You can blame Napoleon for the existence of this chapter. Income tax as we know it today was introduced to pay for a war against the said gentleman. That was in 1799. It was so hated that when it was withdrawn in 1816 all the records were destroyed. However, Sir Robert Peel re-introduced the tax in 1842 and it has been with us ever since.
The lowest standard rate ever charged was 2d in the £ (0.83%) between 1874 and 1876 and the highest was 10/- in the £ (50%) between 1941 and 1946.Employees pay their tax by deduction from their wages under the PAYE scheme. However, self-employed people don’t come within the scope of the PAYE system. Instead they are taxed in arrears on the basis of their previous earnings.
How your business is taxed will depend upon the entity carrying on the business: We’ll deal first with the taxation of sole traders and partnerships. The taxation of limited companies is discussed at the end of the chapter.
Sole Traders And Partnerships
The method of working out the tax liability of sole traders and partnerships is practically the same, except that in the case of a partnership it’s necessary to work out each partner’s share of the total liability.
The Taxes Involved
The taxes that may be involved are:
- income tax – on profits
- Class 4 national insurance – on profits
- taxation on capital gains
- inheritance tax.
The last two taxes don’t normally occur each year. Inheritance tax might occur on death or occasionally on certain gifts. It can be complicated to work out the correct allowances and liability and the reader should get specialist advice if needed.
Capital gains arise on the sale of business (and other) assets. It taxes the increase in the value of the asset during the period of ownership. There are several allowances which relieve the effect of the tax. The main reasons why capital gains could affect a person in business are:
- the sale of certain equipment at a profit on its original cost, and
- more importantly, when a business or business premises are sold.
Again it is suggested that you obtain specialist advice as necessary.
Class 4 national insurance is calculated at the same time as the income tax liability, and these two taxes will be dealt with together.
Income Tax
The accounting concepts (Chapter 8) go part way to defining the profit of the business, but there are some matters still left to the discretion of the accounts producer which affect the profit disclosed. The rate of depreciation, for example, is left to the individual. In addition accounts often include the full cost of running the proprietor’s motor car or other expense, where in practice part of these costs is for his own personal benefit. So that the Inland Revenue can apply the taxes on a standardised profit a computation is needed to adjust the profit disclosed by the accounts to that required by the Inspector of Taxes.
Figure 45 illustrates the way in which the adjustments are made to the accounting profit to arrive at the profit for taxation purposes.
In the computation some of the expenses are disallowed. These include depreciation (and the loss on the sale of a motor car) and also the private element of expenses that has been charged in the accounts. In the illustration the only private expense is the car, but on other occasions it might include the following:
Fig. 45. Illustration of taxation adjustments.
This is not an exhaustive list: each case must be considered on its merits.
Where the proprietor uses goods from the business for his own purposes then an adjustment for this should also be made. If, for example, the business is a newsagents and the proprietor takes cigarettes for his own use the appropriate entries should be made. The removal of the cigarettes without payment changes the profit margin revealed by the accounts, and so the adjustment should ideally be made on the face of the accounts by adding those goods to sales (the other balancing entry of the double entry being included as drawings). However, if the adjustment is not made in the accounts it should be included as an ‘add back’ in the tax computations.
The result of disallowing or adding back expenses to the accounting profit is to remove the effect of charging them in the accounts in the first place.
The reasons for this should be clear for expenditure that is of a private nature. Less clear will be the reason for adding back depreciation: it is done to standardise the depreciation allowance.
As well as certain expenses being ‘added back’ in the computation some of the income is deducted to remove it from the assessable profit. This is not because it escapes tax but because the taxation treatment of this income differs from that of the profits. The main examples of items treated like this are bank interest received and property rental income.
Having arrived at the adjusted taxable profit there are various allowances that can be claimed in respect of depreciation.