Basis period reform: updates since the Finance Bill

In our article ‘Basis period reform: a simplification with complications’ (Tax Journal, 10 September 2021), we summarised the government’s proposals to change income tax basis periods for the taxation of business profits from the current year basis to a tax year basis. We highlighted some complications and practical and commercial issues that businesses will face.

Subsequently, on publication of Finance Bill 2021/22 on 4 November 2021, a number of changes were announced that are designed to alleviate the worst impacts of the transitional rules. In particular:

• It was confirmed that the introduction of the new rules will be deferred by a year, with 2023/24 being the transitional year and full introduction in 2024/25, in response to widespread feedback that businesses needed more time to prepare for such a significant change.
• Transitional profits will be separated out in the tax calculation and should now not affect the level of a taxpayer’s net income that is used to calculate their entitlement to certain reliefs and benefits (step 2 of the income tax calculation at ITA 2007 s 23). However, this currently means that it will not be possible to claim income tax relief (such as for EIS, SEIS and VCT investments) against transitional profits.

The revised legislation also confirms a number of other amendments that will assist businesses:

• If overlap relief creates or augments a loss, this will be treated as a terminal loss, giving a greater opportunity to utilise that loss by being able to carry it back up to three years.
• A claim to any previously unclaimed overlap relief - perhaps overlooked on an earlier change of accounting date - will be allowed, even if technically a claim ought to have been made in an earlier year.
• It will now be possible for a business to change its accounting date to 31 March/5 April in 2023/24 in order to align with the tax year without losing the ability to spread any transitional profits.

HMRC has also committed to further engagement with stakeholders regarding other legislative and administrative easements that may be introduced to aid businesses that decide not to change their accounting date to 31 March/5 April and will, therefore, be required to make apportionments of taxable profits every year. This is expected to take place after the current Finance Bill receives royal assent, and current ideas include:

• allowing provisional figures to be amended at the same time as filing the return for the following tax year;
• extending the filing deadline for those groups of taxpayers most adversely affected; and
• allowing estimated figures used to be corrected via a ‘true-up’ in the following year’s tax return.

It now seems clear that the policy decision to separate out transitional profits in the tax calculation (see FB 2022 Sch 1 para 75) is intended to protect those on low and modest incomes from the unfair impact of the rules on means-tested benefits. It is also clear that there is no desire to remove all of the tax impacts of basis period change (for example, to preserve personal allowances for high earners), and that the legislation is intended to ensure that transitional profit should be taxed as ‘normally’ as possible without unfair consequences. However, HMRC has acknowledged that the current proposals will preserve pensions annual allowances in the years in which transitional profit falls. This change has created the need for particularly challenging calculations to be performed in order to determine the amount of tax due on transitional profits, but HMRC considers that third party software should be capable of dealing with this.

The mechanics of separating transitional profits from ‘normal’ profits in the tax calculation can be illustrated in the boxed example.

Other areas of concern that remain to be considered, particularly for large partnerships, include:

• whether and how foreign tax credits on transitional profit will be relieved, with the interaction with the spreading rules creating additional complexity;
• where profit allocations are made on an accounts year basis, how apportioning across tax years impacts on tax adjustments, particularly for joiners and leavers who may be allocated profit for the whole accounts year but are only partner in one tax year; and
• whether UK-resident members of related UK and overseas firms will have sufficient UK profits in the transitional year to utilise the previously created overlap.

HMRC is clearly listening to constructive feedback on these reforms and making efforts to limit unfair and unintended consequences resulting from the transitional provisions. Whilst these transitional provisions are complex in themselves, incorporating mitigation steps in the new legislation, rather than changing the underlying income tax legislation for calculating tax on profits (ITA 2007 s 23 et al), does seem sensible. After all, the majority of sole traders and partnerships (by number) have a 31 March or 5 April year end, so will not have to calculate transitional profit anyway.

Businesses will need to monitor developments, including the further consultation to be launched by HMRC in spring 2022.