Chapter 14

Managing Your Tax Position

In This Chapter

Finding out how much tax you have to pay

Seeing how to cut that bill, legally

Knowing how to handle employment taxes

Getting through a tax investigation intact

The government raised £591.7 billion in 2012/13 in one form of tax or another, equivalent to roughly £11,500 for every adult in the UK. Not only is the amount colossal but now about a zillion ways exist in which tax is raised. Aside from income tax, which only accounts for £154.8 billion of the money raised, you have value added tax (VAT) and national insurance (NI), which most people brush across. Then you have taxes or reliefs from paying tax on fuel, capital gains, capital expenditure, research and development, business rates, excise duty, a climate change levy, air passenger duty, landfill tax, an aggregates levy, small company tax relief, vehicle excise duties and stamp duties, to mention but a few that the successful owner manager can expect to encounter. Each of these tax categories in turn has a number of its own categories. VAT, for example, is levied at a standard rate, reduced rate, zero rate and exempt from VAT altogether, and the government shifts about the 50 or so product and service categories within each VAT category from time to time. The government has made 44 major changes to the tax system in the UK since 1979 and a couple of thousand minor ones.

If you think that all, or even most, of the profit you make in your business comes your way, think again. The government takes a sizeable slice of everything you make, in one way or another, and gets very nasty if you try to evade its clutches. You may be starting your first business, but government agencies have had centuries to hone their skills in extracting their pound of flesh. Since 1842, when income tax was reintroduced into Britain, everyone in business has been required to account for their income and profits.

Before you reach for your passport and head offshore, taxing entrepreneurs is a fact of life in almost every country in the world, though both the amounts and methods of assessment vary widely. Surprisingly enough, the tax climate in the UK is relatively benign and people here pay less than most. So although you may have to pay tax, you don’t have to pay too much. As a Morgan Stanley advert succinctly puts it, ‘You must pay taxes. But there’s no law that says you gotta leave a tip.’

What follows is a guide to the taxes you should prepare to face, rather than an accurate statement of the amounts involved. In any normal year many tax rates change, and since the credit crunch the pace of those changes has accelerated sharply. VAT, for example, moved from 17.5 per cent, to 15 per cent and then back to 17.5 per cent, and is currently at 20 per cent as I write this edition – and all that in the space of a year or so. Add that to the changes that will come in if Scottish devolution comes to pass and their strong case for devolving corporation tax to the Scottish Parliament is upheld, and the next few years should be even more volatile. (Scotland, by the way, is pushing for a lower rate of corporation tax than that applying to the UK as a whole, as indeed is Northern Ireland. We may soon have some new tax havens close to home.)

A survey of the UK tax system as it stood at October 2012 (www.ifs.org.uk/bns/bn09.pdf) by the Institute for Fiscal Studies outlines the amount of tax raised by category and the changes and new taxes introduced since 1979. Not exactly bedtime reading, more a horror story.

You can keep up to date with all the taxes that apply to business in the UK on the Gov.uk website (www.gov.uk/browse/business/business-tax).

Tackling Taxes for Different Types of Businesses

The government treats sole traders, partnerships and limited companies differently for tax purposes, so I look at each in turn.

Managing your tax position is one area in which timely professional advice is essential. Advice is even more important because tax rules can change every year. Good advice can both help to reduce your overall tax bill and increase the value of profits to the business. Head to Chapter 12 for details on finding good advisers.

Figuring out sole traders and partnerships

A partnership is treated as a collection of sole traders for tax purposes, and each partner’s share of that collective liability has to be worked out. If you’re a sole trader (in other words, self-employed), your income from every source is brought together and the profit is taxed altogether. Income from business is one of a number of headings on your general tax return form.

In the UK, the key taxes that you need to calculate are

• Income tax on profits
• Class 4 NI on profits
• Capital gains tax, on the disposal of fixed assets such as property at a profit, or when the whole business is sold
• Inheritance tax, paid on death or when certain gifts are made

Neither of the last two taxes is likely to occur on a regular basis, nor do they occur in the first few years in business, so I don’t cover them here. When those taxes do come into play, the sums involved are likely to be significant and you should take professional advice from the outset.

