Trading profits and the tax-year basis

1 Cash and accruals bases

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In this TX lecture: The badges of trade (SoFIRM tests) are not examined in FTX; the opening trading-versus-capital discussion is retained as context.

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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 (fixed-rate method below) can be claimed on cars.

For an eligible car, the fixed-rate method uses 45p per business mile for the first 10,000 miles in the tax year and 25p thereafter, instead of actual running costs and capital allowances.

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.

Land/building acquisition costs are not cash-basis trading deductions. Cars use capital allowances or the permitted mileage method. Other excluded capital categories are not examined in FTX.

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. 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 3.

• gifts to customers are only allowable if;

  • they cost no more 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 50 g/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:

The annual trading deduction for a short-lease premium is the landlord’s taxable premium divided by the lease term. Landlord’s taxable premium = premium × (51 − complete lease years) / 50.

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 3).

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.

Otherwise allowable revenue expenditure incurred within seven years before trading starts is treated as incurred on the first day of trading. Capital expenditure follows its own cash-basis or capital-allowance rules.

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Under accruals, irrecoverable trade debts written off and changes in specific allowances for doubtful trade debts can be deductible. A general allowance and non-trade debts are not deductible trading expenses. Under the cash basis an unpaid sale has not been taxed as a receipt, so do not claim a second deduction for the unpaid amount.

4 From a Profit and Loss account to an Income Tax computation

(a) A period of account is the period covered by the profit and loss account but Income Tax computations are prepared for tax years, so a period of account must be matched to a tax year.

(b) A trader may have a year end of 5 April, in which case matching a period of account to a tax year is straightforward, but a trader can choose whatever year end they like.

(c) If the year end is 31 March, then the first few days in April are ignored; i.e. the trading profits of the year ended 31 March 2026 will be taxed in 2025/26.

(d) Special rules are applied when the year end is not 5 April (or 31 March) and also when a trader starts or ceases to trade.

2. Starting To Trade

(a) In the tax year that a trader starts to trade, the assessable trading profits are those that arose from the date trade started until the end of the tax year (5 April), although you should work to the nearest month in the exam; i.e. to 31 March rather than 5 April.

(b) Profits and losses are deemed to arise evenly, and therefore may need to be time apportioned.

3. Continuing Trades

For continuing trades, the trading profit from 6 April to the following 5 April are assessed (but working to the nearest month, that effectively means the trading profit from 1 April to the following 31 March).

4. Cessation of trade

For trades that are ceasing, the trading profits from 6 April to the date of cessation are assessed in the final tax year of trade.

Capital allowances are computed for each accounting period, then deducted before tax-year apportionment. On commencement add eligible asset expenditure; on cessation compute balancing adjustments rather than normal AIA/FYA/WDA. The detailed allowance rules and examples are in chapter 6.

5 Given transition profits

For FTX use the examining team’s simplified computation: given transition profits are spread over 2023/24–2027/28, one fifth each year. Include the stated annual amount separately in income; it may affect the personal allowance and Class 4 NIC. Do not calculate the original transition amount or accelerated spreading.

If a question gives the total remaining from the original five-year spread, identify the annual amount carefully; do not divide an already annual amount again.