Trading Profits Flashcards
What are the steps to tax a sole trader?
Step 1: Adjust profits for the accounting period
Step 2: Deduct capital allowances for that accounting period
= Tax adjusted trading profit for the accounting period
Step 3: Consider which tax year to tax this accounting period in = basis periods
How are the profits of an ongoing business taxed?
The profits of an ongoing business are taxed on a current year basis: the profits taxed in a tax year are those of the twelve month accounting period ending in that tax year
What do you add within the formula for adjusting the accounting profit?
Net profit per accounts +
- Disallowable expenditure
- Taxable trading income not credited in the accounts
What do you deduct within the formula for adjusting the accounting profit?
Net profit per accounts -
- Income included in the accounts that is not taxable trading income
- Capital allowances
What is allowable expenditure?
Allowable expenditure is expenditure incurred wholly and exclusively for trading purposes, not specifically disallowed by legislation.
Some expenditure is allowable for accounting purposes, but not for tax purposes. Such expenditure is disallowable and must be added back to the accounting profit when calculating tax adjusted trading profit
What is the most common example of taxable trading income not included in the accounts? How do you treat this?
When a sole trader removes goods from the business for his/her own use:
- If correctly treated in the accounts (i.e. cost has been removed from purchases): add back the profit element
- If still included in purchases (i.e. no adjustment made to the accounts): add back selling price
What are the main examples of allowable expenditure not included in the accounts?
- Capital allowances
- Business expenses borne personally by the owner
What are two types of non-trading income that may have been included in the accounts but should be removed for tax purposes?
- Income taxed elsewhere e.g. chargeable gains, rental income or savings income
- income that is exempt from tax e.g. exempt capital gains
Is expenditure wholly and exclusively for trading purposes?
No, if:
- it is too remote from the purposes of the trade
- it has both a trade and non-trade purpose (the duality principle)
If there is a dual purpose for expenditure, what do HMRC do?
If there is a dual purpose for expenditure, HMRC will generally accept a reasonable apportionment between business use (allowable) and private use (disallowable)
Are payments to staff allowable?
Most payments to staff are allowable. These include salaries, bonuses and redundancy payments and the cost of providing benefits
What happens if earnings are not paid within nine months of the year end?
If earnings are not paid within nine months of the year end, they are then deductible in the period in which they are paid
Are employers’ contributions to pension schemes allowed?
Employers’ contributions to pension schemes are allowed when paid, rather than on the normal accruals basis
Is training expenditure allowed?
Training expenditure for employees and/or the sole trader is allowable provided that the training is aimed at improving the skills needed in the business
What is an appropriation?
An appropriation is a withdrawal of funds from a business’s profits. These are disallowable as expenses. Common examples of appropriations include:
- the business owner’s salary
- drawings made by a sole trader/partner
Unreasonable payments made to family member employees are classified as appropriations of profit and the excess is therefore disallowed
Are movements in specific provisions allowable?
Movements in specific provisions are allowable but movements in general provisions are disallowable
Are the write-off of trade bad debts allowable?
The write-off of trade bad debt is allowable but the write-off of non-trade bad debts is disallowable and therefore needs to be added back
What are some common examples of capital expenditure which is disallowable when calculating taxable trading profit?
- depreciation
- loss on sale of fixed assets (equally profit on the sale of fixed assets is deducted from net profit)
- cost of capital assets included within repairs and maintenance
- improvements/enhancements
- expenditure required to first bring an asset into a useable state
- capital related expenditure included within legal and professional fees
What are the exceptions to disallowable capital expenditure?
Repairs (returning an asset to its original condition) and maintenance (e.g. redecoration) are allowable costs
Repairs using current industry industry standard materials or technology is allowable even though there is an element of improvement e.g. replacing single glazed windows with double glazed windows
How do you treat a donation?
The treatment of a donation depends on the nature of the organisation to which the sole trader is making the donation:
- small donations to local charities are allowable
- gifts of stock or assets to local charities or schools are allowable
- donations to national charities are disallowable but tax relief may be available through the gift aid scheme
- subscriptions and donations to political parties are disallowable
What about entertaining?
Expenditure relating to client entertaining is disallowable but expenditure relating to staff entertaining is allowable
What about gifting to customers?
The gift of trade samples to customers is allowable.
Other gifts to customers are disallowable unless the item:
- cost < £50 per recipient per year, and
- is not food, drink, tobacco, or vouchers exchangeable for goods, and
- carries a conspicuous advertisement for the business
What about gifting to employees?
Gifts to employees are normally allowable - there is no upper limit (unlike for benefits in kind)
However, the gift may result in an income tax charge for the employee under the benefits rules
How do you treat legal and professional charges?
