The reform of basis periods for the self-employed will go ahead, with a transitional year in the 2023/24 tax year and the new rules to take effect from the 2024/25 tax year. Here we explore the possible impacts on your business and what to do in preparation. 

What are the changes for self-employed businesses?

The new rules will be for self-employed businesses to be taxed on profits earned in a tax year, rather than on the profits of the accounting year ending in the tax year. The transition to a tax year basis will occur in the 2023/24 tax year, 12 months later than originally planned when the consultation launched on 20 July 2021. From 6 April 2024, all self-employed businesses will be assessed to tax on a tax year basis and, for new self-employed individuals, overlap profits will no longer accrue.

The changes are intended to simplify the tax affairs for self-employed businesses. However, there will be complications when implementing the new rules and thereafter for businesses with an accounting year other than 31 March or 5 April. There will be a cashflow impact for businesses in the transitional year and the key date to keep in mind will be 31 January 2025 which is when the tax will be due in respect of the transitional year.

The timing to introduce the reforms should provide businesses sufficient time to plan for tax payments. Businesses may also want to consider the implications of changing their year-end to 31 March sooner rather than later, depending on their profitability as we transition out of the Covid-19 pandemic. 

Businesses with a non-31 March or 5 April year end will have to change their timetable to produce the taxable profit information for its partners. 

What are overlap profits?

Any self-employed business whose accounting year differs from the tax year (31 March is treated the same as 5 April), will have overlap profits e.g. accounting year end of 31 December. Overlap profits are profits taxed twice in the second and potentially third tax year under the current basis period rules. The figure should be entered on an individual’s tax return and carried forward each year until it is utilised.

Is there any relief?

Additional profits arising in the transitional period will be spread over a period of five years under an automatic election. It will be possible to elect out of the spreading to accelerate the charge. There will be a balance between the cash flow implications of paying all the tax in one go against the risk of higher tax rates (due to rate changes and/or higher profits) in the future. We can help with projections.

Self-employed individuals should remember that additional profits from the transitional period will be subject to the new Health and Social Care levy of 1.25% being introduced from 6 April 2022, meaning a marginal rate of 48.25% for additional rate taxpayers. 

How will the new rules operate?

Taking an example of 31 December:

2023/24 tax year (the transitional year):

• 12 months profits to 31 December 2023;

• Plus: 1 January to 5 April 2024 (generally pro-rata based on taxable profit to 31 December 2024);

• Less overlap profits brought forward.

For businesses with higher profits in 2023/24 due to the change in basis, there is an automatic election to spread those additional profits over a period of five years, which you can opt out of.

2024/25 tax year (tax year basis):

• 6 April 2024 to 5 April 2025 (again, generally pro-rated from the two accounting periods)

Are there other considerations?

• Pension contributions: in the transitional year, self-employed individuals should take care when calculating how much they can contribute to their pension. This is because their income may be inflated due to bringing profits forward into 2023/24 which are not covered by overlap relief. The annual allowance of £40,000 is restricted by £1 for every £2 above the income threshold of £240,000 until their income is above £312,000 when the annual allowance is £4,000 (gross). Any unused allowances from the prior three tax years can also be taken into consideration.

• Retiring partners: the timing of a self-employed individual retiring from the business is crucial from both a commercial and a tax perspective so that the tax relief on their overlap relief is optimal. Where partners are approaching retirement, the tax implications of the proposed date should be established and consider whether an alternative date is beneficial due to the introduction of the new rules.

• Capital in the business: the reform to basis periods provides the perfect opportunity for a business to review their level of capital. The business should consider whether their level of capital is sufficient given the new rules being introduced, partners retiring and paying them out and new partners joining, either lateral hires or internal promotions.

What next?

HMRC published draft legislation in Finance Bill 2021/22, which is currently before Parliament.

In the meantime, businesses should establish the cashflow impact of the changes to plan for the tax payment due on 31 January 2025 and beyond. Businesses may also want to consider the impact of changing their year-end to 31 March to simplify their tax affairs from 6 April 2024.