Tax relief for losses and loan releases

The COVID-19 outbreak had a huge impact on the economy that is still being felt now. Sadly, in a tough economic climate, some business owners and investors will fall into a loss position. A small bit of good news is that you can often claim tax relief for losses, although there are a number of conditions to be met before a valid claim can be made.

It is important to be aware of when loss reliefs can be claimed, and how to claim them most effectively. We list below when the main reliefs apply, and their benefits.

Trading losses – income tax

Businesses that operate as a ‘sole trade’ of the owner or group of owners in partnership (i.e. without a separate company or other business entity) have to claim for any losses under the income tax rules. Once a trading loss is established for a tax year, this can be claimed against other non-trading income the individual has in the year, reducing the tax due on it and generating a repayment where tax has already been paid at source on it. In addition, if there is excess loss available, this can be claimed against the individual’s other income in the prior tax year. Once the other income has been relieved, any remaining loss can be set against capital gains in the same or prior tax year. After all these options for relief have been used, any remaining loss can only be carried forward to set against trade profits of future years.

There are special rules for losses made in the first four tax years of trading (they can be carried back up to three tax years to set against other income in those earlier years) – similar rules apply in the final/cessation year of trading. All same year or carry back loss claims must be made within 12 months of the tax return filing deadline (31 January) for the tax year in which the loss arose: carry forward claims must be made within four years. 

Restrictions

Sideways loss relief against income is within the general limitation of income tax reliefs, which restricts total relief in a year to the greater of £50,000 and 25% of ‘adjusted total income.’ This is subject to a small number of exceptions. For uncommercial trades (eg hobbies where there was no reasonable expectation of making a profit in the first place) there is no sideways loss relief available.

Property losses

The COVID-19 lockdown led to many landlords losing rental income and seeing asset values decline. For investors who own and let property without using a corporate entity, if they make a loss for the tax year, the loss is automatically carried forward and set against profits of the same property business in a later tax year. For this purpose, all UK property interests constitute a single ‘property business’, and foreign property interests constitute another separate business. Property partnerships each constitute separate businesses.

While lettings that meet the furnished holiday lettings tests are technically part of the owner’s property business, losses can instead be relieved under the trade loss provisions.

Where the owner’s borrowing on the let property gives rise to excess interest (ie more than the rents received) the excess is treated is a ‘tax reducer’, and unrelieved interest is carried forwarded separately.

Loans and debts

With so many small businesses struggling, it is important to look at how loans and debts that become irrecoverable are treated for tax purposes.

Standard rules

For tax purposes, a debt or loan is an asset of the lender – so they normally fall within the capital gains tax (CGT) rules. However, the basic rules treat a ‘simple debt’ as an exempt asset for CGT purposes – so no loss relief is available if the debt becomes irrecoverable. For example, foreign currency bank accounts are usually treated as simple debt and therefore exempt.

Second hand debts, ie purchased from the original lender, are subject to the normal CGT rules but, in practice, the CGT base cost will in most cases be the value of the debt on its acquisition, which will reflect any impairment (risk of loss) at that time. Debts on security (eg loan notes) also fall within the normal CGT rules, unless they are exempted as ‘qualifying corporate bonds’.

Special debts

Where an individual has lent funds to a sole trader or partner to use in their trade, the lender may claim a loss for CGT purposes if the loan become irrecoverable.

However, where a company has lent money to a shareholder (or an individual with another interest in the capital of the company), writing off the loan – ‘releasing’ it - will be treated as a taxable distribution by the company and taxed as a dividend, and National Insurance Contributions may also be due. Alternatively, if the loan is extended and remains outstanding nine months after the year end without interest being paid, the borrower may be subject to an income tax charge on the ‘beneficial loan’ deemed interest.

Inter-company debts are dealt with under the corporation tax ‘loan relationships’ rules. This is a complex area, and it is important to consider the company’s position before releasing a debt with a corporate borrower. For example, where the companies are not within the same group, if a loan is written off and value passes out of a company/group as a result, that could be treated as a distribution to common shareholders and, therefore, taxable as a dividend.

Legal position

It is important to remember that ‘writing off’ a debt is purely an accounting concept, with no legal effect. Legal steps must be taken to formally release the debt, or it will remain enforceable on the borrower; such steps include executing a deed of release or entering into a contractual settlement.

Capital losses

Losses realised on other assets, eg stocks and shares, usually fall within the CGT rules once the asset has been disposed of.

Standard rules

Losses are firstly set against gains realised in the same tax year with any excess losses carried forward and set against the first available taxable gains (ie gains exceeding the annual exemption) in future tax years. Losses claimed in a year are set firstly against gains chargeable at the highest rate.

Special cases

If you realise a capital loss on a disposal of EIS/SEIS shares or shares in an unquoted trading company for which you subscribed, you may be able to claim relief for the loss against your income.

If you make a capital loss on the sale of an asset to a connected person (calculated with reference to the market value of the asset), relief for the capital loss is restricted to capital gains arising on the disposal of other assets to the same connected person. Therefore, you might consider selling the asset at a loss to a third party, and gifting cash to the connected person instead.

Where an asset you own has become of negligible value (i.e. ‘worth next to nothing’) you may be able to crystallise the capital loss and claim relief for up to a year before your actual disposal of the asset. 

On the sale of a company, it is common for part of the consideration to be in the form of an ‘earn-out’, ie deferred consideration to be paid at a later date. If this right become irrecoverable, the holder may be able to claim relief for its loss, but the precise mechanism for relief will depend on whether the earn-out was ‘ascertainable’ or ‘unascertainable’ at the time of the original disposal.

For partnerships, capital disposals can accrue to a partner on a disposal of an asset by the partnership or on a disposal of all or part of their partnership interest, including on changes in profit-sharing ratios. If, on a withdrawal from partnership or cessation of a partnership, a partner’s initial ‘investment’ is not wholly returned to them, whether they receive relief for that loss will depend on the legal nature of that investment.

Making your loss claim

There are various deadlines and administrative requirements to make loss claims – for example, it is frequently required that a self-assessment tax return is submitted to substantiate the claim. For this reason, if you have a loss for the 2022/23 tax year, submitting your tax return well before the deadline (31 January 2024) will be sensible to speed up any tax refund due.

For help and advice on loss claims, please get in touch with your usual BDO contact.