CHAPTER 2 ADJUSTMENT OF PROFIT GENERAL PRINCIPLES

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1 CHAPTER 2 ADJUSTMENT OF PROFIT GENERAL PRINCIPLES In this chapter you will cover the rules that apply for adjusting accounting profits to obtain the taxable trading profits. In particular you will cover: depreciation; capital expenditure; legal fees; the enduring benefit test; repairs; provisions; the wholly and exclusively rule; private use; clothing; salaries and drawings; goods for own use; appropriations to trading stock; items not taxed as trading income; income on long service contracts; compensation receipts. 2.1 Generally Accepted Accounting Practice The taxable profits of a trade must be calculated in accordance with generally accepted accounting practice (GAAP), subject to any adjustment required or authorised by law in calculating profits for income tax purposes. ITTOIA 2005, s.25 For accounting periods which begin on or after 1 January 2015 a new financial reporting framework has been introduced in the UK. Essentially three new accounting standards have been developed which together form the basis of a new UK generally accepted accounting practice ( new UK GAAP ). The most important of these new accounting standards is FRS 102 The Financial Reporting Standard Applicable in the UK and Republic of Ireland which replaces all existing UK accounting standards. UK companies which are not required to prepare accounts in accordance with international financial reporting standards will use FRS 102 as will all unincorporated businesses such as sole traders and partnerships. Although FRS 102 uses different terminology to that used in the Companies Act 2006, FRS 102 does state that other terminology may be used provided that it is not misleading. The CIOT and the ATT have agreed that they will continue to use the Companies Act 2006 terminology in their exams therefore this manual uses the Companies Act 2006 terminology throughout. References are however made to the new terminology in FRS 102 where it is relevant and a comparison of Companies Act 2006 and FRS 102 terminology has been included at the end of this chapter. 2.2 Introduction Each year a trader will prepare a set of accounts in accordance with generally accepted accounting practice. Those accounts will (usually) show a profit. Reed Elsevier UK Ltd FA 2015

2 However, in computing this profit the trader could have deducted expenditure that HMRC does not allow for taxation purposes. Consequently we are required to make a number of adjustments in arriving at the trader's taxable profit. We start with the profit per the accounts. We then add back certain expenditure which is disallowable for tax purposes. Then we deduct receipts in the accounts which are not taxable as trading income. Finally we deduct capital allowances, which are HMRC's equivalent of depreciation. (We will cover capital allowances in later chapters). This gives the tax adjusted profit, which is acceptable to HMRC. Profit per accounts Add: Disallowed expenditure Less: Items not taxed as trading income Less: Capital allowances Tax adjusted profit X X (X) (X) X It is this tax-adjusted profit which is taxable as trading income. In this chapter we will look at the most common types of expenditure which are not allowed to be deducted for tax purposes, and at receipts which are not taxed as trading income. 2.3 Disallowable Expenditure There are three main categories in this area: Capital expenditure expenditure which gives an enduring benefit to the business. ITTOIA 2005, s.33 Expenditure which has not been incurred wholly and exclusively for the purposes of the trade. ITTOIA 2005, s.34 Specific disallowables given by tax statute and case law. 2.4 Depreciation and Amortisation Depreciation and amortisation are not usually allowed for tax purposes. This is because there are many rates and methods of depreciation, and traders may therefore be encouraged to choose depreciation rates which maximise tax relief. ITTOIA 2005, s.33 Instead, businesses are able to claim capital allowances (CAs) on any plant and machinery used in the trade. CAs are covered in later chapters. 2.5 Capital Expenditure The purchase of capital equipment should be included on a trader's Balance Sheet, (or Statement of Financial Position per FRS 102) as the Balance Sheet shows all the fixed assets (or property, plant and equipment per FRS 102) of the business. These include: motor vehicles; premises; other equipment (photocopiers, computers etc). Reed Elsevier UK Ltd FA 2015

