ACCA F6 FA09 Study Text 2010

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Chapter 5: Trading income

will allow an apportionment of the associated costs, provided that there is an

identifiable part of the expense which is incurred wholly and exclusively for the

trade.

The appropriate percentage of the associated costs of providing an asset with an

element of private use by the owner must therefore be adjusted for (i.e. added to

profit) in the adjustment of profit computation.

Note that adjustments are only made for private use by the owner. The private use

of assets by employees is irrelevant and is ignored in the adjustment of profit

computation. This is because the expenditure is incurred wholly and exclusively for

the purposes of the trade from the business point of view.

All the costs associated with providing the asset for both business and private use

by employees are allowable for income tax (trading income) purposes. The

individual employee is assessed to income tax on the private use under the

employment income rules.

3.6 Appropriations of profit by the owner of the business

Any amounts taken out of the business by a sole trader or by a partner in a

partnership are known as appropriations of profit. They include drawings, salary or

wages for the owner or partner, and interest on capital introduced to the business.

The owner of an unincorporated business is liable to income tax on all the tax-

adjusted profits of the trade, not just on the amount he chooses to draw from the

business.

Accordingly, any appropriations of profit are not allowable deductions for income

tax purposes. Since they are not allowable, they must be added back to profit in the

adjustment of profit computation.

This rule applies only to appropriations of profit by the owner.

Where the business employs the spouse or a child of the owner, the normal costs of

employment of the spouse or child (for example, gross wages or salary, employee’s

and employer’s national insurance contributions, and the employer’s contributions

into the employee’s pension scheme) are allowable deductions for the business,

provided that they are reasonable in relation to the services provided to the

business.

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Disallowable expenditure

 Items specifically disallowed or specifically allowed for tax purposes

 Capital expenditure versus revenue expenditure

 Provisions and allowances against asset values

 Donations and subscriptions

 Interest and royalties

 Legal and professional fees

 Hire and leasing costs

 Gifts

 Entertaining expenses

 Fines and penalties

 Employee-related costs

 Trading income not recorded in the accounts

4 Disallowable expenditure

4.1 Items specifically disallowed or specifically allowed for tax purposes

There are some items of business expenditure that are specifically disallowable for

tax under the trading income rules. There are other expenses which are specifically

allowable. The main examples that feature in examination questions are explained

here.

If a question includes an item of expenditure that does not fall into a specific

category explained here, you should apply the general principles of revenue

expenditure or capital expenditure and then apply the wholly and exclusively test

to make a decision about whether the expenditure should be allowable or not.

4.2 Capital expenditure versus revenue expenditure

In the financial accounts, the cost of purchasing non-current assets is usually taken

to the balance sheet, and depreciation is charged against the profit for the period.

However, if the cost is not significant the purchase may be charged in full against

profit. In addition, the costs of repairs and maintenance of non-current assets are

usually charged against profit.

Any capital purchases, or other capital-related expenditure, that is charged in full

against profit is disallowed in the adjustment of profit computation. The amount of

the expense must be adjusted for by adding it back to profit. This is because the

trading income rules only allow revenue expenditure to be charged against profit

for tax purposes.

Chapter 5: Trading income

Capital expenditure

Capital expenditure is expenditure incurred on an asset which provides an

enduring benefit to the business and, as a result of the expenditure, there is an

element of improvement or enhancement in the value of the asset.

Capital expenditure therefore includes:

 the cost of purchasing non-current assets, and the cost of improvements,

enhancements, extensions, etc

 incidental costs, including legal and professional fees, relating to the purchase,

improvement, etc of a non-current asset

 depreciation and other equivalent write off of capital cost against profit (e.g.

amortisation of leases)

 profit (and loss) on the disposal of non-current assets.

Since they are capital expenditure, all these items are not allowable and must be

added back to profit in the adjustment of profit computation.

