in the P+L, they are disallowed and added back to trading profits. Profit and losses on the sale of fixed assets are also disallowed. Losses on sales of fixed assets are not allowable expenses and should be added back. Profits on sales of fixed assets are not taxable as trading income and should be therefore be deducted in arriving at trading profits.
5.5 Legal Fees
A trader may incur legal fees on the acquisition or disposal of capital assets. These are disallowed as they relate to a capital item.
Legal fees incurred on the renewal of a short lease are specifically allowed. A short lease is a lease of less than 50 years.
5.6 The Enduring benefit test
In the case Atherton v British Insulated & Helsby Cables Ltd, the judge declared expenditure with an enduring benefit is not allowable. This is an expense that will benefit the business for years to follow. The expense will be capitalized in the balance sheet rather than deducted as an expense in the P+L account. Tax law does not give any assistance as to how long an asset needs to be owned for it to be classed as capital. HMRC guidance is where an asset has a life of less than one year it is revenue and is the asset is expected to last at least 2 years it is capital.
5.7 Repairs
Repairs are normally revenue expenditure, whereas the cost of replacing an asset or making an improvement is capital expenditure.
5.8 Initial Repairs
Law Shipping Company v IRC – a company purchased a ship which needed immediate repairs. The company claimed the repairs were revenue bit the courts said the repairs were capital as they were part of the acquisition costs.
5.9 Provisions
Provisions are allowable provided they are properly computed in accordance with GAAP and are in connection with revenue expenditure (not capital). Section 21 of FRS 102 requires a provision can only be recognized in the accounts if:
• The entity has an obligation to make a payment at the reporting sate as a result of a past event
• It is probable that a transfer of economic benefits will be required to settle that obligation
• A reliable estimate can be made of the amount of obligation.
5.10 Wholly and exclusively
Expenses are only deductible if they are incurred wholly and exclusively for the purposes of the trade. If an expense is incurred for a dual purpose (both a business and private element), HMRC permit a tax deduction for the business proportion of the expenditure.
HMRC only allows a proportionate deduction where an expense can be split into identifiable business and non-business parts. If an expense is materially for a private or non-business purpose, HMRC interpret the wholly test strictly and will disallow the expense in full.
5.11 Private expenses of employees
A private use adjustment is only made where the owner of the business deducts expenses which wholly or partly relate to his private affairs. Where the business pays a private expense for an employee: the expense is an allowable deduction for the business and the employee will usually have a taxable benefit.
5.12 Clothing
In the case of Mallalieu v Drummond, the courts said work clothing such as suits was not a disallowable expense. HMRC do accept that protective clothing (hard hats etc.) is allowable expenditure.
5.13 Salaries and drawings
Salaries and NIC contributions are allowable expenses for a business. Drawings are not taxed as employment income and are not allowable as a trading expense. When a trader employee a connected person, the wages are allowed as an expense provided the wages are actually paid, the individual plays a part in the business and the wages are not excessive in relation to the work undertaken. Children’s wages are only allowable if it is not unreasonable for a child to be employed for the work and the payment is in fact in the nature of a wage (not pocket money).
5.14 Accrued wages
Salaries and wages are normally deducted in the period in which they relate to. However, relief is given for accrued wages as long as the wages are paid within 9 months of the end of the accounting period. If not, the accrued amount is added back and relief is given in the period in which the wages are physically paid.
5.15 Goods for own use
If a trader buys stock and then wants to use it for their personal use an adjustment needs to be considered. The principle was established in Sharkey v Wernher, says the trader bought the asset at a cost and then sold it to themselves. We add the sales price to the accounts profit. This principle is now in legislation. This principle only applies to goods (eg completed trading stock), it does not apply to services or raw materials which have yet become stock. For services provided to the sold trader personally or to his household, we disallow the cost of providing the service and similarly disallow the cost of raw materials taken for private use.