3 These items may be eligible for capital allowances. If the trader has included any capital additions in the Profit and Loss ( P&L ) Account (or Income Statement per FRS 102), they should be disallowed and added back in arriving at the trading profits. Profits or losses on the sale of fixed assets are also disallowed. Losses on sales of fixed assets are not allowable expenses and should therefore be added back. Profits on sales of fixed assets are not taxable as trading income and should therefore be deducted in arriving at trading profits. 2.6 Legal Fees A trader may incur legal fees on the acquisition or disposal of capital assets. These are disallowed as they relate to a capital item. Legal fees incurred on the renewal of a short lease are specifically allowed. A short lease is a lease of 50 years or less. 2.7 The Enduring Benefit Test In the tax case of Atherton v British Insulated & Helsby Cables Ltd (1925), the Judge held that expenditure which provides the business with an enduring benefit is not allowable as a trading expense. By enduring benefit we mean that the expense will benefit the business not just in the year in which it is incurred, but also in the years that follow. For example, if a plumber buys a new van, this is a capital expense as the business will have obtained an enduring benefit as a result of the expense. The van will (presumably) be available for use in the business for several years. The purchase of the van is a one-off exceptional expense which the trader will not incur year-onyear. The expense should be capitalised via the Balance Sheet rather than deducted as an expense in the P&L account. However, if a plumber fills his van up with petrol, this does not give an enduring benefit as (a few days later) he may need to do so again. Assuming the van is a business vehicle, petrol costs for the van will go through the P&L account and will be deductible for tax purposes. Tax law does not give any assistance as to how long an asset needs to be owned for it to be classed as capital. In some instances an asset may have a very limited economic life. HMRC guidance is that: where the life of an asset is less than one year the expenditure on that asset should be treated as a revenue expense, and where the life of an asset is expected to be at least two years it is likely to be capital expenditure. If an asset has an expected useful life of between one and two years the treatment of this asset is subjective and we must look at the specific facts of the case to make our decision. Reed Elsevier UK Ltd FA 2015

4 2.8 Repairs The cost of a repair is normally allowable expenditure for tax purposes whereas the cost of replacing an asset or making a significant alteration or improvement to an asset is capital expenditure and as such is disallowed. ITTOIA 2005, s.33 An expense is a repair where it restores an asset to its original condition. The use of modern materials or new technology as part of a repair does not necessarily mean the repair becomes an improvement. For example, HMRC accept that replacing old windows with new double glazed equivalents is a repair rather than an improvement. If after the work is carried out the asset can do just the same job as before, the work is a repair. If however more can be done with the asset, or the asset can be used to do something that it could not do before, then the work is an improvement and is therefore disallowable as capital expenditure. Where an expense is a capital improvement, the notional cost of what it would have taken to repair the asset is not allowed. Replacing a part of an asset is a repair to the asset, but replacing the whole or the entirety of an asset is capital expenditure. What forms the asset is a question of fact. A decision needs to be made whether the asset is in fact a separate asset or is part of a bigger asset to determine if the expenditure is allowable for tax purposes. For instance, fixtures within a building are part of the building and are not an entirety in their own right. Replacing a fixture is a repair to the building. An exception to this rule is where the fixture is an integral feature that is being replaced. If expenditure on an integral feature represents the whole, or more than 50%, of the cost of replacing the integral feature then the whole expenditure is to be treated as capital expenditure and disallowed for tax purposes (although capital allowances will be available on this cost, these will be covered in a later chapter). A deduction is however allowed for expenses incurred on the replacement or alteration of small tools. No deduction is allowed for the initial cost of the items. The type of assets that qualify for this renewals allowance depends on the precise nature of the business being carried on. Common examples of expenditure that would technically qualify for a deduction are: ITTOIA 2005, s.68 Glasses in a public house; Spanners used by a car mechanic; and Cutlery in a cafe. It is common for HMRC to request a breakdown of the trader s repair expenditure in the P&L account as part of an enquiry. 2.9 Initial Repairs If a trader purchases an asset and then spends money on it, is this expense revenue or capital? In Law Shipping Company v IRC, a company purchased a ship which needed some immediate repair work as it did not possess a certificate of sea-worthiness. Reed Elsevier UK Ltd FA 2015

