Use of trading income rules: overview
Allocation of receipts and expenses to a tax year
The general rules for the allocation of rental business receipts and expenses to the correct tax year are outlined below. In brief, the principles that apply to a trade also apply to a rental business.
When receipts included in the profit and loss computation
Receipts are recognised in accordance with normal accountancy principles. This means that a taxpayer includes all incomings earned in the tax year regardless of when they are due or when they are received. For a trading or professional partnership it is normally the incomings of the accounting period ending in the tax year that are included, not the year to 5 April (PIM1040).
Rent is not brought into a year’s tax computation merely because it is received inthe year or because it is due to be paid in the year. Equally, rent is not excluded merely because it is received outside the tax year or it is due outside the tax year. Bring in the proportion of the rent which is earned in the year from the tenant’s use of the property in the year. Exclude the proportion which is earned from the tenant’s right to use the property outside the year.
Where, therefore, a lease provides that rent is payable in advance:
- include the proportion of any rent due before or during the tax year which relates to use of the property during the year, and
- exclude the proportion which is for the use of the property for a period outside the tax year.
Where rent is payable in arrears the same principles apply in reverse:
- include the proportion of any rent due during or after the tax year which is for the use of the property in the tax year, and
- exclude the proportion which is for the use of the property for a period outside the tax year.
Example showing when income earned
Andrew lets a property. He charges a rent annually in advance as follows:
- due 1 January 2005 - £100,000.
- due 1 January 2006 - £120,000.
Taking account of the odd days from 1 - 5 April the rent chargeable for 2005-06 is worked out like this (rounding each calculation up or down to the nearest pound):
- The rent due on 1 January 2005 relates partly to 2004-05 (just over three months) and partly to 2005-06 (just under nine months). So the amount chargeable for 2005- 06 is 270 / 365 days x £100,000 = £73,973.
- The rent due on 1 January 2006 relates partly to 2005-06 (just over three months) and partly to 2006-07 (just under nine months). So the amount chargeable for 2005- 06 is 95 / 365 days x £120,000 = £31,233.
- The total chargeable for 2005-06 is therefore £105,206 (£73,973 + £31,233).
The part of the rent charged for the use of Andrew’s property in January, Februaryand March 2006 is included in his 2005-06 computation even if none of the rent due on 1January 2006 is received until after 5 April 2006. See below for more about the methods ofsplitting receipts and expenses between tax years.
References to ‘receipts’ throughout this manual assume that the ‘earningsbasis’ treatment outlined above is applied.
It follows that receipts may need to be brought in before they have been received in cash. Don’t exclude receipts merely because they have not actually been paid by the year end or because the debt may be bad. But you can, as a separate matter, deduct as an expense the amount of any receipt which has been included in the profit or loss computation and which is genuinely bad or doubtful. There is more about bad and doubtful debts at BIM42700 onwards.
When expenses included in the profit and loss computation
Expenses are also brought into the tax computation using normal accountancy principles and are the converse of the approach to receipts. This means that you deduct any allowable expenses (PIM2000 onwards) which relates to work done for the rental business, or goods and services supplied to the rental business, for a particular tax year to 5 April. For a trading or professional partnership you will normally look at the expenses of the accounting period ending in the tax year, not the year to 5 April (PIM1040).
It does not matter whether a bill is paid before or after the end of the tax year. But, obviously, only genuine business expenses can be deducted. A person can’t, for example, claim a deduction for an uncommercial expense, which they never intend to pay.
There are also special rules for the payment of salaries and wages to employees. You can only deduct amounts actually paid in the tax year or within nine months of the end of it - see BIM47130.
Example showing when expenses deductible
Judy owns a property which she lets:
- Judy has the property painted during March 2006; the work is finished before the end of the month,
- she is billed on 3 May 2006, and
- she pays that bill on 31 May 2006.
Judy deducts the full amount of the bill from the rental income for the year ended 5April 2006. This is the year to which the work related. That same bill can’t, of course, be deducted again in the year ended 5 April 2007 when it is paid. This is because the expenditure isn’t for maintenance work for the year ended 5 April 2007 (and relief has been given in the previous year).
Suppose Judy was also due to pay the following insurance premiums on the property:
- £1,000 on 1 January 2005, this provides cover for the year ended 31 December 2005.
- £1,200 on 1 January 2006, this provides cover for the year ended 31 December 2006.
Just under three quarters of the £1,000 paid on 1 January 2005 (about £750) provides cover for the period 6 April 2005 to 31 December 2005 (just under nine months). Just over a quarter of the £1,200 paid on 1 January 2006 (about £300) provides cover for the period 1 January 2006 to 5 April 2006 (just over three months). So the total insurance premium deductible for the year ended 5 April 2006 is £1,050, being:
- £1,000 x 9 / 12 months = £750,
- £1,200 x 3 / 12 months = £300.
Splitting receipts and expenses between years
As you will have seen from the examples, it is sometimes necessary to time apportion figures to find the amount attributable to the tax year ending on 5 April. To simplify the computations for the purpose of explaining the principle in Judy’s example, the five odd days at the beginning and end of the year (1 April to 5 April) were ignored. This can be done provided it is done consistently for all items in the computation (both receipts and expenses) and the figures are small. Strict daily apportionment calculations are needed where the figures are substantial and a strict comparison would produce a materially different result.
