Cash is King?

The new cash basis for calculating the income tax paid by small businesses was passed into law this July (Finance Act 2013). It will be welcome news for some but unfortunately layering a new method of calculating tax on the established UK tax system has not proved to be a simple matter and as a consequence there are more traps for the unwary than might be imagined. Professional advice is therefore likely to pay for itself.

Which businesses can use the new cash basis?

In essence sole traders and partnerships with a turnover of up to but not including £79,000, or if they are Universal Credit claimants £158,000 (estimates for the 2013/14 tax year). However, there are significant exclusions, for example limited liability partnerships and those businesses which have made use of certain tax allowances such as research and development and business premises renovation allowance. It bears emphasising that the cash basis cannot apply to companies as they pay corporation tax, not income tax.

An election is required

You need to elect to enter into the cash basis within a year of the normal filing deadline of 31st January. However you must exit the scheme once your turnover reaches £158,000 (estimated). You can only choose to exit the cash basis before that if it is ‘appropriate’ for you to use UK GAAP accounting, so elect with care.

How does the current system work?

Business accounts (balance sheet and profit and loss account) are prepared using generally accepted accounting principles (UK GAAP) which involve concepts that many are not comfortable with, such as accruals and prepayments. The profit from the profit and loss (or earnings) statement is adjusted for a number of items in accordance with tax law such as capital expenditure (recorded in the balance sheet) to arrive at the profit subject to income tax.

How does the cash basis system differ?

Cash expenditures are deducted from cash receipts in the accounting period to arrive at the profit subject to income tax. However, as this is an entirely new system in the UK, it has its own unique set of rules which have been grafted onto existing legislation rendering the hoped-for simplicity an unachievable goal for many businesses. For example sometimes market value needs to be substituted for the cash amount and the rules for interest on loans etc. are entirely different as they are capped at £500 for the tax year.

Existing legislation for the tax treatment of capital expenditure – capital allowances – is disapplied and replaced with new rules. Perhaps unsurprisingly it will not be possible to deduct the entire cash purchase price of a car, but this would not apply to cash expended on a motorcycle or van (subject to ‘private use’ restrictions).

How much more complicated can it get?

If you started business prior to 2013/14 GAAP accounting rules should have been applied. Unfortunately if you elect for the cash basis to apply for 2013/14 and subsequent years you need to navigate special rules to ensure, for example, that receipts are only taxed once and expenses relieved once. These complications are repeated when you leave the cash basis.

Are there any other issues to consider?

Yes, relief for tax losses is very limited as they can only be carried forward to future years. Under the UK GAAP system the use of losses is far more flexible and therefore more likely to lead to them being set against taxable income.

What should I do?

Hopefully this article has alerted you to the complications thrown up by this apparent simplification. It is is recommended that you consider your options with your professional adviser.

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Plan now to avoid a tax rate of 55% on your pension income

With Mark Carney predicting an increase in asset prices for the future a very significant number of individuals could be caught out by the new £1.25m pension lifetime allowance which is set to be introduced from 6th April 2014. The lifetime allowance is calculated when pension income is taken (a ‘benefit crystallisation’ event) and is essentially the capital value of your pension at that point. Remember that an £850,000 pension pot will grow to over £1.25m in ten year with a modest growth rate of 4% per annum.

Many more modestly paid individuals have been shocked to find that a slice of their projected pension income could be subject to a draconian 55% tax rate; especially those in the professions and the public sector.

Fixed protection

The good news is that an election (‘Fixed Protection 2014’) can be made for the existing cap of £1.5m to apply provided this is made on or before 5th April 2014 deadline but the bad news is that you will probably have to stop all pension contributions. If you think that you may be affected you should start planning immediately given the extensive time that is usually required to obtain information from pension providers.

Individual protection

If you wish to continue contributing to your pension from 6th April 2014 but fear that you may exceed the £1.25m lifetime allowance by the time you take your pension, you can instead opt for ‘Individual Protection’ (provided you pension pot is at least £1.25m on 6th April 2014). The latest comment on this can be found in pensions newsletter 58. If you make the election (and it is likely that there will be a three year time limit for this) you can achieve protection up to £1.5m based on the value of your pension as at 5th April 2014. It has been announced by HMRC that you can hold both fixed protection 2014 and individual protection 2014 but you can’t apply for them at the same time.

The ‘Individual Protection’ rules will be contained in Finance Bill 2014 clauses which should be released later this year. You should consider applying for 2014 fixed protection even if you have taken advantage of the previous fixed protection arrangements (2012 and earlier).

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HMRC is watching you on LinkedIn

Powerful new software uses social network analysis to connect the dots between disparate sources of information on you, including its own databases and data from websites such as eBay, Facebook and LinkedIn. This is then used to build up a picture of your tax affairs.