Adding up income tax

Under the self-assessment tax system in the UK, you pay taxes for your accounting year in the calendar year in which that accounting year ends. Special rules apply for the first year and the last year of trading to ensure tax is charged fairly.

If your turnover is low – currently in the UK less than the VAT threshold of £77,000 per year – you can summarise your income on three lines: sales, expenses and profit (see this factsheet for details: www.hmrc.gov.uk/factsheet/three-line-account.pdf). If your turnover is above the minimum, you have to summarise your accounts to show turnover, gross profit and expenses by account categories, such as vehicle running costs, advertising, telephone and rent.

No matter how you account for your business income, as a sole trader or partnership you get to deduct a personal allowance amount from your profit figure, paying income tax on your profit minus your personal allowance. The personal allowance is the current threshold below which you don’t pay tax.

Calculating class 4

You calculate class 4 NI based on taxable profits. The percentage you pay depends on what range your profits fall in. Expect to pay around 9 per cent if the number falls in a range from approximately £7,000 to £43,000. Above that figure, you pay 2 per cent. The percentage is paid in addition to the flat-rate Class 2 NI contributions of about £2.50 per week.

All these rates and amounts change in March of every year, but the broad principles remain the same. You can find the latest NI contribution rates on the website of HM Revenue and Customs (HMRC) at www.hmrc.gov.uk/rates/nic.htm.

Looking at levies on companies

Companies have a legal identity separate from those who work in them, whether or not those workers also own the company. Everyone working in the business is taxed as an employee. The company is responsible through the pay as you earn (PAYE) system for collecting tax and passing it to the tax authorities.

Directors’ salaries are a business expense, just as with any other wages, and are deducted from the company’s revenues in arriving at its taxable profits.

Companies in the UK pay tax in three main ways at rates that can change each year. The current company tax rates are published on the HMRC website (www.hmrc.gov.uk/rates/corp.htm).

• Corporation tax is paid on the company’s profits for the year, as calculated in the tax-adjusted profits. The rate of corporation tax in the UK, and in many other countries, depends on the amount of profits made. In the UK, if the profits are less than £300,000, the small companies rate applies, currently 20 per cent. Above £1.5 million, the full rate of around 23 per cent is charged (at the time of writing that rate was due to fall to 21 per cent in 2014). For figures in between, a taper applies (all these figures are subject to annual review in the budget). Corporation tax is payable nine months after the end of the accounting period.
• Dividend payment taxes are levied on the distribution of profit to shareholders. This arrangement gives the appearance of taxing the same profit twice, but through a process of tax credits this double taxation doesn’t generally occur. When a shareholder gets a dividend from a company, it comes with a tax credit attached, which means that any shareholder who pays the basic rate of tax won’t have to pay any more tax. Higher-rate taxpayers, however, do have a further amount of tax to pay.
• Capital gains tax is owed if a company sells an asset, say a business property, at a profit. This capital gain is taxed along the general lines of corporation tax, with lower rates applying to smaller companies.

Assessing the best legal structure

The most important rule is ‘never let the tax tail wag the business dog’. Tax is just one aspect of business life. If you want to keep your business finances private, the public filing of accounts required of companies isn’t for you. However, if you want to protect your private assets from creditors if things go wrong, being a sole trader or partner probably isn’t the best route to take.

Company profits and losses are locked into the company, so if you’ve several lines of business using different trading entities, you can’t easily settle losses in one area against profits in another. But because sole traders are treated as one entity for all their sources of income, they’ve more scope for netting off gains and losses. Here are a few other points to bear in mind:

• If your profits are likely to be small, say well below £50,000, for some time, then from a purely tax point of view you may pay less tax as a sole trader, because as an individual you get a tax-free allowance. Your first few thousand pounds of income aren’t taxable. This amount varies with personal circumstances and can change in the budget each year.
• If you expect to be making higher rates of profit (above £50,000), and you want to reinvest a large portion of those profits back into your business, then you may be better off forming a company. Companies don’t start paying higher rates of tax until their profits are £300,000. Even then, they don’t pay tax at 40 per cent. A sole trader is taxed at the 40 per cent rate by the time her profits reach about £30,000, taking allowances into account. So a company making £300,000 taxable profits can have £54,000 more to reinvest in financing future growth than does a sole trader in the same line of work.
• Non-salary benefits are more favourably treated for the sole trader. You can generally get tax relief on the business element of costs that are only partly business related, such as running a vehicle. A director of a company is taxed on the value of the vehicle’s list price and isn’t allowed travel to and from work as a business expense.

