Chapter 5 - Trading profits

Question 1

What are badges of trade?

Answer 1

The badges of trade are key factors which indicate whether a trade is being carried on.

Question 2

What are the nine badges of trade?

Answer 2

Profit seeking motive

The number of transactions

Nature of the asset

Existence of similar trading transactions or interests

Changes to the asset

The way the sale was carried out

Source of finance

Interval of time between purchase and sale

Method of acquisition

Question 3

What do trading profits cover?

Answer 3

Trading profits cover income from a trade, profession or vocation.

Question 4

Outline the pro-forma for calculating tax adjusted trading profit for sole traders and partnerships

Answer 4

Question 5

What adjustments to trading profits are we concerned with when calculating taxable trading income for sole traders and partnerships?

Answer 5

• disallowable expenditure
• non-trade income
• income not shown in accounts
• expenditure not shown in accounts

Question 6

What is the trading allowance?

Answer 6

A trading allowance is available to individuals who carry on a trade. The allowance is £1,000. If trading receipts for an individual (not partner) for a tax year are less than £1,000, those receipts are not taxable.

Question 7

With regards to trading allowance, what if trading receipts exceed £1,000?

Answer 7

If the receipts are above £1,000 the individual has a choice between calculating their taxable trading income in the usual way, by deducting costs of sale to give taxable trading profits or, by election, deducting deemed expenses of £1,000 from the receipts with no further reduction for actual expenses - the individual will go down whichever route gives the lowest taxable income

Question 8

What should be assumed in an exam with regards to the trading allowance?

Answer 8

In the exam always assume that the trading allowance applies if the receipts do not exceed £1,000, but if the receipts exceed £1,000 you should assume that no election to use the trading allowance has been made, unless told otherwise.

Question 9

What is allowed expenditure?

Answer 9

Expenditure incurred wholly and exclusively for the purposes of the trade, not specifically disallowed by legislation.

Question 10

With regards to allowable expenses, how is capital expenditure treated for taxable trading income for sole traders and partnerships?

Answer 10

Capital expenditure is a disallowable expense and therefore is added back to trading profits

Question 11

What is important to remember about repairs to newly acquired assets to bring them to a working state with regards to allowable expenses?

Answer 11

Repairs to newly acquired assets in dilapidated state is treated as capital expenditure and therefore is a disallowable expense - other repairs are treated as revenue and therefore are allowable

Question 12

With regards to allowable expenses, how is depreciation treated for taxable trading income for sole traders and partnerships?

Answer 12

Depreciation is a disallowable expense and therefore is added back to trading profits

Question 13

With regards to allowable expenses, how is appropriation of profit treated for taxable trading income for sole traders and partnerships?

Answer 13

Appropriation of profit is a disallowable expense therefore if profit given has already deducted any profit appropriations these must be added back

Question 14

What are the different appropriations of proift we are concerened with regarding? How do we adjust for them when calculating taxable trading income for sole traders and partnerships?

Answer 14

• payment of a ‘salary’ to a sole trader or partner - add back
• payment of a salary to a family member which is not reasonable remuneration for the services provided to the business - the excess amount over the salary which would be considered reasonable should be added back
• personal expenses paid by the business (e.g. personal income tax, NI, etc.) on behlaf of the sole trader or partner - add back

Question 15

With regards to allowable expenses, how are provisions treated for taxable trading income for sole traders and partnerships?

Answer 15

• Provisions made against specifc items are allowable expenditure
• General provisions are a disallowable expense therefore the movement in provision from the prior year should be added back or deducted (depending on if provision is increased or decreased) to trading profits

Question 16

With regards to allowable expenses, how are bad debts treated for taxable trading income for sole traders and partnerships?

Answer 16

• Trade bad debts are an allowable expense
• Non-trade bad debts (bad-debts made to friends, loans to employees, etc.) are disallowable expenses and therefore are added back to trading profits

Question 17

With regards to allowable expenses, how is entertaining treated for taxable trading income for sole traders and partnerships?

Answer 17

• Staff entertainment is an allowable expense
• Customer entertainment is a disallowable expenses and therefore is added back to trading profits

Question 18

With regards to allowable expenses, how are gifts treated for taxable trading income for sole traders and partnerships?

Answer 18

Gifts are treated as a disallowable expense unless they meet the following criteria:
* are to employees
* are trade samples (not for resale), limited to one per customer per year
* to customers if they; incorporate conspicuous advertisement for the business, are not food, drink, tobacco or vouchers exchangeable for goods and the total cost per customer is no more than £50

All other gifts are disallowable and therefore must be added back to trading profits

Question 19

With regards to allowable expenses, how are donations to charity treated for taxable trading income for sole traders and partnerships?

Answer 19

• Small donations to local charities are allowable if the gift enhances the public image of the trade
• Donations to national charities and doantions made under Gift Aid are disallowable expenses and therefore are added back to trading profits

Question 20

With regards to allowable expenses, how are political donations treated for taxable trading income for sole traders and partnerships?

