Chapter 28

Tax

You have a choice when sorting out tax on your business: enlist a professional or do it yourself. If you operate as a company, it makes sense to use an accountant or a book-keeper. If you are a sole trader or partner, it can be helpful to use a professional to present your accounts and tax calculations but, provided your business is fairly simple and you have the time, you should be able to do this yourself, and the self-assessment tax system is designed to be workable by non-experts. However, you may still wish to use a professional so that you can devote more of your time to activities you might consider more important, such as getting sales, or developing your product.

If you use a professional to help you prepare your accounts and tax returns, make sure you choose someone who is suitably competent, normally a qualified accountant. Even if you use a professional, you are still ultimately responsible for making the correct declarations and paying the correct tax. If your adviser gets it wrong, you will be the one facing investigations, fines and interest – although you might be able to sue the adviser if they had acted negligently or fraudulently. You may also find that, although professionals will do the paperwork for you, they will not necessarily suggest ways you can save tax unless you specifically ask for their opinion on a particular measure.

Under the self-assessment tax system which you must use if you are self-employed or in a partnership, you can submit your tax return and rely on HM Revenue & Customs (HMRC) to calculate your tax bill for you. Even then, you are still responsible for the accuracy of your bill and expected to make reasonable checks to see that HMRC have got the figure right. You can be fined if you fail to spot an HMRC error.

To keep your tax bill to a minimum and guard yourself against advisers who are no good or HMRC errors, it pays to know a bit yourself about the tax system.

Note that the government has proposed a major change in the way small businesses and the self-employed report their income and tax to HMRC. It is planned that from your first accounting period starting on or after 6 April 2023, self-employed businesses and landlords with income above £10,000 a year will need to follow the digital tax rules. (For companies, corporation tax will become digital from 2026 onwards). If you wish before 6 April 2023, you can voluntarily use software to keep business records digitally and send income tax updates to HMRC, instead of filing a self-assessment return. However, there is a cash flow disadvantage in doing this.

To follow the rules for making tax digital you need to:

• keep digital business records
• get compatible software
• send business income and expenses updates during the accounting year
• submit a final declaration instead of a self-assessment return.

You need to sign up on HMRC’s website. You will find links on www.gov.uk/guidance/find-software-thats-compatible which take you to the current range of software available for that task, including some free versions.

This chapter was last updated in May 2021. There may have been changes that have taken place since that date. Updates are posted on go.pearson.com/uk/he/resources that should keep you abreast of important new information.

The Chancellor announced the introduction of eight new “Freeports” around England which will attract favourable tax and other incentives. These include:

• An enhanced 10% rate of structure and building allowances for the construction of structures and buildings brought into use on or before 30 September 2026.
• Enhanced capital allowances on qualifying expenditure by companies on or after site designation until 30 September 2026 on plant and machinery for use within Freeport tax sites.
• Stamp duty land tax relief for purchases of land and buildings within a Freeport tax site, subject to a “control period” of up to three years and the land being acquired and used in a “qualifying manner”.
• A five-year period of business rates relief in Freeport tax sites in England for new and certain expanding businesses for periods commencing before 30 September 2026.
• Relief from employer national insurance contributions for eligible employees in all Freeport tax sites from April 2022 until at least April 2026, subject to parliamentary approval.

What is in this chapter?

This chapter concentrates on tax if you are a sole trader and describes the current system, not the digital system to be introduced from 6 April 2023. It will not answer every question you may have about how your income tax bill is calculated. But you should be able to gain a working knowledge of the system so you know the key moves to make in dealing with your tax inspector. It does not cover how you are taxed if you run your business in the form of a limited company.

The chapter includes sections on:

• Cash-basis accounts (see below).
• When you pay income tax (p. 372).
• Working out your income tax bill (p. 377).
• Business expenses (p. 378) and tax relief for capital expenditure (p. 383).
• Losses for the self-employed (p. 388).
• Other taxes you might pay: National Insurance contributions (p. 390), capital gains tax (p. 390).
• You and HMRC (p. 392).
• Spare-time earnings (p. 394).
• The black economy (p. 396).

For business rates, see p. 203.

While this chapter focuses on tax for the self-employed, if you run a company and your profits are less than £50,000, you pay tax currently at 19 per cent and it is planned that this will continue. However, from April 2023, corporation tax for companies with profits of £250,000 or more will pay tax at 25 per cent and for profits between £50,000 and £250,000, the rate will be worked out on a sliding scale between 19 and 25 per cent.

Cash-basis accounts

If your business is likely to provide you with sales of £150,000 a year or less, you may be able to opt to avoid using traditional accounting methods and instead base your accounts on what’s known as a ‘cash basis’. This can simplify your life, though there may be some circumstances when it’s the wrong choice to make. And if your sales grow to £300,00 or more, you will have to revert to traditional accounting. The difference between the two methods is that with the cash basis you draw up your accounts based on the cash you receive and pay out in your accounting year. With the traditional accounting method, you draw up your accounts based on what you owe and what you are owed during the accounting year. Sometimes the two methods are the same, but, for example, if you have sent out an invoice for work done and not received payment before the end of the accounting year, the two methods will diverge.

When you pay income tax

If you have been an employee, you’ll have been used to having income tax deducted from your pay before you get it. If you are a sole trader or partner (p. 394), you’ll have to get used to setting aside part of your profits to pay tax as it falls due, though this will change when digital tax accounts become compulsory.

