Trading Profits of Business

Question 1

the nature of trading profits

Answer 1

1. income profits—include trading profits
2. capital profits
   To calculate trading profits for the purposes of income tax, reference should be made to the
   Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005). The ITTOIA 2005 contains
   provisions on ‘Trading Income’ in Part 2; this covers various items but the key one is ‘profits
   of a trade’. The corporation tax code is contained in the Corporation Tax Act 2009 (CTA 2009)
   where Part 3 also contains rules for ‘Trading Income’, and in the Corporation Tax Act 2010

Question 2

The way in which trading and other income profits are taxed depends on the format of the business being carried on.

Answer 2

(1)Sole trade
A sole trader’s income profits form part of their ‘total income’ for the purposes of income tax.

(2)Company
A company’s income profits (along with its capital profits) are charged to corporation tax.

(3)Partnership
The income profits made by a partnership are divided amongst the partners and charged
either to income tax (in the case of individual partners) or to corporation tax (in the case of
corporate partners).

Question 3

Formula of calculation of trading income

Answer 3

chargeable receipts LESS
any deductible expenditure LESS
any capital allowances EQUALS
trading profit (or trading loss).

Question 4

Chargeable Receipts

Answer 4

To be chargeable, receipts of the business must
1. derive from its trade and
2. be income rather than capital in nature (ITTOIA 2005, Part 2; CTA 2009, Part 3, Ch 6).

Question 5

Definition of Trade

Answer 5

No statutory definition.
Lord Reid’s
comments in the case of Ransom (Inspector of Taxes) v Higgs [1974] 1 WLR 1594 may be helpful:
As an ordinary word in the English language ‘trade’ has or has had a variety of meanings or shades of
meaning. Leaving aside obsolete or rare usage it is sometimes used to denote any mercantile operation
but it is commonly used to denote operations of a commercial character by which the trader provides
to customers for reward some kind of goods or services.

Receipts of the trade are those which derive from the trading activity rather than from
circumstances not directly connected with the trade

Question 6

Income

Answer 6

1. There are no clear-cut rules to determine when a receipt is income in nature rather than
   capital (despite the large amount of case law on the subject).
2. As a general rule, however, if something is purchased for the purpose of resale at a profit (such as stock), the money
   received from the resale will be of an income nature.

In contrast, receipts of a capital nature will generally derive from the sale of an asset which was purchased for the benefit or use of the business on a more or less permanent basis rather than for resale. For example, a trader who
purchases some trading premises and who eventually (perhaps many years later) sells them
receives a sum of a capital nature.

3. Some receipts will arise from types of transactions which are different from the sale of goods
   or services, so that the above principles have to be applied by analogy. For example, a sum
   received as compensation for cancellation of a contract for the sale of goods is of an income
   nature because it represents what would have been an income profit if the goods had been
   sold.

Question 7

Deductible Expenditure

Answer 7

1.expenditure which is of an income nature,
2.which has been incurred ‘wholly and exclusively’ for the trade and
3. deduction of which is not prohibited by statute (ITTOIA 2005,
s 34; CTA 2009, Part 3, Ch 4

Question 8

Expenditure of an income nature

Answer 8

(1)If expenditure on an item is incurred for the purpose of enabling the trader to sell that item at a profit, it is of an income nature.

(2)A further relevant (and sometimes more appropriate) test is whether the expenditure
has the quality of recurrence, rather than being once and for all expenditure.

Question 9

‘Wholly and exclusively for the purposes of the trade’

Answer 9

Expenditure which has a dual purpose cannot be wholly and exclusively for one purpose.

Question 10

Common examples of deductible expenditure

Answer 10

(a) salaries;
(b) rent on premises;
(c) utility charges (eg gas, electricity, and telephone bills);
(d) stock;
(e) business rates;
(f ) stationery/postage.

Question 11

Capital Allowance

Answer 11

As described above, expenditure on capital items cannot, in principle, be deducted from chargeable receipts.

Under the Capital Allowances Act 2001 (CAA 2001), where expenditure is incurred on certain assets or activities, a percentage of the capital expenditure will be allowed as a deduction in calculating trading profits in a given accounting period. These deductions are known as capital
allowances.

Question 12

1. Definition of Plant and machinery–for capital allowance

Answer 12

Definition : In Yarmouth v France (1887) 19 QBD 647,
it was said that plant includes whatever apparatus is used by the businessperson for carrying
on their business;

Question 13

Allowance (written down value) for Capital Allwance

Answer 13

At present, for most qualifying assets, the taxpayer is allowed, in each 12-month accounting
period of ownership of the asset, to deduct a ‘writing down allowance’ of up to 18% of the
reducing balance of the cost of the asset in calculating their trading profits.
The reduced balance of the cost at the end of each accounting period is also known as the ‘written-down value’ of the asset.

EXAMPLE
A printer, who owns no other machinery or plant, purchases a new printing press for E500,000. Starting in the accounting period of purchase, and assuming no further purchases , the capital allowances are as follows:
Year 1-18% of E500,000=E90,000 writing down allowance,leaving f410,000 as the written-down value of the asset

Year 2-18% of E410,000=E73,800 writing down allowance,leaving f336,200 as the written-down value of the asset

Year 3-18% of E336,200=E60,516writing down allowance,leaving E275,684 as the written-down value of the asset
etc.
Suppose that the chargeable receipts of the trade less other deductible expenses amount to f1 million each year. This means (following deduction of the writing down allowance)that his trading profit from this source is as follows:
Year 1: E910,000(E1 million less E90,000 writing down allowance)
Year 2: E926,200(E1 million less E73,800 writing down allowance)
Year 3: E939,484(f1 million less f60,516 writing down allowance).