5 They spent the money and claimed the repairs as a revenue expense in the P&L account. However, the Courts held that the repairs were part and parcel of the acquisition costs of the asset as they enabled the ship to be used for the very first time. As a result, these repairs were held to be capital ie linked to the capital acquisition of the ship. Could we argue that the costs are revenue? In the case of Odeon Associated Theatres Limited v Jones, a number of cinemas were purchased just after the war in a very run down state. However, Odeon kept them open to the public and continued to show films. Over a period of time they gradually repaired and renovated the cinemas and brought them up to a much smarter state. As much of the repair work related to dilapidations arising prior to Odeon's purchase, HMRC argued under the Law Shipping precedent that the repair expenses were part and parcel of the acquisition cost ie they were capital. However, as the repairs took place to useable assets, the Court held that the costs were revenue in nature and therefore allowable. The most important factor with regard to repairs on newly acquired assets is whether the asset was purchased in a useable state and was actually used in that state. This principle also applies to let properties. For example, if an individual buys a house, undertakes some repair expenditure to make it lettable, then subsequently lets out the property to a tenant, HMRC will apply the Law Shipping principle and disallow the expense as capital Provisions Provisions are allowable provided that they are properly computed in accordance with FRS 102 and are in connection with genuine revenue expenditure (not capital). Section 21 of FRS 102 requires that a provision can only be made via the P&L account if: a. the entity has an obligation to make a payment at the reporting date as a result of a past event; b. it is probable (ie more likely than not) that a transfer of economic benefits will be required to settle that obligation; and c. a reliable estimate can be made of the amount of the obligation. Unless you have any information to the contrary, if a P&L account contains a provision, you should assume that the accounts have been prepared in accordance with FRS 102 and the provision is therefore allowable Wholly and Exclusively Expenses are only deductible if they are incurred wholly and exclusively for the purposes of the trade. ITTOIA 2005, s.34 If an expense is incurred for a dual purpose for example, there is both a business and a private element to the expense HMRC permits a tax deduction for the business proportion of the expenditure. Reed Elsevier UK Ltd FA 2015

6 However, HMRC will only allow a proportionate deduction where an expense can be split into identifiable business and private parts. So for example, if a car is used partly for business and partly for private purposes, keeping a log of the mileage can be used to identify the precise business use for which a deduction can be claimed. If however the expense is materially for a private or non-business purpose, HMRC interpret the wholly test very strictly and will disallow the expense in full. Illustration 1 Emma is a freelance wedding photographer. She uses her car mainly for business purposes. 80% of her journeys are for the purposes of her trade, but she also uses the car in the evenings for social and domestic use. Her motor expenses are 4,000 a year and these are deducted via the P&L account. What will the allowable deduction be in respect of the motor expenses? HMRC will allow a deduction for 80% 4,000 = 3,200. The non-business element of the motor expense ( 800) should be disallowed and added back to the trading profits. The private use adjustment can apply to any expenditure. For example, if a taxpayer uses, say, 25% of his house as an office for the purposes of the trade, he will be able to deduct 25% of the running costs of his home (electricity bills, mortgage interest etc) in arriving at his taxable profit Private Expenses of Employees A private use adjustment is only made where the owner of the business (ie the trader himself) deducts expenses which wholly or partly relate to his private affairs. Where the business pays a private expense for an employee (eg a gym subscription or medical insurance premium): 1. the expense is an allowable deduction for the business; and 2. the employee will (usually) have a taxable benefit under the employment income rules Clothing In Mallalieu v Drummond, a barrister claimed that the costs of her dark Courtroom dress were allowable as an expense against her professional income because she was required to wear it in Court and would not otherwise wear such clothing in her everyday life. However the Courts were not satisfied that this was the case, as they argued that she would be wearing clothing in Court in any event in order to provide her with warmth and normal decency. When she bought the clothes, there was a subconscious duality of purpose. The clothing costs were therefore disallowed as they essentially satisfied a private purpose. Reed Elsevier UK Ltd FA 2015

