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Let's get technical: basis periods
Nick Craggs explains all about basis periods – your gooner love his analysis (sorry!)
I usually like to begin these articles with a witty, related anecdote. But there is nothing funny about basis periods; students find them difficult, do not like them and they frequently trip AAT business tax students up.
However, there is no reason why students should find them difficult. If they understand the rules then they cannot get them wrong.
Basis periods are a way of calculating how much profit should be taxed when someone sets up as self-employed (or joins a partnership).
So what are the rules?
In the first year, profits from the commencement of trade until the following 5 April are taxed. So, for example, Tony Adams prepared his first year’s accounts up to the year ended
31 December 2016, where he made a profit of £120,000. As this is a 12-month period he must have commenced trade on 1 January 2016. In the first tax year, we tax from the commencement of trade to the following 5 April, which will be
5 April 2016. We will therefore tax three months (we ignore the five days in April) of the 12 months’ accounting period, resulting in the amount of profits which will be taxable being
3/12 x £120,000 = £30,000.
So that’s year one. In year two, the rule is that we tax 12 months of profits, no matter what.
In year two, we ask ourselves: do we have a 12-month period ending in the second tax year, which is 6 April to the following 5 April? In Tony’s case, the second tax year is 6 April 2016 until
5 April 2017, and his 12-month period ended 31 December 2016 does fall into this period. Therefore, in the second year, the profits which will be taxed will be the full £120,000.
The sharp ones among you will note that Tony has made profits of £120,000 but has paid tax on profits of £150,000. The £30,000 of profits which have been taxed twice are known as ‘overlap profits’. These will be deducted from his profits when he ceases trading. At the end of his working life, his profits will have only been taxed once, but this might not be for a number of years. This highlights the fact that a bit of planning always helps when choosing your year end.
However, we will not always have a 12-month period ending in the second year; but we do have to tax a 12-month period in the second year. So what do we do? Well, we make one!
If we have a six-month period ending 30 June 2016, where the profits were £60,000, we need to ‘borrow’ six months of profit from the following period. For example, if the following period was the year ended 30 June 2017, where taxable profits were £180,000, we will take 6/12th of the profit of £180,000 and add this to the £60,000, to equate to taxable profits for the tax year of 16/17 of £150,000. This consists of £60,000 from the period ended 30 June 16, and £90,000 from six months that we have borrowed from the year ended June 2017.
You may be faced with a long accounting period in the second year. We still need to tax a 12-month period in the second year, so we just take the last
12 months of the long accounting period. For example, Steve Bould had a 15-month accounting period ending
31 December 2016 where his taxable profits were £300,000. He would only be taxed on the past 12 months, so his taxable profits would be 12/15 x £300,000 = £240,000.
If the examiner is feeling really nasty they might not give you an accounting period that ends in the second tax year; you may have an accounting period which spans the entire tax year. Either way, we will make a 12-month period as we tax from 6 April at the beginning of the tax year to the following 5 April.
For example, John Jensen has an
18-month accounting period that ends 30 June 2017. His taxable profits are £90,000. For the year 2016/17, we do not have an accounting period that ends in the tax year, so we will just take 12 months of profit, from 6 April 2016 to 5 April 2017. This will be
12/18 x £90,000 = £60,000.
So that is the second year; what happens in the third year?
In the third tax year, the odds are that you will have a 12-month period that ends in the third tax year, so you will just tax that. However, if you do not, you just follow the rules from year two.
So that’s it – learn the rules and you cannot go wrong!
Why don’t you have a go at the following scenario. You can watch me calculate the answers at http://www.first intuition.co.uk/category/aat/
Ray Parlour has the following accounting periods and profits:
• six-month period ended 30 June 2016 with profits of £30,000
• 12-month period ended 30 June 2017 with profits of £120,000
What are the taxable profits in the following tax years?
• Nick Craggs, AAT Distance Learning Manager, First Intuition
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