Sole trader tax changes where year ends don’t match the tax year

As part of the government’s intention to implement a digitally based tax system, HM Revenue and Customs (HMRC) plans to change the rules relating to the way sole traders and partners allocate trading income to tax years. This change is intended to streamline the tax system and to allow for the introduction of Making Tax Digital (MTD) for income tax.

In a nutshell, basis period reform affects sole traders and partners who have a year-end which doesn’t align with the tax year. If you draw accounts to 31st March or 5th April, you will not be impacted by these changes.

In the future, HMRC intends to change the tax system so any business profits will be calculated for the tax year rather than for the accounting year.

Who does the basis period reform affect?

The proposed change will affect self-employed traders, partners in trading partnerships, other unincorporated entities with trading income, such as trading trusts and estates and non-resident companies with trading income charged to income tax.

This measure will only affect the above businesses which draw up annual accounts to a date which is different to 31st March or 5th April. If you draw your accounts to 31st March or 5th April, the changes will not affect you.

The change will not impact limited companies.

Current basis period rules

A sole trade or partnership business generally draws annual accounts to the same date each year, called their ‘accounting date’. Under current rules, business profit for a tax year is usually the profit to the accounting date in the tax year and this is called the ‘basis period’. Complex rules apply in certain cases, including when a business starts, ends or changes the accounting date. Potentially, this can mean overlapping basis periods, which charge tax on profits twice and generate corresponding ‘overlap relief’. These complex rules can be avoided if a 31st March or 5th April year end is used and as noted before, it is only when a non-31st March / 5th April year end is selected that these proposed rules will kick in.

How are the basis period rules changing?

The proposed rule change will mean that a business’ profit for a tax year will be the profit arising in that tax year, regardless of the accounting date.

To achieve this change, 2023-24 will be a catch-up year and this will advance tax liabilities for many.

Basis period changes in brief

• The 2023-24 tax year will be a catch-up year
• The basis period for 2023-24 will be comprised of two parts:
  • the usual part, which is the first 12 months of the basis period, and
  • the catch-up part, being the remainder of the basis period
• Overlap profits must be offset against the profits of the 2023/24 tax year
• These catch-up profits will be spread equally over five years.
• Businesses will face ongoing requirements to apportion profits and it is expected many businesses will decide to align their accounts year end with the tax year – 31st March to 5th April to avoid complicated apportionments
• The timing of an accounts change is important if the business wishes to access the ability to spread profits and avoid a potentially sharp increase in tax
• In many cases, the simplest way forward will be to change the accounts year end in the 2023-24 period

Basis period changes in brief

• Each case is unique and there is no general strategy that can apply to every situation
• You will need to decide what action you wish to take
• Where you wish to avoid ongoing requirements to apportion profits, you could consider changing your accounts year end in the 2023-24 period

For example, a sole trader with a 30th April accounts year end who changed their accounts year end, would draw accounts from 1st May 2023 to 31st March 2024 in 2023/24, 5th April could be adopted instead

In 2023-24, the sole trader would have 12 months of taxable profits to declare for the accounts ending 30th April 2023 plus a portion of the 11 months of profits to 31st March 2024. The remaining portion would then be spread over the next four tax years

Example 2023/24 tax position – 30th April year end

To demonstrate the impact of this change, we have included a worked example below.

Assumptions:

• Profit for the year ended 30/04/2023 = £50,000 – estimated
• Profit for the period (11 months) ended 31/03/2024 = £60,000 – estimated
• Overlap profit = £15,000
• Change of accounts date is made in the 2023-24 period to 31st March

2023-24 profits

'Usual' trading profits - 30/04/2023	£50,000
Catch-up profits - see note 1	£9,000
Total for 2023-24	£59,000

2023-25 profits

‘Usual’ trading profits – 31/03/2024	£60,000
Catch-up profits	£9,000
Total for 2024-25	£69,000

Note 1 – Profits for the catch-up period are the estimated profit for the period ended 31/03/2024 of £60,000, less overlap and then spread over five years:

Profits for the catch-up part	£60,000
Less overlap profit	(£15,000)
Catch-up profit	£45,000	£45,000
Catch-up profit (as above) spread over five years		£9,000

You will see that even with the spreading mechanism, additional profits will be liable to tax, and the sole trader would need to budget for the extra tax that will arise in 2023-24 and the four subsequent years while transition profits are being spread.

