Wednesday, 5 January 2011

TSCB 5: When and how to claim Expenses

The last post covered the basic technical principles behind what type of expenses are claimable and why they might be disallowed for tax purposes. This article covers how to work out when you can claim a (revenue) expense, & how much detail you need to give HMRC about your expenses in your tax return.

To work out your business income & expenses you can’t just look at the actual cash position – the money you received and the money you paid out (‘cash basis’ in accounting speak). You also have to look at money that is owed to you, or you owe others at the end of each Trading Period at your business’ year end (‘Accruals Basis’ in accounting speak).

Some expenses examples of this would be if
  • you’ve ordered and received some raw materials but not paid for them yet (you need to make an Accrual adjustment), or
  • where you’ve paid for something you haven’t had yet, like the line rental on your home telephone (you need to make a PrePayment adjustment).
This article explains what happens to those sort of expenses that are hanging over from one year to the next.

Featured Seller: SoapDragon (Amanda): See her Etsy shop here
and about her work at the foot of this article

It’s important to understand that the Accruals basis really only matters on the last day of your Trading Period – what is outstanding on that year end day itself, not what’s outstanding at any other time. When this article talks about ‘current Trading Period’ it means the one that finishes with the year end date under consideration, which isn’t necessarily the Trading Period that you are actually in the middle of when you read this article.

HMRC’s explanation of the Accruals Basis is that you can only claim expenses in your Trading Period for the amount that you’ve used up of the expense in the Trading Period. It’s worth noting that when HMRC talk about ‘using up’ an expense they’re not talking about the underlying subject matter – for example, the Accruals Basis does not mean that you have to use up everything you’ve bought (ie raw supplies) in the year to be able to claim the expense of buying them – any raw materials you buy but haven’t used yet are called ‘Stock’ (more about that in the next article).

My explanation is that it’s all a matter of timing – the Accruals Basis doesn’t stop you claiming the whole expense, it just tells you when to claim it –
  • all in the current Trading Period (best for your cashflow),
  • all in the next Trading Period (not so good for your cashflow) or
  • split between the current and the next Trading Period (usually pretty neutral for cashflow).
Whilst the Accruals Basis always applies, what really matters for someone trying to do their tax return is whether or not the Accruals Basis means they need to make an adjustment to move (apportion) part or all of a particular expense into the next Trading Period or whether they can claim it in the current one. And that depends on whether or not the transaction
  1. all happened within the current Trading Period (you don’t apportion, you just claim the expense in the current Trading Period), or
  2. began in the current Trading Period but ended in the next Trading Period – it’s a single expense that ran across the year end - (you don’t apportion, you just have to make sure the expense is claimed in the right Trading Period – current or next one), or 
  3.  is an expense that continues across several Trading Periods – it’s an ongoing expense - (you apportion the cost between the current & next Trading Periods).

The Accruals Basis works by categorising expenses that fall into more than one Trading Period into two categories - PrePayments and Accruals (in accounting speak), and there’s only two ways of dealing with them:
  1. Take the whole expense and put it into the correct Trading Period, EITHER the current one OR the next one – this is for expenses that are single transactions that just took time to complete and a yearend occurred in the middle of it, for example you were invoiced or received raw materials before the year end but didn’t pay for them until afterwards (expense), or a slow payer bought an item before the year end but didn’t pay for it until afterwards (income).
  2. Split the expense up between two Trading Periods, the current one AND the next one – this is for expenses that are ongoing, like phone, electricity or gas bills or studio rental costs, you pay for them at regular intervals which don’t coincide with your yearend (ie you don’t just pay for your gas bill or studio rental or Etsy online selling fees on the last day of your Trading Period, you pay quarterly or monthly).
PrePayments happen when you pay for something ahead of time: for example,
Studio Rental Costs: if you have a studio and pay rent annually on 1 December (let’s assume year 1 rent was £100, year 2 rent is £200) but your Trading Period ends on 31 March – you will include 9 months of year 1 rent to the year end of 30 November plus only 3 months rent from year 2, so your claimable rental expense is (£100x9/12=£75 and £200x3/12=£50 giving you) £125 rental expense for the year.

