LECTURE 2: Taxation of Trading Profits

Question 1

INCOME TAX

Answer 1

Charged on the profits of a trade, profession or vocation.

Question 2

Trade

Answer 2

Any venture in the nature of trade (s.989 Income Tax Act 2007)

Question 3

What are the six badges of trade?

Answer 3

1. Subject matter
2. Period of ownership
3. Frequency of transactions
4. Supplementary work
5. Circumstances of Realisation
6. Profit Motive

Question 4

SUBJECT MATTER (Badge of trade)

Answer 4

Rutledge v CIR (1929)
The taxpayer, whilst abroad, bought one million rolls of toilet paper. On his return to the UK he sold them to a single purchaser, making a profit of £10,000. It was held that the vast quantity of toilet paper was purchased for no other conceivable purpose than that of reselling it at a profit.

If tax payer sells assets of a type which might normally be acquired for personal enjoyment or held as a source of income, this may suggest that any profit arising on their sale should be treated as a capital gain rather than a trading profit. If not, the only way they could be turned into an advantage is to sell them (trading profit).

Question 5

Frequency of Transactions (Badge of trade)

Answer 5

Leach v Pogson (1962)
The taxpayer had started a driving school which proved successful and which he later sold. He subsequently set up and sold some 30 driving schools. It was held that the receipts of all sales were receipts of a trade.

The more often that a tax payer repeats a certain type of transaction, the more likely it is that the activity will be construed as trading.

Question 6

Supplementary work (Badges of trade)

Answer 6

Cape Brandy Syndicate v CIR (1921)
Three wine merchants bought a quantity of brandy, blended it with another brand and sold the new blend over several months. It was held that they were trading.
A taxpayer who buys an asset, performs work on the asset so as to make it more saleable and then sells the asset is more likely to be regarded as trading than someone who simply buys and sells an asset without performing any supplementary work.

Question 7

Circumstances of realisation (Badges of trade)

Answer 7

West v Phillips (1958)

The taxpayer was a builder. He built some houses for sale, the receipts from which were assessed as trading income. He also built some houses which he could let as an investment. However due to increased government interference in the form of rent control and high taxation, he decided to sell his “investment” houses. The Court of Appeal held that the houses built as an investment were not connected with his trading activities, and the income from their sale should not be assessed as trading income.

Question 8

Profit Motive (Badge of trade)

Answer 8

Wisdom v Chamberlain (1969)

The taxpayer bought £200,000 worth of silver bullion as a hedge against devaluation. He later sold the silver at a profit of £48,000. The Court of Appeal held that this was a taxable profit, since the bullion had been purchased for the purpose of making a profit.

Question 9

Layout for calculation of taxable profits

Answer 9

Net Profit per accounts X
DEDUCT
Capital Receipts (e.g. gain on sale) (X)
Non-trading income (e.g. bank interest) (X)
Income specifically exempt from tax (X)
Capital Allowances (X)

ADD BACK
Expenditure deducted for accounts purposes but which legislation does not permit as a deduction for tax purposes (i.e. disallowable/non-deductible expenditure) X
Selling price of goods taken by proprietor for his own use X

TAXABLE TRADING PROFIT

Question 10

ALLOWABLE/DEDUCTIBLE EXPENDITURE

Answer 10

leave, no adjustment

Question 11

DISALLOWABLE/NON-DEDUCTIBLE EXPENDITURE

Answer 11

add back

Question 12

When is correction of pre-acquisition dilapidation allowable?

Answer 12

Law Shipping Co v CIR (1923)
The taxpayer purchased a ship, and shortly after purchase, was required to spend over £50,000 on repairs. It was held that some £12,000 of this cost was attributable to the period after acquisition but disallowed the remainder as capital expenditure. The cost of repairs which was disallowed was attributable to the period before the taxpayer purchased the ship. The company presumably paid a lower price than it would have done if the ship had been in an excellent state of repair. Accordingly the cost was incurred to put the asset into a sufficiently good state of repair to enable it to earn profits and was thus capital expenditure.

Was it fit for use? No - expenditure to make it fit for use is capital expenditure.

Odeon Associated Theatres Ltd v Jones (1971)
The taxpayer company purchased a large number of cinemas, which fell into disrepair during and after the Second World War due to the restrictions on building work. After acquisition the company systematically repaired the cinemas over several years but continued to operate them whilst doing so. The Court of Session held that the expenditure was revenue and thus allowable. Although the expenditure was made to rectify deterioration of the assets attributable to the period before purchase, it had not affected their purchase price, and the disrepair had not affected their profit-earning capacity.

Continued to be used - fixed whilst in use.
Cinema bought were fit for use so expenditure is revenue expenditure.