Everything to do with income tax is worked out by reference to tax years. A tax year runs from 6 April one year to the following 5 April. Your tax bill for a particular tax year falls due in three instalments. There are two equal interim payments that are due on 31 January within the tax year and on 31 July following the end of the tax year. These are estimates based on your previous year’s income tax and class 4 NIC liability. There is then a final payment or refund that is made on the following 31 January once your tax bill has been agreed with HMRC.

The interim payments are estimated by initially setting each one equal to half your tax bill for the previous year. If you know your income will be less this year, you can ask for the interim payments to be reduced. If your profits are rising, your interim payments will come to less than you owe. This means, on 31 January, you will have a final payment to scoop up the shortfall and an increased interim payment for the coming year. For example, suppose you have paid two interim payments of £3,000 the tax year just ended (£6,000 in total) but your final tax bill is £8,000. By 31 January, you’ll have to pay a £2,000 final payment plus £4,000 as a first interim payment for the current tax year – in other words, £6,000. Make sure you set aside enough to cover the jump in the interim payment as well as the final payment.

Provided you are registered to make your tax declarations online (see pp. 376, 408), you can arrange voluntarily to pay tax weekly or monthly by direct debit (called a Budget Payment Plan). These are still estimated payments and you may still have a final balancing payment to make on 31 January following the end of the tax year. However, you can adjust the amount you pay at any time, for example, increasing the amount if your profits look as if they will be higher than you had initially expected. A Budget Payment Plan may help you to set aside enough to meet your tax bills. You can find details of how to set up a plan on the HM Revenue & Customs (HMRC) web site.

Which profits are taxed?

Although tax relates to tax years, profits relate to accounting years, which do not necessarily coincide with tax years. You are usually taxed on a ‘current year basis’, which means that your bill for a tax year is based on profits for the accounting year ending during that tax year. For example, if your accounting year ends on 30 April, your bill for the tax year to 5 April 2023 will be based on your accounts for the year to 30 April 2022. But special rules apply in the first years of your business (see below), unless you opt for ‘fiscal accounting’.

With ‘fiscal accounting’, your accounting year is the same as the tax year (i.e. both end on 5 April). In practice, your accounting year does not have to be exactly the same – for example, a year-end of 31 March also counts.

Starting a business

If you have opted for fiscal accounting – see above – there are no special rules applying to the opening years of your business. Right from the word go, you are simply taxed on the profits you make each tax year.

If you have some other year-end, different rules apply for the first one, two or sometimes three tax years of your business. To find out which rules apply, follow these steps:

To decide what profits you have made in a 12-month period or your actual profits for a tax year, you take a proportion of the profits for the relevant accounting period. You do this using either days or months. For example, if your first accounting period lasts 14 months and 2 months fall within the first tax year, in the first tax year you are taxed on 2/14 × profits for the 14-month period.

You cannot do these sums until you have reached the end of the relevant accounting period and have the final accounts. But that does not mean you can put off paying your tax bill. Initially, you will have to estimate what your profits are likely to be and pay tax based on these provisional figures. You then correct the figures and your tax bill as soon as you have the actual profit data.

Overlap profits

Under the opening year rules for a new business, some profits are taxed more than once. In Example 1, David is taxed on 2/16 + 12/16 + 12/16 = 26/16 of the profits for his first accounting period – that is £13,000 instead of the actual £8,000 for the period. The excess £13,000 − £8,000 = £5,000 is his overlap profit. You normally do not get tax relief on overlap profits until your business finally ceases. In the meantime, overlap profits are not increased in line with inflation, so the tax relief might not be worth much in real terms by the time you finally get it.

Choosing when to end your accounting year

You will need to weigh up a number of factors when deciding the best date on which to end your accounting year:

• Fiscal accounting – see p. 373 – makes your tax affairs very simple but will give you the least time to draw up your accounts to meet the self-assessment deadlines (see below).
• A year-end early in the tax year maximises the delay between earning your profits and paying tax on them. This is good for cash flow if your profits are rising. You also have plenty of time in which to draw up your accounts. On the other hand, a year-end early in the tax year will involve higher overlap profits. You probably won’t get tax relief on these for many years and in the meantime inflation will have eroded its value.

If your business is already established, you can choose to alter your year-end. In that case, you might be able to claim some or all of your overlap relief early, but whether overall the change works to your advantage depends on the pattern of profits for your particular business. Get advice from your accountant.

The self-assessment timetable

Under current self-assessment rules, you are required to send HMRC a tax return each year and to pay your tax bill by the due dates. If your profits are £83,000 and your accounting year matches the tax year, you can send in what's known as a short supplement. Otherwise you'll have to use a longer form.

You are responsible for working out how much tax to pay, though you can ask your tax office to do the sums provided you get your return back early enough. Alternatively, if you send in your return via the Internet, your tax bill is automatically worked out for you. If you send back your return late, there are automatic penalties. Similarly, if you pay your tax late, you will be charged interest and possibly fines too. The key dates for your 2021–22 tax bill are given below and you can work out the key dates for your 2022–23 tax bill by simply advancing the dates by one year. However, from the start of your first accounting year period on or after 6 April 2023, this system will no longer apply. You will need to operate a digital tax account and pay tax as you go.

