Basis period reform and Making Tax Digital: What businesses need to know

Basis period reform and Making Tax Digital: What businesses need to know

Getting your taxes right as a sole trader is always a challenge.

But some changes are coming that could have a big impact on certain individuals.

These changes are connected to the introduction to Making Tax Digital (MTD) for Income Tax, but also independent of it. They are likely to affect sole traders and others who are outside the scope of MTD for Income Tax.

The changes aim to simplify things and make life easier, and as such may prove revolutionary for those who hate doing their taxes.

They relate to basis periods, which is to say, the periods for which businesses must calculate taxes.

The new rules affect businesses that have accounting dates and periods that don’t match the tax year (e.g. accounting periods that aren’t 6 April to 5 April).

In this article, we explain the details, plus what you need to know and start doing right now.

Here’s what we cover:

When you start up in business, you have to set up your accounting.

A key part of this is choosing an accounting date. This is the point every year when you draw up your books, and do tasks such as working out your taxes.

All businesses need an accounting date, including sole traders or other unincorporated businesses.

But if you’re established as a sole trader then you may be scratching your head.

You might not recall deliberately choosing an accounting date.

This is because the majority of us default to the tax year to decide our accounting date—5 April. Your accounting period is therefore 6 April to 5 April the following year.

This is sensible because it simplifies working out taxes.

If you started a business in February, for example, then you work out income and expenditure due up to 5 April.

This will only be a few months for the first time you have to calculate your taxes, but following this, you’ll account for 12 month accounting periods from 6 April to 5 April the next year.

This period which is used to determine the taxable profits is known as the basis period. 

For those using the tax year as their accounting period, the basis period and the accounting period match.

But this isn’t always the case.

Let’s take a look at an example to explain why.

Abi is a sole trader who runs a florist. She founded her business in February.

She decided her accounting period started on 15 February, to be precise. This is when she first opened the doors of her shop and put a bucket of red roses outside.

As such, 14 February each year is her accounting date. Her accounting period runs from 15 February each year.

Abi loves the irony of her accounting year-end falling on Valentine’s Day.

But working out Abi’s taxes is a little more complicated than if she’d just chosen the tax year for her accounting and basis period.

This is especially true for the initial period leading up to 5 April in her first few months of business.

The somewhat complicated basis period rules say this is treated as a unique and shorter-than-usual basis period. In other words, Abi must calculate and pay taxes for 15 February to 5 April.

14 February comes around in the following year. Abi pops open the champagne to celebrate her first full year of trading. Well done, Abi!

But when it comes to working out her taxes, she’s left scratching her head when she looks at the basis period requirements.

Her full 12-month trading period is again treated as a complete basis period—from 15 February to 14 February. This is even though it includes the period up until 5 April for which she’s already paid taxes!

In other words, Abi ends up paying tax twice for that initial period of 15 February to 5 April.

You might think that HMRC simply gives Abi the money back as soon as it can. But, no. Sorry, Abi.

The profits of that initial short period are referred to as overlap profits. Abi will indeed get to offset it against her tax bill. But only the final one when she’s ceased trading. 

That could be decades down the line when she retires.

Yes, people do often completely forget about their overlap profits. It’s certainly easy to lose the paperwork.

The basis period rules are complicated. Many people believe they’re unfair.

The great news is that they’re being changed as of the 2024/25 tax year as part of basis period reforms.

As of 6 April 2024, all unincorporated businesses must use 6 April to 5 April as their basis period. It doesn’t matter what their accounting period is.

This causes problems for people like Abi. She can carry on using 15 Feb to 14 Feb as her accounting period.

But, crucially, Abi must now use 6 April to 5 April as the period for which she works out what taxes are due based on her profit and loss.

This will be a legal requirement.

As part of the basis period reforms, 2023/24 year is considered transitional. This one-off basis period will be longer than 12 months for those businesses that don’t have accounting periods that match the tax year.

Abi will have to calculate taxes for a basis period of 15 February 2023 to 5 April 2024—a period of 14.5 months.

The good news is that she will finally get back her overlap profits at this point (assuming she or HMRC can find the documentation detailing it).

The bad news is that Abi will be landed with a larger than average tax bill for that 14.5month basis period. 

