Income tax is levied on the income of an individual arising in a tax year (a tax year runs from 6th April to the following 5th April). However, this is not quite the case with respect to trading profits. For example, for, say, the tax year 2010/11 the trading profits subject to income tax for that year are unlikely to be the trading profits arising between 6th April 2010 and 5th April 2011, as will be seen below.
This, the first of two articles, addresses the basic rules applicable to trading profit taxation; the second article examines planning issues.
John Smith
Let us take the example of John Smith, the plumber, who starts in business as a self employed plumber on the 1st November 2008.
First Tax Year
His first tax year of trading is 2008/09. The trading profits in respect of which he is assessed to income tax for 2008/09 are those which arise from the date of commencement of trading to the following 5th April.
Example 1: John Smith starts to trade on 1st November 2008. His taxable profits for the tax year 2008/09 are those arising from 1st November 2008 to 5th April 2009.
Second Tax Year
His second tax year of trading is 2009/10. The trading profits in respect of which he is assessed to income tax for 2009/10 are determined according to the following rules:
• if accounts have been prepared to a date falling within the second tax year, the taxable profits are those for the twelve months ending on that date or, if the period from commencement of trade to this account date is less than twelve months, the first twelve months; and
• otherwise, if there is no date to which the accounts have been prepared which falls in the second tax year, the taxable profits are those for the tax year itself.
Example 2: John Smith is not sure to what date he wishes to prepare his accounts and considers the following alternatives:
(1) 30th April 2009; or
(2) 31st December 2009; or
(3) 31st May 2010.
Under (1) taxable profits for the second tax year are for the period 1st November 2008 to 31st October 2009 (ie the first twelve months).
Under (2) taxable profits are for the period 1st January 2009 to 31st December 2009 (ie the last twelve months).
Under (3) taxable profits are for 6th April 2009 to 5th April 2010 (ie the exact tax year).
Thus, only if John decides to choose the “otherwise” option (see above) are his taxable profits those for the exact tax year 6th April 2009 to 5th April 2010.
Third Tax Year
For the third tax year (i.e. 2010/11) the taxable profits are those for the period of twelve months ending with the date falling in the tax year to which John prepares his accounts.
Example 3: Under the alternatives of Example 2, John’s taxable profits are:
• under (1) - the twelve months to 30th April 2010;
• under (2) - the twelve months to 31st December 2010;
• under (3) - the twelve months to 31st May 2010.
Subsequent Tax Years
Thereafter, John’s taxable profits for each tax year are those for the twelve months ending with the date falling in the tax year to which he prepares his accounts.
Overlap Profits
For the sharp-eyed reader, it will be clear that for John some of his taxable profits are in fact subject to tax twice; such profits are referred to as “overlap profits” which are generally undesirable. John’s overlap profits will be identified in the next article, together with some planning tips.
Practical Tip
Choose an accounts date which mitigates the amount of overlap profits; this, and other planning issues, will be addressed in the next article.
By Malcolm Finney
