How Will Unincorporated Businesses Be Affected?

The basis period reform will impact those with unincorporated businesses, whether they are a sole trader or a member of a partnership, with accounting periods not ending on either 31 March or 5 April. In introducing the changes, HMRC is looking to prepare for the move to Making Tax Digital by creating a simpler system with a single set of rules for taxing profits and removing the complex rules relating to basis periods and overlap profits.

 The 2023/24 tax year will represent a transition period, where individuals will be taxed on profits for the 12 months to the accounting period which ends during the tax year, plus those from the end of the previous accounting period to 5 April 2024. In the transitional year, HMRC will require tax ‘up front’ on the profits arising in the period from the accounting year-end to the end of the tax year. In effect, this means that there are likely to be significant increases in an individual’s tax liability and careful cash flow planning will be important to ensure this can be funded.

Overlap profit

It's worth bearing in mind that individuals can relieve any overlap profit that they have brought forward. The profit for the 12 months to the accounting period ending in the tax year is referred to as the ‘standard profit’, while the profit from the end of the accounting period to 5 April 2024, is the ‘transitional profit’. The overlap relief is deducted from the latter.  This net profit or loss is then aggregated with the profit or loss realised in the standard period.

Individuals can mitigate the cash flow impact of the basis period reform by spreading the profits earned during the transition period. Where the transitional profits minus the overlap relief brought forward results in a taxable profit, the individual can spread it over a maximum of five years, beginning with the transitional year itself. The Finance Bill 2021-22 also introduced a facility to accelerate the recognition of profits spread in this way. This allows an election to be made for additional profit allocation to kick in at any point during the five-year period. The election must be made within 12 months of the self-assessment filing date for the tax year in which the taxpayer wishes to recognise the additional profits.

Effective tax forecasting

Effective tax forecasting is important for sole traders and members of partnerships; giving them a better understanding of when their tax liabilities will fall, so they can plan ahead. It’s important to be aware that individuals must continue to be self-employed in order to spread profits in this way.  As such, those planning to retire in the near future should seek advice.  Likewise, where the net position is a loss, advice should be sought at the earliest opportunity.

 From 2024/25, the profits of sole traders and members of partnerships will be taxed on a tax year basis. Although it may be simpler in the vast majority of cases, there will not be a requirement to change the accounting year-end.  For example, for those with an accounting period ending 30 June 2024, three months’ profits from the 30 June 2024 accounts and nine months’ profits from the 30 June 2025 accounts will be taxable in the 2024/25 tax year. This means that businesses will have to estimate their profits from the end of the previous accounting period to the following 5 April. Once the accounts to 30 June 2025 are complete, businesses will be required to amend the previous year and report the actual taxable profit that arose during the nine months to 5 April 2025. An amendment to the earlier year will be required for each tax year where the accounting period does not fall in line with the tax year. 

Final Thoughts

HMRC’s basis period reform could see some individuals calculating their tax liability based on almost two years’ worth of profits in one tax year, placing pressure on their cash flow position. By staying abreast of the new rules and planning ahead, unincorporated businesses can prepare to mitigate the cash flow impact of the new rules when they’re introduced. 

About the authors: Amy Cole is a director and Rachael Smith is an assistant manager at accountancy firm, Menzies LLP.