principles of business taxition

Income tax is t he single lar gest ear ner f or t he gover nment making up 30% of t ot al r evenue.. A1.3 Sources of income The t ax legislat ion cat egor ises var ious sour ces of inco

‘Finance Act 2006’

Elsevier But t er wor t h-Heinemann

Linacr e House, J or dan Hill, Oxf or d OX2 8DP

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Fir st published 2007

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CONTENTS

B1: Tr ading I ncome and t he Badges of Tr ade 7 B2: Adj ust ment of Pr of it 14

B4: Capit al Allowances – Def init ion 30 B5: Capit al Allowances – Comput at ion 37 B6: I ndust r ial Buildings Allowances 47 B7: I nt angible Fixed Asset s 64 B8: Resear ch and Development Expendit ur e 73 B9: Tax Law and Account ing Pr act ice 84

C1: Comput at ion of Cor por at ion Tax 91

C3: Shor t Account ing Per iods 110 C4: Long Per iods of Account 116 C5: Cor por at ion Tax Self Assessment (CTSA) 125 C6: Payment of Cor por at ion Tax 141 C7: I nt er est on Lat e Paid Tax 151

C9: I ncome f r om Pr oper t y 161

C11: Relief f or Tr ading Losses 177 C12: Relief f or Ot her Losses 187 C13: Cor por at e Capit al Gains 192

C15: Shar es and Secur it ies: Mat ching Rules 208

223 C17: The Pr inciples of Gr oup Relief 228 C18: Gr oup Capit al Gains 241 C16: Subst ant ial Shar eholding Exempt ion

C20a: Close Company I mplicat ions – Par t 1 261 C20b: Close Company I mplicat ions – Par t 2 266 C21: I nvest ment Companies 271 C22: Cor por at e Vent ur ing Scheme 279

D1: Employed or Self Employed? 288 D2: I nt r oduct ion t o Employment I ncome & Benef it s 295 D3: Company Car & Fuel Benef it s 308 D4: Living Accommodat ion – Taxable Benef it s 318 D5: Loans t o Employees & Use of Asset s 325 D6: Miscellaneous Benef it s 335 D7: Expenses of Employment 343 D8: Calculat ing t he I ncome Tax Liabilit y 353 D9: I nt r oduct ion t o PAYE 360 D10: PAYE End of Year Ret ur ns 369 D11: Class 1 Nat ional I nsur ance Cont r ibut ions 376 D12: Class 1A and 1B Nat ional I nsur ance Cont r ibut ions 388 D13: Ter minat ion Payment s 396 D14a: Occupat ional Pensions and Fur bs 408 D14b: The Ent er pr ise I nvest ment Scheme 417

E1: Over view of t he VAT Syst em 423

E3: Def init ion of Supplies 444 E4: Liabilit y of t he Supply 451 E5: Schedule 8 VATA 1994 – Zer o Rat ing 455 E6: Schedule 9 VATA 1994 – Exempt ions 463

E10a: I nput Tax: W hen t o Recover 496 E10b: Par t ial Exempt ion 511 E11: VAT Recor ds and Ret ur ns 527 E12: Account ing f or VAT 539

E14: Cont r ol Visit s, Appeals and Assessment s 559 E15a: Misdeclar at ion Penalt y 571

E15b: Lat e Regist r at ion Penalt y 577 E15c: Def ault Sur char ge 583 E15d: Repeat ed Misdeclar at ion Penalt y 590 E15e: Ot her Penalt ies, I nt er est and Mit igat ion 596 E16: Ref unds, Repayment Supplement and I nt er est 611

PREFACE

This book pr ovides all t he mat er ial you need f or t he CI MA Pr of essional Development Cer t if icat e in Business Taxat ion W it hin each chapt er you will f ind some examples f or you t o t r y, t o t est you on t he impor t ant r ules cover ed in t he chapt er

At t he end of each chapt er , t her e is a shor t summar y which cont ains a “pocket digest ”

of t he r ules cover ed wit hin t he chapt er These individual summar ies f or m a compr ehensive over view of t he syllabus

As t his manual has been wr it t en specif ically t o cover all ar eas of t he syllabus we ar e conf ident you will f ind t his an invaluable t ool leading t o success in t he ex aminat ion

CIMA TAX TABLES

Income Tax rates 2006-07 2005-06

Starting rate band 1 - 2,150 1 - 2,090

Basic rate band 2,151 - 33,300 2,091 - 32,400

Income Tax reliefs 2006-07 2005-06

Basic amount qualifying for tax relief £3,600

Company cars and fuel

Company cars

Cash equivalent 15% of list price for cars emitting 140g/km

Increased by 1% per 5g/km over the 140g/km limit Capped at 35% of list price

3% supplement on diesel cars not meeting the Euro IV emission standards

or registered after 1 January 2006 (subject to 35% cap)

Van scale charge

£500 (reduced to £350 if more than four years old at the end of the fiscal year)

There is no taxable benefit where an employee takes a van home but is not allowed any other

private use

Fuel scale benefits

For 2006-07 (& 2005-06) the benefit is £14,400 multiplied by the percentage used in

calculating the car benefit (i.e based on carbon dioxide emission rating)

Small and medium sized enterprise limits

Profit limit for lower rate – £10,000

Profit limit for lower rate marginal relief – £50,000

Profit limit for small companies' rate £300,000 £300,000

Profit limit for small companies' marginal relief £1,500,000 £1,500,000

Marginal relief fraction for profits between

Marginal relief fraction for profits between

£300,000 and £1,500,000 11/400 11/400

For FY 2005 there is a minimum corporation tax charge of 19% on PCTCT distributed to non

corporate shareholders This does not apply for FY 2006

Research and Development expenditure and transfer pricing: small and medium sixed

company limits

Balance sheet assets ε43m ε10 million

National Insurance Contributions

2006-07 2005-06

Lower earnings limit £4,368 £84 £4,264 £82

Earnings threshold £5,035 £97 £4,895 £94

Upper earnings limit £33,540 £645 £32,760 £630

Employee’s contributions in 2006-07 (2005-06)

Not contracted out: 11% (11%) on earnings between £97 (£94) and £645 (£630)

1% (1%) above £645 (£630) per week Contracted out: 9.4% (9.4%) on earnings between £97 (£94) and £645 (£630)

1% (1%) on earnings above £645 (£630) per week 1.6% rebate on earnings between £84 (£82) and £97 (£94)

Employer’s contributions in 2006-07 (2005-06)

Not contracted out: 12.8% (12.8%) on earnings in excess of £97 (£94)

Contracted out: Salary related: 9.3% (9.3%) on earnings between £97 (£94) and £645 (£630)

12.8% (12.8%) on earnings in excess of £645 (£630) 3.5% (3.5%) rebate on earnings between £84 (£82) and £97 (£94) Contracted out: Money purchase: 11.8% (11.8%) on earnings between £97 (£94) and £645 (£630)

12.8% (12.8%) on earnings in excess of £645 (£630) 1% rebate on earnings between £84 (£82) and £97 (£94)

