HMRC Basis Period Reform for Sole Traders & Partnerships

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Mandatory basis period reforms have been announced by HMRC for unincorporated businesses, including sole traders, irrespective of their involvement with Making Tax Digital (MTD). This article delves into the details of these reforms and how sole traders and partnerships need to adapt.

Starting from the 2024/25 tax year, affected businesses must use the tax year as their basis period and will only be liable for profits arising in that and subsequent tax years. Overlap profits or adjustments will cease to exist. Sole traders with different accounting periods will use 2023/24 as a transition period, during which they may experience larger tax bills. However, HMRC will offer transitional relief, spreading payments proportionally across the following five years.

Although inspired by Making Tax Digital for Income Tax, the basis period reform is a separate initiative affecting all unincorporated businesses.

What is a basis period?

A basis period is the time frame used for calculating the taxable profits of a business, typically for unincorporated businesses such as sole traders and partnerships. In the UK tax system context, the basis period is the period for which a business is assessed for income tax on its profits.

For most businesses, the basis period aligns with their accounting period or financial year, which is often a 12-month period. However, some businesses may have different accounting periods or irregular trading patterns, which could lead to differences between the basis period and the accounting period.

The basis period is essential in determining the profits to be reported on a business’s tax return and for calculating the amount of tax payable. Any changes to the basis period rules, such as the basis period reforms mentioned earlier, can impact how businesses report their income and pay taxes.

What are overlap profits?

Overlap profits occur when a sole trader or a partnership in the UK has a basis period for income tax purposes that covers more than 12 months. This situation typically arises during the first few years of trading or when a business changes its accounting period.

When a business starts trading, the basis period for the first tax year usually runs from the start of the business to the next April 5th. If the business has a different accounting period, the basis period for the second tax year might include some months that were already covered in the first tax year. The profits from these overlapping months are called “overlap profits.”

Overlap profits are not immediately taxable but are carried forward and deducted when calculating the taxable profits upon the cessation of the business or when the accounting period is changed to align with the tax year. This mechanism ensures that the business is not taxed twice on the same profits.

The basis period reforms discussed earlier in the article aim to eliminate the occurrence of overlap profits by mandating businesses to use the tax year as their basis period.

What is Making Tax Digital (MTD) for Income Tax?

Making Tax Digital (MTD) for Income Tax is a part of the UK government’s broader initiative, Making Tax Digital, which aims to modernise and simplify the tax system. MTD for Income Tax focuses on unincorporated businesses, such as sole traders and partnerships, and landlords with rental income, requiring them to maintain digital records and submit Income Tax updates electronically through compatible software.

Under MTD for Income Tax, businesses and landlords must send a quarterly summary of their income and expenses to HM Revenue & Customs (HMRC). These quarterly updates will be followed by a final end-of-year report, known as the End of Period Statement (EOPS), to confirm the figures and claim any allowances or reliefs. This new process is intended to give taxpayers a more accurate view of their tax liabilities throughout the year, helping them better manage their finances.

MTD for Income Tax aims to make the tax administration process more efficient, reduce errors, and improve the overall experience for taxpayers. It is important to note that MTD for Income Tax is separate from MTD for VAT, which is already in effect for VAT-registered businesses above the VAT threshold.

MTD for ITSA: Introduction Delayed and Threshold Increased

Making Tax Digital (MTD) for Income Tax Self-Assessment (ITSA) aims to revolutionise the tax reporting process for unincorporated businesses, self-employed individuals, and landlords. By implementing MTD-compatible software, digital records will be maintained, and HMRC will receive quarterly updates on income and expenses. However, the government has decided to delay the phased introduction from April 2024 to April 2026, allowing all stakeholders – taxpayers, agents, software providers, and HMRC – more time to prepare. The previous gross income threshold of £10,000 will be raised to £50,000 from April 2026 and lowered to £30,000 from April 2027. Additionally, the government has announced a review focused on the needs of smaller businesses.

Self-employed and Landlords

The mandatory use of MTD-compatible software and quarterly reporting to HMRC will apply to self-employed individuals and landlords:

  • From April 2026, for those with a turnover of more than £50,000
  • From April 2027, for those with a turnover between £30,000 and £50,000

General Partnerships

As previously announced, the government confirmed that MTD for ITSA would not be extended to general partnerships in 2025. However, the government remains committed to introducing MTD for ITSA to partnerships in accordance with its Tax Administration Strategy.

Smaller businesses

A review has been announced to address the needs of smaller businesses, particularly those with a turnover under the £30,000 threshold. The review will examine how MTD for ITSA can be tailored to the needs of smaller businesses, the best ways for them to fulfil their Income Tax obligations, and inform the approach for any further MTD for ITSA roll-out after April 2027.

MTD for ITSA

MTD for ITSA represents a fundamental shift in individual tax reporting, replacing the Self-Assessment tax return with quarterly submissions, an End of Period Statement, and a Final Declaration.

Initially, self-employed individuals and landlords must maintain digital records and submit a quarterly summary of income and expenses to HMRC via MTD-compatible software. At the end of the tax year, individuals can finalise their business affairs using the MTD software, incorporating non-business income sources (e.g., dividends, interest) and capital gains when calculating their final tax position.

HMRC plans to provide individuals with estimated tax calculations based on quarterly reports, assisting with budgeting for tax due. However, the payment due dates for Income Tax will remain unchanged, at least initially.

Key dates for the basis period reform

  • 2022/23: The last year of the existing basis period rules
  • 2023/24: Transitional year for businesses to move to the new fiscal year basis, potentially requiring two sets of accounts for some
  • 2024/25: The first year of the new basis, with businesses taxed only for profits earned in the tax year

Implications of basis period reform for business owners

Business owners can continue using their current accounting period or change it to align with the tax year. If they choose to switch, they must factor in any additional profits from the extended basis period and deduct any overlap profits, resulting in a transitional amount. This amount can be paid proportionally over the next five years or in fewer years if preferred.

Potential difficulties in adjusting

Although there is no requirement to adjust accounting periods, doing so may be necessary for businesses adopting MTD for Income Tax in April 2026 or April 2027. Asynchronous accounting and basis periods could lead to issues submitting accurate end-of-period statements (EOPS) and tax payments, potentially necessitating corrections. Switching to the tax year for the basis period during the transition year could alleviate these issues. Still, businesses need to know their original overlap profits, which may be difficult for older establishments.

We can help

As HMRC relies on us Accountants to disseminate information and explain the details of tax law changes, we play a crucial role in helping businesses understand and adapt to basis period reforms. Our role includes educating the self-employed about the new requirements and guiding them in making informed decisions about adjusting their accounting periods. If you have limited records of overlap profits, contacting HMRC well in advance to request this information is advisable. If this all seems too complicated, get in touch today and let us handle it all for you.

In conclusion, the delay in implementing MTD for ITSA and the adjustments to the income threshold provide additional time for businesses, self-employed individuals, and landlords to prepare for the upcoming changes. As Making Tax Digital for Income Tax Self-Assessment evolves, staying informed and adapting to the new requirements will be crucial for a smooth transition.

Now is the time to explore MTD-compatible software solutions and plan for the future. As your trusted accountants, we at Mercian Accountants are here to guide and support you throughout this process. Don’t hesitate to contact our team for personalised advice, assistance with choosing the right software, and help with implementing the necessary changes to stay compliant with MTD for ITSA regulations. Contact us today to discuss how we can assist you in embracing the future of tax reporting.

About Graham

Accountant specialising in tax, property, and estate planning. A regular speaker at landlord, property Investor, and later life planning events.

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