Sarah Bradford explores the proposed reforms to the basis period rules, and the impact of the move to the tax year basis on profits taxed in the transitional year.
Smaller unincorporated businesses can elect to compute their taxable profits using the cash basis rather than the traditional accruals basis.
The cash basis is a much simpler method as it only takes account of cash in and cash out. However, it will not be for everyone.
The cash basis
Under the cash basis, income is reflected only when payment is received and expenses are taken into account only when paid, regardless of when the work was undertaken or the expenses was actually incurred. There is no need to account for creditors and debtors or to calculate pre-payments and accruals.
Capital expenditure is treated differently under the cash basis too. Special cash basis capital expenditure rules apply, under which capital expenditure is deducted when paid in calculating the profits of the business, unless the expenditure is of a type for which a deduction is specifically disallowed.
The following items of capital expenditure are not allowable as a business expense under the cash basis capital expenditure rules:
- expenditure on the acquisition or disposal of a business or part of a business;
- expenditure on education and training;
- expenditure on the provision, alteration or disposal of an asset which is not a depreciating asset.
- expenditure on the provision, alteration or disposal of an asset which is not acquired or created for continuing use in the trade;
- expenditure on the provision, alteration or disposal of a car;
- expenditure on the provision, alteration or disposal of land;
- expenditure on the provision, alteration or disposal of non-qualifying intangible assets;
- expenditure on the provision, alteration or disposal of a financial asset, any right under or connection with a financial instrument or other arrangement resulting in an economically equivalent return.
Capital allowances are not generally available under the cash basis, although cars are the exception to this rule. While capital allowances can be claimed under the cash basis as expenditure on cars is not deductible under the capital expenditure rules, the ability to claim capital allowances is lost if the business uses the simplified expenses system to work out the deductible amount where the car is used for business purposes. By contrast, the cost of a van is a deductible expense.
The other side of the capital expenditure coin is the treatment of capital receipts. As most items of capital expenditure are deductible under the cash basis, capital receipts are taken into account when working out the taxable profit.
Accruals basis
The accruals basis is the traditional basis for computing profits or losses. Under the accruals basis, income and expenditure is recognised in the period to which it relates (i.e. when the work was done and the expense incurred). As invoices might not be paid in the period, adjustments are necessary to ensure that the profit shown is for the period to which it relates. Consequently, it is necessary to reflect money owed to the business (debtors) and the money that the business owes (creditors). Income and expenditure paid and received in the year may not correspond exactly to the accounting period.
For example, if insurance is paid on 1 January each year for the calendar year, and accounts are prepared to 30 June each year, the insurance paid for 2021 on 1 January 2021 will partially relate to the year to 30 June 2021 (6/12) and partially to the year to 30 June 2022 (6/12). An apportionment is therefore need.
Consequently, under the accruals basis, it is necessary to take account of accruals and prepayments to ensure that items reflected in the account correspond to the period for which the accounts are prepared.
There are also differences in the way in which capital expenditure is treated. Only revenue expenses can be deducted in calculating taxable profits. Relief for capital expenditure is given predominantly through the capital allowances system.
Cash basis v accruals basis
The differences in the way items are treated and the time at which they are taken into account mean that for the same period, the taxable profit or allowable loss calculated under the cash basis will differ to that calculated under the accruals basis. The difference may be particularly apparent around the year end where income and expenditure may fall in different tax years depending on the basis used.
This is illustrated in the following simple example.
Example: When is the income taxed?
Jay is a painter and decorator. He prepares accounts to 31 August each year.
In August 2021, he undertakes a painting job for which he invoices £2,000 on 28 August 2021. The bill is paid on 3 September 2021. He ordered paint and materials for the job on 20 August 2021 costing £500, paying the bill on 10 September 2021.
Under the cash basis, the income is taken into account when paid on 3 September 2021. This falls in the period to 31 August 2022, which is assessable in the 2022/23 tax year. Likewise, the materials ordered in August 2021 are taken into account when the bill is paid on 10 September 2021, which falls in the accounting year to 31 August 2022, assessable in the 2022/23 tax year.
By contrast, under the accruals basis, the income and expenditure is taken into account in the year to 31 August 2021, as this is the year in which the work was undertaken. The accounts will show a debtor of £2,000 and a creditor of £500. The profit for the year to 31 August 2021 is taxed in 2021/22.
Under the accruals basis, the income is taxed and relief for the expenditure is given one year earlier than under the cash basis.
Eligibility for the cash basis
A trader can only elect to use the cash basis if he or she is eligible to do so.
To join the cash basis, a trader must be an unincorporated business, such as a sole trader or partnership with individual partners. The cash basis is not available to companies or limited liability partnerships and partnerships with corporate partners. In addition, the business must have turnover (calculated in accordance with the cash basis rules) of £150,000 a year or less.
Where the same person has more than one business, if they opt to use the cash basis, they must do so for all their businesses. However, this can only be done if the combined turnover from all businesses is £150,000 or less.
Certain business are specifically excluded from joining the cash basis, including farming businesses with a herd basis election and farming and creative businesses with an averaging election.
Remaining in the cash basis
Once a business has joined the cash basis, they can stay in it if their turnover increases until it exceeds £300,000.
Once turnover exceeds £300,000, the business will need to revert to the accruals basis for the next accounting period.
Need to elect
Unlike property businesses for which the cash basis is the default basis if the eligibility conditions are met, traders who wish to use the cash basis must elect to do so. This is easily done by ticking the cash basis box on the self-assessment tax return.
If an election is not made, the accruals basis will apply by default.
Other points
As the time at which income is taxed and relief for expenditure is given is not the same under the cash basis and the accruals basis, some adjustments are necessary when a trader moves from one basis to the other to prevent income being taxed twice or not at all and to prevent relief for expenditure being given once or not at all.
Like everything, there are advantages and disadvantages to using the cash basis. Advantages include its simplicity and the work saved in preparing accounts. It will also give a better idea of the cash flow of the business. The capital expenditure rules provide immediate relief for many items of capital expenditure without limit and without the need to claim and track capital allowances.
On the downside, accounts prepared under the cash basis may not give a true account of the business’s performance. There are also restrictions to be aware of – relief for interest under the cash basis is capped at £500 a year, and where a business has significant borrowings, the cash basis may not be for them. The loss relief provisions are less generous too; sideways loss relief and early years’ loss relief are not available under the cash basis.
Practical tip
If your business affairs are straightforward and your turnover is below £150,000, the cash basis may be for you. However, before deciding whether to make an election, weigh up the pros and the cons.