Annual lower earnings limit £5,035 £4,895

Annual upper earnings limit £33,540 £32,760

Percentage rate between limits 8% 8%

Percentage rate above upper limit 1% 1%

Capital Gains Tax

Retail Prices Index

Where Retail Price Indices are required, it should be assumed that they are as follows

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

This฀page฀intentionally฀left฀blank

A: Introduction To The UK Tax System

I n t his chapt er you will cover t he f ollowing ar eas in over view:

- t he var ious t axes levied in t he UK;

- t he per iod f or which income t ax is char ged;

- t he cat egor isat ion of sour ces of income;

- t he sour ces of income t hat ar e exempt f r om income t ax

A1.1 Taxes in the UK

The UK gover nment r aises in t he r egion of 270 t o 280 billion pounds in t axat ion each year

Income tax is t he single lar gest ear ner f or t he gover nment making up 30% of

t ot al r evenue I ncome t ax is char ged on salar ies f r om employment , on r ent alincome f r om pr oper t ies let out , on int er est f r om banks and building societ ies, on dividends f r om companies and on t he pr of it s of t he self employed

The second lar gest ear ner f or t he gover nment is value added t ax (VAT) This makes up about 23% of t he t ot al gover nment r evenue and is char ged by businesses t o cust omer s on supplies of goods or ser vices in t he UK

Nat ional I nsur ance cont r ibut ions (NIC) make up 21% of t ot al gover nment income Nat ional I nsur ance cont r ibut ions ar e gener ally paid by bot h employer s and employees on ear nings f r om employment , alt hough NI C is also levied on self employed per sons on t he pr of it s of t heir t r ade

I ncome t ax , VAT and NI C ar e t he t hr ee most impor t ant t axes as f ar as r aising money is concer ned, making up about 75% or so of t ot al gover nment r evenue

A lar ge par t of t he r emainder (16%), is made up of duties, being t axes on alcohol, pet r ol and t obacco, as well as cer t ain levies on goods coming int o t he UK

Corporation tax makes up about 8% of t ot al gover nment r evenue, being t he t ax paid by UK companies on t heir t axable pr of it s

The r emaining slice consist s of t he “capital taxes” being capit al gains t ax (CGT), inher it ance t ax (I HT), st amp dut y (SD) and st amp dut y land t ax (SDLT) Capit al gains t ax is t he t ax levied when individuals sell asset s and make a pr of it

A1.2 The tax year

I ndividuals pay income t ax by r ef er ence t o t he “t ax year ” The UK t ax year r uns

f r om 6 April to the following 5 April For example, t he t ax year t hat begins on

6 Apr il 2006 and ends on 5 Apr il 2006 is known as t he t ax year 2006/ 07

The t ax r at es and t ax allowances f or t he 2006/ 07 t ax year , wer e set in t he Mar ch 2006 Budget

Ther e ar e t wo st ages in calculat ing an individual’s t ax liabilit y Fir st we comput e

t he individual’s t axable income f r om all sour ces in t he r elevant t ax year Having

ar r ived at taxable income we t hen apply t he 2006/ 07 tax rates and allowances

t o t hat income, t o ar r ive at t he tax liability f or t he year This t ax will be collect ed by t he HM Revenue & Cust oms (“t he Revenue”) under t he “self -assessment ” syst em This will be dealt wit h in a lat er chapt er

A1.3 Sources of income

The t ax legislat ion cat egor ises var ious sour ces of income Each t ype of income has it s own special r ules This is why we need t o decide what t ype of income an individual has r eceived

W hen we looked at income r eceived by individuals in t he past , t he types of income wer e sor t ed int o Schedules and somet imes f ur t her divided int o Cases This was called t he Schedular system I t st ill oper at es f or companies and so we will be looking at it in det ail when we st udy companies You may well f ind

r ef er ences t o t he old syst em in past quest ions So we will ment ion t he main point s of t he old syst em as we ex plain t he cur r ent way of sor t ing out t he t ypes

of income

The f ir st t ype of income t hat we will t hink about is trading income This cover s

pr of it s f r om a t r ade So, f or inst ance, a self employed per son in business as a

t axi dr iver , or a mar ket t r ader , or a builder or plumber , would be t axed on his

trading income This used t o be called Schedule D Case I income

Tr ading income also cover s pr of it s f r om a pr of ession or vocat ion For inst ance, a

self employed pr of essional such as a solicit or or bar r ist er would also have trading income This used t o be called Schedule D Case II income Tr ading income is a ver y impor t ant t ype of income and we will deal wit h it in a separ at e module

The second t ype of income we need t o consider is property income This is income f r om land and buildings, such as rental income W e need t o keep pr oper t y income f r om UK land and buildings separ at e f r om pr oper t y income f r om non-UK

land and buildings I ncome f r om UK land and buildings used t o be t axed under Schedule A I ncome f r om non-UK land and buildings used t o be t axed under Schedule D Case V

Next , t her e is a ver y impor t ant t ype of income called income f r om earnings and

pensions Earnings cover s salaries, bonuses and non-cash benefits W e will look

at t hese in det ail in lat er sessions This t ype of income used t o be t axed under

Schedule E

Ther e ar e var ious t ypes of savings and investment income A ver y common one is

int er est ar ising f r om UK banks and building societies W e call t his interest

income This t ype of income used t o be t axed under Schedule D Case III

Anot her t ype of invest ment income is dividends received from companies These

used t o be t axed under Schedule F As we will see lat er , dividend income needs

t o be kept separ at e f r om ot her t ypes of invest ment income because it has

dif f er ent r at es of t ax applied t o it

These ar e t he t wo main types of savings and invest ment income

An individual may have income f r om outside the UK W e have alr eady seen t hat

he may have property income f r om non-UK land and buildings He may also have

investment income f r om out side t he UK such as non-UK bank interest or

non-UK dividends All income ar ising out side t he UK is now called foreign income

For eign invest ment income used t o be t axed under Schedule D Case V

I t is impor t ant t o not e her e t hat income can st ill be taxable in t he UK, even if it

ar ises f r om a sour ce outside t he UK As a gener al pr inciple, individuals who live

in t he UK and who wer e born in t he UK will pay UK income t ax on t heir worldwide

income wher ever it comes f r om So, a UK resident will gener ally pay income t ax

on f or eign income

Finally, t her e is income which is char geable t o income t ax which does not f all

wit hin any of t he cat egor ies t hat we have j ust looked at This is called

miscellaneous income I t is t he Revenue' s way of cover ing it self and making sur e

t hat t axable income doesn' t f all t hr ough t he net Miscellaneous income used t o

be t axed under Schedule D Case VI

A1.4 Exempt income

Ther e ar e a f ew sour ces of income which ar e specif ically exempt f r om income

t ax I ncome f r om National Savings Certificates is exempt f r om t ax , as ar e any

winnings on Premium Bonds Any income f r om betting, gaming or lotteries is

exempt f r om income t ax

s 692

I TTOI A

2005

Most social security benefits ar e also exempt f r om income t ax The not able

ex cept ions t o t his ar e t he st at e pension and any j ob-seeker s allowances These

ar e t ax able income

s.660

I TEPA

2003

Any statutory redundancy pay r eceived on t he t er minat ion of an employment is

also ex empt f r om income t ax

70

Example 1

W hich of t he f ollowing sour ces of income ar e ex empt f r om income t ax:

