- Essential Tax Information
Featured tax guide:
small business tax cover image

Self Employed Businesses

How to Cash in Overlap Relief

MANY SOLE traders and business partners have a special tax relief just lying in wait ready to be used when the moment is right. It’s called ‘overlap relief’.

Almost everyone with an accounting date other than 31st March or 5th April will have an entitlement to overlap relief and can ‘cash it in’ any time they choose.

For the latest information on this subject, browse our tax guide for sole traders

Why Hasn’t Everyone 'Cashed In' Their
Overlap Relief Already?

There are two ways to gain access to your overlap relief: cease trading or change your accounting date.

Ceasing to trade is a drastic step: generally not something you are likely to do purely for tax planning purposes. However, it is worth noting that transferring your business to a company is also classed as ‘ceasing to trade’ for these purposes.

Changing your accounting date to access your overlap relief is less drastic, but the downside is that the relief only arises where you are being taxed on more than twelve months’ worth of profit. Despite this, however, there is still generally an overall saving to be made where current profits are at a lower level than the profits arising when the ‘overlap’ first arose. So, with the economy in the state it’s in, now could be a good time to ‘cash in’!

Nikita is a sole trader and runs a business importing novelty costumes and accessories. She commenced trading on 2nd July 2003 and drew up her first set of accounts to 30th September 2004. These showed a profit of £100,000.

For 2003/4, Nikita was taxed on the proportion of her profits falling into the year ended 5th April 2004. On a simple time-apportionment basis, these amounted to £61,050.

For 2004/5, Nikita was taxed on a further twelve months’ worth of profit based on the same accounting period: £80,088.

Hence, although the profits for her first period were just £100,000, Nikita was taxed on a total of £141,138. This created an ‘overlap’ of £41,138 and this is the amount of relief which Nikita will have available to use at some point in the future.

Nikita retains her accounting date of 30th September for several years. In the winter of 2011/12, however, she suffers some very poor trading conditions. The profit of £120,000 which she made in the year ended 30th September 2011 is followed by a profit of just £5,000 in the six months to 31st March 2012.

If Nikita retains her 30th September accounting date, she will be taxed on a profit of £120,000 in the 2011/12 tax year.

If, however, she prepares accounts for the 18 month period ending 31st March 2012, she will be able to reduce her taxable profits for 2011/12 to just £84,956. This will save her a total of around £18,000 in Income Tax and National Insurance.

How? Although this longer accounting period means that she will be taxed on the additional £5,000 profit to 31st March 2012, she will also be able to claim overlap relief of £40,044 (£120,000 + £5,000 - £40,044 = £84,956).

How Is This Done?
Nikita’s first accounting period ended 30th September 2004 lasted 457 days. In 2003/4, she was taxed on 279 days’ worth of profit and, in 2004/5, on 366: a total of 645. Hence, this created 188 days of overlap (645 – 457 = 188).

Nikita’s most recent accounting period was extended by an additional 183 days and all of the profit arising was taxable in 2011/12. She is therefore able to claim relief for 183/188ths of her original overlap: £41,138 x 183/188 = £40,044.

Daily Profit Rate
To decide whether a long accounting period such as the one Nikita used will yield overall savings, we need to compare the daily profit rate in the period when the overlap arose with the daily profit rate in the period by which the accounting period is extended. If the rate in the overlap period exceeds the rate in the extension period, the overall taxable profit will be reduced, thus yielding tax savings.

In the 457 days to 30th September 2004, Nikita’s daily profit rate was £218.82 per day (£100,000/457). In the 183 days to 31st March 2012, it was just £27.32 per day (£5,000/183). Hence, she was reducing her taxable profits by £191.50 (£218.82 - £27.32) for each additional day by which she extended her accounting period.

Saving It For Later
Many sole traders and business partners prefer to hang on to their overlap relief and save it for when they retire, or sell their business. Their logic is that they will need the saving produced by the relief at that time.

Personally, I feel that this view is flawed. A more sensible approach is to ‘cash in’ the relief when it is worth the most.

Certainly, one should wait until there is a saving to be made: either a dip in the daily profit rate below the rate applying at the time that the overlap arose, or a significant increase such that a transfer of the business to a company makes sense.

Apart from this, however, there are two other factors which should be taken into account: inflation and tax rates.

Tax Rates
When Nikita ‘cashed in’ her overlap relief, she was able to save Income Tax at 40% and National Insurance at 2%. Additionally, she saved a further £2,990 in Income Tax because her overlap relief reduced her taxable profits below £100,000 and her personal allowance for 2011/12, which would otherwise have been withdrawn, was restored.

These savings are substantial and it would be hard to see how Nikita could save her overlap relief for a better time.

For many people, however, the daily profit rate in the overlap period is much lower and this effectively means that they will need a daily profit rate in the ‘extension period’ which is so low that they would be a basic rate taxpayer. At current tax rates, the saving arising by ‘cashing in’ their overlap relief would be at just 29% (20% Income Tax plus 9% National Insurance).

Even so, the question remains ‘will there ever be an opportunity to cash in the overlap relief at a higher effective rate?’ If profits increase and they become a higher rate taxpayer, their only opportunities will be on retirement, sale, or a transfer to a company.

If profits reduce or remain similar, their potential savings will not improve and, if they wait until after state retirement age, there will be no National Insurance savings.

The other important factor to consider is the fact that inflation is eating away at the value of your savings. Suppose you have £10,000 of overlap relief available and you could ‘cash it in’ today with an effective saving at 29%, i.e. £2,900.

Instead, you wait until retirement and ‘cash in’ your overlap relief then. Based on current tax rates, this will yield savings at an effective rate of either 29% or 42% if you have not yet reached state retirement age, or perhaps 20% or 40% if you are over state retirement age at that time.

But, if that is twenty years from now, how much is that saving worth in today’s terms? Assuming an average inflation rate of 3.5%, even the maximum £4,200 saving would only be worth £2,111 in today’s terms. Worst of all, for a basic rate taxpayer over state retirement age, the saving of £2,000 would be worth a pitiful £1,005 in today’s money.

In other words ....
For most people, saving their overlap relief until some uncertain date in the future is a case of 29% in the hand versus 42% in the bush. I know which one I would choose!

Creating a Cessation
Another good way to access overlap relief is to transfer the business to a company, or ‘incorporate’, as it is often termed.

Let us suppose that, in our main example, Nikita expected a sensational increase in her profits after 30th September 2011 instead of a reduction.

If she had transferred her business into a company on 1st October 2011, she would be able to claim all her available overlap relief (£41,138) in 2011/12, possibly saving her as much as £20,268 in Income Tax and National Insurance.

All of the available overlap relief may be claimed under these circumstances, regardless of the length of the final accounting period as a sole trader.

Incorporation has many other tax implications, of course, but most of these are advantageous where a large increase in profit levels is anticipated.