Back to basics: Calculating a tax-adjusted trading profit / loss
One of the core skills of an accountant working in tax is being able to adjust an accounting result for tax purposes to reach a tax-adjusted trading profit or loss.
This task forms the starting point for many income tax (for sole trade or partners) or corporation tax (for companies) computations. The starting point and key rules for each tax are the same, but some small differences will be covered on the course.
The starting point for any trading entity is the profit or loss for the accounting period per the accounts.
This accounting result may contain various sources of income such as income from the trade, rental income, savings and investment income, and income from the sale of capital assets. It may also have numerous types of expenses; some relating to the trade and some relating to other activities. Part of the task of adjusting this result for tax purposes is to strip out all of the items that do not relate to the trading activity.
These non-trading items may be taxed elsewhere in the final tax computation, for example; bank interest is taxable as savings income for an individual or as a non-trading loan credit for a company.
Why do we adjust the accounting result?
Broadly speaking, there are three main reasons why we adjust the accounting result in calculating the taxable trading profit. These are:
- Items of a capital nature should not be included within the trading result. This includes both receipts of a capital nature (sales of capital assets or some insurance receipts) and expenses related to capital (depreciation and losses on sale of fixed assets).
- Items that are taxable or tax deductible elsewhere in the computation should not be included within the trading result. Examples include rental income and corresponding rental expenses, investment income and charitable gift aid donations.
- Specific legislative rules either allowing or precluding a deduction. For an individual these rules are found in the Income Tax (Trade and Other Income) Act 2005 (ITTOIA 2005), and for a company, the Corporation Tax Act 2009 (CTA 2009). There are a number of specific rules as well as a general rule (expenses are only tax deductible where incurred ‘wholly and exclusively for the purposes of the trade’).
The third of these reasons is probably the most difficult to get to grips with as it involves learning a number of the legislative rules. The main ones we cover at TC Principles of Taxation are listed below:
Rules restricting deductions – these items must be disallowed in the computation
- Business entertaining and gifts are generally not allowable, subject to some exceptions
- 15% of the leasing cost of high CO2 emission cars
- Movements in general provisions for doubtful debts
- Remuneration unpaid within nine months of the period end
- Class 2 and 4 NIC payments of a sole trade or partner
- Penalties, interest and VAT surcharges
- Crime-related payments
- Drawings of a sole trader or partner
- Dividends paid out by a company
Rules allowing deductions – these items are specifically allowed by the computation
- Expenses that would normally be allowable, incurred in the seven years prior to trade commencing
- Incidental costs of obtaining loan finance
- Payments for restrictive undertaking
- Costs of employees on temporary secondments to charities and educational establishments
- Counselling and retraining costs for redundant employees
- Redundancy payments
- Research and development
These are just a few of the examples of adjustments that may be required due to legislative rules. When you begin TPS Taxation you should use the contents page of ITTOIA 2005 as a handy list of many of these rules. You might want to use two different colours to highlight the rules which restrict relief, to differentiate from those that allow relief.
How do I remember whether to add or deduct?
In exam questions you will sometimes be told about amounts that are in the accounts, and sometimes be told about amounts which have not been shown in the accounts. So it is best not to rote learn the ‘add’ and ‘deduct’ items, but instead to think about the figures in the accounts and how you should adjust in order to reach the taxable profit. Remember that you only need to adjust where the accounting figures do not match the figures that would be in the taxable profits.
Think about a situation where a client has told you they were unsure of how to account for client entertaining and so they have not yet put it in their accounts. We know that client entertainment is not tax deductible. The entertainment is not in the accounting profits. The two treatments match. Therefore, no adjustment is required.
There are some subtle differences to the rules that apply to companies, including adjusting for trading and non-trading loan items, the intangible asset regime, and the enhanced relief available for qualifying research and development costs. All of these items are dealt with as part of the adjustment of trading profits and do not appear as separate adjustments in the TTP proforma.
Finally, remember that capital allowances are also known as ‘tax deprecation’. If you are adding back depreciation in your computation of trading profits you should also be thinking about deducting capital allowances. How we calculate the capital allowances of a business will be picked up in one of our future Back to Basics blogs.
|Net profit or loss per accounts (start with profit before tax for a company)||X|
|Appropriation of profit (drawings)||X|
|Expenditure disallowed by statute||X|
|Expenditure not wholly and exclusively for business||X|
|Expenditure relieved elsewhere||X|
|Income taxable as trading income but not in accounts||X|
|Income taxable elsewhere in computation||X|
|Deductible expenditure not in accounts||X|
|Adjusted taxable trading profit||X|