You can blame Napoleon for the existence of this chapter. Income tax as we know it today was introduced to pay for a war against the said gentleman. That was in 1799. It was so hated that when it was withdrawn in 1816 all the records were destroyed. However, Sir Robert Peel re-introduced the tax in 1842 and it has been with us ever since. The lowest standard rate ever charged was 2d in the £ (0.83%) between 1874 and 1876 and the highest was 10/- in the £ (50%) between 1941 and 1946.

Employees pay their tax by deduction from their wages under the PAYE scheme. However, self-employed people don’t come within the scope of the PAYE system. Instead they are taxed in arrears on the basis of their previous earnings.

How your business is taxed will depend upon the entity carrying on the business:

• sole traders and partnerships
• limited companies.

We’ll deal first with the taxation of sole traders and partnerships. The taxation of limited companies is discussed at the end of the chapter.

SOLE TRADERS AND PARTNERSHIPS

The method of working out the tax liability of sole traders and partnerships is practically the same, except that in the case of a partnership it’s necessary to work out each partner’s share of the total liability.

The taxes involved

The taxes that may be involved are:

• income tax – on profits
• Class 4 national insurance – on profits
• taxation on capital gains
• inheritance tax.

The last two taxes don’t normally occur each year. Inheritance tax might occur on death or occasionally on certain gifts. It can be complicated to work out the correct allowances and liability and the reader should get specialist advice if needed.

Capital gains arise on the sale of business (and other) assets. It taxes the increase in the value of the asset during the period of ownership. There are several allowances which relieve the effect of the tax. The main reasons why capital gains could affect a person in business are:

• the sale of certain equipment at a profit on its original cost, and
• more importantly, when a business or business premises are sold.

Again it is suggested that you obtain specialist advice as necessary.

Class 4 national insurance is calculated at the same time as the income tax liability, and these two taxes will be dealt with together.

Income tax

The accounting concepts (Chapter 8) go part way to defining the profit of the business, but there are some matters still left to the discretion of the accounts producer which affect the profit disclosed. The rate of depreciation, for example, is left to the individual. In addition accounts often include the full cost of running the proprietor’s motor car or other expense, where in practice part of these costs is for his own personal benefit. So that the Inland Revenue can apply the taxes on a standardised profit a computation is needed to adjust the profit disclosed by the accounts to that required by the Inspector of Taxes.

Figure 45 illustrates the way in which the adjustments are made to the accounting profit to arrive at the profit for taxation purposes.

In the computation some of the expenses are disallowed. These include depreciation (and the loss on the sale of a motor car) and also the private element of expenses that has been charged in the accounts. In the illustration the only private expense is the car, but on other occasions it might include the following:

• telephone charges (if home telephone bills are paid through the business)

heating and lighting rent and rates

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where the business is run from the proprietor’s home

This is not an exhaustive list: each case must be considered on its merits.

Where the proprietor uses goods from the business for his own purposes then an adjustment for this should also be made. If, for example, the business is a newsagents and the proprietor takes cigarettes for his own use the appropriate entries should be made. The removal of the cigarettes without payment changes the profit margin revealed by the accounts, and so the adjustment should ideally be made on the face of the accounts by adding those goods to sales (the other balancing entry of the double entry being included as drawings). However, if the adjustment is not made in the accounts it should be included as an ‘add back’ in the tax computations.

The result of disallowing or adding back expenses to the accounting profit is to remove the effect of charging them in the accounts in the first place.

The reasons for this should be clear for expenditure that is of a private nature. Less clear will be the reason for adding back depreciation: it is done to standardise the depreciation allowance.

As well as certain expenses being ‘added back’ in the computation some of the income is deducted to remove it from the assessable profit. This is not because it escapes tax but because the taxation treatment of this income differs from that of the profits. The main examples of items treated like this are bank interest received and property rental income.

Having arrived at the adjusted taxable profit there are various allowances that can be claimed in respect of depreciation.

Capital allowances

As stated above, it is up to whoever produces the accounts to set the rates of depreciation. This is unsatisfactory for the purpose of assessing income tax; accordingly the Inland Revenue have their own system of allowing depreciation called capital allowances.

Capital allowances at various rates are granted in respect of:

• general plant and equipment including motor vehicles
• industrial buildings
• agricultural buildings.

The rates of allowance for industrial and agricultural buildings are currently 4% of the cost of die asset for the first 25 years of the claim. Special rules apply where buildings are sold, or purchased before the full allowance has been claimed by the original owner.

