Which profits are taxed?

Although tax relates to tax years, profits relate to accounting years, which do not necessarily coincide with tax years. You are usually taxed on a ‘current year basis’, which means that your bill for a tax year is based on profits for the accounting year ending during that tax year. For example, if your accounting year ends on 30 April, your bill for the tax year to 5 April 2021 will be based on your accounts for the year to 30 April 2020. But special rules apply in the first years of your business (see below), unless you opt for ‘fiscal accounting’.

With ‘fiscal accounting’, your accounting year is the same as the tax year (i.e. both end on 5 April). In practice, your accounting year does not have to be exactly the same – for example, a year-end of 31 March also counts.

Starting a business

If you have opted for fiscal accounting – see above – there are no special rules applying to the opening years of your business. Right from the word go, you are simply taxed on the profits you make each tax year.

If you have some other year-end, different rules apply for the first one, two or sometimes three tax years of your business. To find out which rules apply, follow these steps:

1. Step one: find the first tax year in which an accounting date falls that is 12 months or more after the date you started in business. Tax for that year is based on profits for the 12 months up to that accounting date. The normal current year basis applies to subsequent years.
2. Step two: there will be one or maybe two tax years before that covered in step one. In the first tax year, you are taxed on the actual profits you make in that tax year. If there is a second tax year and no accounting date falls in it, you are taxed on the actual profits for that year as well.

To decide what profits you have made in a 12-month period or your actual profits for a tax year, you take a proportion of the profits for the relevant accounting period. You do this using either days or months. For example, if your first accounting period lasts 14 months and 2 months fall within the first tax year, in the first tax year you are taxed on ²/₁₄ × profits for the 14-month period.

You cannot do these sums until you have reached the end of the relevant accounting period and have the final accounts. But that does not mean you can put off paying your tax bill. Initially, you will have to estimate what your profits are likely to be and pay tax based on these provisional figures. You then correct the figures and your tax bill as soon as you have the actual profit data.

Overlap profits

Under the opening year rules for a new business, some profits are taxed more than once. In Example 1, David is taxed on ²/₁₆ + ¹²/₁₆ + ¹²/₁₆ = ²⁶/₁₆ of the profits for his first accounting period – that is £13,000 instead of the actual £8,000 for the period. The excess £13,000 − £8,000 = £5,000 is his overlap profit. You normally do not get tax relief on overlap profits until your business finally ceases. In the meantime, overlap profits are not increased in line with inflation, so the tax relief might not be worth much in real terms by the time you finally get it.

Choosing when to end your accounting year

You will need to weigh up a number of factors when deciding the best date on which to end your accounting year:

• Fiscal accounting – see p. 371 – makes your tax affairs very simple but will give you the least time to draw up your accounts to meet the self-assessment deadlines (see below).
• A year-end early in the tax year maximises the delay between earning your profits and paying tax on them. This is good for cash flow if your profits are rising. You also have plenty of time in which to draw up your accounts. On the other hand, a year-end early in the tax year will involve higher overlap profits. You probably won’t get tax relief on these for many years and in the meantime inflation will have eroded its value.

If your business is already established, you can choose to alter your year-end. In that case, you might be able to claim some or all of your overlap relief early, but whether overall the change works to your advantage depends on the pattern of profits for your particular business. Get advice from your accountant.

The self-assessment timetable

Under current self-assessment rules, you are required to send HMRC a tax return each year and to pay your tax bill by the due dates. If your profits are £83,000 and your accounting year matches the tax year, you can send in what's known as a short supplement. Otherwise you'll have to use a longer form.

You are responsible for working out how much tax to pay, though you can ask your tax office to do the sums provided you get your return back early enough. Alternatively, if you send in your return via the Internet, your tax bill is automatically worked out for you. If you send back your return late, there are automatic penalties. Similarly, if you pay your tax late, you will be charged interest and possibly fines too. The key dates for your 2019–20 tax bill are given below and you can work out the key dates for your 2020–21 tax bill by simply advancing the dates by one year.

