Basis period reforms – handling the transition

Part 4 of Finance Act 2022 has set out how the profits of the self-employed sole traders and partners in a partnership will be taxed from 2024/25. This has resulted in a number of changes to the legislation – including abolishing the well-known term ‘basis period’. The changes mean that the profits will be taxed on a tax-year basis – ie to the end of 5 April instead of the profits for the 12 months to the accounting date in the tax year.

From 2024/25, taxable profits will be based on time-apportioned profits of the accounting periods that fall within the tax year.

For example, if a trader prepares their accounts to 31 December every year, their 2024/25 taxable profits would be based on 275 days (out of 366 days) of the 2024 calendar year profits and 95 days (out of 365 days) of the 2025 calendar year profits.

The 2024/25 tax return is due by 31 January 2026. It is unlikely that the trader will be able to finalise the accounts and tax adjustments for the 2025 calendar year accounts in time, hence they may need to file a tax return based on provisional figures and then revise the return later once the correct figures are known. This exercise would be repeated every year thereafter.

To reduce the administrative burdens on businesses – such as two sets of tax computations (from different accounting periods) for each tax year and problems with estimation and possible revisions/ amendments to tax returns following finalisation of accounts – HMRC has suggested the following options to its consultation responses:

• allowing taxpayers to amend a provisional figure at the same time as they file their return for the following tax year
• allowing an extension of the filing deadline for some groups of taxpayers, such as more complex partnerships or seasonal trades
• allowing taxpayers to include in the next year’s tax return any differences between provisional and actual figures in the previous year
• leaving the current rules on provisional figures unchanged, whereby profits can be estimated in a return and amended as soon as final figures become available.

Overlap profits on change of accounting period

There are lots of examples available within HMRC manual from BIM81040 onwards covering various scenario of change of accounting date along with how the overlap relief can be claimed.

Specific provision has been included to ensure that overlap relief is not one of the reliefs restricted under s24A, Income Tax Act 2007 (ITA 2007), which puts a limit on such reliefs of:

(a) £50,000 or

(b) if more, 25% of the taxpayer's adjusted total income for the tax year.

Almost everyone with an accounting date other than 31 March or 5 April will have an entitlement to overlap relief and can ‘cash it in’ either on a change of accounting date or on cessation of the business.

Where a business changes its accounting date, there will generally an overall saving to be made where current profits are at a lower level than the profits arising when the ‘overlap’ first arose.

Who can change the year end?

Where a change of accounting date takes place in year four or later years of trading, three conditions must be met for the basis period for the year of change to end with the new accounting date. The legislative provisions are found in S216-S217 ITTOIA 2005

The three conditions are:

• the first accounts to the new date must not exceed 18 months
• a notice of the change of accounting date must be given:
  • in a self-assessment tax return for the year of change that applies to the person carrying on the trade, and
  • on or before the date that the return is required to be made
• in cases where there has been an earlier change of accounting date (which resulted in a change of basis period) in the previous five years:
  • the latest change must be made for commercial reasons, and
  • those reasons must be set out in the SA return referred to above.

HMRC manual BIM81050 provides more guidance on commercial reasons for changing an accounting date. It is important to remember that obtaining a tax advantage is not a commercial reason (S218(6) ITTOIA 2005)

How to calculate the overlap relief

Once the client decides to change the year end, overlap relief is given as a deduction in calculating the profits of the trade for the tax year in which there is a change of accounting date, if the basis period for that tax year is longer than 12 months. HMRC guidance on basis periods is found at BIM81000 onwards.

The amount of overlap relief given for the tax year in which such a change of accounting date occurs is restricted by reference to the number of days:

• in the overlap period(s) to which the overlap profits relate
• by which the basis period for the relevant tax year (in which the change of accounting date occurs) exceeds 12 months.

Where the accounting date in the year is 31 March or 1-4 April inclusive, the basis period may be treated as ending on 5 April for the purpose of calculating the amount of relief.

The effect of offsetting overlap relief on a change of accounting date is to ensure that tax is paid on 12 months’ worth of profits. If, for example, the basis period is 14 months long then the overlap relief of two months will be deducted. The legislation achieves this result by listing six ‘steps’ used to calculate the deduction, as follows:

• Step 1: add together the overlap profit arising in all previous overlap periods
• Step 2: subtract from that the amount of any deduction already made under these rules; call the resulting figure ‘the remaining overlap profit’
• Step 3: add together the number of days in all previous overlap periods, deduct the number of days already counted per Step 5 below on any previous occasion; call the resulting balance ‘the number of days on which the remaining overlap profit arises’
• Step 4: calculate ‘one day’s worth of remaining overlap profit’ by dividing ‘the remaining overlap profit’ by ‘the number of days on which the remaining overlap profit arises’
• Step 5: calculate the number of days by which the basis period exceeds the length of the tax year (ignoring 29 February if desired) and call the balance ‘the number of days’ worth of overlap profits that may be deducted on this occasion’
• Step 6: multiply the results of Steps 4 and 5 to calculate the amount of the deduction to be made.

The following example shows how these above steps can be applied in practice:

Example

The overlap profit available for relief after 2016-2017 is £54,492 over 340 days.

In 2018/19 the accounting date is changed again from 30 April 2018 to 31 October 2018. The relevant conditions for a change of accounting date are met.

The basis periods are:

The profit for the 18 months to 31 October 2018 is £120,000.

Overlap relief given for 2018/19 is restricted (because at least 12 months’ worth of profit must be brought into the charge to tax for that year).

The basis period for 2018/19 exceeds 12 months by 184 days (549 less 365).

Overlap relief for 2018/19 is restricted to £54,492 x 184/340 = £29,490. Profits taxable for 2018/19 are £120,000 less £29,490 = £90,510.

Overlap profit of £25,002 (over 156 days) remains unused. At cessation any remaining relief will be given in full.

HMRC is yet to issue guidance on how the 2023/24 transition year will work in practice, where some businesses will need to estimate figures and amend as necessary. In the meantime, traders with accounting dates that do not align with the tax year should prepare for any additional tax liability that may arise from these changes.

Useful resources

HMRC manual BIM81080