Taxable Exempt

a) I nt er est on Nat ional Savings Account

b) Dividend f r om a f or eign company

c) Child’s wages f r om a newspaper r ound

d) I ncome f r om Nat ional Savings Cer t if icat e

e) Housing benef it

f ) St at e r et ir ement pension

Answer 1

Taxable Exempt

I nt er est on Nat ional Savings Account

Dividend f r om a f or eign company

Child’s wages f r om a newspaper r ound (not e)

I ncome f r om Nat ional Savings Cer t if icat es

Housing benef it

St at e r et ir ement pension

Not e:

W ages ar e t ax able as employment income The f act t hey ar e paid t o a child is

ir r elevant However , in most inst ances, t he child’s income will be cover ed by

Per sonal Allowances so no t ax will be due

SUMMARY - INTRODUCTION TO THE UK TAX SYSTEM

The main t axes in t he UK ar e income t ax , VAT, NI C, cor por at ion t ax, capit al gains t ax and inher it ance t ax

I ncome t ax is paid f or a t ax year which r uns f r om 6 Apr il t o 5 Apr il

I ncome is cat egor ised int o t he f ollowing sour ces:

Tr ading income

Pr oper t y income - UK

- non-UK Employment income

Savings and invest ment income

For eign income

Miscellaneous income

- int er est income

- dividend income

Some income is exempt f r om income t ax such as:

I ncome f r om Nat ional Savings Cer t if icat es

Pr emium bonds winnings

I ncome f r om Bet t ing and Lot t er ies

Most social secur it y benef it s

St at ut or y r edundancy pay

I ncome f r om I SAs

B: Computation of Taxable Trading Profit

B1: TRADING INCOME AND THE BADGES OF TRADE

I n t his chapt er we will look at t r ading income including:

- t he schedule f or t axing t r ading income;

- t he def init ion of a t r ade;

- t he “badges of t r ade” ar ising f r om case law;

- land t r ansact ions;

- t he ant i-avoidance pr ovisions;

- whet her r eceipt s ar e t axable or not

St at ut or y r ef er ences ar e t o I TTOI A 2005 unless st at ed ot her wise

B1.1 Trading Income

The cat egor y “t r ading income” encompasses bot h income from a trade, f or

example plumbing or building and income from a profession or vocation. A

pr of ession would include account ancy or law A vocat ion includes act ing, ballet

dancing, t heat r ical per f or ming, spor t et c

Pr eviously, under t he old schedular syst em income f r om a t r ade was t axed under

Schedule D Case I , wher eas income f r om a pr of ession or vocat ion was t axed under

Schedule D Case I I Ther e wer e no not able dif f er ences bet ween t he way pr of it s wer e

t axed under DI or DI I

B1.2 The definition of trading

I ncome t ax is char ged on “t he pr of it s of a t r ade, pr of ession or vocat ion” s 5

A t r ade is def ined as ”ever y manuf act ur e, advent ur e or concer n in t he nat ur e of t r ade”

A “t r ade” is def ined in t he legislat ion as a “t r ade”, which is a cir cular def init ion and does

not t ake us a gr eat deal f ur t her Ther ef or e, t he int er pr et at ion of what is meant by t he

t er m “t r ade” has been lef t lar gely t o t he Cour t s The Cour t s have developed a number

of t est s t o det er mine whet her somebody is t r ading These t est s ar e known as t he

“badges of t r ade”

B1.3 The Badges of Trade

Pr of it seeking mot ive

W hen a per son ent er s int o a t r ansact ion, we need t o ident if y whet her t her e is a pr of it

seeking mot ive I t is not t he ex ist ence of a pr of it t hat is impor t ant , it is t he mot ive t o

ear n one However HM Revenue and Cust oms (t he Revenue) will r eally be int er est ed in

t his issue if a pr of it has act ually been ear ned, because t hen t hey have somet hing t o t ax

A t ax payer may ar gue t hat t hey ar e t r ading in or der t o ut ilise a loss t o r educe t heir t ax bill The t axpayer must demonst r at e t he mot ive r at her t han t he exist ence of pr of it t o est ablish t hat a t r ade is being car r ied on

Fr equency and number of similar t r ansact ions

I f we do somet hing once, never t o be r epeat ed again, it is unlikely t hat we would be

t r eat ed as car r ying on a t r ade However if we keep doing it , it is mor e likely t hat we ar e

t r ading For inst ance, assume I sold my car which I had owned f or f our year s I t hen bought myself anot her car and sold t hat one t wo year s lat er I t is unlikely t he Revenue would consider t hat I am t r ading in car s I f , however , I bought and sold car s ever y mont h, it is mor e likely t hat t hey will seek t o t ax t he pr of it s as t r ading income

The most not able case in t his ar ea is Pickf or d v Quir ke wher e a t axpayer pur chased a mill wit h t he obj ect of using it f or t r ading pur poses However it t ur ned out t hat t he mill was in a much wor se st at e t han t hey had imagined and t he best t hing t he t ax payer could

do was t o st r ip all t he it ems out of it and sell t hem piecemeal He made a consider able

pr of it doing t his, so he did it again and again and again As a r esult of t he r epeat ed number of t r ansact ions, it was held t hat t he pr of it s wer e t axable as t r ading income

I f we buy somet hing, do not hing t o it t hen sell it , it is unlikely we ar e t r ading However ,

if we bought a car , put a new engine in it , r espr ayed t he body and made it mor e

at t r act ive t o buy, it is possible we would be consider ed t o be t r ading

Nat ur e of t he asset

W e cannot pin a t r ading label ont o a single one-of f t r ansact ion simply because we cannot

j ust if y t hat t he par t icular asset was pur chased f or any ot her pur pose t han t o r esell it The most not able case in t his ar ea is Rut ledge v CI R

I n t his case, a t axpayer pur chased 1 million r olls of t oilet paper in one single t r ansact ion

He t hen sold t hem on at a pr of it in anot her single t r ansact ion This was held t o be

t r ading (an “advent ur e” in t he nat ur e of t r ade) as t her e was no ot her j ust if iable r eason

t o pur chase such a lar ge quant it y of t oilet paper - he could not ar gue t hat t his was simply over st ocking!

