Trading Profits
Introduction
Badges of Trade
If an individual disposes of an asset, should that transaction be:
▪ Treated as a capital gain (CGT applies) or
▪ Treated as trading income (income tax applies)
Badges of Trade
Subject matter
Length of
Profit motive
ownership
Badges of
Trade
Reasons for Frequency of
sale transactions
Supplementary
work and
marketing
Thank you…
4
Trading Profits
Basic Calculation
Calculation: Tax Adjusted Trading Profit
As accounting profit is calculated according to international accounting standard (IAS) so
adjustment according to taxation rules is needed.
£
Accounting profit xx
Add : allowed income xx
Add : disallowed expenses xx
Less : allowed expenses xx
Less : disallowed income xx
Tax adjusted trading profit (TATP) xx
Calculation: Tax Adjusted Trading Profit
Step 1: Pick up profit amount from the question
Step 2: Read the detailed notes of the question
▪ If the item is incorrectly treated, make the necessary adjustment
▪ If the item is correctly treated, recognise the item in the Tax Adjusted Trading Profit
calculation but mark it as ‘0’.
Thank you…
8
Trading Profits
Disallowed Income
Disallowed Income
Treatment: if included in the profit amount, this is deducted from trading profit to avoid double taxation
▪ Rental income
▪ Interest income
▪ Dividend received
▪ Profit on disposal of fixed asset
▪ Capital insurance receipt
▪ Interest received on overpaid taxes
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11
Trading Profits
Allowed Income
Allowed Income
Treatment : If not already included, it is added to the trading profit
▪ Any income item that would normally be considered as trade receipt
▪ Drawing of stock by the owner
• If the drawing has been recorded in the accounts: add the profit element to the trading
profit
• If the drawing has not been recorded in the accounts: add the selling price in the
trading profit amount
Example
Joshua is running his own business and for the current period of account, his trading profits amount
to £130,000.
This amount is before taking account of any adjustment for the goods that Joshua took from the
business, for personal use. The cost of the goods withdrawn was £900 and they had a selling price
of £1,250.
Identify if and how this adjustment will affect Joshua’s trading profit amount of £130,000, if:
1. No entry has been made of the drawings of the stock
2. If the cost of goods have been adjusted to reflect the stock withdrawn
Solution
▪ Example of allowed income
▪ Trading profit amount of £130,000 to be increased, if not already included
1. Selling price of £1,250
As no adjustment made – so full selling price to be incorporated
2. Profit element of £350 [£1,250 - £900]
As cost of goods have already been adjusted – only profit element needs to be
incorporated
Thank you…
16
Trading Profits
Expenditure
Disallowed Expenditure
Treatment: Add back in the trading profit
▪ Depreciation
▪ Any item not wholly and exclusively related to trade
Allowed Expenditure
Treatment: Deducted from trading profit
▪ Capital allowances (tax depreciation calculated on plant and machinery according to
HMRC rules and regulations)
▪ Structure and Buildings Allowance (tax depreciation on buildings)
▪ Pre-trading revenue expenditure incurred 7 years prior to the commencement of trade –
treated as expense on first day of trading
▪ Short lease premium payment
Example: Pre-trading expense
Alfred commenced trading as a sole trader on 1 September 2022 and prepared his first set of
accounts for the seven-month period ended 31 March 2023. His tax adjusted trading profit for this
period was £63,000. This was before accounting for the £5,000 business marketing expense incurred
in January and February 2022.
Solution
• Business marketing expense is a pre-trading expense – incurred in 7 years prior to start of business
• Will be considered as having taken place on first day of trading
• £5,000 is an allowable expense, to be deducted from £63,000
Example: Short term lease premium
On 6th April 2022, Fallon leased a property for 10 years, from Leno, for use in his business.
Fallon pays a premium of £48,000 for it apart from the annual rent of £9,100.
