On Thursday 23 September, HMRC and Government have announced a delay to MTD for income tax to April 2024 and that proposed changes to basis period reform will be delayed until April 2024 at the earliest. The detailed response to the consultation will be published in due course.
HMRC has announced a new consultation into the reform of ‘basis periods’ for the taxable profits of sole traders and partnerships (and all unincorporated entities with trading income) within the Self-Assessment regime. Published on 20 July 2021 with a deadline for responses by 31 August 2021, the consultation proposes that changes are implemented from the 2022/23 tax year. The transition to the new rules will create cashflow concerns for many individuals and partnerships.
The proposals involve moving from the ‘current year’ basis to a ‘tax year’ basis, meaning that business profits will be calculated for the tax year rather than for the period of account (ie their accounting year) ending in the tax year. This would align the treatment of trading income with non-trading income. Other options considered briefly include mandating an accounting date based on the tax year end, or emulating the corporation tax system and setting reporting and payment dates around the accounting period dates. However, the tax year basis is the government’s clear preference.
The proposals are detailed and include draft legislation published alongside the consultation document. The proposals follow the general direction of travel for the reform of the Self-Assessment regime, including changes under Making Tax Digital to be introduced in 2023, as well as the recently closed call for evidence on timely payments (which suggest that the acceleration of Self-Assessment payments may be on the horizon).
In a separate review, the Office of Tax Simplification (OTS) is also currently considering options for moving the tax year end to 31 March or 31 December. Although the basis periods reform consultation itself does not make reference to the OTS review, this is yet another reform that may affect businesses in the future.
It is clear that the basis period consultation is not about whether the reforms are implemented, but rather how they are implemented. However, the brief consultation period does give businesses a limited opportunity to consider the implications of these imminent changes, and make representations on transitional arrangements to mitigate any adverse impacts.
New tax year basis
Moving to the tax year basis period would require businesses to report for the 6 April – 5 April tax year for trading purposes, regardless of their actual period of account. For practical purposes, the proposed rules allow the periods to be apportioned by reference to months if it reasonable to do so and this is applied consistently. Businesses with non-tax year periods of account would be required to apportion profits or losses across periods of account to adjust their results to the tax year basis. For any periods where accounts are not yet finalised, this apportionment will require estimation and subsequent finalisation.
A business makes up its accounts to 30 June annually.
On the current year basis, its basis period for the 2023/24 tax year would be:
- Profits of the year to 30 June 2023 (ie the accounting period ending within the tax year).
Under the tax year basis, the business will report for the 12 months to 31 March 2024, so the apportionment would be:
- 3/12 of its profits/losses for the period of account to 30 June 2023, PLUS
- 9/12 of its profits/losses for the period of account to 30 June 2024.
Note that if the accounts to 30 June 2024 are not finalised, then this 9 months’ profits/losses will have to be estimated for submission of the 2023/24 tax return, and the tax return subsequently amended once the accounts are finalised.
The additional administrative burden of producing estimates is acknowledged, and options for reducing this are suggested, including allowing the figures to be extrapolated from the prior period and relaxing the need to amend returns when final figures are established.
The consultation also proposes treating periods of account drawn up to 31 March as equivalent to the end of the normal tax year (5 April) so no further apportionment would be required.
Phasing out overlap profits
Commencement, cessations and changes of accounting dates will no longer require the complex opening year and cessation rules, as the relevant periods will simply run to and from the end of the tax years respectively. This will eliminate ‘overlap’ profits and the need for overlap relief in the years after the changes. However, the proposed transitional arrangements do provide for use of existing accrued overlap relief.
The tax year of transition will be 6 April 2022 – 5 April 23 – next year! In 2022/23, continuing businesses will be taxable on their profits on the current year basis (ie for the 12 months to their accounting date in 2022/23, plus the period up to the end of the tax year (ie 31 March for simple apportionment). Depending on the accounting date of the business, this could bring almost up to two year’s profits into charge for the year: businesses with 30 April year ends could be particularly impacted. Given this could lead to a significantly increased tax bill, the proposals provide for the excess charge to be spread over a period of five tax years to mitigate the cashflow impacts.
