In the Autumn Budget 2021, the government announced that it would reform the way that trading profits are allocated to tax years for income tax purposes. The changes were then legislated in Finance Act 2022.
What’s behind the change?
The intention behind the change is to tax profits that are time-apportioned to the tax year instead of the profits for the 12 months to the accounting date in the tax year.
The changes are intended to simplify taxation, but they can create complexity for the individuals and partnerships affected.
Who is affected?
Individuals who are self-employed will be affected, including partners in trading partnerships, if their accounting periods are not aligned to the tax year. Dates from 31 March to 5 April inclusive are treated as aligned to the tax year for this purpose.
Whilst the changes are intended to take effect from the 2024/25 tax year, transitional rules will apply in 2023/24.
What are the current rules?
For income tax purposes, trading profits of a tax year are generally based on the taxable profits for the 12 month accounting period ending in the tax year. So, if an individual prepares their accounts to 31 December, the 2021/22 taxable profits would be based on the accounts for the year ended 31 December 2021.
This is known as the “current year basis” and the period being taxed is the “basis period”.
Opening and closing years of a trading business under “current year” basis
There are special rules in the opening and closing years of a trading business. In the tax year that the trade begins, the taxable profits are normally based on a time-apportioned amount falling between the date of commencement and 5 April.
In the second year, the profits for the first 12 months of trading are normally taxed. If an individual commenced trading on 1 January 2021 and prepared their accounts to 31 December 2021, the 2020/21 profits would therefore be 95/365ths of the profits of the 2021 accounts and the 2021/22 profits would be based on the full 2021 calendar year.
Overlap profits and overlap relief
In situations such as that described above, part of the profits would be taxed twice – this is known as “overlap profits”. The doubly taxed profits are then deducted from the trading profits in the year the trade ceases to eliminate the double taxation – this is known as “overlap relief”. This can happen earlier in some cases if there is a change of accounting date.
If the accounting periods are all aligned to the tax year then overlap profits do not arise which is why many traders choose accounting dates of 31 March or 5 April.
What are the new rules?
From 2024/25, taxable profits will be based on time-apportioned profits of the accounting periods that fall within the tax year – “tax year basis”.
If a trader draws their accounts to 31 December every year, their 2024/25 taxable profits would be based on 270/366ths of the 2024 calendar year profits and 95/365ths of the 2025 calendar year profits.
Although this sounds straightforward, it can be complicated. The 2024/25 tax return is due by 31 January 2026. Most traders will struggle to finalise the accounts and tax adjustments for the 2025 calendar year accounts in time so they will have to file based on provisional figures and then revise the return once the actual figures for the later accounting period are known.
This exercise would then be repeated every year thereafter. HMRC acknowledges the additional administrative burden and they are exploring ways to ease this.
What are the rules for 2023/24?
There are “transitional rules” for 2023/24.
The 2023/24 tax year will act as an alignment year for many businesses that do not date their accounts to 31 March or 5 April.
This re-alignment of tax years will incur an advancement of tax liabilities for these businesses.
As an example, if the trader prepares accounts to 31 December every year, the 2023/24 profits would be based on the whole of the 2023 calendar year accounts together with 96/366ths of the 2024 calendar year accounts, with a deduction for any unused overlap profits that arose in the opening years of trading.
To the extent that this profit figure exceeds the profits for the first 12 months of the extended basis period, spreading provisions apply. These are called “transition profits”. Transition profits are spread equally over five tax years, including 2023/24, but the trader can elect to be taxed on them sooner. Any untaxed transition profits are taxed automatically on cessation of the trade.
Are there any complications?
The acceleration of profits for five years creates some complications depending on the individual’s level of income, for example the £100,000 limit for the personal allowance or the £50,000 limit for High Income Child Benefit Charge. The Finance Act includes provisions to mitigate the impact of this by removing the transitional profits from the main tax computation and creating a standalone income tax charge. The provisions prevent some anomalies, such as the High Income Child Benefit Charge, but the personal allowance taper anomaly remains.
The transitional rules will also result in some businesses recognising nearly two years’ worth of profits in one tax year, which can lead to increased tax bills and potential cash flow issues.
What about losses in the transitional year?
If a loss is received 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.
What you should be thinking about now:
- Look at the cashflow implications of the changes and consider how you will manage them.
- Would a change in your year end to 31 March make the calculation of taxable profits from 2024/25 clearer?
- Get in touch with us so we can help us ensure you are prepared for the transition.
Please contact us should you require further clarification on how these rules affect you and your business.
Disclaimer
The information was correct at time of publishing but may now be out of date.