However, the whole area of company structure is complicated and depends heavily on what you want to achieve. For example, if you want to maximise your entitlement to make pension contributions, then a strategy that’s tax efficient – for example, incorporating (as turning yourself into a limited company is known) – may be a bad idea. Get professional financial advice before you make any decision in this area.

Whiting Partners, a firm of chartered accountants and business advisors, has a useful guide to help you decide, from a tax perspective, which legal structure would be best for you at various levels of annual profits. Check out www.whitingandpartners.co.uk/News/Limited-Company-v-SoleTrader.

Paying Taxes

Most businesses encounter two taxes at some point; the more successful you are, the sooner you get swept into the taxman’s net. Value added tax (VAT) is a tax based on your turnover, and the second – business tax – is based on the profit you make. The HMRC website (www.hmrc.gov.uk) contains all the latest tax rates and details of almost everything you’re likely to need to com-plete your tax returns correctly.

Valuing VAT

As well as paying tax on profits, every business over a certain size has, in effect, to collect taxes too. Value added tax (VAT) is a tax on consumer spending. VAT is a European system, although most countries have significant variations in VAT rates, starting thresholds and the schemes themselves.

HMRC produces a range of leaflets, factsheets and booklets on VAT and other areas of taxation for guidance only (www.hmrc.gov.uk/leaflets). For the latest rules and rates go to www.hmrc.gov.uk/businesses. If in doubt (and the language isn’t easy to understand), ask your accountant or the local branch of HMRC; after all, they prefer to help you to get it right in the first place than have to sort it out later when you’ve made a mess of it.

You get no reward for collecting VAT, but you’re penalised for making mistakes or for sending returns in late. Read on for the nitty-gritty of what you need to do.

Registering for VAT

VAT is a complicated tax. The general rule is that all supplies of goods and services are taxable at the standard rate (anything between 5 and 20 per cent is possible) unless the law specifically states they’re to be zero rated or exempt.

You can register voluntarily for VAT at any time at the HM Revenue and Customs website (www.hmrc.gov.uk/vat/start/register/signup-online.htm), but you must register your business for VAT if your taxable turnover – that is, your sales (not profit) – exceeds £77,000 in any 12-month period (£70,000 if you sell by mail order or via the Internet) or looks as though it may reasonably be expected to do so. This rate is reviewed each year in the budget and changes frequently. (The UK is significantly out of line with many other countries in Europe, where VAT entry rates are much lower.)

In deciding whether your turnover exceeds the limit, you must include your zero-rated sales (things like most unprocessed foodstuffs, books and children’s clothing) because they’re technically taxable; but the rate of tax is 0 per cent. Leave out exempt items like the provision of health and welfare, finance and land. Currently, you don’t have to include business done overseas in your VAT calculations.

It sometimes pays to register even if you don’t have to – if you’re selling mostly zero-rated items, for example, because you can reclaim VAT that you’ve paid out on purchases. Also, being registered for VAT may make your business look more professional to your potential customers.

You can find out how and when to register for VAT at the HM Revenue and Customs website (www.hmrc.gov.uk/vat/start/register/).

Calculating VAT

You may need to extend the simple bookkeeping system I describe in Chapter 13 to accommodate VAT records. For example, the analysed cash book you use in a simple system needs additional columns to accommodate the pre-VAT sales, the amount of VAT and the total of those two figures.