The capital allowances scheme for general plant is based on a written down value at the rate of 25% p.a. However, you may claim a First Year Allowance at a rate of 40%. Thus if a new machine costs £1,000 the allowances on it would be as follows:

		£
Year 1	Cost	1,000
	Allowance 1,000× 40% FYA	400
		_____
		600
Year 2	Allowance 600× 25% WDA	150
		_____
		450
Year 3	Allowance 450× 25% WDA	112
		_____
		338

and so on.

In practice the allowance is not calculated for each item of plant; instead they are accumulated together in a pool. This applies to all types of plant and equipment including motor vans. The FYA items are initially included as a separate pool but it is added to the main pool after the First Year Allowance has been claimed. For more details contact an accountant or the Tax Office.

The exceptions are motor vehicles or other assets where there is an element of private use, and motor cars with an original cost exceeding £12,000. These items must each be calculated separately and each forms a separate pool value. Where there is private use the allowance must be restricted so that only the business proportion is claimed, but the value of the asset is reduced by the full 25% each year. For cars costing over £12,000 the Writing Down Allowance is restricted to a maximum of £3,000 p.a. Also note that First Year Allowance is not available on cars.

When assets are sold the proceeds are deducted from the appropriate written down value. This may then exhaust the particular pool and a negative value be obtained. In this case you will already have obtained more allowances than the loss in the value of the asset since acquisition. Accordingly the excess is clawed back by giving rise to a balancing charge. What if the sale is of the last of the assets within that particular pool? If there is any remaining unallowed positive value in the pool after deducting the proceeds, it shows that the annual allowances were not enough to grant relief for the loss in value since acquisition. Accordingly an additional allowance is given, the balancing allowance.

In some cases, where profits are low, it is not beneficial to claim capital allowances. This is because the tax on the profit will already have been relieved by personal allowances. If capital allowances are claimed then no further relief may be obtained but the value of the pool will be reduced and will therefore restrict allowances available in future years. In such circumstances it is possible to waive the claim to capital allowances for the year.

Net taxable profit

The adjusted profit (net of any capital allowances) is the taxable profit on which you must pay tax. This is rather like the gross pay of someone taxed under PAYE.

Under Self Assessment the basis period of a year of assessment is the accounting year ending within that tax year. Thus if a trader makes up his accounts to 31 December, his basis period for the income tax year 2003/2004 (6 April 2003 to 5 April 2004) is his accounts for the year ended 31 December 2003. There are special rules which apply during the first and last years of the business and there is overlap relief to ensure that the tax is charged on a fair basis. For more details of these rules you should refer to your accountant or to the Inland Revenue.

Unless your turnover (sales) is less than £15,000 then you will need to complete a detailed tax return for the Inland Revenue. This form asks for your accounts to be summarised to reveal the turnover, gross profit and the overheads analysed under 13 headings. There is also provision on the form to enter the expenses that have been disallowed in die calculation of the taxable profit. The actual accounts for your business are no longer sent to the Inspector of Taxes unless he/she specifically requests them.

The personal allowances available to the individual are deducted from the taxable profit and the tax calculated at the current rates on the resulting total. In addition, Class 4 national insurance contributions are payable on the taxable profits between £5,035 and £33,540 at a rate of 8% (2006/2007 rates). On profits over £33,540 Class 4 national insurance is charged at 1%. This is paid in addition to the flat rate Class 2 contributions of £2.10 per week.

If the venture incurs a taxation loss, the loss can be relieved against:

• other income of the same year, or
• the profits of the same trade in any future year.

If the business is a partnership the profit will have to be allocated between the various partners. The rules for doing this can be complex.

Finally, remember that the legal onus is on the individual to tell the Inland Revenue of all his sources of income. There are severe penalties for failing to disclose information. If you start up in business you should notify the tax authorities without delay. Don’t wait for them to contact you. The easiest way to advise them is by completing form CWF1 (available from the Inland Revenue website or tax offices) and sending it to the address shown on the form. There is a penalty of £100 if you fail to notify them within three months of the end of the month in which your business started.

You must also ensure that the information you give is accurate. Under Self Assessment the figures from the accounts are received and processed by the Inland Revenue without any form of review at that stage. The Inland Revenue will even calculate your tax for you based upon those figures but this does not mean that they accept and agree them. They have until a year after the filing deadline in order to review the accounts and raise any queries and if errors are found (perhaps because you have claimed an expense that should not have been allowed) penalties may be charged.

