Clause 209: Rule if there is an accounting date

855.     This is the second of the three clauses whose purpose is to simplify the normal operation of the basis period rules in particular circumstances. It deals with the case where there is an actual accounting date in the tax year.

Clause 210: Rules if there is no accounting date

856.     This is the third of the three clauses whose purpose is to simplify the normal operation of the basis period rules in particular circumstances. It deals with the more complex case where there is no accounting date in the tax year.

857.     That case is more complex because in those circumstances it is necessary:

• to bring a notional accounting date into the tax year, corresponding to the intended accounting date; and

• if the trade begins very near the end of the tax year, to charge the profits of the first tax year as part of the profits of the following tax year.

Clause 211: Treating middle date as accounting date

858.     This is the first of three clauses that, together, prevent the complex change of accounting date rules (in clauses 214 to 220) from applying in particular circumstances. They are based on the non-statutory practice described in paragraph 71175 of the Business Income Manual.

859.     Some taxpayers prefer to prepare their accounts regularly to a particular day in the tax year (for example, the last Friday in September) rather than to a particular date. The chosen day can then fall on a range of (normally) seven dates. Because the chosen day will not, from year to year, fall on the same date this would trigger the change of accounting date rules every year.

860.     These clauses legislate the practice that enables those taxpayers to choose the middle date of the actual dates to which accounts may be prepared as the accounting date. They prevent the change of accounting date rules applying. See Change 56 in Annex 1.

861.     In these clauses the date which is to be taken as the accounting date is referred to as the "middle date" rather than the "mean date" (the term used in paragraph 71175 of the Business Income Manual). "Middle date" better reflects common usage and the fact that the actual accounting date does not normally vary by more than four days from that middle date. The only exception is when the day to which accounts are prepared is at or near the end of February and the day can fall on 29 February. Then the spread of dates on which the chosen day can fall is extended from seven to eight. But the "middle date" is still the fourth of those dates.

862.     These clauses express a rule based on a simple idea. But there are surprisingly complex implications. It is, for example, necessary:

• to express concisely, yet clearly, the "four day" condition while allowing for the fact that accounts may be prepared to a particular day (such as the last Sunday in the year) or to a day in a particular week (such as the last day of a school term);

• to preserve the optional nature of the practice;

• to ensure that taxpayers can, if they wish, move in or out of the practice authorised by the clauses without the same profits being assessed twice or dropping out of charge; and

• to ensure that no profits are assessed twice or drop out of charge when the trade ends.

863.     Because of this complexity the rule is set out in three clauses.

864.     Clause 211 is the first of the three clauses and sets the scene by stating the purpose of the rule and the election requirements.

865.     The bracketed words in subsection (1)(b) address the case of a chosen day that can fall on 29 February.

866.     Subsection (4) make elections as straightforward as possible by adopting the procedures and time limits of the Self Assessment cycle. Unlike the opt out election for the late accounting date rules (see the commentary on clause 208) the election for the middle date rules is "opt in". This is because it is less clear that taxpayers will want automatically to choose the middle date treatment than it is that they will want to choose the late accounting date treatment.

Clause 212: Consequence of treating middle date as accounting date

867.     This is the second of the three clauses that, together, prevent the complex change of accounting date rules from applying in particular circumstances. It states the effect of electing for the middle date treatment.

868.     The clause can apply whether or not the previous year was treated in the same way: if it was not, subsection (2) applies, and if it was, subsection (3) applies. See Change 56 in Annex 1.

Clause 213: Circumstances in which middle date not treated as accounting date

869.     This is the third of the three clauses that, together, prevent the complex change of accounting date rules from applying in particular circumstances. It ensures that when the middle date treatment ceases to apply no profits are assessed twice and no profits drop out of charge.

870.     The clause does this by imposing continuity in profit counting between the two relevant basis periods. This is necessary because when a middle date is used to mark the end of the basis period for the earlier year, the actual date to which its profits are calculated may otherwise result in a gap preceding, or an overlap with, the actual date on which the basis period for the following year begins. This clause ensures continuity between the two when the basis period for the second year is given by any of the provisions listed in subsection (2).

