Basic Period Reform

Finance Bill 2021-22 includes legislation implementing the basis period reform first proposed in the summer. The reform aims to move from taxing sole traders and partnerships that are subject to income tax, from the current method which is generally to tax profits arising to an accounting date ending in a tax year, to taxing such businesses on the profits arising in a tax year.

Whilst this is still an evolving topic, it is unlikely to go away and sole traders and partnerships who do not prepare their accounts by 31 March or 5 April will need to act and consider their positions sooner rather than later.

So, what does this mean?

In the transitional year which is expected to be 2023/24, businesses that do not have an accounting year end date between 31 March and 5 April will need to recognise two profit elements:

• The ‘standard part’ – is the profit on the 12 months’ worth of trading beginning with the start of the basis period and ending in the transitional year
• The ‘transitional part’ – is the profits in respect of the period beginning immediately after the end of the basis period and ending on 5 April 2024.

As you can see from the above, this will mean nearly two years of profits fall into the 2023/24 tax year. Reliefs are available in the form of overlapped profits and spreading, as explained below.

If the business has any overlap profits, it must offset these against the profits of the 2023/24 tax year. There is no facility to allow the business owner to defer the use of overlap relief and save it up to use on a subsequent occasion (e.g., on retirement).

Following several steps involving the deduction of overlap relief and comparison of the amount of the standard part and transitional part, two numbers arise:

• transition profits; and,
• the profits of the tax year 2023/24 (generally the share of the transition profits for 2023/24 plus the standard profit if that was more than nil).

Having calculated the transition profits (after the offset of overlap relief) you are going to be allowed to spread them over five tax years, beginning with the transitional year itself.

While spreading helps to mitigate the cash flow impact of recognising in some cases nearly two years’ worth of profits in one tax year, it has other unwanted consequences. For example, under the original draft of the legislation published in the summer, for those years over which the transitional profit is spread, taxable income would have been increased for the purposes of determining entitlement to personal allowances and the imposition of charges such as the high-income child benefit charge.

Changes introduced in the Finance Bill mitigate this effect however, this also has other repercussions, the most significant being that no credit can be claimed for overseas taxes suffered on the profits being spread. This particularly impacts overseas partnerships with a UK taxable presence and UK partnerships with overseas operations.

If a loss arises in the transitional year, the taxpayer can treat the business as ceasing on 5 April 2024 for the purposes of the terminal loss relief rules. This means that this loss can be carried back for up to three tax years, rather than the standard 12 months, to offset against profits taxed in those years.

From the tax year 2024/25 onwards, owners will be taxed on the profits their businesses generated in the tax year concerned, calculated using a pro-rated proportion of the profits for the accounting periods falling partly in each tax year.

Building on the example above of a business with a 30 April accounting date, in 2024/25, the default position is that the business would be subject to tax on 25 days’ worth of profits from the accounting period ended 30 April 2024 (6 – 30 April 2024) and 340 days’ worth of profit out of the period ended 30 April 2025.

The business can choose to use a different method of measuring the length of the two accounting periods if this is reasonable.

One of the challenges the system of allocating profits from different accounting periods introduces is the fact that the profits from the later accounting period might not be known at the time of the allocation and so will need to be estimated.

The end of the period statement (under Making Tax Digital) and the business owner’s self-assessment tax return will need to be filed by 31 January 2026 for the 2024/25 tax year. If that business has an accounting period ended 31 December 2025, it will only have ended one month prior to this filing deadline. In many cases, this will not leave enough time for accurate accounting figures to be produced by the deadline and hence estimates will need to be used.

Once the final accounting results have been determined and taxable profits calculated, it is likely that an amended return will be filed to reflect these.

As you can see from the above, this is not going to be simple and could have a major impact on sole traders and partnerships that don’t currently prepare their accounts for 31 March or 5 April. Careful consideration will need to be given to determine how best to handle this and no two situations will be the same. Changing to a 31 March or 5 April year-end may seem like the easiest solution but may not suit all businesses.

If you are concerned about how this will impact your business, please contact us.