The software is called, appropriately enough, Connect and is still very much in its infancy, but despite this it already holds billions of pieces of data. Fast forward five to ten years and it is likely that the technology will have improved significantly allowing HMRC to launch investigations with surgical accuracy.

If you have concerns and wish to put your tax affairs in order there is no time like the present to contact your tax adviser. For personal clients note that Connect is being used by HMRC’s Affluent Unit which focuses on individuals with assets in excess of £1m.

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Fines of £1m for high risk tax scheme promoters

In a consultation issued last month Raising the Stakes on Tax Avoidance the Treasury is seeking to isolate high-risk promoters of tax avoidance schemes from mainstream tax advisers such as Alvery (who also follow a strict code of ethics) by increasing HMRC’s information powers and penalties.

There is no doubt that the business model of the aggressive promoter is broken leaving those taxpayers who have been tempted into aggressive schemes in a very precarious situation and HMRC with a 10 year backlog of cases to resolve.

Taking matters into your own hands can be a terrifying experience and are you really going to trust those that sold you the scheme in the first place with your tax affairs? Alvery have considerable experience of resolving contentious matters created by others in both the corporate and personal tax environments.

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New Statutory Residence Test

Seychelles (credit alwarur)

The new test for UK residency (which applies from 6th April 2013) provides greater certainty for arrivers to and leavers from the UK regarding their UK tax liability.

‘Arrivers’ are those individuals who have been non UK resident in the last tax three years and ‘Leavers’ those who have been. Days refer to days in the income tax year (6th April to 5th April).

Automatic non residence

Firstly, there are automatic non residence tests: for ‘Arrivers’, if the individual is present in the UK for fewer than 46 days they are automatically non-resident whereas ‘Leavers’ spending only 16+ days in the UK are resident. There is however a full time ‘working abroad’ exception which can extend the stay in the UK for ‘Leavers’ from 16 up to 91 days (of which up to 30 days can be spent working in the UK).

Automatic residence

Secondly, there are automatic residency tests. Anyone who spends 183 days or more in the UK will automatically be resident. However, ‘leavers’ with only one home which is in the UK may be treated as resident, albeit those who reside fewer than 30 days in their UK property will be treated as non-resident. Working full time in the UK (with up to 25% of the time spent working overseas) will also result in automatic residency.

The five ties

Thirdly, if an individual is neither automatically resident nor automatically non-resident there are a further five ‘ties’ that need to be considered together with the amount of time spent in the UK:

  • Family (spouses, partners and minor children)
  • Accommodation owned or rented (available for 91+ days, and used for one night or more)
  • Substantive work in the UK (40+ working days)
  • UK presence in previous 2 tax years (>90 days in either)
  • For ‘Leavers’ only: Whether more time spent in UK than any other country.

The following table of time spent in the UK together with the 5 ties then determines residency:

Days in UKArrivers (persons not resident in the UK in previous 3 tax years)Leavers (persons resident in the UK in at least 1 of previous 3 tax years)
183+ResidentResident
121-182Resident if at least 2 ties applyResident if at least 1 tie applies
91-120Resident if at least 3 ties applyResident if at least 2 ties apply
46-90Resident if at least 4 ties applyResident if at least 3 ties apply
16-45Non-residentResident if at least 4 ties apply
<16Non-residentNon-resident

The rules are for general guidance only; if you believe you may be affected by this we would always recommend that you seek specific advice tailored to your circumstances.

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Offshoring… yourself?

Does the possibility of a wealth tax make you feel like leaving the country now? We look at the options

Credit: fsc2k5 @sxc.hu

Although emigrating simply to avoid tax may seem like a rather extreme option, if you have been considering leaving the country for other reasons it might be sensible to be open-minded and choose a country that has a favourable tax treaty with the UK. This is quite apart from the non-tax considerations that you need to weigh up in these challenging times.

Treaties and agreements

In principle a bi-lateral double tax treaty overrides domestic law and consequently will determine the taxing rights of the two countries concerned. It behoves you to remember that its primary purpose is the elimination of double taxation. If you are treaty resident overseas (as defined) you ought only to be subject to overseas tax on non UK income. It is also worth noting that there are currently more information exchange agreements in place between jurisdictions than previously.

Home from home

Near to home there is the Isle of Man, Jersey and Guernsey in particular to consider. As an individual you would need to spend on average more than three months a year on the IOM to gain residence there. The avoidance of UK capital gains tax can generally now only be achieved if you actually leave the UK for more than five years, although there are exceptions. You may also wish to consider inheritance taxes (these have their own special treaties of which there are approximately only nine with the UK).

