Basis Period Reform and non-trading income could have significant cash flow impact for partnerships

Jenni York , Personal Tax Assistant Manager, gives insight on Rising Interest Rates: Navigating Cash-Flow Challenges and Tax Implications for Partnerships

Between December 2021 and August 2023, the Bank of England’s base rate was hiked 14 times; from an all-time low of 0.1 per cent to the current level of 5.25 per cent.? A significant challenge for some, but an opportunity for others.? The interest rate increases have been challenging for individuals and businesses with borrowings, on top of the “cost-of-living” crisis, amplifying the squeeze on finances and highlighting the importance of effective cash-flow management. ?

In contrast, savers and businesses that regularly hold large amounts of cash on deposit, such as law firms holding client monies on account, have benefitted from the interest rate increases.

Partnerships with high interest income will have seen profits increase over the last couple of years, and will have also experienced a cash-flow advantage. ?However, there may be an unwanted sting in the tax tail for businesses affected by the Basis Period Reforms being implemented in the 2023/24 tax year. ?These new rules were introduced in Autumn 2021, when interest rates were at a historic low of 0.1 per cent. ?Whilst partnerships may have prepared cash-flow forecasts at that time, planning to reserve sufficient funds for the accelerated tax liabilities caused by the Basis Period Reforms, revisiting the cash-flow position is essential for affected partnerships, in light of the increased interest rates, because of the way the Basis Period Reforms apply to non-trading income, as explained below.

Overview of changes – a recap

?Our previous article on the Basis Period Reforms highlights that the rule changes will affect unincorporated businesses, including partnerships and sole-traders, with accounting year-ends that do not fall between 31 March and 5 April.?

?The Basis Period Reforms mean partnerships will be taxed on profits on a tax year basis, even if their accounting year-end does not align with the tax year.? The changes remove the cash-flow benefit that partnerships previously enjoyed by having a year-end that did not match the tax year. ?Previously, a partnership with a 30 April year-end would have settled its partners’ tax liabilities 22 months after those profits were generated, whereas a partnership with a 31 March year end would be settling tax liabilities for the partners just 10 months after the year-end. ?

?The option, following the reforms, to spread the additional trading profits over a period of five tax years should ease the cash-flow burden. ?However, there is an easily overlooked aspect of the new rules which will have a significant cash-flow impact for partnerships with high levels of non-trading income, such as bank interest.?

Non-trading income – what is the impact?

?Critically, the spreading of additional profits over five tax years is only available for trading profits.? The same provisions do not apply to non-trading income.?

?Non-trading income will typically include bank interest, investment income, and rental income.? As the spreading provisions are not available for non-trading income, partners will be subject to income tax on more than 12 months’ worth of non-trading income in the 2023/24 tax year. ?The resulting tax liability will be due on the usual payment date of 31 January, with the payment on account due by the following 31 July also affected.? For partners in a partnership with a 30 April year-end, for example, this would mean that non-trading income for the entire 23 month period covering 1 May 2022 to 31 March 2024 would be taxable in the 2023/24 tax year.?

?The payments on account required towards tax liabilities for the 2024/25 tax year will also increase, so should be reviewed for each partner to ensure they are not excessive. ?Reducing the payments on account, if appropriate, will help the partnership’s cash-flow position.

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An example to illustrate the cash flow issue

?For a partnership with a year-end of 30 April, the position could be as follows:

?The Facts:

?Partner subject to tax at 45 per cent.?

Partner’s annual share of partnership interest is ￡100,000

Brought forward non-trading overlap profits of ￡10,000

2023/24 tax year

The partner would be assessed on interest income of ￡183,169 (￡100,000 + (￡100,000 x 341/366) - ￡10,000)).?

There is extra taxable income of ￡83,169 (interest income) in the 2023/24 tax year,

The partner’s tax payment due by 31 January 2025 would increase by ￡37,426.?

Payments on account for the 2024/25 tax year would also increase, so will need to be reviewed.

Conclusion – some unintended consequences with significant cash flow impacts

?There are unintended consequences as the Basis Period Reforms are being introduced during a period when interest rates have significantly increased. ?For partnerships this means that it will not be uncommon for non-trading income to make up a significant proportion of a partner’s share of profits in the 2023/24 tax year with the significant cash flow implications highlighted above.? Partnerships should therefore revisit their cash-flow forecasts.

?With tax payments for the 2023/24 tax year due early in 2025, partnerships with high interest income should revisit their cash-flow position now.? This will enable them to plan and if necessary arrange to borrow funds to settle partners’ tax liabilities; challenging when interest rates are at their highest rate for 16 years.

?If you need any support reviewing a partnership’s tax affairs or cash flow position, please contact Jenni York or your usual Shaw Gibbs contact.