Will you be affected by increased tax bills for sole traders and partnerships in 2022?

According to HMRC, 7% of sole traders and 33% of partnerships are currently using non-fiscal accounting year ends. DEFRA estimates there are 180,000 farming sole traders, partners and directors. 50,000 of these individuals who have a non-fiscal year end will be affected by legislation changes to the Draft Finance Bill 2022.

Currently, profits are assessed to tax on a ‘current year basis’, so you consider the accounting year end that falls within the tax year. For example, accounting year end 31 December 2021 falls within the 2021/22 tax year, and any income tax liability is due the following 31 January 2023.

From 2022/23, now to be referred to as the ‘transitional year’, the reporting of accounting data will be aligned with the tax year. To effect this transition, two sets of annual accounts will be considered in 2022/23; those with the accounting year end falling within the 2022/23 tax year, and the following accounts year end will also be apportioned to align the total period to the tax year, 5 April.

Who will be impacted?

This could affect many long-established and large businesses such as legal and professional firms, accountancy practices, doctors, dentists and farmers. Nearly all farms, according to the Farm Business Survey (FBS) have accounting year ends falling between 31 December and 30 April, and farming tenancies often follow the farming year (rather than the fiscal year).

Why is this change being introduced?

In preparation for the transition to Making Tax Digital (MTD) for Income Tax, which comes into effect from April 2023, trading profits will be assessed on a fiscal year basis, irrespective of the business’s accounting year end i.e. from 2023/24 onwards.

HMRC are not asking businesses to change their accounting date, and it remains non-compulsory to adopt a fiscal year for accounting purposes. Although, it should be noted that apportionments from different accounting periods will be required to fit the tax year. Businesses may therefore decide in the long-term to change their accounting period to align with the tax year, to avoid estimated figures and amendments to Self Assessment returns.

For example, a partnership which has an accounting period ending on 31 December would have to consider their accounts for both the 2025 and 2026 year ends, in order to file the partnership tax return for the 2025/26 tax year, which has to be filed by 31 January 2027. This would give the partnership just one month to prepare the 2026 year end accounts, or consider including estimates.

How will this change affect me?

Businesses that currently have a 30 April accounting year end will be particularly affected by the changes proposed, as in the 2022/23 (transitional) tax year, they will be required to report profits for the accounting period from 1 May 2021 through to 5 April 2023 (reporting 23 months of profits). All overlap relief brought forward (which arose when accounting and fiscal years didn’t align) must be used to reduce the taxable profit in the 2022/23 tax year. Any additional profits arising for the business under the new rules can be spread over 5 tax years, starting 2022/23 (to 2026/27), with an option to accelerate the tax charge. However, that could push people into higher tax bands for those years.

Changes/increases to the total taxable income in the 2022/23 transitional year, could have significant further financial impact on individuals, for instance:

• entitlement to means tested state benefits
• clawback of Child Benefit received if the total income exceeds £50,000
• reduction in personal allowance entitlement if income exceeds £100,000
• reduced pension annual allowance affecting how much can be contributed that year
• tax due on life assurance gains, if policies are encashed during 2022/23
• foreign tax credit relief available

Examples:

A. Sole trader

A sole trader draws up their accounts to 30 April. Profits for the year ended 30 April 2022 are £50,000, and for the year ended 30 April 2023 £70,000. They have overlap profits brought forward of £20,000.

The profits for the tax year 2022 to 2023 are as follows:

• Current year basis element – year ended 30 April 2022 – 50,000
• Plus transitional element – 1 May 2022 to 5 April 2023 – 70,000 x 11/12 = 64,166
• Less overlap profits (20,000)
• Total profits for tax year 2022 to 2023 = £94,166

These profits (£94,166) exceed the profits taxable under the current year basis (£50,000) by £44,166 (i.e. the transitional element less overlap profits). The sole trader can therefore elect to spread the excess over up to 5 years.

The minimum amount per year to be added is 44,166 / 5 = £8,833. Under this election, assuming the sole trader chooses to add the minimum amount, the profits for the tax year 2022 to 2023 are 50,000 + 8,833 = £58,833. A minimum adjustment of £8,833 per year will be required to the profits of each of the tax years from 2023 to 2023 onwards (until 2026 to 2023 at the latest) until the £44,166 is extinguished.

B. Partnership

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

The profits for the tax year 2022 to 2023 for Partner A are as follows:

• Current year basis element – year ended 30 September 2022 – 130,000 / 2 = 65,000
• Plus transitional element – 1 October 2022 to 5 April 2023 – (92,000 x 6/12) / 2 = 23,000
• Less overlap profits (40,000)
• Total profits for tax year 2022 to 2023 = £48,000

These profits (£48,000) do not exceed the profits under the current year basis (£65,000), therefore no spreading election can be made by Partner A. Taxable profit for 2022/23 will be £48,000.

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

• Current year basis element – year ended 30 September 2022 – 130,000 / 2 = 65,000
• Plus transitional element – 1 October 2022 to 5 April 2023 – (92,000 x 6/12) / 2 = 23,000
• Less overlap profits (10,000)
• Total profits for tax year 2022 to 2023 = £78,000

These profits (£78,000) exceed the profits under the current year basis (£65,000) by £13,000. Partner B can therefore 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. Under this election, assuming Partner B chooses to add the minimum amount, the profits for the tax year 2022 to 2023 are reduced from £78, 000 to 65,000 + 2,600 = £67,600. A minimum adjustment of £2,600 per year will be required to the profits of each of the tax years from 2023 to 2024 onwards (until 2026 to 2027 at the latest) until the £13,000 is extinguished.

Who won’t be affected?

For businesses which already prepare accounts to 31 March or 5 April these changes will have little impact, and property letting businesses already report to the tax year (even if preparing accounts to 31 March, as that is, by concession, treated as a fiscal year-end).

Quarterly reporting under MTD, and VAT periods?

In accordance with the draft regulations for MTD for Income Tax Self Assessment (ITSA), quarterly updates will need to be submitted within one month from the end of the quarterly period (and can be submitted up to 10 days early i.e. in advance of the quarter end). There will therefore be a window of around 40 days to submit each quarter’s figures.

The first quarterly period must start on the digital start date that applies to that business, and as ALL unincorporated businesses will have a digital start date of 6 April 2023, ALL such businesses will be reporting under MTD for the same quarters. The quarterly filing deadlines will be 5 May, 5 August, 5 November and 5 February, plus, of course, 31 January.

As a result, many unincorporated businesses may consider changing their VAT filing deadlines to fit with the calendar quarters for income tax and their accounting period.

Without such alignment to the fiscal year, under MTD, a self-employed individual who is VAT registered, making up his accounts to 30 April, and owning a residential property, could have up to 13 different submission dates to HMRC within one tax year.

What should I do now?

If your business has an accounting date ending other than 31 March or 5 April, it would be advisable to discuss with your accountant/tax adviser how you are likely to be impacted by this change. You should ascertain, if you don’t already know, how much overlap relief you have brought forward from earlier years, and consider whether a change of accounting date may be appropriate or beneficial for you. An indication of your likely profit forecast in the current accounting year, and the following, will also be useful, to assist your adviser in considering the likely financial impact of these transitional changes on you, and your cash flow.

Professional bodies are currently lobbying the Treasury, urging them to reconsider this proposed reform of the basis period rules, highlighting concerns over the timetable for these changes, and the risk to undermining the integrity of the tax system, if implemented too quickly, especially following Brexit and the pandemic.

This article was written by Johanna Wright. Should you have any questions or concerns regarding any of the above, please contact Johanna or another member of the Tax team using the form below.

 

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