Clause 214: When a change of accounting date occurs

871.     This is the first in a group of seven clauses dealing with changes of accounting date. This is the most complex aspect of the basis period rules. By separating these "change" clauses from the main clauses the taxpayer who does not change accounting date is sheltered from most of that complexity.

872.     Clause 214 determines the basis period for the year in which a change of accounting date takes place. It is based on section 62(1)(a), (2) and (5) of ICTA.

873.     Subsection (1) covers two cases. Normally the year in which the change takes place is the first year in which accounts are prepared to the new date. But sometimes the period of account ending on the new accounting date will straddle an entire tax year (because that period of account is longer than 12 months). In these circumstances the straddled year is the year in which the change is treated as having taken place.

874.     Subsection (2) is necessary to "switch off" the middle date treatment and to allow the provisions of clause 213 to operate if appropriate (see the commentary on clause 213).

875.     Subsection (3) attributes an accounting date to a year which is straddled by the period of account ending with the new accounting date. That is necessary to determine the correct basis period for the straddled year. For example, if the period of account effecting the change of accounting date runs for 15 months from 1 April 2006 to 30 June 2007 an accounting date is treated as falling on 30 June 2006 in the tax year 2006-07 although, in fact, there is no accounting date in that year.

Clause 215: Change of accounting date in third tax year

876.     This clause is the first of two clauses that deal with a change of accounting date in particular years and for which special rules are required. It is based on sections 62(1) and (2)(b) and 63 of ICTA.

877.     The approach in the change of accounting date clauses follows that adopted in the earlier clauses: that the general rule in clause 198 applies unless a specific rule applies. A specific rule will apply when the basis period must be different from that which would be given by the general rule or when additional conditions apply.

878.     In a continuing trade, specific rules will always apply to years in which a change of accounting date occurs after the third year (see clause 216). This is because conditions have to be met for changes of accounting date in those years to be effective for tax purposes (see the commentary on clause 216 and clause 217). But for changes in the second and third years there are no conditions and the general rule will often apply. Clause 215 deals with the case where the general rule does not apply in the third year.

Clause 216: Change of accounting date in later tax year

879.     This clause applies to changes of accounting date occurring at any time after the third year, other than in the final year. It is based on sections 62(1), (2) and (3) and 63 of ICTA.

880.     Changes of accounting date are normally effective for tax purposes and the basis period then aligns with accounts prepared to the new accounting date. But exceptionally, changes of accounting date will not be effective for tax purposes and then the basis period becomes out of step with the period of account.

881.     Subsections (2) and (3) give the main change of accounting date rule. When a change is effective for tax purposes the basis period simply aligns with the new accounting date in the year of change.

882.     Both subsections refer to clause 217 that sets out the conditions that a change must meet to be effective for tax purposes.

883.     When subsection (3) applies, the basis period for the year of change will be longer than 12 months.

884.     Subsection (4) preserves the old basis period, notwithstanding the change of accounting date, when, exceptionally the conditions in clause 217 are not met. This means that apportionment of the profits of the periods of account to the basis period is required.

Clause 217: Conditions for basis period to end with new accounting date

885.     This clause sets out the conditions which must be satisfied for a change of accounting date to be effective for tax purposes. It is based on section 62A(1), (2), (3), (4), and (5) of ICTA.

886.     Subsection (1)(c) imposes a test which may be satisfied by meeting either of two conditions. The first, condition A in subsection (4), is a "no recent change" condition and is of the same "mechanical" type as those in subsections (1)(a) and (1)(b).

887.     The second, in subsection (6), is, in part, a condition of purpose. Unlike the others, it introduces a test which is qualitative in nature. But it becomes relevant only if condition A in subsection (4) is not met. It is therefore likely to apply in relatively few cases. For those reasons and to achieve a simpler rule for the more common cases, the associated Inland Revenue notice and taxpayer appeal rules are stated in a separate clause (clause 218).