(Note: For many businesses, depreciation is a major expense in the financial

accounts. Depreciation and amortisation are capital-related expenses and are not

allowable, so they must be added back to profit. However, there are capital

allowances on items of capital expenditure for trading purposes. Capital allowances

can be thought of as tax-allowable depreciation.)

Revenue expenditure

Revenue expenditure is expenditure incurred in running the business, maintaining

the value of the assets or returning an asset to its original condition. Revenue

expenditure is an allowable cost for trading income purposes.

Revenue expenditure therefore includes:

 repair costs

 maintenance costs

 re-decoration, re-plastering costs, etc.

However, if a business purchases an asset in such a condition that it is not usable

and the purchase price reflects the poor condition of the asset, any expenditure

incurred in bringing the asset into use in the business should be treated as capital-

related expenditure and the expense will be disallowed.

4.3 Provisions and allowances against asset values

In the financial accounts, in accordance with generally accepted accounting

principles (UK GAAP or International Accounting Standards (IAS)), a business may

reflect in the profit figure the movement in provisions or allowances made against

the value of assets at the end of the period. For example, there may be provisions in

the financial accounts against inventory values or allowances against amounts owed

by customers.

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If accounted for under UK GAAP or IAS, the movement in the provision or

allowance in the financial accounts is allowable for trading income purposes.

Similarly, provisions for future costs are allowable against trading income provided

the provision can be estimated accurately and is accounted for under UK GAAP or

IAS.

Normal trade debts that are written off or recovered, and which are reflected in the

accounts, do not need to be adjusted for. This is because they are items wholly and

exclusively relating to the purposes of the trade.

However, the write off of non-trade debts such as a loan to a customer, supplier or

an employee, must be adjusted for by adding back to the net profit.

4.4 Donations and subscriptions

Subscriptions to professional and trade associations (for example, subscriptions to

the ACCA and the Chamber of Commerce) are allowable against trading income

provided they are incurred wholly and exclusively for the purposes of the trade.

Therefore no adjustment is required to the profit figure.

However, donations are usually not allowable against trading income. They must

be added back to the profit, with the exception of small donations to local charities.

In summary:

 small donations to local charities are, by concession, usually allowable

 any political donation or subscription is not allowable

 any donation to a national charity is not allowable, and

 any donation made under the Gift Aid scheme, regardless of size, is not

allowable under the trading income rules.

4.5 Interest and royalties

Interest payable in respect of loans for trading purposes (e.g. bank overdraft

interest, hire purchase interest and loan interest) is allowable against trading

income. Therefore no adjustment is required.

Interest payable on underpaid tax is not allowable for income tax purposes and

must therefore be added back.

In the examination, all royalties payable and receivable, such as patent royalties and

Therefore no adjustment for royalties is required.

In addition, although they are of a capital nature, any costs incurred in relation to

the registration of a patent or copyright for the purposes of the trade are specifically

allowable.

Chapter 5: Trading income

4.6 Legal and professional fees

Legal and professional fees relating to capital expenditure are, in principle, not

allowable against trading income.

However, legal and professional fees relating to revenue expenditure are allowable.

These include legal and professional fees incurred in relation to:

 the collection of debts

 employment issues

 claims for breach of contract (including damages paid, if any, provided the court

action relates to the trade and it is not proven that the business had broken the

law)

 preparing and auditing the financial accounts and normal tax compliance work.

Costs in relation to tax planning advice and appealing against assessments and

investigations are, however, not tax allowable.

Legal and professional costs relating to leases are capital in nature and therefore

not allowable. Thus the costs associated with the setting up of a new lease,

regardless of the length of the lease, would need to be added back in the adjustment

of profit computation.

However, tax rules specifically allow against trading income any legal costs in

relation to the renewal of a short lease (i.e. a lease with a life of ≤50 years

remaining).

4.7 Hire and leasing costs

If a business hires, rents or leases capital assets such as plant and machinery, the

associated hire charges or rental costs are allowable for trading income purposes, as

they have been incurred wholly and exclusively for the purposes of the trade.

