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.