Taxing Your Bottom Line: Company Taxes
Every business must determine its annual taxable income, which is the amount of profit subject to corporate tax or income tax if the business is not a limited company. To determine annual taxable income, you deduct certain allowed expenses from gross income. Corporation tax law rests very roughly on the premise that all income is taxable unless expressly exempted, and nothing can be deducted unless expressly allowed.
Different tax rates on different levels of business taxable income
Personal taxes, which apply to sole traders and partnerships, come on a sliding scale up to a maximum of 40 per cent. When trading as a company a business’s annual taxable income isn’t taxed at a flat rate either. In writing the income tax law, the government gave the little either. In writing the income tax law, the government gave the little guy a break. As of 2011, the corporate income tax rate starts at 20 per cent on the first £300,000 of taxable income, then quickly moves up to a 26 per cent rate on taxable income in the range of £300,001 to £1,500,000, after which it drops back to 20 per cent. Simple it isn’t! The income tax on the taxable income for the year is calculated using these tax rates.
Profit accounting and taxable income accounting
You’re probably thinking that this section of the chapter is about how a business’s bottom-line profit – its net income – drives its taxable income amount. Actually, we want to show you the exact opposite: how income tax law drives a business’s profit accounting. That’s right: Tax law plays a large role in how a business determines its profit figure, or more precisely the accounting methods used to record revenue and expenses.
Before you explore that paradox, you need to understand something about the accounting methods for recording profit. For measuring and recording many expenses (and some types of revenue), no single accounting method emerges as the one and only dominant method. Accountants have a certain amount of legitimate leeway in measuring and reporting the revenue and expenses that drive the profit figure.
What expenses can you claim when you are self-employed? Expenditure can be split into two main categories, ‘Capital’ and ‘Revenue’.
Capital Expenditure: Capital expenditure is expenditure on such items as the purchase or alteration of business premises, purchase of plant, machinery and vehicles, or the initial cost of tools. You cannot deduct ‘capital expenditure’ in working out your taxable profits, but some relief may be due on this type of expenditure in the form of capital allowances. Your Tax Office can give further advice on these allowances.
Revenue Expenditure: Listing all the expenses that can be deducted is impossible but, generally speaking, allowable expenditure relates to day-to-day running costs of your business. It includes such items as wages, rent, lighting and heating of business premises, running costs of vehicles used in the business, purchase of goods for resale and the cost of replacing tools used in the business.
To be deductible, business expenses must be ordinary and necessary – that is, regular, routine stuff that you need to do to run your business. You’re probably thinking that you can make an argument that any of your expenses meet the ordinary and necessary test. And you’re mostly right – almost all business expenses meet this twofold test.
However, HM Revenue and Customs consider certain business expenses to be anything but ordinary and necessary; you can argue about them until you’re blue in the face, and it won’t make any difference. Examples of non-allowable expenditure are your own wages, premiums on personal insurance policies, and income tax and National Insurance contributions. Where expenditure relates to both business and private use, only the part that relates to the business will be allowed; examples are lighting, heating and telephone expenditure.
Debt must really be debt and must have few or none of the characteristics of equity. Drawing a clear-cut line between debt and equity has been a vexing problem for HM Revenue and Customs, and the rules are complex. You’ll probably have to consult a tax professional if you have a question about this issue. Be warned that if you attempt to disguise equity capital as debt, your charade may not work – and the Revenue may disallow any ‘interest’ payments you have made. Payments you have made.