Basis periods reform – potential implications for unincorporated businesses

The Government has issued draft legislation covering proposed changes to basis periods. This may seem a dry, technical subject but it will have far-reaching cash flow and administrative costs for many unincorporated businesses.

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 the 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 all tax on its profits until the January 21 months after that date.

Company tax rules are different and are not proposed to change.

Proposed changes

The proposal is that businesses will be taxed on the profits arising in a tax year for 2023-24 onwards (with a transitional year in 2022-23). The reform aims to make the basis of assessment for trading profits simpler and aligned with other sources of income which then links in with the government’s plans for Making Tax Digital (MTD). MTD is mandatory for self-employed businesses from April 2023.

MTD (for income tax) will apply to unincorporated businesses and landlords with an annual income exceeding £10,000. It is intended that the rules 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 2023, but at a later date (to be confirmed).

These proposals are to enable a tax system from the 19^th century to be shoe-horned into the digital requirements of the 21^st century. The proposed changes to basis period rules include:

• from 2023-24, the profits of the tax year will be the profits arising in that tax year with accounting period profits being apportioned by the number of days or another reasonable basis
• the basis period for the transitional year of 2022-23 will be the current year basis period profits plus the profits which arise in the period from the day after the last current year basis period ends to 5 April 2023
• in the transitional year of 2022-23 all overlap relief brought forward must be used and in subsequent years no further overlap relief can be created
• any additional profits arising for the business under the new rules will be spread over five tax years starting in 2022-23 with an option to elect to accelerate the tax charge
• trading and property 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
• the same basis period reform would apply for businesses that currently use the cash basis to calculate their profits
• the proposals apply to the self-employed, partnerships, trusts and estates with trading income, but they will not affect companies apart from some non-resident companies.

Whilst the proposed change would go largely unnoticed by businesses that use an accounting date of 31 March or 5 April, these changes could be very problematic for businesses that use a different accounting date, such as one later in the tax year. Some of the challenges include:

• two sets of tax computations (from different accounting periods) for each tax year
• problems with estimation and possible revisions/amendments to tax returns following finalisation of accounts (if done after the submission of the tax return)
• acceleration of the tax liabilities in 2022-23 for some businesses who are increasing in profitability
• the spreading of the additional tax charge (from 2022-23) over five years could cause a problem if a partner leaves a partnership during those five years with a tax debt, although further detail will be confirmed after the consultation on the draft legislation.

Therefore, in practice, most businesses may move their accounting date to say 31 March to deal with the challenges above and most accountants will need to process their clients’ accounts at a similar time, unlike phasing their work through the year based on different clients’ accounting dates.

Some partnerships which are owned by members resident in the USA will invariably have their accounting date as 31 December (so as to comply with US tax rules) and these could continue to face the above challenges in so far as the UK tax regime is concerned.

The Government has published a consultation on the proposals which closes on 31 August 2021. The final contents of the Bill will be subject to confirmation in the Autumn.

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