The year 2020

• 31 January First instalment (called a ‘payment on account’) of your tax bill for 2019–20 is due. It is usually set at half your tax bill for the previous year (2018–19).
• 5 April End of 2019–20 tax year.
• April Receive 2019–20 tax return for the tax year just ended or notice to file a return if you normally do this online.
• 31 July Second payment on account for 2019–20 tax bill. This is usually set at half your tax bill for the previous tax year (2018–19).
• 31 October Deadline for sending in your 2016–17 tax return if you are using the paper version. If you miss it, you will either have to file online instead or face a late filing penalty if you stick with the paper return.
• 30 December Latest date for filing your return online if you owe less than £3,000 tax and want it to be collected through PAYE (where you are also getting earnings from a job or a pension) throughout 2021–22 instead of as a single lump sum by 31 January 2021.

The year 2021

• 31 January Last date for filing your 2019–20 tax return online. If your two payments on account come to less than the final bill, you must send in your payment for the remaining tax by this date.

The year 2022

• 31 January Your 2019–20 tax return becomes final 12 months after the date you filed it, so this is the latest date on which your return should become final. The significance is that, if HMRC is going to open an enquiry into your return, it should tell you by the date your return becomes final. However, HMRC can still investigate your tax affairs for other reasons – for example, suspected fraud. And, if your tax return contained any estimated valuations (of, say, property or unquoted shares) that were not fully explained in the return, HMRC can still open an enquiry into that aspect of your return.

The year 2024

• 5 April The normal time limit for you or HMRC to go back and review or reopen a past year’s tax return is four years from the end of the relevant tax year. For example, 5 April 2024 will normally be the last date for reviewing your 2019–20 tax return. However, HMRC can go back up to six years if it thinks you have failed to take reasonable care and 20 years if it suspects fraud. You should keep your records for at least six years.

Payment problems

There is a Business Payment Support Scheme operated by HMRC, which considers requests for extra time to pay taxes (PAYE and VAT) from businesses experiencing difficulties. Normal penalties will not apply to tax paid late if a payment plan is agreed by the tax office, though interest is payable.

What business expenses are allowed?

You can claim, and be allowed, an item as a business expense for tax purposes if it is incurred ‘wholly and exclusively’ for the business. The golden rule with expenses is that if you are in any doubt as to whether an expense is allowable, claim it.

An expense incurred partly for business and partly for private reasons, for example a trip in your car to a customer, is strictly not allowed if you dropped in to see a friend on the way. However, where the business part can be clearly identified or apportioned, you are allowed to make a claim. For example, you can claim part of the cost of running a car for both business and private reasons based on records you keep of your total and business mileage. Similarly, you may be able to claim some of the expenses of using your home for business based on, say, the proportion of floor area devoted to the business and the proportion of time that space is used for business. Typical allowable home expenses will be part of the costs of heating, lighting, cleaning, telephone, insurance and security. You can also treat fixed costs, such as mortgage interest, rent, council tax, home insurance, water rates and general repairs as being partly for business if part of the home is set aside solely for business. Be aware that if part of your home is used exclusively for business, there could be capital gains tax (CGT) to pay on that proportion when you come to sell your home. HMRC* makes a distinction between using part of the home ‘solely’ for business and ‘exclusively’ for business. For example:

• You use your office solely for business from 9 a.m. to 5 p.m. but then for other activities after 5 p.m. If the office represents 10 per cent of the floor space of the home, you would first work out 10 per cent of your fixed costs on the basis of floor area, then take ⁸/₂₄ of the result (the proportion of time the room is used for business) to find the amount you can claim. In this example, the office is used solely for the business part of the time, but not exclusively for business, so there would be no CGT when you sell.
• You use your office solely for business and no other purpose. If it represents 10 per cent of the floor space of the home, you can claim 10 per cent of the fixed costs. In this case, the office is used exclusively for business and so there could be CGT when you sell the home.

However, you may be able to reduce or eliminate any bill by claiming entrepreneurs’ relief, roll-over relief or your normal annual CGT allowance (p. 388).

