BEFORE BUSINESS BEGINS

Starting up

The first key tax date for any business is that on which it opens its doors to customers. HMRC refers to this as the date on which trade commences. It’s important because it’s the point from which HMRC starts to measure the profits and losses on which you’ll pay income tax and National Insurance (NI).

However, no business starts overnight. At the very least you must decide what to call your business, make agreements with business partners as well as taking practical steps, such as setting up a bank account and a means of getting paid by your customers. The lead-in time for getting a business ready to trade can vary significantly; it might be just a few days if you’re setting yourself up as a consultant and working for just a few clients you already know, or it can last months if you’re starting a manufacturing business requiring premises and the installation of heavy machinery.

It’s likely that every business will incur expenses before its trade commences. Without special rules some of these might not qualify for a tax deduction.

 

What are the tax rules for pre-trading expenses?

In a nutshell, the rule for pre-trading expenses allows you to claim a tax deduction for costs relating to your business if they would have qualified for a deduction had you incurred the expense after trading commenced. The rule says that pre-trading expenses are treated as if they were incurred on the first day business commences.

You can claim a tax deduction for costs incurred up to seven years before your trade commences. For example, if your trade commenced on 1 May 2022 expenses back to 1 May 2015 can qualify.

 

Can a deduction be claimed for personal expenses?

The general rule is that no tax deduction is allowed for expenses if they aren’t incurred “wholly and exclusively for the purpose of a trade”. That’s a reasonable and understandable restriction. However, there’s a unique angle to pre-trading expenses which can allow a deduction for costs that might originally not have been incurred with your business in mind. You might have spent money on an item long before you thought about starting a business, but if it was later used for your business and the expense was incurred within the seven-year time limit, the pre-trading rule allows you to claim a tax deduction for it.

Pre-trading expenditure will mostly relate to equipment, for example a car, but the same rules apply to smaller and less obvious items.

Example

John was employed as a designer with a kitchen company. In early 2022 he decides to start his own furniture design firm which he’ll run from an office in his home. In late 2020 he bought new IT equipment and furniture for his home office, which he used almost entirely for private purposes. In mid-2022 he bought a stock of paper, ink cartridges and stationery for his private use. John can claim a tax deduction under the pre-trading expenses rule for the IT equipment and the paper, ink, etc.

 

How much tax deduction can I claim?

Naturally, the amount of tax deduction depends on the cost of an item. Consumables bought pre-trading specifically for your business will be unused when trading starts and so the tax deduction is equal to the cost. However, if the item is durable (for tax purposes this means something that can be used multiple times for a period of two years or more, this is referred to as capital expenditure), e.g. equipment, it might be used or unused or have been bought for the business or for another purpose. The tax relief is allowed for:

• the cost where the item was bought for the business and unused; or
• the “market value”, i.e. the amount you could expect to receive if you sold it to someone unconnected to you, of the item if it was previously used for a purpose other than for your business.

Tax relief can be claimed for the market value of equipment etc. bought by someone else, for a private purpose, but which you start using for your business. For example, a computer bought for you as a gift which you later start using for your business.

 

Does the pre-trade rule apply to all expenses?

No. You don’t need to rely on the pre-trading rule to obtain a tax deduction for stock and materials bought before trade commences if they were purchased specifically for the business. Normally, general accounting rules mean that these types of cost are included as an expense in your first accounts anyway and the tax rules follow the accounting rules in this instance.

 

What about services I pay for before trading?

The same pre-trading rule applies to services as it does to goods. However, in practice it will only be relevant to purchases made specifically for your business. For example, if you take a lease on a retail unit with the intention of running your business from it, you’re unlikely to start trading there on the day you receive the keys; it might need fitting out or other work before you can use it. While your accountant might include the rent for this period, along with the fitting out costs, in your business’s first accounts, for tax purposes they are pre-trade expenses.

 

Are there any NI issues to consider for pre-trading expenses?

You don’t need to register to pay self-employed NI, Class 2 and Class 4, until after you have started trading. Class 4 NI is worked out on your taxable profits which means you’ll only pay NI after normal and pre-trading deductions are taken off. Class 2 NI is payable at a flat rate.

