Basis periods reform from 2023/24

Following the Government’s proposals on changes to basis periods, which were initially announced on 23 March 2021, the draft Finance Bill was published on L-Day (20 July 2021) which then received Royal Assent on 24 February 2022.

The new rules, which affect how unincorporated businesses are taxed, will take effect from 6 April 2024 (i.e. the tax year 2024-25) with the tax year 2023-24 being a transitional year.

Death, taxes and childbirth! There’s never any convenient time for any of them!

Current rules

For all unincorporated trading businesses (such as sole traders, partnerships and LLPs), the basis period for a tax year is the 12 months ending with the accounting date in that tax year. For example, a partnership’s trading profits for the year ended 30 April 2021 will get assessed in the tax year 2021-22 as its accounting date (i.e. 30 April 2021) falls in the tax year 2021-22 (i.e. between 6 April 2021 and 5 April 2022).

There are special rules for the opening and closing years of a business and when there is a change in the accounting period end.

The current rules in the early years of a business (or when a partner gets appointed to the partnership) can create overlapping basis periods which result in profits being taxed twice. These amounts are given as reduction when the business ceases, or when a partner retires.  This relief is called overlap relief.

This adds to complexity, but the rules allow a significant deferral of tax when profits are rising.  For example, a business with a 30^th April year end, will not pay tax on all of its profits until 21 months after that date.

The reasons for the change

The aim of the reform to basis periods rules is to make the basic assessment for trading profits simpler and aligned with other sources of income which then link in with the government’s plans for Making Tax Digital (MTD). MTD is mandatory for self-employed businesses from April 2024.

MTD (for income tax) will apply to unincorporated businesses and landlords with an annual income exceeding £10,000. It will also apply to partnerships (that only have individuals as partners) and trusts with business or property income. All other partnerships (e.g. limited partnerships, limited liability partnerships (LLPs) and those that have corporate partners) are not required to join MTD for Income Tax in April 2024, but at a later date (to be confirmed).

These rules are to enable a tax system from the 19^th century to be shoe-horned into the digital requirements of the 21^st century.  Our view is that whilst it is disadvantageous for most unincorporated businesses, it is a necessary change.

Change from ‘current year’ basis to ‘tax year’ basis

The key reform is the move from the ‘current year’ basis to a ‘tax year’ basis, meaning that the business’s profits (for tax purposes) will be calculated for the tax year rather than for the period of account (i.e. their accounting year) ending in that tax year. The ‘tax year’ basis period will therefore run from 6^th April to the following 5^th April tax year. Businesses whose accounting period does not match the tax year will be required to apportion profits to adjust their taxable results to the tax year basis.

Example 1:

For a business which makes up its accounts to 30 April, its profits for the year ended 30 April 2022 will get assessed in the tax year 2022-23. However, with the change taking effect from 6 April 2024, this business will need to include the following results to determine its taxable profits for the tax year 2024-25:

• 1 month (i.e. one-twelfth) of the results for the year ended 30 April 2024; PLUS
• 11 months (i.e. eleven-twelfths) of the results for the year ended 30 April 2025.

Noting that the 2024-25 tax return will be due for submission by 31 Jan 2026, the accounts for the year ended 30 April 2025 may not yet have been finalised, and therefore the 2024-25 tax return is likely to contain estimated figures which will require amendment once the accounts for the year ending 30 April 2025 have been finalised.

Example 2:

This problem of estimation only gets worse for businesses which use accounting dates from 30 September to 30 March. Take, for example, a business which makes up its accounts to 31 December. Its profits for the ended 31 December 2022 will get assessed in the tax year 2022-23. However, with the change in rules, it will need to include the following results to determine its taxable profits for the tax year 2024-25:

• 9 months (i.e. nine-twelfths) of the results for the year ended 31 December 2024; PLUS
• 3 months (i.e. three-twelfths) of the results for the year ended 31 December 2025.

Noting that the 2024-25 tax return will be due for submission by 31 Jan 2026, it is highly unlikely that the accounts for the year ended 31 December 2025 will have been finalised within one month, and therefore the 2024-25 tax return will invariably contain estimated figures which will require amendment once the accounts for the year ending 31 December 2025 have been finalised.

Therefore, businesses will be faced with additional administrative burdens such as:

• two sets of tax computations (from different accounting periods) for each tax year; and
• problems with estimation and possible revisions / amendments to tax returns following finalisation of accounts (if done after the submission of the tax return).

To minimise the burden caused by having to submit tax returns containing provisional figures, HMRC have suggested some options as administrative easements and they will consult with stakeholders on these options ahead of the transitional year.

Businesses can treat an accounting date between 31 March and 4 April inclusive as being equivalent to ending at the end of the tax year and so would not have to make small apportionments of profits.