Connect ion wit h an exist ing t r ade

Taking an example of a car , let us say t hat as a t ax account ant I sell a car I t is unlikely

t hat I would be t r ading in car s because t her e is no link bet ween selling car s and being a

t ax account ant I f however I was a car mechanic who occasionally sold a car , t he Revenue ar e much mor e likely t o successf ully t ax t he pr of it s on t he sale of car s along wit h my exist ing t r ade as t her e is a dir ect link bet ween r epair ing car s and selling car s

Ot her badges of t r ade would also need t o apply, but such a link is somet hing t hat t he Revenue will look ver y closely at

Financing ar r angement s

I f an asset is pur chased on a shor t t er m loan which t he t axpayer is unable t o f und

wit hout selling t he asset again, t hen t he Revenue can successf ully ar gue t hat t he asset

was pur chased specif ically wit h a view t o selling it

This was cit ed in t he case of W isdom v Chamber lain wher e t he comedian Nor man

W isdom bought a mound of silver bullion on a shor t t er m loan He could not ser vice t he

int er est payment s f r om his exist ing money, but as soon as he sold t he bullion and r epaid

t he loan he f ound he had made a subst ant ial pr of it This pr of it was t axed as t r ading

income

Lengt h of owner ship

I f you have owned somet hing f or a long t ime, it is much easier t o j ust if y t hat you bought

it f or it s enj oyment or f or your own pr ivat e consumpt ion A pr of it on sale would not

t her ef or e be t r eat ed as a t r ading pr of it I f however you have only owned it f or a shor t

per iod it is much mor e likely t hat t he Revenue could successf ully ar gue t hat it was

pur chased wit h t he aim of selling it at a pr of it

The exist ence of a sales or ganisat ion

I n t he case of The Cape Br andy Syndicat e, a syndicat e of char t er ed account ant s

dist illed br andy They dist illed f ar mor e t han t hey could act ually dr ink t hemselves and

sold t he sur plus The Revenue sought t o t ax t hem as t r ading income They ar gued t hat

t hey wer e simply selling what t hey could not physically dr ink t hemselves However as

t hey had set up a special phone line and inf or mat ion desk and published br ochur es and

adver t s adver t ising t heir br andy, t he Revenue successf ully ar gued t hat t hey had

commenced a t r ade

Reason f or t he acquisit ion/ sale

Finally, we will look at how t he asset was acquir ed – ie, whet her pur chased or ot her wise

acquir ed by gif t or inher it ance - and what is t he r eason f or t he sale of t he asset ? By

way of an ex ample, consider Maud who inher it s a war dr obe f ull of f ur coat s f r om her

lat e mot her She does not want t o wear t hem, so she put s an adver t in t he local paper t o

sell t hem The Revenue spot t his adver t and seek t o t ax Maud f or any pr of it s ear ned

As Maud inher it ed t he coat s it is highly unlikely t hat a t r ading label can be pinned t o

t hese t r ansact ions However if Maud had pur chased a war dr obe f ull of f ur coat s,

adver t ised t hem and t hen sold t hem at a pr of it , it is much mor e likely t hat she would be

held t o be t r ading Simply r ealising an inher it ance f or cash is not t he commencement of

a t r ade

I n some cir cumst ances, t he exist ence of one single badge is enough t o show t r ading (as

in t he case of Rut ledge v CI R) However in ot her cases we need t o look at a combinat ion

of t he badges of t r ade The t r igger t o get t he Revenue int er est ed in t he t r ansact ion in

t he f ir st place is t he exist ence of a pr of it

B1.4 Land transactions

The Revenue of t en look closely at t he pur chase and sale of land and buildings, simply due

t o t he size of t he pr of it s involved I t is in t he ar ea of land t r ansact ions t hat t he most cases involving t he badges of t r ade have been t aken t o t he Cour t s

One of t he impor t ant quest ions t o ask is whet her t he t axpayer is “invest ing in land” or

“dealing in land” – “dealing” is t r ading This quest ion which was posed in t he case of Mar son v Mor t on Her e a t axpayer pur chased some land wit h t he int ent ion of holding on

t o it as an invest ment f or at least t wo year s I n or der t o incr ease t he value of t he land,

t he t axpayer applied f or planning per mission Looking at t he badges of t r ade, t his will be

r egar ded by t he Revenue as a modif icat ion t o an asset t o make it mor e saleable

I t was held in t his case t hat because t he or iginal int ent ion was t he pur chase of an invest ment , no t r ade was being car r ied on I t is not what t he t axpayer says which det er mines int ent ions, it is what t he sur r ounding evidence suppor t s Document ed int ent ions made t he dif f er ence

Anot her quest ion t hat we must ask is, is whet her our t axpayer is a r esident in t he

pr oper t y, or a developer who is r ef ur bishing a pr oper t y f or onwar d sale I n t he case of Kir kby v Hughes, a builder pur chased a r un-down house He car r ied out a lot of r epair and r ef ur bishment wor k and sold t he house at a healt hy pr of it He t hen pur chased a

st r ip of land and built a house on it , again selling it at a subst ant ial pr of it He t hen pur chased a bar n and conver t ed it int o a house

The Cour t s believed t hat he was t r ading because t hey could apply enough of t he badges

of t r ade t o him Ther e clear ly was a pr of it seeking mot ive, he had modif ied t he asset s

he pur chased, t her e was a connect ion wit h an exist ing t r ade, and t he lengt h of owner ship in each case was f air ly shor t The pr of it s on t he f ir st house wer e held t o be

t axable as t r ading income along wit h all of t he ot her pr oper t ies he had bought and sold

Looking specif ically at one of t he badges of t r ade we should also ident if y a r eason f or

t he pur chase and a r eason f or t he sale I n t he case of Taylor v Good, a husband pur chased a pr oper t y t o be used as a f amily home However on seeing t he house, his wif e r ef used t o live in it As a r esult he had no opt ion but t o sell t he house Despit e it being a one-of f t r ansact ion, t he Revenue f elt t hat t he badges of t r ade applied because

t he asset was only owned f or a ver y shor t per iod of t ime However , t her e was clear ly anot her r eason f or t he acquisit ion and subsequent sale – t her e was a genuine int ent ion

by t he t axpayer t o live in t he house r at her t han simply t o make a quick pr of it Ther ef or e t he t r ansact ion was held not t o be a t r ading t r ansact ion

B1.5 Frequency of transactions

Michael buys unpr of it able r est aur ant s, t ur ns t he businesses ar ound and sells t hem at a

pr of it He has done t his 12 t imes The idea came t o him when he sold his f ir st

r est aur ant which he had r un as t he owner and manager f or 10 year s

The quest ion we ar e asking is whet her he is char geable t o t ax on t r ading income, f ir st in

r espect of t he r est aur ant s in gener al, which he had r un f or a shor t per iod, but also in

r espect of t he f ir st r est aur ant which he had r un f or a long per iod

W e must look closely at t he badges of t r ade Clear ly t her e is a pr of it seeking mot ive

which is r eadily ident if iable The f r equency of t r ansact ions which Michael is

under t aking point s t owar ds a t r ade Modif icat ions t o t he asset pur chased (t aking an

unpr of it able r est aur ant and t ur ning it ar ound), t he lengt h of owner ship (he owns t hem

f or a r elat ively shor t per iod of t ime) and t he r eason f or t he sale (t o make money), lead

us t o dr aw t he conclusion t hat t hese t r ansact ions will clear ly be t r ading t r ansact ions

The next quest ion is – do t he f ut ur e t r ansact ions t aint t he f ir st one? Unf or t unat ely

t he answer t o t his quest ion is yes I n t he case of Leach v Pogson, an individual had owned

a dr iving school f or a long per iod of t ime bef or e he sold it at a pr of it He t hen

pur chased, t ur ned ar ound and sold numer ous ot her dr iving schools in t he f ut ur e I t was

held by t he Cour t s t hat not only wer e pr of it s f r om sales of t he lat er dr iving schools

char ged t o t ax as t r ading income, but t he or iginal disposal, alt hough or iginally t r eat ed as

a capit al t r ansact ion, will be t ur ned int o a t r ading t r ansact ion because of lat er event s

B1.6 Share Dealing

Mur iel t hinks she has an inf allible syst em t o pr edict shar e pr ice movement s Over a t wo

year per iod she ent er ed int o over 100 t r ansact ions buying and selling shar es She made

a pr of it on some but over all she made a loss, so her syst em was not as inf allible as she

t hought ! W ill she manage t o obt ain loss r elief against her gener al income?

