Basis period reform – the fallout isn’t over yet!

Basis period reform is a significant change to the way the trading profits of sole traders, partnerships, and LLPs are calculated for tax purposes. The tax year 2023/24 is the transitional year, which is the year for which tax returns are currently being prepared.

Tax returns for the 2023/24 tax year must include business profits of the period from the year-end used on the 2022/23 tax return, and 5 April (or 31 March) 2024. Those businesses that prepared accounts to a date before 31 March 2023 will need to include profits of a period which is longer than a year. This will give rise to additional profits charge to tax. These are termed ‘transition profits’ and after offsetting overlap relief brought forward, there are measures in place to pay the tax arising on these profits over a period of time. Read our earlier article about transitioning for basis period reform.

For the following tax year 2024/25, all businesses will report profits for the year to 5 April (or 31 March 2025).

This is of course a move to taxing businesses on profits arising in the tax year, rather than in a year ending in the tax year, which may be to an earlier period. It ensures businesses are aligned in preparation for Making Tax Digital (MTD) and quarterly payments.

There will be other implications of basis period reform as we highlight below.

Further implications of basis period reform transitional rules

The Good News – Treatment of transition profits against income

Any extra transitional profits brought into account during the basis period reform year 2023/24 are not included in net income calculations for income tax purposes. Instead, a standalone tax charge is calculated on transition profits, which is then accounted for later in the tax calculations. Excluding transition profits from net income like this will remove many of the implications of the reform for tax purposes.

Here are two examples of how this could affect business owners.

High Income Child Benefit Charge
Firstly, the effect on High Income Child Benefit Charge (HICBC). The HICBC threshold is based on adjusted net income and so additional profits during the transition period should not cause the threshold to be exceeded.

Pension allowance taper
Secondly, with pension annual allowance taper calculations. The pension annual allowance taper calculations are based on net income, which means that additional transition profits should not result in a lower annual allowance. In addition, transition profits can be used as relevant UK earnings for the purposes of tax relief on pension contributions, which could be good news for some business owners.

Now for the Less Good News

So far, we have highlighted the more positive aspects of the basis period reform transitional rules. Now we will consider the less positive aspects.

Personal allowance tapering
The rules concerning personal allowance tapering are not quite so favourable for transition period profit adjustments.

Every taxpayer has a personal allowance of £12,570, but it is tapered for higher income taxpayers as their income increases. For every £2 a person earns over £100,000, £1 of their personal allowance is lost. You might think that because transition profits are not included within the net income calculations, this wouldn’t affect the personal allowance, but unfortunately it does. This is because of the way this calculation needs to be performed. The standalone tax charge on transition profits is calculated by comparing the tax payable if transition profits were left in net income, with whatever tax would be payable if they were excluded. This means that the personal allowance taper effects may still be felt if transition profits resulted in a higher than usual income (in excess of £100,000).

Payment on Account (POAs)
There may be some changes to the amount of tax to be paid on account (Payments on Account – POAs. This occurs because the POA is estimated according to whatever the previous year’s tax liability was. If transition profits inflated the figure, it will have a knock-on effect on POAs.

Transition profits effect on CGT thresholds?
Capital gains tax (CGT) is charged at different rates depending on income levels. If you are a basic rate taxpayer, you pay CGT at rates of 0 and 18%, depending on the asset sold. Higher rate taxpayers are charged at rates of 20 and 24% (previously 28%) depending on the asset. Given that transition profits affect the amount of personal allowance available, will the same principle apply to CGT? HMRC has verified that unlike the personal allowance tapering affect which remains, CGT rates are unaffected by the level of transition profits.

Clearly there are lots of issues remaining due to the switch to basis period accounting. If you would like help navigating the tax implications, please get in touch via partners@rjp.co.uk.