Phasing out of overlap profits (and relief)

The commencement, cessation and changes of accounting dates will no longer require the complex opening year and cessation rules as the relevant periods will simply run to and from the end of the tax years respectively. This change will eliminate ‘overlap’ profits and the need for ‘overlap’ relief in the years after the changes. However, the transitional arrangements do provide for the use of existing accrued overlap relief.

Transitional year – 2023-24

With the main changes kicking in from the tax year 2024-25, the tax year 2023-24 will be treated as the ‘transitional year’ where continuing businesses will be taxed on the following profits:

• Their profits on the ‘current year’ basis (i.e. for the 12 months to their accounting date which ends in the tax year 2023-24), PLUS
• Profits which arise in the period from the day after the current year basis period to 5 April 2024.

Depending on the accounting date of the business, this could potentially bring almost up to two years’ profits into charge for the year.

Example 3:

For a business which makes up its accounts to 30 April will need to include the following results to determine its taxable profits for the transitional tax year 2023-24:

• results for the year ended 30 April 2023 (12 months); PLUS
• results from 1 May 2023 to 31 March 2024, therefore 11 months (i.e. eleven-twelfths) of the results for the year ended 30 April 2024.

As you will see, 23 months of profits will be taxed in the transitional year 2023-24, resulting in a significantly accelerated (and increased) tax bill.

In the transitional year, all overlap relief brought forward must be used, and in subsequent years, no further overlap relief can be created.

The transitional profits (after the offset of overlap relief) can be spread over a period of 5 tax years to mitigate the cashflow impacts, and individuals can elect to be taxed on the full amount in the transitional year if they so wish. An election can also be made for the additional profit allocation to kick in at any point during the spreading period, within 12 months of the self assessment filing date for the tax year in which the taxpayer wishes to recognise the additional profits. Spreading must commence in 2023-24 and the tax charge can be accelerated thereafter. Should the source of profits cease (because of retirement or sale, for example) then any outstanding profits will be bought into charge in that year.

It has been confirmed that the transitional profit will create a ‘stand-alone tax charge’ and that it will not affect the level of taxpayer’s income that is used to calculate entitlements to relief on pension contributions and Child Benefit. It will also be possible to claim double tax relief (where relevant), e.g. credit can be claimed for overseas taxed suffered on foreign profits arising in the transitional period. An individual will also be able to claim income tax relief for relevant investments (e.g. EIS, SEIS and VCTs) against the stand-alone tax amount (as well as their other income in that year).

Although the initial rules (as per the draft proposals) penalised a business if it changed its accounting date during the transitional year (as it could then not spread any transitional profits), this has now been resolved by the Finance Act and businesses will be permitted to change their accounting date in the transitional and still spread their transitional profits over 5 years.

If a loss arises in the transitional year, then the taxpayer will be able to treat the business as ceasing on 5 April 2024 for the purposes of terminal loss relief rules and therefore this loss could then be carried back for up to 3 tax years, rather than the standard 12 months, to offset against profits taxed in those years.

Practical impacts

In the short term, while the rules may simplify certain technical and practical matters, businesses that do not make their accounts up to 31 March / 5 April will need to consider the impacts of the proposed changes in their cashflow, particularly for the transitional year 2023-24 which could be individuals paying tax in significantly increased amount of profit.

These impacts will continue to be felt going forward as the changes close the timing gap between profits accruing and being brought into charge.

The changes may be particularly challenging for large professional service firms with complex financial and tax affairs, and the impacts will need to be carefully considered and prepared for ahead of the transitional year.

Although these rules will kick-in a year later than initially envisaged, businesses will be well advised to make sure that they make best use of the extra time available.

In the longer term, these reforms may remove some of the cashflow advantages of operating through a partnership model and make it harder for partnerships to finance their working capital. Some businesses may even consider the pros and cons of moving to a corporate structure in due course.

We are seeing almost all affected businesses (due to the ongoing requirement to apportion and/or estimate profits of consecutive accounting periods) changing their accounting date to align with the tax year, e.g. 31 March or 5 April.

Businesses which do not have sufficient profits in the transitional year may find it a challenge to utilise all their overlap relief, and any unutilised overlap relief is then likely to be lost.

Some international partnerships may still have a preference for a 31 December accounting date due to tax rules in other countries, e.g. the USA. On that note, the Office of Tax Simplification are currently evaluating the pros and cons of changing the UK’s tax year end to either 31 March or 31 December, the latter being considered a more radical option, but acknowledging that there may be benefits in aligning the UK with the majority of the international tax regimes.

Please contact us should you require further clarification on how these rules affect you and your business.