The year 2022

• 31 January First instalment (called a ‘payment on account’) of your tax bill for 2021–22 is due. It is usually set at half your tax bill for the previous year (2020–21).
• 5 April End of 2021–22 tax year.
• April Receive notice to file a return for 2021–22 online or you can download a blank form to fill in or request HMRC to send you a paper version.
• 31 July Second payment on account for 2021–22 tax bill. This is usually set at half your tax bill for the previous tax year (2020–21).
• 31 October Deadline for sending in your 2021–22 tax return if you are using the paper version. If you miss it, you will either have to file online instead or face a late filing penalty if you stick with the paper return.
• 30 December Latest date for filing your return online if you owe less than £3,000 tax and want it to be collected through PAYE (where you are also getting earnings from a job or a pension) throughout 2023–24 instead of as a single lump sum by 31 January 2023.

The year 2023

• 31 January Last date for filing your 2021–22 tax return online. If your two payments on account come to less than the final bill, you must send in your payment for the remaining tax by this date.

The year 2024

• 31 January Your 2021–22 tax return becomes final 12 months after the date you filed it, so this is the latest date on which this should apply to you. The significance is that, if HMRC is going to open an enquiry into your return, it should tell you by the date your return becomes final. However, HMRC can still investigate your tax affairs for other reasons – for example, suspected fraud. And, if your tax return contained any estimated valuations (of, say, property or unquoted shares) that were not fully explained in the return, HMRC can still open an enquiry into that aspect of your return.

The year 2026

• 5 April The normal time limit for you or HMRC to go back and review or reopen a past year’s tax return is four years from the end of the relevant tax year. For example, 5 April 2026 will normally be the last date for reviewing your 2021–22 tax return. However, HMRC can go back up to six years if it thinks you have failed to take reasonable care and 20 years if it suspects fraud. You should keep your records for at least six years.

Payment problems

There is a Business Payment Support Scheme operated by HMRC, which considers requests for extra time to pay taxes (PAYE and VAT) from businesses experiencing difficulties. Normal penalties will not apply to tax paid late if a payment plan is agreed by the tax office, though interest is payable.

Working out your income tax bill

For sole traders and partners, you first turn your profits from your accounts into taxable profits (see Example 2):

1If you have taken any items out of stock for your own use, include these in your sales figure at the normal selling price (not cost).

2Deduct from your profits any business expenses that are normally allowable against tax but that you have not included.

3Add back to your profits any business expenses that are not allowable for tax purposes (p. 382).

4Deduct the following items, which are allowable for tax purposes: annual investment allowance (p. 383), any first-year capital allowances (p. 385), writing-down allowances (p. 385), any balancing allowances (p. 387) and loss relief (p. 387).

5Add back any balancing charges from the sale of assets (p. 387).

6Deduct any income that is not part of your trading income and on which tax is paid separately, for example bank interest.

Business expenses

What business expenses are allowed?

You can claim, and be allowed, an item as a business expense for tax purposes if it is incurred ‘wholly and exclusively’ for the business. The golden rule with expenses is that if you are in any doubt as to whether an expense is allowable, claim it.

An expense incurred partly for business and partly for private reasons, for example a trip in your car to a customer, is strictly not allowed if you dropped in to see a friend on the way. However, where the business part can be clearly identified or apportioned, you are allowed to make a claim. For example, you can claim part of the cost of running a car for both business and private reasons based on records you keep of your total and business mileage. Similarly, you may be able to claim some of the expenses of using your home for business based on, say, the proportion of floor area devoted to the business and the proportion of time that space is used for business. Typical allowable home expenses will be part of the costs of heating, lighting, cleaning, telephone, insurance and security. You can also treat fixed costs, such as mortgage interest, rent, council tax, home insurance, water rates and general repairs as being partly for business if part of the home is set aside solely for business. Be aware that if part of your home is used exclusively for business, there could be capital gains tax (CGT) to pay on that proportion when you come to sell your home. HMRC makes a distinction between using part of the home ‘solely’ for business and ‘exclusively’ for business. For example:

• You use your office solely for business from 9 a.m. to 5 p.m. but then for other activities after 5 p.m. If the office represents 10 per cent of the floor space of the home, you would first work out 10 per cent of your fixed costs on the basis of floor area, then take 8/24 of the result (the proportion of time the room is used for business) to find the amount you can claim. In this example, the office is used solely for the business part of the time, but not exclusively for business, so there would be no CGT when you sell.
• You use your office solely for business and no other purpose. If it represents 10 per cent of the floor space of the home, you can claim 10 per cent of the fixed costs. In this case, the office is used exclusively for business and so there could be CGT when you sell the home.

Checklist of expenses you can normally claim

1. General expenses

Claim the expenses of making your product and running your premises:

• Cost of goods you sell or use in your product.
• Selling costs, such as advertising, sales discounts, gifts costing up to £50 a year (if gift advertises your business or product and is not food, drink or tobacco), web site costs.
• Office/factory expenses, such as heating, lighting, cleaning, business rates, rent, telephone, internet costs, postage, printing, printer ink and cartridges, security, stationery, normal repairs and maintenance.
• Proportion of home expenses, if used for work.
• Cost of computer software, if its useful life is less than two years. (If the useful life is longer, it may be treated as capital expenditure (p. 383). Even if the software has a longer life than 2 years you can still claim it as an allowable expense if you make regular payments to renew the licence).
• Other expenses, such as relevant books and magazines, professional fees, subscriptions to professional and trade organisations, replacing small tools, travel expenses (but not between home and work or, usually, lunches).
• Running costs of a car, such as insurance and repairs, delivery charges, charge for hiring capital equipment, leasing payment; but special rules apply to some cars.
• With cash-basis accounting only, you can claim the cost of any equipment (but not a car) that you buy to use in your business as an allowable expense. With traditional accounting, you need to claim a capital allowance.

