Chapter 7 - Trading profits - basis of assessment

Question 1

What is the tax year?

Answer 1

The tax year runs from 6 April to 5 April.

Question 2

Why are rules needed?

Answer 2

Rules are needed to link a period of account of a business with a tax year to find the amount of taxable trading profits for that year.

Question 3

What is a basis period?

Answer 3

The period which is taxable in a particular tax year is called a basis period because it is the basis of assessment for that tax year.

Question 4

What is the basic rule called?

Answer 4

Current year basis (CYB)

Question 5

What is the current year basis (CYB)?

Answer 5

Under the current year basis, the basis period for the tax year is the taxable trading profits for the 12-month period of account ending in that tax year.

Question 6

Are special rules needed in the opening years of business?

Answer 6

Yes

Question 7

Which rule is applied in the first year?

Answer 7

In the first tax year, the actual basis applies.

Question 8

What is meant by the actual basis?

Answer 8

This means that the taxable trading profits for the first tax year are the taxable trading profits of the business from the date of commencement to the following 5 April.

Apportioned to nearest month.

Question 9

What does the basis of assessment for the second year depend on?

Answer 9

The basis of assessment in the second tax year

depends on the length of the period of account ending in the second tax year.

Question 10

What are the four possibilities regarding the basis of assessment for the second year?

Answer 10

1. Less than 12 months long - First 12 months of trading
2. 12 months long - That 12-month period of account
3. More than 12 months long - 12 months to the end of the period of account ending in the second tax year
4. No such period of account - Actual basis (6 April to 5 April)

Question 11

Which rule applies in the third year of tax?

Answer 11

Usually, the current year basis applies to the third tax year of trading because there will be a 12-month period of account ending in that tax year.

Question 12

What happens when there is not a 12-month period of account in the third tax year?

Answer 12

Occasionally, there will not be a 12-month period of account ending in the third tax year. In this case, the basis period will be the 12 months to the end of the period of account ending in the third tax year.

Question 13

What are overlap profits?

Answer 13

The application of the opening year rules means that some taxable trading profits may be
taxed twice.

Such profits are called overlap profits.

Question 14

How do overlap profits arise?

Answer 14

Choosing a period of account which ends on a date other than 5 April will result in this double counting and any trading profits taxed more than once are called overlap profits.

Question 15

What is the treatment for overlap profits?

Answer 15

Overlap profits are carried forward to be relieved in the future, as we will see later in this chapter.

Question 16

What is the final tax year?

Answer 16

The final tax year is the tax year in which the business ceases to trade.

Question 17

What is the basis period for the final tax year?

Answer 17

The basis period for the final tax year is from the end of the basis period for the previous tax year to the date of cessation, trade, ie, the tax year in which the date of cessation of trade falls.

Question 18

What is the treatment of any overlap profits in the final tax year?

Answer 18

Any overlap profits are deducted from taxable trading profits in the final tax year.

Question 19

What is the usual treatment for penultimate year tax?

Answer 19

Usually, the current year basis will apply to the penultimate tax year (ie 12-month period of account ending in the penultimate tax year).

Question 20

What happens if the final period of account exceeds 12 months?

Answer 20

There may be no period of account ending in
the penultimate tax year.

In this case, the basis period for the penultimate tax year will be the 12 months to the normal year-end date falling in that tax year.

Question 21

What is the treatment of relief for overlap profits?

Answer 21

Overlap profits arising in the opening years are deducted from the taxable trading profits in the
final tax year.

Question 22

Is a partnership a taxable person?

Answer 22

A partnership itself is not a taxable person.

Question 23

How are partners liable to income tax?

Answer 23

Each partner is liable to income tax on their share (and only their share) of the partnership’s taxable trading profits.

Question 24

What basis applies to continuing partnerships?

Answer 24

The current year basis applies to continuing partnerships.

Question 25

What rules apply to partners who join and leave the partnership?

Answer 25

Opening and closing year rules apply to partners who join and leave the partnership but the continuing partners remain on the current year basis.

Question 26

Who may use the cash basis to calculate their taxable trading income?

Answer 26

Unincorporated businesses whose receipts for the tax year do not exceed the relevant threshold may elect to use the cash basis when calculating their taxable trading income.

Question 27

Should profits per accounts still be adjusted for tax purposes?

