As Making Tax Digital for Income Tax (MTD ITSA) draws closer, Tax Tuesday this week looks at the current government consultation (ending on 31 August 2021) to alter the way an unincorporated business is taxed from the profits arising in the basis period to the profits arising in the tax year.

The aim of this measure is to simplify the taxation of trading profits before the introduction of MTD ITSA, from April 2023. It isn’t surprising then, that the government have moved so swiftly with this consultation since its announcement, as the proposed tax year basis is set to apply from 2023/24 with 2022/23 being a transition year.

Who will this affect?

This important change will impact on unincorporated entities that pay income tax, sole-traders, partnerships (including LLP’s) and trusts with trading income.

It will only affect those who prepare accounts to a date other than 31 March or 5 April.

What is the proposal?

The proposal will take effect from the 2023/2024 tax year and in that year, you will be taxed on the profits arising in the year ended 5 April 2024 (tax year). If your accounting year end was 30 April your tax liability for 2023/2024 would have previously been based on your profits for the year ended 30 April 2023 (basis period).

To get to this position a year of transition is required, and this is 2022/2023.

It should be noted that HMRC are not saying you have to change your actual accounting date, just the way your profits will be taxed.

Transition year

The tax year 2022/2023 will be a transition period, when businesses who don’t have a basis period aligned to the tax year are brought into line with the ‘tax year basis’.

It is worth noting that for businesses where profits in the transition tax year are higher than if calculated under the current year basis, the Government proposes an election to spread any ‘excess profits’ in the transition year over up to five years.

Probably the best way to see how the profits in the transition year are taxed is to look at some examples and HMRC have provided some in their consultation document, set out below.

Example 1: Sole trader; spreading election

A sole trader draws up their accounts to 30 April. Their profits for the year ended 30 April 2022 are £55,000, and for the year ended 30 April 2023, £66,000. They have overlap profits brought forward of £20,000.

The profits for the tax year 2022-23 are as follows:

Standard component (YE 30/04/22) £55,000
Transition component (01/05/22 to 05/04/23): £66,000 x (11/12) £60,500
Overlap profits bfwd (£20,000)
Profits for 2022-23 £95,500

The profits calculated above (£95,500) exceed the profits under the current year basis (£55,000) by £40,500. The sole trader can elect to spread the excess over up to 5 years. The minimum amount per year to be added is £8,100 (£40,500 / 5).

Profits for 2022-23 where an election is made and the minimum amount is added:

Profits calculated under current year basis £55,000
Adjustment made as a result of the election £8,100
Profits for 2022-23 £63,100

£8,100 will be added to the profits of the tax year for each of 2023-24, 2024-25, 2025-26 and 2026-27.

Example 2: Sole trader; no spreading election

A sole trader draws up their accounts to 30 June. Their profits for the year ended 30 June 2022 are £35,000, and for the year ended 30 June 2023, £20,000. They have overlap profits brought forward of £30,000.

The profits for the tax year 2022-23 are as follows:

Standard component (YE 30/06/22) £35,000
Transition component (01/07/22 to 05/04/23): £20,000 x (9/12) £15,000
Overlap profits bfwd (£30,000)
Profits for 2022-23 £20,000

The profits calculated above (£20,000) do not exceed the profits under the current year basis (£35,000); therefore, a spreading election cannot be made.

Example 3: Partners & the spreading election

A partnership with two 50% profit-share partners draws up its accounts to 30 September. Its profits for the year ended 30 September 2022 are £130,000, and for the year ended 30 September 2023, £92,000. Partner A has overlap profits brought forward of £40,000. Partner B has overlap profits brought forward of £10,000

The profits for the tax year 2022-23 for Partner A are as follows:

Standard component (YE 30/09/22): £130,000 x 50% £65,000
Transition component (01/10/22 to 05/04/23): £92,000 x (6/12) x 50% £23,000
Overlap profits bfwd (£40,000)
Profits for 2022-23 £48,000

The profits calculated above (£48,000) do not exceed the profits under the current year basis (£65,000), therefore no spreading election can be made by Partner A.

The profits for the tax year 2022-2023 for Partner B are as follows:

Standard component (YE 30/09/22): £130,000 x 50% £65,000
Transition component (01/10/22 to 05/04/23): £92,000 x (6/12) x 50% £23,000
Overlap profits bfwd (£10,000)
Profits for 2022-23 £78,000

The profits calculated above (£78,000) exceed the profits under the current year basis (£65,000). Partner B can elect to spread the excess of £13,000 over up to 5 years. The minimum amount per year to be added is £13,000 / 5 = £2,600.

Profits for 2022-23 where an election is made and the minimum amount is added:

Profits calculated under current year basis £65,000
Adjustment made as a result of the election £2,600
Profits for 2022-23 £67,600

£2,600 will be added to the profits of the tax year for each of 2023-24, 2024-25, 2025-26 and 2026-27.

 

Whilst the proposal is still under consultation, it is clear the government are keen to implement this change, in particular in preparation for the introduction of MTD (Please see our earlier ‘Making Tax Digital – getting it right’ blog). We think it is important to consider the real impact of these changes on your business and keep up to date with accurate, timely information. Tax Tuesday will of course, provide further updates when the proposals are approved (or not).

How can we help?

If you would like advice, please don’t hesitate to get in touch with your relationship principal, call 0161 905 1616 or email hc@haroldsharp.co.uk.

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