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Changes to the cash basis for traders

Author: Richard Jones

Published: 02 Feb 2024

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Richard Jones considers the changes provided for by Finance Bill 2023-24 to the cash basis for trades subject to income tax.

Under the cash basis (Ch3A, Part 2, Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005)), an individual carrying on a trade may currently elect to calculate their profits on a ‘cash in, cash out’ basis, rather than using the traditional accruals method of accounting. This is simpler for many individuals as it removes the need for year-end adjustments such as the calculation of accruals and prepayments. 

However, not all unincorporated businesses are allowed to use the cash basis. For example, to enter into the regime, the person’s turnover from their trade must be £150,000 or less (doubled for Universal Credit claimants) for the year. To stay in the regime, their turnover must not exceed £300,000. 

At the Autumn Statement, and following a period of consultation, the government announced that significant changes would be made to the cash basis in order to enable and encourage more businesses to use it. The changes, which are provided for by legislation included in Sch 10, Finance Bill 2023-24, are due to take effect from 6 April 2024. 

The changes

The cash basis will become the default basis of calculating taxable trading profits for income tax purposes for all unincorporated businesses, except for those that are specifically excluded. Excluded businesses include partnerships with one or more corporate partners, LLPs and businesses using the herd basis or making averaging claims.

The cash basis will become the default basis of calculating taxable trading profits for income tax purposes for all unincorporated businesses, except for those that are specifically excluded

The turnover test referred to above is being removed. This means that any sole trade or partnership (subject to the above exclusions) will automatically use the cash basis, unless it elects to use the accruals basis. This includes some extremely large UK and international businesses.

In addition, some of the restrictions placed on claiming relief under the cash basis will be removed, which will make it more attractive to a wider range of businesses. This includes:

  • the removal of the cap on deductions for interest. Presently, the maximum deduction for interest is limited to £500 per year. This restriction is being removed entirely. Given that some large partnerships could now make use of the cash basis, this could lead to some sizeable interest deductions, especially as UK interest rates have increased over the past year or so. I wonder whether the government might look to introduce something along the lines of the corporate interest restriction rules if it perceives that businesses are abusing these deductions; and
  • more options for loss relief. From 6 April 2024, a loss calculated using the cash basis may be offset in the same way as a loss calculated on the accruals basis. 

Businesses already using the cash basis

The main change for those already in the cash basis is that they will no longer need to keep an eye on their turnover for the purposes of determining whether they need to leave the cash basis. Currently, the rules state that a person must leave the cash basis in the tax year following the year in which the total cash basis receipts of all trades carried on by that person exceed £300,000, unless the total cash basis receipts in the later year do not exceed the relevant maximum amount for that year. The second part of this rule ensures that a person who receives unusually high receipts in one year is not penalised.

As cash accounting will become the default for eligible businesses, to use the accruals basis an election under new s25C, ITTOIA 2005 will need to be made. The election has effect for the tax year for which it is made and for every subsequent tax year until an election is made to move back into the cash basis. In the absence of an election under s25C, a business will continue to apply the cash basis from 2024/25 even if its total cash basis receipts exceed the previous limit of £300,000.

As discussed above, from 6 April 2024 there is more scope to obtain relief for interest paid and more options for loss relief, including against general income of the same tax year (s64, Income Tax Act 2007 (ITA 2007)) and against net income in the three years prior to the tax year of loss where that tax year is one of the first four years of trade (s72, ITA 2007).

Businesses currently using the accruals basis

The business will need to make an active decision to continue using the accruals basis from 2024/25, and there are some points to consider when making that decision.

First, there is the potential transitional adjustment that would be required to move on to the cash basis. Broadly speaking, the rules ensure that no item of income is taxed twice, no item of expense is relieved twice and that no items of income or expense are left out of account completely. This means that there should not be any overall impact on the amount of profits recognised, but there may be a cash-flow impact of transitioning to the cash basis. 