Answer 27

Yes. The profit per the accounts must still be adjusted for tax purposes.

Question 28

What are the main differences between cash basis and accruals accounting?

Answer 28

The main differences between cash basis and accruals accounting relate to capital expenditure and interest
payments.

Question 29

How do the basis for assessments rules apply when using the cash basis?

Answer 29

The basis of assessment rules which determine in which tax year the profits of an accounting period are taxed apply in the same way as for accruals accounting traders.

Question 30

Which businesses can use the cash basis?

Answer 30

The cash basis can only be used by unincorporated businesses (sole traders and partnerships) with receipts for the tax year that do not exceed £150,000.

The limit is increased to twice the threshold, £300,000, for recipients of Universal Credit.

Question 31

When must a trader leave the scheme?

Answer 31

A trader must leave the scheme if their receipts in the previous tax year exceeded twice the threshold (£300,000 for 2019/20).

Question 32

How are the limits reduced for accounting periods of less than 12 months?

Answer 32

The above limits are proportionately reduced for accounting periods of less than 12 months.

Question 33

Under the cash basis, how are taxable trading profits calculated?

Answer 33

Total cash receipts less total allowable business expenses paid, subject to adjustments required by tax law.

Question 34

What are the rules that only apply to the cash basis?

Answer 34

The main special rules which only apply to the cash
basis relate to:

1. capital expenditure
2. interest paid

Question 35

What is the treatment when a trader takes stock out of the business for his own use without paying an arm’s length price?

Answer 35

Where a trader takes stock out of the business for his own use without paying an arm’s length price a ‘just and reasonable’ amount (for example the cost of the stock) should be added to the taxable profit (rather than treating the goods as sold at market value).

Question 36

Which capital receipts are deducted from net profits?

Answer 36

Not all capital receipts are deducted from the net profit. Only deduct the capital receipts from the sale of cars and other assets which are not classed as plant and machinery eg, land and buildings.

Question 37

Under the cash basis, what are two specific adjustments that one should be aware of?

Answer 37

1. Where a trader ceases to use a capital asset for the purposes of the trade, the market value
   of the asset at that date is treated as a taxable receipt.
2. When a trader ceases to trade, the value of stock and work in progress is treated as a taxable receipt in the final period of account.

Question 38

Regarding allowable expenses under the cash basis, what are the three main provisions which are specific to the cash basis?

Answer 38

1. Capital expenditure on plant and machinery: Expenditure on plant and machinery (but not
   cars) is an allowable expense for the cash basis.
2. Bad debts: Not an allowable deduction for the cash basis as income is only taxed when it is
   received.
3. Leased cars: The 15% restriction does not apply; ie, amounts paid are allowable in full.

Question 39

Under the cash basis, what is the treatment of interest paid?

Answer 39

Interest paid on a loan is a deductible expense from trading profits (even if the loan is not wholly and exclusively for the purposes of the trade) subject to a maximum of £500 for a 12-month period.

Question 40

Under the cash basis, what is the treatment for payments made to acquire plant and machinery (except cars)?

Answer 40

For traders using the cash basis, payments made to acquire plant and machinery (except cars) which would otherwise qualify for capital allowances are instead allowable expenses when they are made, and capital allowances are not available.

Question 41

Under the cash basis, what is the treatment for receipts made from sales of plant and machinery (except cars)?

Answer 41

Capital receipts from the sale of plant and machinery (except cars) are taxable when received.

Question 42

What are the rules for other assets?

Answer 42

For other assets eg, land and buildings and cars, the same rules apply as for accruals accounting traders. Thus capital payments are disallowed (along with legal fees on such acquisitions) but capital allowances can be claimed on cars in the normal way.

Question 43

How can a trader elect to join the cash basis scheme?

Answer 43

An election to join the scheme is made by ticking the ‘cash basis’ box in the self-assessment tax return. The election applies to all the businesses run by the trader.

Question 44

Under which circumstances do the election to use the cash basis become ineffective?

Answer 44

The election is effective for the tax year for which it is made and all subsequent tax years unless:

(1) the trader’s receipts exceed the eligibility limit (see above); or

(2) (a) there is a change of circumstances which makes it more appropriate to prepare
accounts using UK GAAP; and
(b) the trader elects to calculate profits using UK GAAP.