Business Venture of John Jones - Assignment Example

Business venture of John Jones Introduction The ground of the house of John Jones was used by an incorporated entity for selling plant and garden equipment. Under such scenario John Jones seeks information about the principles that make expenses justifiable from taxation point of view. He has a query about capital allowance for ‘planteria’, as well as about relief available for corporation losses. Further John Jones is worried about Principal Private Residence exemption from capital gain taxes in case he sells the property. All these issues have been examined in this write up in accordance with prevalent tax laws in the United Kingdom. a) Allowable expense to calculate taxable business profits Section 6(1) of the Income and Corporation Taxes Act, 1988 is the charging section so far as profits of incorporated businesses are concerned. It reads: “Corporation Tax shall be charged on profits of companies, for any financial year for which parliament so determines, and where an Act charges corporation tax for any financial year the Corporation Tax Acts apply, without any express provision for that year accordingly.”(Sec 6(1) of Income and Corporation Taxes Act, 1988)1. Sub section 2 of section 6 of the same act further states that income tax shall not apply to income of a company. Accordingly, as far as incorporated businesses are concerned, their taxable profits are not subject to income tax. Instead they are levied corporation taxes on profits. Business incomes are assessed as per Case I and Case II of Schedule D of the taxes Act, 1988. The profits reflected as per accounts of incorporated business, however, are required to be adjusted with following two factors: 1. Expenses that are disallowed as per provisions of the act are added back to profits as calculated by company’s accounts, and 2. Income credited to income statement or profit and loss account of the company but are not subject to taxes are deducted from income as per profit and loss account of the company. With regard to expenses that are disallowed are further subjected to following two basic overriding rules: i) The expenditure must be incurred wholly and exclusively for the purpose of trade, profession or business of the company, and ii) The expenditures are exclusively of revenue nature and not of capital nature. The business expenditures deductible from business receipts should be incurred wholly and exclusively for business purposes. What is wholly and exclusive for the purpose of a trade is a question to be determined as per the principles of ordinary commercial trading. Expenditure may be allowed in one business, whereas that may be wholly extraneous to another business. The basic principles to judge wholly and exclusive character relating to a business of any expenditure are as under: It is not enough that expenditure is connected with the trade of the tax payer. The important thing is that expenditure must really be incidental to the trade itself. As per Viscount Cave LC4 “ A sum of money expended, not of necessity and with a view to direct and immediate benefit to the trade, but voluntarily and on the grounds of commercial expediency and in order to facilitate the carrying on of the business, may yet be expended wholly and exclusively for the purposes of trade.” The expenditure must be for direct purposes of the business of taxpayer and not for the benefit of business related to a third party. It is not necessary that the expenditure may provide benefits over a period of time and not necessarily in the year or period of it occurrence. The expenditure must be incurred and paid out of the profits subject to tax under Taxes Act, 1988. Expenses claimed should have been incurred in the accounting period. Expenditure incurred prior to or subsequent to relevant accounting period, cannot be allowed as deduction, even though those are paid for during the relevant accounting year. Simply speaking expenditure should match the revenue credited to income statement. Expenditure should have been incurred in connection with taxpayer’s own business. Those expenditures that provide benefit to businesses other than tax payer’s business are not allowed. The expenditure must be legal. The matter of distinction between expenditures of revenue nature and those of capital nature has always been full of controversies. However, over a period of time certain principles, stated here under, have been evolved out of various court rulings and development of accounting standards, which are being used for calculating tax profits: The distinction between capital and revenue expenditure must be considered from the nature of ordinary course of business of taxpayer, and the object with which the expense is incurred. “When an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, there is very good reason (in the absence of special circumstances leading, to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.” (Viscount Cave LC)2 An expenditure would not be treated as of capital nature if it results into creation of a capital asset not of the tax payer but that of a third party. For tax payer this may be the expenditure out regular course of business. The principle of enduring benefits may not work at all times. As it has been pointed out by House of Lords in IR v Carron Co4 “What matters is the nature of the advantages in a commercial sense and it is only where the advantage is in the capital field that the expenditure would be disallowed by the application of this test.” Expenditure may provide advantages of enduring nature, but when the advantage of the expenditure is for trading operation only of the tax- payer and the fixed capital remains untouched, the expenditure would be treated as of revenue nature. Keeping in view the above points into view the incorporated business of John Jones would be allowed deductions of following expenditures. Repairs and maintenance of grounds used for business Employees remuneration, directors’ fee, employees’ National insurance Business insurance premiums Traveling expenses relating to business Business advertisement expenditure, if not of capital nature Bank interests and incidental expenses on procuring loans Capital allowance in place ‘Depreciation’ charged to profit and loss account, and such other business expenses of revenue nature. These are few examples of allowable business expenses. However it is also essential to note the expenses that will not be allowed as expenditure while calculating taxable profits. A few examples are as under: Expenditure not arising out of the business selling plants