The rules ensure that no item of income is taxed twice, no item of expense is relieved twice and that no items of income or expense are left out of account completely

This may also have an impact on overall tax paid if the owner moves from one tax bracket to another in the year of transition. For example, a taxpayer who has already been taxed on a deposit in 2023/24 relating to a sale recognised in the 2024/25 tax year will have less tax to pay overall if they are a higher rate taxpayer in 2023/24 and an additional rate taxpayer in 2024/25.

Another adjustment to consider on moving to the cash basis is what to do with any remaining capital allowances pools. Such pools could be relatively rare due to the annual investment allowance (AIA), but there are some items of plant and equipment (eg, cars) that do not qualify for the AIA. 

Any pool that contains only items of capital that can be deducted in full in the year of expenditure under the cash basis will come to an end on transition into that basis and a full deduction for the remaining pool balance is taken in the year of transition. However, if there are also items that had been purchased that are not cash-deductible (eg, cars) then these must remain in the pool on a just and reasonable basis.

In addition to considering the cash-flow impacts of any transitional adjustments and/or not making accounting adjustments going forward, business owners should also consider the following points.

  • On the face of it, using the cash basis simplifies the business’s tax affairs as it removes the need for year-end accounting adjustments. However, especially for larger businesses, it is likely that they will need to prepare accounts under GAAP for other purposes, such as applying for grants or bank loans, to provide a truer picture of business performance.
  • Any business with good financial management is likely to have credit-control procedures in place that will be keeping track of accruals, debtors and prepayments. Translating these into a set of GAAP-compliant accounts shouldn’t involve a significant amount of additional admin.
  • Although most businesses will have most of their expenditure on plant and machinery covered by the AIA, those with eligible annual expenditure in excess of £1m will deduct the excess as if it were revenue expenditure if using the cash basis, hence bringing them into parity with the full expensing regime available to companies. However, business owners making losses may prefer to disclaim capital allowances to take at a time when they are making profits. This is not possible under the cash basis.
  • The cash basis requires complex adjustments for capital assets used for both business and private purposes. For example, a reduction in business use is treated as the sale of part of the asset at current market value. Accounting for private use of capital assets is more straightforward under the accruals basis.
  • In theory, using the cash basis gets the business’s results for the tax year closer to those captured through quarterly reporting that will feature as part of Making Tax Digital income tax self assessment from 2026/27. However, those businesses with a year end that differs from the tax year end will need to calculate taxable results based on a proportion of two different accounting periods each tax year and so may be based on cash entries that are different to those captured under quarterly reporting.

Other rules for cash accounting

It is curious that there are no amendments planned to the equivalent rules for property income in the Finance Bill. This could lead to confusion. For example, the cash basis will be the default option for trades of any size and for property businesses with annual receipts of £150,000 or less. However, a property business with annual receipts in excess of £150,000 will be required to use the accruals basis. Significant differences remain between the trade and the property business rules when it comes to relief for interest and options for utilising losses. 

The main difference between cash accounting for income tax and accounting for VAT is that it is necessary for the latter to determine the date of the tax point of each sale, unless the business has elected into cash accounting for VAT. Use of cash accounting for VAT is subject to the business meeting various conditions, including that the business expects the value of its taxable supplies in the next year to be £1.35m or less. Interestingly, this was one of the turnover threshold points considered in the consultation on reforming the cash basis for income tax, but was rejected in favour of removing the turnover threshold entirely.

The cash accounting schemes for income tax and VAT are broadly the same, although the latter has special rules for particular transactions, such as deposits, payments collected by agents, and imports and exports. Further details can be found in Part 5 of the Cash Accounting Scheme (VAT Notice 731).

Pros and cons

The additional flexibility provided by removing the turnover threshold means that larger unincorporated businesses will have greater choice in how they account for profits for income tax purposes. However, for many businesses currently above this threshold, drawing up accounts under GAAP is likely to remain a feature of their financial management, hence reducing the perceived benefit of switching to the cash basis. Nevertheless, businesses should now be starting to think about whether there are sufficient benefits to justify adopting the cash basis from 6 April 2024.

Richard Jones, Senior Technical Manager, Tax Policy

We discuss this subject, plus an unusual capital allowances case in The Tax Track, the new podcast from ICAEW's Tax Faculty.

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