Income Tax 2: Trading Income, Profit Adjustments, and Capital Allowances

Introduction to Trading Income and Profit Adjustments

• Trading Income Overview:

  • The first step in taxation of business activities is to ascertain whether the activity constitutes a trade, profession, or vocation.

  • Distinctions must be made between trade income and capital gains, as well as trade income versus employment income.

  • Determining trade status often involves the application of legal principles from tort and employment law.

  • Once a trade is established, the objective is to calculate the taxable business profits for the period.

• Recap of Income Tax Fundamentals:

  • Income tax categories include income from employment, savings, and dividends.

  • Statutory Income: The total income before any allowances.

  • Allowable Expenses: Costs that can be deducted from income before tax is calculated.

  • Personal Allowance: A set amount of income any individual can earn before they start paying tax.

  • Dividend Allowance: A specific tax-free allowance for income from dividends.

  • Tax Bands and Rates: The progressive structure determining the percentage of tax owed based on income levels.

The Badges of Trade

• Definition and Purpose:

  • The "Badges of Trade" are a set of principles derived from case law used to identify if profits arise from trade (subject to income tax) or from capital gains (subject to capital gains tax).

  • These badges act as guiding judgements for courts and help in small-scale scenarios, such as property development.

  • Reference: HMRC Business Income Manual $20200$.

• The Eight Badges of Trade:

  • 1. Profit Motive: Did the individual go out of their way to make a profit?

    • Case: Californian Copper Syndicate Limited v Harris ($1904$).

  • 2. Reason for Original Acquisition: Was the intention to dispose of the asset at a profit at the time it was acquired?

    • Case: Hudson Bay Co. Ltd. v Stevens ($1909$).

  • 3. Nature of the Item Sold: Is the asset something that is commonly bought and sold as part of a trade?

    • Case: IRC v Fraser ($1942$).

  • 4. Supplementary Work: Was work performed on the asset to make it more saleable?

    • Case: IRC v Livingston ($1926$).

  • 5. Length of Ownership: Was the asset sold shortly after it was acquired?

    • Case: Rutledge v IRC ($1929$).

  • 6. Method of Securing Sale: Were active steps taken to attract potential purchasers?

    • Case: Martin v Lowry ($1926$).

  • 7. Number of Transactions: Is there a regular pattern of buying and selling the asset type?

    • Case: Pickford v Quirke ($1927$).

  • 8. Related Interests: Does the taxpayer have other interests or professional expertise in dealing with that specific asset?

    • Case: Gloucester Railway Carriage and Wagon Co. Ltd. v IRC ($1925$).

• Practical Example:

  • Cowap regularly buys, renovates, and re-sells run-down houses for a profit. This regular activity and the supplementary work involved strongly suggest a trade rather than an investment.

Calculating and Adjusting Business Profits

• Reporting Basis:

  • Business profits are initially reported in the annual Profit & Loss (P&L) Account or Income Statement using the formula: $\text{Income} - \text{Expenses} = \text{Profit}$.

  • Most businesses utilize the accruals basis of accounting to reflect timing differences.

  • Adjustments are made for creditors (suppliers not yet paid), debtors (clients who have not yet paid), and opening/closing stock valuations.

• The Adjustment Process:

  • Taxable profits often differ from accounting profits. To avoid reproducing entire sets of accounts, the accounting Net Profit is "adjusted" for tax purposes.

  • Expenses included in the P&L must be reviewed to ensure they are allowable for tax. Disallowable expenses are "added back" to the net profit.

• Standard P&L Structure:

  • Sales: $X$

  • Cost of Sales: $\text{Opening stock} + \text{Purchases} - \text{Closing stock} = (X)$

  • Gross Profit: $X$

  • Expenses: $\text{Depreciation} + \text{Other expenses} = (X)$

  • Net Profit: $X$

Allowable and Disallowable Expenses

• The "Wholly and Exclusively" Rule:

  • To be allowable, an expense must be incurred wholly and exclusively for the purpose of trade.

  • Mixed Expenses: If an expense serves both trade and private purposes, only the business portion is deductible.

  • Calculation Example: A trader drives $20,000$ miles a year ($11,000$ business, $5,000$ private, $3,000$ home-to-office, $1,000$ mixture). Total running costs = $\pounds 4,000$.

  • Allowable portion: $(\frac{11,000}{20,000}) \times \pounds 4,000 = \pounds 2,200$.

  • Disallowable portion to be added back: $\pounds 4,000 - \pounds 2,200 = \pounds 1,800$.

• Revenue vs. Capital Expenditure:

  • Revenue Expenses: Deductible (e.g., repairs).

  • Capital Expenses: Not deductible directly; subject to capital allowances (e.g., improvements, high-value assets with a useful life).

  • Definition of Capital: Expenditure committed once and for all with a view to bringing into existence an asset for the enduring benefit of the trade (British Insulated and Helsby Cables v Atherton [$1926$]).

• Goods for Own Use:

  • If a trader takes goods from the business (e.g., a dairy farmer using produced milk), the value added back to profit must be the retail/wholesale price that would have been achieved if sold, not just the cost of production.

