TXF6 UK
Syllabus B. Income Tax And Nic Liabilities B3. Income from self-employment

B3c. Allowable expenditure 3 / 11

Syllabus B3c)

Recognize the expenditure that is allowable in calculating the tax-adjusted trading profit.

Adjusting the accounting profit

Allowable or Disallowable expenses?

Net Profit (PBIT) is adjusted to arrive at Trading profit

The main adjustments are to disallow for tax certain non-allowable expenses and to exclude any non-trading income. 

You must keep in mind that allowable expenses are usually expenses incurred directly because of the business. 

Personal expenses are not allowable.

The general rule is that expenditure not wholly and exclusively for the purpose of the trade is not allowable

£
Net profit X
ADD BACK: Disallowable expenses X
LESS: Income assessable elsewhere (X)
LESS: Non-taxable income (X)
LESS: Capital allowances (X)
Tax adjusted trading profit X

Note:

When preparing this calculation, be careful to start with the NET profit per accounts.

Disallowable expenses

The following expenses are disallowed by a business.

Therefore, if they have been deducted to arrive at net profit, they must be added back.

For example, if the net profit is £10,000 and a disallowed expenses (£1,000) has been deducted, then tax adjusted profit will be £10,000 + £1,000 = £11,000

  • Capital expenditure including depreciation is not allowable

    Note: 
    Repair to an asset is revenue expenditure and is allowable 

    Improvement to an asset is capital expenditure and is not allowable

    For example, purchasing a building to carry out trade in is a capital expense and disallowed, but repairing this building is revenue expense and allowed.

  • Reliefs
     
    - such as qualifying loan interest payments are not allowable as they are dealt with as a deduction from total income. 

    For example, paying interest on a loan used to purchase inventory is known as a qualifying loan interest, this is already deducted under a different heading in the income tax computation, therefore it cannot be deducted again.

  • Entertaining and gifts

    Entertaining is disallowed, unless entertaining employees

    For example, spending money to entertain suppliers of stock is disallowed.

  • Subscriptions and donations

    National charity donations are not allowable

    Charitable donations (made under Gift Aid) these are not allowable as tax relief is given by extending the tax bands when calculating income tax.

    Political donations - these are not allowable

  • Fines and penalties

    Disallowed unless the fine is paid on behalf of an employee and incurred whilst on business

    For example, if the employee receives a parking ticket whilst delivering goods to a customer, this is generally allowable by HMRC.

    A fine for poor health and safety would not be allowable.

  • The owner’s salary, or drawings or interest on capital invested in the business are disallowed

    For example, if the owner of the business pays himself 10% interest on the capital that he has invested of £200,000 - this £20,000 interest is disallowed and cannot be deducted.

  • Interest paid on overdue tax is not deductible and interest received on overpaid tax is not taxable

    For example, if interest is payable of £100 due to the late payment of tax  - this is not allowed and cannot be deducted to arrive at taxable income.

  • Irrecoverable Debts (Trade debt write offs & allowances)

    These are allowable; the tax treatment follows the accounting treatment 

    However non trade write offs are not allowable and so the expense is added back.

    For example if an item of trading inventory was sold on credit, but the actual cash never came from the customer, then this is an irrecoverable debt which is an allowable expense. 

    For example a loan was made to an employee and then the employee left without paying it back and it was written off, then this is an irrecoverable debt, but it is disallowed because it is not a trading item.

Allowable expenses

If they have not been deducted to arrive at tax adjusted profit, they must be. 

For example if net profit is £10,000 and there is an allowed expense of £1,000 that has not been deducted, then the tax adjusted profit will be £10,000 - £1,000 = £9,000

However, If they are correctly deducted, you will indicate these expenses with 0 in the exam, because these items do not require adjustment.

For example if net profit is £10,000 and there is an allowed expense of £1,000 that has been deducted, then the tax adjusted profit will be £10,000 and you will indicate the allowed expense with 0.

  1. Entertaining and gifts

    Gifts to employees are allowable

    Gifts to customers are only allowable if

    • they cost less than £50 per person per year, and 

    • the gift is not food, drink, tobacco or vouchers exchangeable for goods and services 

    • the gift carries a conspicuous advertisement for the business.

    For example as Christmas presents, a sole trader can give his customers pens with the company logo printed on them as gifts, as long as they cost less than £50 per customer.

  2. Subscriptions and donations

    Trade or professional association subscriptions are allowable 

    Charitable donation (Not made under Gift Aid) 

    • if it is wholly and exclusively for trading purposes (e.g promoting business’ name), and it is to a local charity then it is allowable

    For example if a donation was made to a local charity and in return, at the charity fundraiser, the business was shown as a sponsor/organizer, then this would be an allowable expense.

  3. Legal and professional charges

    Allowable if connected with the trade and are not related to capital items specifically allowed by statute: 

    • costs of obtaining loan finance 

    • costs of renewing a short lease (50 years or less)

    For example if a loan was taken out to purchase inventory for trading, the legal costs associated with obtaining this loan and the interest cost of the loan are considered to be allowable expenses.

  4. Interest payable

    Interest paid on borrowings for trading purposes is allowable on an accruals basis therefore no adjustment is needed.

    For example if a loan was taken out to purchase inventory for trading, the interest cost of the loan are considered to be allowable expenses.

  5. Premium paid for the grant of a lease

    The premium itself is disallowed as is any amortization of the premium.