I n or der t o set a loss against ot her income, t he loss must be a t r ading loss – we will come

t o losses lat er in t his cour se The quest ion is whet her Mur iel is dealing or invest ing I n

t he case of Salt v Chamber lain it was held t hat all shar e t r ansact ions ar e capit al in t heir

nat ur e unless t hey ar e under t aken by a pr oper ly r egist er ed shar e dealer Ther ef or e if a

pr ivat e individual (not a shar e dealer ) buys and sells shar es many many t imes, he can

never have t he badges of t r ade pinned on t o t hose t r ansact ions Such pr of it s will be

t axable as capit al gains and subj ect t o CGT wit h all t he advant ages of indexat ion and

t aper r elief

B1.7 Taxable and Non-Taxable Receipts

I f r eceipt s ar e wholly unexpect ed and unsolicit ed, t hey ar e not t axable This is highlight ed in t he case of Simpson v J ohn Reynolds & Co., in which a t axpayer r eceived a volunt ar y payment f r om an ex-cust omer when t hey wer e asked t o cease t o act as t heir insur ance br oker Because t he payment was not invoiced, not expect ed and was pur ely an unsolicit ed gif t , it was not held t o be par t of t he t axable t r ading income

I n Mur r ay v Goodhews, an ex-gr at ia payment given t o a pub landlor d as a r esult of t he cancellat ion of his pub t enancy was held not t o be t axable The r eason f or t his was t hat

t he r eceipt of t he compensat ion had not hing t o do wit h him buying and selling alcoholic

dr inks and r unning a pub – it was as a r esult of t he t er minat ion of t he pub t enancy

However , if amount s ar e expect ed t hen t hey will be t axable I n t he case of Cr eed v H &

M Levinson Limit ed, a t axpayer was of f er ed an ex-gr at ia amount f r om an ex-cust omer and successf ully sued f or mor e As t he r eceipt was clear ly solicit ed and expect ed, it was t axable I n t he case of McGowan v Br own & Cousins, an est at e agent who r eceived compensat ion f or not being appoint ed as let t ing agent , was t axed on t he income as it

r elat ed specif ically t o t he t r ade and was solicit ed and expect ed

SUMMARY - TRADING INCOME AND THE BADGES OF TRADE

Tr ading income encompasses bot h income f r om a t r ade and income f r om a pr of ession or

vocat ion

The st at ut or y def init ion of a t r ade includes t he wor d “t r ade”, so t est s known as t he

“badges of t r ade” have developed f r om case law These include:

- pr of it seeking mot ive

- f r equency and number of similar t r ansact ions

- modif icat ions t o sell an asset

- nat ur e of t he asset

- connect ion wit h an exist ing t r ade

- f inancing ar r angement s

- lengt h of owner ship

- exist ence of a sales or ganisat ion

- how t he asset was acquir ed and t he r eason f or sale

Land t r ansact ions have f eat ur ed in many cases and t he quest ions t o ask also include:

- is t he t axpayer invest ing or dealing?

- is t he t axpayer r esident in t he pr oper t y or a developer ?

I f a ser ies of t r ansact ions ar e t r eat ed as t r ading t his will t aint t he f ir st t ime such a

t r ansact ion was car r ied out so it can no longer be r egar ded as a capit al t r ansact ion

I f a t axpayer has deliber at ely t aken st eps t o t ur n a t r ading t r ansact ion int o a capit al

one, t he pr of it s may be t axed as miscellaneous income

W holly unexpect ed and unsolicit ed amount s ar e not t axable, however if amount s ar e

expect ed t hen t hey will be t axable

B2: ADJUSTMENT OF PROFIT

I n t his chapt er you will cover t he r ules t hat apply f or adj ust ing account ing pr of it s t o

obt ain t he t axable t r ading pr of it s I n par t icular you will cover :

- depr eciat ion;

- capit al expendit ur e;

- t he wholly and exclusively r ule;

- ent er t aining;

- gif t s;

- luxur y car r ent al payment s

St at ut or y r ef er ences ar e t o I TTOI A 2005 unless st at ed ot her wise

B2.1 Introduction

Assume a t r ader pr epar es a set of account s and t hose account s show a pr of it

However , in comput ing t his pr of it t he t r ader could have deduct ed expendit ur e

which t he Revenue may not like Consequent ly we ar e r equir ed t o make a number

of adj ust ment s in ar r iving at t he t r ader ’s t axable pr of it

W e start wit h t he profit per accounts. W e t hen add certain disallowed

expenditure, and deduct items which are not taxed as trading income

This gives us t he “t ax adj ust ed pr of it ”, which is accept able t o t he Revenue

Pr of it per account s X Add: Disallowed ex pendit ur e X Deduct : I t ems not t axed as t r ade pr of it s (X) Tax adj ust ed pr of it X

I t is t his pr of it which is t axable as t r ading income

B2.2 Depreciation

Depr eciat ion is not allowed f or t ax pur poses This is because t her e ar e so many

r at es and met hods of depr eciat ion t he Revenue f eel t hat t r ader s will be

encour aged t o choose depr eciat ion r at es which max imise t ax r elief

Instead businesses are able to claim capital allowances (CAs) CAs ar e

nor mally given at a r at e of 25% on a r educing balance basis on asset s t hat qualif y

as plant and machiner y CAs ar e cover ed in a lat er chapt er

B2.3 Items not taxed as Trading Income

Tr ader s might include all of t heir income in t heir account s, but it is only t r ading

income which is t axed as t r ade pr of it s Ther ef or e all other sources of income

are deducted in ar r iving at t he pr of it f igur e This ot her income will t hen be

br ought back in t he main income t ax comput at ion and t axed accor dingly Typical

examples of non-t r ading income ar e:

A t r ader has t he f ollowing r esult s;

Profit & Loss Account; £ ’000

Tur nover 850 Cost of sales (400)

Depr eciat ion (60)

Profit before tax 280

Tax Computation; £ ’000

Pr of it per account s 280

Add: Depr eciat ion 60

Deduct : Rent al income (50)

I nt er est (20)

