Jenna McArtney
The government announced in the Autumn Budget 2021 that it would reform the way that trading profits are allocated to tax years for income tax purposes.
Broadly, the intention 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. This reform affects individuals who are self-employed, 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).
The changes are intended to take effect from the 2024/25 tax year, with transitional rules applying in 2023/24, here’s what you need to know:
The current rules (“current year basis”)
As it currently stands for income tax purposes, trading profits for a tax year are based on the profits for a 12-month accounting period ending in that year. This is called the “current year basis,” and the period being taxed is known as the “basis period.”
There are special rules that apply in the opening and closing years of a trading business under this basis. In the year that a trade begins, taxable profits are normally based on a time-apportioned amount falling between the date of commencement and 5 April. In the second year, profits for the first 12 months of trading are normally taxed.
If an individual chooses an accounting date other than 31 March or 5 April, they may face certain challenges. For instance, if their first accounts run from 1 March 2021 to 28 February 2022, they will need to file their first tax return for the business using provisional figures because the accounts may not be final yet. They will also need to determine the overlap profits figure and report it on their tax return each year until it is relieved.
Overlap profits occur when the accounting periods do not align with the tax year, resulting in some profits being taxed twice. To remove this complication, the government is seeking to remove the calculation and recording of overlap profits in its reforms.
The new basis from 2024/25 (“tax year basis”)
Starting from the 2024/25 tax year, taxable profits will be based on time-apportioned profits of the accounting periods that fall within the tax year. This means that 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.
While this seems straightforward, it may cause practical difficulties.
The 2024/25 tax return (or digital equivalent) is due by 31 January 2026, and it is unlikely that traders will be able to finalise their accounts and tax adjustments for the 2025 calendar year accounts in time. Therefore, it will be necessary to file based on provisional figures and then revise the return later once the true figures for the later accounting period are known. This process would need to be repeated every year, which could be challenging for many businesses.
Transitional rules in 2023/24
For traders whose accounting periods don’t align with the tax year and who don’t cease trading in the year, the profits in 2023/24 will be based on the period from the end of the 2022/23 basis period to 5 April 2024, with a deduction for any unrelieved overlap profits.
This means that if a trader draws their accounts to 31 December every year, their 2023/24 profits would be based on the 2023 calendar year accounts together with 96/366ths of the 2024 calendar year accounts, minus any unused overlap profits that arose in the opening years of trading.
If the profit figure exceeds the profits for the first 12 months of the extended basis period, spreading provisions apply. These are called “transition profits” and are spread equally over five tax years, including 2023/24. Any untaxed transition profits are taxed automatically when the trade ceases.
However, many respondents to the consultation noted that the acceleration of profits over five years would create anomalies for various allowances and tax charges that hinge on the individual’s level of income.
To mitigate this, the legislation included provisions that remove the transitional profits from the main tax computation and create a standalone income tax charge. This helps to prevent some anomalies, but not all, such as the personal allowance taper anomaly. Losses may arise if unrelieved overlap profits exceed the profits for the extended basis period. If this happens, extended loss reliefs may be available, and the loss can be carried back and set against profits of the same trade in the previous three tax years. Other loss reliefs may also be available.
Although the changes have been badged as a simplification, they generally create complexity for the individuals and partnerships affected. In principle the complexity can be avoided by aligning the business’s accounting period to the tax year.
The team at MMG are continually keeping up to date with changes to legislation to understand what this means for your business and how we can make it as easy as possible for you to stay compliant. We’re always here to help you keep your ducks in a row.