In July 2021, HMRC opened a consultation on a proposed reform to the rules under which profits of unincorporated trading businesses are allocated to tax years, commonly known as the ‘basis period’ rules.
The rules generally apply to all sole traders and also to members of general partnerships and Limited Liability Partnerships (“LLPs”) and will have an impact on anyone who does not draw up their trading accounts to a 31 March or 5 April year end. According to HMRC, this includes 33% of trading partnerships and 7% of all sole traders.
The rules have long been considered to be unnecessarily complicated and sometimes unfair to taxpayers, whilst also offering others the opportunity to defer tax liabilities by up to a year.
The aim of the consultation is to set out a proposal to simplify the rules and set out transitional rules with a view to implementing the amended system before Making Tax Digital is introduced for the self-employed in April 2023.
Existing system
Current year basis
Broadly, under the current rules, sole traders and partners are taxed on their annual profits arising in an accounting year which ends in the tax year in question. For example, partners in a partnership which draws up its accounts to 31 October will be subject to tax on its profits for the year-ended 31 October 2021 in the 2021/22 tax year (the year ending 5 April 2022). This is known as the ‘current year basis’.
Whilst this might already sound unnecessarily confusing, the complexities increase in the opening year of trading, and the year of cessation of a trade (or in the case of partners, on the year of admission to and retirement from a partnership). And that’s without even mentioning the implications of a change of accounting year-end.
Overlap profits
The operation of the opening year rules will usually result in individuals being taxed twice on the same profits, perhaps not an entire year’s worth, but often several months. This double taxation generates ‘overlap profits’, credit for which is ultimately given by deducting these overlap profits from final profits in the year of cessation or retirement. Not only does it seem inequitable that HMRC would tax profits twice in the first instance, but for many sole traders or partners, this could mean that relief is not obtained until several years, or even decades, later. This could result in the taxpayer possibly losing out through the effects of inflation or changes in tax rates. It is also common for individuals to lose track of their overlap profits, especially if they have arisen years and years before they are relieved.
Ultimately, if the old adage that ‘tax deferred is tax saved’ is true, then from HMRC’s perspective in this scenario, tax accelerated is tax won.
On the other hand, many traders or businesses might take advantage of the rules by choosing a 30 April year end which provides maximum deferral of income tax. Under the existing current year basis rules, a business with a year-end of 31 March will have its profits to 31 March 2021 taxed in the 2020/21 tax year (the year to 5 April 2021), whereas delaying the year-end by a month to 30 April 2021 would see it fall in the 2021/22 tax year (the year to 5 April 2022), and so the tax would be deferred by 12 months.
The proposed reform to the basis period rules has the aim of eliminating these disadvantages and opportunities for taxpayers and equalising and simplifying the system.
Proposed reforms
Broadly, the key change would be to subject unincorporated business to tax on profits arising in each tax year rather than on profits in the accounting period ending in the tax year under the basis period rules.
For example, partners in a partnership which draws up its accounts to 31 October would be subject to tax in the 2023/24 tax year on the final seven months profits of the 2023 financial year (April 2023 to October 2023) and the first five months of the 2024 financial year (November 2023 to March 2024). It should be noted that a statutory provision has been proposed to confirm equivalence of 31 March to 5 April for apportionment purposes, so that it can effectively be calculated on a month basis rather than requiring the apportionment of the month of April 5/30ths in one tax year and 25/30ths in the following tax year.
Whilst this would certainly eliminate some of the issues identified above, it does come with complexities of its own. Businesses would be required to apportion and allocate profits from a single accounting period across different tax years every year. Furthermore, many businesses are unlikely to have finalised their accounts in time to provide final figures to HMRC. As set out above, a partner in a partnership with a 31 October year end will need to include the five months of the year ended 31 October 2024 in their 2023/24 self-assessment tax return. This return would be due by 31 January 2025, only three months after the end of the financial year. It is unlikely that final accounts and tax computations will have been prepared by then, which means that provisional, estimated figures would need to be included on the return and then an amended return filed once the figures are finalised.
Finally, businesses that have chosen an accounting year-end early in the tax year e.g. 30 April, are likely to face significant accelerated tax bills to ‘catch up’ on the basis period rules. This will be particularly difficult to stomach for those whose business profits have grown significantly over time such that the overlap relief available is minimal in comparison to the taxable profits and so do not provide significant tax relief.
Summary
Overall, the vast majority of sole traders and unincorporated businesses will not be materially affected by a reform of the basis period rules. However, for those who are, it is fair to assume that the transition to the new system is likely to cause a number of those affected as many new problems as they will solve for others.
If you are a sole trader or partner and would like to discuss the impact for you of the consultation in more detail, please get in touch.
