I think the most important thing to understand it that whilst a business’ right to claim expenses is enshrined in the legislation, there isn’t actually a proper list of what you can claim – there’s a limited list of what you can’t claim, and then there’s exceptions to that list (that you can claim after all – yes, welcome to the weird world of UK tax), but even those aren’t the full story. Which isn’t very helpful to new or small business owners who can’t afford help or don’t know where to look for answers to their questions.
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and about her work at the foot of this article
The right to claim business expenses is limited to expenses that are ‘wholly and exclusively’ incurred or spent for the purposes of the trade. Great, who decides that? Well, in theory, to a certain extent you do, within the boundaries set by previous court cases and Revenue practice, because the UK has a system of Self Assessment (see previous posts). In practice, there are rules of thumb and a lot of informed personal judgement.
One of the most important principles the courts have decided is that the ‘tax treatment follows the accounting treatment’. Fortunately, accountants have spent a lot of time and energy on standardising the accounting treatment of expenses, which everyone is expected to follow. So, whilst you might not prepare formal accounts for your small business (unless you have to for the bank etc), you still need to treat expenses as if you had a multi-million pound business, because then you’ll get it right, also it’s good practice for later when your business takes off and you feature in the Times Rich List!
1. Distinguish between Business and Personal expenses
There are two categories of expenses: business and personal. The distinction between business and personal not just about the rules, it’s a matter of being sensible too – it’s a business purpose to buy supplies to make into products; it’s not a business purpose, it’s personal, to buy a cd to listen to whilst you work, or bottles of water so you don’t dehydrate and sew your fingers to your table.
But just because something is a business expense, it doesn’t mean it’s allowable; there’s a few more hoops to jump through first.
2. Wholly and Exclusively Incurred
An expense must be ‘wholly and exclusively incurred’ for business purposes. What this means is that you spent the money for your business only and that spending the money didn’t directly benefit you or your family (or pretty much anyone else) personally at the same time – you can claim it.
So, there should be no integral element of personal benefit – for example, entertainment expenses aren’t wholly & exclusively incurred, even if you get business from it later, because there’s a personal benefit to that entertainment (lunches, drinks, participation on trips etc). Similarly in general, clothes aren’t wholly & exclusively incurred, because there’s an element of keeping warm and public decency involved. Although if you are required to use particular safety clothing (by law) otherwise you’d go up like a roman candle etc, that’s usually allowable.
If you claim an expense, you need to be able to back it up with a receipt in case HMRC ask questions (more about record keeping later in the Series).
3. Private Use of Business Assets or Business Use of Private Assets
That said, sometimes it is possible to distinguish between the personal and business use of an asset and claim the business part of expenses relating to that asset.
So, if you have an asset that you bought with money arising from the business that you sometimes use for non-business purposes (private use of business asset), or you’ve got an asset you bought with your own money that you sometimes use for business (business use of private asset), say a car, sewing machine or your house – then you can split the costs on a reasonable basis between the two categories and claim the business part of the expense.
The key here is ‘reasonable basis’. HMRC expect you to be honest, sensible and consistent in how you do your cost splits (apportionments in accounting speak) and, if questioned, you need to be able to produce receipts and show how you worked out the splits.
For cars, it’s sensible to keep a mileage book, clearly showing which trips were totally business, which trips were totally personal, and which were mixed: the easiest way to split mixed use trips is work out what proportion of the mileage belongs to personal or business use. Then at the end of the year, you add up all the costs of running the car – insurance, petrol, car tax, services etc – and apportion that total cost by the number of business and personal miles you’ve done – and claim the business element.
It’s the same principle, but a bit harder with sewing machines etc, although it can be done. Instead of keeping a note of the mileage, keep a note of the number of hours you use it for and whether it’s personal or business use. Then do the split based on the number of hours of business sewing and of personal sewing, and claim the business part of any costs.