• Specific Examples:

  • Allowable: Wages, premises rent/rates, advertising, business travel, bad debts.

  • Disallowable (Add Back): Legal penalties and related fees, business entertaining, gifts (exception: gifts under $\pounds 10$ per item with an explicit advert/logo), political donations, and Depreciation.

Depreciation and Capital Allowances

• Depreciation Treatment:

  • Depreciation is an accounting estimate to reflect the "useful life" of a non-current asset (e.g., vehicles, machinery).

  • Methods include "Straight Line" (same amount annually) or "Reducing Balance" (fixed percentage of the written down value).

  • For Tax Purposes: Depreciation is always disallowable and must be added back to net profit. It is replaced by statutory Capital Allowances.

• The Capital Allowances Act 2001:

  • Provides tax relief for assets like plant, machinery, and commercial buildings.

  • Allowances are claimed by the trader and deducted from trading profits. Rates are usually maximums; less may be claimed if profit is low (except for Buildings & Structures).

Annual Investment Allowance (AIA) and Pools

• Annual Investment Allowance (AIA):

  • Enables $100\%$ of the cost of qualifying plant and machinery to be charged against profits in the year of purchase.

  • The AIA limit is currently $\pounds 1,000,000$ for the tax year $23/24$, confirmed as permanent for $24/25$ and beyond.

  • If an accounting period is shorter/longer than $12$ months, the AIA is prorated (e.g., a $6$-month period has an AIA of $\pounds 500,000$).

• General Pool and Writing Down Allowance (WDA):

  • Expenditure exceeding the AIA limit joins the "Main Pool."

  • The Main Pool WDA is currently $18\%$ per annum on a reducing balance basis.

  • Future Change: The Main Pool WDA will reduce from $18\%$ to $14\%$ effective from $6$ April $2026$ for Income Tax.

• Special Rate Pool:

  • Includes integral features of buildings (lifts, heating), solar panels, and long-life assets (life expectancy of $25+$ years).

  • The WDA rate for the Special Rate Pool is $6\%$ per annum.

• Plant and Machinery Definitions:

  • Lifts, central heating, and fire safety systems are considered "plant."

  • Slurry management systems have been classed as plant since the $2009$ Budget.

  • Suspended ceilings are generally NOT considered plant.

Capital Allowances for Cars

• Classification based on CO2 Emissions (Post-April 2021 Rules):

  • $0\,\text{g/km}$ (Electric) or Purely New Electric: $100\%$ First-Year Allowance (FYA).

  • Up to $50\,\text{g/km}$ (and > 0\,\text{g/km}): Main Rate Pool ($18\%$ WDA).

  • Over $50\,\text{g/km}$: Special Rate Pool ($6\%$ WDA).

  • Note: Second-hand electric cars qualify for $18\%$ WDA rather than the $100\%$ FYA.

• Previous Rules (Bought between April 2018 and April 2021):

  • < 50\,\text{g/km} or Electric: $100\%$ FYA.

  • Up to $110\,\text{g/km}$: Main Rate Pool ($18\%$ WDA).

  • > 110\,\text{g/km}: Special Rate Pool ($6\%$ WDA).

• Apportionment for Private Use:

  • Only the business use portion is eligible for capital allowances.

  • Example: A car costing $\pounds 35,000$ with emissions of > 50\,\text{g/km} ($6\%$ WDA) and $75\%$ business use:

    • Total WDA: $\pounds 35,000 \times 6\% = \pounds 2,100$.

    • Claimable Capital Allowance: $\pounds 2,100 \times 75\% = \pounds 1,575$.

    • Balance carried forward in the pool: $\pounds 35,000 - \pounds 2,100 = \pounds 32,900$.

Structures and Buildings Allowance (SBA)

• Eligibility: Applies to expenditure on commercial structures and buildings incurred on or after $29$ October $2018$.

• Rate: Currently $3\%$ per annum on the allowable cost using the straight-line method (recovering the cost over approximately $33.3$ years).

• Exclusions: Land purchase costs and planning permission costs are not eligible for SBA.

• Features:

  • The claim is transferable to new owners.

  • Major renovations initiate a new, separate claim segment.

  • Traders should aim to separate fixtures and fittings to claim under Plant and Machinery (higher rates) where possible.

Special Circumstances and Disposal

• First-Year Allowance (FYA):

  • Allows businesses to claim the entire cost in the year of purchase to incentivize specific investments.

  • A new permanent $40\%$ FYA will be introduced for certain qualifying assets starting January $2026$.

• Short Life Assets:

  • Assets intended to be held for fewer than $8$ years.

  • Can be tracked separately; they attract an $18\%$ WDA.

  • Upon sale, the difference between the selling price and the written-down value is claimed as a final allowance or taxed as a Balancing Charge.

• Balancing Charges:

  • Occur if an asset is sold for more than its remaining written-down value in the tax pool.

  • The excess is added to the business profit and taxed accordingly.