The Government seems intent on simplifying tax for small businesses. The Office of Tax Simplification (OTS) published three documents in February 2012. One document dealt with HMRC administration, and a second dealt with disincorporation relief. The third OTS document looked at simpler income tax for the 'smallest' business, or what it refers to as ‘nano’ businesses.
The OTS concentrated its review of simpler income tax on small unincorporated businesses with a turnover of £30,000 or lower. It recommended that those businesses should be allowed to calculate their profits using receipts and payments, but with the option to use ‘generally accepted accounting principles’ instead. The OTS also recommended simplified arrangements for claiming certain business expenses, such as use of home and business mileage, and allowing a deduction for capital items instead of capital allowances. The OTS had looked at using methods of calculating the tax charge for small businesses other than a profits basis, such as a turnover-based tax, but concluded that receipts and payments accounting was probably the way forward.
HMRC subsequently published the consultation document ‘simpler income tax for the simplest small businesses’ on 27 March 2012. HMRC’s consultation concentrates on just two areas. Firstly, it outlines the introduction of a voluntary simplified cash basis for income tax. Secondly, it consults on simplified arrangements for certain business expenses. The Government proposes to introduce both measures from April 2013.
HMRC’s consultation document states that around 3.5 million individuals undertake trades, professions or vocations in theUK, of which more than 3 million have a turnover below £77,000, which is the VAT threshold from April 2012. Rather than follow the OTS recommendation that the cash basis should apply to businesses with a turnover of up to £30,000, the Government has proposed that the cash basis should apply to businesses with the higher turnover of up to £77,000 instead.
The Government proposes that the cash basis would be entirely voluntary. A small business using the cash basis could therefore revert back to using the normal rules for calculating taxable profits if it wished, although the practicalities of changing from one basis to another would probably make it seem unattractive, particularly if changing the basis frequently. The cash basis will apply to new and existing businesses. An existing business would therefore be able to apply the cash basis. The self-assessment return will probably include the optional facility for individuals to select the cash basis. However, in reality some small businesses may be unable to use the cash basis, e.g. where full accounts under generally accepted accounting practice are required by third parties, such as banks.
The new cash basis will operate by reference to the tax year. This means that it will not be possible for businesses to select a period of account ending on a date other than 5th April. This will obviously have an impact on the timing of tax payments (e.g. comparing an individual with accounts ending on 5th April with another individual who prepares accounts up to 30th April each year). In addition to new businesses, it would seem that if an existing business with a year end of (say) 30 April wished to use the cash basis, the business owner would be compelled to change the accounting date to 5th April. This may not be an attractive prospect for many small businesses.
As mentioned, the Government proposes that entry into the cash basis would be available where receipts for the tax year are below the VAT registration threshold (i.e. £77,000 for 2012-13). Businesses would be allowed to continue within the cash basis until receipts for the tax year exceeded £150,000. In those cases, the normal tax rules would apply from the start of the following year.
The cash basis would be available to businesses carrying on a trade, profession or vocation. Property businesses would therefore be excluded. Companies would also be excluded, as would LLPs, businesses registered for VAT but not using the VAT cash accounting scheme, and financial trading businesses among others. However, general partnerships of individuals would probably be eligible in most cases.
An individual with more than one business would be eligible to use the cash basis, but only if all of the businesses were eligible for, and actually used, the cash basis. Thus if an individual decides to stop using the cash basis and apply the normal rules to one business, all of his or her other businesses must cease using the cash basis as well.
For new businesses, two options are being consulted on in terms of how the cash basis might apply. The first option is that the new business owner would have the option of using the cash basis or using normal rules. The second option is that the cash basis would apply by default, unless the new business opted out and elected to use the normal rules instead.
As far as existing businesses are concerned, it is proposed that the normal tax rules would continue to apply, unless the business owner made an active choice of switching to the cash basis.
Income and expenses
Under the cash basis, trading income would be taken into account in the tax year of receipt. Income would also include ‘money’s worth’ (e.g. the value of goods or services received from a customer instead of cash). Also included in income would be the value of transactions on a non-commercial basis (e.g. stock taken for personal use without payment).Saleproceeds for capital assets such as plant or machinery would also be included, if the original cost of those assets was taken into account previously.
With regard to business expenses, those expenses ‘wholly and exclusively’ for the purposes of the business would be taken into account for tax purposes when those expenses were paid. In addition, allowable expenses would include certain capital expenditure. This deduction would replace capital allowances, which would therefore not be available. As at present, no deduction would be available for capital assets with an 'enduring benefit' to the business, such as land and property. No deduction would be available in respect of cars or motorcycles, as a standard mileage rate for business mileage would be used instead. A deduction would be allowed for the purchase cost of business vehicles such as vans, unless the business chose to apply fixed mileage rates instead.
Certain expenses would not obtain a deduction. This would include, unsurprisingly, entertaining and expenditure for private purposes. In addition, no deduction would be allowed for the cost of borrowings, including interest payments. HMRC’s reasoning for excluding deductions for interest payments is broadly that calculating deductions for interest can involve considering anti-avoidance rules and accounting principles. However, in practice the denial of a deduction for interest payments will probably be a major disincentive for many small businesses that rely on borrowings, particularly in the early years of the business.
