Chapter 7 Business Law and Practice

7.2 Calculating trading profits

• Businesses can make two kinds of profit: Income and Capital

• Income: Generally profits that are recurring in nature e.g rent or trading profit

• Capital: One-off items, such as an owned office building increasing in value

• Income profits made by sole traders or general partnerships form part of their total income for the purposes of income tax

• Income profits for companies’ are charged to corporation tax - as are its capital profits

• Trading profits are calculated largely in the same way for both income tax and corporation tax - but under different statutes

  • Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005) for income tax

  • Corporation Tax Acts 2009 and 2010 for corporation tax

• From 2024/2025 onwards -

  • the default method by which most unincorporated businesses calculate their trading income for income tax purposes is the so-called ‘cash basis’.

  • This effectively taxes the difference between money received and money paid during the
    accounting period and is therefore a simpler way of calculating trading income.

  • Larger or more complex businesses are likely to opt-out because if they wanted to get finance the lender would want to see accounts done in the ‘traditional’ way

7.3 The accounting period of a business

• A business must prepare accounts for an accounting period, usually of 12 months, to show the
  profit or loss made by its trade during those 12 months.

• Trading profits or losses are calculated
  by subtracting deductible expenditure and capital allowances from chargeable receipts:
  

• Chargeable receipts LESS deductible expenditure LESS capital allowances = trading profit/loss

7.4 What are chargeable receipts?

• Chargeable receipts means money received for the sale of goods and services

• Receipts must come from a business’ trade and income profits, not capital profits

• However no single statutory definition of trade or income to rely on

7.5 What is deductible expenditure?

• Money spent ‘wholly and exclusively’ for the trade, and must be of an income nature

• Deduction of x expenses must not be prohibited by statute, such as client entertainment and leasing cars with high emissions

7.6 What is income in nature?

• If the reason for incurring the expenditure is so that the business can sell the item at a profit (eg, stock), it is income in nature.

• Alternatively, if the expenditure is likely one of recurrence (for example, utility bills), again, it will be income in nature.

• Expenditure on items to help the business to trade, e.g the office building, will be capital in nature (and so not deductible)

7.7 What does ‘wholly and exclusively for the purposes of trade’ mean?

• For something to be a deductible expenditure it must be wholly and exclusively for trade

• Case law has applied the definition ‘wholly and exclusively’ strictly

• Following items are commonly deductible and therefore considered wholly and exclusively for trade;

  • Salaries (as long as they are not excessive)

  • Rent on Commercial Properties

  • Utility Bills

  • Stock

  • Contributions to an approved pension scheme for directors/employees and

  • Interest payments on borrowings

7.8 Capital Allowances

• Capital items, such as plant and machinery, cannot in principle be deducted from chargeable receipts when calculating trading profits, because they are not income in nature

• However often essential machinery is expensive, yet businesses must invest in it, AND it devaluates over time

• = creates the issue that businesses have to spend a lot of money on items that are necessary for the business but are valueless after a few years

• To avoid this issue and allow businesses to grow by having the proper machinery - they are entitled to a capital allowance

• This allows them to deduct a proportion of the cost of most capital items from chargeable receipts.

• This will result in the business paying less tax overall.

• The main types of capital asset for which a capital allowance is permitted are plant and machinery.

7.9 What is plant and machinery?

• No statutory definition of plant and machinery

• Case law suggests that plant and machinery includes whatever apparatus business people use to carry on their business.