Different taxes, different considerations

UK income tax depends on residence and capital gains tax currently depends on both residence and ordinary residence. Inheritance tax is domicile driven and harder to shed. Great care is required to make a distinct break with the UK and as there are generally many traps for the unwary you are strongly advised to seek the services of a professional tax adviser as changes are frequent.

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How can a high net worth individual mitigate tax liabilities?

Introduction

HNW - Credit bern161616 @ sxc.hu

High income earners in the UK have found that managing their tax affairs has become increasingly challenging. Political discourse has sought to blur the line between tax evasion (illegal) and avoidance (legal), which could reach its zenith in the Budget on 21st March if a general anti-avoidance rule is introduced. This would make hitherto legal avoidance arrangements illegal if they are deemed to be “abusive”.

The spectre of retroactive legislation (recently highlighted by HMRC action against Barclays) also haunts aggressive tax avoidance arrangements. There must be concern that this could be applied to mass-marketed tax planning schemes, making them illegal and forcing a payment of tax where none had been due.

So what is left for the high income employee?

Despite this furore, tax mitigation and planning remains a legitimate activity. There are still many options, including:

Income tax

  • Share based incentives such as deferred, joint or growth share plans offer the opportunity to arrange matters so that increases in value are only subject to capital gains tax, rather than the more costly income tax.
  • If you are in a position to, setting up a limited liability partnership (LLP) / corporate structure could be considered if it suits your commercial purposes. There can be tax advantages if funds are retained as they can be subjected to corporation tax rates only and some NI savings are possible.
  • We have previously covered the various SEIS, EIS and VCT opportunities that offer considerable tax advantages. As these have been designed by legislation to be incentives for investment, they are unlikely to fall into the traps outlined in the introduction.

Capital gains

  • A high net worth individual is only subject to UK CGT if he/she is UK resident, meaning that emigration is a possible (if extreme) option. Despite the recent Gaines Cooper case, uncertainty over residency rules remains as the new statutory residency test has been pushed back to April 2013. As things stand, one is required to demonstrate non-residency for five complete years. Depending on the circumstances one needs to be prepared to change one's lifestyle, dispose of the main residence and probably not set foot back in UK for at least a year.
  • Even if emigration is unfeasible, entrepreneurs' relief and other statutory reliefs can substantially reduce CGT liability in appropriate circumstances.
  • Otherwise protected cell companies or collective investment vehicles and simple timing of disposals can be used to at least defer gains.

IHT planning

  • Often inheritance tax planning can be left far too late given the level of the nil-rate band at £325,000 and the need to survive 7 years. Maximising the use of business property relief (potentially available also for furnished holiday lettings following the decision in the First Tier Tribunal recently) is normally one of the first plans.
  • Trusts should still be considered even for domiciled individuals despite the draconian changes in 2006.

Conclusion

Tax legislation is complex, and with HMRC becoming more aggressive, dealing with tax has become more pressing. As one does so, it would seem prudent to arrange matters in the most efficient manner possible. There are still many options available, but planning must be implemented more intelligently and carefully than it was in the past. It is probably now essential for planning to have a commercial purpose as artificial transactions undertaken solely for the avoidance of tax are likely to fail.

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Inheritance tax charity relief

It is proposed from April 2012 that if 10% of the ‘net estate’ of a deceased person is given to charity, the remainder of the net estate will be subject to a reduced inheritance tax rate: 36% instead of 40%.

The ‘net estate’ is the amount of the estate that would normally be subject to inheritance tax after deducting any unused nil-rate band and any other deductions (except, of course, the normal deduction for donations to charity).

An example

This is best illustrated as follows:

Daniel dies on 1st June 2012, unmarried and leaving a free estate worth £1,000,000 to his niece. His unused nil-rate band is the full £325,000. This means his taxable estate is £1,000,000 – £325,000 = £675,000.

If nothing is left to charity, the estate will be distributed as follows:

  • Niece: £1,000,000 – £675,000 x 40% = £730,000
  • HMRC: £675,000 x 40% = £270,000

However, if £67,500 of the estate is left to charity (10% of £675,000), it will be distributed thus:

  • Niece: £1,000,000 – £67,500 – (£675,000 – £67,500) x 36% = £713,800
  • HMRC: (£675,000 – £67,500) x 36% = £218,700
  • Charity: £67,500

In other words, the charitable donation of £67,500 is effectively funded by £16,200 from the niece and £51,300 by HMRC.

A win-win situation

If a charitable donation is not included in the will, or is less than the required 10%, then it can be made by deed of variation. This latter scenario could be particularly advantageous to both charity and beneficiaries if, for example, the charitable donation fell just short of 10% of the net estate. In this case the charity and other beneficiaries would gain at HMRC's expense.