However, 15% of the hire charge or rental cost relating to a car with CO

emissions

of more than 160 g/km is specifically disallowed for trading income purposes. (This

rule applies to leases commencing on or after 6 April 2009. However, the previous

rules are no longer examinable.)

Example

Queenie hired a car for a rental cost of £6,600 per annum.

Required

Calculate the amount to add back to profit in the adjustment of profit computation

assuming:

(a) The car has CO

emissions of 170 g/km

(b) The car has CO

emissions of 130 g/km.

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Answer

(a) £6,600x15%=£990willbedisallowed.

(b) As CO

emissions are less than 160 g/km, none of the rental cost will be

disallowed.

4.8 Gifts

The treatment of gifts in an adjustment of profit computation depends on the

recipient of the gift and nature of the gift.

Special rules apply as follows:

 Gifts to customers are not allowable for trading income purposes unless they

carry a conspicuous advertisement for the business and the total cost per

recipient does not exceed £50.

 Gifts of food, drink, tobacco or vouchers exchangeable for goods are not

allowable under any circumstances, whatever the cost, with or without an

advertisement.

 Gifts to employees are allowable for trading income purposes for the business

(but the employee may be taxed on the receipt of a benefit from employment).

4.9 Entertaining expenses

Expenses incurred in entertaining existing or potential customers or suppliers are

not allowable against trading income and therefore need to be added back in the

adjustment of profit computation.

However, expenses incurred in entertaining staff are allowable, provided the

entertainment is for staff and the cost is not part of the cost of entertaining others

(who are not staff).

4.10 Fines and penalties

Any costs associated with breaking the law, such as fines and penalties, are not

allowable for tax purposes and therefore need to be added back to the net profit.

However, parking fines incurred by an employee (but not the proprietor) while on a

business activity are, by concession, allowable against trading income.

4.11 Employee-related costs

The gross salaries of employees and other employee-related costs are allowable as

wholly and exclusively incurred. Other employee-related costs include expenditure

such as:

 the costs of providing benefits such as cars, accommodation, permanent health

insurance, death in service benefit, removal expenses, etc

 employer’s national insurance contributions

Chapter 5: Trading income

 employer’s pension contributions

 compensation for loss of office and redundancy pay

 counselling services provided for redundant employees, etc.

The business can claim all these employee-related costs in full as tax-allowable

expenditure, even if the employee enjoys the benefit of private use of assets (for

example, using a company car for both business and private mileage or a laptop for

both business and personal use).

Since these employee-related costs will have been deducted in full in arriving at the

figure of net profit, no adjustment will be required. However, the individual

employee will be personally assessed to income tax for the element of private use.

4.12 Trading income not recorded in the accounts

Most sources of trading income are correctly reflected in the financial statements of

the unincorporated business.

However, where the owner takes goods/stock out of the business for personal use

or for use by family or friends, the treatment in the accounts must be considered.

The transaction may not have been processed through the accounts at all, or may

have been accounted for at cost (which is the correct accounting treatment according

to UK GAAP).

In both of these circumstances, an adjustment of profit is required because the tax

rules state that the owner must be taxed on the profit of the transaction as if the

goods had been sold to a third party at full market value.

 If not recorded in the accounts, the full market value of the goods must be added

to profit.

 If recorded in the accounts but accounted for at cost, the gross profit that would

have been made on the transaction must be added to profit.

This rule does not apply to the supply of services from the business to the owner.

Paper F6 (UK): Taxation FA2009

Specifically allowable expenditure

 Specific allowable items

 Pre-trading expenditure

 Short leases on a property

 Expenditure paid personally by the owner and not recorded in the accounts

5 Specifically allowable expenditure

5.1 Specific allowable items

Many items of expenditure which are specifically allowed against trading profits

have already been mentioned in the explanations of specifically disallowable items.

There are, however, two other types of specific allowances available against trading

profits which have not yet been mentioned in detail. These relate to:

 pre-trading expenditure, and

 short leases.

