Sarah Bradford explains which businesses can use the cash basis to work out their profits and outlines the implications of doing so.
The cash basis is a simpler way for businesses to work out their taxable profits and losses, as it takes account only of cash in and cash out.
Unlike the traditional accruals basis, there is no need to work out debtors and creditors or prepayments and accruals or to account for stock or work in progress. Instead, under the cash basis, income is recognised when it is received and expenses are recognised when they are paid.
By contrast, under the accruals basis, income and expenditure are matched to the period to which they relate.
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Example: Cash vs accruals basis On 26 January, she purchases some supplies costing £500. She receives the bill on 30 January 2020 and pays it on 6 February 2020. Under the accruals basis, the income is recognised when earned and expenses are recognised when incurred and will fall into the year to 31 January 2020 (i.e. the basis period for 2019/20). By contrast, under the cash basis, the income and expense will be recognised in February 2020 when received. This falls in the year to 31 January 2021, assessable in 2020/21. |
Who can use the cash basis?
Use of the cash basis is optional and eligible businesses can choose whether to use the cash basis to compute their taxable profits or not. It is only available to unincorporated business – it cannot be used by companies or by limited liability partnerships.
However, not all businesses are eligible to use the cash basis. The cash basis is only an option if the total cash basis receipts for all trades carried on by the person in the tax year do not exceed the relevant maximum amount – set at £150,000 a year (or £300,000 for universal credit claimants). Once in the cash basis, the trader can continue to use it unless their income exceeds £300,000.
Certain persons are excluded from using the cash basis. These include (amongst others) partners with one or more corporate partners, businesses that have a herd basis election in place, farmers and creative artists with averaging elections, and businesses that have claimed a research and development allowance.
Special eligibility rules apply to partnerships. While the cash basis cannot be used by limited liability partnerships or those with one or more corporate partners, partnerships comprising individuals can use the cash basis, as long as the qualifying conditions are met. Special rules apply to controlling partners.
Cash basis profits
Where a business meets the eligibility conditions and has elected to use the cash basis, the taxable profits are simply the total amount of the receipts of the trade received during the basis period for the tax year, less the total amount of expenses of the trade paid for during the basis period for the tax year.
This is subject to any adjustments that may be required, for example, capital allowances for cars; although it should be noted that special rules apply to capital expenditure under the cash basis.
Cash basis receipts
The cash basis works on money in and money out. Cash basis receipts are those that are received in the basis period for the tax year – no account is taken of money that is owed for work done. In their guidance, HMRC state that the trader can determine when income is treated as received – for example, when it is paid on a card or when it is credited to the bank account. However, the method chosen should be applied consistently.
One of the consequences of only recognising income once received is that the business will not need to deal with bad debts. If a debt is not paid, (unlike under the accruals basis) under the cash basis the associated income is never taken into account as a receipt.
Special rules apply under the cash basis to capital receipts.
Cash basis expenses
As with receipts, under the cash basis, expenses are recognised when they are paid. The use of the cash basis rather than the accruals basis does not generally affect which expenses are allowable for tax purposes; rather it determines the point at which the relief for the expense is given. General rules apply and an expense will be deductible if it is incurred ‘wholly and exclusively’ for the purposes of the trade.
As under the accruals basis, where there is both a private and a business element to the expenditure, apportionment is needed, with relief only being available for the business element to the extent that this can split out.
Where preferred, the trader can opt to use simplified expenses to work out the deduction for vehicle expenses, office use of own home, and the deduction for private use where the business premises are also used as the home.
It should be noted that special rules apply under the cash basis for capital expenditure and interest payments on loans.
Capital expenditure
The rules on the treatment of capital expenditure under the cash basis were simplified from 6 April 2017 onwards. From that date, capital expenditure is simply deducted in working out the taxable profits unless the expenditure is of a type in respect of which a deduction is specifically prohibited. This is the case where the expenditure is incurred on or in connection with the acquisition or disposal of part of the business or on education or training.
A deduction is also prohibited where the expenditure relates to the provision, alteration or disposal of:
• an asset that is not a depreciating asset (a depreciating asset is one whose value will decline by 90% or more within 20 years);
• an asset not acquired or created for continuing use in the trade;
• a car;
• land;
• a non-qualifying intangible asset; or
• a financial asset.
Although the cost of a car (unlike that of a van) cannot be deducted when calculating profits under the cash basis, capital allowances can be claimed if simplified expenses are not used to work out deductible vehicle costs using permitted mileage rates.
Capital receipts
On the other side of the coin, capital receipts are brought into account as a trade receipt under the cash basis where the associated expense would be deductible.
Interest payments
There is a general rule that prohibits a deduction for interest payable on a loan where the cash basis is used. However, this is subject to a provision that allows a deduction of up to £500 for interest and the incidental costs of obtaining finance, which would otherwise be disallowed. All cash borrowings for business purposes fall within this provision.
As a result, the cash basis may not be suitable for businesses with considerable borrowings. However, the interest cap does not apply to interest on purchases if the purchase itself is an allowable expense.
Need to elect
Unlike landlords, for whom the cash basis is the default basis, eligible traders who wish to use the cash basis must elect to do so. This can be done in the tax return.
Losses
Under the cash basis, losses can only be relieved against later profits of the same trade or, where the business ceases, against profits of the same trade for the three years prior to that in which the business ceased. Sideways loss relief is not available.
Entering and leaving
Adjustments are needed when a business moves into the cash basis, or from the cash basis to the accruals basis, to prevent items being double counted or items falling out of account.
Guidance on the adjustments required can be found in HMRC’s Helpsheet HS222.
Practical tip
If you are eligible to use the cash basis, consider whether it is for you. While it is simpler to operate than the accruals basis, it may not be the best option if you are likely to make a loss or have significant borrowings and would lose interest relief.