Question 14

sale of assets-for Capital Allowance

Answer 14

1. If, in due course, the item of plant and machinery is sold, it will be necessary to compare the written-down value of the asset at the time of sale with the actual sale price in order to assess whether the sale produces a ‘profit’ or a ‘loss’ when comparing these figures.
2. If a ‘profit’ results, this may (subject to pooling – see 21.4.1.4) be the subject of a ‘balancing charge’ and form a chargeable receipt in the accounting period in which the sale takes place;
3. if a ‘loss’ results, there may be a ‘balancing allowance’ (ie a deduction from chargeable receipts in that period).

Suppose that the printer in the Example, at the beginning of Year 4, sells the printing press for
£300,000. If so, they have made a ‘profit’ of £24,316 compared with its written-down value
(£275,684) and the £24,316 will form part of their chargeable receipts in Year 4.

Question 15

pooling for capital allowance

Answer 15

1. In practice, traders will often own more than one item of plant and machinery. To avoid a
   calculation being required every time an item is sold, all expenditure on plant and machinery
   is, in general, ‘pooled’ together and the writing down allowance is given each year on the
   balance of expenditure within the whole pool.
2. If an asset is sold, the sale proceeds are deducted from the value of the pool;

Question 16

Annual investment allowance (CAA 2001, ss 51A–51N) –for capital allowance

Answer 16

1. additional capital allowances have been given in the first year of ownership of an asset
2. every ongoing business now receives an annual investment allowance (‘AIA’) of a maximum of £1,000,000 so that the first £1,000,000 of ‘fresh’ qualifying expenditure on
   plant and machinery incurred in an accounting period will be wholly deductible (in effect a
   100% allowance).

Question 17

Special rules for particular types of assets for capital allowance

Answer 17

(a) Structures and buildings
the Capital Allowances (Structures and Buildings Allowances) Regulations 2019 (SI 2019/1087)
The allowance operates as an annual flat rate of 3% (from April 2020) of qualifying
expenditure. The allowance is confined to expenditure attributable to the physical
construction of the structure or building, not the cost of acquiring the land. The allowance
cannot be claimed on expenditure which qualifies for the plant and machinery allowance.

(b) Short-life assets (CAA 2001, ss 83–89)
If a business thinks an asset will have a useful working life of less than eight years, an election
can be made (within two years after the end of the accounting period in which the expenditure
was incurred) to treat the asset as a short-life asset.

(c) Long-life assets and integral features (CAA 2001, s 33A and ss 90–104E)
Long-life assets are defined as those with an expected working life, when new, of at least 25
years. Again, these rules are complex, but their general effect is to give a less generous writing
down allowance (of 6%) for long-life assets.

‘Integral features’ covers plant and machinery that is integral to a building (such as escalators,
electrical and lighting equipment, and air conditioning systems). Like long-life assets, such
integral features only qualify for a 6% writing down allowance (and are also pooled with them
in a separate ‘special rate pool’).
Both long-life assets and integral features are eligible for the AIA.

Question 18

Relief for Trading Loss

Answer 18

1. start-up loss relief
2. Carry-across/one year back relief for trading losses generally (ITA 2007, ss 64–71
3. Carry-forward relief (ITA 2007, ss 83–85)
   4.Carry-back of terminal trading loss (ITA 2007, ss 89–94)
   5.Carry-forward relief on incorporation of business (ITA 2007, s 86)

Question 19

start-up loss relief

Answer 19

1. Start-up loss relief (also known by HMRC as ‘Early Trade Losses Relief ’) applies if the taxpayer
   suffers a loss which is assessed in any of the first four tax years of a new business.
2. In that case, the loss can be carried back and set against the taxpayer’s ‘total income’ in the three tax years
   prior to the tax year of the loss.
3. This provision might be particularly useful to a person who
   starts a new business having previously had a steady income from a former business or
   employment. While the new business becomes established, it may make losses but the trader
   may be cushioned by claiming back from HMRC some income tax which they have paid in
   their previous business or employment in the earlier years.
   If the taxpayer elects to use this provision, the loss in question must be set against earlier years
   before later years – the taxpayer cannot pick and choose which year’s income is reduced first.
4. the relief if given against the total income before deduction of personal allowances.

Question 20

Carry-across/one year back relief for trading losses generally (ITA 2007, ss 64–71)

Answer 20

(1)Set off against total income (ITA 2007, s 64)
A trading loss which arises in an accounting period is treated as a loss of the tax year in which
the accounting period ends. The loss can be set against:
(a) the taxpayer’s ‘total income’ in the tax year of the loss (defined as ‘the loss-making
year’); or
(b) the taxpayer’s total income in the preceding tax year.
If the loss is big enough to reduce total income to nil using method (a) or (b), the taxpayer has
the option to set the loss against:
(c) the taxpayer’s total income in the loss-making year with the balance of any unused loss
set against total income in the preceding tax year; or
(d) the taxpayer’s total income in the preceding tax year, with the balance of any unused
loss set against total income in the loss-making year