You are still claiming 12 months rental, but you are splitting those 12 months’ rent accurately across your Trading Periods – because the missing 3 months’ rent from year 1 was claimed in your previous Trading Period, and the missing 9 months’ rent from year 2 will be claimed in the next Trading Period.

Accruals happen when you’ve not yet paid for something you’ve already received: for example,
Buying Raw Materials: if you buy raw materials wholesale you often don’t pay the same way as with a retail shop (where you pay at the counter, they give you the goods, it’s all done on the same day). Sometimes you order the materials, they are sent to you along with an invoice that you are supposed to pay within 30 days. On the Accruals Basis, if you order the goods before the year end and
  • If you pay before the year end, there doesn’t need to be an Accrual, the expense is claimed in the current Trading Period.
  • If the invoice arrives dated before the yearend but the goods don’t arrive until after the year end and you don’t pay until after the year end, you make an Accrual and claim the expense in the current Trading Period.
  • The goods arrive before the yearend (regardless of the date on the invoice), but you don’t pay until after the year end, you make an Accrual and claim the expense in the current Trading Period.
  • If nothing else happens before the yearend apart from your action of ordering the goods (ie no invoice, no goods and no payment), then there’s no Accrual and the whole expense falls into the next Trading Period.

With something like your home phone bill – there’s two elements, the line rental which is usually charged for 3 months in advance, and your actual calls which are charged for 3 months in arrears. With the calls costs, you just claim the call cost according to the date on the bill that falls into the Trading Period. Strictly speaking you should apportion the line rental between the period that falls before and after year end into the current & the next Trading Period (as a PrePayment). That said, if your home phone bill (or any other similar) has Mixed Use (see Expenses – The Basics Article), and the business use element is quite small (either as a number or in comparison to the proportion of private use), it is acceptable to ignore PrePayments and just claim the business proportion of the total calls and line rental together for the relevant bills.

With your online shop fees (Etsy/ Dawanda/ Folksy etc), you include the expense according to the date they invoiced you (as an Accrual), not according to the date you finally got around to paying it, if the yearend falls between the two.

It’s a good idea to make life easy for yourself and keep a record of which expenses you treat as PrePayments & Accruals each year; to clearly show what you claimed this year & what’s leftover to be claimed next year. Then when you do next year’s figures there won’t be any danger of missing a claim or double counting one and getting it wrong, and you won’t have to keep doing the same calculations over & over again.

Further Reading:
  • HMRC Helpsheet 222 gives a good introduction here (although without actually telling you it’s the Accruals Basis and PrePayments and Accruals that you need to be doing)
  • HMRC Business Income Manual gives the detail about the Accruals Basis here

What will HMRC want to know about my expenses?

If you have a turnover (that’s sales income before you made any deductions for any reason) of less than £68,000 and your business is very simple for tax purposes, you can use the Short Self-Employment Tax Return pages which means you only need a single figure for income and a single figure for expenses. If you want to, you could split out your expenses on the Short pages at boxes 10 to 19, but you don’t have to.  Here's the link to the Short Self-Assessment Pages and Notes.

But if your business is a bit more complicated you have to use the Full Self Employment Tax Return pages and separate out your expenses into 14 categories. You also have to show the full expense and any part that’s disallowable with the Full pages.  Here's the link to the Full Self-Assessment Pages and Notes.

But even though HMRC might only want you to tell them a single figure for your expenses as a whole or a series of figures for different sorts of expenses; if they ask you questions later, you need to be able to justify what you’ve claimed by showing them receipts and any calculations you’ve done.

The Notes to the Full Pages has a lot more information about what you can claim and what you can’t at pages 8 & 9 than the Notes to the Short pages and even if you only need to give HMRC one total figure for expenses, it’s worth printing these two pages out so you know what to do link here.

The next article is about how to deal with the first HMRC expenses category on the Full pages: Stock & Work In Progress expenses (or costs of goods bought for resale & goods used) and Appropriations (goods used that were given to you or that you take out of the business).

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Addition: Earlier I posted a temporary note whilst I checked whether home phone line expenses are claimable in response to a query on it. Yes they are to the extent of the proportion relating to business use.  Per HMRC Manual here (towards the bottom of the page).

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