Clause 218: Commercial reasons for change of accounting date

888.     This clause deals with three aspects of the "commercial reason" condition in clause 217(6)(a):

• the automatic assumption of commerciality;

• timely notice by the Inland Revenue to the contrary; and

• appeals to the Commissioners if the Inland Revenue's view is disputed.

It is based on section 62A(5), (6), (7), (8), and (9) of ICTA.

889.     Subsection (1) makes the effect of section 62A(5)(b) of ICTA clear: that a change is treated as having been made for a commercial reason in the absence of a timely challenge by the Inland Revenue.

890.     Subsection (6) prevents a wish to obtain a tax advantage from being a commercial reason for the change of accounting date rules.

Clause 219: The year after an ineffective change of accounting date

891.     This clause sets out the rules that apply in the tax year following a year in which a change of accounting date takes place that does not result in a change of basis period. It is based on section 62(3) and (4) of ICTA.

892.     When a change of accounting date takes place that does not result in a change of basis period, clause 216(4) applies and the basis period for the year of change remains the twelve month period ending with the old accounting date. As a result, basis period and period of account fall out of alignment. Such cases may be relatively uncommon. But, where they do arise, specific rules are needed to ensure the proper working of the basis period rules in subsequent years. In those years, the taxpayer can revert to the old accounting date, maintain the new one, or change to a different date altogether.

893.     Subsection (2) deals with the case where, in the year after the ineffective change, the new date is maintained. It allows the rules to operate as though the change takes place for the first time in that later year (rather than in the actual year of change). This allows the taxpayer to make a fresh attempt to change the basis period without, for example, falling foul of the "any recent change" rule in clause 217(4).

894.     Subsection (3) deals with the case where, in the later year, the taxpayer reverts to the old accounting date. This second change is not counted as a change for the purpose of the relevant rules.

Clause 220: Deduction for overlap profit on change of accounting date

895.     This clause allows the deduction of overlap profit in a year in which there is a change of accounting date leading to a change of basis period and that basis period is longer than twelve months. It is based on section 63A(1) and (2) of ICTA and paragraphs 71140, 71155, and 71170 of the Inland Revenue Business Income Manual.

896.     This adjustment for overlap profit is one of the two rules which help to ensure that, over the lifetime of a trade, the total profits assessed exactly equal the total profits earned. (The other, which authorises a deduction of overlap profit in the tax year in which the trade ceases, is in clause 205). And it ensures that, in the year of change, no more than twelve months' profits are assessed.

897.     Calculating the deduction can be quite complex, particularly, for example, if there have been other changes of accounting date and deductions for overlap profit in previous years. Subsection (3) uses a step-by-step method statement to aid calculation.

898.     This clause includes three aspects which have previously been dealt with on a non-statutory basis.

899.     Subsection (4) deals with the first (described in paragraph 71140 of the Business Income Manual). Where profits must be apportioned, it allows the use of any reasonable basis of calculation instead of the measure by days referred to elsewhere in the clause, provided its use is reasonable and consistent. See Change 52 in Annex 1. The wording of subsection (4) makes it clear that the option to choose an alternative basis of apportionment is exercisable only by the taxpayer, not the Inland Revenue.

900.     Subsection (5) deals with the second. It permits a change of accounting date to 31 March (or to 1, 2, 3, or 4 April) to be treated as though it were a change to 5 April (described in paragraph 71170 of the Business Income Manual). This avoids the need to make small restrictions to the deduction for overlap profit and will always work to the taxpayer's advantage. See Change 55 in Annex 1.

901.     Finally, subsection (6) provides the option (described in paragraph 71155 of the Business Income Manual) to disregard 29 February in calculating a deduction for overlap profit if the change of accounting date is to a date falling on 31 March to 5 April inclusive. This always works to the taxpayer's advantage. See Change 57 in Annex 1.

Chapter 16: Averaging profits of farmers and creative artists

Overview

902.     A person carrying on farming or market gardening or a creative artist may make an averaging claim. The claim is for the profits of two tax years to be adjusted. This is possible only if the profits of the two years differ to a material extent.

