Saturday morning. Between sleeping and waking, you hear the rattle of the letterbox coming to you from downstairs, indicating that the postman has been. Who can ever resist that invitation?
Donning your dressing gown, you trudge blearily down the stairs and find a brown envelope, marked “HMRC” on your doormat. Your heart sinks, but having feverishly torn open the envelope to find out the worst at once, your mood suddenly experiences a change. It’s a big fat cheque from the taxman, with your name on it.
Anyone who has experienced the joy of turning the tables on HM Revenue & Customs in this way knows that it is an experience they would like to repeat. This article gives you some pointers on how you might be able to do just that.
The successful entrepreneur, whose business is making money, might be tempted by the title to skip this article. Loss relief is for losers. I would counsel against it, however, because, as you’ll see if you read on, the types of planning actions advocated here can be particularly appropriate for people whose business profits, and personal income, are high. Basically, it’s a call to think again, and have another look at what you’re doing both in and out of the office to see whether you can get that cheque on its way to you in the post.
The Government’s aim, in giving relief for tax losses, is obviously to introduce some semblance of fairness into the system, and relief for trading losses is actually a very powerful tax planning tool. The tax avoidance industry appreciates this point very well, unfortunately. I say “unfortunately”, because the industry that has grown up, of creating “losses” that arguably aren’t really losses at all, in order to take advantage of the tax relief, has led to some punitive restrictions being introduced into the legislation recently. But more of that later.
Let’s, first of all, consider how trading losses can be used. If you incur the trading losses within a limited company, these can be offset against the company’s other income, or capital gains, in the same period or the previous period. A restricted amount of losses, for a temporary period, can be carried back to earlier years, but this isn’t quite the bonanza it seems in practice. Any losses that the company can’t use in this way are carried forward and can be offset against future profits, but only ones arising from the same trade.
It may be worth saying something, here, about the practice of buying companies with brought forward losses. In its simplest form, this tax dodge enables you to put your profitable trade into a company that you bought from someone else, and avoid paying tax on your profits as a result of a loss they made whilst the company was in their ownership.
Treat this with extreme caution. The Revenue don’t like the practice of purchase of trading losses, and there is, in consequence, a fairly difficult restriction on the availability of brought forward losses in these circumstances. Where there is a major change in the conduct or nature of the trade, or where not all of the liabilities, resulting from those previous losses, have been taken over into the new set-up, you can lose the benefit of the loss relief. You should definitely take with a pinch of salt any suggestion that you should pay money for the benefit of losses in a company whose shares you are buying.
Moving on to losses incurred personally, these tend to be very much more useful in practice. Relief can be claimed against your other income, from whatever source, of the same year as the loss or the preceding year. Loss relief can similarly be claimed against capital gains, which is likely to be more useful now that the top rate of capital gains tax is 28%.
If the loss is made in the first four years of carrying on a trade, this can be relieved by way of carry back three years on a “first in, first out” basis. So, if you make a loss in 2011/12, for example, you can claim to offset that loss against your 2008/09 income from all sources. If the loss is big enough to eliminate all of your income for that year, it gets carried forward and offset against 2009/10, and so on.
Relief against other income is referred to by the Revenue as “sideways loss relief”, and it is this relief which has been massively exploited by the promoters of schemes. Usually the schemes involve some kind of borrowing, whereby you put, say, £20,000 into the scheme and borrow another £80,000. Predictably, the £100,000 investment you’ve made into the “trade” that the promoter has set up gets lost, and so you claim relief for a £100,000 loss. If you are a 40% taxpayer, this means you get £40,000 back from the taxman, having actually only ever laid out £20,000 in hard cash. One way or another, the £80,000 you have borrowed never ends up getting repaid.
Because of schemes like this, recent legislation has been passed restricting relief for “non-active” sole traders or partners to £25,000. To be an active trader, you need to devote at least 10 hours a week on average to the trade. So all of these schemes, which involve the punter being a passive investor, effectively, in a trade organised by someone else, are now limited to tax relief that is chicken feed in relation to the numbers one used to be talking about.