If you are not registered for VAT, include the cost of VAT in what you claim, as it is a business expense that you cannot get back through the VAT system. If you are registered for VAT, do not include it, unless it is impossible for you to claim it back from the VAT inspector because, for example, it is included in what you have purchased for part of your business that is exempt for VAT purposes.

If you have opted to use the VAT flat-rate scheme (p. 409), you have a choice. Under the scheme, you pay VAT as a percentage of your VAT-inclusive turnover instead of working out the VAT you have charged less the VAT you can claim back. The VAT you actually hand over to HMRC may be more or less than the VAT you would otherwise have paid. Either:

• you can work out your accounts excluding VAT from both your revenue and your expenses, in which case you record any profit from using the flat-rate scheme as extra revenue or any loss as an additional expense; or
• you can work out your accounts including VAT in both your revenue and expense figures and record the VAT you actually hand over as an expense. This is the simpler method to use.

2. Staff costs

Claim the normal costs of employing people:

• Wages, salaries, bonuses, redundancy and leaving payments, pensions to former employees and dependants (but not your salary or your partner’s salary), training costs, council tax paid on behalf of an employee, if a genuine part of remuneration package subject to PAYE. This includes the cost of employing family members – such as your husband or wife – provided you can show that the work is actually done and that the wage is the going market rate.
• Pension contributions made on employees’ behalf. Cost of providing life, health and sick pay insurance for employees (but not yourself).
• Employer’s National Insurance contributions (but not your own, see p. 390).
• Entertaining staff, for example Christmas party.
• Gifts, subscriptions and contributions for benefits for staff, but these could be regarded as employees’ emoluments.

3. Financial expenses

• Bank charges on business accounts.
• Accountancy and audit fees, additional accountancy expenses needed as a result of HMRC ‘in-depth’ investigation but not if the investigation reveals that profits have been understated.
• Interest on loans and overdrafts for your business, and cost of arranging them (but not interest paid to a partner for capital put into the business, or interest on overdue tax). The rules for loan interest on buy-to-let properties is changing and the relief being reduced-check with HMRC.
• Charge part of hire purchase payments (that is, the interest plus additional costs).
• Business insurance.
• Bad debts that you specifically claim (but not a general reserve for bad or doubtful debts).
• Incidental cost of obtaining loan finance, but not stamp duty, foreign exchange losses, issue discounts or repayment premiums.

Note that if you’re using cash accounting, you can only claim up to £500 in interest and bank charges as an allowable expense.

4. Legal and other expenses

• Legal charges such as debt collection, preparing trading contracts, employee service contracts, settling trading disputes and renewing a short lease (that is, 50 years or less).
• Legal costs of defending yourself against disciplinary action by a body that regulates your profession (but not any fines imposed as a result of that action).
• Premium for grant of lease, but limited to the amount assessed on the landlord as extra rent spread over the term as the lease is paid.
• Fees paid to register trade mark or design, or to obtain a patent.

What is not normally allowed as a business expense

1Your own income and living expenses, ordinary clothes, medical expenses, your NI contributions (p. 390), income tax, capital gains tax, inheritance tax, fines and other penalties for breaking the law (but you could pay a parking fine for an employee), VAT surcharge.

2Depreciation or initial costs of capital equipment, buying a patent, vehicles, computer hardware or software if treated as a capital item (see below), permanent advertising signs, buildings and the cost of additions or improvements to these (but see the ‘Annual investment allowance’ and ‘Capital allowances’ sections).

3If you use traditional accounting, computer software (if a life of more than two years) would not normally be treated as an allowable expense, but you can claim a capital allowance. However, if you use cash-basis accounting for tax purposes, you would claim the use of a computer or printer as an allowable expense.

4An initial lump sum paid for a franchise is not normally allowable (but should qualify for the annual investment allowance and capital allowances), but any part paid for, say, trading stock or staff training (but not your own training) is normally allowable.

5Legal expenses on forming a company, drawing up a partnership agreement, and acquiring assets such as long leases.

6Business entertaining expenses, cost of partners’ meals at regular lunch-time meetings, gifts to customers (but see p. 379), normally charitable subscriptions and donations, and donations to political parties.

7Reserves or provisions for expected payments, such as repairs, and general reserve for bad and doubtful debts (but see p. 380).

8Wages to employees that remain unpaid 18 months after the accounting date.

Tax relief for capital expenditure

The tax rules make a distinction between revenue spending and capital spending. In general, revenue spending is on items that you use up straight away in producing your goods and services or running your business and you can claim these as allowable expenses (see previous section). Capital spending is on items that are durable and that you will use over a period of years. This does not count as an allowable expense and there are different rules for how you claim tax relief on the cost of these items.

Examples of capital spending on which you can claim a capital allowance include:

• equipment
• machinery
• business vehicles, such as cars, vans or lorries
• renovating business premises in disadvantaged areas of the UK
• research and development
• ‘know-how’
• patents.

