Lee Sharpe admits (grudgingly!) that the cash basis may have a role to play for landlords during the Covid-19 pandemic. But reverting back to generally accepted accounting practice once it has passed may also be very useful.
I am no fan of the cash basis. Generally speaking, whenever HMRC or the Treasury tout something as a simplification:
- They mean for them, not for taxpayers;
- It will cost taxpayers – or certainly won’t harm government revenues;
- They think it’s simple because they don’t understand the legislation that they have just unleashed.
These are not mutually exclusive. For example, as regards the cash basis for landlords:
- Rent is usually paid in advance, so having to account for it all, immediately on receipt, means recognising higher profits and paying more tax (at least once).
- The ‘simple’ regime covers 20 pages of legislation. The hard part of the simplification was making sure that the cash basis didn’t materially benefit landlords.
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HMRC’s official guidance is about a dozen pages long. It is astonishingly light on detail.
But let’s set aside the usual criticisms of the cash basis, the abolition of indexation allowance or making tax digital (to name but a few). For once, let’s embrace change! A lot!
Cash basis vs generally accepted accounting practice/accruals
Using the accruals basis means you can prune away payments for periods extending beyond the end of the accounts year, etc. For example, this means you basically ignore receipts on 1 April for the month or quarter commencing 1 April, etc.
Under the cash basis, these have to be included and recognised in full, even if they are almost entirely to do with the following tax year. Of course, this also works in your favour so far as payments and costs are concerned; pay your landlords’ insurance on 5 April and you’ll still get full relief under the cash basis.
Adopting the cash basis under Covid-19
Many tenants (i.e. private and commercial) are facing an uncertain future. Informal rent holidays are becoming increasingly common.
From the landlord’s perspective, accepting deferred payment can mean a significant difference opening up between what has been invoiced and is legally due, and what has actually been received. To an extent, this can be defrayed by agreeing mortgage repayment holidays with the landlord’s lenders.
Example 1: Cash or accruals basis? (1)
Fiona’s business has been hit badly by Covid-19. Many tenants are struggling to pay; she has recovered only about half of the rents due since April 2020.
By the end of March 2021, she has to take a view on how likely it is that she will recover all the outstanding funds legally due because, under the traditional generally accepted accounting practice (GAAP) basis, she can basically exclude only that amount which she thinks she will never receive.
Total annual rent roll (Year to 31 March 2021):£40,000
Actually received £25,000
Outstanding/overdue£15,000
Estimated eventually to be recoverable£12,000
(Bad and doubtful debts of £3,000 are the difference)
Fiona’s income under GAAP is £40,000, less the bad/doubtful debt provision of £3,000 = £37,000.
Fiona’s income under the cash basis is just the £25,000 actually received.
Rents and bad debts for landlords
Essentially, by adopting the cash basis in 2020/21, Fiona stands to save tax on the £12,000 of income she has not yet received, but thinks she will get eventually.
But Fiona also has to consider the effect on her outgoings. Notably, if Fiona has agreed mortgage holidays with any of her lenders, the interest charge would have been allowable under the accruals basis as an expense of letting property in 2020/21, but will be excluded under the cash basis if it has not been paid in 2020/21 (it would still have been included under GAAP as the interest charge is still there; a holiday agreement just postpones payment, it does not write it off.)
Let’s say that Fiona has managed to postpone £2,000 of interest by taking mortgage payment holidays; she is still better off by £10,000 after netting off, if she takes the cash basis.
Assuming that the economy gets back to normal relatively quickly, the real issue with adopting the cash basis in 2020/21 is when all of that outstanding cash (hopefully) ends up getting paid to Fiona in (say) 2021/22. Fiona will basically end up being taxed on an extra £12,000 received in 2021/22, on top of her usual annual profits.
So, Fiona won’t stay in the cash basis.
Back to GAAP
If Fiona is no longer using the cash basis when all the ‘old’ money for 2020/21 is received in 2021/22, it will not automatically be treated as part of her 2021/22 profits.
Under GAAP, that income strictly belongs to 2020/21, and would already have been taxed in 2020/21 under GAAP.
Of course, the legislation acts to trap things that would fall out of charge on a change of basis such as this. The legislation requires Fiona to mop up and adjust for income that would otherwise not be taxed, or be taxed twice; likewise for expenses. But the legislation also states that, where the overall adjustment is to increase profits (‘adjustment income’) it is automatically spread over six tax years.
So, Fiona will save tax on £10,000 in 2020/21 by adopting the cash basis, and then if she adopts GAAP in 2021/22 when all the outstanding money comes in, the old receipts will be taxable, but spread over six years:
Example 2: Cash or accruals basis? (2)
Let’s assume, for simplicity, that Fiona gets all of her usual £40,000 annual rent roll in 2021/22 together with £14,000 of the £15,000 that was outstanding at the end of 2020/21. Fiona thought she would lose £3,000 in bad debts; but in the end, it is only £1,000.
All other things being equal; Fiona first recognises the usual income in 2021/22 according to GAAP, so £40,000.
She then adjusts for income that would have been taxed prior to the changeover to the GAAP basis if GAAP had been used immediately before the change as well as after, but was not taxed because actually the cash basis was used instead. This is basically the £14,000 that Fiona received ‘late’.
Then Fiona has to adjust for the mortgage payment holiday in 2020/21 which meant she didn’t have to pay £2,000 interest in 2020/21. Under GAAP, it should have been claimed in 2020/21, so if she doesn’t adjust for it now, she won’t get relief at all. This is deducted from the £14,000 positive adjustment, leaving Fiona with net adjustment income of £12,000.
While Fiona got immediate relief for the outstanding debts owed when she used the cash basis in 2020/21, adjustment income on changing to the GAAP basis is automatically spread over six years, so Fiona has only to account for £2,000 each year, over 2021/22 to 2026/27. Fiona’s 2021/22 rental profit is just £42,000, not £52,000.
Conclusion
Firstly, this can postpone a substantial amount of tax. If 2020/21 is a bad year for rent arrears, the worse it is, the more tax will ultimately be postponed by moving to GAAP.
It doesn’t matter if Fiona used the traditional GAAP/accruals basis right up to 2020/21 and then moves to the cash basis for just a year before going back, or if Fiona had already been using the cash basis by 2020/21; what matters is adopting GAAP after the cash basis has done its work.
Timing is critical. The ideal year to transition to GAAP is when all or most of the money overdue at the worst point of the pandemic is recovered. For example, it could be 2022/23, depending on how things pan out.
Ironically, if the rental business is big enough, (but not too big), the ‘bounce’ in receipts after rental holidays, etc., could trip over £150,000 in a tax year so the landlord/landlady has to use GAAP.
Moving between bases is more complex than the simple scenario painted above. For example, it is possible to deliberately accelerate the six-year adjustment, to recognise more income earlier on. This could in some cases result in further tax savings, as well as postponement.
