The way in which the tax basis period is calculated for the self-employed and partnerships is set to be reformed ahead of the implementation of Making Tax Digital in April 2024.
How does it work presently?
At present unincorporated businesses are free to choose their accounting year-end. These profits are then taxed according to the tax year in which the accounting year-end falls. A business with a year-end of 30 September 2021 would be taxed on those profits in the tax year running from 6 April 2021 to 5 April 2022 (2021/22), with the tax payable on 31 January 2023.
HMRC thinks that the current rules have created a complex system that is difficult to understand. When a business starts or a partner joins a partnership, the ‘opening year rules’ must be applied, which can create double taxation of some profits, called overlap profits.
Any profits which have been taxed twice on the commencement of trade can then be relieved in the year of cessation of the business or upon the partner leaving the partnership. HMRC has identified that these rules are often not correctly applied, and records of any overlapped profits can often be lost as the period between commencement and cessation of a business can be many years.
HMRC also thinks that these rules can produce an unfair advantage for larger businesses which often have accounting years that are non-coterminous with the tax year. Smaller businesses will commonly have a 31 March year-end for simplification purposes. If a business has an accounting period ending near the start of the tax year this can give up to 21 months before tax is paid on those profits. HMRC are indicating that they wish to end this practice.
What are the changes?
HMRC will tax all unincorporated businesses and LLPs on a tax year basis regardless of the accounting year-end. There is no requirement to change the accounting year end of the business, just the way profits are taxed.
An example is given of a business that has a 31 August 2023 year-end, where the taxable profits would be calculated for the 2023/24 tax year by taking six months of profits from the 31/8/23 year-end and six months of profits from the 31/8/24 year-end. If the 31/8/24 accounts have not been prepared prior to the submission date of the 23/24 tax return, provisional figures can be used and the tax return amended once the final figures are known.
This is confusing, so we can see a lot of businesses changing their year ends to 31 March.
Will there be a transitional period?
HMRC knows that during the 2023/24 tax year when the new rules are rolled out, an increased amount of tax may be payable as more than 12 months of profits can be brought into account. You can offset any overlap profits but, in many cases, these may be considerably lower than current year profits as they were created when the trade was commencing.
Where taxable profits exceed the current year’s profits, excess profits can be spread over five years. It is possible to accelerate the taxation of the spread profits however, they cannot be deferred.
Making Tax Digital for Income Tax
These changes are leading up to Making Tax Digital (MTD) for Income Tax, due to be introduced from 1 April 2024 for sole traders and landlords and 1 April 2025 for partnerships. MTD sees all sole traders, partnerships, and landlords with turnover greater than £10,000 required to keep records digitally and submit quarterly updates to HMRC, with a fifth filing at the end of the year that amends or corrects any mistakes.
HMRC view moving to a tax year basis for taxing profits as a way to reduce the number of submissions taxpayers may need to do. A sole trader who is also a landlord may need to make quarterly submissions for both their business and rental profits. Rental income is taxed on a tax year basis; if the business was not taxed on a tax year basis, they will not be able to combine the two quarterly submissions, increasing the admin burden for the taxpayer.