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 expenditure' is money spent on buying machinery and equipment used for your business. You generally can't deduct the entire amount of your capital expenditure for the year from your trading profits for that year. However, you're allowed to claim tax relief on capital expenditure in certain instances. This tax relief is known as a 'capital allowance', and it allows you to deduct a set percentage of the capital expenditure from your trading profits. The percentage is set by the government. This amount isn't the same as depreciation.

You can claim capital allowances on:

  • the cost of vans and cars, machines, scaffolding, ladders, tools, equipment, furniture, computers and similar items you use in your business;
  • the cost of plant and machinery; and
  • items you used privately before using them in your business.

You 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.

How much can I deduct as a capital allowance?

You may be able to claim 100% of the purchase price of capital items bought during the tax year where the following allowances apply:

  • Research and development (R&D) capital allowances on expenditure on assets or facilities used by your employees to carry out R&D relating to your trade. The amount of R&D tax credits that can be repaid in cash to SMEs in any one year is capped at £20,000 (plus 3 times the SME's total PAYE and NICs liability);
  • First-year allowances on investments in new equipment for energy-saving or water-efficient technology;
  • Allowances for equipment for refuelling vehicles with natural gas, biogas or hydrogen; or
  • First-year allowances for new:
    • Electric vehicles;
    • Cars with C02 emissions no greater than 50 g/km

Annual Investment Allowance

If you buy new plant and machinery that doesn't benefit from the 100% allowances mentioned above, you may be able to deduct an Annual Investment Allowance (AIA) from your profits. The purpose of this is to speed up tax relief on qualifying expenditure, as otherwise the writing-down allowance will apply. This is explained below.

The value of the investment on which businesses can claim this allowance has fluctuated. From 1 January 2019 until 31 March 2023 it will be £1 million. The limit will then return to £200,000.

This means that if, 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.

It's more complicated if the accounting period in question straddles the date that the limit will change back – many business's accounting periods are from April to March. In that case, the limit is apportioned according to how much of the AIA period falls within the accounting period in question. For example, your accounting period is April 2021 to March 2022: for 75% of the period the AIA limit was £1,000,000, 75% of which is £750,000. For the remaining 25% of the year, the limit is £200,000, 25% of which is £50,000. You should, therefore, maximise your expenditure from April to December 2021, when you would have an effective allowance of up to £800,000. If you spend the same amount between 1 January and 31 March 2022, then you receive only £50,000.

Writing-down allowance

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.

Since April 2012, the standard writing-down annual allowance that you can claim each year on a pool of plant and machinery is 18% of the value of that pool. There is a special rate of 6% that applies to the pool of integral features of buildings, like electrical systems, thermal insulation and equipment with a planned life over 25 years, as well as cars with CO2 emissions of more than 130g/km.

However, the government announced in its Spring Budget 2021 a temporary new 'super-deduction' for expenditure incurred on qualifying plant and machinery between 1 April 2021 and 31 March 2023. Qualifying expenditure on assets that would ordinarily qualify for 18% writing down allowances, will be relieved by a super-deduction of 130%, while qualifying expenditure on assets that would ordinarily qualify for 6% writing down allowances, will be relieved by a 50% special rate first-year allowance. Where expenditure is incurred in an accounting period which ends on or after 1 April 2023, the 130% rate is reduced to reflect the proportion of the accounting period falling on or after 1 April 2023, with a minimum rate of 100%.

The new enhanced deductions will not apply to certain categories of expenditure including expenditure on cars and on plant and machinery for leasing.

If the balance of the 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 standard writing-down allowance calculation

If in one tax year, a builder buys new plant and machinery worth £1.5 million, 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 pool of plant and machinery ('main pool') 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

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

The first tax year of a new business

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

The second year of a new business

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

Subsequent years of a new business

In the third and subsequent years, Income Tax will generally be assessed on the profits of the 12-month accounting period ending in that tax year.

Overlap relief

These rules may result in you paying tax twice on 'overlap profits' in the first 3 years of business. For example, if you started business on 1 January 2022 and drew up your accounts for the year ending 31 December 2022, you'd have an accounting date of 31 December. You'd pay Income Tax for profits for the period 1 January 2022 to 5 April 2022 in the 2021/22 tax year. In the 2022/23 tax year, you'd pay income tax on profits for your accounting period of 1 January 2022 to 31 December 2022. You'd therefore end up paying twice on the profits of the overlap period of 1 January 2022 to 5 April 2022.

If you started the business on 1 February 2022 and prepared your accounts at the 31 December each year, you would pay tax:

  • in the tax year 2021/22 on profits made between 1 February 2022 and 5 April 2022;
  • in the tax year 2022/23 for profits made between 1 February 2022 and 31 January 2023 (i.e. for 12 months since the start of trading); and
  • in the tax year 2023/24 on profits made between 1 January 2023 and 31 December 2023.

In this example, you'd pay tax twice on profits between 1 February 2022 and 5 April 2022, and on profits between 1 January 2023 and 31 January 2023.

However, you could reclaim this Income Tax by 'overlap relief' if you end the business. It might be useful to discuss with an accountant the effect of when you start business on your cash flow.

The closing tax year of a business

In the final year, Income Tax will be assessed on the profits made from the end of the most recent accounting period until the date the business ends. However, you can then make a deduction for overlap relief.

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