ACCA F6 FA09 Study Text 2010
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Chapter 4: Employment income
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(e) Employer contributions into the occupational pension scheme of 5% of salary.
(f) Use of a new laptop computer and software for private use which cost the
company £500.
Olga paid the following amounts during 2009/10:
(a) 3% of her salary into the company’s occupational pension scheme.
(b) £2,250 on entertaining clients and suppliers, which Pacific Enterprises plc
reimbursed as they were genuine business expenses.
(c) £400 donation to charity under the approved payroll giving scheme
administered by Pacific Enterprises plc.
Required
Calculate Olga’s employment income assessment for 2009/10.
Answer
£
Salary 60,000
Bonus 15,000
Assessablebenefits
Carbenefit(W1) 6,945
Fuelbenefit(£16,900×35%) 5,915
Carparkingvouchers=exempt Nil
Privatemedicalinsurance 1,300
Permanenthealthinsurance=exempt Nil
Deathinserviceinsurance=exempt Nil
Employercontributionstopensionscheme=exempt Nil
Useoflaptop(£500×20%) 100
Entertainingclientsandsupplie
rs 2,250
––––––––––––––––––––––––––––––––
–
91,510
Allowabledeductions:
Employeepensioncontributions(£60,000×3%) (1,800)
Donationstocharityunderanapprovedpayrollgivingscheme (400)
–––––––––––––––––––––––––––––––––
EarningsfordecidingwhetheranemployeeisaP11Demployee 89,310
Expensesincurredwholly,exclusivelyandnecessarily
=entertainingexpenses
(2,250)
–––––––––––––––––––––––––––––––––
Employmentincome 87,060
–––––––––––––––––––––––––––––––––
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Workings
(W1)Carbenefit g/km Diesel
%
CO2emissions(roundeddowntonearest5g/km) 225
BaselevelofCO
2emissions (135)
90 ÷5 18
Minimumpercentage18
Appropriatepercentage=restrictedtomaximum 35%35
££
Manufacturer’slistprice 26,500
Minus:Capitalcontributiontowardsthecar (4,600)
–
–––––––––––––––––––––––––––––––
21,900 at35% 7,665
–
–––––––––––––––––––––––––––––––
Minus:Contributionfortheuseofthecar(£60×12) (720)
––––––––––––––––––––––––––––––––
Carbenefit6,945
––––––––––––––––––––––––––––––––
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Paper F6 (UK)
Taxation FA2009
CHAPTER
5
Trading income
Contents
1 Does a trade exist?
2 Overview of the trading income assessment for
an unincorporated business
3 The adjustment of profit computation
4 Disallowable expenditure
5 Specifically allowable expenditure
6 Amounts credited in the accounts that are not
taxable as trading income
7 Proforma adjustment of profit computation
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Does a trade exist?
Deciding whether or not a trading activity exists
The badges of trade
1 Does a trade exist?
1.1 Deciding whether or not a trading activity exists
Before starting to compute the trading income assessment of an individual, it is
important to establish that the income should be taxed as trading income. Income
should only be taxed as trading income if a trading activity exists.
What constitutes a trade is widely defined by UK tax law as ‘every trade,
manufacture, adventure or concern in the nature of trade’.
In most cases it is clear that a trading business has been established and the profits
should be taxed accordingly. However, in some cases the decision as to whether or
not a trade exists is not clear-cut.
If a profit is made on the disposal of an asset, it can be argued that:
it is a one-off capital disposal and so should be liable to capital gains tax and
it does not constitute a trading activity.
Alternatively, depending on the type of asset, the disposal may be exempt from tax.
However, the conclusion might not be the same if another similar disposal were to
take place six months later, or one week later, or every four months. It could be
argued that the profits from these disposals should be liable to income tax as trading
income, and that they are not capital gains from a non-trading activity.
Over many years cases have gone to court to decide whether or not a trading
activity exists. As a result of court decisions, there is a list of factors (known as the
badges of trade) which HMRC will consider in deciding:
whether a trading activity exists, and therefore
whether the profits derived from the activities should be taxed as trading
income.
