The rules dictating when the trading profits of unincorporated businesses are subject to income tax are changing. This article explores how this change will interact with the averaging rules for farmers and creative artists.
The basis period changes
From April 2024, the existing basis period rules (the ‘current year basis’) will be abolished and replaced with a tax year basis of assessment. Under the tax year basis, businesses will be subject to tax on their profits arising in the tax year, regardless of their accounting period end.
Tax year 2023/24 will act as a transitional year, in which we switch over from the current year basis to the new tax year basis. In this transitional year, the basis period will be made up of two different elements:
- A 'standard part' being the normal basis period (i.e. the 12 months following the end of the basis period for 2022/23); and
- A 'transition part' running from the end of the standard part to 5 April 2024 (or 31 March 2024 if accounts are drawn up to that date).
In effect, businesses will be required to bring into account an additional amount of profits running from the end of their normal basis period to the end of the 2023/24 tax year. Two measures are allowed to reduce the impact of this:
- businesses can deduct any overlap relief they may have from the additional transition part profits; and
- any remaning transition profits can then be spread over a period of up to five years.
Interaction with the averaging rules
One area of complexity noted during the consultation on this change was how it would interact with the averaging rules for farmers and creative artists found in Chapter 16 of Part 2 of ITTOIA 2005.
The legislation introducing the new tax year basis and dealing with the transitional year can be found in Schedule 1 of Finance Act 2022. This states, at paragraph 74 that:
"No amount of the transition profits for the tax year 2023-24 treated as arising and chargeable to income tax in a tax year (see Step 5 of the calculation in paragraph 70(2) and paragraphs 72 and 73) is to be taken into account in determining “the relevant profits” for the purposes of Chapter 16 of Part 2 of ITTOIA 2005 (averaging profits of farmers and creative artists)."
HMRC's guidance on basis period reform in their Business Income Manual (see BIM81200 onwards) does not provide much more detail on this, and merely states at BIM81350 that "Transition profits should not be taken account in determining “the relevant profits” for the purposes of averaging profits of farmers and creative artists in Chapter 16 of Part 2 of ITTOIA 2005".
In order to get a better understanding of how basis period reform and the averaging rules will interact in pratice, the ATT have engaged further with HMRC. Following this engagement we have drawn up the following examples which we hope will be helpful to ATT members working in this area. For simplicity these examples only consider two-year averaging, though the same principles wll apply for the five-year rules. Similarly, although the examples relate to a farmer, they should apply equally to spreading for the creative industries.
If you have any further questions or comments on these examples, or basis period reform more widely, please contact ATT Technical Officer Emma Rawson.
Example 1 – profits in standard and transition part
Farmer Giles has a year end of 30 September, has been trading for some years and has overlap profits of £5,000. His profits are as follows:
- 30 September 2022 - £10,000
- 30 September 2023 - £20,000
- 30 September 2024 - £40,000
- 30 September 2025 - £15,000
Looking at each tax year in turn:
2022/23
In 2022/23 he will be taxed on the profits for the year ended 30 September 2022 - £10,000. For the purposes of this example we assume he does not opt to average with the previous year.
2023/24
In 2023/24, which is the transition year, he would absent basis period reform have been taxed on profits in the year ended 30 September 2023 - £20,000.
Under the new rules however, in 2023/24 he will be assessed on the profits of the standard part (defined by the current year basis) plus his transition profit (profits of the transition part after overlap relief and spreading).
Taxable profits for 2023/24 before averaging will therefore be:
Year ended 30 September 2023 20,000
Plus transition profit:
Six months* of y/e 30 September 2024 20,000
Less: Overlap relief (5,000)
15,000
Spread over maximum 5 years = (£15,000/5) = 3,000
Total taxable profits 23,000
(* Note that the legislation requires apportionment on a day basis, but we have used months for simplicity in this example.)
For the purposes of averaging, any transition profit brought into account (i.e. the £3,000 this year) is ignored. Only the standard part of £20,000 is considered.
Averaging is permitted, as £10,000 is less than 75% of £20,000
The profits for 2022/23 will be reassessed as if he had taxable profits of £15,000 (being the £10,000 for 2022/23 and the £20,000 standard part profit from 2023/24 added together and divided by two).
The assessable profits of 2023/24 will be £15,000 plus the transition profit of £3,000, making £18,000 in total.
2024/25
We are now in the new rules, so Farmer Giles’ profits are calculated by apportionment (again we are using months for simplicity, a proper calculation would use days):
Six months of the year ended 30 September 2024: 20,000
Six months of the year ended 30 September 2025: 7,500
Total 27,500
Plus spread element of transition profits 3,000
Taxable profits (pre averaging) 30,500
For the purposes of averaging, we again ignore any transition profits.
We are therefore required to compare the £27,500 above with the 23/24 figure of £15,000 (being the assessable profits after averaging with 22/23, ignoring transition profits). As £15,000 is less than 75% of £27,500, averaging is permitted.
The profits for 2023/24 will be reassessed as:
Average for 23/24 and 24/25, ignoring transition profits = (£15,000+£27,500)/2 = 21,250
Plus spread element of transition profits 3,000
Total taxable profits 24,250
The assessable profits for 2024/25 will also be £24,250 (i.e. the average of £21,250 plus the £3,000 of spread transition profits brought in).
Example 2 – profit in standard part, loss in transition part
Farmer Giles has a year end of 30 September, has been trading for some years and has overlap profits of £5,000. His profits and losses are as follows:
- 30 September 2022 - £21,000
- 30 September 2023 - £20,000
- 30 September 2024 – (£12,000) loss
- 30 September 2025 - £15,000
Looking at each tax year in turn.
2022/23
In 2022/23 he will be taxed on the profits for the year ended 30 September 2022 - £21,000. For the purposes of this example we assume he does not opt to average with the previous year.
2023/24
In 2023/24, which is the transition year, he would absent basis period reform have been taxed on profits in the year ended 30 September 2023 - £20,000.
Under the new rules however, in 2023/24 he will be assessed on the profits of the standard part (defined by the current year basis) plus his transition profit (profits of the transition part after overlap relief and spreading)
Taxable profits for 2023/24 before averaging will therefore be:
Year ended 30 September 2023 20,000
Plus transition profit / (loss):
Six months of y/e 30 September 2024* = (6,000)
Plus: Overlap relief (5,000)
(11,000)
Total taxable profits 9,000
(* Note that the legislation requires apportionment on a day basis, but we have used months for simplicity in this example.)
Spreading is not available as there is a loss in the transition part. The taxable profits for the period before averaging are therefore the net £9,000 shown above.
As only transition profits (and not losses) are ignored for the purposes of averaging, we need to compare this £9,000 with the £21,000 in the prior year. Averaging is permitted, as £9,000 is less than 75% of £21,000
The profits for 2022/23 will be reassessed as if he had taxable profits of £15,000 (being the £9,000 for 2023/24 plus the £21,000 for 2022/23, divided by two) and the assessable profits of 2023/24 will also be £15,000.
2024/25
We are now in the new rules, so Farmer Giles’ profits are calculated by apportionment (again we are using months for simplicity, a proper calculation would use days):
Six months of the year ended 30 September 2024 (6,000)
Six months of the year ended 30 September 2025 7,500
Taxable profits (pre averaging) 1,500
As £1,500 is less than 75% of £15,000, averaging is permitted.
The profits for 2023/24 will be reassessed as £8,250 (being £15,000 plus £1,500, divided by 2) and the profits for 2024/25 will also be £8,250.