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UITF 40 Spreading ' Tutorial

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12th Dec 2005
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Rebecca BennyworthBy Rebecca Benneyworth
The full details of the spreading mechanism for income brought into charge by Section 231 ITTOIA 2005 are not yet available ' the draft legislation will be included in the Finance Bill 2006, but may well be available in advance. In the meantime, HMRC has provided the professional bodies with details of how it is currently envisaged that the spreading charge will be taxed.

Businesses affected by applying UITF 40 from 22 June 2005 will be permitted to spread the adjustment income so arising whether they are taxed under income tax or corporation tax. This means that all entities which have a change in accounting policy to align with the new rules will be able to spread their tax over at least three years. However, businesses which have adopted an early change in recognition of income, by following Application note G to FRS 5 will not be able to take advantage of the spreading rules, as they will be available only for accounting periods ending on or after 22 June 2005. Those businesses which have considered adopting UITF 40 early will also not share in the benefits of spreading. The Tax Faculty of the ICAEW is currently making representations to HMRC about those affected by early adoption.

The calculation of the adjustment income is performed at the last accounting date under the old rules. For more details of how this is calculated see my earlier tutorial Tutorial: UITF 40. The amount so calculated comes into charge in the year of change (for most businesses 2005-06) and is spread forwards, producing a tax charge payable on 31 January 2007 and in subsequent years.

The basic rule is that the adjustment income is to be spread initially over three years. The one third so calculated is compared to one sixth of the taxable profits in each year and the lower amount taxed.

Example

With a year end of 31 March, the year of change is 31 March 2006, which means that the tax arises from 2005-06 onwards. Peter is a sole practitioner, and had no WIP at cost in his March 2005 accounts. He has prepared 2006 in accordance with UITF 40, and this has produced adjustment income (calculated as at 31 March 2005) of £30,000. The amount taxable in each year would therefore be £10,000.

Peter's profits for the year ended 31 March 2006 are £24,000, so the amount of adjustment income taxed in 2005-06 is restricted to £4,000 ' one sixth of his annual taxable profits. Thus, the spreading charge will smooth the tax burden, and in Peter's case reduce the rate of tax paid on the adjustment income too.

If Peter's profits in the year ended 31 March 2007 are £60,000, then the amount taxed in that year will be £10,000; this gives advisers the clue on the two to one ratio. If the adjustment charge is more than 50% of the current profit levels, then clearly spreading will extend beyond the basic three year period.

Let us further assume that Peter's profits in year ended 31 March 2008 fall back to £30,000, so by the end of his third year the amounts that have been taxed are :

In 2005-06 £4,000
In 2006-07 £10,000
In 2007-08 £5,000
Total £19,000

There remains a further £11,000 to bring into charge.

For years four to six, the original one third and one sixth rules continue to operate until all of the adjustment income has been taxed, with no limit in year six.

In the year ended 31 March 2009 Peter's profits are £30,000 again. The amount of adjustment income taxed in that year is £5,000, leaving £6,000 untaxed. In 2010 with profits of £24,000 another £4,000 of adjustment income comes into charge, leaving £2,000 which is taxed in the final year, 2011.

Final year

Business with current profits very low in relation to their adjustment income will need to be warned about a significant tax charge in the final year. For example, if the adjustment income is double the annual profits, over half of that amount will be taxed in the final year, as the amounts taxed so far will be equal to 5/12 of the total (5/6 x ½).

Payment of tax

The first tax will be payable on 31 January 2007 for most income tax businesses. This will apply to years ending 30 June 2005 to 31 March 2006. For year ends 30 April and 31 May the effect of UITF 40 is not felt until the 2006 accounts, moving the year of change to 2006-07 and the tax payable to 31 January 2008. For companies the tax will be payable as normal 9 months after the end of their accounting period, unless they are subject to quarterly payment rules for corporation tax.

Under income tax, the additional tax payable at the first instance will reflect a full year's share of adjustment income. Thereafter the tax will, of course fall into the normal payment on account regime. You will need to exercise caution if you need to apply to reduce payments on account in year, to make sure that the effect of the adjustment income coming into charge is included.

Example

Julie's total adjustment income is £45,000. Her profit in the year ended 30 June 2006 is £78,000, but she expects her practice income to reduce to £48,000 in 2007, and is therefore calculating reduced payments on account. She will need to bear in mind that the following profits will be charged:

2006-07 Profits from professional practice £78,000
  Adjustment income (spread) £13,000
     
2007-08 Anticipated profits from practice £48,000
  On this basis ' adjustment income £8,000

Overlooking the adjustment income coming into charge could cause Julie to understate her payments on account with consequent interest charges when the final payment is made.

