HMRC have been consulting on the reform of the basis period rules in preparation for the introduction of Making Tax Digital for Income Tax Self-Assessment (MTD ITSA), which comes into effect from April 2023. A consultation paper was published in July 2021, which sets out new simplified basis period rules. Comments were sought by 31 August 2021 on how best to implement the reforms.
Existing rules – the current year basis
Once an unincorporated business is established, it is taxed on the current year basis. Special rules apply in the opening and closing years of the business. Under the current year basis, the profits that are taxed for a particular tax year are those for the accounting period that ends in that tax year. Consequently, if the business prepares its accounts to 30 June each year, for the 2021/22 tax year, it will be taxed on its profits for the year to 30 June 2021, as this is the year that ends between 6 April 2021 and 5 April 2022.
Under the existing rules, some of the profits of the business may be taxed twice in the opening years. These profits are known as 'overlap' profits. Relief for the double taxation of these profits, known as 'overlap relief', is given when the business ceases, or earlier if there is a change of accounting date.
New rules – tax year basis
The reforms will mean that unincorporated businesses will be taxed on the profits arising in the tax year – i.e., the profits for the period from 6 April to the following 5 April. Where the business prepares accounts to 31 March, these will be deemed to correspond to the tax year (as will the preparation of accounts to any date between 31 March and 5 April).
If you prepare accounts to a date other than 31 March/5 April, you will need to apportion your profits so that they correspond to the tax year. For example, if you prepare your accounts to 30 June, for 2023/24, you will be taxed on 3/12th of the profit for the year to 30 June 2023 (covering the period from 6 April 2023 to 30 June 2023) plus 9/12th of the profit for the year to 30 June 2024 (covering the period from 1 July 2023 to 5 April 2024).
The tax year basis will apply from 2023/24, with 2022/23 being a transitional year.
Estimation of profits
If you have an accounting date late in the tax year and prepare accounts other than to 31 March/5 April, you may not have the second set of accounts available when you come to complete your tax return. For example, if you prepare your accounts to 28 February, for 2023/24 you will be taxed on 11/12th of your profit for the year to 28 February 2024 and 1/12th of your profit for the year to 28 February 2025. The accounts to 28 February 2025 will not be available by 31 January 2025, and you would be expected to file a provisional return, which would be amended later when the information is available.
This will create extra work, and HMRC are looking at alternative estimation approaches, such as making an estimate based on the profits for the quarterly updates submitted under MTD ITSA, extrapolating the profits for the 'known' part of the tax year, and allowing the final figures to be provided as part of the following year's return.
To overcome this, you may prefer to change your accounting date and prepare accounts to 31 March/5 April. This will avoid the need for an apportionment calculation and reduce your workload.
Transitional rules
Transitional rules are needed to move from the current year basis to the tax year basis. The transition year is 2022/23.
For the transition year, the taxable profits for a business that does not have a 31 March/5 April year end will comprise the sum of:
- the standard component (which is the profit assessable in 2022/23 under the current year basis); and
- the transition component (which is the profit for the period from the end of the current year basis period to the end of the 2022/23 tax year).
Any historic overlap relief can be claimed in the transition year by deducting overlap profits from the result of the above calculation.
For example, if you prepare accounts to 30 June each year, for 2022/2023, you will be taxed on the profits for the year to 30 June 2022 (the basis period for 2022/23 under the current year basis) plus profits for the period from 1 July 2022 to 5 April 2023 (the transition component), less any overlap profits. The overlap relief will cover the period from the date on which the business started to the following 5 April.
Spreading excess profits
In the transition year, your profits may be higher than normal. This will be the case if your transition component is more than your overlap relief. If you started your business some time ago, the impact of inflation may mean that your overlap profits are considerably less than the profits of the transition component, even if they both cover the same number of months. If your profits are higher than normal, your tax bill will also be higher, and you may pay tax at a higher marginal rate as a result.
To mitigate the effect of the transition year on cash flow, HMRC plan to allow businesses to elect to spread any excess profits in the transition year over five years.
Equivalence rules
As part of the simplification reforms, HMRC propose that the statutory rule which deems 31 March to be equivalent to 5 April in the first three years of a trade is extended so that it applies to all the years of the trade. This will mean that where accounts are prepared to 31 March, the business would not need to make small adjustments for the profits of the business to correspond to the tax year, which runs to 5 April. The consultation sought views on whether this equivalence rule should be extended to property businesses.
We can help
Please talk to us about what the reforms will mean for your business, and what you need to do to prepare for the introduction of MTD ITSA.