Answer 20

Political donations are a disallowable expense and therefore are added back to trading profits

Question 21

With regards to allowable expenses, how are subscriptions treated for taxable trading income for sole traders and partnerships?

Answer 21

• Trade and professional associations are an allowable expense
• Subscriptions that are not related to the trade or profession are disallowable expenses and therefore are added back to trading profits

Question 22

With regards to allowable expenses, how are fines and penalties treated for taxable trading income for sole traders and partnerships?

Answer 22

• Most fines and penalties are disallowable expenses and therefore are added back to trading profits
• The exception is parking fines incurred by an employee (not a sole trader or partner) on a business activity, these are allowable expenses

Question 23

With regards to allowable expenses, how is interest expenses treated for taxable trading income for sole traders and partnerships?

Answer 23

• Interest paid on money borrowed for business purposes (i.e. bank overdraft, loan interest) is an allowable expense
• Interest paid on late payment of tax is a disallowable expense and therefore must be added back to trading profit

Question 24

With regards to allowable expenses, how are legal and professional expenses treated for taxable trading income for sole traders and partnerships?

Answer 24

• Legal and professioinal fees that are not relating to capital expenditure are allowable expenses
• Legal and professional fees (e.g. conveyancing, architects, surveyor’s fees) relating to capital expenditure are disallowable expenses except for the following specific exceptions: legal costs relating to the renewal of a short lease (50 years or less), costs of registration of a patent or copyright for trade use, incidental costs of raising long-term finance

Question 25

With regards to allowable expenses, how is irrecoverable VAT treated for taxable trading income for sole traders and partnerships?

Answer 25

Irrecoverable VAT is an allowable expense only if the item of expenditure to which it relates is allowable.

Question 26

With regards to allowable expenses, how employment payments treated for taxable trading income for sole traders and partnerships?

Answer 26

Earnings paid to employees are generally allowable (Must be paid within 9 months of the accounting period), this includes:
* tax and NIC (employers and employees)
* redundancy payments (On the cessation of trade, restricted to 3 times the amount of statutory redundancy pay)
* pension contributions to employees registered pension scheme in the accounting period of payment

Related payments for sole traders and partners (i.e. tax, NI, pensions) is appropriation of profit (as previosuly seen) and is a disallowable expense

Question 27

With regards to allowable expenses, how are plant and machinery leasing and rental costs treated for taxable trading income for sole traders and partnerships?

Answer 27

The costs of hiring, leasing or renting plant and equipment , including cars, are allowable expenses.

However for leases taken out on cars with CO2 emissions > 50g/km, there is a disallowance of 15% - you have to disallow 15% of the costs of hiring, leasing or renting the car.

Question 28

With regards to allowable expenses, how is the private use of leased plant and machinery treated for taxable trading income for sole traders and partnerships?

Answer 28

A proportion of the lease cost must be disallowed where there is private use by the sole trader or partner - the rate of disallowance will be dependent on the amount of personal use

This does not apply for private use by employees - only sole traders and partners

Question 29

How is non-trade income adjusted for when calculating taxable trading income for sole traders and partnerships?

Answer 29

Any non-trade income in the accounts must be deducted from trading profit

Question 30

What are the common examples of non-trade income for sole traders and partnerships?

Answer 30

• rental income
• profits/losses on the disposal of fixed assets
• investment income.

Question 31

What is the most common example of trading profits not shown in accounts that will need to be adjusted for when calculating taxable trading income for sole traders and partnerships?

Answer 31

The main example of trading profit not shown in the accounts of the business arises when goods are taken from the business by the owner for personal use.

Question 32

What is the treatment of goods taken by owner when calculating taxable trading income for sole traders and partnerships?

Answer 32

The owner must be taxed on the profit he would have made if the goods had been sold at market value. The adjustment will depend on how the transaction has been shown in the accounts:
* If nothing is recorded in the accounts, add back the selling price - the market value of the item
* If recorded as drawings in accounts at cost, add back the profit which would have been made on sale of the item - market value minus cost

Question 33

What is the most common example of trading expenses not shown in accounts that will need to be adjusted for when calculating taxable trading income for sole traders and partnerships?

Answer 33

The main example of trading expenses not shown in the accounts of the business is business expenditure paid personally by the owner

Question 34

What is the treatment of business expenditure paid personally by the owner when calculating taxable trading income for sole traders and partnerships?

Answer 34

Business expenditure paid personally by the owner is an allowable expense and needs to be added on to the trading profit

Question 35

Outline the method for calculating taxable trading income for sole traders and partnerships

Answer 35

1) Write out the pro-forma pictured
2) Add back any disallowable expenditure
3) Add back on income not shown in accounts
4) Deduct and non-trade income
5) Deduct any expenditure not in accounts
6) This will give adjusted profits before capital allowances
7) Less any capital allowances (see later chapter on how to calculate)
8) This will givve the adjusted taxable trading profit

Question 36

Can these adjsutments be applied to companies?

Answer 36

A lot of the adjustments that are made to taxable profits for sole traders and partnerships are similiar to the adjustments made for companies in their corporation tax with some differences which we will see in later chapter