Nearly 300,000 sole traders face bigger tax bills than expected next year, following the government’s proposal to change the date small businesses report profits.
The move, which also affects partners in accountancy and law firms, would generate billions of pounds for the Treasury years before it would otherwise have received the money.
The changes to tax bills will also eat into the amount of working capital sole traders have for five years as they now have to pay more tax earlier.
A consultation and draft tax bills legislation published last month revealed plans to alter the 12-month period sole traders use to calculate profits, to bring everyone in line with either March 31 or the end of the tax year on April 5.
What this means is that the date sole traders have to pay their tax bills – which small businesses are currently able to defer by having a later date for their end-of-accounting year – will be brought forward.
According to the Financial Times, the measure is expected to affect 280,000 sole traders, based on tax returns for 2019/20.
Currently, businesses can choose the date to which they draw up annual accounts. The date they have to pay tax falls at the end of the tax year in which their accounting period stops.
>See also: What is the definition of a sole trader
But from 2023, the government has proposed that businesses and their partners be required to align their taxable profits with the rest of the country, even if they prepare their accounts to a different date.
There will be a transition year starting from April 2022 for businesses that do not currently use either March 31 or April 5 as a tax date. During it, affected firms will have to pay tax on more than one year’s profits — in the worst case 23 months — to be ready for the new system’s start in April 2023.
However, Joe Spencer, a partner at accountancy firm MHA Macintyre Hudson, believes the government’s proposed tax reforms to simplify reporting could help small business owners and the self-employed to access tax relief on overlapping profits far earlier than they currently can.
Spencer said: “The Treasury’s newly announced tax reforms will bring welcome simplicity to tax reporting for the self-employed and small businesses across the UK. They are an indication of HMRC’s attempt to tax profits earlier, bringing the tax point for these groups in line with those who are employed.
“The current tax system is unnecessarily complex for small businesses, particularly over the so-called ‘basis periods’, as businesses that start and draw up their accounts to a different date than the end of the tax year are often the victims of profits being taxed twice. Accessing the appropriate tax relief for this is complex and can take a long time.
“Although the full details of the reforms are yet to be revealed, if they will enable small businesses to access tax relief on overlapping profits earlier, which seems to be the government’s intent, this will be a significant win for business owners, especially for liquidity and administrative purposes.”
How the government’s proposed tax reforms could affect your small business
Joe Spencer of MHA Macintyre Hudson explains how the Treasury’s proposed tax changes for reporting profits will affect sole traders and small business owners
How will the government’s proposed changes impact small business owners?
The proposed reforms will make it easier for small business owners, the self-employed and sole traders to complete their tax returns. Under these reforms, businesses will be taxed on the profits arising in a tax year, rather than the profits of accounts ending in the tax year. Currently, businesses that start and draw up their accounts to a different date than the end of the tax year are often the victims of profits being taxed twice and relieving the double taxation can be a lengthy, complex process.
The reforms would bring forward the tax point in the year, eliminate overlap profits, and help small business owners spend less time filing their taxes. However, one potential issue could be the impact that paying tax on profits earlier than before may have on businesses’ cash flow.
What potential changes will small business owners face from an administrative perspective?
The main change for a small business owner will be the need to provide accurate and timely information to their tax adviser. This could come at an additional cost for some, however the implementation of HMRC’s Making Tax Digital (MTD) for VAT and its extension from 2023 to income tax, will likely mean that the majority of those impacted will either already be reporting regularly or were going to be required to do so from 2023 anyway, even before this announcement.
One would hope that the proposed reforms will see a simplification of this part of the tax system, which would be in line with the Office of Tax Simplification’s overall strategy.
Some businesses may need to use provisional figures when submitting their tax returns, which will be updated in the end of year return. This doubling of effort may create additional administrative duties.
How much earlier will small business owners be able to claim relief on overlapping profits?
For those businesses with accounting year ends that do not coincide with the tax year, there will be a year of transition where they will be able to access overlap relief.
Should the proposed reforms not occur, the overlap profits will continue until the business ceases (or the individual involved exits the business). Ultimately, the reforms will bring this relief point much further forward for many businesses.
The precise details of the reforms will need consideration but there may be opportunity to plan to utilise historic overlap profits and manage the profits brought into charge in the period that these new rules are applied.
However, whilst overlap relief for these profits will be available, it should be noted that their use may not compensate for the excess profits being brought into charge earlier than they would be e.g. for a 31 December year end, the subsequent January to March figures will be advanced and taxed accordingly as they fall within that tax year.
It is proposed that assessment of such excess profits could be spread over a period of up to five years. The calculation of such ‘excess profits’ and extent to which it takes account of overlap profits is therefore unknown at this stage – the overlap profits may simply cover the additional profits being taxed by the charge meaning that no real benefit will be felt for business owners from their earlier use.”
There have been concerns that some sectors would be negatively impacted from being taxed on profits earlier. How would small business owners in these sectors be potentially impacted?
Seasonal businesses, such as farming, garden centres or leisure businesses are potentially at risk of having multiple peak trade periods being assessed in the same basis period once the reforms come into force.
There will also be some impact on a practical level for those businesses that may wish to realign their accounting year end with the tax year end, in order to avoid having to use provisional figures. There is currently a consultation on the proposed reforms open until 31 August and I expect one of the outcomes to be the disruption it may cause to those affected.
Some small businesses face the risk that they will not be able to access overlap relief as this information will have been ‘lost’ when realigning their accounting year end. Overlapping profits can date back to 1996 and it’s not uncommon for businesses owners to have kept limited records of their profits dating back to this time. It has been mentioned that HMRC should look to inform each business impacted by the proposed reforms of its overlap relief so they have the full picture and can plan accordingly.
How do these reforms fit into the bigger picture of Making Tax Digital for small business owners?
The proposed changes are certainly a positive step in the direction towards MTD. The alignment of the tax year will simplify tax reporting for many. The perceived complexity of having to split a non-tax year aligned accounting year end will cause many business owners to simply switch their year-end to either 31 March or 5 April before the transitional period.
Making Tax Digital for income tax will be implemented from April 2023, and the proposed reforms will apply from 2022/23, so ahead of this next MTD stage. There is concern that the proposed reforms are being rushed through so the two systems work together, for which there will be benefits, but this doesn’t leave long for businesses to adjust to the changes.
Ultimately, the reforms will bring the tax point forward for some businesses, which is all part of the treasury’s plan to collect tax earlier on profits, and bring the self-employed in line with the employed. There is still a long way to go, but the measures presented will assist with future implementation.