03 Feb When is a Loss Not a Loss
When is a loss not a loss for tax purposes?
COMPONENTS OF A BUSINESS
Where a business consists of various activities, of which one is loss-making, the ways in which losses may be taken into account for tax purposes depend on the nature of those different business elements. In particular, there’s normally a clear distinction between a trade and a property business.
In John Henderson v HMRC  (see Follow up ) the First-tier Tribunal (FTT) considered the case of a loss-making farmer whose trading income was supplemented by rental income that he received from a lease of part of his farm. The lease allowed the tenant to occupy the land and carry out quarrying operations, excavating gravel.
INCOME FROM PROPERTY
The taxpayer contended that his income from the tenant arose from exploitation of the farming land and should therefore be treated as part of his farming activity. He argued that it was akin to amounts received from wayleaves and should be included in his trading profits. If this was accepted, he would not have made farming losses.
The FTT noted that s.12 ITTOIA 2005 , which would allow the tenant’s quarrying concern to be treated as a trade, was of no relevance to the landlord. Furthermore, provisions in s.22 and s.273 ITTOIA 2005 allowing income from wayleaves or easements to be included in trading profits applied only where the taxpayer had certain rights falling short of full possession of the land.
LEASE V EASEMENT
By contrast, the tenant in this case had a lease entitling him to possession. It followed that the landlord’s receipts of rent were property income, separate and distinct from his loss-making farming trade.
One consequence of this decision was that the taxpayer had incurred losses in his farming trade. The tribunal agreed with HMRC that the taxpayer had not demonstrated that the trade was being carried out on a commercial basis, and upheld the adjustments to the tax returns – denying sideways loss relief.
RELIEF FOR TRADING LOSSES
If a person who carries on a business makes a loss from a trading activity, it’s possible to carry the loss forward against profits of the same trade in subsequent years or, to a limited extent, they may claim to carry the loss back against profits of the same trade in earlier years.
Alternatively, trading losses may be offset under s.64 ITA 2007 against other general income (or chargeable gains) received in the same year or the preceding twelve months, but s.66 ITA 2007 prohibits such sideways relief unless the trade is carried on throughout the basis period on a commercial basis and with a reasonable expectation of profit.
CAP ON RELIEF
For individuals, sideways relief for trading losses falls within the list of reliefs prescribed by s.24A ITA 2007 , the aggregate amount of which for a tax year (from 2013/14 onwards) cannot exceed the greater of £50,000 or 25% of the individual’s adjusted total income for the year.
THE HOBBY FARMING RULES
In the case of farming or market gardening, a further restriction may apply. If an adjusted tax loss (calculated without regard to capital allowances) has arisen in each of the last five tax years (as distinct from their basis periods), s.67 ITA 2007normally prevents the loss in the sixth year from being relieved sideways against general income.
Instead, the loss can only be carried forward to set against future farming profits. If a profit is made in any tax year (as distinct from its basis period), the five-year clock is reset.
LONG TERM VENTURES
Exceptionally, sideways loss relief may be available beyond five years where it meets a more stringent test set in s.68 ITA 2007 by reference to the “expectations of a competent farmer or market gardener” .
The test is met if a competent person carrying on the farming activities in the current tax year would reasonably expect future profits, but a competent person carrying on the activities in the last five years could not reasonably have expected the activities to become profitable until after the end of the current tax year. HMRC has published guidance on this inBIM85640 (see Follow up ).
HMRC recognises that certain specialised activities, for example stud farms, may take a long time to establish. It’s therefore accepted by concession that in such cases HMRC would not invoke s.67 ITA 2007 until eleven years after the start of the trade, rather than the usual five years. However the trade still needs to be run on a commercial basis and with a reasonable expectation of future profit (and be capable of being shown to be so) to withstand a challenge under s.66 ITA 2007 .
Pro advice 1. In some cases the hobby farming restriction might be circumvented by planning in advance to generate a profit in one particular tax year and thus reset the clock. This might be achieved, for example, by deferring unnecessary expenditure, or by timing crop or herd sales so that two years’ gross margins fall into one year.
Pro advice 2. When trying to generate a profit for a complete tax year (as distinct from its basis period), be aware of the potential impact of adjacent years’ losses as a result of the necessary apportionments. A change of accounting date might help achieve the desired result. Remember that any overlap profit will need to be considered.
Sideways loss relief may also be available beyond the five-year limit where the loss-making farm or market garden is part of, and ancillary to, a larger trading undertaking. This might apply, for example, where a butcher fattens bullocks for his business, or a seedsman or chemical manufacturer runs a farm for testing or improving their products. HMRC has published guidance on this exception at BIM85645 (see Follow up ).
Pro advice. Where a pre-existing farming or market gardening business has diversified, it’s unlikely to be seen as ancillary unless the diversified activity has become the main business and the original farming or market gardening activity now supports and serves the new diversified operation in a functional way.
CONSIDER THE WHOLE
In determining whether a competent person carrying on the farming or market gardening activities would reasonably expect future profits, or whether the exception for farming or market gardening carried on as part of a larger undertaking should apply, it’s necessary to consider the nature of the whole of the activities and the way in which these were carried on in the current tax year.
The distinction between trading and property income applies for corporation tax as it does for income tax.
The general scheme of loss reliefs available to companies is broadly similar to that for individuals, but the detailed rules and time limits differ. For companies there is no equivalent to the cap on otherwise unlimited tax reliefs, and so losses are potentially of more immediate value.
There are hobby farming rules for corporation tax purposes as well, and so companies carrying on farming activities could find losses restricted after five years.