Income Tax on Trading Profits – Are HMRC’s Simplification Proposals Increasing Complexity?

The countdown to Making Tax Digital (“MTD”) for Income Tax has begun with HMRC proposing that those with annual trading profits and/or property profits in excess of £10,000 will be required to keep digital records and submit updates to HMRC on a quarterly basis from April 2023. This will be followed by a ‘Final Declaration’, which replaces the Self-Assessment Tax Return, to report other sources of income and calculate total tax liabilities, which are due for payment by 31 January as is the case now.   

Currently, the self-employed (including those operating in a partnership) report their share of profits according to the accounting year end which falls in the tax year. For example, if accounts are drawn up to 31 October each year, then an individual’s tax return for the 21/22 tax year will report the profits earned in the year to 31 October 2021.   

However, HMRC want to ‘simplify’ this system such that what is reported is based on profits earned in the tax year, rather than the accounting year. Again, using the example of a 31 October year end, this means that the 21/22 tax year would include 7/12ths of the profit to 31 October 2021 and 5/12ths of the profit to 31 October 2022. The proposal is to implement this change in the 23/24 tax year at the same time as the introduction of MTD so that taxpayers can more readily understand what they need to report to HMRC on a quarterly basis.   

Alternatives options being set out by HMRC is to mandate a 31 March year end for all business or to move to a Corporation Tax type system where tax payment dates depend on the date of the accounting year end.   

It is true that the current system of aligning accounting profits to tax years can be complicated, particularly in the first three years of trading and on cessation. Taxpayers find it difficult to calculate and understand ‘overlap relief’ where they have an accounting year end that isn’t 31 March or 5 April and the current system isn’t always to the taxpayer’s benefit, particularly where they are movements in tax rates between when overlap profits are accrued and relieved.   

HMRC propose there will be a transition year in 22/23 whereby taxpayers will align their profits with the tax year end and relieve any overlap profits. Overlap profits cannot be carried forward beyond that date. Continuing with the same example, this means that in 22/23 the taxpayer will be taxed on the profits to 31 October 2022 plus the 5 months to 31 March 2023 less any overlap profits accrued when the business began. For some, this will create ‘excess profits’, pushing taxpayers into higher rates of tax, reducing entitlement to personal allowances and further restricting the ability to contribute to pension or claim child benefit. HMRC have said there will be an option to spread these excess profits over five years to ease the tax and cashflow pressures of the change. 

The other issue is the timing of accounts preparation. In the above example, the accounts to 31 October 2022 would need to be finalised by 31 January 2023 in order to accurately report profits for the 22/23 tax year. HMRC are suggesting that where accounts are not finalised, there will be an option to submit estimates than can later be amended either by updating the return or by adjusting the position in the following tax year. 

At present, the above proposals are at consultation stage, which closes at the end of August. A number of professional bodies have already called for a delay in implementing such significant change when the move to MTD will be challenge enough for many taxpayers. It is also difficult to understand how these proposals fit with the recent review by the OTS on changing the tax year end completely.

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