Window to tax saving: Deferring income may enable small companies to profit from the new regime, writes Tony Foreman

SMALL businesses should be on the alert over radical changes in the taxation of the self employed that begin next month. If firms box clever in the transition to the new regime, they can cut their tax bills.

New businesses

One set of rules will apply to businesses that start after 5 April 1994 - or that are deemed to start after that date because a partner has been admitted or has left the firm.

It is not all bad news: one piece of very good news is that partners will not be jointly liable for the firm's tax but will each be separately assessed on their share of profits.

The assessment for the first tax year will always be made on the actual profits of the business during that year. The assessment for the second tax year will normally be on the profits for the first 12 months of trading. The proprietor will be assessed in year three on the profits for the accounting period ending in that tax year.

This is called the 'current year basis'.

Existing businesses

Assessments are made on the firm, and each partner is personally liable for the entire tax bill. This will continue until 1997/98, unless you cease trading and start up a new business before then. But the assessments will be made on a different basis, and this will be more attractive if your profits are rising steadily.

Once a business has been going for three tax years, its assessments are made on the 'preceding year' basis. This means that a business with a year-end of 30 June will normally be assessed for 1995/96 on its profits for the year ending on 30 June 1994. This is going to change in 1997/98 to the current-year basis. Moreover, the assessment for 1996/97 will normally be based on 12-months - half the profits over a two-year period ending in 1996/97. The two years run from the end of the period assessed on the preceding year basis in 1995/96, and for many businesses this transitional period is just about to start.

For example, a business with a 30 April year-end will be assessed for 1995/96 on its profits for the year ended 30 April 1994 and for 1996/97 on half its profits for the period 1 May 1994 to 30 April 1996.

It will not always be better to be assessed as an existing business, although this will generally be the case for a business that has started in the last 12 months. However, you may be able to choose. While your firm can be treated as a new business if it admits a new partner after 5 April 1994, or a partner leaves, you can elect for a 'continuation' and thus treat the firm as a continuing entity despite the change in partners. There is a two-year time limit for making this election, so it may be possible to wait and see before making a decision on this.

If you are self-employed, and have been in business for many years, you will almost certainly be assessed on the 'preceding year' basis. In 1997/98, this will change to the current- year basis.

Special rules will apply to 1996/97 so that the assessment for that year will normally be made on the average of profits for the preceeding two-year period. This period will be starting fairly soon - so now is the time to plan ahead.

In particular, if your business has accounts made up to 30 April (a popular date for solicitors and accountants), the transitional period will start on 1 May 1994.

There is clearly going to be some advantage in claiming expenses in this year's accounts and deferring income to next year. You will minimise your tax liability for 1995/96 while paying tax on only half of the extra income in your accounts for the year ended 30 April 1995. Here are some possible ways of achieving this desirable state of affairs.

Defer sales. If you do have a 30 April year-end, it may make sense to delay sales until shortly after your year-end.

This will be particularly appropriate for professional firms of solicitors and accountants, which can invoice clients early in their new year rather than at the end of their current accounting period.

Make conservative provisions. The Inland Revenue may reject arbitrary and unrealistic provisions but this still leaves plenty of scope for savings by making prudent and conservative provisions against stock or work in progress and against bad debts.

In particular, do not include partners' time when valuing work in progress.

Do make full provision against doubtful debts.

Pay pension contributions. If you operate a pension scheme for your staff, bear in mind that 'ordinary' pension contributions are an allowable expense for the accounting period in which they are paid.

You should therefore pay such contributions before the end of your accounting period, even if part of the contribution relates to your next year. In some cases, it may even be appropriate to make an 'abnormal' contribution, especially if it does not exceed your ordinary contribution, but this is a subject about which you should take professional advice.

Pay bonuses within nine months. A specific provision in your accounts for bonus payments to staff is an allowable expense only if the bonus payments are actually made within nine months of your year-end.

Forgo rent payable to partners. Many firms occupy premises owned by one or more of the partners. It may make sense to vary the lease so that no rent is payable during the two-year transitional period. In return, the partner concerned would be given a prior share of profit corresponding to the rent forgone. However, take advice as there may be problems if you have a loan that was used to buy the property.

Refinance the firm's borrowings. It may well be a good idea for partners to raise personal bank loans and use the borrowed money to put fresh capital in the firm.

The firm could then use the cash injected to clear part of its overdraft or other bank borrowings. The advantage of this is that interest payable on the partners' bank loans will be allowable in full as a charge against their share of the firm's profits.

There is therefore no question of relief for the bank interest being averaged: the partners will secure full relief for every pounds 1 of interest paid by them, as opposed to 50 per cent (because of the two-year averaging rule) where the interest is paid by the firm and is treated as a trading expense.

Tony Foreman is a tax partner with Pannell Kerr Forster and is the author of the Allied Dunbar Tax Handbook.

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