7 Therefore, an accountant who only normally wears his suit when he is acting as an accountant, would not be able to claim the costs of that suit as a trading expense because he would have to wear something when meeting clients. However, HMRC accept that protective clothing (hard hats, overalls, chefs' aprons etc) is an expense incurred wholly and exclusively for the purposes of the trade and will allow such items. The same applies for actors' costumes Salaries and Drawings Salaries or wages are amounts paid by the business to its employees in return for work undertaken. These wages will be taxed as employment income in the hands of the recipient and will be allowable expenses for the business. Any employer's national insurance paid by the business (Class 1 secondary and Class 1A NIC) is also an allowable expense. Drawings are monies taken from the business profits by the owner / proprietor to meet his own private expenditure. These drawings are not taxed as employment income and are not allowable as a trading expense. If a business deducts the proprietor's wages via the P&L account, these wages are essentially drawings and should be added back. The self-employed proprietor will pay income tax on his taxable trading profits the amounts he actually draws in the year are irrelevant and can be ignored. There is no reason why a trader may not employ a family member to assist him in his business. For example, a self-employed husband may employ his wife to work in a full or part-time capacity. The wages paid to the spouse will be a bona fide deductible expense provided that: a. the wages are actually paid (and are not just a book entry ); b. the wife plays a part in the business; and c. the wages are not excessive in relation to the work undertaken (ie they are of an amount which a third party might pay in return for the same services provided). The employment of the proprietor's children in the trade is a more controversial issue. All individuals (even young children) have a personal allowance for income tax purposes and, without rules to prevent exploitation, many traders would pay their children a wage to use their personal allowance and thereafter claim a tax deduction for the expense. Children's wages will only be allowable if: a. it is not unreasonable for a child to be employed to undertake the particular work; and b. the payment is in fact in the nature of a wage and is not merely pocket money. In Dollar & Dollar v Lyon (1981), a farmer employed his 4 children aged 14, 11, 9 & 7 on the farm, and paid each a wage. The Courts held that the payments to the 14 year old were allowed as genuine wages, but the payments to the younger children were pocket money in nature and did not therefore satisfy the wholly & exclusively test. The Court also took into consideration that it was illegal to employ the 3 younger children. Reed Elsevier UK Ltd FA 2015

8 2.15 Accrued Wages Salaries and wages are usually deducted in the period in which the wages are actually paid. However relief is given for accrued wages as long as the wages are actually paid within 9 months of the end of the accounting period. ITTOIA 2005, s.36 If the accrued wages are NOT paid within 9 months of the end of the period: a. the accrued amount is added back; and b. relief is given in the period in which the wages are physically paid Goods for Own Use A trader will buy trading stock(or inventory per FRS 102). The cost of the stock will be a deductible expense in his P&L account. The trader will later sell his trading stock (presumably for more than he bought it for!). The sale will form part of trading income in the P&L account. The difference between the cost of the stock and the selling price will be the gross profit of the business. Occasionally the trader may decide to take some of the trading stock for his own personal use. In this case we need to make an adjustment to the accounting profit. The principle established in the case of Sharkey v Wernher is that we assume that the trader has bought the stock at cost then sold the stock to himself for its retail selling price ie we assume that the business has made an unconnected third party sale to the individual owner in his personal capacity. Consequently we add the sales price of the stock to the accounts profit. This principle was established by case law but was given statutory authority in Finance Act ITTOIA 2005, s.172b This principle only applies for goods (ie completed trading stock). It does not apply for services or raw materials which have not yet become stock. For services provided by the business to the sole trader personally or to his household we just disallow the cost of providing the service. Similarly, we simply disallow the cost of raw materials taken for private use. Illustration 2 Declan runs his own plant shop and gardening business as a sole trader. During the year ended 31 March 2016 he took plants which cost 300 out of the business and planted them in his own garden. The business has a mark up on cost of 200% on the sale of plants. Declan also used the gardening business to have his lawn at home mowed each week during the summer. The employee was paid 10 an hour and spent a total of twelve hours mowing Declan s lawn. Customers are charged 15 an hour to have their lawns mowed. Reed Elsevier UK Ltd FA 2015

