HMRC proposes changes to the basis periods for Income Tax
The first thing to note is that if your law firm is a partnership/LLP with a 31 March or 5 April accounting date, or if it is a limited company, then you can ignore this article!
For everyone else, you may be interested to learn that HMRC has recently opened a consultation on changing the Income Tax basis period for self-employed individuals and partnerships/LLPs. HMRC’s view is that the changes will “simplify the taxation of trading profits”, and “lead to a closer relationship between the profits arising in a tax year and the tax liability related to them.”
So, what’s this all about?
At present, individuals and partnerships can choose whichever accounting date (financial year end) suits them best. 31 March is a very popular date for law firms, but many have opted for 30 April, 30 June, 30 September, and so on.
The choice of accounting date makes a big difference to when the tax on profits earned is paid, as partners currently pay tax on their profit share for the accounting period ending in any tax year. For example, for a firm with a 30 April accounting date, its basis period in the 2021/22 tax year (i.e. the current tax year) is the accounting period ending in that 12-month window, i.e. the year ended 30 April 2021.
Contrast this with a firm with a 31 March year end – its basis period for the 2021/22 tax year is the year ending 31 March 2022. So, you can see that partners in a firm with a 31 March year end pay their tax much sooner than partners in a firm with a 30 April year end.
This is not the end of the story though. Incoming partners in a firm with an accounting date other than 31 March/5 April are subject to fairly complicated opening year rules, which mean that in the first couple of years of becoming a partner, some profits will be taxed twice, in different tax years. The profits that are taxed twice are known as “overlap profits”, are a fixed amount, and relief for them is usually given when the partner retires, if the firm incorporates to a limited company, or if it changes its accounting date closer to the following 31 March.
HMRC is proposing that all self-employed individuals and partners will in future be taxed on a tax year basis, rather than an accounting year basis. In essence, this means that individuals will pay tax on profits arising in each tax year, regardless of the firm’s accounting date.
This seems sensible, but what does it mean?
Under the proposals, the 2022/23 tax year (i.e. the one commencing 6 April 2022) will be a transition year, in which basis periods will be aligned with the tax year end, and relief will be given for all overlap profits.
From 2023/24 onwards, the new regime will be in place.
Taking a firm with a 30 April accounting date, the partners in that firm will be taxed on the following in 2022/23:
– Profits for the year ending 30 April 2022 XXX – Profits for the 11 months ending 5 April 2023 XXX – Less overlap profits (XXX)
In the 2023/24 tax year, partners will be taxed on their profits arising in the year ending 5 April 2024, i.e.
– 1/12th of the profit from the accounting year ended 30 April 2023 XXX – 11/12ths of the profit from the accounting year ending 30 April 2024 XXX
And so on.
In situations where the overlap profits being deducted are higher than the profits for the 11 months ending 5 April 2023, this will result in partners’ tax bills for 2022/23 being lower than they would otherwise have been. However, given that overlap profits for many individuals will date back years and years, to the time when they first became partners, the opposite is likely to be true, resulting in an acceleration of tax payments.
In their proposal, HMRC recognises that this is a possibility, and have indicated that consideration is being given to allowing individuals to spread any additional tax over a period of up to five years.
What happens if a firm has an accounting date later in a year, such as 31 December?
This is where life starts to get a little complicated, as partners’ tax returns will need to report the following:
– Nine months profit from the accounting period ending in the tax year (April to December)
– Three months profit from the accounting period ending in the following tax year (January to March)
The likelihood is that the accounts showing the latter figure will not have even been started before the tax return is due for submission (there is no mention of a move away from the current 31 January), and therefore partners will need to include their best estimate on the return. The likelihood is that this will then need to be amended once the accounts have been prepared and finalised.
What will this mean in practice?
If the proposals go through, the following seem fairly likely:
- Firms will be tempted to change their accounting date to 31 March or 5 April, to save having to prepare estimates every year. This could make it difficult for partners in those firms to work out how much they can pay into their pensions, as they won’t know what their taxable income will be before 5 April each year.
- Partners that have not saved for their tax as they go along may struggle to find the cash to pay the accelerated tax, even if the Government does allow spreading.
- We will end up in a situation where partners will need to estimate part of their profit share every year, only to then update the estimates for actual figures once accounts have been finalised. This is likely to mean that tax is over or underpaid for a time.
How likely is it that this will happen?
Many have been surprised at how quickly the proposals have been issued, following a recent review of the Tax Administration Framework. It is also a little unusual that HMRC has issued draft tax legislation as part of the consultation, rather than waiting until responses to the consultation have been received.
This, and the fact that HMRC is pressing ahead with plans to introduce Making Tax Digital for Income Tax Self Assessment (MTD ITSA) from April 2023, which will require self-employed individuals to report income on a ‘real-time basis’, all suggest that the proposals will be adopted.
Finally, we all know that the Government is looking for ways to help pay for all of the Covid support over the last 18 months, and this tax windfall would be very helpful, all without having to increase tax rates.
What should firms do (or not) to prepare for this?
It is surprising how many self-employed individuals do not have details of their overlap profit figure, given that pretty much everyone with an accounting date that is not 31 March or 5 April should have one. The overlap profit figure should be reported on the personal tax return each year, but if it is not, then I would recommend that individuals contact their accountant or tax adviser as soon as possible, just to make sure they have it.
If the overlap profit figure cannot be located, then contact HMRC, but my experience is that HMRC’s records may not go back far enough if someone has been self-employed for many years.
I have always been a big fan of including tax reserves in practice accounts, as this allows partners to see how much of their current account belongs to them, and how much belongs to HMRC. If your accounts do not currently include them, consider asking your accountants to work out how the accounts would look if tax reserves were included – you may find that partners have drawn out too much profit. Better to start saving now than leave it until 2023.
Finally, firms might be tempted to change their accounting date to 31 March before 2022/23, but this is unlikely to be a good idea, as the change could result in an accelerated tax liability, which could not be spread over five years.