BIM30510 - Measuring the profits (general rules): statutory rules: basic computational rule
S25, S26 Income (Trading and Other Income) Act 2005, S46, S47 Corporation Tax Act 2009.
The basic rule is that the profits of a trade must be calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in calculating profits for Income Tax or Corporation Tax purposes.
This rule is now an express statutory rule, but it has developed out of case law.
In the case of Beauchamp v F W Woolworth plc [1989] 61TC542 Lord Templeman described the general approach to calculating trade profits at page 574C of 61TC:
‘The expression “profits” is not defined, and there is no express provision for the deduction of the expenses incurred in earning profits, but it is only possible to arrive at the computation of the profits of a trade after setting against the receipts the expenditure necessary to earn them according to the ordinary principles of commercial accounting.’
Lord Templeman went on to consider a particular required adjustment: that the computation should exclude items of a capital nature:
‘The expression “annual profits” confirms that income tax is to be charged on profits of an income nature as opposed to capital profits…Moreover, … in computing the amount of the profits of a trade, no sum shall be deducted in respect of any sum employed or intended to be employed as capital…It follows that while expenses incurred in earning profits may be deducted for the purposes of assessing income tax on the profits of a trade, such expenses as may be incurred in respect of capital transactions are not so deductible.’
The exclusion of capital items from the computation of profits is a key concept derived from the decisions of the courts over the last two hundred years. The courts have distinguished between capital receipts and expenditure which are generally to be excluded (subject to any statutory rule to the contrary), and revenue receipts and expenditure which are to be included in the computation (if their inclusion is in accordance with generally accepted accounting practice and again subject to any statutory exceptions). The exclusion of capital items is also now required by statute. The capital/revenue divide is considered at BIM35000 onwards.
The approach to computing trade profits, therefore, is a two-stage process as follows:
- Ascertain the profits of the trade for the period computed in accordance with generally accepted accountancy practice.
- Adjust the accountancy profits in accordance with any tax rules or principles which differ from generally accepted accountancy practice.
In essence, therefore, if there are no relevant tax rules or principles which affect a particular case, generally accepted accountancy practice will determine the amount of the taxable profit for the period. The relationship between tax on trade profits and accountancy is considered in detail at BIM31000 onwards.
The requirement to calculate the profits in accordance with generally accepted accounting practice does not impose any requirement for audit, disclosure or any other requirement under the Companies Act 2006 (other than requirements about the basis of profit calculation) on any taxpayer not otherwise subject to those requirements.
These basic rules are subject to special rules for businesses using the cash basis (see BIM70000 onwards), barristers and advocates in the early years of practice (see BIM70060 onwards), Lloyd’s underwriters (see BIM61551) and any other rules applying to particular businesses.
The same rules generally apply in calculating trade losses as apply in calculating profits.