On Thursday 27 January 2022, HMRC and the government responded to feedback from BDO (and others) and announced a number of proposed changes to the way the basis period reform transitional rules will work from April 2024. These are designed to alleviate the most unfair impacts of the transitional rules, but the proposals will still accelerate tax charges for many individuals in partnerships.
The key reforms 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.
The move to this new tax year basis will involve a transitional (catch-up) year for many sole traders and partnerships that do not use 5 April or 31 March as their accounting date. This will advance tax liabilities for many. The original proposal was to make this change from 2023/24, but the change has been delayed until 2024/25, with 2023/24 as a transitional year.
The proposals are now detailed in draft legislation (Finance Bill 2022), and it is hoped there may also be further administrative easements before the changes come into effect. The proposals follow the general direction of travel for the reform of the Self-Assessment regime, including changes under Making Tax Digital (now also delayed until 2024), as well as the recently closed call for evidence on timely payments (which suggests that the acceleration of Self-Assessment payments may be on the horizon).
New tax year basis
Moving to the tax year basis period will 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 is 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 2024/25 tax year would be:
- Profits of the year to 30 June 2024 (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 2025, so the apportionment would be:
- 3/12 of its profits/losses for the period of account to 30 June 2024, PLUS
- 9/12 of its profits/losses for the period of account to 30 June 2025.
Note that if the accounts to 30 June 2025 are not finalised, then these 9 months’ profits/losses will have to be estimated for submission of the 2024/25 tax return, and the tax return subsequently amended once the accounts are finalised.
The additional administrative burden of producing estimates is acknowledged, and HMRC has now suggested options for reducing the impact that it will consult on further ahead of the transition year, including:
- Allowing taxpayers to amend a provisional figure at the same time as they file their return for the following tax year
- Allowing an extension of the filing deadline for some groups of taxpayers, such as more complex partnerships or seasonal trades
- Allowing taxpayers to include in the next year’s tax return any differences between provisional and actual figures in the previous year
- Leaving the current rules on provisional figures unchanged, whereby profits can be estimated in a return and amended as soon as final figures become available.
The legislation will also treat 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, cessation 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 2023 – 5 April 2024. In 2023/24, continuing businesses will be taxable on their profits on the current year basis (ie for the 12 months to their accounting date in 2023/24, 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 years’ 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 profit to be spread over a period of five tax years to mitigate the cashflow impacts (although individuals can elect to be taxed on the full amount in the transition year).
In addition, following strong representations to the government, including from BDO, the latest draft legislation includes clauses intended to remove some of the more unfair impacts of the transitional catch-up. Complex rules will mean that, while transitional profits will be taxed on individuals in the five year “spreading” period (or solely in 2023/24 if the taxpayer opts for that), they should not affect the level of the taxpayer’s income that is used to calculate things like their entitlement to certain reliefs and benefits (such as Child Benefit, pension contributions etc): the transitional profit will now create a ‘stand-alone tax charge’. However, in some circumstances, the transitional rules may still push some taxpayers into a higher income tax band – particularly if they opt out of spreading.
The way that the stand-alone tax charge was originally proposed to be included in an individual’s tax calculation meant that it may not have been possible to claim double tax relief where any element of the individual’s profit had been taxed overseas (ie where a partnership had profits from other jurisdictions). It also meant that the transitional profit would always have been taxed – ie it would not have been possible to claim income tax relief (such as for EIS, SEIS and VCT investments) against the transitional profit. The amendments proposed on 27 January 2022 will include the stand-alone tax charge at a different step of the individual’s tax calculation for the year (each year when spreading). This means that it will be possible to claim double tax relief where relevant, and that an individual can claim income tax relief for relevant investments against the stand-alone tax amount (as well as their other income in that year).
While it is good news that, in principle, overseas taxes suffered on foreign profits arising in the transitional period will now be relievable, there will nevertheless be practical difficulties in determining the foreign tax credits that can be claimed. This will be particularly complex where the transition period profits are spread over multiple years (up to five years).
Basic example of transitional rules
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 2023 is £20 million.
For the 2023/24 tax year, assuming all members are on the current year basis:
- Members’ basis period would be - 12 months to 30 April 2023, 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 2023/24, continuing members would be taxable on:
- Their share of profits of the 12 months to 30 April 2023, plus
- Their share of 11/12ths of the profits to 30 April 2024.
This brings the profits taxed into line with the tax year basis to 31 March 2024, but results in 23 months of profit being taxed in the transitional 2023/24 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 2023, 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. Without the automatic five year spreading of profits rule, this would result 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.
Another positive move is that the updated legislation appears to allow for transitional profits to be calculated for 2023/24 and to be spread over five years even if the business changes its accounting date in that year: something many businesses are considering is moving their accounting date to 31 March or 5 April, to make future annual administrative processes easier.
The original consultation on these reforms identified 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 2025 and stays as a member for a number of years until departing on 28 February 2028. 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 2023/24 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 the impacts will need to be carefully considered and prepared for ahead of the transitional year. The one-year deferral is welcome, but businesses would be well advised to make sure that they make the best use of the extra time available.
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. 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. Therefore, more changes could be coming in the longer term.
There are a number of other areas of concern that arise on the transition to the new rules, many of which are not addressed to date, including:
- 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 a 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
- How to identify relevant foreign tax credits with the many adjustments and apportionments required.
BDO’s Professional Services team is one of the largest in the UK, and the team are experts in dealing with a range of businesses in sectors from legal, recruiting, consultancy to private equity and asset management. We can help you to analyse the impact that the reforms will have on your business, prepare financial projections, and consider any remedial action that may be appropriate.
To learn more about the problems these changes will cause, please visit our Professional Services Hub where you can read our response to HMRC’s consultation and our blog; Basis period reform – a real can of worms!. For help and advice, please contact Neil Williams or Jitendra Patel.
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