What are the proposed tax changes for the self-employed, sole traders and partnerships?

Proposed Tax Reforms

Simpler Calculation of Profits

Following the “Tax Day” announcements in March this year, the government is pressing ahead with its proposals for reform of the tax system. Making Tax Digital for Income Tax will be mandated for self-employed people (including those in partnership) with an annual income of more than £10,000 from April 2023. Ahead of this, the government is proposing to “simplify” the basis on which profits from self employment are taxed and a consultation on this ended on 31 August 2021. The consultation states that the proposal will be announced later in the year, with the intention that the tax year from April 2022 will be when the transition to the new basis is made.

 

The Current Position

Aside from the first two or three years of trading, and when the trade ceases, self employed earners are taxed on their profit for a twelve-month accounting period ending within the tax year (the “basis period”). This arrangement when it was introduced in the mid-1990s was called the “Current Year Basis”. Traders and partnerships, referred to as “businesses” in the government’s consultation document, are free to decide on the date on which that twelve month period ends, though once that date is fixed they are expected to use it year on year. Some businesses choose an accounting date early in the tax year and by doing so with a good understanding of the basis period rules as they stand, they can defer paying tax on profits until some time after they were actually realised.

The rules relating to the early years and final years of trading are not straightforward and the consultation paper claims, in my view correctly, that particularly for sole traders or small businesses they can lead to errors in the profits declared to HM Revenue and Customs. For example, there may be an element of profit for a given accounting period that is subjected to tax twice in the initial trading years and this is termed an “Overlap Profit”, more on which later.

It is obvious that as the government expects all businesses to be able to accurately self-report profits under the Making Tax Digital provisions, the rules for calculating those profits must be clear and straightforward. So what do they have in mind?

 

The Proposal

Instead of taxing the profit from the period of twelve months ending in the tax year, the government proposes to move to taxing the profits that arise in the period from 6 April in one year to 5 April the following year, or the twelve months from the beginning of April to the end of March - they will be happy with either. Businesses will still be free to choose the date to which they make up a twelve month period of accounts, but to take a common example, a business that makes up accounts to 31 December each year will be expected to report 9/12ths  of the profit from one accounting period plus 3/12ths of the profit from the following one.

The consultation document states that 93% of sole traders and 67% of partnerships already align their accounting period with the tax year, or the year to 31 March, but what about those businesses that do not?

 

The Transitional Year

If the government implements this proposal, for the tax year 2022/23 businesses with an accounting date other than 31 March or 5 April will be taxed on their profit for the accounting year ending within the tax year (as currently) plus the portion of their profit from the start of the following accounting period to 31 March, or 5 April,  2023. Potentially therefore a much larger taxable profit and commensurate increase in tax to pay. All sole traders and partners in businesses would be obliged to claim any Overlap Relief that may be available to them, and they would have the option to elect to pay the additional liability over a period of five tax years. Even so, there will almost certainly be a boost in revenue for the Treasury.

The consultation recognises that businesses that prepare accounts to a date in Q3 or Q4 may not have final figures for the later accounting period before the date on which the resultant tax becomes due. It proposes that those businesses use provisional figures initially, to be displaced by those from the final accounts once they are complete. This is permissible under the present Self Assessment regulations.

 

What Might the Problems Be?

Though in principle any simplification to the UK’s ever-burgeoning tax code should be welcomed, there is a dismal history of confusion and unintended consequences from previous “reforms” and this proposal has the potential for these in royal measure.

Responses to the consultation have begun to be published by various professional bodies, one being the Tax Faculty of the ICAEW, who argue that it is just too soon for such a fundamental change. Why not wait to see how well Making Tax Digital for Self Assessment works in practice and allow that to bed in?

In addition Overlap Relief, which the consultation claims will soften the blow of the transitional provisions for businesses and partnerships with an accounting date not currently aligned with the tax year, is quantified when an individual first sets out in business so I anticipate that for many people, the figure will have become lost in the mists of time. I doubt that HM Revenue and Customs will have retained a note of it. Even when the number has been recorded, it will relate to an early year’s profit that may be insignificant by comparison to the current level.

There are a raft of other considerations. Businesses may choose an accounting date that is not aligned with the end of the tax year for a variety of reasons. 31 December is the international standard for the end of the tax year, so for example large partnerships that operate in more than one jurisdiction might use that date by default. Equally, many businesses are seasonal so the date to which they prepare accounts may be referenced to their particular trading activity.

When a business prepares accounts to a date in Q3 or Q4 of the financial year and it is impractical to realign the accounting date to coincide with the tax year, the need to produce provisional figures to be amended later will perpetuate and become an additional administrative burden. There is scope too, in parallel with the existing Self Assessment provisions around electing to reduce payments of tax on account, for HM Revenue & Customs to charge interest on any underpayment of tax resulting from using provisional figures.

I would like to think that consideration has been given, or will be, to the effect of the transitional year provisions on allowances and reliefs that are income-geared. Will these be referenced to the profit figure for the accounting year that ends in 2022/23, or is the apportioned figure to the end of the tax year also factored in? How would that affect, say, the threshold at which the tax-free Personal Allowance is eroded for higher earners? In fairness, the consultation invited comments on these and other related issues and they are far from insoluble, but they create another layer of complexity.

Easy to parrot the professional bodies and I would genuinely like to be more positive, but I do wonder if making this change with such imminent effect would actually, really, simplify very much at all.

 

For more information and guidance on how the proposed changes could impact your business, please get in touch with me.