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Completely at a Loss?
by David Whiscombe
Published in Taxation magazine
Gloom and doom – it seems to be all around, particularly in the property sector: which set me thinking about losses and in particular, property income losses.
How can you make use of them? Curiously, both the computation and use of these losses varies according to whether the business is conducted through a corporate or a non-corporate vehicle. Indeed even the name is different – companies still have the traditional Schedule A while non-corporates have “income from a property business”. The rules governing each unfortunately seem to owe a little less to common sense than one might have hoped.
Non-corporates
Let’s look at non-corporates first. This term includes individuals either acting solely or in partnership (including a Limited Liability Partnership) but also companies resident outside the UK which have a UK property business.
For these non-corporates, interest on borrowings to buy property or on loans to fund repairs, improvements or alterations is an expense of the property income business as is interest payable on an overdraft or hire purchase agreement. In other words it is a deduction from gross rents in the same way as any other expense. As a result is far more likely that a loss will arise on a property business carried on by a non-corporate than it is for property business carried on by a company.
The legislation dealing with losses from property businesses is in ITA 2007, S117 et seq. It is strange that the provisions taxing property income are in ITTOIA but the provisions governing losses are in ITA but it all helps to keep tax interesting.
Losses can be set sideways against general income only to the extent that they arise from capital allowances or from “relevant agricultural expenditure”. This term means any expenses deductible in respect of maintenance, repairs, insurance or management of the estate: but it does not include any loan interest (S123 ITA 2007) – a hangover, one assumes, from the time when loan interest was separately deductible.
Losses arising from furnished holiday lettings are of course treated in the same way as losses from a trade and, like other trading losses, can be set off sideways against general income for the year of loss or of the previous year (S64 ITA 2007). However, the offset of these losses is subject to all the restrictions generally apply to an offset of trade losses: in particular it is very likely that as a question of fact a partner in a furnished holiday lettings business will be a “non-active partner” as defined at ITA s103B with the result that the annual £25,000 cap on the offset of losses will apply.
Any losses which cannot be set sideways (and this will be the case for most rental businesses) can be carried forward but can only be set against property income profits of the future. There is no opportunity to set these losses against any other income or gains.
So for individuals and partnerships the opportunities to use losses are rather restricted, as shown in the example below:-
Example 1: LLP’s
Slightly Suspect Hotels LLP owns 2 hotels, it runs one as a trade and lets the other to another hotel chain.
The LLP has trading losses carried forward of £250,000 and is relying on the capital growth of the property to ultimately make a profit. It also has losses in 2009 arising from capital allowances on expenditure on the rented hotel
For 2008/09, the position is:-
| Case I Loss Property Business Loss |
(50,000) |
Losses c/fwd to 2009/10 - £300,000 |
| (Including loan interest £50,000 and capital allowances £75,000) |
(125,000) |
Losses c/fwd to 2009/10 - £125,000 |
In 2009/10 the LLP makes a trading loss of £20,000 and sells the trading hotel as a going concern giving rise to a chargeable gain of £1m. It has a rental profit (after loan interest) of £40,000
2009/10
| Case I loss | (20,000) |
|
| Property Business Profit | 40,000 |
|
| Less loss b/f | ( 40,000) |
0 |
| Capital Gain | 1,000,000 |
|
| Chargeable Gain | 980,000 |
- It would be possible to set the Case I loss for the period of £20,000 against the capital gain under S261B TCGA 1992 but only if there is no other income for the year.
- The property income loss cannot be set against the capital gain leaving a gain of £980,000 chargeable.
- The remaining trading losses of £300,000 will be lost and the balance of the property income loss of £85,000 can only be set against property income of the future.
- The property business loss of £75,000 in 2008/09 arising from capital allowances could be set sideways if the partners have any other general income for the year.
On the other hand, the rate of CGT for a non-corporate will be just 18% (or conceivably 10% in a very limited range of circumstances where Entrepreneurs’ Relief is due) and the restriction on the use of losses for income tax purposes has to be weighed against the CGT advantage when deciding on whether a corporate or LLP structure is better for a property investment business.
By contrast, the scope for using losses in a company is much greater:
Companies
The legislation governing corporate losses is in S392A ICTA 1988. This provides that a Schedule A loss is first set off, for the purposes of corporation tax, against the company’s total profits for that period. So if an investment property has been sold at a gain in the period a Schedule A loss for the same period can be set against any capital gain arising on the disposal - or indeed against any other income or gains.