 

What about VAT on pre-trade expenses?

The VAT position is more complex than that for income tax. Generally, VAT which you pay on pre-trading costs can be reclaimed but, of course, you must register for VAT before you can do this. Unlike income tax the key date for VAT is not when trade commences but when you register for VAT. Therefore, you might incur pre-trading expenses, followed by pre-registration expenses after trade has commenced. The good news is that the same set of rules apply to both situations to determine whether or not you can reclaim VAT.

 

What’s the general rule for reclaiming pre-registration VAT?

VAT paid on goods or services before registration can be reclaimed where the purchase was for the business to which the registration relates. The usual rules for recovering VAT apply to pre-registration purchases as they do after registration. So, if you wouldn’t be allowed to reclaim VAT on a purchase once you’re registered because, say, it related to a sale of exempt goods or services, neither would you be entitled to reclaim VAT if the purchase were pre-registration.

What are the VAT time limits?

There are time limits for pre-registration VAT:

• for goods, e.g. stock and equipment, they must be “on hand” and have not been consumed, i.e. completely used, prior to the date of registration. Plus, the goods must have been bought within the time limit set out in VAT Regulation 111; for businesses with a registration date on or after 1 April 2010 the time limit is four years; and
• for services, e.g. in the case of services, broadband, rent, the purchase must not be more than six months before the date of registration.

VAT paid on goods on hand at registration can’t be deducted if the VAT was incurred outside the time limits set out in Regulation 111. This includes VAT incurred on services applied to the goods. For example, the services of a builder apply to materials, such as bricks, plaster, paint, etc.

Note. You can back date a registration by up to four years. This can allow you to reclaim VAT that would otherwise be outside the time limit. However, you must then account for VAT on supplies you made after the date of registration. Of course, this won’t be a problem if you haven’t made any sales yet.

HMRC allows you to register as an intending trader. This means that even where you are only in the planning or preparation stages of your business, and so not normally entitled to register you can do so and reclaim VAT on your costs. This can prevent claims for VAT on expenses, especially services, falling outside the pre-registration time limits.

 

Does non-business use before registration affect the amount of VAT reclaimable?

No, only future use determines the amount of VAT you reclaim. HMRC doesn’t require you to reduce the amount of VAT you reclaim in respect of pre-registration use of fixed assets.

For example, VAT incurred on a van purchased three years before registration, which you used for business and private journeys, would be recoverable in full when you register - subject to the normal rules. However, the normal rule is that you must either restrict the amount of VAT you reclaim to reflect future private use or use the so-called Lennartz method to account for VAT of the private. Lennartz allows you to reclaim all the VAT on a purchase and then account to HMRC for later private use of the item. It can only be used for certain types of purchase. This is explained in HMRC’s input tax manual.

If you purchased a van for £15,000 plus VAT of £3,000 for your business in April 2019 and register for VAT on 1 November 2022, you can reclaim the whole £3,000 if the van is to be used only for business after registration. If, however, you expect to use the van 10% of the time for non-business journeys you should restrict your claim by 10% to £2,700.

The pre-registration rules don’t allow you to reclaim VAT on purchases that were wholly for non-business or private purposes regardless of any subsequent business use. For example, you buy a van to use for wholly private purposes. Three years later you register for VAT and use the van exclusively for business. The VAT paid on the van is permanently outside of the VAT system because it was not used for business activities at the time it was bought.

Note. There are special rules for pre-registration VAT on certain high value goods, such as buildings and IT equipment. Broadly, they allow you to reclaim all the VAT as for other goods, but there will be a charge if there’s non-VATable use in the following ten years.

WHEN TRADE COMMENCES

The next stage

After the pre-trading period the next key tax date is when you open your doors to customers; in HMRC’s words when trade commences. Depending on the type of business it might not always be clear precisely when this is, but pinpointing it to a specific day is rarely significant.

