Sarah Bradford looks at the forthcoming changes to the rules that determine which profits are taxed for a particular tax year.
In preparation for the introduction of making tax digital for income tax self-assessment (MTD for ITSA), the rules that determine which profits of an unincorporated business are charged to tax for a particular tax year are being reformed.
The existing basis period rules, which tax profits of an established business on a current year basis, are being abolished. Instead, from 2024/25 the profits of an unincorporated business will be taxed on a tax year basis. To facilitate the move from the current year basis to the tax year basis, the 2023/24 tax year will be a transitional year.
Existing current year basis
Once an unincorporated business is established, under the current year basis the profits taxed for a particular tax year are those for the accounting period that ends in that tax year.
Different rules apply in the opening and closing years of a business.
Example 1: Current basis period rules
Michael is a sole trader. He started his business in 2012. He prepares his accounts to 31 December each year.
The profits assessed for the 2021/22 tax year are those to 31 December 2021. The accounting date of 31 December 2021 falls within the 2021/22 tax year.
Under the current year basis, some of the profits assessed for a particular tax year may not fall within that tax year.
In Example 1 above, Michael is taxed on his profits for the year to 31 December 2021 in the 2021/22 tax year, irrespective of the fact that part of that period (i.e., 1 January 2021 to 5 April 2021) falls within the 2020/21 tax year.
Under self-assessment, the date on which tax is payable is determined by reference to the tax year rather than to the accounting period for which the profits are taxed. By choosing an accounting date early in the tax year (say, 30 April), the trader is able to benefit from a long window before tax for the period is due. Where the accounting date is 30 April, only the period from 6 April to 30 April falls in the tax year in which the profits are taxed.
Opening year rules and overlap profits
Different rules apply to tax the profits in the opening years of the business. These rules may result in some profits being taxed twice. These are known as overlap profits.
- In year one, the profits taxed are those from the date that the business starts to the end of the tax year.
- In year two, the profits assessed depend on whether there is an accounting date in that year which is at least 12 months from commencement. Where there is, the profits taxed are those for the 12 months to the accounting date. Otherwise, the profits of the first 12 months are taxed.
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From year three onwards, the current year basis applies and profits taxed are those for the 12 months to the accounting date in the tax year.
In years one and two, overlap profits may arise. These are profits that are taxed in both years.
Example 2: Overlap profits
Michael started his business on 1 March 2012. For 2011/12 (year 1), he is taxed on profits for the period 1 March 2012 to 5 April 2012.
For 2012/13 (year 2), he is taxed on profits for the first 12 months (i.e., 1 March 2012 to 28 February 2013). The profits for the period from 1 March 2012 to 5 April 2012 were also taxed in year 1. These are overlap profits.
Overlap profits on a change of accounting date
Overlap profits can also arise on a change of accounting date.
These can arise where the period from the end of the last accounting period to the new accounting period is less than 12 months.
Relief for overlap profits
Relief for overlap profits is currently given on cessation or on a change of accounting date where the basis period for the tax year is longer than 12 months.
New rules: tax year basis
From 2024/25, the profits charged to tax under ITSA are those for the tax year. This means that the profits which will be taxed for 2024/25 are those for the period 6 April 2024 to 5 April 2025.
Where accounts are prepared to 5 April each year, this is relatively straightforward as no apportionment is needed. Furthermore, under ‘equivalence’ provisions, an accounting date between 31 March and 4 April inclusive is regarded as being equivalent to the tax year, and again no apportionment is needed.
However, where accounts are prepared to a different date, it is necessary to carry out an apportionment calculation to match the profits from two accounting periods to the tax year. This can be done on the basis of the number of days falling in the tax year, or by reference to another method as long as it is reasonable and used consistently (e.g., using months rather than days).
Example 3: Tax year basis – Apportionment of profits
Michael continues to prepare accounts to 31 December each year. He has profits of £36,000 for the year to 31 December 2024 and profits of £42,000 for the year to 31 December 2025.
The 2024/25 tax year spans two accounting periods – the year to 31 December 2024 and the year to 31 December 2025. Consequently, to arrive at the profits for the tax year, it is necessary to undertake an apportionment calculation.
The period 6 April 2024 to 31 December 2024 (270 days) falls within the year to 31 December 2024, and the period from 1 January 2025 to 5 April 2025 (95 days) falls within the year to 31 December 2025.
Profits assessed for the 2024/25 tax year are £37,489 ((270/366 x £36,000) + (95/365 x £42,000)).
Transitional year: 2023/24
Transitional rules apply for 2023/24 to move from a current year basis to a tax year basis and to pick up any profits that would otherwise fall out of charge. Relief is also given in 2023/24 for any unrelieved overlap profits.
The profits that will be assessed in the transitional year where accounts are prepared to a date other than 31 March to 5 April inclusive are to be found by adding together two components and deducting any unrelieved overlap profits. The two components are:
- the ‘standard’ component – this is the profit assessable for the 2022/23 tax year under the current year basis; and
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the transition component – this is the profit attributable to the period running from the end of the current year basis period to 5 April 2023 (the end of the 2022/23 tax year).
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Example 4: Profit calculation for transitional year |
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For the transitional year, Michael would be taxed on profits for: |
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Spreading of transition component
In the transitional year, without any modifications, unincorporated businesses that do not prepare accounts on a tax year basis would be taxed on the profits of more than 12 months. Where the tax date falls early in the tax year, the number of additional months to bring into account will be more than where the accounting date is late in the tax year.
For example, where accounts are prepared to 30 April, the transition component will be 11 months, but where accounts are prepared to 31 January, the transition component is only two months.
To prevent taxpayers suffering a high tax bill in 2023/24 (and potentially being taxed at a higher marginal rate), the transition component is not taxed in full in 2023/24. Instead, it is spread over five years starting with 2023/24. This happens automatically, but the trader can elect for it not to apply if they would prefer it to be taxed in full in 2023/24. This may be the case if there are losses to relieve, or if the personal allowance may otherwise be wasted.
Consider a change of accounting date
You may wish to consider changing your accounting date to 31 March (or to a date between 1 and 5 April) to simplify matters and avoid the need for an apportionment calculation.
Where this is done prior to 2023/24, the current provisions on a change of accounting date will apply instead of the transitional rules.
Practical tip
Plan ahead for the new rules and consider whether a change of accounting date is worthwhile.
