Taxation( Finance Act 2015)

Brunel Business School

MG 3027

Majid Aminzare
( MSc , BSc , MICB, ACCA(P.Q ))
Surgery Hours:
Friday 16:00 – 18:00

Week 10
Income from Self-employment-
Computation of Income
1
 Income from self-employment
Computation of income

Purpose:
•Describe and apply the badges of trade

•Prepare the tax adjusted trading profit/loss

•To show how the profits of a self-employed

person are charged to income tax.

2
 Income from self-employment
Computation of income
Introduction :
 The profits of a self-employed person are charged
to income tax by the Income Tax (Trading and
Other Income) Act 2005.
 A self-employed person may be conducting a trade
or may be exercising a profession or vocation .
 The profits of trades , professions and vocations
are all taxed in accordance with the same set of
rules .
 The terms “trader” and “sole-trader” will be used
to refer to any self-employed person , regardless of
whether that person is actually conducting a trade
or is in fact exercising a profession of vocation .
3
 BADGES OF
TRADE

IS THE
INDIVIDUAL
TRADING?

YE NO
S SURPLUSES MAY BE
THE PROFITS ARE SUBJECT TO CAPITAL
TREATED AS GAINS TAX OR
TRADING INCOME COMPLETELY
EXEMPT FROM TAX

4
 Income from self-employment
Computation of income
Nature of trade :
‘Trade includes every trade , manufacture ,
adventure or concern in the nature of trade .’
Although the above is the statutory definition of
a trade ,in practice it is not a very helpful
one. What constitute a trade has been
reviewed numerous times by the courts and
criteria have been developed and are set out
by a Royal commission. These criteria which
should be considered are known as the
‘badges of trade’.
5
 Income from self-employment
Computation of income
Badges of trade :
The badges of trade which are used to determine if an
activity is in the nature of a trade are as follows:
The subject matter of the transaction
-are the goods of a type normally used for
trading?
If a taxpayer sells assets of a type which might
normally be acquired for personal enjoyment or held
as a source of income ,this may suggest that any
profit arising on their sale should be treated as a
capital gain rather than a trading profit .But if the
assets concerned do not provide personal enjoyment
and do not yield income, it would seem that the only
way in which they could be turned to advantage is
by selling them. 6
 Income from self-employment
Computation of income
Badges of trade :
The length of the period of ownership
-short period of ownership is more likely to
indicate trading.

Trading stocks are normally retained for only a

short period before being sold ,whereas assets
acquired for personal use or as a source of
income are generally retained for longer
.Therefore ,if assets are bought and sold
within a short space of time it is more likely
that any profit made will be treated as a
trading profit. 7
 Income from self-employment
Computation of income
Badges of trade :

The frequency of similar transactions by the

same person
-frequent transactions indicate trading.

The more often that a taxpayer repeats a

certain type of transaction, the more likely it
is that the activity will be construed as
trading .

8
 Income from self-employment
Computation of income
Badges of trade :

Supplementary work, improvements and

marketing
-work performed on goods to make them
more marketable indicate trading.

A taxpayer who buys an asset ,performs work on

the asset so as to make it more saleable and
then sells the asset is more likely to be
regarded as trading than someone who simply
buys and sells an asset without performing any
supplementary work . 9
 Income from self-employment
Computation of income
Badges of trade :

The Motive
-intention to profit may indicate trading.

The presence of a profit motive in the mind of

the taxpayer when acquiring an asset
provides strong evidence of trading.

10
 Income from self-employment
Computation of income

The Calculation of trading profits :

It is usually necessary to make a number of
adjustments to the net profit shown by the
accounts in order to arrive at the trading
profit for tax purposes.

11
 Income from self-employment
Computation of income
Adjustments can be summarised as follows :
£ £
Net profit shown by the accounts xxx
Add:
I. Expenditure shown in the accounts xxx
But not deductible for tax purposes
II Trading income not shown in the accounts xxx
xxx
xxx
Less:
I. Expenditure deductible for tax purposes xxx
But not shown in the accounts
II Non-trading income shown in the accounts xxx
xxx
Trading profit adjusted for tax purposes
xxx

12
 Income from self-employment
Computation
Disallowed expenditure:
Certain classes of expenditure are disallowed when
computing trading profits . If any of these types of
expenditures have been deducted in the accounts
of a self-employed person , then the amount of
expenditure must be “added back” to the profit
shown by the accounts. The main classes of
disallowed expenditure are identified below :
(a)Capital Expenditure

I. Any improvements to the fixed assets

II. Legal or professional fees incurred in relation to

an item of capital expenditure .
III.Depreciation and amortisation charges

IV.Losses on the disposal of non-current assets.

