Basis period reform: what does it mean for unincorporated businesses and LLPs?
These changes will affect all sole traders, unincorporated partnerships and LLPs that currently do not prepare their annual accounts to a reference date ending between 31 March and 5 April.
This is despite the delay to making tax digital for income tax and significant representation from the industry.
Current continuing businesses
The current basis period rules mean that established sole traders and partners/members in ongoing businesses pay tax based on the financial performance of the business in the 12-month accounting period which ends in the tax year.
If a business prepares accounts for the 12 months ending 31 December 2022, and this is not the first period of account, then the profits from this period (after adjustments) would be taxed on the individual in their tax return for the 2022/23 tax year.
Current opening year rules
Different rules apply to individuals in the first tax year that they start to trade.
Partners or members are typically treated as starting to trade on the date that they are admitted into the partnership or LLP.
In their first tax year of trade, an individual is taxed on their profits from the date of starting to trade to the end of that tax year (5 April).
For example, a new partner joins on 1 January 2021, where the accounting year-end is 31 December 2021.
The first period that they are taxed is 2020/21, with income being their profits from 1 January 2021 to 5 April 2021.
The next tax year, 2021/22, they are taxed on the first 12 months’ profits, being 1 January 2021 to 31 December 2021.
There is a portion of profits taxed twice in these tax years. This is known as ‘overlap profit’.
The new basis period rules
The new rules dictate that, from 2024/25, all unincorporated businesses will be taxed on the profits generated between the start and end of the tax year, from 6 April to 5 April.
This will apply regardless of the year-end that the business prepares its accounts to.
HMRC will allow a year-end that falls between 31 March and 5 April to be treated as if it falls at the end of the tax year.
So, if a business has an accounting year-end of 31 December, it will have to apportion profits from two accounting periods to fit into the 6 April to 5 April timeline.
If the accounts have not been finalised before the tax return filing deadline, then estimated profits will have to be included.
The 2023/24 transition year
2023/24 will be the key tax year when it comes to the new rules, as this will be the year of transition.
Individuals will be taxed on a long period of account ending 5 April 2024. This period will pick up all untaxed accounting profits generated up to this date.
Relief will be given for any overlap profits generated under the current basis period rules.
In our example of an ongoing 31 December accounting year-end, in 2023/24 the tax return will have to include profits for the 12 months ended 31 December 2023 plus profits for three months ended 5 April 2024.
Transitional profit spreading
There are rules that allow the payment of the tax liability generated from transitional period profits to be spread over five tax years, beginning with the year of transition.
This should ease cash flow, by ensuring the extra tax due on these profits is not paid entirely in the 2023/24 tax year.
|Year-end 30 September 2023||£100,000|
|Period 1 October 2023 to 31 March 2024||£50,000|
|Less: overlap profits brought forward||(£20,000)|
Under the current rules, the taxable profits for the 2023/24 tax year would be £100,000 but the changes see taxable profits of £130,000 for 2023/24.
This is a significant impact on cash flow.
The excess profits of £30,000 can therefore be spread across five tax years, with an additional £6,000 taxable over the five years from 2023/24 to 2027/28.
You should consider whether changing your business’ accounting year-end to 31 March or 6 April is beneficial.
Unless there is a significant commercial driver to maintain a different year-end, it’s likely that most businesses will choose to align their year-end with the tax year.
Maintaining a different year-end will see an increase in accountancy fees, as financial accounts will need to be prepared alongside estimated figures up to 31 March or 5 April.
You should review your future tax liabilities, and when and how these will become payable.
In some cases, it may prove beneficial to change your accounting year-end in the 2022/23 tax year rather than waiting until the 2023/24 transitional year.
While this means that excess profits cannot be spread over five years, if profits exceed £125,000, an additional £25,000 will fall to be taxed at 45% – as opposed to 40% in the 2023/24 tax year – due to the reduction in the additional rate band.
The cash flow impacts on your business clearly need to be factored in.
You now have the opportunity to plan any change to your accounting year-end that may reduce the administrative burden that these new rules may create.
We strongly recommend that you start planning for this change sooner rather than later.