Otherwise known as a “Tax Deductible” expense, an allowable
expense is one that both is deducted from your accounting profit, but also
crucially your taxable profit. The word ‘allowable’ indicates that it is allowable
for tax purposes. As a simple example:
A builder makes sales in the year of £70,000. Of this, the materials they purchased amounted to £20,000. Materials are clearly an allowable expense, and so they reduce the profit by £20,000, but they also reduce taxable profit by the same amount.
If we imagine that the tax rate is a flat 20% on all profits, then a £20,000 expense reduces your tax payable by £4,000 (£20,000 x 20%).
By contrast, a disallowable expense will reduce your accounting profit, but not your taxable profit. In the example above, if the £20,000 was to be a disallowable expense, it would still reduce the accounting profit down to £50,000, but taxable profit would remain at £70,000. In other words, there is no reduction in tax payable despite the expense.
Using the same theoretical tax regime above, the builder will still pay £14,000 of tax (£70,000 x 20%) despite only making an accounting profit of only £50,000.
What is the difference between a non-business expense, and a disallowable expense?
Realistically, disallowable expenses are few and far between. The two most common examples for small business tend to be the following:
- Customer entertaining – this being perhaps gifts for customers, paying for a meal out with them, or paying for tickets to an event for them.
- Legal and professional expenses which are not directly related to business operations – for example the expense for incorporating a company or changing its share structure.
The most likely question to be asked then is actually a much
Is it an allowable business expense, or is it just not classed as a business expense at all?
The general criteria that needs to be met for an item to be
classified as a business expense is that it is bought wholly and exclusively
for business purposes.
This makes most expenses pretty easy to clarify. Builder buys some cement for a job? Obviously allowable. Builder pays for a service for their personal car? Obviously not. But there are more than a few categories where there is much more of a grey area:
Clothing is a classic example where you can use the ‘wholly and exclusively’ test to get your answer. In simpler terms, an item of clothing will be an allowable expense only if it is bought specifically for business use and cannot realistically be worn elsewhere. For our builder, this means items like steel toe cap boots or for an engineer, a boiler suit.
Outside of the trade environment, company branded clothing would also be allowable – again, it is very clear that this is business only.
HMRC will likely look much less favourably on clothing items that, even though you have only bought for them work, could easily be worn elsewhere – for example hoodies, trainers or even a suit.
If you own a small limited company, whether you can put vehicle expenses
through or not is very simple – does the Limited Company own the vehicle, or do
you own it personally? If you own it personally (whether that be actually own
it, lease it, rent it or finance it) then you cannot put vehicle expenses
through the business accounts.
If you use the vehicle for business travel, then you should keep a mileage log, and all business mileage can be put through the business accounts as an allowable expense at 45p per mile. What’s more, assuming the company has the cash and your directors loan account is in credit, the company can pay you this amount tax free.
Sole trader or partnership
For unincorporated businesses there are usually two situations here:
1) There is a commercial vehicle, for example a Van, which is clearly and obviously for business only
2) There is a vehicle which is used both for business and private purposes
In the 2nd situation, all business expenses and tax reliefs will be apportioned by the percentage for which you actually use the vehicle for business. You should use a reasonable estimate for this percentage which you would feel comfortable explaining should HMRC investigate.
Do I need to keep my receipts and invoices?
The simple answer is yes, but it again the rules do depend on whether you operate as a Limited Company or not.
If you are a sole trader or partnership, HMRC state that you must keep your records for at least 5 years after the 31 January submission deadline of the relevant tax year.
For example, the 2019/2020 tax return is due by January 2021, so you must keep records for this year until the end of January 2026.
For a Limited Company, you must keep your records for 6 years from the end of the financial year, or longer if:
· they show a transaction that covers more than one of the company’s accounting periods
· the company has bought something that it expects to last more than 6 years, like equipment or machinery
· you sent your Company Tax Return late
· HMRC has started a compliance check into your Company Tax Return
Keep in mind that records do not have to be stored physically – if you have them stored digitally then this is fine.
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