Tr ading I ncome 270

I t is t his Tr ading I ncome which is br ought int o t he t r ader ’s income t ax

comput at ion as ear ned income

B2.4 Disallowed expenditure

Ther e ar e t hr ee main cat egor ies in t his ar ea

• Capital expenditure - t his is any expendit ur e which gives an “endur ing

benef it ” t o t he business Ther e is a lar ge amount of case law in t his ar ea

which we will cover shor t ly

s 33

• Expenditure which has not been incurred “wholly and exclusively” f or t he

pur poses of t he t r ade Again t her e is a lar ge amount of case law in t his

ar ea

s 34

• Specific disallowables given by t ax st at ut e and case law

W e shall ex amine each of t hese in t ur n

B2.5 Capital expenditure

The pur chase of capital equipment should be included on a trader’s balance

sheet, as t he balance sheet shows all t he f ix ed asset s of t he business These

would include:

• mot or car s;

• pr emises;

• ot her equipment (phot ocopier s, comput er s et c)

These it ems ar e eligible for capital allowances or industrial buildings

allowances (I BAs) and t hese r ules will be cover ed in lat er chapt er s

I f t he t r ader has included any capital additions in t he Pr of it and Loss Account ,

t hey should be disallowed and added back in ar r iving at t he Tr ading I ncome

W her e capit al addit ions qualif y as plant or machiner y, capit al allowances will be

given inst ead

W e also disallow profits or losses on the sale of assets Losses on sales of

asset s ar e a disallowed ex pense and should t her ef or e be added back Pr of it s

on sales of asset s ar e not t axable as Tr ading I ncome and should t her ef or e be

deducted in ar r iving at t r ading pr of it s

The t r ader may have also incur r ed legal fees on the acquisition of capit al

asset s These ar e disallowed as t hey relate to a capital item However , legal

f ees incur r ed on t he renewal of a short lease are specifically allowed A shor t

lease in t his cont ext is a lease of less t han 50 year s

B2.6 Wholly and exclusively

Ex penses ar e only deduct ible if t hey ar e incur r ed “wholly and exclusively” f or

t he pur poses of t he t r ade

s 34

Private expenditure

W hen pr epar ing account s, t r ader s of t en include it ems which r elat e in whole or in

par t t o t heir own pr ivat e af f air s (ie not t o t he business) For example a t r ader

may decide t o deduct a “salary” which he pays t o himself out of t he pr of it s of

t he business This “salar y” is not t axable on him as employment income since his

pr of it s ar e char ged t o t ax as a self -employed individual (he is not an employee)

Consequent ly we add back any salar y or wages dr awn f r om t he business by t he

pr opr iet or in ar r iving at t he t ax adj ust ed pr of it Salaries paid to employees

are allowable as t her e is a cor r esponding char ge t o income t ax on t he

employment income

Mortgage interest r elat ing t o t he t r ader s pr ivat e r esidence is clear ly a pr ivat e

ex pense and is not incur r ed “wholly and ex clusively f or t he pur poses of t he

t r ade” I t should t her ef or e be added back However , int er est paid on a loan t o

buy business premises (shop, of f ice et c) will be allowed as a deduct ion

Motor expenses ar e a good ex ample of a pr ivat e expendit ur e Assume a t r ader

dr ives a car , and he agr ees wit h t he Revenue t hat t he car is used 70% of the

time for business purposes However , he deduct s all of t he cost s of r unning

t he car in his pr of it and loss account (eg, all f uel, r epair s, insur ance, r oad t ax

et c) I f 70% of t he cost s ar e incur r ed f or business pur poses, 30% of the costs

must be disallowed as t hey r elat e t o pr ivat e expendit ur e which has not been

incur r ed wholly and exclusively f or t he pur poses of t he t r ade 30% of the

motor expenses should be added back t o t he pr of it

Pr ovided t he t ax payer pr oposes a per cent age which r easonably r ef lect s t he

pr ivat e element of t he expense, t he Revenue will usually accept it

The pr ivat e use adj ust ment can apply t o any expenditure For ex ample, if a

t axpayer uses, say, 20% of his house as an of f ice f or t he pur poses of t he t r ade,

he will be able t o deduct 20% of t he mor t gage int er est in ar r iving at his t axable

pr of it I f he has deduct ed t he f ull amount in his account s, we would need t o add

back 80%

Travel expenses

Ther e has been a lar ge number of cases going bef or e t he Cour t s wit h r egar d t o

t he “wholly and ex clusively” t est f or t r avel expenses

I n t he case of Newsom v Rober t son, a self employed bar r ist er claimed t he cost s

of travel from his home in Surrey to his Chambers in Cent r al London The

bar r ist er ar gued t hat he wor ked in bot h locat ions – f r om t ime t o t ime he needed

t o pr epar e cases and r ead t hr ough client f iles at home However , he was not

list ed in t he t elephone dir ect or y as a bar r ist er at his home addr ess, and he did

not want his client s visit ing him at his home He could have car r ied out his

paper wor k in Chamber s, it was j ust t hat he chose t o wor k f r om home As a

r esult , t he Cour t s wer e not satisfied t hat t he t r avel ex penses had been incur r ed

wholly and exclusively f or t he pur poses of his pr of ession and t her ef or e

disallowed t he cost s

I n Hor t on v Young, a br icklayer wor ked at a number of dif f er ent sit es He

negot iat ed his cont r act s and kept his r ecor ds at his home I n or der t o lay br icks

he obviously had t o travel to the site at which t he br icks needed laying

Ther ef or e t he Cour t s wer e sat isf ied t hat any t r avel cost s wer e incur r ed wholly

and ex clusively f or t he pur poses of t he t r ade The builder ’s fixed place of

I n Sar geant v Bar nes, a dent ist t r avelled f r om his home ever y mor ning t o his sur ger y Cost s of t r avelling f r om home to work are not allowed as a deduct ible

ex pense f or self -employed individuals as t hey ar e not incurred for the purposes

of the trade However , t he dent ist would st op of f at t he lab on his way t o wor k

t o pick up bit s and pieces of equipment he r equir ed t o inser t int o his pat ient s’ mout hs He t hen dr ove on t o t he sur ger y

The dent ist ar gued t hat t he cost s of t r avel bet ween t he lab and the surgery

wer e allowed, ef f ect ively saying t hat his wor k st ar t ed on r eaching t he lab However t he Cour t s wer e not sat isf ied t hat t he cost s wer e deduct ible as t he dent ist would have passed t he lab in any event as it was on his nor mal r out e int o

t o wor k Ther ef or e as he did not incur any extra travel costs, t he expenses wer e not deduct ible

Clothing

I n Mallalieu v Dr ummond, a bar r ist er claimed t hat t he cost s of her dar k Cour t r oom dr ess wer e allowable as an expense against her pr of essional income because she was r equir ed t o wear t hem in Cour t and would not ot her wise wear such clot hing in her ever yday lif e However t he Cour t s wer e not satisfied t hat

t his was t he case, as t hey ar gued t hat she would be wearing clothing in Court in any event in or der t o pr ovide her wit h warmth and normal decency The clot hing cost s wer e t her ef or e disallowed as t hey sat isf ied a pr ivat e pur pose

Ther ef or e, an account ant who only nor mally wear s his suit when he is act ing as an account ant , would not be able t o claim t he cost s of t hat suit as a t r ading expense because he would have t o wear somet hing when meet ing client s

However , t he Revenue do accept t hat protective clothing (har d hat s, over alls, chef s apr ons et c) is an ex pense incur r ed wholly and ex clusively f or t he pur poses

of t he t r ade and will allow such items The same applies f or act or s’ cost umes