    The allowable amount is: 

    (51 – n)/50 ×    Premium

    An alternative calculation that you may have seen before is: 
    Premium - (2% x (n-1) x Premium)

    n = number of years of the lease

    This is shown in Topic: Premiums granted for short leases.

  6. The private expenditure of the business owner

    If the owner uses a car in the business and 20% of his mileages private, then only 80% of motor expenses are allowable. 

    However if the owner provides an employee with a car, and 20% of the mileage is for private use by the employee, then the full amount of motor expenses is allowable. (The employee is taxed on the private use under Employment Income).

    Private expenses example
    If the owner uses his own 4 storey premises as his place to conduct trading and incurs expenses of £1,000, but he also lives on one of the floors, then 1/4 of the expenses have been used for private purposes and £250 will be disallowed and £750 will be allowed.

  7. Any salary paid to the family of the owner of the business must not be excessive. Only salary at the commercial rate for the work done is allowable.

    For example John ran his business as sole trader and employed his wife Mary to work for him as a sales executive. Other sales executives are paid £750 per week, but his wife was paid £1,000. Only £750 will be an allowable expense, because the remaining £250 will be considered to be excessive.

  8. If an owner removes goods from the business for his own use he must add back the item as a sale at market value, unless the owner accounts for the cost of the goods in the business accounts then they need only add back the lost profit on the item.

    For example if the owner of a business takes goods from his store that cost him £750 and would normally be sold for £1,000. He must either record the sale of £1,000 and deduct cost of £750 - therefore increasing the profit of his store by £250.

    Or, he can simply add £250 to the net profit in his accounts.

    This would only work if the owner has not included the purchase figure in the accounts.

    Read the question carefully, for example, if the owner had included the item in purchases, then the sale of £1,000 would need to be added to profits in order for there to be an overall profit of £250 left to tax.

  9. Pre-trading expenditure

    – allowable if it is expenditure incurred in the seven years before a business commences to trade then it is treated as an expense incurred on the day the business starts trading and follows the above rules.

    This is shown in Topic: Relief for pre-trading expenditure.

Illustration:

Sunny is self-employed running a retail shop. 

Sunny’s statement of profit or loss for the year is as follows:

£ £
Gross Profit 140,880
Expenses:
Depreciation 4,760
Light and heat (Note 1) 1,525
Motor expenses (Note 2) 4,720
Professional fees (Note 3) 2,300
Rent and rates (Note 1) 3,900
Repairs and renewals (Note 4) 5,660
Sundry expenses (Note 5) 2,990
Wages and salaries (Note 6) 84,825
110,680
Net profit 30,200

Notes

Note 1: Private accommodation

Sunny and his wife live in a flat that is situated above the clothing shop. 

Of the expenditure included in the statement of profit or loss for light, heat, rent and rates, 40% relates to the flat.

Note 2: Motor expenses

During the year, Sunny drove a total of 12,000 miles, of which 9,000 were for private journeys.

Note 3: Professional fees

Professional fees are as follows:
£
Accountancy - including £250 in respect of a capital gains tax computation. 700
Legal fees in connection with the purchase of the clothing shop 1,200
Debt collection 400
Total 2300

Note 4: Repairs and renewals

The figure of £5,660 for repairs and renewals includes £2,200 for decorating the clothing shop, and £1,050 for decorating the private flat.

The building was in a usable state when it was purchased.

Note 5: Sundry expenses

The figure of £2,990 for sundry expenses, includes £640 for gifts to customers of food hampers costing £40 each, £320 for gifts to customers of pens carrying an advertisement for the clothing shop costing £1.60 each, £100 for a donation to a national charity, and £40 for a donation to a local charity’s fete. 

The fete’s programme carried a free advertisement for the clothing shop.

Note 6: Wages and salaries

The figure of £84,825 for wages and salaries includes the annual salary of £15,500 paid to Sunny’s wife. 

She works in the clothing shop as a sales assistant. 

The other sales assistants doing the same job are paid an annual salary of £11,000.

Note 7: Goods for own use

During the year, Sunny took clothes out of the shop for his personal use without paying or accounting for them.

The cost of these clothes was £460, and they had a selling price of £650.

Note 8: Plant and machinery

The capital allowances available for the year are £13,060.

(In the actual examination you may be required to prepare a capital allowances computation and work out this figure. - see Topic B.3.h)

Calculate Sunny’s tax adjusted trading profit.

Solution:

Tax adjusted trading profit
£ £
Net proft as per accounts 30,200 
Add: Items debited in P&L – not allowed for tax purposes 
Depreciation 4,760 
Light and heat (40% × £1,525)  610
Motor expenses (9,000/12,000 × £4,720) 3,540
Personal tax work  250
Legal fees re purchase of new shop (capital)  1,200
Rent and rates (40% × £3,900)  1,560
Decorating private flat  1,050
Gift of food hampers  640
Donation to national charity 100
Excessive remuneration to Sunny’s wife 
(£15,500 – £11,000)  4,500
Own consumption (goods were included in purchases) 650
18,860
Adjusted trading profIt  49,060
Less: Capital allowances (given - note 8)  (13,060) 
Tax adjusted trading profIt  36,000

Note: Personal taxation expense has been added to the net profit because personal expenses are not allowable.

Note: The purchase amount for the shop has been added back because this is not a trading revenue expense, this is a capital expense.

Note: The donation to the local charity is allowable but the donation to the national charity is not allowable.