HMRC reform of income tax basis periods in preparation for Making Tax Digital

On 4 November 2021 HMRC published a summary of responses to the ‘basis period reform’ consultation issued in July, setting out proposals to simplify the rules under which profits are allocated to tax years using basis periods.

Overview

The aim of the proposal is to simplify the system of allocating trading income to tax years. The reform will mean that the self-employed and partners in trading partnerships will 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 changes will mainly impact 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.

This could simplify Making Tax Digital (MTD) for Income Tax, which has now been delayed by a year. The rationale for the delay is that the impact of the pandemic means individuals and businesses need more time to prepare. MTD for income tax will now be mandated from 6 April 2024 for sole traders and landlords with income over the threshold.

The basis period reform will mean MTD quarterly updates for trading and property income will be aligned with each other and the tax year. This will significantly reduce the number of different reporting dates taxpayers with both sources of income have to consider.

General partnerships will not be required to join MTD for Income Tax until April 2025, with LLPs and partnerships with corporate members not expected to join until a year or more after that, although this is still to be confirmed.

Current position

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 trade. 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.

New rules

The new rules will replace the ‘current year basis’ rules with a ‘tax year basis’ with effect from the 2024/25 tax year, when Making Tax Digital (MTD) for IT will also be introduced. A ‘tax year basis’ will 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 will 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 Government will explore a number of options as to how to deal with the administrative burden of updating provisional figures ahead of the transition year in 2023/24.

The changes will also remove the disadvantages and complexities associated with overlap profits and overlap relief.

Transition year

In preparation for the proposed ‘tax year basis’ in 2024/25, there will be a transition period in 2023/24. In the transition year, all businesses will 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 2025, when the balancing payment for 2023/24 is due.

To mitigate the cashflow impact, any excess profits arising in the transition tax year will automatically be spread over a period of five years. There will, however, be the option to elect out of the spreading provisions and to accelerate the charge.

Any excess profits arising in the transition tax year will be treated as a one-off separate item of taxable profits, rather than as part of a business’s normal trading income. This is intended to minimise any impact on allowances and means-tested benefits. 

In the event there is excess overlap relief arising in the transition year, the time period for these losses to be carried-back will be extended from one to three years.

If a trade ceases before the whole of the transition period profits have been charged to tax, the balance will be 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 new rules.

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 2023/24;
• 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; and
• for retiring partners, these changes 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 ran 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. The OTS suggested that any change should not take effect in the immediate future, and should not be implemented before other projects are complete, from 2023 at the earliest. It recommends that in the short-term the Government and HMRC pursue ways to formalise arrangements to allow taxpayers to use a 31 March cut off to stand in for 5 April in respect of the calculation of profits from self-employment and from property income, ahead of the implementation of MTD for Income Tax.

HMRC published draft legislation alongside the consultation in July. This has been updated in Finance Bill 2021/22, which is currently before Parliament.

Ref: NTAJ14082184

DISCLAIMER
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 2022/23.