If you are in doubt about the taxation of your business then contact your local Inspector of Taxes, or discuss things with a qualified accountant. An accountant’s fee will usually be money well spent because they may be able to save you at least as much in tax.

Limited Liability Partnerships

With just a few modifications, LLPs are taxed in the same manner as ordinary partnerships (see above).

COMPANY TAXATION

We saw in Chapter 1 mat a limited company is a separate legal entity. As such it is responsible for the payment of its own tax on profits. It is not for the owners of the business to pay the tax themselves. An outline of the taxation structure for companies is set out in Figure 46.

In small companies, the owners of the business (the shareholders) are also often the directors. What the directors get by way of salary or bonus is taxable as a liability of them as individuals. In most cases the tax is

collected via the PAYE system in the company; the directors don’t normally pay the tax directly to the Collector of Taxes.

As with any other form of wages, directors’ remuneration is a company expense; it reduces the profit of the company charged to tax.

The profit of the business, after directors’ remuneration, is adjusted to arrive at the taxable profit in the same way as for individuals and partnerships (see earlier in this chapter). However, the taxation treatment of some items differs between individuals and companies. When an individual uses a business asset for private purposes it is normal to disallow part of the expenses charged in the profit and loss account by adding a proportion of the amount to the profit in the taxation computation. This increases the business profit chargeable to tax; since it is the responsibility of the individual to settle the tax liability it means that he/she must pay the tax on the benefit he/she has obtained.

Clearly, for a limited company responsible for its own taxation liability, it would not be right for it to suffer an extra liability on benefits provided to directors. Accordingly the value of these benefits is not adjusted within the company’s taxation computation; instead each director is assessed for income tax on the value of the benefits received.

Two stages of tax for companies

Since 1965 the profits of companies have been taxed in two stages:

• on the company profits for the year (corporation tax)
• on the distribution of profit to the shareholders by way of dividend.

At first sight this seems to tax the profits twice, but the system is so arranged that (with certain restrictions) the tax paid on company profits is not charged again when the profits are distributed to shareholders.

Corporation tax

Corporation tax is charged on the company profits for the accounting year. The rate of tax depends on the size of the profits and whether it has any associated companies.

For small companies which are not associated with others and do not receive dividend income the corporation tax rates for the 2006 Financial Year (year commencing on 1 April 2006) can be summarised as follows:

	Band	Rate(%)
On the first	£10,000	0
On the next	£40,000	23.75
On the next	£300,000	19
On the next	£1,200,000	32.75
Over	£1,500,000	30

Where there are dividends received or the company has associated companies the rules become more complicated and you should seek professional help.

Corporation tax is payable nine months after the end of the accounting period. So for example if the company’s year end is 31 January the tax will be payable on the following 1 November.

Dividends and tax credits

When an individual gets a dividend from a company, it comes with an associated tax credit. This means that if he/she is liable to tax at the basic rate he/she won’t have to pay any more tax. In other words the company has paid tax on the profits earned, so when the profits are shared among the shareholders via the dividend then they have already suffered tax and so don’t have to pay the tax again.

The rate of tax credit is 10% of the gross value of the dividend. For basic rate taxpayers this income is assessed at an ‘investment rate’ of 10% so there is no further tax due. For higher rate taxpayers the ‘investment rate’ is 32.5% and so allowing for the 10% tax credit there is a further 22.5% of tax to pay.

Capital gains in companies

Capital gains made by companies are worked out in the same way as for individuals, but they have to pay corporation tax at the relevant rate. If the company qualifies for small company relief then its tax rate will be 20%; if it doesn’t it will be 30%. The marginal relief also applies (see above).

The accounting implications of taxation

Since a limited company is a separate legal entity it is responsible for paying its own taxes. This is not like the sole trader or partnership, where the individuals running the business are responsible for paying the tax. The tax on their business profits will depend on their individual circumstances, such as their tax allowances and their taxable income from other sources.

Since taxation is an expense of the limited company it must be included in its accounts. As the liability to pay tax is due nine months after the company’s year end, then corporation tax will normally appear as:

• a charge in profit and loss account, and
• a creditor on the balance sheet.

SUMMARY

• Companies are responsible for their own taxation.
• Companies pay corporation tax on their profits.
• Dividends received by basic rate taxpayers do not attract a further tax liability.
• The liability to taxation should be included in the accounts of companies.