Tax Adjusted Trading Profit – Individuals

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1 Badges of Trade

The following tests are used to establish if a transaction(s) should be treated as trading and taxed as income and therefore subject to Income Tax and Class 4 NIC, or whether they should be treated as capital transactions and treated as capital gains and therefore subject to Capital Gains Tax.

You can use the mnemonic SOFIRM to help you remember the tests, which are known as 'The Badges of Trade'.

1.1 Subject matter

Whether a person is trading or not may sometimes be decided by looking at the subject matter of the transaction.

1.2 Length of ownership

Where items purchased are sold soon afterwards, the transactions are likely to be treated as a trade. If acquired unintentionally (e.g. by inheritance) and then sold, it is unlikely that trading has taken place.

1.3 Frequency of transactions

Transactions of a capital nature will be interpreted as trading transactions where their frequency indicates the carrying on of a trade.

1.4 Supplementary work and marketing: Improvement

When work is done to make an item more marketable, or attempts are made to find purchasers, the transactions are more likely to be treated as a trade.

1.5 Reason for sale

The circumstances/reason for the sale (being forced to make a sale to raise cash may indicate not trading).

1.6 Profit motive

The presence of a profit motive will be a strong indication that a person is trading.

2 Taxable trading profits for unincorporated businesses

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From 2024/25, unincorporated businesses (sole traders/partnerships) calculate their taxable trading profit under the CASH BASIS.

Under the cash basis:

1.   Include cash received and cash paid (i.e. no accruals) during the accounting period.

2.   Cash received and cash paid includes not only cash received from customers/paid to suppliers, but also cash received/paid on the sale/purchase of capital assets that would normally qualify as plant and machinery for capital allowances purposes (see later) with the exception of cars.

3.   Capital allowances and running costs, or the fixed rate mileage allowance (see later) can be claimed on cars.

Unincorporated businesses can elect to use the ACCRUALS BASIS in which case capital allowances can be claimed on all capital assets (including cars) that qualify as plant and machinery. If the question is silent, assume that the CASH BASIS is being used.

COMPANIES must use the ACCRUALS BASIS.

3 Adjusting the accounting profit

3.1 Introduction

The tax adjusted trading profit for inclusion within the income tax computation is not the same as the profit shown in the statement of profit or loss.

Accounting profits, or net profit before tax, may have to be adjusted to arrive at tax adjusted trading profit. The main adjustments are to disallow for tax certain non-allowable expenses debited in the accounts and to exclude any non-trading income credited in the accounts.

The proforma used to calculate tax adjusted trading profits is as follows:

Note:

When preparing this calculation, be careful to start with the NET profit per accounts.

READ THE QUESTION CAREFULLY!

It is important to understand that the object of the exercise is to isolate the profit that purely relates to the business's TRADING activities.

*Just because an expense is disallowed at this point does not mean that the expense is not tax deductible. For example, it may be deductible as a property expense.

3.2 Typical expenditure by a business

The general rule is that expenditure not wholly and exclusively for the purpose of the TRADE is not allowable.

READ THE QUESTION CAREFULLY!

If an expense is not allowable but has been deducted in arriving at the net profit figure, then it must be added back in the adjustment to profits calculation (to reverse what was done in the statement of profit or loss).

The treatment of some expenditure is different depending on whether the CASH BASIS or the ACCRUALS BASIS is being used.

1. Capital expenditure

• on land and buildings is not allowable.

• depreciation and losses/profits on sales are not allowable.

• a repair to an asset is revenue expenditure and is allowable.

• improvement to an asset that qualifies as plant and machinery for capital allowance purposes is allowable under the CASH BASIS but is generally not allowable under the ACCRUALS BASIS.

1. Reliefs, such as qualifying loan interest payments (see Chapter 2) are not allowable as they are dealt with as a deduction from total income.

2. Irrecoverable/Impaired Debts (Trade debt write offs & allowances)

• Trade debt write offs and movements in specific allowances are allowable under the ACCRUALS BASIS, however non-trade write offs are not allowable.

• Under the CASH BASIS, as income is only accounted for when received, then bad debts will not arise in the accounts.

1. Entertaining and gifts

• entertaining is disallowed, unless entertaining employees.

• gifts to employees are allowable but may be included as an assessable benefit within employment income for the employee - see Chapter 9.

• gifts to customers are only allowable if;

  • they cost less than £50 per person per year, and

  • the gift is not food, drink, tobacco or vouchers exchangeable for goods and services

  • the gift carries a conspicuous advertisement for the business.

