Income Tax


What is Income Tax?

Sole traders are subject to Income Tax.

This is a tax on income. Not all income is taxable and you're only taxed on 'taxable income' above a certain level. Even then, there are other reliefs and allowances that can reduce your income tax bill. In some cases, this will mean you don't have to pay any tax.

Trading profit

Trading profit is the income of your business that HM Revenue and Customs (HMRC) will be taxing. It's calculated by adding all the trade receipts of a business together and deducting its expenses. Not all expenses are deductible; if in doubt, get professional advice, or contact HMRC.

Most receipts of a trade, like those from sales, can be easily identified. Others are more complicated. For example, money received as a token of personal appreciation when a trading relationship ends wouldn't be a trade receipt. However, money received as compensation when a trading contract is cancelled would be a trading receipt.

Deductible expenditure

In calculating trading profit, you can deduct expenses that are:

  • of an income nature;
  • incurred wholly and exclusively for the trade; and
  • not banned by special tax rules.

These expenses are called 'deductible expenditure'.

Expenses of an income nature

To be deductible, expenses must be income in nature. This means they're regular or recurring expenses rather than one-off expenditure. Payments for electricity, telephone charges, staff salaries and interest on loans, etc. are likely to be expenses of an income nature as they're incurred repeatedly.

One-off expenditure on assets that will be kept by the business for a longer period are capital expenses. These aren't deductible from trading profits. However, you may be able to deduct capital allowances instead. See 'Capital allowances' below for more information.

For example, if you're an antique dealer, the cost of buying stock is an expense of an income nature, as your business will sell this stock to earn income. Therefore, when calculating trading profits, you can deduct the expenses of buying stock from trade receipts. However, the cost of buying an antique desk for your office is of a capital nature. You'll keep this desk and use it in your business in the long-term, rather than sell it to generate income. It isn't a deductible expense.

Capital allowances

What is a capital allowance?

'Capital expenditure' is money spent on buying machinery and equipment used for your business. You generally can't deduct the entire amount of your capital expenditure for the year from your trading profits for that year. However, you're allowed to claim tax relief on capital expenditure in certain instances. This tax relief is known as a 'capital allowance', and it allows you to deduct a set percentage of the capital expenditure from your trading profits. The percentage is set by the government. This amount isn't the same as depreciation.

You can claim capital allowances on:

  • the cost of vans and cars, machines, scaffolding, ladders, tools, equipment, furniture, computers and similar items you use in your business;
  • the cost of plant and machinery; and
  • items you used privately before using them in your business.

You can't claim a capital allowance for things that you buy or sell as your trade - these are deducted from profits as deductible expenses. If you buy on hire purchase, you can claim a capital allowance on the original cost of the item, but the interest and other charges count as deductible expenses.

How much can I deduct as a capital allowance?

You may be able to claim 100% of the purchase price of capital items bought during the tax year where the following allowances apply:

  • Research and development (R&D) capital allowances on expenditure on assets or facilities used by your employees to carry out R&D relating to your trade;
  • First-year allowances on investments in new equipment for energy-saving or water-efficient technology;
  • Allowances for equipment for refuelling vehicles with natural gas, biogas or hydrogen; or
  • First-year allowances for new:
    • Electric vehicles;
    • From April 2018, cars with C02 emissions no greater than 50 g/km – before that, it was emissions no greater than 75 g/km

Annual Investment Allowance

If you buy new plant and machinery that doesn't benefit from the 100% allowances mentioned above, you may be able to deduct an Annual Investment Allowance (AIA) from your profits.

Originally, for the 2012/13 tax year, all businesses had an AIA of 100% on the first £25,000 of qualifying expenditure on plant and machinery. However, this increased on 1 January 2013 to £250,000. It has been increased further to £500,000 for such expenditure made between 6 April 2014 (1 April 2014 for Corporation tax) and 31 December 2015. It was lowered to £200,000 as of 1 January 2016.

This means that if, for example, you spent over £500,000 on plant and machinery in your accounting period from 1 January 2015 to 31 December 2015, you could deduct 100% of the first £500,000 from your profits. You could then claim the standard writing-down allowance (see 'Writing-down allowance' below) of 18% on amounts in excess of £500,000 spent on buying new plant and machinery.

If, however, the only item of plant and machinery you bought in that period was a machine for £300,000, this expenditure would fall completely within the AIA. Therefore, you could deduct 100% of the cost (i.e. the full £300,000) from your trading profits for that year.

If you spend £300,000 for the year on plant and machinery after 1 January 2016, you will only be able to claim the AIA of 100% of £200,000. You will then only be entitled to the writing-down allowance on the balance of £100,000.

Writing-down allowance

Each year, instead of depreciation, you're allowed to deduct from your trading profits a 'writing-down allowance' for your capital expenditure. This allowance therefore reduces your trading profits before they're taxed.