On the principle of telling the whole story, warts and all, I’ll also make the point, here, that if you are a member of an LLP or limited partnership, your available losses are restricted to the amount of capital injection into the business that you use against the losses. On the face of it, this might imply that, if your capital account pre loss is £50,000, you can only have £50,000 relief even if the actual loss available for relief in the LLP is £100,000. Actually, though, this common view is mistaken. If you are willing to have the full £100,000 debited to your capital account, with the result, in our example, that you become £50,000 overdrawn, you can, we think, offset the whole £100,000 loss. The cost of doing so, of course, is that your limited liability is compromised to that extent: if the LLP were to go bust, the amount you owe on capital account would be called on by the liquidator.
Having said that, I think I have exhausted the negative side of the rules. Now let’s look at the positives.
Firstly, the existence or otherwise of relievable losses can depend on how you structure the business. If you simply have one trade in a single trading entity, and overall the trade is profitable, you clearly have nothing to form the basis for a loss relief claim.
However, it’s not difficult to be a bit more creative than that, in your business structuring thinking. Separating out part of the trade, whether or not this is a distinguishable type of activity from the main trade, can result in that separate part showing losses, perhaps especially in the earlier periods. It’s obviously easiest if this separated out part of the trade has some distinguishing feature, like representing a new geographical market for your goods or services, or any new type of service, or a new physical location from which it is carried out. This will make the accounting easier, and also avoid possible issues of the goodwill of the business having been moved from one entity to another – which in itself can sometimes give rise to tax problems. However, if you don’t have any rationale for separating out part of the business in this way, the idea isn’t necessarily without mileage. You just have to be a bit more careful in your accounting and in the transactions you enter into to bring about the separateness.
So let’s imagine you’ve identified how you are going to hive off a separate business unit from your main business. Or, perhaps, you are looking at an entirely new business in any event, albeit using part of the financial resources of the old business to fund the set-up costs. How should things be structured to maximise the opportunity for personal loss relief?
Normally speaking, how not to do it is simply to set up the new arrangement as a division of an existing limited company. The losses of the separate activity are swallowed up in the overall profitable trade. No, instead you should consider setting up the business in a separate entity such as a partnership, sole trader, or LLP. Set up losses are then available either for the general loss relief against other income of the current or previous year, or against income from three years back under the early years loss relief provision.
So here’s the first instance of the alchemy referred to in the title of this article: what might, without intelligent structuring, have been just an ingredient in the overall costs of a profitable trade, carried on in a company, becomes personal losses available for immediate relief. As with all the sideways loss relief rules, you have to show that the trade concerned has been carried on on a commercial basis with a reasonable expectation of profit, but having got over that hurdle, all you need to do is sit back and wait for the HMRC cheque. I’m taking for granted, in all of this, that the rates of tax you will have paid as an individual are higher than those in the company, and in any case it’s nice to have a personal cheque rather than putting the losses into the company and reducing the corporation tax cheque the company pays over to the taxman.
To sum up, I believe the most important secret in the loss alchemist’s art is getting the structure right. But there are two other aspects of the rules that you should be aware of, and take the necessary action, in order to maximise your relief.
The first of these is the question, that everyone should ask themselves, as to when a hobby turns to a commercial trade. This is particularly the case with “hobby farming”, but applies to a vast number of spare time interests as well. If your hobby is travelling, for example, why not become a professional travel writer? If you’re into music, why not launch a record label, etc., etc.? Once you’ve reached the stage of being able to show that the hobby has turned into a commercial business, all the expenditure you may have incurred on travelling, equipment, and so on, becomes fodder for a loss claim against other income and gains.
The other point to be aware of is the fact that you can sometimes show a tax “loss” even when you haven’t actually made a loss, in accounting terms, at all. The prime example of this is where you’ve bought some kind of equipment in connection with the separate activity, and have been able to claim accelerated tax depreciation, or capital allowances, on this expenditure. In some cases, 100% relief is available in the first year in which you buy the equipment concerned, which might be a vehicle, computer equipment, or more specialised plant and machinery. You haven’t actually made a real loss in this situation, of course, because you have an asset which will hopefully be good for many years use. But, from the tax point of view, you are treated as if the capital cost is a dead loss in year one. So if this generates a start up loss, as it seems likely to do in most circumstances, the start up loss, in the right structure, can then release repayments of a lot of tax that you have paid over the last few years.
I hope, then, I’ve said enough here to show that loss relief isn’t just for losers. Instead, it can be more like a way of bringing the taxman in as a capital contributor to your business or personal finances. It all comes down to thinking intelligently about what you’re doing and, of course, making sure you have the right advice before jumping in a certain direction, rather than after.