9 Calculate the amounts that would be added back in arriving at the tax adjusted trading profit of Declan s business. Declan has taken stock out of the business for personal use. Therefore we need to add back the selling price of the stock. We have been told that the mark up on cost of the plants is 200%. This means that the gross profit is 200% of cost. The cost of sales expense is 100%, so the selling price must therefore be 300% of cost (ie 3 times the cost of sales figure). We know that the cost of the plants is 300 so the selling price must be 900. % Selling price (balancing figure) Less: Cost of sales (300) (100) Gross profit We must add back 900 for the plants taken out of the business for personal use. By adding back the sales price of stock taken out of the business for personal use by the sole trader we are effectively doing two things: 1. Removing the cost of the stock from the cost of sales expense; and 2. Adding back the gross profit that would have been made if the stock had been sold for its retail selling price. If we are told that the trader has already removed the cost of the stock in his accounts by performing the double entry for drawings (which is to Dr Drawings and Cr Purchases expense with the cost of the stock) then the adjustment required for tax purposes is to add back the gross profit that would have been made if the stock had been sold for its retail selling price. Declan s lawn has been mowed by his gardening business. For services provided to the sole trader personally we just add back the cost of providing the service which in this case is 120 (being 12 hours at 10 an hour). The total amount to add back is therefore 1,020 ( ) Appropriations to Trading Stock If a trader takes an asset which is used in his trade but isn't part of his trading stock, and he then brings it into the business as trading stock, then the cost of the stock for the purpose of the accounts is the market value at the time it was introduced. This may be the case where a property developer has a fixed asset which he uses in his trade (eg a building), and then he takes that building as part of his trading stock to be developed. ITTOIA 2005, 172C For CGT purposes, the trader will also be deemed to have disposed of the fixed asset (to himself) at market value so a capital gain will arise. In this instance the trader can elect not to have a CGT disposal but instead to have the cost of the stock reduced by the chargeable gain. This will reduce the gain to nil but will result in the stock having a lower cost (and therefore a higher trading profit when the stock is eventually sold). TCGA 1992, 161 Reed Elsevier UK Ltd FA 2015

10 Illustration 3 Sarah runs a small property development business from an office in St Albans. The office building cost 100,000 in June On 15 August 2015, Sarah moved her business to a larger office in Watford and decided to redevelop the St Albans office in order to sell it to a commercial buyer. The St Albans office was worth 250,000 in What are the tax implications of Sarah deciding to redevelop the St Albans office for resale? Sarah has taken a fixed asset used in her business (the St Albans office) and has appropriated this to her trading stock. Therefore: 1. She is deemed to have sold the office to herself for its market value ( 250,000). This gives her a capital gain of 150,000; and 2. She has bought trading stock for her property development business for 250,000. Alternatively Sarah can make an election under s.161(3) TCGA 1992, in which case: 1. The gain of 150,000 is reduced to nil; and 2. The cost of the stock in her property development business is reduced by 150,000 and will now be 100,000. Given that capital gains are charged at 18% and 28% and that trading profits are likely to be taxed in the future at 40% and 45%, Sarah may not wish to make the election but may instead simply pay the CGT on the disposal of the fixed asset Items Not Taxed as Trading Income Not all receipts which a trader includes in his business accounts will be taxed as trading income. Traders might include income in their accounts which is not derived from their trade. Typical examples of non-trading income are: rental income; bank interest; profits on sale of fixed assets; sundry miscellaneous income. Any non-trading income is deducted in arriving at the taxable profit figure. Profit per accounts Add: Disallowed expenditure Less: Items not taxed as trading income Less: Capital allowances Tax adjusted profit X X (X) (X) X This other income will then be brought back in the main income tax computation and taxed accordingly. Reed Elsevier UK Ltd FA 2015