Partnerships

In the absence of draft legislation it is difficult to make predictions about the impact of spreading on partners, but it would be sensible to assume that each partner would be allocated his share of the adjustment income in 2005-06 or 2006-07 according to the rule in Section 860(4) ITTOIA 2004. This allocates the adjustment income between the partners in the profit sharing ratio applying to the period preceding the change. Once allocated, it is likely that the spreading rules will then apply to each partner's individual share of the adjustment charge, compared to his own share of the profits of the firm in each year. It does leave one wondering how the charge will be spread for those partners leaving the firm in the year prior to UITF 40 applying, as they would technically take a share in the adjustment income, but have no subsequent share in the profits. This aspect will need special rules form the legislator, and there is still time for the partnership spreading rules to be amended to make more sense.

However, it would be equally unfair to charge incoming partners a share of the adjustment income in later years, as they would be presented with a tax charge on profits that they did not participate in ' a problem currently facing partners who have retired.

So good news for many firms ' or at least, less bad news!

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By peter.georgearthur.co.uk
14th Feb 2006 09:01

UITF spreading calculation
Following on from Rebecca Bennyworth's UITF 40 Spreading Tutorial, what happens to the spreading calculation if a sole trader incorporates on or after 22nd June 2005 eg Last full accounting period year ends 31st March 2005, with a final accounting period to say 30 September 2005. Do you have to multiply the final 6 months profit by 12/6 to 'do the maths' as regards whether the spreading will be over a 3 or 6 year period?

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Rebecca Benneyworth profile image
By Rebecca Benneyworth
14th Dec 2005 14:26

Not in public domain yet, Clive
I have the information because the professional bodies were mailed with details in the form of a reply from Dawn Primarolo to Ian Morris as head of the CCAB. Details were released internally to interested parties (myself included), and the ICAEW Tax Faculty wrote on the subject over the weekend, so I decided that the information is now open to comment on.
I hope that we'll get draft legislation to comment on before the Bill is released after the 2006 Budget, as some aspects of this are a bit tricky - and particularly the partnership rules. We shall also need to know what happens when the main income source ceases - does this crystallise the rest of the charge?

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By AnonymousUser
02nd Jan 2006 16:47

Partnership retirement
My partner retired on 31st October 2004. Accounts for the period up to that date were prepared on the basis that Work in Progress was included at "Cost" of both staff and partner time but an adjustment has been made in the tax computations - as it has been for many years - to remove partner time and include only the cost of staff time in calculating taxable profits. My first accounts as a sole practitioner have been prepared for the year ended 31st October 2005, adopting UITF 40 and including the estimated realisable value of all staff and my time. They will form the basis of my Self-Employment income for 2004/05. Had the October 2004 accounts been prepared on a similar basis and no adjustment been made in the computations, the taxable profit based on those accounts would have been £44k greater. Am I correct in treating this £44k as "other income" in the partners' individual 2005 tax returns? If so is this spreadable - at least by me? All this does, of course, ignore the settlement between us, which was based on the realisable value of WIP at 31/10/04. Any input would be appreciated.

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Rebecca Benneyworth profile image
By Rebecca Benneyworth
03rd Jan 2006 11:00

Not on 2005, but 2006
Christopher, you are correct that the uplift on the 2004 accounts is the amount of your "adjustment income" but this is taxed in the year of change - that is 2005-06 as you have adopted UITF 40 in the accounts to 31 October 2005. So this amount will be shown on the 2006 tax return which is your sole trader return. However, looking at the partnership rules, provided that both you and your partner are continuing to carry on the trade (separately) the adjustment should be taxed on you in the profit sharing ratio in the last year of the partnership. (See section 860 ITTOIA 2005) So you could enter your share on your sole trader return, he would then declare his share on his own return. If he is no longer carrying on the trade then life is a little more complicated. I hope HMRC give us some practical guidance about this when it arises.
As far as spreading goes we won't know how it will be spread until we see draft legislation.
As a general point, there is no instance in which a UITF 40 adjustment can be taxed in 2004-05 so there should not be any on 2005 tax returns. Any firm who chose to apply the principles as a result of interpreting Application note G to FRS 5 WILL be affected before 2005-06, and will not at present get the benefit of spreading.

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