  • This includes all goods and chattels which they keep for permanent use in their business, but
    not stock in trade

  • eg manufacturing equipment, computers, tools, office equipment

• Value of most capital assets reduce over time

• Every financial year the business is entitled to a ‘writing down allowance’ ‘WDA’

  • WDA is 14% of the value of the business’s plant and machinery (when valued at start of financial year)

  • This 14% will be deducted from the chargeable receipts for calculating trading profits from that year

  • The reduced value of the plant and machinery is known as the ‘written-down value’ of the asset

7.10 Pooling

• Working out the capital allowance of each plant and machinery item would be onerous so all plant and machinery within a business is pooled and WDA is calculated from this

• If an asset is sold, the proceeds of the sale are deducted from the value of the whole pool

7.11 Annual Investment Allowance - AIA

• In addition to the writing down allowance, businesses are entitled to an annual investment allowance (‘AIA’)

• AIA allows businesses to deduct the whole cost of plant and machinery purchased in that particular accounting period from chargeable receipts (not just 14% of the value of those assets, as with capital allowances)

• AIA is set at £1 million -

  • So the first 1 mill spent on qualifying plant and machinery in an accounting year will be wholly deductible

  • Groups of companies will only receive one AIA

7.11 Annual Investment Allowance - Full expensing (for companies only)

• Full expensing allows companies to deduct 100% of the cost of brand new plant and machinery purchased in that particular accounting period from chargeable receipts

• The amount that can be deducted is uncapped

• To fully expense plant and machinery, they must be brand new (not second-hand)

7.11 Annual Investment Allowance - Comparison

G

7.12 Relief for a trading loss: Unincorporated Businesses

• When calculating trading income, for a sole trader or partner, this may result in a loss

• The taxpayer may be able to claim relief for trading losses by deducting the trading loss from other income (meaning they pay less tax overall)

• If a taxpayer has multiple businesses that have made a loss that is entitled to a relief - they can choose which relief to claim

  • Sometimes they may be eligible to claim the other relief under a different provision

• Partners can decide individually which relief they want to claim in relation to their share of the partnership’s losses

• Taxpayer must apply for the relief - they are not automatically applied by HMRC

7.12 Relief for a trading loss: Unincorporated Businesses - Types of Relief

Start-up loss relief (AKA early trade losses relief)

• If taxpayer suffers a loss in any of the first four tax years of the new business

• The loss can be carried back and set against the taxpayer’s total income in the three tax years immediately prior to the tax year of the loss

• This relief is helpful for people who have started a business but previously had an income from another business/employment - can claim back some previous income tax

• Claim for this must be made on or before the first anniversary of 31 January following the end of the tax
  year in which the loss is assessed

Carry- across/one-year carry-back relief for trading losses generally

• Trading losses in an accounting period are treated as losses of the tax year in which the accounting period ends.

• There are four options for this relief. The losses can be:

  • Set against total income for the same tax year, or

  • Set against total income from the tax year preceding the tax year of the loss

  • set against total income from the same tax year until that income is reduced to zero, with the balance of the loss being set against total income from the tax year preceding the tax year of the loss; or

  • set against total income from the tax year preceding the tax year of the loss until that income is reduced to zero, with the balance of the loss being set against total income from the tax year of the loss

Set-off against capital gains

• Allows loss relief against chargeable capital gains as well as against income

• This relief allows the taxpayer to set trading losses against chargeable gains in the same tax year, and applies when a taxpayer has claimed carry- across relief but not all of the loss has been absorbed

• The taxpayer must claim this relief on or before the first anniversary of 31 January following the end of the tax year in which the loss is assessed

Carry-forward relief

• A taxpayer may carry forward their trading loss for a tax year and set it against subsequent profits which the trade produces in subsequent years, taking earlier years first.

• Losses can be carried forward indefinitely until the loss is exhausted, so if several years go by before the trade makes a profit against which to set the losses, this is no bar to claiming the relief.

• Although technically can be carried forward indefinitely - the taxpayer must notify HMRC if they intend to claim this relief no more than 4 years after the end of the tax year in which the loss was incurred

A taxpayer can use all of carry-forward, carry- across and carry-back reliefs in relation to the same loss, until the loss is wiped out.