Children’s wages

I n Dollar & Dollar v Lyon, t he pr ecedent was set t hat wages paid t o t he childr en

of t he t r ader ar e only deduct ible pr ovided t hey can sat isf y t he “wholly and

ex clusively” t est W e t her ef or e need t o demonst r at e t hat if we did not employ our own childr en, we would need t o employ somebody else’s childr en t o per f or m

t hose j obs (f or inst ance, wor king in t he shop on a Sat ur day or doing a paper

r ound) The wages paid should be at a reasonable market rate, nowadays bear ing

in mind t he Nat ional Minimum W age I f in t he Revenue’s view t he childr en’s’ wages put t hr ough t he account s ar e simply t heir pocket money (as in t he Dollar & Dollar case), t he cost s would not be deduct ible

Accountancy fees

I n Smit hs Pot at o Est at es Limit ed v Bolland, t he costs of a tax appeal, even

t hough it was successf ul, wer e not allowed as t hey wer e not incur r ed wholly and

exclusively f or t he pur poses of t he t r ade The company had incur r ed t he cost s

in its capacity as a taxpayer, not in it s capacit y as a t r ader Ther ef or e t he

cost s did not r elat e specif ically t o it s trade

Following on f r om t his case, t he Revenue will not accept a deduct ion f or t he cost

in pr epar ing an individual’s per sonal t ax r et ur n even t hough t he r et ur n will

include det ails of t he Tr ading I ncome This is because t he cost is being incur r ed

in t he individual’s capacit y as a taxpayer, not in his capacit y as a t r ader

So how do we t r eat account ancy f ees levied f or dealing wit h a tax enquiry? The

Revenue has issued a St at ement of Pr act ice st at ing t hat if t he enquir y r elat es

specifically to the trading income and as a r esult of t he enquir y no additional

profits are brought within the charge to tax, any cost s incur r ed in dealing

wit h t hat enquir y will be allowed f or t ax pur poses

SP 16/ 91

Finance lease assets

The r ule on f inance lease asset s der ives f r om t he case of Gallagher v J ones

Pr ior t o t his case, many t axpayer s claimed act ual r ent als payable under f inance

leases r at her t han t he commer cial char ges which had been put t hr ough t he

account s However in t he case of f inance leased asset s, a deduct ion is given f or

the depreciation element together with the interest charge This is t he only

exception to the rule that depreciation is not allowed f or tax purposes This

r ule is r ef er r ed t o in t he Revenue’s St at ement of Pr act ice 3/ 91

SP 3/ 91

B2.7 Specific disallowables

Cost s incur r ed by a t r ader in entertaining anyone except the trader’s own

staff ar e specif ically disallowed by t ax legislat ion

S.45

Gifts of it ems ar e also gener ally disallowed unless;

(i) t he asset s gif t ed cost under £50; and

(ii) t he gif t must bear t he business name, logo or a clear advertisement; and

(iii) t he gif t should not include food, drink or tobacco.

The Revenue ar e r eluct ant t o give f ull r elief f or t he leasing cost s of luxur y car s

A luxury car in t his cont ext is a car cost ing more than £12,000 I n t his

inst ance, we only allow r ent al payment s given by t he f or mula below:

s 48

Allow: £12,000 + P x Rental payment

2P

wher e P = r et ail pr ice of t he car when new

This f or mula can be f ound at s.48(2) I TTOI A 2005

The luxur y car r est r ict ion does not apply t o t he leasing of car s which:

(i) ar e elect r ically pr opelled; or

(ii) have car bon dioxide emissions less t han or equal t o 120g/ km

This exempt ion applies t o expendit ur e incur r ed on or af t er 17 Apr il 2002 on t he

hir ing of a car which is f ir st r egist er ed on or af t er t hat dat e

Example 1

A Mer cedes SLK is leased f or £ 6,000 p.a The car cost £ 25,000

Calculat e t he amount of t he ex pense t hat would be allowable and t he amount

t hat would be disallowed

Example 2

St at e whet her t he f ollowing ex penses incur r ed by a sole t r ader ar e allowable or

disallowable f or t ax pur poses:

Allowable Disallowable

a) Loss on sale of a comput er

b) Amor t isat ion of goodwill

c) Employee st eals t he pet t y cash

d) Ent er t aining t he local vet

e) Legal f ees incur r ed on pur chase of a new building

f ) I nt er est on lat e paid VAT

g) Depr eciat ion on a f inance leased asset

h) Pur chase of a new washing machine

a) Loss on sale of comput er (Capit al) X

b) Amor t isat ion of goodwill (Type of depr eciat ion) X

c) Employee t hef t of cash (Business r isk – wholly and

ex clusively)

d) Ent er t aining t he local vet (Not st af f ) X

e) Legal f ees on new building (Capit al) X

f ) I nt er est on lat e paid VAT (Fine) X

g) Depr eciat ion on f inance leased

SUMMARY - ADJUSTMENT OF PROFIT

Adj ust ment s must be made t o t he pr of it per account s t o ar r ive at a t ax adj ust ed

pr of it s on sales of f ixed asset s

Disallowed ex pendit ur e must be added back and includes:

- depr eciat ion (ex cept on f inance leased asset s)

- capit al expendit ur e

- losses on sales of f ixed asset s

- legal f ees on acquisit ion of asset s (except r enewal of lease < 50 yr s)

- expenses not incur r ed wholly and exclusively f or t he t r ade

- pr ivat e expendit ur e

- t r avel expenses f r om home t o wor k

- nor mal clot hing (but not pr ot ect ive clot hing which is allowable)

- childr en’s wages if r eally pocket money

- cost s of a t ax appeal

- ent er t aining (unless st af f )

- gif t s (unless < £ 50, bear ing t he business name and not f ood, dr ink nor t obacco)

- a pr opor t ion of luxur y car r ent als (not “gr een” car s)

£ 12,000 + P x Rent al payment (P = r et ail pr ice of new car )

2P

A measur e of r elief f or capit al expendit ur e is available f or t r ader s inst ead of depr eciat ion Cer t ain it ems will be eligible f or capit al allowances or indust r ial buildings allowances (cover ed lat er )

B3: CAPITAL v REVENUE

I n t his chapt er we shall look mor e closely at t he r ules f or dist inguishing whet her

expendit ur e is capit al in nat ur e (and t her ef or e disallowable) or r evenue in nat ur e and

hence would not lead t o any adj ust ment t o pr of it s You will lear n about :

Sect ion 33 I TTOI A 2005 disallows any sum employed as capital in t he

business This would include it ems such as loan repayments I f f or inst ance, a

t axpayer bor r ows money t o pur chase a business pr emises, any r epayment s he

makes back t o t he bank r elat ing t o t he capit al of t he loan will not be t ax

deduct ible However any int er est element will be allowable

s 33

The cost of capital acquisitions is also disallowed A capit al acquisit ion f or

t hese pur poses is any expense which gives an enduring benefit t o t he business

