The way business profits are taxed is about to change: basis period reform explained

Overview

• The way unincorporated business profits are taxed is changing in 2024/25 subject to a transitional accounting year in 2023/24
• If the accounts period does not align to the 5 April tax year this is likely to have an effect on an individual's tax payments due
• The 2023/24 'transition' year may result in a higher tax burden
• Elections can be made to spread the cost of the accelerated tax

The key reforms

In the Autumn 2021 budget the government announced that it would reform the way that profits are allocated for Income Tax purposes.

From 2024/25 the profits taxed in a tax year will match those of the year itself, rather than being taxed on a 'current year basis', where the profits of an accounting period are broadly subject to Income Tax.

The new tax year basis

Under current rules, an unincorporated business with an accounting period of 31 December 2024 would be taxed on those 12 months of profits in the individual's 2024/25 tax return.

But the new reforms mean this business owner will be taxed on the profits from 6 April 2024 – 5 April 2025 in the 2024/25 tax return. This will require an apportionment of profits from the 31 December 2024 accounts (which will include the profits from 6 April 2024 – 31 December 2024) as well as part of the profits from the 31 December 2025 accounts (to include the profits from 1 January 2025 – 5 April 2025).

What is the purpose of these reforms?

The reason for these reforms is to simplify one part of the tax system and help prevent 'small businesses making errors in their tax returns'. This seems reasonable, especially as there will no longer be a creation of 'overlap profits', which in the early years of a business are taxed twice.

On the other hand, you could argue that these reforms create more complexity as we will now have to apportion accounting profits and may even have to include estimated profits.

This reform will also help businesses align with the forthcoming Making Tax Digital for Income Tax and Self-Assessment which comes into force from 6 April 2024.
 

How will the changes come into effect?

In order to align the basis periods from the 2024/25 tax year for everyone, there will be a transitional period in 2023/24 tax year which will bring all untaxed profits into charge.

How the transitional year will work

Let's look again at the example of an unincorporated business with an accounting period of 31 December 2024.

Under the current rules, the business owner will be taxed on the profits to 31 December 2023 in the 2023/24 tax year.

Under the new reforms the profits from 6 April 2024 – 5 April 2025 will be taxed in the 2024/25 tax year.

Without a transitional rule, the profits from 1 January 2024 – 5 April 2024 would not be subject to tax and so the rules bring these profits into charge in the transitional year.

The business owner will therefore be subject to tax on profits for the 15 month period from 1 January 2023 to 5 April 2024 in the 2023/24 tax year which might create a higher than anticipated tax burden.

Tax relief on 'overlap profits'

During the transitional year the tax payer will be able to relieve any historic 'overlap profits' which might reduce the taxable profits. These are the amount of profits taken twice in the initial years of the trade. These however could be negligible compared to current year profits.

A transitional complication which will ease the tax burden

Once the reformed basis of taxation is underway, it should be fairly simple to keep on top of the profits which are subject to tax, though there may be the need to apportion profits between tax years.

However, as the transitional year is likely to increase the tax burden on those individuals affected, it is possible to 'spread' the additional tax cost over a period of five years. This means that 20% of the 'additional' profits (subject to a calculation) can be taxed in each of the five years from 2023/24, instead on being taxed in one hit in the 2023/24 tax year.

Practical implications

For 2024/25 to 2028/29 a taxpayer could therefore be paying tax on the 12 months of profits arising in that tax year, as well as 20% of the profits arising from the transitional changes in 2023/24. Good record keeping will therefore be essential to make sure we are correctly taxing all of the profits from an unincorporated business.

Finally, it is worth noting that these rules only effect unincorporated businesses. Limited companies will therefore not be affected.

Here to help

Please do not hesitate to contact one of the Knill James tax team if you would like to chat through how this, or the forthcoming Making Tax Digital changes, might affect you or your business.