On 20 July 2021, HMRC published a new consultation on ‘basis period reform’ setting out a proposal to simplify the rules under which profits are allocated to tax years using basis periods.
The aim of the proposal is to simplify the system of allocating trading income to tax years, with self-employed individuals and partners in trading partnerships being among those affected.
The reform would mean those affected would be taxed on profits arising in a tax year, aligning the way self-employed profits are taxed with other forms of income, such as property and investment income.
The proposal will mainly affect those businesses that do not draw up annual accounts to 31 March or 5 April, and those that are in the early years of trade.
The proposal could simplify Making Tax Digital (MTD) for Income Tax, when it is mandated from 6 April 2023, by aligning MTD quarterly updates for trading and property income to the tax year. This would significantly reduce the number of different reporting dates that taxpayers with both sources of income have to consider.
At present, profits or losses disclosed on tax returns filed by self-employed individuals are generally based on a business’s set of accounts ending in the tax year – this is known as the ‘current year basis’.
More complex rules apply in determining the basis period in the early years of trade. Where the accounting date is not 5 April or 31 March, self-employed individuals are taxed on some profits twice, generating ‘overlap profits’. These are carried forward and ‘overlap relief’ is given in the final tax year of when the business ceases. This ensures profits generated throughout the duration of that trade are only taxed once.
Many businesses take advantage of the current basis period rules, which make it possible to defer the payment of income tax on profits by up to a year by choosing an accounting date early in the tax year, whereas those businesses that have an accounting date in line with the tax year will be paying income tax on profits much earlier.
The consultation sets out a proposal to replace the ‘current year basis’ rules with a ‘tax year basis’ with effect from the 2023/24 tax year. Having a ‘tax year basis’ would mean taxing those profits (or relieving losses) that arise in the tax year.
Businesses with an accounting date other than the end of the tax year would need to apportion profits or losses from different accounting periods to fit in with the tax year. This may mean using provisional figures in tax returns if the accounts and tax computations for the later accounting period are not prepared before the 31 January filing deadline. Amendments may therefore be required to tax returns once final figures are available.
The proposal would also remove the disadvantages and complexities associated with overlap profits and overlap relief.
In preparation for the proposed ‘tax year basis’ in 2023/24, there would be a transition period in 2022/23, when all businesses would have their basis period moved to the end of the tax year and any overlap relief given.
For businesses with an accounting date other than the tax year end, this could accelerate profits into an earlier tax year, increasing tax liabilities for the transition year. This may impact cashflow, particularly around 31 January 2024, when the balancing payment for 2022/23 is due.
To mitigate the cashflow impact, an election is proposed to spread any excess profits in the transition tax year over a period of up to five years. Similarly, an election is proposed to accelerate excess profits in any tax year, not just the transition year, with any balance spread over the remaining five-year period.
If a trade ceases before the whole of the transition period profits have been charged to tax, however, the balance is immediately brought into charge in the tax year of cessation.
Practical implications and considerations
We can work alongside businesses and individuals to understand the impact of the proposals.
It is important to keep the following in mind:
- Businesses may need to finalise annual accounts and tax computations earlier, which may incur additional costs.
- While there is currently no statutory requirement for businesses to adopt an accounting date aligned with the tax year, many businesses may choose to adopt a 31 March year end in the transition year 2022/23, in order to spread additional profits over the subsequent five years.
- There may be a cashflow impact as a result of extra tax in the transition year and extra costs of complying with the new rules and accelerating accounts preparation.
- It will be necessary to understand the options to spread and/or accelerate transition period profits and the impact this will have.
- For retiring partners, these proposals could alter the optimal date for retirement, as well as accelerate transition period profits in the final tax year.
Businesses may also wish to review their current structure to ensure it is still the right vehicle for them.
The consultation will run alongside:
- proposals for more timely payments of income tax on profits under MTD, which may also have a cashflow impact on businesses; and
- a review by the Office of Tax Simplification (OTS) of the potential for moving the end of the tax year to 31 March or 31 December. There is currently no indication of when this proposed change might take effect.
The consultation ends on 31 August 2021 and a decision on the detailed implementation of these proposals could be announced later this year, possibly at the Budget on 27 October. Given HMRC has already taken steps to produce draft legislation alongside the consultation, it is possible that only minor changes to the draft legislation will be made.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Tax legislation is that prevailing at the time, is subject to change without notice and depends on individual circumstances. Clients should always seek appropriate tax advice before making decisions. HMRC Tax Year 2021/22.
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