Chris Thorpe offers an overview on the tax-efficient use of losses for tax purposes.
A major, yet fairly basic, part of income and corporation tax planning consists of the efficient use of losses, i.e. offsetting those losses against other profits. Many of the infamous tax avoidance schemes involved the (artificial) creation of losses to offset against other income and thus reduce or claim back tax.
Income and corporation taxes allow for losses incurred in the current year to be offset against profits and gains in the same year and carried forward to future years. However, it is important to consider what type of losses can be used. Those losses must come from a commercial source; losses derived from a hobby (which would, almost by definition, lead to the creation of losses) will not attract tax relief.
Commercial or a hobby?
So how does HMRC determine whether losses can be offset? Taking the rules contained within ITA 2007, s 66 (which are mirrored for corporation tax purposes), firstly the business from which the losses emanate must be run on a commercial basis; it must be run on sound and universally-recognised business principles, i.e. what would the average businessperson in the same line of work do? Secondly, and related to this, the business must be run with a view to ultimately make a profit.
The fact that plenty of money is involved and business is done on a large scale with numerous employees does not change the fact that, ultimately, the undertaking could still be a hobby. A classic example is illustrated by the case of Team Origin LLP v. HMRC [2017] UKFTT 378 (TC), whereby the LLP employed 67 people and operated out of offices in London, Portsmouth and Valencia; but that didn’t change the fact that, ultimately, it was operated to allow the principal member to enter his yacht in the America Cup. Though it incurred losses of £32 million within four years, the First-tier Tribunal agreed with HMRC that a profit was never going to be a possibility – a profit was never possible unless the race was won, and the outlay was always huge. Thus, there was no commercial basis to the undertaking – no one wanting to make a profit would be involved.
In another case (staying on the yachting theme), Roulette V2 Charters LLP v. HMRC [2019] UKFTT 537 (TC), the charter yacht was used primarily by one of the two LLP members; the yacht was in an individual’s name, it was used by him and his son during peak summer season, the website hadn’t been updated, insurance coverage was inadequate and all the losses were assigned to one member. HMRC also held that the member had under-estimated the depreciation of the yacht within the accounts, and as such, the correct level of depreciation would mean an accounts profit was never possible. The First-tier Tribunal held that whilst the LLP members’ intention to make a profit was sincere, their conduct was ‘amateurish’ and akin to a sandwich shop which was closed during lunchtime; the resulting losses were therefore disallowed.
Make a profit…or else!
Farming takes these rules and adds a degree of measurement to them. The legislation (at ITA 2007, s 67) addressing ‘hobby farming‘ expects a competent farmer to be able to turn a profit after five years’ activity and thus disallows losses to be offset against the sixth year’s profit. If a competent farmer is operating a type of farming which inherently requires longer to realise a profit, the five years may be extended. HMRC accept that stud farming (for example) often requires 11 years before being profitable.
Therefore, the losses which can be used against other income must be the produce of a genuine business – it needn’t be on a large scale nor even be immediately profitable; but the owner must intend for it to be profitable at some stage, and conduct themselves in a manner recognised by a competent businessperson engaging in the same trade.
