Law guide: Business start-up

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Income Tax

Income Tax

What is Income Tax?

Sole traders are subject to Income Tax.

This is a tax on income. Not all income is taxable and you're only taxed on 'taxable income' above a certain level. Even then, there are other reliefs and allowances that can reduce your income tax bill. In some cases, this will mean you don't have to pay any tax.

Trading profit

Trading profit is the income of your business that HM Revenue and Customs (HMRC) will be taxing. It's calculated by adding all the trade receipts of a business together and deducting its expenses. Not all expenses are deductible; if in doubt, get professional advice, or contact HMRC.

Most receipts of a trade, like those from sales, can be easily identified. Others are more complicated. For example, money received as a token of personal appreciation when a trading relationship ends wouldn't be a trade receipt. However, money received as compensation when a trading contract is cancelled would be a trading receipt.

Deductible expenditure

In calculating trading profit, you can deduct expenses that are:

  • of an income nature;
  • incurred wholly and exclusively for the trade; and
  • not banned by special tax rules.

These expenses are called 'deductible expenditure'.

Expenses of an income nature

To be deductible, expenses must be income in nature. This means they're regular or recurring expenses rather than one-off expenditure. Payments for electricity, telephone charges, staff salaries and interest on loans, etc. are likely to be expenses of an income nature as they're incurred repeatedly.

One-off expenditure on assets that will be kept by the business for a longer period are capital expenses. These aren't deductible from trading profits. However, you may be able to deduct capital allowances instead. See 'Capital allowances' below for more information.

For example, if you're an antique dealer, the cost of buying stock is an expense of an income nature, as your business will sell this stock to earn income. Therefore, when calculating trading profits, you can deduct the expenses of buying stock from trade receipts. However, the cost of buying an antique desk for your office is of a capital nature. You'll keep this desk and use it in your business in the long-term, rather than sell it to generate income. It isn't a deductible expense.

Capital allowances

What is a capital allowance?

Capital allowances are a type of tax relief for businesses.

Capital allowances enable you to deduct the cost of certain capital assets (known as 'plant and machinery') from your business's taxable income. Capital allowances are available instead of depreciation, which is not allowed as a tax deduction.

The types of capital allowances are:

  • Capital allowances for specific costs and acquisitions, including for research and development
  • First year allowances
  • The Annual Investment Allowance
  • Writing-down allowances

Plant and machinery

Plant and machinery includes:

  • items that you keep to use in your business, including cars
  • parts of a building considered integral, known as 'integral features'
  • some fixtures, for example fitted kitchens or bathroom suites
  • alterations to a building to install plant and machinery - this does not include repairs
  • costs of demolishing plant and machinery

You cannot claim plant and machinery allowances on:

  • things you lease (unless you have a hire purchase contract or long funding lease) - you must own them
  • items used only for business entertainment
  • land
  • structures
  • buildings, including doors, gates, shutters, mains water and gas systems

You also can't claim a capital allowance for things that you buy or sell as your trade - these are deducted from profits as deductible expenses. If you buy on hire purchase, you can claim a capital allowance on the original cost of the item, but the interest and other charges count as deductible expenses.

Allowances for research and development

The rules are complicated. For more information, see the HMRC guidance

First year allowances

If you buy an asset that qualifies for 100% first year allowances, you can deduct the full cost from your profits before tax.

You can claim 'enhanced capital allowances' (a type of 100% first year allowance) for the following equipment, which must be new and unused:

  • electric cars and cars with zero CO2 emissions
  • plant and machinery for gas refuelling stations, for example storage tanks or pumps
  • gas, biogas and hydrogen refuelling equipment
  • zero-emission goods vehicles
  • equipment for electric vehicle charging points
  • plant and machinery for use in a freeport tax site, if you're a company

You can claim 100% first year allowances in addition to your Annual Investment Allowance, as long as you do not claim both for the same expenditure.

If you do not claim all the 100% first year allowances you're entitled to, you can claim the part of the cost you have not claimed using writing-down allowances.

Annual Investment Allowance

You can deduct the full value of an item that qualifies for Annual Investment Allowance (AIA) from your profits before tax.

If you sell the item after claiming AIA you may need to pay tax.

You can claim AIA on most plant and machinery up to the 'AIA amount' (currently £1 million).

You cannot claim AIA on:

  • Cars that you buy and use in your business. A car for this purpose means a vehicle that: is suitable for private use (this includes motorhomes); most people use for private i.e. non-business purposes; and was not built for transporting goods. Motorcycles, lorries, vans and trucks are not cars and you can claim AIA on these.
  • Items you owned for another reason before you started using them in your business.
  • Items given to you or your business.

For items you cannot claim AIA on, you can claim writing-down allowances instead.

If you spend more than the AIA amount, you can claim writing-down allowances on any amount above the AIA. If a single item takes you above the AIA amount you can split the value between the types of allowance.

If you do not want to claim the full cost, for example you have low profits, you can claim:

  • writing-down allowances instead; or
  • part of the cost as AIA and part as writing-down allowances

You can only claim AIA in the period you bought the item.

For example:

You spend over £1 million on plant and machinery in your accounting period from 1 January 2021 to 31 December 2021, you could deduct 100% of the first £1 million from your profits. You could then claim the standard writing-down allowance (see 'Writing-down allowance' below) of 18% on amounts in excess of this spent on buying new plant and machinery.

If, however, the only item of plant and machinery you bought in that period was a machine for £300,000, this expenditure would fall completely within the AIA. Therefore, you could deduct 100% of the cost (i.e. the full £300,000) from your trading profits for that year.

Writing-down allowances

Each year, instead of depreciation, you're allowed to deduct from your trading profits a 'writing-down allowance' for your capital expenditure. This allowance therefore reduces your trading profits before they're taxed.