Expenditure on legal and professional fees is allowable if incurred for the purposes of trade, e.g.:
- legal fees chasing debts
- charges incurred in defending the title to fixed assets
Legal and professional fees relating to capital expenditure are generally disallowable, e.g. fees associated with acquiring new fixed assets
Which aspects of legal and professional charges are allowable?
The following expenses relating to capital assets are exceptions to these rules:
- fees and other costs of obtaining long term debt finance are allowable
- the cost of registering patents is allowable
- the expense of renewing a short lease (a lease for 50 years or less) is allowable, although the legal expenses incurred on the initial granting of the lease are not
When does the flat rate disallowance of 15% apply to car lease payments?
- for leases taken out before 6 April 2018 where CO2 emissions exceed 130g/km
- for leases taken out on/after that date where CO2 emissions exceed 110g/km
If the leased car is used by the sole trader partly for business and partly for private use, then there will also be a disallowance for the private use
What’s the best way to deal with a leased car with private use?
Work out the allowable expense first, being 85% of the business proportion of the leasing cost, and then the disallowance is the remainder
Are fines allowable?
Fines are generally disallowable but parking fines incurred by an employee (but not the business owner) whilst on work business are allowable
What about interest?
- Interest on borrowings for the purpose of the trade (e.g. business account overdraft) is allowable
- Interest on late paid tax is disallowable
What about irrecoverable VAT?
Irrecoverable VAT is allowable if it relates to allowable expenditure
What trading allowance applies to sole traders?
A trading allowance of £1,000 applies to sole traders (not partnerships)
When do a sole trader’s trading receipts need to be declared for tax purposes?
If a sole trader’s trading receipts (not profits) are less than £1000 those receipts are not taxable and do not need to be declared for tax purposes
If a sole trader’s trading receipts are more than £1,000 the taxpayer can elect to deduct the allowance from the receipts rather than any actual expenses incurred
The election applies to all of the individual’s trades and relates to a specific tax year
How should you treat trading receipts in the exam?
In the exam, assume the trading allowance applies if receipts are less than or equal to £1,000, but if receipts are greater than £1,000 assume that no election to use the trading allowance has been made unless told otherwise
How do you calculate trading profits under the cash basis?
Total cash receipts - total allowable business expenses paid
How do you calculate the tax adjusted trading profits under the cash basis?
Same as for the accruals basis:
- adjust the figure in the accounts for tax purposes (e.g. for goods taken for personal use by the sole trader)
- apply basis period rules
What do taxable receipts include under the cash basis?
- all amounts received in the period including card receipts and cheques
- cash received on the sale of plant and machinery (except for cars)
- receipts not included in the accounts (e.g. where the trader takes goods for own use)
When the trader takes goods for his or her own use without paying an arm’s length price, a ‘just and reasonable’ amount should be added to trading profits (e.g. the cost of stock)
What do taxable receipts NOT include under the cash basis?
- cash received on the sale of assets not classed as plant and machinery (e.g. land and buildings)
- income taxed elsewhere (e.g. interest income)
What are the exceptional allowable payments under the cash basis?
- business expenses paid
- interest paid on business loans, subject to a maximum of £500 p.a.
- the full business proportion of car lease payments (i.e. no 15% disallowance for high emission cars)
- payment for plant and machinery (except for cars)
- capital allowances for cars
What do allowable payments not include under the cash basis?
- bad debts (as income is only taxed when received from the customer there will not be any bad debts for tax purposes)
- capital allowances on plant and machinery other than cars
- capital expenditure (e.g. purchase of a building)
When can an unincorporated business join the scheme under the cash accounting basis?
An unincorporated business may join the scheme if cash receipts for the tax year do not exceed the registration threshold of £150,000 (if the sole trader receives Universal Credit, this threshold is doubled)
The trader must leave the scheme if receipts in the previous tax year exceeded twice the registration threshold for that year
The combined receipts of all the trader’s businesses must be considered in deciding whether a trader can use the scheme
What happens once a trader has made the election for the cash basis?
Once a trader has made the election for the cash basis on his or her self-assessment tax return it will apply for the current tax year and all subsequent tax years provided the trader’s receipts do not exceed the limits
Having elected to use the cash basis, the sole trader may elect to prepare accounts in accordance with UK GAAP instead if this would be more appropriate
What ‘badges of trade’ would HMRC consider to determine whether someone is trading?
- Subject matter of the transaction (personal use, investment or sale)
- The length of the period of ownership (shorter periods of ownership may indicate trading)
- The frequency or number of similar transactions by the same person
- Supplementary work and marketing
- The circumstances responsible for the realisation
- The motive
- The method of finance used to acquire the asset
- The method of acquisition and source of finance
- If the transactions are similar to those of the taxpayer’s existing trade it could indicate trading
