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Basis Period Reforms – Do you have sufficient funds?

Content created by Private Client Assistant Manager, Rachael Smith

The basis period reform will impact those with unincorporated businesses, whether you are a sole trader or a member of a partnership. The basis period reform will not affect businesses with accounting year ends to 5 April or 31 March.

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The major practical issue for taxpayers to consider on the basis period reform will be the effect on their cashflow. In the transition year, HMRC are asking for tax ‘up front’ on the profits arising in the period from the accounting year end to the end of the tax year.

In addition to paying tax up front on these transition profits, taxpayers will also pay tax on more than 12 months profit unless their accounting year end is 31 March. For example, those with a 30 April year end will pay tax on 23 months profit in the transition year. This may result in significant increases in an individual’s tax liability, subject to the availability of overlap relief, and this may be mitigated by the ability to spread the profit over a maximum of 5 years. However, careful cashflow planning will be needed to ensure these additional tax liabilities can be funded. 

Current rules

Under the current rules, individuals are taxed on their profits arising in the accounting period ending in the relevant tax year, for example profits in the year ended 30 June 2022 will be taxed in 2022/23 tax year.

The change in the basis period will apply to all unincorporated businesses.

New Rules

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From 2024/25 profits will be taxed on a tax year basis. For example, for the year ended 30 June 2024, 3 months of the profits from the 30 June 2024 accounts and 9 months of the profits from 30 June 2025 accounts will be taxable in the 2024/25 tax year.

HMRC accept that this may require estimates for the period in which accounts have not yet been completed. However, they have advised that taxpayers will either need to go back and amend the earlier years on completion of the accounts or that an adjustment may be included in the following tax year.

HMRC are not yet sure what the following year adjustment will look like, but it is most likely that there will be an additional entry on the tax return.

Transition period

The transition period will be the 2023/24 tax year where individuals will be taxed on the profit for the 12 months to the accounting period which ends during the tax year, plus the profits from the end of the previous accounting period to the 5 April 2024.

As there will be more than 12 months of taxable profit this is where individuals can relieve any overlap profit brought forward from the start of their trade. If an individual has more than one trade the overlap profit for each is treated separately.

The profit for the 12 months to the accounting period ending in the tax year is referred to as the standard profit. The profit from the end of the accounting period to 5 April 2024 is the transitional profit.

The overlap relief is deducted from the profit realised in the transitional period. This net profit or loss is then aggregated with the profit or loss realised in the standard period.

Transitional period is a profit

Where the transitional profits less overlap relief brought forward results in a taxable profit the individual can spread the profits over 5 years.

The election applies automatically, however there is an option to accelerate the recognition of the spread profit. The election needs to be made within 12 months of the self-assessment filling deadline for the tax year in which the individual wants to recognise additional profits.

This may be preferred where the future tax rates are uncertain, and the individual would rather have more profits taxed at the current rates than risk a rise in future income tax rates. It may also be beneficial where there has been a less profitable year of trading and the individual is taxed at a lower rate of income tax in one of the following 5 years.

Remember it is only the profits in the transitional period that can be spread, not the total profits.

An example:£
Taxable profits to the year ended 31 December 2023100,000
Taxable profits from 1 Jan – 5 April 202440,000
Overlap relief brought forward(25,000)
Taxable profits in 2023/24 tax year (standard period)100,000
Add: transitional period (40,000 – 25,000)15,000

Profits available for spreading15,000

2024/252025/262026/272027/282028/29
Spread profits3,0003,0003,0003,0003,000
Alternative election3,0009,0001,0001,0001,000
Business ceases3,0003,0009,000

Transitional period is a loss

Where the transitional period is a loss but the standard period is a profit, the net loss of the transitional period is offset against the profit of the standard period.

For example:

Taxable profits to the year ended 31 December 2023100,000
Taxable profits from 1 Jan – 5 April 202420,000
Overlap relief brought forward(35,000)
Taxable profits in 2023/24 tax year (standard period)100,000
Plus transitional period (40,000 – 25,000)(15,000)
Taxable profits in 2023/24 tax year85,000

Transitional period is a loss, standard period is a profit, net position is a loss

Where the transitional period loss is greater than the profit of the standard period i.e. a net loss is realised, then the terminal loss relief rules can apply.

These rules allow you to carry back the loss for up to 3 years, starting with the most recent year.

Unlike terminal loss relief, if all of the loss cannot be realised against the profit of the three earlier years, the remainder can be carried forward and set against profit of the same trade under the normal loss relief rules.

Transitional period is a profit, standard period is a loss, resulting in a net loss

Unlike the rules set out above, if the standard period is a loss, terminal loss relief will not apply. In this scenario the normal rules for loss relief will apply where the loss can be offset against current year other income, carried back 12 months against trade profits or carried forward and set against future profits of the same trade.

Practical implications

There are various tax implications to consider in the transitional period in particular. The most obvious being the restriction of the personal allowance where income exceeds £100K.

HMRC have confirmed that the profits from the transitional period are not included in adjusted net income and therefore will not impact the availability of the personal allowance.

The tax liability on the profit realised in the transitional period will however be included in the total tax liability when making a deduction for various tax reducers, for example EIS relief.

As the transitional profit is not included in the adjusted net income, it does not impact the thresholds for pension contributions. For example, where the annual allowance is tapered for income exceeding £240K, the transitional profit is not taken into account when determining if these thresholds are exceeded.

Although the transition profit will not be included in adjusted net income, it is considered relevant earnings for pension purposes.

The maximum you can contribute into your pension, subject to the annual allowance is a maximum of £3,600 or your relevant earnings. Including the transitional profit in the net relevant earnings may increase the maximum pension contributions that some individuals can make.

If you would like to understand more about Basis Period Reform please get in touch with your usual Menzies contact or email rachaelsmith@menzies.co.uk

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