April 2023 will bring a major shake-up of the rules dictating when trading profits of unincorporated businesses are subject to income tax. The existing rules, which tax the profits of the accounting period ending in a tax year (often referred to as the ‘current year basis’), will be replaced with a tax year basis of assessment. Under the tax year basis, sole traders and partnerships will be taxed on the profits arising in the tax year itself, effectively breaking the link between accounting date and tax reporting.
The good news is that businesses which already draw up their accounts to 31 March or 5 April will be unaffected by this change – HMRC estimates this will include 93% of sole traders and 67% of partnerships. However, businesses with any other year-end face temporarily increased tax bills, as well as an increase in their ongoing administrative burdens if they can’t change their accounting year end.
The new tax year basis comes into full effect in the tax year 2024/25. However, the changes will start being felt before then, with the tax year 2023/24 acting as a ‘transitional year’ in which we switch over from the current year basis to the new tax year basis.
As set out below, this transitional year has its own complicated rules around calculating taxable profits. These will, in many cases, result in extra tax being payable.
Before getting into the complexities of the transitional year, it makes sense to first look at how the new tax year basis will work from 2024/25 onwards. As noted above, under the tax year basis, businesses will be taxed on their profits arising in the tax year, regardless of their accounting period. For example, the profits taxable in 2024/25 will be those arising in the period from 6 April 2024 to 5 April 2025.
One helpful relaxation is that businesses which have a ‘late accounting date’ (between 31 March and 4 April) can treat this as being the same as 5 April. Effectively, businesses with a 31 March year end can treat their accounting period as being the same as the tax year, removing the need to worry about what to do with the extra five days of trading profit in early April.
Businesses with a 31 March or 5 April year-end will therefore not see any change as a result of the tax year basis coming into force. However, all other businesses will need to apportion their profits into tax years. This apportionment should be done on a day basis by default (though a different time period can be used if it is reasonable to so and the same method is used consistently). For example, for a business with a 31 December year end, the taxable profits for 2024/25 will comprise 270 days of profits from the year ended 31 December 2024 and 95 days from the year ended 31 December 2025.
One additional complication of the new tax year basis is that, depending on the accounting date of the business, the second set of accounts may not be finalised by the filing deadline for a tax year. Continuing our example of a business with a 31 December year-end, it is highly unlikely that the accounts for 31 December 2025 will be ready by the 31 January 2026 filing deadline for the 2024/25 tax return. The business will therefore have to include a provisional figure in the return in respect of the profits from that set of accounts, and then correct this later. HMRC have said that they will relax their current rules, which require provisional figures to be corrected as soon as possible, and instead allow 12 months from the filing deadline of the return. In our example, this means that the business would have until 31 January 2027 to correct the provisional figures in its 2024/25 return.
This requirement to apportion, and potentially also to calculate and correct provisional figures, will be an ongoing annual requirement for affected businesses. The only real way to avoid the additional work and adviser’s fees this will generate is to change to a 31 March or 5 April year end (more on this later).
As noted above, 2023/24 will act as a transitional year in which we switch over from the current year basis to the tax year basis.
This will be achieved by taxing the normal basis period (i.e. the accounting period ending in tax year 2023/24) plus an extra amount of profits to bring us up to the end of the tax year. For example, a 31 December year end will be taxed on their:
This will result in more than 12 months’ worth of profit being taxed in 2023/24. Two measures are provided to help alleviate any additional tax arising as a result:
Tax year 2023/24 represents the last possibility for businesses to deduct overlap relief – no amounts can be carried forward past this year and any amounts not used will be lost. However, if deducting overlap relief results in a loss, or increases an existing loss, then an extended three year carry back will be available. HMRC are currently looking at how best to provide overlap figures to taxpayers and agents.
Although spreading of any remaining excess profits is allowed over up to five years, an election can be made to accelerate the amount of profits brought into account in any one year. This may be worth considering if businesses have a year when profits are lower, or other reliefs available. However, it should not be assumed that spreading will always be available – this may not be the case if there are losses, or overlap profits particularly high. In all cases, the specific steps set out in the legislation need to be followed to determine the amount of additional profits to be brought into account in 2023/24.
Once those profits are determined, it is then necessary to calculate the tax arising on them. This is not as simple as applying the relevant marginal tax rate. Instead the legislation sets out specific steps to be followed. In summary, these adapt the usual income tax calculation in s23 ITA 2007, such that the additional profits are stripped out of net income. The tax arising on them is then calculated separately and brought back into account as a standalone amount of tax. Excluding the additional profits from net income in this way helps reduce the impact on other areas of the tax system - for example, they shouldn’t be taken into account when looking at thresholds for the High Income Child Benefit Charge and Tax-Free Childcare. However, this approach doesn’t address all possible interactions. In particular, it will not prevent an individual’s personal allowance being tapered where the transitional rules take their income over £100,000.
Advisers who have clients with a year-end other than 31 March or 5 April need to talk to them soon about the impact this change may have. Not only will they potentially need to budget for a temporary increase in tax bills, but they will also face additional ongoing additional costs and administrative burdens as a result of the need to apportion profits, and potentially use and correct provisional figures.
The only way to avoid these ongoing costs and administrative burdens is to change to a 31 March or 5 April year-end. However, this may not be possible or desirable, especially in certain industries such as farming. If the decision is taken to change, care needs to be taken on timing. If the business wants to access spreading, they will only be able to do so if they make the change in 2023/24. Another advantage of changing then is that some of the usual rules which restrict accounting period changes (such as the need for a commercial reason if you have made a previous change recently, or the 18-month limit on a set of accounts) don’t apply in that year.
If clients can’t switch to a 31 March or 5 April year-end, you will need to start planning now as to how you will handle the extra work arising.
For those wanting to read more, the legislation introducing the new tax year basis, and setting out the transitional year rules, can be found in Sch1 of Finance Act 2022. HMRC have also published guidance in their Business Income Manual at BIM81200 onwards.
Emma Rawson
ATT Technical Officer
Emma is also the author of the Bloomsbury Professional Making Tax Digital Tracker which sits in a number of our online services.