This is a significant advantage for a company compared with an individual or partnership but it does not stop there. The benefits apply even to losses brought forward.
This is because “excess Schedule A losses” (meaning losses which cannot be set off against current year profits) are carried forward and treated as a loss of a future period. Thus Schedule A losses can be carried forward against any other profits in the future. They are not restricted to set off against future Schedule A income but can be set against any other income or capital gains that might arise.
Better still, in the hands of a company, Schedule A losses do not even disappear when the rental business comes to an end. Provided the company continues to have some kind of investment business the losses simply change their form and are carried forward as expenses of management and in this new guise the losses continue to be carried forward for as long as the investment business continues and can be offset not only against investment income but against total profits including capital gains (whether on investment assets or trading assets) or even against trading income.
Possibly the only restriction on the use of Schedule A losses of a company is that they cannot be carried back.
There is however a small fly in the ointment - for UK-resident corporate property investors, interest paid on borrowings to purchase or repair or improve property, or indeed interest on an overdraft connected to the property business are governed by the loan relationship rules in Finance Act 1996.
So, unlike the position for income tax - interest is not an expense in computing the rental business profits but is a separate deduction with its own set of rules which are different from and less favourable than those apply to corporate Schedule A losses although they are more flexible than those applying to non-corporate property income losses.
S83 FA 1996 contains the provisions. The interest will create or contribute to the snappily-named “non-trading deficit on loan relationships” (“NTDLR”). Such a deficit can first be set off against any profits of the company, of whatever description, for the deficit period; and any deficit not used in this way can be carried forward and set against non-trading profits of the company for succeeding accounting periods. This means that the deficit can be carried forward against future Schedule A profits or against capital gains but not against any trading profits of the future.
Burrowing into the provisions of Sch 8 Finance Act 1996 reveals that a NTDLR can also be carried back for a period of 12 months but in that case utilisation is restricted to an offset against income chargeable under Case III (which will include – and usually be limited to - interest received).
This minefield of set-offs can lead to interesting problems. Consider the following example where the economic facts are substantially the same as for the LLP considered above, but now in a corporate environment:-
Example 2: The corporate environment
Dubious Hotels Ltd owns 2 hotels – it runs one as a trade and lets the other to a different hotel chain.
It has trading losses carried forward of £250,000 and is relying on the capital growth of the property to ultimately make a profit. It also has Schedule A losses in 2009 arising from capital allowances on expenditure on the rented hotel.
The interest on borrowings to fund this capital investment create a non-trading deficit on a loan relationship.
For 2009 the position is as follows:-
| Case I Loss | (50,000) |
Losses c/fwd to 2010 - £300,000 |
| Sch A loss | (75,000) |
Losses c/fwd to 2010 - £75,000 |
| NTLD | (50,000) |
Deficit c/fwd to 2010 - £50,000 |
In 2010 the company sells the trade hotel giving rise to a chargeable gain of £1m.
The computation for 2010 is:-
| Case I Loss | (20,000) |
|
| Sch A Profit | 40,000 |
|
| Less NTDLR of the year | (50,000) |
|
| Excess NTDLR | (10,000) |
| Capital Gain | 1,000,000 |
|
| Less:- | ||
| Sch A Loss b/f | (75,000) |
|
| NTDLR b/f | (50,000) |
|
875,000 |
||
| Corporation tax profit | 845,000 |
- The trading losses b/f of £300,000 cannot be used against any other income and will be lost.
- The NTDLR for the year is set against other income for the period in preference to the Sch A losses b/f (but this preference would not apply to trading losses b/f which must be set off first).
- (Bizarrely, had there been a trading profit, the Sch A loss could have been set against it but not the non-trading loan deficit).
Like so much else in the tax world these days, one is left with the impression that the rules are more complicated than they should be and what, one wonders, can be the logical reason for the huge differences between the treatment of companies and non-companies?
Nonetheless, differences there certainly are and the adviser must acquaint himself with them or look to his PI policy - being “completely at a loss” is not an option!
David Whiscombe is an Associate Director at BKL Tax and can be reached on 0208 922 9104, email david.whiscombe@bkltax.co.uk.
