Lee Sharpe considers how the cash basis has developed and why HMRC is so keen on the cash basis for landlords, the self-employed and partnerships.
The cash basis for unincorporated trading entities was originally introduced by FA 2013 to apply from 2013/14 (FA 2013, Sch 4).
Initially:
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The focus was fundamentally on mainstream trading entities such as the self-employed and small partnerships (but not entities that involved companies).
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Only smaller businesses were eligible – the monetary test*, typically across an individual’s trading businesses in aggregate, tracked the VAT ‘12-month’ threshold (£79,000 in 2013/14) –
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The business’ (or businesses’) gross annual receipts had to be at or below that threshold to be able to join in the first place; while
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They had to leave the cash basis, broadly if and when gross annual receipts exceeded twice the annual VAT threshold.
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While theoretically, there was no distinction between capital and revenue expenditure, restrictions were introduced to ensure that, basically, the trader would get no better or more wide-ranging tax relief than they might hope to secure under the existing capital allowances regime – annual investment allowance. So, no deduction simply for spending (say) £200,000 on new business premises (simplification so long as there’s no chance it will cost HM Treasury any money!).
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The only relief for losses was by way of carry-forward.
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The relief for loan interest was restricted to just £500 per annum.
*These entry and exit thresholds were doubled for those in receipt of Universal Credit.
Barriers to adoption
While promoted alongside the cash basis, the simplified expenses regime (motoring expenses, use of home for business, etc.) does not require one first to adopt the cash basis. However, there were several aspects that acted to discourage use of the cash basis.
The limit for interest expense applied primarily to ‘monetary borrowings’, so things like credit card interest on business expenses, hire-purchase or trade credit were fine, to the extent that the outlay was for business purposes. Even so, a business hoping to secure formal borrowing for serious growth would likely need more than the measly £500 annual limit available under the cash basis.
Furthermore, a bank or similar prospective lender – including potentially for private borrowings such as mortgages – might well insist on the last three years’ financial statements drawn up in accordance with Generally Accepted Accounting Principles (GAAP) – which would mean accounting for accruals, and not simply recognising ‘cash in and cash out’ as per the cash basis. (NB to be clear, GAAP is much more than simply matching accrued income against accrued expenditure; but it is the key division against the cash basis).
In a similar vein, the prohibition for any entity involving a body corporate was imposed because financial statements must be drawn up to comply with the Companies Act 2006.
But perhaps the greatest possible downside to adoption from a tax perspective would be that an individual having adopted the cash basis could not use the traditionally flexible loss reliefs against other income of the current or previous tax year, or on commencement, etc.
Changes to boost take-up of the cash basis – Cash basis for landlords
Finance Act 2017 included two main developments applicable from 2017/18:
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For the existing regime, the entry and exit thresholds were simplified to £150,000 and £300,000, respectively, breaking the link with the VAT threshold.
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A new cash basis for (non-corporate) landlords was introduced to parallel the existing regime for traders, but notably:
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it automatically became the default for non-corporate landlords – from April 2017, they would have to opt OUT of the cash basis and INTO the GAAP or traditional accruals basis (and do so every year); and
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there was no numeric annual cap on tax relief for finance costs (although there was a new formal calculation to restrict relief where the landlord had extracted too much capital from the business, as well as the ongoing restriction for finance costs for residential lettings).
Point (1) is evidence that HMRC was really keen for smaller businesses to use the cash basis – in behavioural terms, a taxpayer has to deliberately opt out and has to renew that decision every year. This was not so much because HMRC believed that taxpayers and landlords, in particular, actually benefitted from the cash basis, but because it was easier for HMRC in its long march to MTD. It wants as few discrepancies as possible between the figures on a taxpayer’s return and those supplied in bulk by banks, letting agents and similar institutions. This was only the beginning.
Latest changes
The current draft of the Finance Bill 2023-24 includes provisions broadly to align the ‘old’ cash basis for traders with that for landlords so that, from 2024/25:
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with a few exceptions for business categories still ineligible to use the cash basis, all businesses that do not involve corporate entities will be set on the cash basis and will have to opt out of using GAAP or accruals; and
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the annual cap for loan interest will be removed.
Furthermore:
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the entry and exit annual turnover thresholds will be abolished; and
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the restrictions to the wider range of trading loss reliefs, preventing relief against other income or previous incomes, will be removed.
Relaxing the restrictions on the availability of interest costs and loss relief should be welcomed, as they remove two significant disincentives from the regime. £500 was miserly even back in 2017; but of course, interest rates today are roughly ten times what they were when the cash basis was originally introduced.
I suspect that provisions to remove the annual turnover threshold for landlords (as has applied from the introduction of that regime in April 2017) will be snuck in, ere long. Very few people actually understood how they worked for married couples and property partnerships anyway – least of all, HMRC.
Conclusions
It is arguable that a great many small businesses would naturally adopt the cash basis but for those pesky accountants insisting that accurate financial statements be consistently drawn up in accordance with GAAP. But it is also arguable that those accountants may actually have been doing something right, given that the official Tax Information and Impact Note published alongside the Autumn Statement 2023 predicts that the changes will net HM Treasury a further £115 million in 2025/26, in spite of the significant concessions on finance costs and loss reliefs, etc.
While HMRC’s officers may be relieved that they no longer need tax their brains over the complexities of accounting fundamentals, I suggest the real driver for this simplification is software design, and making almost everyone ‘cash basis by default’ will mean that the most basic MTD-compliant software packages – particularly the cheapest or ‘free’ versions – will likely get away with offering precious little functionality to accommodate accruals matching, etc. And it will, of course, be easier for HMRC to check against figures provided by third parties that will naturally be on a cash basis.
It may also mean that there is nothing technically to prevent even quite substantial unincorporated businesses from deliberately maximising their cash outlay in February and March while easing off from collecting their outstanding debts over a similar period, while most non-corporates are obliged to follow a tax-year basis period as well (although practical constraints remain, particularly if a business does not have the cash reserves to allow it to be so flexible). March may prove to be a slow month for bailiffs and other debt collection agents in years to come. The irony that MTD has forced HMRC to want to abandon GAAP or accruals for millions of taxpayers will not be lost on veteran agents who will recall how HMRC used to insist on GAAP for the great majority of businesses, despite not really understanding accruals all that well.
Finally, the special adjustments required if and whenever a business decides to transition from the cash basis to the more traditional and accurate GAAP or accruals basis will normally – and potentially quite usefully – be spread over up to six tax years (Finance Bill 2023-24 includes corresponding amendments to ITTOIA 2005, s 239A to accommodate that the cash basis will be the new default, rather than by election). GAAP may yet prosper.
