What A Difference A Date Makes!

Ken Moody highlights potential income tax and National Insurance contributions savings on choosing or changing the accounting date of a sole trader or partnership.

The tax legislation does not suggest what date a sole trader or partnership should make their accounts up to. The most convenient date may often be 5 April to coincide with the tax year, and may be suitable if the level of profits is reasonably stable. However, choosing a different date, or changing the existing date, might save or at least defer considerable amounts of tax especially where profits are increasing or there are fluctuations.

There are rules which identify the basis period for a year of assessment, the ‘general rule’ being that the basis period is the period of twelve months ending with the accounting date in that year. The general rule is then modified where the accounting period ending in the year is longer or shorter than twelve months, and there are special rules which apply to the opening years of assessment for a new business.

When a new business starts, the tax assessments for the opening years are based on the following:

Year 1

Profits from the date of commencement to 5 April; and

Year 2

If the period from commencement to the first accounting date is less than twelve months, the basis period is the first twelve months. If the first accounting period is longer than twelve months, the general rule applies. If there is no accounting period ended in the year (because the accounting period is longer than twelve months and ends in Year 3, the basis period is the tax year.

Chris buys a newsagent business on 1 January 2016. He makes his first accounts up to 30 June 2017, for which period his tax adjusted profit (after capital allowances) is £50,000. His assessments will be:

1 January 2016 – 5 April 2016: £50,000 x 95/546 = £8,700

6 April 2016 – 5 April 2017: £50,000 x 365/546 = £33,425

1 July 2016 – 30 June 2017 (general rule applies): £50,000 x 365/546 = £33,425 

As it happens, Chris is a shrewd entrepreneur, and having learned the ropes of the business he introduces some new side-lines and earns profits of £80,000 (tax adjusted) for his next year. 

If he makes his accounts up to 30 June 2018, his total assessable profits for the four years 2015/16–2018/19 would be £75,550 + £80,000 = £155,550.

If he had made his accounts up to 5 April, and let’s say his profit to 5 April 2019 is again £80,000, his profits for those same years would be £50,000 + £80,000 + £80,000 = £210,000.

By choosing a 30 June year end, Chris will have paid less tax earlier than he would have done if he had chosen 5 April as his accounting date. In tax, most of us would regard ‘a bird in the hand’ as a saving.

With a 30 June accounting date, the profits of the period from 1 July 2016 to 5 April 2017 have been doubly assessed, as that period forms part of the basis periods for both 2016/17 and 2017/18. The profits for the ‘overlap’ period (i.e. £50,000 x 279/546 = £25,550)are the profits assessable for the three years 2015/16–2017/18 which exceed the £50,000 result for the first accounting period (i.e. £75,550 - £50,000 = £25,550). This is carried forward as overlap relief, and is offset against the profits for the final year of assessment or on a change of accounting date. 

Suppose Chris sells the shop on 30 June 2022, for which year his profits are £100,000. Subject to overlap relief, he is assessable for 2022/23 on a full year’s profits even though he traded for only three months in that tax year. If he took a job following the sale his self-assessment for 2022/23 would also include salary from (say) July 2022 to 5 April 2023, which may increase his higher rate exposure.

The overlap relief will reduce the final assessment to £74,450. Being based on the profits of the early years of the business, increased profits in later years and inflation tends to dilute the ultimate effect of the relief. It is often the case, however, that a business will be ‘running down’ prior to cessation. If the profits to 30 June 2022 had been £50,000, the relief would obviously have had a greater impact on the final year’s assessment. 

Let’s now suppose that Chris’ entrepreneurial zeal didn’t kick in for a couple of years. Having started in business on 1 January 2016 he decides to make his accounts up to 31 December to coincide with the calendar year, and he has since steadily made profits of £50,000 (tax adjusted) each year. 

His overlap relief based on £50,000 would be for the period 1 January 2016 to 5 April 2016 i.e. £50,000 x 95/365 = £13,014. For his second year, the general rule applies and he is assessable on the profit for the year ended 31 December 2016. In April 2020, the shop next door to Chris’ newsagent comes up for sale, which Chris buys and is able to extend his shop into the new premises. He expects this to increase his profits for the year to 31 December 2020 to £100,000, and to about £130,000 on an ongoing basis.

Chris’ accountant advises him to extend his accounting period from 31 December 2019 to 30 April 2020. His profits from 1 January to 30 April 2020 remain constant and so let’s say his profit for the extended period to 30 April 2020 is £65,000. The situation for 2019/20 therefore is that there is no accounting period ending in the year 2019/20. In those circumstances, the rules say that the basis period is the twelve months beginning immediately after the end of the basis period for the previous tax year, which is therefore from 1 January 2019 to 31 December 2019. For 2019/20, he therefore self-assesses profits of £65,000 x 365/485 = £48,917. Because the basis period is not more than twelve months, none of the overlap relief is used. If Chris had merely extended his accounting period to 5 April 2020, there would have been an accounting period ended in 2019/20 of 460 days, in which case that would form the basis period for 2019/20 and as this is longer than twelve months, this would have been reduced by the overlap relief of £13,014.

For 2020/21, the general rule applies and so the basis period is the twelve months ended 30 April 2020, so £65,000 x 365/460 = £51,576. As this overlaps with the basis period for 2019/20 (i.e. the period from 1 July 2019 to 31 December 2019), this gives rise to further overlap relief carried forward of £65,000 x 184/460 = £26,000.

By adopting a 30 April year end, Chris has deferred tax and National Insurance contributions on profits of about £50,000. The general rule will apply to Chris’ self-assessment for the following year 2021/22, and so the basis period will be the twelve months ending 30 April 2021. Chris expects profits to be circa £130,000, but if he made up his accounts to 31 December 2020 the results could be similar or perhaps even greater. 

There are, however, some restrictions. An accounting period cannot exceed 18 months, and for an effective change of accounting date there cannot have been another change of accounting date within the five preceding tax years unless the change is for commercial reasons.

If a year-end of (say) 5 April 2017 is simply extended to 30 April 2017, this may not be effective because that means that there is no accounting period ended in 2016/17, and so the assessment is based on the twelve months beginning after the end of the previous basis period (i.e. 6 April 2016 to 5 April 2017). If increased profits are anticipated for 2016/17, it is the year to 5 April 2016 which needs to be extended to 30 April 2016, to avoid the increased profits being assessable for 2016/17 – otherwise one may be ‘shutting the door after the horse has bolted’! Naturally a degree of foresight is therefore required.