This post comes out of a discussion on Folksy about how to deal with Stock Expenses under the Accruals Basis.
What are these? Well it's a special little calculation that HMRC expect you to do so that you only get tax relief on the cost of raw materials used to make finished products, where you have actually sold/ gifted or destroyed (ie they've left your business) the value of those raw materials in that Accounting Period.
Huh? Oh ok, you can't have tax relief for all the raw materials you buy in the year you buy them, you only get tax relief to the extent they've actually all been used up - either by sales, by gifts, or some plonker's spilled coffee on it and you're never going to be able to sell it and you put it in the bin. Those you get tax relief on. You don't get tax relief on unused raw materials sitting in a cupboard, nor on the value of raw materials that's been used for finished products that are also sitting in a cupboard unsold.
Don't be ridiculous, they wouldn't expect that, my business is too small! I just claim for all my raw materials when I buy them. Oh dear. That's unfortunate. Because that's so NOT what HMRC expect you to do. At the moment (until the new rules come in) the only basis defensible in law is the Accruals Basis. So your approach is not certain - because you have no idea how relaxed HMRC are going to be about whether or not you are doing what you should be. They are duty bound to chase all tax owed (down to £1) and are bound themselves to follow the law, and they expect you to as well. You might be lucky, they might never ask, or if they do ask, you might be able to negotiate your way out of it - but can you be sure of that? In my view, no. If you want to be certain, follow the rules!
And in the unlikely event they ever came for a chat about what you do, they'd expect you to (a) do it properly in future, (b) have another go, redo your figures on the right basis and (c) charge you the unpaid tax cos you were doing it wrong and (d) potentially penalties up to 100% of the value of the unpaid tax on top for not fessing up as soon as you realised you'd been doing it wrong, and not voluntarily going to them to sort it out.
Arghh! Should I have another look at what I've done before, just to see how bothered I am about this? Yes. But what you do after you've had another look is entirely up to you. I recommend having a phone call with HMRC to see if they're bothered about it (depends on how big your numbers are and how much tax they've lost as a result), then following their advice. But it's your business, you do what you want. (NB: make sure you take a note of the full name of who you talked to, the date & time and EXACTLY what they said and what you said, you might need to rely on it later!)
Hmm ok. How do I work out what I should have been doing under this Accruals Basis? And how do I compare that to what I will be doing if I elect for this new proposed Cash Accounting basis then? You're in luck. As I said at the top, I've been boring people on Folksy about Stock Expenses. I did a full example, using words. But it wasn't so easy to read, so I did a spreadsheet - 2 pages showing how the numbers work for both the Accruals Basis and the new Cash Accounting proposals.
Here it is - it's a pdf you can download from Dropbox & print off here. (If you're not printing it off, the rest of this blogpost is not going to make any sense at all!)
The basic premise (if you don't use Folksy and just want to look at the calculations):
There's a single product. It's made of wire, thread & a button.
The retail price is £20, the wholesale price is £15.
But the seller uses 2 different sorts of buttons in that product.
1. They put £54.50 (the cost of raw materials to make 8 items) into the business (page 2 - cashflow)
2. They use that money to buy the raw materials, a roll of wire, a hank of thread and 2 packets of buttons (page 2 - cashflow) and then they fill in their Raw Materials Log (page 1 - top box).
3. They make 8 items - show the materials they've used in the Raw Materials Log (page 1 top box) and also fill in their Design Brief/ Recipe (page 1 - middle box), and also start off their Finished Products Log (page 1 - bottom box) to show what stock they've got available to sell.
4. They make some sales - 4 items - they receive money (page 2 - cashflow). They show the sales (2 of each button variation) in the Finished Products Log (page 1 - bottom box).
5. They give one item to their mum and record that in the Finished Products Log (page 1 - bottom box).
6. Some idiot spills coffee over one item (that would be me then!), it's unsaleable so it's thrown into the bin. They record that 'wastage' in the Finished Products Log too (page 1 - bottom box).
7. It's the end of the year. They need to work out what to put on their tax return. So they work out:
7a. Their income - under the Accruals Basis that's total sales plus the retail value of the gift to their mum. Under the new Cash Accounting basis that's total sales plus a 'fair & reasonable adjustment' for the gift - which I've decided is the value of raw materials thrown away (this makes the gift tax neutral. With the Accruals basis you get relief on the raw materials but end up paying tax on the profit you never received cos it was gifted. Under the new Cash Accounting, it means you are effectively taking those raw materials out of your business). They get that information from their Finished Products Log (number sold) and their PayPal etc sales records (in this case I've taken the £20 retail price from the Design Brief (both on page 1).
7b. Their expenses - obviously there's going to be heat & light, and tools and listing/ selling/ Paypal fees, fair table fees etc. But I've ignored those, we're just looking at the expenses they incurred when they bought the raw materials, and how (and when) they get tax relief for them.
So, that's workings 2 box at the bottom of page 2 for the Stock Expense under the Accruals Basis. The Stock Added figure comes from the Raw Materials Log (page 1), as does the Raw Materials held @ end. The Raw Materials in finished products comes from the Finished Products Log (page 1). The figure that drops out of the bottom goes into workings 1 Tax Calculation (left box, middle of page 2).
