A new tax system starting in 2023 will simplify tax administration for small businesses and the self-employed, but it could be a significant change.
Currently, tax returns are based on a set of accounts that end in the tax year on 5 April. This becomes more complex for newly registered businesses who draw a set of accounts based on dates which do not correspond to the tax year (April to April). In these circumstances, tax is paid initially in the first tax year until the end of that tax period and then again, based on the entire accounting year. Profits are effectively taxed twice before being reduced to take into account double taxation.
The complexity of these rules lead to huge numbers of mistakes and errors every tax year, with many businesses being unaware they can claim overlap tax relief and therefore end up paying tax twice.
Under the new system:
- Businesses will be taxed on profits the year they are earned – not on profits of accounts that end in the tax year.
- This removes the need for ‘overlap relief’ because businesses will no longer be taxed twice.
- The new system is intended to be easier to understand and will reduce the time spent filling out tax returns.
In addition, there will be a short transition period from April 2022-2023 to prepare for full implementation from April 2023 onwards.
We spoke to accountants and tax experts to find out what they’re doing to support their clients in preparing for these new tax reforms if they go ahead.
Reforms could cause significant challenges, so clients need to update antiquated systems
Max Porter, Private Client Director, ATC Tax
These tax reforms have the potential to simplify the process for smaller businesses paying income tax, especially as it should remove overlap issues that exist in the current system for those whose accounting year is not aligned with the tax year. At the moment, such businesses can be charged twice on the ‘overlapping’ basis period and there can be complex or limited opportunities for claiming relief on these unnecessary costs.
But in the short term, the journey to that point could cause significant challenges for businesses that do not currently prepare accounts by 31 March or 5 April. For these businesses, the changes could mean added administrative burden, or worse, cashflow issues.
Next steps: Businesses have a relatively limited timeframe to prepare under the current proposals. It’s vital they seek professional guidance as early as possible. Advice professionals have the key responsibility of highlighting which of their clients will potentially be affected by the reform and they should also anticipate any issues that might arise as a result.
We are advising businesses to:
- Invest in modern accounting software and systems for those still using antiquated systems.
- Don’t rush into making drastic changes – the legislation is still being drafted.
- Remain informed about the plans and follow proceedings with a keen eye.
Verdict: The reforms can cause significant challenges for businesses so businesses should consider updating antiquated systems while keeping up to date with latest developments.
This is driven by MTD, so we’re advising clients to invest in bookkeeping software and digital processes
Harriet Wignall-Parry MAAT ACCA, Accounts Manager, The Accountancy Partnership
Although taxation changes may seem daunting to SME owners, the proposals tie in with the introduction of Making Tax Digital (MTD) for income tax, so there are already big reforms on the horizon.
As well as easier processes, the simplified tax reforms will bring an easing of cashflow issues. Businesses can sometimes be taxed twice in their first year, and although HMRC keeps the extra tax to offset against the next return, start-ups could do with keeping that cash in their own bank.
Next steps: We have always tried to keep clients in line with the tax year to avoid overlaps of profit and we advise new clients to have their first year as a short period to meet the end of the tax year. For any businesses currently straddling two tax years, it is worth beginning to consider moving the year-end in preparation for the reforms.
As the basis period reform is part of the Making Tax Digital plan, we are also trying to get all clients onto bookkeeping software. Our research has revealed that 37% of SME owners are currently using outdated, non-digital procedures, so getting up to speed before MTD comes into force is advisable.
Verdict: The reform is part of HMRC’s MTD plan, so we’re advising clients to use bookkeeping software to get up to speed with digital processes.
The new system removes the ability to plan, so clients must monitor the accounts and cash flow situation
Tim Walford-Fitzgerald, Private Client Partner, HW Fisher
For the last 25 years, sole traders and partnerships have had a well-understood arrangement: taxable profits are based on the accounts that finish in that tax year. For anyone preparing accounts to 31 March or 5 April, to coincide with the tax year-end, this is very straightforward. For anyone choosing a different year-end, for example, to match more closely with a seasonable business, it has been more complex. A trade-off applies since the accounts would miss out some of the later months in the tax year. The businesses pay tax on the profits later, but they are taxed twice on the same profits in the opening years when profits are normally lower.
This double taxation remains in place until the taxpayer retires when it is reversed but with no further relief for the years that pass in between.
HMRC are now proposing to end this by taxing all businesses on the profits made in the tax year and all existing businesses will be forced to add the later months to next year’s profits.
For some businesses, this will be an additional 11 months of profit being added in, resulting in 23 months of profit being taxed in one year.
While HMRC is allowing the double-taxed profits to be reversed early and for the extra profits to be spread, the impact of this on business cash flow may still be dramatic. This proposal removes choice and the ability to plan properly for a significant number of businesses. Few sole traders and partners are able to withdraw all the profits they earn, as cash is always needed to fund the working capital that keeps the business afloat.
Next steps: Small businesses should ensure they continue to keep on top of their accounts as the impact on cash flow under the new system is likely to be significant.
Verdict: The new system removes choice and ability to plan, so it’s more important than ever to keep up to date with accounts and on top of cash flow.
David Nunn is Content Manager at AAT.