HM Revenue and Customs (HMRC) has announced significant reforms to the basis period method for taxation, impacting unincorporated businesses and limited liability partnerships (LLPs). These reforms, effective from 6 April 2023, introduce changes to how taxes are calculated and paid. In this blog, we’ll delve into the details of these reforms and explain what they mean for your business.
The Current System
Currently, the basis period rules dictate that established sole traders and partners/members in ongoing businesses pay taxes based on the financial performance of the business within a 12-month accounting period ending in the tax year. However, for businesses that prepare accounts for the 12 months ending between 31 March and 5 April, these changes will apply.
The Opening Year Rules
Different rules apply to individuals in their first tax year of trading. Partners or members are treated as starting to trade on the date they join a partnership or LLP. In this initial year, taxation occurs based on profits from the start of trading until the end of the tax year.
The New Basis Period Rules
Starting from 2024/25, all unincorporated businesses will be taxed on profits generated between the start and end of the tax year (6 April to 5 April). This rule applies regardless of the business’s accounting year-end. HMRC will allow a year-end falling between 31 March and 5 April to be treated as if it falls at the end of the tax year.
Transitional Period and Relief
The transition to the new rules occurs in the 2023/24 tax year. Individuals will be taxed on a long period of account ending on 5 April 2024, encompassing previously untaxed profits. Relief will be granted for any overlap profits generated under the current basis period rules.
Transitional Profit Spreading
Rules allow the tax liability from transitional period profits to be spread over five tax years, starting with the transition year. This eases cash flow by avoiding a sudden increase in tax due in the transition year.
Impact on Cash Flow
The changes can significantly impact cash flow. An example (scroll to bottom of post) illustrates how taxable profits can increase under the new rules, leading to the possibility of spreading the excess tax liability over five years.
Considerations and Next Steps
Businesses should evaluate whether changing their accounting year-end to 31 March or 6 April is advantageous. Aligning with the tax year could be beneficial in most cases, though commercial considerations may vary.
It’s crucial to review future tax liabilities, especially if changing the accounting year-end before the transitional year might be advantageous. Factors like increased tax rates should be considered.
The HMRC’s basis period reforms bring substantial changes to taxation for unincorporated businesses and LLPs. Understanding these changes and their implications for your business is vital for effective financial planning and management. It’s recommended to start planning early to mitigate potential cash flow impacts and administrative burdens associated with the new rules. Adapting to these changes can ensure your business remains financially resilient and compliant in the evolving tax landscape.
Example: Impact of Basis Period Reform on a Sole Trader
Meet Sarah, a sole trader who runs a successful graphic design business. Currently, her business’s accounting year-end is 30 June, and she pays taxes based on her profits within that 12-month period. However, with the new basis period reform taking effect from 6 April 2023, Sarah’s tax calculations are about to change significantly.
Under the Current System (Tax Year 2022/23):
Sarah’s accounting year-end: 30 June Her taxable period for 2022/23: 1 July 2021 to 30 June 2022 Tax calculation based on this period
Now, Let’s See How the Reform Affects Sarah (Tax Year 2023/24):
Sarah’s accounting year-end: 30 June Transition year: 2023/24 (from 6 April 2023 to 5 April 2024) New taxable period for 2023/24: 1 July 2022 to 5 April 2024 Tax calculation based on this extended period
In this scenario, the new basis period reform extends Sarah’s taxable period for the transition year, incorporating almost nine additional months of business activity (from 1 July 2022 to 5 April 2024) into her tax calculation. This extended period could lead to a higher taxable profit figure due to the inclusion of more months of business activity.
Furthermore, if Sarah’s business accounts for the year ending 30 June 2024 are not finalised by the tax return filing deadline, she will have to estimate her profits for the remaining months and include them in her tax return.
Impact on Sarah’s Cash Flow and Planning:
- Higher Tax Liability: The inclusion of extra months’ profits could potentially result in a higher tax liability for the transition year (2023/24). Sarah needs to prepare for this increased tax payment, which might affect her cash flow.
- Transitional Profit Spreading: To ease the cash flow impact, Sarah can take advantage of the transitional profit spreading option. This allows her to spread the additional tax liability resulting from the extended taxable period over five years, starting from the transition year. While this helps manage immediate cash flow concerns, it’s essential to understand the long-term financial implications.
- Accounting Year-End Consideration: Sarah may need to evaluate whether changing her accounting year-end to align with the tax year (6 April to 5 April) is more beneficial for her business. This decision would impact how profits are calculated and taxes are paid in the future.
- Early Planning: Sarah should start planning for these changes well in advance. She may choose to adjust her accounting year-end before the transition year to avoid potential surprises and to take advantage of any tax-saving opportunities.
Sarah’s case highlights the importance of understanding how the basis period reform can affect individual businesses. Each business’s situation is unique, and considering the implications of the reform on cash flow, tax planning, and overall financial strategy is crucial for adapting effectively to the new tax landscape.