Small business and tax blog

The following statements are not necessarily true:

“I will get tax relief on a payment if it comes out of my business account.”
“I won’t get tax relief on a payment unless it comes out of my business account.”
“If I don’t bank my takings into my business bank account, I won’t have to pay tax on them.”
“If my bank balance is overdrawn, I won’t have to pay any tax.”
“I need separate bank accounts for my different businesses and rental properties.”
“If I make enough payments before the end of the year, I won’t have to pay any tax.”
“A limited company must have its own bank account.”

To understand why, it helps to look at business transactions (income and expenses) as being divided into 2 parts:

• the underlying legal substance of the transaction, and
• the payment for it.

The underlying legal substance is by far the most important aspect. It is what is really happening - for example, A is buying goods from B, or B is carrying out a service for A. Every transaction will involve an initial negotiation and agreement between 2 or more parties about what will be supplied, and what the cost will be.

This process is often not as formal as a written legal contract, and it may be as simple as a customer entering a shop and selecting a product to take to the checkout for payment. Once an agreement is reached, even if it is only a verbal or informal agreement, the substance of that transaction will be fixed. The payment that completes the transaction could be made from any bank account, from any person on another’s behalf, at any time (or even never), and it would not change the nature of the transaction that had been started.¹

The underlying legal substance of the transaction determines:

• Who is involved in the transaction. For example, person A is providing a service to person B.

  Every business transaction will be between at least 2 legal entities, where a legal entity is usually either an individual, a business partnership or a limited company. Remember that for an individual there is no legal distinction between the person and any of the businesses they run as a sole trader - they are all the same entity.

  It follows that if a company director places an order using his own name (and not the company name), and the invoice also uses those details, the purchase has been made by the director, and not the company, even if the company pays the invoice on the director’s behalf. In this case, the company is not entitled to automatic tax relief in the same, straightforward way as if it had properly made the purchase in its own name.

• The nature of the transaction. For example, the sale of a car.

  This is also important for tax purposes, since there are many detailed rules on what types of income are taxable and which expenses are tax deductible. These rules are almost always based on the underlying nature of the transaction rather than the bank account from which the payment was made, mainly because it is a lot more difficult to avoid tax by manipulating the former than the latter.

  It follows that if an expense has been incurred for genuine business purposes, it will usually be available for tax relief, regardless of the source of the payment. Similarly, a private payment cannot be turned into a tax deductible business expense simply by paying it out of a business bank account - that would be too easy!

• The timing of the transaction. For example, when the deal was agreed, and when it was completed.

  This is also important for business tax purposes, since in most cases it is the underlying timing of the transaction that is important rather than the date of the bank payment. This is because the tax is based on net profit, and it is more realistic to measure profit by underlying commercial activity than by bank payments and receipts. It is also more difficult to avoid tax by manipulating the timings of a legal commitment made with an independent third party, than by adjusting the timing of the payment.

  It follows that paying all suppliers shortly before the end of the business year will not accelerate the tax relief on those payments, since the tax relief is instead obtained when the goods or services are ‘used’ within the business. Similarly, in most cases delaying the issue of sales invoices or delaying the deposit of cheques into the bank until the first day of the next business year is not a viable way of postponing the tax on that income.

Having explained the importance of the underlying legal substance of the transaction, the following practicalities should also be noted.

1. While a limited company is not legally obliged to open a company bank account and use it to operate its business, it is overwhelmingly recommended that it should do so. Apart from the obvious accounting convenience of having all relevant company bank transactions in the one, proper place, the company can run into considerable legal and tax difficulties if the business is run through the private bank account of a director.
2. There is no legal or tax reason why a sole trader with one or more businesses cannot run them all through a personal bank account. However, the year end tax work is obviously made much easier if all transactions relating to each separate business are grouped together into separate bank accounts. At the very least, it saves having to pay your accountant to filter out your weekly personal shopping trips to Tesco in the process of adding up your proper business expenses. More on bank accounts for sole traders
3. In some cases, particularly when the amount of tax at stake is small, the Revenue often agree that the tax can be based on the timing of bank transactions rather than underlying income and expenses. There is also a VAT scheme for small businesses that enables VAT payments to be based on payments and receipts rather than invoices. Some types of non-business income, such as employment income and investment income, are generally taxed when they are actually received.

Footnotes
1. Romalpa clauses are sometimes used when selling goods. These are statements by the supplier that the customer will not legally own the goods until they have been paid for. These clauses are not always legally enforceable, but they may enable the goods to be recovered by the supplier if the customer becomes unable or unwilling to pay. They usually have little relevance to the accounting and tax issues being discussed here. back

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