Checklist of expenses you can normally claim

What is not normally allowed as a business expense

1. Your own income and living expenses, ordinary clothes, medical expenses, your NI contributions (p. 387), income tax, capital gains tax, inheritance tax, fines and other penalties for breaking the law (but you could pay a parking fine for an employee), VAT surcharge.
2. Depreciation or initial costs of capital equipment, buying a patent, vehicles, computer hardware or software if treated as a capital item (see below), permanent advertising signs, buildings and the cost of additions or improvements to these (but see the ‘Annual investment allowance’ and ‘Capital allowances’ sections).
3. If you use traditional accounting, computer software (if a life of more than two years) would not normally be treated as an allowable expense, but you can claim a capital allowance. However, if you use cash-basis accounting for tax purposes, you would claim the use of a computer or printer as an allowable expense.
4. An initial lump sum paid for a franchise is not normally allowable (but should qualify for the annual investment allowance and capital allowances), but any part paid for, say, trading stock or staff training (but not your own training) is normally allowable.
5. Legal expenses on forming a company, drawing up a partnership agreement, and acquiring assets such as long leases.
6. Business entertaining expenses, cost of partners’ meals at regular lunch-time meetings, gifts to customers (but see p. 378), normally charitable subscriptions and donations, and donations to political parties.
7. Reserves or provisions for expected payments, such as repairs, and general reserve for bad and doubtful debts (but see p. 379).
8. Wages to employees that remain unpaid 18 months after the accounting date.

Annual investment allowance

You can claim 100 per cent tax relief for spending on plant and machinery, excluding cars, up to the amount of your annual investment allowance (AIA). This is £1 million from 1 January 2019 until 31 December 2021.

If the accounting period on which your tax bill is based is more or less than 12 months, the allowance is increased or reduced pro rata. If you had an accounting period that straddles the point when the amount of the allowance changes, you get just a proportion of the AIA for that year.

Every business, whether sole trader, partnership or company, has an AIA. There are anti-avoidance rules to prevent you claiming extra AIA by artificially splitting your business into more than one entity.

If you spend more than your AIA, you can carry the excess forward and get tax relief on it in future years by claiming writing-down allowances (p. 383), unless the spending qualifies for a first-year allowance (p. 383) – this is on top of your annual investment allowance.

The AIA is not given automatically. You must claim it and you do this through the self-employment supplement of your tax return. You choose whether to claim and how much (up to the maximum for which you are eligible). Unused AIA cannot be carried forward. You also choose which expenditure to set your AIA against, which may be important if you have to carry some spending forward and different writing-down allowances would apply to different capital items (p. 383).

Capital allowances

In your accounts, you gradually write off the cost of a capital item as depreciation. But depreciation is not an allowable expense for tax purposes: you have to add it back but can claim capital allowances instead on any spending that is not covered by your annual investment allowance. Capital allowances are basically a standardised measure of depreciation.

The main capital allowance is writing-down allowance (WDA). This writes off your spending at a fixed rate year after year (see below). However, to encourage certain types of spending, you can in some cases claim a higher capital allowance for the year in which you spend the money. This higher allowance is called a first-year allowance. So, if you are buying a capital item, to work out what relief you can claim, work through the following sequence:

1. Can you claim a first-year allowance? If so, this gives you immediate 100 per cent relief for the item, whatever its cost, with no balance to carry forward and without using up any of your AIA (see above).
2. Do you have any unused AIA for the year? If so, you get immediate 100 per cent relief up to the unused AIA for the year. On any excess over the AIA, you get relief by claiming WDAs.
3. Claim WDAs for any other capital spending.

First-year capital allowances

First-year allowances are available alongside the AIA. Currently they are all 100 per cent allowances, which means you write off the full cost of the item in the accounting year in which you buy it. You can claim these allowances for spending on:

• eligible new environmentally friendly equipment under the Enhanced Capital Allowance (ECA) Scheme until April 2020. For example, energy-saving boilers, refrigeration equipment and water meters. Get details from the Energy Technology List (search the www.gov.uk web site);
• some cars with low CO₂ emissions; new zero-emission goods vehicles;
• plant and machinery in the parts of enterprise zones that apply as assisted areas. This allowance has been extended to 31 March 2020.

Writing-down allowances

Capital spending that you cannot fully write off in the first year is put into a capital pool and you gradually get relief by claiming WDAs. These are main capital pools:

• Main pool: this covers spending on most items. The WDA is 18 per cent.
• Special rate pool: this covers spending on long-life assets (items expected to have an economic life of at least 25 years) and the integral features of your business premises. Integral features include, for example, electrical systems, cold water systems, space or water heating systems, ventilation or air purification systems, lifts and escalators, spending on solar panels. It also includes cars with CO₂ emissions of more than 130 g/km. The WDA for items in the special rate pool is 8 per cent (6 per cent from April 2020).
• Structures and Building Allowances of 2 per cent from 29 October 2018.

