BIM81320 - Transitional rules: calculating the income tax liability on the transition profits

S23 of Income Tax Act 2007 sets out the calculation of income tax liability.

To calculate the income tax liability for a tax year where an amount of the transition profits has been treated as arising, the steps in section 23 ITA 2007 are modified. This will apply for tax years 2023-24 to 2027-28.

The transition profits are excluded from the net income amount to reduce the impact on benefits and allowances. However, the tax that would have been charged on them had they been included in the net income amount is added to the tax calculation instead.

The calculation must be amended as outlined below:

i)	At Step 1 of the s23 calculation, transition profits are to be identified and treated as a separate component of total income, “the transition component”.
ii)	Apply Step 2 as normal by deducting from the components, including the transition component, the amount of any relief under a provision listed in section 24 to which the individual is entitled for the tax year. However, you should then exclude the transition component from the sum of the amounts of the components left after this step. This total is the “net income”. Follow Steps 3 – 5 of the s23 calculation as normal to give amount A.
iii)	Prepare a notional calculation with the same amounts of income at Step 1, and the same deductions made at Step 2. For this notional calculation only, include the amount of transition profits in “net income”. Follow Steps 3 – 5 of the s23 calculation as normal to give amount B. Note that the amounts of allowances given at Step 3 may be different, as these will be based on this notional value of “net income”.
iv)	Calculate the difference between amounts A and B, amount C. Treat amount C as an amount of tax calculated at Step 4 of the s23 calculation.

Example 23 – calculating tax on transition profits

A trader has standard profits of £20,000 and transition profits of £8,000 for 2023-24. The amount of transition profits treated as arising in each of the tax years from 2023-24 onwards is £1,600 (£8,000 x 20%). They also have £3,000 of trade losses carried forward from the previous year. The trader is entitled to their personal allowance of £12,570. They have no other income.

The income tax liability on the transition profits is calculated as follows:

i): The two components of “total income” are:

Standard profits £20,000
Transition profits £1,600

ii): Calculate A – do not include transition profits in net income

Component of total income	Standard profits	Transition profits
Profits	£20,000	£1,600
Less trade losses c/f	(£3,000)
Revised profits	£17,000	£1,600
Net income	£17,000 (Not including transition profits)
Deduct personal allowance	£17,000 - £12,570 = £4,430
Calculate tax liability at 20%	£4,430 x 20% = £886 (A)

iii): Calculate B – include transition profits in net income

Component of total income	Standard profits	Transition profits
Profits	£20,000	£1,600
Less trade losses c/f	(£3,000)
Revised profits	£17,000	£1,600
Net income	£18,600
Deduct personal allowance	£18,600 - £12,570 = £6,030
Calculate tax liability at 20%	£6,030 x 20% = £1,206 (B)

iv): Calculate the difference between amounts A and B to give amount C. Treat amount C as an amount of tax calculated at Step 4 of the s23 calculation.

The difference is £1,206 - £886 = £320. This is the tax liability for the transition profits.

Example 24 – calculating tax on transition profits, notional net income above £100,000

A trader has standard profits of £98,000 and transition profits of £20,000 for 2023-24. The amount of transition profits treated as arising in each of the tax years from 2023-24 onwards is £4,000 (£20,000 x 20%). The trader is entitled to their personal allowance of £12,570. They have no other income.

The income tax liability on the transition profits is calculated as follows:

i): The two components of “total income” are:

Standard profits £98,000
Transition profits £4,000

ii): Calculate A – do not include transition profits in net income

Component of total income	Standard profits	Transition profits
Profits	£98,000	£4,000
Net income	£98,000 (Not including transition profits)
Deduct personal allowance	£98,000 - £12,570 = £85,430. The full amount of the personal allowance is deducted as net income is below £100,000.
Calculate tax liability at 20% for the first £37,700 above the personal allowance	£37,700 x 20% = £7,540
Calculate tax liability at 40% for the remaining income	£47,730 x 40% = £19,092
Total tax liability	£7,540 + £19,092 = £26,632 (A)

iii): Calculate B – include transition profits in net income

Component of total income	Standard profits	Transition profits
Profits	£98,000	£4,000
Net income	£102,000
Deduct personal allowance	£102,000 - £11,570 = £90,430. The personal allowance is reduced as the net income is above £100,000.
Calculate tax liability at 20% for the first £37,700 above the personal allowance	£37,700 x 20% = £7,540
Calculate tax liability at 40% for the remaining income	£52,730 x 40% = £21,092
Total tax liability	£7,540 + £21,092 = £28,632 (B)

iv): Calculate the difference between amounts A and B to give amount C. Treat amount C as an amount of tax calculated at Step 4 of the s23 calculation.

The difference is £28,632 - £26,632 = £2,000. This is the amount of tax due on the transition profits.