There is an annual investment allowance, for most of these items, but with cars, items you owned for another reason before you started using them in your business and items you were given for your business, you claim writing-down allowances instead of the annual investment allowance. For a few items you can also claim an ‘enhanced capital allowance’ such as for some cars with low CO2 emissions or new zero-emission goods vehicles.

To qualify for relief, capital spending must be ‘wholly and exclusively’ for the business. But this does not mean you cannot claim relief for some item that you use in your private life as well as your business. For example, if you use a car half for business and half for private purposes, you treat the car as if it is made up of two separate assets and claim allowances just for the half that counts as a business asset.

If you bring into your business something you already owned privately, you can claim tax relief based on the market value of the item at the time you brought it into the business.

The way in which you pay for equipment does not affect the annual investment allowance or capital allowances you can claim. But you do not claim these allowances for the interest on a loan or overdraft to buy equipment – this is an allowable expense (p. 380) not part of the cost of the asset. If you buy on hire purchase, the hire charge part is also a business expense and, with leased equipment, you claim the rental as an expense (p. 380) not a capital cost.

You cannot claim a capital allowance if your accounts are worked out on a cash basis.

Annual investment allowance

You can claim 100 per cent tax relief for spending on plant and machinery, excluding cars, up to the amount of your annual investment allowance (AIA). This is £1 million until 31 December 2021.

If the accounting period on which your tax bill is based is more or less than 12 months, the allowance is increased or reduced pro rata. If you had an accounting period that straddles the point when the amount of the allowance changes, you get just a proportion of the AIA for that year.

Every business, whether sole trader, partnership or company, has an AIA. There are anti-avoidance rules to prevent you claiming extra AIA by artificially splitting your business into more than one entity.

If you spend more than your AIA, you can carry the excess forward and get tax relief on it in future years by claiming writing-down allowances (p. 385), unless the spending qualifies for a first-year allowance (p. 385) – this is on top of your annual investment allowance.

The AIA is not given automatically. You must claim it and you do this through the self-employment supplement of your tax return. You choose whether to claim and how much (up to the maximum for which you are eligible). Unused AIA cannot be carried forward. You also choose which expenditure to set your AIA against, which may be important if you have to carry some spending forward and different writing-down allowances would apply to different capital items (p. 385).

Capital allowances

In your accounts, you gradually write off the cost of a capital item as depreciation. But depreciation is not an allowable expense for tax purposes: you have to add it back but can claim capital allowances instead on any spending that is not covered by your annual investment allowance. Capital allowances are basically a standardised measure of depreciation.

The main capital allowance is writing-down allowance (WDA). This writes off your spending at a fixed rate year after year (see below). However, to encourage certain types of spending, you can in some cases claim a higher capital allowance for the year in which you spend the money. This higher allowance is called a first-year allowance. So, if you are buying a capital item, to work out what relief you can claim, work through the following sequence:

First-year capital allowances

First-year allowances are available alongside the AIA. Currently they are all 100 per cent allowances, which means you write off the full cost of the item in the accounting year in which you buy it. You can claim these allowances for spending on:

• within freeports, eligible new environmentally friendly equipment under the Enhanced Capital Allowance (ECA) Scheme can be claimed by companies until 30 September 2026. For example, energy-saving boilers, refrigeration equipment and water meters. Get details from the Energy Technology List (search the www.gov.uk web site);
• some cars with low CO2 emissions; new zero-emission goods vehicles.
• From 1 April 2021 until 31 March 2023, companies can claim 130 per cent of expenditure on qualifying plant and machinery in the first year, known as ‘super-deduction’. This is not available for the self-employed.

Writing-down allowances

Capital spending that you cannot fully write off in the first year is put into a capital pool and you gradually get relief by claiming WDAs. These are main capital pools:

• Main pool: this covers spending on most items. The WDA is 18 per cent.
• Special rate pool: this covers spending on long-life assets (items expected to have an economic life of at least 25 years) and the integral features of your business premises. Integral features include, for example, electrical systems, cold water systems, space or water heating systems, ventilation or air purification systems, lifts and escalators, spending on solar panels. It also includes cars with CO2 emissions of more than 130 g/km. The WDA for items in the special rate pool is 6 per cent, but for companies until April 2023, there is a super-deduction rate of 50 per cent.

To work out the WDA for each pool, you take the value of the pool at the start of the accounting period plus any new items that do not qualify for the AIA or first-year allowances and multiply the total by the appropriate rate. Deducting the WDA from the value of the pool gives you the value of the pool at the start of the next period. See Example 3 below.

You do not have to claim the maximum WDA. You might want to claim less if, for example, claiming the full amount would waste other reliefs or allowances. Claiming a lower WDA means you carry forward a larger pool which increases the maximum WDA you can claim next year.

If you have an accounting period that straddles an April when the WDA rates change, the WDA for the year is a weighted average of the rates that applied before and after 6 April.

When it comes to selling an asset on which you have claimed capital allowances, you have to reduce the value of your pool by the lower of the sale proceeds or the original cost. Do this before working out the amount of the allowance you can claim for the accounting year in which you sell the asset. If the sale proceeds are more than the value of the pool, the difference (the balancing charge) will be taxable as if it were extra profit for the year. Note that this also applies to an asset that has formed its own separate pool (see below). If the sale proceeds come to less than the pool value of an asset you sell, you can’t normally get any tax relief on the residue, unless it was a short-life asset (see below). However, when your business stops trading for good, if the proceeds from getting rid of all the assets in the pool come to less than the value of the pool, you can claim the difference as a balancing allowance that will reduce your tax bill for that year.