In the longer term, this change could also cause cashflow challenges as the sole trader will have to pay tax closer in time to when their profits are earned.

Moving to a 31st March or 5th April year end in the transition year will reduce the ongoing administrative burden of having to apportion profits, and we anticipate this will be widely adopted.

Want to know more about the basis period changes?

Please see below our Q&A section which highlights some of the main issues to be aware of.

TaxAssist Accountants love working with sole traders and partnerships and can help you decide on the best course of action to deal with these proposed changes.

To find out more about our services and to book a free consultation, call 0203 146 8390 or fill in our online enquiry form.

Basis period reform – FAQs

Does this impact my limited company?

This change applies to sole traders and partnerships but does not affect limited companies.

Will HMRC delay this change and will it definitely come in?

It is hoped there may be some easements to these proposals, but it is now widely anticipated that HMRC will press ahead with the changes.

If I have extra catch-up payments, will this impact my entitlement to Child Credit benefit or abate my personal allowance if my income exceeds £100,000?

The way the catch-up payment will be taxed is complicated due to the way it is intended to fit into the tax computation. The broad outcome of this is to reduce the impact on allowances and means-tested benefit.

Catch-up profits are treated as a separate one-off item of taxable income which is excluded from net income, and this means catch-up profits will not impact determining entitlement to personal allowances or the imposition of charges such as the high-income child benefit charge.

It should also be noted that for partnerships with overseas operations, this treatment could inadvertently prevent them from claiming relief for overseas taxes suffered on the profits being spread. It remains to be seen how HMRC will address this.

Do the catch-up profits have to be spread?

The default position is for spreading to take place over five years, starting with 2023-24. However, you can choose to accelerate the charge rather than spreading it over the five years

What happens if I cease trading in the transition period, before all catch up payments have been taxed?

If you cease to trade during the transition period, then the full balance of profits that have not yet been spread will be brought into account in the final tax year of trade

What if I change my accounts year end before 2023-24?

If you change your accounting year end before 2023-24, there is no facility to spread any excess profits.

Is it always better to change the accounts year in the 2023-24 transitional year?

Not in every case. You could decide to take the increase in tax earlier and not take advantage of the spreading option. Things will depend on the exact facts and circumstances of your business, including projected profits.

What if I don’t change my accounting year end?

From 2024-25 businesses will be taxed on the profits generated in the tax year, calculated using a pro-rated proportion of the profits of the accounting falling partly in each tax year.

For a business with a 30th April year end, the business would be taxed on 25 days of profits from the year ended 30 April 2024 and 340 days from the year ended 30th April 2025.

Potentially the business could pro-rate on a monthly rather than daily basis.

This would create many complexities for the business:

• Profits from the later year end may be unknown and so will need to be estimated.
• If a business has an accounting year end of December, the December 2025 profits would need to be known by 31st January 2026 to allow for the pro-rated tax figures to be calculated. This will leave very little time to accurately predict profits.

HMRC is looking at a number of options to mitigate the impact of the change but keeping with a year-end which is not aligned to the tax year will cause additional work and increase accountancy costs in some cases.

Date published 19 May 2022 | Last updated 19 May 2022

This article is intended to inform rather than advise and is based on legislation and practice at the time. Taxpayer’s circumstances do vary and if you feel that the information provided is beneficial it is important that you contact us before implementation. If you take, or do not take action as a result of reading this article, before receiving our written endorsement, we will accept no responsibility for any financial loss incurred.