The cash basis would operate inclusive of VAT if applicable, i.e. receipts and payments would include any VAT element. VAT payments to HMRC would be an allowable expense, and VAT refunds would be business receipts.
With regard to loss-making businesses, if the cash basis gave a negative result, it is proposed that this amount could only be carried forward against any future profit (or 'positive result’), i.e. no ‘sideways’ relief would be available against the individual’s other sources of income. Business owners would therefore need to think carefully whether to use the cash basis, particularly in the early years of a new business when ‘sideways’ relief can be particularly important.
As mentioned, before using the cash basis for the first time, an existing small business with a period of account ending other than on 5 April under normal tax rules would need to bring its period of account to an end on 5th April. When a small business enters or leaves the cash basis, it may need to make adjustments to taxable income. For example, in the first year of using the cash basis, an existing business may need to consider adjustments for tax purposes in respect of accruals and prepayments, stock, and capital allowances. Similar considerations would apply when a business switches from using the cash basis to using the normal rules, to ensure that receipts are taxed only once, and expenses are allowed only once.
The second element of simplified income tax for small businesses is simplified expenses. The consultation breaks these down into three main areas; firstly, a standard mileage rate for business use of cars and motorcycles; secondly, flat rate expenses for business use of home; and thirdly, flat rate adjustments for personal use of business premises. Using simplified expenses would avoid the potential complexity of calculating actual expenses in these categories.
Simplified expenses would be compulsory for businesses using the cash basis. However, unincorporated businesses using the normal tax rules would be able to use any of the simplified expenses rules if the business owner chose to do so.
Standard mileage rates
Standard mileage rates for business use of motor vehicles would replace relief for actual expenditure on purchasing, maintaining and running a motor vehicle. At present, mileage rates are sometimes used by small business owners, but simplified expenses will put this practice onto a statutory basis. In addition to replacing deductions for expenses such as fuel, insurance and repairs, no capital allowances would be available in respect of any motor vehicle on which the mileage rate basis is used. It will be necessary for the business owner to maintain a record of business miles travelled in order to calculate the mileage allowance available. Once the mileage rate has been used for a particular vehicle, it will not be possible to change the basis in subsequent tax years.
Use of home
The proposal for flat rate expenses for business use of home is that taxpayers would be able to claim a standard deduction for business use of home, if certain core business activities are undertaken at home for at least 25 hours per month. So if less than 25 hours were spent on such activities in a particular month no deduction would be available for that month. Core business activities to be undertaken at home might include providing goods or services to customers, or possibly sales and marketing. However, activities such as storage or administration (e.g. preparing accounts and tax returns) would not qualify. The level of flat deduction would depend on the time spent undertaking the qualifying business activity, and would range from £8 per month (i.e. up to £96 per year) to £24 per month (i.e. up to £288 per year). A simpler alternative method is also proposed, which is that a single flat rate deduction would apply, regardless of the extent of business use of the home. The proposed flat rate is £16 per month, or £192 a year. These amounts are unlikely to get many taxpayers very excited!
With regard to the flat rate adjustment for the personal use of business premises, the proposal is to introduce standard fixed-rate amounts which would be excluded from total establishment costs claimed for tax purposes, depending on the number of persons occupying the business premises.
Helpful for some
Overall, the proposed cash basis and simplified business expenses should be very helpful for many small businesses, particularly new start-ups. The cash basis will perhaps be less attractive for some existing businesses due to the reasons outlined above. However, the proposed rules are not compulsory and businesses will therefore be able to opt into the cash basis if it is beneficial for them to do so. Of course, the proposals may change between the end of the consultation period on 22 June 2012 and their introduction in April 2013.
HMRC Administration is another proposed area of simplification. Various 'tools' have recently appeared on HMRC’s website, such as the ‘online business tax dashboard’ to enable businesses to see how much tax they have already paid and how much they still owe, and a self-employed ready reckoner, to enable self-employed individuals to budget for tax liabilities.
The OTS also prepared a report on the possible introduction of a disincorporation relief for small businesses. 'Disincorporation' for these purposes broadly means the transfer of a company’s business from the company to its shareholders, who would then continue to carry on the business in an unincorporated form. The OTS proposed that disincorporation relief would be aimed at small trading companies no longer wishing to operate as a corporate entity, where there is no commercial need to operate through a company. The proposed relief would allow a company holding internally generated goodwill, plus land and buildings and plant and machinery, to pass to an unincorporated business with no tax charge on the company, and no distribution charge on the shareholders as a result of transferring those assets. In response to the OTS documents on disincorporation relief, HMRC is consulting on making it easier for small companies to become unincorporated.
Finally, with regard to IR35 and personal service companies, it was announced in Budget 2012 that the Government will be introducing a package of measures to tackle avoidance through the use of personal service companies. This would include the requirement for officeholders and/or controlling persons who are integral to the running of an organisation to have PAYE and NIC deducted at source by the organisation by which they are engaged. HMRC and the Treasury published a consultation document 'The Taxation of Controlling Persons' on 23 May 2012, following the publication of guidance notes ('Business entity tests: Example scenarios') on 9 May 2012.
Mark McLaughlin CTA (Fellow) ATT TEP