Trading Profits

Question 1

What are the steps to tax a sole trader?

Answer 1

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

Question 2

How are the profits of an ongoing business taxed?

Answer 2

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

Question 3

What do you add within the formula for adjusting the accounting profit?

Answer 3

Net profit per accounts +

• Disallowable expenditure
• Taxable trading income not credited in the accounts

Question 4

What do you deduct within the formula for adjusting the accounting profit?

Answer 4

Net profit per accounts -

• Income included in the accounts that is not taxable trading income
• Capital allowances

Question 5

What is allowable expenditure?

Answer 5

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

Question 6

What is the most common example of taxable trading income not included in the accounts? How do you treat this?

Answer 6

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

Question 7

What are the main examples of allowable expenditure not included in the accounts?

Answer 7

• Capital allowances

- Business expenses borne personally by the owner

Question 8

What are two types of non-trading income that may have been included in the accounts but should be removed for tax purposes?

Answer 8

• Income taxed elsewhere e.g. chargeable gains, rental income or savings income
• income that is exempt from tax e.g. exempt capital gains

Question 9

Is expenditure wholly and exclusively for trading purposes?

Answer 9

No, if:

• it is too remote from the purposes of the trade
• it has both a trade and non-trade purpose (the duality principle)

Question 10

If there is a dual purpose for expenditure, what do HMRC do?

Answer 10

If there is a dual purpose for expenditure, HMRC will generally accept a reasonable apportionment between business use (allowable) and private use (disallowable)

Question 11

Are payments to staff allowable?

Answer 11

Most payments to staff are allowable. These include salaries, bonuses and redundancy payments and the cost of providing benefits

Question 12

What happens if earnings are not paid within nine months of the year end?

Answer 12

If earnings are not paid within nine months of the year end, they are then deductible in the period in which they are paid

Question 13

Are employers’ contributions to pension schemes allowed?

Answer 13

Employers’ contributions to pension schemes are allowed when paid, rather than on the normal accruals basis

Question 14

Is training expenditure allowed?

Answer 14

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

Question 15

What is an appropriation?

Answer 15

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

Question 16

Are movements in specific provisions allowable?

Answer 16

Movements in specific provisions are allowable but movements in general provisions are disallowable

Question 17

Are the write-off of trade bad debts allowable?

Answer 17

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

Question 18

What are some common examples of capital expenditure which is disallowable when calculating taxable trading profit?

Answer 18

• 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

Question 19

What are the exceptions to disallowable capital expenditure?

Answer 19

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

Question 20

How do you treat a donation?

Answer 20

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

Question 21

What about entertaining?

Answer 21

Expenditure relating to client entertaining is disallowable but expenditure relating to staff entertaining is allowable

Question 22

What about gifting to customers?

Answer 22

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

Question 23

What about gifting to employees?

Answer 23

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

Question 24

How do you treat legal and professional charges?

Answer 24

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

Question 25

Which aspects of legal and professional charges are allowable?

Answer 25

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

Question 26

When does the flat rate disallowance of 15% apply to car lease payments?

Answer 26

• 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

Question 27

What’s the best way to deal with a leased car with private use?

Answer 27

Work out the allowable expense first, being 85% of the business proportion of the leasing cost, and then the disallowance is the remainder

Question 28

Are fines allowable?

Answer 28

Fines are generally disallowable but parking fines incurred by an employee (but not the business owner) whilst on work business are allowable

Question 29

What about interest?

Answer 29

• Interest on borrowings for the purpose of the trade (e.g. business account overdraft) is allowable
• Interest on late paid tax is disallowable

Question 30

What about irrecoverable VAT?

Answer 30

Irrecoverable VAT is allowable if it relates to allowable expenditure

Question 31

What trading allowance applies to sole traders?

Answer 31

A trading allowance of £1,000 applies to sole traders (not partnerships)

Question 32

When do a sole trader’s trading receipts need to be declared for tax purposes?

Answer 32

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

Question 33

How should you treat trading receipts in the exam?

Answer 33

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

Question 34

How do you calculate trading profits under the cash basis?

Answer 34

Total cash receipts - total allowable business expenses paid

Question 35

How do you calculate the tax adjusted trading profits under the cash basis?

Answer 35

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

Question 36

What do taxable receipts include under the cash basis?

Answer 36

• 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)

Question 37

What do taxable receipts NOT include under the cash basis?

Answer 37

• 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)

Question 38

What are the exceptional allowable payments under the cash basis?

Answer 38

• 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

Question 39

What do allowable payments not include under the cash basis?

Answer 39

• 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)

Question 40

When can an unincorporated business join the scheme under the cash accounting basis?

Answer 40

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

Question 41

What happens once a trader has made the election for the cash basis?

Answer 41

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

Question 42

What ‘badges of trade’ would HMRC consider to determine whether someone is trading?

Answer 42

• 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