The way in which business income is charged to income tax is changing from 6 April 2023, affecting all self-employed individuals, partners in trading partnerships, unincorporated entities with trading income, and non-resident companies with trading income charged to income tax.

Under the current system, income declared on an income tax return is determined by the business accounting yearend date. This date can be chosen by each individual business. The profit or loss arising in the 12 months ending with the accounting yearend date (the ‘basis period’) is then deemed to be the profit or loss for the tax year in which the yearend falls.

There are specific caveats to this treatment, especially in the early years of trading when sometimes profits are tax twice creating 'overlap profits' that are usually only relieved by deduction when the accounting yearend changes or on cessation of the trade which may be many years later.

In order to combat the somewhat unintuitive method of profit calculation through the current basis period method, the government introduced a proposal on 23 March 2021 to remove basis periods. Under the new legislation, from 6 April 2024, all unincorporated business profits shall be reported in line with the UK tax year, 6 April to 5 April, irrespective of the business accounting yearend date.

The new tax year system will require the apportionment of profits between accounting years for those businesses that do not draw their accounts to 5 April; this may require estimations and subsequent amendments for those unable to prepare finalised accounts prior to the self-assessment filing deadline.

This will remove the need for overlap profits as businesses will report profits or losses relating to each tax year, rather than potentially spanning multiple years. Those businesses with existing overlap profits will have the opportunity to use them in the transition period.

Whilst the new basis reform rules will come into force from 6 April 2024, a transition period will begin in the prior tax year commencing 6 April 2023. Businesses that do not have an accounting yearend date aligned to 5 April will be required to report additional profit or loss from their accounting period end date to 5 April 2024.

There is potential for significant increases in taxable profit for those businesses with an early accounting yearend that are also required to report additional profit through to 5 April 2024.

To alleviate these issues, unused overlap relief will be available to offset against taxable profit arising in the transition period and businesses will have the option to spread any excess taxable profit over the 5 tax years, commencing from the transition year.

Any additional taxable profit arising from the transitional year will not be deemed income for purposes of determining abatement of personal allowances for high earners, or other tax charges such as the high income child benefit charge.

It is also worth noting that the accounting yearend dates of 31 March and 5 April may be used equivalently (unless an election is made), and no apportionment is required for the 5 days to 5 April, if accounts are drawn to 31 March.

ABC Trader is a sole-trader business with an accounting yearend to 30 April.

The business has 11 months of overlap profit totaling £77,000.

Profit of £100,000 arises in the period 1 May 2021 to 30 April 2022. Using the basis period rules this profit will be assigned to the 2022/23 tax year as the accounting yearend falls within this year. No adjustment is required as the new rules are yet to take effect.

Profit of £150,000 arises in the period 1 May 2022 to 30 April 2023. This profit will be taxed in 2023/24 using the basis period rules. However, this tax year is the transitional period, meaning all profit arising up to 5 April 2024 must be taxed.

Profit of £120,000 arises in the period 1 May 2023 to 30 April 2024. To ensure profits are taxed to 5 April 2024, a further £110,000 will be taxed in 2023/24 equal to the profit earned in the 11-month period 1 May 2023 to 5 April 2024.

Therefore, the total profit taxed in 2023/24 is £260,000 (150,000 + 110,000). Overlap relief of £77,000 is deducted, leaving taxable profit of £183,000.

The ‘excess’ profit taxed in this year is £33,000, being the total profit of £183,000 less the profit taxed under the basis period rules of £150,000. The business will have the option to spread this excess profit evenly over 5 tax years, resulting in additional profit of £6,600 per year.

Profit of £150,000 arises in the period 1 May 2024 to 30 April 2025. The calculation of profit will be based on those arising in the tax year, i.e. 6 April 2024 to 5 April 2025. From the above, a 1/12 share of remaining profit from the accounting year ended 30 April 2024 will be included (£10,000), as well as 11/12ths of the profit to 30 April 2025 (£137,500).

Therefore, total taxable profit is £147,500.This will be increased by £6,600, if the business has elected to spread the transition profits.

The calculation of profit for future tax years, i.e. 2025/26 onwards, will be on a tax year basis.

As noted above, the transition period can bring significantly increased taxable profit and cause cash flow issues for those businesses not currently using a tax year accounting yearend. There is scope to plan and reduce these issues by changing the business accounting yearend prior to the transition period.

Continuing with the business above, we shall now assume the business had prepared accounts to 30 April 2022. They then decide to draw accounts to 31 October 2022.

Profit of £120,000 arises in the period 1 May 2020 to 30 April 2021. This profit is taxed in the 2021/22 tax year under the basis period rules.

Profit of £100,000 arises in the period 1 May 2021 to 30 April 2022. The business then draws accounts to 31 October 2022, generating profits of £75,000. The total profits of £175,000 will be taxed in 2022/23, less relief for 6 months of overlap profits of £42,000. Taxable profit is £133,000.

The business has 5 months of overlap profit remaining of £35,000.

Profit of £150,000 arises in the period 1 November 2022 to 31 October 2023. This profit will be taxed in 2023/24 using the current basis period rules. However, this tax year is the transitional period, such that all profit arising up to 5 April 2024 must be taxed in this year.

Profit of £120,000 arises in the period 1 November 2023 to 31 October 2024. To ensure profit is taxed to 5 April 2024, a 5/12 share of the profits in this accounting year will be taxed in 2023/24 totalling £50,000.

The total profits therefore taxed in 2023/24 are £200,000 (150,000 + 50,000). Overlap relief of £35,000 is deducted, leaving taxable profits of £165,000.

The ‘excess’ profits taxed in this year are £15,000, which can either be spread over 5 years or taxed immediately.

Profit of £150,000 arises in the period 1 November 2024 to 31 October 2025. The calculation of profit will be based on those arising in the tax year, i.e. 6 April 2024 to 5 April 2025. From the above, a 7/12 share of remaining profit from the accounting year ended 31 October 2024 will be included (£70,000), as well as 5/12ths of the profit to 31 October 2025 (£62,500). Total taxable profit is therefore £132,500. This will be increased by £3,000 if the business has decided to spread the transition profits.

A change of accounting yearend date prior to the transition period may offer some cash flow benefits as a reduced number of months are taxed in the transition period. However, it is worth noting that no ‘spreading’ is available with a change of accounting yearend, whereas the transition period does allow excess profits to be spread over 5 years if desired.

This change should simplify the yearend process for the majority of unincorporated businesses going forward, though will generate potentially significant excess profit in the near term and is an added complication for those with accounting yearend dates that are not in line with the tax year.

The transition year will generate potentially significant excess profits for those without a yearend aligned to the tax year, with a provision to allow the spreading of excess amounts over 5 tax years. Consideration should be given to the cash flow benefits of changing accounting yearend prior to the transition period.