One of the ‘badges of trade’ used by HMRC to determine if a trade is being conducted is the presence of a ‘profit motive’ where the “object of acquiring an asset was to re-sell it at a profit, without any intention of holding it as an investment.”
However, for various reasons, a business may incur losses instead of profits. The method of loss relief depends on several factors and scenarios.
Default Position
For sole traders or partners who incur trading losses, the default treatment is to carry forward that loss to offset against future profits from the same trade or profession. Note the words ‘same trade’ – this therefore restricts relief to profits from that identical trade. There is no time limit, and the relief applies automatically; no claim is needed.
Whilst this relief is straightforward, its value relies heavily on the expectation of future profitability. For start-up businesses and those in early-stage development, carrying losses forward is often the most practical, and possibly the only, method of relief available.
In contrast, businesses suffering a downturn in trade or ceasing operations may not be eligible and alternative reliefs should be considered for more immediate tax benefit.
Sideways Relief: Income
One of the most flexible forms of relief is sideways relief, which allows a trading loss to be offset against:
- general income of the same tax year; or
- general income of the preceding year.
Claiming this relief can provide an immediate tax benefit, which could even lead to a tax repayment if other income has already been taxed. However, several conditions must be met, the most significant being the commerciality test. Relief is denied if the trade is not being conducted on a commercial basis. HMRC emphasises that ‘commercial’ does not necessarily mean ‘profitable’; they expect the business to be run similarly to other commercial enterprises in the same trade.
Losses incurred in the early years of a trade, profession, or vocation have separate loss relief provisions with different commercial tests.
Individuals may claim loss relief by deducting from their total income for the three tax years prior to the loss year, with earlier years taking priority over later ones. Nonetheless, the trade must continue throughout the basis period on a commercial basis, being conducted in a manner that makes profits reasonably expected either during the basis period or within a reasonable time thereafter. If losses occur in a trade that has generated losses for five or more consecutive years, sideways relief is generally blocked, unless the taxpayer can demonstrate a reasonable expectation of profit.
Sideways Relief: Capital Gains
A sometimes-forgotten relief exists for trade losses that cannot be relieved in any other way. Certain income losses that fail the usual sideways relief criteria may still be set against capital gains arising in the same tax year.
This relief can only be claimed where the sideways income loss is not relievable, and is particularly valuable where income sideways relief is denied due to the commerciality restrictions, despite the losses being genuine and the taxpayer having taxable gains in the year (e.g., from property or share disposals). The set-off must be claimed – it is not automatic
While this relief does not allow losses to be carried forward against future gains, it can lead to substantial tax savings when a taxpayer has already realised gains in the same year.
For companies, the default position for loss relief allows offset of trading losses against other profits in the same accounting period. If not fully utilised, these losses can be carried back to offset profits from previous years, or carried forward to future accounting periods.
Practical Tip
HMRC imposes a limit of £50,000, or 25% of adjusted total income, if higher, on the amount of losses that can be offset against income for tax purposes. The limit applies to all losses incurred, not just trading losses. Therefore, the cap can significantly limit the practical benefit of a sideways loss claim, especially for high-income individuals with large losses.