But for the new Cash Accounting (right box middle of page 2) it's much simpler, you just take the raw materials purchased from the Raw Materials Log (page 1) - none of this faffing around with what raw materials you've got left unused or sitting in unsold stock.
8. They use the Income and Expenses figures to work out their profit/ (loss). Then work out the tax (both boxes middle page 2).
Under the Accruals Basis the tax due £13.25 is higher than that for the Cash Accounting at £6.20. Why? Because the tax relief on raw materials is delayed until they leave your business under the Accruals basis, you get it all up front on the Cash Accounting. Also, you're paying tax on profit you've not actually had on the Accruals basis for the gift.
9. They pay the tax, and end up with £12.25 cash in the cashflow (left box, top of page 2) under the Accruals Basis and £19.30 (right box, top of page 2) under the Cash Accounting.
So, all that fuss over the Stock Expense, it just affects how much tax I pay? Yup. And how much tax I pay affects how much money I have made in the year (cashflow)? Yup.
Hmmm. So what if I've actually been using this new Cash Accounting basis all along? I refer my dear reader to what I said above, you shouldn't have been. It's up to you whether to talk to HMRC about it. I know I'm right on this, because their Tax Information & Impact note (see TSCB 14 for a link to that) makes it quite clear that at the moment, the Accruals Basis is the only basis. And they make no mention of those rules being relaxed for small businesses in it - although in practice, unofficially and therefore not able to be relief upon with any certainty - that can happen - especially where the numbers are tiny, and definately where there's no loss of tax to them.
In an ideal world, because the whole reason the new Cash Accounting system has been invented in the first place is exactly because Small Businesses either weren't doing it properly or it was tying them up in red tape if they did, or because they find it difficult to understand - you'd hope that HMRC would offer an Amnesty for people who were getting it wrong in the past. So far they haven't. I haven't heard that they will. But who knows! If they do, I can't imagine them doing that until July 2013 when the new rules are set in stone when the Finance Bill is enacted.
Could you wait until July to find out? Yes. Is that wise? Well we'll only know the answer to that with hindsight. (sorry!) You have to make up your own mind, I can't tell you what to do, I can only tell you the strict rules, because that gives you certainty. The strict rule is, no, you have to tell HMRC within a reasonable time of realising you got it wrong. And there's deadlines for making changes to tax returns. And the penalties for getting it wrong are now behaviour based - they're higher if HMRC catch you, lower if you volunteer the information to them. Normally they're not any more than 100% of the unpaid tax recovered, they can even be 0%.
Do you think many people will be in this position? Having got it wrong without knowing? Well in the Tax Information & Impact Note, HMRC says that 30% of the small businesses eligible for the new rules are unrepresented - don't have formal bookkeeping/ accounting/ tax advisors. Of those who are advised, 2% should be able to do it for themselves in future, leaving 68% who will want to stick with paying for someone to do it for them.
And though each individual business may only owe a couple of hundred pounds of tax maximum through getting it wrong, that soon adds up over the sheer number of businesses involved, even if it's only a few of those 30% comparatively. HMRC will be considering the impact to them of offering an Amnesty, how much tax they'll permanently lose vs. the cost to them of chasing everyone up. That's why they do Amnesties in the first place - to give people a risk free & certain way of getting up to date and within the law. Often though all an Amnesty does is reduce the potential penalties, the unpaid tax is still due.
Oh OK. Well I don't do anything else, I don't pay tax because all my income is within the Personal Allowances. Then if you're making profits - don't bother talking to HMRC about it (once you've checked that the real numbers under the Accruals Basis still leave you in that position, if not, you must talk to HMRC about it), just get it right in future. But if you're making losses, you do need to check how you should have done it under the Accruals Basis, because your losses might be inflated/ too high, and then be getting you too much tax relief when you claim them in later years against future profits.
I have a day job, I pay tax on it, so I pay a tiny bit of tax on my crafting business profits. Then as above, you check what the real numbers should be, and if it's materially different, talk to HMRC. What's material? I can't say, you have to ask them, but I do know that if HMRC did actually do a formal enquiry, if they want you to change the way you do it, they will ask you to pay the unpaid tax arising from doing it the way they didn't like in the past - definitely £100 of tax, maybe £50 of tax? Who knows. You'll need to know whether you're a basic rate (20%), higher rate (40%) or additional rate (50% or 45%, depends on which tax year) taxpayer to work out the tax lost.
What if I'm currently doing the Accruals Basis right and I move to the new Cash Accounting basis - how will that work? I've got no idea. We've got to wait for the draft legislation and explanatory notes to be issued by HMRC (which will have 'transitional rules' to explain how to claim the opening balance of stock brought forward from the old rules into the new rules. I hope!) I would imagine you just claim the expenses you've not been able to claim because you've not sold the stock in earlier years together with your new expenses. (In the downloadable example that's £20.75 of raw materials both unused and sitting in Finished Products - Workings 2: Stock Expense on page 2) But there might be restrictions.