The way we allocate profits to tax years for sole trade and partnership businesses is set to change in the 2023/24 tax year. The current system used to allocate profits was designed in the 1920s and creates a situation whereby businesses that do not have an accounting period that is aligned with the tax year may pay tax on profits in a certain period twice. This is called an overlap period. The current system allows businesses to declare profits of an accounting period in whatever tax year that period ends. Going forward, no matter what your accounting period, you will be assessed on the profits arising in the tax year.
Speaking personally, there was nothing that terrified me more when I was sitting my accountancy exams than basis periods. Therefore HMRCs argument that the complex system currently in place results in many thousands of errors on tax returns every year, rings true to me. It also, no doubt, helps that this reform will result in a bumper tax collection over a 4 year period which is currently estimated at £1.715bn.
How will this work in practice?
The Transitional Year
In the transitional year, 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’ – being the profit of the 12 months’ worth of trading beginning with the start of the accounting period ending in the transitional year (23/24)
• The ‘transitional part’ – being the profits in respect of the period beginning immediately after the end of the basis period and ending on 5 April 2024.
[Example: A business has an accounting period end date of 30 September. Their standard part will be the period 1 October 2022 to 30 September 2023 and their ‘transitional part’ will be the period starting 1 October 2023 and ending on 5 April 2024.]
Using Overlap Relief
Against this aggregated profit period, the business must offset overlap relief (this reduces the profit by the element of profit that was taxed twice when you initially commenced trading). There is no restriction on this relief.
If the offsetting of overlap profits in the transitional year results in a loss you can claim relief by applying this loss against profits of the previous three tax years on the basis of ‘terminal loss relief’ rules.
Spreading the Tax effect and Mitigating other problems
The element of additional profit attributed to the transition can be spread over a five year period. There is scope for accelerating the recognition of all or part of these profits, and recognising them unevenly over the five year period. This will allow some tax payers to avoid higher rates of tax.
In order to prevent this blip affecting peoples eligibility for personal allowances, child benefit and other means tested benefits, the net profit that will be declared on the return will only be the ‘standard part’. Additional tax will be added on in respect of the amount of the ‘transitional part’ that is being declared in that year.
After the ‘Transition’ – Tax years 2024/25 and onwards
If you choose to maintain an accounting period that does not tie in with the tax year end, then you will be required, on a yearly basis to declare profits on the basis of a pro-rating of the accounting profits of two different years. In many cases the difficulty with this is the fact that the profits from later accounting periods might not be known at the time of allocation and so will need to be estimated. This also makes it likely that post submission deadline adjustments will be required to returns however HMRC are reviewing this particular issue with consultees at the moment and there may be some other flexibility introduced to the system to ease this particular issue.
What you need to consider
Firstly you need to consider whether it might be easiest to change your accounting period to fall in line with the tax year, as it will save you administrative headaches down the line. In reviewing this you should also consider the impact that Making Tax Digital for Income Tax is going to have on your business when it is introduced on 6 April 2024.
You need to consider the cashflow impact this might have on your business, particularly if you have low overlap profits. Do you need to review your overdraft facility?
Consider the impact this will have on your requirement to prepare your accounting information for your accountant. A business with a 30 April accounting year end date used to have 22 months to draw up accounts before the self assessment filing deadline. These businesses will now have 10 months. If bookkeeping efficiency is an issue for you then consider whether a software change, or more external assistance is needed.
JRW are here to help you prepare for this change. If you want to talk through your options please get in touch.
Updated By Christiaan Hansen, Head of Tax, November 2023