There is another way in which you might be able to fully write off the residual cost of an asset (whether you still own it or not). If the value of your main pool or your special rate pool falls to £1,000 or less, you can claim a WDA equal to the amount remaining in the pool. This applies separately to the main pool and special rate pool so you can claim extra WDAs to a maximum of £2,000 in one year. You can claim less than the maximum if you want to.

What is not included in the main pool or special rate pool

These items have separate pools of expenditure (single asset pool). The rate is either 6 per cent or 18 per cent depending on the item:

• If you choose, any piece of plant and machinery (but not cars) that you expect to sell or scrap within five years of buying. With these short-life assets, for example tools or a computer, you have to choose to put it in a separate pool within two years of buying it. If, when you sell the equipment, you sell it for less than its value after deducting the capital allowances you have claimed on it, you will be able to write off the difference in that year. If you sell it for more than the value, the difference will be taxable as if it were extra profit. If you do not sell it within eight years of the fourth anniversary of the end of the accounting year in which you bought the item, its value will be added to your main pool as if it had never been treated separately.
• Items that you use both privately and for business. You can claim capital allowances only for the part that corresponds to the business proportion of your use.

Losses for the self-employed

If you have made a loss in your business, you normally claim tax relief on it by deducting it from other income or a capital gain, or by carrying the loss forward and deducting it from future trading profits from your business.

Note that there is an overall cap on the tax reliefs for a loss that a person can claim. For losses made in 2020–21 and 2021–22, the cap will be £2 million (previously £50,000 or 25 per cent of income if higher). The trading losses for 2020–21 and 2021–22 can be carried back for three years to offset against profits. This may reduce the immediate relief that would otherwise have been available, although any unused losses can still be carried forward to offset against future profits of the same trade (see below).

Deducting the loss from other income and capital gains

You can either deduct your trading loss from any other income or capital gains that you have in the tax year in which your loss-making accounting year ends, or you can carry the loss back and set it against other income or gains for the previous tax year. Other income could be, for example, dividends from shares or earnings from a job.

You must claim this relief within 12 months of the 31 January following the end of the tax year to which the loss relates. For example, suppose you have been in business for some time, your accounting year ends on 31 July and you made a loss in your 2020–21 accounting year. These accounts form the basis of your tax bill for the 2021–22 tax year. Your tax return and final tax settlement for 2021–22 are due on 31 January 2023. You then have a further 12 months – in other words, until 31 January 2024 to elect to deduct your losses from other income and gains for 2021–22 or for 2020–21.

If you have other deductions that will reduce the tax bill on your other income and gains to nil in one of the tax years, opt to deduct the loss in the other year. If after setting the loss against income and gains for one or both years, there is still some loss left over, you can carry the excess forward to set against future profits (see below).

Deducting the loss from future trading profits

If you make this choice, you carry forward the loss and set it against the next future profits from the same trade. If you have any losses left over, you carry them forward against future profits ad infinitum, until they are used up. If you are going to use your loss in this way, you have to use the whole of the loss before you can use any other deductions, such as outgoings or allowances, that you may have. The main disadvantage of making this choice to use up your loss relief is that it takes a while to turn it into cash.

To use this option, you must tell your tax office within four years of the end of the tax year to which the loss relates. For example, if the loss was made in the accounts being assessed for the 2021–22 tax year, you have until 5 April 2026 to make your claim.

If you are starting a new business

If you spend money before your business actually starts, it may count as pre-trading expenditure. It will be set against the earnings of your business in its first year and, if it creates a loss, you can get loss relief. You can get tax relief on expenditure going back seven years.

There is special tax treatment for any losses you make in the first four tax years of a new business (as long as HMRC believes it was reasonable to plan for profits during that period). You can get a tax refund by setting the loss against any other income (for example, wages from a job) that you had in the three years before the loss. Set the loss off against the earliest year of income first, then the next earliest and so on.

If you want to set off your loss in this way, you need to tell HMRC in writing within 12 months of the 31 January following the end of the tax year to which the loss relates.

Other taxes you might pay

National Insurance contributions

If you are self-employed, you normally have to pay Class 2 National Insurance contributions. If your earnings from self-employment are expected to be less than a certain amount, £6,515 in 2021–22, you can claim exemption from payment, but this is seldom worth doing given the value of the state benefits you lose. Class 2 NI is paid at a flat rate of £3.05 a week in 2021–22, which you can pay monthly by direct debit or you will be sent a bill each quarter. Paying Class 2 contributions means you may be able to claim Employment Support Allowance, basic maternity allowance and retirement pension, and your spouse or civil partner might get bereavement benefits in the event of your death.

If your earnings from your business are above a certain amount, £9,569 in 2021–22, you will have to pay Class 4 contributions. These are earnings-related, collected along with income tax and are 9 per cent of your profits between the lower limit up to a specified maximum, £50,270 in 2021–22, and 2 per cent of all earnings above the upper profit limit.

Capital gains tax

You do not normally pay capital gains tax (CGT) on business stock you sell, but you might have to pay it when you dispose of land and buildings, plant and machinery or goodwill, or shares in your business if you operate as a company. Disposing includes selling, giving away, exchanging or losing.