Clause 221: Claim for averaging of fluctuating profits

903.     This clause sets out who may make an averaging claim. It is based on section 96 of ICTA (farmers) and Schedule 4A to ICTA (creative artists). In the case of creative artists a claim may be made in respect of the profits of a trade carried on wholly outside the United Kingdom. See Change 58 in Annex 1.

904.     In the case of a person assessed on the remittance basis, the assessment is on the amount of "sums received" rather than the profits. So a claim may not be made in respect of income assessed on the remittance basis.

905.     Subsection (2) extends the meaning of farming to include market gardening and factory farming. See Change 59 in Annex 1.

906.     Subsection (4) makes it clear that "profits from a trade" means the amount before the deduction of losses. If a loss is sustained in the trade for the relevant tax year subsection (5) ensures that it does not create a negative profit for the purposes of averaging; it results in a profit of nil.

907.     The reference in section 96(7)(c) of ICTA to any deduction for stock relief under Schedule 9 to FA 1981 is spent. Schedule 9 was repealed by ICTA. So this Chapter omits the reference.

Clause 222: Circumstances in which claim may be made

908.     This clause sets out the circumstances in which an averaging claim may be made. It is based on section 96 of, and Schedule 4A to, ICTA.

909.     Subsection (2) makes explicit the fact that a claim may be made in relation to a tax year which was the later year on a previous averaging claim. This rule is merely implicit in the opening words of section 96(1) of ICTA.

910.     Subsection (4) is based on the rules in section 96(4)(b) of and paragraph 4(2) of Schedule 4A to ICTA. The rule in section 96 of ICTA provides that no claim is to be made in respect of any tax year "in which the trade is (or by virtue of section 113(1) [of ICTA] is treated as) set up and commenced or permanently discontinued". The rule in this clause follows the wording in Schedule 4A to ICTA.

911.     There is some doubt whether "the trade" referred to in ICTA can mean a partner's "deemed trade" (see section 111(4) of ICTA). It is generally accepted that individual partners cannot make an averaging claim in relation to the year in which they start or permanently cease to carry on a qualifying trade in partnership. This subsection makes clear that the rule applies to a partner's deemed trade. See Change 60 in Annex 1.

Clause 223: Adjustment of profits

912.     This clause sets out the way in which the profits of each of the two tax years for which a claim is made are adjusted. It is based on section 96 of, and Schedule 4A to, ICTA. It also includes a signpost to Schedule 1B to TMA.

913.     There are two methods for adjusting the profits.

914.     Subsection (3) sets out the first method. The profits of the two years are added together and then averaged.

915.     Subsection (4) sets out the second method. The subsection uses a method statement to show how a more complex calculation is made. The aim is to achieve a straight line taper from a full adjustment when the profits differ by 30% to no adjustment when they differ by 25%.

Clause 224: Effect of adjustment

916.     This clause explains the effect of adjusting profits after a claim is made. It is based on section 96 of, and Schedule 4A to, ICTA.

917.     Subsection (4) deals with the relationship between an averaging claim and claims for relief under any other provision of the Income Tax Acts.

918.     Section 96(9)(a) of ICTA provides that the time limit for the making of these other claims is the last day of the period during which the averaging claim is capable of being revoked. This clause describes the time limit as being the last date on which the averaging claim could have been made. The actual time limit remains unchanged.

Clause 225: Effect of later adjustment of profits

919.     This clause explains the effect of adjusting profits after a claim is made. It is based on section 96(5) of, and paragraph 10 of Schedule 4A to, ICTA.

920.     Subsection (4) sets out the rule for a further averaging claim. This clause removes any doubt that the normal 22 month time limit applies. See Change 61 in Annex 1.

Chapter 17: Adjustment income

Overview

921.     This Chapter sets out the rules for dealing with two sorts of changes in the way profits of a trade are calculated.

922.     The first sort of change is in the way the accounts are drawn up. The general rule is that profits must be calculated on the basis of accounts drawn up in accordance with generally accepted accounting practice (see clause 25 and section 50 of FA 2004). There is an exception to this general rule for some barristers and advocates (see clause 160), who may calculate their profits on a cash basis.

