Tax basis period reform – Are you affected?

Historic treatment

Up until and including the 2022/23 tax year, the self-employed and unincorporated businesses were taxed on the ‘current year basis’, meaning taxable profits for a tax year are based on the accounting period ending in a tax year. For example, accounting profits to 31 December 2022 will be taxed in the tax year 6 April 2022 to 5 April 2023 i.e. the 2022/23 tax year.

What’s happening now?

From the 2024/25 tax year (6 April 2024) onwards, all individual members in a partnership will be assessed on the profits arising in the tax year, irrespective of the date to which the partnership accounts are drawn up.

In practical terms, when considering a partnership with a year end of 31 December 2024, an individual member’s profits that will be subject to tax in the 2024/25 tax year will be made up of:

• 9/12th of the profits of the year to 31 December 2024; and
• 3/12th of the profits of the year to 31 December 2025.

With the 2024/25 tax return due for submission by 31 January 2026, it is highly unlikely that the profits for the year to 31 December 2025 will have been calculated by this date. As a result, an estimate of the profits would need to be made for the period to meet the filing deadline. Once the actual profits to 31 December 2025 have been calculated, the 2024/25 tax return will need to be amended.

This will not be a one-off; the inclusion of 9/12th of the profits from one year and an estimate of 3/12th from the next, followed by amending the tax return, will be a requirement for each tax year going forward.

In essence, the tax liability of the member will ultimately be the same (assuming the same tax rates and thresholds apply), but a proportion of the following year’s profit will be taxed 12 months earlier. There will be an increased administrative burden due to the amendments required to the member’s tax returns each year.

To mitigate the level of administration, it may make sense for a number of businesses to change their accounting year end to 31 March to 5 April, so that it aligns with the tax year, removing the need to apportion different accounting periods and file provisional figures. However, this will not always be practical in the Financial Services industry, particularly where funds and/or investors have a significant US interest, which report on a calendar year basis.

Transition year

The current 2023/24 tax year is a transitional year. The taxable profits for a member will be calculated as follows:

• 12 months profit relating to the accounting year to 31 December 2023; and
• 3/12th of the profits relating to the accounting year to 31 December 2024 (known as the transition period); less
  Any overlap profits brought forward.
• A member will in effect be taxed on 15 months of profit during this tax year but will obtain relief for any overlap profit incurred.

Overlap profits are the profits that have been taxed twice when a member joined the LLP under the opening year rules. This figure can be obtained from HMRC if the member or their advisor are unaware of it, or calculated if the relevant information is available.

The ‘excess’ profits in the transition period can be spread equally over a five-year period, starting with the 2023/24 tax year, thereby spreading the tax payable, but it does not have to be. The ‘excess’ is the 3/12th of the profit from the 31 December 2024 year, less the overlap profit available. Members will need to review their individual tax positions to determine the best course of action.

For illustrative purposes and to highlight the principles, we have provided an example below on how the reform could impact a member for the 2023/24 tax year:

From the illustration above, this member will be subject to Income Tax and Class 4 National Insurance Contributions on £2,475,000 of profits in the 2023/24 tax year. This is on the basis that the member chooses not to spread the ‘transition period’ profit.

The transition period profit in the above example is £475,000 (£625,000 – £150,000). If spread, £95,000 would be taxable in 2023/24, bringing the total taxable profits for the year to £2,095,000 (£2,000,000 + £95,000). The tax years from 2024/25 to 2027/28 inclusive will each have an additional £95,000 of profits subject to tax at the marginal rate for that tax year.

Queries?
The transition year is the current tax year (2023/24) and the rules come into full effect from April 2024, so now is the time to review your options. If you have any queries, then please reach out to Senior Manager, Kiran Chotai.