Basis period reform

In the 2021 Autumn budget, the government announced that it would reform the way that trading profits are allocated to tax years for income tax purposes. Subsequent to this announcement, legislation has been enacted which provides that with effect from 6 April 2023, trading profits are going to be chargeable based upon those arising in a tax year rather than based upon the accounts whose end date falls within a tax year.

The changes will affect individuals who are self-employed and members of partnerships (including limited partnerships and limited liability partnerships) who do not currently draw up their accounts to the end of a tax year i.e. 31 March to 5 April.

Current rules

Under the current rules, a sole trader or member of a partnership who draws up their annual accounts to a date ending between 6 April and following 5 April would normally be taxable on those accounting profits for that tax year, e.g. if annual accounts are drawn up to 30 April 2022 the individual would be taxable on those profits for the tax year ended 5 April 2023.

The main exception to this normal practice is in the first couple of years of commencing a new venture/joining an existing partnership. In these first couple of years, if accounts are drawn up to a date other than the end of the tax year, i.e. 31 March to 5 April, profits/losses are assessed as follows:

• For the tax year in which the venture commences – The individual will be taxable based upon a time apportioned amount of any profits/losses arising from the date of commencement through to 5 April. 
• For the second tax year, profits/losses will be assessed depending upon if an accounting period ends in the tax year and the length of that accounting period as follows:

-Accounting period ends in tax year with accounts drawn up for a period of less than 12 months – The individual will be taxable based upon the profits/losses up to the accounting date plus a time apportioned amount of any profits/losses arising in the subsequent accounting period up to a date which is 12 months following commencement of the venture.

-Accounting period ends in tax year with accounts drawn up for a period of more than 12 months – The individual will be taxable based upon a time apportioned amount of any profits/losses arising for the period of 12 months up to the end of the accounting period.

-No accounting date ending in the tax year - The individual will be taxable based upon a time apportioned amount of any profits/losses arising for the period that is the same as the tax year.

By way of a simple example, if a sole trader commenced trading on 1 May 2020 and drew up the first set of accounts to 30 April 2021, the profits would have been taxed as follows:

2020/21         Taxable profits 1 May 2020 – 05 April 2021 (pro rata results for year ended 30 April 2021)

2021/22         Taxable profits 1 May 2020 – 30 April 2021

2022/23         Taxable profits 1 May 2021 – 30 April 2022

As can be seen, the individual has been taxed twice on the period 1 May 2020 – 5 April 2021. This creates “overlap relief” which is utilised either on cessation or possibly on a change of accounting period, reducing the profits chargeable. If a loss had arisen for this period, this loss could only have been utilised once and as such no overlap relief would be available.

New rules

From the tax year 2024/25, the current basis period rules as outlined above cease to apply with individuals taxable upon a time apportioned amount of any profits/losses arising for the period that is the same as the tax year.

Moving forward from the example used previously, the sole trader continues to draw up annual accounts to 30 April. For the 2024/25 tax year, the individual will then be taxed based upon a proportion (25/365) of their profits for the year ended 30 April 2024 plus a proportion (340/365) of their profits for the year ended 30 April 2025. 

Although this sounds relatively simple, it has the effect of bringing forward when the profits are taxed and may cause complexity as to how quickly the accounts for the later period need to be drawn up. This will become more difficult for those with year ends later in the tax year and may require estimates and/or amended returns to be submitted once final results are known, which will have the knock-on effect of doubling up on time and costs.

To arrive at this tax year basis for the 2024/25 tax year, transitional rules will be in place for the 2023/24 tax year.

If we continue with the above sole trader example who draws up accounts annually to 30 April, the individual will be taxable on profits during this transition period as follows:

2022/23          Taxable profits 1 May 2021 – 30 April 2022

2023/24         Taxable profits 1 May 2022 – 5 April 2024 less any overlap relief

2024/25          Taxable profits 6 April 2024 – 5 April 2025

As can be seen, for the 2023/24 tax year, the sole trader is being taxed on profits for approximately 23 months less any deduction for overlap relief which may be available. For those individuals whose profits have increased substantially since the overlap relief was created, the additional eleven months of profits being taxed is likely to be substantially more than the overlap relief available.

To the extent that the 2023/24 taxable profits calculated above exceed the taxable profits for the year ended 30 April 2023, spreading provisions may apply. These excess profits are called “transition profits” and can be spread equally over five tax years including 2023/24, but the individual can elect to be taxed on them sooner. It should be noted that these spreading provisions only apply to trading profits. Where a partnership has other sources of income, these will be taxed in full in the year of transition.

The changes were originally planned in order to implement Making Tax Digital for Income Tax (MTD). Whilst the implementation of MTD has been delayed recently from 6 April 2024 to 6 April 2026, these changes in basis periods will still go ahead from 6 April 2023.

For those affected, we would suggest that the following are considered:

• Whether a change in accounting period is appropriate
• Cashflow implications of the change