By Lee Sharp for Tax Insider
This article was first published in April 2020 in Tax Insider Professional newsletter - to start your free trial, click here
Lee Sharpe looks at the loss reliefs available on the commencement of a new business.
This article covers the key loss reliefs available to businesses on commencement:
- General sideways loss relief against total income (not available only on commencement).
- Opening years losses.
- Losses on incorporation.
- Transfer of trade under common beneficial ownership.
General sideways loss relief
Most practitioners will already be familiar with the standard income tax relief against general income for trading losses (ITA 2007, ss 64–66). The relief is very flexible and should not be overlooked simply because it is not exclusive to opening years.
Where the taxpayer makes a trading loss, either individual or in partnership with others, they can elect to set all of that loss (it is an ‘all or nothing’ claim) against:
- General income of the year of the loss.
- General income of the previous tax year.
- In either case, any excess loss not so relieved against the chosen year may then be applied against general income of the other tax year. This last is typically referred to as a ‘both years’ election but even so, the taxpayer must designate in which of the two years the losses must be relieved first (and so far as possible) before any surplus is then claimed against the other year.
Note that, while these must be losses arising from a trade, profession or vocation, it is not necessary for the trade to have been carried on in the previous tax year when claiming for relief to be carried back to the previous tax year. It is therefore potentially quite useful on business commencements.
Sideways loss relief may also be claimed against any capital gains made in the year of loss or previous tax year, effectively as an extension to a loss already claimed against general income in that tax year (TCGA 1992, s 261B). This is an optional extra claim, again ‘all or nothing’ once invoked.
Finally, there is a separate claim against general income that applies to losses arising in property businesses (ITA 2007, s 120). However, the claim is against general income of the tax year of the loss or of the following tax year. The relief is available only to the extent that the loss is attributable to capital allowances (or ‘agricultural expenses’ as defined) and is therefore of limited utility to most residential letting businesses.
Losses in early years
Losses in the first four tax years of the commencement of a trade, profession or vocation may be set against general income of the three tax years preceding the loss year, taking the earliest year first (the second year only if there are still unused losses available) and then the most recent year last.
This may seem quite generous, but note that the order is strict, and it is only losses in the first tax year that will be able to go back up to three tax years prior to the tax year of commencement; losses in the second tax year of trading will be able to go back to back only two tax years prior to commencement (and to the tax year of commencement itself).
While it is generally up to the taxpayer to choose the first accounting reference date, the commencement date and where it sits in that first tax year is a question of fact (that is once a taxpayer has decided to commence, the date is set). Even so, the selection of the ‘year-end’ can often influence the size of the loss attributable/apportioned to the commencement tax year; capital allowances can often also be varied to suit, as mentioned above.
Finally, note that pre-commencement expenditure is, strictly, deemed to have been incurred on the first day of trade (ITTOIA 2005, s 57), with similar provision for capital allowances qualifying expenditure incurred prior to the trade’s commencement (CAA 2001, s 12). In many cases, this can mean that very substantial losses can be deemed to have arisen over a very short period of time – or longer, if the taxpayer prefers.
Traps for the unwary
Beware that, for all these reliefs:
- losses are set against general income and can be quite wasteful in some circumstances
- reliefs are not available to trades and so on that have adopted the cash basis
- they are subject to the cap on ‘unlimited tax reliefs’ (at ITA 2007, s 24A), and can be further capped if the claimant is ‘inactive’ in the trade, broadly, spends less than ten hours a week on it (ITA 2007, s 74A)
- the trade must have been carried on (on) a commercial basis, with a view to the realisation of profit (ITA 2007, ss 66 or 74; see below) - but this last one does not apply to property losses set against general income
While these loss reliefs can be quite wasteful, note that any part of the loss attributable to capital allowances may usually be adjusted because the capital allowances regime affords wide discretion to disclaim (limit the amount claimed) from £0 to the maximum available. This applies to the standard writing down allowance and annual investment allowance claims (CAA 2001 ss 56(5), 51A(7) respectively), but not to balancing events.
Commerciality and view to a profit
Taxpayers who make successive claims for trading losses will often see HMRC challenge the commerciality or profitability of the venture – and particularly with successive commencement losses.
Note that the respective restrictions in the legislation for general sideways losses and for opening years losses are not the same. HMRC’s Business Income manual at BIM85735 states the section 74 requirement that “profits… could reasonably be expected to be made in the basis period or within a reasonable time afterwards” is actually a tougher test than the section 66 requirement to be carrying on a trade “so as to afford a reasonable expectation of profit” (ironically, that same guidance then goes on to recommend that HMRC officers challenging opening years relief under section 74 should also try to deny general sideways relief under section 66!).
The ‘reasonable expectation’ test has frequently entertained the tribunals, recently with a glut of tax avoidance scheme cases, and boat chartering – see, for example, Anthony & Anor (re TJ Charters LLP) v HMRC  UKFTT 9 (TC) and Roulette V2 Charters LLP v HMRC  UKFTT 537 (TC). Farming cases tend to orient around the specific rules designed primarily to prevent relief for ‘hobby’ farming or market gardening, at FA 2007, ss 67, 68.
Losses on incorporation
This is an unusual relief that risks being overlooked. It covers scenarios where either an individual or a partnership of individuals incorporates a loss-making business in exchange primarily for shares and those carried-forward losses would otherwise be unrelieved.
The individual’s (share of) losses notionally brought forward on incorporation can then be set against personal income from the company – salary, interest, rent or dividends – so long as the company carries on the transferred business and the individual retains all of the shares throughout the tax year in question. See HMRC’s guidance at BIM85060.
Transfer of trade under common beneficial ownership
An owner-managed business type trading company may get into difficulties, such that the trade succeeds to a similarly-owned company. So long as the underlying beneficial ownership of both companies is common as to at least 75%, the successor company may inherit:
- the former company’s trading losses
- its qualifying expenditure pool for capital allowances purposes
The beneficial ownership rules are generous and would be deemed to be 100% common when the ownership is transferred on succession between family members such as spouses or siblings, or to grandchildren.
However, the ‘inherited’ reliefs can be partly or fully restricted, broadly where the successor company does not take on all the original company’s relevant liabilities. Note that the treatment is mandatory where all criteria are satisfied, although it is frequently overlooked, despite potentially being quite valuable (CTA 2010, s 940A). See HMRC’s Company Taxation manual at CTM06000 et seq.
While advisers will be familiar with most (if not all) of the above loss reliefs, they are perhaps increasingly difficult to spot if taking on a new client without knowing some detail about their previous history – and bearing in mind that a client might not simply volunteer that they incurred substantial losses/failures in the past.