TTR Barnes

As of 6^th April 2024 business profits for sole traders, unincorporated businesses and limited liability partnerships should be calculated inline with the tax year,” rather than on the “current period basis”, thus aligning all accounting periods to the tax year end.  This Basis Period Reform is part of the Government’s overall plans for introducing Making Tax Digital (MTD) by April 2026 and will allow for the future quarterly reporting and annual statements required from the self-employed.  The changes will be fully implemented for the 2024/25 tax year, with transitional rules applying in 2023/24.

 The Basis Period Reform may impact forthcoming tax liabilities for many self-employed business owners whose accounting periods are not currently aligned to the tax year (date ending between 31^st March – 5^th April).  In this article we outline the key changes and what they could mean for you.

First, An Explanation of Overlap Profits and Overlap Relief

The potential impact of the Basis Period Reform on tax liabilities is due to the inclusion of overlap profits.  It helps to first understand what this means before explaining the Basis Period Reform.

Income Tax is currently calculated based on the “current year basis”, using profits up to the end of the accounting period within that tax year.  For example an accounting period ending 31^st December 2023 would be the “basis period” on which the profits would be taxed in the 2023/24 tax year.

Under the current rules, there can be overlapping basis periods (e.g. if a new partner is appointed, during the opening/closing years of business, or if there is a change to the accounting period). When this occurs profits can be taxed twice creating overlap profits.

When a business has overlap profits brought forward, they can claim overlap relief when the business ceases, a partner retires or there is a change in accounting date. This reduces the taxable profits for the year, by deducting the overlap profits from the actual profits in the tax year.

Example of the Creation of Overlap Profits

Ryan is a sole trader who started trading on 1^st August 2017.  He has selected an accounting period that ends on 31^st July.    The below example shows the time periods he currently uses to calculate tax.

Basis Period Reform:  What is Changing?

Transitional Rules for 2023/2024

The tax year 2023/24 will be a transition year. This means self-employed business owners will move to the new way of calculating taxable profits for the tax year. Businesses will need to declare the total profits from the end of the last accounting date in the tax year 2022 to 2023, up to 5 April 2024. This means profits generated over a longer period will be taxable in the transition year.

The transition year 2023/24 presents an opportunity for all businesses currently trading, regardless of accounting date, to use any overlap relief due.  In the tax year 2023/24 businesses can use any overlap relief resulting from overlap profit when the business first started.

Whether overlap relief is used or not, HMRC recognises that many businesses will be impacted by a higher initial profit calculation.  It has therefore introduced “spreading rules”.  These rules mean that tax due on any transitional profit remaining, even after the deduction of any overlap relief, can be spread over a period of 5 years. This is done by taking  20% of the additional profits in the transition year and taxing them over the next 5 years.

The rate of tax paid over the 5 years will be in line with the rates of tax applicable to each forthcoming tax year at the time of payment.  It is therefore important to understand that tax rates could go up or down in the later years.

It is important to note that, in the instance of losses – either in the transitional period or in the previous accounting period – additional complexities will need to be taken into account during tax calculations and the use of spreading rules.

Going back to our example earlier of how overlap profits are created with Ryan.

In the transition year of 2023/24, Ryan would normally prepare a set of accounts to 31^st July 2023. Due to the basis period reform, he will need to either lengthen this period to 31^st March 2024 or prepare a short set of accounts for the period 1^st August 2023 to 31^st March 2024.

Whichever is chosen Ryan will be able to utilise the 8 months of overlap profits.

Let says Ryan had profits of £24,000 for the year to 31^st July 2023, and in the additional period to 31^st March 2024, profits arose of £17,600. Ryan would be taxable in the year to 5^th April 2024 on £41,600.

If say he had brought forward overlap profits of £10,000, the amount that is taxable would be reduced to £31,600.

What are the options if you are affected?

Although the reform will remove the complications associated with overlap profits moving forward, we can see that it also presents potential issues for those businesses affected.

Essentially there are two options should you be impacted by the Basis Period Reform

• Align your accounting period with the tax year

(HMRC has advised that any date between 31^st March and 5^th April can be selected as the accounting year end.)

• Continue to time-apportion your profits for the two accounting periods that fall within a tax year

In most cases it is going to be easier to align your business accounting year with the tax year. Though additional tax maybe due in the transitional year, it will make it easier administratively in future years.

Impacts of the Basis Period Reform

Less time to prepare and submit accounts, meaning provisional submissions

Under the new rules, businesses who do not currently draw accounts to the end of the tax year or 31^st March will have a much shorter period to finalise their figures. For example, a business drawing accounts to 30^th April currently has 22 months before they are required to file their Self Assessment, however under the new rules this will be reduced to just 10 months.

Except in the instance of highly simplified business models, a business owner with an accounting period end date close to the Self Assessment deadline of 31^st January would find it difficult to calculate and submit their final accounts in time, meaning provisional accounts would need to be submitted, followed by revised accounts at a later date.

This adds an increased administrative burden to their business, as well as the accounting costs associated with this.

Cash flow impact

Businesses will also need to consider the impact of the reform on their cash flow, particularly during the transitional year of 2023/2024, as calculations of profit may increase considerably and many businesses will be required to pay their tax bills much sooner than under the previous rules.

Another impact of the changes is that the opportunity for the longer-term cash flow advantages seen in partnership models will lessen – meaning it may be more beneficial to move to a corporate structure.

Tax Rate Bands and Associated Benefits

The changes may also push individuals into a higher tax rate band – particularly if the business ceases before the fifth year of trading.  This has the potential to impact associated benefits, (e.g. child benefit, tax credits, tax-free childcare, marriage allowance and pension contributions), meaning the individual would be even further impacted financially.  HMRC has, however, made allowances for this but this relies on the accurate separation of profits during the accounting period and profits during the transitional period in the tax submission for tax year end 2023/204.

What to do next

If you are self-employed and think you may be impacted by the Basis Period Reform (i.e. your current accounting period differs from the tax year end) you should seek advice from a financial or accounting professional.  The application of the new rules is complex, particularly during the transitional phase, and could have considerable impact on your tax liabilities.  Please do talk to one of our expert team about your individual circumstances.

All information correct at time of going to print/live and on the best knowledge and understanding of the author at the time. This article is for general information only and does not constitute financial advice or recommendations for individual circumstances. No responsibility is taken for any actions taken on the base of the information within this article.