Tax Changes for Unincorporated Entities: Change in the Basis Period

What is an Unincorporated Entity?

A business owner and an ‘unincorporated business’ are the same, and the owner(s) personally bear all results of the business. Examples include sole traders and partnerships.

Who will be affected by the change?

Any unincorporated entities with an accounting year end (also referred to as ‘the accounting reference date’) other than 31 March or the fiscal year end, 5 April, will be affected.

What is the change?

This measure changes the way trading income is allocated to tax years. This new measure, also referred to as ‘changing the basis period’ will ultimately see tax liabilities for all unincorporated entities be aligned to the fiscal year (or 31 March as HMRC accepts this to be a reasonable substitute for 5 April).

What is the ‘Basis Period’?

The ‘basis period’ is ordinarily the 12-month period preceding the business year end (accounting reference date) to which accounts are typically made up to. Specific rules determine the basis period in certain cases, including during the early years of trading. These rules can create overlapping basis periods which can result in profits being taxed twice which generate ‘overlap relief.’ This is usually released on cessation of the business or retirement. Overall, this basis of taxation is called the ‘current year basis.’

Why is the change being made?

The main objective of the basis period reform is to simplify the taxation of trading profits.

Legislation has been passed by Parliament which will enable HMRC to enforce the basis period reform and accelerate the receipt of tax from unincorporated entities with a year-end other than 31 March or the fiscal year end of 5 April.

Example of ‘current year basis’:

A sole trader has a year-end of 30 April. Under the existing regime, accounts are prepared to 30 April 2021 and the profits will be declared in the individual’s 2021/22 tax return submitted to HMRC by 31 January 2023. The 2021/22 payments on accounts would need to be paid to HMRC by 31 January 2022 and 31 July 2022 with any balancing payment due by 31 January 2023, some 21 months after the respective accounting period has ended.

Changing the Basis Period

The change will take place in the 2023/24 tax year, referred to as the ‘transitional year’, so all unincorporated entities from 1 April 2024 (2024/25 tax year) will be taxed under the ‘tax year basis’. This will see a business’s profit or loss for a tax year being the profit or loss arising in the tax year itself, regardless of its accounting reference date. This will remove the basis period rules and prevent the creation of further overlap relief.

The transition

The transition to the ‘tax year basis’ will start from the beginning of the period in which the accounting reference date falls within the 2023/24 fiscal year but for tax purposes, the period will continue to 31 March/5 April 2024. The first 12 months form the ‘standard’ part whilst the additional period to 31 Mar/5 April 2024, is referred to as the ‘transitional’ part. Any overlap profits brought forward must be offset against taxable profits in the 2023/24 'transitional' part, following which two numbers will arise:

• 'Standard profits' (to the original accounting date falling in 2023/24) and
• 'Transitional profits' (a shorter period to 31 March/5 April 2024)

Starting with the transitional year (2023/24), the tax on the transitional profits (after deducting overlap relief, if any) can be spread over a five-year period or an election can be made to pay the transitional tax before this. Tax on the ‘standard profits’ will be payable in full as per the previous rules.

Whilst there is no requirement to change your accounting reference date, this may be a good opportunity to do so to ensure the profits reported annually are aligned to the profits taxed each year.

What are Overlap Profits

When an individual starts to trade or joins a partnership and the year-end for the business is not aligned with the tax year, some profits can be taxed twice in the first and second tax years. These profits are known as 'overlap profits'.

Example of the transitional year and ‘tax year basis’:

A partnership has an accounting reference date of 30 September, this date being that which the annual accounts are prepared to. The last year that this period will follow the ‘current basis period’ is the year to 30 September 2022. From 1 October 2022, the partnership enters the ‘transitional year’ with the ‘standard profits’ to 30 September 2023 and the ‘transitional profits’ to 31 Mar/5 April 2024. Payments on account for 2023/24 remain payable by 31 January 2024 and 31 July 2024 and following the deduction of overlap profits, any remaining tax due is payable by 31 January 2025. This will also include one fifth of the tax due on the transitional profits.

Thereafter, profits will be taxed on the tax year to 31 March/5 April with tax on the transitional profit being added to the annual tax liability to 2027/28 (unless an election to pay all transitional profit tax is made prior to the final year).

The impact on you

If you fall within the criteria which requires a change in the basis period for your business, you will not pay additional tax but there may be an acceleration in the payments of tax you owe. The changes may result in significant tax balances through the transitional period, so it pays to plan ahead and be prepared for the change. To ‘fail to plan’ is to ‘plan to fail’!

Armstrong Watson LLP

We have a long and established history of assisting clients navigate their way through tax legislation. If you require assistance with the ‘change in basis period’ and want to understand more about the impact it may have on your taxable profits, please contact your local Armstrong Watson representative.