Income Tax Basis Period Consultation

Income Tax Basis Period Consultation

Last month HM Revenue & Customs (HMRC) announced a short consultation period until 31 August 2021 to allow comments on the proposed abolition of basis periods, the fundamental rules of when business profits (self-employment or partnership income, but not company profit) are taxed. These are undoubtedly complicated, and can often be seen as unfair, for the taxpayers who have to pay tax twice on their early year profits of trade, with Overlap relief only generally being given many years later, when the business is wound up.

What are HMRC suggesting?

Instead, HMRC are suggesting that everyone is taxed on their profits earned in the tax year, irrespective of their accounting year end. This may mean submitting Tax Returns based on estimated figures, requiring full amendment once the actual figures are known after the accounting end date. In addition, in the first year of these new rules in 2022/23, some businesses may be taxed on the profits of 23 months in one tax year. There will be an option of spreading the additional profit that would not normally have been taxed in 2022/23 over a five-year transition period, but some taxpayers will see increased taxation from these proposed changes, as more income may be taxed at the higher and additional rates.

Who will be affected by these changes?

It is likely that the proposed rules will affect partnerships and Limited Liability Partnerships (LLPs), and their partners, more than individual self-employed people, as only 7% of the self-employed use a different account end date than 31 March/5 April, but 33% of partnerships and LLPs use different year end dates. This can be for many reasons, from allowing more time to prepare accounts for large professional partnerships, to the anniversary of the month of incorporation for LLPs (who must be registered at Companies House). Partnerships and LLPs have often been in existence for many years, so the accounting end date can be historic, decided on by partners who are long retired.

HMRC do concede that some businesses who have accounting year ends from 30 April to 28 February may have commercial reasons for those account end dates. Going forwards, any year ends that are not aligned to 31 March/5 April will be genuinely commercial, as they feel most businesses will move their accounting end date for simplicity in completing tax returns.

Overlap relief

Overlap relief (which is how the taxpayer gets relief for the profit that is taxed twice in the early years) is a problem area of taxation, as according to HMRC, many taxpayers do not claim the reliefs they are entitled to. In the run-up to the change of the rules, both advisers and taxpayers will have to spend time establishing the amount of overlap relief that can be claimed in the 2022/23 tax year, if those records have not entered on the Tax Return annually. But even if the overlap details can be located, due to businesses growing in early years, and the diminution of value over the years, overlap relief may not reduce the profits of a good year by a significant amount, and certainly not by enough to bring the 2022/23 tax year profit down to an amount that is consistent with the twelve months’ profit HMRC suggest. But as of 6 April 2023, overlap relief will be abolished, no longer required, and no longer a problem.

Apportioning accounts and making estimates

For those businesses that decide not to change their accounting end date, a lifetime of apportioning accounts, with potentially making estimates of future profits and amending annually awaits. HMRC are asking which year ends are likely to be more problematic, as it is likely that accounts for year ends from 31 March through to 30 September will be able to be prepared by the 31 January following the end of the tax year, the filing date of Tax Returns. In these cases, it will be a case of apportioning, but there should be limited estimating. But the second set of relevant accounts for the year ends after 30 September through to 28 February would often be finalised after the tax return filing date, so estimates would have to be used. This is likely to cause problems for any partnerships and LLPs that are part of a large or international group of businesses, who may use 31 December for the whole group.

The draft legislation

HMRC say they do not want to legislate that all businesses must use 31 March/5 April as a year-end date, but in practice, these proposed rules will encourage many businesses to change their year-end. For some businesses, particularly partnerships, they may look at companies who can chose any year-end and feel that incorporation is an alternative to be considered. But the flexibility of partnerships and LLPs should not be overlooked, as there are a number of advantages, and incorporation can be expensive.

The draft legislation is already written, so it is likely that these changes will come in, and they are probably necessary with the introduction of Making Tax Digital. But affected taxpayers should be prepared for 31 January 2024, which may be an expensive day.

For further information on the areas raised in this insight, or to discuss in more detail, please speak with your usual Azets contact or a member of our tax team.