As an individual, the main CGT rules, for personal assets or business assets on which you have to pay CGT are:

• Capital gains tax is charged at two rates. From 6 April 2019, these will be 10 per cent and 20 per cent. To find out which applies, you add your chargeable gains to your income for the year. Any part of the gains falling in the basic tax rate band or below is taxed at 10 per cent. Any part that falls into the higher-rate tax band or above is taxed at 20 per cent. Note that chargeable gains on residential property, such as buy-to-let, are taxed at 28 per cent.
• You have a yearly CGT tax-free allowance, which means you can make up to £12,300 of otherwise taxable gains in 2021–22 without having to pay any tax.
• You can claim business asset disposal relief (used to be called entrepreneurs’ relief) when you dispose of part or all of your business. This limits the tax rate to 10 per cent on the first slice of chargeable gains on business assets that you sell during your lifetime. This slice is set at £1 million. To qualify, the business must be a trading business and you must have held the asset for at least two years. If it is a company, you must be an employee or director who owns at least 5 per cent of the shares and voting rights.

If you sell or otherwise dispose of assets from your business, and make a gain, you could pay capital gains tax on the gain. But if you replace the assets in the three years after the sale or one year before the sale of the old one, you can claim roll-over relief and defer paying capital gains tax. You can also claim relief if you do not replace but use the proceeds to buy another qualifying business asset. You usually get the relief by deducting the gain from the old asset from the acquisition cost for the new one. So when you sell the new one, the gain on it has been increased by the size of the gain on the old one. However, if you replace again, you can claim further roll-over relief. And so on. Capital gains tax will not have to be paid (under current legislation) until you fail to replace the business asset.

Not every business asset qualifies for the relief. But if it is land or a building used by the business, goodwill, fixed plant or machinery, for example, it will qualify for roll-over relief.

If you work from home, think carefully about the space you use for your business:

• If you use part of your home exclusively for business, you maximise the amount you can claim in allowable business expenses (p. 378) but a proportion of your home becomes liable for CGT. There may be no CGT to pay if the gain comes to less than your annual allowance or you are able to claim roll-over relief (because you will also be using part of a new home for the business).
• If you do not use any part of the home exclusively for business, there will be no CGT when you sell the home. However, non-exclusive use reduces the proportion of the home-related costs that you can claim as allowable business expenses (p. 378).

For more information on capital gains tax, contact HM Revenue & Customs (HMRC).

You and HMRC

When you first start in business

When you first start working for yourself, you need to register for HMRC online services on the HMRC web site. (Your online account is also known as a Government Gateway account.)

If you have finished a job as an employee, you will have form P45, which you can send to HMRC (but take a copy) so that the amount of your personal allowances and the amount of tax to be paid for that tax year can be sorted out. If you start self-employment part way through the tax year, having been an employee before, you can ask for a refund of part or all of the tax paid under PAYE if you can show that you will otherwise pay too much tax. This can help with the cash flow problems of starting the business.

Once you have started a business

When you first start in business, there are no interim payments of tax for the first year or so, because there is no track record from a previous year on which to base any payments. You’ll be sent a tax return in the April following start up and, as usual, you have until the following 31 January to send in your return and to pay the tax due. For example, you might start in business in, say, February 2021. You’ll get a tax return in April 2021, and your first tax payments must be made by 31 January 2022. At that time, you’ll pay all the tax due for the 2020–21 tax year plus the first interim payment for 2021–22, which will be set at half the amount due for 2020–21.

Being investigated

During the 12 months after your accounts and tax payments are finalised, HMRC can choose to audit your return and assessment. After 12 months have passed, HMRC can still investigate you, but only if it suspects fraud or discovers an error.

If you have been selected for audit or investigation, HMRC must by law write to you telling you that this is the case. It does not have to tell you why you are being investigated, but it must say whether your whole tax affairs are being investigated or just some aspect of it, for example how you calculated your capital allowances. The tax officer has wide-reaching powers to ask for any relevant records, and the self-employed are required, by law, to keep records for five years after 31 January following the end of the tax year to which they relate. If you fail to produce the records asked for, you will be fined. Records can be on paper, digital or part of a software programme.

The tax officer may request an interview, the purpose of which will probably be to establish:

• why your business, and hence profit, is different from other similar businesses;
• whether you have correctly calculated adjustments for tax purposes;
• if you have assessed your own tax bill, whether you have made any errors or omissions;
• if the amount shown for what you have taken out of the business seems adequate to support your lifestyle. You may need to work out an estimate for your living expenses, for example general household expenses, as well as leisure expenditure and so on.

If the tax officer is satisfied with your records and explanation, there will probably be a fairly minor, or even no, adjustment to your accounts. However, if a more serious view is taken, you may find that your figures for profit for this and previous years are increased.

Either following or during the investigation, you will be sent an assessment if extra tax is deemed to be due. You will have to pay interest on the tax, and there may also be penalties.

Do you count as self-employed?

It may be obvious that you are self-employed, but sometimes it is not clear-cut. You cannot simply declare yourself self-employed; you will have to convince HMRC that you are. And recently, HMRC has been taking a closer look at those claiming to be self-employed, particularly sub-contractors working in the construction industry, and people ceasing to be employees but returning to the same work as consultants, and reclassifying them as employees. The sort of points that will help you to establish self-employment are:

1Working for more than one customer.

2Showing that you control what you do, whether you do it, how you do it and when and where you do it.

3Providing the major items of equipment you need to do your job.

4Being free to hire other people, on terms of your own choice, to do the work that you have agreed to undertake.