Carry-back of terminal trading loss

• Any loss incurred by a taxpayer in the final 12 months of trading can be carried across and set against trading profits from the final tax year and the three years preceding the year of the loss

• However losses should be set against other profits from the same tax year first - then the year before etc

• No cap on relief under this provision

• A claim for carry- back of terminal trading loss must be made no more than four years after
  the end of the tax year to which the claim relates

Carry-forward relied on incorporation of business

• If a taxpayer incorporates their business by transferring it to a company wholly or mainly in return for shares, any trading losses which have not been relieved can be carried forward and set against any income they receive from the company, such as their salary or dividends

• to be ‘wholly or mainly in return for shares’ - 80% or more of the consideration for the business being transferred must be shares in the company

• The taxpayer can set the losses against more than one form of income until the loss is fully absorbed

  • And in any order they choose, usually whatever will give the best tax advantage

• No cap on what can be relieved under this provision

• Whilst losses can be carried forward indefinitely, the taxpayer must notify HMRC of its intention
  to claim the relief no more than four years after the end of the tax year in which the loss was
  incurred

Cap on reliefs

• Start-up relief and carry- across/carry-back relief are all subject to a cap of the greater of
  £50,000 or 25% of the taxpayer’s income in the tax year in relation to which the relief is
  claimed

• Cap does not usually have a significant impact because the cap only applies to income from sources other than the trade which produced the loss

7.14 Value Added Tax (VAT)

• Generally, VAT is charged every time a business supplies goods or services.

• The current rate of VAT is a flat rate of 20%

• The business charges the customer VAT at 20% on the value of the goods or services (‘output tax’)

• The VAT the business itself pays is ‘input tax’

• The business deducts input tax from output tax - and pays this difference to HMRC

• VAT does not cost businesses anything because the business recovers the VAT it has paid from the VAT it charges

7.14 Value Added Tax (VAT) - Defining Terms

Value Added Tax Act 1994, VAT is ‘charged on any supply of goods or services made in the United Kingdom where it is a taxable supply made by a taxable person in the
course or furtherance of any business carried on by him’

Supply of Goods and Services

• Any transfer of the whole property in goods is a supply of goods

• This includes intangible goods such as interest in land, or electricity supplies

• Anything done for consideration but is not a supply of goods is a supply of services e.g legal advice

Exempt Supplies

• Some supplies are exempt from VAT, such as supplies of residential land, postal services, education and health services

Taxable Person

• This is a person who makes or intends to make taxable supplies and who is, or is required to be registered under the VAT Acy 1994

• A person must be registered if the value of their taxable supplies in the preceding 12 months exceeded £90,000

Course of Business

• s.94 VAT Act 1994 - business includes any trade, profession or vocation

• A supply in the course of business includes the disposal of a business or any of its assets

Value of Supply

• This is what the goods or services would cost if VAT were not charged

• A price is considered to include VAT unless stated otherwise

Tax payable to HMRC

• Anyone registered for VAT must submit a return to HMRC and pay the VAT it owes within one month from the end of each quarter in respect of taxable supplies made in that quarter

• They have to pay the VAT they have charged (output tax) minus any VAT they have paid in their course of business (input tax)

• If input tax exceeds output tax, the person will
  receive a rebate

Zero-rated and exempt supplies

• These are supplies where the customer does not pay any VAT e.g books, certain foods, water

• The person who makes zero-rates supplies can reclaim any VAT they have paid HMRC

• A person who makes only exempt supplies cannot register and will not be able to reclaim any VAT

VAT registration

• Anyone making taxable supplies of more than £90,000 in any 12-month period must register and charge VAT

• Those making less than this can choose to register but are not obliged to

• However, only those registered can reclaim input tax they have paid

  • Some choose to by balancing the advantages of being able to reclaim input tax VS being able to undercut VAT-registered rivals

Tax Invoices

• A person making a taxable supply to a taxable person must provide a tax invoice, an invoice showing information such as the VAT number, the value of supply and the rate of tax charged

• The person charging VAT must have tax invoices in respect of all of the input tax they are
  reclaiming

Penalties

• Failure to comply with VAT legislation can lead to a range of criminal and civil penalties, as
  well as being required to pay any unpaid tax with interest