1.2 The badges of trade
In cases where there is doubt as to whether or not a trading activity exists, HMRC
will consider six factors to decide the appropriate tax treatment.
Chapter 5: Trading income
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No single factor is more important than another and no single factor will determine
the treatment on its own. HMRC will look at all the facts of the given situation in
making a decision.
The badges of trade (i.e. factors to consider) are as follows:
(1) The subject matter of the transaction and the motive at the time of purchase
(2) The reason for the disposal
(3) The length of ownership
(4) The frequency of transactions
(5) Altering the asset before resale
(6) Other general circumstances.
The subject matter of the transaction and the motive at the time of purchase
The intentions of the individual at the time of purchase are important. It is
considered that there are only three reasons for the purchase of an asset:
for personal use
as a long-term investment, to sell ultimately at a gain and possibly produce
income during ownership (e.g. investment property, shares, paintings)
for resale at a profit.
Only the last of these three reasons suggests that a trading activity exists.
However, there must be a profit motive at the time the asset is acquired to suggest
that an individual is trading. The asset must be acquired with the intention of
selling it at a profit at a later date.
Acquiring an asset as a gift or by inheritance from a relative suggests that any profit
made on the sale does not constitute a trading transaction.
The reason for the disposal
The motive behind the disposal is also considered.
If the individual is forced to sell the asset in order to raise funds and alleviate
personal financial problems, the transaction is unlikely to be treated as a trading
transaction. However, if the sale is not a forced sale, it is more likely to be
considered part of a trading activity.
The length of ownership
In general, the shorter the length of the period of ownership before disposal, the
more likely that HMRC will consider the transaction to be in the nature of a trading
activity.
The frequency of transactions
Similarly, the more frequent the number of similar transactions, the more likely the
transactions will constitute a trading activity.
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Altering the asset before resale
If an individual purchases an asset and then alters the asset in some way, HMRC is
likely to treat the profit on disposal as a trading profit.
Therefore any manufacturing process or repairs that enhance the value of the asset,
or simply repackaging an asset to increase its attractiveness in the market place, will
signify a trading activity.
Other general circumstances
Other circumstances suggesting that a trading activity exists include evidence of the
setting up of a business vehicle, advertising expenditure to promote the business,
registering for VAT, and printing business stationery.
If an individual raises finance to purchase and/or process the asset before resale, the
raising of finance also suggests that a trading activity exists.
The extent to which the individual relies on the profit as a source of income is also a
factor to consider.
Chapter 5: Trading income
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Overview of the trading income assessment for an unincorporated
business
The principles of assessing trading income
Preparation of the trading income assessment for income tax
Proforma trading income assessment computation for income tax
2 Overview of the trading income assessment for an
unincorporated business
2.1 The principles of assessing trading income
An unincorporated business is a business owned and managed by an individual (i.e.
a sole trader) or by two or more individuals operating in partnership.
The trading income assessment for an individual with an unincorporated business is
based on the financial accounting results of the business.
The net profit in the financial accounts must be adjusted for taxation purposes
because the treatment of some items for tax purposes differs from accepted
accounting practice:
Some items of expenditure in the financial accounts cannot be deducted as an
expense in calculating the taxable profit.
Some items of expenditure are allowable for taxation purposes, but the amount
of expenditure that is allowable must be calculated under special tax rules rather
than by following the accounting convention rules. An important example is the
calculation of how much capital expenditure is allowable for tax purposes.
Under the tax rules, capital allowances are calculated. The amount of these
capital allowances is different from the depreciation charges in the financial
accounts.
2.2 Preparation of the trading income assessment for income tax
There are three key steps in the calculation of a trading income assessment for a sole
trader:
Step 1: Prepare an adjustment of profit statement
The first step is to prepare a statement adjusting the net profit of the business (in the
financial accounts) to calculate the adjusted profit before capital allowances.
