Income tax: Making Tax Digital proposed changes

You may be aware that HMRC have proposed to change the way in which partnerships and self-employed individuals are taxed under self-assessment. It will affect those who currently have an accounting year-end that doesn’t align with the tax year-end of 5 April/31March.

The proposal is part of the transition towards Making Tax Digital (MTD), which is due to take effect from April 2023.

What are the current rules?

Under the current rules, an unincorporated business (partnership or sole trader) can choose whatever date they wish to draw up their annual accounts. That accounting year-end date determines in which tax year those profits are assessed for tax. For example, an accounting year ended 30 April 2021 will be taxed in the tax year ended 5 April 2022, since the 30 April 2021 falls within that tax year. An accounting year ended 31 March 2022 is aligned with the tax year-end, and so is also taxed in the tax year ended 5 April 2022.

Therefore, you can see that a business with an accounting year-end date further away from the tax year-end will be paying more of their tax in arrears. This can be a cashflow advantage when profits are rising.

When you’re in partnership, all partners will have the same accounting year-end date, determined by the year-end date of the practice accounts. Partners can’t choose a different accounting year-end date from one another.

Under the current rules, when a partner joins a partnership, they are brought into the current tax system under the opening-year rules. During these early years the partner will be taxed on profits twice. For example, if a practice has a 30 April accounting year-end, this is eleven months behind the tax year-end. Accordingly, under the opening year rules, the incoming partner will be taxed on eleven months of profits twice. These double taxed profits are known as overlap profits.

An individual will only ever pay tax on profits once, over their life in the practice, since those overlap profits are relieved (deducted from profits) when the accounting year-end is moved closer to the tax year-end or they retire from the business.

Partners will all have different overlap profits, as they’re determined based on their profit share in their opening years, or with the introduction of self-assessment.

What is the proposed change?

HMRC’s proposal is that everyone will pay tax on 12 months of profits to the end of the tax year, i.e. to the 31 March/5 April, from 2023.

This means that all those with non 31 March/5 April year-end dates currently will relieve their overlap profits, and the proposal is that this will happen in the transitional year, 2022/23.

It doesn’t mean businesses have to change their accounting year-end date. If they continue to keep a 30 September accounting year-end, then for their tax return they will take six months of profit from one set of accounts and six months from the next set of accounts, and add those together in order to be assessed on 12 months, on a tax-year basis.

We expect though, that several of our medical practices would consider moving their accounts year-end to a tax-year basis since it aligns with the NHS financial year-end and may be easier to manage.

What are the consequences of this change to my tax bill?

Overlap profits were created when an individual joined the practice or (if earlier) when self-assessment was introduced in 1995/96. Overlap profits are not indexed, and therefore, they are unlikely to represent current profits, i.e. if you have overlap profits representing six months of profits when you joined the business, they may be less than your current six months of earnings. This is especially true if you have been at your practice for some time, practice profits have increased, initially you joined on a reduced parity share or on fewer sessions than you currently work.

Accordingly, when you move to this new tax basis, you will have an advancement of tax that otherwise would not hit you until you retire.

HMRC do recognise that, when these new rules are implemented, you could pay significantly more tax because of relieving your overlap profits.

If that increase exceeds the current-year profits, then the proposal is to allow you to spread the excess profits over, up to five years to help cashflow. However, there will certainly be some other problem areas to consider.

1. The five-year spreading will be a complicated calculation and may affect your tax rate bands for the following five years, i.e. loss of personal allowance, putting you into a higher tax band or losing some entitlement to, say, child benefit.
2. The annual allowance pension tax charge has been an issue over the last few years affecting those whose taxable income is above a certain threshold. Although that threshold has been increased, relieving overlap profits may mean an increase in taxable pay, which could give rise to a higher than otherwise, pension tax charge.
3. The calculation of pensionable pay for GP partners follows the tax treatment, i.e. if you have a non 31 March/5 April accounting year-end, then you will be paying pension contributions in arrears and have notional pensionable-pay overlap profits recorded on your pension certificate. If NHS Pensions move the calculation of your pensionable pay in line with tax legislation, then this could also give rise to additional pension contributions becoming due. We don’t know if NHS Pensions have considered their position or whether they will also allow a five-year spreading. If the pensionable pay calculation does also change, then you could have a rise in your pensionable pay for 22/23 because of relieving pension overlap. In turn, this may have the consequence of higher pension savings and so annual allowance pension tax charges.
4. There will be additional costs for practices, even if you decide to retain your current year-end, due to the complicated nature of the proposed calculations and having to take profits from two sets of figures and the spreading provisions. If practices choose to change their accounting year-end to the 31 March, there may be an extra set of accounts required to be prepared in the tax year, and over quite a short period of time. Therefore, giving rise to additional professional fees and indeed your time to collate two sets of accounts information.

Whatever the outcome of the consultation, it seems likely that this is the direction of travel for HMRC and it does fit in with their proposal for making tax digital.

Please note this is a proposal at present and not tax legislation and therefore no decision is needed. Please contact us before taking any action or for further details.  You can find contact details on the Our People section of the Larking Gowen website. Alternatively, call 0330 024 0888 or email enquiry@larking-gowen.co.uk.

Lizzy Lloyd