923.     If there is a change from the cash basis to the earnings basis, some receipts and expenses may fall out of account. This sort of change was dealt with originally in the rules that became section 104(4) to (7) of ICTA. Those rules were replaced by the rules in section 44 of and Schedule 6 to FA 1998. The 1998 rules were replaced by section 64 of and Schedule 22 to FA 2002.

924.     The second sort of change is in the way tax adjustments are made. These are the adjustments "required or authorised by law in calculating profits for tax purposes" (clause 25). This sort of change was dealt with for the first time by the 2002 legislation.

925.     Clause 860 applies the rules to trades carried on in partnership.

Clause 226: Professions and vocations

926.     This clause makes it unnecessary to specify repeatedly that the rules in this Chapter apply to a profession or vocation as well as a trade. It is new.

Clause 227: Application of Chapter

927.     This clause sets out the circumstances in which an adjustment may arise. It is based on section 64 of FA 2002.

928.     Section 64 of FA 2002 refers to a change of the basis on which profits are calculated. This might mean any change of basis. But paragraph 3(2) of Schedule 22 to FA 2002 makes clear that it does not include a change which occurs on a change of ownership of a trade.

929.     The trading income rules in this Part are generally "person-based". So this clause applies when a person changes the basis. That person must be the same before and after the change of basis. So this clause reproduces the effect of paragraph 3(2) of Schedule 22 to FA 2002.

930.     An adjustment has to be made if:

• the "old basis" accorded with the law or practice at the time; and

• the "new basis" accords with the current law and practice.

931.     The difference in wording is to cater for a case in which a decision of the Courts makes it clear that a previously accepted view of the law was wrong. In that case, the old basis accorded with the practice but not the law. The 1998 rules did not cater for this. But the 2002 rules (and the rules in this Chapter) do.

932.     Section 64(1)(a) of FA 2002 refers to "a change of basis in computing the profits for the purposes of Case I or II of Schedule D". So the change of basis rules are "rules applicable to Cases I and II of Schedule D" (section 65(3) of ICTA) and apply to foreign trade profits assessed under Schedule D Case V.

933.     This conclusion is reinforced by the fact that, if the adjustment is negative, any relief under paragraph 5 of Schedule 22 to FA 2002 is given by way of "a deduction in computing profits".

934.     The clause refers to "a trade". So the rules apply to trades carried on wholly outside the United Kingdom as they apply to trades carried on at least partly in the United Kingdom.

935.     There is a transitional rule in Schedule 2 to this Bill. An adjustment arising from a change of accounting basis before 6 April 1999 is not charged to tax if the recipient was born before 6 April 1917.

Clause 228: Adjustment income and adjustment expense

936.     This clause sets out the treatment of the adjustment. It is based on paragraphs 4 and 5 of Schedule 22 to FA 2002.

937.     If the adjustment is positive it is called adjustment income. Adjustment income is charged as trading income under clause 229. Section 64 of, and Schedule 22 to, FA 2002 create a charge under Schedule D Case VI if there is a positive adjustment on a change of basis. This Bill deals with the income where it logically belongs. In this case, the income is trading income.

938.     In the case of foreign trades, a positive adjustment on a change of basis is charged to tax under Schedule D Case VI in the source legislation even though the profits of the trade are chargeable under Case V. This Chapter treats trades carried on wholly abroad in the same way as trades carried on wholly or partly within the United Kingdom (unless the income is assessable on the remittance basis).

939.     The charge in the source legislation under Schedule D Case VI has consequences for loss relief and the charge to Class 4 national insurance contributions. This Chapter preserves the position for loss relief in clause 232(3). The Bill preserves the position for Class 4 national insurance contributions because the consequential amendments to the social security legislation ensure that those contributions are charged only on profits chargeable under Chapter 2 of Part 2 of this Bill.

940.     If the adjustment is negative it is called an adjustment expense. An adjustment expense is dealt with in clauses 233 and 234.