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When HMRC become interested in your hobby

Credit: plex @sxc

As we alluded to in our article on the Rise of Tax Investigations, HMRC will soon be launching a campaign using web bots to trawl through e-marketplaces such as eBay, Etsy and Amazon. They will be targeting those who run businesses through such sites, but clearly there is scope for those who simply sell goods on a regular basis to be caught by the campaign.

At what point, though, does selling handmade birthday cards on Etsy or your services as a photographer constitute self-employment rather than just a hobby?

How do I know if I'm trading?

The line between hobbies and trading can be a blurred one. It is judged by several criteria known as the “badges of trade”. These include:

  • Profit seeking motive
  • Frequency and number of similar transactions
  • Nature of the asset being sold
  • Length of ownership of that asset
  • Reason for the acquisition/sale of the asset
  • Connection with an existing trade
  • Advertising

Just one of these badges may be enough to show trading, but more usually a combination is considered. HMRC are most concerned with profit seeking motive as if there is no profit there's nothing to tax. Such a motive will arise when you seek to do more than simply cover the cost of your materials.

What are the tax implications?

If you have determined that you are trading you will be liable to income tax and National Insurance Contributions if you earn over certain thresholds. Even if these thresholds aren't met, you must inform HMRC within 6 months of the end of the tax year or you may be fined £100 for failure to notify. Registering as self-employed can be done by completing form CWF1 (pdf) or online. Once registered, you will need to complete a self assessment tax return by the 31st January following each tax year.

Income tax

Any profit you make will be taxable if your total earnings (including any other employment) exceed the personal allowance (£7,475 for 2011/12). Whether or not you make a profit, though, you will need to record your income and expenses on your tax return. Assuming you complete this online your income tax liability will then be calculated for you.

If you make a trading loss then this can be offset against your other income for the year, or carried forward or back against income for other years subject to various rules. However, if HMRC determine that there is no profit seeking motive to your hobby they will disallow any losses from it.

National Insurance

Self-employed people are generally required to pay both Class 2 and Class 4 National Insurance Contributions (NIC). However, if you are earning below the small earnings exception (£5,315 for 2011/12) you can elect not to pay Class 2 NIC by completing form CF10 (pdf) and if you earn below the lower profits limit (£7,225 for 2011/12) you don't have to pay Class 4 NIC.

The rates for National Insurance Contributions are set out on HMRC's NIC page.

VAT

If your “hobby” has grown into a fully-fledged business you might have to start to think about VAT. If your turnover for the previous 12 months exceeds £73,000 (2011/12) or will exceed that amount in the next 30 days alone (perhaps due to a big order for your birthday cards) then you will need to register for VAT. This will usually make your goods more expensive for your customers (assuming they're not VAT registered themselves) but if so you will generally be able to claim back input VAT on your supplies.

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HMRC launch Contractual Disclosure Facility

On the 31st January HMRC added a new string to their bow in their crackdown on tax fraud: the Contractual Disclosure Facility. It represents a tightening of HMRC’s Code of Practice 9 (pdf) civil investigation of fraud procedure. The aim is reduce the 20% of cases under the old system (pdf) in which no disclosure was made.

Same bark, more bite

Under the previous Code of Practice 9 (CoP9), taxpayers suspected of tax fraud were given the opportunity to opt for a civil investigation, giving them immunity from criminal prosecution in return for disclosing their affairs to HMRC. HMRC was bound to the civil process unless “materially false statements are made or materially false documents are provided with intent to deceive in the course of a civil investigation”, which allowed those who had opted for the old CoP9 to stall and ultimately fail to disclose their affairs.

As the name suggests, the Contractual Disclosure Facility (CDF) introduced in the new CoP9 formalises matters by requesting that the taxpayer signs a contract promising that they will disclose their tax affairs promptly. Failure to do so will be breaking the terms of the contract and will lead to being thrown out of the civil route and into criminal one.

The new system

When HMRC write to a taxpayer suspected of fraud they will offer the CDF, which if refused will usually lead to criminal prosecution. Taxpayers seeking civil proceedings must:

  • Sign the CDF contract promising full disclosure and ongoing co-operation
  • Make an outline disclosure of their tax affairs within 60 days
  • Pay all tax, penalties and interest due
  • Cease the fraudulent activity

Take care, seek advice

The CDF does not apply to mistakes, errors or avoidance schemes. It only applies to tax fraud, and therefore if you receive a letter offering the Contractual Disclosure Facility it must be treated very seriously. HMRC acknowledges this, stating in their CoP9 that “you are strongly advised to seek independent professional advice.”

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