Basis period reform – what do I need to know?

In broad terms, HMRC has sought to simplify the current rules of allocating profits to tax years using basis periods. Instead, it will tax the profits arising within the tax year. The intention is that moving to a tax year basis and aligning the way self-employed profits are taxed with other forms of income, such as property and investment income, before the implementation of Making Tax Digital for Income Tax will enable a smoother transition.

Law firms drawing their accounts to 31 March will not be impacted by these rules, as partners are already taxed on profits arising within the tax year. However, many UK headquartered firms have historically chosen to adopt a 30 April year-end due to cash flow benefits. Having a 30 April year-end results in a 21-month gap between the end of the accounting year in which the profits are earned and the tax becoming payable.

While the removal of basis periods will provide simplification for some business, including smaller partnerships, for larger professional service firms it raises two key challenges:

For many firms, the acceleration of the partners’ tax paid on their profit share will be the key challenge, in spite of an automatic spread of the additional charge. Law firms typically use partners’ tax reserves as a form of working capital and therefore the earlier payment of tax may require the firm to obtain an additional source of financing.

Financial institutions have historically provided funding to law firms in the form of partner loans for capital contributions and working capital, even where facilities remain undrawn. However, current geopolitical events and inflationary pressures may make additional financing more difficult to obtain and more expensive to service.

For other firms, the administrative implications of basis period reform may outweigh any potential funding requirements. The move to a tax-year basis may mean that firms have to prepare two sets of tax computations based on two sets of accounts to apportion the tax-adjusted profit to 31 March / 5 April. We understand that not all law firms will be able to manage this by the current tax filing deadline. Firms may have to file their partnership tax returns on a provisional basis and make subsequent amendments.

At the time of writing, HMRC is considering whether to change the current approach to filing provisional partnership tax returns; potentially by altering the filing deadline, providing additional time to file an amended return, or introducing a true-up mechanism. Each option provides both advantages and challenges. HMRC has committed to providing an update this Autumn, to allow firms and advisors to plan for their future compliance obligations.

HMRC is also looking at easements for complex and large partnerships. One suggestion is for firm-level reporting to notify HMRC of any amendments, which could then automatically feed into the partners’ tax returns rather than making individual amendments. From a firm’s perspective, this should lessen the compliance obligations.

Pending the outcome of HMRC’s administrative easements, we expect firms of a particular profile, notably those that operate wholly or primarily in the UK, to consider changing their year-end to 31 March to mitigate some of the compliance obligations.

Partners have the option to accelerate their tax liability and bring additional amounts into charge within the five-year period. However, we expect that where firms reserve for partners’ tax, there will be a firm-level policy to ease the administrative requirements and record keeping. Such policies might provide flexibility in specific circumstances, for instance on partner retirement or in the case of falling profits.

While there are nuances within the legislation, particularly where the firm operates internationally, as a first step we recommend modelling the cash-flow impact of the potential acceleration of partners’ tax payments to determine whether additional funds are required. Once more details are known regarding the compliance process, firms should then consider the practical implications, including whether or not it would be beneficial to align the year-end with the tax year.