Those self-employed people who have been in business since before 1994 and who have experienced rising profits in recent years are particularly vulnerable. Under the old system the self-employed were taxed on their profits for the previous tax year. So, for someone with a 30 June year end, the assessment for, say, the tax year ending on 5 April 1993 (the 1992/93 tax year) would have been based on the profits to 30 June 1991. If profits were rising, this clearly gave them a massive cashflow benefit.
The introduction of self-assessment did two things. Firstly, it introduced a current year basis of assessment, so the taxable income for a given year is determined by looking at the accounting period ending in that year. Secondly, it introduced a new payment system under which the tax bill for a year is settled in three parts: two provisional instalments in January and July, then a final payment the following January.
To make the change from a prior-year basis to a current-year basis the Inland Revenue brought in a transitional year, 1996/97. During that year the taxable profits were determined by using the average of the two accounting years ending in 1996/97. Tax payers felt the benefit of that low 1996/97 assessment when they paid provisional instalments for 1997/98 due on 31 January 1998 and 31 July 1998, because those instalments were based on the previous year's tax liability, rather than their current liability. This favourable outcome means that many self-employed will have been lulled into a false sense of security by these payments, thinking that all their bills will be at the same sort of level.
For them the day of reckoning is looming on 31 January. On that day two things happen. First, there is likely to be a big back payment to catch up with their tax for 1997/98. Second, the first provisional instalment for 1998/99 falls due. This will be half the tax for 1997/98, which of course was the first year under the full current year system. It's a double blow, a ticking bomb.
For example, Mr Robinson draws up accounts to 30 June. In the year to 30 June 1995 he earns pounds 25,000 and his profits have been increasing at the rate of 25 per cent a year since then. On 31 January 1998, depending on his circumstances, he will have made a payment of under pounds 3,500. On 31 January 1999 his bill will be around pounds 8,500!
If you are self-employed and potentially in this position, what can you do? First, look at your pattern of earnings over recent years and find out how much the problem affects you. If possible, calculate your 31 January 1999 liability as early as possible. Next, determine how you are going to meet that liability and plan your cash flow very carefully. It may be possible to make a payment into your pension scheme now, elect to have it treated as paid in the previous tax year and so reduce your 1997/98 taxable income.
Do, though, take proper professional advice.
For further queries, contact the press officer, Rebecca Harding, on 0171-304 8639.
David Oliver, is a partner at Arthur Andersen.