Step 2: Calculate the capital allowances available
The next step is to calculate the capital allowances available for plant and machinery
and, if applicable, industrial buildings.
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Step 3: Calculate the trading income assessment for the correct tax year
The last step is to apply special basis of assessment rules to the figure of adjusted
profit after capital allowances, in order to decide in which tax year the profits will
be taxed. These rules are explained in a later chapter.
2.3 Proforma trading income assessment computation for income tax
A proforma for the computation of trading income is shown below.
£
Net profit X
Add/Deduct: Required adjustments of profit (Step 1)
X/(X)
Adjusted profits before capital allowances X
Minus Capital allowances (Step 2)
Plant and machinery (X)
Industrial buildings (X)
Adjusted profit after capital allowances X
Chapter 5: Trading income
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The adjustment of profit computation
Preparing an adjustment of profit computation
Basic adjustment of profit computation
The principles of allowable expenditure
The wholly and exclusively test
Private use by the owner
Appropriations of profit by the owner of the business
3 The adjustment of profit computation
3.1 Preparing an adjustment of profit computation
There are two key steps for calculating the adjusted profit figure.
Step 1: Review the expenditure charged in the financial accounts
The first step is to review the items of expenditure charged in the financial accounts,
in order to identify the items that are not allowable for tax purposes under the
trading income rules. These items of expenditure are often referred to as
disallowable expenditure and must be added back to the net profit as shown in the
financial accounts.
Step 2: Review the amounts credited to the financial accounts
The second step is to review the amounts credited to the financial accounts to
identify any items that are not assessable as trading income. These amounts are
deducted from the net profit to leave only the profits that relate to the trading
business.
3.2 Basic adjustment of profit computation
A proforma for calculating the adjusted profits figure is shown below.
£
Net profit in the accounts X
Add Items of expenditure charged in the accounts that are not
allowable for tax under the trading income rules
X
Add Trading income not recorded in the accounts X
Minus Amounts credited in the accounts that are not taxable as
trading income
(X)
Minus Amounts not charged in the accounts that are allowable for
trading income purposes
(X)
Adjusted profits before capital allowances X
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3.3 The principles of allowable expenditure
In order to be an allowable expense for tax purposes, the expenditure:
must be revenue expenditure (not capital expenditure), and
must be incurred wholly and exclusively for the purposes of the trade, and
must not be specifically disallowed by statute law.
Most items charged as expenses in the accounts satisfy this rule and are allowable
expenditure, therefore no adjustment is required.
3.4 The wholly and exclusively test
The wholly and exclusively test requires that an item of expenditure, to be tax-
allowable, must be:
incurred for the purposes of the trade and
incurred wholly and exclusively for trading purposes.
For example, the cost of sales, and the normal direct production and distribution
costs of a business are incurred wholly and exclusively for the purposes of the trade.
3.5 Private use by the owner
The requirement for expenditure to be for the purposes of the trade means that any
expenditure that is far removed (remote) from the purposes of the trade is not
allowable. This principle is often referred to as the remoteness test.
Accordingly, when a business pays for personal expenditure of the owner that is not
related to the trade, the expenditure is not allowable. For example, the personal
income tax liability and national insurance contributions of the owner are not
allowable. If the business pays for these items, they must be added to profit in the
adjustment of profit computation.
If expenditure is not incurred wholly and exclusively for trade purposes it is also
not allowable. Therefore, where a business incurs expenditure that is partly for
business and partly for the private purposes of the owner:
the expenditure is not incurred wholly and exclusively for the purposes of the
trade and so
is not allowable.
Examples of expenditure not incurred wholly and exclusively for the purposes of
the trade include:
motor expenses incurred in running the owner’s car, when the car is used partly
for business and partly for private mileage, and
expenditure on telephones used partly for business and partly for private calls.
In theory, all this type of expenditure should be disallowed, because the
expenditure has a dual purpose (business use and private use). However, HMRC