This could seriously impact her cash flow.

To make life easier, people like Abi will be allowed to deduct the overlap profits from her extra-large tax bill, and then pay part of this tax bill (known as the transitional profits) over the following 5 years, interest-free. This will mitigate the effect on her cashflow.

At the moment, we assume any business making the switch will declare the transitional profits as part of either itsSelf Assessment tax return each year, or its Making Tax Digital for Income Tax final declaration. However, the government may introduce further steps to this process which will be revealed before MTD for Self Assessment arrives in April 2026.

Some people have good reasons to use unusual accounting dates. For example, those involved in seasonal businesses, such as tourism or farming, don’t earn profits consistently across the whole 12 months of a year.

Non-tax-year basis periods often work in their favour, as it can with some businesses that work with non-UK businesses that observe different tax and accounting dates.

For businesses such as these, switching to the accounting period to match the basis period is complicated and will require expert input. However, after the new rules, these businesses must also comply with them to adjust their basis period to match the tax year—there are no exemptions. 

As this is a complex situation for a minority of businesses, further guidance will be published by the government before the 2026 MTD launch. 

The introduction of Making Tax Digital for Income Tax influenced the basis period reforms.

Seen in this light, the basis period reforms are an attempt to simplify the reporting requirements for MTD for Income Tax.

Somebody like Abi might own 3 businesses.

Let’s say she also had a mail order flower business. This had an accounting date of 1 June. She also receives rental income from the flat above her shop.

Making Tax Digital requires periodic reports at least every quarter.

Because of their differing basis periods, Abi could seemingly have found herself having to produce 12 such reports at various times of the year for her 3 businesses.

And that’s not to mention the requirement for an end of period statement for all three businesses, and a single final declaration bringing together all Abi’s income tax data.

The basis period reforms don’t change the requirements to produce these reports, statements and the declaration.

But it will mean that the deadlines for doing so with Abi’s three businesses are the same, so she can take care of them all at the same time.

It’s worth noting that using accounting software will also make Abi’s life easier. Creating periodic reports will be largely automated, for example.

If you use the tax year as your basis period then you’ve nothing to worry about. No changes will be required.

If you have an accounting period that doesn’t match 6 April to 5 April—there are 4 potential issues: 

  1. For the tax year 2024/25 and later, you’ll have to calculate the taxes you owe based on the tax year, rather than based on your accounting period.
  2. Your basis period for the year 2023/24 will be extended to 5 April 2024, which could lead to a higher tax bill. Additionally, if you have any overlap profits from when you first started in your business, you’ll need to find the documentation so this can be claimed back. You may also need to use provisional figures, which the government will allow for during this transition, as long as you provide an update with accurate figures.
  3. You may wish to adjust your accounting date to match the tax year to simplify your accounting. However, this isn’t mandatory and the decision can be a complicated one for certain kinds of businesses.
  4. You can spread your 2023/24 transitional profit over 5 years if you wish, without any special permissions. But this will require forward planning to ensure your cash flow isn’t affected.

If you’re affected by the basis period reforms, the single best piece of advice is to immediately seek advice from an accountant or other tax professional.

A lot of preparation work will be involved ahead of time, along with an increased need to forecast your cash flow to ensure your meet the tax obligations for the transitional year, which started in April 2023.

If you decide to adjust your accounting period to match the tax year then this will require further preparation.

If you decide to go it alone, without expert help, you’ll need to understand the existing basis period rules.

HMRC guidance such as the Business Income Manual can help. Then you should read up on details about the  itself. 

From 29 August 2023, HMRC will make a new online form available that will allow people to request the overlap profit information it holds, prior to this a phone call or a paper form was needed to request this data.  

For those affected, basis period reform is a classic example of how a little work now could pay dividends in simplified tax calculations and submissions further down the line.

Remember that while basis period reform was influenced by the move to Making Tax Digital, it affects all unincorporated businesses regardless of whether they’re affected by either Making Tax Digital for VAT, or Making Tax Digital for Income Tax.

Making a start as soon as possible and seeking expert advice is vital if you are affected.

Editor’s note: This article was first published in January 2022 and has been updated for relevance.

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