The start of trading means you no longer have to consider the pre-trading tax rules; expenses and income from now on are subject to the general tax and accounting rules. You will need to step up your record keeping ensuring that accurate accounts can be produced for HMRC, other regulatory authorities, your bank and similar organisations, and of course you and your business partners.

 

Do I need to tell HMRC that I’m in business?

You may already have told HMRC that you’re starting a business by registering for VAT during the pre-trading period. There’s no requirement to notify it you have started trading as it will be apparent from your VAT returns. However, you may need to tell HMRC separately for NI purposes, which also serves as a notification for income tax purposes.

Note. Despite what you might read there is no legal requirement to notify HMRC for tax purposes that you’ve started a business or that it has started trading. However, there is a requirement in some circumstances to do so for NI.

Where you have a liability to income tax, whether it arises from business profits or other income, you must tell HMRC about it no later than 5 October following the end of the tax year for which you owe tax. The only exception to this is where HMRC has, before the October date, asked you to complete a tax return for the year in question, in which case there’s a deadline for completing and sending it to HMRC. If you miss the 5 October deadline there are penalties, usually ranging between 10% and 100% of the tax liability you didn’t tell HMRC about.

Using HMRC’s official notification process ensures that you won’t get caught for a penalty for not notifying it about your business.

 

Is there a special procedure for partnerships?

It’s up to each partner to tell their tax office that they are now in business as a partner. In addition, one of the partners, or the business’s accountant, must tell HMRC about the existence of the partnership.

 

What happens after I’ve notified HMRC?

Apart from HMRC issuing you with a tax reference number (unique taxpayer reference (UTR)), unless you had one already, you probably won’t hear from HMRC until it issues you with a notice to submit a tax return to declare all your income including your business profits. If you’re in partnership, the nominated partner, i.e. the one given the role of communicating with HMRC, will be notified of the UTR for the partnership. A tax return will also have to be submitted for the partnership.

Where your business profits are less than the NI small profits threshold, £6,725 for 2022/23, you won’t have to pay Class 2 NI contributions. Following the government’s announcement at the 2022 Spring Statement, where profits exceed this, but do not exceed £11,908 for 2022/23, no contributions are payable but you will receive a notional credit toward your NI-linked benefit entitlement, e.g. the state pension. The calculation is part of the self-assessment for tax and so no special form needs to be completed to take advantage of the exception from Class 2 contributions. 

if your profits are below £6,725 you can choose to pay Class 2 NI on a voluntary basis if you wish. This could be worthwhile as it is a relatively inexpensive way of building up state pension entitlement.

THE FIRST TAXABLE PERIOD

Compliance

Once your business is up and running the tax payable on its profits isn’t a day-to-day consideration. It comes to the fore a few times a year: when you prepare your accounts and tax return, and when you pay your self-assessment tax bills. In between times good record keeping is paramount. Not recording expenses or income, or doing so incorrectly, will mean you’ll pay to little or too much tax. Paying to little might sound attractive, but if HMRC discovers errors you’ll have to pay the shortfall, plus interest and probably stiff penalties.

Good record keeping is the key to maximising tax deductions and using the tax breaks available. If you aren’t comfortable or experienced in bookkeeping it will pay you to engage a specialist to do the work for you. However, they’ll need your input and help to ensure that money received, and costs incurred, by the business are allocated correctly. This will ensure correct tax bills and maximum tax efficiency.

Having kept good business records you’re now ready to prepare your accounts and consider the tax position.

 

How do I work out profits?

Usually standard accounting principles are used to calculate profit. However, some special adjustments are required to adjust the profit to arrive at the taxable amount. For example, where your business incurs an expense which relates partly to personal use by you or your business partners.

Accounting principles require your business accounts to reflect income due from sales, even if you haven’t been paid by your customer, and expenditure you’ve incurred even if you haven’t paid by your supplier. However, since April 2013 there’s been an alternative option. Small businesses can choose to prepare accounts using the cash basis of accounting. This allows you to work out your taxable profits based only on income you have received and expenses you have paid. This potentially simplifies record keeping. Companies are excluded from this, regardless of their size.

 

Who can use cash accounting?

