Businesses frequently make losses in their early years. Start-up businesses may have to incur expenses long before any earnings arise, leading to trading losses. For tax purposes, these losses may be increased in the UK by capital allowances on the purchase of assets for the business, especially if the assets qualify for the 100% first year allowance for energy saving and water efficient technology. The annual investment allowance, reduced to £25,000 for 2010/11, also provides some tax relief for small businesses.
Loss relief for an unincorporated business
Where an unincorporated business incurs a trading loss, this loss can be carried forward and offset against future profits of the same trade. This same trade rule is strictly enforced so where one trade stops and another is started by the same person the losses of the previous trade cannot be carried forward. Where the same person is carrying on two trades, a loss of one trade cannot be carried forward against the future profits of the other trade.
The trader is not given any choice of which future profits can be relieved by the loss and cannot elect to only offset part of the loss. This means that the carried forward losses may reduce trading profits for future years but at the same time may cause the trader’s personal allowance (the annual tax exemption which is £6,475 for 2010/11) to be wasted. If the tax loss includes capital allowances on assets purchased, the situation may be improved by disclaiming the capital allowances in the year, postponing some of the tax relief until later years.
Trading losses can also be offset against the total income of the trader for the tax year in which the loss occurs or for the previous year or for both years. The losses can for example be offset against savings income or any employment income received in the current or previous year. The trading loss for a tax year (to 5 April) is normally defined as the trading loss for the “basis period” (normally the accounting year) that ends within that tax year. This loss relief must be claimed by the 31 January of the second tax year following the tax year of the loss.
The loss cannot be set partially against the losses for both years. The loss must be relieved against the total income of one of the years and then if the taxpayer chooses the remainder of the loss (if any) can be offset against the total income of the other year. To offset the losses against the total income of the previous year it is not necessary for the trade to have been carried on in that previous year. Losses still unrelieved after the claim for relief against total income of a year may also be offset against capital gains for that year, at the taxpayer’s discretion.
When considering this loss relief, the trader should be careful not to waste the personal allowance for one or both years. This may affect the calculation of where to offset the loss. In looking at the possibility of offsetting the loss against capital gains, the trader must consider the availability of capital losses, which can first be offset against capital gains, and should be careful not to waste the capital gains annual exemption.
Losses that are incurred in the first four tax years after the commencement of a trade can be used in more ways than other losses. The UK tax law provides for such losses to be carried back and offset against the trader’s income for the previous three years. As the losses can be offset against the total income of the trader, this means that a person who was previously receiving employment income before starting the business can offset the trading losses against that income, resulting in a tax repayment. This is the most valuable loss relief for a business in the opening years.
An extended loss relief introduced during the recession allows losses incurred in tax years 2008/09 and 2009/10 to be carried back against profits of the same trade in the previous three years. They must be offset against profits of a later year before those of an earlier year. Although the loss carry-back to the previous year is unlimited, the carry-back to the other two years is limited to £50,000 in total.
Where a business ceases to trade, making a loss in the final period, it may be possible to obtain a tax repayment. Losses in the closing twelve months of a trade can be carried back against trading profits of the year of cessation and the previous three years.
Corporation tax loss relief
Where an unincorporated business is transferred to a company, in exchange for shares in the company, any unrelieved trading losses of the business can be carried forward and offset against the company’s trading profits provided that the company continues the same trade.
Where a company makes a loss in an accounting period, this loss can be carried forward and offset against future profits of the same trade. A company can also elect to offset trading losses against profits of the same accounting period. Any losses remaining after being offset against the profits in the same year can be carried back against profits of the previous twelve months if the company chooses to do so. Any remaining losses after this can still be relieved against future profits of the same trade.
The carry-back of loss relief for companies was extended for companies during the recession. Trading losses for periods between 24 November 2008 and 23 November 2010 can be offset against the company’s profits in the previous three years. The amount of loss that can be carried back to the previous twelve months is unlimited but the amount carried back to the two periods before this is limited to £50,000 in total.
HM Revenue and Customs www.hmrc.gov.uk
“Taxation” by Alan Meville, fifteenth edition, FT Prentice Hall 2010