Taxing times

Adam Bernstein
Monday, December 20, 2021

Towards the end of the summer, HMRC announced a consultation on proposals which would radically alter how unincorporated businesses – sole traders and partnerships – are taxed.

To many, the concept simplifies what is already a complex tax regime. But to others, it carries the risk of more administration and greater levels of taxation. Termed ‘Basis Period Reform’, the changes were originally due to transition in from April 2022, but following feedback, this was put back a year to April 2023.

Kirsty Swinburn, a tax senior manager at BHP, says that the new system will apply to all sole traders and partnerships and “will mainly affect those businesses that currently have anything other than a 31 March or 5 April accounting year-end”.

According to an estimate reported by the Financial Times, some 280,000 sole traders and 250,000 partners could be caught up in the change based on 2019/20 tax returns. And this estimate is backed by Richard Wild, head of Tax Technical at the ATT: “The government says that 93% of sole traders and 67% of partnerships already draw up their accounts to 31 March or 5 April, and so won’t be affected by the changes. So, the impact is limited to the 7% of sole traders and 33% of partnerships that use a different accounting date. But that’s still around 528,000 individual taxpayers.”

The proposals

To understand the changes, Wild says it’s important to consider the current position. He explains that at present, “businesses are taxed on the profits they make in their accounting period which ends in the relevant tax year. The UK’s tax year runs from 6 April to the following 5 April. So, under the existing rules, if a business has an accounting year-end of 31 December, for the tax year 2021-22 it will be taxed on the profits for the year ended 31 December 2021 as that is the accounting date which falls in the 2021-22 tax year.”

He continues: “But when the new rules are in place, and if the business does not change its 31 December accounting date, in the tax year 2024-25 the business will be taxed on 9/12 of its profits arising in the accounting period ended 31 December 2024, plus 3/12 of its profits arising in the accounting period ended 31 December 2025.”

As Swinburn outlines, under the government’s proposals, “businesses will be taxed on profits earned in a given tax year, irrespective of their accounting year-end, with an apportionment being applied if required”.

Fortunately, as part of the reform, 31 March will be deemed as equivalent to 5 April. Many businesses use 31 March as their accounting date, so this is a sensible change.

Bringing the change in

The question for many is when the change will begin. On this Swinburn says that as the proposals presently stand, the ‘tax year basis’ would replace the ‘current year basis’ entirely from 2024/25.

“However,” says Swinburn, “2023/24 will be the transitional tax year and the transitional adjustments involving the use of the historic overlap profits may, depending on profit levels, increase the tax liability for that year. Any additional tax would be payable 31 January 2025.” 

‘Overlap profits’ describes a part of a tax period that has been taxed twice. It nearly always occurs in the second year of trading. If an account period end date of 31st March or 5th April is selected, no overlap profit arises.

In explaining how the transitional year will work, Wild says that it’s designed to “allow the current basis period rules to ‘catch up’ with the new regime”. So, with the above example, he says that in 2023-24, profits would be taxed on the year ended 31 December 2023 plus 3/12 of the profits for the year ended 31 December 2024.

But with the potential for tax to be paid twice because of the overlap, he adds that there are proposals to allow a five-year spread of the additional tax for those businesses adversely affected “to prevent a big tax bill arising in the transition year”.

And Swinburn agrees, saying that having accounts that straddle two years can create complexities, particularly in “the opening years of a business when profits can be assessed twice, and ‘overlap’ profits created. This overlap is used when the business ceases, but the value is often eroded by time, or lost if a record isn’t kept”.

What to do

As to what to do next, many businesses will no doubt want to consider changing their year-end to either 31 March or 5 April, “both of which,” says Swinburn, “are accepted as aligning with the tax year.” But she cautions that “consideration should always be given to any industry-specific factors” before making changes.

In explaining more on this, Wild points out that some businesses might have a particular accounting period date because it is appropriate for their business. “Also,” he says, “those with international connections, such as professional partnerships, have an accounting date which aligns with their international counterparts.” In other words, there will be many businesses unwilling or unable to change their accounting date.

That said, Swinburn says that for those businesses currently experiencing poor trading results, arising from the pandemic for example, early adoption of a 31 March on 5 April year-end may be beneficial. But she, again, says that “this needs to be looked at on a case-by-case basis and professional advice should be sought”.

And for those sole traders and partners in businesses with anything other than a 31 March or 5 April year-end Swinburn’s advice is that they “should ensure they have a record of their overlap profits as relief for this will need to be claimed in the 2023/24 tax year at the latest. This figure should have been recorded on the tax return each year”. Again, professional advice may need to be sought if it hasn’t.

Wild too recommends that taxpayer’s seek advice. But this, for him, yields up another problem. While most affected businesses are likely to have an accountant or tax adviser who will help them navigate the changes and decide on the most appropriate course of action, “around 20% of affected businesses do not have an adviser, and they might need to find someone to help, or hope that HMRC’s guidance and helplines will provide adequate support”.

To this he adds that any business owner that misses the changes will, at a minimum, end up paying the wrong amount of tax. But, he adds: “There could be more serious consequences, such as penalties, or missing out on allowances and reliefs that might otherwise have been available”.

Of course, there is nothing written down in the proposals that requires businesses caught by the proposals to change their accounting year-end but as Swinburn details, “businesses that don’t will need to do an apportionment each year”.

And there’s one last problem noted by Wild, and it’s one that’s a function of time where accurate accounting figures may not yet be available.

He refers back to his example where the tax return for the 2024-25 tax year is due by 31 January 2026: “3/12 of the profits arising for the year ended 31 December 2025 must be reported in [that] return as those profits are being taxed in 2024-25. But it is highly unlikely that the accounts for the year ended 31 December 2025 will have been prepared by 31 January 2026 – just one month later.” His point is that if the return is to be filed on time, it will be necessary to include estimates of those profits, which will then need to be corrected later. More administration for taxpayers to cope with.

What comes next

Swinburn highlights that the proposed reforms are all part of the government’s Making Tax Digital (MTD) programme. MTD has been in place for VAT for a number of years now and she says that “MTD for Income Tax is scheduled to be introduced from 6 April 2024, so aligning with the start date for these is part of the proposed reforms”.

Swinburn notes that MTD for Income Tax will apply to all self-employed businesses and landlords with annual business or property income above £10,000. She says that “at its core is a requirement for quarterly reporting, a process which will be much simpler if all businesses are on a tax year basis for the assessment of profits.”

Nevertheless, as to how these proposals are regarded, Wild comments that there is scepticism that the proposals will bring any real simplification, as “it seems to swap one set of largely one-off complexities that arise when a business commences or changes its year-end, with recurring complexities based on apportionment and estimation.”

And even with the extra year to bring the change in, he thinks that “it’s all very rushed, even though we are dealing with – in the government’s words – ‘the fundamental building blocks of the tax system’”.

To his mind, “the simplification claims seem questionable, and more realistically that it’s to facilitate the introduction of MTD for ITSA... although it’s hard to ignore the £2bn-plus tax revenues this measure will generate.”

Summary

So, while in general the proposed change seems a sensible one, there will be winners and losers. From a professional standpoint, it’s clear that as both Swinburn and Wild note, taking early advice on a taxpayer’s particular circumstances is essenti

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