Solution
• Per annum rent expense of £9,100 – allowable business expense
• Per annum amount of the premium assessable – also an allowable business expense
P – [P x (2% x (n- 1)] 48,000 – [48,000 x 2% x (10 – 1)] 39,360
= = = £3,936 per annum
No. of years in the lease 10 10
Thank you…
22
Trading Profits
Expenditure: Guidelines
Revenue vs Capital Expense Items
General Expenses
Revenue expenses: Capital expenditure:
Allowed Disallowed
Donations
Donation
Religious, educational,
Political party & gift aid
culture, charitable:
donation: Disallowed
Allowed
If:
Donation is of reasonable amount
Donation is made to organization
operating at a local level
Legal Fees
Legal Fees
- Related to acquisition
- Related to business
of fixed asset
- Related to renewal of
- Issuance of ordinary
short lease
shares
Allowed Disallowed
Fines and Penalties
Fines and Penalties
Car parking fine incurred by
All other fines: Disallowed
employee: Allowed
Entertainment
Entertainment
Customers/ Suppliers:
Employees: Allowed
Disallowed
Gifts
Gifts
Customers/ Suppliers:
Employees: Allowed
Allowed
If:
- Cost of gift should be ≤ ₤50
- Gift should carry eye catching advertisement of
trade
- Gift should not be food, drinking, tobacco item or
voucher exchangeable goods
Fees, Subscriptions, Interest on Loan
Fees/ Subscriptions, Interest
and incidental cost of loan
Trade related: Allowed Non-trade related: Disallowed
National Insurance Contributions
National Insurance
Contributions
- Class 1 - Class 2
- Class 1 A - Class 4
Related to employee: Related to employer/
Allowed sole trader: Disallowed
Irrecoverable Debts
Bad Debts and provision
- Non-trade related
Trade related - Loan to employee
written off
Allowed Disallowed
Car Lease
Car lease rental
CO2 emissions
≤ 50g/km: Whole > 50 g/km: 15% of
business portion of the business portion
expense is Allowed is Disallowed
Miscellaneous Expense Items
▪ Educational courses related to trade are allowed expenditure
▪ Loss due to theft by employee is an allowed expense
▪ Fines and penalties related to any criminal offences are disallowed
▪ Damages paid if related to trade (and not for breach of law) are allowed
▪ Contribution to approved pension scheme for employees are allowed
▪ Appropriation account, salaries paid to partners and interest on capital are disallowed
Thank you…
35
Trading Profits
Exam Layout
£ £
Net Profit as per Accounts
+ Disallowed Expenditure:
▪ Expenses not related to trade
▪ Capital expenditure including initial repairs
▪ Depreciation/ Amortisation/ Impairment of assets
▪ Fines or penalties – unless incurred by employee
▪ Element of personal expense by owner
▪ Extra salary payments to owner’s relatives
▪ Gift aid donation
▪ Loss on disposal of assets
▪ Entertainment of suppliers and customers
▪ Donations to political parties/ national charities
▪ 15% of lease rent for motor cars emitting > 50 g/km CO2
+ Allowed Income:
▪ Drawings of goods by owner
▪ Impaired debt recovered
- Disallowed Income:
▪ Rental income
▪ Bank interest
▪ Dividend income
▪ Profit on disposal of assets
- Allowed Expenditure:
▪ Any expense ‘wholly and exclusively’ related to trade
▪ Revenue natured expenses such are regular repairs etc
▪ Impaired debts or provision for these (as per UK GAAP or IFRS)
▪ Entertainment and gifts for employees
▪ Donations to local charities for advertisement
▪ Gifts to third parties provided ≤ £50 per person per annum;
not food/ drink/ tobacco items and given for purpose of advertisement
▪ Gifts of inventory as samples
▪ Capital Allowances or/ and Structures and Building Allowances
TAX ADJUSTED TRADING PROFIT
Example
Tom had a profit before taxation amount of £600,000 for the period of account ended 31 March 2023. This had been
arrived at after the following adjustments:
Income:
▪ Profit from disposal of an asset: £40,000
Expenses:
▪ Depreciation of assets: £54,000
▪ Gift Aid Donation: £5,000
▪ Staff dinner: £7,000
Tom’s accountant later informed him of the following 2 pieces of information:
▪ The goods withdrawn by Tom for his own use have not been accounted for. Their sales value was £12,000
▪ Capital Allowances for the year ended 31st March 2023 were calculated as £41,000
Solution
TATP Y/E 31 March 2023 £
Profit as per accounts 600,000
Profit from disposal of asset (40,000) ▪ Profit from disposal of an asset: £40,000
Depreciation 54,000 ▪ Depreciation of assets: £54,000
Gift Aid Donation 5,000 ▪ Gift Aid Donation: £5,000
Staff dinner 0 ▪ Staff dinner: £7,000
Drawing of inventory 12,000
▪ The goods withdrawn by Tom £12,000
Capital Allowances (41,000)
▪ Capital Allowances £41,000
Tax Adjusted Trading Profit 590,000
Solution
TATP Y/E 31 March 2023 £
Profit as per accounts 600,000
Profit from disposal of asset (40,000)
Depreciation 54,000 Tom – Income Tax Computation – 22/23
Gift Aid Donation 5,000 NSI
Staff dinner 0 £
Drawing of inventory 12,000 Trading Profits 590,000
Capital Allowances (41,000) Property Income ???
