Understanding the HMRC Basis Period Reform
Posted 2 months ago by Alison
Last year saw a significant change in the way unincorporated businesses approach tax returns, thanks to the UK government implementing basis period reform. While intended to simplify reporting for sole traders and partnerships, the reforms that came into effect on 6 April 2024 have created additional reporting requirements for some businesses following the transitional 2023/24 period. With around 3.1 million sole proprietorships in the UK, the number of businesses impacted is significant.
Basis period reform means that an individual's business profits will be taxed on a tax year basis from 2024/25 onwards, affecting the accounts of unincorporated businesses, including self-employed traders and partnerships that pay income tax. Previously, companies could work out their annual accounts using year-end or accounting dates. So, if a business had an accounting year-end date of 30 September, taxable profits would be calculated from 1 October to the year-end date of 30 September for the relevant tax year.
From this tax year, however, HMRC's basis period reform means all unincorporated businesses must use the UK tax year of 6 April to 5 April for income tax assessment. This effectively breaks the link between the accounting date chosen by a business and when they are taxed on their profits.
This not only means that accounts need to be ready in time, but it could also mean higher tax bills, so it's essential to be aware of the changes and their implications.
Understanding Basis Period Reform
To be fully aware of what basis period reform will mean for your business, it's important to understand what a basis period is and how this differs from an accounting period. A basis period is the timeframe used to calculate tax. The current basis period rules mean income tax is calculated on the profits earned during a business' accounting period. The accounting period and basis period are the same for many companies, but the business can choose the accounting period. So if, for example, a business started trading on 1 January, its accounting period could run from that date until 31 December. On the other hand, the basis period is the period that HMRC uses for tax.
From the 2024/25 tax year, all unincorporated businesses have to use the UK tax year for income tax assessment, regardless of their accounting period.
Perhaps not surprisingly, there has been concern and confusion surrounding these changes. For example, there have been misunderstandings around whether businesses can distribute excess profits if they adjusted their accounting period for 2023/24, something that could impact tax liabilities and introduce additional administrative costs. While there have been suggestions that aligning accounting periods with the tax year dates in 2023/24 prohibited the distribution of any excess profits generated under the transitional rules, this was not the case.
It should also be noted that while businesses need to abide by these new rules, they can still draw up accounts to any date they wish. However, not aligning with the tax year will mean additional work when it comes to preparing a self-assessment as figures may need to be apportioned from more than one set of accounts, and it may be the case that provisional statistics need to be filed and later amended.
Impact on Businesses
To meet the new requirements, any self-employed individuals or partners in partnerships who do not use an accounting period end date between 31 March and 5 April will need to make changes to the way business profits for tax returns are calculated.
During the transitional year of 2023/24, the basis period was made up of two elements. What is known as a 'standard part' was the normal basis period (ie the 12 months following the end of the basis period for 2022/23); while a 'transition part' ran from the end of the standard part to 5 April 2024 (or 31 March 2024 if the accounts are drawn to that date).
Those with an accounting period ending between and including 31 March and 5 April may also have been affected in the 2023/24 tax year if they had unused overlap relief, which can be used to reduce taxable business profits. Overlap relief is based on overlap profits, which may arise if a business has not always used a 5 April accounting date, in which case profits can be taxed twice.
If a business didn't use its overlap profits before the 2023/24 tax year, then they must be used this year or they will be lost due to basis period reform.
For those that have recently started a new business, there are specific rules to be aware of. In the first tax year, the basis period will continue to be the period from the date that trading began until the following 5 April. In the second tax year, there are a number of potential scenarios. For those who have prepared a set of accounts for at least 12 months that end in that second tax year, the basis period is the 12 months ending on the accounting date. If there are no accounts that end in the tax year, the basis period will run from 6 April to the following 5 April. For those whose accounts end in the tax year, but are less than 12 months long, the basis period is the first 12 months of trading. These scenarios mean that some profits may be taxed twice, in which case overlap profits and relief will again come into play.
Financial Management
When collating records to take basis period reform into account, calculating transition profits is key. HMRC has an online calculator to help with this. As part of the reforms, in 2023/24 businesses were taxed on the profits of the 'standard part' and the 'transition part' of the basis period. 'Transition profits' were based on the profits of the transition part, on a time-apportionment basis, less any unused overlap profits.
If there was excess overlap, it will have been set against the profits of the standard part. If transition profits are more significant than zero, they are spread equally over the five tax years from 2023/24 to 2027/28, although it is possible to accelerate all or part of them.
It's also possible that the changes will have significant cash flow implications. Indeed, businesses that don't have a 31 March or 5 April year-end will have needed to add additional months into the following year's profits and could potentially face tax on up to 23 months' profit in one year. While overlap relief will help, accurate cash flow projections and being clear about what tax is due and when is crucial as these changes are naviagted. Accountants can play a key role here, carrying out regular cash flow modelling and working through potential scenarios in order to advise clients on the best approach to the changes now and into the future.
Benefits of the Reform
Given the potential concerns for sole traders and partners, it's important to point out that there are possible benefits to the reform too, and the changes have been introduced with the aim of simplifying tax reporting in the longer term. For example, the reforms will remove existing requirements of the basis period rules such as double taxation of early years of trading profits and maintaining accurate records of overlap profits and relief, which HMRC says are often lost and not utilised by taxpayers.
It will also add consistency to the system. Under the previous system, two businesses that are identical except for their accounting date may have very different taxable profits for a tax year. The tax year basis will remove this difference, leading to fairer outcomes between businesses. Businesses with non-tax year basis periods currently experience double taxation in the early years of trading, with relief generally given on cessation. Using the tax year basis will remove this complexity and lead to a clearer and more transparent relationship between the profits arising in a tax year and their tax liability.
The reforms also align trading income with other forms of income, such as interest and dividends. For businesses that do not draw up their accounts to 31 March or 5 April, introducing the tax year basis for trading income will bring the payment of tax closer to the time that profits are earned. According to HMRC, this will make it easier for businesses to save for their tax obligations, improve compliance, and reduce tax debt write-off.
With Making Tax Digital for Income Tax Self-Assessment set to be introduced from April 2026 for businesses with a turnover of £50,000 or more, and from April 2027 for those turning over at least £30,000, it's also the case that these reforms may make compliance easier by aligning basis periods with the tax year. It should also make estimated tax liability calculations more accurate.
AccountsPortal Features
Given the scope of the changes and their potential impact on cash flow, accounting software will have a key role in ensuring businesses accurately report their figures at the right time and can pay the tax due. AccountsPortal, for example, offers extensive tax and VAT management capabilities and the ability to view easy-to-understand real-time reports so users can have clarity about their financial position. Balance sheets, profit and loss statements, and ageing reports can all be quickly created, viewed, and shared so all parties know the situation. It's also easy to stay on top of cash flow with a real-time recording of the money moving in and out of business and bank feeds to sync bank statements with AccountsPortal.
Free unlimited support also means that any issues or questions arise, they will be answered quickly and accurately by a team member.
Action Steps
For those impacted by basis period reform, HMRC has a range of online tools to help businesses prepare, from in-depth information on the changes to videos and webinars. For anyone still unsure of how the reforms will impact them, speaking to an accountant or financial advisor is to be recommended.
Further Reading
A Guide to VAT on Property Transactions