Calculating the VAT element of any transaction can be confusing. Following these simple steps helps you always get it right:

1. Take the gross amount of any sum (items you sell or buy) – that is, the total including any VAT – and divide it by 120, if the VAT rate is 20 per cent. (If the rate is different, add 100 to the VAT percentage rate and divide your transaction amount including VAT by that number.)
2. Multiply the result from Step 1 by 100 to get the pre-VAT total.
3. Multiply the result from Step 1 by 20 to arrive at the VAT element of the bill.

Completing the VAT return

VAT returns are where a computer-based bookkeeping system wins hands down. The accounting package automatically generates VAT returns. All you have to do is enter the current VAT rate. If you get web-enabled software updates, you may not even have to do this.

Basically, VAT inspectors are interested in three figures:

• The amount of VAT you collected on the goods and services you sold.
• The amount of VAT collected from you by those who’ve sold you goods and services.
• The difference between those two sums. If the difference is positive, that’s the amount of VAT due to be paid. If the number is negative, you’re entitled to reclaim that amount.

For a business, VAT is a zero-sum game – you don’t make money and you don’t pay money – the end consumer picks up the tab.

The final two numbers are a check on the reasonableness of the whole sum. You have to show the value of your sales and purchases, minus VAT, for the period in question.

The person registered for VAT has to sign the VAT return. Remember that a named person is responsible for VAT – a limited company is treated as a person in this instance. Not only are you acting as an unpaid tax collector, but you also face penalties for filing your return late or incorrectly. You have to keep your VAT records for six years and periodically you can expect a visit from a VAT inspector.

Sending in VAT returns

Each quarter, or each year if you take that option, you have to complete a return that shows your purchases and the VAT you paid on them, and your sales and the VAT you collected on them. The VAT paid and collected are offset against each other and the balance sent to HMRC. If you paid more VAT in any quarter than you collected, you get a refund.

To help smaller businesses that may struggle with the more traditional VAT return, HMRC has introduced the Flat Rate Scheme (FRS), which enables eligible businesses to calculate their VAT payment as a percentage of their total turnover. You still have to put VAT on your sales invoices, but you don’t have to do the input and output tax return to settle up your VAT. Your VAT liability is agreed as a percentage of all your sales. This percentage is allocated by HMRC based on the type of trade your business carries out. You can find out more about the Flat Rate scheme at www.hmrc.gov.uk/vat/start/schemes/flat-rate.htm.

Virtually all VAT-registered businesses must submit their VAT returns online and pay any VAT due electronically. The very few exceptions include businesses going into insolvency and those businesses run by practising members of a religious society whose beliefs prevent them from using computers. You can find out all about completing your VAT return online and paying the tax due electronically at www.hmrc.gov.uk/vat/vat-online/moving.htm.

Choosing cash or income accounting

Generally, VAT is levied on invoiced sales, so in theory and often in practice occasions can arise when you have to pay VAT on sums you haven’t collected yourself. This unhappy state of affairs can happen if you send out an invoice at the end of the quarter and your customer hasn’t paid by the time you have to make the VAT return. If this situation proves a major problem, you can usually elect to pay VAT on a cash basis, rather than the strictly more correct income recognition basis that’s triggered when you send out your invoices.

You can find out whether you’re eligible to operate a cash VAT scheme at www.hmrc.gov.uk/vat/start/schemes/cash.htm.

Minimising tax on profit

You have no reason to arrange your financial affairs in such a way that you pay the most tax! While staying within the law by a safe margin, you can explore ways to avoid as opposed to evade tax liabilities. This avoidance is a complex area and one subject to frequent change. The tax authorities try most years to close loopholes in the tax system, while highly paid tax accountants and lawyers try even harder to find new ways around the rules.

