Tax Talk: Changes to basis period

what they mean for you

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Many businesses will be affected by an HMRC proposal to bring basis periods in line with the tax year.

HMRC has published draft legislation and a consultation on the reform of ‘basis periods’ for the taxation of trading income. It will affect sole traders, partnerships and all unincorporated businesses. The proposed reform aims to simplify the reporting of business profits to HMRC under the Making Tax Digital rules which come into effect in the tax year 2023/24.

Generally, businesses draw up annual accounts to the same date each year, called the ‘accounting year end date’. Currently, a business profit or loss for a tax year is the profit or loss for the year to the accounting date falling in the tax year, called the ‘current year basis period’. Specific rules apply to determine the basis period for early years of trading (where there is a change of accounting year end date) and in the year of cessation.

The proposal means that, for all such businesses, the taxable profit will instead be based on the actual profits for the tax year. HMRC are promoting this change as a simplification, which for people starting out in business in the future is likely to be the case, removing the situation where the profits in the opening years are in effect taxed twice, with relief only available when the business ceases.

The new rules begin from the tax year 2023/24, though there will be a transition to the new rules for the tax year 2022/23 – which is only seven months away.

Who will be affected?

The proposed changes will affect individuals, partnerships and trusts with trading income, including income from a profession or vocation.

For those with an accounting date of 31 March or 5 April, the new rules will have no significant impact, as this will be treated as equivalent to the tax year. But businesses with other accounting year end dates will be affected, some more than others.

The proposed reform

Businesses with accounting year ends other than 31 March or 5 April, will have their taxable profits determined according to the accounting periods covering the tax year. For example, for a business with a 31 December year end, its profit for the tax year 2023/24 will be 9/12 of the profit for the year ending 31 December 2023 plus 3/12 of the profit for the year ending 31 December 2024.

Businesses with accounting dates later in the year may not have the second set of accounts prepared by the tax return filing date for that tax year. That means they may need to estimate the taxable profits in the tax return, and confirm or amend the overall taxable profit at a later date.

The proposed tax year basis should simplify the reporting of quarterly updates for trading income under the Making Tax Digital rules which begin from the tax year 2023/24. 

Transition period

The tax year 2022/23 will be a transition period and, depending on the business’ accounting year end, may have a significant effect on the taxable profits for that year.

The profit for tax year 2022/23 will be made up of two parts. Firstly, the accounting year ending in the tax year 2022/23 (the old current year basis period) and, secondly, the actual profits from the end of the accounting period used in the first part – up to 5 April 2023. Here is an example:  

For a business with a 30 April year end the taxable profit will comprise two components:

· profit for the year ended 30 April 2022 – the standard/current year component
· profit from 1 May 2022 to 5 April 2023 – the transitional component.

Here, profits for a 23-month period will be taxable in the year 2022/23. To compensate for this concentration of taxable profits, any ‘overlap profits’ carried forward from earlier years of trade must be deducted from the profits of the transitional year. However, in many cases it is likely to be the case that relief for overlap profits in early years will be far lower than the additional months’ profits that are subject to tax in 2022/23. Therefore, where profits in the transitional tax year are higher than if calculated on the current basis, the Government proposes an election to spread any ‘excess profit’ over a period of up to five tax years.

Begin tax planning now

The time scale for this standardisation of the tax year basis is extremely short and, for many businesses, the impact on cash flow will be significant. It may be beneficial to consider changing the accounting year end date before the new rules come into effect, and to plan carefully for the cash flow impact on increased tax payments and ongoing Making Tax Digital reporting. 

Some of the advantages of operating a business under the partnership model will be diminished under the new rules. Businesses may consider incorporating to a ‘limited company’ falling under the corporation tax regime.

These are fundamental changes to the basis period for charging tax. For many they will mean having to pay tax on trade profits earlier than before. Businesses should seek comprehensive tax advice to make sure they fully understand the proposed reform and its’ real impact, so that they are in the best position to operate under the new rules.