Basis Period Reform: Adjustments from April 2024
Many of those self-employed or working for an unincorporated business would have been buoyed when the government announced a delay in the Making Tax Digital for Income Tax Self Assessment (MTD ITSA) regulations. The new date of April 2026 was announced, which must surely mean a delay in the accompanying Basis Period Reform?
Unfortunately, this was not the case, with the Basis Period Reform still going ahead with effect from April 2024. In theory, it is a relatively straightforward reform, but in practice, there are several factors to consider, such as proportioned profits and overlap profits brought forward.
Who is affected by Basis Period Reform?
Before we go any further, it is crucial to identify the relevant parties affected by Basis Period Reform. It is the self-employed (sole traders) and partnerships, with an accounting period which does not end between 31 March and 5 April. So, if your accounting period ended on 31 March, you won’t be impacted; if it is 6 April, you will be.
What is the idea behind Basis Period Reform?
The idea is simple; to bring the self-employed and partnerships into line with the tax year end for profits. As we will cover in a moment, no legislation will force you to change your business year-end. However, from 2024/25 going forward, you will be taxed on your income over the tax year even if you still maintain a business year end outside of 31 March to 5 April.
At first glance, it may be difficult to understand why someone would look to maintain a business year-end outside of this period. They will need to apportion profits from different company accounting years, each year, which can get complicated. There may be a reason why the business needs to retain a particular year-end; for example, it might be quieter and the best time to carry out stock-taking without impacting normal business operations.
Basis Period Reform: The basics
The 2023/24 tax year is a transition period after which self-employed and partnership businesses will be taxed on their income over the traditional tax year. To effectively rebase this charging period, those affected must extend their last accounting year to 5 April 2024. This means they will be taxed over an extended period. However, to minimise the impact on cash flow, an element of the taxable profits is staggered over a five-year period.
Some businesses will also be able to use what is known as overlap profits, which are profits from the early days which may have been taxed twice.
How to calculate overlap profits
Before moving on to transitional profits and the realigning of year-end dates with the tax year, we will briefly examine overlap profits. This anomaly only occurs when a business year end is not in sync with the tax year.
Example
Business accounts period: 1 January to 31 December
If the business commenced on 1 January 2021, a portion of the full-year profits would be taxed at the tax year end, 5 April 2021 for the tax year 2020/21. So, when the full-year accounts are produced, from 1 January 2021 to 31 December 2021, three months of profits will be used as the basis for tax for the 2020/21 tax year.
Assuming the company made profits of £120,000 in the full year, then £30,000 (3/12 x £120,000) would be apportioned to the 2020/21 tax year and taxed accordingly. The overlap occurs in the following tax year, where the profits for the full 2021 calendar year (i.e. £120,000) would be used as the basis for the tax calculation for the tax year 2021/22. So, in effect, £30,000 of profit has been taxed twice – in each of the tax years in question.
Therefore, the business is carrying forward overlap profits of £30,000, typically used if the accounting period is changed further down the line or the company closes/ceases trading. In effect, the business is reclaiming back tax on the double-taxed £30,000 profit.
In the following examples, while we haven’t directly considered overlap profits, they would be offset against profits in the transitional period.
Transitional profits
We now move on to calculating transitional profits where a sole trader or partnership has a year-end outside of the period between 31 March and 5 April. There are several scenarios to consider, such as constant profits, increasing profits, decreasing profits, extended accounts or full-year and partial accounts. A lot to take in!
Stagnant, increasing and decreasing profits
So, from the 2024/25 tax year, all sole traders and partnerships will be taxed on their profits between 6 April and the following 5 April. We will now look at the transition period and how a change in profits will dictate the correct route.
