How to Calculate Your Taxable Profits

Introduction

Calculating your taxable business profits is more than just adding up your income and subtracting what you've spent. You need to make specific adjustments following HMRC rules, claim capital allowances (tax relief on equipment and vehicles), and distinguish between allowable and non-allowable expenses. This guide takes you through the process step-by-step so you can accurately complete the self-employment pages of your Self Assessment tax return.

Understanding the basic calculation

Your taxable profit starts with your accounting profit—the figure shown in your business accounts after deducting day-to-day running costs from your income. However, your accounting profit and your taxable profit are rarely the same number.

You need to make adjustments to arrive at the figure HMRC uses to calculate your tax bill. This means adding back certain expenses that aren't allowable for tax purposes, and deducting capital allowances and other reliefs you're entitled to claim.

What counts as turnover

Your turnover is your total business income before deducting any expenses. This includes all sales, fees, commissions, and any other income your business receives. You must include income even if you haven't been paid yet, unless you're using the cash basis (which only counts money actually received and paid out).

Deducting cost of sales

If you buy goods to resell, or materials to make products, these costs reduce your profit. Cost of sales includes the purchase price of stock you've sold, plus any direct costs of producing goods. However, you can only claim for items you've actually sold—stock you still have at the end of your accounting period doesn't count yet.

Allowable business expenses

An expense is allowable if it's incurred "wholly and exclusively" for business purposes. This is a strict test. The expense must be necessary for running your business and provide no significant private benefit.

Common allowable expenses include rent for business premises, business insurance, employee wages, professional subscriptions relevant to your trade, and accountancy fees. You can also claim for repairs and maintenance that keep existing assets in working order.

Non-allowable expenses you must add back

Certain expenses that appear in your accounts cannot be deducted for tax purposes. You must add these back to your profit when calculating your taxable figure.

Non-allowable expenses include your own wages or drawings, capital expenditure (buying equipment or vehicles), depreciation shown in your accounts, business entertaining costs, and any expenses with a significant private element that hasn't been properly separated.

Fines and penalties cannot be claimed. Neither can the cost of improving assets, as opposed to repairing them—an improvement makes something better than it was, whilst a repair simply restores it to working condition.

Capital allowances

Capital allowances are the tax system's replacement for depreciation. When you buy equipment, vehicles, or other capital assets for your business, you cannot deduct the full cost as an expense. Instead, you claim capital allowances over time.

The Annual Investment Allowance (AIA) lets you claim 100% tax relief on most plant and machinery in the year you buy it, up to the annual limit. If you spend more than the AIA limit, or buy items that don't qualify for AIA, you'll claim a percentage of the remaining cost through the main rate or special rate pool.

You must deduct capital allowances from your profit after adding back any depreciation shown in your accounts—otherwise you'd be claiming relief twice.

Balancing charges

If you sell or dispose of a business asset for more than its tax written-down value, you may face a balancing charge. This is added to your profit to recover capital allowances you've already claimed. A balancing charge ensures you don't get more tax relief than the asset actually cost you.

Using the cash basis

The cash basis is a simpler way of calculating profits available to sole traders and some partnerships. Under cash basis, you only count income when you actually receive it and expenses when you actually pay them, rather than when invoices are issued.

This option is available if your turnover is within the relevant threshold. The cash basis has different rules for certain expenses and capital allowances, so make sure you understand which method you're using.

Simplified expenses

Instead of calculating the business proportion of actual costs for vehicles, working from home, and business premises partly used as your home, you can use HMRC's simplified expenses flat rates. These rates are published figures based on miles driven, hours worked from home, or number of people living in business premises.

Simplified expenses can save time and record-keeping, but they may not always give you the most tax-efficient result compared to claiming actual costs.

Accounting periods and basis periods

Your accounting period is the period covered by your business accounts—usually 12 months. Your basis period is the period on which you're taxed in a particular tax year.

For most established businesses, the basis period matches your accounting period. Special rules apply when you start or cease trading, which can create overlap profits—profits taxed in more than one tax year. You receive overlap relief when you stop trading or change your accounting date.

Commencements and cessations

Different rules apply when you start or close your business. In your opening years, the way your profits are allocated to tax years depends on when in the year you started and your accounting date. When you cease trading, you may be able to carry back losses from your final year to earlier years under terminal loss relief rules.

Partners and partnerships

If you're in a partnership, the partnership calculates the total profit, then allocates shares to each partner according to the profit-sharing agreement. Each partner then reports their share on their personal Self Assessment return. The partnership itself files a Partnership Tax Return showing how profits are divided.

Completing your tax return

Once you've calculated your taxable profit, you enter this figure in the self-employment section of your Self Assessment return. You'll need to provide standard accounts information including your turnover, expenses, and net profit before any adjustments. You then show your adjustments and capital allowances to arrive at your final taxable profit figure.

Keep full records to support all figures you enter. HMRC may ask you to provide additional information about your calculations, particularly if anything appears unusual or if your business is selected for a compliance check.

Sources

• How to calculate your taxable profits (Self Assessment helpsheet HS222)
• Information from your accounts (Self Assessment helpsheet HS229)

This article provides general guidance based on current HMRC rules. For advice specific to your situation, speak to your accountant.