In late July 2021, the government announced a consultation on proposals which would change the way that sole traders and partnerships are taxed. While in some ways it is a welcome simplification of often complex tax rules, it could lead to nasty financial problems and personal financial failure for those caught out by the move.It was originally proposed that these rules would come in from next April but following feedback it was announced that they will be delayed until April 2023.
In fact, so great are the changes that Kirsty Swinburn, a tax senior manager at BHP, considers that it could lead to an acceleration of tax liabilities for many businesses. And Emma Rawson, a technical officer at the Association of Taxation Technicians (ATT), agrees, noting that “in the 2023/24 tax year when the change is introduced, special transitional rules may result in more profits being taxable than would normally be the case”.
As to whom it will affect, Kirsty says that the plans are for the new system to apply to all sole traders and partnerships but “will mainly affect those businesses who currently have anything other than a 31 March or 5 April accounting year end”.
According to an estimate reported by the Financial Times, some 280,000 sole traders and 250,000 partners could be caught up in the change based on 2019/20 tax returns. And despite rising levels of incorporation of practices, many in the profession will be caught out by the new rules once they come in.
Kirsty details that under the current regime, businesses are taxed based on the profits for the accounts year ending in the tax year – “so if a business has a 30 June year end, its 2020/21 tax will be based on the 30 June 2020 accounts”.
This, she says, creates complexities, particularly in “the opening years of a business when profits can be assessed twice, and ‘overlap’ profits created. This overlap is used when the business ceases, but the value is often eroded by time, or lost if a record isn’t kept.”
Under the government’s proposals, these businesses will be taxed on profits earned in a given tax year, irrespective of their accounting year end, with an apportionment being applied if required
Under the government’s proposals, these businesses will be taxed on profits earned in a given tax year, irrespective of their accounting year end, with an apportionment being applied if required. As Emma highlights, “for those with accounting years which do not align with the tax year, the planned changes are very significant”.
Bringing the change in
The question for many is when will the change occur? On this Kirsty says that as the proposals presently stand, the “tax-year basis” would replace the “current-year basis” entirely from 2024/25.
She adds that “2023/24 will be the transitional tax year, and the transitional adjustments involve the use of the historic overlap profits”. This may, depending on profit levels, increase the tax liability for that year. In fact, as Kirsty sees it, among those who will be most affected are “those who experience really good trading results in the 2023/24 transitional year – so it has the potential to hit them just as they are bouncing back”.
Emma Rawson highlights the problem with an example: “Let’s assume a sole trader normally draws up their accounts to 30 April each year. In tax year 2023/24 they would, under the current rules, be taxed on their profits for the year ending 30 April 2023. However, under the proposed new rules, they would instead be taxed on their profits for the year ending 30 April 2023 and their profits for the period from 1 May 2023 to 5 April 2024, less any overlap profits.” This, she says, effectively results in up to 23 months’ worth of the profits being taxed in 2023/24, rather than the usual 12 months.
This … effectively results in up to 23 months’ worth of the profits being taxed in 2023/24, rather than the usual 12 months.
And she cites a worked example that HMRC has given in the consultation. A sole trader has profits to 30 April 2024 of £55,000, profits to 30 April 2023 of £66,000 and overlap profits of £20,000. Bypassing the maths, Emma says that under the new regime “this results in £8,100 of extra profits being taxable in 2023/24, and each of the following four years. For a higher rate taxpayer, that equates to extra tax payable of £3,240 a year.”
Any additional tax would be payable 31 January 2025.
But in mitigation, Kirsty says that “there are proposals to allow a five-year spread of the additional tax for those businesses adversely affected, but this has not yet been finalised”. This five-year spread is crucial to dampening the impact in her opinion; without it there will be some real pain.
And for those that worry about HMRC wielding a large stick, for the moment at least it’s not being that aggressive towards collecting tax from individual taxpayers; rather it’s offering easy to access “time to pay” arrangements. However, Kirsty questions the future, noting “whether that continues as we emerge from the pandemic and the state of the nation’s finances starts to take centre stage above the pressing need to support individuals and businesses through the worst effects of the pandemic, only time will tell”.
The change may result in many considering whether to change their year end to either 31 March or 5 April, “both of which,” says Swinburn, “are accepted as aligning with the tax year”.
That said, Swinburn notes that for those currently experiencing poor trading results, arising from the pandemic for example, early adoption of a 31 March or 5 April year end may be beneficial. But she says that “this needs to be looked at on a case-by-case basis”.
For those sole traders and partners in businesses with anything other than a 31 March or 5 April year end her advice is that they “should ensure they have a record of their overlap profits as relief for this will need to be claimed in the 2023/24 tax year at the latest”
And for those sole traders and partners in businesses with anything other than a 31 March or 5 April year end her advice is that they “should ensure they have a record of their overlap profits as relief for this will need to be claimed in the 2023/24 tax year at the latest. This figure should have been recorded on the tax return each year.”
Of course, there is nothing written down in the proposals that requires businesses caught by the proposals to change their accounting year end but as Swinburn details, businesses that don’t will need to do an apportionment each year. She warns – and emphasises – that “those with a 31 December year end would have just one month to prepare the accounts before the figures have to be submitted to HMRC”.
What comes next?
The proposed reforms are all part of the government’s Making Tax Digital (MTD) programme. MTD has been in place for VAT for several years now and MTD for income tax is scheduled to be introduced from 6 April 2024, so aligning with the start date for these is part of the proposed reforms.
MTD for income tax will apply to all self-employed businesses and landlords with annual business or property income above £10,000. As Kirsty comments, “at its core is a requirement for quarterly reporting, a process which will be much simpler if all businesses are on a tax-year basis for the assessment of profits”.
So, while in general the proposed change seems a sensible one, there will be winners and losers, and most will move to a tax-year basis for their accounts to remove the extra administrative burden, and potential time pressures, associated with the need to apportion. Some, who don’t fall into line and who are poor at putting money away to pay their tax, could be forced into hardship and financial distress.
For Emma, the solution is clear: “As businesses could still be feeling the impacts of the COVID-19 pandemic by the time the rules come into force, they should consider working with their tax adviser or agent to model what the extra tax payable may be, and budget accordingly.”