To work out the WDA for each pool, you take the value of the pool at the start of the accounting period plus any new items that do not qualify for the AIA or first-year allowances and multiply the total by the appropriate rate. Deducting the WDA from the value of the pool gives you the value of the pool at the start of the next period. See Example 3 below.

You do not have to claim the maximum WDA. You might want to claim less if, for example, claiming the full amount would waste other reliefs or allowances. Claiming a lower WDA means you carry forward a larger pool which increases the maximum WDA you can claim next year.

If you have an accounting period that straddles an April when the WDA rates change, the WDA for the year is a weighted average of the rates that applied before and after 6 April.

When it comes to selling an asset on which you have claimed capital allowances, you have to reduce the value of your pool by the lower of the sale proceeds or the original cost. Do this before working out the amount of the allowance you can claim for the accounting year in which you sell the asset. If the sale proceeds are more than the value of the pool, the difference (the balancing charge) will be taxable as if it were extra profit for the year. Note that this also applies to an asset that has formed its own separate pool (see below). If the sale proceeds come to less than the pool value of an asset you sell, you can’t normally get any tax relief on the residue, unless it was a short-life asset (see below). However, when your business stops trading for good, if the proceeds from getting rid of all the assets in the pool come to less than the value of the pool, you can claim the difference as a balancing allowance that will reduce your tax bill for that year.

There is another way in which you might be able to fully write off the residual cost of an asset (whether you still own it or not). If the value of your main pool or your special rate pool falls to £1,000 or less, you can claim a WDA equal to the amount remaining in the pool. This applies separately to the main pool and special rate pool so you can claim extra WDAs to a maximum of £2,000 in one year. You can claim less than the maximum if you want to.

What is not included in the main pool or special rate pool

These items have separate pools of expenditure:

• If you choose, any piece of plant and machinery (but not cars) that you expect to sell or scrap within five years of buying. With these short-life assets, for example tools or a computer, you have to choose to put it in a separate pool within two years of buying it. If, when you sell the equipment, you sell it for less than its value after deducting the capital allowances you have claimed on it, you will be able to write off the difference in that year. If you sell it for more than the value, the difference will be taxable as if it were extra profit. If you do not sell it within eight years of the fourth anniversary of the end of the accounting year in which you bought the item, its value will be added to your main pool as if it had never been treated separately.
• Items that you use both privately and for business. You can claim capital allowances only for the part that corresponds to the business proportion of your use.

Deducting the loss from other income and capital gains

You can either deduct your trading loss from any other income or capital gains that you have in the tax year in which your loss-making accounting year ends, or you can carry the loss back and set it against other income or gains for the previous tax year. Other income could be, for example, dividends from shares or earnings from a job.

You must claim this relief within 12 months of the 31 January following the end of the tax year to which the loss relates. For example, suppose you have been in business for some time, your accounting year ends on 31 July and you made a loss in your 2018–19 accounting year. These accounts form the basis of your tax bill for the 2019–20 tax year. Your tax return and final tax settlement for 2019–20 are due on 31 January 2021. You then have a further 12 months – in other words, until 31 January 2022 – to elect to deduct your losses from other income and gains for 2019–20 or for 2018–19.

If you have other deductions that will reduce the tax bill on your other income and gains to nil in one of the tax years, opt to deduct the loss in the other year. If after setting the loss against income and gains for one or both years, there is still some loss left over, you can carry the excess forward to set against future profits (see below).

Deducting the loss from future trading profits

If you make this choice, you carry forward the loss and set it against the next future profits from the same trade. If you have any losses left over, you carry them forward against future profits ad infinitum, until they are used up. If you are going to use your loss in this way, you have to use the whole of the loss before you can use any other deductions, such as outgoings or allowances, that you may have. The main disadvantage of making this choice to use up your loss relief is that it takes a while to turn it into cash.

To use this option, you must tell your tax office within four years of the end of the tax year to which the loss relates. For example, if the loss was made in the accounts being assessed for the 2019–20 tax year, you have until 5 April 2024 to make your claim.

If you are starting a new business

If you spend money before your business actually starts, it may count as pre-trading expenditure. It will be set against the earnings of your business in its first year and, if it creates a loss, you can get loss relief. You can get tax relief on expenditure going back seven years.

