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I hesitate to raise a query on this subject since Mike Truman has declared 'the last word' some weeks ago, but I am confused and do not know how to complete my 2004-05 tax return. Our year-end is 30 June and we are therefore required to value our work in progress at 30 June 2005 on a recoverables basis for tax purposes rather than at cost as previously.
If this is the case, do we not also have to adjust the opening work in progress onto the same basis, and will this not then create a charge under Schedule D, Case VI, which will fall into 2004-05? If this is right, the tax 'bombshell' is going to occur on 31 January 2006, but the articles I have read on the subject suggest that the one-off effect of the change will impact on the amount due in January 2007 or even 2008.
Please tell me I have another year to save up, and why!
Query T16,728 — Old Wanderer.
Reply by Thicket.
Following the issue of Application Note G (ANG) on 'income recognition' in November 2003, there has been some controversy over how this was to be applied, in particular to professional partnerships. The accounting treatment has now been resolved by publication of UITF 40, and the ICAEW has published commentary on both the accounting and tax treatments in the form of 'frequently asked questions' (FAQs) and these are particularly addressed to professional service firms.
As far as tax is concerned, it was always the case that this change in the accounting policy would be likely to increase the tax liabilities of those affected. The advice from HMRC remains (as it has always been) 'this is an accounting matter; once the accountants have sorted it out, we will tax the business accordingly'.
The year ending 30 June 2005 will be the first year in which Old Wanderer adopts UITF 40. Assuming the effect is significant, this is likely to amount to a change in accounting policy (or 'accounting basis' to use the language of the Taxes Acts).
Where both the old and the new bases comply with UK GAAP, the tax rules will be found in FA 2002, s 64 and Sch 22. For income tax purposes, these have been rewritten and are to be found in ITTOIA 2005, ss 226 to 240. (The FA 2002 rules continue to apply for companies.)
Any increase in profits arising as a result of a change in the accounting basis and which has not already been brought into account for tax purposes, is subject to income tax. This is 'adjustment income', rather than an addition to trading profits. The charge is treated as arising on the last day of the first period for which the new basis is adopted. If the change results in profits having been overstated (unlikely in this case), it is treated as a trading expense.
The increased charge will not be included in the calculation of interim payments on accounts of the tax year in which the change occurs. These will have been calculated by reference to the taxable profits of the previous year. Thus the amount of any adjustment income will be included in the final balancing payment due 31 January following the end of the tax year in which the change of accounting basis occurs.
Interim payments on account for the next year will be based on the total amount charged to income tax in the year of change. This includes the adjustment income charge. However, it is not likely that a similar level of adjustment charge will arise in the following year because of the 'one-off' nature of the charge arising from the speeding up of income recognition. Therefore consideration will need to be given to a claim under TMA 1970, s 59A(4) to reduce the payments on account in the following year.
In Old Wanderer's case, his year-end is 30 June 2005. Let us suppose that, on analysis, it is concluded that additional income of £12,500 needs to be recognised, and that the equivalent amount at 30 June 2004 was £10,000. As a result, the accounting profit will be increased by £12,500 of which £10,000 will be adjustment income and £2,500 will be additional trading income. The profits for the year-end 30 June 2005 fall to be taxed in 2005-06 and to the extent that the extra liability has not been covered by payments on account, the additional tax will fall due on 31 January 2007. From the rules given above, it is clear that there is no question of revising the 2004-05 tax computations. This adjustment income charge is disclosed in boxes 13.1 to 13.3 on the main tax return as 'other income' (and not as part of trading profits). It is suggested that some explanation is entered in box 23.7 as additional information.
Any 'adjustment income' charge is not subject to Class 4 NICs, but will be relevant earnings for pension purposes.
The current position is that it seems unlikely that the Government will offer any spreading provisions, but Old Wanderer may like to keep a watch in the professional press for any last minute change of mind.
Reply by Smee.
The tax rules for a change in accounting basis are set out in ITTOIA 2005, ss 226 to 240. The increase in the profits as a result of adopting UITF 40 is treated as 'adjustment income' rather than an addition to trading profits. The detailed steps for calculating adjustment income are set out in s 231. The charge is treated as arising on the last day of the accounting period for which the new basis is adopted.
In the case of Old Wanderer, his client has a 30 June year-end and therefore the uplift will be treated as arising on 30 June 2005. This accounting period will form the basis for tax charge for 2005-06. The increased element of the tax charge will be taxed as adjustment income and will be due on 31 January 2007, the due date for the submission of the self-assessment tax return for 2005-06.
