The government have recently published a consultation outlining a reform of the ‘basis period’ rules. Due to take effect in the 2022/23 tax year, this reform could lead to large tax liabilities in some cases.
Each year self-employed individuals and members of partnerships are charged Income Tax on the profits arising from their activities. Ordinarily, the profits arising in the accounting period which ends in a tax year are taxed. So, for a business with a June accounting year end, the tax liability for the 2021/22 tax year will be those arising in the year ended 30 June 2021. This is known as the ‘accounting year basis’.
However, these rules can be complex, especially in the opening years of a business. It can also lead to a time-lag between profits being earned and when tax is due. In the example above, tax won’t be paid on the profits for the period from 1 July 2020-30 June 2021 until 31 January 2023.
With the upcoming introduction of Making Tax Digital for individuals, which will require the reporting of profits on a quarterly basis, the government are looking to ‘simplify’ matters by moving all self employment and partnership businesses onto a ‘tax year basis’. With profits being taxed in the tax year that they arise.
In the consultation, the government are proposing the transition will take place in the 2022/23 tax year. In this year, an individual will be taxed on their normal accounting year basis as well as the period following the end of the accounting year to the 31 March/5 April 2023. Carrying on the example from above, in the 2022/23 year the business would be taxed on the year to 30 June 2022 as well as the profits for the period from 1 July 2022 to 31 March 2023. This is effectively taxing 21 months’ worth of profits in one year. Any ‘overlap’ profits generated in the past, due to basis period overlapping and being taxed on the same profit for than once will be offset, however in many cases these are much lower than current profit levels.
Take an example of a partner who has an annual profit share of £80,000 and the partnership accounts are drawn up to 30 June. The overlap profits brought forward are £10,000. The tax payable in the 2021/22 and 2022/23 tax years would be as follows:
|Year ended 30 June 2021||£80,000||Year ended 30 June 2022||£80,000|
|Period from 1 July 2022 – 31 March 2023||£60,000|
|Tax & National Insurance||£23,690||Tax & National Insurance||£49,720|
In this transition year, the tax liability has more than doubled, with additional tax of over £26,000. This can present huge challenges to cash flow and a significant reduction in cash available for drawings. To assist with this, the consultation suggests that this additional tax can be paid over 5 years. However, as shown in this example, this will still mean £5,200 of additional tax being payable in each of the following five years.
The changes affect a self employed sole trader in the same way.
As mentioned, these changes are still at the consultation stage however with the government keen to progress with Making Tax Digital as quickly as possible this simplification will need to be introduced quickly.
At Scrutton Bland, our team can help with forecasting for these additional tax liabilities and suggest planning opportunities that will assist in lowering the amount of tax due. This can include things like making use of multiple tax allowances and adjusting the timing of capital expenditure so that Capital Allowances are utilised in the right accounting period. We can also discuss the options in terms of incorporation of the business and other alternative structures.