Question 13

What does expenditure have to be to be allowable?

Answer 13

Must be revenue rather than capital expenditure.

Question 14

If a building is not fit for use at purchase is expenditure to bring into working condition allowable?

Answer 14

No - expenditure to make it fit for use is capital expenditure.

If the building or asset is continued to be used and is fixed whilst being used it is allowable so revenue expenditure.

Question 15

When are losses on sale/depreciation disallowable?

Answer 15

1. Correction of pre-acquisition dilapidation
2. Enlargement or improvement of the asset.
3. Replacement of the whole entity rather than part. - capital

Question 16

What is duality?

Answer 16

· Duality (Wholly and exclusively)
Mallalieu v Drummond (1983)
A lady barrister claimed as an expense the cost of replacing and cleaning the black and sombre clothing which she had to wear in court, claiming that she would not wear such clothing out of court. It was held that the clothing had a dual purpose – that of keeping her decent and warm, and that of meeting the requirements of her profession. The costs were therefore disallowed.

Expenditure which serves both a business purpose and a private purpose cannot be allowed in full. If the expenditure can be apportioned with reasonable accuracy, then the private element is disallowed.

Question 17

When is expenditure allowable under duality rules?

Answer 17

However, an apportionment between private and business use (or the fixed rate deduction scheme) is generally permitted for:-

• Motor expenses
• Heat and light in home used for business
• Telephone calls

Question 18

Remoteness (for the purposes of trade)

Answer 18

Expenditure which has no connection with the trade is disallowed.
In Strong and Co of Romsey Ltd v Woodifield [1906] 5 TC 215, compensation was paid to an inn customer when a chimney fell on him. It was held that the payment was not deductible by the company. The loss was ‘incidental to their trade of innkeeping.’

Question 19

When are fines, penalties, etc allowable and not allowable?

Answer 19

Not allowable - VAT penalties, tax penalties, fines incurred by proprietor, partner

Allowable - Employees parking fines

Question 20

When are Entertaining and gifts allowable and not allowable?

Answer 20

Generally not allowable.

Allowable - Expenditure on staff if reasonable
Gifts to customers costing less than £50, carrying a conspicuous advert, not food, drink, tobacco, or vouchers

Question 21

When are subscriptions and donations allowable and not-allowable?

Answer 21

Not allowable - Political donations, allowed to deduct for accounting purposes but not deductible for tax purposes.

Allowable - Small donations to local charities (not to national)
Subscriptions to trade associations, professional bods.
Cost of seconding employees to charity (let employee go and work for a charity).

Question 22

When are legal and professional charges allowable and not allowable?

Answer 22

Not allowable - charges incurred acquiring new capital assets or legal rights. 
Issuing shares
Defending tax appeal
Defending criminal charges
Acquiring a new lease (capital)

Allowable -
Debt collection
Defending an action for breach of contract
Preparing contracts of employment
Costs of acquiring loan finance
Renewal of a lease of 50 years or less (greater than 50 years is not allowable)

Question 23

When are appropriations of profit allowable and not allowable?

Answer 23

Not allowable:
Depreciation (different form of depreciation for tax purposes - capital allowances)
General allowances/provision
Employees’ wages
Directors’ wages accrued in the accounts, if paid within 9 months of year end.

Allowable:
Specific allowances/provisions
Employees’ wages
Directors’ wages accrued in the accounts, if paid within 9 months of the year end.

Question 24

When are travelling expenses allowable and not-allowable?

Answer 24

Not allowable:
Home to place of work, holiday element.
Bowden v Russell and Russell (1965) a solicitor attended a conference on foreign law in North America – it was held that there was a dual purpose, professional and holiday.

Allowable:
Place of work to third location, travel abroad.

Question 25

When is clothing allowable, not allowable?

Answer 25

Generally disallowable

Allowable - protective clothing, uniforms.

Question 26

When is pre-trading expenditure allowable/not allowable?

Answer 26

Allowable:
Expenditure incurred not more than 7 years prior to commencement.
Of a kind which would normally be allowable if a trade were being carried on.

Question 27

When are redundancy payments, payments in lieu of notice allowable?

Answer 27

On cessation of trade - 4x statutory amount

Otherwise, without limit if wholly and exclusively for the purposes of trade.

Question 28

When is fraud and embezzlement allowable/not-allowable?

Answer 28

Allowable - if by an employee and a conviction is obtained

Not-allowable - if by owner/director

Question 29

Period of ownership (badges of trade)

Answer 29

If assets are bought and sold within a short space of time it is more likely that any profit made will be treated as trading profit

Question 30

Wholly and exclusively

Answer 30

In general, expenditure is deductible (allowable) when computing trading profits only if it is incurred wholly and exclusively for the purpose of trade