The self-employed (sole traders) and partnerships can use cash accounting if the annual turnover does not exceed £150,000, unless certain elections (mainly applying to farmers) have been made. You can elect on the self-assessment tax return to use the cash basis. You must stop using the cash basis the year after your turnover exceeds £300,000.

If you are claiming Universal Credit you can use the cash basis if your business’s annual turnover is £300,000 or less. However, the same upper limit applies for leaving it.

 

Are any businesses excluded from the cash basis?

Yes, the following types of business are excluded from using the cash basis:

• a partnership which includes a company or other organisation as one of the partners
• limited liability partnerships
• farmers who use the “herd basis”
• where you have made a profit averaging election
• if your business involves mineral extraction
• Lloyd’s underwriters
• if your business involves dealing in investment securities or lease premiums
• if you’re a minister of religion
• where you deal in pool betting duty
• businesses dealing in waste disposals
• cemeteries and crematoria businesses
• if you make payments as an employment intermediary.

 

How do I elect to use the cash basis?

Prepare your accounts using the cash basis and notify HMRC by ticking the relevant cash basis box on the self-assessment tax return.

 

What is the trading allowance?

Some businesses start off very small or are only ever that way by design. The “trading allowance” is intended to simplify the tax position for these. It can be claimed for business income received on or after 6 April 2017. It has two forms:

1. It exempts from income tax up to £1,000 of business income. If your business income is no more than that there’s no need to claim the allowance or tell HMRC about your income as the allowance automatically applies.
2. If your business income is more than £1,000 you can claim the trading allowance instead of business expenses you incur. Only business income received in excess of £1,000 will be taxable.

Before claiming the trading allowance consider the following:

• if income goes over £1,000, HMRC will need to be informed. The deadline for this is six months from the end of the tax year
• business costs are not deductible. So if your business expenses exceed income, it is not possible to claim any loss relief if you claim the trading allowance. In this situation it’s better to ignore the allowance and claim the expenses you actually incur
• the £1,000 is deductible whatever the expenses actually incurred, so if income is, say, £3,000 and expenses are only £300, the full £1,000 is deductible.

 

Can I choose the date to which I prepare my business accounts?

Yes. While ultimately you’ll pay tax on the same amount of profit whichever accounting date you choose, the amount of tax you pay might differ. This is because, until at least April 2024, where your accounting year (financial year) doesn’t coincide with the tax year there are rules for allocating profits between tax years. The profit for a tax year is that for the “basis period”. The basis period is for the:

• tax year in which business commences, the profits from the start date to the end of the tax year in which it falls
• second tax year, the profit for the first twelve months since business commenced
• third and subsequent years, the profit for the accounts ending in the tax year (if they are for a period of twelve months or more)
• final year of your business, that for the period between the end of the previous accounts to the date your business ceased.

Because you can choose accounting dates for periods exceeding or less than twelve months, there are many special rules which modify the basic rules, for example to prevent tax being paid on profits twice.

Note. From April 2024 the rules for allocating profits will change so that the basis period for taxable profits for a tax year will be those arising in the tax year (6 April to 5 April) instead of those shown in the accounts which ended in the tax year. For example, if a business’s accounts end on 30 April, the profits for the tax year 2024/25 will be 1/12th of those shown by the accounts to 30 April 2024 or the month of April 2024 plus 11/12ths of the profit shown by the accounts to 30 April 2025. The tax year 2023/24 will be a transitional year with special rules so that the move from the old to the new methods don’t result in profits being taxed twice.

LOSSES

What if my business makes losses in the early years?

Because of start-up costs and the time it takes to establish a business, losses are more likely in the early years in the life of your business. There are special rules which allow you to use those losses to reduce tax you’ve paid on income before you started in business.

Losses that arise in the first four tax years of trading can be used to reduce the tax payable on your income of the three tax years preceding the loss, earliest year first. The maximum amount of loss you can use in this way for a single tax year is capped at £50,000 (or 25% of adjusted total income if that’s higher). Adjusted income is your total taxable income plus any pension payments which may be deductible.

