Basis period reform

Introduction

The government announced in the Autumn Budget 2021 that it would reform the way that trading profits are allocated to tax years for income tax purposes. The announcement followed a consultation published by HMRC on 20 July 2021. The changes were legislated in Finance Act 2022. Broadly, the intention is to tax profits that are time-apportioned to the tax year instead of the profits for the 12 months to the accounting date in the tax year. This reform affects individuals who are self-employed, including partners in trading partnerships, if their accounting periods are not aligned to the tax year (dates from 31 March to 5 April inclusive are treated as aligned to the tax year for this purpose). The changes will take effect from the 2024/25 tax year, with transitional rules applying in 2023/24.

Although the changes have been badged as a simplification, they generally create complexity for the individuals and partnerships affected. In principle the complexity can be avoided by aligning the business’s accounting period to the tax year, but in practice there are often commercial or international tax considerations that make this impractical. HMRC acknowledged in their summary of responses that the changes would create additional administrative burdens for these taxpayers. HMRC consulted on ways to ease these burdens, but on 2 December 2022 they confirmed that they would only implement the very limited easement of allowing amendments to be made at any point in the amendment window (i.e. up to the anniversary of the filing deadline). In practice this is unlikely to provide much benefit to the taxpayers affected.

The changes

The current rules (“current year basis”)

For income tax purposes, trading profits of a tax year are generally based on the profits for the 12 month accounting period ending in the tax year (subject to adjustments for disallowed expenditure, depreciation etc). For example, if an individual draws their accounts to 31 December every year, the 2021/22 taxable profits would be based on the accounts for the year ended 31 December 2021. This is known as the “current year basis” and the period being taxed is the “basis period”.

Special rules apply in the opening and closing years of a trading business under the current year basis. In the tax year that the trade begins, the taxable profits are normally based on a time-apportioned amount falling between the date of commencement and 5 April. In the second year, the profits for the first 12 months of trading are normally taxed. If an individual commenced trading on 1 January 2021 and drew their accounts to 31 December 2021, the 2020/21 profits would therefore be 95/365ths of the profits of the 2021 accounts and the 2021/22 profits would be based on the full 2021 calendar year. Part of the profits would therefore be taxed twice (“overlap profits”). The doubly taxed profits are normally deducted from the trading profits in the year the trade ceases to eliminate the double taxation (“overlap relief”), but this can happen earlier in some cases if there is a change of accounting date.

Overlap profits do not arise if the accounting periods are all aligned to the tax year. For this reason, most traders choose accounting dates of 31 March or 5 April. If traders use alternative dates, they typically need to file their first return for the business using provisional figures as the accounts might not be final (e.g. if the first accounts run from 1 March 2022 to 28 February 2023, the tax return for 2021/22 was due on 31 January 2023, a month before the accounting period finished). They also need to determine the overlap profits figure and report this on the tax return each year until it is relieved. It is the calculation and recording of overlap profits that the government is seeking to remove in these reforms.

The new basis from 2024/25 (“tax year basis”)

From 2024/25, taxable profits will be based on time-apportioned profits of the accounting periods that fall within the tax year. For example, if a trader draws their accounts to 31 December every year, their 2024/25 taxable profits would be based on 270/366ths of the 2024 calendar year profits and 95/365ths of the 2025 calendar year profits.

Whilst this is relatively simple on paper, it will cause difficulty in practice. The 2024/25 tax return is due by 31 January 2026. Unless the business is very simple, it is unlikely that the trader will be able to finalise the accounts and tax adjustments for the 2025 calendar year accounts in time. It is therefore necessary to file based on provisional figures and then revise the return later once the true figures for the later accounting period are known. This exercise would be repeated every year thereafter. 

Transitional rules in 2023/24

For traders whose accounting periods are not aligned to the tax year, and who do not cease trading in the year, the profits in 2023/24 will be based on the period from the end of the 2022/23 basis period to 5 April 2024 with a deduction for any unrelieved overlap profits. For example, if the trader draws their accounts to 31 December every year, the 2023/24 profits would be based on the whole of the 2023 calendar year accounts together with 96/366ths of the 2024 calendar year accounts, with a deduction for any unused overlap profits that arose in the opening years of trading. To the extent that this profit figure exceeds the profits for the first 12 months of the extended basis period, spreading provisions apply. These are called “transition profits”. Transition profits are spread equally over five tax years, including 2023/24, but the trader can elect to be taxed on them sooner. Any untaxed transition profits are taxed automatically on cessation of the trade.

During the consultation, many respondents noted that the acceleration of profits for five years would create anomalies for various allowances and tax charges that hinge on the individual’s level of income (e.g. the £100,000 limit for the personal allowance taper, the £50,000 limit for the High Income Child Benefit Charge and the pension annual allowance taper thresholds). The legislation included provisions that were intended to mitigate the impact of this by removing the transitional profits from the main tax computation and creating a standalone income tax charge. The provisions are effective in preventing some anomalies, such as the High Income Child Benefit Charge and pension annual allowance taper, but not all. In particular, the personal allowance taper anomaly remains.

Losses may arise in the transitional year if the unrelieved overlap profits exceed the profits for the extended basis period. To the extent that the loss has been generated by the overlap relief, extended loss reliefs may be available. The loss can be treated as a “terminal loss”, which can be carried back and set against profits of the same trade in the previous three tax years. Other loss reliefs may also be available.

Interaction with Making Tax Digital for Income Tax

HMRC state that this reform is needed in order to implement Making Tax Digital for Income Tax (MTD). Under MTD, businesses will be required to send quarterly digital updates to HMRC, based on transactions in tax year quarters, and provide a digital “End of period statement” to finalise the taxable profit for the tax year. For partnerships, this would include the allocation of the profits of the tax year to the relevant partners.

For most sole traders with turnover exceeding £50,000, MTD is mandated from 6 April 2026. This will be extended to sole traders with turnover exceeding £30,000 from 6 April 2027. The government is consulting on how the regime should apply to smaller businesses. Partnerships will be brought into MTD at a later undefined date. See here for further information on MTD for Income Tax.