There is special tax treatment for any losses you make in the first four tax years of a new business (as long as HMRC believes it was reasonable to plan for profits during that period). You can get a tax refund by setting the loss against any other income (for example, wages from a job) that you had in the three years before the loss. Set the loss off against the earliest year of income first, then the next earliest and so on.

If you want to set off your loss in this way, you need to tell HMRC in writing within 12 months of the 31 January following the end of the tax year to which the loss relates.

Capital gains tax

You do not normally pay capital gains tax (CGT) on business stock you sell, but you might have to pay it when you dispose of land and buildings, plant and machinery or goodwill, or shares in your business if you operate as a company. Disposing includes selling, giving away, exchanging or losing.

The main CGT rules are:

• Capital gains tax is charged at two rates. From 6 April 2019, these will be 10 per cent and 20 per cent. To find out which applies, you add your chargeable gains to your income for the year. Any part of the gains falling in the basic tax rate band or below is taxed at 10 per cent. Any part that falls into the higher-rate tax band or above is taxed at 20 per cent.
• You have a yearly CGT tax-free allowance, which means you can make up to £12,000 of otherwise taxable gains in 2019–20 without having to pay any tax.
• You can claim entrepreneurs’ relief when you dispose of part or all of your business. This limits the tax rate to 10 per cent on the first slice of business assets that you sell during your lifetime. This slice is set at £10 million for the first disposal. There is no minimum age limit for claiming this relief. To qualify, the business must be a trading business and you must have held it for at least one year (from 6 April 2019, two years). If it is a company, you must be an employee or director who owns at least 5 per cent of the shares and voting rights.

If you sell or otherwise dispose of assets from your business, and make a gain, you could pay capital gains tax on the gain. But if you replace the assets in the three years after the sale or one year before the sale of the old one, you can claim roll-over relief and defer paying capital gains tax. You can also claim relief if you do not replace but use the proceeds to buy another qualifying business asset. You usually get the relief by deducting the gain from the old asset from the acquisition cost for the new one. So when you sell the new one, the gain on it has been increased by the size of the gain on the old one. However, if you replace again, you can claim further roll-over relief. And so on. Capital gains tax will not have to be paid (under current legislation) until you fail to replace the business asset.

Not every business asset qualifies for the relief. But if it is land or a building used by the business, goodwill, fixed plant or machinery, for example, it will qualify for roll-over relief.

If you work from home, think carefully about the space you use for your business:

• If you use part of your home exclusively for business, you maximise the amount you can claim in allowable business expenses (p. 377) but a proportion of your home becomes liable for CGT. There may be no CGT to pay if the gain comes to less than your annual allowance or you are able to claim roll-over relief (because you will also be using part of a new home for the business). If there is a CGT bill, it may be reduced if you can claim entrepreneurs’ relief.
• If you do not use any part of the home exclusively for business, there will be no CGT when you sell the home. However, non-exclusive use reduces the proportion of the home-related costs that you can claim as allowable business expenses (p. 377).

For more information on capital gains tax, contact HM Revenue & Customs (HMRC)*.

When you first start in business

When you first start working for yourself, you need to register for HMRC online services on the HMRC web site*. (Your online account is also known as a Government Gateway account.)

If you have finished a job as an employee, you will have form P45, which you can send to HMRC (but take a copy) so that the amount of your personal allowances and the amount of tax to be paid for that tax year can be sorted out. If you start self-employment part way through the tax year, having been an employee before, you can ask for a refund of part or all of the tax paid under PAYE if you can show that you will otherwise pay too much tax. This can help with the cash flow problems of starting the business.

Once you have started a business

When you first start in business, there are no interim payments of tax for the first year or so, because there is no track record from a previous year on which to base any payments. You’ll be sent a tax return in the April following start up and, as usual, you have until the following 31 January to send in your return and to pay the tax due. For example, you might start in business in, say, February 2019. You’ll get a tax return in April 2019, and your first tax payments must be made by 31 January 2020. At that time, you’ll pay all the tax due for the 2018–19 tax year plus the first interim payment for 2019–20, which will be set at half the amount due for 2018–19.

Your tax return

If your business is very small and the rest of your tax affairs uncomplicated, you may receive a short four-page tax return. HMRC will have selected you for the short return on the basis of your previous years’ affairs, but it is up to you to make sure that you are eligible to use the form. If not, you need to contact HMRC to get the full tax return (or alternatively use the online tax return service). Anyone with more complicated business affairs will in any case be sent the full return.