5Correcting unsatisfactory work in your own time and at your own expense.

If you do the above, there will probably be little difficulty in persuading an inspector that you are self-employed. You can check whether you are likely to be classified as employed or self-employed, at the gov.uk website.1

Spare-time earnings

There is no quick answer to the question of how you will be taxed if you have spare-time earnings. It will depend mainly on whether your income counts as starting a business. You might find yourself in a dilemma as to how your spare-time earnings will be taxed if:

• you are still employed but earning some extra money in your spare time. You might be doing this either because you have started your business in a small way to see how it goes before you take the plunge and hand in your notice; or because you are doing the occasional bit of freelance work to boost your income;
• you are not employed, but you are starting your business on a part-time basis. This could be the case if you are at home looking after young children, for example. Some people who earn extra income in this way hope that they will be able to keep it out of the clutches of the HMRC. Very often they ask for payment in cash. In the section ‘The black economy’ (p. 395), you will see how HMRC can catch you and what the penalties are if you are caught.

There are tax-free £1,000 allowances for money earned in what has been called ‘the sharing economy’. This will cover money earned from occasional jobs, trading in goods and services, or income from property. So, if you earn money from renting out your driveway for parking or providing a lift share, the first £1,000 will be tax-free.

What you must do

By law, you must notify HMRC when you get income from a new source. This can be done online through the HMRC web site. You have to do this within six months of the end of the tax year in which the income first arose. The onus is on you to give this information, and you cannot plead as an excuse that you did not receive a tax return. Nor does it make any difference whether you are making a profit or a loss; what matters is that you are receiving payments from a new source that your inspector does not know about. If you do not reveal this information about a new source of income, not only will you have to pay the tax due on that income but you will usually have to pay a penalty on top (linked to the amount of tax you owe and how cooperative you are) plus interest on any tax paid late.

Bear in mind that, if the new source of income amounts to business income, you must in any case tell HMRC that you have started in business as soon as possible (p. 60).

Casual income

If you don’t succeed in convincing HMRC that your new source of income is a business, your income could be treated as casual. Casual income will generally be taxed on an actual basis – that is, tax for any tax year will be based on the actual income you have from that source during the tax year. This contrasts with self-employment, where tax is based on the profits for an accounting period ending during the tax year. Self-employment gives you more scope for building in a time lag between making the profits and paying tax on them.

A disadvantage if your income counts as casual is that the treatment of losses is less favourable than if you are taxed as being self-employed. If you make a loss, it can only be deducted from profits taxed in the same way, made either in the same tax year or in the future. It cannot be deducted from any other income you have, for example from your job if you have one.

The black economy

It is illegal to try to conceal any earnings. The tax officer has various ways of discovering that you are earning money. Employers who make use of freelance staff, such as consultants, writers and caterers, can be made to give details to HMRC of the payments made. There is also a department in HMRC that keeps an eye on advertisements in the press to make sure that any source of income has been declared. And if you annoy any neighbours, acquaintances or customers who suspect what you are doing, you also run the risk that they might inform on you.

Once HMRC has started an inquiry into your affairs, you will find it very time-consuming. You may find you end up paying interest on unpaid tax from the day it was due until the date of payment; the current rate of interest is 2.5 per cent. On top of that, you can have penalties slapped on, for example for:

• failure to tell HMRC about taxable income or gains within six months of the end of the tax year, with the penalty geared to the tax you owe and how cooperative you are;
• failing to send in your tax return by 31 January following the end of the tax year. If your return is even one day late, there is an automatic penalty of £100 (even if you do not owe any tax). If you still have not delivered your return three months after the deadline, you can be charged £10 a day up to a maximum penalty of £900. If your return is still outstanding after six months, you face a further penalty of £300 or 5 per cent of the tax you owe if this is greater. And after 12 months, there is another fine of £300 or 5 per cent of the tax you owe, except that if your case is deemed serious, the penalty can be increased to 100 per cent of the tax you owe. Keep in mind that these are all penalties for failing to get your tax return in and are additional to the tax you must pay and any fines and interest for paying the tax late;
• fraudulently or negligently sending in an incorrect return, with the penalty geared to the tax you owe, how the mistake came about and the degree to which you cooperate with HMRC to put it right.

Summary

1Consider an accounting year-end that will give the greatest delay between earning the profits and paying the tax if you expect profits to rise year by year.

2If you want to keep your tax affairs simple, choose fiscal accounting – see p. 373.

3Remember to claim all your business expenses. Where possible, get invoices and receipts to back up your claims.

4If you use your car partly for business, you can claim part of your car expenses (and capital allowances). If you work from home, you can claim part of the running expenses, but watch out for CGT.

5Try to cut down the risk of being investigated by HMRC. For example, do not omit items from your tax return, such as bank interest. If you know your profit margin is lower than others in the same business, or if you make a loss, explain why.

6To avoid fines, keep an eye on the various tax deadlines: 31 October if you are filing a paper return, 31 January if you file online, and pay any outstanding tax by 31 January following the end of the tax year.

7You must by law keep records relating to your tax return and assessment for nearly six years. You’ll be fined if you can’t produce the necessary records when asked.

8Tell HMRC about any new source of earnings within six months of the end of the tax year in which the earnings first arose or within three months of starting up if the new income is from self-employment.

______________

1 www.gov.uk/guidance/check-employment-status-for-tax