Stagnant profits
Where profits are stagnant, for example, £10,000 a month, it makes no difference whether you create one set of accounts covering 18 months or two sets covering 12 months and three months. The calculations will be as follows:-
One set of accounts
Over the 15-month period, making profits of £10,000 a month, the total profits would be £150,000. If we pro-rata the profits on a 12-month and three-month basis, we would arrive at the following figures:-
12 month profits = 12/15 x £150,000 = £120,000
Transitional profits = 3/15 x £150,000 = £30,000
As the transitional profits are taxed over a five-year period, in this instance, the figure would be £6000 a year. So, during the period under review, tax will be calculated on profits of:-
£120,000 + £6000 = £126,000
Two sets of accounts
By creating two sets of accounts, we can identify the profit breakdown as follows:-
12 month profits = £120,000
Transitional profits = £30,000
Spreading the £30,000 transitional profits over five years equates to £6000 a year, with taxable profits for the extended period as follows:-
£120,000 + £6000 = £126,000
As the profits are constant over the 15-month period, there is no heavier weighting towards either the first 12 months or the transitional period. Consequently, the taxable profits are the same whether working from two sets of accounts or an extended set of accounts covering 18 months.
Increasing profits
In the following example, we will assume that in the calendar year 2023, the business makes a profit of £120,000, with profits increasing to £20,000 a month during the three-month transitional period, January 2024 to April 2024.
One set of accounts
Over the 15-month period (1 January 2023 to 5 April 2024), profits would be £180,000. Then we need to break this down on a pro-rata basis into the 12-month period and the transitional three-month period:-
12 month profits = 12/15 x £180,000 = £144,000
Transitional profits = 3/15 x £180,000 = £36,000
As the transitional profits are spread over five tax years, to minimise the impact on cash flow, there is a further calculation:-
£36,000/5 = £7200
Consequently, during the 15-month period from January 2023 to April 2024, the business would be taxed on profits of £151,200.
Two sets of accounts
If we used two sets of accounts, using the above example, there would be a profit of £120,000 in the full year, with a profit of £60,000 in the three-month transitional period. Therefore, the profit calculation for tax purposes is as follows:-
12 month profits = £120,000
Transitional profits = £60,000
As the tax charged on transitional profits is spread over five years, the taxable profit for this period is:-
£60,000/5 = £12,000
Therefore, for the extended 15-month period, tax would be charged on profits of £132,000. In this instance, as the greater monthly profit occurred in the transitional period, which is then spread over five tax years, there is a benefit in doing two different sets of accounts.
Decreasing profits
In the next example, we will assume that in the calendar year 2023, the business makes a profit of £240,000, with profits reduced to £10,000 a month during the three-month transitional period.
One set of accounts
Using the figures above, we can see that over the 15-month period, profits came in at £270,000. To calculate the taxable profit, we need to pro-rata this into a 12-month period and a transitional three-month period. The calculation is as follows:-
12 month profits = 12/15 x £270,000 = £216,000
Transitional profits = 3/15 x £270,000 = £54,000
As the transitional profits are spread over five tax years, to minimise the impact on cash flow, there is a further calculation:-
£54,000/5 = £10,800
Consequently, if we pro-rata profit over a 15-month period, the taxable profits would be:-
£216,000 + £10,800 = £226,800
Two sets of accounts
We will now look at the difference in taxable profits using two sets of accounts, 12 months and the three-month transitional period. Using the above information, we know the spit is as follows:-
12 month profits = £240,000
Transitional profits = £30,000
We now need to spread the transitional profits over a five-year period as follows:-
£30,000/5 = £6,000
As we aren’t using pro-rata profits over a 15-month period, the tax is more heavily weighted to the first 12 months with tax paid on the following figure:-
£240,000 + £6000 = £246,000
Should you go with one set or two sets of accounts?
When it comes to the Basis Period Reform, and the use of one set or two sets of accounts, the following summary should help:-
- Constant profits – There is no difference using one set or two sets of accounts.
- Increasing profits – As profits are weighted towards the transitional period, with the tax charge spread over five years, it is better to use two sets of accounts.
- Decreasing profits – In this instance, using one set of accounts would help, increasing the element of pro-rata tax in the transition period, with the tax charge spread over a five-year period.
There are other issues to consider, such as the cost of producing the accounts, relief allowances, overlap profits, etc.; therefore, you must take advice from your accountant.
Basis Period Reform – Summary
On the surface, what may seem a relatively straightforward transition period becomes more complex if the profitability of your business were to change between the traditional year-end and the transitional period. The above examples show the benefits of using one and two sets of accounts and the calculations for reference.
If you require further information, please do not hesitate to contact us, and we can look at your situation in more detail.