HMRC has issued a consultation document setting out a proposed simplification of the income tax system in relation to basis periods for computing income tax. This would be intended to simplify compliance procedures for small unincorporated businesses; and would allow them to transition more smoothly to the requirements of Making Tax Digital, reducing mistakes and helping businesses to send in correct returns.

Proposed system

Currently tax returns filed by the self-employed, sole traders and partnerships are prepared on the basis of the accounts ending in the relevant tax year. Where the accounting year of the business does not coincide with the tax year the profits shown by accounts drawn up for a period ending within that tax year are taken as the basis for the tax charge.

Under the proposed changes businesses would be taxed on their business profits actually arising in a tax year, in line with the taxation of other types of income (e.g. property and investment income). The system would be applicable to sole traders and partnerships.

Whereas under the current rules a business making up accounts to 30 September would, for the 2023/24 tax year, base its tax computation on the profit in the accounts to 30 September 2023, under the new system it would use base its computation on half the profit for the year to 30 September 2023 and half the profit for the year to 30 September 2024.

Disadvantages of the current system

Owing to the complex rules that are applied to the years of commencement and termination of a business, new businesses are currently often taxed on the same profits twice in the opening years. As a result there are overlap profits which are carried forward and can later be applied to claim overlap relief on termination of the business. If the business does not keep records carefully, it may lose sight of the overlap relief to which it is entitled. A number of years may pass before the overlap relief is claimed and records can be lost.

HMRC notes that larger businesses do not have any problem with applying these rules and often take advantage of the current rules, which make it possible to defer the payment of income tax by choosing an accounting date early in the tax year.

Small businesses do not normally do this as they give priority to keeping their tax affairs as simple as possible. The smaller businesses are therefore more likely to choose an accounting date that is aligned with the tax year.

Advantages of new rules

If the proposed changes are enacted they would resolve the problems surrounding overlap relief as well as ending the tax deferral advantages from selecting a particular accounting date. The choice of accounting date could then be based purely on commercial considerations.

The change to using the actual profits of a year would reduce the number of times businesses with more than one source of income would be required to report their income under Making Tax Digital for Income Tax, as the income period for the various taxes would be the same.