Don’t lose out! Making best use of trading losses

Sarah Bradford examines the options for obtaining relief in respect of a trading loss.

While most traders would prefer to make a profit rather than a loss, where a tax loss is made the tax system offers options for relieving that loss.

As a general rule, the aim should be to obtain relief at the highest possible rate and as early as possible without wasting personal allowances.

The choices available depend on whether the ‘cash basis’ is used.

Option 1: relief against other income

The option to set the loss against other income of the same and/or previous tax year is a useful one, particularly if the taxpayer has significant other income which is taxable at the higher or additional rates of tax. This relief is also known as ‘sideways loss relief’.

The relief works by allowing the taxpayer to set the loss against other income of the current tax year and/or the previous tax year. Where a claim is made for both the current and the previous tax year, the taxpayer must specify which tax year takes priority. The loss must first be set against the first choice year, and any balance remaining after income for that year has been reduced to nil can be set against the second choice year – it is not possible to make a partial claim, for example, to preserve personal allowances.

It should be noted that a claim for sideways loss relief cannot be made where accounts are prepared using the cash basis.

Example 1: ‘Sideways’ loss relief

Kevin makes a loss of £20,000 from his gardening business in 2018/19. He has other income of £10,000 in that year. In 2017/18, he has general income of £35,000.

Kevin prepares accounts using the accruals basis.

For 2018/19, Kevin’s other income is fully covered by his personal allowance of £11,850. There is no point in him making a sideways loss relief claim for that year, as he would not save any further tax and his personal allowance would be wasted.

However, by claiming sideways loss relief for 2017/18, Kevin is able to set the loss of £20,000 against his general income of £35,000 for that year, reducing his income to £15,000. As this is more than his personal allowance of £11,500 for that year, making the claim will not result in his personal allowance being wasted.

Carrying the loss back against Kevin’s general income of 2017/18 will generate a tax repayment of £4,000 (i.e. £20,000 @ 20%).

It is possible that income for one year may be covered by losses from more than one year. In the above example, if Kevin had also made a loss in 2017/18, it would have been possible to make a claim to set the 2017/18 loss and the 2018/19 loss against general income of 2017/18. In this situation, the loss of the year of the claim takes priority.

Option 2: Extending relief to chargeable gains

It is possible to extend a sideways loss relief claim to include chargeable gains where a person does not have sufficient to offset the loss in full. This may be beneficial where a person has significant net capital gains in excess of the annual exempt amount.

However, if claiming an extension to chargeable gains results in the annual exempt amount being wasted, the extension is unlikely to be worthwhile. Again, this option is not available where the cash basis is used.

Example 2: Trading loss against capital gains

In 2018/19, Ruth makes a trading loss of £25,000. She has no other income for that year, but makes a gain of £40,000 on the sale of an investment property.

Claiming sideways loss relief for that year and extending the claim to include chargeable gains will reduce the chargeable gain from £40,000 to £15,000, leaving a gain of £15,000 before deducting the annual exempt amount for the year of £11,700.

By claiming relief in this way, she will save capital gains tax of £4,500 (£25,000 @18%).

Option 3: Carry forward of losses

Where relief for a loss has not been relieved under another provision, the loss can be carried forward and set against losses of the same trade. This option is available regardless of whether accounts are prepared under the accruals basis or the cash basis; indeed, unless early years or terminal loss relief is in point, it is the only way in which trading losses can be relieved where a cash basis election is in force.

Even if there are other options, carrying the loss forward may be preferable if, for example, making a sideways loss relief claim would mean that personal allowances are wasted.

Anti-avoidance provisions exist to prevent losses being used where there is a substantial change in the nature or ownership of the trade.

Example 3: Carry-forward of loss

Tim makes a loss of £30,000 in 2018/19 in his web design business. He prepares accounts using the cash basis.

In 2019/20, he makes a profit of £20,000.

The loss of £30,000 is carried forward. Tim elects to set it against the profits of 2019/20, reducing the profit for that year to nil. The balance of the loss of £10,000 is carried forward to set against future profits.

It should be noted that it is not possible to tailor the claim to preserve personal allowance. However, Tim could choose not to set the loss against profits of 2019/20, but to carry it forward to later years.

Trading losses in early years

Special rules apply to losses made in the early years of a trade. The rules allow a loss made in the tax year in which the individual first carried on the trade, or in any of the three succeeding years, to be relieved against total income of the preceding three tax years. The loss is relieved against an earlier year before a later year.

This relief is not available where a cash basis election is in force.

Carrying back the loss relieves the loss at the earliest opportunity and can generate a tax repayment.

Example 4: Loss in first year of trading

David was previously employed on a salary of £50,000 per annum for 2017/18, 2016/17, and 2015/16.

He sets up a business as a carpenter in 2018/19 and makes a loss in his first year of trading of £20,000.

He anticipates making a profit in the following year of £10,000. David can elect to carry this loss back three years against his income of 2015/16, generating a tax repayment for that year.

Terminal loss relief

An additional relief is available for the loss made on the cessation of the business (known as a terminal loss relief).

A claim for terminal loss relief can be made if the person permanently ceases to carry on a trade and makes a terminal loss. The terminal loss is the loss made in the period beginning at the start of the final tax year and ending with the date of cessation plus any loss in the previous 12 months that falls into the previous tax year.

The terminal loss may be relieved against the profits of the trade for the final tax year and previous three tax years. Relief is given against a later year before an earlier year.

Losses and capital allowances

Capital allowances are treated as part of a trading loss for loss relief purposes, and care should be taken to determine whether it is beneficial to claim capital allowances or not.

Not claiming capital allowances (or claiming a writing down allowance instead of the annual investment allowance), thus reducing the amount of the loss, may leave the taxpayer better off by allowing personal allowances to be preserved.

Capital allowance claims are not ‘all or nothing’ claims, and the capital allowances claim can be tailored according to the circumstances to achieve the best possible result.

Remember the loss relief cap

Relief for certain losses is capped each year at the greater of 25% of income and £50,000. The cap applies to various types of loss relief and to relief for qualifying interest.

Practical Tip:

The options available for relieving losses depend on whether a cash basis election is in force or not, and also on whether the loss is incurred in the opening or final years of the trade. Crunch the numbers to see which option gives the best result.