How does the new tax-free trading allowance work?

Spring Budget 2017
May 19, 2017
Employee Expenses Reform
May 19, 2017
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How does the new tax-free trading allowance work?

In April 2017 two new tax-free allowances for were introduced for micro businesses. One applies to trading and miscellaneous income and could save you tax on up to £1,000. How can you take advantage of it?

It was a pleasant surprise when in the 2016 Budget the Chancellor announced two new tax allowances of £1,000 each. Both apply for 2017/18 and later years. One is for trading income and the other for rents from property. There were suspicions that there might be hidden catches, but now that the rules have been published, the allowances appear to be as originally advertised. Of course, there are the inevitable terms and conditions.

Trading allowance

The trading allowance (TA) involves the trickiest rules and so we’ll look at this now and leave the property allowance for another day. The first point to note is that while the original announcement said the TA would apply only to trading income, it’s been extended to cover miscellaneous income such as royalties, income from estates and more, but only if it’s not already taxable under other rules (see The next step ).

Exclusions

The TA is aimed at individuals and so doesn’t apply to a partner’s share of partnership income. It’s also not given if you derive trading income from a partnership, say a fee for providing consultancy services, at a time when you’re a partner or have a connection with the partnership, e.g. you’re married to a partner. A similar block applies if you derive trading income from a close company (broadly, one that’s controlled by five or fewer people) in which you own or control shares or your spouse or a family member does. These rules prevent the TA being used to extract tax-free money from a company or partnership.

Full or partial allowance

The rules which determine how the TA is applied are somewhat fiddly, but they boil down to this:

  • it applies to the total of your trading income (but see the next point). If you have two different trades the TA can be split between them. How you allocate it is up to you
  • if generally accepted accounting principles are used to work out profit on income the TA doesn’t apply. The same is so if accounts are prepared using the cash basis. This means the TA won’t usually apply to income from self-employment that’s your only source, or one of your main sources, of earnings. The TA is aimed at ad hoc or minor trading income, such as selling on eBay. Money from selling your unwanted possessions doesn’t count as taxable income
  • the TA is deducted from income that’s actually been received, so not to money you’re owed (debtors)
  • income received is measured according to basis periods (accounting periods). A basis period can start and end on different dates to the tax year. (see The next step).

Tip. The TA automatically applies to income of less than £1,000, but you can elect for it not to. You might do this where your tax-deducible expenses exceed the income, so that you can claim a tax deduction for the loss. You can also elect for it to apply where income is more than £1,000. This allows you to deduct the full £1,000 TA instead of your actual expenses (see The next step ).

The trading allowance automatically applies to income of up to £1,000 received by very small businesses, and to certain miscellaneous income, thus making it tax free. If your income exceeds £1,000, you can elect to deduct the allowance in place of your actual expenses.

TRADING ALLOWANCE – MISCELLANEOUS INCOME

The original announcement introducing the trading allowance by the Chancellor said it would apply only to trading income, but it’s been extended to cover miscellaneous income such as royalties, income from estates and more, but only if it’s not already taxable under other rules. The miscellaneous income that can be covered is set out in s.574 Income Tax (Trading and Other Income) Act 2005. It says:

574 Overview of Part 5

(1) This Part imposes charges to income tax under—

(a)Chapter 2 (receipts from intellectual property),

(b)Chapter 3 (films and sound recordings: non-trade businesses),

(c)Chapter 4 (certain telecommunication rights: non-trading income),

(d)Chapter 5 (settlements: amounts treated as income of settlor),

(e)Chapter 6 (beneficiaries’ income from estates in administration),

(f)Chapter 7 (annual payments not otherwise charged), and

(g)Chapter 8 (income not otherwise charged).

(2) Part 6 deals with exemptions from the charges under this Part.

(3) See, in particular, any exemptions mentioned in the Chapters of this Part.

(4) The charges under this Part apply to non-UK residents as well as UK residents but this is subject to section 577(2) (charges on non-UK residents only on UK source income).

(5) This section needs to be read with the relevant priority rules (see sections 2, 575 and 576).

TRADING INCOME BASIS PERIOD

Matching profits

A sole trader or partnership can choose an accounting period end date which doesn’t coincide with the tax year. Therefore, to ensure consistency tax “basis periods” are used to attribute profits to tax years.  Basis periods are also used when working out the income received for a tax year for the purpose of the trading allowance.

The rules for determining a basis period are in some situations tricky, but can be summarised as follows:

  • the general rule is that the basis period for a tax year is the end of the accounting period which ends in that year

Example. Cheryl has been trading for several years and prepares her accounts to 31 December each year. The basis period for 2017/18 will be the twelve months to 31 December 2017. The tax will be payable by 31 January 2019.

  • in the first tax year of a business the basis period starts on the date it commenced and ends on the next 5 April
  • the basis period for the second year follows the general rule only if the accounting period ending in that year is at least twelvemonths long. If there is an accounting period that ends in the second tax year which is less than twelve months long, some of the first basis period is used again to create a twelve month long basis period

Example. Cheryl commences trading on 1 January 2017, and makes up accounts to 30 June 2017 (six months). The first basis period is 1 January 2017 to 5 April 2017. The second is 1 January 2017 to 31 December, so Cheryl will include all the profits from the 30 June 2017 accounts, and add half of her profits for the accounting period ended on 30 June 2018 year.

if there is no accounting period ending in the second tax year, the basis period is the whole of the tax year

  • in most situations, the third-year basis period follows the general rule. However, if there is a long period of account ending in the year, the rules for year two are followed

Example. Cheryl commences trading on 1 January 2017, and prepares her accounts for the 18 months to 30 June 2018. The first basis period is 1 January 2017 to 5 April 2017. For the second basis period, there is no accounting period ending in the tax year so the basis period is 6 April 2017 to 5 April 2018. For the third basis period, there is not an accounting period of at least twelve months ending in the tax year, so the basis period is the twelve months to that date, i.e. 1 July 2017 to 30 June 2018

  • where there is a change of accounting date after the third year and before the final year of a business, the basis period for an accounting period of less than twelve months is the twelve months ending on the new accounting date. If the accounting period is longer than twelve months, the basis period is twelve months from the end date of the last basis period.

TRADING ALLOWANCE – EXAMPLES

Where income qualifying for the trading allowance (TA) is less than £1,000 the whole of the income is tax exempt.

Example 1. Jan sells new cosmetics through an auction site. In the year to 31 December 2017 (her chosen accounting period) the total she receives from customers is £820. The TA automatically applies to the whole of her income which is therefore exempt from tax.

Where income qualifying for the trading allowance is less than £1,000 the whole of the income is tax exempt unless an election is made to disapply the TA.

Example 2. Jan sells new cosmetics through an auction site. In the year to 31 December 2017 (her chosen accounting period) the total she receives from customers is £820. Jan’s tax deductible trading expenses for the same period are £1,100. She makes a loss from her trading. She elects for the TA not to apply. She is now able to claim tax relief for the loss.

Where income qualifying for the trading allowance is greater than £1,000 the TA doesn’t automatically apply, but election can be made to so that it does.

Example 2. Ann sells her paintings through an auction site. In the year to 31 December 2017 (her chosen accounting period) the total she receives from customers is £1,800. Ann’s tax deductible trading expenses for the same period are £200.  She elects for the TA to apply. She is now able to deduct the £1,000 TA from her income in place of her expenses.

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