In the current environment, where cash is king, being able to plan tax cashflows is vital. Even better, if firms can take action that may actually help to mitigate tax cashflows or bring forward relief to assist, while the worst of the economic impact takes effect.
The taxation of partnerships and LLPs has always been more complex than that of companies. I have on many occasions seen new partners struggle to get to grips with the opening year rules, overlap relief and payment on account regime when they are faced with their first year as a partner. However, the complexity of the rules can have its advantages. Typically, partnerships with an accounting year end other than 31 March will have benefited from a cashflow advantage when paying the tax on profits. This is generally advantageous when profits are rising.
In the current climate, where law firms may have seen a dip in their profits, whether temporary during lock-down or over the longer term, considering changing the firm’s year-end may help ease cashflow.
Example 1
Consider Amos, a self-employed lawyer, with an annual taxable profit of £125,000. However, due to the COVID-19 pandemic, for the 6 months to September 2020 he makes a loss of £50,000. He considers extending his year-end from 31 March 2020, creating an 18-month period ending on 30 September 2020, with a taxable profit of £75,000.
On a change of accounting date, Section 214 Income Tax (Trading and Other Income) Act 2005 (ITTOIA) determines that the change occurs:
(1)(a) in the first tax year in which the accounts are drawn up to the new accounting date; or
(1)(b) if earlier, in the first tax year in which accounts are not drawn up to the old accounting date.
In this case section 214 (1)(b) applies and the change occurs in the 2019/20 tax year. The effect of this is to tax profits for 2019/20 based on a 12-month period corresponding to the new accounting date, i.e. the 12 months to 30 September 2019. Therefore, going back to our example:
| Do nothing | Change accounting date | ||
| £ | £ | ||
| 2019/20 | year to 30 March 2020 | 125,000 | |
| year to 30 September 2019 | |||
| 6/12 x £125,000 + 6/18 x £75,000 |
87,500 |
The above example shows that there is an immediate reduction in taxable profits for 2019/20 of £37,500, which assuming the individual has no other income and is subject to class IV national insurance reduces the liability for the year by £20,750. Payments on account for 2020/21 will also be reduced.
Assuming profits return to the normal level of £125,000 per annum for the second half of the year, we can see the impact of the change of accounting date on the 2020/21 tax year:
| Do nothing | Change accounting date | ||
| £ | £ | ||
| 2020/21 | year to 31 March 2021 | 12,500 | |
| year to 30 September 2020 | |||
| 12/18 x 75,000 | 50,000 |
Whilst the taxable profit for 2020/21 is higher with the change of accounting date to 30 September, looking at the taxable profits spread over the two years, the profits have been evened out. Amos, therefore, uses his personal allowance in 2020/21, which may otherwise have been lost, and he can utilise his basic rate band in each tax year. Spreading the profit more evenly over the two years will enable at least some tax relief to be available for pension contributions and gift aid payments without the need for a tax claw back. Due to this, Amos has not only improved cashflow but achieved a real tax saving by lowering his tax liability spread over the two years.
Furthermore, the tax liability has been spread and part of it pushed to a later date - in this example to 31 January 2022 - giving Amos time to trade through the worst of the position, reconfigure his business if necessary and consider expanding his practice into more profitable areas. The tax saved has been valuable working capital to enable him to do this and keep the business afloat.
If our lawyer was a member of a Limited Liability Partnership (LLP) with the same profitability profile, there will be a tax saving for every member of that LLP. The tax benefits will vary from individual to individual. However, if there are 30 members, extrapolating these figures gives a cash saving in January 2021 of over £622,500.
A change of year-end away from 31 March will generally give rise to overlap profits. Whilst a detailed look at these provisions is outside the scope of this article, any profit profiling needs to consider the impact of overlap profits.
Care needs to be taken when looking at changing year-ends. Those not used to dealing with partnerships and sole traders, may assume that it makes no difference whether you extend the accounting period so that there is an 18 month period to 30 September 2020, or you simply have a short 6 month period from 1 April 2020 to 30 September 2020.
Example 2
In the example shown above, there is no accounting period ended in the 2019/20 tax year. Therefore, as we have seen the basis period corresponds with the 12 months drawn up to the new accounting, i.e. 12 months to 30 September 2019 (even though accounts are not actually made up to this date). If the period is instead shortened, so that there is a 6-month period to 30 September 2020 rather than taking place in 2019/20, the change takes place in 2020/21 with 12 months to 30 September 2020 forming the basis period. The impact of this can be seen in the example below:
| Do nothing | Change accounting date | ||
| £ | £ | ||
| 2019/20 | year to 31 March 2020 | 125,000 | 125,000 |
| 2020/21 | year to 31 March 2021 | 12,500 | |
| year to 30 September 2020 | |||
| 6/12 x £125,000 less £50,000 loss | 12,500 |
This shortened basis period does not have the desired effect of reducing the tax payment due on 31 January 2021.
A final word of caution
The rules regarding change of accounting date do not apply in the first three years of trade. Furthermore, in order to be effective in subsequent years, the change of accounting date must be a valid change as set out in section 217-218 ITTOIA 2005. To be effective for tax purposes the following conditions must be satisfied:
1. appropriate notice of the change must be given to HMRC; and
2. the first accounting period ending with the new date must not exceed 18 months; and
3. either condition A or condition B must be met:
- Condition A – there has been no change of accounting date that was effective for tax purposes in the 5 tax years immediately preceding the tax year in which the current change of accounting date occurs; or
- Condition B – the notice given to HMRC in 1 above sets out the reason for the change and HMRC are satisfied that the change is made for commercial reasons.
Every situation is different, and care should be taken to work through the figures, and the legislation to ensure that the change is effective, and the basis periods result in the assessment of profits as expected. Given the potential impact on the timing of tax liabilities, every firm should look at their results and, taking into account both commercial and tax implications, consider whether a change of year-end could offer an immediate cash flow benefit.
Karen Hine is a tax partner at RSM who specialises in advising professional service firms and their partners. If you would like to discuss any of the issues raised in this article, please contact her.