For example, in the case of Judy’s insurance premiums, the apportionment was made using whole months (see example above). A strict daily calculation of the premiums attributable to 2005-06 is as follows (rounding answers up or down to the nearest pound):
- £1,000 premium due 1 January 2005 x 270 / 365 days = £740,
- £1,200 premium due 1 January 2006 x 95 / 365 days = £312.
The total amount Judy can deduct on the strict basis is therefore £1,052, compared to£1,050 on the whole month basis. The difference here is negligible and the whole month basis is acceptable.
Unusual patterns of rental payments - rent holidays etc.
Sometimes landlords will grant a lease with an initial rent-free period. For example, a landlord may grant a 20-year lease with five years to run to the next rent review. No rent is payable in the first year and a rent of £10,000 a year is payable in years 2 to 5 inclusive. There are many variations on this theme.
Accountancy practice in this area is developing. Under UK accounting practice (UITF28) the total rent due is spread evenly over the period of the lease to which it relates. This normally means over the period to the next rent review. Even spreading applies both to the tenant paying the rent under a lease of a property and to the landlord who gets the rent.
In the example, the total rent due in the first five years (£40,000) is split evenly between the years so that £8,000 relates to each of the first five years. The landlord brings in £8,000 of receipts each year. The tenant deducts £8,000 rent each year. This treatment reflects the substance of the matter; there isn’t really a rent-free year - the total rent under the lease secures the property for the whole five years.
A straight-line spread isn’t necessarily the only correct basis, but any other basis needs to be properly justified as being, in all the circumstances, a more rational and systematic solution. In most cases there will be no better way of dealing with the problem.
For periods of account beginning on or after 1 January 2005 companies and other entities, for example partnerships and unit trusts, may use international accounting standards for tax purposes. The international standard equivalent to UITF28 is SIC15 (lease incentives).They give different results:
- Under UITF28 the lease incentive is spread over the shorter period of the lease term and the date of the first rent review to market rates.
- Under SIC15 the incentive is spread over the lease term regardless of the rent review periods.
For more about the relationship between tax and accountancy - see BIM31000onwards.
Use of cash basis
The ‘earnings basis’ treatment of receipts and expenses as outlined above follows ordinary commercial accountancy methods. Accruing income and expenses in this way gives the correct measure of business profits. However, rental business profits based on cash received and paid in the tax year may not be materially different from the strict earnings basis profits where:
- rental incomings fall due at frequent intervals (say weekly or monthly), and
- business expenses are paid at similarly short intervals.
We are, therefore, prepared to accept the use of a ‘cash basis’ (profits based on the cash paid and received in the year) provided all the following conditions are met:
- the case is small; by ‘small’ we mean where, for any year, the total gross receipts of a rental business (before allowable expenses are deducted) don’t exceed £15,000, and
- the ‘cash basis’ is used consistently, and
- the result is reasonable overall and does not differ substantially from the strict ‘earnings basis’.
We reserve the right to apply the strict basis where there are unusual features; for this purpose we take into account any material effect on other people, including in particular anyone on the strict ‘earning basis’.
The summary given above includes a broad outline of the principles that apply for computing trading income. For detailed guidance refer to the Business Income Manual.
Similarities to trading income rules
The trading income rules which apply to a rental business include the following:
- Profits should be determined on the same normal commercial principles, such as:
- include revenue items and exclude capital items - see BIM35000 onwards,
- determine profits on an accruals basis not a cash basis (except in the limited circumstances described above).
- Use the same statutory rules in determining what expenses to allow in computing the profits - see BIM42100 onwards. (For example, apply the rule that no expense is allowable unless it is wholly and exclusively for the purposes of the business.)
Differences from trading income rules
In certain ways the computation of property income is different.
- Trade basis periods are not used (but see PIM1040 for partnerships).
- Trade loss rules do not apply to Schedule A (except for furnished holiday lettings - see PIM4130).
- Some statutory rules apply only to rental income (for example the taxation of premiums received - see PIM1200 onwards).
- Some trading income rules don’t apply (see PIM1104).
Applying Case I statutory rules - IT to 2004-05 and CT
Many of the Case I statutory rules apply to Schedule A. ICTA88/S21A (1) as amended byFA98/SCH5 requires the profits or gains, or losses, of a Schedule A business to be computed as if the provisions in Part IV Chapter V of ICTA88 apply to it as they do in computing the profits or gains of a trade under Schedule D Case I, unless there is express provision to the contrary. Express exclusions are dealt with in PIM1104.
Part IV Chapter V includes many Case I computational provisions. In particular, it includes ICTA88/S74 so that the familiar ‘wholly and exclusively’ rule applies to Schedule A.
Certain other statutory provisions also apply to Schedule A as they do for Case I - see PIM1102.
Case I profits are computed by determining profit on ordinary commercial lines and then adjusting if necessary to take account of specific provisions of the Taxes Acts. (See the Tax Case references in BIM42100 onwards.) Apply the same principle to Schedule A.
Applying the trading income rules - IT for 2005-06 onwards
The trading income rules in Part 2 of ITTOIA05 that apply for the purposes of computing the profits of a rental business are set out in ITTOIA05/S272 (2) - see PIM1103. In particular the familiar ‘wholly and exclusively’ rule applies to property income. ITTOIA05 has not changed the law, but it has made the computation rules easier to follow.