Instead of calculating separate writing-down allowances every year for every item of plant and machinery, plant and machinery is generally put in a pool. The writing-down allowance is calculated for the pool.

In the tax year in which you buy an item of machinery, you would deduct any capital allowances available in the first year, such as the AIA:

  • from your trading profits to reduce them before they're taxed; and
  • from the cost of the machinery bought that year to get the residual value of the machinery. This residual value is added to the pool of plant and machinery.

The value of the pool of plant and machinery would be the total value of plant and machinery you've bought less all the capital allowances you've claimed for this plant and machinery.

The value of the pool is reduced by the writing-down allowance for each year, so that you start the next tax year with a lower pool. Writing-down allowances are a percentage of the balance of the pool rather than a percentage of the original cost of the plant and machinery.

The percentage you deduct depends on the item.

You must group items into pools depending on which rate they qualify for. The pools are:

Main rate pool: You can claim 18% tax relief on all plant and machinery you buy, unless the items need to go into the special rate pool

Special rate pool: You can only claim 6% tax relief on special rate pool items. These include parts of a building considered integral; items with a long life; solar panels; thermal insulation you've added to a building and cars with CO2 emissions over a certain threshold

You must work out how much you can claim separately for each pool.

If the balance of a pool of plant and machinery is less than £1,000 in a 12-month accounting period, instead of the normal writing-down allowance, you may be able to claim a 'Small Pools Allowance' of up to £1,000 to completely write it off.

Example of a main rate pool writing-down allowance calculation

(This assumes that a 100% first year allowance is not available.)

If in one tax year, a builder buys new plant and machinery worth £1.5 million (all of which qualifies for the main rate pool), he would deduct his AIA of £1 million from his trading profits in that tax year.

Assuming the builder has no other plant and machinery, the capital expenditure for which a capital allowance hasn't been claimed, £500,000 would form his main rate pool of plant and machinery for the next tax year.

Year 1: Capital allowance = AIA of 100% of £1 million, leaving £500,000 as the pool

In the following tax years, his writing-down allowance would be 18% on the balance of the pool each year.

His writing-down allowances are as follows:

Year 2: 18% of £500,000 = £90,000, leaving £410,000 as the reduced balance of the pool

Year 3: 18% of £410,000 = £73,800, leaving £336,200 as the reduced balance of the pool

Year 4: 18% of £336,200 = £60,516, leaving £275,684 as the reduced balance of the pool

Suppose that the builder's trading profits (after deducting expenses) are £1.5 million, £1.2 million, £1.8 million and £1.5 million for Years 1, 2, 3 and 4 respectively. The builder's income for tax purposes is as follows:

Year 1: £1.5 million - £1 million (AIA) = £500,000

Year 2: £1.2 million - £90,000 = £1,110,000

Year 3: £1.8 million - £73,800 = £1,726,200

Year 4: £1.5 million - £60,516 = £1,439,484

Income Tax on trading profit

Until the end of the 2022/23 tax year

Income Tax on trading profits was assessed under the following rules:

In the first tax year of a new business, Income Tax was assessed on the profits made during that tax year, i.e. from the date you started your business to the following 5 April.

In the second tax year, the Income Tax assessment period depended on the accounting date that you chose for your business, i.e. the last date in your accounting year. If, in your second year of business, there were less than 12 months between the start of trading and your accounting date, you were taxed on the income for 12 months since the start of trading. If your accounting date was 12 months or more from the start of trading, you were charged income tax on the profit in the 12 months ending with your accounting date.

In the third and subsequent years, Income Tax was generally assessed on the profits of the 12-month accounting period ending in that tax year. This was called the 'current year' basis.

The current year basis rules might have resulted in you paying tax twice on 'overlap profits' in the first 3 years of business. For example, if you started business on 1 January 2021 and drew up your accounts for the year ending 31 December 2021, you had an accounting date of 31 December. You paid Income Tax for profits for the period 1 January 2021 to 5 April 2021 in the 2020/21 tax year. In the 2021/22 tax year, you paid income tax on profits for your accounting period of 1 January 2021 to 31 December 2021. You therefore ended up paying twice on the profits of the overlap period of 1 January 2021 to 5 April 2021.

If you started the business on 1 February 2021 and prepared your accounts at the 31 December each year, you paid tax:

  • in the tax year 2020/21 on profits made between 1 February 2021 and 5 April 2021;
  • in the tax year 2021/22 on profits made between 1 February 2021 and 31 January 2022 (i.e. for 12 months since the start of trading); and
  • in the tax year 2022/23 on profits made between 1 January 2022 and 31 December 2022.

In this example, you paid tax twice on profits between 1 February 2021 and 5 April 2021, and on profits between 1 January 2022 and 31 January 2022.

However, you could reclaim this Income Tax by 'overlap relief' if you end the business.

In the closing tax year of a business, Income Tax was assessed on the profits made from the end of the most recent accounting period until the date the business ended. However, you could have then made a deduction for overlap relief.

For the 2023/24 tax year

The 2023/24 tax year was a transitional period and transitional rules applied.

From the beginning of the 2024/25 tax year

For the 2024-25 tax year onwards, the current year basis rules will not apply, and you will instead be taxed on your profits for the tax year.

If your accounting period doesn't coincide with a tax year, you may need to calculate your taxable profits for the tax year by apportioning your profits for the 2 accounting periods that overlap the tax year. Any apportionment that is necessary should generally be made in proportion to the number of days in the relevant periods.

For example, if you prepare your accounts at 31 December each year, you will calculate your taxable profits for the 2024/25 tax year based on:

  • your profits in the 270 days of your 2024 accounting period that fall within that tax year; and
  • your profits in the 95 days of your 2025 accounting period that fall within that tax year.

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