Instead of calculating separate writing-down allowances every year for every item of plant and machinery, plant and machinery is generally put in a pool. The writing-down allowance is calculated for the pool.

In the tax year in which you buy an item of machinery, you would deduct any capital allowances available in the first year, such as the AIA:

  • from your trading profits to reduce them before they're taxed; and
  • from the cost of the machinery bought that year to get the residual value of the machinery. This residual value is added to the pool of plant and machinery.

The value of the pool of plant and machinery would be the total value of plant and machinery you've bought less all the capital allowances you've claimed for this plant and machinery.

The value of the pool is reduced by the writing-down allowance for each year, so that you start the next tax year with a lower pool. Writing-down allowances are a percentage of the balance of the pool rather than a percentage of the original cost of the plant and machinery.

Since April 2012, the standard writing-down annual allowance that you can claim each year on a pool of plant and machinery is 18% of the value of that pool. There is a special rate of 8% that applies to the pool of integral features of buildings, like electrical systems, thermal insulation and equipment with a planned life over 25 years, as well as cars with CO2 emissions of more than 130g/km.

If the balance of the pool of plant and machinery is less than £1,000 in a 12-month accounting period, instead of the normal writing-down allowance, you may be able to claim a 'Small Pools Allowance' of up to £1,000 to completely write it off.

Example of standard writing-down allowance calculation

If in February 2013, a builder buys new plant and machinery worth £266,000, he would deduct his AIA of £250,000 from his trading profits in 2012/13.

Assuming he has no other plant and machinery, the capital expenditure for which he hasn't yet claimed a capital allowance (£266,000 - £250,000 = £16,000) would form his pool of plant and machinery ('main pool') for the next tax year.

Year 1: Capital allowance = AIA of 100% of £250,000, leaving £16,000 as the pool

In the following tax years, his writing-down allowance would be 18% on the balance of the pool each year.

His writing-down allowances are as follows:

Year 2: 18% of £16,000 = £2,880, leaving £13,120 as the reduced balance of the pool

Year 3: 18% of £13,120 = £2,361.60, leaving £10,758.40 as the reduced balance of the pool

Year 4: 18% of £10,758.40 = £1,936.51, leaving £8,821.89 as the reduced balance of the pool

Suppose that the builder's trading profits (after deducting expenses) are £300,000, £350,000, £360,000 and £370,000 for Years 1, 2, 3 and 4 respectively. The builder's income for tax purposes is as follows:

Year 1: £300,000 - £250,000 (AIA) = £50,000

Year 2: £350,000 - £2,880 = £347,120

Year 3: £360,000 - £2,361.60 = £357,638.40

Year 4: £370,000 - £1,936.51 = £368,063.49

Income Tax on trading profit

Income Tax on trading profits is assessed under the following rules:

The first tax year of a new business

In the first tax year, Income Tax will be assessed on the profits made during that tax year, i.e. from the date you started your business to the following 5 April.

The second year of a new business

In the second tax year, the Income Tax assessment period depends on the accounting date that you've chosen for your business, i.e. the last date in your accounting year. If, in your second year of business, there is less than 12 months between the start of trading and your accounting date, you'll be taxed on the income for 12 months since the start of trading. If your accounting date is 12 months or more from the start of trading, you'll be charged income tax on the profit in the 12 months ending with your accounting date.

Subsequent years of a new business

In the third and subsequent years, Income Tax will generally be assessed on the profits of the 12-month accounting period ending in that tax year.

Overlap relief

These rules may result in you paying tax twice on 'overlap profits' in the first 3 years of business. For example, if you started business on 1 January 2014 and drew up your accounts for the year ending 31 December 2014, you'd have an accounting date of 31 December. You'd pay Income Tax for profits for the period 1 January 2014 to 5 April 2014 in the 2013/14 tax year. In the 2014/15 tax year, you'd pay income tax on profits for your accounting period of 1 January 2014 to 31 December 2014. You'd therefore end up paying twice on the profits of the overlap period of 1 January 2014 to 5 April 2014.

If you started the business on 1 February 2014 and prepared your accounts at the 31 December each year, you would pay tax:

  • in the tax year 2013/14 on profits made between 1 February 2014 and 5 April 2014;
  • in the tax year 2014/15 for profits made between 1 February 2014 and 31 January 2015 (i.e. for 12 months since the start of trading); and
  • in the tax year 2015/16 on profits made between 1 January 2015 and 31 December 2015.

In this example, you'd pay tax twice on profits between 1 February 2014 and 5 April 2014, and on profits between 1 January 2015 and 31 January 2015.

However, you could reclaim this Income Tax by 'overlap relief' if you end the business. It might be useful to discuss with an accountant the effect of when you start business on your cash flow.

The closing tax year of a business

In the final year, Income Tax will be assessed on the profits made from the end of the most recent accounting period until the date the business ends. However, you can then make a deduction for overlap relief.