and garden equipments. Payout of dividends. Acquisition of treasury stocks Capital expenditures, such as improvements of premises. Directors’ life insurance payments. Appropriation of profits, such as transfer to reserves, and payments or provisions of taxation. b) Capital Allowances Assuming ‘Plantaria’ that will house delicate tropical plants is a building and not a temporary structure, the incorporated business of Jones will be entitled to claim capital allowance in accordance with provisions of Capital Allowance Act, 2001, read with Taxes Act, 1988. The relevant provisions are detailed as under: i) Capital allowances on building are available in respect of industrial buildings, Agricultural buildings, and hotels. As Plantaria houses plants it will be treated as ‘agricultural building’. ii) Capital allowance on ‘Plantaria’ will depend upon the type of agricultural building Plantaria is because as per sec.361(1)(a) of Capital Allowance Act5, agricultural building allowance is available on buildings like farmhouses, farm building or cottages or on the construction of fence and other works. Also as per section 369 of the said act6, only reasonable proportionate expenditure on such building would be treated as qualifying expenditure for the purpose of capital allowance iii) Assuming the ‘Plantaria’ is being used entirely for housing plants, the entire expenditure on such expenditure shall be treated as qualifying expenditure and capital allowance would allowed while calculating the taxable profits of the incorporated entity of Jones. iv) Rate of capital allowance on buildings, industrial as well as agricultural, it is 4% till 2007-08. Budget 2007 announced a phased out withdrawal from tax year 2008-09 in successive 1% each year. That means the rate of capital allowance on building would be 3% with effect from April 2008, 2% with effect from April 2009, 1% with effect from April 2009, and it will completely diminish thereafter. It may be noted that above budget proposals are yet to be notified. v) It is important to note that in accordance with section 3(1)7 of the said Act no capital allowance is available unless the tax- payer makes a claim for it in the tax return itself. C) Relief of Trading Losses Trading loss of a limited company can be dealt with under two ways, namely, by carry forward of loses, and by carrying back of losses. It may be noted that setting off of losses against other income (other than business income) is not allowed to corporate entities as per the provisions of the law. Carry Forward The company is entitled to carry forward the trading losses and set off such losses against the income of immediately next year. If the income from such next year is insufficient to set off losses, then the trading losses can be carried forward from year to year till those are completely set off. In other words there is no limit with regard to number of years the trading losses to be carry forward in the case of incorporated business. Carry Back The company has also the option of carrying back trading losses. But in case of incorporated businesses, trading losses can be carried back to one year only, and set off against the earlier profits of company. D) Exemption for Principal Private Residence Where a taxpayer carries on a business from part of his Principal Private Residence (PPR), and that part of PPR is exclusively set aside for the purpose of that business, then the tax payer will have to pay capital gain tax on the proportionate gains arising for such portion of house on selling of such Principal Private Residence. There are three conditions for the charge of capital gain tax under this scenario: The Principal Private Residential property should belong to the tax payer, The tax payer carries on the business from part of his PPR. In other words the business belongs to tax payer, and The portion of the house where business is carried out is exclusively set aside for such business purposes. This exclusive setting aside of the property is very important. In the case of John Jones, the property belongs to him and a business is also being carried out but by a corporate entity. No information is available whether John Jones is member of such incorporated entity or he is merely charging rent from such business. Accordingly it is difficult to say that business belongs to John Jones. Business will belong to him only when John has controlling interests in the corporation. This is possible only on John having majority shareholding or voting powers in the company. Secondly, no exact information is available on the fact that John has set aside the portion of house exclusively for such incorporated business. In the absence of two important and basic information, it can be concluded as under: John can claim the exemption of Principal Private Residence from capital gain tax when he decides to sell the house in near future only if The portion of the house is not exclusively set aside for the purpose of the business of the corporation, and John has no controlling interests in the company either by way of holding majority shareholding or majority voting power. Conclusion John Jones need to understand that business profit calculated as per company accounts and as per taxation laws are two different things. Taxable profits are calculated based on certain principles that may be different book profits. Allowable expenses for calculating taxable profits surrounds two basic principles of ‘wholly and exclusivity for business purposes’, and secondly only expenditure of ‘revenue nature’ are allowed under tax laws. Plantaria is an agricultural building and therefore entitled to capital allowance as per provisions of Capital Allowances Act 2001. Corporation trading losses are capable of being carried forward for indefinite period till those are set off against profits of coming years; and also those can be carried back only for one year. PPR exemption will be available if John has not exclusively set aside the grounds for use of incorporated business, and also if John has no controlling interest in the company References 1 Income & Corporation Taxes Act, 1988 ( a Consolidated Act), Part I Sec 6(1), http://www.opsi.gov.uk/Acts/acts1988/ukpga_19880001_en_2 2 Viscount Cave LC in case of Atherton v British Insulated & Helsby Cables Ltd., 10 TC 155,(1926) AC, 205 3 ibid, 10 TC 155, 191 (HL) 4 IR v Carron Co., 45 TC 18 5 Capital Allowances Act, 2001, Agricultural Building allowances, Part 4 Sec. 361(1), page 19, http://opsi.gov.uk/acts/acts2001/ukpga_20010002_en_19 6 ibid, Part 4 section 369 7 ibid, Part 1, Chapter 1 section 3(1), 3(2) Read More