XYZ LLP is a professional services firm with 40 members. It draws up its accounts to 30 April and profit for the 12 months to 30 April 2022 is £20 million.
For the 2022/23 tax year, assuming all members are on the current year basis:
- Members’ basis period would be - 12 months to 30 April 2022, and
- Members would be taxed on their shares of the profit of £20 million (in total, paying approximately £9 million income tax and NIC).
New transitional rules
Under these proposals, on transition to the tax year basis in 2022/23 (ie continuing members would be taxable on:
- Their share of profits of the 12 months to 30 April 2022, plus
- Their share of 11/12s of the profits to 30 April 2023.
This brings the profits taxed into line with the tax year basis to 31 March 2023, but results in 23 months of profit being taxed in the transitional 2022/23 tax year.
The firm estimates its profits for the additional 11 months to be a further £20 million, which, added to the £20 million for the period of account to 30 April 2022, brings a total of £40 million of partnership profits into charge in the transitional year.
The members have an aggregate of £5 million overlap relief which will be required to be claimed in the transition year, leaving them taxable on their shares of £35 million, resulting in approximately £16 million total income tax and NIC due - £7 million more than on the current year basis – an average of £175,000 more per member (although this could be paid over five years).
The consultation identifies some specific partnership issues.
The tax year basis will reduce the complexity of joiners and leavers having different bases of assessment to other partners, as the commencement and cessation rules will no longer apply. Specific rules for partnerships with trading and other sources of income can also be removed as individuals will report and pay tax on all partnership income on a tax year basis.
John joins ABC LLP on 1 February 2024, and stays as a member for a number of years until departing on 28 February 2027. ABC LLP has been trading for a number of years and prepares its accounts to 31 December.
Note that while John pays tax on the same profits under both sets of rules over the four year period, moving to the tax year basis will mean paying tax on some profits earlier than under the current rules. Calculations are rounded to months.
In the short term, while the rules may simplify certain technical and practical matters, firms that do not make their accounts up to 31 March/5 April will need to consider the impact of the proposed changes on their cash flow: particularly for the transitional year 2022/23 which could see partners paying tax on significantly increased amounts of profit. The impacts will continue to be felt going forward, as the changes close the timing gap between profits accruing and being brought into charge.
These changes may be particularly challenging for large professional service firms with complex financial and tax affairs, and with the proposal for implementation from the next tax year, the impacts will need to be considered and prepared for quickly.
In the longer term, the reforms will remove some of the cashflow advantages of operating through a partnership model and make it harder for partnerships to finance their working capital. It is possible that some firms will want to consider the pros and cons of a move to a corporate structure in due course.
The ongoing requirement to apportion and/or estimate profits of consecutive accounting periods may lead many businesses to consider changing their accounting date to align with the tax year. Again, this would require careful consideration, particularly for larger partnerships with complex accounting processes, and other factors would need to be taken into account. For example, some international partnerships may have a preference for a 31 December accounting date due to tax rules in other countries. As noted above, the OTS is currently evaluating the pros and cons of changing the UK’s tax year end to either 31 March or 31 December, the latter being considered the more radical option, but acknowledging that there may be benefits in aligning the UK with the majority of international tax regimes. More changes could be coming.
There are a number of other areas of concern that arise on the transition to the new rules, many of which are not addressed in the consultation, including:
- How to give the overlap relief on transition where the overlap on creation included foreign tax credits
- How foreign tax credits will be treated where the five year transitional election is made
- Where allocations are made on a fiscal year basis, how apportioning across tax years impacts on tax adjustments, joiners and leavers who may be allocated profit for the whole fiscal year but are only partner in one tax year, and on capital allowances claims,
- For UK-resident members of related UK and overseas firms, whether they will have sufficient UK profits in the transitional year to utilise the previously created overlap.
BDO’s professional services team is one of the largest in the UK, and the partnership tax team are experts in dealing with a range of business in sectors from legal, recruiting, consultancy to private equity and asset management. We can help you analyse the impact the reforms will have on your business, prepare financial projections, and consider any remedial action that may be appropriate.
For help and advice, please contact our local tax experts or log your query here.