Tax Adjusted Trading Profit 590,000
Total Income ???
Personal Allowance (12,570)
Taxable Income ???
Thank you…
41
Trading Profits
Cash Basis
Criteria: Cash Basis
▪ Joining criteria: if cash receipts in a year are ≤ £150,000
▪ Discontinuation criteria : if cash receipts in a year become > £300,000
Cash Basis: Rules
▪ Cash received and paid in the current period of account is picked up regardless of which
period it actually relates to
▪ There is no distinction between revenue and capital transaction so assets purchased are a
cash expense when paid (this excludes motor cars) and assets sold generate cash receipts
▪ Capital allowances are non cash items so they are ignored except for on motor cars
Cash Basis: Format
Receipts (including sale of equipment) xxx
Expense payments (including the purchase of equipment) xxx
Trading profit (or loss) xxxx
Cash Basis: Cars
▪ The actual running and capital costs of owning a motor car are ignored.
▪ A business using the cash basis can use the approved mileage allowances to calculate the
deduction for business mileage.
The rate is 45p per mile for the first 10,000 miles, with a rate of 25p per mile thereafter.
Cash Basis: Personal Expenses
▪ If personal use is being made of the building that has been acquired for trade, then instead
of working out the portion of expenses that will be disallowed, a fixed amount will be given
in the exam.
Cash Basis: Trading Loss
Trading Loss can only be carried forward and adjusted against future trading profit
Thank you…
49
Trading Profits
Partnership
Partnership
Step 1: Make the required tax adjustments to the Accounting Profit figure.
▪ Drawings of inventory by any of the partners/ owners
Sales value recognized as allowable income
▪ Personal use of asset or personal element in expense
Only business portion of expense is allowed – personal element is treated as disallowed
Partnership
Step 2: Refer to the Partnership Agreement
▪ Salary to partner – if any
▪ Interest on capital – if any
▪ Profit/loss split as per Profit Sharing Ratio
Changes in Partnership
▪ Partner joining the business
▪ Partner leaving the business
▪ Changes in the Profit Sharing Ratio
Example
A, B and C have been in partnership for several years’ and prepare accounts to 30 June annually. Profits
have always been shared equally after allocation of salaries of £10,000 and £8,000 to A and B
respectively and interest on capital of 5% to each of the three partners. The partners have capital
invested amounting to:
A £20,000
B £16,000
C £12,000
On 31 December 2021, C left the partnership and withdrew his capital to start his own business. The
remaining two partners continued with the same salaries and interest on capital, sharing any balance
equally between them. The adjusted profit of the partnership for tax purposes for the accounting year
ending 30 June 2022 was £120,000.
Required:
Calculate the profit share attributable to each partner for the accounting period ending 30 June 2022.
Example continued
Year ended 30 June 2022:
TATP £120,000
1 July 2021 – 31 December 2021:
3 partners: A, B and C
TATP £60,000
1 January 2022 – 30 June 2022
2 partners: A and B
TATP £60,000
Solution
Share of Partnership profits
A B C Total
£ £ £ £
July – December 2021
Salary 5,000 4,000 - 9,000
Interest on capital 500 400 300 1,200
Profit share 16,600 16,600 16,600 49,800
22,100 21,000 16,900 60,000
January – June 2022
Salary 5,000 4,000 N/A 9,000
Interest on capital 500 400 N/A 900
Profit share 25,050 25,050 N/A 50,100
30,550 29,450 0 60,000
Total 52,650 50,450 16,900 120,000
A B C
£ £ £
July – December 2021 16,900
July 2021 – June 2022 56,250 50,450
Basis Period 22/23 22/23 21/22
A – Income Tax Computation – 22/23 B – Income Tax Computation – 22/23 C – Income Tax Computation – 21/22
NSI NSI NSI
£ £ £
Trading Profits 56,250 Trading Profits 50,450 Trading Profits 16,900
Total Income ??? Total Income ??? Total Income ???
Personal Allowance (12,570) Personal Allowance (12,570) Personal Allowance (12,570)
Taxable Income ??? Taxable Income ??? Taxable Income ???
Thank you…
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