The full tax return includes supplementary pages for self-employment, which ask for name, address and description of your business, the period on which your tax bill is based and details of the business’s income, expenditure and profits. You must also fill in the details required in the main section of the tax return and fill in the supplement ‘Self-employment’. There is a short version of the supplement for businesses with a turnover of less than the VAT threshold (p. 401). Exceptionally, you might not have all the information you need to complete the return on time – for example, if you have not yet made up your first set of accounts. In this case, you should estimate what your profits will be and enter provisional figures on the supplementary pages. These should be as realistic as possible, taking into account all the information you have to date. Your tax office wants to know why figures are not yet available and when you think they will be.

Normally, if your tax return is incomplete, you will be treated as having missed the deadline and will face a penalty if tax is paid late as a result. However, HMRC says that a return containing provisional figures will not be treated as incomplete, provided you have taken all reasonable steps to obtain the final figures and you make sure you send final figures to your tax office as soon as they become available. There will be interest to pay if the finalised figures show that more tax was due than the provisional figures indicated.

Note that the system is going to be completely transformed with the abolition of the tax return and the introduction of new digital tax accounts for some 5 million small businesses, but not before April 2020. The account will be pre-populated by HMRC, where possible, and will work like an online bank account that you can check at any time.

Being investigated

During the 12 months after you have filed your tax return together with your self-assessment (if you are working out your own tax), HMRC can choose to audit your return and assessment. After the 12 months have passed, HMRC can still investigate you, but only if it suspects fraud or discovers an error.

If you have been selected for audit or investigation, HMRC must by law write to you telling you that this is the case. It does not have to tell you why you are being investigated, but it must say whether your whole return is being investigated or just some aspect of it, for example how you calculated your capital allowances. The tax officer has wide-reaching powers to ask for any relevant documents, and the self-employed are required, by law, to keep documents for five years after 31 January following the end of the tax year to which they relate. If you fail to produce the documents asked for, you will be fined.

The tax officer may request an interview, the purpose of which will probably be to establish:

• why your business, and hence profit, is different from other similar businesses;
• whether you have correctly calculated adjustments for tax purposes;
• if you have assessed your own tax bill, whether you have made any errors or omissions;
• if the amount shown for what you have taken out of the business seems adequate to support your lifestyle. You may need to work out an estimate for your living expenses, for example general household expenses, as well as leisure expenditure and so on.

If the tax officer is satisfied with your records and explanation, there will probably be a fairly minor, or even no, adjustment to your accounts. However, if a more serious view is taken, you may find that your figures for profit for this and previous years are increased.

Either following or during the investigation, you will be sent an assessment if extra tax is deemed to be due. You will have to pay interest on the tax, and there may also be penalties.

Do you count as self-employed?

It may be obvious that you are self-employed, but sometimes it is not clear-cut. You cannot simply declare yourself self-employed; you will have to convince HMRC that you are. And recently, HMRC has been taking a closer look at those claiming to be self-employed, particularly sub-contractors working in the construction industry, and people ceasing to be employees but returning to the same work as consultants, and reclassifying them as employees. The sort of points that will help you to establish self-employment are:

1. Working for more than one customer.
2. Showing that you control what you do, whether you do it, how you do it and when and where you do it.
3. Providing the major items of equipment you need to do your job.
4. Being free to hire other people, on terms of your own choice, to do the work that you have agreed to undertake.
5. Correcting unsatisfactory work in your own time and at your own expense.

If you do the above, there will probably be little difficulty in persuading an inspector that you are self-employed. You can check whether you are likely to be classified as employed or self-employed, at www.gov.uk/guidance/check-employment-status-for-tax

What is the taxable income?

The taxable income for your partnership is worked out in much the same way as if you were working on your own and taxed as a sole trader. From your sales figure, you can deduct business expenses that are allowable for tax purposes (p. 377). Your partnership can get tax relief on capital expenditure (annual investment allowance and capital allowances, pp. 381–385) and losses (p. 385). Each partner can set their allowances against their share of the profits.

If your partnership has any non-trading income, such as interest, this will not be included in the taxable profits of the partnership but taxed as investment income. In practice, partnership investment income is normally allocated in the same ratio as the profit share, and each individual partner is given a tax bill for the investment income. Any capital gains of the partnership will be subject to capital gains tax.