1. Subscriptions and donations

• trade or professional association subscriptions are allowable,

• charitable donation (not made under Gift Aid);

  • if it is small and made wholly and exclusively for trading purposes (e.g. promoting business’ name), and it is to a local charity then it is allowable.

  • national / international charity donations are not allowable.

• charitable donations (made under Gift Aid) are not allowable.

• Political donations - these are not allowable.

1. Legal and professional charges

• disallowable if the item to which they relate is disallowable (e.g. land and buildings).

• If related to an asset that qualifies as plant and machinery for capital allowance purposes, then allow under the CASH BASIS, but disallow under the ACCRUALS BASIS.

• Allow if connected with the trade, e.g. drawing up staff contracts etc.

• specifically allowed by statute:

  • costs of obtaining loan finance for trading purposes

  • costs of renewing a short lease (50 years or less)

1. Interest payable

• interest paid on borrowings for trading purposes is allowable.

1. Lease rentals on cars with CO₂ emissions exceeding 50g/km

• Under the ACCRUALS BASIS, the disallowed amount is 15% of the leasing charges p.a.

• Under the CASH BASIS, the whole amount is allowable.

1. Premium paid for the grant of a lease

• the premium itself is disallowed as is any amortisation of the premium.

• the allowable amount for each year of the lease is:

where n is the number of years of the lease.

1. Fines and penalties - Disallowed unless a parking fine paid on behalf of an employee and incurred whilst on business.

2. The accounting profit must be adjusted for the private expenditure of the business owner. For example, if the owner uses a car in the business but 20% of his mileage is for private journeys, then only 80% of motor expenses are allowable.

However if the owner provides an employee with a car, and 20% of the mileage is for private use by the employee, then the full amount of motor expenses is allowable. (The employee is then taxed on the private use as employment income - see Chapter 9).

1. Any deduction described as the owner’s salary, or drawings or interest on capital invested in the business is disallowed.

2. Interest paid on overdue tax is not deductible and interest received on overpaid tax is not taxable.

3. Any salary paid to the family of the owner of the business must not be above the normal commercial rate for the job.

Only salary at the commercial rate for the work done is allowable, any excess is added back.

1. If an owner removes goods from the business for his own use, then under the ACCRUALS BASIS he is treated as making a sale to himself at market value.

• If the transaction has not been recorded in the accounts, then add in the selling price.

• If the transaction has been recorded in the accounts at cost price, then add in the profit.

Under the CASH BASIS, If the transaction has not been recorded in the accounts,then add in the cost price. If the transaction has been recorded in the accounts at cost price, then there is no adjustment needed.

(p)   Pre-trading expenditure – allowable if it is expenditure incurred in the seven years before the business commences to trade then it is treated as an expense incurred on the day the business starts trading and follows the above rules.

4 Fixed/flat rate expenses (cash basis and accruals basis)

In respect of cars, instead of claiming capital allowances and running costs, the trader may instead use a fixed (or flat) rate deduction for tax purposes. The actual capital cost of acquiring a car for use in the business, the running costs and the sale proceeds are excluded from the profit calculation.

The trader can instead claim as a deduction against the trading profit a mileage allowance for the business mileage. The allowance is at a rate of 45p per mile for the first 10,000 business miles and 25p thereafter. This replaces all costs of the car (with the exception of parking and toll roads).

Other flat rate expenses:

Premises used as both home and business premises such as a small hotel, guest house, bed and breakfast or public house can elect to claim a flat rate private use adjustment to apply in respect of private use of the property for such expenses as food, heat and light rather than attempting to compute a business/private split of the expenditure. Initially, all these costs are deducted and the flat rate private use adjustment is added back. Note this is an add back not a deduction.

The relevant flat rates will be provided in an examination question and are based on the number of occupants. For example if the property had one occupant the add back would be £350 per month or part thereof (£4,200 per annum) and for two occupants it would be £500 per month (£6,000 per annum).

The flat rate add back does not include other property expenses such as rent or loan interest payments.

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In exam questions, in Section C, students are required to put in a zero adjustment for any items that do not require an adjustment to ensure that students deal with all items on the profit and loss account.

The wording might be as follows:

Note: You should indicate by the use of zero (0) any items which are not taxable or deductible.

The same style of proforma is used for sole traders, partnerships and Limited Companies and is highly examinable.

Learn the proforma.

And read the question carefully.