Alan Pink looks at ways of achieving and maximising effective tax relief for irrecoverable loans to other businesses by individuals.
Always ready to tax you on any kind of profit or gain you’ve made, HMRC are much slower to allow relief for losses; a prime example is in the area of loans that an individual has made to someone else for the purpose of a trade, which turn out to be bad.
The rules for claiming relief on bad business loans are actually much freer and easier if you are a limited company than they are for an individual, who can only claim them against capital gains – and even then only if certain stringent criteria have been met, which are described below.
This is quite an important point to consider when someone has come to you and asked you to loan them money in order to start a trading business. If you are running a limited company yourself, this is one good tax planning reason why, instead of using your own funds to loan to the other person, you use funds in the company.
Loan or ‘equity’?
The restrictive nature of loss relief for a bad business loan, as a capital rather than ‘income’ loss, suggests strongly that you should be looking at other ways of structuring things, and perhaps doing a bit of lateral thinking at the same time, as in the following plausible scenario.
Example 1: If only it had been done differently…
Edwina is entering into a speculative property development, and approaches John for a loan of £100,000 to help her finance this. The arrangement is that, in return for his investment, John will receive interest equal to 25% of the profits of the development. John thinks this is a very good idea, and duly pays over the loan.
Unfortunately, during the excavations of the site to throw up the new block of flats, it is discovered that the ground is contaminated, and a huge amount of money ends up getting spent on decontaminating it. The result is an overall loss, and John doesn’t get any of his £100,000 back, let alone receiving any interest. This would seem to be a capital loss, and as John has no capital gains, and none is in prospect, effectively he gets no relief.
It’s almost a cosmetic difference, but if the arrangements had been accounted for as a joint venture (JV), with £100,000 from John being shown as his equity investment in the JV, he would be eligible for loss relief, effectively of £100,000, and this could be treated as a trading loss, available for offset against his other income. Really, this could be seen as being only fair, because John has entered into a trading enterprise and the commercial reality is that he is a joint venture partner.
However, if it has been accounted for as a loan, with the word ‘interest’ used, you can expect resistance from HMRC to any claim against income. It’s all about not just lateral thinking, but also presentation.
Capital losses
As I’ve commented already, the default position is that a bad loan to a trader is a capital loss (i.e. a loss that can be used against capital gains, and thereby reduce any liability to capital gains tax on those gains). Of course, some bad loans get no relief at all, in particular loans which don’t meet the criterion of being for the purposes of the trade. But there are other hurdles to jump, with a fall at any of them resulting in no tax relief:
- the borrower must be UK resident (I believe that this requirement applies at the time of the loan, rather than necessarily at the time it goes bad);
- the loan must not be a ‘debt on a security’ (i.e. it must not be assignable);
- the benefit of the loan must not have been passed on to anyone else between being made and going bad; and
- the loan must not have gone bad by reason of any act or omission of the lender.
This last requirement is certainly a major pitfall in many cases. If HMRC can argue that (for example) a creditor could have recovered the amount loaned by giving more support to the borrower, or alternatively if they could argue that the lender has not properly exercised his legal rights in trying to achieve repayment, relief can be denied, no matter how good the trading ‘cause’ was in which the money was lent.
Finally, of course, you can lose your entitlement under this rule (headed ‘Relief for loans to traders, and found in TCGA 1992, s 253) by simply omitting to claim the relief, or to claim in time.
‘Smart’ timing of loss relief claims
This brings us on to a rather more positive aspect of the planning situation for bad loans.
As with the relief against capital gains tax for assets which have become of negligible value, you have options as to when (i.e. in which year) you claim the relief; and this can make a lot of difference to how much tax you save as a result. Consider the following example.
Example 2: Timing of loss relief claim (1)
Gordon has been approached by his friend Henry with a proposition to start a new microbrewery. Henry needs another £10,000 to finance the set-up, which Gordon agrees to lend him. Unfortunately, Henry has a previously unsuspected tendency to ‘drink the profits’, and the brewing company goes bust, leaving Gordon and his £10,000 loan ‘out in the cold’.
When Gordon hears the bad news, he reviews his tax position. As it happens, he has made £10,000 of capital gains in the same year, from selling certain blue chip shareholdings. So on the advice of his accountant he does not put in a claim for the loss of the £10,000 loan to the brewing company. This would do no good, because it would only end up getting offset against the £10,000 gains in the same tax year, which are in any case covered by Gordon’s capital gains tax annual exemption.
The loan is still just as bad next tax year, of course, so Gordon claims it then, and because he has no gains in that subsequent year, it is available to carry forward and get some effective relief, hopefully, against any future gains he makes after that.
This is an example of careful timing of making the loss claim, taking advantage of the fact that you can effectively make such a claim, like a ‘negligible value’ claim, at any time after it has become bad. You are not restricted to making the claim in the year in which it is first seen to be bad.
Here’s another example of creative use of this flexibility on the timing of the claim.
Example 3: Timing of loss relief claim (2)
Clare is a business ‘angel’. That is, she has a fair amount of spare cash washing around, and is able to lend money to various businesses in order to give them a financial leg up. At any one time she will have a portfolio of ten or twelve such business loans, not all of which, of course, come good.
There comes a time when Clare decides to sell an investment property, and she realises a reasonably significant capital gain on that, of £200,000. In order to mitigate the tax on this gain, she does a careful review of her whole portfolio of business angel loans.
After careful consideration, she concludes that the loans to businesses C and G are irrecoverable, and in fact have both probably been irrecoverable for some years. She puts in a claim in the same year as the capital gain on the disposal of property, and thereby the loss is offset and reduces the immediate tax liability.
