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LPC - BLP MODULE - CALCULATING TRADING PROFITS AND TAXATION (DISTINCTION)
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Notes on how to calculate trading profits and tax
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BLP – CALCULATING TRADING PROFITS AND TAXATIONCalculation of trading profits of a business.
A business may make two kinds of profit: income and capital.
If the profits are recurring by nature, they are likely to form income profits.
The way in which trading and other income profits are taxed depends on the format of the
business being carried on.
A sole traders income profits form part of his ‘total income’ for the purposes of income tax.
A company’s income profits are charged to corporation tax.
The income profits made by a partnership are divided amongst the partners and charged
either to income tax, in the case of individual partners, or to corporation tax if they are
corporate partners.
The way in which trading profits are calculated is broadly the same for both income tax and
corporation tax.
The rules are contained in different statutes.
Income Tax Legislation: Income Tax (Trading and Other Income) Act 2005.
Corporate Tax Legislation: Corporation Tax Act 2009.
A business must prepare accounts for an accounting period, usually of 12 months, to show
the profit or loss made by its trade. Although the profit and loss account for the accounting
period will be used as a starting point for ascertaining the figure which is taxable, some
adjustment will usually be required as some of the expenses likely to be shown on the profit
and loss account are not generally allowed as deductions for tax purposes and the
calculation must be revised to satisfy the tax rules prior to submission to HMRC.
For Tax purposes the trading profits or trading loss of a business for an accounting period
are calculated in the following way:
Trading profit = Chargeable receipts LESS any deductible expenditure LESS capital
allowances.
Chargeable Receipts.
To be chargeable receipts of the business must derive from its trade and be income rather
than capital in nature.
Trade.
o Despite the frequency with which trade appears in the tax statutes it does
not have a statutory definition.
o Ransom (Inspector of Taxes) v Higgs – ‘denote operations of a commercial
character by which the trader provides to customers for reward some kind of
goods or services’
o Receipts of the trade are those which derive from the trading activity rather
than from circumstances not directly connected with the trade.
Income
, o There are no clear-cut rules to determine when a receipt is income in nature
rather than capital/
o As a general rule if something is purchased for the purpose of resale at a
profit the money received from the sale of such an item will be of an income
nature.
o Receipts of a capital nature will generally derive from the sale of an asset
which was purchased for the benefit or use of the business on a more or less
permanent basis rather than for resale.
o A sum received as compensation for the cancellation of a contract for the
sale of goods is of an income nature because it represents what would have
been an income profit if the goods had been sold.
Deductible Expenditure.
In calculating taxable trading profits there must be deducted from chargeable receipts of
the trade any expenditure which is of an income nature which has been incurred ‘wholly
and exclusively’ for the trade and deduction of which is not prohibited by statute. (Section
35 ITTOIA 2005, Ch 4 Part 3 CTA 2009).
Expenditure of an ‘income nature’
o If expenditure on an item is incurred for the purposes of enabling the trader
to sell that item at a profit, it is of an income nature.
The expense to a trader of buying his stock is of an income nature and
deductible from chargeable receipts in calculating trading profits.
o Does the expenditure have the quality of recurrence?
All expenditure on general overheads such as electricity, telephone
charges, staff salary and rent have the quality of recurrence.
Interest paid on borrowing for business purposes will also generally
qualify as being expenditure of an income nature.
‘Wholly and Exclusively for the purposes of trade’
o Expenditure which has a dual purpose cannot be wholly and exclusively for
one purpose.
Common examples of deductible expenditure.
o Salaries
o Rent on premises
o Utility charges
o Stock
o Business rates
o Stationary/postage.
Capital Allowances.
Expenditure on capital items cannot, in principle, be deducted from chargeable receipts
when calculating trading profits for an accounting period because it is not of an income
nature.
This can cause severe cash flow problems for a business that needs to invest in expensive
capital items to help produce the goods or services in which it deals. In order to alleviate
this problem legislation allows a specified amount of the cost of certain capital items or
activities to be deducted each year in calculating trading profits.
The principle category covered is plant and machinery.
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