In preparation for the introduction of Making Tax Digital in April 2024 there are significant changes to the way profits from self-employment and partnership profit shares (including LLPs (Limited Liability Partnerships)) will be taxed from April 2023.
This will affect those businesses whose accounts do not align with the tax year (i.e., 31 March/5 April). This is the biggest change to the way such profits are taxed since the introduction of Self-Assessment back in 1996. (Although the UK tax year runs to 5 April HMRC have confirmed that they will treat 31 March as coterminous for the purpose of these changes and for ease of reference 31 March has been used in the examples below.)
The current tax rules for unincorporated businesses (prior to 2023/23)
Where a self-employed individual or partner in a partnership produces annual accounts for a 12-month period to say 30 June, the profits for that 12-month period are taxed in the tax year in which the year-end falls.
Example:
The profits for an accounts’ year end of 30 June 2021 are reportable on the tax return for the tax year ended 5 April 2022, with tax due for payment on 31 January 2023.
Different rules apply in the opening and closing years.
What’s changing? New tax rules for unincorporated businesses (from April 2023)
From 2024/25 unincorporated businesses will be taxed on the profits of the tax year (for example, on the profits for the period from 1/6 April 2024 to 31 March/5 April 2025).
The 2023/24 tax year is a transitional year in which unincorporated business that do not already prepare accounts for the tax year will need to move to a tax-year accounting basis.
Example:
For an unincorporated business with an accounts’ year end of 30 April 2023, the period on which profits are assessed for tax in 2023/24 will be:
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Plus, any profits for the period from 1 May 2023 to 5 April 2024,
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Less any overlap profits not already relieved.
What is Overlap Relief?
An overlap of profits may occur in the opening years of the business because, due to the current system, some profits are taxed twice.
Example: if you started your business on 1 January 2015 and prepared your accounts to 31 December, you would be taxed on the profits for the period from 1 January 2015 to 5 April 2015 in 2014/15 (actual basis) and on the profits for the period from 1 January to 31 December 2015 in 2015/16 (first 12 months).
In this situation, the profits for the period from 1 January 2015 to 5 April 2015 are taxed twice. These are overlap profits.
Overlap profits may also arise if you change your accounting date (as may be necessary in 2023/24). Overlap Relief applies by deducting the amount of profits that were subject to a double tax charge on the cessation of the trade, leaving a partnership, or on a change of accounting date.
The key issues of applying Overlap Relief when changing your accounting date are:
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The profits in the opening years of a business are typically lower than those of an established business.
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A business may make a loss in its first accounting period in which case there would be no overlap profits available for relief.
If the business has any overlap profits, it must offset these against the profits of the 2023/24 tax year. There is no option to allow the business owner to defer the use of overlap relief and save it up to use on another occasion.
The impact of changing your accounting year-end
These changes are going to have the biggest impact on those businesses with accounts whose year ends at the start of the tax year (e.g., April/May/June). There are two key areas to be aware of:
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Cashflow: the timing of when the tax on your profits is due may be accelerated.
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Example: Accounts year end: 30 April 2023
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Under current rules, the tax due for that 12-month period is due on 31 January 2025 (a period of 21 months)
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Under the new rules, the profits for the 12-month period to 30 April 2023 and the 11 months to 31 March 2024 (the transitional year adjustment) are due on 31 January 2025. Overlap relief may be available to reduce this liability
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Going forward, for the 2024/2025 tax year the profits due for the 12-month period to 31 March 2025 would become due on 31 January 2026 (10 months).
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Reduction in the time available to report accounting figures to HMRC
Under the new system, the tax payment deadline and the reporting deadline for unincorporated businesses will align (31 January). This means that the time an unincorporated business with a 30 April year end must report final figures to HMRC will reduce by 11 months.
The introduction of Making Tax Digital for Income Tax in 2024 means that self-employed individuals will also need to report profits to HMRC quarterly as well.
Spreading of transitional profits
All of this means that many unincorporated businesses are going to incur significantly higher reportable profits for tax purposes in the 2023/24 transitional year. Fortunately, HMRC have offered some help.
For those business that incur excess profits that are brought into charge in 2023/24 (the transition profits) these will be spread, automatically, over five years, starting with the 2023/24 tax year.
There is an option available to elect for the spreading of profits not to apply and for them to be taxed in full in 2023/24.
If your business ceases before the transition profits have been taxed in full, any balance not yet brought into charge is taxed in the final year.
The spreading of transition profits may mean that you have higher than normal tax bills for the next five years.
Example
N.B. The rules are complex – this is a very simplified example for illustrative purposes only.
A self-employed decorator makes up their annual accounts to 30 April each year. They started trading on 1 May 2002.
In the accounts for the first 12 months to 30 April 2003 their profit was £12,000. As such the overlap period from 1 May 2002 to 31 March 2002 will have been taxed twice (once in the 2002/2003 tax year which taxes the 11 months to 31 March 2003 and again in the 2003/2004 tax year which would have taxed the full 12-month period to 31 March 2003). The overlap period of 11 months equates to £11,000.
In the accounting period to 30 April 2023 the taxable profits are £50,000. As this is the transitional year, we also must bring in the 11-month period to 31 March 2024 which has profits of £45,000. The total taxable profits in 2023/2024 are therefore £95,000. From this we can deduct the overlap relief of £11,000 to leave a net profit of £84,000. If an election is made to disapply the spreading of transitional profits the tax due amounts to £25,500 (ignoring payments on account).
Where there is no election, the profits for the transitional profit (which in this case is £34,000 being £45,000 less overlap relief of £11,000) is spread over 5 years.
So instead of taxing £84,000 in 2023/24 the amount taxed is the £50,000 profit plus 1/5 of the transitional profit being £6,800. The tax on £56,800 is £14,000.
How Moore can help
As with any change this is going to be a challenging period. If you do not currently prepare your accounts on a tax year basis, we can help you understand what the changes to the basis period rules mean for your business. We can also help you prepare for the change.
Areas for consideration will be:
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In most cases it is likely to be beneficial for affected businesses (due to the ongoing requirement to apportion and/or estimate profits of consecutive accounting periods) to change their accounting date to align with the tax year, e.g., 31 March or 5 April.
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Consider whether to change your accounts year sooner (will depend on profit levels and forecasts) – but bear in mind that the option to spread profits over five years only applies to the transitional tax year (2023/24).
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Retain your current accounts year – for some businesses there will be other reasons than tax to consider. However, this will mean that an apportionment of two accounting periods would be needed for tax reporting purposes. This would lead to estimates being reported for tax purposes which require later amendment. This is not ideal and HMRC would charge interest on any underpayment of tax.
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If you have been considering incorporating your business the impact of these changes may also have a bearing on that decision.
For further advice, please contact your local Moore office.