Prepare for an early tax bill
Consultants should watch out for a tax rise, thanks to new accounting rules which will reqire work in progress to be included in a business's accounts.
Plans from accountancy regulator the Accounting Standards Board (ASB) could result in a potentially significant uplift in profits and hence tax bills for consultants - probably in January 2007.
The ASB has decided that work in progress - work performed by consultants but which has not yet been billed - must be valued at selling price in their accounts from now on.
So this means including the income in your accounts as you perform the work, not when you bill it.
The fear is that the first application of the new rules will result in a one-off increase in accounting profits. Taxable profits must follow accounting profits, and so the increased profits will mean higher tax bills being levied.
Who will be affected? The new rules apply to all contracts for services provided over a period of time. Accordingly, most professionals will be hit - including consultants.
Don't be fooled by the word 'contract' and assume that it won't apply to you. A contract can be written or oral. Consultants trading as unincorporated entities such as sole traders and partnerships will be affected, as will companies.
The example below shows how the new rules will work.
HOW THE RULES WILL WORK
Consultant Mr Stock practises in his own name with a year-end of 31 March, and earns taxable profits for 2006 of £200,000.
His expenses are minimal and he does not record any work in progress under existing rules. He usually has about one month of uncompleted work at the year-end.
His accounts for the year ended 31 March 2006 will be subject to the new rules. He should therefore include in his accounts the value of the right to receive consideration in respect of uncompleted work. Mr Stock calculates this to be £20,000.
As a result of the change in accounting policy, his profit for the 2006 tax year will be increased by £20,000.
As a higher-rate taxpayer, he will face an additional tax charge on this increased profit of £8,000 (£20,000 at 40 per cent).
This will be due on 31 January 2007 and represents an increase of ten per cent in his normal tax bill of £80,000 - being £200,000 at 40 per cent.
If you performed work before the end of the financial year but did not raise an invoice until afterwards, you would have to include that income in your accounts. The date that the invoice is raised will have no bearing on when you include the income in your accounts.
This is a radical departure from the current situation. It is important to understand that the effect of the new rules will be to advance the recognition of income, which will trigger the one-off tax charge.
Most consultants will be affected - some more than others. Having done a quick calculation for one consultant, I have estimated that he faces a potential increase of about 20 per cent in his tax bill.
I wouldn't imagine that his situation will prove to be the norm, but don't underestimate the effect - it could be considerable.
The tax authorities will be on the lookout for practices that they believe should be applying the new accounting rules but which are not doing so.
An accounting adjustment to show the increased income will have to be shown separately on your tax return, and the absence of such an adjustment could prompt official questions. Failure to act promptly could therefore lead to the unwelcome result of a tax inquiry.
If these changes apply to you, follow the suggested plan of action. Having an early meeting with your accountant would also be advisable.
SUGGESTED ACTION PLAN
- Estimate the likely increase in income
- Calculate the amount of tax that will become payable
- Establish the date the tax will become payable
- Determine what records will be required to support the valuation
- Discuss with your accountant possible ways by which the effect may be mitigated
- Calculate the amount of tax that will become payable
Willie MacKenzie is a chartered accountant and tax adviser specialising in hospital consultants. He can be contacted on 01483 419922, by email at wtm@accmac.plus.com or visit www.wesaveutax.co.uk