Here are some of the areas to keep in mind when assessing your tax liability:

• Make sure that you include all allowable business expenses. Especially when you’ve recently set up in business, you may not be fully aware of all the expenses that you can claim. Discuss this with your accountant and check out HMRC’s website (www.hmrc.gov.uk/incometax/relief-self-emp.htm) for more information.
• If you’ve made losses in any tax period, under certain circumstances you may carry them forward to offset future taxable profits or backward against past profits.
• You can defer paying capital gains tax if you plan to buy another asset with the proceeds. This arrangement is known as rollover relief and you can use it normally up to three years after the taxable event. Check out this website for the latest position on this and other capital gains tax reliefs: www.hmrc.gov.uk/cgt/businesses/reliefs.htm.
• Pension contributions reduce your taxable profits. You may even be able to set up a pension scheme that allows you some say over how those funds are used. For example, your pension fund can be used to finance your business premises. The pension fund in effect becomes your landlord. The company then pays rent, an allowable business expense, into your pension fund, which grows tax free.
• If you do intend to buy capital assets for your business, bring forward your spending plans to maximise the use of the writing-down allowance, which is the portion of the cost of the asset you can set against tax in any year. For example, if you propose to buy a computer or a very low-emission motor vehicle, you may be allowed to charge 100 per cent of the cost in the year you make the purchase. And if you know in March that you intend to buy a new computer later that year, by making the purchase before 5 April you can take the writing-down allowance in that tax year. If you delay until after that date, you have to wait until the following tax year to get the benefit of a lower tax bill. Find out more on this subject at www.hmrc.gov.uk/capital-allowances/basics.htm.
• Identify non-cash benefits that you and others working for you can take instead of taxable salary. For example, a share option scheme may achieve the same, or better, level of reward, with less tax payable.
• Examine the pros and cons of taking your money out of a limited company by way of dividends or salary. These routes are taxed differently and may provide scope for tax reduction.
• If your spouse has no other income from employment, she can earn a sum equivalent to her annual tax-free allowance (currently about £8,000) by working for your business. HMRC is currently looking hard at the taxation of husband and wife partnerships and companies, so check with your accountant to confirm what is allowed. The HMRC website (www.hmrc.gov.uk/manuals/bimmanual/BIM72065.htm) gives you its take on the subject.
• If you incurred any pre-trading expenses at any stage over the seven years before you started up in business, you can probably treat them as if you incurred them after trading started. Such expenses can include market research, designing and testing your product or service, or capital items such as a computer bought before you started trading and then brought into the assets of your business.
• You may be able to treat the full purchase price of business assets you bought through hire purchase in your capital allowances calculation.

This list is indicative rather than comprehensive. Taxation is a field in which timely professional advice can produce substantial benefits in the form of lower tax bills.

Tax Cafe (www.taxcafe.co.uk/business-tax.html) publishes a range of regularly updated business tax advice guides aimed at anyone wanting to find out how to pay less tax legally.

Handling Employment Taxes

Not only must you pay tax on your business profits and collect VAT from suppliers for onward transmission to an ever-hungry exchequer, but you also have to look after your employees’ tax affairs too. As an employer you have a legal responsibility to ensure that an employee’s taxes are paid, and you can end up picking up the tab yourself if the employee fails to. So ensure that you collect tax from employees’ pay before paying them.

Paying PAYE

HMRC collects income tax from employees through the pay as you earn (PAYE) system. The employee’s liability to income tax is collected as it’s earned instead of by tax assessment at a later date. If the business is run as a limited company, then the directors of the company are employees. PAYE must be operated on all salaries and bonuses paid to directors, yourself included.

HMRC now issues booklets in reasonably plain English about how PAYE works. The main documents you need to operate PAYE are

• A deduction working sheet (Form P11) for each employee
• The PAYE Tables – two books of tax tables are in general use, which are updated in line with the prevailing tax rates:
  • Table A Pay Adjustment Table shows the amount that an employee can earn in any particular week or month before paying tax
  • Tables B to D and LR Taxable Pay Tables show the tax due on an employee’s taxable pay
• Form P45, which is given to an employee when transferring from one employer to another
• Form P46, which is used when a new employee doesn’t have a P45 from a previous employer (such as a student starting work for the first time)
• Form P60, which is used so that the employer can certify an employee’s pay at the end of the income tax year in April
• Form P35, the year-end declaration and certificate for each employee – this form is used to summarise all the tax and NI deductions from employees for the tax year
• Form P6, the tax codes advice notice issued by the inspector of taxes telling you which tax code number to use for each employee

You work out the tax deduction for each employee using the following steps. (For week read month, if that is the payment interval you use.)

