What is a Trade?
The profits of an individual who undertakes a trade or business personally (as opposed to through company or some other vehicle) is subject to special income tax rules. Tax law calls business activity the carrying on of a “trade”.
Whether or not an activity is a “trade” is a question of interpretation. For example, a one-off transaction may not be a “trade”. It could involve a capital gain or it might simply be wholly exempt from taxation. There are a number of factors which will determine whether there is a “trade”. The so-called “badges of trade” are certain circumstances which may point to the existence of a trade. There is no decisive test. If goods or services are provided regularly with a commercial motive this will generally indicate that there is a trade.
The type of asset bought and sold is relevant. An asset acquired for investment for private use which is capital in nature would not generally be subject to income tax on its sale. Goods bought as stock are usually subject to income tax on the profits from their sale.
In order to be considered as an investment or capital asset and not as trade “stock”, the asset must be income producing or held for an aesthetic reason. When an individual acquired a million rolls of toilet paper and resold them it was held to be a trade rather than an investment. Length of ownership can be relevant but is not conclusive.
The frequency and number of similar transactions by the same person is relevant. However, a single transaction can be deemed to be a trading as in the toilet roll example above. Supplementary work such as making the items more marketable or improving it would be an indication of a trade. The intention of making a profit makes it more likely a transaction will be viewed as a trade.
The nature of the asset does not matter in the question as to whether or not trade is involved. The sale and purchase of land or shares can be a trading activity under certain circumstances. The position is much the same as under Irish Taxation Law
Ascertaining Trade Income for Tax
The starting point is the 12-month financial accounts for the business ending in the tax year. The taxable profits are based on the profits in this accounting period. These accounts must then be adjusted so as to add back deductions which tax law does not allow and subtract make certain deductions allowed by tax law, but not reflected in accounting practice.
There are special rules in respect of opening years. In the first year, profits are calculated from the date of commencement to the 5th April of that year. This is effectively the actual income for the period. If there is a 12 month period of account in the second year, then this period applies. Otherwise, it is based on the first 12 months of trading.
In year three, the normal period i.e. 12 months ending on the accounting date applies. There is an adjustment for any overlap. Overlap profits are those that are assessed in more than one tax year. It may be possible to relief overlap profits earlier by changing the accounting date.
There are equivalent rules in respect of the final years of a trade. They ensure that the profits not previously assessed are assessed at this point. The overlap profits from commencement are deducted.
If there is a change in accounting date may have certain tax advantages. However, it is necessary to notify HMRC on or before the 31st January of the following tax year as to the changes concerned. The new account period must not exceed 18 months. If the period between the old accounting and the new accounting date is longer than 18 months two separate accounts will have to be prepared. There must not have been a change in the accounting date in the last five years.
Adjusting the Profits for Tax
There is the certain deal of freedom within accounting rules. There may be elements of subjectivity in the way certain transactions and positions are shown in financial accounts. For policy reasons, certain types of deductions are not available or are limited or treated differently in the tax computation, in order to protect the tax base. For this reason, the financial accounts must be adjusted to ascertain the taxable profits.
Any expenditure which isn’t wholly and exclusively for the purpose of the business is not deductible. A self-employed trader isn’t able to eat lunch at home and claim the extra cost as a tax deduction. This is not wholly and exclusively for the purpose of the trade. Where expenditure has been partly incurred for a business, a proportionate amount may be allowed e.g. use of a car.
Appropriation from accounts such as business owner’s salary, interest on capital drawings is not allowed as a deduction. These in effect represent an appropriation of the income itself. Salaries in excess of certain amounts paid to family members are not fully deductible.
Income included in accounts that is not taxable trading income should be deducted e.g. capital receipts on sale of assets. Other forms of miscellaneous income such as savings and dividend income and exempt income will appear in financial accounts this will need to be deducted by way of adjustment. These categories of income and gains are taxed under different tax headings, but they are not part of the trading income calculation.
Expenditure on capital is not allowed as an expense. Capital profits and capital losses must be taken out of the financial accounts. Questions can arise as to the difference between revenue expenditure and capital expenditure in the context of repair. Repair of assets will be revenue expenditure, but an improvement will not be. The initial cost of repairs for making assets usable is usually not deductible. It is deductible if the asset could be put into use before the repairs are carried out.
Provisions for future costs are allowable provided they are calculated in accordance with U.K. GAAP (accounting practice rules) and their estimation is sufficiently accurate. A general provision is not otherwise deductible.
Capital expenditure is dealt with under a separate system. Depreciation in financial accounts is added back. So-called “Capital Allowance” rules only apply. See our separate note on capital allowances. Many types of capital expenditure do not qualify for capital allowances e.g. purchase cost of offices. Other types of allowances are allowed, at different times and differing amounts to the deductions in financial accounts.
They are certain expenditure items which are specifically allowed or not allowed by tax law. Expenditure for private purposes is not allowed. Where it is for a mixed purpose, it is apportioned.
Business entertainment expenses are disallowed.
Small Business Options
Traders and those supplying professional services whose annual income is below £150,000 may compute their profits and losses on a cash accounting basis. An election must be made.
It allows calculation on the basis of monies received from monies paid without adjustments for accruals,pre-payments and stock. There are simplified allowances for plant and machinery, Interest of up to £500 p/a is allowed on an unrestricted basis.
Moving to a standard basis is required when turnover exceeds £300,000.
There is general provision for adjustments on moving to a standard accounting basis.
There is also an option for a flat rate deduction of business expenses. Vehicle expenses are allowed for purchase and running costs at a fixed rate per mile. There are round sum allowable amounts for use of a private home based on the number of hours worked there per month.
From 6th April 2017, a tax-free allowance of £1,000 is available for individuals. It applies to small trading income. The reporting obligation does not apply where the gross income is below £1,000.