This same date will apply to all firms with a year-end that falls after the start of UITF 40 up to 5 April 2006.
For service providers with year-ends falling after 5 April 2006, but before 22 June 2006, any adjustment income will arise in 2006-07 and the tax charge will be payable on 31 January 2008.
The interim payments of account for the next year will be based upon the total amount charged to income tax for the year of the change. This will include an adjustment income charge. As an adjustment income charge will not arise in the next year, the calculated interim payments are likely to be overstated.
Old Wanderer should consider making a claim under TMA 1970, s 59(4) to reduce the payments on account for the next year.
Finally, an adjustment income charge should not be included in the self-employment pages of the tax return even though it arises as a result of carrying out a trade or profession. Instead, the charge will have to be shown in boxes 13.1 to 13.3 on page four of the main tax return. You may wish to provide further details in box 23.7 (additional information).
Editorial Note.
Since replies have been received, the Pre-Budget Report has been published and states that 'The Government will legislate in Finance Bill 2006 to enable most businesses affected by the March 2005 changes in the income recognition rules in UK Generally Accepted Accounting Practice (GAAP) to spread any extra tax charge over three years, while those businesses most severely affected will be able to spread the charge over a period not exceeding six years'.
The ICAEW website (www.icaew.co.uk/taxfac/index.cfm?AUB=TB2I_88773%7CMNXI_88773) states that the final details will not be available until the Finance Bill is published, but under the current proposals, the adjustment income will be taxed over a minimum of three years, but this could extend to six years if the taxable profits are low relative to the adjustment income.
The ICAEW provides the following example.
'Take a business which is severely affected by UITF 40 and whose adjustment income is more than 100%, say 120%, of the normal taxable profit. Assume the normal taxable profit is 100 and the adjustment income is 120.
'One third of the adjustment income is 40, but the additional taxable income each year is restricted to
16 2/3% or one-sixth of the taxable profit of 100.
'If the taxable income remains unchanged over the next five years, the addition to the taxable profits will be capped at 16 2/3% each year, but in the sixth year that amount and the balance of the so far untaxed adjustment income, in this case 20, will also be taxed, a total addition to the normal taxable income in that final year of 36 2/3. Five years of 16 2/3 plus a sixth and final year charge of
36 2/3 making a total of 120.'
Reply by Disenchanted.
I am not surprised that 'Old Wanderer' is confused by the new provisions. It must be emphasised that compliance with FRS 5 and the 2005 FRSSE is voluntary, although ITTOIA 2005, s 227(2) refers to 'accepted practice' when there is change in the basis of accounting.
However, statements by the ICAEW and HMRC appear conclusive, and give a completely new meaning to the phrase 'Working Together'. The consequences are hardly palatable for small practitioners, and could well drive a further wedge between them and their respective professional institutes.
The provisions concern 'revenue recognition', but as far as accountants are concerned this is largely a euphemism, as it is work in progress that concerns them. This has to be valued now at selling price, inclusive of partners' and principal's time. Completed, but unbilled work will be valued at the full recoverable fee, and audit, accounts and tax work in progress at a proportion of the fee, taking into account irrecoverable time. The total of unbilled work at selling price should be disclosed within debtors at 30 June 2005 as 'amounts recoverable under contracts'.
ITTOIA 2005, s 231 and 232 deal with 'adjustment income', which is the thrust of 'Old Wanderer's' query. In his case he is correct that the work in progress must be valued at selling price at both 30 June 2004 and 30 June 2005. The accounts for the year ended 30 June 2005 will reflect opening and closing work in progress at selling price and will be declared on the self-assessment tax return in the normal way.
The difference between the work in progress at selling price at 30 June 2004 and cost plus price at the same date (already declared) represents the 'adjustment income'. In accordance with s 232(1), despite the fact that this adjustment falls within the year 2004-05, it does in fact represent miscellaneous income to be declared for the year 2005-06, with the additional tax payable on 31 January 2007 (subject to any 'spreading' provisions if the professional institutes are successful in their negotiations with HMRC on this point).
No Class 4 NIC is imposed on this miscellaneous income. However it represents earned income for pension premium purposes, and losses can be set against it. It is also regarded as miscellaneous income for tax credit purposes.
'Old Wanderer' is advised to review the cash flow of his practice in order to meet the additional tax liability due on 31 January 2007. Accelerated billing of clients will help, with regular (perhaps monthly) billing in suitable cases. Clients can be informed that earlier, regular or monthly billing is due to a change in invoicing procedure to reflect the timing of the tax charge on the practice. Whether or not clients will accept this reason is another matter altogether. Another possibility is trying to persuade clients to pay estimated fees by a monthly standing order, with the balance payable on completion of the work. I survived by this method during the 1971 postal strike.
