Prepare for the great tax catch-up

Most law firm partners visibly shudder at the mention of “overlap profits” and “overlap relief”. The good news is that they are soon to be a thing of the past. The bad news is that their removal may cause a significant call on many firms’ working capital, where they reserve for partners’ tax, or on partners’ own cash resources, where their firm doesn’t do so. So careful steps are needed to plan ahead for it.

The way in which trading income of unincorporated businesses is allocated to tax years is changing. The existing “current year basis” is set to be replaced with a new, simpler “tax year basis”. The new system will result in unincorporated businesses being taxed on their profits arising in a given tax year, regardless of their accounting date. This change will affect all self-employed traders, whether individuals, partnerships or LLPs.

It dovetails with the introduction of Making Tax Digital for income tax, from April 2024 for sole traders, April 2025 for general partnerships and, as yet unconfirmed, April 2026 for LLPs.

The new measures will come into force in the 2024-25 tax year rather than 2023-24 as originally proposed, with a transition period in the tax year 2023-24. This welcome deferral gives businesses much-needed time to prepare properly for the changes. 

The proposed changes are detailed in the Finance Bill 2021-22.

Policy objective

The overall aim of the reform, stated by HMRC, is to create a simpler, fairer and more transparent system by which to tax self-employed trading income.

The new rules will remove the need for the complex basis period rules. The introduction of a tax year basis will also result in businesses paying their tax liabilities nearer to the time that the relevant profits have been earned. It is expected that this will improve compliance and reduce tax debt write-off, as businesses should be in a better position to plan their tax payments.

The new rules will also bring the tax treatment of trading profits into line with that of other forms of income for individuals.

Current position

The current position is that trading profits are assessed on a current year basis, under which the basis period for a tax year is, normally, the 12 months ending with the accounting date that falls during that tax year. This means that the profits or losses disclosed on a tax return are based on the business’s accounts that end in that tax year.

Under the current rules, two businesses that are identical in all aspects other than their accounting date may have significantly different taxable profits for the year. 

This is because the current year basis makes it possible to defer the payment of tax on profits by electing to set the accounting date early in the tax year.

There are specific, more complex rules that apply to determine the basis period in the early years of trading, which can result in businesses experiencing double taxation during this time on “overlap profits”. These profits are carried forward, and “overlap relief” is given when the business changes its accounting date or ceases trading or the individual partner retires. The overlap relief provisions ensure that profits which are generated by the trading business are only taxed once. However, there can be a significant gap between the year in which the tax is actually paid and the year in which the relief is applied.

As an example of the current year basis, assume Drumsheugh Law LLP, a two member firm, starts in business on 1 July 2010. It makes a respectable profit of £100,000 in its first year of trading to 30 June 2011 and £200,000 in its second year to 30 June 2012. The partners’ combined taxable profits will be as follows:

Tax year 2010-11 – 1 July 2010 to 5 April 2011 – 9/12ths of £100,000, i.e. £75,000

Tax year 2011-12 – first full year profits from 1 July 2010 to 30 June 2011, i.e. £100,000

Tax year 2012-13 – second full year profits from 1 July 2011 to 30 June 2012, i.e. £200,000

It will be noted that although profits in the relevant period totalled £300,000, tax has been paid on profits of £375,000. This excess of £75,000, being the proportion of the first year profits that is taxed twice, is the “overlap profit” for which “overlap relief” will be available in due course.

New rules

The new rules will replace the existing current year basis with a tax year basis, under which the profits or losses disclosed on a tax return will be the profits or losses arising in the current tax year (from 6 April to 5 April). This would remove the need for overlap relief, as no overlap profits will be generated, and also the ability of businesses to choose a specific accounting date to defer the payment of tax on profits.

The new rules do not mandate a specific accounting date for businesses. Businesses will still have the flexibility to choose an accounting date to suit their commercial requirements. However, where the accounting date is not the end of the tax year, businesses will be required to apportion their profits for tax purposes. This will create a new administrative burden.

Businesses with an accounting date between 31 March and 5 April will be unaffected by the new rules, as the rules will treat these dates as equivalent.

Continuing our example, the intervening years have been kind to Drumsheugh Law LLP and it makes a profit of £500,000 in the year ending 30 June 2024, £600,000 in the year ending 30 June 2025 and £640,000 in the year ending 30 June 2026. The partners’ taxable profits will be as follows:

Tax year 2024-25 – 3/12ths of £500,000 and 9/12ths of £600,000, i.e. £575,000

Tax year 2025-26 – 3/12ths of £600,000 and 9/12ths of £640,000, i.e. £630,000

Transition period

Special rules will apply in the 2023-24 tax year to allow businesses to transition from the current system to the new rules. During this period, businesses will be taxed on their profits using the current year basis (i.e. for the 12 months ending with the accounting date that falls between 6 April 2023 and 5 April 2024), plus the apportioned profits for the period between the accounting date and the end of the tax year.

The transitional provisions will result in tax liability being accelerated for many businesses. Depending on the accounting date, a business may be charged to tax on almost two years’ profits in a single tax year. To mitigate the impact of this, the transitional period additional profits will be automatically spread over a period of five years. It will be possible to opt out of spreading the profits and elect to pay tax on the full amount in the transition period.

Drumsheugh Law LLP made a profit of £480,000 in the year to 30 June 2023. With its profit of £500,000 to 30 June 2024, the partners’ taxable profit for the transitional year is as follows:

Tax year 2023-24 – 12/12ths of £480,000 and 9/12ths of £500,000, i.e. £855,000.

Against this will be set the overlap profit of £75,000 from when the business started, leaving the partners with a combined taxable profit of £780,000.

The additional profit is the amount for the period 1 July 2023 to 5 April 2024 less the overlap relief, i.e. £300,000. 

This will be automatically spread equally over the five years commencing 2023-24, subject to each partner having the option to accelerate the assessment of their portion. It is also accelerated for any partner who retires during that five year period.

Practical consequences

The ongoing administrative burden of apportioning or estimating profits to be included in a tax return may result in businesses opting to change their accounting date to align with the tax year. This may not be possible or desirable for all businesses, particularly seasonal businesses or those operating internationally as they are likely to have set accounting dates for commercial purposes.

Particularly where a business’s accounting date falls later in the tax year, it is unlikely that they will have their accounts finalised by the filing deadline for the prior tax year, into which a portion of the current accounting year’s profit falls to be assessed. Where this is the case, these businesses would be expected to submit their tax return using provisional figures based on estimated profits. The Government is exploring, ahead of the transition period in 2023-24, a number of options as to how any provisional figures will be updated.

Concerns have been raised regarding how the spreading of profits arising during the transitional period might impact an individual’s entitlement to certain reliefs and benefits. It has been confirmed that these profits will be treated as a one-off separate item of taxable profits, rather than as part of a business’s normal trading income, so as to minimise any impact on allowances and means-tested benefits. Nevertheless, these excess profits may push taxpayers into a higher income tax band, thus resulting in a greater tax liability.

Even with the spreading of additional profits, these changes are likely to lead to a significant increase in partners’ tax liabilities for the 2023-24 tax year. While the mandatory offset of overlap relief will assist, it is unlikely to provide a complete solution. It is essential that firms seek advice as soon as possible and start to plan funding for these changes now.