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Tax Simplifier 15: The cash basis for small businesses

    The 'Tax Simplifier' series aims to make the case for a much simpler tax code with practical recommendations for policy change on a regular basis. Blogs are published twice per week, on Monday and Thursday. Read David's previous blog on multinationals. You can follow David on Twitter @TaxSimplifier.

    The cash basis of taxation for small businesses has to date attracted remarkably little attention in the press. But it is an option available to over 3 million businesses. It is worth looking at.

    First, some background.

    It was only in 1998 that the cash basis was forbidden as an alternative method of calculating profit for most professions and vocations.

    In 2009 a Treasury consultation took place on a proposal that companies having a low turnover should be able to elect for a cash basis instead of being taxed on an earnings basis. But taxpayers were not persuaded that this would result in significant simplification and so the proposal was dropped.

    In February 2012 the Office of Tax Simplification (the “OTS”) produced a report on simplifying tax for unincorporated businesses. It emphasised that in their work they were looking at the smallest businesses, with a turnover of under £30,000 a year, with little or no capital investment and probably no employees. The report recommended that such businesses should be able to use the cash basis, whilst retaining the option to use the earnings basis if they preferred. But it was puzzling that the report did not refer to the 2009 consultation, which created the unfortunate impression that it was not frankly addressing all the issues.

    The OTS recommended that the turnover limit should be kept low so as to establish whether the new rules did produce simplification, and to give a chance to iron out any unforeseen consequences. And it was considered that the necessary changes to legislation could be relatively straightforward.

    A consultation document came out soon after the 2012 Budget and it proposed that the cash basis could be retained until turnover exceeded £154,000 p.a.

    But at this point there had been no detailed public evaluation of the proposal, either by the OTS in their papers or in the Treasury consultation document.

    In December last year the report on the Treasury consultation and draft legislation was published, and only then did some of the implications become clear.

    Under the cash basis rules a loss in the business cannot be set against other income for tax purposes. So instead of making his life easier the possibility of using the cash basis may have the new businessman, anticipating early losses, reaching for the paracetamol. Should he start with the earnings basis, so as to use any tax losses more effectively, and then suffer what may be the considerable complications of moving later to the cash basis? Such a move would involve adjustments relating to closing stock, work in progress, debts due to and from the business, assets on which capital allowances can still be claimed, and so on. These adjustments have not been properly explained to the public.

    Interest of up to £500 on general borrowings will be allowable under the cash basis, while no such limit applies to the earnings basis. How does a taxpayer assess these future unknown contingencies in his business?

    Simplicity has not really been improved for anyone. Many businesses would be well advised to prepare accounts on an earnings basis, whatever they do for tax, because only then will they have the information they need concerning such things as stock levels, bad debts, and underlying profitability.

    And in fact most very small business already send in tax returns which are effectively on the cash basis rather than an invoicing basis for regular sales and expenses. HMRC do not seek to interfere with this if timing differences are unlikely to be material.

    We cannot know now how taxpayers would have responded to the consultation had they been given a fair picture of what to expect. The original OTS recommendation to limit the application of the cash basis until its benefits have been confirmed and any problems have been identified and resolved has been ignored.

    This is not to say the cash basis will inevitably be a disaster - who knows? But the process by which it has been introduced has been seriously undermined by inadequate evaluation, explanation and consultation.

    David Martin enjoyed a career spanning 23 years as a tax lawyer within a large City Law Firm, latterly as Head of the Tax Department, before taking early retirement in 2002. During that time he advised both company and individual clients. He now lives a less pressurised life in Devon with his wife and two daughters and maintains an active interest in tax law.

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