Are you or your client affected by overlap profits and overlap relief? Wondering what the impact is and how any overpaid tax can be paid back on cessation? Then you’re in the right place! In this guide, you’ll discover what overlap profits are and how overlap relief works on cessation. I’ll also include examples to help you further understand. If this affects you, read on to find out more.
Table of contents
- 1. Overlap Profits Explained
- 2. How to Avoid Overlap Profit
- 3. What is Overlap Relief?
- 4. HMRC Overlap Relief on Changing of Accounting Periods
- 5. How to Claim Overlap Relief
- 6. Update
Friendly Disclaimer: Whilst I am an accountant, I’m not your accountant. The information in this article is legally correct but it is for guidance and information purposes only. Everyone’s situation is different and unique so you’ll need to use your own best judgement when applying the advice that I give to your situation. If you are unsure or have a question be sure to contact a qualified professional because mistakes can result in penalties.
1. Overlap Profits Explained
Overlap profits occur when someone who is registered as self-employed chooses to report their income and expenditure in the self-employment section of their tax return for an accounting period that is not the same as the tax year. These overlap profits will normally arise in their first 3 tax returns. This is because HMRC force individuals to use basis periods to ensure that all self-employed individuals are taxed across the same 12 month period. This stops one sole trader from including numbers on their self-assessment tax return that may be more advantageous in reducing their tax bill more than another sole trader.
If a sole trader chooses to draw up their income and expenditure for the accounting period that matches the tax year, then basis periods and overlap profits won’t arise.
1.1 How Overlap Profits Arise
A sole trader registers as self-employed on 1 July 2018 choosing an accounting period of 30 June each year. Here are the basis periods for the first three tax years of trading, starting 2018/2019:
|Tax Year||Basis Period|
|2018/2019||1 July 2018 to 5 April 2019|
|2019/2020||1 July 2018 to 30 June 2019|
|2020/2021||1 July 2019 to 30 June 2020|
Profits for the period 1 July 2018 to 5 April 2019 are reported twice in the tax return for 2018/2019 and 2019/2020. This means self-employed tax is paid twice because it is included in two separate tax returns.
1.2 Overlap Profits from Changing Accounting Periods
Following on from the above, the sole trader has now been trading for some years. Consequently, they decide to change accounting periods. In the tax year 2021/2022 they also decide to lengthen their accounting period to 30 September. The basis period for 2020/2021 was 1 July 2019 to 30 June 2020, but the new one for 2021/2022 will be 15 months long (1 July 2019 to 30 September 2021). That means there are overlap profits for the period 1 July 2019 to 30 June 2020.
If your accounting period in the tax year before you make the change is more than 12 months after the end of the basis period for the previous tax year, your basis period is the period between the end of the basis period for the previous tax year and the new accounting end date.
1.3 Overlap Profits from Shortening Accounting Periods
Following on from the first example, instead of lengthening accounting periods, the sole trader decides to shorten their accounting period to 31 May. The basis period for 2020/2021 was 1 July 2019 to 30 June 2020. That means the new one for 2021/2022 will be 1 June 2020 to 30 May 2021. The result is that there will be overlap profits will be for the month of June 2020.
If the new accounting date is less than 12 months after the end of the basis period for the previous tax year, the basis period is the 12 months ending on the new accounting date.
2. How to Avoid Overlap Profit
The easiest way for the self-employed to avoid overlap profit is to choose an accounting period that matches the tax year. That includes income and expenses on your tax return for an accounting period that ends either 5 April or 31 March.
HMRC considers the 5th April and 31 March to be the end of the tax year for tax return purposes because it can make reporting easier.
3. What is Overlap Relief?
Overlap relief is tax relief for any double tax paid on overlap profits and it can be claimed when:
- Changing accounting periods;
- Cessations of self-employment, including if that is due to forming a Limited Company.
It means that sole traders will have paid the right amount of income tax and National Insurance on their business profits for the whole time they are self-employed.
4. HMRC Overlap Relief on Changing of Accounting Periods
Overlap relief can be gained as a deduction against taxable profits by changing accounting period for a business is changed so that the basis period for that tax year becomes longer than 12 months.
However, the amount of relief that can be claimed is restricted to:
- the number of days in the overlap period(s) to which the overlap profits relate;
- 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.
A self-employed business owner has an accounting period end date of 31 May each year and started trading on 1 June 2014. Here’s how the profits of each accounting period are taxed through self-assessment using after adjusting for basis periods:
|Tax Year||Basis Period||Profits|
|2014/2015||1 June 2014 to 5 April 2015||£12,000|
|2015/2016||1 June 2014 to 31 May 2015||£15,000|
|2016/2017||1 June 2015 to 31 May 2016||£18,000|
|2017/2018||1 June 2016 to 30 November 2017 (18 months)||£25,000|
|2018/2019||1 December 2017 to 30 November 2018||£19,000|
Overlap profits occurred from 1 June 2014 to 5 April 2015. In the tax year 2017/2018, they decided to change their accounting period from 31 May to 30 November. The overlap relief that they can claim in 2017/2018 is restricted because the basis period exceeds 12 months by 183 days so overlap relief is restricted, meaning they can claim overlap relief of £6,016 (£10,126 * (183÷308)).
5. How to Claim Overlap Relief
Overlap relief is one of HMRCs income tax allowances and reliefs that can be claimed on your self-assessment tax return in the year the claim is made.
In the example above, overlap relief can be claimed on their 2017/2018 Tax Return by setting this figure against taxable profits. This leaves remaining overlap relief of £4,109 which can be used on cessation of self-employment so that across the life of a business the amount of taxable profits exactly matches the number of days a person has traded for.
5.1 How to Claim Overlap Relief on Cessation
Following on from the example above, there are remaining overlap profits of £4,109 and the final amount of overlap relief can be claimed on the final self-employment tax return section filed with HMRC. The amount of £4,109 can be set against the final profits declared to HMRC.
As part of making tax digital and a desire by HMRC to simplify the tax system, proposals are being discussed that will effectively end basis periods and stop overlap profits from arising from 6 April 2023. These reforms are currently in discussion and you can find out more about the basis period reform here.