Kevin Read warns that the transition rules for unincorporated businesses are less generous than you might think.
I have previously discussed issues around changing the accounting date in 2023/24: the transition year to the ‘tax year’ basis of assessment for unincorporated businesses. The additional profits arising in the year (after set-off of any overlap profits brought forward) are ‘transition profits’, which are both ignored for adjusted net income purposes (so do not impact on income for personal allowance abatement or high-income child benefit charge purposes) and automatically spread over five years for income tax purposes, starting in 2023/24.
In some circumstances though, the transition profits may still be taxed at an effective rate of up to 60%.
Example: Rohit changes accounting date
Rohit is a self-employed sports journalist with a 30 April year end. His profits have accrued evenly at £8,000 per calendar month in recent years. His overlap profits brought forward are £16,000 and he has negligible other income.
He decides to change his accounting date to 31 March 2024 (which can be treated as a 5 April year end under the new rules).
For 2023/24, he will have:
-
Standard basis period profits (y/e 30 April 2023) £96,000
-
Transition basis period (11 months to 31 March 2024) £88,000
Less: overlap profits b/fwd £(16,000)
Transition profits £72,000
The transition profits will be spread over five years, so the total taxable profits in 2023/24 will be:
£96,000 plus £14,400 [1/5 (£72,000)] = £110,400.
The legislation
FA 2022 Schedule 1 para 75 sets out the rules that must be applied when calculating the tax liability on the transition profits. The usual income tax calculation in ITA 2007 s 23 is amended to treat the transition profits as a separate component of total income (the transition component). This transition component is relieved in accordance with step 2 (so, for example, personal allowance and trading losses can be set against it) but is then taken out of the initial calculation of ‘net income’ and any following steps.
The tax arising on the transition component is then brought back in as a separate amount of tax at step 4 of the calculation, being the difference between:
- the tax payable if the transition component were included in net income after step 2 in ITA 2007, s 23; and
-
the tax payable if the transition component were omitted from net income.
This methodology means that someone like Rohit, who normally does not pay income tax at more than 40%, will have a higher tax rate applied to their transition profits.
Rohit’s income tax liability for 2023/24
-
Tax liability ignoring transition profits £
Income 96,000
PA (12,570)
Taxable income 83,430
Tax: 37,700 @ 20% = 7,540
45,730 @ 40% = 18,292
£25,832
-
Tax liability if transition profits are included as part of net income
Net income (96,000 + 14,400) 110,400
Abated PA (12,570 – ½ [110,400 – 100,000] (7,370)
Taxable income 103,030
Tax: 37,700 @ 20% = 7,540
65,330 @ 40% = 26,132
£33,672
The difference in these figures is £33,672 – £25,832 = £7,840. This is the tax liability on the transition profits in 2023/24. This gives a marginal rate of tax on these profits of 7,840/14,400 = 54.44%!
His total income tax liability for 2023/24 is therefore £25,832 plus £7,840 = £33,672.
Practical tip
Traders with annual profits a little below £100,000 may end up with significant tax charges on transition profits over a five-year period. Those seeking to cease trading during the spreading period, which would cause all remaining transition profits to come into charge in one year, may instead wish to wind down their business more slowly, reducing their normal profits each year to well below £100,000.