If a partner has other income or gains that do not come as a result of the partnership, the partner will be taxed on these as an individual in the normal way.

Who pays what tax?

• Profits are normally taxed on a current year basis (see p. 372). For example, the tax bill for 2019–20 will be based on profits for the partnership accounting year ending in 2019–20.
• Profits are divided between the partners according to their profit-sharing agreement for the accounting year being taxed – that is, there is no mismatch between your share of the profits and the tax bill.
• Tax is worked out for each partner individually based on each share of the profits as if each of you were running your own separate business. If the partnership is new or you have newly joined an existing partnership, opening year rules (p. 372) apply to you personally.
• Tax on investment income is also worked out for each partner individually. For this purpose, untaxed investment income is allocated to each partner as if it were income from a second business but based on the same accounting period as the partnership’s mainstream business. Taxed investment income is allocated to each partner but on the basis of the amount received in each tax year.
• Each partner is responsible only for their own tax bill on their own share of the profits. You can’t be asked to stump up the money if other partners don’t pay their tax bills.

Tax returns

In April each year, both the partners and the partnership as a whole receive a tax return. The partnership tax return is completed on behalf of the partnership as a whole and shows the income, expenses and so on for the partnership. The partnership return must be returned to the tax office or filed online by the normal deadline of 31 January following the end of the tax year but, in practice, it will need to be ready much earlier than that.

Each partner has his or her own tax return to complete and return to the tax office by the deadlines described earlier in this chapter (p. 374 – October 2019 or 31 January 2020 for the 2019–20 tax return). The partner’s tax return includes supplementary pages relating to his or her partnership income. The details that must be included are based on information contained in a ‘partnership statement’. The partnership statement is a copy of information given in the partnership return.

Therefore, the partnership return must be completed early enough for partners to complete their own paperwork in good time. Timing could be very tight if the partnership has an accounting date late in the tax year. An early accounting date gives the maximum time for getting the accounts prepared ready for early completion of the partnership return.

Changing partners

Each partner is treated as if they were running their own business, so normal opening year rules (p. 372) apply to you personally when you join a partnership. Similarly, there are closing-year rules, which are applied individually to you if you leave a partnership.

Losses for partners

Losses can be treated in much the same way as if you were a sole trader (p. 385). You and your partners share the losses on the same basis as you would share any profits; the losses are apportioned on the basis applying in the year in which they arise.

You can each treat your losses as you want. One of you can set them off against other income, while the other can carry them forward and set them off against future partnership profits.

However, if you are a non-active partner who does not spend much time running the business, the amount of losses for which you can claim relief by setting them against other income and gains (p. 386) or setting them against income for earlier years (p. 386) is limited to the amount you have contributed to the partnership. This ‘sideways loss relief’ is generally further restricted to the lower of 25 per cent of total income and £25,000 for losses incurred. You will count as a non-active partner if you devote on average less than ten hours a week to the business.

You can still claim relief without any restriction by carrying losses forward to set against future profits from the same business.

What you must do

By law, you must notify HMRC when you get income from a new source. This can be done online through the HMRC web site. You have to do this within six months of the end of the tax year in which the income first arose. The onus is on you to give this information, and you cannot plead as an excuse that you did not receive a tax return. Nor does it make any difference whether you are making a profit or a loss; what matters is that you are receiving payments from a new source that your inspector does not know about. If you do not reveal this information about a new source of income, not only will you have to pay the tax due on that income but you will usually have to pay a penalty on top (linked to the amount of tax you owe and how cooperative you are) plus interest on any tax paid late.

Bear in mind that, if the new source of income amounts to business income, you must in any case tell HMRC that you have started in business as soon as possible (p. 59).

Casual income

If you don’t succeed in convincing HMRC that your new source of income is a business, your income could be treated as casual. Casual income will generally be taxed on an actual basis – that is, tax for any tax year will be based on the actual income you have from that source during the tax year. This contrasts with self-employment, where tax is based on the profits for an accounting period ending during the tax year. Self-employment gives you more scope for building in a time lag between making the profits and paying tax on them.

A disadvantage if your income counts as casual is that the treatment of losses is less favourable than if you are taxed as being self-employed. If you make a loss, it can only be deducted from profits taxed in the same way, made either in the same tax year or in the future. It cannot be deducted from any other income you have, for example from your job if you have one.