Trading Income
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.
Scope of Charge
The Income Tax (Trading and Other Income) Act 2005 provides that trading profits of a person who is resident in the United Kingdom are chargeable to income tax wherever the trade is carried out. The trading profits of a non-UK resident are chargeable to income tax if the trade is carried out wholly or partly in the UK.
Questions may arise as to whether income is derived from employment or self-employment. This categorization can be important, considering the obligations on the employer regarding PAYE and national insurance contributions, as well as implications under a range of other legislations. See the separate chapters on the distinction between employment and self-employment.
Non-trading income in the accounts is not subject to trading profits. The account should be adjusted to remove income subject to other heads of charge, such as investment and rental income. Profits made on the disposal of capital assets must be removed. Although they constitute income for accounting purposes, they are capital expenses.
Post-cessation income may be taxed as trading income. Deductions are allowed on the same basis as if they occurred during pre-cessation.
Small Business Options
From 2013 onwards, small unincorporated businesses may calculate their profits for tax purposes on a cash basis. In this case, the taxable profit is the difference between income actually received and expenses actually paid. This removes the general accruals and pre-payments reflected in accounts through the working capital cycle, typically constituting debtors, creditors, and stock.
The small business is one which has total receipts, which should not exceed the VAT threshold in the year concerned. This is £79,000 in 2013. The treatment is optional.
Traders and those supplying professional services whose annual income is below £150,000 in 2017 may compute their profits and losses on a cash accounting basis. An election must be made.
If a business has the cash basis, it may do so if its receipts in subsequent years up to the point in time when receipts exceed twice the threshold. Receipts and all amounts received in connection with the business during the accounting period including disposal of noncurrent assets. These are VAT inclusive and include VAT refunds.
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.
Expenses or payments made during the accounting period, wholly and exclusively for trade purposes. This includes capital expenditure. Certain special rules apply to motor vehicles. Expenditure in buying a car is not allowable. Businesses may claim flat rate allowances in relation to motor expenses.
Capital allowance expenditure is only allowed in respect of plant and machinery. Loan interest is allowed up to £500. Capital allowances may only be claimed in relation to motor vehicles.
If a loss is incurred, it can only be carried forward against profits arising in the same trade in the subsequent year. It is not allowed to use it against other income of the taxpayer generally.
Any unincorporated business may use a simplified flat rate allowance scheme in calculating its expenses for tax purposes. Once again, this is not mandatory but it is not subject to a cap. Motor expenses may be calculated by reference to employee mileage rates published. No other expenses or capital allowances are allowed in relation to the vehicle.
A self-employed person uses a home for trade and business purposes may claim the standard deductions depending on the number of hours spent working from home. They are relatively modest. Similar deductions apply in respect of the private use of business premises. This is prescribed by statute.
There is also an option for a flat rate deduction of business expenses. 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.
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.