What is Being Put in Place?
The objective is to tax profits based on the tax year instead of the profits for the 12 months to the accounting date in the tax year. The changes will take effect from the 2024/25 tax year, with transitional rules applying in 2023/24.
The 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).
Potential for Added Complexity
Although the changes have been positioned as a simplification, they can 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, but in practice there are often commercial or international tax considerations that make this impractical.
HMRC have acknowledged that the changes will create additional administrative burdens for these taxpayers. HMRC consulted on ways to ease these burdens but confirmed that they would only implement very limited easement, which in practice is unlikely to provide much benefit to the taxpayers affected.
The Changes in More Detail
The current rules are known as the ‘current year basis’, where for income tax purposes, trading profits of a tax year are generally based on the profits for the 12 month accounting period ending in the tax year (subject to adjustments for disallowed expenditure, depreciation etc).
For example, if an individual compiles their accounts to 31 December every year, the 2022/23 taxable profits would be based on the accounts for the year ended 31 December 2022.
Special rules apply in the opening and closing years of a trading business under the current year basis but they are outside the scope of this note.
‘Tax Year Basis’ – the New Basis from 2024/25
From 2024/25, taxable profits for traders who’s accounting period is not aligned with the tax year, will be based on time-apportioned profits of the accounting periods that fall within the tax year. For example, 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.
Whilst this is relatively simple on paper, it will cause difficulty in practice. The 2024/25 tax return is due by 31 January 2026. Unless the business is very simple, it is unlikely that the trader will be able to finalise the accounts and tax adjustments for the 2025 calendar year accounts in time. It is therefore 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 exercise would be repeated every year thereafter.
Transitional Rules in 2023/24
For traders whose accounting periods are not aligned to the tax year, and who do not 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.
For example, if the trader draws their 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.
Anomalies that May be Created
- During the consultation process, many respondents noted that the acceleration of profits for five years would create anomalies for various allowances and tax charges that hinge on the individual’s level of income. The legislation included provisions that were intended to mitigate the impact by removing the transitional profits from the main tax computation and creating a standalone income tax charge. The provisions are effective in preventing some anomalies but not all.
- Losses may arise in the transitional year, if the unrelieved overlap profits exceed the profits for the extended basis period. To the extent that the loss has been generated by the overlap relief, extended loss reliefs may be available. The loss can be treated as a ’terminal loss’, which 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.
Interaction with Making Tax Digital for Income Tax
HMRC state that this reform is needed in order to implement Making Tax Digital for Income Tax (MTD). Under MTD, businesses will be required to send quarterly digital updates to HMRC, based on transactions in tax year quarters, and provide a digital ‘End of Period Statement’ to finalise the taxable profit for the tax year. For partnerships, this would include the allocation of the profits of the tax year to the relevant partners.
For most sole traders with turnover exceeding £50,000, MTD is mandated from 6 April 2026. This will be extended to sole traders with turnover exceeding £30,000 from 6 April 2027. The government is consulting on how the regime should apply to smaller businesses. Partnerships will be brought into MTD at a later undefined date.
Assistance and Additional Information
For assistance regarding the taxing of profits time-apportioned to the tax year or if you require any additional information, please contact Paul Webb at Dixcart UK: firstname.lastname@example.org