The appropriate entries must then be included on the 2005-06 self-assessment tax return in due course. The 'adjustment income' should be declared in boxes 13.1 — 13.3, with an explanation in the 'white space' at box 23.7.
It will also be necessary to claim a reduction of the payments on account of tax for year 2006/2007 in accordance with TMA 1970, s 59(A)4. Otherwise HMRC will be demanding payments on account of the non-recurring 'adjustment income' in that year. Boxes 18.6 and 18.7 on the return for 2005-06 should be completed, once again with an explanation in box 23.7.
Reply by Kalonymous.
One day, the profession might look back with amusement at the fiasco, which led to UITF 40 — in particular the fact that, according to the Accounting Standards Board, everyone had misunderstood SSAP 9 ever since its inception in 1975. However, in the meantime, subject to any last-minute change of heart from the Government (perhaps to be announced as part of the forthcoming Pre-Budget Report), the impact of UITF 40 will be the sudden acceleration of tax liabilities on business profits and considerable wailing and gnashing of teeth.
There may be some individuals who feel that the rules effectively changed upon the introduction of Application Note G to FRS 5 (in November 2003). I am prepared to accept that this might have been the ASB's intention. However, as a matter of accounting practice, Application Note G was not generally accepted as having that effect. Consequently, GAAP, the basis for calculating profits for tax purposes, was not amended until UITF 40 was issued in March 2005.
It is assumed that Old Wanderer will wish to delay for as long as possible compliance with SSAP 9 as interpreted by UITF 40. Consequently, his practice's accounts will first need to adopt the 'new' rules for the year which ended 30 June 2005.
As a matter of practicability, it would be hard to imagine that a pronouncement by the Urgent Issues Task Force issued three weeks before the end of the 2004-05 tax year and coming into effect two and a half months later should give rise to additional tax bills in respect of 2004-05 (although a few years ago that was a distinct possibility). However, the legislation further provides that any additional tax will relate to 2005-06 and will fall due on 31 January 2007.
Under the current legislative régime, the rules are covered by ITTOIA 2005, Pt 2 Ch 17. In particular, s 227 refers to a change of accounting basis from one (albeit previously) acceptable basis to another. Chapter 17 determines whether or not there is a taxable adjustment that needs to be made (and, if so, how much it is). In particular, s 231 makes it clear that one does not adjust the earlier year's profits; instead one is required to aggregate the profits that now need to be recognised but would not have been recognised had the pre-UITF 40 régime persisted. It is assumed that Old Wanderer will have such an adjustment. Consequently, Old Wanderer then has to turn to s 232. That section provides that this adjustment is treated as income 'arising on the last day of the first period of account for which the new basis is adopted'. In Old Wanderer's case, this income is therefore treated as arising on 30 June 2005. It will therefore be taxed in the 2005-06 year with any extra tax falling due on 31 January 2007. (Those practices with accounting years ending between 6 April and 21 June (inclusive) will have an extra year to pay their additional tax.) Although the legislation no longer refers to Schedule D (or Case VI), the effect is the same as it was pre-2005. In particular, the charge arises under ITTOIA 2005, Pt 2 but is nevertheless excluded from a corresponding National Insurance Contributions charge because the charge does not arise from Pt 2 Ch 2 (see SSCBA 1992, s 15(1)(b)).
It should be noted that the reference to 31 January 2007 is, by necessity, a simplification. Because of the rules concerning payments on account, some practices with falling income levels, might feel the effect of the change in rules on 31 January and 31 July 2006; this would occur in situations where the 2005-06 tax bill (but for UITF 40) would have been less than that for 2004-05. Equally, one must factor in the payments on account that might fall due on 31 January and 31 July 2007 (or 2008) in addition to the increased balancing payments that are payable.
Reply by T.S.
I can confirm that Old Wanderer has another year to save up to pay his tax on the uplift to work in progress charge imposed by UITF40. Whilst it is correct that the opening work in progess, in this case the valuation at 30 June/1 July 2004 has to be increased, FA 2002, Sch 22 para 4 (2)(a) provides that the uplift is to be treated as income arising on the last day of the first period of account for which the new basis is adopted. In this case this will be 30 June 2005 which falls within the 2005-06 tax year.
Dependent on the size of the uplift and profit trends within the business, care will also need to be taken in considering the payments on account for 2007-08 in January 2007 since the 2005-06 liability will contain the tax relating to the uplift.