The cost of improvements t o business pr emises is disallowed The r eplacement

of a par t of t he pr emises wit h t he near est moder n equivalent , r ef lect ing

t echnological impr ovement s, is allowable However , if an it em is subst ant ially

upgr aded, t he whole expendit ur e may be capit al

Specif ically t he Revenue now accept s t hat r eplacing single glazed windows by

double glazed equivalent s count s as a r epair The Revenue’s pr evious view was

t hat such ex pendit ur e would ‘nor mally’ be an impr ovement and t her ef or e

disallowed

B3.2 Initial repairs

I f a t r ader pur chases an asset and t hen spends money on it , is t his ex pense

capit al? I n Law Shipping Company v I RC, a company pur chased a ship which

needed some immediat e r epair wor k as it did not possess a cer t if icat e of

sea-wor t hiness They spent t he money and claimed t he r epair s as a r evenue expense

in t he pr of it and loss account However , t he Cour t s held t hat t he r epair s wer e

par t and par cel of t he acquisition costs of t he asset as t hey enabled the ship to

be used for the very first time As a r esult , t hese “r epair s” wer e held to be

capital – i.e linked t o t he capit al acquisit ion of t he ship

Could we ar gue t hat t he cost s ar e r evenue? I n t he case of Odeon Associat ed Theat r es Limit ed v J ones, a number of cinemas wer e pur chased j ust af t er t he war in a ver y r un down st at e However , Odeon kept t hem open t o t he public and cont inued t o show f ilms Over a per iod of t ime t hey gr adually r epair ed and

r enovat ed t he cinemas and br ought t hem up t o a much smar t er st at e As much

of r epair wor k r elat ed t o dilapidat ions ar ising pr ior t o Odeon’s pur chase, t he Revenue ar gued under t he Law Shipping pr ecedent t hat t he r epair s expenses wer e par t and par cel of t he acquisit ion cost – ie, t hey wer e capit al However , as

t he repairs took place to useable assets, t he Cour t held t hat t he costs were revenue in nature and therefore allowable The most impor t ant f act or wit h

r egar d t o r epair s on newly acquir ed asset s, is whet her t he asset was purchased

in a useable state and was actually used in t hat st at e

B3.3 Repair v Replacement

A repair t o an it em is nor mally allowed as a revenue expense wher eas replacing

an ent ir e it em is nor mally consider ed a capital acquisit ion Ther e ar e t wo cont r ast ing cases her e I n Bullcr of t Main Collier ies v O’Gr ady, a business owned a

f act or y On t he same sit e t her e was a f r eest anding chimney The chimney was in

a poor st at e of r epair and t he most economic t hing t o do was t o knock it down complet ely and r ebuild it This was held t o be a replacement of an entire asset

and capital in nat ur e – i.e a capit al acquisit ion of a br and new chimney

However , in Samuel J ones & Co (Devondale Lt d) v CI R, a company owned a

f act or y which had a chimney act ually at t ached t o it The chimney was demolished and r eplaced wit h anot her one The t ax payer successf ully ar gued t hat t his was a

repair to a subsidiary part of the factory and not t he r eplacement of an ent ir e asset The cost s wer e revenue in nat ur e and t her ef or e allowable

Ther ef or e as f ar as r epair s ar e concer ned, if a t r ader act ually r epair ing a part

of an asset , t hat is a genuine r epair and t he cost s will be allowed However , if a

t r ader is r eplacing an asset in it s entirety, t hat is a capit al it em

B3.4 Staff costs

St af f cost s ar e gener ally a revenue expense unless they relate to a capital project. For example, if a f ir m of builder s employs it s own st af f t o const r uct a new head of f ice, we would capit alise t hose par t icular st af f cost s on t he balance sheet as t hey ar e par t of t he acquisit ion cost s of t he new head of f ice (t he new

of f ice being a capit al asset employed in t he business)

Anot her example would be a f ir m of account ant s employing st af f who have developed a new int er nal account ing sof t war e package t o be used long-t er m in

t he business The st af f cost s her e ar e likely t o be linked t o a capit al t r ansact ion and t hey should be disallowed Capit al allowances should inst ead be claimed on

t he sof t war e development cost s We will deal wit h capit al allowances in a lat er session

I n I RC v The New Zealand For est I nst it ut e Limit ed, t he company pur chased a

number of r esear ch under t akings f r om t he New Zealand Gover nment W hen t he

under t akings wer e pur chased, t he company t ook over all of t he employees’

cont r act s of employment Some of t he st af f wer e ent it led t o accr ued holiday

pay, which was duly paid by t he company who claimed it as a r evenue expense

However , t he Pr ivy Council held t hat t his was capital, r elying on t he decision of

Law Shipping The holiday pay f or med par t of t he acquisition costs of the

undertakings, and wer e cont r act ual obligat ions The company had pur chased an

asset (t he new r esear ch under t akings) and wer e immediat ely r equir ed t o spend

money on it That is a capit al t r ansact ion

J ames Snook & Co Limit ed v Blasdale involved a company owned by a number of

dir ect or s The dir ect or s wer e also shar eholder s The buyer was pur chasing t he

shar es in t he company in r et ur n f or a cash payment t o t he shar eholder s

The acquisit ion of shar es is nor mally t r eat ed as a capit al t r ansact ion and t he

pur chaser would t her ef or e not be able t o obt ain t ax r elief in ar r iving at t heir

t axable pr of it s However , t wo of t he boar d dir ect or s (who wer e also

shar eholder s) wer e t o be made r edundant as well as selling t heir shar es

The pur chaser negot iat ed wit h t hese t wo member s t hat t he cash t hey r eceive

would be t r eat ed as compensation for loss of office This way t he pur chaser

could t r eat t he payment as par t of staff costs (ie, as an allowable r evenue

ex pense) However , t he Cour t s did not agr ee The t r ansact ion was t r eat ed as

capit al as t her e was a direct link between the cash and the sale of shares

The Revenue will t r y t o link a payment t o a capit al t r ansact ion wher ever possible

I n t his sit uat ion, it would have been bet t er f or t he pur chaser t o buy t he shar es

(at a discount ed pr ice), keep t he boar d member s on f or , say, 6 mont hs, t hen

make t hem r edundant The r edundancy payment in t his inst ance payment would

most likely be t r eat ed as a r evenue ex pense

B3.5 Training costs

The acquisit ion of new ex per t ise is t r eat ed as capit al For example, assume an

individual want s t o t r ade as an account ant The cost s incur r ed by t hat individual

t o acquir e t he r elevant exper t ise and pass t he account ancy exams will not be

t r eat ed as an expense in ar r iving at his t axable pr of it but will simply be a cost

incurred to enable him to trade in t he f ir st place

I n a similar sit uat ion, t he cost s incur r ed by an individual put t ing t hemselves

t hr ough t r aining t o become a dr iving inst r uct or would also be treated as capital

as t hese ar e cost s t o put t hat per son in t he position to trade, and ar e not

incur r ed as part of actually trading

Ongoing, update or development training, once qualif ied, will be allowed as a

r evenue ex pense because t her e is a dir ect link bet ween t he expense being

incur r ed and t he income being r eceived as an account ant or dr iving inst r uct or