13
 Income from self-employment
Disallowed expenditure-continue....
(b) Appropriations of profit
I. The owner drawings and salary are disallowed

II. The owner’s personal income tax payments and

personal national insurance contributions are also
disallowed .
III.Excessive salary paid to a sole trader’s family member

(c) Provisions
I. A provision will be disallowed if it cannot be
estimated with sufficient accuracy.
II. Transfers to a general provision for doubtful debts are
usually disallowed , since the amount involved is
insufficiently accurate.
III.Transfer to a general stock provision would usually be
disallowed .
14
 Income from self-employment
Computation
Disallowed expenditure-continue....
(d) Entertainment and gifts
I. The cost of entertaining customers is disallowed .

II. Staff entertaining cost are allowable but the

employees concerned may incur an income tax
liability if the amount involved is excessive.
The cost of gifts is also disallowed , other than:
I. Gifts to employees , if made wholly and
exclusively for trade purposes.
II. Gifts to customers costing no more than £50 per
customer per year , displaying a conspicuous
advertisement for the business and not consisting
of food , drink or tobacco. 15
 Income from self-employment
Computation
Disallowed expenditure-continue....

The cost of gifts is also disallowed , other than:

I. Gifts of trading stock (or inventory) or used plant
and machinery to designated UK educational
establishments, charities or community amateur
sports clubs.
II. Reasonably small gifts to local charities ,if made
wholly and exclusively for trade purposes (e.g. a
charitable gift which attracts favourable publicity
and enhances the firm’s public image)
III.Contributions made to local enterprise agencies
,training and enterprise councils and urban
regeneration companies. 16
 Income from self-employment
Computation
Disallowed expenditure-continue....
(e) Political donations
I. Political donations and subscriptions are usually not
allowed . But political donations which result in a
definite benefit to the trade may be allowed.
(f) Non-trade bad debts
Bad debts incurred in the course of trade are allowable
.But loans written off are generally not allowable unless:
I. The taxpayer is in the business of lending money and the loan
concerned was made in the course of trade or
II. The loan was to an employee and was made by reason of the
employment and for trade purposes ; in this case , the written-off
loan will usually be taxable on the employee as income from
employment.
III. Transfer to a specific bad-debts provision are allowable but transfer
to a general provision are usually disallowed .
17
 Income from self-employment
Computation
Disallowed expenditure-continue....
(g) Fines and penalties
I. Fines or penalties incurred because of infringements of
the law are not regarded as trading expenses and are
disallowed . An exception occurs if an employer pays
parking fines incurred by employees whilst on their
employer’s business. Such payments are usually allowed
when computing trading profits but may then be
assessed on the employees as income from employment.
(h)Criminal payments

I. A payment is disallowed if the making of the payment in

itself constitutes a criminal offence (e.g. A
bribe).payments to blackmailers or extortionists are also
disallowed.

18
 Income from self-employment
Computation
Allowable expenditure
(a) Interest . Interest ,including credit card and
overdraft interest , is allowable if it is incurred for
trade purposes . But interest paid on overdue tax is
disallowed .
(b) Legal and professional fee. Fees are allowed if
incurred in connection with the collection of trade
debts, the raising of loan finance , the renewal of short
lease( a lease of up to 50 years), a legal action for
breach of contract ,audit and accountancy fees. . Legal
and professional fees relating to capital expenditure
are specifically disallowed.
(c) Staff defalcations . Losses caused by the dishonesty
of an employee are normally allowable. But
defalcations of a person having control over the
business (e.g. Business partner) are not allowed . 19
 Income from self-employment
Computation

Allowable expenditure continue ….

(d) Pre-trading expenditure . Expenditure incurred
during the seven years before starting to trade is
treated as if incurred on the first day of trading
and is allowable so long as the expenditure is of a
type which would normally be allowable.

(e) Short lease premiums. A premium paid for the

grant of a short lease of business premises( 50
years or less) is discounted according to the
length of the lease and is then allowed in equal
annual instalments over the period of the lease. 20
 Income from self-employment
Computation
Allowable expenditure continue ….
(f) Damages. Damages and compensation
payments are allowed if incurred for the
purposes of the trade.

(g) Value added tax. If a trader pays VAT in

relation to an item of expenditure and is
unable to reclaim that VAT ,the amount of
VAT suffered will be allowable so long as the
item of expenditure is itself allowable.

21
 Income from self-employment
Computation
Allowable expenditure continue ….

(h) Travel expenses. The cost of business travel

is allowable but the cost of travelling between
home and work is generally disallowed.
Traders whose annual turnover does not
exceed the VAT registration threshold
(£82,000)may use the approved employee
mileage rates to calculate their expenses in
relation to a motor vehicle. No other motor
expenses or capital allowances may then be
claimed in relation to the vehicle concerned.
22
 Income from self-employment
Computation
Allowable expenditure continue ….
(i) Leased cars. The amount of the lease rental
payments allowed in relation to a leased motor car is
restricted if the car has an emission rating of more
than 130g/km .The restriction takes the form of a
flat-rate disallowances of 15% of the lease rental
payments. This restriction does not apply if a car is
leased for no more than 45 days .Nor does it apply to
cars acquired under hire purchase agreements.

