In the 2021 Autumn Budget the government announced that it would change the way sole trade profits or partnership profit shares are allocated to tax years – these changes come into effect from the current 2023/24 tax year.
Firstly, who does this affect?
The proposed changes will affect self-employed individuals, partners in a partnership or LLP, trading trusts and estates and other unincorporated entities with trading income charged to income tax, with a year end other than 31 March or 5 April.
What are the current rules?
Currently the above-mentioned businesses can choose any year-end they wish and prepare their accounts up to that same date each year. Then, when it comes to doing their tax return they will be taxed on the accounting year-end which falls within the tax year. For example, a year end of 30 June 2022 will be taxed in the 2022/23 tax year and a year end of 31 January 2023 will also be taxed in the 2022/23 tax year, as both year-ends fall within the period 6 April 2022 to 5 April 2023 i.e. the 2022/23 tax year.
When your business has a year-end that is not in line with the tax year (i.e. not 31 March/ 5 April) there are extra complexities and adjustments required in the first and last years which can create something called overlap profit.
What is changing?
From the 2023/24 tax year onwards, affected businesses will instead be taxed on the profits (or losses) arising in the business during the period from 6 April to 5 April (or the 12 months to 31 March), regardless of the business’ accounting date.
One of the questions you’ll likely ask is how you go from getting taxed on your accounting year-end, to the tax year-end of 5 April instead.
The answer is that the 2023/24 tax year is treated as a transitional period where you would get taxed on your year-end as normal, plus the remaining months in the tax year.
The potential issue with this is that you will likely be taxed on more than the normal 12 months during the transitional year of 2023/24. This not only could cause you to pay more tax, but it could also cause you to reach the next tax band and start paying higher rate tax, losing your personal allowance etc.
To help minimise the impact of this any excess profits arising during the transitional year will be treated as a one-off separate item of taxable income, rather than including it as part of the business’ regular trading income. In addition, any overlap profit from when you first started the business is offset against the transitional profits.
Then, any additional profits arising from the transitional period can be spread over a period of up to 5 years to help minimise the impact on cash flow. However, if the business ceases or you retire within those 5 years any untaxed ‘transitional profit’ will become taxable in full in the year of cessation.
A sole trader has a year end of 31 December. Their 2023/24 taxable profits would be calculated as follows:
Step 1 – Calculate transitional profits
As the trader would have usually prepared accounts to 31 December 2023, the transitional period will run from 1 January 2024 to 31 March 2024 (i.e. to the end of the tax year). Their profit for this period is as follows:
1 January to 31 March 2024 profit £20,000
Less: Overlap profit brought forward (£5,000)
Total transitional profits £15,000
Divide by 5 years =
Minimum transitional profits charged to tax £3,000 per year for 5 years
The £15,000 transitional profit is automatically spread over the 5 years from 2023/24 to 2027/18 (i.e. £3,000 per year), although you can opt to bring in more than the minimum.
Step 2 – Calculate total taxable profits
Year ended 31 December 2023 profit £70,000
Transitional profits to be recognised (per step 1) £3,000
Total taxable profits it 2023/24 £73,000
There are also complicated rules around how losses are dealt with in the 2023/24 tax year, and the treatment will depend on the following factors:
- what period the loss is in i.e. in the standard year end or the transitional period
- if there is an overall profit or an overall loss, after taking into consideration the standard year end, the transitional period and any overlap profit relief
- if there is an overall loss, how much of this loss relates to overlap profit.
Therefore, if you have made losses, we will review this and any potential relief available on an individual basis.
Should I change my year-end?
Since you will be having to report profits to 31 March/ 5 April each year and pay tax on this basis it will likely be easier to change your year-end to this date. However, this will need to be considered on an individual basis along with the practicalities of how this is done. For example, do you have one long period of account, or is it beneficial for you to produce two sets of accounts in the period which presents greater opportunity in relation to the flexible treatment of transitional profits.
If you choose not to change your year end you will effectively still be taxed on the profits being incurred during the period 6 April to 5 April the next year, however, this will instead be done by apportioning the two accounting periods which cover the tax year. For example:
A sole trader has year-end of 31 October which they want to keep. Therefore, to prepare their 2024/25 tax return the figures would be obtained as follows:
31October 2024 year end: 7/12ths of the taxable profit (as 7 months fall within the 2024/25 tax year)
31 October 2025 year end: 5/12ths of the taxable profit
As such they would need to ensure the 31 October 2024 and 31 October 2025 accounts are both completed before the 2024/25 tax return filing deadline of 31 January 2026. If the October 2025 accounts cannot be completed in time an estimate would need to be included on the tax return, then the return amended once final figures are available.
Why is this being done?
Although it may not seem like it in the first year, the intention is to have a simplification of the current rules, whereby each business can be taxed on different periods in a tax year and there are often complicated calculations during a business’ first and last years of trade.
This will also help with the government’s plans to have all businesses reporting under Making Tax Digital for Income Tax Self Assessment (MTD for ITSA), by aligning accounting periods with the tax year. More information on MTD for ITSA can be found here.
Finally, what should I do next?
Please do not hesitate to give your regular contact a call to discuss any queries or concerns on 01242 776000 or email firstname.lastname@example.org. We also recommend keeping an eye on our website and social media pages for any further updates.