Tackling the cash basis conundrum

This year marks the tenth anniversary of the introduction of the cash basis – a simplified regime for calculating taxable profits for the self-employed. However, take-up remains low, with more than two thirds of eligible businesses (around three million taxpayers) not using it.

HMRC released a consultation earlier this year on expanding eligibility for the cash basis and encouraging more businesses to opt in. Below, I explore why the scheme might not be a good fit for some businesses, and what impact HMRC’s proposals could have.

Cash vs accruals

The cash basis allows eligible, unincorporated businesses to calculate their taxable profits based on when income is received and expenses paid. Unlike the standard ‘accruals basis’, there is no need to prepare full accounts or worry about debtors and creditors, pre-payments, stock adjustments etc. Most capital expenditure (other than cars) can also be deducted as an expense in full.

For some businesses, the cash basis may represent a significant simplification. However, as discussed below there are restrictions on who can apply it, as well as special rules on interest and losses that could act as a deterrent.

Outside of tax, there are many reasons why businesses may choose traditional accruals accounting over the cash basis. Put simply, businesses do not just produce accounts for tax purposes. Accruals accounting provides a truer measure of profitability and position in any given period. In particular, businesses may find accruals accounting better if they have seasonal or fluctuating trades or carry large amounts of stock.

A full set of accruals accounts may also be required by banks and other investors – for example if a self-employed individual applies for a mortgage or business loan.

HMRC proposals

Currently, to join the cash basis a business must have turnover of no more than £150,000 (£300,000 if the individual claims Universal Credit), and must leave if turnover exceeds £300,000.

HMRC are concerned that these entry and exit thresholds prevent businesses from accessing the cash basis who would otherwise. They therefore propose either increasing the thresholds to match the VAT cash accounting scheme (entry threshold £1.35 million, exit threshold £1.6 million) or scrapping them entirely.

As outlined in our consultation response, we believe there is limited benefit in this. Accurate accounting is even more important for larger and more complex businesses, and for many the cash basis is often simply not suitable.

Another of HMRC’s proposals is to make the cash basis the default method for calculating taxable trading profits. This may increase take up amongst new businesses, but again the cash basis won’t be suitable for everyone, so we may still see a large number opting back into the accruals basis.

If the cash basis were to be made the default, an extensive education campaign would be needed, alongside clear guidance and support from HMRC to ensure businesses make the right decision for them and apply the rules correctly.

Interest and loss restrictions

The cash basis rules currently contain two restrictions which could deter otherwise eligible businesses from adopting it:

• A £500 cap on interest deductions
• Losses can only be used against profits of the same trade, with no ‘sideways’ loss relief available against other income.

The £500 interest limit was set over ten years ago, when the Bank of England base rate was only 0.5%. In today’s climate of high (and increasing) interest rates, there is a strong argument for this to be raised significantly, even beyond the £625, £750 or £1,000 proposed by HMRC in their consultation.

In our view, relaxing or removing the restriction on sideways loss relief would encourage more businesses to use the cash basis, especially new businesses expecting to make a loss in their earlier years. Under the current rules, these businesses would have to wait a significant time to get relief through carrying any such losses forward.

The way forward

Overall, whilst HMRC’s efforts to expand the cash basis may benefit some businesses, there are others for whom it will simply never be suitable.

There appears to be limited merit in merely adjusting entry and exit thresholds, or even making the cash basis the default. Instead, to drive greater take-up, any such changes need to be coupled with relaxation of the rules around losses and interest.

Regardless of what approach is taken on the cash basis, clear and comprehensive HMRC guidance will be needed to ensure taxpayers are able to make informed decisions about what is right for their business.