Your accounts show every cost the business has paid, but not all of them reduce your tax bill. Some expenses are disallowed by law, either because they are not wholly and exclusively for the business, or because tax rules deal with them in a different way.
The result is that your taxable profit is often higher than the profit in your accounts. Knowing which costs are disallowed helps you understand your tax bill and avoid surprises.
The wholly and exclusively test
The starting point is that an expense must be incurred wholly and exclusively for the purposes of the trade. A cost that has a private purpose as well as a business purpose fails this test.
Where a cost is dual purpose but there is an identifiable business part, that part can be claimed. A phone used for both business and personal calls, or a vehicle used for both, can be apportioned. Something with a single mixed purpose, such as everyday clothing worn to work, cannot.
Common disallowed expenses
- Client entertaining. Taking clients or suppliers out for a meal or to an event is never deductible, however good the business reason. Staff entertaining, such as a staff party, is deductible.
- Fines and penalties. Parking fines, speeding fines and HMRC penalties are not deductible.
- Private costs. The private element of any cost, or personal spending paid through the business.
- Depreciation. This is added back and replaced with capital allowances.
- Capital expenditure. The cost of buying assets is relieved through capital allowances rather than as an expense.
- General provisions. A general provision for bad debts, for example, is not deductible. A specific provision against a named debt usually is.
- Political donations.
- Legal costs on capital items. Most legal fees relating to buying property or other capital assets.
Timing differences
Some costs are allowed, but not in the year they appear in the accounts. For companies:
- Bonuses are deductible in the year they are accrued only if paid within nine months of the year end.
- Employer pension contributions are deductible only when paid, not when accrued.
Dividends are not an expense at all. They are a distribution of profit after tax, so they never reduce taxable profit.
A worked example
A company's accounts show a profit of £80,000. Included in its costs are:
- Client entertaining of £2,000
- Depreciation of £6,000
- A parking fine of £150
- A general bad debt provision of £3,000
The company is entitled to capital allowances of £5,000. Its taxable profit is £80,000, plus £11,150 of disallowed costs, less £5,000 of capital allowances, which is £86,150.
At this level of profit, the company pays corporation tax at an effective marginal rate of 26.5 percent on the extra £6,150, which is £1,629.75 more than if all the costs had been allowed.
Sole traders and partnerships
The same principles apply to the self-employed. The most common issues are private use of vehicles, phones and home costs, and personal spending through the business bank account. Keep business and personal spending separate and record how any apportionment has been worked out.
Why it matters
Disallowed costs are still real costs. They reduce your cash and your accounting profit, but you get no tax relief on them. A £100 client lunch costs the business £100, whereas £100 spent on a deductible cost might effectively cost between £73.50 and £81 after corporation tax relief.
This does not mean you should avoid entertaining clients. It just means you should budget for the full cost.
What to do
- Code client entertaining and staff entertaining to separate accounts in your bookkeeping.
- Keep personal spending out of the business bank account.
- Note the business proportion of any dual-use costs and how you worked it out.
- Pay bonuses within nine months of the year end and make pension contributions before it, if you want relief in that year.
If you would like us to review how your costs are treated for tax, book a free call.
