Reforms to the period of taxation for sole traders, partnerships & LLPs

The way in which the tax basis period is calculated for the self-employed and partnerships is set to be reformed ahead of the implementation of Making Tax Digital in April 2024.

What are the current rules?

At present unincorporated businesses are free to choose whatever accounting year-end they wish. These profits are then taxed according to the tax year in which the accounting year-end falls. For example, a business with a year-end of 30 September 2021 would be taxed on those profits in the tax year running from 6 April 2021 to 5 April 2022 (2021/22), with the tax payable on 31 January 2023.

HMRC believes that the current rules have created a complex system that is difficult to understand. When a business starts or a partner joins a partnership, the ‘opening year rules’ must be applied, this can create double taxation of some profits, called overlap profits.

Any profits which have been taxed twice on the commencement of trade can then be relieved in the year of cessation of the business or upon the partner leaving the partnership. HMRC has identified that these rules are often not correctly applied and records of any overlapped profits can often be lost as the period between commencement and cessation of a business can be many years.

HMRC also believes that these rules can give an unfair advantage to larger businesses which often have accounting years that are non-coterminous with the tax year. Smaller businesses will commonly have a 31 March year-end for simplification purposes. If a business has an accounting period ending near the start of the tax year this can give up to 21 months before tax is paid on those profits.

What are the changes?

HMRC will tax all unincorporated businesses and LLPs on a tax year basis regardless of the accounting year-end. There is no requirement to change the accounting year end of the business, just the way profits are taxed.

For example, if a business has a 30 September 2023 year-end the taxable profits would be calculated for the 2023/24 tax year by taking six months of profits from the 30/9/23 year-end and six months of profits from the 30/9/24 year-end. If the 30/9/24 accounts have not been prepared prior to the submission date of the 23/24 tax return provisional figures should be used, and the tax return amended once the final figures are known.

That, however, would just seem to confuse matters, so we envisage that accounting year ends will change to 31 March, unless there is a strong commercial reason for a different year-end.

Will there be a transitional period?

HMRC recognised that during the 2023/24 tax year when the new rules are implemented this could see taxpayers paying a significantly increased amount of tax as more than 12 months of profits may be brought into account. It will be possible to offset any overlap profits but, in many cases, these may be considerably lower than current year profits as they were created when the trade was commencing.

Where taxable profits exceed the current year’s profits excess profits can be spread over five years.

This is demonstrated in the following example:

A sole trader has a year-end of 30 June. The profits to 30 June 2023 are £30,000 and for 30 June 2024 are £60,000. They have overlap profits brought forward of £5,000.

Taxable profits for 2023/24 are:

1 July 2021 – 30 June 2023 30,000

1 July 2022 – 31 March 2024 60,000 x 9/12 45,000

Less: overlap profits (5,000)

Taxable profits 2023/24: 70,000

As these profits exceed the current year profits of £30,000 the excess of £40,000 can be spread over five years. The minimum amount per year to be added is £8,000 (40,000/5). An election to spread the profits would therefore see 2023/24 taxable profits of £30,000 + £8,000 = £38,000.

£8,000 would then need adding to the taxable profits for the subsequent four tax years.

It is possible to accelerate the taxation of the spread profits however, they can not be deferred.

Making Tax Digital for Income Tax

These proposals are seen as a forerunner to future reform and Making Tax Digital (MTD) for income tax which is due to be introduced from 1 April 2024 for sole traders and landlords and 1 April 2025 for partnerships. MTD sees all sole traders, partnerships, and landlords with turnover greater than £10,000 required to keep records digitally and submit quarterly updates to HMRC.

HMRC consider that moving to a tax year basis for taxing profits will reduce the number of submissions taxpayers may need to do. For example, a sole trader who is also a landlord may need to make quarterly submissions for both their business and rental profits. Rental income is currently taxed on a tax year basis, if the business was not taxed on a tax year basis they may not be able to combine the two quarterly submissions, greatly increasing the admin burden for the taxpayer.

What is next?

If you think that you will be affected by these proposals, please speak with our Professional Practices team as soon as possible.

We can then discuss the pros and cons of changing your year-end and the best time to do this.