Specialist legal accountants, Armstrong Watson, have warned law firms could see significant changes to the way they are taxed, which may lead to higher tax bills, following the launch of a government consultation on basis period reform.

The consultation seeks views on how to implement a proposal to simplify the rules under which profits of an unincorporated trading business are allocated to tax years using basis periods.

The proposed changes would affect the self-employed (sole traders), partnerships, LLPs, trusts, and estates with trading income. Unincorporated businesses that do not draw up annual accounts to 31 March or 5 April, and those in the early years of trade, will be the most affected. Companies, except for some non-resident companies, will not be impacted. 

Sole traders, partnerships and LLPs are currently taxed on their accounts ending in the tax year, and a business can choose any date to prepare accounts to. 

Some businesses have kept the same accounting date for many years, while others have an accounting date that ties in with busier or quieter periods, either to maximise annual results or make year-end procedures easier. 

HMRC’s preference is for everybody to prepare accounts to 31 March each year to tie into the tax years that end on 5 April.

Armstrong Watson legal sector partner, Andy Poole, explained: “The reform would mean law firms would be taxed on profits arising in a tax year and is intended to align the way self-employed profits are taxed with other forms of income, such as rents received or investment income. 

“For example, under the current rules, a law firm with a year end of 30 June 2021 would be taxed on these profits in the tax year to 5 April 2022, but under the proposed changes, 9/12ths of the profits would be taxed in the previous tax year to 5 April 2021. 

“For a firm that retains its traditional accounting date, the taxable profit to enter on the tax return will be made up of apportionments from two sets of accounts, making it difficult to see how this can be described as a simplification!”

If implemented, the tax year starting 6 April 2022 will be a “transitional” year, with the new rules fully introduced from April 2023. Accountancy professionals have already started to lobby the government to extend the timescale to allow businesses and accountants the opportunity to understand and implement the changes. 

If a firm decided to move its accounting date to 31 March, there is a transitional adjustment in the tax year ending 5 April 2023. Armstrong Watson have warned that firms that have had their current accounting date for a long time, or who have significantly increased their profits since commencement, could face an unexpected increased tax bill. However, Armstrong Watson understand there is likely to be the facility to spread the additional tax charge over five years.

While HMRC said the new system aims to reduce the time spent by small businesses filing tax returns, and to make rules fairer, more logical and easier to understand, Armstrong Watson believe the driving force behind the proposals is to assist with the introduction of Making Tax Digital (MTD) for non-company businesses from April 2023. This will involve the completion of a quarterly submission of data to HMRC. 

Poole commented: “Whilst these changes may simplify matters for small businesses not using an accountant, they are likely to increase complexity and accelerate tax bills for many law firms, not least when there are changes of partners on an accounting year end date that does not tie into the end of a tax year.

The consultation period is short and the proposed start date for transition in April 2022 suggests that HMRC will be pushing ahead with this in order to ensure that quarterly reporting under MTD in April 2023 can be introduced on time as planned.”

The consultation closes on 31 August 2021.


 

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