(j) Patent royalties. Patent royalties that are paid for

trade purposes are allowable. The cost of registering
a patent ( or trademark) is also allowable.

23
 Income from self-employment
Computation

Trading income not shown in the accounts:

The most common example of trading income
being omitted from the accounts of a business
occurs when the owner of the business
appropriate trading stock for his or her
personal use .
Own consumption of trading stock is accounted
for at market value.
This means that the profit of the business for tax
purposes should be increased by the selling
price of the goods , less any contribution made
by the owner. 24
 Income from self-employment
Computation

Non Trading income shown in the accounts:

Any non-trading income which is shown in the
accounts of a business must be deducted when
computing trading profits.

I. Income which is taxed under another

heading(e.g. Interest , property income ).
II. Profits made on the disposal of non-current
assets
III.Decreases in general provisions or allowances.

25
 Income from self-employment
Computation

Expenditure not shown in the

accounts :

The most common example of allowable

expenditure not being shown in the accounts
of a business is the capital allowances .

26
 Income from self-employment
Example Computation
On 1 June 2015 William Wise ,aged 38 ,commenced in self
employment running a retail clothing shop.
William’s income statement for the year ended 31 May 2016:
£ £
Gross profit
139,880
Administration expenses:
Depreciation 4,760
Light and heat (Note1) 1,525
Motor expenses(Note2) 4,720
Repairs and renewals (Note 3) 5,660
Rent and rates (Note1) 3,900
Professional fees (Note 4) 2,300
Wages and salaries(Note 5) 83,825

(106,690) 27
 Income from self-employment
Example Computation
£ £
33,190
Other operating expenses(Note 6)
( 2,990)
Net Profit 30,200

Notes :
(1) Private accommodation

William and his wife live in a flat that is situated above the
clothing shop. Of the expenditure included in the income
statement for light, heat ,rent and rates ,40% relates to the flat.
(2) Motor Expenses

During the year ended 31 May 2016 , William drove a total of

12,000 miles, of which 9,000 were for private journeys.

28
 Income from self-employment
Example Computation

Notes :
(3) Repairs and renewals
The figure of £5,660 for repairs and renewals includes £2,200
for decorating the clothing shop during May 2016 ,and
£1,050 for decorating the private flat during June 2015 .
The building was in a useable state when it was purchased.
(4) Professional fees £
Accountancy 700
Legal fees in connection with the purchase of the shop
1,200
Debt collection 400
2,300
Include in the figure for accountancy is £250 in respect of
capital gains tax work.
29
 Income from self-employment
Example Computation

Notes :
(5) Wages and Salaries
The figure of £ 83,825 for wages and salaries includes the
annual salary of £ 15,500 paid to William’s wife .She
works in the clothing shop as a sales assistant, and
£4,500 drawing by William from the business during the
year.
(6) Other operating expenses
The figure of £ 2,990 for other operating expenses,
includes £ 640 for gifts to customers of food hampers
costing £ 40 each, £ 320 for gifts to customers of pens
carrying and advertisement for the clothing shop
costing £ 1.60 each , £ 100 for donation to a local
charity ( carried a free advertisement for the clothing
shop). 30
 Income from self-employment
Example Computation

Notes :
(7) Goods for own use
During the year ended 31 May 2016 , William took
clothes out of the shop for his personal use without
paying for them , the cost of these clothes was £460 ,
and they had a selling price of £650 .
(8) Plant and Machinery
The capital allowances available for the year ended 31
May 2016 are £13,060 .
Calculate William’s tax adjusted trading profit for
the year ended 31 May 2016.

31
 Income from self-employment
Example
Computation
£ £ £
Net Profit as per accounts
30,200
Add
Depreciation 4,760
Light and heat (40% x 1,525) 610
Motor expenses(9,000/12,000 x 4,720) 3,540
Decorating Private flat 1,050
Capital gain tax work 250
Purchase of new shop 1,200
Rent and rates (40% x 3,900) 1,560
William’s Drawing 4,500
Gift of food hampers 640
Donation to national charity 100
18,210
32
 Income from self-employment
Example Computation
£
£
Bal b/f 18,210
30,200

Add
Goods for own consumption 650

18,860

49,060
Less : Capital allowances
( 13,060 )
Tax adjusted trading profit
36,000 33
 Income from self-
employment
 Subject
Matter
 Period of Badges of CAPITA
ownership Trade L GAINS
 Frequency
 Improvement
Work Additional
 Reason for TRADING Trading
sale INCOME
Income
 Motive

ADJUSTMEN Allowable
TS TO Expenditu
PROFIT res

Non- Additional
Trading Expenditu
Income res 34