1. Add the current week’s gross pay to the previous total of gross pay to date, to show the total gross pay up to and including this week of the tax year.
2. Check the tax code number of the employee in Table A, to arrive at the figure of tax-free pay for that particular week.
3. Deduct the amount of tax-free pay from the total pay to date, to get the amount of taxable pay.
4. Work out the tax due on the total taxable pay for the year to date using Table B. Then make the appropriate deduction to allow for the tax due.
5. Deduct the amount of tax already accounted for in previous weeks from the total tax due, to work out the tax due for the week.

Allocating national insurance

As well as deducting income tax, as an employer you must also deduct national insurance (NI) contributions. Three rates of contributions apply for NI purposes:

• Table A – the most common rate, used in all cases except for those who qualify for Table B or C
• Table B – used for certain married women who have a certificate for pay-ment at a reduced rate
• Table C – used for employees who are over pension age

For Tables A and B, you need to calculate two amounts: the employee’s contribution and the employer’s contribution. For Table C, no employee’s contribution is payable. You record the amounts of contributions on the same deduction working sheets that you use for income tax purposes.

You can find the amounts of NI due by referring to the appropriate table. The tables show both the employee’s liability and also the total liability including the employer’s contribution for the week or month. You must record both these figures on the deduction working sheet.

Accounting for employment taxes

When you pay out wages and salaries to your staff, you need to record the net pay in your cash book as well as the PAYE and NI you’ve paid to the collector of taxes.

If you’ve only one or two employees, then the record of the payments in the cash book, together with the other PAYE documentation, is probably sufficient. But if you’ve any more, you should keep a wages book.

The deductions working sheet gives you a record of the payments made to each employee throughout the year. You also need a summary of the payments made to all employees on one particular date.

The law requires that employers must provide their staff with itemised pay statements, known as payslips. These payslips must show

• Gross pay
• Net pay
• Any deductions (stating the amounts of each item and the reason the deductions are made)

As an employer, you’ve a legal obligation to operate PAYE on the payments you make to your employees if their earnings reach the NI lower earnings limit (LEL). The HMRC website has details on the basics of employment taxes and related matters (www.hmrc.gov.uk/payerti/forms-updates/rates-thresholds.htm).

Surviving a Tax Investigation

If your books are in good order and you honestly report your income and expenses, you should have little trouble from the authorities. However, serious penalties exist for tax misdemeanours, and you’re required to keep your accounts for six years. So if at any point tax authorities become suspicious, they can dig into the past even after they’ve agreed your figures – back six years if they suspect you’ve been careless, and back twenty years if they believe you’ve intentionally filed false accounts.

If you’re found to have underpaid tax, you have to pay any tax you owe, plus interest, as well as a penalty of up to 100 per cent of the tax owed. These penalties are big business for HMRC: research published in October 2012 by UHY Hacker Young, an accounting firm, indicates that HMRC netted £434 million in extra tax and fines for small and medium-sized companies in the preceding year.

A tax investigation can be triggered for a variety of reasons, ranging from the banal to the frankly terrifying. A number of businesses are put under the spotlight each year, and you may just be pulled out of the hat. Or you may be in an industry that for one reason or another is being investigated generally. However, the more likely reason is that your accounts have shown major and unexplained changes (unusually high expenses, for example) or that you’ve been noticed for having a lifestyle inconsistent with the profits you’re reporting. This revelation can come about through a diligent tax inspector, an envious neighbour, a disgruntled former spouse or employee, or indiscreet gossip in the pub.

However the investigation is triggered, you need professional advice from your accountant immediately. And it would certainly be prudent to protect yourself from any problems by getting insurance against a tax, VAT or NI investigation.

Joining the Federation of Small Business gives you immediate professional support and essential protection for tax matters (www.fsb.org.uk/tax-protection). Membership starts at £120 a year, plus a £30 joining fee, plus VAT. Also check out Tax Donut, which has useful advice on dealing with a tax enquiry (www.taxdonut.co.uk/tax/tax-problems-and-investigations/tax-investigations).