Income Tax: Basis period reform for partners and self-employed

Generally, a business will draw up annual accounts to the same accounting date each year.

Currently, a business’ profit or loss for the tax year is usually the profit or loss for year up to the accounting year in the tax year e.g. a partnership draws up accounts to 30 April each year. The profit or loss for the accounting year to 30 April 2021 is what is included in the 2021/22 tax year.

Specific rules determine the basis period in certain cases, including the early years of trade.  These rules can create overlapping basis periods, which charge tax on profits twice and generate corresponding ‘overlap relief’, which is usually given in the year of cessation. Overall, this basis of taxation is referred to as the ‘current year basis’. Currently, you can have a situation where two identical businesses pay tax at very different timescales because of their difference in basis periods. See our flyer explaining the current year basis rules in more detail.

HMRC are proposing to amend the basis of taxation to a ‘tax year basis’ with effect from 2023 to 2024, so that a business’ profit or loss for a tax year is the profit or loss arising in the tax year, regardless of the accounting year end. This would remove the ‘current year basis’ rules and removes the creation of overlap relief.

The policy objective is to simplify the taxation of trading profits, particularly with the implementation of Making Tax Digital (MTD) being introduced from 2023, which may be a welcome change for some businesses.

However, the change would result in a transitional period during 2022 to 2023 to be ready for the new rules. The transitional period would mean that businesses that do not have an accounting date aligned to the tax year will be brought in line, and all overlap relief utilised at that point. The tax year basis would then start in the year 2023 to 2024.

For businesses with higher profits in 2022 to 2023 due to changes in the basis of taxation, the government is considering an election to spread the additional profits over a period of up to 5 years.

How will it affect you?

As with any consultation we do not know what the eventual result with be and how it will be implemented.  HMRC have already considered alternative rule changes before opening the consultation so it would be safe to assume that the proposal is likely to be implemented, and if so, business with an accounting period not aligned to the tax year should prepare for changes in 2022 to 2023.

Benefits of the change would mean partners or self-employed individuals will have their profits taxed in the same way as other income they receive such as rental income, as well as the alignment of MTD being easier to navigate.

However, the change may result in tax liabilities being brought forward, as profits will be brought in to an earlier year than they may have previously been declared, with resulting additional costs incurred.

Although HMRC will potentially offer a 5 year election, this could have cash flow implications and additional administrative burdens. Some businesses may not be able to finalise accounts for the later period to be able to finalise the figures for the tax year when transitioning to the new rules, therefore some business owners and partners will need to estimate their income and then amend their returns at a later date, which could result in additional administrative costs.

Partnerships have a unique set of challenges because each partner may have a different amount of overlap relief depending on when they started.

Example

HMRC have provided examples of how the changes will look in practice, one of which being:

A sole trader draws up their accounts to 30 April. Their profits for the year ended 30 April 2022 are £55,000, and for the year ended 30 April 2023 £66,000. They have overlap profits brought forward of £20,000.

The profits for the tax year 2022 to 2023 are as follows:

  • Current year basis element – year ended 30 April 2022 – 55,000
  • Plus transitional element – 1 May 2022 to 5 April 2023 – 66,000 x 11/12 = 60,500
  • Less overlap profits (20,000)
  • Total profits for tax year 2022 to 2023 = £95,500

These profits exceed the profits under the current year basis by £40,500 (i.e. the transitional element less overlap profits). The sole trader can therefore elect to spread the excess over up to 5 years.

The minimum amount per year to be added is 40,500 / 5 = £8,100. Under this election, assuming the sole trader chooses to add the minimum amount, the profits for the tax year 2022 to 2023 are reduced to 55,000 + 8,100 = £63,100. A minimum adjustment of £8,100 per year will be required to the profits of each of the tax years from 2022 to 2023 onwards (until 2026 to 2027 at the latest) until the £40,500 is extinguished.

As you can see, depending on a business’ accounting date, the changes can mean higher profits will be taxable than the business would usually be expecting.

Contact us

Once the consultation is complete and we have more information we will inform you of action to take.

If you have any queries in the meantime please do not hesitate to contact Laura Dickson at laura.dickson@taitwalker.co.uk.