Basis period reform – where are we now?

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.

Our research suggests there are still some gaps in law firms’ preparation for the change. In 2023, 43% of respondents said that their firm had modelled the tax impact and had no need for funding to settle tax liabilities, but 16% of respondents said that their firm had not considered any next steps. While this was a decrease from the 28% of respondents reported in 2022, this represents a meaningful number of law firms that remain unprepared.

For many firms, the acceleration of the partners’ tax paid on their profit share will be the key challenge, despite 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. The first accelerated tax charge will impact many firms in January 2025.

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.

In the year since our last law firm survey, we have seen firms increasingly speak with their banking partners regarding the potential need to obtain additional financing. The banks themselves are also increasingly familiar with basis period reform and the implications for their professional services client base.

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 must prepare two sets of tax computations based on two sets of accounts to apportion the tax-adjusted profit to 31 March / 5 April.

For firms with a 30 April year end, this will only allow for 9 months between the end of the financial year and the 31 January tax filing deadline, and during that period an audit may need to be undertaken and trading profits must be allocated between the partners. We understand that not all law firms will be able to manage this by the current tax filing deadline and therefore may have to file their partnership tax returns on a provisional basis and make subsequent amendments.

To date, provisional tax figures must be updated ’without delay’ once final figures become available. It has now been confirmed that this requirement will be relaxed, and taxpayers will instead be able to amend their return to finalise the provisional figures in line with normal amendment time limits. This will generally be by 31 January following the filing deadline.

In order to manage the level of compliance required, firms have been considering whether to move to a 31 March year-end. At the time of writing, several firms have, or are, in the process of changing their year-end, with some others looking to move within a relatively short period. Other firms, notably US law firms and UK firms with a broad international footprint, currently prefer the option of retaining their current accounting date.

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, in the case of falling profits or because of changes in tax rates.

The technical nuances of the rules are now, for the most part, well understood.

Now is the time for action, and we consider these the three key steps that all impacted firms should take:

1. Model the cash-flow impact of the partners’ tax payments.
2. Determine how any accelerated tax will be funded and/or how the firm’s cash position could be improved.
3. Review the compliance process and decide whether to change to a 31 March year end.