5.2 Pre-trading expenditure

Expenditure incurred prior to the business’s first day of trading is, in principle, not

incurred wholly and exclusively for the purposes of the trade, as a trade does not exist at

that time.

However, tax law specifically permits pre-trading expenditure to be allowable

under the trading income rules, and treated as if incurred on the first day of trading,

provided the expenditure:

 was incurred within the seven years prior to the first day of trading, and

 would be allowable expenditure if incurred after the first day of trading.

5.3 Short leases on a property

Where a landlord grants a short lease on a property and receives a premium, this is

treated for tax purposes partly as property income of the landlord and partly as a

capital receipt.

The tenant who is granted the lease pays the premium to the landlord and in

addition is usually required to pay rent on a monthly or quarterly basis.

If the tenant uses the property for the purposes of a trade, in the financial accounts

the lease will be treated as follows:

 The premium is shown in the balance sheet as the cost of the lease.

Chapter 5: Trading income

 The premium is written off over the life of the lease against profit in each

accounting period (i.e. depreciation of the premium is charged against profit,

and is referred to as amortisation of lease in the accounts).

 Any rent payable is charged against profit for the period.

In the tenant’s adjustment of profit computation, the following treatment must be

applied:

 The rent payable is allowable for trading income purposes as wholly and

exclusively incurred; therefore no adjustment is required for the rent.

 The amortisation of the lease is capital-related and therefore is not allowable; it

must be added back to profit.

 A specific allowable deduction is available against trading profit instead of the

amortisation charge.

The annual allowable deduction is the landlord’s property income assessment in

respect of the premium received spread over the length of the lease. It is calculated

as follows:

Premium paid to landlord X

Minus 2% × premium × (n – 1) (X)

Property income assessment on the landlord (re the premium only) A

Annual allowable deduction against profit for the tenant = (A ÷ n) X

where: n = number of years of the lease

The allowable deduction against profit is sometimes called notional rent.

If the tenant obtained the lease part-way through their accounting period, the

notional rent must be time-apportioned according to the number of months the

lease was held by the tenant in the accounting period.

Example

Rupert owns a property which he decided to lease on 1 January 2010. He granted a

25-year lease to Susan for a premium of £98,000 and quarterly rent of £6,800 payable

in advance starting on 1 January 2010.

Susan prepares her accounts to 30 June each year. She has capitalised the lease on

her balance sheet and, in addition to the rent payable, she has charged amortisation

of £1,960 against her profit for the year ended 30 June 2010.

Required

Calculate the adjustments Susan needs to make to her profit for the year ended 30

June 2010 for trading income purposes.

Paper F6 (UK): Taxation FA2009

Answer

Adjustment of profit – Susan: year ended 30 June 2010

Add back Amortisation charge £1,960

Deduct Allowable deduction (see working below) £1,019

No adjustment is required in respect of the rent payable because:

 it has been charged against the profit, and

 it is tax allowable since it is incurred wholly and exclusively for the purposes of

the trade.

Property income assessment for Rupert in 2009/10:

Premium paid to Rupert 98,000

Minus 2% × £98,000 × 24

(47,040)

Property income assessment 50,960

Allowable deduction for Susan in year ended 30 June 2010:

Annual allowable deduction against profit

(£50,960 ÷ 25 years) 2,038

Allowable deduction for year ended 30 June 2010: £2,038 ÷ 6/12

(leased for 6 months of Susan’s accounting period)

1,019

5.4 Expenditure paid personally by the owner and not recorded in the

accounts

If an owner incurs a business expense and pays for it personally, the expense is still

allowable for income tax purposes (provided it complies with the normal rules for

allowable expenses). The expense can therefore be deducted in the adjustment of

profit computation.

A common example occurs where a sole trader uses a room in his home as an office

for business purposes. The business proportion of expenses incurred in heating and

lighting the room and a proportion of telephone calls etc is allowable expenditure,

even if paid for personally by the sole trader.