Basis periods are fundamental in UK tax law, particularly for unincorporated businesses such as sole traders and partnerships. They determine the timeframe for which profits are assessed for income tax purposes. A basis period is the period for which a business’s taxable profits are calculated. Established businesses pay tax based on the business’s financial performance in the 12-month accounting period, which ends in the tax year. For example, if a business prepares accounts for the year ending 31 December 2022, the profits from this period would be taxed in the individual’s tax return for the 2022/23 tax year.
For individuals in their first tax year of trade, different rules apply. They are taxed on their profits from starting to trade to the end of that tax year (5 April). For instance, if a new partner joins a partnership on 1 January 2021, where the accounting year-end is 31 December 2021, they are taxed on their profits from 1 January 2021 to 5 April 2021 for the 2020/21 tax year. The following tax year, they are taxed on the first 12 months’ profits, being 1 January 2021 to 31 December 2021. This system can lead to a portion of profits being taxed twice in these tax years, known as ‘overlap profit’. This overlap profit is usually relieved when the business ceases or when the accounting date changes. However, this can lead to complexity and confusion for taxpayers, which is one reason why HM Revenue and Customs (HMRC) is implementing reforms to the basis period rules.
To illustrate the current system, let’s consider a sole trader who started their business on 1 July 2022 and has an accounting year-end of 30 June. For the tax year 2022/23, they would be taxed on their profits from 1 July 2022 to 5 April 2023. For the tax year 2023/24, they would be taxed on their profits for the 12 months from 1 July 2022 to 30 June 2023. This means that the profits from 1 July 2022 to 5 April 2023 are taxed twice, creating overlap profits.
The Upcoming Reforms to Basis Periods
HMRC have implemented reforms to the basis period rules, which will take effect from 6 April 2024. The new rules will mean that all unincorporated businesses, including sole traders, partnerships, and limited liability partnerships (LLPs), will be taxed on the profits generated between the start and end of the tax year, from 6 April to 5 April, regardless of their accounting period. This change is designed to simplify the tax system for unincorporated businesses by aligning the tax year with the basis period, eliminating the concept of overlap profits and the complexity that comes with it.
This change will affect all sole traders, unincorporated partnerships, and LLPs that need to prepare their annual accounts to a reference date between 31 March and 5 April. This reform is being implemented despite the delay in Making Tax Digital for income tax and significant representation from the industry. Under the new rules, HMRC will allow a year-end between 31 March and 5 April to be treated as if it falls at the end of the tax year. However, if a business has an accounting year-end that does not align with the tax year, it must apportion profits from two accounting periods to fit into the 6 April to 5 April timeline. If the accounts have yet to be finalised before the tax return filing deadline, then estimated profits will have to be included.
The Impact of the Reforms
The reforms will simplify the tax system for unincorporated businesses by aligning the tax year with the basis period. This will eliminate the concept of overlap profits and the complexity that comes with it. However, it will also mean that businesses with an accounting year-end that does not align with the tax year will need to adjust their accounting practices and possibly face increased administrative costs. The transition to the new rules will also have significant implications for the tax liabilities of businesses. The 2023/24 tax year will be a transitional year, during which individuals will be taxed on a long period of account ending 5 April 2024. This period will pick up all untaxed accounting profits generated up to this date. However, relief will be given for any overlap profits generated under the current basis period rules.
To illustrate the impact of the changes, let’s consider this example. A business with a year-end of 30 September 2023 has profits of £100,000 for that year and additional profits of £50,000 for the period from 1 October 2023 to 31 March 2024. Under the current rules, the taxable profits for the 2023/24 tax year would be £100,000. However, under the new rules, the taxable profits for 2023/24 would be £150,000, less any overlap profits brought forward.
The Transitional Year and Spreading of Payments
The 2023/24 tax year will be key for the transition to the new basis period rules. During this year, individuals will be taxed on a long period of account ending 5 April 2024, including all untaxed accounting profits generated up to this date. Relief will be given for overlap profits generated under the current basis period rules. To ease cash flow, HMRC has introduced rules thatallow the payment of any additional tax liability generated from transitional period profits to be spread over five tax years, beginning with the year of transition. This means the extra tax due on these profits willbe paid only partially in the 2023/24 tax year. For example, suppose a business has excess profits of £30,000 in the transitional year. In that case, these can (certain to qualifying criteria being met) be spread across five tax years, with an additional £6,000 taxable over the five years from 2023/24 to 2027/28.