Note. This tax break can’t be used where you’ve opted for cash accounting.

Example

Sally’s business made a loss of £70,000 in 2023/24, the second year of trading. She had taxable income (salary) in 2020/21 and 2021/22 of £40,000 and £35,000 respectively. Sally can use the loss to reduce the tax on her 2020/21 income first and then 2021/22.

£40,000 would be first set against the income of 2020/21. The remaining £30,000 would be set against Sally’s 2021/22 income of £35,000, leaving £5,000 taxable, which would be covered by Sally’s personal allowance for that year.

 

Can I use business losses to reduce tax on my other income?

If your business makes losses in any other period than its final twelve months of trading, you can use them to reduce tax payable on other income of the same tax year or the previous one. This is known as sideways loss relief.

The relief is capped to losses of £50,000 (or 25% of your adjusted total income if higher). Broadly, your adjusted total income is your taxable income less pension contributions.

If you own or part own your business but aren’t actively involved in running it, that is devote ten or more hours to it per week on average, sideways loss relief is further restricted to a maximum of £25,000 per tax year.

If any loss remains after claiming the maximum sideways loss relief, it can be carried forward and used to reduce profits of the same business in later years.

Note. Individuals using the cash basis of accounting cannot claim this relief.

To help businesses which took a financial hit from the pandemic the government introduced a temporary measure which allows business owners to set losses they make for 2020/21 and 2021/22 against their other income (up to £50,000/25% of adjusted total income cap) for the previous three years instead of just one. For example, losses for 2021/22 can be used to reduce the tax payable on other income for 2018/19, 2019/20 and 2020/21. Losses must be used against the most recent of the three years first, then the second most recent and finally the third.

 

Can I use business losses against future profits?

Unless you claim early years’ loss relief or sideways loss relief, business losses are by default carried forward and used to reduce the first available profits of the same trade in later years. There is no cap on this relief.

You have until the 31 January in the year following that to which the loss relates to claim early years’ or sideways loss relief. This gives you time to look at the next year’s profit and decide whether it would be best to use the loss against tax on other income or allow the loss to be carried forward to reduce future tax.

Note. Because a loss relief claim can’t be withdrawn once made, don’t rush into your decision. First work out what will give you the greatest tax saving.

 

How do business losses affect my Class 4 NI contributions bill?

Loss relief claimed against business profits reduces your Class 4 NI (profit-related NI) liability as well as your tax bill.

Where you claim loss relief which reduces tax on non-business income the amount of Class 4 loss relief won’t be affected. This means that you may have more NI loss relief remaining than income tax relief.

Example

Brian made a loss of £10,000 in his first year of trading to 31 March 2022. In the following year to 31 March 2023 he expects to make a profit of £18,000.

Brian claims £10,000 early years’ loss relief against his employment income for the years before he started his business. Because the loss wasn’t used against business profits a loss of £10,000 for NI purposes will be set against his £18,000 profit for the year to 31 March 2023.

For 2022/23 Brian’s taxable profit is £18,000, but his profit liable to Class 4 NI is only £8,000.

Can I use business losses to reduce my capital gains tax bill?

If you make a business loss and have no income against which to use loss relief you can instead use losses to reduce tax payable on capital gains for the same year.

The relief isn’t subject to the £50,000 restriction that applies to sideways or early years’ loss reliefs for income tax.

Example

Steve has incurred a trading loss for 2021/22 of £70,000. He has other taxable income in 2021/22 of £20,000, as well as capital gains of £18,000, and had total taxable income in 2020/21 of £25,000.

Steve can set £20,000 of the loss against his 2021/22 income, but his personal tax-free allowance of £12,570 will be wasted as a result.

As an alternative, he can set £25,000 of the loss against his 2020/21 income, but that would mean his personal allowance for that year would be wasted.

If he makes both claims, he can also set £18,000 of the loss against the 2021/22 capital gains if he wishes.

If he makes all three claims, £7,000 of losses (£70,000 - £20,000 - £25,000 - £18,000) is carried forward and set against the next available profits of the trade.