It’s July, normally the start of summer holidays, and generally a time to relax and enjoy the weather. However, if you file a tax return, there is a good chance you will have received a letter from HMRC requesting a tax payment – that’s always enough to spoil a delicious Magnum.
You see, HMRC operates a system called Payment on Account (“POA”), which are interim payments in respect of your taxes. They request these payments every six months – on 31 January and 31 July. When the tax is finalised and filed for the tax year, these two payments are deducted from the balance, with this balance being due on following 31 January.
Why do they do this? The system is designed to smooth out your taxes and make the final balancing payment a little less of a shock. HMRC are all too aware that taxpayers are not always the best at saving for their taxes and without this system, they might find themselves asking for money the taxpayer no longer has. HMRC does not want to make you bankrupt if they can help it.
The other reason is less altruistic. A large chunk of their tax revenue is collected at source by employers using the PAYE system. This means HMRC has received the taxes within a month of the salary being paid. However, for taxes on other types of income, including self-employment income, are not due until the 31 January after the tax year end (the same day the tax return is due). So, for the year ended 5 April 2023, the taxes wouldn’t be due until 31 January 2024. Therefore, HMRC is waiting between 10 and 22 months to collect the taxes on the earned income. This is detrimental to their cash flow, and this is eased somewhat by POAs.
As an aside, self-employed people could have chosen a different year end to draw up their accounts to increase the time lag between the income being earned and the taxes being paid. For example, accounts drawn up to 30 April 2022 would still only need to be filed as part of the year ended 5 April 2023 tax return and, therefore, the wait for HMRC increases to between 21 and 33 months. This particular quirk is due to be closed shortly.
POAs are calculated based on the prior tax year, with 50% payable in the January during the tax year and the second 50% payable in July just after the tax year ends. Of course, this does create some issues. If your income increases, the payments on account will be insufficient and your balancing payment will be large and might still take you by surprise.
The alternative is that your income decreases and instead you end up overpaying. This can be remedied by electing to reduce your payments on account. However, as this might be somewhat of a guess, this can be risky as HMRC will charge interest where the POA have been excessively reduced.
There are some exclusions to the POA system. If the tax due is less than £1,000 there won’t be any POAs due. Also, if 80% of the total tax has already been collected via other means (usually via PAYE where the taxpayer has a main job and a side self-employment), the POAs won’t be due. Also, for reasons I won’t bore you with, student loan repayments and Class 2 National Insurance amounts are excluded from the calculation for the POAs.
One of the major headaches is for the first year you are pulled into POAs. Imagine the first year of your trade, the year ended 5 April 2023, you owe taxes of £5,000. This will be due on 31 January 2024. However, there will also be the first POA for the year ended 5 April 2024. This is calculated as 50% of the prior tax year, so you also owe £2,500 on 31 January 2024. This means you owe a total of £7,500 on 31 January 2024. Then, on the 31 July 2024 you have to pay the second POA of 50%, so another £2,500.
Now, the taxes due for the year ended 5 April 2024 turn out to be £8,000. The two POAs mean your balancing payment due on 31 January 2025 is £3,000 (£8,000 – (2 x £2,500)). BUT, don’t forget the first POA for the year ended 5 April 2025 is also due on 31 January 2025, and that will be 50% of the prior year, so another £4,000. Therefore, a total of £7,000 will be due on 31 January 2025. And on and on this process goes.
Eventually, as your income stabilises and the taxes become more regular, this lumpiness should diminish, but it very rare for a sole trader to have exactly the same profits year on year, so there will always be some sort of balancing payment or refund.
It is unclear whether the movement to MTD from April 2024 and the quarterly returns HMRC will required (see here for more info on that) will change the tax collection system. There has been nothing said yet, but it would not be that surprising if payments were required quarterly instead of half yearly. Either way, it is likely going to mean the tax payments will be more accurate as you’re less likely to overpay if you know your profit figure each quarter.
Finally, and something I stress to anyone just getting into business and entering the work of self-assessment for the first time (and sometimes people who have been doing it for years) – make sure you reserve for taxes. Even if you do nothing else all year, and manically rush to get your records together before the deadline, just make sure you have been squirrelling away tax money as you go along. The exact amount to reserve is hard to say as it depends on your year-end profits, but for those starting out a decent amount would be 25% of your income. It might not be the exact amount due once it’s all been calculated, but at least this stops the last-minute panic also mean looking for extra cash to pay the tax when you come to 31 January.
This is general guidance, with general examples, and does not constitute formal advice. Each taxpayer is different; therefore, we recommend that you consider your options carefully with an expert before taking any actions.
If you want to discuss any of the above, or any other matter, just give us a call on 020 7183 3383 or email info@kma-spotlight.com.