Tax year 2023/24 represents the last possibility for businesses to deduct overlap relief – no amounts can be carried forward past this year, and any unused amounts will be lost. There are specific criteria relating to the utilisation of overlap relief. The interaction of the standard profits, the transitional profits and the deduction of any overlap profits will determine whether the resulting profits can be spread over five years or if the profits should be taxed in full during the 23/24 tax year. Jack Ross can help you navigate this complexity.
The New Tax Year Basis
| Current Rules | New Tax Year Basis Rules |
| Tax based on profits of the accounting period ending in the tax year | Tax based on profits from 6 April to 5 April |
| Overlap profits can arise in the early years of trading | No overlap profits |
| Different rules for the first year of trading | Same rules for all years |
| Profits are taxed twice in certain circumstances. | No profits are taxed twice. |
From 2024/25 onwards, businesses will be taxed on their profits arising in the tax year, regardless of their accounting period. For example, the profits taxable in 2024/25 will be those arising in the period from 6 April 2024 to 5 April 2025.
Businesses with a 31 March or 5 April year-end will therefore remain the same as a result of the tax year basis coming into force. However, all other businesses will need to apportion their profits into tax years.
One additional complication of the new tax year basis is that, depending on the accounting date of the business, the second set of accounts may still need to be finalised by the filing deadline for a tax year. For example, a business with a 31 December year end is highly unlikely to have the accounts for the year to 31 December 2025 ready by 31 January 2026 filing deadline for the 2024/25 tax return.
The requirement to apportion, and potentially also to calculate and correct provisional figures, will be an ongoing annual requirement for affected businesses. The only real way to avoid the additional work this will generate is to change to a 31 March or 5 April year end. Consider changing the accounting period date to 5 April as it would mean that the accounts information can be completed more easily on the respective tax returns. It would also make reporting for Making Tax Digital (MTD) for Income Tax simpler for businesses who fall into the new MTD regime.
Summary of the Main Changes
- Understanding Basis Periods in the UK Tax System:
- Basis periods determine the timeframe for assessing profits for income tax, typically aligning with a 12-month accounting period. For new traders, profits are taxed from the date of starting to trade to the tax year’s end, sometimes leading to ‘overlap profit’. These complexities have led HMRC to reform basis period rules.
- Upcoming Reforms to Basis Periods (Effective from 6 April 2024):
- The reforms will align the tax year with the basis period for all unincorporated businesses, taxing profits from 6 April to 5 April, regardless of the accounting period. The change aims to simplify the tax system by eliminating overlap profits and the associated complexities.
- Impact of Reforms on Accounting Practices and Tax Liabilities:
- While simplifying the system, businesses with non-aligned accounting year-ends will need to adjust their practices, possibly incurring increased administrative costs. The transitional year 2023/24 will also have significant tax implications, including the potential increase in taxable profits.
- Transitional Year and Spreading of Payments (2023/24):
- During the transitional year, all untaxed accounting profits will be taxed up to 5 April 2024, with relief for overlap profits. To ease cash flow, HMRC will allow tax liability from transitional period profits to be spread over five years, starting with the transition year.
- Introduction of the New Tax Year Basis (From 2024/25):
- Businesses will be taxed on profits arising within the tax year, regardless of the accounting period. This may require ongoing annual apportionment and calculation of provisional figures, leading some businesses to consider changing their accounting period to align with the tax year.
- Next Actions and Planning:
- The changes will significantly impact unincorporated businesses, requiring careful planning. Aligning the accounting year-end with the tax year could mitigate increased accountancy fees and administrative burdens. An early review of future tax liabilities and potential year-end changes may also be beneficial.
Next Actions
The upcoming changes to the basis period rules will have significant implications for unincorporated businesses. It is important to start planning for these changes sooner rather than later. Changing your business’s accounting year-end to align with the tax year would be beneficial. Maintaining a different year-end could lead to increased accountancy fees and administrative burdens.
You should also review your future tax liabilities and when and how these will become payable. In some cases, changing your accounting year-end in the 2022/23 tax year may be beneficial rather than waiting until the 2023/24 transitional year. If you have any questions, please get in touch with your usual accountant at Jack Ross.