A significant consequence of such a commercial decision will be ‘overlap relief’.
Many businesses will be looking to re-set their trading period/year with the promise of lockdown finishing and may look to extend periods of account for this reason. There may be a number of commercial reasons around these extensions. A consequence of this commercial decision will be ‘overlap relief’.
Impact of overlap relief
Almost everyone with an accounting date other than 31 March or 5 April will have an entitlement to overlap relief and can ‘cash it in’ either on a change of accounting date or on cessation of the business.
Where a business changes its accounting date, there will generally an overall saving to be made where current profits are at a lower level than the profits arising when the ‘overlap’ first arose. So, a benefit from the commercial decision to extend is this relief could help the cash flow for the small businesses when they need it the most, as many SMEs are likely to be in a position of lower profits in the 2020 -2021 tax year.
Who can change the year end?
Where a change of accounting date takes place in year four or later years of trading, three conditions must be met for the basis period for the year of change to end with the new accounting date.The legislative provisions are found in S216-S217 ITTOIA 2005.
The three conditions are:
the first accounts to the new date must not exceed 18 months
a notice of the change of accounting date must be given:
in a self-assessment tax return for the year of change that applies to the person carrying on the trade, and
on or before the date that the return is required to be made
in cases where there has been an earlier change of accounting date (which resulted in a change of basis period) in the previous five years:
the latest change must be made for commercial reasons, and
those reasons must be set out in the SA return referred to above.
HMRC manual BIM81050 provides more guidance on commercial reasons for changing an accounting date. It is important to remember that obtaining a tax advantage is not a commercial reason (S218(6) ITTOIA 2005)
How to calculate the overlap relief
Once the client decides to change the year end, overlap relief is given as a deduction in calculating the profits of the trade for the tax year in which there is a change of accounting date, if the basis period for that tax year is longer than 12 months. HMRC guidance on basis periods is found at BIM81000 onwards.
The amount of overlap relief given for the tax year in which such a change of accounting date occurs is restricted by reference to:
the number of days in the overlap period(s) to which the overlap profits relate; and
the number of days by which the basis period for the relevant tax year (in which the change of accounting date occurs) exceeds 12 months.
Where the accounting date in the year is 31 March or 1 – 4 April inclusive, the basis period may be treated as ending on 5 April for the purpose of calculating the amount of relief.
The effect of offsetting overlap relief on a change of accounting date is to ensure that tax is paid on 12 months’ worth of profits. If, for example, the basis period is 14 months long then the overlap relief of two months will be deducted. The legislation achieves this result by listing six ‘steps’ used to calculate the deduction, as follows:
step 1: add together the overlap profit arising in all previous overlap periods
step 2: subtract from that the amount of any deduction already made under these rules; call the resulting figure ‘the remaining overlap profit’
step 3: add together the number of days in all previous overlap periods, deduct the number of days already counted per Step 5 below on any previous occasion; call the resulting balance ‘the number of days on which the remaining overlap profit arises’
step 4: calculate ‘one day’s worth of remaining overlap profit’ by dividing ‘the remaining overlap profit’ by ‘the number of days on which the remaining overlap profit arises’
step 5: calculate the number of days by which the basis period exceeds the length of the tax year (ignoring 29 February if desired) and call the balance ‘the number of days’ worth of overlap profits that may be deducted on this occasion’
step 6: multiply the results of Steps 4 and 5 to calculate the amount of the deduction to be made.
The following examples show how these above steps can be applied in practice:
The overlap profit available for relief after 2016-2017 is £54,492 over 340 days.
In 2018-2019 the accounting date is changed from 30 April 2018 to 31 October 2018. The relevant conditions for a change of accounting date are met.
The basis periods are:
12 months to 30 April 2017
18 months to 31 October 2018
12 months to 31 October 2019
The profit for the 18 months to 31 October 2018 is £120,000.
Overlap relief given for 2018-2019 is restricted (because at least 12 months’ worth of profit must be brought into the charge to tax for that year).
The basis period for 2018-2019 exceeds 12 months by 184 days (549 less 365).
Overlap relief for 2018-2019 is restricted to £54,492 x 184/340 = £29,490. Profits taxable for 2018-2019 are £120,000 less £29,490 = £90,510.
Overlap profit of £25,002 (over 156 days) remains unused. At cessation any remaining relief will be given in full.
A sole-trader business that started to trade on 1 July 2013 and made up accounts to 30 June 2014 was taxed twice on the profits for the period 1 July 2013 to 5 April 2014, a period of 279 days. The amount of profits taxed twice, representing the overlap profits, was £9,000.
In a later year, the business shows profits of £25,000 for a period of 15 months to 30 September 2019, a period of 457 days. An overlap relief deduction can be made from the 2019–20 taxable amount of £2,968 calculated as follows:
457 – 365 = 92
(92/279) × £9,000 = £2,968
On a later change of accounting date, the overlap relief available would be £6,032 (£9,000 less £2,968) and the number of days’ worth would be 187 (279 days less 92). If there were no later change of accounting date but the business ceased to trade, in the year of cessation a final deduction of £6,032 would be available from the assessment.
You can find some more related guidance on how to utilise trading losses within this article.