11 In exceptional circumstances, rental income from the letting of surplus business accommodation can be treated as arising from the trade as opposed to being treated as property income. ITTOIA 2005, s.21 This will be the case where: a. the premises being let are temporarily surplus to requirements; b. the let premises are part of a building in which another part is being used in the trade; and c. the letting receipts are relatively small Income on Long Service Contracts Section 23 of FRS 102 sets down the rules for the recognition of income on long term service contracts. Unlike manufacturers and retailers, service providers must account for uncompleted (and unbilled) work at the end of their accounts year as income under normal circumstances. Where the outcome of the transaction can be measured reliably, an entity should recognise the revenue associated with a transaction by reference to the stage of completion of the transaction at the end of the accounting period. Income must be recognised as the contract progresses rather than when contracts are completed. However, the amount of revenue recognised should also reflect any uncertainties as to the amount the customer will accept and pay. So, for example, if a barrister works on the no win, no fee basis, the income should not be recognised until the case is won. But where an accountant is part way through preparing a client's tax return at his accounting year end, then revenue should be determined in a manner appropriate to the stage of completion, on the assumption that the work will progress to completion. Essentially this means that businesses must recognise their work-in-progress (WIP) within their accounts and pay tax on it as the work arises, not when the work is finally completed and billed Compensation Receipts The way in which compensation receipts are taxed depends on what the compensation relates to. Any compensation received for damages to or depreciation of an asset is a capital receipt and is not taxed as trading income. Such receipts may be subject to CGT. However, compensation received for the cancellation of a trading contract will generally be taxed as trading income if the contract receipts would themselves have been trading receipts had the contract been completed. Reed Elsevier UK Ltd FA 2015

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13 EXAMPLES Example 1 State whether the following expenses incurred by a sole trader are allowable or disallowable for tax purposes: a) Loss on sale of a computer b) Amortisation of goodwill c) Purchase of a new photocopier d) Legal fees incurred on purchase of a new building e) Legal fees on acquisition of new 20 year lease f) Legal fees on renewal of 20 year lease g) Repairs to photocopier h) Wages to his secretary i) New suit to wear for client meetings Disallow Y/N Example 2 Tony runs a shop selling garden furniture. His accounts show a net profit of 50,000. During the year Tony took home a new set of tables and chairs for his garden. The furniture cost 500. The mark up on cost of the furniture is 150%. No other adjustments are required for tax purposes. Calculate the taxable trading profit. Reed Elsevier UK Ltd FA 2015

14 Example 3 Alicia is a self-employed interior designer. Her accounts for the year ended 30 June 2015 show the following: Sales 89,500 Add: Interest on business deposit account ,750 Less: Expenses Depreciation (3,000) New computer (2,000) Wages for employee (1) (20,000) Car running costs (2) (2,500) Loss on sale of old computer (650) Accountancy fees (400) Net profit 61,200 Notes: 1. The wages include an accrued bonus of 5,000. The bonus was actually paid to the employee on 30 April Alicia's car is used 70% for business purposes. 3. Capital allowances in the year were 4,000. Calculate Alicia's taxable trading profit. Reed Elsevier UK Ltd FA 2015

15 ANSWERS Answer 1 Disallow a) Loss on sale of computer (Capital) Y b) Amortisation of goodwill (Depreciation) Y c) Purchase of a new photocopier (Capital) Y d) Legal fees incurred on purchase of a new (Capital) Y building e) Legal fees on acquisition of new 20 year lease (Capital) Y f) Legal fees on renewal of 20 year lease N g) Repairs to photocopier N h) Wages to his secretary N i) New suit to wear for client meetings Y Answer 2 Profit per accounts 50,000 Add: Selling price of stock taken for own use ( %) 1,250 Taxable trading profit 51,250 Tutorial Note: If the mark up on cost is 150%, this means that the gross profit is 150% of cost. The cost of sales is 100%, therefore the sales income must be 250% of cost. If we multiply the cost figure of 500 by 250% (ie by 2.5) this gives us the selling price of the furniture which is 1,250. Answer 3 Profit per accounts 61,200 Add: Depreciation 3,000 New computer 2,000 Wages (not paid within 9 months) 5,000 Motor expenses (30% 2,500) 750 Loss on sale of old computer ,400 Less: 72,600 Deposit interest (250) Capital allowances (4,000) (4,250) Taxable trading profit 68,350 Reed Elsevier UK Ltd FA 2015