If you work from home, then you can claim part of your household running expenses. HMRC have some very good examples in their guidance about how to split and claim the business use here
With each of these splits (apportionments) – if it is capable of being split and you’ve got the records to back it up, and the way you’ve split the cost is reasonable, then as long as the part you’re claiming is wholly and exclusively incurred for business purposes, you can legitimately claim it.
In case you are wondering, there is a difference between using an asset for mixed purposes (business & private use) and an expense in itself having an element of personal benefit (making it fail the wholly & exclusively test) – but it’s not very obvious – it’s a question of whether the personal element is capable of being split from the business element on a reasonable basis, or whether the personal element is so inextricably linked to the business use that it can’t be split. It’s something you need to be aware of, but not worry about too much, as the next few posts will explain a bit more about what can & can’t be claimed and when and why.
4. Distinguish between Revenue & Capital Expenses
Finally, just because an expense is ‘wholly and exclusively’ incurred with private use stripped out, it doesn’t necessarily mean you can claim it outright – how and what and when you can claim also depends on whether the expense is classed as ‘Revenue’ or ‘Capital’.
An expense is classed as a ‘revenue’ expense if it is used in the day to day running of the business. You could say, if it is used up – for example, heat, light, stationery, raw supplies, petrol etc – the money you use to buy these things ‘circulates’ by being turned into profit (so HMRC sometimes call it ‘circulating capital’ in the sense of capital being money used in the business to generate income or revenue).
But when you buy something fixed, it is a ‘capital’ expense, and could be said to be used over & over again without being used up – for example, your home or studio, car, computer, printer, sewing machine, grinder, or other tools etc. (so HMRC sometimes call it ‘fixed capital’ in the sense of capital being used to buy permanent items because there is no turnover of income directly related to that item).
Why does this matter? Because revenue expenses can be claimed outright in their entirety, you incur the expense in the trading period, you can claim that expense in that trading period. But capital expenses are often not eligible to be claimed: and if they can be claimed, the cost is spread over more than one trading period & tax year using the ‘Capital Allowances’ scheme.
The Capital Allowances scheme allows you to claim part of the capital expense over a number of years (roughly equating to the number of years that item is used in the business), although sometimes and for certain capital items you can claim the full expense in a single year – which is why it’s worth listening to the Chancellor’s annual budgets because that’s when he decides you can do this. So sometimes you can do a bit of easy tax planning and buy capital items when the Chancellor’s got one of his special Capital Allowances deals on, and get the tax relief much earlier than you would otherwise, and gain a cashflow advantage. There’ll be a post on capital allowances later in the Series.
So, the basics are to be able to distinguish:
- Between Business vs. Private use
- What’s Wholly and Exclusively Incurred and what fails the test
- When you can split out private use to claim partial business use, and
- Between Revenue & Capital expenses
Basic: have a look at page 7 onwards of the HMRC Notes for the Long Self Employment Tax Return pages here Yes I know, your turnover is under £68,000 so you don't need to tell HMRC the detail so you don't need the Long pages. I agree, but you do need to know what expenses you can and can't claim, because they're the same whether or not they're a lump sum in a single box on the return, or split out over lots of boxes - and it's easier to learn if you look at them split out into the same categories as HMRC use for big businesses, also its easier to search on HMRC website for more information if you know what HMRC call particular expenses.
Comprehensive: the deductions section of the HMRC manual here (but bear in mind this manual is not just for sole traders like you but also partnerships and companies so make sure you understand which sort of business is being discussed in any particular section because sometimes the rules are different for each sort of business.)
The next post will be about expenses that are specifically claimable or disallowable
Featured Seller: NiftyKnits (Heather) says that her Meerkats have taken on a life of their own - you name it she'll knit it. They're knitted to order, ready to ship in a week. Heather's motto? 'I knit therefore I am'
Find her at http://www.niftyknits.etsy.com/ or http://www.niftyknits.co.uk/